I would like to focus my remarks on swaps market reform and specifically on how it fits into the international context.
International Swaps Market – Historically Unregulated
As you all know, with just the click of a mouse, risk can spread around the globe. We surely saw this as the financial system failed in 2008.
As the financial system failed in 2008, most of us learned that the insurance giant AIG had a subsidiary, AIG Financial Products, originally organized in the United States, but run out of London. The fast collapse of AIG, a mainstay of Wall Street, was again sobering evidence of the markets’ international interconnectedness. Sobering evidence, as well, of how transactions booked in London or anywhere around the globe can wreak havoc on the American public.
Swaps, now comprising a $700 trillion notional global market, were developed to help manage and lower risk for commercial companies. But they also concentrated and heightened risk in international financial institutions. And when financial entities fail, as they have and surely will again, swaps can contribute to quickly spreading risk across borders.
Leading up to the financial crisis, swaps were basically not regulated in Asia, Europe or the United States.
There were many reasons put forth as to why swaps should not be regulated. Let me touch upon just three of those reasons, as I believe they are relevant to today’s ongoing debates about the proper role of financial regulation.
First, it was claimed that the swaps market was an institutional marketplace with “sophisticated” participants so expert and self-interested that the market would discipline itself. In 2008, this notion unraveled quickly as swaps contributed to the crisis.
Second, it was claimed that swap dealers did not need to be specifically regulated for their swaps activity, as they or their affiliates already were generally regulated as banks, investment banks, or insurance companies.
The 2008 crisis revealed the inadequacy of relying on this claim. While banks were regulated for safety and soundness, including their lending activities, there was no comprehensive regulation of their swap dealing activity. Similarly, bank affiliates dealing in swaps, and subsidiaries of insurance and investment bank holding companies dealing in swaps, were not subject to specific regulation of their swap dealing activities. AIG’s downfall was a clear example of what happens with such limited oversight.
Third, it was claimed that swaps should not be regulated in the United States, as they were not regulated in Europe or Asia. It was said that regulation here would push these markets overseas.
International Swaps Market – Reform
The role the swaps market played in the 2008 crisis led to a new international consensus that the time had come for comprehensive regulation.
No longer should the public be vulnerable to the risks of a market supposedly “sophisticated” enough to take care of itself.
No longer should the public be told that since financial entities were already generally regulated, that their swaps activity does not warrant specific regulation.
And no longer should we wait to protect American taxpayers and promote commonsense reforms of the U.S. swaps market, even if others around the globe have yet to act.
Fortunately, however, there is now a global commitment to reform.
When President Obama gathered together the G-20 leaders in Pittsburgh in 2009, they agreed that the swaps market needed to be reformed and that such reform should be completed by December 2012.
In 2010, the U.S. Congress and the President came together and passed the historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act).
The goal of the law is to:
- Bring public market transparency and the benefits of competition to the swaps marketplace;
- Protect against Wall Street’s risks by bringing standardized swaps into centralized clearing; and
- Ensure that swap dealers and major swap participants are specifically regulated for their swap activity.
The CFTC has already completed 33 rules implementing these critical swaps market reforms. We are on schedule to complete the nearly 20 remaining reforms this year, but until we do, the public is not fully protected.
Other major market jurisdictions, including Europe, Japan and Canada, have also made real progress on their reform efforts.
Cross-Border Application of Dodd-Frank’s Swaps Reforms
Among the important remaining matters, the Commission is working with fellow regulators here and abroad on an appropriate and balanced approach to the cross-border application of Dodd-Frank swaps market reforms.
The CFTC will soon seek public comment on guidance regarding the cross-border application of Title VII rules.
In putting together this release, we’ve already benefitted from significant input from market participants. Throughout our nearly 60 rule proposals, we’ve consistently asked for input on the cross-border application of swaps reforms.
Commenters generally say they support reform. But in what some of them call a “clarification,” we find familiar narratives of the past as to why many swaps transactions or swap dealers should not be regulated. Some commenters have expressed the view that if a transaction is done offshore, it should not come under Dodd-Frank. Others contend that as long as an offshore dealer is regulated in some capacity elsewhere, many of the Dodd-Frank regulations applicable to swap dealers should not apply.
But the law, the nature of modern finance, and experience strongly suggest otherwise.
The law: Dodd-Frank Act
The Dodd-Frank Act mandates in Section 722(d) that swaps reforms shall apply to activities outside the U.S. if those activities have “a direct and significant connection with activities in, or effect on, commerce” of the United States.
When Congress and the Administration came together to draft the Dodd-Frank Act, they recognized the lessons of the past by expressly setting up a comprehensive regulatory approach specific to swap dealers. They directed the CFTC and the SEC to oversee swap dealers for business conduct, recordkeeping, and customer protection, even if those entities may be regulated as banks by prudential regulators. Moreover, Congress expressly directed the CFTC and SEC to oversee a new requirement for central clearing and trading in these markets. This was the case even though many market participants are otherwise regulated.
