Speech by SEC Commissioner:
Defining Dealers and Major Participants in the Swap Market Taking into Account the Lessons Learned in the Financial Crisis
Commissioner Luis A. Aguilar
U.S. Securities and Exchange Commission
December 3, 2010
American businesses are among the best in the world. These businesses have become successful because of the American culture of hard work, honesty, and creative thinking. Successful companies also understand the need to take calculated and measured risks.
Swaps are important to commercial business
Every day, companies across the country open for business and, in doing so, take on risk. These risks include:
- credit risk — such as manufacturing cars and leasing them to consumers,
- interest rate risk — such as borrowing under a floating rate credit facility; and
- market risk — such as offering equity compensation to hire and retain talented workers.
Businesses should be taking on these and many other kinds of risk to grow their companies and, ultimately, the economy. It is these risks that give rise to companies’ use of swaps as a mechanism to transfer risk to other parties who are willing to take it on.
The responsible use of swaps and other derivatives is an important way to facilitate this transfer, and as a result, American businesses can engage in better risk management. There can be little doubt that the market for swaps is significantly larger than the traditional cash markets, at least in part, in order to accommodate the demand for risk management.
Use of swaps led to significant damage
In the recent financial crisis, however, the use of swaps directly and indirectly contributed to the damage to the financial system. Our task is to balance the avoidance of similar damage in the future, and the facilitation of companies’ ability to continue to engage in risk management transactions. Thus, it is essential that a stronger, more robust swap market emerge. Investor confidence, certainty and transparency are important components of such a market. In addition, greater transparency and liquidity in the swap market should benefit companies by improving the beneficial aspects of hedging, such as reducing the cost of capital.i
Earlier this year, Congress and the President enacted the Dodd-Frank Act to reform Wall Street and to, among other things, improve the swap market. Congress recognized that “Gaps in the regulatory structure allowed … risks and products to flourish outside the view of those responsible for overseeing the financial system. Many major market participants, such as AIG, were not subject to meaningful oversight by federal regulators.”ii
The financial reform legislation seeks to close these gaps by empowering regulators to establish a comprehensive regulatory regime for swaps. Under the Dodd-Frank Act, swaps will be regulated by the SEC and the CFTC, and, in particular, swap dealers, security-based swap dealers, major swap participants and major security-based swap participants are required to be registered and regulated.
Today’s proposal aims to establish the parameters of this new regulatory regime, and defines who is and who is not a dealer and who is, and who is not, a major participant subject to regulation. I am pleased to support the proposal as it facilitates commercial hedging activity while attempting to reduce systemic risk, enhance transparency and improve customer protection.
As we establish the new regulatory regime covering swaps, regulators must use their new authority given in a judicious, but effective, manner in order to begin to correct and prevent the problems that contributed to the crisis. In so doing, we should incorporate the lessons learned in the financial crisis.
Lessons from the financial crisis
What are some of these lessons? Congress found that “excessive risk taking by AIG and certain monoline insurance companies, as well as poor counterparty credit risk management by many banks, saddled our financial system with an enormous—and largely unrecognized—level of risk.” iii When measuring risk and valuing securities, it is well documented that many of the assumptions used and conclusions reached by financial industry participants turned out to be wrong. As Treasury Secretary Geithner has put it, “in this financial crisis you saw … [c]atastrophic failures in judgment by people running these institutions”iv and that the problems in the shadow banking system “was a pure failure of market discipline.”v
Relying on market participants to set regulatory parameters
There are aspects of today’s proposal that would look to the industry in establishing essential parameters and standards. Have we done so judiciously? To that end, I encourage commenters to help us to assess whether, and to what extent, regulators should rely on industry judgment and practices.
