The derivatives proposals before us begin the process to require that over-the-counter derivatives be centrally cleared and to determine which derivatives qualify for the exception to this clearing process.
To understand the actions we take today, we must remember how we reached this point. The events of the last several years culminated in the financial crisis. This crisis implicated the over-the-counter (OTC) derivatives market as a major source of systemic risk. OTC derivatives were used to construct highly leveraged speculative positions that threatened the firms themselves and a broad group of counterparties.
In addition, the OTC market is opaque and highly concentrated in approximately a dozen major dealers. The failure of a dealer could have resulted in the nullification of trillions of dollars worth of contracts and could have exposed derivatives counterparties to sudden risk and loss, exacerbating the cycle of deleveraging and withholding of credit that characterized the crisis.1 The Congressional Research Service noted that, “during the crisis, all the major dealers came under stress, and even though derivatives dealing was not generally the direct source of financial weakness, a collapse of the $600 trillion OTC derivatives market was imminent absent federal intervention. The first group of Troubled Asset Relief Program (TARP) recipients included nearly all the large derivatives dealers.”2
In response, the Wall Street Reform legislation enacted earlier this year tasks regulators to make fundamental changes to the OTC derivatives market. The centerpiece of the derivatives market reform is mandatory central clearing of swaps. The legislation charted a course to require that swaps be centrally cleared as much as possible.3
In the context of this overarching objective, however, Congress recognized that it was appropriate to exclude certain security-based swaps from the clearing requirement. For example, as was stated in the Report of the Senate Committee on Banking, Housing, and Urban Affairs: “Some parts of the OTC market may not be suitable for clearing and exchange trading due to individual business needs of certain users. Those users should retain the ability to engage in customized, uncleared contracts while bringing in as much of the OTC market under the centrally cleared and exchange-traded framework as possible. Also, OTC (contracts not cleared centrally) should still be subject to reporting, capital, and margin requirements so that regulators have the tools to monitor and discourage potentially risky activities, except in very narrow circumstances. These exceptions should be crafted very narrowly with an understanding that every company, regardless of the type of business they are engaged in, has a strong commercial incentive to evade regulatory requirements.”4
The SEC has been tasked with direct responsibilities in carrying out this mandate to bring OTC swaps into a centrally cleared, exchange-traded environment.5 It is the Commission’s responsibility to perform an ongoing review of the OTC market to identify categories of swaps that should be centrally cleared, and to review applications from clearing agencies to determine if a category of swaps must be cleared. The Commission also must implement the exception for end users to the general rule of mandatory clearing, so that it provides businesses with the flexibility to manage commercial risks using customized OTC swaps without undercutting Congress’ stated legislative goal that the vast majority of OTC swaps be centrally cleared.
Today’s two proposals are consistent with these goals and I support the staff’s recommendations.
Finally, I join my colleagues in thanking the staff for their commitment and dedication as we move forward in reforming the OTC derivatives market to prevent future bailouts by the American public. In particular, I would like to thank the staff of the Division of Trading and Markets, with whom I have been discussing these issues at all hours of the night and weekends.
1 See, Congressional Research Service Report for Congress, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title VII, Derivatives, Mark Jickling and Kathleen Ann Ruane, August 30, 2010 (summarizing that “The financial crisis implicated the unregulated over-the-counter (OTC) derivatives market as a major source of systemic risk. A number of firms used derivatives to construct highly leveraged speculative positions, which generated enormous losses that threatened to bankrupt not only the firms themselves but also their creditors and trading partners. Hundreds of billions of dollars in government credit were needed to prevent such losses from cascading throughout the system. AIG was the best-known example, but by no means the only one. Equally troublesome was the fact that the OTC market depended on the financial stability of a dozen or so major dealers. Failure of a dealer would have resulted in the nullification of trillions of dollars worth of contracts and would have exposed derivatives counterparties to sudden risk and loss, exacerbating the cycle of deleveraging and withholding of credit that characterized the crisis. During the crisis, all the major dealers came under stress, and even though derivatives dealing was not generally the direct source of financial weakness, a collapse of the $600 trillion OTC derivatives market was imminent absent federal intervention. The first group of Troubled Asset Relief Program (TARP) recipients included nearly all the large derivatives dealers.”)
2 Id.
3 See, Report of the Senate Committee on Banking, Housing, and Urban Affairs regarding The Restoring American Financial Stability Act of 2010, S. Rep. No. 111-176 at 34 (stating that ”Some parts of the OTC market may not be suitable for clearing and exchange trading due to individual business needs of certain users. Those users should retain the ability to engage in customized, uncleared contracts while bringing in as much of the OTC market under the centrally cleared and exchange-traded framework as possible.” (emphasis added)).
4 Id.
5 See, Report For Congress, supra note 1 at 5 (stating that “In order to provide more stability to the OTC derivatives market, the Dodd-Frank Act requires that most derivatives contracts formerly traded exclusively in the OTC market be cleared and traded on exchanges.”).