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THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS REPORT ON OVER-THE-COUNTER DERIVATIVES MARKETS AND THE COMMODITY EXCHANGE ACT
SUBCOMMITTEE ON RISK MANAGEMENT,
RESEARCH, AND SPECIALTY CROPS
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED SIXTH CONGRESS
FEBRUARY 15, 2000
Serial No. 10643
Page 2 PREV PAGE TOP OF DOCPrinted for the use of the Committee on Agriculture
COMMITTEE ON AGRICULTURE
LARRY COMBEST, Texas, Chairman
BILL BARRETT, Nebraska,
JOHN A. BOEHNER, Ohio
THOMAS W. EWING, Illinois
BOB GOODLATTE, Virginia
RICHARD W. POMBO, California
CHARLES T. CANADY, Florida
NICK SMITH, Michigan
TERRY EVERETT, Alabama
FRANK D. LUCAS, Oklahoma
HELEN CHENOWETH-HAGE, Idaho
JOHN N. HOSTETTLER, Indiana
SAXBY CHAMBLISS, Georgia
RAY LaHOOD, Illinois
JERRY MORAN, Kansas
BOB SCHAFFER, Colorado
JOHN R. THUNE, South Dakota
WILLIAM L. JENKINS, Tennessee
JOHN COOKSEY, Louisiana
Page 3 PREV PAGE TOP OF DOCKEN CALVERT, California
GIL GUTKNECHT, Minnesota
BOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
CHARLES W. STENHOLM, Texas,
Ranking Minority Member
GARY A. CONDIT, California
COLLIN C. PETERSON, Minnesota
CALVIN M. DOOLEY, California
EVA M. CLAYTON, North Carolina
DAVID MINGE, Minnesota
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
TIM HOLDEN, Pennsylvania
SANFORD D. BISHOP, Jr., Georgia
BENNIE G. THOMPSON, Mississippi
JOHN ELIAS BALDACCI, Maine
MARION BERRY, Arkansas
MIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
Page 4 PREV PAGE TOP OF DOCBOB ETHERIDGE, North Carolina
CHRISTOPHER JOHN, Louisiana
LEONARD L. BOSWELL, Iowa
DAVID D. PHELPS, Illinois
KEN LUCAS, Kentucky
MIKE THOMPSON, California
BARON P. HILL, Indiana
JOE BACA, California
WILLIAM E. O'CONNER, JR., Staff Director
LANCE KOTSCHWAR, Chief Counsel
STEPHEN HATERIUS, Minority Staff Director
KEITH WILLIAMS, Communications Director
Subcommittee on Risk Management, Research, and Specialty Crops
THOMAS W. EWING, Illinois, Chairman
BILL BARRETT, Nebraska,
NICK SMITH, Michigan
TERRY EVERETT, Alabama
FRANK D. LUCAS, Oklahoma
SAXBY CHAMBLISS, Georgia
Page 5 PREV PAGE TOP OF DOCRAY LaHOOD, Illinois
JERRY MORAN, Kansas
JOHN R. THUNE, South Dakota
WILLIAM L. JENKINS, Tennessee
GIL GUTKNECHT, Minnesota
BOB RILEY, Alabama
GREG WALDEN, Oregon
MICHAEL K. SIMPSON, Idaho
DOUG OSE, California
ROBIN HAYES, North Carolina
ERNIE FLETCHER, Kentucky
GARY A. CONDIT, California,
Ranking Minority Member
CALVIN M. DOOLEY, California
EARL F. HILLIARD, Alabama
EARL POMEROY, North Dakota
SANFORD D. BISHOP, Jr., Georgia
JOHN ELIAS BALDACCI, Maine
MIKE McINTYRE, North Carolina
DEBBIE STABENOW, Michigan
BOB ETHERIDGE, North Carolina
CHRISTOPHER JOHN, Louisiana
LEONARD L. BOSWELL, Iowa
KEN LUCAS, Kentucky
Page 6 PREV PAGE TOP OF DOCMIKE THOMPSON, California
C O N T E N T S
Condit, Hon. Gary, a Representative in Congress from the State of California, prepared statement
Ewing, Hon. Thomas W., a Representative in Congress from the State of Illinois, opening statement
Smith, Hon. Nick, a Representative in Congress from the State of Michigan, prepared statement
Stabenow, Hon. Debbie, a Representative in Congress from the State of Michigan, prepared statement
Stenholm, Hon. Charles W., a Representative in Congress from the State of Texas, opening statement
Brodsky, William J., chairman and chief executive officer, Chicago Board Options Exchange, on behalf of the U.S. Securities Markets Coalition
Gordon, M. Scott, chairman, Chicago Mercantile Exchange
Grove, Richard E., Jr., executive director and chief executive officer, International Swaps and Derivatives Association
Page 7 PREV PAGE TOP OF DOCPrepared statement
Lackritz, Marc, president, Securities Industry Association
Miller, William P., II, senior vice-president and independent risk officer, Commonfund
Nazereth, Annette L., Director, Division of Market Regulation, Securities and Exchange Commission
Parkinson, Patrick M., Associate Director, Division of Research and Statistics, Board of Governors of the Federal Reserve System
Statement of Chairman Alan Greenspan
Paul, C. Robert, General Counsel, Commodity Futures Trading Commission
Rappaport, Daniel, chairman, New York Mercantile Exchange
Rosen, Edward J., Cleary, Gottlieb, Steen & Hamilton, on behalf of
the Ad Hoc Coalition of Commercial and Investment Banks
Sachs, Lee, Assistant Secretary, Financial Markets, U.S. Department of the Treasury
Young, Mark D., partner, derivatives and financial services, Kirkland & Ellis, on behalf of the Chicago Board of Trade
Prepared statement of Mr. David P. Brennan
Page 8 PREV PAGE TOP OF DOCSubmitted Material
Champion, Robert R., Champion Securities, statement
Managed Funds Association, statement
THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS REPORT ON OVER-THE-COUNTER DERIVATIVES MARKETS AND THE COMMODITY EXCHANGE ACT
TUESDAY, FEBRUARY 15, 2000
House of Representatives,
Subcommittee on Risk Management,
Research, and Specialty Crops,
Committee on Agriculture,
The subcommittee met, pursuant to call, at 9:40 a.m., in room 1300, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Smith, Everett, Chambliss, Moran, Thune, Jenkins, Gutknecht, Riley, Walden, Simpson, Fletcher, Condit, Dooley, Pomeroy, Baldacci, Etheridge, Boswell, Lucas, Thompson, and Stenholm [ex officio].
Also present: Representative Clayton
Staff present: Ryan Weston, subcommittee staff director; Christy Cromley, legislative assistant; Greg Zerzan, associate counsel; Wanda Worsham, chief clerk; Callista Bisek, assistant scheduler/clerk, and John Riley, minority consultant.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Page 9 PREV PAGE TOP OF DOC Mr. EWING. The hearing of the Subcommittee on Risk Management, Research, and Specialty Crops to review the President's Working Group on Financial Markets report on over-the-counter derivatives markets and the Commodity Exchange Act will come to order. I welcome all of you and I welcome the first panel.
I hope this hearing will provide our members the opportunity to hear the rationale behind the recommendations and findings in the President's Working Group report on over-the-counter derivatives and the Commodity Exchange Act. Today's list of esteemed witnesses includes many of those who worked to draft the report and many of those in the industry who would conduct business in accordance with the report if it were to be implemented.
I hope that our meeting here today didn't interrupt anyone's Valentine's plans. My staff today, I gave a speech earlier this morning and my staff had a joke in there knocking attorneys, and I said I need new staff if they don't know that their boss is an attorney. And now I have a joke in my opening comments, when supposedly my wife asked me what I wanted for Valentine's Day and I told her I wanted the CFTC reauthorization bill. Can't fire your wife, but you can fire your staff. [Laughter.]
I want you to all know, though, that I am serious about the Commodity Exchange Act modernization, and I hope that the subcommittee's track record makes that apparent. We have laid the groundwork for much of the legislative challenge before us. The President's Working Group report on OTC derivatives was requested by the House and Senate Agriculture Committee chairmen in September 1998 and presented to the committee in November 1999.
The committee's request for the President's Working Group, was ''to conduct a study concerning the OTC derivatives market and provide legislative recommendations to Congress regarding whether these markets require additional regulation.''
I want to thank the President's Working Group for its report, and make it clear that legal certainty and the proper regulatory structure for the OTC markets have always been important to me. However, it is only one aspect, though, of the CEA modernizations. The President's Working Group report clearly points out two other issues that merit the subcommittee's attention.
Page 10 PREV PAGE TOP OF DOC First, regulatory relief for domestic futures exchanges continues to be of importance to ensure that U.S. futures exchanges can compete globally. Chairman Greenspan said it most clearly in his testimony last week:
Already the largest futures exchange in the world is no longer in America's heartland. Instead, it is in the heart of Europe. To be sure, no U.S. exchange has yet to lose a major contract to a foreign competitor, but it would be a serious mistake for us to wait for such unmistakable evidence of a loss of international competitiveness before acting.
While the President's Working Group report does not give details on regulatory relief for futures exchanges, it does conclude that the CFTC should provide appropriate regulatory relief for the exchange-traded financial futures.
I would like to note that Chairman Combest, Ranking Member Stenholm, and some of our colleagues in the Senate and I have signed a letter to Chairman Rainer asking him and the CFTC to provide us with a proposal for futures market regulatory relief. He and many others at the Commission have worked hard to produce that proposal. I am looking forward to an in-depth briefing later this week, and hope that the proposal helps give us guidance for legislative regulatory relief.
Another aspect of CEA modernization I would like to address is the Shad/Johnson Accord. The President's Working Group members believe that the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying securities market and the regulatory arbitrage are resolved.
Chairman Combest, Ranking Member Stenholm, Chairman Bliley and I all signed a letter to Chairman Levitt of the SEC and Chairman Rainer of the CFTC, asking them to create and present to us a plan regarding the Shad/Johnson. We hope to have their proposal and response by February 21 of this year.
Page 11 PREV PAGE TOP OF DOC As Senator Lugar noted in his hearing last week, we are on an expedited time frame to pass legislation this year. While it may be difficult, we shall make a strong attempt to see legislation pass the House. Now that banking modernization has been dealt with, it is time for the financial industry to move on to the CEA modernization.
While Chairman Lugar hinted that there may be a new chairman of the Senate Agriculture Committee, I can say with absolute certainty there will be a new chairman of this subcommittee next year.
I look forward to hearing from you, Mr. Sachs, an overview of the President's Working Group report, and other President's Working Group members' comments, as well as those from many segments of the financial industry. While I intend for the focus of this hearing to be on the President's Working Group report, I do know that discussion will arise regarding some of the other issues I have mentioned in this statement. This will be our first step toward CEA modernization, but I am betting that it will not be the last.
Before I introduce our first panel, the Chair would allow members of the subcommittee to submit statements for the record at this time.
[The prepared statements of Members follow:]
PREPARED STATEMENT OF HON. NICK SMITH
Mr. Chairman, thank you for holding the first hearing of the year on the reauthorization of the Commodity Exchange Act. I am looking forward to hearing from the distinguished list of witnesses who will discuss the unanimous findings of the President's Working Group regarding the proper treatment of the over-the-counter derivatives market.
One of the goals for Commodity Exchange Act reauthorization should be to provide legal and regulatory certainty to the over-the-counter market. With its recommendations on the legal certainty of swaps, the Treasury amendment and electronic trading, I am hopeful that this unanimous report will provide Congress with the guidance it needs for achieving this important goal. The Working Group's recommendations, however, cannot exist in a vacuum. Another important goal of reauthorization is providing regulatory relief for those entities that fall within the Commodity Exchange Act. The Working Group recognized that its recommendations regarding the over-the-counter market must be implemented simultaneously with any change of regulation for the futures exchanges.
Page 12 PREV PAGE TOP OF DOC This committee is faced with the difficult task of drafting this complicated legislation in a year drastically shortened by a full Congressional calendar and a Presidential election. Congress probably has a 3-month period of time to pass this bill or resign itself to the fact that it will not get done until next year. However, the ramifications of waiting are considerable. Given the fact that we will have a new administration, a new Congress, and even a new chairman of this subcommittee. A thorough discussion and review this year and possibly next has merit. To achieve consensus on comprehensive reauthorization legislation with the new administration and the new Congress is an important consideration. We should move ahead with a full review and CFTC reauthorization by September 30, 2000. However, developing the final, best possible legislation for OTC derivatives is more important than whether it is completed this year or next.
PREPARED STATEMENT OF HON. GARY A. CONDIT
Thank you for holding this hearing, Mr. Chairman. I welcome this opportunity to discuss the working group report with both the stakeholders and Federal agencies that will be impacted by any efforts to modernize the Commodity Exchange Act.
To me, the most significant attribute of the report is the unanimous consent among Federal agencies in nearly all subject areas addressed. I applaud this leadership cooperative and balanced efforts are vital if any attempts at modernization are to be successful in our legislative efforts.
The report's general goal of providing legal certainty to over-the-counter derivatives in our financial markets is one that we all share. There is no question that U.S. businesses must be able to have confidence in their investments. Furthermore, regulation should not limit the application of new technologies in the marketplace nor hinder innovative product development. As repeatedly emphasized by our stakeholders, investors will find markets elsewhere to meet their needs if not provided in the United States.
Page 13 PREV PAGE TOP OF DOC Mr. Chairman, while the working group's report has provided a set of recommendations, I was surprised by its briefness. For example, I would like to know how much of the $80 trillion derivative market is booked in the United States. How many institutions are major dealers? Are end users more or less comfortable than they were when we last addressed these issues in 1992? Is the industry in the United States
becoming more or less competitive overtime? How has the relationship between the OTC and the exchange markets evolved? And finally, is the US continuing to develop and supply the financial tools necessary to provide the risk management tools needed by our farming community, and increasingly used by individual families and personal investors? These concerns should be addressed if legislative changes to the Commodity
Exchange Act are to apply to all stakeholders.
The second surprising aspect of the report to me was that no alternatives were discussed. As you are aware, Mr. Chairman, some of our witnesses take exception to the details of the report. I am glad we will have the opportunity to hear today from the exchange community and the end users. Regardless of the limited scope of the report, there is no doubt that changing one aspect of the financial community will impact others. We must ensure that moving towards the goal of regulatory certainty for a certain class of products does not leave a less competitive atmosphere for others. I commend the CFTC for already addressing regulatory relief issues and look forward to more progress in this area.
To me, there are two overwhelming challenges faced by the subcommittee this yeara short time to do legislative business and the need for cooperation among Federal agencies and stakeholders. The subcommittee will require creative ideas and constructive criticism if there is to be any development of passable legislation this year. We are all aware that if one group chooses to oppose an idea, then nothing will be accomplished. There is one aspect that we all can agree onthe modernization of the Commodity Exchange Act is long overdue. I challenge the stakeholders represented by all the witnesses today to help us in this task and to take on a spirit of cooperation as the subcommittee moves forward to make significant improvements to the Commodity Exchange Act.
Page 14 PREV PAGE TOP OF DOC Mr. Chairman, I am grateful for your continued leadership in this issue and look forward to working with you and with members of the subcommittee in our efforts this year. Thank you.
STATEMENT OF HON. DEBBIE STABENOW
Mr. Chairman, thank you for bringing the subcommittee together today to review the President's Working Group Report on over-the-counter derivatives markets and the Commodity Exchange Act. I would also like to take this opportunity to thank the three panels of witnesses for providing their expert testimony at today's hearing.
Last fall, the President's Working Group produced a report that is the result of careful consideration of the issues and compromise. The report was written to address four key goals: (1) Promote innovation, competition, liquidity, and transparency, (2) Reduce systemic risk, (3) Protect Retail Customers, and (4) Maintain U.S. leadership in derivatives markets.
We have long road ahead of us. Three committees in the House of Representatives share jurisdiction over these issues and the Commodity Exchange Act should be reauthorized by the end of the year. I am eager to hear testimony from today's witnesses to determine if the four goals have been adequately addressed by the working group report and I am ready to work with the administration and the other committees to resolve this issue.
Mr. EWING. We have Mr. Lee Sachs, Assistant Secretary for Financial Markets, U.S. Department of the Treasury; Mr. C. Robert Paul, General Counsel, Commodity Futures Trading Commission; Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics, Board of Governors, the Federal Reserve System; and Ms. Annette L. Nazareth, Director of the Division of Market Regulation, Securities and Exchange Commission. I welcome you all, and we will start with you, Mr. Sachs.
Page 15 PREV PAGE TOP OF DOCSTATEMENT OF LEE SACHS, ASSISTANT SECRETARY FOR FINANCIAL MARKETS, U.S. DEPARTMENT OF THE TREASURY
Mr. SACHS. Thank you, Mr. Chairman, Mr. Stenholm, members of the committee. Thank you for giving me the opportunity to discuss the report of the President's Working Group on Financial Markets on over-the-counter derivatives markets and the Commodity Exchange Act. I know the issues covered in this report have been a focus of this committee for some time, and on behalf of the members of the working group, we thank you for the leadership you have demonstrated on these important matters.
I would like to address three topics today: first, the growing importance of over-the-counter derivatives in the U.S. economy; second, the objectives that guided members of the working group while developing our recommendations and the importance of enacting those recommendations within the shortest reasonable time frame; and, third, I would like to give a very brief overview of the six recommendations that the working group has produced.
One of the most dramatic changes in the world of finance during the past 15 years has been the extraordinary development of the markets for financial derivatives. Over-the-counter derivatives have transformed the world of finance, increasing the range of financial products available to corporations and investors and fostering more precise ways of understanding, quantifying and managing risk.
OTC derivatives now play an important role in our markets and economy by increasing the liquidity and efficiency of financial markets, facilitating commerce, supporting a more efficient allocation of capital across the economy, and indirectly supporting higher investment and a growth in living standards in the United States and around the world. More specifically, OTC derivatives help American businesses to hedge and manage risk more effectively and help reduce the cost of borrowing for American individuals and companies.
This important market is large and it is growing rapidly. The estimated notional value of OTC derivatives contracts is approximately $80 trillion. This market can offer many benefits to those who use it properly. For example, the agricultural sector benefits from OTC derivatives in a very direct way. By using OTC derivatives to hedge their exposure to volatile movements in foreign currency markets, farmers can build on this certainty to invest more in their businesses and export more of their produce to overseas markets.
Page 16 PREV PAGE TOP OF DOC Mr. Chairman, it is important for us to develop a legal framework that is as modern as the market it addresses. It is our judgment that because the counterparties to OTC transactions are highly sophisticated, and because the issues involved are enormously complex, government can best contribute by promoting a framework of market discipline. The objective of government should not be to protect individual institutions, but rather to protect the system as a whole. And of course government should have a continuing role with respect to the protection of individual retail customers.
With these broad principles in mind, the working group's report had four major objectives:
First, to reduce systemic risk in the OTC derivatives market by removing legal impediments to the development of clearing systems and ensuring that those systems are appropriately regulated.
Second, to promote innovation in the OTC derivatives market by providing legal certainty for OTC derivatives and electronic trading systems, and thereby encouraging competition.
Third, to protect retail customers by ensuring that appropriate regulations are in place to deter unfair practices in all markets in which they participate, and by closing existing loopholes that allow unregulated entities to pursue such unfair practices.
And, finally, to maintain U.S. competitiveness by providing a modernized framework that will lead those engaged in the financial services industry to continue the operation of their business in the United States and thereby ensure the continued leadership of American capital markets.
With those objectives in mind, the working group developed six unanimous recommendations:
First, create an exclusion from the Commodity Exchange Act for most swap agreements. The exclusion would apply only to agreements between sophisticated parties, and only for financial derivatives that do not have finite supplies; meaning, for example, that the exclusion would not apply to agricultural commodities. The enactment of such an exclusion would promote legal certainty that is essential for the integrity of this market.
Page 17 PREV PAGE TOP OF DOC Second, create an exclusion for electronic trading systems; and, third, permit the use of appropriately regulated clearing systems for OTC derivatives. These two recommendations both go to the objective of allowing sophisticated parties to organize together to trade OTC derivatives in ways that are most efficient for them, in ways that promote transparency to each other, and in ways that permit clearing arrangements which mitigate systemic risk in the event of counterparty default.
Our fourth recommendation is to clarify the original intent of the Treasury amendment. As you will recall, Mr. Chairman, the Treasury amendment addresses the question of regulation of trading in foreign exchange and government securities derivatives. The proposal would clarify the scope of their exclusion from regulation, but would at the same time recognize the CFTC's authority with respect to unregulated bucket shops and other practices affecting retail customers.
Our fifth and sixth recommendations are highly technical in nature, and address the exempt status of hybrid instruments. These recommendations address some potential jurisdictional disputes, but I am pleased to report that these disputes have been resolved with the unanimous agreement of the parties involved.
Mr. Chairman, the President's Working Group has presented the Congress with a set of unanimous recommendations pertaining to the growing and increasingly important market for OTC derivatives in the United States. We believe that these recommendations, taken together, would reduce systemic risk; promote innovation, competition, efficiency and transparency in our financial markets; protect retail customers; and maintain American leadership in OTC derivatives markets.
As you referred in your opening comments, Mr. Chairman, while the working group's report focuses on OTC derivatives, we recognize the importance of ensuring an appropriate and not overly burdensome regulatory environment for exchange-traded derivatives. The Working Group supports the CFTC's ongoing efforts to explore regulatory relief in this area, without prejudging the results of their analysis. We look forward to working with the CFTC and other members of the working group and with this committee to ensure that our markets remain the most competitive and innovative in the world, while assuring the integrity of these markets is protected for all participants.
Page 18 PREV PAGE TOP OF DOC Finally, Mr. Chairman, on behalf of the Secretary I would like to thank all Working Group members for their efforts in producing this report. As you indicated, a lot of work did go into producing it, and we are happy to present you with a set of unanimous recommendations.
With that, I thank you and look forward to your questions.
[The prepared statement of Mr. Sachs appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Sachs.
STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION
Mr. PAUL. Thank you, Chairman Ewing, Congressman Stenholm, and other members of the subcommittee. On behalf of CFTC Chairman Rainer, I appreciate the opportunity to come here and discuss the recommendations of the President's Working Group on Financial Markets regarding the Commodity Exchange Act and over-the-counter derivatives transactions.
OTC derivatives transactions, as we know them today, do not present regulatory concerns within the scope of the act. Excluding this activity will not diminish the CFTC's ability to carry out the statutory mission it is charged to fulfill.
Like exchange-traded futures, OTC derivatives are risk-shifting instruments. The Working Group, however, has determined that, unlike futures, prices established in OTC derivatives transactions do not serve a significant price discovery role. The Working Group has also concluded that most OTC derivatives are not susceptible to manipulation.
OTC transactions are entered into and traded by sophisticated institutional traders who are able to look out for themselves in these markets. Because there is no manifest regulatory interest that warrants CFTC oversight of OTC derivatives, Chairman Rainer supports the exclusion proposed by the working group.
Page 19 PREV PAGE TOP OF DOC In 1992, Congress authorized the CFTC to issue a rule exempting swap agreements from most provisions of the act. Lately, however, evolution in the OTC derivatives market has rendered the exemption inadequate.
The swaps exemption does not apply to OTC contracts that are standardized, cleared, or executed under conditions that approximate those of an organized exchange. Technology, however, is dramatically changing the structure and nature of many aspects of the financial services industry. The rise of electronic, screen-based trading has blurred the line drawn in the Commission's swaps exemption between bilateral and multilateral trading. The growth in swap volume, and the acceptance of these contracts by a wider range of users, has led to their standardization. Public policy must meet these advances in the OTC market.
Currently, the Commission's rule exempts bilateral swaps from most provisions of the CEA except those prohibiting manipulation and fraud. The swaps exemption does not alter the CFTC's responsibility to take action against this misconduct, but the agency's ability to act may be contingent upon proving that transactions are futures or options.
This is a critical point to remember: At no time has Congress or the CFTC made the definitive judgment that swap transactions are in fact subject to the CEA's jurisdiction. The combination of responsibility with no more than contingent authority is simply bad public policy because, as a practical matter, the CFTC cannot exercise its retained enforcement authority under the swaps exemption without exacerbating the existing legal uncertainty in this area.
Apart from legal certainty issues regarding OTC derivatives, the working group report contains recommendations aimed at improving the regulatory framework for other financial instruments. To address the problems associated with foreign currency bucket shops, the working group recommended that the CEA be amended to give the CFTC explicit jurisdiction over unregulated entities that sell foreign exchange instruments to the retail public at large.
While examining the applicability of the act to OTC markets, the CFTC has also conducted an inquiry into whether its current regulatory scheme is appropriately tailored to today's environment for exchange-traded futures. During the past several months, the agency has undertaken a serious effort to answer the question: What degree of exchange-traded regulation is necessary to serve the public interests entrusted to it?
Page 20 PREV PAGE TOP OF DOC Impending technological changes require the CFTC to scrutinize the continued viability of its one-size-fits-all regulatory structure that currently applies to every futures transaction. While that process is not yet complete, certain clear principles have emerged: First, the historic needs of traditional physical commodities should not be the basis for regulating every futures contract traded today. Second, institutional market participants do not require all of the protections designed for retail traders.
At its core, this plan will afford market participants the opportunity to operate in a regulatory environment suited to the product traded and the participants trading it. The key policy elements of this plan include a move from direct to oversight regulation, a move from prescriptive rules to flexible performance standards, and the increased use of disclosure-based regulation.
This plan will not impair the agency's ability to assure the fundamental market integrity that is expected when conducting futures exchange transactions in the United States, or when relying upon the prices set in U.S. exchange-traded markets. The Commission will continue to exercise its authority to oversee their continued integrity.
Thank you again for the opportunity to testify before you today. Chairman Rainer and I look forward to continued collaboration with the rest of the working group and members of this committee to see these recommendations enacted into law this year.
[The prepared statement of Mr. Paul appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Paul.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM
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Mr. PARKINSON. Thank you, Chairman Ewing, Congressman Stenholm, other members of the committee. I will forego the opportunity to make a prepared statement. I would like to place in the record a copy of the statement that Chairman Greenspan delivered to the Senate last week. That is the one which Chairman Ewing quoted from in his opening remarks. I will be pleased to answer any questions you might have, either about Chairman Greenspan's statement or about the President's Working Group's report. Thank you.
[The information appears at the conclusion of the hearing.]
Mr. EWING. Ms. Nazareth.
STATEMENT OF ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, SECURITIES AND EXCHANGE COMMISSION
Ms. NAZARETH. Thank you, Chairman Ewing and members of the committee. Likewise, in the interest of time and to avoid repetition, I would also be willing to forego my oral statement, and I would ask that my written statement be entered into the record.
I would also just like to reiterate the support expressed by the other members of the working group for the recommendations in the over-the-counter derivatives report, and I would be pleased to answer any questions that you might have.
[The prepared statement of Ms. Nazareth appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much. I want to recognize that the ranking member of the full committee, Mr. Stenholm, and I apologize for not giving you an opening statement, but would turn to you now for any comments or questions you may have.
Page 22 PREV PAGE TOP OF DOCOPENING STATEMENT OF HON. CHARLES W. STENHOLM, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF TEXAS
Mr. STENHOLM. Thank you, Mr. Chairman, for holding this very important hearing this morning. The reauthorization of the Commodity Exchange Act, as you have already stated, is a very high priority of our committee this year, and I look forward to working with you, with Ranking Member Condit, with Chairman Combest and other members of this subcommittee and the full committee, to make it a successful legislative effort.
Mr. Chairman, the President's Working Group has taken an important step with the report it has presented to the Congress. I believe the members' unanimous agreement will enable Congress to rise above turf issues and do what is right for our financial system. As we add more detail to our discussion, differences will almost surely emerge. The agreement we see today on broad principles, however, will help to guide this committee and the Congress to an effective result.
While there is much to be commended in the working group report, I had hoped it would provide a more detailed profile of the over-the-counter derivatives industry as well as a more detailed discussion of the rationale behind the recommendations.
For example, what options were considered other than those in the report, and why were they rejected? What did the working group learn about the evolution of the market, including characteristics of dealers and end users, number of participants, and measures of competitive balance? What lessons can be drawn from derivatives regulation in other nations? How have the terms of contracts evolved? What is known about the point of view of end users regarding the current market and the recommendations of the working group?
These are many of the questions I know will come out in this hearing and other witnesses that you will hear today, Mr. Chairman, and the work of the full committee. And I know that after resolving these questions, we will be able to move forward and deliver your Valentine present to you, Mr. Chairman.
Page 23 PREV PAGE TOP OF DOC I hope our other witnesses will add to this picture. I am aware the members of the working group are fully willing to provide the additional detail, and I look forward to its inclusion in the subcommittee's hearing record.
Mr. Chairman, again, thank you for holding this hearing. I look forward to participating as much as I can and listening, and very much appreciate the number of the committee that is here today, because this is a rather highly complex and technical issue for anybody, including we Aggies.
Mr. EWING. Thank you, Mr. Stenholm, and I think it is appropriate to recognize we have a good attendance today, and that I think reflects on the responsibility that this subcommittee has in trying to move legislation.
Mr. SMITH. Mr. Chairman, permission for other members to put in writing their opening statements?
Mr. EWING. Absolutely, anybody who has a statement, it will be included in the record.
We talk about, one of the recommendations is, I think was an exclusion of the OTC swaps market from the Commodity Exchange Act. How do you see the difference between that and the current exemption? And if there is an exclusion, who is responsible for oversight? Who is responsible if we have a problem and we need some Government intervention? Mr. Sachs.
Mr. SACHS. Thank you, Mr. Chairman. Before I answer your question, I would also ask that the written statement that we provided also be entered into the record.
Mr. EWING. They will be.
Mr. SACHS. The question about exclusion versus exemption from the Commodity Exchange Act is one of the first questions that this group wrestled with, and we came to the conclusion that excluding certain transactions from the Commodity Exchange Act was the most appropriate course.
Page 24 PREV PAGE TOP OF DOC The reason we came to that conclusion primarily was that one of our objectives was to provide the greatest legal certainty that we could for these markets, and excluding certain transactions, the ones to which you refer, from the act we felt would provide the greatest legal certainty of all the other options that were considered, including different types of exemptions.
And, I am sorry, you did ask who would be responsible in the event of problems. Our framework, both in this study and in the study that we released last spring with regard to highly leveraged institutions, is built on several concepts, one of which is the concept of private sector discipline. This group felt that, given the complex nature of these instruments, that the best way to regulate them, if you will, is through private regulation, not through Government oversight as provided under the Commodity Exchange Act.
Again, as I referred to, at least in my written remarks, the Commodity Exchange Act was primarily designed to address issues of broad manipulation and price discovery. The instruments that we are recommending be excluded from the act, we did not feel were readily susceptible to manipulation. The participants that would be allowed to participate in these markets have the resources and the wherewithal to either protect themselves against fraud or, in the case that they are defrauded, to pursue remedy through the court system. And, third, we did not feel that the market for over-the-counter derivatives currently serves a price discovery function.
So, for those three reasons, and to provide the greatest legal certainty possible, we recommended that these transactions be excluded from the Commodity Exchange Act.
Mr. EWING. Does anybody else wish to comment on that?
Mr. EWING. At the time that the concept paper, I think, was issued by the CFTC a year ago, there was some talk about the uncertainty that that might create in the market. Is there evidence that that uncertainty impacted the market? I mean, we are talking about the exclusion.
Page 25 PREV PAGE TOP OF DOC Mr. SACHS. I am sorry, Mr. Chairman. I just missed the first part of your question.
