Protecting our Economy Demands Adequate Capital and Margin Requirements for Security-Based Swaps

by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission

SEC Open Meeting
Washington, D.C.
October 17, 2012

One of the most important goals of Title VII of the Dodd-Frank Act is to reduce the risks posed by large, uncollateralized derivatives positions — not just the risks to the players in the market, but also the risks to the entire financial system, the broader economy, investors, taxpayers, and working men and women. To appreciate the significance of these rules, we only need to remember the desperate effort, and massive taxpayer support, required in 2008 to prevent insurance giant AIG´s huge exposure to credit default swaps from destroying that firm virtually overnight, imposing large losses on counterparties across Wall Street, and potentially triggering further panic and failures.¹

I support today´s proposal. The rules we consider today seek to achieve four broad goals:

• First, the rules would augment the financial stability of nonbank security-based swap dealers and nonbank major security-based swap participants by setting minimum capital requirements for these entities, and by imposing minimum liquidity requirements on those dealers that calculate net capital using models.
   
• Second, they seek to prevent the build-up of large, AIG-style, uncollateralized exposures in uncleared security-based swaps by imposing margin requirements for transactions in these instruments.
   
• Third, they seek to protect counterparties of security-based swap dealers by setting requirements for the segregation of excess securities collateral and net funds owed to the counterparties, so that this property can be identified and returned to the counterparties in the event a dealer goes bust.
   
• And fourth, the rules would enhance the future financial stability of "alternate net capital" firms — generally, the very largest broker-dealers — by substantially increasing the minimum dollar amounts of required net capital and tentative net capital and by imposing minimum liquidity requirements.

As the rulemaking release acknowledges, the capital and margin provisions of today´s proposal will affect the economics of entering into security-based swaps that are not cleared. However, as we consider today´s proposal, we must remember why we are considering these rules in the first place. We are considering these rules because a grave financial crisis — in which unregulated derivatives played a central role² — imposed immense costs on the American economy, with tragic effects on American workers and families.

By one estimate, this financial crisis caused economic damage to our nation of at least $12.8 trillion.³ And the response to this near catastrophe included historic legislation mandating significant financial reform that, among other things, requires long-overdue comprehensive regulation of over-the-counter derivatives. Accordingly, we must neither forget why strong requirements for capital, margin, and segregation are necessary, nor forget the great harm that can result if the rules we eventually adopt are not sufficiently strong. We should strive for efficient regulations that enhance the market´s resiliency and that substantially reduce risk in the financial system.

I look forward to receiving comments from the public as to whether today´s proposals set appropriate requirements to minimize the likelihood that trading in over-the-counter derivatives will again threaten the financial system. In particular, I invite comment and supporting data on the following questions:

• Do the proposed minimum net capital requirements for nonbank security-based swap dealers and nonbank major security-based swap participants adequately safeguard the financial stability of these entities, especially as their portfolios grow larger and more complex?
   
• Do the proposed rules adequately safeguard the capital of nonbank security-based swap dealers and nonbank major security-based swap participants when they do not collect margin from non-financial commercial end users?
   
• And, which proposed alternative will ultimately make the financial system safer — requiring the exchange of initial margin between security-based swaps dealers, or not requiring it?

I would like to thank the staff for the significant work that went into this release and, in advance, for the important work that remains on this and other Title VII requirements.

¹ In the case of AIG alone, taxpayers had to commit up to $182.5 billion to rescue a large, systemically important company that would otherwise have failed due to its massive exposures to credit default swaps. See Hugh Son, "AIG´s Trustees Shun ‘Shadow Board,´ Seek Directors," Bloomberg (May 13, 2009), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.

² See, e.g., 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 29 (2010) ("Many factors led to the unraveling of this country´s financial sector and the government intervention to correct it, but a major contributor to the financial crisis was the unregulated over-the-counter (‘OTC´) derivatives market."), available at http://www.gpo.gov/fdsys/pkg/CRPT-111srpt176/pdf/CRPT-111srpt176.pdf.

³ Dennis Kelleher, Stephen Hall, and Katelynn Bradley, "A Report from Better Markets: The Costs of the Wall Street-Caused Financial Collapse and Ongoing Economic Crisis is More than $12.8 Trillion," at 1 (Sept. 15, 2012), available at http://bettermarkets.com/sites/default/files/Cost%20Of%20The%20Crisis.pdf.