Why Financial Markets Need Referees

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Gary Gensler, outgoing chairman of the U.S. Commodity Futures Trading Commission, oversees a swaps market that is 25 times the size of the U.S. economy. The ire he’s garnered from Wall Street suggests that he has been effective in reining in deals that led to worldwide financial and economic collapse five years ago.

An edited transcript of the conversation follows.

Knowledge@Wharton: We are speaking with Gary Gensler, chairman of the U.S. Commodity Futures Trading Commission. Thank you for joining us today, Gary.

Gensler: It’s terrific to be back at my alma mater.

Knowledge@Wharton: Your career on Wall Street has not prevented you from being a target of criticism by your former Wall Street colleagues. And most of that is happening because of the way you would like to interpret [the Dodd-Frank Wall Street Reform and Consumer Protection Act] and other financial reforms. Now, your tenure comes to a close at the end of 2013. A lot of people [in that position] would be buffing up their plaques on the wall and starting to pack their boxes. But instead, you are involved in one of the most intense debates of your entire career at the Commission. You are also overseeing a market of derivatives that is somewhere between $400 trillion and $600 trillion or $700 trillion dollars. Could you talk about what this latest intense debate is about? It has to do with overseeing overseas derivatives and getting them, or not getting them, onto an exchange?

Gensler: Well, let me start by saying these financial contracts called derivatives or swaps were at the center of the 2008 crisis and eight million people lost their jobs in that crisis. And large businesses, like the insurance company AIG — we Americans, as taxpayers, bailed them out because they were so interconnected with the rest of the economy through the unregulated swaps marketplace. That’s what this is about — insuring that there is transparency in the markets, insuring that large financial firms have the freedom to fail rather than each of us Americans putting our hard-earned dollars in to bail out those businesses.

AIG, you might remember, had a large swaps business, which actually was run overseas. Their far-flung operations nearly brought down our U.S. economy. This most recent debate about the cross-border application was to insure that our laws are not strictly territorial, but that they actually will cover the far-flung operations — the branches and guaranteed affiliates of U.S. financial institutions. And we’ve been successful. Congress gave us those authorities and our Commission voted up guidance in July to do that.

Knowledge@Wharton: That is a parallel situation to the banks and bank regulations, correct — where “To Big to Fail” is a problem, and preventing that, partly because so many operations can be overseas. So, you face that same problem. You have, as I understand it, overseas regulators, or certainly financial folks overseas, who aren’t very happy about this and are coming to it kicking and screaming, and probably fighting it in many legal ways, too. So, what is your defense when the U.K. or some other country says, wait a minute — this transaction originated here in London. You can’t impose your regulations, Washington, on what we’re doing over here?

Gensler: Well, actually we have been on a journey together, from 2009, when President Obama got the leaders of 20 nations together in Pittsburgh — it was called the G-20 Summit. And there was broad agreement on bringing new oversight to these once-dark markets. And Europe, Canada, Japan, the U.S. — we’ve been on this journey together. They have had very strong laws in place in Europe and in Japan and the U.S. We might be a little ahead on timing, and that creates challenges because of different timing. But we really are on this journey together.

“That’s what this is about — insuring that there is transparency in the markets, insuring that large financial firms have the freedom to fail rather than each of us Americans putting our hard-earned dollars in to bail out those businesses.”

Knowledge@Wharton: So, what are the broad strokes that you agree on? I know the devil is in the details and there are some gray areas, and there are a lot of details in this.

Gensler: A fair review is that in three or four areas, we’re smack on about the same place and in a couple of areas we’re not. So, reporting to regulators, meaning all of these transactions have to be reported to regulators — that’s been going on in the U.S. since December of last year — $400 trillion of derivatives [have been] reported into the data repositories here in the U.S. as we speak. There is something called central clearing that helps lower the risk of the marketplace. It has been around for 120 years in other markets. We’ve just brought this common sense reform to the swaps market. In the U.S. we have phased it from March until October, and it is now fully in place. And the last data we had was that nearly three quarters of the transactions in the middle of September were being cleared in the interest rate markets.

Europe will put that in place sometime in the middle to second half of next year. So, there are some timing differences. And then, we have what is called the risk mitigation techniques that the various dealers have to have. [They have to] clean up their back office — the boring back office part of this. But swaps have to be documented. They have to be confirmed. They have to be reconciled. In all of those three areas we’re really in sync. I would say the one area that … we Americans have put into law and others have yet to join … is that the public benefits from transparency.