Mr. EWING. I was following up on exclusion versus exemption, and I said when the CFTC working paper was issued a year ago, there was an outcry about legal certainty and what problems that would make in the market. I just was questioning whether anybody at the table had any evidence that there was an impact on the market.
Mr. SACHS. I guess I can take that question. When that paper was released, there was a heightened concern about legal uncertainty. That report, that paper, raised a number of questions that caused anxiety in the marketplace. When that came out, I actually was in the market at that time and recall the anxiety that we felt and other members of the financial community felt when that report was released.
Again, coming back to the point that you raised about exclusion versus exemption, this is one of the reasons, though certainly not the only reason, that this group felt that an exclusion was the most appropriate path to go down as opposed to an exemption because, as one of the panelists pointed out in last week's hearing, there are changes in administration, there is turnover at these agencies, and opinions can change about the appropriate approach to regulation of these markets.
It is precisely that, the uncertainty created by that kind of activity, that led us, that leads us to the conclusion that excluding these transactions from the Commodity Exchange Act as opposed to going down the exemption path is the most appropriate approach.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Thank you, Mr. Chairman. I want to begin by commending you for holding this hearing. I have very much appreciated the way you have approached the Commodity Exchange Act reauthorization all along, which is to have a rather thorough set of background hearings so that as we get closer to an action point as a committee, we are somewhat backgrounded in what is truly a technically challenging area to master; extremely interesting, however.
Page 26 PREV PAGE TOP OF DOC The question I will have, the series of questions I will have will relate to areas that the President's Working Group suggests clarifications but really it is clarifications of exemptions. In other words, we are making it clear that CFTC authority does not apply, and I am wondering whether there has been other jurisdiction, other regulatory authority that will apply.
Specifically codifying, as you suggest, the exemptions for swaps, establishes legal certainty. That is wonderful, that it removes a cloud that presently hangs over these transactions in the minds of some, not in the minds of others. But is this a set of transactions, then, that is utterly without regulatory recourse to those participants?
Mr. PARKINSON. Again, I think to stress what Lee said earlier, I think our conclusion is these are transactions where we can safely rely on market discipline, not Government regulation, as the primary instrument for meeting the underlying public policy objectives of the statute.
That said, for those that may be uncomfortable with that conclusion, most of the major dealers in these markets are banks that are already regulated either by the U.S. banking regulators or by foreign banking regulators, so that in many cases there is some oversight being provided to the providers of the services.
Mr. POMEROY. That is very interesting. Let's explore that for a minute. Does banking regulation presently have a dimension of expertise relative to the activities within these market transactions? Do you think regulators are capable of assessing some of the issues beyond safety and soundness in the functioning of those types of market activities?
Mr. PARKINSON. Well, certainly if we get into the area of sales practices, there has been plenty of work both at the Federal Reserve and at the Office of the Comptroller of the Currency on those issues. But again I want to come back to my first point, which is that our primary conclusion is that we should be relying on private market discipline, not on the Government, to meet the public policy objectives in this area. But I think there is plenty of expertise about OTC derivatives, at least at the U.S. banking regulators, and I think at most of the banking regulators abroad where you have large-scale dealers.
Page 27 PREV PAGE TOP OF DOC Mr. POMEROY. Does the workand this is for anybodyit seems to me as though in clarifying what is an over-the-counter derivative and the establishment of a clearing, advancing the clearing function as is advanced in the President's Working Group, you are changing a bit some of the traditional characters you associate with that type of instrument, the uniquely negotiated instrument between two parties. I mean, you are making it more fungible and kind of beginning to blur, at least in my mind, distinctions with activities that might have been exchange-traded earlier. Would you comment on that?
Mr. SACHS. Sure. I can address that. The two recommendations, I think, to which you are referring, the one regarding electronic trading facilities and the one regarding clearing systems, are intended to do a couple of things.
The first, the electronic trading systems recommendations, are intended to make the market for over-the-counter derivatives more efficient, more transparent; to reduce the costs to businesses of hedging their exposure to interest rate risk or foreign currency risk, for example. And the recommendation with respect to clearing systems is designed to reduce systemic risk. We feel quite strongly that adoption of that recommendation would help to further that objective.
As far as blurring the lines, if you will, between different products, the approach that we took, again to refer back to some comments that I made earlier, we took the approach that it was more appropriate for us to look at what the Commodity Exchange Act was originally designed to do, which is to protect against fraud and manipulation and to promote price discovery. And for those instruments and those transactions and those participants to which those objectives did not apply, to exclude those transactions from the act, and then having done that, to make the trading in those instruments more efficient, transparent, flexible and cheaper for the end user.
Admittedly, this does further blur some of the lines between different types of instruments. But, again, if we can assure that where retail customers have access to the market, that there are protections in place for them against unfair practices, and in instances where the instruments are readily susceptible to manipulation, that there are protections under the Commodity Exchange Act against that, that we feel that although these two recommendations may indeed further blur some of the distinctions, that the benefits that the markets would achieve as a result of having these recommendations implemented more than outweigh the potential costs of having these lines further blurred.
Page 28 PREV PAGE TOP OF DOC Mr. POMEROY. Thank you. Is there more, to the sophisticated party, for purposes of participating in these transactions, than capital-based, the amount of money they have?
Mr. SACHS. There is not reallywe have drawn the line based on size. There is really no way to test sophistication of counterparties or, excuse me, of participants in these markets, so we drew the line at based on size.
Mr. POMEROY. In conclusion, I think it will be very helpful going forwardI commend the working group. I think you have gotten together, and a year ago we were all kind of despairing that you seemed to be of many minds on these things, and if you couldn't sort it out, we sure the hell couldn't sort it out. I am really pleased that you have been able to pull together.
I think as we evaluate whether we agree with your conclusions or not, if we could highlight, as I have tried to do in my questions, those areas that we are really backing off of regulatory overlay, and clearly understand who then will be participating in this unregulated environment, that will tee up very cleanly the public policy issue and help us determine whether that is a call we are comfortable with or not. Thank you very much.
Mr. SACHS. Thank you, Congressman.
Mr. EWING. Thank you, Mr. Pomeroy.
Mr. EVERETT. Thank you, Mr. Chairman. Thank you for calling what is, as Mr. Stenholm said, this complicated hearing. I am sure we all want to understand everything about this.
Mr. Sachs, you mentioned that the outstanding derivative contracts are at $80 trillion. That is an increase of about 11 percent in the last 6 months. How much of that business involves U.S. counterparties, and is the business booked in the United States at the same rate that it is booked in Europe and overseas, the same rate as world trade?
Page 29 PREV PAGE TOP OF DOC Mr. PARKINSON. I think the $80 trillion figure is derived from a survey that is conducted or organized by the Bank for International Settlements essentially the bank for central banks, and the way the data are collected, is on the basis of where their head office is located, but we don't know how much of that, say it is J.P. Morgan reporting a number, we don't know how much of that is being booked or negotiated at J.P. Morgan offices in New York as opposed to London or Tokyo or where have you.
Again, when in other surveys we have looked at this by center, the most recent data I saw did show that it was growing more rapidly outside the United States, particularly in London, than inside the United States. But I think we have to be carefulI don't think the data allow us to tease out what exactly the factors are that are driving that difference in growth rates. It is a complicated thing where many factors are coming to bear.
Mr. EVERETT. Thank you. Let me go back to something the chairman was talking about. The first recommendation from the working group is to create and exclusion from the CEA for most swaps agreements in order to provide legal certainty. Mr. Sachs, I have a three-part question here:
Don't the majority of swaps currently transacted already have an extremely high degree of legal certainty? Swaps today must reach the four guidelines under part 35 of swaps exemptions.
Also, is a higher degree of legal certainty needed for all swaps or only a certain type of swaps, such as equity swaps?
And then, finally, are swaps on single securities already legal? I guess the answer there is yes. But does the President's Working Group recommendation, if it is implemented, enforce that idea?
Mr. SACHS. I am not sure I got all three of those questions down, but your first question regarding legal certainty in the market now, there is a greater degree of legal certainty with respect to certain types of swaps than there is for other types of swaps, for instance, and this is all relative. We are striving to provide the greatest legal certainty possible, but as I said, it is a matter of degree, and there is greater certainty today for instruments such as interest rate swaps than there is for some securities-related swaps, as you referred to I think in one of your latter questions.
Page 30 PREV PAGE TOP OF DOC But it is not perfect legal certainty. As we learned in 1998, when the paper that the chairman referred to earlier was released, there was a great degree of legal uncertainty in the market and it caused quite a disruption. It is for that reason that we are recommending, that reason and others, that we are recommending an exclusion from the Commodity Exchange Act, because there is no greater legal certainty than that which can be provided in statute by this committee and the Congress.
I didn't get all of your question. I think your second question was regarding equity swaps, is there uncertainty for equity swaps or is it all swaps? Again, my answer to that question is similar to the one I just gave. There is currently greater uncertainty with respect to swaps that relate to securities than there is for interest rate swaps. But again, we seek to maximize the legal certainty that we can provide, and therefore have recommended an exclusion for all these instruments, both securities-related and interest rate swaps, for example, from the Commodity Exchange Act.
Mr. EVERETT. And the working group's recommendations will enforce that idea of
Mr. SACHS. Yes, sir. Yes. That was your third question. I apologize.
Mr. EVERETT. Finally, let me ask you, if implemented, how will the report change the responsibilities and jurisdictions of each member of the President's Working Group and of the committee?
Mr. SACHS. As far as how, I will attempt to answer that question, but maybe some of my other colleagues would care to address how it would affect them.
The recommendations in our report would not have a tremendousit is not immediately obvious to me that it would have a tremendous impact on any of the agencies at this table. The CFTC, for instance, and Bob may want to address this question himself, would probably be impacted more significantly by the results of the study they are undertaking with regard to exchange-listed futures, than they would by virtue of the recommendations that we have made, that we have made in this report. Certainly at Treasury it would not change anything that we do.
Page 31 PREV PAGE TOP OF DOC Mr. EVERETT. Mr. Paul.
Mr. PAUL. Yes, Congressman. Let me address the issue on CFTC jurisdiction. We believe that the report, the recommendations of the report, if enacted, would clarify the CFTC jurisdiction.
I also want to just back up to your question concerning part 35 exemption, because I think that is also in my bailiwick. That was one of your four-part question to Mr. Sachs. I think that the working group recommendations represent an important move forward from the part 35 exemption because currently, in order to comply with part 35, you must meet all the criteria, and those criteria no longer suit the current market.
As I pointed out in my remarks, and as Mr. Sachs pointed out and as the working group report also reflects, swaps, the evolution of the swaps market has led to greater standardization. In order to qualify under part 35, it must be bilateral, it cannot be cleared. We think that by permitting and recognizing the standardization of swaps, and not requiring that swaps not be standardized as a requirement for their enforceability, we think will lend greater legal certainty to the markets and also encourage the development of clearing systems that would reduce systemic risk.
So although part 35 may be working for certain swaps today, we think that it is not keeping up with the market. And that also ties in with what Congressman Pomeroy was asking about, with the blurring of distinctions. We are not causing the blurring, we are reacting to it, and we are trying to respond to it to make sure that we can interject legal certainty where it might be lacking, and where we can do whatever we can to minimize systemic risk.
With respect to the CFTC jurisdiction, coming back to your last question, however, in addition to clarifying the CFTC jurisdiction by excluding those swaps that the President's Working Group recommends be excluded, there are also some other things that the working group report does.
Page 32 PREV PAGE TOP OF DOC It recommends that the CFTC be given explicit jurisdiction to prosecute and take action against bucket shops that may be preying upon the retail public in foreign currency products. We think that is an important development. The Working Group also recommends and, as Chairman Ewing pointed out, as the letter from Congress on November 30 has asked that the CFTC undertake a review of its own regulations so that we may be able to adapt to the changing market structure and make sure that what we are doing is appropriate for the futures exchanges.
So I think there is a lot in the working group report that goes beyond simply the exclusion of swaps from the Commodity Exchange Act, so I think it both clarifies and in some respects even strengthens the jurisdiction of the CFTC.
Mr. EVERETT. Anybody else? Thank you, Mr. Paul, Mr. Sachs, Mr. Chairman.
Mr. EWING. Thank you. I want to recognize Congressman Condit, the ranking member for the subcommittee, for a statement and/or questions.
Mr. CONDIT. Thank you, Mr. Chairman. I do have a statement, and I would like to include my statement in the record and just quickly ask a question.
I guess Mr. Paul can respond, or whoever the appropriate person is. I would just like to know, will the oversight of the clearinghouse require a statutory change? Which agency or agencies should have jurisdictional oversight of the clearinghouse? Are you folks requiring or requesting or supporting a statutory or legal change? What standards do you propose to require and enforce for the clearinghouse?
Mr. PAUL. Well, I will start off with the answer, Congressman, though I am going to have to seek some help from some of my colleagues here to give you a complete answer.
The clearinghouse recommendation that the President's Working Group report has made would require legislative action because currently clearing would not be permitted for over-the-counter derivatives transactions without violating the part 35 swap exemption that I just was alluding to earlier. So to that extent we would need to ensure that clearing would not otherwise render a currently legal swap illegal as an off-exchange future.
Page 33 PREV PAGE TOP OF DOC Beyond that, what the President's Working Group report has recommended is that the current clearinghouses would be able to extend their purview into over-the-counter transactions and would continue to be regulated by those regulators that they are currently subject to. So for futures clearinghouses, they would be overseen by the CFTC; for securities clearinghouses, they would continue to be regulated by the Securities and Exchange Commission; and then for a new clearinghouse, I believe the report recommends that those be subject to the Fed or other banking regulators.
Mr. CONDIT. Did anyone else want to respond to whether there is a legislative remedy? Does that pretty much
Mr. SACHS. I think that covers it.
Mr. CONDIT. Thank you, Mr. Chairman.
Mr. EWING. Mr. Moran.
Mr. MORAN. Mr. Chairman, thank you. Thank you for the opportunity to participate in these hearings, and I thank the panel and the working group for their efforts in resolving some issues for us.
The report focuses upon regulatory relief. Is there anything else that needs to be done to reduce systemic risks within the markets, the futures markets, or to otherwise protect consumers, or are consumers adequately protected?
Mr. SACHS. Congressman, thank you for your question. As you indicated, our report did make a number of recommendations with respect to reducing systemic risk. We are always looking for other ways to help reduce systemic risk. It is one of the challenges that we continuously focus on and will continue to focus on.
We made recommendations in the report that my colleague Mr. Paul just referred to with respect to clearing. We think that facilitating the development of appropriately regulated clearing systems could greatly reduce systemic risk. We made recommendations with respect to electronic trading facilities which we believe could increase the efficiency and transparency of these markets. We also believe that that should serve to reduce systemic risk. And we reiterated some recommendations that we made in our hedge fund study that we released last spring which we also believe could serve to further mitigate systemic risk, including the provisions in the bankruptcy bill with respect to financial contract netting.
Page 34 PREV PAGE TOP OF DOC Mr. MORAN. Consumer protection?
Mr. SACHS. With respect to consumer protection, what we sought to do in this report was ensure that wherever retail investors had access to a market, whether that is in the futures area or foreign exchange or any other market, that there were consumer protections in place. And we looked at each one of the markets, and the one place where we did see a hole, if you will, was in the area of foreign exchange. And we did make a recommendation, a very specific recommendation in our report that the CFTC be granted explicit authority to police, to ensure that there were no unregulated bucket shops operating in that area that could take advantage of consumers.
Mr. MORAN. Mr. Sachs, in Chairman Greenspan's testimony, let me quote if I can, this is page 6:
In markets with significant economies of scale and scope, like those for standardized financial instruments, there is a tendency toward consolidation or even natural monopoly. Throughout much of our history this tendency has been restrained by an inability to communicate information sufficiently . . . In recent years, however, this constraint is being essentially eliminated by advances in telecommunications. We have not yet seen clear evidence of a trend toward natural monopoly. But the diffusion of technology often traces an S-shaped curve . . . Once we reach the steep segment of the S-curve, it may be too late to rationalize our regulatory structure.
What is Chairman Greenspan asking us to address? Those to me send out a message of concern, fear, the necessity of acting. What story is the chairman telling us?
Mr. SACHS. I can try to address that question, but given that Pat is here, I would probably prefer that he interpret the chairman's words.
Page 35 PREV PAGE TOP OF DOC Mr. MORAN. And I meant to say Mr. Parkinson. I am sorry, Mr. Sachs. I didn't mean to put you on the spot.
Mr. SACHS. That is quite all right.
Mr. PARKINSON. I would point out that that was in the portion of his testimony that talked about the issues with respect to traditional exchanges, the need for regulatory relief for financial futures, and also the Shad/Johnson issue that was teed up in the report but not resolved.
I think his point is that we are in a world where global competition is more and more significant because of the advances in telecommunication, and it was his intent to urge all those involved to move forward and to address these issues, for fear that if they don't, we could see activity concentrating in a single location. And the way things stand, where the marketplace perceives lots of unnecessary regulations in our country, if that happens, that location is unfortunately, likely to be outside the United States.
So I think that whole segment of his remarks, the context and the bottom line is the need to address the issues about regulatory relief that the CFTC is currently grappling with and the Shad/Johnson issues which your parent committee and the Commerce Committee have already urged the CFTC and SEC to resolve.
Mr. MORAN. Failure to act has two problems. One, our pride, or employment opportunities within the United States; but perhaps what the chairman, what you are telling me that we ought to also be concerned about, if this moves offshore, it may be a concentration or a very monopolistic circumstance.
Mr. PARKINSON. I think he is saying that it all could end up in one place, and the point is that if that is not in the United States, there is a loss of job opportunities, profit opportunities, and quite frankly a loss of ability for U.S. policymakers to influence the way things take place.
Page 36 PREV PAGE TOP OF DOC Mr. MORAN. Thank you, Mr. Parkinson. I thank the chairman.
Mr. EWING. Thank you, Mr. Moran.
Mr. BALDACCI. Thank you very much, Mr. Chairman.
Mr. Chairman, thank you very much for these hearings, and I want to thank the working group for its report. It is a step in the right direction, but it is a very small step and it does not deal up front with the issue about the CFTC regulation in terms of the questions that Mr. Moran asked.
And as a follow-up to that and in Chairman Greenspan's testimony ''Already the largest futures exchange in the world is no longer in the American heartland; instead, it is now in the heart of Europe.'' And the reason, I think, that theone of the larger reasons that has been is because of our slow pace at developing and implementing a structure to be able to meet the times.
And, I mean, I have been through this now for a few years and it is the same old song. We get a working group working on it, we are piecemealing the exemptions, and we are trying to sort of Band-Aid the approach and placate the people, but I think we are in danger of, frankly, all of the horses leaving the barn. I would really be really interested in hearing from the Fed representative again in this new world economy and following up on the chairman's words, what overall strategy that you think would be consistent with that for us to look at the reauthorization of the CFTC.
Mr. PARKINSON. Well, again, I think we have high hopes that the current commission under its new leadership will do what is needed in this area. I think in terms of the working group in this area, I think the most important thing that it said, it urged and supported the CFTC's review, and it set down a principle, which was that exchange-traded futures should not be subject to regulations that are unnecessary to achieve the CEA's objectives.
Page 37 PREV PAGE TOP OF DOC That really is the philosophy that is underlying the working group's report with respect to OTC derivatives: Identify the objectives, ask if regulation is necessary to achieve those objectives, and if not, get rid of the regulations. That same philosophy ought to be applied to exchange-traded futures.
Now, because there are some remaining differences, particularly I think in the area of retail participation, at least in certain of those markets, you may conclude that in some circumstances regulation is necessary on the exchanges that is not necessary elsewhere, but the case ought to be made. It shouldn't simply be presumed that because those exchanges for many, many years have been regulated the way they have been regulated, that that continues to be appropriate.
I take it that what the CFTC is endeavoring to do is essentially more or less a zero-based review of what the regulatory structure should be, but I am sure Bob can elaborate on that.
Mr. PAUL. Let me try to answer that as well, Congressman. We are very enthusiastic about the regulatory relief proposal that we intend to deliver to Congress by the end of this week. Under the dynamic leadership of Chairman Rainer, the entire staff at the CFTC has been working feverishly since November, even before we got the letter from Congress endorsing the President's Working Group report's call for regulatory relief for the U.S. exchanges. And we think that we are developing a program that is extremely flexible, that will provide the U.S. markets with a framework that will carry them into the next century, and that will maintain or help to sustain the prominence of U.S. markets in the world economy.
Mr. BALDACCI. I will be very interested in getting that draft report, as it relates to the reauthorization and also as it relates to these markets. The concern I share with other members is that at a time where the United States has a terrific economy, and it has been helped because of efficiencies in competition, that in this particular area we seem to have lost our way.
Page 38 PREV PAGE TOP OF DOC And it has been something that has been a constant drumbeat on my part, and other members of the subcommittee and the committee, and I just think that the sooner that we can address this issue, the sooner that we can reinforce the prominence, as it was stated earlier, so that we have an impact on policy, so that we just completely aren't responsive to some other foreign entity's control over an aspect of our financial future, especially when you talk about $80 trillion.
So, Mr. Chairman, I want to be able to enter a statement into the record, and thank you and those for being here today.
Mr. EWING. Thank you, and your statement will be included in the record.
Mr. SMITH. Thank you, Mr. Chairman.
Would you help me understand some of the background? How was the selection made of the individual representatives of the organizations that served on this committee?
Mr. SACHS. On this panel or on the
Mr. SMITH. No, no. On the President's Advisory Commission that did this report.
Mr. SACHS. The history of the working group came out ofsome folks who have been around longer than I have may be able to fill in some of the detailsbut this Working Group has been around since 1987, when it was established on the heels of the stock market crash. The principals of the working group are the principals of the agencies you see here. It is chaired by the Secretary of the Treasury, and includes the chairmen of the Federal Reserve, the SEC, and the CFTC, and those are the members of the group, along with other agencies of the Government that participated, but the four principle agencies are the ones that you see represented here.
Page 39 PREV PAGE TOP OF DOC Mr. SMITH. So maybe part of my question is, where is the minority report? What were some of the debates that maybe this committee and the Commerce Committee should be aware of in terms of the greatest differences between the working group members in deciding? What were some of the areas that received most debate and most discussion in terms of where we should be going and the regulation involved? Where is the other side of the story, I guess is what I am asking.
Mr. SACHS. Well, we debated each of the issues. When we sat down, when the members of the working group sat down to address the questions that were posed by Congress, we all decided, all the principals of the working group decided that we were going to try and come up with the best policies for the over-the-counter derivatives market and, to the greatest extent possible, put aside questions of jurisdiction. We debated all of the issues that
Mr. SMITH. You debated everything, but what I am just looking for, are there other areas where there was some disagreement, where there was real debate? Instead of giving this committee the final conclusion and say we finally agreed on this, should this committee be looking at some of those areas where there was real question in terms of finalizing a policy on this legislation?
Mr. SACHS. You know, as I said, Congressman, we debated all the issues. Early on we focused on, we agreed to focus on policy and not jurisdiction. We did spend a good deal of time discussing some of the questions that have already been posed here this morning, such as exclusion versus exemption. We debated what the impact would be on the various markets. We debated what would promote the greatest legal certainty. We debated what issues wouldwhat steps we could take that would mitigate systemic
Mr. SMITH. No, no, no. Yes, I appreciate it, and maybe there isn't any. I am just looking for some of the alternatives such as Mr. Stenholm suggested. Can we get anything more than the final report as far as what we are debating, rather than simply a justification of what ended up in what I suspect at least to some extent is a compromise report? Mr. Greenspan came before this committee 2 years ago and talked about the differences between the on-exchange and the over-the-counter derivatives, and the kind of oversight that would be reasonable at that time.
Page 40 PREV PAGE TOP OF DOC I guess maybe one of my questions, since this is an agricultural committee, what are the differences you see between the agricultural derivatives and the financial derivatives, and the justification of why they should be treated differently?
Mr. PAUL. Let me try to take a crack at that, Congressman. The President's Working Group report was clear in its recommendations in excluding nonfinancial commodities with finite supplies from its recommendations. Obviously, nonfinancial commodities with finite supplies would cover the agricultural products. We believe that it is important to leave those products within the jurisdiction of the Commodity Exchange Act, subject to the oversight of the CFTC.
So I guess with respect to drawing the line between financials and agriculturals, or at least the nonfinancial with finite supply, a determination was made that, as Mr. Sachs pointed out earlier, where there is no susceptibility to manipulation in the underlying product, where the market is not used for price discovery, and where the market is not accessible to retail customers, there is no justification for the jurisdiction of the Commodity Exchange Act or for oversight by the CFTC. The agricultural markets, however, have all of those features, and that is why they will remain under the jurisdiction of the CEA.
Mr. SMITH. And so conceptually we should group the on-exchange financial futures with their over-the-counter relatives, rather than grouping the financial futures with the traditional agricultural futures?
Mr. PAUL. Not necessarily, Congressman. To the extent that the futures exchanges are used as a source of price discovery for some of the financial contracts, that still would justify oversight by the CFTC. And to the extent that those markets are available to retail customers, that also would warrant continued oversight by the CFTC.
Mr. SMITH. Is there a greater detail record, in case we wanted to pursue it, in terms of the discussion? Is there a recorded history of the debate of your meetings over the last couple of years?
Page 41 PREV PAGE TOP OF DOC Mr. PAUL. I will answer that. I will turn it over to Mr. Sachs after this. Not to my knowledge. I think it is important to remember that the members of the working group, at least I certainly got this message from our chairman, very important that the group reached a consensus and that all of the members of the working group firmly believed in the recommendations that the report ultimately made. And it was important simply because the reason for the report was to address legal uncertainty in the markets.
And by reaching unanimity among the four members of the working group, and I think that both Secretary Summers and Chairman Greenspan made this point effectively last week in the Senate hearings, it is very important to send the message to the markets that the four members of the working group were in agreement as to the basic recommendations. So I think it may undermine that consensus if we were to concentrate on the differences that were discussed in reaching the final agreement.
Mr. SMITH. Thank you, Mr. Chairman.
Mr. EWING. Thank you, Mr. Smith.
Mr. ETHERIDGE. Thank you, Mr. Chairman, and let me join the others in saying how much I appreciate you having the hearing, and giving us time to increase our learning curve in this process. This is a difficult area, but it also means it is a very important area, and I want to thank the members of the panel who are here today and the working group for the work they have done. There are going to be a lot of questions we are going to have to have as we increase the learning curve.
Congressman Moran talked a few minutes ago about this whole area of helping reduce the systemic risk in the industry as we move forward, and I won't go into that any more. There is a couple other points I want to get in the time that I have, but that is an area I think that is important as it reflects to the consumer and others, especially at a time when we are seeing the markets grow tremendously and we look to the fivefold increase now in the last decade.
Page 42 PREV PAGE TOP OF DOC I want to touch on something you just covered a minute ago and go into it a little deeper. How important is it that we pass provisions to assure legal certainty in the derivatives market this year? Let me follow that up with, what happens if we don't? Now, I know you talked about will it move offshore, but I would like to hear a little bit more detail on that.
Mr. SACHS. Congressman, thank you for your question. It is, we feel, very important to move forward on this as quickly as possible. As you indicated, we are seeing a migration of this business into overseas markets, and as I believe one of the panelists last week, maybe Chairman Greenspan, indicated that once these markets do migrate offshore, for instance as happened with the Euro dollar futures contract, it is very, very difficult to bring them back. It is primarily for that reason that we recommend that this legal certainty be provided to the greatest extent possible and as soon as possible.
I don't know if any of my colleagues want to further address this.
Mr. ETHERIDGE. Well, in that light, given that it has taken 13 years to get to this point, literally since you started the formation of the working group, is it possible to achieve real regulatory relief for the U.S. futures exchanges this year?
Mr. PAUL. With respect to relief for the exchanges, as I stated earlier, we are optimistic about the initiative that we have undertaken pursuant to our exemptive authority under section 4(c) of the act, and we think that the proposal, the outline of which we are delivering to Congress on Friday, will set forth a structure that will provide meaningful reform for some of the regulatory burdens that the exchanges may find themselves under now, and that will provide a more flexible framework that is adapted to the current market conditions and the technology and innovations that currently characterize the futures markets both here and abroad.
That does not require legislative action. We are doing as much as we possibly can do on our own, under our own initiative, with our own powers. But to provide the kind of relief that the over-the-counter markets require, clearly that will require congressional action.
Page 43 PREV PAGE TOP OF DOC Mr. PARKINSON. If I can just add, I think the two reasons we need congressional action are: first, the CFTC's exemptive authority does not extend to equity swaps, so they cannot provide the needed certainty there; only Congress can do that; and, second, again at least at the Fed we have a longstanding preference for a statutory exclusion to a regulatory exemption, because of the fact that exemptions are subject to subsequent amendment by future commissions. And I guess we feel so strongly, at least in the OTC area, and we have concluded so firmly that we don't need regulation under the CEA for these products, we believe that the exclusion is the right route.
Mr. ETHERIDGE. Thank you, Mr. Chairman.
Mr. SMITH [presiding]. We have to figure out who is next.
Mr. THUNE. Mr. Chairman, I have no questions at this time.
Mr. SMITH. Mr. Gutknecht.
Mr. GUTKNECHT. Thank you, Mr. Chairman. I will try to sort through this. I have been in the State legislature, now in Congress, and I would have to say this is the most complicated issue I have ever had to deal with. It is very, very difficult, and we appreciate the work you folks have done to help us try to sort this out.
I must say that my greatest concern is not just the proliferation of the number of derivatives and things that can be traded, but that we are moving more and more to electronic trading. And I have a real fear or I don't know what, concern, something about where you have live people at a live exchange with real human beings, they serve as a buffer to sometimes wide, wild gyrations. But we are moving, it seems to me, towards more electronic trading of all kinds of things where computers are going to be talking to each other, and I think the potentialI mean, my own sense is, the potential of another meltdown like we had with Long Term Capital is greater.
Now, within the context of your recommendations, can you help allay those fears?
Page 44 PREV PAGE TOP OF DOC Mr. SACHS. Congressman, you raise an interesting question and one that all of us, this committee, members of this panel, will be facing for some time. It is my experience that markets and investors will migrate, investors will migrate to that market which provides the greatest liquidity, the greatest efficiency, and the greatest transparency, and
Mr. GUTKNECHT. But that would argue that they would not go to electronic trading.
Mr. SACHS. And if that is the case, then they wouldn't. My point is that we are not sitting here on this panel suggesting what the markets should do. We want to present a framework that will allow the market to decide what the most efficient, most transparent, most liquid market would be.
If market participants determine, as you have suggested, that having a number of people trading, for instance as they do in the pits, then that indeed is where the market participants will migrate. If on the other hand they were to determine that an electronic trading system were to provide the greatest efficiency, the greatest transparency and the greatest liquidity, then that is probably where market participants would migrate.
Again, we are not trying to guide the market in any one direction. The market will guide itself. We just want to assure that we are not precluding the market from going down the path that it believes is the most appropriate and the most efficient.
Mr. PAUL. Congressman, let me just add that I am not sure that I agree with your conclusion that the electronic markets don't provide those things. I think the three points Mr. Sachs hit on, liquidity, transparency and efficiency, many might argue can be delivered by electronic systems, and I think that is one of the main reasons why now the largest exchange, the largest futures exchange, does reside in Europe as opposed to the United States, because that is a purely electronic market.
Page 45 PREV PAGE TOP OF DOC I agree with Mr. Sachs that the working group and certainly not the CFTC is choosing what mode the markets should shift to, but we are going to let the markets decide that. And I think that because of things like the clean audit trail that electronic trading can provide, because of some of the information it can provide on market depth and things like that, I think the jury is still out as to which markets may be more efficient. And I think we want to make sure that we provide the flexibility to allow innovation in technology to develop, and then let the markets choose where they want to do their trading.
