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  • John D. Macomber, Principal, JDM Investment Group
  • Gary Gensler, Chairman, Commodity Futures Trading Commission
  • David Wessel, Economics Editor, Wall Street Journal

January 12, 2010

JOHN D. MACOMBER:  Good evening, everybody, good evening.  Welcome to the Atlantic Council.  My name’s John Macomber, and on behalf of my fellow trustees, some of whom I see right around in front of me, and on behalf of the whole staff, I want to welcome you to our session today with Gary Gensler.

This is number five in a series that was started some time ago, underwritten by the Deutsche Bank, which is aimed at exploring the issues of, in some depth, the economic crisis and trying to figure out a way of mapping our economic and financial future.  Gary is number five and there will be a few more after – a series of people who we think represent some of the most creative and best speakers and thinkers on the whole issue of the financial issues that we’re coping with, and also, not just the definition of the problem, but the possibilities of solutions that are also practical and doable.

We’ve had a wonderful group of people.  Some of you may have been to several of these sessions.  We had, most recently, the president of the World Bank; prior to that, the head of the Deutsche Bank; prior to that, we had a couple of – two European Union commissioners – I’m purposely not getting into the names because I don’t want you to track them down – you’ll find out more about that later; the Egyptian finance minister, who brought an unusually cogent and somewhat different point of view; and the president of the Center for Global Economic Development.

So it’s been a broad spectrum of people and Gary fits in very nicely with this.  All of us are optimistic that he’s going to add a lot to our growing body of knowledge, and all of which, we will get to the point where we can put together in some sort of a package with the Congress, with all of you and with general members of the press.  In particular, he’s going to talk about the new regulations, or the regulatory environment, and the over-the-counter market, and particularly relating to derivatives.

Derivatives, I know for some of you, is sort of a dirty word.  It’s a complicated word.  It happens to be one of those little, long words that makes a very huge impact on the way our markets work and the way our whole world functions.  One very obvious point, but one that we need to bear in mind, is that as of September 10th, last year, which was my official date of when the crisis really, really began, it dramatically showed the interconnectedness of the world.

And it wasn’t a matter of, sort of, dribbling out; it happened like that.  The interconnectedness of the world and the fact that, with a crisis of magnitude in one part, within 24 hours, the rest of the world had come to a realization that we are in real trouble.  And it was not, as one of our former finance ministers of a European country said, something that the Americans have all to themselves; they soon found out it was a worldwide crisis.

Gary Gensler has had an unusually broad and varied, and I like to think, rather deep exposure and experience in this world, which enables him to bring something that we’re not always going to get from other people.  He’s had a long career in different parts of government, and of course, he has a very significant and important career in the private sector.  In the Treasury Department, from which he most recently came, he was undersecretary for domestic finance and prior to that, he had the secretary for the financial markets.

Parenthetically, somewhere along the lines, he was working with Paul Sarbanes, if I remember correctly, on something called the Sarbanes-Oxley, which is not the subject today.  You can reserve that – I’ll put him off in a corner and you can talk to him about that one later on.  The subject today is derivatives, regulation and the CFTC.  He also worked at Goldman Sachs for about 18 years, and I think at his last post, was co-head of finance.  And that was a very important job and he obviously handled that with great distinction.

So without any further ado, we’re delighted to have him here.  He’s going to add a lot to our discussion and we count on you to help him add a lot to this discussion.  Ladies and gentlemen, Gary Gensler.  (Applause.)

GARY GENSLER:  Good evening.  Thank you to the Atlantic Council for inviting me here.  Thank you, John, for those kind remarks.  I thank you, in advance, David, who I think is going to be asking me, probably, less kind questions.  But it’s great to see you as well.

The topic of your series, of course, is mapping the economic and financial future, and I think it’s of utmost importance.  We suffered through the worst financial crisis in 80 years, where the financial system and the financial regulatory system failed the American public.  And a healthy financial future requires that we bring comprehensive – Reuben; my predecessor at the CFTC, Reuben Jeffery – to bring comprehensive reform to the over-the-counter derivatives marketplace.

And I believe it’s critical that we bring transparency to this market and address the significant information advantage that currently is enjoyed by Wall Street.  This will improve pricing and lower costs for businesses and their consumers.  Now, economists and policymakers, for decades, have recognized that market transparency benefits the public.  In the aftermath of the last great financial crisis, President Roosevelt worked with Congress in the 1930s to bring broad reform to the futures and securities marketplaces.  Futures and securities were not only regulated to protect against fraud and manipulation and other abuses, but also to ensure that transparency and competition was in these marketplaces.

Companies that need to raise capital or borrow capital, for example, can see and rely upon transparent markets to see where their securities are priced.  Hedgers and speculators can use futures to trade in a marketplace and see where it’s priced.  All market participants and the public benefit from these bold reforms of the 1930s.

Today, we face a similar set of choices, but it’s in the over-the-counter derivatives marketplace, currently an opaque market concentrated with a small number of financial institutions that I would say contributed to a financial system that was brought to a brink of collapse.  Roosevelt, in his administration, recognized that transparency, a key to market-based reform, was critical to ensure that the market functions well.

We now, I believe, must bring a similar level of transparency and benefit to the public to the over-the-counter derivatives market.  The more transparent a marketplace is, the more liquid it is for standardized instruments.  The more transparent a marketplace is, the more competitive it is.  And the more transparent a marketplace is, the lower the cost for hedgers, borrowers and ultimately, their customers.

And the best way to bring such transparency is through regulated trading facilities and exchanges.  Such centralized venues not only bring greater transparency, but increase competition amongst market makers and allow these market makers to provide liquidity to the greatest number of participants.  And what does it mean when you bring competition to markets?  It usually means lowering prices and, I believe, lowering risks to the overall system.

