Global Reform for Derivatives Markets

LSE: Public Lectures and Events | Guest: Gary Gensler, Chairman of the U.S. Commodity Futures Trading Commission (CFTC)

Date: October 13, 2011

Episode Overview

This episode features Gary Gensler, Chairman of the U.S. Commodity Futures Trading Commission, discussing the challenge and necessity of global derivatives market reform. Against the backdrop of the 2008 financial crisis and ongoing global regulatory responses, Gensler details the implementation of the Dodd-Frank Act in the United States, parallel efforts in Europe (notably EMIR), and the essential need for international coordination to ensure effective, transparent, and resilient financial markets. The lecture is followed by a detailed Q&A with scholars and market practitioners.

Key Discussion Points & Insights

1. Context: The Financial Crisis and Regulatory Failure

• Gensler frames the discussion with a reflection on the 2008 financial crisis, emphasizing systemic failures—not only within financial institutions, but crucially among regulators worldwide.
• The crisis exposed how even those with no direct link to derivatives suffered severe consequences due to leverage and risk embedded in opaque markets (03:00–04:20).

"The financial system failed... but also the regulatory system itself failed."
— Gary Gensler (03:00)

2. Derivatives 101: What They Are and Their Growth

• Gensler provides a pedagogical history of derivatives:
  • Origins: Started as tools for grain farmers to lock in prices; evolved from forward contracts (requiring delivery) to futures (allowing trading without delivery).
  • Modern Swaps: In the 1980s, swaps were invented to hedge financial risks—primarily interest rates and currency exposure.
• Derivatives vastly expanded, especially in ‘off-exchange’ or ‘over-the-counter’ (OTC, i.e., unregulated) forms (06:30–07:30).

3. Role of Derivatives in the Financial Crisis

• Swaps, particularly credit default swaps (CDS), amplified risk and interconnectedness, often with little capital cushion—a key factor in the crisis (04:00–05:10).
• AIG Financial Products (headquartered in London) is cited as a major example, with $180 billion in U.S. taxpayer bailout required (04:33–05:20).

4. Principles of Effective Markets: Transparency, Competition, and Regulation

• Gensler emphasizes economic principles:
  • Markets function best when transparent, open, and competitive—citing U.S. traditions of financial regulation since the 1930s (05:25–06:30).

"Markets work best when they are transparent, open and competitive."
— Gary Gensler (05:30)

5. Dodd-Frank Act: Key Regulatory Reforms

• Central Objectives (08:44):

  1. Transparency:
     • Mandates real-time (post-trade) and pre-trade transparency for swaps—reported to both the public and regulators (08:46–09:11).
  2. Central Clearing:
     • Swaps must clear through central counterparties (CCPs), which lowers systemic risk by standing between counterparties and marking trades to market daily, requiring collateral (09:12–15:24).
  3. Dealer Regulation:
     • Dealers (mainly large banks) subject to capital and margin requirements, plus business conduct standards (15:55–18:29).

• International Comparison:

  • Europe is enacting similar reforms (EMIR for clearing; MiFID revisions for trade transparency) (09:35–13:05).
  • Critique: To be successful, regulation must be global, as risk and transactions easily move across borders.

6. The Case for Harmonization and Global Coordination

• The swaps market is enormous ($300 trillion in U.S. notional value; $620 trillion globally), and highly international (03:43; 51:24).
• Emphasizes ongoing coordination with European and Asian regulators, aiming for ‘comparable and comprehensive’ regulatory regimes to prevent regulatory arbitrage (17:36–20:27, 21:12).

"The effectiveness of reform really will depend on our partnership together."
— Gary Gensler (23:46)

7. Challenges and Potential Unintended Consequences (Audience Q&A Highlights)

a. Is International Uniformity Risky?

• Tim Frost (LSE Governor) raises: Could uniform regulations increase systemic risk if everyone behaves the same under stress?
  • Gensler’s Response (27:17): While acknowledging trade-offs, he defends global minimum standards, particularly for risk management and transparency, as migration to laxer jurisdictions would otherwise undermine reform.

"Capital and risk can at a click of a button...migrate to the darker market... I think transparency helps markets, lowers cost."
— Gary Gensler (27:17–28:41)

b. Asia and Fragmentation

• Peter Norman (researcher): Notes Asian fragmentation and asks about clearinghouse failures.
  • Gensler describes active global outreach and acceptance of cross-border clearinghouses, provided they're well-regulated. He notes past failures (Hong Kong ’87, Paris, Malaysia) and emphasizes the need for robust risk management in CCPs (30:07–32:01, 32:02–33:23).

c. Extraterritoriality and US Person Definition

• Baron Shrine (Morgan Stanley): Asks about legal definitions for cross-border transactions.
  • Gensler explains the CFTC will seek public input to clarify, but basic test is whether activity has direct/significant effect on U.S. commerce (33:30–35:37).