Mr. GUTKNECHT. Well, Mr. Parkinson, would you respond toI mean the last time when it happened with Long Term Capital, it was the chairman who had to sort of step in and sort things out. Doesn't that become even more complicated and difficult if you are talking about electronic trading that happens in cyberspace?
Mr. PARKINSON. I don't think that is necessarily so. I think it is important to remember that when we discussed the implications of Long Term Capital and discussed the policy prescriptions that were appropriate in light of it, the Commodity Exchange Act did not play a large part in those discussions. Why was that? Because the problem there was not OTC derivatives per se, it was leverage more generally, and the real issues are improving risk management across the board as it governs the trading in OTC derivatives, securities, what have you, and that is where the thrust of the effort has been.
I think Bob made the important point, that I don't think there is a public policy reason for choosing for or against electronic trading. We ought to let the marketplace decide. I think in terms of concerns about risk, the issues are different, but there are always issues of how to structure appropriate internal controls and how to manage your risk.
You mentioned you feel better about humans being involved. I guess that depends on who the humans are. When we think of all the stories about rogue traders over the years, those were human beings behaving in ways that it turned out we didn't much approve of. In fact, I think if we have the proper controls, vogue trading is more difficult or can be made more difficult, not less difficult, in the electronic trading environment.
Page 46 PREV PAGE TOP OF DOC But, again, it is all dependent on the firms instituting the appropriate internal controls to make sure that decisions being made by traders, whether they are being executed by yelling out an order or typing into a terminal, are decisions that are consistent with the objectives of the firm and the risk parameters that the board of directors and senior managers have set out.
Mr. GUTKNECHT. Just that point, my colleague here made a very interesting side comment that human beings at least respond to the time-tested motives of greed and fear. Computers don't, though. They just crank away. And I don't know if we have an answer for that, but it just strikes me that I don't feel real comfortable with the direction we are going, especially when we are starting to talk about billions and billions of dollars.
Ultimately if large firms walk into that casino and they lose billions of dollars, that is their business; I don't care. But if they start to drag our own monetary policy and other very large institutions with them, then all of a sudden it is not just a matter of them taking certain risks. And I understand that the reason they practice the derivatives and the swaps and so forth is to minimize risk, but I am still not satisfied that we have really come to grips with the potential of a big problem and whether or not we have the regulatory wherewithal to deal with it.
Mr. SACHS. Congressman, if I could just add a comment or two to this dialog.
When you first laid out your question, you talked about the concerns surrounding electronic trading. I just would like to point out that the recommendation we are making is to exclude electronic trading facilities, which isactually it is a means of communication, it is not, the decision function in these systems is not, quote, in the hands of computers. It is still in the hands of individuals who are making the actual decisions as to what to buy and sell. Admittedly, they are assisted in various of these strategies by computers, but the actual decision to buy or sell on these systems, as it is in the pit, is made by the individuals.
Page 47 PREV PAGE TOP OF DOC As far as sorting things out when there are problems, I agree and I think we would all agree that that is something on which we all need to focus and have focused. No one here would suggest to you that there won't be problems in the future. A number of our recommendations, however, are designed to facilitate the work-out of those problems when they do occur, for instance, our recommendation with respect to clearing, our recommendation with respect to the provisions in the bankruptcy bill that reference contract netting and offsets. So I just wanted to make sure that I made that clear.
Mr. EWING [presiding]. Thank you, Mr. Gutknecht. I think that is a line of questioning that is on many people's mind, and it is good to have that discussion.
A guest on our subcommittee today, Mrs. Clayton, welcome back.
Mrs. CLAYTON. Thank you. A former member, as well.
Again, this is certainly over my head, but the principles of it is not, and the principle, as the chairman stated in the Senate hearing, was the determination whether we ought to impose Government regulation. Chairman Greenspan says imposing Government regulation on the market can impair its efficiency. And I guess my question is going beyond the efficiency of the market, as to the fairness and the manipulation and the fraud, and that is a different principle.
I just wanted to know from the collective members or the individuals if we should assume that the efficiency principle is stronger than the fraud principle or the manipulation principle or the fairness principle. And so to the extent efficiency drives all of those over-the-counter trading to Europe or to Asia, does it make any difference? As to efficiency, the market works itself out to its best position.
And how do we therefore give credence to this in terms of the public policy or assuring that it is fair. Is it only the transparency requirement? How do we assure that there is not fraud or manipulation? And confidence, I should say, in it. Certainly when we had the hedge failure some time ago, that certainly didn'twhat was called the Long Term Capital management hedge fundthat did not instill confidence. It probably wasn't fraud.
Page 48 PREV PAGE TOP OF DOC But could you just help us out, help me out, this struggling former member trying to understand how the marketplace assures the participants that its only and primary principle is not efficiency but also fair play, lack of fraud, lack of manipulation, and there are other principles that we are trying to.
Mr. PARKINSON. I don't think that Chairman Greenspan meant to suggest that the goals of protecting the public from market manipulation and fraud should be subordinated to the goal of efficiency. Rather, given that regulation inherently does have a negative effect on efficiency, you should regulate only if that is necessary to protect the public against fraud and manipulation. But, indeed, if that is necessary, then by all means proceed to regulate.
I think the question is, in the case of many of the products that we are talking about here and the markets in which they are traded, whether it is necessary. If you have a financial derivative where the supply is virtually unlimited, it is very difficult to conceive of that contract being manipulated. If the participants in that market are sophisticated investors, they are not susceptible to fraud in the same way that the retail public is.
And one point of view is that we should not be protecting, for example, large banks and securities firms and other large institutional investors from fraud; they should be protecting themselves, and they have the incentive and the capacity to do so. They are not at the disadvantage that a member of the retail public might be if they were to participate in these same markets.
So, again, it is not a matter of subordinating those important public policy objectives to the objective of efficiency. It is recognizing the adverse effects of efficiency, and therefore regulating only if it is necessary to achieve those other equally important objectives.
Mrs. CLAYTON. Thank you. Could you tell me, is there a mechanism in place that identifies when that threshold is being approached, as to when there is a need? Is there a monitoring process that is in place now, that allows you to feel confident, that protectsrather, large banks ought to protect themselvessay the smaller participant in the marketplace?
Page 49 PREV PAGE TOP OF DOC Mr. SACHS. Congresswoman, I will attempt to answer that question. As far as there being a specific mechanism in place, there is not one that immediately comes to mind, but we have attempted to craft our recommendations in such a way that, as my colleague Mr. Parkinson was pointing out, that if we exclude only those instruments which are not readily susceptible to manipulation, and we only allow participants who can either protect themselves against fraud, or in the case that they are defrauded, address those issues through the court system, that by doing that up front we don't necessarily have to have a mechanism in place to address the issues to which you refer.
Having said that, I would like to emphasize what Pat said a moment ago and I think what all the panelists said last week at the Senate hearing, which is that there is a balance here and we do have to weigh the costs and benefits of various regulations and laws. We have attempted to do that in our recommendations by essentially drawing the lines where we have recommended they be drawn.
Mr. EWING. Thank you, Eva.
Mr. RILEY. Thank you, Mr. Chairman.
This is certainly a complicated process for me, and I am trying to work through it. But as I have listened to the testimony today, I have come up with two or three questions that may be elementary to you but I would like some clarification on.
Mr. Sachs, a moment ago you said that the markets will tend to migrate to the most efficient, transparent, less regulated markets. By saying that, I wonder, if we enact the working group's policy, how then will our markets compare to Europe's? Will we be as efficient? Will we be as transparent?
Mr. SACHS. Congressman, thank you for your question. I do not believe I said that the markets would migrate to those that are less regulated. If I did, I did so in error. What I was attempting to suggest was that participants in the market will migrate to those markets and those venues where there is greatest liquidity, transparency, and efficiency. The concept of less regulation isn't one I was trying to convey. Appropriate regulation is fine.
Page 50 PREV PAGE TOP OF DOC Mr. RILEY. How competitive will our markets be with the European markets, if this Working Group recommendation is implemented?
Mr. SACHS. I think our markets will be quite competitive. Our markets have always been the most competitive in the world. The markets have advanced tremendously in recent years. We have made a series of recommendations here that we believe would bring the regulatory framework up to speed with where the market has gone, with the way the market has developed, and if our recommendations are implemented, we feel quite strongly that the American capital markets will compete quite effectively with other jurisdictions throughout the world.
Mr. RILEY. A second question. Since this is an agricultural hearing, you say that we will continue to have basically the same regulations on our agricultural products as we do today. Is that true also of Europe and other trading centers around the world? And, if so, doesn't that put us at a classic disadvantage with the rest of the world?
Mr. SACHS. Maybe Bob is better equipped to answer this question than I am. I am not entirely familiar with agricultural product regulation overseas.
Mr. RILEY. Well, it is my understanding from what I have heard this morning, any finite product is still going to be regulated much in the same manner that it is today. Is that true of the rest of the markets in the world? And, if so, doesn't that put us at some kind of distinct disadvantage?
Mr. PAUL. That is a very difficult question, Congressman. Let me try to answer it this way. To the extent that the products traded in markets overseas are also traded on regulated exchanges, they are subject to regulatory schemes not unlike ours. One key difference is that they may be under a single regulator, but different jurisdictions have different rules that obtain on those things.
I don't think that we would be at a distinct disadvantage that I am aware of, because there are certain regulatory principles that have been adopted by most of the developed countries through IOSCO and other international organizations of financial and agricultural regulators. So I think that it is a difficult question to answer, but I guess suffice it to say that there are different regulatory schemes which may or may not compare favorably to ours.
Page 51 PREV PAGE TOP OF DOC Mr. RILEY. One of the things that has bothered me ever since I have been on this committee is our inability to have a policy that accentuates agricultural products, and it seems to me if the same problems that would exist in securities markets or any other markets, if they don't apply to agriculture, why don't they? And I just have a basic problem understanding why, if we are losing market share, which all of us on this committee know that we are, it seems to me like we would do everything that we possibly could to enhance that market. This doesn't seem to address it at all.
Mr. PAUL. Let me go back to something else I talked about earlier, and that is our own regulatory reform initiative. We think that the proposals that we will be presenting to Congress at the end of this week for regulatory reform for all U.S. exchanges, including those that trade agricultural products, will benefit the agricultural markets, so we are not standing still with respect to our regulatory approach to the agricultural products.
The CFTC considers the agricultural products very important. The participants in the agricultural markets are very important from our standpoint as to those that require our protection and the ability to promote innovation and flexibility in those markets.
So I think that we are addressing that through our own exemptive authority as well as our ability to, in essence, rewrite our rules, as Mr. Parkinson put it, from ground zero. So I think that we will be trying to provide the agricultural markets with effective regulatory reform that should maintain their prominence against their competition throughout the rest of the world.
Mr. RILEY. Well, as all of you understand agricultural products are one of our major exports. It just seems to me if I was doing swaps and derivatives today and I still had to work under the same regulatory system that I have, I would probably rather do it in Europe, which makes absolutely no sense to me. If we are going to have this basic relief, then I don't understand how you exclude agriculture.
Page 52 PREV PAGE TOP OF DOC My time is probably up, but let me ask you one other question. How did you arrive at the size determinant? How did you come up with a definitive number for the exclusion?
Mr. SACHS. I suppose I can address that question, Congressman. For businesses we essentially just followed the guidelines that are already in place with the swap exemption. For individuals, we decided to raise the bar from, I think it was $10 million before to $25 million now, and there were essentially two reasons for that. One, it was just to make sure that the participants in these markets truly were large, large participants, and wanted to restrict to the greatest extent possible retail participation; and also that that was a numberthese recommendations were crafted at a time during which the financial modernization bill was being written, and that was a number that was being used in one or two places in that bill at that time, so that is where it came from.
Mr. RILEY. Well, the reason I asked that, some of the most sophisticated investors I have ever known won't trade in the $25 million bracket, but I think they should have every option to participate in the same broad network as a larger one if they meet certain criteria for their institutional knowledge and ability to do this. It seems somewhat strange to me to say that you have to deal in certain sizes rather than in certain sophistication levels.
Now, how you would determine that, I don't know, but like I say, some of the most sophisticated people I have ever known, some of the most astute investors I have ever known, might trade at the $8 to $10 million level, not at the $25 million, and I think they should have the same option, the same right to do so. And can we carve out any kind of exclusion for those, if they meet a certain criteria or a certain standard of sophistication, that would allow them to do so?
Mr. SACHS. Congressman, certainly it is up to this committee and others to figure out how to draw this line
Page 53 PREV PAGE TOP OF DOC Mr. RILEY. Yes, but I think you will have to come up with some kind of criteria for us to look at in order to be able to judge. I am not too sure this committee has the sophistication to do it. It is something that I hope you will look at.
Mr. SACHS. We will continue to look at this, and will work with the committee as you craft the legislation that goes along with these recommendations.
Mr. RILEY. Thank you.
Thank you, Mr. Chairman.
Mr. EWING. Well, Mr. Riley, I think this committee is very sophisticated. If you want to pick on the witnesses, you can pick on the witnesses; you just can't pick on the committee.
Mr. RILEY. A point well taken.
Mr. EWING. Mr. Stenholm, and then Mr. Thune.
Mr. STENHOLM. Thank you, Mr. Chairman.
A question for Ms. Nazareth and Mr. Paul: The letter that Chairman Rainer and Chairman Levitt received from this committee and the Commerce Committee asking that you begin talks on reforming the Shad/Johnson Accord and report to the committee by the 21st of February, how are these discussions going?
Ms. NAZARETH. Well, we are actively involved in discussions relating to the Shad/Johnson Accord, as requested by Congress. As you can imagine, these are very difficult issues because they are issues of regulatory arbitrage and investor protection, and so we are very mindful of the insider trading issues, the market manipulation issues, the suitability issues, margin issues. These are all things that we are trying to address in these discussions, and the discussions are ongoing.
Mr. PAUL. Let me just echo Ms. Nazareth's comment that characterizes this as a very complicated issue, and it is a big challenge for both of our staffs. I will say that we are making every effort to work through these difficult issues, and last week, along with other members of the CFTC staff, I met with members of the SEC staff not less than three times, and we have more meetings this week, and we are making every effort to hammer out some sort of resolution to this very difficult issue. So we have taken those letters extremely seriously and we are making every effort to try to respond.
Page 54 PREV PAGE TOP OF DOC Mr. STENHOLM. You are going to make it. Sure, you are.
Mr. PAUL. I appreciate your confidence, Congressman.
Mr. STENHOLM. You will come up with a way to work through it.
You know, there has been a kind of a tone of many of the questions this morning that is of concern to me also, and this is not going to be necessarily a question. Maybe it will be, and if you would care to respond, I would appreciate having it.
In the aftermath of the Long Term Capital management bailout, Euro Money magazine reported that the incident illustrated that financial services firms' capital reserves were not calculated to account for the most severe possibilities. The chief executive of Credit Suisse financial products was quoted as saying that financial regulators need to rectify problems because it will be difficult for the market to do this on its own, given the competitive pressure of business.
We notice from time to time we get into situations in which, as I have heard my colleagues saying before, than banks that are big, as we have said, if you lose a billion or two, so what? Or any individual that can lose that kind of money, so what? I don't disagree with that. But there seems to come a point from time to time in which that ''too big to fail'' becomes a national policy concern.
Just last week I observed in reading that when suddenly folks began to think seriously that we might actually pay off the debt held by the public in a time certain, that the bond market reacted in a way in which the, quote, sophisticated traders have never put into their calculations as something that might happen, and it caused everybody to step back.
And I guess as we pursue this, as to what is to be exempted and what is not to be exempted, I hope that we will also continue to look at the unforeseen; those things that can occur in an $80 trillion market, of which I get a little, I guess a little bit concerned sometimes. Mr. Riley's question a moment ago, when we talk about finite, we know we have got X bushels of wheat. Don't we have X bushels of dollars or Euros? I mean, is there just unlimited quantities of this stuff that just keeps coming up? I guess, if so, then that is another problem.
Page 55 PREV PAGE TOP OF DOC But, any comments? Reassure me a little bit.
Mr. SACHS. I will make a couple of comments. You raise some very important issues, as always, Congressman. I would say a couple of things.
Number 1, our recommendations with respect to what should be excluded from the Commodity Exchange Act, as I mentioned earlier, are designed to addressto exclude transactions and instruments that we believe are not readily susceptible to manipulation or fraud, and that the types of incidents to which you are referring, whether it is a Long Term Capital or near failure or failure of another financial institution, would not necessarily be impacted by greater regulation under the Commodity Exchange Act.
For example, one of the most celebrated financial failures in the recent past was that of Barings. That was a large, regulated institution trading regulated instruments that were listed on a regulated exchange. I don't think anyone can sit here or should sit here and tell you that there won't be those types of incidents in the future.
The question that we set out to address is, with respect to our report, what is appropriate regulation under the Commodity Exchange Act? We did make some recommendations in the report, as I said, to address, as I said earlier, to address the fallout of the kind of incident you are discussing, to facilitate the work-out of that type of incident, but history has shown repeatedly that regulated institutions trading regulated instruments can face trouble as well. It is not necessarily the trading of an over-the-counter instrument that is the cause or a contributor to that kind of failure.
I don't know if I addressed all your points.
Mr. STENHOLM. Mr. Parkinson, any comment?
Mr. PARKINSON. Just that I think you have put your finger on what is the most important issue from the perspective of systemic risk, and that is leverage, or stated another way, capital adequacy. Do firms have enough capital to absorb the potential losses that are inherent in the positions and strategies that they are adopting? That is an important concern. It is one that is actively being addressed by the banking supervisors. We have been constantly trying to improve the capital requirements that apply to banks, and that is an ongoing, perhaps never-ending effort.
Page 56 PREV PAGE TOP OF DOC I would say that in terms of the question of what is exempted, what is not exempted, I think you have to ask what bearing does that have on the need for capital in an institution. Whether an instrument is exempted or not exempted doesn't affect the inherent market risk characteristics of that instrument, how much you can gain or lose because of market movements from holding that instrument.
What it does affect is the legal risks, and I guess one message here is, given that as you say we never know quite how much capital is enough and we are concerned about excessive leverage, we want to avoid the danger that losses might be compounded, in the event of unexpected market developments, by efforts by counterparties to avoid enforcement of the contracts by appealing to the Commodity Exchange Act. And that is why, by addressing the legal uncertainty issues, in fact you are making a contribution to addressing concerns about leverage and potential losses exceeding the capital that firms have available to meet them.
Mr. STENHOLM. I gather by that answerMr. Pomeroy asked earlier a similar question along this linein the bank regulation you are looking, you do look regularly, or whoever the regulator does look at leveraging and capital adequacy from the bank examiner standpoint?
Mr. PARKINSON. Absolutely, and in such analyses you look the full portfolio positions that an institution is holding, whether they are over-the-counter, on exchanges, whether in the United States or outside the United States. You look at the risk characteristics of the full portfolio, so in that sense we are addressing the leverage issue, particularly with respect to the market risks of trading in these various instruments.
Mr. EWING. Mr. Thune.
Mr. THUNE. Thank you, Mr. Chairman. And by the way, Mr. Chairman, I just want it to be noted for the record how sophisticated I think you are.
Mr. EWING. You are doing very well on this committee, too.
Page 57 PREV PAGE TOP OF DOC Mr. STENHOLM. Mr. Chairman, you want to call for a vote on that?
Mr. THUNE. Get that on the record.
Mr. SACHS. The panelists concur.
Mr. THUNE. Let me, and I guess I would be anxiouswhat I would like to see come out of this, and I think your Working Group recommendations give us some direction on this, but to define just exactly what it is that we can accomplish, there are some things that are seriously in need, obviously, of being fixed.
And like Mr. Stenholm, I am anxious to find out what recommendations you might have, under what conditions you think that single-stock futures might be permitted, trading might be permitted, so hopefully if that is something that can be addressed in the context of what we need to get done this year. Obviously the legal certainty issue is paramount consideration, but I think we all are interested in what can we come to agreement on, what can we find consensus on, and what can we get done, knowing that there are some of these things that need to be addressed in the near term.
Just a couple of questions. I guess I would be curious, coming back to this whole question of manipulation, have any of you dealt with financial manipulation in the past?
Ms. NAZARETH. Our agencies certainly have. I am sure we, perhaps not personally but certainly through our agencies, have spent a great deal of time focusing on financial manipulation.
Mr. THUNE. Right. Are there specific cases, though, from which you can draw on past experience, things that we might be able to avoid in the future?
Ms. NAZARETH. I think to a certain extent the underpinning of this report reflects the fact that because of the experience that these agencies have with dealing with financial manipulation, I think that that very much colored where the group came out in terms of what was an appropriate area to basically exempt entirely from the kinds of regulations that focus on financial manipulation.
Page 58 PREV PAGE TOP OF DOC And here essentially it was over-the-counter derivatives that were bilateral transactions. The $25 million number was really a proxy for sophistication. That was an area, given I think the significant experience that people whose agencies are represented here had, we thought that that was an appropriate area to exempt from regulation.
Mr. THUNE. Mr. Sachs, there has been some talk recently about whether or not the Treasury might be planning on scaling back future 30-year bond issuances. Is there a possibility that 30-year bonds could become a manipulable commodity if that happened?
Mr. SACHS. The trading of instruments that relate to Government securities is addressed in the Treasury amendment, and those instruments are specifically excluded, by virtue of falling under the Treasury amendment, are specifically excluded from the Commodity Exchange Act. To the extent that any derivative is used to manipulate the price of a security, whether it is Treasuries or any other security, the SEC has authority to look into that activity. So whether it is Treasury securities or other securities that are referenced in an over-the-counter derivative, the SEC would certainly look into that.
Ms. NAZARETH. I think it is fair to say, though, I can venture to say even with a 30-year bond, there are enough substitutes for that that I don't think we wouldI assume we wouldn't ultimately consider that a product of finite supply, the way you would an agricultural commodity.
Mr. SACHS. Congressman, if I could add to that, the great majority of the derivatives we are discussing today are cash settled. In other words, the security, whether it is a Treasury or other security, is not necessarily deliverable at the termination of that swap. So, for instance, you and I could enter into an interest rate swap and create new supply, essentially, just by virtue of signing the same piece of paper.
Mr. THUNE. So you don't have a concern that there would be any limit or that the supply would be finite on
Page 59 PREV PAGE TOP OF DOC Mr. SACHS. Not for the instruments we are discussing today, no.
Mr. THUNE. Ms. Nazareth, could you kind of compare what is going on regarding electronic trading in the futures exchanges to the situation with electronic trading on stock exchanges?
Ms. NAZARETH. That is an interesting question. I am somewhat less familiar with the futures exchanges, but certainly on the stock exchanges I think we are seeing more and more development over time towards more electronic trading. I don't think that that has happened, frankly, quite as quickly as we thought it would in some of the traditional exchanges, but I think we are seeing in our marketplace more and more new entrants, either as electronic communications networks, or we now have a soon to come on line fully electronic options exchange. It will be the first options exchange, if the commission approves it, to be registered in 27 years. And so I think we are definitely seeing a movement towards more electronic trading, certainly in the securities markets.
Mr. THUNE. Mr. Paul, do you have anything to add on that?
Mr. PAUL. I guess I just would reiterate my comment earlier with respect to EUREX, which became the largest exchange in the world as a result of focusing on electronic trading, and how 2 years ago it had overtaken the LIFFE exchange in London as the primary market for the Bund contract simply by dint of improving the efficiency of its electronic trading.
And what we see currently in the United States is a lot of joint alliances between our exchanges and some of the overseas electronic exchanges, as well as the Cantor exchange which haswhich was established as a purely electronic exchange. And we just issued an approval for a pilot program for that exchange to engage in block trading, and it will be interesting to see how that evolves.
Page 60 PREV PAGE TOP OF DOC Mr. THUNE. Do you think that the recommendations of the working group bring us closer to or further away from standards observed in other countries, in foreign jurisdictions that you examined during the course of your deliberations on this?
Mr. PAUL. Well, I mean, I think electronic trading is an issue that is being grappled with by regulators around the world, and I think that the Financial Services Authority in the United Kingdom, for example, is dealing with almost exactly the same issues that we are dealing with; the same with regulators in Germany and France and elsewhere.
I think, without comparison shopping, I think what we are trying to do is develop the best regulatory approach that provides the flexibility that will enable our markets to evolve and innovate technologically, so that they can sustain their position of prominence throughout the world.
Ms. NAZARETH. I agree with Mr. Paul's response. I think that what the report does is, it permits the markets to avail themselves of these techniques which have substantial benefits for reducing systemic risk. It certainly doesn't mandate that the markets move towards more electronic trading, but it permits it, and it doesn't basically cause these transactions to then fall within the Commodity Exchange Act by virtue of availing themselves of those techniques.
Mr. THUNE. I thank the panel, and Mr. Chairman, I yield back the balance of my time.
Mr. EWING. Thank you, Mr. Thune, and my thanks to the panel for an excellent time, and I think that we had a very good discussion of some of the important issues, and you are welcome to stay for as much or all of the hearing. Thank you very much.
Mr. SACHS. Thank you, Mr. Chairman.
Mr. EWING. Our next panel will be Mr. Scott Gordon, chairman of the Chicago Mercantile Exchange; Mr. Daniel Rappaport, chairman of the New York Mercantile Exchange; and Mr. Mark Young, a partner, Derivatives and Financial Services, Kirkland & Ellis, on behalf of the Chicago Board of Trade. If these gentlemen will come to the front and take their seats, we will go ahead with the second panel.
Page 61 PREV PAGE TOP OF DOC Thank you, gentlemen, and I have introduced each of you as you came forth, and so we will start with you, Mr. Gordon.
STATEMENT OF M. SCOTT GORDON, CHAIRMAN, CHICAGO MERCANTILE EXCHANGE
Mr. GORDON. Thank you, Mr. Chairman, and Ranking Member Condit, members of the committee. I am Scott Gordon, chairman of the Chicago Mercantile Exchange, and I thank you for the opportunity to appear here today. I am pleased to be accompanied by Jim McNulty, our new president and CEO, who joins us with 25 years experience in the OTC markets. He has been an end user for 25 years, he has been a provider of services for 25 years. He also knows the exchange markets in depth. It is clear that our focus will be on what is best for our end users and clients.
I ask that my written testimony be submitted for the record, and I will give a very brief synopsis.
We welcome the opportunity to offer our view on the report of the President's Working Group on Financial Markets. I want to begin by unequivocally expressing our support for the efforts of the CFTC under Chairman Rainer to reexamine and reassess the regulatory structure of our industry. The commission's initial revisions to its thick book of regulations demonstrates a commitment to bring regulatory burdens into line with regulatory needs.
That said, and without criticism of our regulator's endorsement of the report, it is fair to say that the CME is extremely concerned. It is clear to us that the report's proposal unjustifiably tilts the playing field against existing exchanges.
The Chicago Mercantile Exchange, the Chicago Board of Trade, and the New York Mercantile Exchange have been working for some time to change the underlying philosophy of financial service regulation. Our goal was equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. After careful assessment of the PWG report, we are disappointed that our efforts to create a fair and level playing field have not been rewarded.
Page 62 PREV PAGE TOP OF DOC While the working group recognizes the regulatory disparities and blurred product distinctions that handcuff U.S. futures exchanges in today's global market, the report does almost nothing to address those issues. This omission is a serious flaw. The report calls for some changes that are in accord with our principles. However, its recommendations for regulatory relief and legal certainty will immediately benefit the over-the-counter market, as well as enterprises that operate unregulated exchanges, without timely relief for us.
The report begins with a conservative call for legal and regulatory certainty for OTC swaps. It veers from that simple principle to a radical realignment of markets and regulators by redefining a swap to include standardized, cleared, financial futures contracts traded on electronic exchanges. The call for legal certainty for bilaterally negotiated swap contracts, which we firmly support, has been converted into a demand for the exclusion from the CEA for exchange-traded and cleared financial futures.
My written testimony includes a detailed analysis, so I won't go into that here, but I want to draw special attention to this discrepancy between the treatment proposed for OTC and exchange-traded equity derivatives. Shad/Johnson restrictions now apply to both exchange and OTC transactions. The Working Group proposes to exclude swap agreements that reference nonexempt securities from the CEA. In fact, the PWG urges that single-stock futures be permitted both OTC and on nonregulated exchanges.
We are confounded by the irreconcilable contradiction between the PWG conclusion that OTC swaps, including equity swaps, should be excluded from the CEA, while refusing to endorse revisions to the Shad/Johnson Accord for regulated markets. There is no principled reason to support unregulated trading in a product while refusing to permit identical products to trade in the well regulated, price-transparent and liquid environment provided by the CME.
Although we are frustrated with the one-sided recommendations in the report, we will continue to support fundamental fairness in any legislation that this committee comes up with. You, this committee and congressional leaders have demonstrated commitment to tackling some difficult disparities, and CFTC Chairman Rainer has agreed with this principle. We hope to work with the President's Working Group and Congress to provide that comprehensive reform of risk management markets.
Page 63 PREV PAGE TOP OF DOC The CFTC under Chairman Rainer has demonstrated its resolve to adopt justified exemptions for financial products traded on our exchange. We are concerned, however, that regulated exchanges will remain at a serious competitive disadvantage unless and until parity of regulation is achieved.
Thank you again, Mr. Chairman, for your hard work and for the work of this committee, and we look forward to working with you on this issue.
[The prepared statement of Mr. Gordon appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Gordon.
STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK MERCANTILE EXCHANGE
Mr. RAPPAPORT. Thank you, Mr. Chairman. My comments are very similar to that of Scott Gordon, so again I will try to keep them brief.
We support legal certainty for the OTC marketplace, but we do support it in the exemptive form as opposed to the exclusory form. We think that it is important that the regulators in some format maintain some level of jurisdiction in order to manage through a crisis, to the extent that one develops in one of these marketplaces and has its ripple effect on the exchanges themselves.
But the President's Working Group report, from the exchange perspective, I believeand I think it is, not speaking for the Board of Trade at this point, is virtually unanimousis that the OTC marketplace went in looking for legal certainty and came out with a lot more, as Scott has just said. Standardized contracts are now being requested to be cleared and creating a virtual indistinction with the exchange marketplace, yet it is advocating a completely different regulatory regime.
Page 64 PREV PAGE TOP OF DOC The report itself acknowledges that the existing regulatory environment is disadvantageous to the exchanges versus the OTC market, and the report itself also acknowledges that if the President's Working Group report recommendations are actually implemented, the strong possibility exists that the disparity in regulation will be exacerbated. So rather than resolving the issues for the exchanges, the report points out, acknowledging the differences, that these recommendations go further in widening that gap.
Mr. Chairman, in your initial comments you said that this report is the first step on the road towards modernization, and you will bet that it is probably not the last one. And Congressman Baldacci said that, in referencing the report, it is a step but it is a small one. We would agree with that, but I have to say that we are a little concerned in terms of a lot of the discussion that goes on today, in that a lot of it is, call it away from the report, not necessarily related to the specific recommendations.
And while this is a very complex issue, we hope that the negative implications that the implementation of these recommendations would have will not be lost on this committee, and that this committee will not permit the complexity of the issues to camouflage the lack of reconciliation of the disparity of regulation. And we look forward to clarifying those issues for you and working with you to bring this to resolution. Thank you.
[The prepared statement of Mr. Rappaport appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Rappaport.
