- Why the CFTC is the right agency to take control of the over-the-counter derivatives market
- The two "complementary regimes" needed for reform
- Why reform efforts failed in the '90s
- How to overcome today's obstacles to reform
Gensler became chairman of the Commodity Futures Trading Commission in May 2009. He previously served as the U.S. Treasury Department assistant secretary of financial markets (1997-1999) and under secretary of domestic finance (1999-2001). Before joining the Treasury Department, Gensler worked at Goldman Sachs for 18 years. This is the edited transcript of an interview conducted on Aug. 6, 2009.
So you've been out in front advocating for ... regulation of derivatives. Explain what you're thinking at this point.
I believe that we need to bring broad reform to the over-the-counter derivatives marketplace. We must lower the risk for the American public and increase the transparency of these markets. We have a gap in our regulatory structure today, and unless we fill it, we won't be able to, as I said, lower the risk of the system and increase transparency.
The financial system failed the American public; it terribly failed the American public. And the financial regulatory system failed the American public. And there are many parts of that failure, but one of the failures is that we have not been regulating the over-the-counter derivatives marketplace.
Some people will write that credit default swaps [CDS], other derivatives basically took the economy to the brink of disaster last year. Explain why, or your view of that.
My view is that there are many root causes of this terrible calamity in the markets, in the financial system -- great global imbalances in savings rates and economic imbalances, but also that the financial system itself, and the financial regulators, failed the American public, because only part of that is the derivatives. But the over-the-counter derivatives allowed a great deal more risk to be taken in the system, and it also allowed certain financial companies, unregulated by and large, to take such a dominant amount of risk that it put homeowners in every state and ordinary citizens at great risk.
The Commodity Futures Trading Commission was set up to oversee risk markets for not only agriculture commodities but also futures, which are a form of derivatives, and energy products and then financial products. Every day an American can turn on their TV and see a little report as to what some things called the Dow Jones futures are trading, or the stock market's futures, S&P [Standard & Poor] futures. We oversee the markets in these instruments.
We also believe we have to regulate derivatives that are not currently on exchanges. We need to bring them onto exchanges, bring them into central regulation. And the CFTC, along with the Securities and Exchange Commission [SEC], can bring a great deal of expertise to protect the public. ...
The Commodity Futures Trading Commission has not historically regulated these over-the-counter derivatives, what some people call swaps. This was because of its statute, it was because of numerous court cases, and it may have just been also due to the culture of the markets at that time.
What we need to do now, though, is we need to work with Congress to make sure that we have affirmatively the authority to regulate these markets.
This is the right place for that?
The Commodity Futures Trading Commission is an agency that oversees risk markets and the derivatives marketplace called futures. We think we have great expertise in this regard. But working along with the Securities and Exchange Commission, because there's some products that should come under their jurisdiction as well, I think that we can get this right for the American public.
During the '90s, especially mid- to late '90s, these products were growing much more complicated, and the markets were growing and growing. … You were at Treasury. What was the attitude toward regulation of these products? …
A great deal has changed since the 1990s in markets. They've grown far more global in nature. They've grown far more electronic, recalling that the Internet was not even a factor in the 1992 presidential election, and now in this last election so much was done on the Internet.
Well, that's true about markets as well. In the early to even the mid-1990s, markets were either with people on the floor of the New York Stock Exchange, or these markets would be with brokers and traders on telephones. So much has changed even in the products that were being issued. These markets in the 1990s were primarily, if not almost exclusively, helping manage risk in interest rates and currencies.
And in the last five or eight years we had this new product called credit default swaps [that so] raised proportions that it brought down this large insurance company, AIG [American International Group].
How was Alan Greenspan viewed back then?
He was the chairman of the Federal Reserve. The Federal Reserve had done a great deal as a central bank to help promote a very strong economy. During the Clinton administration, 22 million jobs were created. We went from a period of deficits to surpluses. So I think that there is a very positive public and congressional feeling about the economic times and the economic stewardship. ...
