Reforming Over-the-Counter Derivative Markets

Wednesday, January 6, 2010

This session was part of the C. Peter McColough Series on International Economics.

MERIT JANOW: Good Morning. Good Morning. Why Don't We Get Started?

My name is Merit Janow, a professor at Columbia University and it's my privilege to moderate this morning's breakfast with Gary Gensler, chairman of the CFTC.

Today's meeting is part of the C. Peter McCullough Series on International Economics. And I think it is Chairman Gensler's first visit to the CFR since he was sworn in in May, and in the interests of time since you have his bio, I will be very brief in this introduction.

His bio attests to his extraordinary and deep background in financial markets and regulation, having previously served as undersecretary of the Treasury of Domestic Finance, assistant secretary of financial markets and while at Treasury, was awarded the department's higher honor, the Alexander Hamilton Award.

He also served as a senior adviser to the chairman of the Senate Banking Committee, as well as having had extensive market experience coming from his 18 years at Goldman Sachs, including as co-head of finance.

He has written a well-recognized book and I recall that he featured in Michael Lewis' book, When Genius Failed, as part of the solution to the long-term credit management problem which was, of course, a more limited moment of crisis in Wall Street history.

We are at a critical and still fluid moment in financial and regulatory reform in the U.S. with a host of issues, particularly with respect to derivatives that falls squarely on the CFTC's shoulders or that envision an expanded role for the CFTC and broader oversight of the financial system.

So our game plan this morning is for Chairman Gensler to start us off with his perspectives, followed by a few minutes of discussion with me and then we'll open it up to this expert audience for questions.

This meeting is on the record and we invite you to please turn off all of your electronic devices, and when we go into questions, please identify yourself and ask a concise question.

So with that, Chairman Gensler. (Applause.)

GARY GENSLER: Good morning. I want to thank Merit for those kind words of introduction and the Council on Foreign Relations for inviting me to speak today. I also want to wish all of you a happy new year and I hope that all that you wish for for this year comes true.

Now, for me, that's financial regulatory reform and I must admit it's also that my daughter get into the college of her choice, having just filled out all those wonderful forms.

In 2008, the financial crisis left us with many lessons and many challenges to tackle. From addressing institutions that are too big to fail to reforming mortgage underwriting and sales practices, it is essential that the federal government take significant steps to prevent the next crisis.

But this morning, I'd like to focus my comments on the need for comprehensive reform of over-the-counter derivative marketplace and as Merit said, takes some questions from the group.

In the year since the crisis, some have asked: why is it important to bring greater regulation to derivatives? And why is it important to do it now?

I believe the financial crisis certainly highlighted the need for regulatory reform for this marketplace, but even if the crisis had not occurred, the evolution of these markets would still warrant broad reform.

Derivatives are contracts as many of you know used by corporations, municipalities, nonprofits and others to protect themselves against risks of future changes in the markets and they're very complex products, but really at the core it's a simple thing. It's a matter of hedging future price and movements in the marketplace and other movements in the marketplace. But every consumer is touched by a corporation that uses a derivative. Some of these corporations hedge interest rate risks; some purchase products from overseas and hedge currency risk and if you flew over the vacation to visit family, it's likely that the airline hedged the jet fuel risk, the price of that jet fuel through some derivative and if you're thinking about home heating oil, the home heating oil -- and I know in New York it's a lot of steam heat and so forth. But that home heating oil is hedged somewhere in the system with derivatives.

Many derivatives, called futures, are currently regulated. They're regulated by the Commodity Futures Trading Commission, a commission I have the honor to chair. Futures are standardized, liquid derivative and they've been traded actually all the way back to the 1860s. They are used to hedge all different types of risks, but initially as you may know, they were used to hedge risks for corn and wheat and the grain products and the agricultural markets and they allowed farmers to hedge just as today we hedge other risks, but to hedge a future change in the price of corn or wheat. And they also allowed that farmer to access a national market pricing rather than some local dealer-led pricing.

Now, it's interesting because after much debate, these markets were regulated starting in the 1920s, but it took about 60 years of debate actually, post-Civil War all the way through post-World War I and then the financial crisis that occurred then before these markets were regulated. And Congress responded, of course, in the 1930s, finally, with covering regulation of central markets for futures. And that's how about it stood all the way through the 1970s. The markets expanded to energy futures, to interest rates futures, even the small things that started up called equity futures, the S&P 500 future that you can think about it. But then things changed in 1981, so really not that long ago, but that's when the first over-the-counter derivative transaction occurred. It was a currency transaction, I think it was World Bank and Solomon Brothers, maybe IBM was in the mix somewhere there, too.

