Health care wasn't the only area where the federal government launched an exchange this month designed to fix a broken system.
On Oct. 2, the Commodity Futures Trading Commission (CFTC) oversaw the launch of “swap execution facility" platforms. Called the “future of derivatives trading” by Bloomberg, these platforms are the culmination of reforms in Dodd-Frank designed to bring price transparency to the opaque and dark over-the-counter derivatives market that helped cause the financial crisis.
And, unlike the health-care exchanges in Obamacare, these electronic platforms launched without any notable problems. The Wall Street Journal reported no significant glitches, as roughly $462 billion in interest-rate swaps and $26 billion worth of credit derivatives were traded in these swap execution facilities (SEFs) in the first week alone.
To better understand both the launch of this crucial part of financial reform, as well as how the status of derivatives reform is going more broadly, I spoke with Gary Gensler, the chairman of the CFTC. This interview has been edited for clarity and length.
Mike Konczal: What is a swap execution facility?
Gary Gensler: A swap execution facility is where buyers and sellers of a special derivative called a swap can meet to enter into contracts.
Think of an exchange, like the New York Stock Exchange for stocks or exchanges for futures. These kinds of exchanges have been regulated by the federal government since the 1930s. But swap execution facilities had not been under any oversight. [As part of Dodd-Frank,] Congress decided to repeal these exemptions, with the public benefiting from greater transparency in these markets.
As of Oct. 2, we have fulfilled Congress’s mandate that these trading platforms be registered, properly licensed and come under oversight.
MK: How did the launch of the first regulated SEFs go? Were you satisfied with the start?
GG: I was pleased. Though the CFTC was in darkness due to the shutdown, we actually were able to bring some light to the swaps markets. There are 17 registered swap execution facilities. After the shutdown is resolved, we’ll have a few more. The first day of platform trading, there were about 1,200 transactions on these platforms. It’s grown, and late last week it was around 2,000 transactions a day. These are significant numbers, measured in the hundred of billions of dollars.
MK: Transparency is a key goal here, but that can mean of lot of different things. Can we clarify what we mean by transparency when it comes to derivatives reform?
GG: A central component of financial reform is bringing transparency to the dark market known as swaps. We do that in several critical ways.
First, every transaction, 100 percent of the market, after the trade is done, has to report to the public the price, volume and key terms of the transaction. And that went live throughout 2013. Like a modern-day ticker tape, you can go and see the price and volume of these transactions. That transparency did not exist before.
The second part is transparency to regulators, so they can see potential risks. And, since the beginning of this year, the derivative market has been pouring into data repositories.
The third component is that, for the many years these trades go on, sometimes for 10 or 20 years, every day while that transaction is outstanding, the dealers now have a requirement to tell their customers what they value the trade at. That was not required before.
The fourth is the transparency of these swap execution facilities and other exchanges. These provide transparency to the public before transactions occur. This includes bids or offers, or what somebody wishes to buy or sell something at a given price. That will be a significant portion of the market. This part is what was launched this month, and it will ensure that buyers and sellers know what the bids and offers are before transactions.
MK: How will the SEFs evolve in the next few years? And how will the market itself change?
GG: This is a paradigm shift. The crisis of 2008 was in part because of the swaps market, and it was, by and large, a dark market. These exchanges and other reforms brings the $400 trillion market into the light.
As for evolving, early next year there will be another important part of implementation. It will become mandatory to transact certain types of swaps through these swap execution facilities or other regulated exchanges. That’s the next critical moment.
MK: A few years from now how much of the market will still be over-the-counter?
GG: We have some data on that now. We have already implemented another key Dodd-Frank reform, which is the requirement that standard contracts be brought into central clearing. As of the middle of September, over 70 percent of the interest rate swap market was being brought into central clearing. That’s a critical component of reform. That’s also the opportunity that exists; we’ll see as much as half, and perhaps two-thirds, of the market being brought to transparent trading platforms.
MK: Could either these SEFs, or the clearinghouses you just mentioned, introduce new systemic risks or become Too Big To Fail in their own right?
GG: Let me say that swap execution facilities and trading exchanges are a place where buyers and sellers meet and trade. Though there’s some risk, I do not think that they pose a significant risk to the public.
Clearinghouses, which are a different part of reform, stand between buyers and sellers, and ensure that if one of them goes bankrupt the clearinghouse will complete the transaction. Clearinghouses have existed since the 1890s, and they have stood the test of time through wars, depression and the 2008 crisis. They are far better than leaving the risks inside the banks, though the clearinghouses have to be fully regulated and live up to strong risk management. But it’s better than leaving the risks for the next AIG.
MK: It’s been reported that the information from the derivatives market coming in isn’t clear enough for regulators to use yet. How will that evolve in the future?
GG: We do have over $400 trillion of swaps data in the data repository at this time. But it’s being reported by 87 different swap dealers and by hundreds of other market participants. So, naturally, some of the data is coming in with different formats.
