This evening, I will focus on derivatives reform—not only because I have been most involved in that work, but also because it is the area where, in some ways, we have traveled the farthest. We have gone from a world in which there was essentially no regulation, by any jurisdiction, of certain activities to a remarkable level of international cooperation in the implementation of a sensible, common framework.
The derivatives markets are comprised of futures, options, and swaps. Most people do not participate in these markets directly. And yet they profoundly affect the prices we all pay for food, energy, and most other goods and services.
These markets enable utility companies and airlines to hedge the cost of fuel. An auto manufacturer can fix the cost of its aluminum supply. Exporters can manage fluctuations in foreign currencies, and businesses of all types can lock-in their borrowing costs. A pension fund that wants to make sure it can pay out benefits over a very long horizon can use these markets to help lock in its ability to do so. In the simplest terms, derivatives help businesses throughout the world, up and down the economic value chain, manage price volatility. In short, derivatives help manage risk.
While most of the derivatives markets worked well during the crisis, one large and unregulated segment intensified the damage. This was the over-the-counter swaps market, and in particular credit default swaps. At the time of the crisis, the swaps market was a tangled spider web of bilateral transactions, particularly among the world’s largest financial institutions, with no transparency and nothing to ensure adequate capital or collateral. Therefore, a default by one institution could easily lead to a cascade of defaults with devastating consequences.
This very scenario brought global financial companies, such as AIG, to the brink of collapse. Had it collapsed, it would probably have taken the U.S. economy down with it. Therefore, our government committed a total of $182 billion dollars over the course of several months to prevent that from happening—an unfathomable sum.
Reforming the Financial System
Over the last several years, regulators from around the world, including in particular the UK and the EU, have also been implementing these measures. And they are working. For example, over 80 percent of swap transactions are being cleared today, as compared to only about 15 percent in 2007. And margin is being posted and collected for uncleared swaps.
A significant focus of our efforts during my tenure as CFTC chairman has been to increase international coordination and harmonization of these reforms. The lack of harmonization was a major criticism when I took office, and we have made tremendous progress there as well.
For example, we’ve harmonized collateral requirements, also referred to as bilateral margin, for uncleared swaps worldwide. We are coordinating clearing requirements. Last year, the U.S. and EU reached a landmark agreement that resolved critical issues regarding the supervision and recognition of clearinghouses—one which brought our regulatory regimes closer together. And there are many joint international efforts taking place with regard to clearinghouse resilience, standards for data reporting, and in a number of other areas.
The derivatives reforms are just one part of the global efforts to strengthen the financial system in the wake of the crisis. The G20 leaders agreed to many other actions, including establishing the Financial Stability Board (FSB), with a mandate to promote financial stability and assess vulnerabilities in the global financial system.
Regulators around the world have strengthened the capital and liquidity standards for banks. Common equity levels are ten times higher than pre-crisis, leverage is much lower, and reliance on short-term funding has declined. So-called “shadow banking” is being addressed. There also has been substantial work done to give governments the tools to resolve or shut down failing institutions without taxpayer funds--to create a system in which a major institution can fail without causing a broader systemic problem.
In all these areas, there is still work to do. There are sometimes disagreements over the best path, even among those who support the basic objectives. But I believe we are in a much better place today than eight years ago.
Impact of Recent Events on International Regulatory Framework
So what effect will recent political events have on the regulation of financial markets? Will we see an abrupt halt, or a reversal, in the actions taken to reform the global financial system? What about the prospects for continued international cooperation in these matters? If, in fact, these recent political events signal opposition to certain aspects of globalization, in particular to the free movement of people and goods across borders, are we entering a period when nations will be so focused on domestic priorities that we should expect less international cooperation when it comes to regulation of the financial system? And will competing nations end up racing toward lower regulatory standards in order to attract capital or business?
It is too early to know or even reasonably predict what exactly will happen.
