10 years after dark pools of derivatives contributed to the Great Recession, former Commodity Futures Trading Commissioner Sharon Bowen tells Kate & Luigi how she helped bring transparency to the market and visited a few grain silos along the way.
10 years after dark pools of derivatives contributed to the Great Recession, former Commodity Futures Trading Commissioner Sharon Bowen tells Kate & Luigi how she helped bring transparency to the market and visited a few grain silos along the way.
Speaker 1: You know what, right now, breaking news here. Stocks all around the world are tanking because of the crisis on Wall Street.
Speaker 2: It was a historic day with Wall Street shaken to its very foundation today.
Luigi: Hi, I’m Luigi Zingales, at the University of Chicago.
Kate: And I’m Kate Waldock, at Georgetown University. You’re listening to Capitalisn’t, a podcast about what’s working in capitalism today.
Luigi: And most importantly, what isn’t.
Kate: On today’s show, we have the great pleasure of welcoming Sharon Bowen. Sharon served as the commissioner of the US Commodity Futures Trading Commission, or the CFTC, from 2014 to 2017. Before that, she was vice chair of the Securities Investor Protection Corporation and before that, she was a partner at Latham & Watkins. Welcome to the show.
Sharon Bowen: Thank you, thank you for having me.
Luigi: Let’s start by going back to 2008. In September of that year, the world was coming to an end. On Monday, Lehman filed for bankruptcy. On Tuesday, AIG asked for the government to rescue them.
Speaker 6: What in the world is happening on Wall Street?
Speaker 7: Two-year note yields went from 190 to 166 in the blink of an eye.
Speaker 8: I have never, live, looked at the DOW Jones Industrial board and seen a 600-point loss.
Speaker 9: Who knows where this is going to end up? This is volatility we haven’t seen of course, since way before you and I were born.
Speaker 10: By what Warren Buffet once called financial weapons of mass destruction.
Luigi: Sharon, when was the first time in that ominous fall that you got a sense that this was really big and this was really scary?
Sharon Bowen: I would say it was the weekend before, I was starting to get emails to basically say don’t be surprised if you see numbers being thrown out about some investment banks being sold for $2 or some of them possibly going out of business. There were a lot of rumors over that weekend. When I woke up that morning and just saw the market just go straight, straight down, it was scary. It was absolutely scary, and I don’t think any of us really knew what it really meant. We just knew it was really bad. It was really, really bad. And you saw the pictures on the news of people packing up their boxes, businesses closing down, the restaurants that used to rely on the businesses to come to eat lunch were closed, and the dry cleaners that used to clean were closed. The taxi services and car services that used to be there closed.
Being in New York City, I saw sort of the ugly parts of the financial crisis pretty much up close and personal.
Kate: Are you allowed to talk about your clients at the time, and whether any of them were particularly affected by what happened to Lehman and AIG?
Sharon Bowen: Well, all of them were affected obviously. Lehman had been a client of my former firm.
Kate: Oh, wow.
Sharon Bowen: We knew people who actually worked there.
Luigi: When you were invited by President Obama to serve on the CFTC, did you feel like a sense of mission that here we are many years later, and we tried to prevent what happened in 2008 and as we will discuss with the listeners in a second, the CFTC plays an important role in preventing a repeat. Did you have a sense of mission?
Sharon Bowen: I did, but it actually started with my being the acting chair of SIPC, Securities Investor Protection Corporation. SIPC traditionally is a sleepy organization, but during my time, we had the Lehman Brothers bankruptcy, we had the Madoff scandal, we had MF Global. We had some of the most notorious–
Luigi: An easy time.
Sharon Bowen: Yes, and through that lens, I got to meet with many investors who were severely harmed financially from the marketplace, and as I mentioned before, seeing the devastating effects on family members and people’s retirement savings. I actually did, I really felt a calling to do it, plus as it turned out, I was the first African-American commissioner of the CFTC.
Kate: That’s amazing.
Sharon Bowen: It was quite an honor to play in that role, but as I said then at the time of my confirmation hearing, that I wanted to be a voice of the voiceless, those who traditionally had never had a seat at the table.
Luigi: That’s exciting because most people probably don’t know what the CFTC is, and you said giving a voice to the voiceless, and when people think about giving a voice to the voiceless, I don’t think they think of the CFTC as the primary place, but I think it’s a very important role. How do you explain to your kids, to your mother, to your friends what is the CFTC and why it was so important what you did there?