Now, the over-the-counter derivatives marketplace actually isn’t that old.  It started in 1981 on a currency swap, I believe, between World Bank and Solomon Brothers and IBM.  But in that period of time, the derivatives marketplace has grown up quite a bit.  Now, derivatives, of course, are contracts where hedgers can meet speculators and the hedgers can hedge a risk of a future change in a price.  Early stage of the market, of course, is highly tailored, where hedgers would go into a bank and enter into bilateral transactions.

But in the last three days, this marketplace has grown significantly, ballooning to approximately $300 trillion in notional amount, nearly 20 times the U.S. economy when just measured in the arithmetic.  The contracts have become much more standardized in that period, and rapid advances in technology, particularly in the last 10 years, facilitate more efficient trading.

And yet, while this marketplace has changed so significantly over the period of time, there’s one constant.  The constant is, it remains a dealer-dominated marketplace, lacking in the transparency that I know the public so benefits from in the securities and futures marketplace.  Wall Street retains an information advantage.  When a Wall Street bank enters into a bilateral transaction with a customer, the bank knows how much the last customer paid for a similar transaction, but that information is not generally shared with the next customer that comes in.  The bank internalizes that information and benefits from it.

For example, if an oil producer comes in and wants to, in essence, sell oil in the future and protect if the price is going to go down, and then an airline comes in and wants the other side – wants to sort of buy oil or buy jet fuel in the future, worrying about the price going up – those two don’t meet in a central marketplace, but they meet with the dealer in between, the dealer knowing the information and that deal flow.

With the buyer and seller not meeting in a transparent market, the opaque over-the-counter derivative marketplace, as it exists today, Wall Street profits from the spreads between the bids and offers that are wider than they would be in a transparent market.  Now, again, this is a stark contrast to what we have in the securities and the futures marketplaces, where the public can see the price of the last transaction as the transactions move forward.

I don’t think we would tolerate this in other markets operating similar to the over-the-counter derivatives marketplace.  It would be like buying an apple in a grocery store and not knowing where it was last priced, or even deciding to fill up a tank of gas and not being able to see what the price of gas is going to be, and driving down the street into another gas station to fill up that low tank of gas.  Or it would even be like trying to put 100 shares into your 401(k) and now knowing what the last trade in that stock was.

Or just imagine a corporate treasurer or corporate CFO wanting to do an underwriting – wanting to issue stock or bonds – and not having the benefit to know where are those securities traded in the marketplace.  So I think that we need to bring the similar benefits of transparency and centralized marketplaces to the standard, over-the-counter derivatives marketplace.

Now, some have said that we can address transparency through recordkeeping and reporting and what’s called trade repositories for these swap transactions.  And I’m for that.  But that only brings transparency to the regulators – the people that would either fill my job in the future or Mary Schapiro’s job or the federal banking regulators’ jobs.  That transparency is very important to protect against fraud and manipulation and other market abuses.  But that’s not the transparency that market participants benefit from, really.

Market participants and public transparency enables them – the oil producer, the retailer –to lower their cost of hedging, see where the last transactions occurred, helps them understand whether they should even hedge a transaction and see what the pricing is.  And it’s best facilitated through exchanges or trading facilities.

Now, some opponents of reform argue that the lack of transparency really wasn’t at the center of the crisis, that the crisis had to do with other issues – mortgage sales and underwriting practices, not enough capital in the banks, et cetera, great imbalances in our savings rates and the like – and yet, I think the inability to price many complex assets was at the center of the crisis.  Let us not forget that mortgage securities derivatives and this new word that the public learned – toxic assets – of course, toxic assets are loans are securities, which were held by the banks, that were too difficult to price.

Why were they too difficult to price?  Because there was no transparent market for pricing either the assets or the components of the risks that were embedded in these contracts, or these assets.  The ability to price derivatives in a central marketplace would not only provide pricing for the rest of the derivatives marketplace, but a lot of the reference securities that are referenced off of similar risks, that are in these markets.

Now, again, there are opponents of this.  I keep listing some of their opposition.  But there are opponents of reform who’ve welcomed transparency.  In fact, they say publicly they embrace transparency in the over-the-counter derivatives marketplace, but they think there should be exceptions or exemptions for many of the transactions.  These exemptions for so-called end users – that the big banks, maybe they should be required to bring their trades to central trading platforms – the dealers to dealers – but exemptions for their customers.

This so-called end-user exception would exempt end users, possibly those that speculate, possibly those that hedge – depends on the language of these exceptions – but many businesses, municipalities, nonprofit organizations would not be required to have their transactions with Wall Street brought to transparent trading venues.  I believe exempting an entire class of transactions reduces the amount of information that otherwise would be available in the marketplace.

Now, it’s hard to estimate how much would be left out, but data by the Bank for International Settlement indicates that approximately 40 percent of the derivatives marketplace is dealer-to-dealer – between reporting dealer and reporting dealer.  So depending upon what happens to the other 60 percent and how end-user exceptions are defined, some significant portion of the standard market would be left out – left in an opaque, bilateral world, even if it’s a standard transaction.

Through seeing the price and volume of derivatives contracts in a timely manner, each actor in our economy – the retailer, the home heating oil company, the mortgage provider – can best price and lower their risk.  And so the corporate treasurer who can see, on a real-time basis, the transactions that other corporate treasurers are into benefits from seeing that.

Just as a driver gets to see what the price of gasoline is when they want to fill up their tank of gas and can see those signs along the highway, just as you can in the securities market as you’re trying to underwrite your securities, see where your stock or bonds trade, I believe that corporate America, the municipalities, nonprofits should be able to see where the transactions are going down in the standardized market.  So then and end-user exception, really, in my mind, only benefits Wall Street and doesn’t benefit Main Street or the corporations that provide services to America.