STATEMENT OF MARK D. YOUNG, PARTNER, DERIVATIVES AND FINANCIAL SERVICES, KIRKLAND & ELLIS, ON BEHALF OF THE CHICAGO BOARD OF TRADE
Page 65 PREV PAGE TOP OF DOC Mr. YOUNG. Thank you, Mr. Chairman, and good morning and good afternoon, I think. Chairman David Brennan of the Board of Trade and President and CEO Thomas Donovan were unable to be here today because they have a regularly scheduled board meeting dealing with some of the critical issues facing the Board of Trade and other exchanges, and that is how to deal with the modern world and how to restructure themselves so they are able to compete effectively in the modern world. In many ways those issues and those challenges overlap with the same issues and challenges that you face legislating in this area today, and I will address those in a moment.
I would like to say at the outset that the Board of Trade also wants to compliment CFTC Chairman Rainer for the energy that he has brought to the CFTC and the insight that he has brought to the CFTC. We have a better working relationship, I believe, today with the CFTC than we have had at any time in the recent past, and we look forward also to the proposal that they will unveil later this week, and to offering to you our observations on that proposal.
The President's Working Group report was focused on the question of line drawing. What instruments should be excluded from the Commodity Exchange Act, and how do you draw that line? That is an appropriate inquiry. We think it is an important inquiry. We believe that providing legal certainty to the over-the-counter market is an absolutely valid public policy goal.
At the same time, the way in which the working group report drew that line, they admit blurs the distinction between the exchange markets and the over-the-counter markets, and as a result creates serious competitive implications for the exchanges. What does that really mean? What it really means is that under the working group's report, fungible, standardized, centrally traded and cleared instruments for the first time would be excluded from the Commodity Exchange Act, excluded from the scheme of regulation that applies to exchanges.
What it really means is that you can no longer think of the world as being a world in which there are exchange markets and over-the-counter markets. Instead, there is a world where there are derivative markets, and what you have to consider is what is fair for all derivative markets. And that is where the work of the CFTC and Chairman Rainer comes into play. What the CFTC is doing now is considering its regulatory regime and attempting to modernize it for the new world, and again, we are anxiously looking forward to their work.
Page 66 PREV PAGE TOP OF DOC There has been some talk today about equity derivatives and equity swaps and the working group report and the Shad/Johnson issues, and I know that you have received a lengthy submission from the securities exchanges on Shad/Johnson. Since I have a minute or two, I just thought I would like to anticipate some of the things that you are going to be discussing with them and perhaps get into some of those issues in more detail in this panel.
What is interesting about the securities exchange submission to you is that it runs many pages complaining about the regulatory arbitrage that would be created if you permitted single-stock futures to trade on futures exchanges or under the Commodity Exchange Act, but there are no complaints in their submission relating to standardized, fungible, centrally traded and cleared equity swaps.
We don't think the label ''swaps'' versus the label ''futures'' should carry that much weight. We think the real label that you should be focusing on is the one we have in common with the over-the-counter instruments, and that is derivatives. We believe that what you need to come up with, as Scott Gordon said, is a scheme that is fundamentally fair to all equity derivatives, no more, no less. That does not mean that all equity derivatives need to be regulated alike, but it does mean that we need to call an apple an apple and an orange an orange, and we can no longer hide behind this label of equity swaps is different than futures based on equity derivatives.
The best example I have of why we can no longer live in that world deals with the Board of Trade's agreement with the EUREX exchange that has been referred to today as the leading exchange in the world. The Board of Trade has a joint venture with EUREX. Under this joint venture agreement, EUREX cannot trade single-stock futures. That is as a result of a contractual agreement between the Board of Trade and EUREX.
If the Board of Trade were to waive that provision and allow EUREX to list single-stock futures, EUREX could list futures contracts on U.S. stocks like IBM and AOL, and the interesting thing about that is that the only people who couldn't trade those instruments, as a result of the Shad/Johnson restriction, would be U.S. investors, U.S. participants.
Page 67 PREV PAGE TOP OF DOC Now, major financial institutions will be able to trade those instruments. They will just do it overseas and book those transactions overseas, so that none of that revenue will come to these shores, and the Shad/Johnson provisions that the securities exchanges very much want to retain would be a barrier to tax revenue in this country but it wouldn't be a barrier to trading. The sophisticated investors will find a way to trade overseas. The retail investor would not be able to do that, in all likelihood, and would not be able to participate in these transactions. And the Chicago Board of Trade would get a portion or a substantial portion, hopefully, of the transaction fee to be earned on those transactions occurring on the EUREX exchange overseas.
So I think what this example typifies is that you can no longer think about the world as it was in 1922 when the Grain Futures Act was passed, or 1936 when the Commodity Exchange Act was passed. We are now in the year 2000. We are trying to enact a statute, work on a statute that looks to the future, and hopefully looks to that future and creates a world that will be fundamentally fair to all participants in the derivatives market.
[The prepared statement of Mr. Brennan appears at the conclusion of the hearing.]
Mr. EWING. Thank you. Thank you, gentlemen, for your giving us the other side of the story.
Mr. Gordon, you talked about the report being flawed, I think, in your statement. Would you reiterate again what you think is the largest or the major flaw in the working group report?
Mr. GORDON. Well, Mr. Chairman, I think I can categorize it in two respects. One is in terms of timing. There is a disconnect between what the working group would offer, which is immediate relief for OTC markets, which, by the way, we don't argue with that, but to the extent that that happens prior to futures exchanges getting relief, that is a serious disconnect and something that we need to consider.
Page 68 PREV PAGE TOP OF DOC With respect to specifics, I mentioned and Mr. Young mentioned equity derivatives. There is certainly a disconnect there. There is a disconnect with respect to clearing, in that OTC markets would presumably be able to clear any products, even products that replicate what we do now, and yet we as futures exchanges would not be able to clear the corresponding products. I think that is problematic.
We are looking for functional equivalence. If it is an apple, to use Mr. Young's analogy, if it is an apple, then let us both trade it and clear it and regulate it as an apple; and if it is an orange, we will do the same thing. But I think that that would categorize the two problems that I would have with the report.
Mr. EWING. Does anyone else want to comment on that?
Mr. RAPPAPORT. Just quickly, and it sort of reiterates what I said before but I will take every opportunity that I get to say it, we went into this whole process a while ago looking for legal certainty in the OTC marketplace, which all of us support, and it seems that we have come out with a lot more. And not only have we come out with a lot more, but the initial issue that we have discussed on numerous occasions hasn't even begun to be address.
Now, as we have said, we are still waiting for the other piece of this in the CFTC's proposal as to how the regulated exchanges are going to come into some degree of regulatory parity with the OTC marketplace, and we hope that it will give us the relief that we are seeking.
Mr. EWING. Do you believe it possible to have regulatory parity with the over-the-counter market? I mean, the structure, the difference in structure of the organized exchanges and the over-the-counter market, how do you see us getting to regulatory parity when there is such a difference in structure?
Mr. RAPPAPORT. Mr. Chairman, the only thing I can say in that regard is that we have an equity market that is the envy of the world, and in that marketplace I can buy 1 share of IBM next to the largest Wall Street house buying 10 million shares, and it works and it works really well, and everybody is trying to replicate it at this point.
Page 69 PREV PAGE TOP OF DOC And that is the state of affairs that we would like to achieve for the derivatives markets. We don't think that the public should be excluded from participating in those markets, in terms of bifurcating the market and putting the public investor, or the retail investor, as people like to refer to them when they seek to exclude them from the sophisticated investor. We think the equity markets have handled that very, very well.
I think one of the problems is that the Commodity Exchange Act has outlived its useful life, and we keep trying to work within it. And if that is what we have to do, that is what we will do, but when you start with that and try to fit the square peg into the round hole, you are going to come up with an imperfect solution.
Mr. EWING. Well, if the Commodity Exchange Act has outlived its useful life, is it your suggestion that we do away with that, or that there be some other regulatory scheme take its place, or how would you solve that problem?
Mr. YOUNG. Mr. Chairman, as a Commodity Exchange Act lawyer, when I hear people saying the Commodity Exchange Act has outlived its usefulness, I get very nervous, so I will have to jump in and answer this question.
Mr. EWING. I noticed you holding your heart there.
Mr. YOUNG. Absolutely. For many years the Chicago Board of Trade and the other exchanges have testified before you and before other committees and asked for a complete overhaul of the Commodity Exchange Act to modernize it. That call is much more significant and much more important today, as technology and globalization and other innovations, including the over-the-counter market, have changed the world in which these markets operate so dramatically.
Today we have a statute that really doesn't work. It draws lines and distinctions that are artificial, not real, and that are not tied to valid public policy goals. One of the most significant things that is in the working group report and that is very sound in the working group report is the notion that only regulation that is tied to valid public policy goals should be offered, and that includes regulation of exchanges.
Page 70 PREV PAGE TOP OF DOC So what we are seeing, hopefully, in the working group report is a framework for creating the new Commodity Exchange Act, that would include the three things that I think everybody has mentioned today: legal certainty for those instruments that should be excluded from the statute; fairness, regulatory fairness for those instruments and those execution facilities and clearing facilities that should be included in the statute; and, third, the opportunity for everybody to compete in the area of equity derivatives.
Mr. EWING. Thank you.
Mr. CONDIT. If I may, I would like to go back to the chairman's question earlier. The most common concern is regulatory relief, and I know that Mr. Gordon and Mr. Rappaport made some general comments about regulatory relief. Mr. Gordon, was there any other items that you didn't mention, or Mr. Rappaport, on regulatory relief, on a specific proposal, or did we hear all those? What do you think should occur in terms of regulatory relief?
Mr. RAPPAPORT. The report itself doesn't offer any regulatory relief in any of the recommendations for us, so we didn't get anything out of the report. The only thing that the report does is exacerbate the disparity of regulation that currently exists by giving the OTC marketplace a greater degree of deregulation.
Mr. CONDIT. I understand you have already said you thought the report was flawed and it didn't go far enough, so on and so forth. So then have you given us your specific recommendations for regulatory relief? I heard some, but I want to make sure
Mr. RAPPAPORT. Yes. I don't think we have given them today, and I really haven't offered any today. We have on different occasions offered them, and they really focus around the point that it is one marketplace.
We can talk about these distinctions, and most of them are artificial in the sense that we service the same marketplace. The OTC marketplace and the exchange marketplace basically sell the same products to the same customers for the same purpose. So to the extent that the OTC marketplace has this ability to service them in a much less regulated environment, they get the ability to customize their product and customize their service much more in tune with the needs of the marketplace, outside of the lack of flexibility that is contained in the regulatory structure.
Page 71 PREV PAGE TOP OF DOC I do think, though, that the CFTC, to echo the remarks of the Board of Trade and the CME, has in the last few months taken extraordinary steps to make an effort to give the exchanges regulatory relief, and could go further, I suppose, through its 4(c) exemptive powers. That is if you asked where could we get it, we could get it in 4(c). My only comment in that regard is that it seems as though the 4(c) initiative is going down the road of bifurcation of the market, which in the end will be better than it is today but will exclude the retail public from participating in a fair marketplace.
Mr. CONDIT. Mr. Gordon, did you want to respond?
Mr. GORDON. No. I just would make the general comment that the three exchanges you see in front of you have offered previously to this committee and to others a five-point plan that has us or has Congress rationalizing the CEA and transforming the CFTC to an oversight agency. That is the first point. The second point is to expand access to allow those that are outside our industry but are registered providers of service, to be able to allow our service. The third part is certainly a repeal of Shad/Johnson. I spent some time talking about that. The fourth is that like products are treated and regulated in like fashion. I spoke about that at length.
And, fifth, finally is that there is legal certainty, which we all agree, I think everyone in this room, I think everybody that could appear in front of this committee and other committees in other venues will say we should have legal certainty for OTC products. We totally agree with that. I think the issue is, you have to look at reform and rationalization in a comprehensive way, and not just pick pieces here or there. But if we can get these five points, I think it is a very good starting point.
Mr. CONDIT. Mr. Young, I don't know if you have anything to add to that, or do you think that is pretty much covered?
Mr. YOUNG. It is pretty much covered. We agree with those five points. The Chicago Board of Trade and the Chicago Mercantile Exchange and the New York Mercantile Exchange I think are all on the same page.
Page 72 PREV PAGE TOP OF DOC The critical distinction that we tried to enunciate in those points was that if it was a privately negotiated derivative, it should be excluded from the statute. If it is a publicly executed transaction, then the execution facility should be subject to the statute under performance standards administered by the CFTC, the clearing system should be subject to oversight, but there should be a general ratcheting down and rationalization of regulation for those instruments still subject to the statute.
Mr. CONDIT. Thank you, Mr. Chairman. Perfect. Right on the money. Thank you.
Mr. EWING. Just one quick question here. Is legal certainty and removal from all regulation by the CFTC, are they one and the same, for the OTC market?
Mr. RAPPAPORT. No. I mean
Mr. EWING. When you talk about we are all in favor of legal certainty, does that meanin the report they would be exempt from the act, they would be without regulation.
Mr. RAPPAPORT. Actually, excluded.
Mr. EWING. Excluded. I am sorry. Exempt is the old word.
Mr. RAPPAPORT. Right.
Mr. EWING. Yes. Excluded.
Mr. GORDON. The idea that a bilaterally negotiated private transaction is excluded and given legal certainty, we have no problem with that.
Mr. YOUNG. But if it is excluded from the statute, it is excluded from CFTC regulation and CFTC jurisdiction. And what we are saying, traditionally we have said we would prefer an exemption because an exemption allows the regulator to pull something back if there is a problem down the road, and some people have raised legitimate questions about that.
Page 73 PREV PAGE TOP OF DOC On balance, however, we think that if you draw the line correctly, there should be less problem giving the over-the-counter market what I will call full legal certainty through an exclusion that would allow those products to be offered in an atmosphere where they are not subject to the Commodity Exchange Act, not subject to a potentially different interpretation of the Commodity Exchange Act that would pull them back, not subject to a reform of an exemption down the road that would add cost to those transactions. What we would be saying in the statute is, these instruments are not on the CFTC's bus and never will be, until Congress acts or doesn't act in the future.
Mr. EWING. Thank you.
Mr. RAPPAPORT. Mr. Chairman, could I just add something to that?
Just on that point, this marketplace thrived for years, the OTC market, and it is up to $80 trillion. The issue of legal certainty arose, when the CFTC I think issued it concept release was when we first started to hear somewhat about the legal uncertainty.
So I think what the other agencies are concerned about and what we have heard is that over time perhaps the personalities and the leadership of the agencies may change, and they would prefer an exclusion rather than an exemption so that if the personalities do change and there develop some other jurisdictional conflicts, that the likelihood is greater that those conflicts won't develop in the obviously exclusionary environment as opposed to the exemptive one. But the marketplace thrived in an exemptive environment for 10 years.
Mr. EWING. Mr. Pomeroy.
Mr. POMEROY. Thank you, Mr. Chairman. Well, I certainly agree with the comment that agency direction can change. I myself have a whiplash from watching CFTC. They went from micromanagement of all activity within the exchange to can't give away the jurisdiction fast enough. And we have got to sort out, probably the right place to land is somewhere in between.
Page 74 PREV PAGE TOP OF DOC But I would hope that we are not so enamored with this new working relationship between the agencies, which we asked for last year, that we take without serious evaluation areas where public interests have not been regulated or provided for in a new environment, a new regulatory environment. So your assistance, I thought your testimony has been really quite excellent, is helpful in terms of trying to identify areas where public interests aren't being protected, or where there is a disparate regulatory structure that disadvantages in particular the exchanges and won't endure over the long haul. I mean, in the end if you have got similar activities but being conducted in a disparate regulatory fashion, you are going tosooner or later the more regulated environment I think will lose all business or a good deal of it, and the change will happen over time. It is not a fair arrangement.
Let's look at a couple of issues you point to. There is way more here than we can really work through in terms of trying to systematically identify things for which a public interest might attach and might not. Just by way of format, let me respond to you, Mr. Young, on the CEA and whether it has outlived its usefulness or not.
I think that as you try to develop a statutory framework for regulation, it is easier, although it is a convoluted way to do it, but scrapping it altogether and trying to hammer in a brand new statute and structure has got a lot of risks of unintended consequences. The three issues that you mention that we need to work toward, legal certainty, regulatory fairness for facilities, and an opportunity to compete on equities futures would be kind of the three things on your agenda that you would be wanting. The three things that I would want on mine, basically, is legal certainty; consistent protection for public interests, particularly antifraud and antimanipulation; and, third, a deregulation, to the extent consistent with protecting public interests that you can achieve.
So with that framework, if we are more or less agreeing on the approach, we can maybe identify areas where some of the parsing within the working group just doesn't make much sense. You mentioned, Mr. Gordon, the different treatment of principal-to-principal transactions as opposed to intermediary transactions?
Page 75 PREV PAGE TOP OF DOC Mr. GORDON. I didn't, but I can speak to that.
Mr. POMEROY. Whose testimony is that? Oh, it is in your written testimony.
Mr. GORDON. I am sorry. I didn't mention it here today.
Mr. POMEROY. All right. Ultimately, is that a distinction that makes any sense? In your written testimony you seem to imply no.
Mr. GORDON. Trades that are done on our exchange end up being between the exchange and some 60 or 70 of our clearing members. All of whom have very high levels of capital: sufficient levels of capital, we monitor them, they are monitored by others, and to the extent that they are principals and they are doing trades on our exchange. That is why we made the distinction of principal-to-principal versus retail. I am not sure where you are going with the
Mr. POMEROY. Well, do the principals turn around or have a retail dimension to what they are doing?
Mr. GORDON. But that is true also in the over-the-counter markets where you have intermediaries, you have dealers that do transactions that are one-off with customers. So to the extent that it happens, what happens in the over-the-counter markets very often times happens in similar fashion on exchange. We use different terminology to talk about them, but it is something that is similar.
Mr. POMEROY. But there is a distinction beingthere are protections, regulatory protections for the exchange retail activity, and to the extent you ultimately have over-the-counter non
Mr. GORDON. One of the many points that we are trying to make is that exchanges should be able to operate our marketplace with wide latitude. I think you will find and have found that it is in our best interest to have the highest levels of integrity, to have all the surveillance and compliance function that we have. We spend a lot of time and resources doing that. That is what gives us the integrity that brings business to our market, so we are going to continue to do that regardless.
Page 76 PREV PAGE TOP OF DOC Mr. POMEROY. Well, on that one, the expansion of the clearing, the definition of a clearing entity, do you think that takes away from you a significant incentive to keep activity routed through the exchange?
Mr. GORDON. To the extent that the over-the-counter markets are allowed to clear these products, we should be able to clear those products. Many of those products replicate what we do. They are basically clones of what we do on the exchange, so you can look at it as the OTC markets being able to clear exchange-like products. That is fine, as long as we can clear OTC products, which is something that we think we can do as well as anybody. So if the OTC clearing organizations can clear our products, we should be able to clear OTC products. We are very happy to compete. I think we will be the low cost provider of choice. But to the extent that there is a disconnect in terms of timing, that becomes a serious problem.
Mr. EWING. Mr. Gutknecht.
Mr. GUTKNECHT. Mr. Chairman, we do have to run and vote, but I did want to make a quick statement, because I want to thank this panel as well as the next panel. I can't stay because I have got to be on the floor. But I want to read from Mr. Brennan's testimony real quickly, and I think it begins to, it is starting to make sense to me.
He says in his testimony, ''Congress should not tip the competitive scales in one direction or another,'' talking about the industry and electronic and pit trading. ''If it decides to enact regulatory exclusion for multilateral transaction execution facilities, that exclusion should treat electronic and physical trading environments alike.''
I finally have figured out how this makes sense to politicians. This is a little bit like campaign finance reform. Everybody talks about we need reform and all of this, but on one hand what some of my colleagues are talking about is putting more regulations on money that is already regulated and doing little to regulate money that is not regulated.
And it seems to me that the message here is clear, and I hope that as we go forward on this, we will at least be even-handed, at the very least be even-handed. If anything, we ought to figure out, if we can't havewe have got to watch some of this electronic stuff even closer, in my opinion.
Page 77 PREV PAGE TOP OF DOC Mr. Chairman, I know our time has expired.
Mr. EWING. Well, Mr. Gutknecht, we will be even-handed and fair, we hope.
Gentlemen, we have had, all the panel that is left has had their questions, so I am going to excuse you and hope that you will stay for the final panel, which we will convene in probably about 10 minutes. As soon as this vote is completed and we have one more vote, we will be right back and do our last panel.
Mr. RAPPAPORT. Thank you, Mr. Chairman. Mr. Chairman, I just forgot, can I get my written comments into the record? Thank you.
Mr. EWING. Absolutely. All written comments will be included in the record.
Mr. EWING. The subcommittee will come back to order, and we will have our third panel. Welcome. I am sorry to keep you waiting, but we are pleased to have you here.
First we have Richard E. Grove, Jr., executive director and chief executive officer of the International Swaps and Derivatives Association. Mr. Edward Rosen, and he represents an Ad Hoc Coalition of Commercial and Investment Banks. Good to see you, Ed. Mr. Marc Lackritz, president of the Securities Industry Association. Mr. William Brodsky, chairman and chief executive officer of the Chicago Board of Options. And Mr. William P. Miller, II, senior vice-president and independent risk officer, Commonfund, and chairman, End Users of Derivatives Council of the Association for Financial Professionals. That is a mouthful. But welcome, all of you, and we will start with Mr. Grove.
STATEMENT OF RICHARD E. GROVE, JR., EXECUTIVE DIRECTOR AND CHIEF EXECUTIVE OFFICER, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
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Mr. GROVE. Thank you, Chairman Ewing. I am the CEO of ISDA, the International Swaps and Derivatives Association. Before joining ISDA, I was actively engaged for many years in sales and trading of OTC derivatives and other financial products. ISDA has had the privilege of appearing before and working with this subcommittee for many years, and we are very pleased to be here again today.
ISDA's more than 450 members include the world's leading dealers in off-exchange, principal-to-principal derivatives transactions. These transactions are typically referred to as swaps, and their status under the CEA is the focal point of the report of the President's Working Group.
Swaps, as you know, Mr. Chairman, are powerful tools that enable American businesses and other end users in each of the 50 States to manage the interest rate, currency, commodity, credit, and other related risks that are inherent in their activities. In this way, businesses and other users of swaps are able to lower their cost of capital, manage their credit exposures, and increase their competitiveness both here and abroad by focusing on their core areas of expertise.
The United States has been a leader in the development of swaps, and American businesses were among the earliest to benefit from these risk management tools. The dramatic growth in the volume and diversity of swaps is probably the best evidence of their importance to and acceptance by end users, and it is no coincidence that the United States economy and the volume of swaps both grew dramatically during the last decade.
Let me add at this point that ISDA's membership includes many of the businesses, financial institutions, government entities and other end users that rely on swaps to manage their financial and commodity market risks with a degree of efficiency and effectiveness that would not otherwise be possible.
Page 79 PREV PAGE TOP OF DOC The Working Group report is the product of a great deal of effort by each of the members of the group and their colleagues. It reflects a solid understanding of and sensitivity to the factors that enable the U.S. financial markets to so efficiently allocate capital and so effectively sustain economic growth. The report embodies an unprecedented consensus among four key financial regulators that legislation should be enacted to provide legal certainty for swaps.
As you know, legal certainty simply means that parties, both the dealers and end users, must be certain that the provisions of the swaps agreements that they enter into are enforceable. Any uncertainty with respect to the enforceability of swaps creates risks not only for the parties involved but for the financial system as a whole. For example, when unilateral actions by the CFTC in 1998 suggested that the CFTC might treat some swaps as futures contracts, congressional action was required to preserve legal certainty for swaps and thus ensure continued market stability.
The underlying policy considerations were not addressed by Congress in 1998. They have now been carefully considered by the working group. The Working Group concluded that financial swaps do not present public policy concerns of the sort that the CEA is intended to address, and that legal certainty can therefore best be provided by an exclusion from the CEA.
In one respect, ISDA believes that Congress should go further than the working group report by excluding from the CEA swaps involving commodities with deep and liquid markets, such as various energy products. Indeed, the failure to do so may stifle the continued development of innovative energy risk management tools in the United States, to the detriment of American businesses and other end users.
That having been said, ISDA agrees with the broad thrust of the working group's recommendations. There is broad consensus on the merits of the issue, and I cannot emphasize too strongly ISDA's belief that the time for congressional action to provide legal certainty is now.
Page 80 PREV PAGE TOP OF DOC I would also stress that legal certainty should be provided in a manner that does not restrict financial innovation. As you know, Mr. Chairman, U.S. financial institutions and U.S. technology companies are world leaders in their respective fields. From the broad perspective of our national interest, we should not compromise this leadership position by creating or maintaining regulatory structures that discourage financial institutions from using and benefitting from the most efficient and innovative technology available.
To summarize, ISDA hopes that the working group's report will serve as the catalyst for the enactment of bipartisan legislation this year to provide legal certainty for swaps. As described more fully in our written statement, ISDA also believes that this legislation should provide appropriate regulatory relief for the futures exchanges.
Let me conclude with the promise that ISDA will remain committed to working with this subcommittee on a cooperative and constructive basis to ensure that the key objective of legal certainty for swaps is translated into legislative reality this year. Thank you, Mr. Chairman.
[The prepared statement of Mr. Grove appears at the conclusion of the hearing.]
Mr. EWING. Thank you.
STATEMENT OF EDWARD J. ROSEN, CLEARY, GOTTLIEB, STEEN & HAMILTON, ON BEHALF OF THE AD HOC COALITION OF COMMERCIAL AND INVESTMENT BANKS
Mr. ROSEN. Thank you, Mr. Chairman. We appreciate the continued leadership role that you have been playing on this issue.
The coalition that I represent welcomed the PWG recommendations, and I think the most important element of those recommendations was the consensus that was accomplished. For the first time we have four agencies that are going in the same direction, and it was only a year ago when interagency competition posed a very serious threat for our financial markets that took congressional intervention to resolve. Looking back on that one year and the situation that confronts us today, I think it is a very important point in time for us to try to build on the consensus that has been created in the President's Working Group report and move forward.
Page 81 PREV PAGE TOP OF DOC The exchanges I think have it right. This is about line drawing. I am sure that the individual agencies, left to their own devices, would have drawn some lines a little differently. Then you would have had four reports, and if you think this is confusing, think how confusing that would have been.
The coalition itself that I represent would have drawn some of these lines differently. But even acting on the recommendations as they are, without redrawing the lines, is going to provide a very significant benefit both in terms of removing obstacles to innovation in this country, protecting our competitive position and ensuring the vitality of our domestic financial market.
In going forward, I think one thing that we would emphasize is the need to maintain a balanced perspective on the different issues that lay before us, because some of these issues are very important, and some of the issues are desirable in terms of their resolution but are less important.
Clearly, legal certainty, resolution of the mess, the jumble that has become of this regulatory environment, is very important. It would be very nice to resolve the stalemate that has arisen over the issue of single-stock futures, but we think that it must be borne in mind that that issue is not as serious or important an issue to the markets as the other issues that have been the focus of the discussions this morning.
I would like, if I may, Mr. Chairman, to jettison the balance of my oral testimony because in some senses it is much less interesting than the debate and discussion that arose in the course of the earlier panels, which raised some questions which I would like to move to, if I may.
One issue that was raised was the failure of the President's Working Group report to address the issue of relief for exchanges, and I would just like to put that to rest in the sense that it wasn't their mandate. They weren't requested to do it, and frankly I think it would have been regarded as presumptuous if the other agencies told the CFTC what it should be doing with respect to the regulation of activities within its own jurisdiction.
Page 82 PREV PAGE TOP OF DOC The other important point that has been raised is this question about parity and fairness, and how do you parse this when you are drawing lines. And the truth of the matter is that it is not just about functional equivalents and it is not just about economic equivalents.
I can give you examples of economically equivalent, identical instruments that are subject to completely different regulatory regimes. I can lend money to you for a rate of interest and it is a totally unregulated transaction. I could do an exactly similar transaction in the capital markets and it would be subject to comprehensive regulation by the SEC. If I am a bank, I can make an identical commercial loan that is not subject to direct regulation, apart from the bank's independent regulation; of if I am a bank, I can issue certificates of deposit to the public which comes under a completely different scheme. Or I might be an insurance company.
All of those are economically identical instruments subject to different regulatory regimes, so being economically identical doesn't answer the question, and functional similarity doesn't answer the full question. Where I think the President's Working Group report and the CFTC's initiative provide the most value to us is in stripping away the labels and saying, what is the sum total of the regulatory issues that are raised by this activity?
And so we are going to look at the products, we are going to look at their attributes, we are going to look at the participants in the market, we are going to look at the way they do business and determine what policy issues are raised. And if you devise a regulatory regime both for the OTC markets and for the regulated exchange markets that attach only those regulatory consequences that are appropriate, then this sort of issue of unfair competition should strip away. And if the exchanges are looking at a business model that is successful in competing against them, that is subject to a different regime by virtue of raising different issues, then you have got to ask the question, should I be preserving my business model or should I be converting my business model?
Page 83 PREV PAGE TOP OF DOC That is the kind of debate that we ought to be having. I don't think the President's Working Group report takes us off that focus. I think it for the first time sets us in the direction of focusing on those issues, and we just want to confirm, if there was ever any question, that the coalition is committed to being a positive force in resolving these issues. Because you noted in your opening remarks, Mr. Chairman, quoting Chairman Greenspan, that the largest futures exchange is no longer in the United States. It would be folly to think that the same thing couldn't happen to the OTC markets, and that is the reason why we feel the time has come to resolve these issues.
[The prepared statement of Mr. Rosen appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Rosen.
STATEMENT OF MARC LACKRITZ, PRESIDENT, SECURITIES INDUSTRY ASSOCIATION
Mr. LACKRITZ. Thank you, Mr. Chairman. Mr. Chairman, Congressman Condit, my name is Marc Lackritz, and I am president of the Securities Industry Association. We represent nearly 800 broker dealers, and our larger members are all active in every aspect of the derivatives markets.
I appreciate the opportunity to testify this morning on the report of the President's Working Group, and I would ask, Mr. Chairman, that a full copy of my written statement be included in the record.
Mr. EWING. It will be included in the record, without objection.
Mr. LACKRITZ. Thank you.
Page 84 PREV PAGE TOP OF DOC When I testified before this subcommittee 2 years ago, Mr. Chairman, you were considering enacting legislation in response to CFTC Chairwoman Born's concept release on OTC derivatives. That concept release actually called into question the legal status of OTC derivatives. But since that time, two important things have happened.
First, Congress passed wise legislation imposing a moratorium on further CFTC action, and we would like to commend you and your subcommittee, Mr. Chairman, for your role in enacting this very important legislation.
Second, the President's Working Group unanimously adopted a practical set of recommendations for modernizing the CEA in the context of OTC derivatives and new technology. These recommendations would help ensure that U.S. markets retain our international preeminence in financial innovation, and we commend the President's Working Group and enthusiastically support all of these recommendations.
But we note, however, that these recommendations will be of little value if Congress fails to act. We urge you to maintain U.S. leadership by moving promptly to enact these recommendations into law. By so doing, you will have taken an important step forward in ensuring legal certainty for OTC derivatives.
My written testimony discusses our position in more detail. I would simply like to urge the subcommittee to take the following specific actions:
First, exclude bilateral transactions, including those based on nonexempt securities, from the CEA. Furthermore, please codify an exclusion from the CEA similar to the CFTC's current hybrid exemption. Legal uncertainty has haunted the OTC derivatives markets for years, as you have heard earlier today in other testimony. Unfortunately, the CFTC currently lacks the statutory authority to grant exemptions for some of these contracts, creating incentives for firms to conduct these activities outside the United States. A legal exclusion of these products is the right solution.