Sharon Bowen: There are two different ways that I explain it. For the everyday person, I try to explain how the electricity in your home, your heating bills, the gasoline you put in your car, the milk that you drink, everyday products are financed through instruments that we regulate in our commodities markets. We have our roots in agriculture. Initially, the CFTC really started as a means for farmers and ranchers and manufacturers to hedge against the future prices of products, so it’s a way for farmers and ranchers to mitigate the fluctuation of prices going up and being able to lock in today the price of a particular ingredient so they would have some certainty in terms of that price.
For other people, I will sometimes say it’s things like how much you pay for your mortgage. Interest rates, everybody’s tied to it, credit default swaps are tied to it, financial currencies are tied to it, so they’re financial instruments and obviously, derivatives, some of them a little bit more esoteric instruments, but again, they’re used for hedging.
Virtually every corporation uses it. Everyone is really affected by it, frankly, every day.
Kate: You gave the example of let’s say a farmer using commodities futures or derivatives to hedge the future price of some input, let’s say it’s like feed for their livestock, but one of the dangerous things about derivatives, correct me if I’m wrong, is that you don’t have to be a farmer in order to buy let’s say those derivatives. You could be like a regular person. It could be me, and if I want to take a bet on the price of feed going up, I could buy a derivative that will pay off if it goes up by a lot, and if it goes up by a huge amount, in let’s say like an unlikely event, chances are I won’t have to pay much to take that bet. Is that part of what makes derivatives so risky?
Sharon Bowen: Well obviously, there is speculation in our markets. You’re correct in the sense that we did hear, while I was at the agency, from some of the farmers and ranchers who really were concerned about the volatility in their markets and who thought that the high-frequency traders were in their markets and making price discovery much more difficult for them. Whenever we hear things like that from end users, we take those kinds of things seriously. We take a look at the markets, but speculation in and of itself is not bad. That is part of price convergence and price discovery, but it’s the excessive speculation and the manipulation of the market that we protect against.
Kate: By end user, you mean people who are truly using derivatives in order to hedge against risk, right?
Sharon Bowen: Correct.
Luigi: It will be useful to de-mystify the term derivatives, because people use it all the time and many listeners might say, “What exactly is a derivative?” Now, a derivative takes its name from the fact that there is a security whose payoff derives from the payoff of something else. If you own a house, hopefully you have insurance on that house and that insurance is a derivative because the payoff of that insurance derives from the payoff of the house. In that particular case, the insurance is a hedge, it protects you against the possibility of fire, earthquake, something that might destroy the value of what for many of us is the most important asset, which is your home.
Like for insurance, there are many derivatives that are meant to hedge, to cover the risk of what people do, from people planting in their harvest, to people using livestock to feed their animals, and so on and so forth. However, as Kate pointed out, in order for the market to work properly, you don’t have only hedges, you have people that provide the service with the hedges that have the terrible name of speculators, and those speculators in part serve to make the market liquid, in part may actually destabilize the market.
In the last 10 or 15 years, the number of participants in these markets has increased dramatically. And especially in many commodities markets, there used to be mostly final users, and around 2004-2005, we saw an impressive entry of the typical financial institutions, the Goldmans and Morgan Stanleys of this world, and not surprisingly, the final users started to complain because the volatility went up. What is your view on that, if you have one?
Sharon Bowen: Right, well see, taking it to the extreme, we can talk about the financial crisis, when in fact, we were not regulating those derivatives. We had no idea what was happening in those dark pools in the market, and as a result of the financial crisis, as you know, the Dodd-Frank Act came into place, and that expanded greatly the powers of the CFTC to regulate the so-called derivatives, the esoteric transactions that clearly exacerbated the financial crisis at the time. With that, extensive rules were put into place to require, for example, capital to be there that normally was not required by some of the financial institutions.
We required that they be cleared in a much more transparent way and executed on platforms. For the swaps and derivatives that were not subject to what we would call margin, we made sure that the cost of capital was even higher, so we really wanted to force onto a lit exchange those very transactions that were really dark and opaque. We had no idea what they were at the time. Through Dodd-Frank, we were able to bring some transparency to the market and to try to mitigate the systemic risk that those kinds of instruments really posed.
Kate: To clarify what you just mentioned about clearing, which was an important part of Dodd-Frank, yes, there were a lot of derivatives that were cleared prior to the financial crisis, but there were some derivatives that were sort of operating in the shadows. Let’s say I was a speculator and I wanted to just make some money by making a bet that locked in the future price of let’s say corn feed. If I were to make that bet one-on-one with my investment bank prior to the financial crisis for certain derivatives, the government might not know about it at all. This could’ve just operated in the shadows.
