Garrett Delivers Keynote Address to ISDA Conference
September 23, 2009
Scott Garrett (R-NJ) delivered the keynote address to the International Swaps and Derivatives Association (ISDA) Regional Member Conference in New York City, New York.
Garrett’s prepared remarks are below:
Thank you for the opportunity to speak with you today at ISDA’s Regional Conference, and thank you to ISDA CEO Bob Pickel and Chairman Eraj Shirvani for inviting me to participate in today’s activities.
I have a lot of respect for this organization and this industry, which has been responsible for a multitude of financial innovation as well as coordinating industry groundrules in an area that has opened up so many more opportunities for thousands of companies around the world to enhance their risk management strategies and procedures.
As a member of the House Financial Services Committee, and the lead Republican on the Capital Markets Subcommittee, I am here today to share with you one man’s perspective on regulatory and legislative developments in the area of OTC derivatives.
As you all know, there are a number of proposals currently being considered to “reform” the derivatives marketplace.
I come from a free market perspective – so perhaps more than most people, I am wary of greater government intervention in the derivatives market, or any other market, for that matter.
President Reagan famously quipped: “The nine most terrifying words in the English language are, “I’m from the government, and I’m here to help.”
While humorous, the quote obviously underscores a serious philosophical principle that I share – government should be smaller and less intrusive in the lives of Americans and should interfere less with our economy, our markets, and the nation’s entrepreneurial spirit.
There are areas of our financial markets and the relevant government regulatory structure that should be reformed, but I approach this exercise with the goal of restoring market discipline as much as possible and restricting the amount of government intervention in our markets to a level that is no more than necessary.
Certainty is needed in regards to the extent of government intervention, as its ad hoc approach has caused great uncertainty and kept a large amount of much-needed private funding on the sidelines throughout efforts to get the economy back on track.
Furthermore, government intervention, while well-intentioned, often has unintended consequences that negatively impact market participants and the overall economy.
We have already seen a number of proposals, and the outline of others, to reform the regulation of the over-the-counter derivatives markets. While Chairmen Frank and Peterson have spent a lot of time negotiating the outline of a proposal that they’re hoping both Financial Services and Agriculture committee Democrats can agree upon, the Treasury Department in the meantime has come forward with a massive and complicated proposal of its own. And it is my understanding that the Treasury Department proposal, rather than the Frank/Peterson outline, will now serve as the base document for the bill the House will consider.
There are a number of problems with the Treasury proposal that I won’t go into detail about, but I have heard to it referred to as “fundamentally flawed.” There are fundamental problems with the definitions it sets forth, it is unnecessarily complex in the way it has been drafted, and it is overly prescriptive, giving regulatory agencies too little flexibility in enforcing proposed new rules.
The European Union is also considering different ideas for regulating the derivatives markets. I was just over in Europe for several days of meetings with regulators, members of parliament and market participants, to get a better perspective on what issues folks are focusing on over there.
My worry is that politicians and others on both sides of the Atlantic are looking for proverbial “boogeymen” on which to blame our financial crisis, and derivatives have become popular products to demonize.
In the popular dialogue about derivatives, opinion often masquerades as fact. Derivatives have been demonized by many who unfortunately choose to perpetuate myths about these products, instead of developing the sophisticated understanding of how they work that serious policymaking demands. In order to do justice to the taxpayers who have funded over a trillion dollars in bailouts, as well as the thousands of businesses and investment managers that rely on derivatives to manage risk, it’s important to dispel these myths and understand the nuanced reality of both the perils and the benefits these financial products provide.
These myths extend to the over-the-counter (OTC) derivatives markets as a whole, oftentimes failing to take into account the wide variety of products available to firms within the OTC market, and threaten to apply a sledgehammer where a scalpel is needed. In reality, derivatives played a limited role in the current financial crisis, and the knee-jerk reaction to mandate clearing for all derivatives products and apply bank-like regulations to non-bank market participants threatens to create serious harm not only to financial markets but more importantly to thousands of non-financial companies that America needs to create economic growth.
AIG’s failure is often pointed to as a primary reason for the need to completely revamp the regulatory structure of the OTC derivatives market. At root, however, the problems at AIG were grounded in the company’s failure to appropriately assess the risks of its portfolios of mortgage-backed securities (MBS) and collateralized debt obligations (CDOs).
Failure to properly assess these risks was not confined to AIG. The truth about the financial crisis is that poor housing finance-related risk assessment, misguided regulatory policy and lax oversight were among the primary contributors to the economic turmoil.
Too many mortgage loans were made to individuals who ultimately couldn’t afford to make their payments, and regulators failed to appropriately identify the risk of such loose lending standards. Whether the losses came on mortgage loans, mortgage-backed securities, or credit default swaps that guaranteed mortgage-backed securities, the underlying problem was as basic as it is pervasive: too much money was loaned to too many people who couldn’t repay it.
The regulatory policies and distorted incentives that created this crisis are unfortunately still largely with us, and fixing them will require a commitment to upset established constituencies and some politicians’ longtime supporters.