Page 85 PREV PAGE TOP OF DOC Second, remove impediments in the Commodity Exchange Act to electronic trading of derivatives. Market participants should be able to take full advantage of electronic trading systems, but in the current legal environment, using electronic systems could turn a legitimate transaction into an illegal, off-exchange futures contract. In an industry that has embraced and thrived on new technology, the right answer is to permit the OTC derivatives market to use modern electronic technology.
Third, remove restrictions on the clearance and settlement of OTC derivatives. Under the swaps exemption, clearing and settling a transaction is restricted. However, doing such actually mutualizes and reduces risk in the system and to the market. And so we agree with the working group that clearing should be encouraged, and should not alter the legal status of the transaction.
Fourth, clarify the Treasury amendment by replacing the term ''board of trade'' with the term ''organized exchange'' to minimize legal ambiguities under that provision. Congress has determined that institutions active in the foreign exchange and government securities markets do not require the protection of the CEA. Further, we agree with the working group that Congress should give a clear grant of authority to the CFTC to regulate bucket shops that prey on the public.
And, finally, undertake an interagency dialog to examine the complex issues presented by single-stock futures. Single-stock futures should not be permitted to trade without first undertaking an extensive examination of the appropriate regulatory infrastructure. Issues such as the integrity of the underlying securities market and questions such as margin, sales practices, short-swing profits, regulatory reporting, et cetera, must be addressed before taking further action. Resolution of these issues by the relevant regulators are an essential predicate.
We believe that Congress has an excellent opportunity this year to address the issues of legal certainty affecting the OTC derivatives market. Rarely does such a broad consensus emerge on such very complex issues. Delay will only further discourage innovation, and it risks encouraging further migration offshore. Once gone from our marketsas has been described before, particularly by Chairman Greenspanand established abroad, it is very unlikely that these products will return.
Page 86 PREV PAGE TOP OF DOC We would respectfully urge the subcommittee, Mr. Chairman, to build on your solid record of previous legislation to encourage prudent risk management and technological innovation by enacting into law the recommendations of the working group's report. We stand ready to assist your committee in enacting the legislation this year. Thank you.
[The prepared statement of Mr. Lackritz appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
STATEMENT OF WILLIAM J. BRODSKY, CHAIRMAN AND CHIEF EXECUTIVE OFFICER, CHICAGO BOARD OPTIONS EXCHANGE, ON BEHALF OF THE U.S. SECURITIES MARKETS COALITION
Mr. BRODSKY. Mr. Chairman, Mr. Condit, Mr. Moran, it is good to be back before this committee.
As you know, I am chairman and chief executive officer of the Chicago Board Options Exchange, but I am here actually representing the U.S. Securities Markets Coalition, which you can see from my testimony. I ask to have my written statement submitted for the record in its entirety. It represents 10 securities organizations, from the American Stock Exchange, the Nasdaq, the Chicago Board Options Exchange and others around the country. I addition, I am pleased to say that the New York Stock Exchange, although not a member of the coalition, supports the views that we express here today.
I would like to make one clarification to comments made earlier today and has been talked about several times, and that is that EUREX has now surpassed the Board of Trade as the biggest futures exchange in the world. In some respects, that is true, but if you look at EUREX for what it really is, it is not just a futures exchange. EUREX trades futures. It also trades stock index options and it trades options on individual stocks. So actually if you took the EUREX exchange and compared it to the U.S. equivalent, which would be the Board of Trade and its progeny, the CBOE, we would still be by far the largest in the world.
Page 87 PREV PAGE TOP OF DOC The real difference is that we are still the only country in the world that separates the jurisdiction between equity derivatives and futures derivatives on equities, and so it is kind of interesting. If the CBOE had not had to separate itself from the Board of Trade 27 years ago, there would have been a very large exchange then that would still be the largest in the world, but because of our jurisdictional issues in the United States, we end up with two exchanges.
Let me just cover my remarks briefly, particularly as it relates to the Shad/Johnson Accord. We support the working group's approach on the Shad/Johnson issue, which is to keep in mind that single-stock futures are a very close substitute for stocks; second, recognize that issues about the integrity of the stock market and regulatory arbitrage must be addressed before taking more formal action in this area; and, third, to give the CFTC and the SEC an adequate opportunity to determine whether stock futures should be permitted, and if so, under what conditions.
But the Shad/Johnson issue, in our view, is not necessary to be dealt with to accomplish CFTC reauthorization. I have been involved with CFTC reauthorization since 1982, and I always have seen how market participants and people who appear before you try to add ornaments to the tree of reauthorization. We believe strongly that Shad/Johnson in general and stock futures in particular do not need to be ornaments to the reauthorization tree, nor need they slow up the process for you to accomplish reauthorization as a Valentine's gift for your wife.
We have no objections to stock futures as a financial product. Indeed, stock futures in several respects can be a very efficient financial instrument, but it is tremendously important to carefully consider the appropriate regulatory rules under which stock futures should be allowed.
The current regulatory structure for equity-based derivatives is a historical accident, one put together purely for political reasons at a time before stock index futures had ever traded. The Shad/Johnson Accord created an artificial and illogical separation between closely related products. We are the only country in the world that divides the regulation of these products in any way. Trust me, no country will ever copy this model, and ultimately it may hurt the ability of U.S. markets to compete abroad. Let's not compound that mistake.
Page 88 PREV PAGE TOP OF DOC At its core, the Shad/Johnson issue is whether we care about protecting our equity markets, which are the best in the world, and protecting investors. Given that there are nearly 80 million U.S. investors in the stock market today, this is a constituent issue for every Member of Congress. Protecting their retirement and other savings should be paramount to you. A recent issue of the Washington Post quoted the number of 77 percent of U.S. household assets are in securities today.
The securities laws were designed to protect investors. A comprehensive regulatory plan has been developed by the SEC over the years, and it has achieved that objective. Stock futures, if offered, should fall under that umbrella of protections. How would you answer the question of a constituent that calls and explains that he or she was duped by an unscrupulous sales person pitching IBM futures, and after having had a bad experience, called the SEC for assistance and was told that the SEC can do nothing about it?
We are not opposed to competition that stock futures would bring to the option or stock markets. However, that competition must be fair. It is not enough to have similar rules. We must have identical rules that are applied equally, a true level playing field, the same field with the same referees.
I urge you not to unnecessarily rush this process. It is imperative that the ultimate regulatory framework applicable to stock futures protect our markets and investors, and protect and promote fair competition. Thank you very much.
[The prepared statement of Mr. Brodsky appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much.
STATEMENT OF WILLIAM P. MILLER, II, SENIOR VICE-PRESIDENT AND INDEPENDENT RISK OFFICER, COMMONFUND; CHAIRMAN, END USERS OF DERIVATIVES COUNCIL, ASSOCIATION FOR FINANCIAL PROFESSIONALS
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Mr. MILLER. Thank you, and good afternoon. Our testimony represents over 14,000 finance and treasury professionals who, on behalf of over 5,000 corporations and other organizations, are significant participants in the Nation's payment systems, credit and capital markets, including derivatives.
We believe it is time to modernize the legal and regulatory structure governing domestic derivative markets, including the Commodity Exchange Act. Consequently, we urge Congress to update the Commodity Exchange Act to remove legal uncertainty to privately negotiated bilateral swap transactions, and to encourage the innovation and growth of appropriately regulated electronic systems and clearing facilities.
We also urge Congress to take measures to ensure that, by permitting appropriately regulated OTC electronic trading systems and clearing facilities, it does not impose unfair competitive disadvantages on regulated exchanges; it encourages the establishment of an alternative to the OTC market for less sophisticated end users, in which they could access the risk management tools in a more controlled environment; and to reconsider the restrictions on futures on securities contained in the Shad/Johnson Accord provisions of the Commodity Exchange Act.
[The prepared statement of Mr. Miller appears at the conclusion of the hearing.]
Mr. EWING. My thanks to all of you.
Mr. Brodsky, explain to me or to the committee, too, the difference between trading an option and trading a future on an individual stock.
Mr. BRODSKY. Well, we don't have stock futures in this country so I can't use that as a comparison, but in concept, in the way it is traded in other markets, it is a very similar product. These are instruments that derive their value from the underlying stock, and so therefore they are both derivatives on the underlying stock, they are both susceptible to the same manipulation aspects, whether it is a future or an option. And the basic difference between a future and an option is the option gives you the right and the future gives you the obligation, but they are derivative products. They are derivative on the stock market.
Page 90 PREV PAGE TOP OF DOC Mr. EWING. Your exchange trades individual options on stocks, but you are opposed to that same effort on a futures contract.
Mr. BRODSKY. No, I am not opposed to the same instrument on a future contract. I am merely looking at the issue of how we regulate these markets. I think it is very important to recognize that when the CBOE was formed, the Board of Trade very wisely and necessarily had to register a separate institution or exchange under the SEC, because they created an option market on U.S. securities.
And all we are saying is, don't go back to Shad/Johnson and try to figure out what Shad/Johnson meant, as much as to understand the structural underpinning of why the CBOE is a securities exchange today and not a futures exchange. If the Board of Trade could have made the CBOE a futures exchange, there wouldn't be two exchanges today.
And the SEC's full panoply of regulation that has been built up over 60 years on insider trading, market manipulation, suitability, all the things that have made our securities markets so deep and so broad and where so many participants are retail participants is very much based on the securities market structure that has evolved over the years. All I am saying is that futures on those stocks really fit very much within the same concept of regulation that has existed for now 27 years in the single option market.
Mr. EWING. Well, thank you, and that is the distinction that I wanted you to make. It is really not the act of trading the single futures or the option, but the act of who regulates that transaction.
Are there any there on this panel who would find fault with the trading of futures on individual stocks if they were regulated the same as options?
Mr. ROSEN. Mr. Chairman, I think, speaking for the coalition, I think we absolutely are not opposed to the trading of single stock futures under the right circumstances.
Page 91 PREV PAGE TOP OF DOC The question is, what does that mean, and what does it mean to say ''regulated by the SEC,'' and with respect to what, and how do you avoid issues such as unnecessary duplicative regulation? Are you going to make a futures exchange who wants to do this be both regulated as a futures exchange and a securities exchange? How are you going to make this work in an efficient way, and allocate jurisdictional responsibilities in such a way that you don't waste regulatory resources and burden the market in a way that impedes the trading of the product?
But, at the same time, I think we do think it is very important that the same issues that are presented under the securities laws, because these are on individual securities, get addressed and get addressed appropriately. But I think the devil lies in those details.
Mr. EWING. I think probably, would everybody on this panel agree that one of the biggest impediments right now to reauthorization is the issue of Shad/Johnson?
Mr. BRODSKY. I don't agree on that.
Mr. EWING. You don't?
Mr. BRODSKY. I don't believe that Shad/Johnson has any necessary place in the reauthorization process. It has nothing to do with the reauthorization of the agency. The agency should be reauthorized. I applaud the work of Mr. Rainer in trying to deregulate the futures exchanges, and I think that there are many issues such as legal certainty, which should be addressed and none of them has anything to do with the Shad/Johnson Accord.
Mr. LACKRITZ. If I could just note, I think that at some level the issue of single-stock futures is kind of a red herring with respect to the reauthorization bill before you. What you have with respect to the President's Working Group is, you have unanimity among four regulatory agencies. You also have unanimity among, I think, every witness that has appeared before you this morning that in fact the most important priority in this legislation is to resolve the OTC derivatives' legal uncertainty, and that can be done now because there is broad consensus. And so we would urge you to act as urgently as possible to resolve this uncertainty.
Page 92 PREV PAGE TOP OF DOC Mr. ROSEN. I think I would agree with what I think is the underlying sentiment in your question, which is that it is the most complex and contentious issue and the most difficult of the issues to resolve, but I think we believe that it is important that the resolution of these other issues not be held hostage to the resolution of that issue, if it proves impossible to overcome.
Mr. EWING. Anyone else?
Mr. MILLER. I agree with Mr. Rosen.
Mr. EWING. You all agree. Thank you.
Mr. CONDIT. I just want to pick up, I don't know that I really have a question, but Mr. Rosen I think dealt with the issue about the report, and that the report you thought was a pretty good report, pretty adequate. There were some comments earlier in testimony about it was a faulty report or it didn't go far enough, but just for the record, most of you believe that it pretty much did what it was asked to do. Is that correct? It was defined, what it should do, and it pretty much did that?
Mr. ROSEN. I think we believe the answer to that question is yes. As I said, there are some respects in which we would also have drawn some of the lines somewhat differently, but we don't think we should allow perfection to be the enemy of accomplishing the good.
Mr. CONDIT. But, I mean, I think the report has given us a starting place for us to proceed and move as a committee. You would agree with that?
Mr. ROSEN. Absolutely.
Mr. CONDIT. Let me ask Mr. Miller, and I don't know if I have this correct, Mr. Miller, but your group objects to too much deregulation of derivatives. Is that correct? And if so, can you explain why you sort of have a contrary position?
Page 93 PREV PAGE TOP OF DOC Mr. MILLER. Our members represent a broad spectrum, from those which are on one end not as sophisticated, and at the other end very sophisticated, and at the sophisticated end we are very interested in the antifraud, antimanipulation and counterparty assurance. But other than that, letting the market go where it may, we are large enough where we can take the agreement that the dealers give us and modify it to suit us, to give us the protections we need as a counterparty.
Our concern is that in the evolution of participants, the end users that use these markets, they are going to grow in their sophistication, that when they are first starting, they are not as wise to the idiosyncracies or just the difference in the playing field, and we are interested in having them have a certain amount of customer protections and safeguards such as those that are embedded in the futures market.
And when you put this in context, you are looking at a $90 trillion market, and it would be my view that when you look at the dealer community, that is going to be, about 90, 80 to 90 percent of that market is going to come from I would say a couple dozen of the largest dealers. And at the other end of the spectrum you have the end users which are much more diffused. So there is that need for a structure at the lower market segment that we think would be valuable to help encourage people, as they grow, to be responsible users of the derivatives market.
Mr. ROSEN. May I add a perspective on that issue?
Mr. CONDIT. Sure.
Mr. ROSEN. I think one of the things that motivated the way the President's Working Group report came out, and I think this is consistent with an observation that Chairman Greenspan made in the Senate hearings, one of the things that is really remarkable is, given the size of this market, how few the problems have been. It really is, particularly in terms of counterparty relationships.
Page 94 PREV PAGE TOP OF DOC These are counterparties that generally have the ability to take care of their problems with the people with whom they deal, and reputation is everything in this market. If you get a reputation for dealing in an inappropriate way with an end user, you will lose that business, and that is as good a market discipline as you could get.
Mr. CONDIT. Mr. Chairman, thank you.
Mr. EWING. Mr. Moran.
Mr. MORAN. Mr. Chairman, thank you, and I apologize for not hearing everyone's testimony on the panel.
Mr. Grove, in your conclusion you have a sentence that says, ''The ability of clearing systems to develop without regulatory impediments may reduce systemic risk by allowing financial institutions to reduce the possibility of widespread loss due to default.'' What is that sentence intended to convey? And why the use of the word ''may''?
Mr. GROVE. There are several ways to achieve the objective that clearing might achieve, which is to reduce systemic risk. The most commonly used means today are through bilateral contracts and bilateral netting. We are now seeing a move in the market to a greater use of collateral. That is another way to secure obligations between two counterparties and thereby reduce systemic risk.
So clearing is but one of the mechanisms that the market could avail itself of, but at the moment in the United States the market is impaired by virtue of the regulatory environment. So we are not saying that clearing is something that we have to have and that will be used in every case, but we would certainly like to have the option to avail ourselves of clearing when it is appropriately structured and appropriately regulated.
Mr. MORAN. Is there any suggestion there that clearing may not reduce systemic risk?
Mr. GROVE. No, no suggestion that clearing may not reduce systemic risk, but that it may not be the preferred option.
Page 95 PREV PAGE TOP OF DOC Mr. MORAN. It is a positive, reducing regulations on clearing activities is a positive; it just may not be the option that would be best suited for the circumstances in reducing risk.
Mr. GROVE. That is correct. It may be used in some circumstances but perhaps not in all circumstances.
Mr. MORAN. And this was my intended question for the previous panel, but perhaps you can help me understand this, any of you. The President's Working Group is made up of Government officials who presumably represent the American people, who are intelligent folks, who have a sense of fairness, I assume. Why do the exchanges, why do they come before the committee with such a different opinion of the result of the President's Working Group? What was missing in the discussions? Is it just a matter of policy, and they are on the wrong side of the policy? Is there more politics and jurisdiction issues here? And in particular the CFTC, which regulates those folks, were they not an advocate forwould they not be a natural advocate for the positions taken by the exchanges?
Mr. GROVE. Go ahead.
Mr. ROSEN. That is an excellent question, Congressman. I think a large part of the problem is in the asymmetry of the process, which I think was reflected in the testimony that you missed, which is to say they saw the OTC derivatives piece of the puzzle but they didn't see their own deliverance, so they are left with the perspective that they are overregulated, with very substantial relief for the OTC market, and I think that reinforced their concerns that this was moving in a direction that would exacerbate their perceptions of the existing
Mr. MORAN. Is that not true? This does exacerbate the problem for which they have a concern.
Mr. ROSEN. Well, if this were the only thing that were transpiring in the landscape, it would, but you must recall that the President's Working Group was not requested to address the question of what the CFTC should do within the scope of its own jurisdiction. And I think that one of the reasons why you heard such positive testimony from the exchanges is because I think they are seeing for the first time a process in the agency that they believe may actually result in some positive developments.
Page 96 PREV PAGE TOP OF DOC The perspective that I would bring on it is the following. If the regulatory consequences of various market structures are rationally related to the policy issues that are raised by that, then you should have a situation in which the market participants can choose the business model and the regulatory implications, and there wouldn't be a basis for complaining that A is regulated more than B, if it is the nature of A's activities that give rise to the need for additional regulation.
And then the exchanges can be in the position of saying, which business model is the most attractive for me, and I think that puts them in a new world. They are used to their existing business model, and so I think seeing these other business models with different regulatory overlays is somewhat unnerving to them. But I think once you are in a universe in which the playing field is rationally arrayed, then you can be a rational selector of your business model within that universe.
Mr. MORAN. So the problem is, we are in an irrational world?
Mr. ROSEN. We are in an evolving process.
Mr. LACKRITZ. Could I add to that?
I think that one of the factors that is involved here is that, and I think what I heard them saying, they didn't object, for example, to achieving legal certainty for OTC derivatives. What they said was, in a sense, ''Give us ours, too.''
And yet they have chosen to be in a business with a business model that in fact is a different kind of market than the OTC derivatives market. As the President's Working Group report pointed out, the OTC market is a different market. It is all institutional, it doesn't serve a price discovery function, and it is not subject to manipulation. All of those functions attend to the foreign exchange futures market that they are representing.
So I think that I would concur with what Mr. Rosen had said, but I would also just suggest that in fact they are dealing with a different marketplace, and yet not dealing with the opportunity to change and evolve to meet the new circumstances as opposed to trying to just sort of ''Give me mine, too.''
Page 97 PREV PAGE TOP OF DOC Mr. GROVE. I would just like to add, quickly, that the OTC derivatives market is one of the most competitive segments of the financial markets. As a banker, I come from the banking side, the dealing side of the business. As a banker, when dealing with corporates, I would often be up against 20 different banks trying to offer similar services to the clients, so it is already a very competitive segment of the financial markets.
The end users who we represent would certainly welcome more competition, and I can tell you that the dealers, given that there are so many dealers already, wouldn't be adverse to there being more competition. So if this committee and Congress ultimately concludes that it can extend appropriate regulatory relief to the exchanges in a way that would allow them to compete more effectively with the OTC derivatives markets, and at the same time preserve legal certainty, and take into account the work of the President's Working Group which argues very compellingly that there is no policy justification for increased regulation in the OTC derivatives market, that is a result that we would welcome.
Mr. MORAN. Thank you for your response.
Mr. MILLER. Could I just add and make a comment here, too, please?
With regard to the exchanges, as end users we find that having the futures available to us is imperative for pricing some of our OTC products. So as you look at the balance between regulation in one market versus the other, and it has a tendency to reduce volume or activity, let's say, in exchange-traded products, that is going to change the effectiveness of that price for us that we will use to value some of our OTC products. So it is very important that, as you engage in the revision of the Commodity Exchange Act, you take into account the usefulness that futures provide to us, so as we don't lose that in the transition.
Mr. MORAN. Thank you.
Thank you, Mr. Chairman.
Page 98 PREV PAGE TOP OF DOC Mr. EWING. Do you have any other questions?
Mr. MORAN. I don't, Mr. Chairman.
Mr. EWING. Mr. Condit?
Mr. CONDIT. No.
Mr. EWING. Any comments from the panel?
Mr. ROSEN. We look forward to working with you and this subcommittee on these issues, Mr. Chairman.
Mr. EWING. Thank you. Thank you very much, and I look forward to working with you. And our hearing is adjourned. The record will stay open for 5 working days for anyone who wishes to submit information in writing for the record. Thank you all very much.
[Whereupon, at 1:34 p.m., the subcommittee was adjourned, subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]
Statement of Scott Gordon
Chairman Ewing, members of the committee, I am Scott Gordon, chairman of the Board of Directors of the Chicago Mercantile Exchange. I am proud to introduce our new president and chief executive officer, Jim McNulty. Jim has been a strong force at every level of our industry, from over-the-counter-trading to the application of technology. We expect him to lead our efforts to find compatible regulatory and business solutions to some of the problems we are addressing here today.
The Exchange welcomes this opportunity to offer its view of the Report of the President's Working Group on Financial Markets. I want to begin by unequivocally expressing our support for the efforts of the CFTC, under Chairman Rainer, to reexamine and reassess the regulatory structure of our industry. The Commission's initial revisions to its thick white book of regulations demonstrates a commitment to bring regulatory burdens into line with regulatory needs. That said, and without criticism of our regulator's endorsement of the report, it is fair to say that the CME is extremely concerned. It is clear to us that the report's proposal unjustifiably tilts the playing field against existing exchanges.
Page 99 PREV PAGE TOP OF DOC The Chicago Mercantile Exchange, the Chicago Board of Trade and the New York Mercantile Exchange have been working for some time to change the underlying philosophy of financial service regulation. During 1999, we presented a five-part program for CFTC reauthorization. We agreed that OTC markets suffer from legal uncertainty that should be resolved by changing the Commodity Exchange Act. We supported legal certainty for privately negotiated over-the-counter transactions, sought major revisions to the Shad/Johnson Accord, and called for rationalization of regulation for the entire financial services industry.
However, we urged that any legislation should be fair and even-handed. Our goal was equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. After careful assessment of the Report of the President's Working Group on Financial Markets, we are disappointed that our efforts to create a fair and level playing field have not been heeded.
While the working group recognizes the regulatory disparities and blurred product distinctions that handcuff U.S. futures exchanges in today's competitive global market, the report does almost nothing to address those issues. This omission is a serious flaw. The report calls for some changes that are in accord with our principles; however, its recommendations for regulatory relief and legal certainty will immediately benefit the over-the-counter market and enterprises that operate unregulated exchanges without timely relief for us.
The report begins with a conservative call for legal certainty for OTC swaps. It veers from that simple principle to a radical realignment of markets and regulators by redefining a swap to include standardized, cleared, futures contracts traded on exchanges regulated by the SEC or by bank regulators. The call for legal certainty for a bilaterally negotiated contract has been converted into a demand for the exclusion from the CEA of exchange traded and cleared financial futures.
BILATERAL FINANCIAL DERIVATIVES:
Page 100 PREV PAGE TOP OF DOC The PWG's recommendation for legislative action is: ''An exclusion from the CEA for bilateral transactions between sophisticated counterparties (other than transactions that involve non-financial commodities with finite supplies).''
The PWG minimizes the impact of its proposal, claiming: ''This recommendation provides greater legal certainty and removes doubts about enforceability, making the U.S. a more attractive derivatives market.'' We think the proposal in its current form has far more serious jurisdictional and market fairness consequences than are described.
The exchanges do not object to an exemption from the CEA for true bilateral OTC transactions in financial instruments. We have, however, questioned the purpose of an ''exclusion'' rather than an exemption. The PWG recommends that excluded swap agreements may be fungible and cleared by a clearinghouse that is not regulated by the CFTC. This recommendation obviously strips the Commission of jurisdiction over instruments that are indisputably futures contracts.
The PWG's proposed exclusion overrides Shad/Johnson restrictions that now limit OTC transactions. The PWG proposes to exclude swap agreements that ''reference non-exempt securities'' from the CEA. We are confounded by the irreconcilable contradiction between the working group's conclusion that over-the-counter swaps, including equity swaps, should be excluded from the CEA while refusing to endorse revisions to the Shad/Johnson Accord for regulated markets. There is no principled reason to support unregulated, over-the-counter trading in a product while refusing to permit identical products to trade in the well regulated, price-transparent and liquid environment provided by the CME.
If equity swaps are excluded from the CFTC and the CFTC's exclusive jurisdiction is eliminated, these products could be claimed by the SEC jurisdiction. The PWG's suggestion that it is deregulating the OTC market needs to be carefully parsed. In fact it may only be stripping the CFTC of its jurisdiction over equity derivatives and paving the way for the SEC to take over the market.
Page 101 PREV PAGE TOP OF DOCELECTRONIC TRADING SYSTEMS
The PWG's recommendation for legislative action is: ''An exclusion from the CEA for electronic trading systems for derivatives provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts that involve non-financial commodities with finite supplies.''
The Working Group advocates a complete exclusion for certain principal-to-principal transactions executed by means of electronic trading platforms that are indistinguishable from the trading systems used by the CME, the CBOT and NYMEX. The Working Group recommends distinct regulatory treatment of principal-to-principal exchanges and agency exchanges, but does not advance a compelling policy argument to support the distinction. In fact, all transactions at the CME and at the CBOT are also on a principal-to-principal basis. Both exchanges work directly only with their own clearing members and not with the ultimate customers of those members. There is no difference between a trade executed for the member's account and a trade executed for the account of a member's customer.
The existence of an agency relationship between a customer and its futures commission merchant is relevant to the question of the degree to which the firm that places the order, the customer's agent, ought to be regulated. It has no logical bearing on whether the exchange on which the order is executed needs to be regulated.
Moreover, it is often the case that contracts entered into by a principal on a principal exchange are immediately transferred to a customer. The PWG's proposal of distinctly different regulatory treatment for exchanges that permit intermediaries to represent customers and exchanges that require intermediaries to trade for their own accounts and then do a back-to-back transaction with the ultimate customer is not logical. It is clear that the customer of a dealer trading on a principals only exchange is inherently less advantaged than the customer of an intermediary trading on an exchange like the CME.
Page 102 PREV PAGE TOP OF DOC The PWG concludes the electronic trading systems are good for OTC derivatives without questioning whether it is logical to refer to exchange traded derivatives as if they were still over-the-counter products. The PWG recommends that most financial derivatives, including swaps on single equities, or single stock equity futures in our parlance, be excluded from the CEA if traded on an exchange that requires all trades to be on a principals only basis. The result will be that dealers and large customers will be able to trade single stock futures on an exchange so long as it is not a futures exchange regulated by the CFTC. In effect, this provision constitutes a de facto transfer of CFTC jurisdiction over exchange traded equity based derivatives to the SEC.
On the positive side, the working group's proposal will seek clarification of the Treasury amendment to reverse the interpretation that it exempts all transactions by unsophisticated investors in foreign currency futures from the protections of the Commodity Exchange Act. We strongly support this clarification, which we believe will help to control the meteoric growth of Internet-based bucket shops that have been defrauding the American public.
The PWG's exact recommendation for legislative action is: ''A clarification of the Treasury amendment that clears the way for the CFTC to address the problems associated with foreign currency ''bucket shops'' and excludes all other transactions in Treasury amendment products from the CEA, unless they are conducted on an organized exchange.''
That benign sounding recommendation also hides a wholesale realignment of CFTC jurisdiction and a major concession to foreign currency dealers, the bond dealers and securities dealers. The PWG, while proposing to restore the CFTC's jurisdiction over bucket shops, carves out a special exemption for derivative exchanges operated by an entity that is supervised by the SEC or bank regulators or an entity that is affiliated with such a regulated or supervised entity. This means that an affiliate of a broker-dealer that is not itself regulated by the SEC, can operate an exchange for foreign currency futures transactions outside the jurisdiction of the CFTC. The PWG's recommendation suggests a philosophy that the CFTC should be stripped of all jurisdiction over any entity that is even tangentially related to a bank or a broker-dealer. This far-reaching proposal to transfer jurisdiction to the SEC and bank regulators is not even explained.
Page 103 PREV PAGE TOP OF DOC In addition, The PWG's definition of ''organized exchange'' is ''an exchange that is open to retail or agency transactions and that serves a self-regulatory function . . ..'' This language permits an exchange, identical to the CME in every way except that it does not maintain a surveillance and compliance department, to trade and clear currency and government security futures without any CFTC regulation. No logical explanation is offered to support this strange position. If the PWG's recommendation were based on regulatory principle, rather than jurisdictional realignment, it would be required to approve complete deregulation of the CME's currency futures if the CME agreed not to exercise any form of self-regulation in that market.
The report recommends that Congress ''enact legislation to provide a clear basis for the regulation of clearing systems that may develop for OTC derivatives.'' The CME supports the concept but suggests that it be expanded to permit fair competition among clearing systems and to give market users a free choice among providers of clearing services. The report suggests that SEC and bank regulated clearing houses be permitted to clear both the cash and derivative instruments. CFTC regulated clearinghouses would be limited to derivative contracts. This allocation of power and responsibility will preclude effective competition among clearinghouses and drive business toward those clearinghouses that are entitled to clear the largest base of products. We believe that market users - not Congress or the PWGshould make the choice of clearing agency.
The Working Group recommends, ''enactment of a provision to clarify that the Shad-Johnson Accord shall not be construed to apply to hybrid instruments that have been exempted from the CEA.'' This proposal will permit banks to issue CD's whose value fluctuates as if the CD were a fully margined futures contract on a single stock. The CME does not oppose such instruments or their issuance by banks. It objects to banks being able to sell and trade futures contracts on single stocks while that privilege is denied to futures exchanges.
Page 104 PREV PAGE TOP OF DOCMISCELLANEOUS
Finally, the working group does not address one of our objectives for reauthorization. We proposed that access to derivatives exchanges be expanded by permitting banks and broker-dealers to deal in futures contracts without separately registering with the CFTC. We remain convinced that the legislative program we put forward is an important proposal that reflects sound public policy. We will continue to work for legislation that incorporates our proposal.
Although we are frustrated with the one-sided recommendations in this Report, we will continue to support fundamental fairness in any legislation to reform the U.S. regulatory structure. Congressional leaders have demonstrated their commitment to tackling some difficult market disparities, and CFTC Chairman Rainer highlighted his support for serious reform in a recent speech to industry leaders in Chicago. We hope to work with the President's Working Group and Congress to provide that kind of comprehensive reform of the risk management markets.
The CFTC, under Chairman Rainer, has demonstrated it is prepared to move toward justified exemptions for financial products traded on our exchange. We are concerned, however, that regulated exchanges will remain at a severe competitive disadvantage unless and until parity of regulation is achieved. If the working group's recommendations are adopted without corresponding relief for regulated exchanges, the balance will be swung irretrievably against parity of regulation.
Statement of the International Swaps and Derivatives Association, Inc.