Part of what clearing did was not only to bring these transactions into light, make sure that somebody was monitoring them, but clearing or clearinghouses also make sure that whoever was taking the other side of the bet, whoever would have to pay out in the future, potentially, has enough money on hand, enough capital in order to meet let’s say what would happen if I were to receive some money in the bet. Is that an accurate way of describing the role of clearinghouses?
Sharon Bowen: That’s a really good job of it, I think. To bring onto the markets those transactions that were otherwise opaque. Most of those that got us into trouble were the credit default swaps and interest rate swaps and those kinds of transactions that were kind of off-exchange. You’re correct, one of the mandates was to introduce central clearing of standardized products into the market, and because of that, I mean at that time it was something like a $700 trillion notional amount market. It was a huge market that we really, frankly, didn’t know how big it was.
We have now created a whole new structure where these transactions take place in clearinghouses, and those transactions as you say are subject to margin, which is collateral, i.e. cash or highly liquid instruments to support the payment of those obligations. The clearinghouse stands in the middle of the buyer of the trade and the seller of the trade if you will, they stand in the middle and their job is to mitigate the risk that the trade would fail. That’s the purpose of the clearinghouse. Whereas before, people had to depend on each other’s credit as to whether or not they were worth the transaction.
That was the major difference in bringing clearinghouses and the transparency. At the same time, the participants in the clearinghouses were required to be registered. The third thing that happened was data had to be reported.
Luigi: Sharon, you mentioned the magic word, credit default swap. This word was unknown to the large public until 10 years ago, when it became a matter of conversation all over the country because they were one of those derivatives that might have caused or exacerbated the financial crisis. Let’s first explain what they are: credit default swaps is basically nothing else than insurance against the possibility that a borrower may default and not pay the actual amount. Instead of being an insurance written by an insurance company, it is actually an instrument traded on the market.
Here, I need to bring you back to history because historically, the CFTC did not have any authority to regulate these kind of derivatives, and a very courageous woman, Brooksley Born, in ’98 tried to actually ask for the authority to do so because she realized that these instruments were traded over the counter, which means between banks, and there wasn’t really a good understanding of what was happening, and in particular, there was a fear that too much risk was taken and this risk might materialize as it unfortunately did in September 2008.
When she insisted that, she found herself surrounded by a bunch of angry men, can I say that, starting from the Federal Reserve chairman at the time, Alan Greenspan, to the Secretary of the Treasury at the time, Larry Summers, and they actually said that this was a terrible idea and made everything possible to stop this from taking place, and so she ended up resigning. Did I tell the story correctly, Sharon?
Sharon Bowen: I wasn’t there at the time, but as I understand the story, you’re right. Former commissioner Born was one of the first to signal the problem that could be inherent in these types of products. My understanding at the time was that some of the other potential regulators, the Fed and the Treasury, thought because the transactions were between highly sophisticated investment banks trading with each other, they were sophisticated enough to be big boys playing in the same field, if you will.
Luigi: Yeah, you used the right term, big boys.
Sharon Bowen: Right.
Kate: One of the, I guess, concerns I think voiced by Greenspan and Summers and others against bringing these sorts of derivatives and swaps onto centrally cleared exchanges was that there’s some cost to having to do that, correct? You have to pay some sort of fee. You aren’t allowed to operate privately anymore. Also, you have to comply with the rules of the clearinghouse or the exchange. I think one of their concerns was that if the US started imposing these rules, a lot of these transactions would go offshore to potentially riskier domiciles. Do you think that that’s actually a legitimate concern?
Sharon Bowen: It was a concern and, you know, as a result of the financial crisis, we had the meeting of the G20 in Pittsburgh, which is really sort of the beginnings of the creation of Dodd-Frank, where the major financial centers and countries said, “We need to work together to make sure that our markets are protected globally,” because these markets are global markets, the transactions don’t stop at our borders. It’s really important, and at that time, a number of working groups, international working groups were formed to try to create standards across jurisdictions. I think our agency at the time with the CFTC, and I’m sure it’s the case today, works really closely with international regulators, particularly those in Europe, where things like interest rate swaps and CDSs are traded in a large percentage outside of the US.