I think we also need to lower risk in the system by creating over-the-counter derivatives market transactions that come into what’s called centralized clearing.  Derivatives are intended to lower risk in the system – transferring risk and lowering risk – but a great lesson out of this crisis is, they actually concentrated risk.

They actually concentrated risk in the five or six large financial institutions – all TARP recipients – that are the main dealers.  They obviously also concentrated risk in that insurance company so many Americans learned – AIG – which, by the way, each of you might want to ask when are you going to get your $600 back.  That’s what each of you have in AIG, as an American.  It’s just $180 billion divided by the number of Americans.

But to reduce the interconnectedness of these derivative dealers, I believe we need to lower risk by having centralized clearing.  Clearinghouses act as a middleman between two parties in the derivatives trades, as they’re arranged.  And they require the dealers to post margin on a daily basis and mark to market the transactions.  Now, why is this important back to transparency?


Because some people have said that they really like the idea of transparency – in fact, they would love to be able to accommodate it – but they would hate to have central clearing required of these end users.  And they’ve even asked, is it possible to get transparency and still protect these corporate end users so they wouldn’t have to post collateral to the clearinghouses.  And I want to say today, absolutely, you can.  You can do one without the other.


Though I believe, as a public policy matter, all standard transactions should come to a clearinghouse, if Congress decides otherwise – if they decide that these clearinghouse benefits should not be there in these transactions – I believe it’s important that we bring those transactions to the trading venues – the transparent trading venues.  And in fact, it can be done.

One trading platform today already provides such a service, where an end user can decide whether they clear their transaction or not, who their counterparties are that they’ll accept, but they get the benefit of the transaction being on a central trading platform – the benefit of transparency – even though they figure out their own credit arrangements.

Now, I understand improving transparency and lowering risk would mean significant changes in Wall Street.  This is not just little tinkering around the edges.  But after the first financial crisis of the 21st century and the worst in the last 80 years, I don’t think it’s time to just tinker around the edges.  I worked on Wall Street for 18 years.  I was honored to work with talented individuals, like Reuben, who is here.  I remember when you were hired.  (Laughter.)

Highest level of professionalism, but it doesn’t mean that Wall Street’s interests are the same as the public’s interest.  Wall Street’s interest in maximizing their revenues – they’re pursuing a fiduciary duty to their shareholders, and as is so evident in the midst of this year’s bonus season, about maximizing compensation to their employees.  But they do not owe a similar interest to the taxpayers.  And in fact, they’ve made their case very actively on the Hill against many of the important aspects of reform.

But in 2008, as we watched the financial system fail, it is now time to bring the over-the-counter derivatives marketplace into regulation, to change how it functions so that this function benefits the public and protects the American taxpayers.  And I think with that, David, you come up and you start asking me those tough questions, and maybe we’re taking questions from the audience as well.

DAVID WESSEL:  Well, thank you very much.  Whoa, it’s a long way down.  Be careful.  I’m very pleased to be here, and to be substituting, but not impersonating, Fred Kempe, who many of you know is much taller than me, much smarter and speaks much better German.  But Fred asked me to do this, and I thought, what better opportunity to understand what went wrong in our financial system than have a couple of former Goldman Sachs guys and a former Lehman Brothers guy?  I mean, we’re really getting to the root of all evil here, I think, right?  (Laughter.)

MR. GENSLER:  We’ve looped you in, Reuben.

MR. WESSEL:  You did that.  I didn’t even know who he was until you pointed him out.  So he can thank you for that.  (Laughter.)  What we’re going to do – I’m just going to ask Gary a couple of questions, and then we’ll take questions from you all.  And we’ll be here until about 6:30, so that will give us about 40 minutes.  As Mr. Macomber said, Gary’s had a career both inside and outside government.  What he didn’t mention, of course, was that during Hillary Clinton’s campaign for government, Gary Gensler was, without a doubt, the highest-net-worth chauffer in American history, driving around the candidate through the wilds of New Hampshire, or wherever you were.  (Laughter.)

Gary, let me start with one thing that I want to understand.  If we’re thinking about the solutions, we have to think a little bit about the causes.  And do you think that derivatives were, at the root of this crisis, a contributing factor?  What’s the problem that we’re trying to solve here?

MR. GENSLER:  I think it’s a very good question.  I think over-the-counter derivatives were amongst the root, I might say – so more than just a contributing factor, but not the only piece.  I think that there were significant global imbalances – low savings rates, as I referred to, here and high elsewhere; I think we had considerable asset bubbles that existed in the housing markets; very poor underwriting practices and sales practices in the mortgage markets; very real problems with the ratings agencies and the process of rating these structured products.

But I do think that over-the-counter derivatives helped to concentrate risk, I think, rather than lowering and mitigating risk.  This is a real problem.  I think that, as it relates to AIG and Lehman Brothers and some of the failed institutions, they were insufficiently regulated and that we have to bring broad, comprehensive regulation to the dealers themselves – as I pointed out, we have a real weakness in the comprehensive regulation of the dealers.

But as I said, I also think that a lack of transparency is a real lesson, and though some will contend, well it’s not quite at the heart of this financial crisis, I believe that we must reform it because transparency is at the heart of well-functioning financial markets, and it could well be that if we don’t fix it, we won’t really have learned the lessons of toxic assets and hard-to-price assets.

MR. WESSEL:  So it was the dealers in derivatives who had more risk than the rest of the world recognized that caused the problem?

MR. GENSLER:  I think that – take, for instance, AIG.  AIG was a dealer.  They had about a $450 billion book of business in credit default swaps.  And that did, in essence, concentrate a lot of risk that, when externalized, was to the taxpayers.  So in essence, the people on the hook are your $600, each of you, which you haven’t gotten back yet.  And I do think that over-the-counter derivatives, where you can have significant leverage, as well, contributed in a significant way to the crisis.

