December 2, 2011
Good morning, I’d like to thank the Office of Financial Research (OFR) and the Financial Stability Oversight Council (FSOC) for hosting this important conference and for inviting me to speak. Thank you, Tim, for the introduction.
Lessons of 2008
Three years ago, the financial system failed, and the financial regulatory system failed as well. We are still feeling the aftershocks of these twin failures.
There are many lessons to be learned from the crisis. Foremost, when financial institutions fail, real people’s lives are affected. More than eight million jobs were lost, and the unemployment rate remains stubbornly high. Millions of Americans lost their homes. Millions more live in homes that are worth less than their mortgages. And millions of Americans continue struggling to make ends meet.
Second, it is only with the backing of the government and taxpayers that many financial institutions survived the 2008 crisis.
A perverse outcome of the crisis may be that people in the markets believe that a handful of large financial firms will – if in trouble – have the backing of taxpayers. We can never ensure that all financial institutions will be safe from failure. Surely, some will fail in the future because that is the nature of markets and risk. When these challenges arise though, it is critical that taxpayers are not forced to pick up the bill – financial institutions must have the freedom to fail.
Third, high levels of debt – and particularly short-term funding at financial institutions – was at the core of the 2008 crisis. When market uncertainty grows, firms quickly find that their challenges in securing financing, so called problems of “liquidity,” threaten their solvency.
Fourth, the financial system is very interconnected – both here at home and abroad. Sober evidence from 2008 was AIG’s swaps affiliate, AIG Financial Products, which had its major operations in London. When it failed, U.S. taxpayers paid the price. Further evidence is the risk posed to the U.S. economy from the ongoing debt crisis in Europe.
Lastly, while the crisis had many causes, it is evident that unregulated derivatives, called swaps, played a central role. Developed in the 1980s, swaps, along with the regulated futures market, help producers, merchants and companies lower their risk by locking in the price of a commodity, interest rate, currency or other financial index. Our nation’s economy relies on a well-functioning derivatives market – an essential piece of a healthy financial system.
But over the last thirty years, the unregulated swaps market grew by orders of magnitude and is now seven times the size of the futures market. During its growth, the market lacked the transparency of the futures and securities markets, and risk accumulated. Swaps, which were developed to mitigate and spread risk, actually added leverage to the financial system – with more risk backed by less capital.
Swaps also contributed significantly to the interconnectedness between banks, investment banks, hedge funds and other financial entities. Large financial institutions once regarded as too big to fail were also regarded as too interconnected to fail. Swaps concentrated and heightened risk in the financial system and to the public.
Congress and the President responded to the lessons of the 2008 crisis – they came together to pass the historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
The law gave the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) oversight of the more than $300 trillion domestic swaps market. That’s more than $20 of swaps for every dollar of goods and services produced in the U.S. economy. At such size and complexity, it is essential that these markets work for the benefit of the American public; that they are transparent, open and competitive; and that they do not allow risk to spread through the economy.
To date, the CFTC has finalized 18 rules to make the swaps marketplace more open and transparent and lower risk to taxpayers. We have a full agenda of public meetings to consider more final rules this month and into next year.
FSOC and OFR
To help protect the public, the Dodd-Frank Act included the establishment of the FSOC. This Council is an opportunity for regulators – now and in the future – to ensure that the financial system works better for all Americans. There has been a tremendous amount of coordination and consultation amongst the eight FSOC agencies on the Dodd-Frank rule-writing process, and we will continue this close working relationship as we finalize additional important rules.
The Dodd-Frank Act also created the OFR within the Treasury Department to support the Council and its member agencies by collecting and standardizing data and using this data to perform analysis of our financial system.
Bringing Transparency to the Swaps Market
One of the most important goals of Dodd-Frank reform is shining the light of transparency on the opaque swaps markets. The more transparent a marketplace is, the more liquid it is and the more competitive it is. When markets are open and transparent, prices are more competitive, markets are more efficient, and costs are lowered for companies and their customers. Transparency benefits the entire economy.
While the derivatives market has changed significantly since swaps were first transacted, a constant is that the financial community maintains information advantages over many members of the public. When a Wall Street bank enters into a bilateral derivative transaction with a corporation, the bank knows how much its other customers are willing to pay for similar transactions. That information, however, is not generally made available to the public. The bank benefits from internalizing this information.
The Dodd-Frank Act helps level the playing field by bringing transparency to the three phases of a swaps 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, it 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.
Such public transparency, both pre-trade and post-trade transparency, reduces the costs to users of swaps. Furthermore, such transparency enhances clearinghouses as reliable pricing and liquidity are at the core of clearinghouse risk management.
And third, Dodd-Frank brings transparency to swaps over the lifetime of the contracts. If the contract is bilateral, swap dealers will be required to share mid-market pricing with their counterparties. If the contract is cleared, the clearinghouse will be required to publicly disclose the pricing of the swap.
The Dodd-Frank Act also includes robust recordkeeping and reporting requirements for all swaps transactions. The CFTC and the OFR are working closely together to gather data that will give regulators a window into the risks posed to the system. By contrast, in the fall of 2008, there was no required reporting about swaps trading, and this lack of market transparency made the risk that had spread throughout the financial system all the more difficult to identify.
The CFTC has completed rules that, for the first time, provide a detailed and up-to-date view of the physical commodity swaps markets so regulators can police for fraud, manipulation and other abuses. The large trader reporting rule we finalized establishes that clearinghouses and swap dealers must report to the CFTC information about large trader activity in the physical commodity swaps markets. The rule went into effect November 21. For decades, the American public has benefitted from the Commission’s gathering of large trader data in the futures market, and now will benefit from the CFTC’s new ability to monitor swaps markets for agricultural, energy and metal products.
We also finished a rule, which became effective October 31, establishing registration and regulatory requirements for Swap Data Repositories, which will gather data on all swaps transactions.
Moving forward, we are working to finish rules relating to the specific data that will have to be reported to the CFTC for swaps, including a regime for legal entity identifiers. These reforms will provide the Commission with a comprehensive view of the entire swaps market, furthering our ability to monitor market participants and to protect against systemic risk.
We also are looking to soon finalize real-time reporting rules, which will give the public critical information on transactions – similar to what has been working for decades in the securities and futures markets.
In addition, we are working on final regulations for trading platforms, such as Designated Contract Markets, Swap Execution Facilities and Foreign Boards of Trade – all of which will help make the swaps market more open and transparent. On Monday, the Commission will consider a final rule to implement the Dodd-Frank provision for registration of Foreign Boards of Trade.
Exchanges and trading platforms will allow investors, hedgers and speculators to meet in an open and competitive central market. Even market participants who are exempted from the mandatory trading requirements will benefit from the transparent pricing and liquidity that trading venues provide.
In conclusion, it is precisely during times of heightened market uncertainty that transparency is even more essential. It is critical that we implement the Dodd-Frank reforms to protect the American public and strengthen our economy.
Now, there are those who might like to roll back some of these reforms and put us back in the regulatory environment that preceded the crisis three years ago. But that regulatory system failed. It didn’t protect the American public. The only thing that provided a lifeline to the U.S. economy and saved the financial system was the American taxpayer.
Some have raised cost considerations about our rules. Many of these comments have been very helpful. But far more costly is the fact that the public remains unprotected from the risks of the swaps market. We cannot forget that eight million jobs were lost largely by people who never used derivatives. And the risks are still out there.
Thank you, and I’d be happy to take questions.
Last Updated: December 2, 2011