You’re absolutely right, it was expensive. Industry did have to invest a lot of money, but I think it was well worth the cost to mitigate the kinds of risk that we would have such a devastating effect again. At least with the margin, having margin there and collateral—sort of the two defenses, if you will, to a failure of a clear member—that, I think, gives us the possibility that we’re less likely to have another taxpayer bailout, which was the whole point.
Luigi: Some people, not of course all, but some people interpret the cost benefit analysis as, I see a cost, I don’t see benefits, let’s get rid of all of it. That, of course, is wrong. It’s also wrong that any regulation is useful because as we were discussing earlier, there are a lot of pieces of regulation that are more burdensome than useful. Cost benefit analysis is useful, but it’s challenging, and particularly when the benefit is preserving the trust of investors in the marketplace, which–
Sharon Bowen: It’s priceless.
Luigi: It’s priceless, exactly.
Sharon Bowen: Yeah, it really is priceless. I mean you do want to have investors have the confidence to be in our markets. If they think it’s a rigged system, that’s not a good system. I think that transparency is always the key. Having fair, transparent markets, as long as we can keep our markets fair and transparent, I think you’ll have investor confidence. That works for all participants, not just investors, but competition is competition. The brokers, they compete against each other so they’re not going to want to see one person game the system over someone else either. They want to see a level playing field.
Kate: I want to switch gears, if I may. If I’m correct, when you resigned from the CFTC, you cited your lack of ability to form a quorum amongst commissioners as part of the issue. In order for there to be a quorum, there’s supposed to be five commissioners, there have to be three for there to be a quorum, but there were only two commissioners that were even standing at the time that you resigned, right?
Sharon Bowen: When I left, two new commissioners were in place. In June, I had announced my intent to resign, I didn’t give a date certain. Part of my announcement of my intent to step down was my hope was that I would add a little pressure if you will to Congress because if I left, it was questionable how much chairman Giancarlo could do by himself. And you’re right, it should be a five-person commission, and whichever party is in charge in the White House gets to pick the chairperson of the agency, and the majority would be three Republicans, two Democrats.
I can tell you, my experience is the CFTC is not a partisan agency. There is no Republican answer or Democrat answer, it’s that we all are trying to achieve the right answer. During the time I was there as a commissioner, I think the number of times that all of us voted unanimously was like over 95 percent. For the most part, we pretty much reached consensus.
Luigi: Should we take from this, I don’t want to put words in your mouth, but should we take that maybe some of this anti-regulatory stand that we hear in the newspaper that seems to destroy this is a bit excessive? That in reality, this is a normal process of pendulum that after a crisis, you tend to regulate and when you regulate, sometimes you tend to overdo it, and then you go a little bit back and you try to find what is really important and dismiss the parts that might be excessive or excessively burdensome?
Sharon Bowen: No, I think that’s right. Also, not just us, but the Europeans with MiFID II, they’re also going through a review of their rules to see how they can make their rules better at the same time but yes, no, you’re absolutely right, and that makes sense. These rules are complicated. Some of them did have unintended consequences that we really attempted to try to eliminate those cases where we were putting undue costs and burdens on particularly end users who were not posing a systemic risk to our market. The kinds of changes we made were to try to correct some of those unintended consequences.
I think at the same time, the industry is fully invested in the protections we now have in place and you would be hard-pressed to find, you’ll find them complaining about the cost but you’d be hard-pressed to find one who would not say that we’re not better protected today than we were before 2008.
I think that makes us more competitive. In fact, some of them will tell you, that makes us more competitive and it makes our financial markets, frankly, the envy of the world because in fact, our markets are safer.
Kate: But there are still derivatives out there that are relatively opaque, right? There are derivatives that aren’t cleared, particularly ones that are more complicated. Is there any way to know whether they pose systemic risks?
Sharon Bowen: All swaps, whether they’re cleared or uncleared, are reportable and subject to margin, but are there dark pools out there? I’m sure there are dark pools that are out there but-
Kate: What is a dark pool exactly? Can you just define that really quickly?
Sharon Bowen: Yeah, that’s off-exchange. I call it dark because it’s not on an exchange—there’s no transparency, which is why it’s dark. I’m not sure why it’s a pool, it could be a park.
Luigi: The name sounds very ominous but why are you afraid of those dark pools?
Sharon Bowen: We got bit by one in 2008. It was like an avalanche. It hit us in a way that we had no idea, it was a pretty bad bite. We should all be afraid of dark pools.
Luigi: I think then the major problem is you don’t see them coming because-
Sharon Bowen: Correct.
Luigi: The reason why they’re called dark is because you don’t see the data, and transparency is a big help in those situations.