For example, the proposal being put forward today permits market participants to measure their current mark-to-market exposure to swaps using “industry standard practice” for purposes of determining whether an entity has a sufficiently “substantial position” -- such that registration as a major participant is required.vi Under the proposal, an entity would be a major participant in security-based swaps if an entity’s current uncollateralized exposure in a major category of security-based swap is $1 billion or more.vii Under this test, the key measurements will be (1) the gross exposure and (2) the value of any collateral posted against it. For each of these important determinations, the proposal relies on market participants to themselves measure the exposure and value the collateral, pursuant to “industry standard practices.” Recent history indicates that valuations can be unreliable, particularly in periods of irrational exuberance or market turmoil.viii
Industry standard practice generally requires positions to be valued at the termination price,ix which should be generally appropriate,x provided the execution of this principle is responsible. I know that industry standard practice often tries to get it right, and that many industry participants often take the lead in making improvements to practices that are seen to be deficient or have led to past mistakes. I commend those efforts. Industry should not be afraid to lead. In fact, they are often in the best position to act quickly and effectively. And I know many market participants are, particularly these days, being conservative in their decision making. I also am aware that the rules we are proposing today, including those that would rely on market participant valuations, fit within a larger system of rules being developed for the swap markets. These other rules may facilitate better discipline and valuations,xi and may otherwise indirectly reduce the likelihood of collateral valuations that are unduly risky.xii
However, we were just recently in a time where industry standard practice resulted in significant damage to the financial system from which the entire country continues to suffer. Market participants went ahead with risky practices because they feared that, if they did not, they would lose business or employees — they felt they had to ‘keep dancing while the music played,’ even if they had concerns.xiii It is also well documented in examples and results that market participants held rosy, but incorrect, views of the strength of their risk management systems.xiv We must keep these lessons fresh in mind when crafting rules.
It is not hard to imagine a future time period, similar to technology stocks in the 1990s and real estate in the last decade, where a class of assets could sharply rise in value. In fact, I hope that time comes soon based on strong economic fundamentals for the sake of the public as a whole. However, a time of rising asset values also could be a time when financial entities, in the pressure to keep business, might become too generous in valuing collateral posted by swap counterparties or otherwise engage in imprudent risk management. We must craft rules that will serve the public interest in good times and bad - when market participants are cautious and when they are more susceptible to irrational exuberance.
The issues related to measuring exposure also apply to valuing collateral. It is important that the value of collateralization posted against positions is conservative. Historically, there have been questions about whether collateralization really provides enough safety against risks to the financial system. For example, “counterparties’ current credit exposures [to Long Term Capital Management] were in most cases covered by collateral.”xv Moreover, as the Report of the President’s Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management explained,
collateral can mitigate credit risk in trading relationships, it does not eliminate it. For example, the liquidity support provided to a hedge fund may be withdrawn during periods of stress when it is most needed. This vulnerability of the fund, in turn, can affect other hedge fund counterparties, especially those that use collateral to control credit risk. In other words, the requirement to cover the mark-to-market exposure with collateral can foster a false sense of security because a hedge fund’s ability to post collateral may evaporate, leaving the counterparty that relies on collateral with the unsatisfactory prospect of liquidating positions in a declining market.xvi
So I will be interested in the views of commenters on measuring exposure and valuing collateral, and particularly on how the final rules should strike the appropriate balance between relying on market participants and limiting financial industry discretion.
Commercial hedging exclusion
Another lesson from the past crisis is the harm that can flow from gaps in regulation, such as exemptions and exclusions that do not strike the appropriate regulatory oversight balance.xvii I believe the hedging exclusion, as proposed, strikes the appropriate balance. The principle behind the hedging exclusion is that swaps hedging a commercial risk are unlikely to present significant systemic or counterparty risks. This should be true for effective hedges, as payments a business would need to make to its swap counterparty should be offset by profits arising from the hedged commercial activity.xviii The exclusion also should have the effect of providing appropriate flexibility to commercial enterprises to use swaps without posting margin.
There are two key fulcrum points that could enlarge or shrink the exclusion of swaps that hedge commercial risk. First, determining what risks from a business’s operations are, and what risks are not, commercial. Recognizing the statute does not simply say all swaps used to hedge a risk are excluded, and limits it to commercial risks, it seems unlikely that all risks a business faces and could hedge would qualify. At the same time, of course, we do not want to discourage appropriate commercial risk management. This is an important line to draw and I look forward to commenters views on how we should strike this balance.
The second fulcrum point that could enlarge or shrink the exclusion is determining how effective a hedge must be for it to qualify. Current accounting rules require a hedge to be “highly effective” to qualify for hedge accounting, and I understand the Financial Accounting Standards Board is reconsidering these standards to improve their workability and the financial reporting of hedging activities.xix By contrast, the proposal requires a hedge to be “economically appropriate,” to mitigate an identified commercial risk. This release explains that a hedge is economically appropriate if a reasonably prudent person would consider the security-based swap to be appropriate for managing the identified commercial risk, and the swap does not introduce any material quantum of the identified risk (such as by overhedging) and does not introduce any basis risk or other new types of risk more than reasonably necessary to manage the identified risk. Determining whether a hedge is “economically appropriate” will be a crucial determination and I particularly ask for commenters to address this component of today’s proposal.