What was the general attitude at that point about the role of the regulatory agencies, about what regulation was good or bad, when it was too much? …
Well, I can only speak to my view. My view is that the American public best benefits from a regulated market economy. There's three words there: "regulated market economy." President [Franklin Delano] Roosevelt recognized this in the 1930s when he called for Congress to adopt regulations to both regulate the securities markets and the commodities markets. That's when we ended up with the Securities and Exchange Commission, something called the Commodities and Exchange Act that set up our agency subsequently.
And that's why I believe we need to do this in this derivatives marketplace, the over-the-counter derivatives marketplace as well, to bring greater transparency and lower risk in the markets today.
You ask about the 1990s. … Knowing what we know now, I believe we should have done more to protect the American public at that time through stronger, more vigorous regulation.
We did push for many things that were not achieved. We pushed for regulating derivative dealers, the big houses that deal in these products, that were affiliated with the Wall Street investment banks. That was not achievable at the time through the legislative process.
We pushed, in fact, along with the Department of Housing [and Urban Development (HUD)], ... to bring more rules of the road for selling mortgages to the American public, particularly subprime mortgages. And I personally testified on the Hill on this. It was not achievable through the legislative process at the time. But I think we should have pushed harder. I think we absolutely should have pushed harder to bring greater transparency and protect the public.
Brooksley Born becomes head of CFTC in 1996. She seemed to have a different point of view toward regulation than some of the other powers that be. What was your role at that point? You were at Treasury. Can you explain what your role was?
I was part of [the] Treasury group supporting the secretary and the deputy secretary. I was an assistant secretary of the Treasury for financial markets, so my primary role was helping to determine how we went from deficits to surplus, and that we actually paid down the debt, was what I spent a lot of time on. But I was also [advising] the secretary and the deputy secretary with regard to capital markets. ...
How was it to work there? What was the feeling of where you guys were going, what you were doing, what your role was?
[Secretary Robert Rubin] was open to ideas and very inclusive throughout the building. He saw that we should be open and available to the White House when they had various policy debates that he wanted us to be supportive of, and staffing them on various things. He's a very able leader who listened to all points of view, made sure that we ran a process that got outside points of view as well. ...
CFTC at some point puts out a concept release [a report released to the public outlining a proposed rule change] asking multiple questions about how to deal with some of these markets. ...
It's a period of time I wasn't directly involved, so I can't speak for the Department of Treasury. I was involved later. The Commodity Futures Trading Commission did not, at that point in time, regulate, nor did any other regulator regulate these markets, here in the United States or in Europe.
The agency was raising very good questions at the time about these markets. ... The questions that we've raised now are well informed by reading the concept release that I went back to and read very closely and have kept by my side. ...
There [was] a debate ... in this period as to the outstanding contracts that were in this very complex marketplace and their legal enforceability. [Under] most interpretations of the laws, they were fully enforceable. But there was a modest, small risk as to whether they were enforceable. ...
[In] the over-the-counter derivatives marketplace -- which was not regulated by any U.S. regulator, European regulator or Asian regulator -- there were hundreds of thousands of contracts measured in the trillions of dollars. And most interpretations were they were all legally enforceable and they were good contracts. But there was a small uncertainty, based upon how the statutory language was written, as to their enforceability. And even a very small question that the lawyers were raising -- various lawyers in the markets and various lawyers in regulatory agencies -- was addressed by Congress later in a bill [Commodity Futures Modernization Act] that they passed in 2000. It seems now in hindsight a small issue, but that was what led to that legislation in 2000.
... Were we overconcerned at that point? …
I think looking back now, based on what we know now and how the markets have developed -- and a lot has changed since then in terms of the marketplace -- we should have done more to bring broad reform to this marketplace. The legislative initiative that occurred during that period of time did do some very good things. It for the first time brought forward in statute ways to do centralized clearing. And even today there's a big debate about centralized clearing, but for the first time we were able to do it in statute.
