Swaps – developed to help manage and lower risk for commercial companies – also concentrate and heighten risk in international financial institutions. When these entities fail, as they have and surely will again, swaps can quickly spread risk across borders.
Following the crisis, when President Obama gathered together the G-20 leaders in Pittsburgh in 2009, a new consensus formed internationally. Swaps, which were basically not regulated in the United States, Japan or Europe, should now be brought into the light of regulation.
Despite different cultures, political systems and financial systems, we've made significant progress on a coordinated and harmonized international approach to reform.
In 2010, the U.S. Congress passed the historic Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). To date, the CFTC has completed 33 swaps market reforms. We are on track to finish the nearly 20 remaining reforms this year.
Japan, Europe and the largest provinces in Canada have also made substantial legislative progress on reform.
I would like to highlight the progress we're making together on transparency, clearing and margin.
Promoting transparency to the public in the swaps market is critical to both lowering the risk of the financial system, as well as to reducing costs to end users.
The CFTC has completed key transparency rules. Starting as early as September, real-time reporting to the public and to regulators will become a reality. We are nearing consideration of the final swap execution facility rule, which will bring pre-trade transparency to the marketplace.
The G-20 leaders recognized reporting to regulators is not enough. Public market transparency is critical to promoting competition and lowering risk. The Japanese and Europeans have public transparency proposals in front of their legislative bodies that would further align international reform efforts.
Clearinghouses also significantly benefit from public market transparency, as they need to mark their positions to market daily, as well as rely on liquid markets when a clearing member defaults.
While our approaches are not identical, there is a great deal of consistency among the major market jurisdictions in lowering risk by bringing standardized swaps into central clearing. We are collaborating internationally on clearinghouse rules, as well as on determinations as to which swaps must be cleared. It is my hope that the CFTC’s first clearing determinations will be put out for public comment this summer and completed this fall.
The CFTC’s determinations are likely to begin with standard interest rate swaps in U.S. dollars, Euros, British pounds and Japanese yen, as well as a number of credit default swap indices.
The CFTC is working with the Federal Reserve, the other U.S. banking regulators, the Securities and Exchange Commission (SEC), and international regulators and policymakers to align margin requirements for uncleared swaps. I think it is essential that we align these requirements globally, particularly between the major market jurisdictions. An international release on margin requirements will be put out for public comment shortly. The approach will be consistent with the approach the CFTC laid out in its margin proposal last year. We anticipate, in addition, formally reopening the comment period on our initial proposal so that we can hear further from market participants in light of the international release.
Cross-border Application of Swaps Market Reforms
Though what I've reviewed so far may have been of interest, I guess that Rich and Sally Miller invited me here today mostly to tell you how reforms will affect those of you in the international banking community.
Section 722(d) of the Dodd-Frank Act, states that swaps reforms shall not apply to activities outside the United States unless those activities have “a direct and significant connection with activities in, or effect on, commerce of the United States.”
The CFTC plans to soon put out to public comment our interpretation and related guidance on this provision to get public feedback, including from your members.
Let me touch upon how it relates to U.S. financial institutions, and then discuss how it relates to international institutions.
Recent events at JPMorgan Chase are a stark reminder of how swaps traded overseas can quickly reverberate with losses coming back into the United States.
We've seen this movie before. Financial institutions set up hundreds, if not thousands of legal entities around the globe. During a default or crisis, risk of overseas' branches and affiliates inevitably flows back into the United States.
We saw this with AIG.
We saw this with Lehman Brothers. Among Lehman Brothers’ complex web of affiliates was Lehman Brothers International (Europe) in London. When Lehman failed, this London affiliate, with more than 130,000 outstanding swaps contracts, failed as well. Who stood behind these swaps contracts? The U.S. mother ship, Lehman Brothers Holdings, had guaranteed many of them.
We saw this with Citigroup. It set up numerous structured investment vehicles (SIVs) to move positions off its balance sheet for accounting purposes, as well as to lower its regulatory capital requirements. Yet, Citigroup had guaranteed the funding of these SIVs through a mechanism called a liquidity put. When the SIVs were about to fail, Citigroup in the United States assumed the huge debt, and taxpayers later bore the brunt with two multi-billion dollar infusions. And where were these SIVs set up? They were launched out of London and incorporated in the Cayman Islands.