And the early stages of this new market was highly tailored to meet hedgers' specific needs. Contracts were negotiated between a dealer and a corporation seeking to hedge its risk. The contracts were bilateral, that means they were between usually one party and another, they weren't in some multilateral central marketplace. And the transactions were kept on the balance sheets of banks and the banks assumed the risk of the transactions and the resulting profits or loss.

In the last three decades, the over-the-counter derivatives marketplace, though, has grown up. It's certainly no longer embryonic stage and yet it still remains unregulated. From a total notional amount of less than $1 trillion in the 1980s, the notional value now has ballooned to $300 trillion. Just putting it in context, that's about 20 times our economy. Now, I know it doesn't quite work this way, but if you bought $50 of gas at the gas station, you can think somewhere in the economy there might be $1,000 of over-the-counter derivatives behind that $50 in that tank of gas.

The contracts have become much more standardized in these 30 years. The contracts have also given the rapid advances in technology, particularly in the last ten years; we can facilitate the trading of these on electronic trading platforms. But while so much has changed in these last 29 years since derivatives, over-the-counter derivatives were invented, one thing still is constant and that is it's still a dealer-dominated market and still is unregulated.

When a corporation or another end-user wants to hedge a risk, they go to their bank and they get a price quote. When they enter into a transaction, those transactions largely stay on the books of the banks. The price is not discovered in a transparent trading market, such as in exchanges or other platforms and the risk is not transferred off the dealer's books to a central clearinghouse. This leaves significant risk in the system, risk that just a year ago was borne, not by the individual banks, frankly, but ultimately it was borne by everybody in this room. It was borne by the American taxpayers in the largest financial bailout in history.

And much like the debate that went on after the last crisis in the 1930s about whether potential regulation for futures and securities markets were warranted and would help the American public, we're now debating whether the over-the-counter derivatives marketplace should be regulated. And while the recent crisis seems to have eased and many banks are repaying their TARP money, I believe that we still must enact regulatory reform to promote transparency and reduce risk in this evolving over-the-counter derivatives marketplace.


Now, financial intermediation, I'm in New York. You all know more about it now than I do. I'm sort of a washed up old banker. I left to see Bob Katz here and others, but I left, now, I guess, it's 13 years ago Wall Street. But financial intermediation, that is the pricing and allocation of capital and risk in society, very critical to the economy, every part of our economy. But this intermediation can be done two ways; it can be done by financial institutions, typically banks or through the benefit of centralized marketplaces. The more standardized the product is, the more able it is to be brought to a central marketplace. The more specific and tailored it is like a specific loan to a corporation, the more likely it's done by financial intermediaries. And, of course, standard products like stocks are traded on a marketplace.

Over-the-counter derivative contracts have become much more standardized. In fact, by some estimates, two-thirds to three-quarters of interest rate products could be standardized. By other estimates in the energy space and other commodity markets, half of the market is standard enough to be brought to clearing and exchanges.

So with this standardization, and again, by the rapid growth and computerization, derivative transactions, I believe, that the time has come to benefit from central marketplaces and central market structures, which both lower risk and promote transparency, all allowing market participants to see how the contracts are priced.

Now, some opponents of reform, some I would say in this room would say this really wasn't at the center of the crisis; the crisis was about mortgage underwriting practices, the crisis was about not enough capital in the banks and so forth. But I believe that the over-the-counter derivatives marketplace was, in fact, part and parcel to this crisis and it's critical to understanding what went on.

We have all witnessed firsthand, of course, the effect of unregulated derivatives had on the entire economy and everybody in this room put money into AIG, in fact, it was $600 for each of you and that's just simple arithmetic, it's $180 billion divided across our citizenship, but it's true, it's $600 of your money and you don't have it back yet.

But the lessons of the crisis, to me, go much further than AIG. While derivatives are intended to help transfer and lower risk in the economy, the crisis actually demonstrated how can they concentrate risk among just a few big banks. All the major derivatives dealers, I would have to add all of them were recipients of taxpayer TARP money. They internalized their derivatives trading, retaining significant risk. Those banks have become increasingly interconnected as well with other institutions. And this market has become highly concentrated, maybe five or six big institutions here in the U.S., maybe 15 around the globe are really at the center of this derivatives marketplace.

So there are far many institutions, tens of thousands around the globe connected, but there's this handful. So there's very few hubs and lots of spokes in this marketplace. And this risk becomes sort of like a spider's web and we all got caught in it collectively 15 months ago when AIG failed. Data collected by the way by the Bank of International Settlement indicates about 40 percent of over-the-counter derivatives are transacted between the dealers, dealer to dealer. That means about 60 percent is with others, with other financial institutions as you would hope and expect and with corporate end-users as well.

