Werewolves of Change:
Remarks before the ISDA Derivatives Trading Forum on Regulatory Change
April 28, 2021
Thank you, Scott [O’Malia], for that kind introduction and for inviting me to be part of today’s Derivatives Trading Forum. I will begin with my standard disclaimer that the views that I represent are my own and not necessarily those of the Securities and Exchange Commission or my fellow Commissioners.
Indeed, that disclaimer is particularly important at a time of leadership transition. We just last week welcomed a new chairman—Gary Gensler. Although he is still getting settled in, the Commission will soon be busy addressing the issues that he identifies as priorities for the coming months and years. Chairman Gensler is, of course, something of a known quantity for many of you in this audience. Those of you who have been in the industry for a while had the opportunity to see him hard at work during his tenure as chairman of our sister agency, the Commodity Futures Trading Commission. Indeed, Scott [O’Malia], as a Commissioner of the CFTC, worked alongside Chairman Gensler during that time. Those of you who have come to the industry more recently are doing business under a regulatory framework for swaps that is, in large part, the product of Chairman Gensler’s vision. I anticipate that he will apply the same work ethic and outlook to his new role as Chairman of the SEC, informed, of course, by the experience that we have had with that regulatory framework in the intervening years.
Before we turn to some issues that Chairman Gensler faces as he begins his tenure at the SEC, let us look back to a 1940 speech relevant to the theme of today’s forum by a prior chairman of the SEC, Chairman Jerome Frank. He explained that, while change for its own sake is not praiseworthy, sometimes even when legal change is needed—as it might be in response to a new technology—people resist it. He observed that change pushes people, who have an affinity for routine, out of their comfort zone:
Recognizableness confers immense emotional satisfaction. The new requires adjustment, reorientation. Disequilibrium results which is unpleasant, fatiguing. Interruption of routine demands reflective thinking, keeping the mind in suspense while making judgments. And there is pain in every suspended judgment. Most of us, most of the time, are routineers who want to avoid that pain, that uncomfortable condition of tension. The old settled ways do not provoke mental discomfort, do not awake us from pleasantly tranquil dogmatic slumber.
He closed the speech with an enticing line from a short story by Peter Fleming, brother of James Bond author Ian Fleming. The protagonist in that short story “describes his uncle as a man ‘not cursed with overmuch imagination, who saw no reason to cross frontiers of habit which the years had hallowed into rigidity.’” Chairman Frank went on to explain: “That uncle, who detested the unusual, had, be it noted, a child who was a werewolf.” “The story,” Frank concluded, “is a parable.”
Unable to resist Chairman Frank’s teaser, I proceeded to disregard my aversion for scary stories and read The Kill. In Fleming’s tale, the werewolf son, rejected by his creature-of-habit father, takes revenge on the heirs installed in the disowned son’s place by ripping out their throats. Had I not been guided by Chairman Frank’s literary analysis, I am quite sure that I would not have spotted the parable about the importance of getting out of our comfort zones and adapting to change. Read through Frank’s filter, the message seems to be that if you do not embrace change, change will grab you ruthlessly by the throat—an appropriately cautionary watchword for today’s forum on regulatory change.
With that unsettling thought in mind, let us talk about LIBOR. As you all know well, most LIBOR tenors will disappear by the end of this year, and the rest will be gone a year-and-a-half later. A month ago, Randy Quarles, Vice Chair for Supervision at the Federal Reserve, acknowledging that “[a]djusting to a new reality can be difficult,” made it very clear that “[t]here is no scenario in which a panel-based USD LIBOR will continue past June 2023, and nobody should expect it to.” Trillions of dollars of contracts that reference LIBOR, however, remain, and market participants have continued over the past year to build LIBOR into contracts. Some of these LIBOR-based contracts have effective fallback language to address the impending cessation of LIBOR, but many do not. Making the shift to alternative reference rates presents an unprecedented mix of legal, operational, systems, and business challenges across the financial industry and the broader marketplace. In the eyes of one regulatory observer, this transition marks “the largest financial infrastructure change to date, surpassing in size and complexity the conversion to the Euro and the Y2K conversion.” Unlike the Y2K conversion, we are not going to wake up one day to realize we have nothing more to worry about; we will be waking up to thorny LIBOR transition issues years from now.