Economists have shown for decades that transparency, price and volume of transactions help the broader public. It helps the 99%-plus of the public that might use these contracts. But it does shift some of the information advantage from Wall Street to Main Street. We’ve put that in place. We have post trade reporting in the U.S. That means every transaction is reported publicly now. We’re just initiating that trading platforms as well have to be registered. But, as you might know, Europe is only now passing a law to do that as well. And I think they will pass a strong law, but there are some differences because there is about a two-year gap on the law.

Knowledge@Wharton: When that gap is closed, will there be incentives for some organizations to try to originate outside of these 20 countries? There is always the argument that if you regulate too much then things just go underground and they become less transparent. But you’re saying your agency in September helped to capture three quarters of the swaps in the U.S. But can I go to … some other country, outside of these 20 countries, and initiate my swap and avoid some of this paperwork?

Gensler: Well, risk knows no geographic border or boundary. So, what we’ve done here in the U.S. is said that if you’re a U.S. [entity] or if you’re an overseas branch of that U.S. [entity], or you’re an overseas affiliate that is guaranteed by the U.S. [entity], you are covered by these reforms. That only makes sense because we have to remember the lessons of the crisis: It’s that so many U.S. banks came asunder because of their off-shore enterprises in the Cayman Islands and elsewhere. If you want to set up in the Cayman Islands and you have nothing to do with the U.S., by all rights go ahead. But if you’re guaranteed back here by the mother ship in the U.S. or a branch back here in the U.S., then you need to be covered.

Knowledge@Wharton: Sounds like a pretty advanced state of global regulation. How would you compare that to what has happened in banking? Are the two industries … following parallel tracks? Or do you think that this swap business is maybe a little bit ahead now?

Gensler: We have been very successful at the Commodity Futures Trading Commission. We were given about 60 rules to write by Congress. That was three years ago. And as we are here today, we’ve completed 61, in fact, rules, guidances and orders. And for the last year, the markets have been coming into compliance. I’m very proud of all of the people at the CFTC. We’ve largely completed the task the President and Congress gave us. That’s partially true for bank regulation around the globe but it’s not as far along.

Knowledge@Wharton: You have been credited as saying that the CFTC is not going to allow the creation of another Enron loophole. Could you tell us what you were referring to when you said that?

Gensler: Well, there were various reforms that Congress passed 13 years ago in a different era. And as part of those reforms, there was an allowance, an exemption for trading platforms from registration. Think about it as you could operate a restaurant or maybe a casino without having a proper license, without having to allow inspectors to come into your restaurant or your casino. And that was all right — that’s where Congress was in 2000. It came to be known as the “Enron loophole” — a number of senators and Congressmen, and even Senator Obama in June of 2008, put out a release saying that they felt that we should close this Enron loophole — that we should no longer have unlicensed restaurants or casinos in the swaps trading area.

That’s what Congress did. They repealed that exemption — with rules that we completed that went into effect on October 2 of this year. Now if you want to trade on a trading platform, it has to not only have a license, but it also has to have certain business conduct. It has to be open to the whole broad public, not just to a select few. And these reforms will really help transparency in our economy.

“But swaps have to be documented. They have to be confirmed. They have to be reconciled.”

Knowledge@Wharton: You talked about a market of $400 trillion. Put that next to the entire U.S. economy, which is about $16 trillion. So, it’s a big number. Confronted with that, one has to ask though: How can you possibly regulate something so big and sprawling? What are some of the fundamental principles that you start out with when you do that? And how did you accomplish what you did?

Gensler: Here is a market that actually is 25 times the size of our economy — the notional amount. The risk is not quite that big. The fundamental principle — going back to basics — is that transparency matters. You can shift information from the few dealers to the broad public and that makes an economy work better. That is true whether it is in automobiles, where we now can go on the Internet and we can see the price of automobiles before we go into the dealership. And it’s as true and important in these swaps.

Knowledge@Wharton: Is the market your primary enforcer in a way?

Gensler: Well, beyond that, we promote economic activity and efficiency in markets, which is a fancy economic word saying that it costs you less if the market is transparent. I have three daughters and they’re young. I wouldn’t give them the keys to the car if I didn’t think there were rules of the road, if years ago, the state legislatures hadn’t passed laws to have traffic lights and stop signs and cops on the beat to insure against drunk drivers. I just wouldn’t give my daughters the keys to the car.