Over-regulation or improper regulation of derivatives markets would represent a misguided response to problems that came out of other parts of our financial system. Although certain proposed remedies might sound good politically, they could have major unintended negative consequences, not just for our financial markets, but for our broader economy.
Mandating clearing for most, if not all, derivatives contracts and applying bank-like regulations to the broader derivatives markets are two frequently mentioned options for derivatives regulation.
While the private sector is already moving forward with several central clearinghouse proposals that should have positive benefits for the marketplace, mandating the use of central clearinghouses for derivatives contracts has the potential to restrict liquidity, limit the ability of businesses to hedge their unique risk, and tie up capital that could be used to promote business development.
In addition to mandating clearing, the regulatory reform plan advocated by the Obama administration and supported by House Democrats extends heavily flawed banking-style regulations to businesses that use derivatives by subjecting them to capital requirements, business conduct rules, and margin requirements.
And don’t forget, much of the failure in our financial markets had its roots in the heavily regulated banking sector. Are we sure we want to “reform” much of the rest of our economy by expanding this failed regulatory structure?
Another proposal that could have negative unintended consequences is a prohibition on so-called “naked” derivatives transactions. Such a proposal ignores or misunderstands the dynamics of a properly functioning derivatives market in which there needs to be a buyer for every seller and a seller for every buyer. Restricting naked transactions will reduce liquidity in derivatives markets, making it more difficult for a company to legitimately hedge its risk if you don’t allow speculators into the market to take the other side of the hedging transaction.
There are things that can be done to improve the transparency and stability of the OTC derivatives markets. The private sector is already moving forward on many of these fronts. As I mentioned above, the private sector has committed to supporting centralized clearing platforms and centrally reporting OTC trade data. Previously, industry spearheaded other initiatives to provide market stability, including the ISDA Master Agreement and the recent so-called “Big Bang Protocol”.
It is also worth noting that there have been a number of notable credit events over the last year, with the Lehman failure perhaps the most significant, and each event has been handled in a very orderly fashion by the existing OTC infrastructure.
The bottom line is that we should not be rushing this process. We need to take our time and get this right.
94% of the 500 largest global firms use derivatives to manage risk.
Rather than reducing risk, poorly-conceived regulatory reform could exacerbate it for a major portion of our economy
Much of OTC market risk is concentrated in the already heavily regulated banking industry.
My preference would be to explore to what extent regulators already have oversight responsibilities to ensure firms are taking appropriate risks and to set proper capital and collateral requirements.
It is my understanding that there will be another hearing in the House Financial Services Committee focusing on derivatives in early October. Chairman Frank has said that he would like to mark up much, if not all, of financial services reform legislation by the end of October.
While that goal is possible to reach, it would be difficult. And keep in mind that there have been several previous timetables set forth by the Chairman and the administration that have not been met:
First we heard that the Administration wanted a reg reform proposal done before the G20 meetings in April.
Then we were going to mark up resolution authority legislation by Memorial Day
Then we were going to do Systemic risk in June
Then we were going to mark up the new consumer agency and derivatives legislation in July
So, previous timetables have not been met (which is good), and this latest goal may not be either.
In the Senate, there was potential for even more delay if Sen. Dodd had left the banking committee panel to go to the HELP Committee, but he announced last week that he will be staying at Banking. Still, as difficult and complicated a process as it is to move all of the massive proposals in the House, it is even more difficult to do so in the Senate.
The stated goal by the administration is to have financial services reform done by the end of this year. That will be a very difficult goal to achieve – and I would argue that we will have rushed the process if it is achieved.
The importance of international coordination is also important to keep in mind as we move forward with the reform process. After my recent meetings in Europe, I became more aware of efforts underway over there. Mis-matched regulatory approaches could lead to more of the OTC markets moving overseas, so it is important that policymakers keep abreast of what initiatives our overseas counterparts are moving forward with.
It will be interesting as proposals move through Congress over the next several months (and potentially years) whether consensus can be reached on appropriate responses to the current crisis.
I continue to urge my colleagues to tread cautiously in an area that will impact so much of our economy.
Will Congressional responses to the crisis address the problems that actually led to the problems that we are experiencing?
I am not overly optimistic that this will be the case, but that is all the more reason for me to continue to actively engage on these issues, to encourage greater market discipline, and to articulate the free market principles that I believe are so important to the long-term strength of our markets and our financial system.
In that regard, I close my remarks with an appeal to many of the ISDA members in the room today – You need to talk with your customers -- representatives from companies that use OTC derivatives as end-users to hedge their risks – and tell them how important it is for them to weigh in on this issue with their members of Congress. And they need to weigh in soon.
Legislation to re-regulate the OTC derivatives market could move through the House Financial Services Committee within a month.
The corporate end-users of derivatives are the potential “grass roots” movement on this issue that, if activated, could significantly move the debate on this issue and the outcome of proposed legislation.
If members of Congress hear from constituent companies that proposed legislation could greatly impact a company’s ability to properly hedge its risk, then that just may catch the collective attention of those members of Congress.
Thank you for this opportunity to speak to you today and I look forward to your questions.