Remarks of Commissioner Brian D. Quintenz Commodity Futures Trading Commission at the ICDA 39th Annual European Summit (Bürgenstock)

September 18, 2018

Introduction

Thank you for that kind introduction.  Before I begin, let me quickly say that the views contained in this speech are my own and do not represent the views of the Commission.

It is truly an honor to be giving this evening’s keynote at the Bürgenstock conference.  This event has a long and distinguished history – starting in 1980 and originating in Switzerland before moving this year to Frankfurt.  This is my first time in Frankfurt – a city that has been reborn and rejuvenated through focused effort and attention to detail.  As I enjoyed some of the city today, I was struck by old and new coming together, by how the modern can take on historic character.

In many ways, Frankfurt is the physical representation of our global financial market and its own recent history.  The trust and confidence in the markets – shattered and laid bare following the financial crisis – has been largely re-established – reborn and rejuvenated – through the significant attention and focused effort of the international regulatory community. 

I’d like to reflect today on the financial crisis.  I’ve heard some label the crisis as a failure of capitalism.  I disagree with that.  For capitalism to function properly, transparency is required.  Transparency provides the marketplace with the information necessary for the appropriate assessment of risk, from calculating cost of capital to evaluating risk-adjusted returns, which allows for the efficient allocation of resources.  Capitalism without transparency is like democracy without accountability.

In many ways, for me, that was the major lesson of the crisis – our financial markets lacked crucial forms of transparency that prevented capitalism from functioning properly, that prevented the market from supplying the appropriate level of accountability to assess risk and allocate capital.  Ultimately, that lack of transparency fueled a panic which turned a severe recession into an almost catastrophic crisis.

In my view, the reason a normal, cyclical recession turns into a full-blown financial crisis is an ensuing market panic, which causes liquidity and lending to freeze.  Panics are usually fueled by an opacity of information – a lack of transparency into the true risk in the system.  In 2007-2008, that opacity was very present in the over-the-counter (OTC) derivatives markets:  in firms’ exposures to the housing markets, their exposures to each other, and the true risk from those exposures – liquidity risk as opposed to capital insufficiency.  Nowhere was this confluence of opacity more present than with AIG. 

On September 16, 2008, exactly ten years ago this past Sunday, the Federal Reserve Bank of New York provided an emergency $85 billion loan to keep AIG, a global company with about $1 trillion in assets prior to the financial crisis, from a liquidity insolvency.  When all was said and done, AIG lost $99 billion in 2008 and received over $180 billion in taxpayer funds to prevent its default.[1]   

AIG found itself in such dire financial straits through the activities of one division within the company, AIG Financial Products.  That division wrote credit default swaps (CDS) on over $500 billion of assets, including $78 billion on collateralized debt obligations relating to residential mortgages of which $63 billion had exposure to subprime mortgages.[2]  When AIG established this directional CDS position, it did not post any initial margin with its counterparties or otherwise set aside capital for future potential losses.  Instead, under the terms of these bilateral contracts, AIG was only required to post margin in the event the market value of the underlying mortgage-backed securities dropped, or if AIG itself suffered a credit downgrade.[3]  In fact, for an insurance company, AIG’s collateral situation was somewhat unique.  Many of AIG’s competitors, including monoline financial guarantors, were not required to post any collateral until actual losses occurred.[4]

In July 2007, after the credit ratings agencies downgraded their ratings of mortgage-backed securities, AIG received its first collateral call from Goldman Sachs.[5]  Surprisingly, up until these collateral calls, top AIG executives – including the CEO and Chief Risk Officer – were unaware of the collateral provisions in AIG’s CDS agreements that required AIG to post collateral if the market value of the underlying securities dropped.[6]  It soon became apparent that the Office of Thrift Supervision, which supervised AIG on a consolidated basis, also was not aware of the collateral provisions in these contracts.[7]

From July 2007 onward, AIG disputed its requirements to post collateral with counterparties, arguing that AIG’s models showed no long-term losses on the underlying mortgage-backed securities.  Counterparties countered that the contracts required AIG to post collateral if market value fell, regardless of the fact the losses were so far unrealized.  And yet, even while these potentially crippling collateral disputes were ongoing, AIG’s CEO, Martin Sullivan, who would eventually step down as the company’s billion dollar losses mounted, continued to focus publicly on only the temporary capital effect of unrealized losses and the low probability of realized losses, describing the CDS contracts as so “carefully underwritten and structured … [that] we believe the probability that [the business] will sustain an economic loss is close to zero,”[8] and stating in a November 2007 presentation that the underlying CDOs “would have to take losses that erode all of the tranches below the ‘Super Senior’ level before AIGFP would be at risk.”[9]  

What he did not describe, however, was AIG’s precarious liquidity position should margin calls be triggered by either mounting mark-to-market losses or a downgrade of the firm’s credit rating. This potential liquidity drain was further exacerbated by AIG’s securities lending activity, which invested a substantial portion of its cash collateral in illiquid mortgage-backed securities that became trapped in the credit freeze.[10]  Shockingly, despite that existential liquidity risk, AIG stated flatly in February 2008 that, “AIGFP…has the ability and intent to hold its positions until contract maturity or call by the counterparty.”[11]