MR. WESSEL:  And is credit default swaps, as kind of these insurance policies against other companies defaulting on their debt – are they a particular problem, or are they just an illustration of what you think the big problem was?

MR. GENSLER:  I think they’re both.  I think they’re an illustration of how interconnected the world – John talked about the interconnectedness, which I think is accurate and correct.  But we now live in a world where these large financial institutions are not, quote, “too big to fail,” but they’re also too interconnected to fail.  So there’s a lot of debate this week about AIG and where did the money go.

Where did your money go?  It went through AIG to other financial institutions around the globe.  Well, if AIG, quote, “had been allowed to fail,” that interconnectedness with thousands of other counterparties was because of their derivatives book.  I think credit default swaps are also an additional problem that AIG highlighted, but it’s not the only part – it’s the highest part of the narrative, but it’s not the only problem.

MR. WESSEL:  Right.  Now, you made the case, in your remarks, that the dealers – the banks – have an interest in not having transparency because they obviously benefit – a bigger bidder spread means there’s more money to be made as a dealer – so that seems logical.  But you also made the case that it would be in the interest of the end users, whether it’s farmers or John Deere or GE Capital or TIAA-CREF or whoever, to go in the direction you want.

Yet, as I read the situation, the end users are as much a problem for you on the Hill as the dealers.  So what is it that you see in their interests that they don’t see?

MR. GENSLER:  Well, I think that corporate end users are concerned that if we lower risk by having what’s called central clearing, that they might have to put up collateral, post-margin, to these clearinghouses and they’re concerned that may raise their costs.  I believe there’s no free lunch and we need to lower risk in the system and that the banking system has externalized a lot of risk to taxpayers.

But if the end users are persuasive and persuasive on Capitol Hill to have, quote, “an end-user exception” from clearing, there is a separate and very important part about transparency.  And I said in my comments, I’ve yet to meet any corporation that doesn’t want added transparency.  What they went to ensure themselves is they can get the transparency and still be exempt from a clearing requirement.  And I believe there is a way to do that.  There’s currently an exchange that does it.  It’s not used that often, but it’s technically feasible in today’s computer world.  And I think that’s a huge plus.

MR. WESSEL:  And the House rejected even that, basically, right?

MR. GENSLER:  That is correct.  It is my job and one of my lessons from the last time I served, is to continue, I believe, to make the case for what I think is good public policy.  And the Senate is another venue.

MR. WESSEL:  Can we step back a little bit and think about the financial regulation?  There was, immediately following the worst days of the crash, a great deal of anxiety on Wall Street, I think, about a rush to regulate – that Congress would do things that would seem to make sense to them now, but would strangle innovation and hurt the economy in the future.

As you know, some of those charges were made about the Sarbanes-Oxley bill that passed during the earlier crisis.  But instead, what we’ve seen is – I’m not sure what the rush to regulate – maybe it’s a resistance to regulate.  And the bill has moved quite a bit from the proposal that you signed onto with the administration, to the House version.  And Lord knows where it’s going in the Senate.  What’s your big picture, here?  What’s going on?  Why, given that we had such a shock to the system – I mean, Ben Bernanke called it, in his speech over the weekend, the worst financial crisis in modern history – a phrase that if I used in the Wall Street Journal, some editor would say, how the hell do you know that?  And yet, nothing seems to be happening very fast on Capitol Hill.  What’s your analysis?

MR. GENSLER:  Would your editors accept that it’s the worst in 80 years?

MR. WESSEL:  Probably, yeah.

MR. GENSLER:  All right, so there.  So that’s what I put in my speech.

MR. WESSEL:  Right, so you’re safe.

MR. GENSLER:  I’m safe.  I think, as the financial crisis got through the worst period in the first few months and then it appeared to stabilize and the stock market moved back a bit, that Wall Street has been able to be more successful in their advocacy on Capitol Hill to moderate the proposals.  That’s their right in our democracy and we live in a great democracy.

I believe that’s also probably what they’re doing to pursue their fiduciary duties – or what they believe are their duties.  But I think we, in Washington, have a different job.  I think we, in Washington, have the job to look out for the American public, not only to make sure that there’s not a similar crisis in the future, but that we learn the lessons from this crisis to bring greater transparency and lower risk to the system.

So I think we’re closer than we ever would have been without the crisis.  We’ve had a strong bill through the House of Representatives to regulate over-the-counter derivatives.  I would hope that we would narrow these end-user exceptions, that we would bring more transparency to these markets, but this change is part of our classic political process.

MR. WESSEL:  So are we as vulnerable today to another crisis as we were in September 2008?

MR. GENSLER:  Well, I think that we’ve done a great deal of things administratively.  I think the Federal Reserve, certainly, and the Treasury did many things along with the FDIC to ensure that we got through that period.

But we have yet to do anything to regulate the over-the-counter derivatives marketplace, so I think on that, we’re about where we were.  Though, of course, the bank regulators better understand this market, though AIG is effectively shut down that large, toxic derivatives business.  But we have yet to do anything to regulate a $300 trillion notional amount market.

MR. WESSEL:  And so how would you characterize the current health of the financial system?

MR. GENSLER:  I think, David, I’m going to leave it to the bank regulators and the prudential regulators to characterize that, if I could.

MR. WESSEL:  Okay, so now I finally got a question he’ll duck.  So do we have mikes here – or do we –

MR. GENSLER:  So if I ducked earlier, you would have turned it to the audience?

MR. WESSEL:  Yeah, yeah, right.  So here’s the deal:  Stand up – give him the mike – stand up, say who you are, and – remember – questions end with a question mark.

Q:  Jeff Steinberg.  The $300 trillion figure that you’re talking about, from the last comptroller of the currency data, 97 percent of those derivatives are held by five financial institutions.  And it seems that this is one of the factors motivating people like Paul Volcker, John Reed and, now, Nick Brady to call for a restoration of Glass-Steagall.  There’re bills in the House and Senate on this.