I appreciate the work that ISDA has done to help facilitate the transition among participants in the derivatives markets with its fallbacks protocol and more generally with its early appreciation of the magnitude of this change and the importance of alerting market participants to it. Outside of the world of large swaps dealers, many market participants are not as far along in confronting and addressing the issue. The SEC continues to pay close attention to developments in this area. Through the Alternative Reference Rates Committee (ARRC) and other avenues, the SEC has been working closely with our fellow regulators, regulated entities, and issuers to make sure that we all are taking steps to deal with the risks and challenges this change presents.
Given the number of entities and contracts affected, staff across the Commission are working on the LIBOR issue. Last summer, for example, our Division of Examinations issued a risk alert highlighting an examination initiative that would be looking at regulated firms’ LIBOR transition readiness. Among the issues of concern that the alert identified were (1) exposures to LIBOR-linked contracts extending beyond the expected expiration date, (2) operational readiness for transition to alternative reference rates, (3) adequacy of disclosures to investors regarding firms’ efforts to transition away from LIBOR, and (4) potential conflicts of interest arising out of the transition to new reference rates. Staff across multiple SEC divisions and offices have been working with other regulators and communicating with regulated firms and issuers to identify and address other areas of concern. In January, for example, the staff warned that LIBOR discontinuation “could have a significant impact on the municipal securities market and may present a material risk for many issuers of municipal securities and other obligated persons.”
Earlier this month, a subcommittee of the House Financial Services Committee held a hearing on LIBOR, which included representatives of the SEC and a number of other federal financial regulators. The hearing centered around a piece of legislation under consideration in Congress that would provide fallback language for contracts that do not contain such language. It is modelled on a recently passed New York law that would insert a replacement rate into “tough legacy contracts” that do not have fallback language. This kind of legislation would override private contracts, which is a serious matter, but the alternative is a lot of litigation, which is also a serious matter.
As consideration of this legislation and other issues related to LIBOR transition continue to draw attention, the SEC will continue, in the words of our prior Chairman, Jay Clayton, to “encourage registrants to proactively transition to market-based reference rates and [to] stand ready to assist market participants.” Chairman Gensler is well equipped to lead the SEC’s ongoing work in this area. In fact, when he was Chairman of the CFTC, he was already making the case for moving away from LIBOR. He acknowledged the magnitude of such an undertaking, but thought it worth the difficulty because “continuing to reference such rates diminishes market integrity and is unsustainable in the long run.” Apparently, not one to fall prey to the werewolves I mentioned above, in calling for “a smooth transition,” he said “I recognize that change can be hard, but change is also a natural part of life.”
As we move away from LIBOR because its precision masks a much more ambiguous reality, I am disconcerted that neither regulators nor market participants have learned the deeper lesson that the LIBOR debacle teaches us, namely the dangerous power of metrics that distort reality by creating the illusion of precision. We have not yet fully accounted for the costs of disentangling ourselves from the LIBOR web, yet we are rushing headlong into adopting measures in the ESG space that themselves convey an impression of precision while being very poorly calibrated to identifying meaningful responses to the problems that are cited to justify their adoption. A common brown-to-green rating scale, for example, that appears to be a simple, useful tool in assessing an issuer or financial product, might in fact prove to be a simplistic measure that tells us nothing meaningful or that even inadvertently promotes environmentally destructive capital allocation. Before we align the entire financial system around measures that convey an enticing, but perhaps inaccurate degree of certainty, we ought to reflect on our LIBOR experience. Former Governor of the Bank of England Mark Carney explained the problem with LIBOR this way:
Libor is meant to measure the short-term unsecured funding costs of banks. But the reality is that, since the financial crisis, Libor really has become the rate at which banks don’t lend to each other. Bank funding markets have changed enormously. Banks no longer take sufficient short-term wholesale deposits to form the basis for a robust transaction-based Libor benchmark. As a result Libor is overly reliant on expert judgement rather than actual transactions. And global markets remain overly reliant on Libor, a benchmark that may not exist beyond 2021. That reliance is neither desirable nor sustainable.
Similarly, we can build a neat set of ESG metrics that then get incorporated into a whole array of financial transactions, but if that neat set of metrics represents expert judgment rather than reality, will not capital be misallocated? If it conveys a false sense of confidence, will its mere presence not mislead investors and others?