When the financial system failed, of course, these risks were externalized to the public. They didn't stay inside these banks, but they were externalized to the public in the big bailout.

I believe comprehensive reform, therefore, should include three critical components. First, we must explicitly regulate the dealers themselves. Leading up to the crisis, it was assumed that the banks that dealt in derivatives were already regulated, and thus it did not need to be explicitly regulated for this business. I think the crisis clearly demonstrates how this was a flawed assumption.

While banks and securities firms were regulated by their prudential regulators, many of their affiliates that traded derivatives and were ineffectively or lightly regulated, certainly, that was the case in Lehman Brothers and AIG. And even where derivatives were traded right inside a regulated bank, the banks were not regulated explicitly for the derivatives trading.

Second, I believe regulatory reform must now bring sunshine to this opaque over-the-counter derivatives market. Over-the-counter derivatives are traded out of sight, not only of the federal regulators, but frankly, out of sight of market participants. This was the core of the financial crisis. Some might debate this. But let us recall that in the midst of the crisis, there was an inability to price so many assets and we can recall stories about inability to price mortgage derivatives or the public learned this term, "toxic assets," which two years ago, nobody would have said, well, what's that and then all of a sudden, Congress in a quick move had to listen to the Secretary of the Treasury and the head of the Federal Reserve request $700 billion to stabilize the financial system.

So bringing transparency to this market does shift an information advantage from Wall Street, the small group of derivative dealers to a broader market. This not only benefits, by the way, the end-users by shifting that information advantage, but it also increases competition in this marketplace. It lowers barriers to entry to other market makers and to liquidity providers who can provide the product to the corporate and non-profits that need to hedge. And a great number of market makers can only benefit economic activity as well.

Now, we would not tolerate in other markets such concentration and such off-market trading. I don't think so. I don't think anybody in the room would raise their hand and say let's take the stock market or the futures market to where we have the over-the-counter derivatives market. It's sort of like right now if you went into a store to buy an apple and you didn't know where the price of the apple was and I don't mean the Apple computer, but we could talk about that, too. And it's sort of like if you were going to buy 100 shares of a stock for your 401(k) and you didn't know where the market was for that either. It could just stay in sort of a dark, some people in the stock market talk about dark pools. The over-the-counter derivatives market is a dark ocean. That's really what we have. Now, I understand that that's not what some would wish to change.

I want to say is third is the interconnectedness, third, derivatives reform really has to address the interconnectedness in the market, standard over-the-counter derivatives, I believe, should be moved into well-regulated clearinghouses. In the market today, trades are left on the books of the dealers that transact the business, this, of course, is in the interest of the dealers because it keeps a close working relationship with the client, with the customer. That's a good thing in business, whether you're selling soap or you're selling derivatives. But if an interest rate derivative is entered into, it's on the books for years often, sometimes 30 years and as markets move, the value of the transactions change, but the interconnectedness remains. And the crisis showed how the interconnectedness doesn't lessen risk in the economy, but it concentrates risks and ultimately it's externalized to the American public and the taxpayer.

No matter how much we try to address too big to fail, there's still this interconnectedness, too interconnected to fail so to speak that the government is sitting there and a future Treasury Secretary, future head of the Fed is saying, can we really let them fail?

So I think clearinghouses can act as a middleman where the two parties of the transaction take the trade into the clearinghouse. It does require the dealers and the end-users to post collateral, so if one party fails, the other is protected. It's essential though to reduce risk in the system, otherwise, we end up with repeats of this crisis, sometimes, I don't know what year it would be, but it would be a similar circumstance where an institution was too interconnected.

Now, I do understand with 18 years on Wall Street and with all the time I spent down in Washington that improving transparency and lowering risk would be big changes for Wall Street. We'd move standardized over-the-counter derivatives out of a dealer-dominated market and into a centralized marketplace. And working on Wall Street, I work with talented, highly professionals individuals, but Wall Street's interests are not always the same as the American public's interests. Wall Street's interests in maximizing their profits, maximizing revenues and the compensation to their employees. That's what they should be doing, but that's different than what Congress and what we are doing right now about trying to reform the system. And we watched the greatest crisis in 80 years. We watched the financial system frankly fail the American public. I believe it's time to change the way these markets both function and how they're regulated

So with that, I thank you for inviting me here. I look forward to Merit's questions and the rest of you. Though we are on the record, and somebody says I was hoping -- I think Ted said he was hoping for Chatham House rules -- being a government official and with a lot of people in the room, it's always on the record, but I'll try to be as open and please be open with your questions as well. (Applause.)