I’d like to get your take on whether that kind of thing would be part of a regulatory restructuring that at least ensures that depositors and borrowers are not caught up in this potential next crisis.

MR. GENSLER:  I think it’s an excellent question.  I think one of the things that we Americans are all vulnerable to is how concentrated the financial industry has become and is likely to become even more concentrated.

One just can look at other industries, whether it’s the airline industry and the auto or steel or drug manufacture industry – it’s a nature of getting increasing concentration.  And so now, as you say, there are five significant dealers in this country, and maybe five to eight overseas.

I think that substantially raises the stakes on regulating these financial institutions and having significant regulation and increased capital, and so forth, in those.  It’s why I’m so committed to trying to get central clearing for so many of these transactions; that’s why I would narrow the end-user exception.  If we can’t narrow it completely, at least explicitly say that hedge funds, for instance, would have to have their trades cleared in central clearing.

It’s one of the ways to address the very good points that former chairman Volcker raised about size, scale and scope.  In essence, that’s how I read it.  It’s to ensure that these large financial institutions have some focus, that they’re in the lending business, they’re in the securities underwriting business; but in the case of over-the-counter derivatives, that we move their transactions off the books into centralized clearing.

That’s why I’m so focused on transparency, as well.  I think transparency helps lower risk because if – particularly in over-the-counter derivatives.  If more of those are priced on central markets, then that can be a reference to other things.  So many of their assets, whether they’re loans, whether they’re mortgages, are priced in reference to these other markets.


Q:  Ed Burger (ph).  One of the things you did not mention explicitly had to do with the issue of margin rules for this area.  My understanding is that this instrument that you’re talking about, in fact, is relieved of any margin rules – relative to the securities market, at least.  Why shouldn’t the same rules, same types of rules and same level of rules be applied to this one, as well?

MR. GENSLER:  Ed, I’m glad you raised it.  I didn’t talk about margin because I was focused largely on transparency and I decided today was to talk about transparency – but next Tuesday.

I think that there’s a broad consensus that we have to regulate the over-the-counter derivatives dealers and those dealers to lower risk, we would require them to have capital.  Capital is the amount of money that an institution sort of has, not so much put aside, but they have an equity capital and maybe subordinated debt as a cushion against losses.

And then also, margin.  Margin is what is collected from the counterparties as a sense of a performance bond in case one of the counterparties fails.     I believe that margins should be applied in both the case of those that are centrally cleared – and there should be margin on the cleared transaction – and on those customized transactions that are left with the banks.  The banks should collect or pay margin to their counterparties that they keep.  And I would hope that we were successful with Congress doing it.

I think it’s a little different than the securities marketplace but it has a great similarity of trying to lower risk in the system and ensure that if one party fails, there’s enough money put aside to unwind the transaction.

And the big lesson of AIG – that’s 62 billion, one-third of the 180 billion that we talk about.  About one-third of it went out very quickly out of AIG for margin and collateral pay to other financial institutions.  I think if we had had rules that margin had to be posted on a regular basis, AIG couldn’t have gotten that out of kilter.  It would have been caught sooner and it would have limited AIG specifically, as Ed said, if there was margin requirement.

MR. WESSEL:  On the aisle, there?

Q:  Thank you.  Garth Trinkl, Department of Commerce.  You’ve spoken about the domestic setting of regulation properly but could you talk, either of you, about the international regulatory and supervisory setting going forward as the world evolves towards this – beyond G-7 toward G-20 with Europe and Japan and China and Australia having their own ideas about OT – over – they, of course, have smaller derivatives markets but if there’s the failure to get the clearinghouse system that you want, is there some way internationally that information can be provided to the IMF or the BIS to deal with some of the things that you’re concentrating on rightfully domestically?

MR. GENSLER:  I’m very optimistic that we’re going to be able to move internationally.  You mentioned the G-20.  When the president met in Pittsburgh in the G-20 in the fall, heads of state – it’s remarkable but in the heads-of-state statement, it said that we would require standardized derivatives to be centrally cleared and brought to transparent trading facilities.  In a G-20 statement; in heads of state.

The European Commission subsequently in October put out their principles for a reform that included mandating central clearing and trading of standard derivatives and higher capital charges and margin for the nonstandard derivatives.  We have different cultures, different political systems; it’s likely that we’ll have some differences.  But I think we’re moving in a fairly consistent way internationally.

But of course, that’s no excuse.  We have to do the reform here because if we don’t do it here, then it won’t occur overseas.  Some have said we can’t do it here because they’re worried all the transactions will go overseas, but I think it’s the reverse.  I think this is the one time that, if we do this, cover the whole product suite, cover clearing and trading.

It appears right now that Europe’s with us, and I think if Europe’s with us – and from my conversations with other countries – I think we will bring this together in a largely consistent manner.

MR. WESSEL:  There’s a couple over here.

Q:  Yeah, Ted Knutson with Complinet.  It’s a daily securities and banking regulatory news service.  Follow-up question to that gentleman’s:  Let’s say Congress passes derivatives regulation this year.  How quickly do you get an international regime?  Obviously, getting 20 countries to agree is going to take a lot more time than getting one country to take action.


MR. GENSLER:  Ted, I think – as I understand it, the European Commission is going to send draft legislative language to the European parliament.  They’re looking at taking that up this summer.  So that process will, of course, take its time.  I can’t speak to each individual country but I think that what you’ll find is if the U.S. Congress successfully sends something to the president this year and the European parliament does its thing this year, you’re going to see a lot of the other countries do, as well.


MR. WESSEL:  Is there significant trading in over-the-counter derivatives outside of the European Commission’s zone in our country?

MR. GENSLER:  No – well, I’ve seen estimates; there’s about 85 percent between our two zones.