That’s what we were doing in this swaps market. It was unregulated. And because of the crisis, Congress said no, we have to have common sense rules of the road for the big highways of finance, the same way we might have for the back roads for my daughters. That’s the basic principle.

Knowledge@Wharton: After they ran the tractor trailer off the road.

Gensler: Well, they did…. That’s what we saw. AIG and others had fantastic accidents and they took out the bystanders. You could have been a pedestrian, so to speak, on the road and you could have been one of eight million that lost your job — having never heard of a credit default swap. My mom — she’s 86 — still asks me, “Gary, what’s a swap?”

Our job in Washington, and it’s very different from the one I once was fortunate enough to work at on Wall Street for many years, but our job is to look out for that broad public interest — transparency and lowering risk, and insuring against manipulation and fraud for the general public.

Knowledge@Wharton: It’s interesting that with the AIG bailout, which I think was something like $180 billion in the end?

Gensler: That’s right. $600 for each and every American.

Knowledge@Wharton: I know that they claimed, not that long ago, that they paid it back with interest. And I know there are a lot of folks who say that is miscounting or mis-accounting. There are a lot of other costs that weren’t added up in there, and that there was probably actually a direct loss to the taxpayer. But putting that accountability aside, what you mention is interesting — that eight million jobs were lost. [AIG was] a big contributor to that. That is never on the ledgers. That’s never counted. That is separate and apart from the $180 billion that they paid back.

It sounds like you’re concerned about that and I find it interesting because you don’t hear a lot of concern about that more generally. It tends to be about the debits and credits, and it turns into a technical discussion a lot of times, and the human side is lost.

Gensler: No, there is a very real human side beyond the eight million people that lost their jobs. Millions found themselves with homes that were valued less than their mortgages. And millions found their pensions and savings lower. Hundreds of thousands of businesses didn’t make their budget in 2008 and 2009. There are real live consequences to the public from what might be considered otherwise sort of narrow part of the economy.

Do you know that the non-finance side in our economy employs 94% of private sector jobs? And of the other 6%, most of that is insurance or community banks. Only a very small slice is what we might call Wall Street.

Knowledge@Wharton: But they produce more than 40% of the profits, I think.

“Would anybody come to the football games on Sundays if there were no referees? I mean, for a week or two it might be interesting. But after that it would not. We need referees to insure that people have confidence in the markets.”

Gensler: Ultimately, finance has got to serve the real economy. Finance is about allocating the money in society to the best uses so that my family’s savings or your family’s savings is allocated to another family that wants to take out a mortgage or to somebody who has a good idea and wants to innovate and start a business. Finance is about serving the rest of the economy. And these complex market swaps, if well regulated, are a component of serving the rest of the economy but not taking down the rest of the economy.

Knowledge@Wharton: I cite the 40%, not so much to underline the importance of the industry — of course it is very important — but to also note that there are many economists and financial observers from across the spectrum who say that that it is an imbalanced economy when you have that much of your economy based in finance.

Gensler: And economists will say if you bring efficiency to a market, you usually narrow the profit spread and can produce the same product for less cost. We all like it that our computers cost less today than they did three years ago or 10 years ago. Transparency in the swaps market will provide the risk reduction of swaps but for a lower cost.

Knowledge@Wharton: Your agency was responsible for bringing in something like almost a billion dollars worth of funds — is that correct — over the last year or so?

Gensler: Well, in the heart of the 2008 crisis, what our agency, the CFTC, found is that large financial institutions — banks — were readily and pervasively rigging the interest rate market. There is something called the London Interbank Offer Rate, which is in many of your viewers’ mortgages and student loans and business loans. And that marketplace was being rigged by major banks. We have brought four actions – collectively, there are four actions against three big banks and one broker. [The CFTC has] brought in, I think, over $2 billion to the U.S. Treasury. Somebody went back and they figured out that that added up to the last 17 years of our agency’s funding.

Knowledge@Wharton: Maybe in the future, you’ll be able to get a small cut of that?

Gensler: We’re a good investment to the American public because you need cops on the road. You need somebody looking. We’re also a good investment, I would contend, to Wall Street, though they don’t always agree with what we do. Their brand is wrapped up in the confidence in the markets. Could you imagine, would anybody come to the football games on Sundays if there were no referees? I mean, for a week or two it might be interesting. But after that it would not. We need referees to insure that people have confidence in the markets.

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