Good afternoon. I thank the Chamber of Commerce for inviting me to speak with you today on regulatory reform of over-the-counter (OTC) derivatives, also known as swaps. Today’s Capital Markets Summit comes only two days after the Senate Banking Committee passed financial reform legislation that makes historic progress toward comprehensive regulatory reform of the OTC marketplace. I look forward to working with Chairman Dodd and Senate Agriculture Committee Chairman Blanche Lincoln in the coming months to build off that progress. It is an honor to speak after Chairman Lincoln, who will be instrumental in the effort to bring reform to the derivatives marketplace.
I also want to thank the Chamber for the constructive exchange of ideas we’ve had since last fall regarding this very important effort. Furthering up on these discussions, I would like to focus specifically on two critical items still being debated. First, exemptions for end-users from clearing. Second, mandated transparency – through exchanges and other regulated trading venues – to benefit the economy and the businesses you represent.
Now, some in the financial industry have said that the safer market regulations and transparency we are proposing may slow down capital markets or raise costs. Well, we have all seen how “expensive” derivatives markets can be without sufficient regulation. We are calling for new safety mechanisms – for new transparency requirements – precisely because the current system cost taxpayers very heavily.
Our financial system is a complex network. It handles an enormous volume of traffic – the U.S. over-the-counter derivatives market is approximately $300 trillion notional amount. The volume is growing on a global scale, as is the network’s complexity. When faced with a similar challenge, earlier generations invented traffic lights and street lamps to lower risk and shine light on a complex and increasingly voluminous network. Now, do yellow and red lights slow down traffic? Do street lamps bring sunshine on otherwise dark and dangerous roads? Absolutely. Could we run a high volume transport network safely without them? Absolutely not. Traffic lights may add costs for all network users, but can anyone imagine a traffic system without safety regulation? Of course not.
So, to those who sincerely raise concerns about safety and transparency measures that we recommend bringing to the derivatives markets, think about a regulation-free highway network – no traffic lights – no street lamps – no traffic cops – not even a stop sign – the next time you are driving in Washington, D.C., New York City or possibly more appropriately on Main Street in so many towns in America.
End-User Exemption
A central goal of regulatory reform is to lower risk in the derivatives marketplace and to the American public. So that corporations can effectively hedge their risk, tailored, or customized, products should be permitted to trade bilaterally, with the dealers being regulated with appropriate capital and business conduct standards for these transactions. For standardized derivatives, however, clearinghouses are the best way to lower risk. They act as middlemen between two parties to a transaction, guaranteeing the obligations of both parties. Clearinghouses are a form of traffic lights keeping the roads safer. They have effectively reduced risk since first developed in the late 19th century in the on-exchange derivatives markets, known as futures markets. The Federal Government began regulating clearinghouses after the last great financial crisis in the 1930s – with the CFTC’s predecessor regulating clearinghouses for futures and the Securities and Exchange Commission (SEC) regulating clearinghouses for securities and later securities options. Those clearinghouses functioned effectively both in clear skies and during stormy times – through the Great Depression, numerous bank failures, two world wars and the 2008 financial crisis – to lower risk to the American public.
Over this same time, we have watched repeated cycles in the financial sector where numerous banks and financial institutions have failed, causing great stress to the economy and the public. AIG, for example, did not clear its over-the-counter derivatives transactions through a clearinghouse, and its failure left the American public with the burden of paying off its uncleared contracts. In fact, every American in this room has $600 committed to AIG.
All standardized transactions, regardless of whether they are between two Wall Street banks or between a bank and a corporation, should be subject to a clearing requirement. Now I recognize that many of you disagree with me on this issue and favor exemptions from clearing for businesses hedging their risk. You have concerns that the margin – or collateral – required to clear derivatives could be costly. Derivatives dealers, however, already charge counterparties for credit extensions when they do not clear their transactions. How can you know that these costs charged by the dealers – embedded and opaque – are less than the margin associated with clearinghouses? At least margin requirements imposed by clearinghouses are transparent to all market participants and subject to review by the appropriate regulator.
Still, I recognize that this has raised a legitimate debate. So I understand that we may not agree on whether transactions with non-financial corporations should be exempt, but I hope that we can agree that all standardized transactions between two financial institutions should be subject to a clearing requirement. This should include transactions between Wall Street banks, hedge funds, insurance companies, finance companies or other financial end-users. This would lower risk in the economy that could ultimately spread to your member businesses.