JANOW: Thank you very much. Well, I guess I'd like to start with a very general question and then get perhaps a specific one and the general one is this. As you look at the U.S. financial system today, how would you assess the risk situation as compared with say a couple of years ago with respect to over-the-counter derivatives? And are the reforms that are on the table in the House and the Senate bill deal with those risks sufficiently in your view?

GENSLER: The question is risk in the system and how we're doing on reform. I think that though we've stabilized some and the financial system is stronger than it was 15 months ago, I think the question was more narrowly to the derivatives books of business on Wall Street. And I have to say candidly we don't really know. This is an opaque market and that even the regulators don't have a really good picture of the risks that are embedded in the derivatives' books.

One would hope that there's less risk today than was two years ago, and certainly, in one line of work, the credit default swap market and how that was all tied to the mortgage market. There's a lot of reason to believe that the risk was higher in 2007 than it is now in the credit default businesses. But beyond that, this very large $300 trillion business, I don't think that we have good statistics on.

On the second question, I think that there's a very real consensus to bring reform to the derivatives marketplace. It's, of course, part of the broader reform agenda of the administration and the president. The House passed the bill. It wasn't everything we wanted, but it was a very strong bill with derivatives and now we move to the Senate and our founding fathers laid out a very good system. I'm a fan of it, but it's going to take some time. But I do think that there will be something particularly on derivatives that the president will be able to address.

JANOW: Okay. Thank you. Let met get a little bit more into these bills and how they might dovetail with some of the issues you've surfaced. You've spoken about the importance of achieving greater transparency and in the operation of these markets and I think that the House and Senate bills address that by requiring changes with respect to both clearing and trade executions.

So I'd like to ask a bit about both of those aspects. And with respect to clearing, I think the House bill does impose a central clearing requirement on swaps, which I think is exactly what you're asking for. But it does also provide an exemption for corporate end users.

And so my question is: How significant is this exemption? Do you think that it materially undermines the objective of transparency? How do you view that exemption?

GENSLER: Well, the marketplace right now is not brought to central trading facilities and it's not generally brought to central clearing. Some of it is, but not much of it.

So what Congress is grappling with is, one, do we require this? And two, if so, which transactions? The good news is the House of Representatives requires both the transparent trading and central clearing, but as Merit said, there's then the exception to the rule. And I've been a proponent as I've just said in my comments that I think that anything that's standard enough to be listed on an exchange, we should move to a market-base trading. And I think that I know there's some corporations in the room or representatives of corporations, I think this benefits every corporation. I think it benefits every consumer in America because economists have shown over the decades that when you bring transparency to markets, you lower the bid ask spread -- that's the difference between buying and selling or hedging a risk. You bring more market participants in. It's more competition and open and competitive markets. And so we're going to continue to try to work with the Senate and convince more members of that.

On the clearing side, which is after the trade occurs, after the trade occurs, many corporations have raised the concern they feel that, well, this will cost them something if it also has to be in central clearing. I believe the two can be separated; you could do one without the other, but I also believe that it would be a stronger bill to have that.

Statistics are hard to get in this market, again, it's a very opaque market, but just working off the Bank of International Settlement Data, they show about 40 percent of the market is dealer-to-dealer. So depending upon how the exceptions are, it could leave out over half the market. So the dealer-to-dealer market has to be brought onto exchanges and clearing and some portion of end users.

JANOW: Okay. Thank you. Well, let me ask you then about the trading side of it is, and as I understand it, the bill requires that swaps have to be exchanged, traded or traded on some kind of execution facility. So I guess my question is, in your view, is the transparency element equal under both of those settings, an exchange or some kind of execution facility or do you see a difference in the amount of transparency that will follow?

GENSLER: I think transparency is absolutely critical. I think it was not only at the heart of the crisis, but it's how we promote economic activity in America. And I think we need to move from the dealer-dominated, sort of club world of five or six firms pricing these to a more open and competitive marketplace. And I think it can be done either way. I think it can be done in a fully regulated exchange environment or it can be done in a regulated trading platform.

What do we mean? In today's world of computers, you can put together a trading platform that's an electronic trading platform and still be regulated. It still would have to post the trades as they occur and you'd see the price and volume as they occur and I think you can bring a great deal. And we currently have this in the futures market. We have it in the securities market. There's a fully regulated New York Stock Exchange, I see Bob here, the NASDAQ and so forth, but there's also alternative trading platforms. I think if they have the right regulation for transparency, either can work, though they have a little bit different -- it's not one size fits all.