We did recommend to do more. We recommended to bring greater oversight to the derivative dealers affiliated with the Bear Stearns and Lehman Brothers and so forth. We were not able to achieve that in Congress. But we should have done more. We should have recommended really mandating a lot more reform in this area. I doubt, if I might say, that it would have gotten much legislative support given the times and given some of the particular leadership of the committees. But I still think, knowing what we know now looking back, we should have done more.
Why was Born sort of onto this early? She was sort of a lonely voice. What was she worried about?
I think now, being chairman of the Commodity Futures Trading Commission, there's a lot about … the expertise that this agency brings -- this is the one agency that oversees the derivatives marketplace, a slice of the derivatives marketplace we call futures, by statute we have exclusive jurisdiction over that. And there's such a similarity between futures and swaps, and they're sometimes almost indistinguishable. I think being chairman of this agency certainly informs me in terms of what I'm promoting, and would naturally inform any chairman, I would think.
Being in the seat that you're in now, that Born was in at that point, [is there] a natural sort of feeling that this is a territory that you need to take care of, because if you don't no one else will?
I think this is a great agency, and the people in this building are thinking nearly every day about the derivatives marketplace, whether it's the derivatives marketplace we call futures or the derivatives marketplace we call swaps or over-the-counter derivatives. They're thinking about both.
And if I can just use a term -- the reason it's called "over the counter" is because it's not on an exchange. It's as if you walked into a store and you just personally bought something over the counter. In this case you go to a large Wall Street firm and do a transaction, currently not regulated. It wasn't regulated in the 1990s; it's not regulated now. We should regulate them.
What should be and should not be on the exchanges?
I believe strongly that we need two complementary regimes. We need to regulate the dealers, these 20 or 30 large global financial firms that issue these derivatives. How should we regulate them? We should make sure there's a lot lower risk, and we do that by capital and having margin requirements. Capital means money put to the side in case of crisis and so forth.
We're going to enhance the integrity of markets by business conduct standards, protecting the public against fraud and manipulation, and lastly, [promoting] transparency by record keeping and reporting. …
But I don't think that's enough. I think we also need to mandate that the standard product, the product that can be put onto an exchange and put onto what's called centralized clearing, be done.
Why is that? An exchange, just like the New York Stock Exchange or the Chicago Board of Trade for agricultural commodities, brings transparency. That means anyone in the public could know what the price is, what somebody is willing to buy or sell this risk contract [for]. And even though they're very complicated contracts, if it's a small hospital in your township, if it's a small school, or even a large business in your state, they could then look to this exchange and say, "This is where it's priced." They'd get the benefit of that.
Some people will argue -- and they argued back then -- that these deals are being done between two very savvy organizations. These are not private citizens; you don't need the government overview. Your point of view on that?
My point of view is that … these big institutions still would benefit, and the public, 300 million Americans, would benefit if we lowered the risk in this system and we add to transparency. Every end user, every institution, even if they're big and savvy, would benefit from knowing what some other institution just paid for just one of these things. We would promote economic activity, I believe, if we brought a lot of sunlight into this area. ...
Give us an understanding of what [the Long-Term Capital Management hedge fund] case was, why it was considered to be such a serious event, and how you got involved in it.
I joined the Department of Treasury in the fall of 1997, and this was a period of time that many nations were having economic difficulty and difficulty paying their own debts -- Korea, Indonesia, Thailand; subsequently in 1998, Brazil, Russia. It's come to be called the emerging debt crisis or the emerging-market debt crisis. But what we know is there was a lot of uncertainty in capital markets and a lot of uncertainty as to whether this would come back and affect the American public and their pocketbooks and their jobs and their livelihoods.
In the fall of 1998, just around the period of time that Russia, as a nation, was about to default on their debt [and] there was great uncertainty about Latin American debt, a hedge fund in Connecticut called Long-Term Capital Management went to the brink of its existence. ...
How did you hear about it? Take us to that moment.
I was familiar with Long-Term Capital Management as an entity. It was one of the largest investment funds, which we called hedge funds at the time. And it was run by very prominent individuals who once worked, I believe, at Salomon Brothers and elsewhere. So in my role as an assistant secretary for financial markets at the Treasury, we stayed abreast of some market dynamics.