Furthermore, the CFTC has had a long history of working with international regulators to coordinate oversight of entities dually registered and regulated here and abroad. We have done so with foreign clearinghouses and futures commission merchants, and under Dodd-Frank, we will for foreign boards of trade as well.
The Nature of Modern Finance
The nature of modern finance is that financial institutions commonly set up hundreds if not thousands of “legal entities” around the globe with a multitude of affiliate relationships. They do so in an effort to respond to customer needs, funding opportunities, risk management and compliance with local laws. They do so as well, though, to lower their taxes, manage their reported accounting, and to minimize regulatory, capital and other requirements, so-called “regulatory arbitrage.” Many of these far-flung legal entities, however, are still highly connected back to their U.S. affiliates.
Large, international financial institutions are managed as an integrated web of legal entities. Affiliates provide each other far more than simply equity capital and funding. They generally share a common brand name. They are interdependent, sharing treasury, custodial, brokerage and depository functions. They generally use common information technology and other operational support. They also transact with each other, including as swaps counterparties. Adding to this is that they often also provide guarantees to outside market participants on the performance of their affiliates.
Financial markets and counterparties of large, international financial institutions have come to understand these basic features of modern finance. When one affiliate of a large, international financial group has problems, it’s accepted in the markets that this will infect the rest of the group. If a financial run starts on one part of a group, almost regardless of where it is around the globe, it invariably means a funding and liquidity crisis rapidly spreads to the entire consolidated entity. I think Congress was well aware of this reality when it applied swaps market reforms to those activities that have a direct and significant effect on the commerce or activities of the United States.
This nature of modern finance has been painfully played out in the 2008 crisis and since.
The story of AIG is well known. Its subsidiary, AIG Financial Products, operating out of London, brought down the company and nearly toppled the U.S. economy.
But Congress was aware of far more than the AIG example when it wrote the key provisions of Dodd-Frank. Let me mention three from the 2008 crisis, Lehman Brothers, Citigroup and Bear Stearns, as well as one from ten years earlier, Long-Term Capital Management.
When Lehman Brothers collapsed in 2008, it had a complex web of affiliates. This included Lehman Brothers International (Europe) (LBIE), an unlimited liability company in London. At that time, it had more than 300 outstanding creditor and debtor balances with its affiliates amounting to more than $21 billion in total. What happened to LBIE is directly relevant to the current discussions about cross-border application of swaps reforms, as LBIE had more than 130,000 swaps contracts outstanding when it failed. Many of its counterparties were guaranteed by the parent, Lehman Brothers Holdings, back in the United States. Not only did LBIE’s customers pay the price. Over $28 billion in client assets and money were caught up in the bankruptcy of the UK entity. This uncertainty led, further, to a run on many other financial institutions when customers feared for their positions and collateral housed in overseas affiliates of other U.S. financial institutions.
In the lead-up to the crisis, Citigroup, along with a number of other banks, created numerous structured investment vehicles (SIVs) to move positions off balance sheet and manage both capital requirements and reported accounting. But Citigroup, for example, still stood behind these vehicles through a form of a guarantee, called a liquidity put. If the SIV couldn’t fund itself, Citigroup would ensure the funding. When the SIVs’ funding did dry up, Citigroup ultimately assumed their huge debt directly onto its balance sheet, and taxpayers later bore the brunt with two multi-billion dollar governmental infusions.
Bear Stearns in 2007 bailed out two of its sinking hedge fund affiliates, which had significant investments in subprime mortgages. Bear Stearns did so to preserve its reputation, as well as its ability to continue funding itself. The result was the same: Bear Stearns took on the risk of its failing affiliates. This was just the beginning of the end, as within months, the Federal Reserve provided extraordinary support to the failing Bear Stearns.
Congress also was well aware of the history of the large hedge fund, Long-Term Capital Management (LTCM), which failed in September 1998. The Federal Reserve, in order to avert systemic risk, encouraged LTCM’s major swap counterparties to take over the failing hedge fund and wind it down over time in an orderly fashion. At the time, I was asked by the Treasury Secretary to visit the firm and give him an assessment of the situation. This hedge fund, with approximately $4 billion in capital and a balance sheet of over $120 billion, had a swaps book totaling in excess of a $1.2 trillion notional. The very real concern was that if the firm collapsed and these swaps transactions failed simultaneously, shocks to the economy and the American public would be significant.
How does this relate to today’s discussions about cross-border application of swaps reform? You guessed it – the vast numbers of these swaps had been booked overseas … actually, in Long-Term Capital Portfolio LP, a partnership registered in the Cayman Islands.