As hard as it is to measure the rates at which banks lend to one another, it is even harder to measure how green a particular investment , issuer, or transaction is. Consider the decision about whether to invest in a multifamily apartment company. An investment in the company might get the green light under existing taxonomies if the company announces plans to rip out all the natural gas stoves in its rental units and replace them with new electric stoves. Yet, whether that decision really is green would depend on many factors, including whether the stoves need replacing, whether the old stoves will end up in a landfill, what kind of environmental effect the manufacture of the new stoves will have, and how the electricity to power the electric stoves will be sourced. An energy project might get good green marks if it involves wind rather than fossil fuels, but can those marks incorporate the effect of wind turbines on bats and thus on pesticide use? These are perhaps overly crude examples, but the point is that a lot of factors need to be weighed when making capital allocation decisions.
We all want to believe that we are making the world a better place. Helping investors to implement their ESG strategies is part of your contribution to doing so. I urge you all, however, to be cautious. As people who understand better than most others that numbers, metrics, and models can lead and mislead, you have a responsibility to your shareholders and your customers not to embrace approaches that will harm the capital markets, the financial system, or the planet. I understand there is often an immediate reputational benefit to signing on to initiatives that can be branded as pro-climate, sustainable, or ESG, but it would be ironic indeed if you tie your firms’ fortunes (along with those of your shareholders and customers) to a movement that undermines those objectives and the financial system’s ability to serve society for an illusory short-term reputational boost. I will make the same cautionary pitch to my own agency as we too seek the reputational boost that ESG standard-setting would bring us. These issues are important ones, which only underscores the need to proceed with care.
Another more pedestrian issue on the agenda, but one where Chairman Gensler’s experience will be an asset, is overseeing the implementation of the SEC’s security-based swap framework for dealers. Thanks to the efforts of former Chairman Clayton, that registration regime is set to go live in the fall. One of the unexpected pleasures that I had during my first three years as a Commissioner was the opportunity to work closely with Chairman Clayton on to complete work on our security-based swap dealer rulebook, something that was incomplete when Chairman Clayton arrived at the SEC. Before becoming a Commissioner, I raised many concerns about the Dodd-Frank Act and how regulators had implemented it. When I became a Commissioner, though, my job description changed. Congress had charged the SEC with standing up a framework to regulate the security-based swap market, that work was unfinished when I arrived at the Commission, and it was now my responsibility as a member of the Commission to work to complete it.
During the nearly three years of my partnership with Chairman Clayton on this project, the Commission was able to refine the Commission’s approach to several aspects of cross-border application of our rules; to provide tailored, time-limited relief intended to ease implementation by allowing reliance on existing CFTC frameworks; and to finalize the capital and margin requirements for security-based swap dealers and major security-based swap participants. We also were able to issue the first substituted compliance determination, which I hope has helped pave the way toward effective and efficient regulation of this global market.
Much work remains to be done before the regime goes live in the fourth quarter of this year. We have issued a substituted compliance order for Germany, and we have two outstanding proposed substituted compliance orders (for France and the United Kingdom). The comment period closes for these proposals on May 3. If you have comments or concerns, please get them in on time, and if you have not already talked to the staff, please do so. My hope is that the Commission will be able to move quickly on finalizing these orders, and your timely engagement with us and our staff is essential to achieving this objective. Similarly, if your firm expects to rely on substituted compliance in a jurisdiction other than the ones I mentioned, please do what you can to ensure that the application for that jurisdiction is completed as soon as possible, including by reaching out to the local authorities if necessary. Time is running short: Analysis of these applications takes time, as does implementing necessary changes to your systems and operations.
Other aspects of the security-based swap regime are less pressing, but nevertheless on the agenda. For example, we have not adopted a registration regime for security-based swap execution facilities (SEFs). We issued a proposal in 2011 and reopened the comment period in 2013. Given the developments in the industry in the meantime, we might want to reopen the comment period again before moving to a final rule. Regardless of how we proceed with the SEF regime, the security-based swap markets would not seem particularly conducive to mandates to centrally clear or trade on a SEF.
