As Prepared for Delivery
Thank you very much, Eraj, for that kind introduction. Good morning and thank you all for the opportunity to be here today.
Over a year ago, in the midst of the worst financial panic since the Great Depression, President Obama gathered with Congressional leaders of both parties to discuss the urgent need for financial reform.
He said at that meeting, “The choice we face is not between some oppressive government-run economy or a chaotic and unforgiving capitalism. Rather, strong financial markets require clear rules of the road, not to hinder financial institutions, but to protect consumers and investors, and ultimately to keep those financial institutions strong. Not to stifle, but to advance competition, growth and prosperity. And not just to manage crises, but to prevent crises from happening in the first place, by restoring accountability, transparency and trust in our financial markets.”
A few months later, the Administration unveiled a sweeping set of reforms designed to do precisely what the President said: to lay the foundation for a safer, more stable financial system; one that fully protects the benefits of market-driven financial innovation while safeguarding against the dangers of instability and market-driven excess.
In putting forward these reforms, the Administration made a basic judgment: that we cannot let the memory of the crisis fade without taking action.
We cannot afford to wait to establish stronger supervision for financial firms – especially for the largest, most interconnected;
To create an independent consumer financial protection agency to set and enforce clear rules of the road, so that consumers can make the choices that are right for them;
To protect taxpayers from risk of loss, by separating the business of banking from speculative proprietary trading;
To give us the tools to end the belief that any firm is “too big to fail”;
And to bring transparency and oversight to key markets, including the over-the-counter derivatives market.
Each of these reforms is necessary and long overdue.
Not surprisingly, I’d like to focus today on OTC derivatives – and to lay out what we believe is the clear, unambiguous case for reform of the OTC derivatives market.
The rapid growth and innovation in the markets for derivatives, especially OTC derivatives, has been one of the most significant financial developments of the last few decades.
These financial instruments have served and continue to serve an important purpose. Used properly, they help businesses – from airlines to farmers to manufacturers – manage the risks that arise in the normal course of business. And used properly, they help financial institutions better serve their clients and customers, making it easier for them to make markets and to extend credit.
But at the same time, the rapid growth in the use – and misuse – of derivatives has exposed our financial system to risks it was not prepared to bear.
These products grew up on the financial frontier without the basic protections and oversight that existed in most of the rest of the system.
Firms have been allowed to write massive amounts of credit protection without the capital to back it up.
Large parts of the OTC derivatives markets operate with no transparency – for regulators, for market participants, or for the public.
The SEC and CFTC have limited ability to police fraud and manipulation.
When the crisis hit in 2008, we paid a high price. The panic was far more severe and far harder to manage because of these regulatory gaps and weaknesses.
Because derivatives like credit default swaps (CDS) were traded on a bilateral basis, few understood the magnitude of aggregate derivatives exposures in the system.
Risks embedded in AIG’s $400 billion exposure to CDS, which brought that global institution to its knees and threatened to bring the financial system down with it, went unseen by the market and by regulators alike.
And the turmoil following Lehman’s bankruptcy had much to do with uncertainty surrounding the exposure of Lehman’s counterparties to the more than 900,000 derivatives positions Lehman held as of August, 2009.
Both Lehman and AIG highlight the opacity the OTC derivatives markets. And like the collapse of Long Term Capital Management ten years before, both Lehman and AIG highlight the complex web of derivatives counterparty exposures that can entangle the entire financial system in times of crisis – and that makes it so dangerous when a large, interconnected firm goes down.
That is why a comprehensive, seamless, and tough framework for regulating over-the-counter derivatives is an essential element of financial reform, key to ending the problem of “too big to fail.”
And that is why the Administration has said, loud and clear, that we will oppose efforts to weaken or undermine the strong regulatory framework that Senate Banking Committee Chairman Dodd put forward.
The derivatives bill passed out of the Senate Agriculture Committee yesterday under the leadership of Chairman Lincoln is also strong. And we were encouraged to see a Republican Senator join with Democrats in moving forward on this issue.
We will continue to work with Chairman Dodd, Chairman Lincoln, and Senate leadership to make sure that the final derivatives provisions remain strong.
Under the provisions of both the Senate Banking and the Senate Agriculture Committee bills, there is a so called “end user exemption” that is narrow and focused.
But for any firm not covered by that narrow exemption, all standardized derivatives must be cleared through a central clearinghouse.
And all standardized derivatives trades must be executed on regulated exchanges or regulated electronic trading platforms.
There will be no barrier to using customized derivatives when customization is necessary and appropriate.
But all OTC derivative dealers and major swap participants will be strictly supervised, and will be required to maintain substantial capital buffers to back up their obligations.
Detailed information about all derivatives trades will be readily available to regulators.
And the CFTC and SEC will be given full authority to police these markets.
These reforms will help prevent market manipulation, fraud, and other abuses.
These reforms will help prevent the OTC derivative markets from threatening the stability of the financial system.
I know that many of you have concerns about some of these proposals. So let me state the clear case for the proposals we have put forward.
Central clearing of standardized derivatives will substantially reduce the risk that arises from the complex web of bilateral derivatives exposures. In its place, for standardized derivatives, there will be a simpler and safer hub and spoke relationship between traders and the clearinghouse.