MS. JANOW: Okay. Let me ask you one last question before opening it up and this is perhaps a little bit of inside baseball, but at one point there seemed to have been consideration of merging the CFTC and the SEC and I gather that's no longer really on the table or under discussion. But as I look at these bills a bit, it seems that they're expecting far greater cooperation and coordination between the agencies with respect to rule development and market oversight.

And so my question is this, I mean, what degree of cooperation or integration or collaboration do you think is achievable and desirable? And you know, it's sometimes said that the CFTC is more of a principles-based culture and the SEC is much more rules-based and there's a debate as to which is really more advantageous as a regulatory approach.

What's your sense of how far this process is going to push collaboration and what form it should take?

GENSLER: Just as a little bit of background. When President Roosevelt went to Congress after the last crisis in the '30s, he actually called for that we needed to have market oversight and regulation of the securities market and the commodities market, and at that time what came out of it was the Securities and Exchange Commission and our predecessor, which was actually part of the Department of Agriculture, but the great securities laws of '33 and '34 and ours was in '36, all happened at that same time.

So for the last 70 some years, we have two market regulators, one looking at capital formation and issuers and investors, that's the SEC and one looking at these derivative contracts, which initially were called futures, sort of risk contracts. And that's about where it stays, largely for historic reasons. And so our challenge is to make sure the two agencies work better together because in political Washington so often you can get a little boundaries and turfy. And the president actually asked Mary Schapiro and myself earlier this year to look at how we could bring the agencies more in harmony and we put out a report in October. I wouldn't suggest anybody reading it late at night. But we put out a report with about 20 recommendations, 14 of which I think needed congressional action. We've been successful on four or five of them, but trying to bring more consistency where it's appropriate. In some places, we don't think it is appropriate. But I'll give you one example where I'd like to move towards Mary's at the SEC. In the securities world, there's insider trading laws as we all know and it's a dominant piece of it and it's not in the commodities world, you know. If you know how much grain is in a grain elevator, you can trade on that. And that is roughly good, but then we noticed in studying this, we all knew that movie "Trading Places." Do you remember that movie, Eddie Murphy and so forth? And some of you remember at the end, he trades on stolen reports on frozen concentrate orange juice, stolen from the government.

Right now, that's not illegal. So we think we should go to Congress and make sure that if you steal information like Eddie Murphy, well, actually I don't know if Eddie Murphy stole it, that we close that.

So those are the types of things and that's a light-hearted one, but an important one that we get better. And Mary and I have a very good relationship, but we also have to consider we're not going to be in these jobs forever. We turn over and there's going to be other people in these jobs.

JANOW: Okay. Well, thank you very much. With that, why don't we open it up to our audience and please wait for the mike and identify yourself.


QUESTIONER: Herbert Levin. Mr. Chairman, two questions, first, could you give the international side? If your proposals carry through, what happens in London and Hong Kong for example? And second, could you tell us who is opposed to everything you want and who are they? And why do they oppose you? (Laughter.)

GENSLER: On the second question first, many people in this room and you could look at the program in the back, but on the first question -- I'll return to the second question. On the first question, there is a surprising degree of international coordination on this. There's always a concern of a race to the bottom because capital knows no geographic boundary, risk knows no geographic boundary.

The Europeans through the European Commission have put out their proposals in October of what to do and they're consistent in terms that all standardized derivatives be brought to clearing and to central trading. They haven't put a lot of details and flush that out yet, but they're working on those details and they'll probably bring it to the European Parliament this summer. We have a lot of dialogue back and forth, between Europe and here, we have about 80 or 85 percent of the overall derivatives marketplace. I think they're also challenged by the same question of whether there's corrupt exemptions that Merit talked about earlier, and even today, I was reading an article in The Financial Times that some 160 CEOs signed some letter that they want an exemption there.

So they have the same political pressures so to your second question. Corporate end users of derivatives are concerned -- will this in some way raise their costs? And of course, there's no free lunch and risk was mispriced and part of the crisis was mispriced. But the principle and Hong Kong is not as engaged right now, but in Japan, China we've had dialogue, Canada and all of Europe. I'm optimistic. We're largely walking along the same path on this derivatives reform.

In terms of who is opposed, primarily the five or six largest Wall Street firms because it does; they have a fiduciary duty to their shareholders to maximize profits. The information advantage is theirs right now. If we shift that to a market-based structure, it lowers some of it. And even centralized clearing diminishes their key role with their clients. It means the product is a little less sticky in an economic term.

So I think often where you stand on matters of public policies depends where you sit and so, you know, if I was in their shoe, I'd probably be at the same place they are.