This statement is submitted by the International Swaps and Derivatives Association, Inc. (ISDA) to the Subcommittee on Risk Management and Specialty Crops of the United States House of Representatives in connection with the subcommittee's February 15, 2000 hearing on the November 1999 Report of the President's Working Group on Financial Markets on Over-The-Counter Derivatives and the Commodity Exchange Act.
Page 105 PREV PAGE TOP OF DOCOVERVIEW
ISDA is an international organization and its more than 450 members include the world's leading dealers in off-exchange principal-to-principal derivatives transactions (collectively swaps transactions) that are the focal point of the report. These dealer-members are among the principal customers of the futures exchanges that are regulated by the Commodity Futures Trading Commission under the Commodity Exchange Act. In addition, ISDA's members also include many of the businesses, financial institutions, governmental entities and other end-users that rely on swaps transactions to manage their financial and commodity market risks with a degree of efficiency and effectiveness that would not otherwise be possible.
ISDA has consistently urged Congress to enact legislation to modernize the CEA. A modernized CEA should provide legal and regulatory certainty for all financial contracts, minimize systemic risk, encourage financial innovation and facilitate competition in the United States and abroad. Moreover, a modernized CEA should foster efficient, liquid and low cost financial transactions. Regulatory burdens that increase the cost or decrease the availability of risk management tools to businesses and other end-users should be imposed only in those cases where less burdensome means, including market discipline, have not been effective.
ISDA believes that the report should serve as a catalyst for the enactment of bipartisan legislation in 2000 to modernize the CEA. The report reflects an extraordinary consensus reached by the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission and the Chairman of the CFTC. Consistent with the report, Congress should explicitly clarify that swaps transactions generally are excluded from the CEA and thus ensure that swaps transactions are enforceable in accordance with their terms. As stated in the report, ''. . . an environment of legal certainty . . . will help reduce systemic risk in the financial markets and enhance the competitiveness of the U.S. financial sector.'' Indeed, as the report noted, the failure to do so ''. . . would perpetuate legal uncertainty or impose unnecessary regulatory burdens and constraints upon the development of these markets in the United States.''
Page 106 PREV PAGE TOP OF DOC This statement summarizes ISDA's views on certain of the recommendations of the report, including those related to legal certainty, electronic trading and clearing of swaps transactions; the Treasury amendment; hybrid instruments; the regulation of swaps dealers; and netting. ISDA also supports including in the CEA modernization legislation provisions to provide comprehensive regulatory relief to the regulated futures exchanges. While a detailed consideration of exchange regulation was beyond Congress' specific mandate to the President's Working Group, there is a broad consensus that action is now required, both by Congress and the CFTC, to modernize exchange regulation. ISDA would welcome legislation that increases both the autonomy of the futures exchanges and their efficiency and cost-effectiveness. Legislation that provides legal certainty for swaps transactions and regulatory relief for the futures exchanges is urgently needed and should be enacted in 2000.
LEGAL CERTAINTY FOR SWAPS TRANSACTIONS
Swaps transactions are effective tools that enable American businesses and other end users in each of the 50 States to manage the interest rate, currency, commodity, credit and other related risks that are inherent in their activities. In this way, businesses and other users of swaps transactions are thereby able to lower their cost of capital, manage their credit exposures, and increase their competitiveness both in the United States and abroad by focusing on their core areas of expertise. For example, if a business has floating-rate debt outstanding and is concerned that interest rates will rise, it can use an interest rate swap to create the same cash flow as a fixed-rate obligation. Similarly, if a business has the right to receive non-dollar revenues from a foreign-based affiliate, it can use a currency swap to hedge its exposure to fluctuating exchange rates. The United States has been a leader in the development of swaps transactions and American businesses were among the earliest to benefit from these risk management tools.
Unlike exchange-traded futures contracts, swaps transactions provide end-users with an opportunity to tailor the key economic terms of their transactions to their specific risk management needs. This almost limitless flexibility has led to the dramatic growth in the volume and diversity of swaps transactions. Thus, while the majority of swaps transactions relate to interest rates and foreign currency, there is increasing use of commodity, energy, credit, equity and other types of swaps transactions.
Page 107 PREV PAGE TOP OF DOCThe dramatic growth in the volume and diversity of swaps transactions is probably the best evidence of their importance to, and acceptance by, end users. The United States has been a leader in the development of swaps transactions and American businesses were among the earliest to benefit from these risk management tools. It is no coincidence that the U.S. economy and the volume of swaps transactions both grew dramatically during the last decade.
One of ISDA's principal goals since its inception has been to promote legal certainty for swaps transactions. For example, ISDA has sought to establish (1) clarity concerning how swaps transactions will be treated under the laws and regulations of the U.S. as well as other countries throughout the world; (2) certainty that swaps transactions will be legally enforceable in accordance with their terms and not subject to avoidance; and (3) certainty that key provisions in swaps transactions (including netting and termination provisions) will be enforceable, even in the case of the bankruptcy of one of the parties. ISDA has supported legal certainty initiatives in the U.S. and abroad. In addition, ISDA has developed master documentation templates for swaps transactions that are today used in the United States and around the world by the vast majority of swaps participants for their transactions.
A principal recommendation of the report is that Congress enact legislation to provide legal certainty that swaps transactions will be enforceable in accordance with their terms. ''Legal certainty'' simply means that parties (both dealers and end users) must be certain that the provisions of the swaps agreements they enter into are enforceable. The importance of legal certainty cannot be overstated. Any uncertainty with respect to the enforceability of a swaps transaction presents an obvious and significant source of risk to the individual parties to the transaction. As the report emphasizes, any such uncertainty creates risks for the financial system as a whole and undermines the U.S. role as a key global financial center. More importantly, as stated in the report, ''an environment of legal certainty . . . will help to reduce systemic risk in the financial markets and enhance the competitiveness of the U.S. financial sector.'' Finally, any legal uncertainty limits the realization of the powerful risk management benefits that swaps transactions provide to businesses and other end-users.
Page 108 PREV PAGE TOP OF DOC The CEA has been a significant source of legal uncertainty because the CEA generally provides that off-exchange ''futures'' contracts are illegal, but it does not define the term ''futures'' contract. Thus, if a swaps contract were ever declared to be a ''futures'' contract, that contract would be illegal as a matter of law unless it qualified for an exclusion from or exemption under the CEA, such as the Treasury amendment exclusion or the administrative exemption for certain swaps transactions. For more than 10 years, Congress, financial regulators and others worked actively to preserve and promote legal certainty that swaps transactions are not appropriately regulated under the CEA. These incremental measures have fostered the rapid growth of swaps transactions as an essential risk management tool but have not eliminated all uncertainty or addressed obstacles to continuing innovations.
Concerns that the CEA may create legal uncertainty are neither academic nor speculative. In 1998, unilateral actions by the CFTC suggested that the CFTC might treat certain swaps transactions as ''futures''. Because, as stated earlier, off-exchange futures contracts that do not qualify for an exclusion from or exemption under the CEA are illegal, this suggestion nearly shattered the settled expectations of the financial markets that United States swaps transactions were enforceable in accordance with their terms. The resulting uncertainty was particularly acute with respect to those categories of swaps transactions (such as swaps based on non-exempt securities) not eligible for the existing administrative exemptions from the exchange-trading requirement of the CEA. These concerns were sufficiently far reaching that Congress was required to enact a moratorium on most CFTC actions with respect to swap transactions in order to preserve legal certainty and market stability. That legislation was an important action that served to calm concerns of the markets during this time. It is important to note that this was a temporary measure and it did not attempt to resolve issues related to the underlying causes of legal uncertainty. The legislation also directed the President's Working Group to conduct a study of the treatment of swaps transactions under the CEA. The report reflects the results of that study.
Page 109 PREV PAGE TOP OF DOC In addition to its concerns that legal uncertainty poses systemic risk, the working group concluded that ''[a] cloud of legal uncertainty has hung over [swaps transactions] . . . in the United States in recent years, which, if not addressed, could discourage innovation and growth of these important markets and damage U.S. leadership in these arenas . . .''
Legal uncertainty creates barriers to innovation. For instance, as the report notes, ''uncertainty involving OTC derivatives has hampered private sector efforts to utilize electronic trading systems that would enhance market efficiency and transparency.'' Financial institutions in the United States must have the opportunity to respond to market changes and customer demands without having to overcome unnecessary regulatory obstacles that do not exist elsewhere in the world.
The Working Group also concluded that there was no compelling policy justification for regulating swaps transactions under the CEA. This conclusion is consistent with the view taken by the CFTC itself in its 1989 Swap Policy Statement (which remains in effect) that swaps transactions generally are not appropriately regulated as ''futures'' under the CEA. This view in turn formed the policy foundation for Congress' action in 1992 directing the CFTC to use its new exemptive authority to exempt most swaps transactions from almost all provisions of the CEA. In light of its conclusion that swaps transactions generally need not be regulated under the CEA, the working group recommended that Congress provide ''legal certainty'' by enacting a new statutory exclusion for swaps transactions, including swaps involving non-exempt securities, between sophisticated counterparties.
ISDA agrees with the report's conclusion that there is no compelling policy justification for regulation of swaps transactions under the CEA. Participants in swaps transactions are sophisticated entities that do not require the special protections available to retail investors in exchange-traded futures contracts. Moreover, swaps transactions do not serve the price discovery functions or present the potential for manipulation, that serve as the policy rationales for CEA regulation.
Page 110 PREV PAGE TOP OF DOCENERGY AND OTHER COMMODITY DERIVATIVES
The Working Group concluded that the proposed new statutory exclusion for swaps transactions should not encompass swaps involving non-financial commodities in finite supply. The report notes that there are special factors that make agricultural markets susceptible to pricing distortions and manipulation; that there have been efforts in the past to manipulate the prices of certain metals and that the cash markets for many non-financial commodities depend upon the futures markets for price discovery.
While the majority of swaps transactions today involve financial ''commodities,'' swaps transactions involving many physical commodities, such as some energy products, are becoming increasingly important hedging tools. Congress needs to provide comparable treatment for other types of swaps transactions where a compelling policy rationale for regulation under the CEA cannot be demonstrated. If distinctions of the type contemplated by the report are to be drawn, Congress should consider the impact the definition of non-financial commodities in finite supply would have on new and emerging products. ISDA believes new and emerging products should receive comparable legal certainty treatment where rationale for CEA regulation cannot be demonstrated.
ISDA believes that most non-financial swaps transactions that prudently can be included in the legal certainty provisions enacted for swaps on financial commodities. For example, the market for various energy products is very deep and liquid thus less susceptible to price distortion and manipulation. The report did not cite any specific evidence that the commodity swaps market has been subject to manipulation. The underlying cash markets remain the source of the price discovery the CEA seeks to protect. Increased liquidity to these markets is in large part due to deregulation of the energy markets, which has allowed the market to grow and innovate. Unless comparably treated, innovative risk management transactions in areas such as energy may be stifled to the detriment of U.S. businesses and other U.S. end-users For this reason, ISDA believes electronic trading systems for conducting swaps transactions in energy derivatives should also be excluded from regulation under the CEA.
Page 111 PREV PAGE TOP OF DOC SDA also believes that while financial and other liquid swaps transactions should be excluded from the CEA, Congress should reaffirm the applicability of the current swaps exemption for products that cannot prudently be included under the proposed new statutory exclusion. This is particularly important to assure that legal certainty exists for transactions that remain subject to exemptive authority.
ISDA agrees with the recommendation of the report that the CEA be amended to ensure that execution of excluded swaps transactions, including energy and commodity swaps, through electronic trading systems does not provide a basis for regulation of either the transactions or the system. As noted earlier, energy swaps generally should be excluded from the CEA.
Congress and regulators should focus on the underlying activities that are conducted on electronic trading systems and not on whether one kind of technology or another is employed to carry on those activities. For example, a swaps transaction between two dealers or between a dealer and one of its institutional customers that is not now regulated under the CEA when effected by telephone should not be subject to regulation when it is conducted through the use of a more ''contemporary'' electronic system.
Historically, swaps transactions have been negotiated through telephone conversations. Dealers dealt over the telephones directly with other dealers or indirectly through brokers. The fact that computers are replacing telephone conversations should not lead one to conclude that unregulated transactions need to be regulated. Systems that limit participation to a single dealer and its customers do not present the same public policy issues that exist for trading on organized futures exchanges. A single-dealer system where only one market maker is transacting with its customers does not pose the same risks as an exchange in which the entire market is participating.
Page 112 PREV PAGE TOP OF DOC Additionally, some multiple-dealer systems automate the services traditionally performed by an interdealer voice broker. Using a screen-based system to carry out the same basic activity does not fundamentally change the public policy implications of an interdealer voice brokerage, whether voice or electronic. Issues of price manipulation, systemic failure and retail customer abuse are highly unlikely in systems limited to principal-to-principal transactions by substantial counterparties.
Electronic trading is becoming an integral component of the U.S. financial markets. ISDA believes this is a positive development and shares the views expressed in the report that ''the introduction of electronic trading systems for OTC derivatives has the potential to promote efficiency and transparency, and by enhancing liquidity and enabling firms to impose more reliable controls on their traders, to reduce, risks.'' Technological advances have and will continue to increase the liquidity, transparency and efficiency of the financial markets. In addition, the use of electronic trading systems will promote the integrity of financial markets by providing a ''real time'' audit trail. Electronically enhanced execution, and the immediate and accurate electronic capture of trade data, facilitates trading and operational efficiencies connected with the execution and clearance of transactions.
Electronic trading also facilitates the development of ''real time'' risk management systems. This is consistent with the policy of U.S. regulators to encourage increased focus on market risk and the use of sophisticated risk management measures. Moreover, increasing the efficiency of risk management and decreasing its costs will benefit the economy in general and not simply market participants.
For these reasons, Congress must ensure that the U.S. regulatory framework does not discourage developments in this area. The United States must continue to be competitive in the global derivatives business. If the regulatory framework is unable to accommodate and facilitate this development of electronic systems this business will most assuredly be conducted abroad. Unfortunately, as the report itself acknowledges, this is not now the case because some have contended that the use of an electronic system to enter orders to execute transactions under some circumstances may disqualify the transactions from the Swaps Exemption even though the same transactions executed via telephone communications would be exempt. Historically, swaps transactions have been negotiated through telephone conversations. Dealers dealt over the telephones directly with other dealers or indirectly through brokers. The fact that computers are replacing telephone conversations should not lead one to conclude that unregulated transactions need to be regulated.
Page 113 PREV PAGE TOP OF DOCExclusion from the CEA of electronic systems for swaps transactions that are limited to sophisticated counterparties trading for their own accounts as recommended in the report will encourage development of electronic trading systems and remove uncertainty about the applicability of the current swaps exemption to the development of electronic trading systems.
The report correctly recognizes that clearing may reduce counterparty risks otherwise associated with swaps transactions and in turn can reduce systemic risk by generally reducing the possibility of loss due to default. As the report also recognizes, however, current law tends to discourage the use of clearing systems since they may jeopardize the application of the current administrative exemption for certain swaps transactions that are cleared. ISDA supports the recommendations of the report that the CEA be amended to ensure that the use of clearing systems for swap transactions will not adversely affect the status of swap transactions under the CEA. ISDA also believes it is necessary to explicitly clarify that contracts that are cleared should not be regulated under the CEA simply because they are cleared.
ISDA also recognizes that the ability of clearing to reduce risk depends upon prudent operation. As the report points out, ISDA understands that clearing may concentrate risk and that the risk management systems used by clearinghouses may therefore have regulatory implications. It is important to note, however, that Federal bank supervisors have managed to supervise banks' involvement in major payment systems with virtually no regulation. ISDA believes that Congress should ensure that duplicative regulation or supervision does not occur among U.S. regulators and that U.S. regulators should be permitted to rely on the oversight performed by any other G7 regulator.
THE TREASURY AMENDMENT
Under the Treasury amendment to the CEA, swaps transactions in or involving foreign currency, government securities or certain other enumerated ''underlyings'' are excluded from the CEA unless ''such transactions involve the sale thereof for future delivery conducted on a board of trade''. ISDA believes that the Treasury amendment has worked well for more than 25 years and provides a more stable framework for legal certainty than does the current administrative exemption for certain swaps transactions. In ISDA's view, the Treasury amendment should be retained as an integral part of a modernized CEA.
Page 114 PREV PAGE TOP OF DOC Nevertheless, a tremendous amount of litigation has arisen with respect to the Treasury amendment. Many of these issues have now been resolved and the principal remaining issue concerns the scope of the term ''board of trade''. ISDA agrees with the recommendation of the report that the Treasury amendment be modified by Congress to substitute ''organized exchange'' for ''board of trade''. This clarification is an essential part of the legal certainty agenda. It would ensure that the Treasury amendment would be administered in accordance with its original purpose to exclude from the CEA all transactions in the enumerated products that are not conducted on an organized futures exchangewhether or not the transactions are conducted on electronic trading facilities or are subject to clearing and settlement arrangements. As noted earlier, ISDA believes that the development of electronic trading systems and clearing facilities which provide the additional benefits of enhanced portfolio diversification, credit risk management and market access should be encouraged with respect to swaps transactions generally and this is no less true in the case of swaps transactions covered by the Treasury amendment.
ISDA agrees with the report's recommendation to provide legal certainty for hybrid instruments that reference non-exempt securities by clarifying that the Shad-Johnson accord shall not be construed to apply to hybrid instruments that have been exempted from the CEA.
Hybrid instruments are securities or deposits (already regulated by the SEC or banking regulators) that possess features similar to commodity futures and commodity options and facilitate risk management and investment opportunity. OTC contracts based on or involving non-exempt securities allow parties to transfer the risk associated with changes in the price of an underlying security, basket of securities or securities index without transferring ownership of the securities themselves. These transactions permit institutional investors and portfolio managers the flexibility to hedge risks associated with securities markets and to invest in new and emerging financial markets. They also allow firms to diversify their exposures to credit risk thereby providing an important systemic risk management function.
Page 115 PREV PAGE TOP OF DOC It is important that there be no questions about the legal enforceability of these transactions in the U.S. Many market participants, including U.S. firms, have sought to enter these types of transactions in jurisdictions outside the United States because the legal framework for these transactions are more favorable.
REGULATION OF SWAPS DEALERS
ISDA agrees with the report's recommendation that no legislative action be taken with respect to regulation of non-affiliated OTC derivatives dealers. In reaching this conclusion, the report notes that swaps dealers that are not affiliates of banks, broker-dealers or FCMs account for only a small percentage of swaps transactions and cites ''the apparent effectiveness of counterparty discipline in containing the risk-taking of such . . . dealers''. ISDA welcomes the decision of the working group not to seek regulation of swaps dealers and believes it is important to underscore why this is the correct result from a policy point of view.
While many swaps dealers or their affiliates are regulated by, for example, banking regulators, they are not regulated because of their swaps activities. Instead, in the case of banks for example, they are regulated because they hold taxpayer-insured funds and have a special role with respect to protecting public funds. In short, they are regulated by reason of their institutional nature and all of their transactionsnot just their derivatives transactionsare subject to supervision. In some instances, as in the case of insurance companies, this regulation occurs at the State level, but the regulatory rationale is based on ensuring that these firms remain sufficiently solvent to meet their obligations to policyholders. No compelling policy case has been put forth for governmental regulation of derivatives dealers solely because of their participation in swaps transactions.As noted earlier, swaps transactions are entered into by sophisticated counterparties acting as principals. Each is capable of assessing the credit risk of their counterparty or will otherwise rely on credit rating agencies or professional advisors. Dealers with lower credit ratings will find their proposed swaps transactions rejected by other financial market participants or they will be entered into only if significant credit enhancements are provided. This self-policing in the swaps industry has worked well to date. While some dealers have failed, those failures did not come near to having systemic consequences. Those who seek to extend regulation into this area of the market should bear the burden of demonstrating the need for regulation and that the benefits of implementing such regulation exceed the cost.
Page 116 PREV PAGE TOP OF DOCNETTING
ISDA, as an early leader in the advancement of netting contracts, agrees with the report's recommendation to enact into law improvements in the netting regime for derivatives.
The April 1999 report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management states, ''the ability to terminate financial contracts upon a counterparty's insolvency enhances market stability. Such close-out netting limits losses to solvent counterparties and reduces systemic risk. It permits the solvent parties to replace terminated contracts without incurring additional market risk and thereby preserves liquidity. The ability to exercise close-out netting also will generally serve to prevent the failure of one entity from causing an even more serious market disruption.''
ISDA has long advocated improvements to the United States Bankruptcy Code, the Federal Deposit Insurance Act (FDIA), and the Federal Deposit Insurance Corporation Improvement Act (FDICA). Provisions to allow cross-product netting and expansion and clarification of financial contracts eligible for netting minimize the risk of a disruption within or between financial markets upon the insolvency of a participant in those markets. ISDA believes these provisions, which were passed by the Senate in February 2000, should be enacted into law as expeditiously as possible.
ISDA notes that other jurisdictions, including the European Union, have enacted legislation to make clear that the netting of financial obligations is effective under their current bankruptcy regimes. Other countries with major financial centers are enacting legislation that ensures that their financial markets rest on solid legal foundations. Financial market participants will conduct business in those centers that provide that foundation. Market participants will insist on legal opinions confirming the strength of these foundations. They will seek to avoid markets and participants in markets with weak netting and banking regimes. Enactment of these enhancements to the Bankruptcy Code, the FDIA and the FDICIA will help to better ensure the vitality of the United States financial markets.
Page 117 PREV PAGE TOP OF DOCREGULATORY RELIEF FOR U.S. FUTURES EXCHANGES
ISDA also believes that CEA modernization legislation should include provisions to ensure that comprehensive regulatory relief will be provided to U.S. regulated futures exchanges. Indeed, ISDA's dealer-members are among the principal users of the futures exchanges.
While a detailed consideration of exchange regulation was beyond the scope of Congress's specific mandate to the President's Working Group in the context of this Report, regulatory relief for the U.S. futures exchanges is long overdue. For too long, they have operated under an outdated statute. Swift action is required to modernize regulation of the futures exchanges, increase their autonomy, efficiency and cost effectiveness. Futures exchanges in the United States, due to regulation, are at a competitive disadvantage vis-a-vis offshore exchanges. ISDA agrees with the report's recommendation that existing regulatory structures (particularly those applicable to markets for financial futures) should be reviewed to determine whether they appropriately serve valid regulatory goals and believes appropriate regulatory relief should be provided for exchange-traded financial futures.
The recommendations of the report that are unanimously supported by the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission and the Chairman of the Commodity Futures Trading Commission should serve as a catalyst for Congressional action to modernize the CEA, promote legal certainty for swaps transactions and provide comprehensive regulatory relief for the futures exchanges.
ISDA wishes to specifically emphasize that implementation of the report's recommendations will achieve the important goal of reducing systemic risk in the OTC markets. Legal certainty for swaps transactions will permit businesses, financial institutions, government entities and other end users to manage their financial and commodity market risks with a degree of efficiency and effectiveness that would not otherwise be possible. The development of electronic trading serves to reduce systemic risk by increasing liquidity, efficiency and transparency of the financial markets. The ability of clearing systems to develop without regulatory impediments may reduce systemic risk by allowing financial institution to reduce the possibility of widespread loss due to default. Finally, an improved netting regime for derivatives to allow orderly termination of financial contacts upon a counterparty's insolvency preserves market liquidity and market stability thereby preventing serious market disruption.
Page 118 PREV PAGE TOP OF DOC ISDA commends Congress for its thoughtful review of issues relating to the OTC markets and modernization of the Commodity Exchange Act, thus far. The House and Senate Agriculture Committees have been diligent in their review of the issue. Both committees have held numerous hearings and forums designed to solicit information for the purpose of identifying solutions to the issues at hand.
ISDA recognizes that the Congress will wish to examine these issues from its own perspectives as well. To that end, ISDA and its members remain committed to working constructively with Congress, the Administration, the relevant regulatory agencies and others in the private sector to secure legislation to modernize the CEA.
Testimony of Alan Greenspan
I am pleased to be here today to underscore the importance of this committee's efforts to modernize the Commodity Exchange Act and to express my support for the recommendations for amending the act that were contained in the report by the President's Working Group on Financial Markets entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act.
THE NEED FOR LEGISLATION
Over-the-counter derivatives have come to play an exceptionally important role in our financial system and in our economy. These instruments allow users to unbundle risks and allocate them to the investors most willing and able to assume them. A growing number of financial and nonfinancial institutions have embraced derivatives as an integral part of their risk capital allocation and profit maximization. In particular, the profitability of derivative products has been a major factor in the significant gain in the finance industry's share of American corporate output during the past decadea reflection of their value to nonfinancial industry. Indeed, this value added from derivatives itself derives from their ability to enhance the process of wealth creation throughout our economy.
Page 119 PREV PAGE TOP OF DOC In light of the importance of OTC derivatives, it is essential that we address the legal uncertainties created by the possibility that courts could construe OTC derivatives to be futures contracts subject to the CEA. The legal uncertainties create risks to counterparties in OTC contracts and, indeed, to our financial system that simply are unacceptable. They have also impeded initiatives to centralize the trading and clearing of OTC contracts, developments that have the potential to increase efficiency and reduce risks in OTC transactions. As I shall discuss more fully later in my remarks, rapid changes in communications technology portend that time is running out for us to modernize our regulation of financial markets before we lose them and the associated profits and employment opportunities to foreign jurisdictions that impose no such impediments.
To be sure, the Congress and the Commodity Futures Trading Commission have taken steps to address these concerns about the CEA. The Futures Trading Practices Act of 1992 gave the CFTC authority to exempt OTC derivatives from most provisions of the act. In early 1993 the CFTC used that authority to create an exemption for OTC derivatives that reduced legal uncertainty for a wide range of transactions and counterparties. Unfortunately, some subsequent actions by the Commission called into question market participants' understanding of the terms of the 1993 exemption. Now, under the leadership of Chairman Rainer, the Commission is considering reaffirming and expanding the terms of the 1993 exemption. Nonetheless, even with such an important and constructive step by the Commission, legislation amending the CEA would remain critically important. The greatest legal uncertainty affecting existing OTC transactions is in the area of securities-based contracts, where the CFTC's exemptive authority is constrained. Furthermore, as events during the past few years have clearly demonstrated, regulatory exemptions, unlike statutory exclusions, carry the risk of amendment by future Commissions.
PRINCIPLES OF REGULATION
Imposing government regulation on a market can impair its efficiency. Thus, when evaluating the need for government regulation, one must clearly identify the public policy objectives of the regulation. As the working group's report discusses, the primary public policy purposes of the CEA are to deter market manipulation and to protect investors against fraud and other unfair practices.
Page 120 PREV PAGE TOP OF DOC We must of course assess whether government regulation is necessary to achieve those objectives. The regulatory framework of the CEA was designed for the trading of grain futures by the general public, including retail investors. Because quantities of grain following a harvest are generally known and limited, it is possible, at least in principle, to manipulate the price of grain by cornering a market. Furthermore, grain futures prices are widely disseminated and widely used as the basis for pricing grain transactions off the futures exchanges. The fact that grain futures serve such a price-discovery function means that if attempts to corner a market result in price fluctuations, the effects would be felt widely by producers and consumers of grain.
The President's working group has considered whether regulation of OTC derivatives is necessary to achieve these public policy objectives of the CEA. In the case of financial OTC derivatives transactions between professional counterparties, the working group has agreed that such regulation is unnecessary and that such transactions should be excluded from coverage of the act. Importantly, the recommended exclusion would extend to those securities-based derivatives that currently are subject to the greatest legal risk from potential application of the CEA.
The rationale for this position is straightforward. OTC transactions in financial derivatives are not susceptible tothat is, easily influenced bymanipulation. The vast majority of contracts are settled in cash, based on a rate or price determined in a separate highly liquid market with a very large or virtually unlimited deliverable supply. Furthermore, prices established in OTC transactions do not serve a price-discovery function. Thus, even if the price of an OTC contract were somehow manipulated, the adverse effects on the economy would be quite limited. With respect to fraud and other unfair practices, the professional counterparties that use OTC derivatives simply do not require the protections that CEA provides for retail investors. If professional counterparties are victimized, they can obtain redress under the laws applicable to contracts generally.
Page 121 PREV PAGE TOP OF DOC The working group also considered whether the introduction of centralized mechanisms for the trading and settling of what heretofore have been purely bilaterally negotiated and settled transactions would give rise to a need for additional regulation. In the case of electronic trading systems, the working group concluded that regulation under the CEA was unnecessary and that such systems should be excluded from the act, provided that the contracts are not based on nonfinancial commodities with finite supplies and that the participants are limited to sophisticated counterparties trading solely for their own accounts. Electronic trading of such contracts by such counterparties, it was reasoned, would be no more susceptible to problems of manipulation and fraud than purely bilateral transactions. It was suggested that some limited regulation of such systems might become necessary in the future if such trading systems came to serve a price-discovery function. But it was agreed that creation of a regulatory system for such systems in anticipation of problems was inappropriate. As I have already noted, the vast majority of OTC derivatives simply are not susceptible to manipulation. Thus, even if those contracts come to play a role in price discovery, regulation of the trading mechanism might still be unnecessary.
In the case of clearing systems for OTC derivatives, the working group concluded that government oversight is appropriate. Clearing tends to concentrate risks and responsibilities for risk management in a central party or clearinghouse. Consequently, the effectiveness of the clearinghouse's risk management is critical for the stability of the markets that it serves. Depending on the types of transactions cleared, such oversight might appropriately be conducted by the CFTC under the CEA. Alternatively, it might be conducted by the Securities and Exchange Commission, the Federal Reserve, the Office of the Comptroller of the Currency, or a foreign financial regulator that one of the U.S. regulators has determined satisfies appropriate standards. Provided such government oversight is in place, OTC transactions that would otherwise be excluded from the CEA should not fall within the ambit of the act because they are cleared. If market participants conclude that clearing would reduce counterparty risks in OTC transactions, concerns about legal risks associated with the potential application of the CEA should not stand in their way.
Page 122 PREV PAGE TOP OF DOCTRADITIONAL EXCHANGES
The working group's report does not make specific recommendations about the regulation of traditional exchange-traded futures markets that use open outcry trading or that allow trading by retail investors. Nevertheless, it calls for a review of the existing regulatory structures, particularly those applicable to financial futures, to ensure that they are appropriate in light of the objectives of the act. Consistent with the principles of regulation that I identified earlier, the report notes that exchange-traded futures should not be subject to regulations that are unnecessary to achieve the CEA's objectives. The report also concludes that the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved.
I want to underscore how important it is for us to address these issues promptly. I-cannot claim to speak with certainty as to how our complex and rapidly moving markets will evolve. But I see a real risk that, if we fail to rationalize our regulation of centralized trading mechanisms for financial instruments, these markets and the related profits and employment opportunities will be lost to foreign jurisdictions that maintain the confidence of global investors without imposing so many regulatory constraints.
My concerns on this score stem from the dramatic advances in information technology that we see all around us. In markets with significant economies of scale and scope, like those for standardized financial instruments, there is a tendency toward consolidation or even natural monopoly. Throughout much of our history this tendency has been restrained by an inability to communicate information sufficiently quickly, cheaply, and accurately. In recent years, however, this constraint is being essentially eliminated by advances in telecommunications. We have not yet seen clear evidence of a trend toward natural monopoly. But the diffusion of technology often traces an S-shaped curve, first diffusing slowly, but then rapidly picking up speed. Once we reach the steep segment of that S-curve, it may be too late to rationalize our regulatory structure.
