Below is testimony given by CFTC Chairman Gary Gensler on OTC derivatives regulation before the House Committee on Agriculture on Sept. 22.
Good morning Chairman Peterson, Ranking Member Lucas and members of the Committee. Thank you for inviting me to testify today regarding the regulation of over-the-counter derivatives. I am pleased to testify on behalf of the Commodity Futures Trading Commission (CFTC).
One year ago, the financial system failed the American public. The financial regulatory system failed the American public. We must now do all we can to ensure that it does not happen again. While a year has passed and the system appears to have stabilized, we cannot relent in our mission to vigorously address weaknesses and gaps in our regulatory structure. As a critical component of reform, I believe that we have to bring comprehensive regulation to the over-the-counter (OTC) derivatives markets. We must lower risk, promote greater market integrity and improve market transparency.
The need for reform of our financial system parallels what we faced as a nation in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress responded to the then clear need for reform by enacting the Securities Act of 1933, the Securities Exchange Act of 1934 and the Commodity Exchange Act of 1936.
We need the same type of comprehensive regulatory reform today. Just as we then brought regulation to the commodities and securities markets, we now need to bring regulation to markets for risk management contracts called over-the-counter derivatives.
Comprehensive Regulatory Framework
Comprehensive regulation of the OTC derivatives markets will require two complementary regimes – one for regulation of the derivatives dealers, or the actors, and one for regulation of the derivatives markets, or the stages.
This regulatory framework must cover both standardized and customized swaps. This should include all of the different products, such as interest rate swaps, currency swaps, commodity swaps, equity swaps and credit default swaps, as well as all of the derivative products that may be developed in the future. We should eliminate exclusions and exemptions from regulation for OTC derivatives.
Congress should extend the regulatory regimes of the Commodity Exchange Act (“CEA”) and the federal securities laws to fully cover OTC swaps in all commodities. I believe that the law must cover the entire marketplace, without exception.
Only with two complementary regimes that regulate both the derivatives dealers and the derivatives markets can we ensure that federal regulators have full authority to lower risks, promote transparency and prevent fraud, manipulation and other abuses.
This Committee took leadership on OTC derivatives regulation by passing H.R. 977 in February. The joint framework for OTC derivatives legislation announced by Chairmen Peterson and Frank also includes essential provisions to protect the American public
The legislative proposal submitted to Congress by the Treasury Department on behalf of the Obama Administration is a very important step toward comprehensive regulation of the OTC derivatives markets. The CFTC and the Securities and Exchange Commission worked with the Treasury Department on many of the most important provisions of the Administration bill.
Regulating Derivatives Dealers
Only by comprehensively regulating the institutions that deal in derivatives can we oversee and regulate the entire derivatives market. Through regulating the dealers, we can ensure that regulations apply to both standardized and customized products.
Derivatives dealers should be required to meet capital standards and margin requirements to help lower risk. Imposing prudent and conservative capital and margin requirements on all derivatives dealers will help prevent derivatives dealers or counterparties from amassing large or highly leveraged risks outside the oversight and prudential safeguards of regulators. Many of these dealers, being financial institutions, are currently regulated for capital. I believe, however, that we need to explicitly have in statute and by rule capital requirements for their derivatives exposure. This is even more important for those dealers who are not currently regulated or subject to capital requirements.
Customized derivatives are by their nature less standard, less liquid and less transparent. Therefore, I believe that higher capital and margin requirements for customized products are justified. This Committee addressed the issue of standardized versus customized swaps in H.R. 977.
Congress also should explicitly authorize regulators to require derivatives dealers and counterparties to segregate, or set aside, from their own funds the margin collected from counterparties. This would help ensure that counterparties are protected if either counterparty to the customized OTC transaction experiences financial difficulties.
Dealers should have to comply with business conduct standards to protect market integrity and lower risk. The CFTC and the SEC should be authorized to apply the same enforcement authority that we currently have over the futures and securities markets to OTC derivatives and those who trade them. Both the markets and the public benefit when there is a cop on the beat.
Business conduct standards also should ensure the timely and accurate confirmation, processing, netting, documentation and valuation of all transactions. These standards for “back office” functions will help reduce risks by ensuring derivatives dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks.
To promote transparency and market integrity, a comprehensive reporting and recordkeeping regime should be established for swaps, including swap repositories – for both standardized and customized products. This should include mandatory public disclosure of aggregate data on swap trading volumes and positions. A complete audit trail of all transactions should be available to the regulators.
The financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system. Every single taxpayer in this room – both the members of this Committee and the audience – put money into a company that most Americans had never even heard of. Approximately $180 billion of the tax dollars that you and I paid went into AIG to keep its collapse from further harming the economy. The AIG subsidiary that dealt in derivatives – AIG Financial Products – was not subject to any effective federal regulation of its trading. Nor were the derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks. We must ensure that this never happens again. We cannot afford any more multi-billion-dollar bailouts.