JANOW: Thank you. Over here. Sir?

QUESTIONER: Bill Williams, Sullivan & Cromwell. Has the administration or the SEC and CFTC ever considered consolidating all protection of investors and consumers with respect to financial services and products in one central agency?

GENSLER: Well, Bill, I think its been debated probably since the 1930s when President Roosevelt went to Congress. It certainly was debated actively in the '70s when our agency, the CFTC came out of the Agriculture Department and it was set up as a commission. And it was debated again even this year.

I think merger for merger sake though, just as it in commercial enterprises, a merger for merger sake often isn't the reason to do things, and at the center of the crisis, there wasn't anybody I think in Washington or outside that said two market regulators versus one was at the center of this crisis, I mean, there were a lot of other things probably at the center of the crisis. So what the president and the Secretary of the Treasury and the administration decided is let's focus on what was at the center of the crisis rather than trying to make some boxes look good on an organization chart.

But now what we have done is tried to, like I said, have this report on how we can bring more harmony or consistency to some of the things that we're doing.

JANOW: Thank you. Over here.

QUESTIONER: Dave Denun (sp) from NYU. My question is a comparative one. If transparency and open trading are a good thing today, why weren't they a good thing a decade ago when you and Secretary Rubin and Deputy Secretary Summers so strongly opposed them then?

GENSLER: Very good question and I think that for all of us who served, knowing what we know now looking back, we should have fought harder for the American public and to protect the public and promote transparency.

I think that these markets have evolved; computerization has certainly evolved. So 1981 was the first derivative transaction, this currency trade that I talked about.

Throughout the '80s and even well into the '90s, much of the market was bilateral, it was not, in fact, computer platforms didn't exist to make them multilateral, but largely remained individually negotiated probably for the first decade. You got into the second decade of the market. You started to have more standardization, but still a mixed market, but still not on computer platforms and so forth. And looking back now, would it have been better then that we did it, yes, but that doesn't take the burden off us now, today, 29 years into this marketplace, I think it's incumbent to try to move to centralized market structures where we can. And if upwards as I quoted some statistics as upwards to two-thirds or three-quarters are standard enough, there would still be some that are truly bilateral. But I think on the standard market, we should try to move that onto the benefits of transparency.

JANOW: In the back, please. Yes, sir?

QUESTIONER: Very interesting discussion. Could you comment on the -- could you -- John Bergman (sp) speaking -- could you comment on the importance of margin requirements and how they're set, and should they be set?

GENSLER: Margin is an amount of money put aside to protect certain risks. In the futures and derivatives marketplace, these are long-dated contracts. You could be hedging the price of corn, gasoline or an interest rate for years or months. And so entering a trade in January, six months later, the markets have moved. And so what margin is used for is almost some people call it a performance bond, but the question is if the markets have moved and there's an exposure and what happens if one of the parties to the transaction now fails?

So margin is very important in that regard. AIG, because of their credit ratings and I see a member from S&P here, but due to their credit ratings, many people said AIG didn't need to post margin and then when they got downgraded, when the rating got downgraded in September of 2008, all of a sudden, $30 billion needed to be posted, the mark to market evaluation. And that was an awful situation.

So I think the posting of margin is a harsh discipline, but an important discipline. It happens on a daily basis in derivatives contracts and lowers risk to the entire system. Corporate America has said we prefer not to do that. They actually are being charged an extension of credit in their derivatives contracts right now, but they prefer not to have an explicitly charged. They want it sort of implicitly charged in the contracts and that's part of the debate, public policy debate, weighing that back and forth. But in posting margin, lowers risk to the system, and again, there's no free lunch here.

With no margin, the risk is still there and sometimes it gets externalized to taxpayers.

JANOW: Thank you. Over here.

QUESTIONER: Thank you. Thank you, Commissioner Gensler. And I applaud your --

JANOW: Could you identify yourself?

QUESTIONER: I'm sorry, Baldas (sp) from Carlek's (sp) Investment Advisers. I applaud your efforts on regulation, transparency and on central clearinghouse in terms of the focus of the reform. It seems to me looking at it and when history is written, regulatory failure and failure of regulators was a fundamental and critical aspect of this crisis. The focus in recent times and even in the aftermath of the crisis has been more on Wall Street; you've got politics there.

The question I have for you is how much of the focus today and the reform is on the nature of the regulators, competent, well-paid regulators who are able to effectively do the task that eventual legislation will charge them with so in the instance of the Bernie Madoff case, the regulators seem to have been amongst the only people in the sophisticated land scale who didn't understand option trading. When the Madoffs of the world went to the (black swans ?) of the world, they -- quickly people figured out things were not adding up.