Along with LIBOR transition, implementation of the security-based swap dealer regime has been on the agenda for a long time now and was going to happen regardless of who became chairman of the SEC this year. If your firm is facing unexpected challenges in either of these areas, I hope you will reach out to the Commission. Given the importance of moving quickly, it is good that we have a new chairman who can hit the ground running on these issues. Chairman Gensler knows these markets well, and I think he understands the importance of helping market participants navigate the challenges of operating a global business across a patchwork of local regulatory frameworks in various stages of development. If other implementation challenges remain—for example, I have heard some concerns persist regarding implementation of initial margin requirements and trade reporting requirements—please continue to engage with us.
I suspect that many of you are wondering what other changes you have to look forward to under the new leadership at the SEC and other agencies. I share that interest and look forward to hearing Chairman Gensler set out his priorities for the coming months. Market events, of course, will dictate some of the agenda. The staff is working on a report about the events related to meme stock trading earlier this year, and some regulatory initiatives may come out of that work. Similarly, as we understand more about the failure of Archegos Capital Management, discussion about regulatory changes might be appropriate. As usual, commentators have gotten a head start and have identified a number of regulatory responses, including possible regulation of family offices and enhanced disclosure requirements for synthetic stock positions created through the use of total return swaps and possibly other derivative instruments. Determining which proposed regulatory response will develop momentum is hard, and resisting that momentum once it has started is even more difficult. Let us not assume, as regulators so often do, that there is a problem and that since something needs to be done, any “something” will do. Let us instead carry out the necessary analyses to determine whether there is a problem that market participants cannot resolve on their own.
Preventing family offices from losing their fortunes is not in the category of problems that the SEC needs to step in to solve. I am much more interested in expanding access to our capital markets so that less well-heeled families can build their fortunes. Similarly, the mere fact that trading desks at some financial institutions lost a lot of money should not cause us a great deal of concern as long as their activity was consistent with our rules. The very nature of trading in the financial markets means that trading desks occasionally will lose money.
Financial regulators do have a legitimate interest in risk management at regulated entities, and it may be worth exploring whether there were problems in this area that need to be addressed. But even here, such events inevitably serve as lessons for risk managers (underscored by the demotions and firings that followed the Archegos failure), but they need not serve as justifications for more regulation. The counterparties of market participants like Archegos have the strongest incentive to get their risk management processes correct and to determine whether those processes have weaknesses that need to be addressed. I encourage you all to take this responsibility seriously, to identify weaknesses, and to work to remedy them.
Thank you for the chance to join you today. I would be happy to take your questions now. More importantly, looking forward to a road that is likely to be rich with regulatory change, I extend an offer to you to talk to me about how we can make that road smoother. The goal is to achieve the intended objectives without unnecessarily inhibiting the ability of our markets to achieve their objective of serving people. Working together appropriately to adapt the regulatory framework to market developments, I am sure that we can keep the werewolves at bay.
 Jerome N. Frank, Chairman, SEC, Address before The Association of the Bar of the City of New York: Fairness and Feasibility, 10 (Mar. 27, 1940), https://www.sec.gov/news/speech/1940/032740frank.pdf.
 Id. at 11.
 Peter Fleming, The Kill (1931), https://www.scaryforkids.com/kill/#:~:text=The%20Kill%20is%20a%20classic,Alfred%20Hitchcock's%20Bar%20The%20Doors.
 Press Release, Financial Conduct Authority, Announcements on the end of LIBOR (May 3, 2021), https://www.fca.org.uk/news/press-releases/announcements-end-libor.
 Randal K. Quarles, Vice Chair for Supervision, Keynote Remarks at “The SOFR Symposium: The Final Year,” an event hosted by the Alternative Reference Rates Committee (ARRC) (Mar. 22, 2021), https://www.federalreserve.gov/newsevents/speech/quarles20210322a.htm.
 Id. (noting that the ARRC “estimates there are approximately $223 trillion in financial contracts based on USD LIBOR.”).
 The End of LIBOR: Transitioning to an Alternative Interest Rate Calculation for Mortgages, Student Loans, Business Borrowing, and Other Fin. Products: Hearing Before the Subcomm. on Inv. Protection, Entrepreneurship, and Cap. Mkt. of the H. Comm. On Fin. Serv. 117th Cong. (2021), https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=407534 [hereinafter The End of LIBOR Hearing], 1 (statement of Daniel E. Coates, Senior Associate Director, Federal Housing Finance Agency), https://financialservices.house.gov/uploadedfiles/hhrg-117-ba16-wstate-coatesd-20210415.pdf.
