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.
The Dodd-Frank Act
To address these changes in the derivatives markets as well the real weaknesses in swaps market oversight exposed by the financial crisis, Congress included a significant package of reforms in the Dodd-Frank Act.
Broadening the Scope
Foremost, the Dodd-Frank Act broadened the scope of regulatory oversight of the derivatives market. The CFTC and the Securities and Exchange Commission (SEC) will, for the first time, have oversight of the swaps and security-based swaps markets.
Furthermore, the Dodd-Frank Act extended the CFTC’s oversight to include registering foreign boards of trade providing direct access to U.S. traders. A foreign board of trade seeking to register in the U.S. will have to establish certain rules similar to U.S. exchanges. This new authority enhances the Commission's ability to ensure that U.S. traders cannot avoid essential market protections by directly trading economically equivalent contracts on foreign exchanges.
Importantly, the Dodd-Frank Act brings transparency to the derivatives marketplace. Economists and policymakers for decades have recognized that market transparency benefits the public.
The more transparent a marketplace is, the more liquid it is, the more competitive it is and the lower the costs for hedgers, borrowers and their customers.
The Dodd-Frank Act brings transparency in each of the three phases of a transaction.
First, it brings pre-trade transparency by requiring standardized swaps – those that are cleared, made available for trading and not blocks – to be traded on exchanges or swap execution facilities.
Second, the Dodd-Frank Act brings real-time post-trade transparency to the swaps markets. This provides all market participants with important pricing information as they consider their investments and whether to lower their risk through similar transactions.
Third, the Dodd-Frank Act brings transparency to swaps over the lifetime of the contracts. If the contract is cleared, the clearinghouse will be required to publicly disclose the pricing of the swap. If the contract is bilateral, swap dealers will be required to share mid-market pricing with their counterparties.
Additionally, the Dodd-Frank Act includes robust recordkeeping and reporting requirements for all swaps transactions so that regulators can have a window into the risks posed in the system and can police the markets for fraud, manipulation and other abuses.
Another key reform of the Dodd-Frank Act is to lower risk posed by the swaps marketplace to the overall economy by directly regulating dealers for their swaps activities and moving standardized swaps into central clearing.
Oversight of swap dealers, including capital and margin requirements, business conduct standards and recordkeeping and reporting requirements will reduce the risk posed to the economy by these dealers.
The Dodd-Frank Act’s clearing requirement directly lowers interconnectedness in the swaps markets by requiring standardized swaps that are entered into and amongst financial institutions to be brought to central clearing.
Effective regulation requires an effective enforcement program. The Dodd-Frank Act enhances the Commission's enforcement authorities in the futures markets and expands them to the swaps markets. The Act also provides the Commission with important new anti-fraud authority and anti-manipulation authority based upon similar authority that the SEC, Federal Energy Regulatory Commission and Federal Trade Commission have for securities and certain energy commodities.
These new authorities expand the CFTC's arsenal of enforcement tools so that, for the first time, we can go after reckless fraud, fraud-based manipulation schemes and reckless and harmful disruptive trading. We will use the tools to be a more effective cop on the beat, to promote market integrity and to protect market participants.
Another critical reform of the Dodd-Frank Act relates to position limits. Position limits have served since the Commodity Exchange Act passed in 1936 as a tool to curb or prevent excessive speculation that may burden interstate commerce.
In the Dodd-Frank Act, Congress mandated that the CFTC set aggregate position limits for certain physical commodity derivatives. The Dodd-Frank Act broadened the CFTC’s position limits authority to include aggregate position limits on certain swaps and certain linked contracts traded on foreign boards of trade in addition to U.S. futures and options on futures. Congress also narrowed the exemptions traditionally available from position limits by modifying the definition of bona fide hedge transaction, which particularly would affect to swap dealers.
When the CFTC set position limits in the past, the agency sought to ensure that the markets were made up of a broad group of market participants with a diversity of views. At the core of our obligations is promoting market integrity, which the agency has historically interpreted to include ensuring that markets do not become too concentrated.
Only with reform can the public get the benefit of transparent, open and competitive swaps markets. Only with reform can we reduce risk in the swaps market – risk that contributed to the 2008 financial crisis. Only with reform can users of derivatives and the broader public be ensured of market integrity in the futures and swaps markets.
Each one of the derivatives’ reforms is critical to protecting the public.
It is essential that there be oversight of the entire derivatives market, including swaps and futures. It is essential that we shine the light of transparency on the swaps market to ensure that they work for the American economy. It is essential that we lower risk in these markets to prevent taxpayers from footing the bill of future financial institution failures. It is essential to have effective cops on the beat to police both the swaps and futures markets for fraud, manipulation and other abuses. And it is essential to complete the task of implementing the aggregate position limits regime, Congressionally mandated to guard against the burdens of excessive speculation.
There have been suggestions to delay implementation of the Act or limit funding for the CFTC, despite its significantly expanded mission.
The CFTC must be adequately resourced to police the markets and protect the public. The CFTC is taking on a significantly expanded scope and mission. By way of analogy, it is as if the agency previously had the role to oversee the markets in the state of Louisiana and was just mandated by Congress to extend oversight to Alabama, Kentucky, Mississippi, Missouri, Oklahoma, South Carolina, and Tennessee.
With seven times the population to police, far greater resources are needed for the public to be protected. If the agency’s funding does not grow - or worse, gets cut - we would be unable to enforce new rules in the swaps market to promote transparency, lower risk and protect against another crisis. It would hamper our ability to seek out fraud, manipulation and other abuses at a time when commodity prices are rising and volatile.
Unnecessary delay in implementing the Dodd-Frank Act will increase risk to the American people and leave significant uncertainty in the marketplace. Until the CFTC completes its rule-writing process and implements and enforces those new rules, the public remains unprotected.