MR. WESSEL:  Okay.  Right next to you?

Q:  I’m Dana Marshall.  It’s very nice to see you.

MR. GENSLER:  Hi, Dana.

Q:  Hi, Gary.  In keeping with the nature of this organization being also involved with broad foreign policy questions, let me ask you one that branches out a little bit.  I’ll ask it very broadly; you can decide how you want to answer it.  And the question is simply this:  What’s the net impact of this greatest financial crisis in the last 80 years on the successful conduct of American foreign policy?  And if you believe that there’s been a negative, how can we start to drive ourselves out of that ditch?

MR. GENSLER:  Now, Dana, I think it goes beyond my remit as the chair of the Commodity Futures Trading Commission, so –

MR. WESSEL:  So do you think that this crisis has hurt the ability of the United States to give effective advice to the rest of the world on how to run a financial system?  (Laughter.)

MR. GENSLER:  What I think – I’m a firm believer that the American public has benefited from a regulated market economy.  And one of the wonderful things that came out of the 1930s – you can debate the details – is that we had transparent, open, competitive securities and futures marketplaces.  And that was – I think it still continues to be – quite a model for other countries as other countries reformed in the ’50s to the ’90s and adopted broader market reforms.

I think we absolutely have to do the same in the over-the-counter derivatives marketplace.  I think it’s hard to hold up that same set of leadership and model if we don’t do that.  I think, clearly, the crisis means we have got to do other things, as well.


MR. WESSEL:  There was a question – did you have a question?  All right, back there and then over here.


Q:  Joe Gagnon, Peterson Institute.  So you mentioned AIG and the margin requirements, and so – as I understand it – margin requirements are linked to ratings by the rating agencies, and AIG was able to get away with what it did because it had a triple-A rating.  So would you favor scrapping that practice?

And also, more generally, do you think that where margin requirements are needed, should they be raised?  Are they high enough?  Is leverage more broadly a major cause of why this crisis was so costly?  I mean, we had bubbles before that burst which weren’t leveraged and didn’t cause the harm that this one did.

MR. GENSLER:  Margin as used in the derivatives marketplace, whether it’s in futures or in these over-the-counter derivatives, acts as a performance bond.  If one of the parties fails, there’s enough money there to basically unwind the transaction.  But as you say, there’s also a significant leverage that comes from derivatives transactions.

In AIG’s case, you saw both.  In AIG’s case, they were entering in the transactions where, as David said, they were, in essence, writing insurance.  About two-thirds of their credit default swap business was written on European banks.  European banks were buying protection and then going to the European bank regulators to get lower capital charges because they were basing it upon AIG’s good name – originally a triple-A rated name.

The other third was in the U.S. mortgage markets, but in both cases, AIG was not posting margin.  So it was like – you know, it was great.  They were basically just using the U.S. taxpayers as backstop.  I mean, they probably didn’t write that in their business plan but that’s what they were doing.

Real reform has to address that.  I think margin should be posted to central clearinghouses, that the standard transactions should come to that clearinghouses, and it shouldn’t be ratings-related.  AIG of the future would have to post margin.  And that would also, in a sense, address some of the leverage issue because once you have to start posting even a performance bond margin you have to consider how many of the trades you enter.

MR. WESSEL:  There’s one in the front row here and then the woman on the aisle and then we’ll move to this side.  Why don’t you give it to the woman in the white sweater for the next one?

Q:  Robert Turetta (sp) with International Investor.  There’s still one disconnect here that I didn’t hear you mention, and that is with the disconnect between the risk at the professional level and something that would come back to haunt them later on.  In other words, I know how attractive the commissions and fees can be for these people writing these contracts.  Teams can earn a million a week easily.  But there is a disconnect between the risk that they’re imposing on their own firms.

So similar to what some of the discussions are both in Europe and here in terms of loan portfolios being tied – you know, fees and commissions being tied to the future performance of those portfolios – is there any discussion or thought being given to how derivative contracts would also require that risk to eventually trail back to the originators?

MR. GENSLER:  If I understand your question, it’s a little bit of the heads-I-win, tails-you-lose sort of thing.  Like, if you’re writing these contracts and you work for a big bank, you can collect the fees and maybe collect compensation.  And this is a challenge.

I mean, it was a challenge when I was on Wall Street, too.  You put somebody in a trading desk and they take on a lot of risk at a firm, and it looks for a while they’re making money and they make a lot of money for themselves.  It’s a very real challenge not only of management on Wall Street but then a challenge to the taxpayers because what’s happened through the crisis is now it appears that maybe the taxpayers are going to step in to the next crisis.

And I think to the earlier question – I think it was to Ed’s question – I mean, I think at the core, we have to address this issue of sort of the moral hazard that it appears that things are so big, they might fail, and the taxpayers would step in; they’re so interconnected, we might step in.  So I focus on derivative and I say, we absolutely have to bring as much to the clearinghouses, as much to the transparent trading venues.

One small piece on the dealer regulation, I think that the SEC and the CFTC need to be able to write business conduct standards to protect against fraud, manipulation and other abuses.  And it appears that Congress will support.  But to your core, whether the individual sitting in a seat will have bad incentives, that is still an issue that I don’t think we’ve addressed in this legislation.

MR. WESSEL:  Ma’am?

Q:  My name is Sunjin Choi.  I’m a defense analyst.  Chairman Gensler, I’m interested in the current structure of CFTC; its ability to proper surveillance work.  And second, CFTC’s interaction with the Federal Reserve and Treasury.

When I look at CFTC’s activity for the past 10 years, your manpower has reduced 25 percent while market activity has been increased by six times.  So are you able to do proper work?

The second question is what if former chairman of Federal Reserve, former secretary of Treasury, former chairman of SEC invite Mrs. Brooksley Born again, how is the conversation going to start?  (Chuckles.)  Thank you.