But most particularly, I received a phone call. I was at home, and I got a call, as I would often get a call from the Treasury operator. And the Treasury operator said, "The secretary's on the phone for you." And it was Secretary Rubin on a Saturday. And I even remember the call, because my then-1-year-old was sitting on my lap trying to take the phone from me, and the secretary of the Treasury wants to have a conversation with me about this hedge fund that apparently was about to go under. So that's when I learned about it.
He shared some things with me over the phone that he had learned from the Federal Reserve, and shared with me that there were going to be some meetings the next day in Connecticut at Long-Term Capital Management.
As it developed, after that phone call I actually joined the Federal Reserve that Sunday in Connecticut.
How serious a problem was this viewed to be? Why was it a serious problem? What were the concerns about the reverberations through the system? ...
Long-Term Capital Management was a hedge fund that had a significant balance sheet. I think it was over $100 billion. But it also had very large positions in the over-the-counter derivatives marketplace. And if it came down, the question -- and all it was was a question -- is, how would that affect the American public? How would that reverberate through the system and affect everybody's livelihood in the country?
So we were monitoring it. We went up to Connecticut that weekend. The Federal Reserve then took some steps to coordinate a private-sector solution. I mean, there was no government money that was put in, but a group of 10 or 12 private-sector institutions came to put some temporary money in Long-Term Capital to then wind it down.
There was a temporary solution to avoid the bankruptcy of Long-Term Capital Management, which we thought would happen by that Wednesday. We thought maybe it was going to last two or three more days. And it was a question mark. Nobody really knows what would have happened if it went under. But the Federal Reserve of New York coordinated some meetings for a private-sector resolution, and then Long-Term Capital Management was unwound over the next 18 months or two years.
And the lessons learned? I mean, there were a lot of people that were very concerned about this and thought that this did bring up some points that needed to be dealt with about regulation, about over-the-counter derivatives. What were the lessons learned, or not understood well enough, at that point?
I think there are many lessons learned from that circumstance then. And then, even looking back 11 years now, you can take them in the context of the crisis that we went through last year. But at the time, the lessons actually came together in a report (PDF) of the President's Working Group that following spring. We felt that as a group -- and I helped to staff that report, because it's a report of the secretary of the Treasury and the head of the Federal Reserve -- some of the lessons [included] that we needed to do more to regulate these markets [and] that the private-sector firms also needed to do more around risk management, their risk with these entities.
I believe the report (PDF) that following [fall] was the first time we recommended greater oversight of derivative dealers which were affiliated with the Wall Street investment banks. It led to some of our recommendations later to have what's called centralized clearing of these derivatives.
But, looking back 11 years later, I think there's additional lessons about some of the moral hazard, what happens when government gets involved, even in a private-sector solution in the financial markets. ...
Did we miss something? Were there things that should have been learned from Long-Term Capital that were not learned?
I believe that looking back now, all of us, with the lessons we have from the 11 years passed, should have done more to protect the American public. Long-Term Capital Management was ... smaller ... than these large institutions, the AIGs and the Lehman Brothers and the Bear Stearns that brought the financial system to the precipice last fall. But I do think that there are lessons from that period of time about what we have to do going forward now. We have to lower the risk in the system.
One of the big lessons from Long-Term Capital Management is also that we have to make the system less interconnected. We live in a system that's highly connected, a global system. We all can go on the Internet and communicate with somebody in Malaysia or in France, or buy products. But also the financial system is similarly connected. If one big institution is going to fail, tumble, it's so connected it might bring down the other institutions and bring down the American public. And I think that the great lesson we started to see in Long-Term Capital Management, it was rather interconnected even for a hedge fund.
And I believe that's why we have to regulate derivatives now. We have to have these things called clearinghouses that help lower risk. They make the system less connected, these big financial institutions. I believe in a sense we need to be able to let the system be less connected and thus, if one institution were to fail, less prone to hurt the American public. …
Some of the recommendations were fully supported at Treasury and the CFTC, but not necessarily at the other federal regulators. Some of the recommendations were supported by housing markets between HUD and Treasury, but not necessarily at the Federal Reserve. I think that that was a challenge for us at the time. But also there were different times and different leadership of committees, and different philosophies of the times.