Page 123 PREV PAGE TOP OF DOC Already the largest futures exchange in the world is no longer in the American heartland; instead, it is now in the heart of Europe. To be sure, no U.S. exchange has yet to lose a major contract to a foreign competitor. But it would be a serious mistake for us to wait for such unmistakable evidence of a loss of international competitiveness before acting. As our experience with the vast eurodollar markets demonstrates, once markets with scale and scope economies are lost, they are very difficult, if not impossible, to recapture.
Statement of Daniel Rappaport
Mr. Chairman, and members of the committee, my name is Daniel Rappaport. I am chairman of the Board of Directors of the New York Mercantile Exchange (NYMEX or the Exchange). NYMEX is the world's largest exchange for the trading of energy and metals futures and options contracts. NYMEX also offers trading in certain foreign equity index futures and option contracts.
On behalf of NYMEX, I wish to thank you for the opportunity to participate in today's hearing on the report prepared by the President's Working Group on Financial Markets entitled ''Over-the-Counter Derivatives Market and the Commodity Exchange Act.
The Working Group initiated the report following a request from Congress and a joint request from the Chairmen of the House and Senate Agriculture Committees. The Working Group was asked to study the OTC markets, develop policy and make legislative recommendations. I will first present an overview of our response before providing comments on specific recommendations in the report.
The Working Group's Report makes a number of thoughtful recommendations for OTC derivatives. These recommendations are based upon the implicit consensus of the working group that derivatives trading ''should not be subject to regulations that do not have a public policy justification.'' We strongly support this principle of public policy. This principle should apply to derivatives transactions generally, whether traded in the OTC market or in a market that has been regulated by the CFTC.
Page 124 PREV PAGE TOP OF DOC Even though the report's scope is limited by design, the fleeting treatment of exchange-traded derivatives in the report is nonetheless a cause for concern. The Working Group correctly noted that a number of market participants have concluded that ''U.S. futures exchanges are at a competitive disadvantage to OTC derivatives as the result of CEA regulation.'' Furthermore, the working group also observed that market participants believe that initiatives that would introduce electronic trading and clearing for derivatives outside of the CEA, which are both recommended in the report, could further ''exacerbate this perceived imbalance.'' The report recognizes the regulatory disparities and blurred product distinctions that unduly restrict U.S. exchanges in today's competitive global market. Yet, while recommending additional regulatory relief for the OTC market, the report does not directly address the long-standing regulatory dilemmas faced by U.S. futures exchanges.
As a basic principle of public policy, attempts at serious and comprehensive regulatory reform should be fair and even-handed both for OTC and exchange markets. The report, when viewed on a stand-alone basis as an agenda for legislative reform, falls short of meeting that standard.
In order to promote competition and market efficiency through the exercise of prudent public policy, Congress should make reforms to the CEA for exchange markets at the same time that it undertakes amendments to the CEA pertaining to the OTC market. The need for regulatory relief for regulated U.S. futures exchanges is at least as urgent, if not more so, as the need for legal certainty for the OTC market.
There is now a strong and widely-shared consensus in the financial community that comprehensive reform of the CEA is overdue and is urgently needed. Market users believe that Congress needs to modernize and streamline regulation of exchange-traded derivative transactions. A number of exchange-traded futures contracts, such as NYMEX's Light Sweet Crude Oil futures contract, are highly liquid contracts that are traded almost exclusively by sophisticated institutional traders. For such contracts, there is a critical need to balance regulatory burdens with the regulatory objectives to be achieved from such regulation.
Page 125 PREV PAGE TOP OF DOC Mr. Chairman, NYMEX believes that this committee has signaled its commitment to tackling some difficult market disparities. Congress should aim for a fundamentally fair approach in any legislation to reform the U.S. regulatory structure.
We also note that CFTC Chairman William Rainer highlighted his support for serious reform in a speech late last year to industry leaders in Chicago. In a subsequent speech in New York, Chairman Rainer indicated that he had established a CFTC staff task force to review existing regulatory burdens on regulated exchanges and on intermediaries and to consider alternative approaches permissible under the CFTC's current authority. Chairman Rainer further indicated that he hoped to establish an appropriate level of regulation that would make being regulated by the CFTC an attractive business option.
We credit this committee and the current Chairman and commissioners at the CFTC for their willingness to wrestle with long-standing regulatory disparities, and we hope to work with the CFTC, the President's Working Group and Congress to achieve comprehensive reform of the risk management markets.
RESPONSES TO SPECIFIC RECOMMENDATIONS
Exclusion of Financial Swap Transactions from the Commodity Exchange Act. The great majority of swap transactions, as indicated in the report, involve financial derivatives such as interest rate, foreign exchange and equity products. The Working Group chose to group these products as one financial category to be excluded from the CFTC's jurisdiction.
Specifically, in the report, the working group recommended that Congress create a statutory exclusion from the CEA for bilateral swap transactions between sophisticated counterparties, but specified that this statutory exclusion would not be available for swap transactions involving non-financial commodities with finite supplies. In other words, the proposed statutory exclusion for bilateral swap transactions would be available only for financial commodities. In addition, the restriction on standardized terms for swap agreements contained in current part 35 of the CFTC's regulations would not be included in this statutory exclusion. Rather than a statutory exclusion for non-financial commodities with finite supplies, the working group instead recommended that the CFTC retain its current authority to grant exemptions involving non-financial commodities where exemptions are in the public interest and otherwise consistent with the CEA.
Page 126 PREV PAGE TOP OF DOC With regard to legal certainty for OTC transactions, NYMEX has consistently supported the CFTC's use of its exemptive authority to create part 35, which generally exempts bilateral swap transactions between sophisticated counterparties from most provisions of the CEA. We further agree with the working group that OTC markets suffer from legal uncertainty that should be resolved by amending the CEA.
Again, however, we believe strongly that addressing this uncertainty is best undertaken in the context of a comprehensive reform of the CEA that is fair and even-handed both for OTC and exchange markets. The Working Group has justified its proposed exclusion by asserting that OTC financial derivatives executed between sophisticated counterparties are determined in a highly liquid market with a very large deliverable supply. The Working Group suggests that these products are not susceptible to manipulation, do not implicate concerns about customer abuses and therefore do not need to be regulated by the CFTC. These same characteristics also apply to a number of futures and option contracts now trading on futures exchanges regulated by the CFTC. Fundamental fairness and due process require that like economic products traded between the same types of counterparties receive comparable regulatory treatment. Thus, these futures and option contracts also should be should eligible for the same light-handed regulatory treatment.
In particular, certain tangible commodities are traded between sophisticated counterparties and involve a highly liquid market and very large deliverable supply. We believe that such commodities do not require the same level of regulation as less liquid contracts that have significant participation by retail customers.
It is probably appropriate to review each physical commodity on a case-by-case basis, and it may be further appropriate to review the characteristics of the markets on which such products are traded. Therefore, we are not opposed to a review process that makes such a determination. However, we believe that Congress should amend the CEA to provide clear guidance to the CFTC that certain contracts, including physical commodities that are traded between sophisticated counterparties and that involve a highly liquid market and very large deliverable supply, are deserving of sweeping changes in their regulatory burden.
Page 127 PREV PAGE TOP OF DOCELECTRONIC TRADING SYSTEMS
The CFTC's part 35 provides an exemption from most CFTC regulatory requirements for swap agreements entered into between eligible swap participants provided that: (a) the swap agreement is not part of a fungible class of agreements that are standardized as to their material economic terms; (b) creditworthiness is a material consideration in entering into the swap agreement; and (c) the swap agreement is not traded on a ''multilateral transaction execution facility.''
The Working Group recommended that the CEA be amended to permit excluded swap transactions to be traded under certain conditions via electronic trading markets. Specifically, the working group recommended that Congress clarify that entering into or trading excluded swap agreements, i.e., transactions between eligible swap participants that do not involve non-financial commodities with finite supplies, through electronic trading systems would not create a basis for regulation by the CFTC, provided that the systems limit participation to sophisticated counterparties trading for their own accounts. The Working Group's recommendations to omit the restriction on fungible instruments from the terms of the proposed statutory exclusion and to permit swaps to be traded on electronic trading facilities would thus eliminate two of the key regulatory conditions that have been applicable to eligible swaps under part 35.
Earlier in the report, the working group noted that, because certain instruments serve risk-management needs of a large number of market participants, ''the extent to which market participants engage in large numbers of transactions increases.'' Indeed, not only is it the case that most of the business engaged in by OTC market participants involves standardized product specifications, but these product specifications often are blatantly identical to the terms and conditions of parallel futures contracts traded on regulated futures exchanges. Swap agreements provide for an opportunity to negotiate the terms of the swap agreement, such as credit terms. However, as the report also noted, ''in practice this opportunity may not be used to a great extent . . ..'' In other words, the line separating swap agreements from exchange-traded futures transactions is becoming less and less distinct each day. To that extent, this dividing line is now less a product of the characteristics of the instruments themselves and more a function of their regulatory treatment.
Page 128 PREV PAGE TOP OF DOC To allow swap transactions to be traded on a centralized electronic trading facility would largely obliterate this dividing line. It also would appear to create the same policy interests that have been thought to be applicable to regulated futures exchanges.
The Working Group, by suggesting that excluded swaps be permitted to be traded on electronic trading systems, is asking Congress to create explicit statutory preferential regulatory treatment for one type of financial instrument, swap agreements, over an equivalent financial instrument that is already trading on a regulated exchange. If Congress was to follow that advice, it would be setting itself up to decide which financial instruments should be allowed to thrive and which instruments should be curtailed.
Rather than having Congress dictate this result by its apportioning of regulatory burden, we suggest that the more appropriate role for Congress would be to ensure a level regulatory playing field for comparable products and let the market decide. Establishing public policy on a principled basis requires consistency in regulatory treatment for entities for which no real regulatory distinction can be drawn. Therefore, derivatives that are labeled as futures and are traded on centralized electronic trading systems should receive the same regulatory treatment as derivatives that are labeled as swaps and are also traded on centralized electronic trading systems.
The report further recommends that swaps excluded from the CEA could be cleared and could be regulated by the CFTC, another Federal regulator, or a foreign financial regulator that satisfies appropriate standards. The report suggests that the applicable regulator should depend upon the type of other contracts cleared by the clearing entity. Thus, for example, clearing organizations that clear futures generally could clear OTC derivatives subject to the oversight of the CFTC, while securities clearing agencies could clear OTC derivatives with the exception of instruments involving non-financial commodities. As to such non-financial instruments, the report recommends that the CFTC be authorized by Congress to develop rules establishing and regulating clearing systems for these types of OTC derivatives (to the extent that they are exempted by the CFTC in a manner that allows clearing).
Page 129 PREV PAGE TOP OF DOC While we recognize that providing clearing facilities for OTC derivatives can serve a valuable function in reducing systemic risk, we agree with the working group that clearing systems, which involve the centralization to some extent of financial risk, should be subject to appropriate Federal regulation. In general, we believe that clearing organizations that presently clear futures and options on futures also should be permitted to clear OTC derivatives. In particular, we agree with the working group that it is appropriate for Congress to authorize the CFTC to regulate clearing systems for OTC derivatives for non-financial commodities. In addition, though, we would argue that the rules promulgated by the CFTC for the clearing of OTC derivatives should provide regulatory parity on clearing rules as between futures contracts and OTC products.
As to financial commodities, we believe that the division of jurisdiction among Federal regulators deserves further study to clarify potential differences in regulatory treatment of comparable products. We believe that Congress should review carefully whether this proposed division of jurisdiction might give rise to disparities in regulatory treatment between classes of similar financial instruments and thus could generate competitive concerns based upon such regulatory disparity.
REGULATORY RELIEF FOR EXCHANGE-TRADED DERIVATIVES
The appropriate level of regulatory burden for exchange-traded derivatives is not directly addressed in the report. However, buried in the report is what may be characterized as a general principle for determining this regulatory level. The report stated that ''[e]xchange trading should not be subject to regulations that do not have a public policy justification.'' We strongly agree with this organizing principle.
The report recommends that Congress give the CFTC explicit statutory authority to provide appropriate regulatory relief for exchange-traded futures if deemed by the CFTC to be consistent with the public interest. We believe that such statutory authority would be useful to the extent that it clarifies that the CFTC has been given exemptive authority by Congress that is even more sweeping in scope than that contained in section 4(c) of the CEA.
Page 130 PREV PAGE TOP OF DOC By comparison, the report states that continuing regulation of trading activity for particular exchange-traded futures contracts is warranted depending upon the degree of: (1) accessibility to these markets by retail customers; (2) price discovery occurring in such markets; and (3) the susceptibility of such markets to market manipulation. The report indicates that, to the extent that these factors are less relevant, ''regulatory adjustments'' may be necessary.
We generally agree that the extent of retail participation in a contract and its susceptibility to manipulation are relevant factors in determining the appropriate level of regulation. On the other hand, we note that, with the continuing proliferation of electronic billboards and quote dissemination systems for OTC products, OTC markets are now also providing a price discovery function for certain products, albeit a function that is different in certain respects from the function provided by regulated futures exchanges. Therefore, we question the appropriateness of this factor as a standard for determining the appropriate level of regulation for exchange-traded derivatives.
The report discussed eliminating the CFTC's exclusive jurisdiction of futures contracts. The report did not make a formal recommendation in this area, and noted that the CFTC is still reviewing the consequences of this change. We believe that it is appropriate for the CFTC to weigh all of the ramifications of making such a change. However, we would suggest that consistency in regulatory treatment is advanced if one regulator is charged with sole jurisdiction for futures contracts; the CFTC has served in that role for a sufficient period as to develop real expertise with regard to such products. Therefore, we believe that the CFTC is well-positioned to offer consistency in regulatory treatment and could thus diminish the likelihood of creating further regulatory disparities and the competitive disadvantages resulting from such disparities.
Page 131 PREV PAGE TOP OF DOCSINGLE STOCK FUTURES
The Working Group members, while not making a formal recommendation, agreed that the current prohibitions on single stock futures can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved. We believe that these issues are resolvable, and we support such a repeal.
As a basic principle of public policy, attempts at serious and comprehensive regulatory reform should be fair and even-handed both for OTC and exchange markets. The report, taken as the basis for a legislative reform program, falls short of meeting that standard. The report recognizes the regulatory disparities and blurred product distinctions that unduly restrict U.S. exchanges in today's competitive global market, but does almost nothing to address those issues.
As a regulated, public futures market, we have serious concerns regarding our future ability to serve effectively and efficiently a demanding marketplace under the present regulatory regime. We urge this committee and the Congress to provide urgently needed flexibility to exchanges to develop and provide innovative risk management products and trading methods, and to support harmonization of the regulatory structure. We credit this committee and the current Chairman and commissioners at the CFTC for their willingness to wrestle with long-standing regulatory disparities, and we hope to work with the CFTC, President's Working Group and Congress to achieve comprehensive reform of the risk management markets.
Mr. Chairman and Members of the committee, NYMEX thanks you for your consideration and pledges its full support to work with you and your staff to address these issues and any others that may be of concern to you. Thank you very much.
Statement of William P. Miller
Page 132 PREV PAGE TOP OF DOC Good morning, Mr. Chairman and members of the Subcommittee on Risk Management, Research and Specialty Crops, of the Committee on Agriculture. I am William P. Miller, senior vice-president and independent risk officer of Commonfund, which provides investment management services for educational institutions. I am honored to offer this statement on behalf of the End-Users of Derivatives Council of the Association for Financial Professionals (AFP), formerly the Treasury Management Association.
Founded in 1994, the Council has represented over sixty organizations that use derivatives to manage risk, and has been in the forefront of end-user development in the derivatives market since its inception.
AFP represents over 14,000 finance and treasury professionals who, on behalf of over 5,000 corporations and other organizations, are significant participants in the Nation's payment systems, credit and capital markets. Many members are responsible for their organizations' derivatives activities with the primary objective of risk management. Organizations represented by members are drawn generally from the Fortune 1000 and the largest of the middle market companies, and they have an active interest and sizable stake in any regulatory and legislative changes affecting usage of derivatives.
Our statement addresses the President's Working Group on Financial Markets report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act.
Our members and the firms they represent generally share the view, embodied in the President's Working Group Report, that it is time to modernize the legal and regulatory structure governing domestic derivatives markets, including the Commodity Exchange Act. Globalization of the economy and increasing business and investment competition have intensified the needs of our membership for the essential risk management tools that over-the-counter and exchange-traded derivatives provide. At the same time, the current regulatory structure limits the array of available products and delivery alternatives, imposes unnecessary legal risks and associated transaction costs on market participants, and unnecessarily impedes our members' access to potentially significant ''dealer only'' trading markets.
Page 133 PREV PAGE TOP OF DOC Consequently, we urge that Congress update the CEA: (1) to give legal certainty to privately-negotiated, bilateral swap transactionsincluding equity swapscovering financial commodities and entered into between ''eligible swap participants'' acting in a principal capacity; and (2) to encourage the innovation and growth of appropriately regulated electronic trading systems and clearing facilities. We also urge Congress: (3) to take measures to ensure that by permitting appropriately regulated OTC electronic trading systems and clearing facilities it does not impose unfair competitive disadvantages on regulated exchanges; (4) to encourage the establishment of an alternative to the OTC market for less sophisticated end-users in which they could access risk management tools in a more controlled environment; and (5) to reconsider the restrictions on futures on securities contained in the Shad/Johnson Accord provisions of the CEA.
We agree with the President's Working Group that achieving legal certainty in swap transactions is crucial. Swap market participantsespecially dealer institutions in all their counterparty relationships, and end-users when they transact directly with other end-users without the intermediation of a dealerknowingly confront real enforceability concerns. They must deal with the residual risk that their counterparties (or more likely their counterparties trustees or receivers in bankruptcy or insolvency) may seek to avoid the performance of their obligations under, or to recover losses on, contracts based solely on the contracts failure to comply with the terms of an exclusion or exemption under the CEA.
It is impossible to quantify the costs of the legal uncertainty with which markets are faced. Nevertheless, one can safely say that any legal uncertainty presents an avoidable danger to today's enormous and extremely efficient global swaps markets, which operate on thin margins and high volumes and depend on legal certainty for their economic viability. Given the size and importance of swap markets, legal uncertainty implies systemic risks and could have profound consequences in the event of future market turmoil or instability.
Page 134 PREV PAGE TOP OF DOC Because of the importance of swap markets to our members' institutions and to the overall economy, we urge Congress to modify the CEA to provide for legal certainty of swap transactions. As we have previously testified, a possible solution to this legal uncertainty would be either: (1) to determine unequivocally that swaps are not covered by the CEA; or (2) to exempt swaps from the exchange-trading requirement of the CEA even if they are at some point considered to be futures.
ELECTRONIC TRADING SYSTEMS AND CLEARING FACILITIES
We agree with the working group that the introduction of electronic trading systems for OTC derivatives has the potential to promote efficiency, transparency and liquidity, to lower transaction costs and improve internal controls, and thus to mitigate systemic risk. Therefore we support the working group's conclusion that entering into or trading excluded swap agreements through electronic trading systems ''does not provide a basis for regulation of the systems.'' In addition, we are troubled by the unintended consequences of CFTC regulations that have led the creators of new systems, in order not to violate the CEA, to exclude end-users, including those that are eligible swap participants. If valid public policy reasons for limiting electronic systems only to dealers exist, they have been neither clearly nor persuasively articulated. Given the potential efficiencies and systemic risk management benefits of electronic trading systems, we believe that the CEA should not prohibit such systems, and that steps should be taken to ensure that it does not operate to exclude from those systems any eligible swap participants.
Perhaps the most prominent new swaps system is the ''Blackbird'' system, an electronic 'dealer only'' market for the trading of bi-lateral interest rate and currency derivatives transactions, recently established by Derivatives Net. The fundamental regulatory argument of Blackbird (see, generally, statement of Shawn A. Dorsch, president and chief operating officer of DNI Holdings, Inc., concerning Re-authorization of the Commodity Exchange Act, before the Committee on Agriculture, Nutrition and Forestry, U.S. Senate, September 23, 1999) and presumably of any other dealer only electronic system is that such systems are nothing more than ''electronic analogs'' of existing voice brokers who now serve swap dealers. As with Blackbird, such systems would do nothing other than provide their users with computer-based electronic communications systems that serve as more efficient alternative means for the direct negotiation and agreement of bilateral transactions otherwise excluded or exempted from CEA coverage. They would not constitute exchanges or clearinghouses, nor would they enter into transactions, provide credit support, take or add credit risk, or change the individual customized nature of swaps.
Page 135 PREV PAGE TOP OF DOC In our view, electronic trading systems present compelling opportunities to improve the efficiency and transparency of swap markets for the benefit of all market participants and the financial system. Participants would enjoy access to a vastly superior means than that currently provided by voice brokers of determining market prices and other contract terms. It is immensely easier and quicker to assess market demand and swaps pricing by scrolling through a list of screen generated bids and offers rather than by canvassing brokers telephonically. Furthermore, contract execution is speedier, more efficient and less prone to error when conducted electronically than when conducted either telephonically or by facsimile. Finally, electronic trading systems should enhance the integrity of users' internal controls by creating real time audit trails that limit the errors that might otherwise arise from paper-based systems. And by providing real time pricing, such systems could also greatly enhance the ability of participants to monitor and control counterparty risk limits and performance assurances and to manage the risks of their entire portfolios.
Electronic systems should contribute to the efficiency of swaps markets without either distorting the price discovery function or presenting any material opportunities for market manipulation. As the working group notes, markets for financial derivatives, the vast majority of which are settled in cash, generally take their prices from separate markets for financial commodities. Thus they ''do not serve a significant price discovery function.'' Furthermore, the prices of financial commodities are not easily manipulated, because the separate markets for financial commodities have a ''very large or virtually unlimited deliverable supply.''
For the foregoing reasons, we strongly recommend that the existing regulatory framework be modernized (1) to permit the establishment of electronic trading systems, (2) to provide at a minimum for limited regulation aimed at enhancing market transparency and price discovery and (3) to permit end-users who are eligible swap participants and act on a principal only basis to participate in those systems. Furthermore, our members would oppose any effort to establish a regulatory framework that requires electronic trading facilities to deny access to end-users that are eligible swap participants. The removal of existing artificial regulatory restrictions on the ability of all eligible swap participants to participate fully in OTC derivatives markets should improve the efficiency of the financial system and contribute to more effective market discipline and counterparty risk management.
Page 136 PREV PAGE TOP OF DOC We also agree with the working group that appropriately regulated clearing systems should be permitted under a modernized legislative framework. The Commodity Futures Trading Commission has traditionally considered ''the necessity for individualized credit determinations'' to be one of the hallmarks of an exempt swap transaction. By interposing a clearing organization between the two counterparties to a swap, clearing systems would obviate the need for individualized credit determinations. But in so doing they would also undermine that traditional hallmark of exempt swaps and thus jeopardize the applicability of established exemptions to contracts that are so cleared.
The question that must be asked, then, is whether the lack of individualized credit determinations due to the use of a clearing system somehow militates in favor of CEA regulation; we believe that it does not. As the CFTC itself has acknowledged in its 1989 swaps policy statement, although clearing organizations have traditionally been hallmarks of futures contracts, they are not necessary to futures contracts. Likewise, not all contracts that are subject to clearing constitute futures. Given the enormous counterparty risk management benefits of clearing systems, as well as the extent to which they promise to mitigate systemic risk, clearing of OTC derivatives ought to be permitted. However, such clearing concentrates credit risk in clearing facilities and thereby renders such facilities integral to the management of systemic risk. Since the risk reduction benefits derived from clearing depend on the viability of the clearing facilities, legislation should be enacted that establishes a clear basis for the regulation of clearing systems, particularly of clearinghouses' operations and risk management systems.
COMPETITIVE EFFECT ON REGULATED FUTURES EXCHANGES.
Regulated exchanges play an important role in U.S. capital markets and in systemic risk management. Many of our members depend on exchange-traded products in their own treasury and risk management activities. Yet U.S. futures exchanges are today being bombarded by a number of serious competitive challenges, both domestically and internationally, and these events may ultimately threaten their continuing viability. Most importantly, some argue that if fully enacted, the recommendations of the President's Working Group would effectively authorize the development of an OTC derivatives market that would compete directly with the organized exchanges. In such a competition, the argument goes, the exchanges would be vulnerable because they are subject to heavy-handed CEA regulation.
Page 137 PREV PAGE TOP OF DOC While we do not have detailed suggestions for solving the exchanges' competitive dilemma, we do urge that Congress take all precautions to ensure that it does not enact any measures that place U.S. exchanges at unfair competitive disadvantages. We further suggest that rather than not modernize the existing regulatory framework, the preferred approach, subject to our comments set forth immediately below, would be to lift many of the existing onerous restrictions to which exchanges are now subject.
In our view, many of the restrictions to which exchanges are currently subject consist of customer safeguards and protections that will likely warrant retention even in a modernized regulatory environment accessed only by eligible swap participants. We recognize that OTC derivatives markets are and must be markets in which both dealers and end-users are ready, willing and able to assume responsibility for their own actions. (See, e.g., Federal Financial Institutions Examination Council Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities, 63 Fed. Reg. 20191, 20194 (April 23, 1998) (Irrespective of any responsibility, legal or otherwise, assumed by a dealer, counterparty, or financial advisor regarding a transaction, the acquiring institution is ultimately responsible for the appropriate personnel, understanding and managing the risks of the transaction.) Yet in reality not all end-users and prospective end-users are equally sophisticated, nor of course do they all have the same financial resources, personnel and technological capabilities. Consequently, a large number of end-users still depend heavily on their dealers for information and explanations regarding the fair value and risks of their OTC derivatives. Such dependence increases the risk, especially in times of market volatility or instability, of counterparty disputes and thus potential legal liability.
While we do not believe it would be in anyone's best interests to create more stringent rules for derivatives markets based on the sophistication level of participants that otherwise qualify as eligible swap participants, the needs of less sophisticated eligible swap participants need to be addressed. Instead of imposing more stringent practices and standards on dealers who transact with less-sophisticated counterparties, Congress should encourage the development of some form of facility to serve as an alternative to existing OTC markets for those counterparties. Although we have not formulated any detailed plans for such a facility, we suggest that it would be a facility that would trade a limited range of ''plain vanilla'' products on standardized legal and credit terms.
Page 138 PREV PAGE TOP OF DOCSHAD/JOHNSON ACCORD
The President's Working Group unanimously recommends that the Securities and Exchange Commission (SEC) and CFTC work together and with Congress to determine whether to permit U.S. trading of single-stock futures and, if so, under what conditions. A closely related issue is the extent to which Congress should permit trading on narrowly defined securities indexes. Our membership generally favors any measure designed to offer markets the broadest possible array of financial products and so we support the working group's recommendation. However, we have less certitude on some of the underlying issues.
Some concerns have been raised by our members about the possibility that futures contracts might increase volatility in the price of the underlying stocks. These concerns are tempered by the realization that equivalent volatility may develop from the trading of single-stock options, appropriate combinations of which can replicate the economics of long and short single-stock futures positions. Economic research on volatility impacts relied on by Judge Easterbrook in Board of Trade of the City of Chicago v. SEC, a case cited by the working group, dispels some but not all of our members' concerns.
Other voices argue in favor of single-stock futures trading in the U.S. because this activity has already emerged in foreign markets. One potential unintended consequence of the current ban on single-stock futures trading is that the only market segments unable to trade single-stock futures on domestic equity securities would be those domiciled in the U.S. Lastly, our members agree generally that significant benefits would likely accrue to market participants who were able to implement risk management and investment decisions by using single-stock futures and futures on narrowly defined equity indexes.
We note that we are currently polling our members to determine, among other things, (1) whether and the extent to which the prohibition contained in the accord against single-stock futures and futures on most narrowly-based stock indexes has an impact on their risk management practices and (2) whether they believe that the trading of single-stock futures on securities issued by their institutions would likely increase or decrease volatility of those securities prices.
Page 139 PREV PAGE TOP OF DOC As end-users of derivatives, we favor a market environment in which a wide array of products is available to us, and in which we can access these products as efficiently as possible. We believe that Congress now has before it an opportunity to promote the continued growth of such a market by modernizing certain aspects of the Commodity Exchange Act in the course of reauthorizing the Commodity Futures Trading Commission. Specifically, we support changes in the Commodity Exchange Act that would:
establish legal certainty concerning privately-negotiated, bilateral swap transactionsincluding equity swapscovering financial commodities and entered into between ''eligible swap participants'' acting in a principal capacity; and
encourage the innovation and growth of appropriately regulated electronic trading systems and clearing facilities.
We also urge Congress to take measures to ensure that by permitting appropriately regulated OTC electronic trading systems and clearing facilities it not impose unfair competitive disadvantages on regulated exchanges, to encourage alternative OTC markets for less sophisticated end-users, and to reconsider the restrictions on futures on securities contained in the provisions of the CEA known as the Shad/Johnson Accord.
We appreciate the opportunity to present our views on these far-reaching and complex issues.
Statement of Annette L. Nazareth
Chairman Ewing and members of the subcommittee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission as you consider issues pertaining to the reauthorization of the Commodity Futures Trading Commission. My testimony focuses on the report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act (OTC Derivatives Report), which the President's Working Group on Financial Markets (Working Group) submitted to Congress last November.
Page 140 PREV PAGE TOP OF DOC As you know, the application of the Commodity Exchange Act to transactions involving over-the-counter derivative instruments raises significant questions of public policy. The Commission has welcomed the opportunity to study some of these questions in coordination with other members of the working group. The rapid evolution of OTC derivatives markets requires a regulatory approach that promotes greater legal certainty as well as innovative financial instruments. The Working Group's Report and its recommendations represent an important step toward this goal.
I. THE GROWTH OF OTC DERIVATIVES MARKET
It is widely recognized that OTC derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of American capital markets. Indeed, U.S. markets and market professionals have been global leaders in derivatives technology and development.
OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to isolate and manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to reduce exposure to fluctuating exchange rates. Because of the range of benefits these products offer, the OTC derivatives market has grown tremendously during the past two decades. According to data from the Bank for International Settlements, at the end of June 1999, the total estimated notional amount of outstanding OTC derivative contracts was $81.5 trillion.
II. FINDINGS AND RECOMMENDATIONS OF THE OTC DERIVATIVES REPORT
In preparing the OTC Derivatives Report, the working group's task was fairly specific: to focus on how a particular piece of legislation, the CEA, might be modified to address issues related to OTC derivatives markets. Accordingly, the report makes recommendations in several areas.
Page 141 PREV PAGE TOP OF DOC Swap Agreements. Regulators have focused on the treatment of swaps for over a decade. In 1989, the CFTC issued a Policy Statement, noting that ''most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations.'' After receiving exemptive authority under the Futures Trading Practices Act of 1992, the CFTC followed up with its 1993 Swap Exemption. Notwithstanding the Exemption's relief for some transactions, concerns arose about its scope. Because Congress did not explicitly determine whether swaps fell under the CEA absent such an exemption, the status of swaps remains unclear.
In light of this legal uncertainty, the OTC Derivatives Report recommends that Congress amend the CEA to exclude bilateral swap agreements (other than transactions involving non-financial commodities with finite supplies) between eligible swap participants, acting on a principal-to-principal basis, provided that the transactions are not conducted on a multilateral transaction execution facility (MTEF). The Commission believes that excluding qualifying instruments from the CEA should create greater legal certainty than the current approach that merely provides for the possibility of exemption, thus leaving open the question of whether such instruments are futures.
Electronic Trading Systems. In addition to focusing on the regulatory treatment of particular instruments, the OTC Derivatives Report explores questions raised when electronic systems facilitate the trading of OTC derivatives. It is worrisome that legal uncertainty might hinder technological development in the OTC derivatives market since technological innovation could promote transparency and efficiency. Moreover, the use of technology could help firms to apply more reliable internal controls on traders and to reduce risk.