Depending on how this debate comes out, up to 60 percent of the standardized marketplace could be left without the essential traffic regulations that will lower risk in the system. Exemptions may be intended to only apply to corporate customers, but they could bring along exemptions for transactions between dealers and their financial customers as well. According to recent data collected by the Bank for International Settlements, in the largest over-the-counter derivatives market – the single-currency interest rate market – only 34 percent of the market is comprised of transactions between two dealers. Nine percent is between a dealer and a non-financial end-user, like the vast majority of the Chamber’s member businesses. Fifty-seven percent is between a dealer and a financial end-user. My pitch to you – knowing that we might not agree on whether the nine percent of the market comprised of commercial end-users should be subject to a clearing requirement – is that the 57 percent of the market comprised of financial end-user transactions should be covered. This would significantly reduce in the future the same risk that reverberated throughout the economy during the financial crisis. How else do we reduce the risks posed by dealers that are both “too big to fail” and “too interconnected to fail?” If financial parties are exempt from clearing their transactions, we must ask ourselves why taxpayers should again be on the hook for the risks of an interconnected financial system.
Effective reform cannot be accomplished by any nation alone. It will require a comprehensive, international response. I’m glad to report that during my visit last week with regulators in Europe, they shared with us their goal for a narrow end-user exemption, specifically indicating that all clearable derivatives entered into by financial institutions come into central clearing.
Transparency in the OTC Marketplace
Traffic lights are not the only tools necessary to protect drivers. We also have street lamps that bring light to a complex network. These lamps make the roads more efficient and safer, and it is the same type of light we must bring to the over-the-counter derivatives marketplace.
Since the 1980s when they were first developed, over-the-counter derivatives have been traded out of sight of regulators, market participants and the American public. An opaque market, concentrated within a small number of financial institutions, contributed to a financial system brought to the brink of collapse. We now must bring transparency to the derivatives markets. And this must not simply be transparency to regulators, as important as this is, but to the public as well.
The more transparent a marketplace, the more liquid it is, the more competitive it is and the lower the costs for companies that use derivatives to hedge risk. The best way to bring transparency is through regulated trading facilities and exchanges. Such centralized trading venues not only bring greater transparency, but also increase competition in the markets by encouraging market-making and the provision of liquidity by a greater number of participants. A greater number of market makers brings better pricing for businesses and lower costs for consumers.
Despite difference that we may have on other elements of reform, this is an area where we should agree. Bringing transparency to the over-the-counter derivatives marketplace would lower costs through a more efficient and publicly available price discovery process. Imagine for a moment if this type of transparency were removed from the securities marketplace. Imagine if a corporate treasurer wanted to buy back a certain number of shares for their company but did not know where the market priced the stock. Why should you enter into a derivative transaction with a bank without similar knowledge of where the broader marketplace prices the derivative? By bringing sunshine to the over-the-counter derivatives marketplace, your members and their customers will benefit.
Transparency also is essential to lowering risk. During the financial crisis, Wall Street and the Federal Government had no price reference for many assets – assets that we began to call “toxic.” Further, exchanges and other regulated trading venues make it possible for clearinghouses to get reliable pricing information and determine the liquidity of particular contracts. This is essential for a clearinghouse to adequately manage their risk and thus lower risk to the economy and the public.
Now some of your members do not support this transparency effort – namely the big Wall Street dealers that profit from inefficiencies in the derivatives marketplace. But with transparency, we can shift part of the information advantage away from the few big banks to the other three million businesses that you represent. Regulatory reform will be incomplete if we do not bring sunshine to the opaque over-the-counter derivatives market.
We have had constructive discussions with the Chamber and others in the business community about a transparency requirement. What we have heard most often is that your members like greater transparency if it can be accomplished without a related requirement of posting margin to clearinghouses. Though you know my views on the benefits of central clearing, nevertheless, we can separate the two requirements. Trading platforms already exist that allow end-users to decide not to centrally clear a transaction and instead settle them on a bilateral basis. We also have heard and agree with the appropriateness that regulators allow for large or so called block trades to be accommodated as they are in the securities and futures markets. If Congress does allow for a narrow non-financial exemption from clearing, we still should mandate swap dealers bring all transactions in clearable and listed contracts to exchanges or trading platforms.
For those clearable transactions that do not trade on a regulated trading platform for any reason, statutory language should be enacted that establishes real time public reporting for those swaps. We have seen the benefits of such real time reporting in the corporate bond market, where it aided liquidity and lowered costs.
Closing
Traffic lights and street lamps have protected drivers for decades by making the roads safer and easier to see. It is time that we bring similar reforms to the over-the-counter derivatives marketplace. With additional safety mechanisms and sunshine in this market, the businesses that use derivatives, the broader economy and the American public will benefit. I thank you for inviting me to speak with you on these critical issues, CFTC PAGE 4 OF 5
and I look forward to continuing to work with the Chamber over the coming months. I’d be happy to take your questions.