And through careful supervision, capital requirements and regulation of the margining and other risk management practices of clearinghouses, we can ensure that clearinghouses are well protected against potential losses.
Of course, not every derivative contract can be cleared. But many can. Many more can be cleared than are being cleared today. And to state it bluntly: the large OTC dealers simply do not have a sufficient incentive to speed up the process of standardization. Large dealers profit too handsomely from the current system in which they have far more information and far more leverage than other market participants.
We have proposed a practical, reasonable method for identifying those derivatives that can and should be centrally cleared:
If a derivative contract is already accepted for clearing by one or more clearinghouses, and if it is approved by the CFTC and the SEC, it should be centrally cleared. And at the same time, the CFTC and the SEC should have authority to proactively require central clearing of derivatives contracts that are sufficiently standardized and liquid or whose economic terms are substantially the same as contracts that are already centrally cleared.
This two-channel approach takes advantage of the expertise of private clearinghouses. But it also protects the market from clearinghouses imprudently seeking new business, as well as from clearinghouses that might seek to preserve the OTC market for the benefit of their owners.
In addition to requiring standardized derivatives to be centrally cleared, we have also proposed – and both the Banking Committee and the Ag Committee bills include – a requirement that standardized derivatives be traded on exchanges or regulated electronic trading platforms.
The benefits of exchange trading are obvious. Exchange trading improves transparency and price discovery – allowing end users, large and small, to judge more effectively whether and how to hedge their risks, and giving regulators and market participants important, real-time market insights.
We believe that a more standardized, more transparent, and more liquid market for derivatives will not only make the system safer – it will lower the costs for end users, borrowers and, ultimately, their customers.
And because customized products are often priced in relation to standard products, exchange trading of standardized derivatives will increase efficiency even in the customized, OTC market.
While clearing and exchange trading will ultimately make the derivatives market safer and more efficient for end users, there is an argument that the margining requirements would present some challenges for some end users.
That is why some have argued for a focused exemption from the clearing requirement for end users that are not dealers or major swap participants, that are predominantly engaged in non-financial activities, and that are hedging their real risks.
But any exemption must be drawn narrowly. We cannot allow a reasonable exception to become an expansive loophole.
And to provide maximum transparency, we have proposed that even trades that are exempt from the central clearing requirement because of the end-user exemption nonetheless be reported on or through exchanges or electronic trading platforms.
The public reporting of price and volume information imposes no undue burdens, and makes the market as a whole more transparent, more efficient, and easier for regulators and market participants alike to monitor.
Now let me just reiterate one point: we have not proposed – and the Senate is not considering – a ban on customized derivatives.
We recognize that there is a legitimate and valuable role for customized derivatives traded in over-the-counter markets. Where managing a particular risk requires the use of a customized contract, we do not object to customization.
But to ensure that the market in customized products does not give rise to unmanaged risk, dealers and other major swap market participants must be subject to much higher prudential standards than they are today.
By imposing conservative capital and margin requirements on derivative dealers and major market participants, we will help ensure that no firm is able to take large, highly leveraged risks in the derivatives markets, without holding adequate capital. Higher capital and margin requirements on customized OTC derivatives will also provide the market with incentives to move more derivatives onto exchanges.
And in addition, by requiring complete disclosure of all customized derivatives transactions, and putting in place a comprehensive reporting and record-keeping regime, we will ensure full regulatory visibility into the OTC market.
We cannot allow firms to build up massive positions with inadequate protection, beyond the scrutiny of supervisors. We cannot afford another AIG.
I know that, recently, ISDA has stated its commitment to taking some initial steps toward transparency, standardization and more effective collateral requirements.
We welcome those commitments. But make no mistake: they are not enough. There can be no substitute for effective regulation and oversight of a market so large, so important and – still today – so un-supervised.
Derivatives should reduce risk, not magnify it. They should be a force for stability, not panic. With the right regulation and the right supervision, innovation in the derivatives markets will benefit every American business, large and small.
One last point before closing: as you in this room know better than anyone, the derivatives markets are global. Fixing the gaps and weaknesses in the United States’ regulatory system is necessary but not sufficient. So as we work to make our own system stronger, we will continue to work internationally to ensure that our comprehensive regulatory regime for OTC derivatives is matched by a similarly effective regime abroad.
Indeed, this weekend Secretary Geithner is meeting with his G-20 counterparts to press the urgent case for reform, and to build on the strong consensus we have forged.
But we should not wait for others to act before fixing a broken system. We must take the lead. Failing to embrace change when change is clearly needed has never been the secret to America’s success as a global financial center.
America’s success has been based on stability, strength, liquidity, efficiency – and the smart regulation that makes all of those things possible.
Right now, back in Washington, the debate over financial reform is moving to the Senate floor. The stakes could not be higher for the American people. After more than a year of bipartisan discussion, after relentless consultation with experts and interest groups on every side of every issue, the time has come to act.
These reforms will force very consequential changes in these markets. So it is no surprise that some are fighting to weaken the new framework.
But for the first time, there is a broad and unwavering consensus behind a comprehensive set of protections to make our derivatives markets more transparent, more efficient, more equitable, and more stable.
We must not miss this opportunity to build a stronger financial system.