 See, e.g., The SOFR Symposium: The Final Year (ARRC broadcast Mar. 22, 2021), https://players.brightcove.net/62612260001/ZvrDIQ1n6X_default/index.html?videoId=6242777314001 (including a panel of representatives of non-financial corporations discussing that many borrowers were not being offered non-LIBOR alternatives).
 See Examination Initiative: LIBOR Transition Preparedness, Risk Alert, SEC Office of Compliance Inspections and Examinations (June 18, 2020), https://www.sec.gov/files/Risk%20Alert%20-%20OCIE%20LIBOR%20Initiative_1.pdf
 See, e.g., Public Statement, Division of Corporation Finance, Division of Investment Management, Division of Trading and Markets, and Office of the Chief Accountant, SEC, Staff Statement on “LIBOR Transition” (July 12, 2019), https://www.sec.gov/news/public-statement/libor-transition.
 Office of Municipal Securities, SEC, Staff Statement on “LIBOR Transition In The Municipal Securities Market.” (Jan. 8, 2021), https://www.sec.gov/municipal/oms-staff-statement-libor-transition-municipal-securities-market.
 The End of LIBOR Hearing, supra note 8.
 See Memorandum from the FSC Majority Staff, to Members of the Committee on Financial Services, on the Apr. 14, 2021, Subcommittee on Investor Protection, Entrepreneurship, and Capital Markets Hearing entitled, “The End of LIBOR: Transitioning to an Alternative Interest Rate Calculation for Mortgages, Student Loans, Business Borrowing, and Other Financial Products, 5 (Apr. 12, 2021), https://financialservices.house.gov/uploadedfiles/hhrg-117-ba16-20210415-sd002.pdf.
 See S.B. 297, 238th Leg. Sess. (N.Y. 2021).
 Public Statement, Jay Clayton, Chairman, SEC, Statement on Developments Related to the LIBOR Transition (Nov. 30, 2020), https://www.sec.gov/news/public-statement/clayton-libor-2020-11-30.
 Public Statements & Remarks, Gary Gensler, Chairman, Commodity Futures Trading Comm’n, Remarks on LIBOR before the Global Financial Markets Association’s Future of Global Benchmarks Conference (Feb. 28, 2013), https://www.cftc.gov/PressRoom/SpeechesTestimony/opagensler-133.
 Mark Carney, Governor, Bank of England, Speech at the Markets Forum 2018, Bloomberg Headquarters: Staying Connected, 5 (May 24, 2018), https://www.bankofengland.co.uk/-/media/boe/files/speech/2018/staying-connected-speech-by-mark-carney.pdf.
 Robert Bryce, Not In Our Backyard: Rural America is fighting back against large-scale renewable energy projects, Center of the American Experiment, 12 (April 2021), https://files.americanexperiment.org/wp-content/uploads/2021/04/Not-in-Our-Backyard-Robert-Bryce.pdf.
 Press Release, SEC, SEC Issues Substituted Compliance Order for Germany and Notice of Substituted Compliance Application and Proposed Substituted Compliance Order for France (Dec. 22, 2020), https://www.sec.gov/news/press-release/2020-332.
 Press Release, SEC, SEC Issues Notice of Substituted Compliance Application and Proposed Substituted Compliance Order for United Kingdom and Reopens Comment Period for Notice and Proposed Substituted Compliance Order for France (Apr. 5, 2021), https://www.sec.gov/news/press-release/2021-57.
 Registration and Regulation of Security-Based Swap Execution Facilities, 76 Fed. Reg. 10947 (proposed Feb. 28, 2011) (to be codified at 17 C.F.R. pt. 240, 17 C.F.R. pt. 242, & 17 C.F.R. pt. 249), https://www.federalregister.gov/documents/2011/02/28/2011-2696/registration-and-regulation-of-security-based-swap-execution-facilities.
 Reopening of Comment Periods for Certain Rulemaking Releases and Policy Statement Applicable to Security-Based Swaps, Exchange Act Release No. 34-69491, 76 Fed. Reg. 10947 (proposed Feb. 28, 2011), https://www.sec.gov/rules/proposed/2013/34-69491.pdf.