What’s critical is that regulators can look at a data repository and search and filter the data consistently. There are some growing pains in any parts of reform. The data is there. It will take well into next year and perhaps longer to ensure that it is searchable in a consistent and easy way. What we’ve done is identify the 21 first data fields that have to be cleaned up and made more standard, and then we’ll go down the 100 or so data fields.
MK: One issue with the launch of these new facilities is “cross-border” derivatives, or derivatives that are executed in other countries. Do they have to follow our rules? This is a broader issue with derivatives reform, as regulators from Europe and other countries are pushing back against Dodd-Frank. How is it going, and where will it end up?
GG: Congress wanted us to not forget the lessons of 2008. That the far-flung operations of U.S. financial institutions can bring risks crashing back to here to our shores. AIG operated out of London, and it nearly toppled the U.S. economy. Many years earlier, a hedge fund out of Connecticut, LTCM, with over a trillion dollars in their derivatives book, was falling apart, and they booked their derivatives in the Cayman Islands.
Congress didn’t want us to forget those lessons. So this agency finalized guidance this year, ensuring that the off-shore branches, guaranteed affiliates and, yes, even those P.O. box hedge funds that are operated in the United States, are covered by financial reform. As of Oct. 9, those entities all have to come under the clearing, public transparency and other reforms of Dodd-Frank.
We are, though, working with European, Asian, Canadian and Austrian regulators that if there’s comparable reform in their jurisdictions then we could could defer to those reforms in those jurisdictions.
MK: Do you feel you have the support of other U.S. regulators on this? There are reports, from Bloomberg for instance, that the Securities and Exchange Commission and the Treasury Department are concerned about these reforms.
GG: I do. I think Secretary [Jack] Lew, and before that Secretary [Timothy] Geithner, have been terrific on these points. Mary Jo White and Mary Schapiro of the SEC have been fabulous. We are on a journey together with the Europeans and others. We do have different cultures and political systems and even crises. There are times where, like a good marriage, some difference come up. I was married for 20 years to a wonderful woman named Francesca, and we didn’t agree every day of the week. But it was a wonderful marriage, and we have a wonderful relationship with Europe.
There are some timing differences, as well as gaps in our regulatory regimes. Sometimes they went a little further, or we went a little further. But we have a path forward, and we’ve sorted through many issues already. And the Treasury Department and the SEC have been very supportive.
MK: There are parts of derivatives reform that haven’t ended up where you wanted them to be. The number of bids swap dealers have to solicit isn’t what you wanted, while the D.C. District Court is fighting you on position limits. What parts of reform are you nervous about not having ended up where you need them to be in order for reform to work overall?
GG: For reform to sustain itself, a critical part was to ensure we had broad support and consensus. As we operated at this commission we sought consensus wherever we can. About 86 percent of the rules or guidances were bipartisan. I think that is important for sustaining it over the years.
But throughout building consensus there are compromises. Each of us brings a different perspective to the task at hand. I feel very good about where we are. I think going forward, two critical things are there, and we’ve already mentioned them. The first is the mandate in early 2014 to trade on the swap execution facility. There will be issues as that comes about, and it’s important to have that requirement of transparency.
The second is the continuing issues that arise from the cross-border application of swaps reform. Working with Europe and other countries, there are bound to be issues there, as this is a global business. I think we’ll have to be adaptive along the way to get right.
MK: It’s been a little over three years since Dodd-Frank was passed. How do you feel the CFTC has done with rule-writing for derivatives overall?
GG: I’m so proud of this agency. We were tasked by Congress to do something quite unusual in government. And that is to bring a whole regime to what is now known to be a $400 trillion market where there was no oversight prior to that. We were tasked to do 60 individual rules and guidance, and we have largely gotten that done. We did it largely by consensus, with two-third unanimous. We have gotten to implement these reforms starting in 2012, currently with about 40 or 50 key implementation dates.
This doesn’t meant that there’s not a lot of work still to be done, and as time goes on we may need to evolve or change what has been put in place. But we have largely completed what Congress set out for us to do.
MK: Almost unique among officials in the post-crisis era, you have been involved with both designing what reform should look like, as well as implementing those general ideas into very specific rules years later. What would you have done differently if you had to start it all over again?
GG: It’s been a remarkable privilege that then-President-elect Obama asked me to serve. And I do recall sitting down with just a yellow pad with Tim Geithner and Mary Schapiro at the presidential transition and framing out what financial reform might be. Because of the remarkable work of the Congress and the White House we got this through.
When you ask what we would have done differently, Congress gave us one year to implement all this. Of course, we’ve taken three years. So, we wanted to get it right, rather than just hit the clock, but it was a more significant task than any of us really had understood in 2010.
Mike Konczal is a fellow at the Roosevelt Institute, where he focuses on financial regulation, inequality and unemployment. He writes a weekly column for Wonkblog. Follow him on Twitter here.