MR. WESSEL:  Okay, so let me try and frame this.  So the first question, I think, is do you have enough staff and enough authority to do the job that you described in our fragmented financial regulatory system?

MR. GENSLER:  Our agency was shrunk quite a bit in the last administration.  With the help of Congress, we are currently back to at least the size we were in 1999.  It’s only about 600 people, by the way.  We’re actually the size of one battalion in the U.S. – you said defense.  We’re not a whole division or army; just one battalion.  It’s about 600 people.  We have put in requests for significant more funding.  I don’t want to get ahead of the president’s budget that comes out in a few weeks as to what’s going to happen there.

But we dramatically need to grow.  We need to automate a lot of our compliance and surveillance.  We are fortunate enough to get a lot of trade information and position information on a daily basis, but we’re now in a very significant systems restructuring so that we can use systems to do the compliance and surveillance in the marketplace.

In terms of authorities, David, no, we don’t have the authorities.  That’s what we’re working with Congress on.  If we get those authorities, we’ve actually recommended that we would have to increase our staff by about 240 more people.  And that’s public information that we shared with the Congressional Budget Office.  So we’d need a lot more.

MR. WESSEL:  Our second question referred to Brooksley Borne who is a former chairwoman of the CFTC, who famously tried to impose some regulation on the derivatives market and didn’t succeed.  Do you think that we would have been better off if Bob Rubin and Alan Greenspan had taken her advice?

MR. GENSLER:  I am fortunate enough to consult with Brooksley on some regular basis, even now.  I think that we need to regulate the derivatives marketplace.  And of course Brooksley had raised those questions in a concept release about 10 or 12 years ago.

And many of the questions that she raised in the concept release are the same choices and questions we’re addressing now.  Now, we’ve learned a lot in those 10 years.  And I think, looking back, looking back at that time, knowing what we know now and the evolution of the markets, we absolutely need to regulate these markets, which are the similar questions that Brooksley raised.

MR. WESSEL:  Over here?  Sarah Lynch?

MR. GENSLER:  Hey, Sarah.  Good to see you.

Q:  Hey, how are you?  Sarah Lynch with Dow Jones.  I had a transparency follow-up question.

MR. GENSLER:  Is David with Dow Jones?

Q:  Yeah, he sits next to me.  I had a transparency follow-up question.

MR. WESSEL:  Well, you know, I think just because it’s just like Goldman Sachs, you know?  We take care of each other.  (Laughter.)

MR. GENSLER:  But I left there 12 years ago!  (Laughter.)

Q:  The House bill that was passed preserved the ability of dealers to do voice brokering.  So my question is, how does that really – the fact that that was included in the bill, how does that change the status quo of the way they operate, for the most part, today?  And if that ends up getting ultimately passed into law, is that going to be a problem for getting the level of transparency that you are hoping to see out of these new regulations?

MR. WESSEL:  Can you pass the mike forward to the gentleman in the row in front of you and can you explain what voice brokering is?

MS. GENSLER:  Just to broaden out the question a little bit, what the administration proposed is that derivative transactions be brought to either fully regulated exchanges like the Chicago Mercantile Exchange or the New York Stock Exchange, if you’re thinking about fully regulated exchanges, or to trading platforms, regulated trading platforms which came to be called swap execution facilities, a term that’s really a creation of this legislation – but similar to trading venues in the securities and futures market, regulated.

And the statute does include numerous core principles and rules and gives the CFTC and SEC an ability to write further rules about these execution facilities.  What Sarah has asked is – the House passed legislation included in the swap execution facilities voice brokers and raised rightly, what does that mean?

I believe – but certainly this will be subject to more discussion with the Senate as we move forward – that they would still have to comply with all of the rules.  So whatever core principles that we would bring to the marketplace, whatever transparency and requirements for post-trade transparency to report the trades or pre-trade transparency and all of the other rules that they’d have to comply with.

Now, that might be a shift in their business model a bit.  But that’s how I read it.  But it is – you’re right to raise it because, for instance, we were concerned about every word in this statute and sometimes the way that good reform gets moderated, one might even say watered-down, is by just a couple of key words inserted in a bill and everybody has a nice signing ceremony but something gets undercut.  And so I thank you for raising the issue.

MR. WESSEL:  The gentleman here?

Q:  Peter Sharfman, MITRE.  I guess a very naïve question:  You started by describing a situation in which hedgers and speculators get together with the aid of dealers and a lack of transparency enables the dealers to make more money, presumably at the expense of the hedgers and speculators.

Given that the dealers are kind of politically unpopular these days, how do you account for the fact that your proposal has had such tough sledding in Congress?

MR. GENSLER:  Well – (chuckles) – I wouldn’t count them out.  And they have a right in our great democracy to present their case; and they present their case.  And they fax around talking points, as they have, and they’ve lobbied the Hill actively – either directly or they lobby the business community.

And as it relates to the end-user exception, corporate America, to some extent – not all of them – are concerned about this central clearing issue.  So there they have gotten some allies in a sense.  But on transparency I truly believe it’s far better for corporate America to have the transparency.

MR. WESSEL:  Can you just explain why an end user would not want to go to central clearing, because you’d have to post collateral?

MR. GENSLER:  Corporate – corporations today enter into derivative transactions with Wall Street.  And those derivative transactions help hedge a risk, but they also are, in essence, an extension of credit.  They are an extension of credit in case the market price of oil or interest rates move in the future.  And so that arrangement, if moved to central clearing, on a daily basis would have to be measured and the measurement is called marking it to market.  And on a daily basis they would have to stand behind that marking to market.

And so that’s what – there is a legitimate public policy debate.  I’m on one side of it; some of corporate America is on another side.  And I respect there is a healthy and logical debate.  There is less of that debate on the transparency.  I mean, most people want transparency; corporate America would like the transparency, I believe, if they can protect themselves about some concern about posting these margins.