All in all, I think the recommended approach is a reasonable proposal. If we get these concepts right, then this proposal will be appropriately tailored to serve its purpose, while not unduly introducing risk to the financial system by excluding entities from regulation. Accordingly, I look forward to commenters’ views on whether the proposal gets it right.
I will end my remarks by praising the dedication of the staff, and my own counsel Zak May, for their hard work on these recommendations. This proposal reflects the long hours and dedication over the past several weeks, including over the Thanksgiving holiday weekend, and thanks to them are richly deserved. I also appreciate the significant efforts and contributions of expertise from the Commissioners of the Commodity Futures Trading Commission and its staff in preparing the joint proposals.
i See, e.g., H Adam B. Ashcraft and Joćo A. C. Santos, “Has the Credit Default Swap Market Lowered the Cost of Corporate Debt?” Federal Reserve Bank of New York Staff Reports, No. 290, July 2007 (evaluating claims that “credit derivatives such as the credit default swap (CDS) have lowered the cost of firms’ debt financing by creating for investors new hedging opportunities and information,” and finding “no evidence that the onset of CDS trading affects the cost of debt financing for the average borrower,” but that companies “with liquid CDSs benefit from both a statistically significant and economically meaningful reduction on the interest rates they pay on their bank loans once their CDSs start to trade widely.”).
ii 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 43 (2010). See also, Id. at 133 (stating that “Some of our regulators actively embraced deregulation, pushed for lower capital standards, ignored calls for greater consumer protections and allowed the companies they supervised to use complex financial instruments to manage risk that neither they nor the companies really understood. Moreover, many actors in the financial system—the ‘‘shadow’’ banking system—have escaped any form of meaningful regulation.”).
iii Id. at 29-30 (quoting Financial Regulatory Reform: A New Foundation, Department of the Treasury, June 2009).
iv See, Interview of Treasury Secretary Timothy Geithner, Meet the Press, April 18, 2010 (stating that “in this financial crisis you saw a range of just terrible things happen. Catastrophic failures in judgment by people running these institutions.”).
v Secretary Timothy F. Geithner, Testimony Before the Financial Crisis Inquiry Commission, Causes of the Financial Crisis and the Case for Reform, May 6, 2010. http://www.ustreas.gov/press/releases/tg690.htm
vi See, proposed Exchange Act rule 3a67-3(b)(1), which provides: “Aggregate uncollateralized outward exposure in general means the sum of the current exposure, obtained by marking-to-market using industry standard practices, of each of the person’s security-based swap positions with negative value in a major security-based swap category, less the value of the collateral the person has posted in connection with those positions.” (emphasis in original).
vii See, proposed Exchange Act rule 3a67-3(a), which provides in pertinent part: “For purposes of section 3(a)(67) of the Act, 15 U.S.C. 78c(a)(67), and § 240.3a67-1 of this chapter, the term substantial position means security-based swap positions, other than positions that are excluded from consideration, that equal or exceed either of the following thresholds in any major category of security-based swaps: (1) $1 billion in daily average aggregate uncollateralized outward exposure.”
viii See, e.g., Sim Segal, The Fed's Stress Tests Are No Good, Forbes, December 1, 2010 (stating that “The financial crisis itself was caused by a combination of many different risks events. In addition to economic downturn, here are other risk events that occurred at the same time and contributed to the crisis. There was the mispricing of credit default swaps, which occurred because the swaps were essentially insurance products, and bank risk personnel didn't have the intensive actuarial risk training and expertise on pricing, reserving and setting up capital for such products. There was the mispricing of collateralized debt obligations, in part because of poor setting of assumptions. And there was the misalignment of incentives between management and shareholders, because incentive compensation wasn't adjusting for the risk exposure generated by compensated individuals.”). http://www.forbes.com/2010/12/01/federal-reserve-banks-stress-tests-leadership-citizenship-fed.html
ix Under the ISDA Credit Support Annex, “Exposure” — a measure that determines the flows of collateral between counterparties based on market movements — is defined by reference to the amounts that would be payable if the transaction were terminated.