So I'd be interested in your view on the regulators themselves, better-paid, better educated, better trained. How much of the focus is on that?

Thank you.

GENSLER: Well, one, I think it's clear the regulatory system failed and the financial system failed. It was not like just one or the other. I also think that it's a matter of regulatory culture and some of it is societal and even going back to this question about the 1990s, I mean, it's broad-based, it's not one person or one institution. Over the counter derivatives, we're not regulated here in the United States; we're not regulated in Europe, in Hong Kong as was the earlier question. It's a worldwide incremental consensus. But also in the last administration an agency like ours was shrunk. So from 1999 to 2008, the CFTC head count shrank 25 percent in a period of time that the volumes in the marketplace went up five to sixfold, that we went from open outcry pits to electronic trading and we didn't update our market surveillance.

Our market surveillance and compliance right now is not automated. We talk about flash orders and automated trading, the CFTC should have the same engine where we can look at the hundreds of thousands of trades in an automated way and that hasn't been done. We don't really have 21st century computers. We need to do that.

So a lot of it is also -- we are asking for additional regulatory authorities, but a lot of it is even what we do with our current authorities, how we use systems to look over the market and how we embed a regulatory culture that protects the public and promotes market efficiency.

There's a lot of blame to go around.

JANOW: Thank you. Benn Steil, please.

QUESTIONER: Benn Steil, Council on Foreign Relations.

One problem that's been raised with regard to the idea of pushing standardized contracts on exchanges that there's no hard and fast way to determine exactly what a standardized contract is. Some amount of regulatory discretion is obviously needed and we can probably expect banks to be clever in terms of avoiding. Do you think so?

I'm just a cynic at heart. One alternative approach that's been put forward, therefore, is simply to impose higher capital requirements on over-the-counter deals as opposed to deals that take place on exchange or on central clearing platforms and I wanted to see what you thought of that alternative.

GENSLER: I think that the marketplace does have a significant portion that is relatively standard and can be brought into a clearinghouse and if a clearinghouse is willing to clear it, and, yes, there needs to be some regulatory involvement in that as well and it can be well managed, it should be in central clearing.

I also think if it can be listed, whether it's in some of these alternative trading platforms or the fully regulated markets, that if an exchange lists it, that's a good sign. But on the rest of the market, whether that's a quarter of the market, a third of the market that can't be standardized or maybe even if it were half of the market, your question is: Should there be higher capital charges? And I think that economics and finance would say, yes, the reason is it's less transparent and less liquid.

So capital -- earlier question was about margin, but capital is a cushion at the large financial institutions to protect against what if they fail, to have some cushion there. And the liquid products that they have on their books should have less capital charges than the less liquid, I mean, if you have something that is 100 shares of IBM and it's trading every day, that probably makes sense to have less capital than something that's a private placement of equity that has no observable pricing.

The same way for the derivatives marketplace. If it's standard one year interest rate swap and it's relatively standard, that should have really minimal capital charges, but if it's an exotic credit default swap on a funky mortgage derivative that some people in this room will create next year, it seems to economics and finance -- it should be a higher capital charge. And the Europeans to an earlier question have put that -- that's one of their main pieces is that they want higher capital charges for the non-standard product.

JANOW: In the back.

QUESTIONER: Thanks. I'm Daniel Sternoff with Medley Global Advisors.

I wonder if you could speak a little bit about position limits in the energy futures space. There had been a push to --

GENSLER: We made it all the way to 8:55.

QUESTIONER: Exactly. Without the question. There had been a push to put some proposals out by December or before the winter solstice. I think it would technically be autumn as you had wanted. We haven't seen them; we're in the New Year.

I wonder if you could comment on where your process stands and what is behind the delay and take it away.

GENSLER: Sure. Well, I'm not planning to make any public announcements today on proposed position limits, but just to give a little background to our agency, when we were formed again all the way back to the 1930s and Congress debated what it meant to regulate these derivatives marketplaces, there was a recognition that hedgers meet speculators in a marketplace and that it's important, the hedger wants to lay off risk and there's somebody on the other side that meets them in a marketplace and we call them speculators that bear that risk. But at the same time, Congress embedded in our statute a provision that we shall set position limits to protect the markets, the burdens that might come in the markets from excessive speculation, more specifically, the burdens to interstate commerce.

So for many years, we have set position limits in agricultural markets, and, in fact, working with the exchanges, there were position limits through 2001, through the summer of 2001 in the energy markets.