But I want to offer a few observations and suggestions for what I believe is the proper way forward, particularly as it applies to the area under my jurisdiction, derivatives. My belief is that to repeal or dismantle the reforms we have implemented would be a major mistake. These reforms have made the financial system more resilient, which contributes to a strong economy. Their repeal would not contribute to improving the economic conditions that might have given rise to populist discontent expressed in recent elections. But at the same time, these reforms are not perfect—they can surely be improved upon. And more importantly, the goal of building economies that create opportunity for all requires more than just preventing financial instability. On that score, we have more to do.
I want to focus first on whether we will see less international cooperation in implementing reforms. I certainly hope not, because I believe it is actually necessary to address the concerns about economic opportunity and growth that may have been expressed in these recent votes.
Let me explain that. I noted that when I took office, there were many complaints about the lack of harmonization of these derivatives reforms across international borders.
In response, I would point out that there are very few areas of financial regulation that are harmonized across national boundaries. Consider securities laws: if a company wants to make a public offering of securities, compliance with U.S. law does not entitle it to do a public offering here in the UK. It must instead comply with local laws in each jurisdiction. There are significant differences in national regulatory regimes when it comes to secured lending, corporate tax policy or just about any other area you might name.
I believe many in the derivatives industry presumed that there should be harmonization because they were used to a world in which there was no regulation before the crisis. Global banks were able to transact swaps across borders without worrying about differences in rules, because there were no rules to worry about. But that’s in part what led to the problems we faced in the financial crisis. AIG built up its excessive risk through an operation here in London into which U.S. regulators had no visibility. And the crisis spread from its origins in the U.S. mortgage industry in large part because investors around the world purchased mortgage-backed securities and derivatives that were not regulated in the U.S. or in their home countries.
In short, the global nature of the financial system had outstripped the ability of national regulators to oversee it. This was not only true in derivatives, it was true in other areas as well. There is a global market for finance—capital moves in a microsecond from one jurisdiction to another, and with it the investment that can create jobs. But we still regulate the system through nation-states; there is no global regulator. And what we have been doing since the crisis is trying to catch up—working, as individual nations, to plug the regulatory holes and deficiencies that contributed to the causes of the crisis, and to do it in a coordinated way so that we have effective regulation of the global financial system.
If we enter a period when there is less international cooperation in regulating the global financial system, or worse, regulatory competition, that is likely to increase the risk of financial instability, which can in turn lead to another crisis that causes the type of suffering we saw last time.
Clearly though, these recent political events may lead to some changes in the current regulatory framework.
Looking to the Future
These examples—clearinghouse resilience, as well as market liquidity and its relationship to automated trading—remind us that markets evolve constantly. They change in response to regulation, but also, and perhaps more importantly, they evolve as a result of technological advances, macroeconomic conditions, and other factors.
So as regulators, we must make sure we are not just looking backwards, addressing the causes of past problems, such as the financial crisis. We must be looking forward as well. There is no greater example of this than the need to focus on the risk of cyberattack. This is probably the greatest single threat to financial stability today. It has been a priority of mine, and I hope it will continue to be so for the CFTC. And I hope that any debate over the reforms we have already made does not distract us from facing the new challenges and opportunities ahead.
Let me conclude with this. We are unlikely to predict what will cause the next financial crisis. But the measures we have implemented in response to the 2008 financial crisis have made the global financial system more resilient. The international cooperation in their implementation has been unprecedented. We are responding to the fact that the global financial system had outstripped the ability of national regulators to oversee it. All this work helps reduce the likelihood of a repetition of the terrible economic damage and suffering we experienced just a few years ago, suffering which surely contributed to the discontent witnessed at the polls.
But that discontent also reflects other forces, in particular the broader challenges facing our economies as a result of structural shifts due to decades of globalization and automation. And addressing those issues requires additional, potentially much broader, responses. Whether that involves job retraining, infrastructure funding, tax reform or other policy changes is beyond the scope of my speech. Regardless of how you voted in the American election or the Brexit referendum, those economic concerns deserve to be fully addressed. I hope our political systems and leaders can meet that challenge while maintaining reasonable regulation of the global financial marketplace.
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