8. Market Structure: What Gets Cleared?

• Prof. Dempster (Cambridge) queries what proportion of the notional $620 trillion swaps market will really be centrally cleared.
  • Gensler: Dealer-to-dealer and dealer-to-financial (about 90%) are significant, especially in interest rates (likely “well over half” will be cleared) but not all products have sufficient liquidity for clearing (36:06–37:59).

9. Market Impact, Liquidity, and Cost Concerns

• Lan Sukla (ex-head, Canadian banks): Warns overregulation might drive banks out, reduce liquidity for corporates, and impact real-economy uses of ‘vanilla’ derivatives (41:02–42:35).

"We really rely on these financial institutions to be there in the future...to manage the liquidity needed."
— Lan Sukla (41:02)

• Gensler counters that public risk reduction outweighs possible lower bank profits:

"If you took one basis point...out of a $300 trillion marketplace...that's US$30 billion. All of corporate America would get some benefit."
— Gary Gensler (43:02–43:37)

10. Coordination with the SEC and Regulatory Gaps

• Audience notes U.S. regulatory overlaps between CFTC (commodities/interest rate swaps) and SEC (credit default swaps), risking inconsistent standards.
  • Gensler notes close cooperation but admits some differences persist due to distinct statutory origins and market structures (46:05–47:17).

11. Segregation, Portability & Client Protections

• Roy (industry): Highlights that customer protections in the clearing process differ between the U.S. (segregation, portability via FCMs) and Europe.
  • Gensler: Agrees—segregation and portability are crucial, with U.S. rules embedding these features (48:39–49:53).

12. Looking Forward: China and the Future of Regulation

• Gensler envisions China’s swaps market outgrowing the U.S. in coming decades, and urges them to “not take 30 years” to implement effective regulation, as transparency and risk controls must be in place before markets reach systemically risky scale (51:41–52:22).

Notable Quotes & Memorable Moments

• On the Human Cost of the Crisis:

  "Eight million Americans are still out of work. That had no connection to these exotic products."
  — Gary Gensler (42:35–42:56)

• On the Need for Consensus:

  "Effective reform cannot be accomplished by one nation alone. It will require comprehensive international response."
  — Gary Gensler (23:23–23:32)

• On Transparency’s Role:

  "The more transparent a marketplace is, the more liquid, the more competitive it is."
  — Gary Gensler (10:16–10:28)

• On Market Size:

  "There’s a $620 trillion swap market around the globe...That’s $12 of swaps for every dollar of goods and services in the global economy."
  — Gary Gensler (51:24–51:39)

Timestamps for Key Segments

• 03:00 — Systemic failures of financial and regulatory systems
• 04:33 — AIG as an example of derivatives contagion
• 06:30 — Explanation and history of derivatives, swaps & futures
• 08:44 — Three pillars of Dodd-Frank swap regulation
• 13:49 — Explanation of central clearing and its risk reduction
• 16:09 — Dealer regulations: Capital/margin requirements and risk mitigation
• 18:29 — Role of business conduct, back office standards
• 19:31 — Global coordination: Memorandums, mutual recognition, collaboration with Europe
• 23:32 — Call for comprehensive international response
• 27:17 — Should we worry about global regulatory uniformity? (Q&A)
• 36:06 — What percent of market will be centrally cleared? (Q&A)
• 41:02 — Will regulation kill market liquidity? (Q&A)
• 46:05 — Coordination with SEC, regulatory overlaps (Q&A)
• 48:39 — Segregation & portability in clearing client assets (Q&A)
• 51:41 — Gensler’s advice to China

Tone & Language

Gensler employs a conversational, sometimes wry tone, blending technical expertise with analogies (grain markets, gas stations, the cost of regulation vs. benefits). He is candid about the U.S. and Europe's unfinished business, and forthright in defending transparency and international standards as public goods outweighing private sector complaints.

Summary Takeaway

The global derivatives market is too large and interconnected for national approaches to suffice. The Dodd-Frank Act, EMIR, and related reforms mark a historic shift toward real-time transparency, robust clearing, and international consensus. But challenges remain—balancing uniformity and innovation, safeguarding liquidity without repeating past mistakes, and ensuring reforms keep pace with innovation and globalization.

Gensler’s parting message: “We ought to get the job done” with urgency and mutual cooperation, or risk repeating the very failures the world cannot afford.