June 9, 2011
Good afternoon. I thank Sandler O’Neill and Rich Repetto for inviting me to speak today. I am honored to be back with you, having been with you last year just as Congress was enacting historic legislation – the Dodd-Frank Wall Street Reform and Consumer Protection Act.
The 2008 financial crisis was very real. Millions more Americans are out of work today than if not for the financial crisis. Millions of homeowners now have homes worth less than their mortgages. Millions of people have had to dig into their savings; millions more haven’t seen their investments regain the value they had before the crisis. As Americans are still struggling, still out of work and still very careful with their spending, we all are directly affected. And there remains significant uncertainty in the economy.
The 2008 financial crisis came upon us because the financial system failed. The financial regulatory system failed as well. They failed the American public and they failed everybody in this room. When AIG and Lehman Brothers faltered, we all paid the price.
Though there were many causes to the crisis, it is clear that swaps played a central role. They added leverage to the financial system with more risk being backed up by less capital. They contributed, particularly through credit default swaps, to the bubble in the housing market and helped to accelerate the financial crisis. They contributed to a system where large financial institutions were thought to be not only too big to fail, but too interconnected to fail. Swaps – initially developed to help manage and lower risk – actually concentrated and heightened risk in the economy and to the public.
Who would deny that AIG’s ineffectively regulated $2 trillion swaps portfolio, cancerously interconnected to other financial institutions, tragically contributed to the crisis?
Each part of our nation’s economy relies on a well-functioning derivatives marketplace. The derivatives market – including both the historically regulated futures market and the heretofore unregulated swaps market – is essential so that producers, merchants and other end users can manage their risks and lock in prices for the future. Derivatives help these entities focus on what they know best – innovation, investment and producing goods and services – while finding others in a marketplace willing to bear the uncertain risks of changes in prices or rates.
With notional values of more than $300 trillion in the United States – that’s more than $20 of swaps and futures for every dollar of goods and services produced in the U.S. economy – derivatives markets must work for the benefit of the American public. Members of the public keep their savings with banks and pension funds that use swaps to manage their interest rate risks. The public buys gasoline and groceries from companies that rely upon futures and swaps to hedge their commodity price risks.
That’s why oversight must ensure that these markets function with integrity, transparency, openness and competition, free from fraud, manipulation and other abuses. Though the CFTC is not a price-setting agency, recently volatile prices for basic commodities – agricultural and energy – are very real reminders of the need for common sense rules in the derivatives markets.
The derivatives markets have changed significantly since the Commodity Futures Trading Commission (CFTC) was established in 1975.
A new unregulated derivatives market – the swaps market – developed in the 1980s. The swaps market has grown in size and complexity to far outstrip the futures market – more than seven times the size.
The futures market has changed dramatically as well.
First, the markets have become much more electronically traded. Instead of being traded in the pits, more than 80 percent of futures and options on futures were traded electronically in 2010.
Second, the makeup of the market has changed. In contrast with the early days of the
CFTC, swap dealers now comprise a significant portion of the markets. Also, investors today treat commodities as an asset class for passive index investment. Based on published CFTC data, financial actors, such as swap dealers, managed money accounts and other non-commercial reportable traders, make up a significant majority of many of the futures markets.
For example, based upon CFTC data as of May 31, 2011, only about 12 percent of gross long positions and about 20 percent of gross short positions in the WTI crude oil market were held by producers, merchants, processors and users of the commodity.Similarly, only about 10 percent of gross long positions and about 39 percent of gross short positions in the Chicago Board of Trade wheat market were held by producers, merchants, processors and users of the commodity.
Third, based upon CFTC data, the vast majority of trading volume in key futures markets – up to 80 percent in many markets – is day trading or trading in calendar spreads. Thus, only a modest proportion of average daily trading volume results in reportable traders changing their net long or net short futures positions for the day. This means that only about 20 percent or less of the trading is done by traders who bring a longer-term perspective to the market on the price of the commodity. We plan to publish historical data on directional position changes later this month on our website to enhance market transparency.