Recently, we’ve had another stark reminder of how trades overseas can quickly reverberate with losses coming back into the United States. According to press reports, the largest U.S. bank, JPMorgan Chase, just suffered a multi-billion dollar trading loss from transactions in London. The press also is reporting that this trading involved credit default swaps (CDS) and indexes on CDS. It appears that the bank here in the U.S. is absorbing these losses. And as a U.S. bank, it is an entity with direct access to the Federal Reserve’s discount window and federal deposit insurance.
Cross-border Legislative Initiative
There is a legislative approach under consideration, HR 3283, that I am concerned would lead to vast parts of the swaps market not coming under reform. It would substantially reduce transparency and increase risk to our financial system and the economy.
It does so by excluding from U.S. reform the swaps transactions between a London branch of a U.S. bank and offshore entities. It also does so by excluding from U.S. reform many of the swaps transactions of U.S. entities’ oversees affiliates, even those swaps transactions that are guaranteed for their performance or payment by the financial institution here in the United States.
Unfortunately, we’ve seen this story before, and we know how it ends: particularly in a crisis, risk flows directly back into the United States.
If this or similar legislation were enacted, it is likely that U.S. banks, hedge funds, insurance companies, asset managers and other financial entities would transact their swaps with each other offshore, branch to branch, or guaranteed affiliate to affiliate. The results: particularly in a crisis, risk would still directly flow back here, while the transactions and related jobs may be overseas.
CFTC Cross-Border Release
In the context of the law, the nature of modern finance and experience, the CFTC staff will soon be recommending to the Commission to publish for public comment a release on the cross-border application of swaps market reforms. It will consist of interpretive guidance on how these reforms apply to cross-border swap activities. It also will include an overview as to when overseas swaps market participants, including swap dealers, can comply with Dodd-Frank reforms through reliance on comparable and comprehensive foreign regulatory regimes, or what we call “substituted compliance.”
There is further work to be done on the CFTC cross-border release, but the key elements of the staff recommendations are likely to include:
- First, when a foreign entity transacts in more than a de minimis level of U.S. facing swap dealing activity, the entity would register under the CFTC’s recently completed swap dealer registration rules.
- Second, the release will address what it means to be a U.S. facing transaction. I believe this must include transactions not only with persons or entities operating in the United States, but also with their overseas branches. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk of a bank and its branches. Likewise, I believe this must include transactions with overseas affiliates that are guaranteed by a U.S. entity, as well as the overseas affiliates operating as conduits for a U.S. entity’s swap activity.
- Third, based on input the Commission has received from market participants, the staff recommendations will include a tiered approach for requirements for overseas swap dealers. Some requirements would be considered entity-level, such as for capital, risk management and recordkeeping. Some requirements would be considered transaction-level, such as clearing, margin, real-time public reporting, trade execution and sales practices.
- Fourth, such entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could comply with these requirements through substituted compliance.
- Fifth, such transaction-level requirements would apply to all U.S. facing transactions, but for certain transactions between an overseas swap dealer (including a foreign swap dealer that is an affiliate of a U.S. person) and counterparties not guaranteed by or operating as conduits for U.S. entities, Dodd-Frank may not apply. For example, this would be the case for a transaction between a foreign swap dealer and a foreign insurance company not guaranteed by a U.S. person.
Nearly four years after the financial crisis and two years since the passage of Dodd-Frank, it’s critical that we fully implement the historic reforms of the law. It’s critical that we do not retreat from reforms that will bring greater transparency and competition to the swaps market, lower costs for companies and their customers, and protect the public from the risks of these international markets.
In 2008, the financial system and the financial regulatory system failed. The crisis plunged the United States into the worst recession since the Great Depression with eight million Americans losing their jobs, millions of families losing their homes and thousands of small businesses closing their doors. The financial storms continue to reverberate with the debt crisis in Europe affecting the economic prospects of people around the globe.
The CFTC has made significant progress implementing reform having largely finished the rule proposals, and now having completed well over half of the final rules.
As we get closer to the finish line, though, in what some may call a “clarification,” we find familiar narratives of the past as to why many swaps transactions or swap dealers should not be regulated – those transacted cross border or those transacted by overseas swap dealers.
But again, the law, the nature of modern finance, and the experiences leading up to the 2008 crisis, as well as the reminder of the last two weeks, strongly suggest this would be a retreat from much needed reform.
We’ve seen time and again that U.S. overseas branches, overseas affiliates guaranteed by a U.S. entity, and overseas affiliates acting as conduits for U.S. entities bring risk crashing back onto U.S. shores. We’ve seen time and again the financial industry structure around commonsense rules meant to promote transparency or protect the public.
With so much riding on the outcome of financial reform for the American public, we as regulators must guard against today’s well-meaning “clarifications” developing into tomorrow’s loopholes.