So Congress was not totally onboard?
There were many members of Congress that would be onboard, but it usually takes the leaders of relevant committees, too.
… What's your view of the 2000 CFMA [Commodity Futures Modernization Act]?
... The American system was regulating futures, but not these other things, over-the-counter derivatives. We need to do that now. We need to regulate these over-the-counter derivatives. ...
I think we must do this now. I think there is the consensus among experts, among academics, and most importantly, if I might say, among political leadership here in Washington.
I do believe that some of the animal spirits are coming back, though, to Wall Street, and there's going to be those challenges that are inevitable in any public debate, that the big derivative dealers will raise questions about what we're saying, because we're talking about regulating these big Wall Street institutions, and regulating them for more capital to lower risk. ... We're talking about greater transparency for the public. Again, these big Wall Street firms might have a little bit different point of view.
So I believe the consensus exists. I believe we must do this. But I recognize that there will be a debate from the other side.
And the people say that that other side is like five lobbyists for every congressman. It's a very difficult fight to fight when you've got the banking industry against you, and there is a gathering steam here of a battle to come. What are the difficulties you must overcome to push forward with some of these regulations?
I think that it's a battle worth fighting, and it's a battle to protect the American public, to bring greater transparency and lower risk. One of the challenges is this is a very complex, detailed world. So in discussing this with members of Congress, we have to bring to it, as an agency and as an administration, enough technical expertise so that we can help not only inform the public and inform Congress about these matters, but when somebody takes the opposing point of view, that we understand that point of view and we know how to sort through what sometimes is like a dust storm of complexity.
Why is this important?
It's very important because we can't let this happen again. … You could be living in Iowa as a farmer, or you could be living in Maryland as a doctor and have no relationship with a company called AIG, and wake up one day and $180 billion of your money -- this is the American public's money; this isn't Wall Street's money -- had to go into an insurance company that was so lightly regulated that the system might have come down if they failed.
[How much of a factor was the era of deregulation that Alan Greenspan and others represented in causing the recent crisis?]
I think there are many factors in this crisis. The financial system failed the American public. The financial regulatory system failed the American public. There were also imbalances. I mean, we as a nation were saving far too little and borrowing far too much. ...
With the current laws, you could have done so much more. That's why, as chairman of the Commodity Futures Trading Commission, I'm not only asking Congress for these new authorities, but I also believe in our current authorities. We have to use all our current authorities that we have. I'm not sure that the prior administration had the same attitude about using all the current authorities that we have, as well as working to get new ones. ...
Looking back a lot of people will ask, what if Born had gotten her way? What's your view on that? ...
I believe there were many factors that led to this crisis: global imbalances; a regulatory culture of an administration; gaps in our regulatory system; mortgage sales practices that preyed upon the American public. I think all of us looking back think about this, and think, what could we have done more? If we could have done just any one of these factors, it certainly would have been helpful. But there was more than just one factor that, I believe, led to this crisis.
... Historically speaking, looking back, what do we take from this?
I take with it that we have to do more to protect the American public.
And as far as Brooksley [Born's] legacy?
I'm honored to be chairman of the Commodity Futures Trading Commission, to sit in the office that Chair Born sat in. I'm honored that she takes my calls and we talk, and I can seek her advice. I think she has a great place in the history of this agency. ...
People say the CFTC is sort of a backwater ... regulatory agency. Does CFTC have the power, does it have the budget, does it have the ability to really oversee this very complicated and huge market?
Upon getting to the CFTC, I was delighted to find really terrific expert staff here, but not enough. During the prior administration, this agency was shrunk over 20 percent. I mean, there's fewer people here now than in 1999, and the markets have grown fivefold. So the markets are five times bigger, and the place has one out of five people left. This math seems upside down to me.
So working with Congress, we need a lot more resources. But we do have the expertise; we just need more of it.