By June 2008, AIG had posted $13.2 billion of collateral with counterparties, causing a severe liquidity strain on the company.[12]  Then, on Monday, September 15, all three ratings agencies downgraded AIG, triggering an additional $13 billion in cash collateral calls.[13]  AIG was unable to meet these collateral calls, amassing a $12.4 billion unfunded exposure to its counterparties, and prompting the Federal Reserve to offer assistance.[14] 

Of course, hindsight is 20/20, and AIG’s assessment of the value and liquidity risk of its CDS contracts proved to be terribly wrong.  Yet, the market’s view into AIG’s financial problems was hindered by the opaque nature of the OTC derivatives markets.  Traded off-exchange, with no regulatory documentation or reporting requirements, it was often difficult to ascertain market participants’ OTC exposures to one another, making it impossible to distinguish between creditworthy firms and firms that had taken on excessive risk.[15]  In addition, without any public reporting requirements, the marketplace had limited price discovery visibility, and existing OTC positions became increasingly difficult to value. 

The more firms doubted the third-party exposures (and therefore the creditworthiness) of their trading partners, the less willing they were to trade, the more likely they were to issue large margin calls on unfunded positions, and the more exacerbated each firm’s own liquidity and credit position became.[16]  Even when counterparty relationships were known, valuation disputes were common given the lack of price transparency and resolution mechanisms were often inadequate to facilitate timely reconciliation.[17] 

Introducing Transparency into the Derivatives Markets

Our financial system today bears little resemblance to its state ten years ago, in large part due to the commitment of G-20 members to enact meaningful reforms to repair the global financial market and support future financial stability and prosperity.[18]  As the story of AIG reveals, firms grappled with three main types of opacity during the financial crisis: firms’ exposures to underlying assets, firms’ exposures to each other, and firms’ liquidity needs regarding those exposures.  Each of these forms of opacity has been addressed by the post-crisis reforms of data reporting, clearing, and margin.  I think it is helpful to take each reform in turn to see how it sheds light on counterparty and position exposures, as well liquidity issues.

Data

As I have said previously, I believe increasing transparency in the OTC derivatives market is the most important of the post-crisis reforms.  Transparency promotes market integrity by facilitating efficient price valuations and the identification of trading relationships, both critical pieces of information that were absent in 2008. 

Today, the CFTC can see an individual firm’s swap transactions with various counterparties and answer the basic questions of who, what, when, and where with respect to the swap markets.  This data is also disseminated anonymously to the public in real-time in order to provide post-trade transparency to the markets.  The United States is not alone in making significant strides toward transparency.  All 24 member jurisdictions of the Financial Stability Board (FSB) have fully implemented, or are in the process of implementing, trade reporting requirements.[19] 

Despite these significant improvements, we unfortunately have a long way to go and wasted a lot of precious time.  One of the primary objectives of the G-20 Pittsburgh summit was to ensure that regulators could readily analyze swap data to identify and measure risk exposures in the market, in particular counterparty credit risk.  We are still in the process of achieving that goal.  This past spring, the Committee on Payments and Market Infrastructures and the International Organization of Securities Commissions (CPMI-IOSCO) harmonization group, co-chaired by the CFTC, published detailed technical specification guidance on critical data elements (CDEs).[20]  

For the first time, harmonized guidance exists specifying the margin and collateral information critical to performing meaningful risk analysis.  The CFTC is currently working on implementing the CDEs.  Once these fields are adopted across jurisdictions, global aggregation and measurement of risk, including counterparty credit risk, increasingly becomes a reality.  It will finally be feasible for regulators to determine the aggregate swaps exposure between two counterparties or a single firm’s aggregate exposure to a particular product or market.

Of course, in order for this global aggregation to occur, regulators must share access to the relevant swap data within their jurisdictions.  The CFTC recently finalized regulations establishing the process by which the CFTC will grant access to swap data to foreign and domestic authorities.[21]  I hope other jurisdictions will reciprocate so that jurisdictional boundaries do not impede our oversight over systemic risk, which flows across those very same boundaries.    

Clearing

Centralized clearing is foundational to post-crisis reforms.  Almost three quarters of FSB jurisdictions have implemented OTC clearing requirements for standardized derivatives; seven more are in the process of doing so.[22]  Clearing notional levels for interest rate and credit default swaps have increased significantly from their pre-crisis levels of 24% and 10%, respectively.[23]  By 2017, based on data collected by the CFTC on U.S. reporting entities, about 85% of all new interest rate and credit default swaps are being cleared.[24]  

Clearing addresses opacity on many fronts.  From a counterparty credit risk perspective, it takes bilateral risk that was once dispersed across many counterparties and consolidates it within one regulated central counterparty, where risk is centrally managed and margined.  It also provides transparency into a firm’s directional exposures, as well as its liquidity profile, through daily mark-to-market margining. 