Sharon Bowen: Yes, absolutely.
Luigi: Going back to the decision-making process, you are saying that there is a procedure of course ...
Sharon Bowen: Yes.
Luigi: ... where you hear all the sides but one of the concerns is banks have very good lawyers and lobbyists that are representing their side, and farmers and individual users are not as well-organized and they tend not have good lawyers and good lobbyists. What do you do to-
Sharon Bowen: You’d be surprised by that, actually.
Luigi: How do you make sure that you’re not fooled by this imbalance? It’s kind of you are a judge in which on the one hand, you have a slick lawyer, on the other hand, you have somebody defending himself?
Sharon Bowen: Right. Well, it’s interesting, so all three of us had Wall Street backgrounds, and none of us had an ag background. And so we all met the farmers and ranchers. We went out to the grain elevator here outside of Chicago, we made trips to see the whole process, which really, frankly, I encourage everyone to do that. You will view food a lot differently after you go through that-
Kate: Can you just show up at a farm and ask to be on a grain elevator?
Sharon Bowen: It’s a lot more sophisticated than you can even imagine, the use of GPS and the use of technology to tell you how often to water. I mean it’s just fascinating, but because of our financial backgrounds, I think people were, they knew they couldn’t pull the wool over our eyes, frankly. We had represented some of them in past. We had the business background and Giancarlo also had represented the wholesale markets, former chairman Massad had worked on derivatives when they first started, as I did too in my career. So we were pretty familiar with the financial part of it, so there was no hocus pocus with firms being able to pull a fast one on us.
Kate: The Intercontinental Exchange, ICE, isn’t that one of the clearinghouses that regulates derivatives?
Sharon Bowen: They do have a couple of the clearinghouses that we regulated at the Exchange.
Kate: With all due respect, are you concerned at all about going from the CFTC to a clearinghouse that you were formerly regulating?
Sharon Bowen: Yeah, so the way I would view it is, I bring a level of expertise, obviously as a board member, I’m not a part of the management with the day-to-day operations of any of the subsidiaries. Frankly, the things I’ve always stood for, transparency, which is really key, investor protection, those are the kinds of traits and qualities that ICE really stands for.
Luigi: I suspect you’re probably one of the toughest customers on that board.
Sharon Bowen: That’s correct. It takes guts for someone to want to have a former cop on the beat, if you will, on your board, it means you have confidence in your operations.
Kate: Sharon, I have a term for you, it’s a little bit of a jargony term: you’re a BAMF POC boss lady, which is a very specific economics term that stands for badass mofo person of color, extraordinary woman.
Sharon Bowen: Oh, OK. That’s a good one.
Kate: Yeah, it’s a term that we throw around a lot in academia.
Sharon Bowen: OK.
Kate: I wanted to ask you if you could tell us a little bit about how you got to where you were, what the toughest parts of your journey were, and also whether you have advice for young women and young people of color for how to make it in law and finance?
Sharon Bowen: That’s about three books that you just asked me.
Kate: OK.
Sharon Bowen: I can give you-
Kate: Well, can you give it to me in two minutes?
Sharon Bowen: I can give it to you in two minutes. I had an interest in markets pretty early on in college. Majored in economics at the University of Virginia. Didn’t know what I wanted to be when I grew up. Applied to business school and law school. Northwestern and the University of Chicago were the only two schools that gave me full scholarships to both the business school/law school. Went to Northwestern for law school/business school.
Luigi: Sorry you made the wrong choice.
Sharon Bowen: Yeah, you know, what can I say?
Kate: It’s pretty rare.
Sharon Bowen: Yeah.
Kate: I mean I’d never heard of anyone who had a full ride at both.
Sharon Bowen: Yeah. No, I got academic scholarships to both schools, but wasn’t really sure what I wanted to do. I spent summers at Goldman Sachs, Chicago Board of Trade. Started my career at Davis Polk & Wardwell. Like most young people, thought I’d work for two years, retire at the age of 30 at Goldman Sachs. Loved the practice of law a lot, and as a fifth-year corporate associate, as Latham was growing its New York office, became a partner, had great clients, great work. Just really fortunate.
The advice I would give to people is to follow your passion in terms of the things that motivate you to want to get up every morning, and treat it like a marathon.
Kate: Well Sharon, it has been a great honor and a great pleasure having you on the show. I learned a lot today about the CFTC. I think I maybe understand what it does now.
Sharon Bowen: Pleasure to be here.