We saw this with Bear Stearns. Its two sinking hedge funds it bailed out in 2007 were incorporated in the Cayman Islands. Yet again, the public assumed part of the burden when Bear Stearns itself collapsed nine months later.
And remember Long-Term Capital Management? When this hedge fund failed in 1998, its swaps book totaled in excess of $1.2 trillion notional. The vast majority were booked in its affiliated partnership… in the Cayman Islands.
There are some in the financial community who want us to ignore these hard lessons of past financial institution failures.
They might tell you that swap trades booked in London branches of U.S. entities shouldn't be brought under Dodd-Frank reform.
They might tell you that affiliates, even when guaranteed by the mother ship back here in the United States, shouldn't come under Dodd-Frank reform.
They might tell you that affiliates acting as conduits for swaps activity back here shouldn't be brought under Dodd-Frank reform.
If we follow their comments, the result would be that American jobs and markets would move offshore, but, particularly in times of crisis, risk would come back to affect our economy.
So what has the CFTC staff recommended to the Commission?
First, when a foreign entity transacts in more than a de minimis level of U.S. swap dealing activity, the entity would register under the CFTC’s swap dealer registration rules.
Second, the staff recommendation includes a tiered approach for overseas swap dealer requirements. This is largely consistent with comments received from major international swap dealers. Some requirements would be considered entity-level, such as for capital, risk management, recordkeeping and reporting to swap data repositories (SDRs). Some requirements would be considered transaction-level, such as clearing, margin, real-time public reporting, trade execution and sales practices.
Third, entity-level requirements would apply to all registered swap dealers, but in certain circumstances, overseas swap dealers could meet these requirements by complying with comparable and comprehensive foreign regulatory requirements, or what we call “substituted compliance.”
Fourth, transaction-level requirements would apply to all U.S. facing transactions. For these requirements, U.S. facing transactions would include not only transactions with persons or entities operating or incorporated in the United States, but also transactions with their overseas branches. Likewise, this would 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.
Fifth, 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 transaction-level requirements 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.
What does this mean for your membership?
So it means that if a legal entity has over $8 billion in market making swaps activity with U.S. market participants, it should be preparing to register as a swap dealer. For foreign financial institutions, swaps with U.S. persons or their overseas branches would count toward the de minimis threshold. In the midst of a default or a crisis, there is no satisfactory way to really separate the risk posed to a branch from being transmitted to its parent bank.
Swap dealer registration will be required two months after we finalize with the SEC the joint rule further defining the term "swap." The further definition rule is now before Commissioners at both agencies.
It means the entity would have to comply with the various Dodd-Frank provisions applicable to swap dealers, though in certain cases, this may be done through substituted compliance.
In addition to the interpretive guidance, the CFTC also is considering a release on phased compliance for foreign swap dealers. The separate release addresses comments from international and U.S. market participants. For overseas swap dealers that register with the CFTC, the release provides for phased compliance in the following manner:
Compliance with transaction-level requirements with U.S. persons and branches of U.S. persons would be required;
Entity-level requirements (other than reporting to SDRs) that might come under substituted compliance may be delayed for up to one year. During that time, the CFTC would be moving to complete the cross-border interpretive guidance and would work with market participants and foreign regulators on plans for substituted compliance; and
For overseas swap dealers, swap transactions with U.S. persons and branches of U.S. persons would be required to be reported to a SDR (or the CFTC).
The CFTC has had a long history of recognizing comparable regulations of foreign regimes. We have entered into numerous memoranda of understanding on both information sharing and supervisory coordination with our international counterparts with regard to foreign clearinghouses, exchanges and intermediaries.
The 2008 crisis – caused in part by swaps – was the worst financial and economic crisis Americans have experienced since the Great Depression. Eight million Americans lost their jobs, and millions of families lost their homes.
The crisis was a failure of the financial system and of financial regulation. The high levels of debt and excessive risk that contributed to the crisis continue to reverberate in Europe and the United States.
The CFTC is well over halfway to finishing critical swaps market reforms bringing transparency to this market and lowering its risk to the public. We’ve taken into account more than 30,000 comment letters, held 1,600 meetings with the public and hosted 18 roundtables. But now it's time to finish the job.
Some in the financial community have suggested that we retreat from these critical reforms. But the ever-growing financial storm clouds hanging over Europe and the lessons from the U.S. financial crisis should guide us that now is not the time to retreat from reform. Now is the time to promote transparency and protect the public.