So what we did shortly after I got to the Commission, we do it in the agricultural markets. We used to do it with the exchanges in the energy markets. The law says we're supposed to do this and should we take a look at this. We had some hearings last summer. I believe that we need to seriously consider this and seriously consider it really to best promote the markets, to best promote fair and orderly markets and ensure that they work in a way without concentrated outside positions in these marketplaces. So that's what we've been taking a look at, but I'm not here today to announce anything on position limits.

Jim Johnson. I have to disclose we served together at the Department of Treasury and on the Obama transition. He's a great friend.

QUESTIONER: But this will be a fair question. (Laughter.) Jim Johnson, Debevoise & Plimpton.

Mr. Chairman, I think many of us in the room, particularly in the enforcement area would be interested in hearing your sense of the priorities for enforcement, both at the CFTC, but in this new age of collaboration of the CFTC and SEC.

GENSLER: So you want me to let you know which one of your clients that we might be coming after? (Laughter.)

I can't speak for Khuzami and the SEC and so forth like that, but our priorities, one legislative priority, and then, two, with regard to the case load we have.

In terms of legislatively, we feel we want to enhance our ability to go after disruptive trade practices, some would say manipulation. But in terms of how the markets work in the futures market, we want to sort of increase the burden or maybe we'd help you get future clients legislatively and the House supported that where there is specific trade practices around the closing prices of markets and how markets are easily manipulated, but to enhance that and we feel that's very needed for what we do around disruptive trade practices.

In terms of our actual work in the enforcement area, we're small compared to the SEC. We have about one-seventh the number of lawyers in our enforcement wing that the SEC has. But our principle things -- we're overwhelmed with Ponzi cases right now, I mean, it's like when the tide went out, there were just so many things that you could see. We bring about -- nearly half of our Ponzi cases we bring along with the SEC. We've had a tremendous help from the Justice Department and in 2009, every referral we gave to Justice they worked with us on which was a terrific success rate, but it's a lot of Ponzi cases. Unfortunately, that's been crowding out some of our traditional manipulation investigations and that's been hard just given our limited staff.

I think I haven't said anything that I'm breaching the wall here.

JANOW: Let me ask you the last question. As you look out to a world and it does seem that there's a lot of consensus and favor of moving to clearing and trading --

GENSLER: Just a question of those exceptions.

JANOW: Just a question of those exceptions and that's important, but it does seem that there's a lot of support for the notion of increasing transparency and addressing risk through clearing and trading.

Do you look at the equities oversight model as one that you are going to replicate? And what I'm thinking about here is one might imagine that you know firms will want to get into clearing and trading. And so I guess what I'm wondering is, does it matter who owns these instruments looking to questions of conflict, for example, down the road. How do you think about the market structure evolving and avoidance of conflict?

GENSLER: Well, I think market structure does matter, I mean, that's at the core of what we're recommending. It's not just regulatory failure as we were talking about and was asked, it's not just Wall Street. But I think the structure of these markets is important and that we should move now 28, 29 years into this market to embed some centralized market structures, but that they should be -- competition is critical, that trading venues should have open access to clearing platforms. The futures marketplace is more vertically integrated where the trading platforms and the clearing are vertically integrated. The equities model and I'm trying to follow your question, but the equities model in Congress did something where there was common clearing in the 1970s, and so there's better competition amongst trading platforms.

I think that's a better model for this over-the-counter derivatives. It's not taking up what happens in the futures world, but in this over-the-counter derivatives, I think that's a far better model that we should try to encourage that competition. Government shouldn't pick the winner and losers amongst the trading platforms, and for that matter, shouldn't pick the winners or losers in the clearinghouses either.

There was a provision the House passed, I'm into political Washington, but there is a House-passed provision by Congressman Lynch of Massachusetts that actually spoke to some conflicts of interest in terms of the governance of these very important trading venues and clearinghouses, and though the details to me are less important than the goal, the goal is one I share is that the governance of these trading platforms and the governance of the clearing needs to be open and not just dealer controlled. And that a clearinghouse be able to take members that maybe aren't dealers, I mean, if somebody can meet the risk management standards, why should a hedge fund not be able to be a member? In New York, you understand the difference between buy side and sell side, but why not have the buy side be able to be a member of these clearinghouses if they can meet the standards?

So I think the goal that Congressman Lynch had and the House passed the amendment, but it might get further debate in the Senate is a worthy goal to make sure that the governance of these entities are overseen by the SEC or the CFTC, but also very open and we recognize that there always conflicts and we have to try to make sure that these work for the benefit of the public as well.

JANOW: Well, thank you very much. The Council is very strict on time, so we'll have to call it an end, but please join me; this has been a terrific discussion.

Thank you so much, Gary. Thank you. (Applause.)







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