x By contrast, counterparties to Long Term Capital Management were providing LTCM with “flexible credit arrangements” prior to LTCM becoming distressed. See, Report of the President’s Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management, April 1999 (the “PWG Report”), at 12. However, as LTCM deteriorated, counterparties began marking LTCM’s positions at liquidation price, and by doing so demanded additional collateral at a time when LTCM’s liquidity was severely stressed. See, id, at 13 (noting that “LTCM’s repo and OTC derivatives counterparties were seeking as much collateral as possible through the daily margining process, in many cases by seeking to apply possible liquidation values to mark-to-market valuations.”).
xi For example, by providing more transparent pricing of the same or similar products to those being valued.
xii For example, the capital and margin requirements that will be applicable to security-based swap dealers and major security-based swap participants pursuant to Section 15F(e) of the Securities Exchange Act established under Section 764 of the Dodd-Frank Act. It is expected that, where one party to a swap is subject to these rules, collateral instruments posted in respect of a swap position would be valued at least as conservatively as a similar instrument for purposes of calculating regulatory capital. See, e.g., Proposing Release at footnote 95 (stating that “to the extent the valuation of collateral posted in connection with swaps or security-based swaps is subject to other rules or regulations, we would expect that the valuation of collateral for purposes of the major participant calculations would be consistent with those applicable rules.”).
xiii See, Interview with Charles O. Prince, III, in the Financial Times, July 9, 2007, referring to Citigroups’s leveraged lending practices: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” See also, Prince Finally Explains His Dancing Comment, New York Times Dealbook, April 8, 2010, (“Mr. Prince said there was a great deal of competitive pressure to make these loans even though the private equity firms were “driving very hard bargains,” and had to make sure Citi had a piece of the action. ‘My belief then and my belief now is that one firm in this business cannot unilaterally withdraw from the business and maintain its ability to conduct business in the future,’ Mr. Prince said. One of the consequences of not dancing, Mr. Prince said, was that Citi could lose the private equity firms as clients and lose bankers that have those relationships. He compared running a firm like Citi to managing a baseball team where none of the players have contracts.”). http://dealbook.nytimes.com/2010/04/08/
xiv See, e.g., Merrill Painfully Learns the Risks of Managing Risk, New York Times, October 12, 2007 (describing a memorandum from E. Stanley O’Neal to employees of Merrill Lynch one quarter before the bank announced that it would take a $5 billion write-down and expected a loss of 50 cents a share, which memorandum stated “More than anything else,” Mr. O’Neal wrote, “the quarter reflected the benefits of a simple but critical fact: we go about managing risk and market activity every day at this company. It’s what our clients pay us to do, and as you all know, we’re pretty good at it.”). https://www.nytimes.com/2007/10/12/business/12insider.html
xv PWG Report at 15. http://www.ustreas.gov/press/releases/reports/hedgfund.pdf.
The proposed definition of Major Security-Based Swap Participant is designed to avoid some of the concerns about current exposure presented by the near-failure of Long Term Capital Management because the notion of “substantial position” includes future exposure. See, Proposed Rule 3a67-3(c) under the Securities Exchange Act.
In the case of Long Term Capital Management’s counterparties, their “potential future exposures were likely not adequately assessed, priced, or collateralized relative to the potential price shocks the markets were facing at the end of September 1998, and relative to the creditworthiness of the LTCM Fund at that time.” PWG Report at 15.
xvi PWG Report at 8-9.
xvii Under the statute, swaps that are used to hedge or mitigate a commercial risk are not required to be included when calculating the size of an entity’s exposure for the purpose of determining whether the entity has a substantial position in security-based swaps. The SEC and CFTC are responsible for defining the parameters of this exception in their respective regimes.
xviii See, discussion at pages 79 and 82-83 of the Proposing Release (stating that the proposed hedging exclusion “is intended to exclude from the first major participant test security-based swaps that pose limited risk to the market and to counterparties because the positions would be substantially related to offsetting risks from an entity’s commercial operations;” and seeking comment on whether “the proposed definitions appropriately exclude from the scope of the definition swaps and security-based swaps that would be less likely to pose risks to counterparties and the market, by virtue of gains or losses on those swaps being offset by losses or gains associated with an entity’s commercial operations.”).
xix See, e.g., Financial Accounting Standards Board, Proposed Accounting Standards Update: Financial Instruments (summarizing recent proposals, including efforts to simplify reporting of hedging activities). http://www.fasb.org/cs/ContentServer?site=FASB&c=Document_C&pagename=FASB%2FDocument_C%2FDocumentPage&cid=1176157940250