Margin for Uncleared Derivatives

Since 2008, the Basel Committee on Banking Supervision (BCBS) jurisdictions with the most active derivatives markets have all implemented margin requirements for uncleared derivatives.[25] 

In 2017, the top 20 derivatives market participants collected $130.6 billion of initial margin from unaffiliated counterparties, an increase of nearly 22% from the prior year.[26]  When you add in variation margin, a total of $1 trillion was collected by these market participants for their uncleared derivatives transactions in 2017.  The aggregate amount of margin associated with uncleared derivatives will only increase in 2019 and 2020, as smaller, previously out-of-scope counterparties become subject to regulatory margin requirements.  

For both cleared and uncleared swaps, initial and variation margin requirements reduce the likelihood of losses in the event of a default.  As a result of margin requirements, positions are marked-to-market daily and collateral is available for potentially uncovered future exposures.  Margin requirements create certainty about the liquidity needs of a market participant’s positions.  Under today’s margin regime, AIG would not be allowed to establish such a large directional position without setting aside collateral reserves.  Additionally, unlike AIG’s confusion, firms now understand they must be able to fund their margin positions to respond to market developments, regardless of whether a particular position will ultimately result in a loss. 

As a complement to these new margin requirements, Basel’s liquidity coverage ratio (LCR) aims to ensure that large banking organizations have sufficient liquidity to absorb significant economic shocks.[27]  The LCR specifically requires firms to take into account additional liquidity needs that could arise due to losses from derivatives positions and the collateral supporting those positions.[28]  Taken together with margin, the LCR provides transparency into a firm’s liquidity needs and makes it more likely that a firm will have the liquidity necessary to withstand acute, short-term liquidity shocks.

Defeating Our Own Good work:  Capital and Cross-Border Disputes

Ten years later, much of the opacity that froze the OTC derivatives markets has been illuminated thanks to data reporting, clearing, and margin requirements.  Regulators and market participants have a clearer picture of a firm’s exposures, counterparties’ exposures, and related liquidity needs.  However, instead of promoting liquidity and effective risk mitigation, some post-crisis reforms inadvertently may be directly working against this progress:  in particular, capital requirements and cross border regulation.

Capital ensures that firms are able to continue to operate during times of economic and financial stress by providing an adequate cushion to protect them from losses.  Just as important, capital is designed to give the marketplace confidence that any given firm has a high probability of surviving the next crisis.  Therefore, crafting appropriate capital levels is linked to the state of market transparency.  As transparency increases, a static level of capital should generate more confidence in a firm’s solvency.  Said differently, a certain amount of capital may be very insufficient in a market with significant opacity but provide high confidence in a market with broad transparency.

Therefore, minimum capital standards for firms should not be established in a vacuum.  Instead, when evaluating capital requirements, regulators must consider the collective impact that post-crisis reforms – like reporting, clearing, and margin – have had on the derivatives markets and on the market’s ability to better estimate risk and allocate resources.  Regulators should take a holistic view of how these reforms are interrelated to ensure that their cumulative effect is the desired one. 

With respect to capital requirements, I worry that the accepted mantra has become the higher and more restrictive the capital standard, the better.  Respectfully, I disagree.  Capital requirements need to be appropriate and commensurate to a firm’s risk.  In the case of derivatives, I believe that our current capital models do not adequately take into account margin’s mitigation of counterparty credit risk, and in some cases, like the leverage ratio, work against the benefit of these important reforms. The leverage ratio penalizes the increased liquidity which firms now hold as a result of important initiatives like the LCR mentioned above because it treats safe assets the same as risky assets.  The leverage ratio also penalizes the beneficial regime of posting initial margin against swap exposures, treating the initial margin which banks hold on behalf of clients as a leverageable asset of the firm, instead of recognizing it as the risk-reducing property of customers.

Secondly, the risk of fractured liquidity pools is growing due to cross-border regulatory disputes over the extraterritorial application of jurisdictions’ rules. The full promise of the 2009 G-20 reforms cannot be realized by a single nation acting alone, but it can be actively defeated if each jurisdiction imposes its rulesets on others.

While we are here at the 10^th anniversary of the financial crisis, it was four years ago at this very conference, that then CFTC Commissioner, now CFTC Chairman, Christopher Giancarlo, articulated his concept of a cross-border regime based on deference to home country regulators, rather than regulatory overreach.[29]  More recently, he has put forth a blueprint for how nations, through deference, can support a global, liquid, transparent swaps market that fully lives up to the G-20 reforms.  I fully support his vision and look forward to learning more of the details in the weeks to come.

Conclusion

We have made remarkable progress in our efforts to rebuild our markets since the financial crisis.  I hope we continue to build on that progress by thoughtfully assessing how all the interrelated pieces of the derivatives markets fit together, so that the vitality, resiliency, and health of our economies continues to grow.