MR. WESSEL:  So a question in the back there.  I think I saw someone, yeah?

Q:  Hi, Chairman Gensler, Dawn with Bloomberg News.

MR. GENSLER:  Hi.  Good to see you.

Q:  Good to see you.  Could you tell me whether or not AIG would fall under the exemption for end users under Barney Frank’s bill as currently drafted?

MR. GENSLER:  AIG would be a swap dealer.

Q:  They would?


Q:  And on the end-user exemption, how much of the current market would be exempt?  Or how much of AIG’s business would be exempt from that particular –

MR. GENSLER:  Again, it’s a statistic that is not knowable to the CFTC.  What we do know is that about 40 percent of the reported market based upon BIS data is reporting dealer to reporting dealer.  So what portion of the other 60 percent would be exempt under the bill is not discernable to myself.

Now, maybe the Wall Street firms have figured this out, how much of – how many of their counterparties could be exempt.  The words in the bill say if they are hedging a commercial risk for operating a balance sheet.

But some portion of that 60 percent – probably a significant portion of the 60 percent – but what portion, I don’t know.

Q:  But most of AIG’s business is customized, correct?

MR. GENSLER:  Oh, I’m sorry.  Your question was specific to one firm.  I was giving you a general market answer.

MR. WESSEL:  Woman here on the aisle.

Q:  Hi.  My name is Mindy Reiser (sp).  A question you may not want to answer, but you know the backlash –

MR. GENSLER:  Oh, Mindy, I’ll (duck ?) any question.  I mean, David can answer it for me.

Q:  All right.  Okay.  You know the backlash against the bonuses that some of your former colleagues have gotten.  Do you have any thoughts at all on that?  We did have a tsar at a certain point; I think he is still around dealing with compensation.  Do you have any thoughts at all you want to share with us on this matter that has exorcised editorial writers and others?

MR. GENSLER:  (Chuckles.)  Well, Mindy, you gave me an out when you said anything I want to share.  (Laughter.)

MR. WESSEL:  Well, you alluded in your comments to compensation and suggested that there was at least a legitimate issue there about whether the firms that got bailed out by the taxpayers should at this point be able to get – the individuals should get so much money.

MR. GENSLER:  Look, I mean, part of the incentive structure on Wall Street is fiduciary duty to shareholders.  Part of the incentive structure is compensation.  I mean, there has been a model on Wall Street for many years that shares generously revenues with employees.

To most of America, it seems out of balance.  When I was on Wall Street, it seemed out of balance to me and I was a benefactor of it.  And so it may well be that it’s more out of balance now or the same out of balance.  And there is significant benefit that the financial intermediation that happens on Wall Street brings to America.  But is it such a benefit at these compensation levels?  That is for other agencies and other departments.

But I do think that it’s part of the reason why Wall Street is actively engaged in advocating on Capitol Hill to moderate reform.

MR. WESSEL:  I think we have time for one more.  You asked one already.  Can we go over here?  Wait for the mike.

Q:   John Lyman.  I’m not an expert on the subject area, but I have worked in –

MR. WESSEL:  You’ve got to hold the mike towards you.

Q:  I have worked in the insurance business and I know something about trying to price environmental risk, et cetera.  Was there a fundamental problem that people were writing instruments that they just didn’t understand?  And do we have a problem that we still don’t understand necessarily the risk involved in some of the instruments that are being written?  And how do you rectify that?  It goes back to the question that was raised over here.

MR. GENSLER:  I think the question is, are there risks in the derivative marketplace that the firms that are writing these contracts or even the counterparties that are hedging don’t fundamentally understand and how do you guard against that?

I think the answer is yes, absolutely.  I think one of the number-one ways to help guard against it is transparency.  I think that corporate treasurers who could see where standard derivatives are priced and traded would be better able to guard themselves against the quick salesmen and the structured product party coming to them to sell them something.

I’ll tell one story because we’re going to close – and I won’t say the firm.  But there is a firm on Wall Street that I know this occurred.  There is this structuring desk.  The structuring desk usually sits right by derivatives parties and structure new transactions, new ideas to take to the sales force.  And the sales force goes out to the corporations and the various institutions.

So this happens across these five large firms and the others that used to exist, where the structuring desk is constantly coming up with new ideas on how to structure something – you know, CDO-squared and all of these various instruments.

Well, in one of the firms, which I won’t name, the sales force used to call the meetings “Where’s Waldo?” meetings.  Now, you remember that kids’ book where you look and you turn the pages.  Maybe some of you don’t know, but there is a book where you open the book and you’re always constantly looking for the little character with the red hat or whatever called Waldo.  And, really, it takes you 20 minutes to find the little character somewhere – and your kids, anybody who has got young kids, I still have kids that are home and everything.

Well, they called it “Where’s Waldo?” because they always knew that there was a lot of profits hidden in these transactions but it was going to take them 20 minutes or a few days after the meeting to figure out where there structuring desk – at the same firm, between colleagues – was structuring these complex derivatives, but asking the sales force to go take it to their customers.

So these are very complex transactions sometimes.  I believe if somewhere in the order – various estimates – but between two-thirds and three-quarters of this marketplace is standard enough to be brought to trading platforms.  You bring that two-thirds or three-quarters to the trading platforms then that’s a reference; that’s a real reference.  And so the corporate treasurer that is getting sold the next this or that, even if it’s customized, has some benefit to say, well, why am I doing that when I can do this standard derivative over here?

And you’re hiding Waldo somewhere in the picture.  I can’t find it, but I’ll take the one I can see over here.

MR. WESSEL:  Well, with that, I want to thank you, Gary, for being so open and for people for asking such good questions.  Thank you very much.  Any closing benediction?  (Applause.)

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