Speech by SEC Commissioner:
Clearinghouses for Security-Based Swaps Must Place the Public Interest Above Commercial Interests
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
SEC Open Meeting
October 13, 2010
The over-the-counter derivatives market has grown to enormous size without meaningful oversight or regulation. It has also operated without transparency or adequate risk management. And the resulting cost to the American taxpayer has been substantial. 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.1 Central to Congress’s effort to reform the financial system is bringing over-the-counter derivatives out of the dark and subjecting them to regulation, transparency, and appropriate risk management. And an essential part of this effort is moving the market in security-based swaps toward trading on transparent venues and clearing through central counterparties.
Although the Commission has many years of experience in regulating trading and clearing for equity securities, the market for security-based swaps is different. Most significantly, it is far more concentrated. As the Office of the Comptroller of the Currency noted in its most recent report on bank derivatives activity, “Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 96% of total banking industry notional amounts and 85% of industry net current credit exposure.”2 These U.S. banks are joined by a handful of foreign institutions to form a highly concentrated group of swap dealers.
Given the existing concentration of power in the OTC derivatives market, Congress was adamant that its efforts to reform this market not be undermined by conflicts of interest in clearing agencies, security-based swap execution facilities (SEFs), and exchanges that trade security-based swaps. In fact, Congress mandated that rules to mitigate such conflicts should be among the first that we promulgate regarding derivatives. The priority that Congress has assigned to these rules is appropriate. The rules that this agency adopts regarding conflicts of interest in clearing agencies, SEFs, and exchanges for security-based swaps will be crucial to the success or failure of efforts to reform this market and to protect both investors and taxpayers from disastrous consequences. Thus, we must be certain, first, to correctly identify the conflicts that exist or may arise and, second, to design rules that appropriately mitigate these conflicts.
Our proposing release describes a number of the conflicts that may arise. For example, the small group of dealers that dominate the market have incentives to avoid competition and transparency by, among other things, restricting clearing agency membership, limiting indirect access to clearing facilities, and restricting the products that clear. Participants in a clearing agency may also have incentives to lower the amount of collateral they must place at the clearing agency, without appropriate regard to risk management, a particular concern where, as here, there is the possibility of liquidity support from the Federal Reserve in the event of an emergency.3 Because we are proposing rules in an area where we have little historical experience, the notice-and-comment process will be especially important in determining whether we have identified the appropriate conflicts of interest. I urge all commenters to address whether we have identified all the conflicts that may arise.
Our proposing release also proposes a number of mechanisms intended to mitigate conflicts of interest. I have questions, however, regarding whether these proposals will be sufficient. Again, I urge commenters to analyze our proposals. Will they adequately address the conflicts of interest that may lead to reduced competition and transparency or to increased systemic risk? Are the ownership, voting, and board membership restrictions that we have proposed effective enough? Are there other tools that we should use?
For example, our proposing release notes that the Commission intends to undertake a separate future rulemaking to require clearing agencies to adopt their own procedures to identify and address existing or potential conflicts of interest and to establish minimum governance and fitness standards for members of their boards of directors and committees of the board. Should we do that as part of this rulemaking? And should we be more prescriptive in doing so? What kinds of governance and fitness standards would be appropriate? Our colleagues at the CFTC recently proposed their own conflict of interest rules, and they included some proposals that we have not. Their proposals would:
- require board members of derivatives clearing organizations, designated contract markets, and SEFs to have sufficient expertise;
- require these entities to clearly articulate the duties of their board members to comply with all statutory, regulatory and self-regulatory responsibilities;
- require the board of directors of these entities to annually review the performance of each board member;
- require these entities to have procedures to remove board members if the member’s conduct is likely prejudicial to sound and prudent management; and
- prohibit these entities from linking the compensation of public directors and other non-executive board members to business performance.4
Should the SEC pursue similar governance proposals? And are there other proposals that we should consider – such as a role for the SEC or another impartial body in selecting directors – to ensure that the boards of clearing agencies, SEFs, and exchanges put the public’s interest in competition, transparency, and safety and soundness ahead of commercial interests?
This rulemaking raises many crucial issues, and I have reservations about whether today’s proposal adequate addresses all of them. Ultimately, however, I am willing to vote to publish the proposing release so that the Commission can benefit from the views and information we will receive through the notice-and-comment process.
In conclusion, I join my colleagues in thanking the staff for their work to date on this project. I urge the staff not only to carefully consider the comments that we receive, but also to affirmatively seek out the information required to ensure that we identify all of the relevant conflicts of interest and that we create strong rules that adequately address them.
1 Hugh Son, “AIG’s Trustees Shun ‘Shadow Board,’ Seek Directors,” Bloomberg (May 13, 2009), http://www.bloomberg.com/apps/news?pid=newsarchive
2 OCC’s Quarterly Report on Bank Trading and Derivatives Activities, Second Quarter 2010, http://www.occ.treas.gov/ftp/release/2010-113a.pdf.
3 Sec. 806(b) of the Dodd-Frank Act provides that the Board of Governors of the Federal Reserve may authorize a Federal Reserve Bank to provide to a designated financial market utility, such as a clearing agency, discount and borrowing privileges in unusual or exigent circumstances.
4 Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities Regarding the Mitigation of Conflicts of Interest, at 26-28, http://www.cftc.gov/ucm/groups/public/@newsroom/documents/