The OTC Derivatives Report therefore recommends that Congress amend the CEA to exclude certain types of electronic trading systems for derivatives, provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts that involve non-financial commodities with finite supplies. Systems clearly not covered by the definition of MTEF in the current Swap Exemption would be covered by this exclusion. The exclusion would also cover systems that assist eligible swap participants communicating about or negotiating bilateral agreements. In addition, the exclusion would cover systems (including ones where bids and offers are open to all participants) where: first, the system only allows participants to act solely for their own account, and, second, the system is not used to enter into agreements requiring a party to make physical delivery of a non-financial commodity with a finite supply.
Page 142 PREV PAGE TOP OF DOC Moreover, to avoid disadvantaging existing futures and commodities exchanges, those exchanges designated by the CFTC as contract markets also would be permitted to establish these kinds of electronic trading systems for swaps.
Clearing Systems. Like electronic trading systems, clearance systems for OTC derivatives transactions are subject to legal uncertainty. Because of their importance, the OTC Derivatives Report recommends that Congress enact legislation to regulate clearing systems used for OTC derivatives. More specifically, the SEC, the CFTC, another Federal regulator, or a foreign financial regulator satisfying appropriate standards would regulate clearing systems for OTC derivatives.
Clearing systems that clear futures, commodity options, and options on futures could also clear OTC derivatives (other than OTC derivatives that are securities), subject to CFTC oversight. In addition, clearing agencies subject to SEC oversight could clear OTC derivatives other than instruments involving non-financial commodities with a finite supply. Under the working group proposal, legislation would authorize the CFTC to develop rules for the establishment and regulation of clearing systems for OTC derivatives involving non-financial commodities with a finite supply (to the extent they are exempted by the CFTC in a manner allowing clearing). All other OTC derivative clearing systems would need to organize as a bank, bank subsidiary or affiliate, or Edge Act corporation that would be subject to the supervisory jurisdiction of the Federal Reserve or the Office of the Comptroller of the Currency.
The OTC Derivatives Report also recommends that a clearing system subject to regulation by one agency should not become subject to regulation by another agency by virtue of clearing OTC derivatives. Finally, the report recommends allowing clearing through foreign clearing systems supervised by foreign financial regulators that the appropriate U.S. regulator has determined satisfy appropriate standards.
Hopefully, this framework will encourage the development of clearing systems for OTC derivatives products.
Page 143 PREV PAGE TOP OF DOC The Treasury Amendment. The OTC Derivatives Report also focuses on providing greater certainty for instruments covered by the Treasury amendment. The Treasury proposed this amendment in 1974 out of concern that the broad statutory definition of ''commodity'' would subject OTC markets in government securities and foreign currency to CEA regulation. Accordingly, the amendment excludes a list of instruments from the definition of commodity. These listed instruments, however, still may be subject to CEA regulation when traded on a ''board of trade.'' By proposing to replace ''board of trade'' with ''organized exchange,'' the OTC Derivatives Report seeks to more clearly delineate the parameters of the limitation on the exclusion.
The OTC Derivatives Report further recommends that the Treasury amendment be clarified to allow the CFTC to address problems associated with foreign currency ''bucket shops.'' Transactions in foreign currency futures and options would be subject to the CEA if entered into between a retail customer and an entity that is neither regulated or supervised by the SEC or a Federal banking regulator nor affiliated with such a regulated or supervised entity.
Hybrid Instruments and CFTC Exclusive Jurisdiction. Although the members of the working group did not reach consensus in the OTC Derivatives Report that all hybrid instruments should be entirely excluded from the CEA or that a hybrid instruments rule needs to be codified at this time, the CFTC has agreed that it will not propose any new rule about hybrid instruments without the concurrence of the other Working Group members. This decision reflects recognition of the interests of the SEC and bank regulatory agencies in this area. These interests arise because hybrid instruments possess characteristics of securities and bank products.
The OTC Derivatives Report, however, urges Congress to clarify that the Shad-Johnson Accord should not be construed as applying to hybrid instruments that have been exempted from the CEA.
Page 144 PREV PAGE TOP OF DOC Finally, over the years, the clause in the CEA granting the CFTC ''exclusive jurisdiction'' over certain matters has caused confusion. Questions have been raised over the appropriate regulator and regulatory scheme for complex derivative instruments possessing attributes of securities and futures contracts. All Working Group members agreed to recommend amending the CEA to explicitly clarify that insofar as hybrid instruments may be subject to the CEA, the exclusive jurisdiction clause shall not be construed to limit the authority of the SEC and the bank regulatory agencies with respect to such instruments.
Other Issues. Single Stock Futures: The unanimous findings of the OTC Derivatives Report reiterate the Commission's position that although single stock futures may possess elements of traditional futures contracts, they also have the characteristics of traditional securities. Accordingly, when considering the Shad-Johnson Accord's ban on single stock futures, one must recognize that regulatory issues associated with the introduction of such products would be complex. Indeed, the members of the working group agree that numerous issuesincluding but not limited to margin levels, insider trading, sales practices, real-time trade reporting, floor broker activities, and CFTC exclusive jurisdiction over futures contract marketswould have to be resolved before the ban could be reconsidered.
As you know, Chairmen Combest, Congressman Bliley, and Congressman Ewing asked that the SEC and the CFTC report back to their respective committees and subcommittees later this month on issues associated with modifying the Shad-Johnson Accord. The Commission staff has been working diligently with their counterparts at the CFTC to review the relevant issues. We look forward to sharing our views with the committee on these issues when our Report is submitted.
Regulatory and Tax Arbitrage: The report recognizes that derivative products may be tailored to circumvent regulation or tax consequences that would apply to other financial products. The Commission endorses the working group's view that, in most instances, the way to address regulatory arbitrage is to amend underlying statutes and regulations that most closely pertain to the regulatory goal to be achieved.
Page 145 PREV PAGE TOP OF DOC Netting: With respect to netting, the Commission supports the working group's reiteration of the need for improvements in the close-out netting regime for derivatives and other financial instruments under the Bankruptcy Code and bank insolvency law. The Working Group's April 1999 report, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (Hedge Fund Report), previously recommended this course.
Derivatives Dealers: The OTC Derivatives Report also reiterates a recommendation from the Hedge Fund Report regarding certain derivative dealers. Generally, derivatives dealers enter into derivatives contracts with end users and other dealers. Such dealers may use OTC derivative instruments to hedge their own financial risk, and most in the U.S. are banks or bank affiliates or affiliates of broker-dealers or futures commission merchants (FCMs). Although banking regulators supervise the banks and their affiliates, most affiliates of broker-dealers and FCMs remain unregulated.
For OTC derivatives dealers, private counterparty discipline is now the primary mechanism for limiting potential losses from counterparty defaults and reducing systemic risk. The OTC Derivatives Report calls for government regulation to supplement, but not substitute for, private market discipline. Both regulated and unregulated OTC derivatives dealers have employed private counterparty credit risk management, and some tools exist for Federal regulators. As the Hedge Fund Report noted, however, limitations on SEC and CFTC access to information about the activities of unregulated affiliates of broker-dealers and FCMs create a gap in financial market oversight. Thus, the Hedge Fund Report called for Congress to provide the SEC and CFTC with enhanced authority to obtain risk assessment information. The OTC Derivatives Report reiterates this recommendation.
The OTC Derivatives Report only represents a beginning. In addition to implementing the report's recommendations, we must continue to study the OTC derivatives market as it develops. With input from Congress and industry participants, I feel confident that we can meet any regulatory challenges while allowing the efficient development of this market.
Page 146 PREV PAGE TOP OF DOC The rapid evolution of OTC derivatives markets requires a regulatory approach that promotes greater legal certainty as well as innovative financial instruments. The OTC Derivatives Report represents a balanced approach. The Commission appreciates the opportunity to consider these issues, and looks forward to interacting with the working group, your committee, and other legislators as they consider implementation of changes recommended in the OTC Derivatives Report.
I would be happy to answer any questions you might have.
Statement of Lee Sachs
Mr. Chairman, Mr. Condit, members of this committee, thank you for giving me the opportunity to discuss the report of the President's Working Group on Financial Markets on Over-the-Counter Derivatives Markets and the Commodity Exchange Act. The issues covered in the report have been a focus of this committee, and on behalf of the members of the working group, we thank you for the leadership you have demonstrated on these important matters.
The over-the-counter derivatives market is an important component of the American capital markets and a powerful symbol of the kind of innovation and technology that has made the American financial system as strong as it is today. Yet the continued development of this market will depend to a great extent on the development of a clear and effective regulatory environment.
The report contains the unanimous recommendations of the President's Working Group on Financial Markets which is chaired by Secretary Summers and includes, among others, the Chairmen of the Federal Reserve, the Commodity Futures Trading Commission and the Securities and Exchange Commission. In its report, the working group recommends the enactment of legislation to reform the legal framework affecting the OTC derivatives market. Taken together, these changes would provide legal certainty, contribute to the reduction of systemic risk, protect retail customers, and stimulate the competitiveness of America's financial markets.
Page 147 PREV PAGE TOP OF DOC Let me divide my remarks into three parts:
First, the growing importance of OTC derivatives in the U.S. economy.
Second, the objectives that guided Members of the working group when deciding on its recommendations and the importance of enacting those recommendations within the shortest reasonable time frame; and
Third, the six recommendations that the working group has produced.
I. THE ROLE OF OTC DERIVATIVES IN THE U.S. ECONOMY
Mr. Chairman, our financial sector is the central nervous system of the American economy. As our economy and our financial markets have evolved over the past two decades, so too have the needs of the financial sector. Most notably, in an era of globalization, volatility of interest rates, increased securitization and the growth of the bond markets relative to the traditional loan markets, businesses and financial institutions have required a more diverse and effective set of tools for managing risk.
In that sense, the over-the-counter derivatives market has grown directly in response to the needs of the private sector. An OTC derivative is an instrument that allows a party seeking to reduce its risk exposure to transfer that exposure to a counterparty that wants and may be in a better position to assume the risk. This is an important development that has significantly enhanced the ability of businesses to manage their risk profiles, to compete more effectively in the global marketplace, and to deliver more efficiently and at lower cost a wide range of services and products to the American consumer.
Because of these rising demands, the notional value of global OTC derivatives has risen more than five-fold over the past decade, to more than $80 trillion according to estimates produced by the Bank for International Settlements.
Operating within a proper and appropriate framework of legal certainty, the benefits to the American economy of OTC derivatives would continue to grow. For example:
Page 148 PREV PAGE TOP OF DOC By helping businesses and financial institutions to hedge their risks more efficiently, OTC derivatives enable them to pass on the benefits of lower product costs to American consumers and businesses.
By allowing for the transfer of unwanted risk, OTC derivatives promote the more efficient allocation of capital across the economy, further increasing American productivity.
By providing better pricing information, OTC derivatives can help promote greater efficiency and liquidity of the underlying cash markets that feeds into a stronger economy for all Americans.
And, by enabling more sophisticated management of assets, including mortgages, consumer loans and corporate debt, OTC derivatives can help lower mortgage payments, insurance premiums, and other financing costs for American consumers and businesses.
Thus, OTC derivatives have the potential to bring important benefits to our economy. The goal of the recommendations of the President's Working Group is to ensure that these benefits can be realized. At the same time, we need to recall that the emergence of the OTC derivatives market has come during an era of unprecedented economic strength and prosperity.
It is to be expected that in times of distress some participants in this market, as in other financial markets, will be adversely affected. What needs to be protected, however, are not individual institutions but the system as a whole. The challenge is to strike the appropriate balance between the creation of a regulatory regime of legal certainty that allows the economy to realize the benefits of OTC derivatives while still providing appropriate protection for retail customers and the system. We believe that our recommendations strike such a balance.
Now let me turn to the more specific goals of the working group in producing the report.
II. OBJECTIVES OF THE WORKING GROUP'S REPORT
Page 149 PREV PAGE TOP OF DOC Mr. Chairman, the members the President's Working Group believe that a strengthened OTC derivatives market can contribute to the greater efficiency of the U.S. economy. They further believe that a failure to act in this area would risk a situation in which the existing legal framework for our financial markets would seriously lag the development of the markets themselves.
In the absence of an updated legal and regulatory environment, needless systemic risk might jeopardize the broader vitality of the American capital markets; innovation might be stifled by the absence of legal certainty; and American consumers might be deprived of the benefits that a more appropriate legal framework would deliver. We also risk an erosion of the competitiveness of American financial markets, with an increasing amount of business moving offshore to jurisdictions where the regulatory framework has kept up with the pace of change.
It was with these priorities in mind, Mr. Chairman, that last year you requested the working group to study the OTC derivatives market and recommend what changes were required. The Working Group worked on the assumption that legislative action would be required within a timeframe appropriate to the growing importance of the OTC derivatives market - and taking into account this market's potential contribution to the efficient functioning of the American financial sector and to that of the economy as a whole.
Accordingly, the working group sought to achieve four objectives:
To reduce systemic risk in the OTC derivatives market by removing legal impediments to the development of clearing systems and ensuring that those systems are appropriately regulated.
To promote innovation in the OTC derivatives market by providing legal certainty for OTC derivatives and electronic trading systems. This would strengthen the overall legal framework governing the OTC derivatives market that, in turn, would stimulate greater competition, transparency, liquidity, and efficiency and deliver stronger benefits to U.S. consumers and businesses.
Page 150 PREV PAGE TOP OF DOC To protect retail customers by ensuring that appropriate regulations are in place to deter unfair practices in all markets in which they participate and by closing existing legal loopholes that allow unregulated entities to pursue such unfair practices.
To maintain U.S. competitiveness by providing a modernized framework that will lead those engaged in the financial services industry to continue the operations of their businesses in the United States, and thereby assuring the continued leadership of American capital markets.
III. THE RECOMMENDATIONS OF THE PRESIDENT'S WORKING GROUP
Before outlining the working group's recommendations in greater detail, it bears emphasis that the working group did not reach its conclusions lightly. In view of the technical nature and history of many of the issues considered, the unanimous nature of our recommendations is very significant. It is our firm belief that the situation calls for legislation at the soonest appropriate opportunity.
I will now turn to the recommendations.
1. Create an Exclusion from the CEA for most Swaps Agreements. The Working Group is recommending that an exclusion for certain swaps between eligible counterparties be codified by Congress in the Commodities Exchange Act. This exclusion would be similar to the CFTC's 1993 rule exempting swaps. It would not, however, extend to agreements involving non-financial commodities with finite supplies that could potentially be subject to manipulation, such as agricultural commodities. The CFTC would retain exemptive authority for these types of swaps including swaps related to agricultural commodities. The exclusion would cover equity swaps, a category of swaps about which there is also some amount of legal uncertainty.
Mr. Chairman, this recommendation would provide legal certainty by excluding interest rate and equity swap agreements from the scope of the CEA and remove doubts about the enforceability of these contracts in the courts. It is clear to the working group that this exclusion is the best approach to assure that the OTC derivatives market can develop within the kind of innovative and legally stable environment on which the continued competitiveness of our financial markets will depend. The exclusion would also contribute to the permanent clarification of the status of OTC derivatives that is essential for the integrity of the market.
Page 151 PREV PAGE TOP OF DOC The current legal uncertainty concerning whether swaps are subject to the CEA has its roots in the 1974 legislation that created the CFTC. That legislation significantly increased the scope of the CEA by broadening the definition of what constitutes a ''commodity.'' As a result, most interest rates, for example, are now considered ''commodities'' under the CEA, and exchange-traded interest rate futures are thus regulated by the CFTC. We do not believe that off-exchange transactions that are tied to interest rates are themselves futures contracts and therefore should not be subject to CFTC regulation. To some market participants, however, there has been uncertainty on this critical question.
The Working Group members perceive no compelling evidence of problems involving the swaps that we are recommending for exclusion that would warrant regulation under the CEA. Rather, we believe that an exclusion is appropriate because the participants in such transactions are generally capable of making informed investment decisions and do not require the additional protections provided under the CEA. We further believe that the legal certainty provided by statute will be more durable and reliable than that provided by regulations, which are more easily changed.
The CEA is designed primarily to address issues of fraud, manipulation, and price discovery. Sophisticated participants can protect themselves against fraud or can seek legal redress if they are defrauded. There is little evidence to suggest that markets for financial OTC derivatives are readily susceptible to manipulation. And, in the case of derivatives based on securities, existing securities laws would in any event be applicable to any attempts to manipulate security prices. In addition, financial OTC derivatives do not yet serve a primary price discovery function. And the activities of most OTC derivative dealers are already subject to direct or indirect Federal oversight.
2. Create an Exclusion for Electronic Trading Systems. Our second recommendation would create an exclusion from the CEA for electronic trading systems that limit participation to sophisticated parties trading for their own accounts. Again, the exclusion would not apply to trading systems involving non-financial commodities with a finite supply such as agricultural commodities.
Page 152 PREV PAGE TOP OF DOC By confining the exclusion to trading systems involving only qualified participants, this recommendation is designed to protect retail customers without unnecessarily obstructing innovation where regulation is not justified. Importantly, electronic trading systems promote transparency and efficiency and thus reduce the cost of trading interest rate and other types of swap contracts. In that sense the exclusion would strengthen the competitiveness of the American OTC derivatives market.
At the same time, while agreeing that an exclusion from the CEA is appropriate, the working group has undertaken to monitor the development of electronic trading systems for OTC derivatives going forward, with a view to evaluating whether limited regulation of these systems to enhance market transparency and price discovery should become appropriate at a later date.
3. Permit the Use of Appropriately Regulated Clearing Systems for OTC Derivatives. The third recommendation of the report would permit the creation of clearing systems for OTC derivatives while requiring that such systems be subject to appropriate regulation. This proposal is designed to reduce systemic risk by encouraging the creation of appropriately regulated clearing systems for OTC derivatives.
Well-designed clearinghouses can contribute significantly to reducing systemic risk: first, by diminishing the likelihood that the failure of a single market participant can have a disproportionate effect on the market as a whole; and second, by facilitating the offsetting and netting of contract obligations. A reduction in systemic risk would in turn enhance the stability of our financial system and increase its competitive edge. Nonetheless, in view of the concentration of risk within these entities, the working group believes that regulation of such clearing systems is appropriate.
4. Clarify the Original Intent of the Treasury Amendment. This recommendation would clarify the Treasury amendment in two ways. First it would enable the CFTC to address the problems associated with foreign currency ''bucket shops'' by codifying the CFTC's authority to regulate such entities and to prosecute such entities when they attempt to defraud retail customers. This would support the CFTC's objective of regulating entities that allegedly defraud retail customers, thus strengthening protection for small investors.
Page 153 PREV PAGE TOP OF DOC Second, the recommendation would preserve CFTC authority over Treasury amendment transactions on ''organized exchanges'' while excluding most other transactions in Treasury amendment products from the scope of the CEA.
The Treasury amendment was originally designed primarily to exclude trading of OTC derivatives tied to underlying government securities and foreign exchange from the regulatory scope of the CEA. The exclusion, as currently worded, applies to all such contracts unless the transaction involved the sale of futures on a ''board of trade.'' But uncertainty persists about the precise meaning of what constitutes a ''board of trade'' and whether it could be interpreted to encompass entities such as investment and commercial banks.
As a result, the working group recommends that the term ''board of trade'' be replaced by the phrase ''organized exchange'' to provide legal certainty for OTC instruments excluded under the Treasury amendment and that an appropriate statutory definition of ''organized exchange'' is provided.
5 & 6. Clarify the Exempt Status of Hybrid Instruments. The final two recommendations are highly technical in nature and designed to enhance legal certainty by clarifying that hybrid instruments that reference securities can be exempted from the CEA. The recommendations also resolve potential jurisdictional disputes between the CFTC and other regulators with respect to such instruments by limiting the exclusive jurisdiction clause of the CEA.
Mr. Chairman, the President's Working Group has presented the Congress with a set of unanimous recommendations pertaining to the growing and increasingly important market for OTC derivatives in the United States. We believe that these recommendations, taken together, would reduce systemic risk, promote innovation, competition, efficiency and transparency in our financial markets; would protect retail customers, and help to maintain American leadership in OTC derivatives markets.
Page 154 PREV PAGE TOP OF DOC In this context, we believe that legislation is necessary. We suggest a paradigm for that legislation that recognizes that with the appropriate legal framework, the OTC derivatives market can make a valuable contribution to the efficient functioning of the American capital markets, with benefits for both businesses and consumers. Under the existing regulatory framework, as the report makes clear, there is a risk that these benefits will not be fully realized.
The Working Group's report focuses on OTC derivatives. At the same time, while not the subject of our report, we recognize the importance of ensuring an appropriate and not overly burdensome regulatory environment for exchange-traded derivatives. The Working Group supports the CFTC's ongoing efforts to explore regulatory relief in this area, without prejudging the results of their analysis. We look forward to working with them and other members of the working group to assure that our markets remain the most competitive and innovative in the world, while assuring the integrity of these markets is protected for all participants.
Thank you. I would now welcome any questions that you may have.
Statement of C. Robert Paul
Thank you Chairman Ewing, Congressman Condit and members of the subcommittee. On behalf of Chairman Rainer, I appreciate the opportunity to come here and discuss the recommendations of the President's Working Group on Financial Markets regarding the Commodity Exchange Act and over-the-counter derivatives transactions.
U.S. financial markets generally are the envy of the world, whether we are speaking of futures, swaps or securities. Each of these sectors plays an important role in maintaining America's leadership in this area.
Our country's position in the OTC market is affected by uncertainty over the legal status of many derivatives transactions. This uncertainty turns on whether or not transactions could be invalidated under the CEA.
Page 155 PREV PAGE TOP OF DOC The members of the working group are unanimous in their assessment of America's national economic priorities for the over-the-counter derivatives markets. These goals have already been mentioned, namely:
to promote technological innovation, competition, efficiency, liquidity and transparency; and
to reduce systemic risk by encouraging the market to develop regulated clearing systems.
The ability to achieve these will be enhanced through greater legal certainty for the OTC market. Congressional action to exclude OTC financial derivatives from the Act would provide such certainty.
OTC derivatives transactions as we know them today do not present regulatory concerns within the scope of the Act. Excluding this activity will not diminish the CFTC's ability to carry out the statutory mission it is charged to fulfill.
When the Commodity Exchange Act was written, Congress articulated the rationale for regulating futures transactions. First, the Act establishes the economic utility of futures trading, stating that futures prices ''are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining prices to the producer and the consumer of commodities. In addition to their price discovery function, futures transactions are used by commercial entities ''as a means of hedging themselves against possible loss through fluctuations in price.'' CEA section 3.
The second prong of Congress' rationale for regulation is that the ''transactions and prices of commodities'' are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed. The risks of price distortion and manipulation are the factors ''rendering regulation [of these markets] imperative . . .'' CEA section 3. Congress thus identified the overarching public mission of the CFTC as that of preventing price manipulation and ensuring price transparency.
Page 156 PREV PAGE TOP OF DOC Like exchange-traded futures, OTC derivatives are risk-shifting instruments. The Working Group, however, has determined that, unlike futures, ''prices established in OTC derivatives transactions do not serve a significant price discovery role.'' PWG Report at 16. The Working Group also has concluded that ''[m]ost OTC derivatives are not susceptible to manipulation.'' Id.
According to the Bank for International Settlements, 72 percent of OTC derivatives are interest rate contracts and 26 percent are foreign exchange contracts. A report issued recently by the Office of the Comptroller of the Currency stated that interest rate contracts constitute 79 percent of derivatives held in U.S. commercial banks. Interest rate and currency products, which together comprise 98 percent of the OTC derivatives market, do not present the concerns Congress addressed in mandating the regulation of futures.
Moreover, OTC transactions are entered into and traded by sophisticated institutional traders, who are able to look out for themselves in these markets. Also, most dealers in the swaps market are either affiliated with broker-dealers or futures commission merchants that are regulated by the SEC or the CFTC, or are financial institutions that are subject to supervision by Federal bank regulatory agencies. Therefore, the activities of most derivatives dealers already are subject to direct or indirect regulatory oversight. PWG Report at 16.
Because there is no manifest regulatory interest warranting CFTC oversight of OTC derivatives, Chairman Rainer supports the exclusion proposed by the Working Group.
Congress and the CFTC have acted before to resolve legal uncertainty affecting OTC derivatives. In 1992, amid strong signals that swap market participants feared their contracts could be declared unenforceable, Congress responded decisively, strongly encouraging the CFTC not to regulate swaps entered into by sophisticated parties. Congress authorized the CFTC to provide exemptive relief for swaps without requiring the agency to make a threshold determination that particular exempted transactions fell within its jurisdiction. The CFTC promptly issued a rule exempting swap agreements from most provisions of the Act except prohibitions against fraud and manipulation, provided the swaps meet certain conditions.
Page 157 PREV PAGE TOP OF DOC The CFTC's swaps exemption worked relatively well. Lately, however, evolution in the OTC derivatives market has rendered the exemption inadequate for some purposes.
The swaps exemptive rule does not apply to OTC contracts that are standardized, cleared, or executed under conditions that approximate those of an organized exchange. Technology, however, is dramatically changing the structure and nature of many aspects of the financial services industry. The rise of electronic, screen-based trading has blurred the line drawn in our swaps exemption between bilateral and multilateral trading. The growth in swap volume, and the acceptance of these contracts by a wider range of users, has led to their standardization. Public policy must meet these advances in the OTC market.
Chairman Rainer shares the belief with the other members of the working group that the development of regulated clearing systems should be encouraged. Clearing systems can employ a variety of risk management tools, such as mutualizing risk and offsetting multiple obligations. Consequently, clearing systems help reduce systemic risk by lowering the possibility that the failure of a single market participant could disproportionately disrupt the overall market.
Finally, the Commission's rule exempts bilateral swaps from most provisions of the CEA except those prohibiting manipulation and fraud. The CFTC thought it prudent to retain its jurisdiction to act in the event the agency learned that participants were engaging in fraudulent or manipulative conduct and that transactions executed under the exemption were, in fact, futures.
The swaps exemption does not alter the CFTC's responsibility to take action against this misconduct. In a given set of circumstances, however, the agency's ability to act may be contingent upon proving that transactions are futures or options. This is a critical point to remember: at no time has Congress or the CFTC made the definitive judgment that swap transactions are, in fact, subject to the CEA's jurisdiction. The combination of responsibility with no more than contingent authority, is simply bad public policy because as a practical matter, the CFTC cannot exercise its retained enforcement authority under the swaps exemption without exacerbating the existing legal uncertainty in this area.
Page 158 PREV PAGE TOP OF DOC Apart from legal certainty issues regarding OTC derivatives, the working group report contains recommendations aimed at improving the regulatory framework for other financial instruments. To address the problems associated with foreign currency bucket shops, the working group recommended that the CEA be amended to give the CFTC explicit jurisdiction over unregulated entities that sell foreign exchange instruments to the retail public at large.
Abusive promoters have exploited regulatory gaps to sell foreign currency contracts to financially unsophisticated individuals, making exaggerated claims of profit opportunities and failing to disclose the risks of these inherently volatile instruments. Promoters often prey upon senior citizens, recent arrivals in this country and other vulnerable segments of society.
Many of these enterprises simply pocket investor funds; others channel funds to currency markets, but typically do so without adequate segregation or disclosure. As fraudulent foreign exchange companies proliferated, the agency in 1998 issued a consumer advisory through the mass media warning the public about these schemes. Cases filed by the CFTC against illegal foreign currency operations during the 1990's have involved more than $250 million in customer funds.
Courts in which the CFTC has brought enforcement actions have reached varying decisions regarding our jurisdiction over these instruments. In those jurisdictions where we have not been foreclosed judicially from enforcement action, we continue to move aggressively against retail foreign currency fraud. We also cooperate with state, local and other Federal authorities to bring a halt to this activity.
The Working Group asks Congress to clarify the CFTC's authority to regulate these instruments so that it may provide a stronger deterrent to fraud and abuse while providing a zone of comfort and rational oversight to legitimate enterprises that want to offer foreign currency contracts to the retail public.
Page 159 PREV PAGE TOP OF DOC While examining the applicability of the Act to OTC markets, the working group also conducted an inquiry into whether the CFTC's current regulatory scheme is appropriately tailored to today's environment for exchange-traded futures. During the past several months, the agency has undertaken a serious effort to answer the question: what degree of exchange-traded regulation is necessary to serve the public interests entrusted to us?
This inquiry is at the heart of the process that the CFTC has engaged in over the last several months. A strong consensus exists between Congress and the working group that such a review is needed.
Impending technological changes require the CFTC to scrutinize the continued vitality and viability of its one-size-fits-all regulatory structure that currently applies to all futures transactions. While that process is not yet complete, certain clear principles have emerged: one, the historic needs of traditional physical commodities should not be the basis for regulating every futures contract traded today; two, institutional market participants do not require all of the protections designed for retail traders.
At its core, this plan will afford market participants the opportunity to operate in a regulatory environment suited to the product traded and the participants trading it. The key policy elements of this plan include a move from direct to more oversight regulation; a move from prescriptive rules to flexible performance standards; and the increased use of disclosure-based regulation.
This plan will not impair the agency's ability to assure the fundamental market integrity that is expected when conducting futures exchange transactions in the United States, or when relying upon the prices set in U.S. exchange-traded markets. The Commission will continue to exercise its authority to oversee their continued integrity.
In conclusion, Mr. Chairman, time is not our ally in establishing a framework that achieves our national economic priorities with respect to derivatives trading. Technology has made it increasingly easy to establish rival markets in foreign jurisdictions; technology has also increased the speed with which new innovations are introduced and widely used by market participants. Because of these realities, Chairman Rainer asks Congress to act expeditiously on the recommendations of the working group.
Page 160 PREV PAGE TOP OF DOC Thank you again for the opportunity to testify before you today. Chairman Rainer looks forward to continued collaboration with the rest of the working group and the members of this committee to see these recommendations enacted into law this year.
Testimony of Edward Rosen
This Coalition is grateful for the opportunity to present the subcommittee with the Coalition's views regarding the report of the President's Working Group on Financial Markets entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act. The Coalition supports the recommendations set forth in the report and urges the subcommittee to incorporate the report's recommendations in legislation during this session.
The six Coalition firms are major participants in all U.S. financial markets, including the securities markets, Government securities markets, foreign currency markets, futures markets and derivatives markets. These firms are in the forefront of financial product innovation and compete globally with non-U.S. financial institutions for international business in all financial markets.
These firms have established the Coalition for one purpose: to present to Congress a consensus, market-sensitive view on necessary revisions to the Commodity Exchange Act. As major participants in all financial and derivatives markets, and as members of nearly every major trade association affected by the CEA, this group is able to provide a singular perspective that cuts across product lines and reflects the integrated character of the global markets for these products.
The Coalition welcomes and endorses the subcommittee's reexamination of the CEA in light of the evolving needs of the markets and market participants, and we particularly support the subcommittee's interest in developing amendments to the CEA designed to remove barriers to innovation and to resolve issues of legal certainty that affect the use of over-the-counter derivative instruments under the CEA.
Page 161 PREV PAGE TOP OF DOC The Coalition commends the members of this subcommittee in particular for their leadership role in addressing these issues.
The Coalition applauds the success achieved by the working group in reaching consensus positions on the difficult issues presented by OTC derivatives in the context of the CEA. The unanimous recommendations embodied in the report represent an extraordinary accomplishment. The Coalition strongly endorses the working group's recommendations to provide greater legal certainty for OTC derivatives transactions and to remove obstacles to the development and use of clearing and electronic trading systems in the OTC derivatives markets.
As noted below, the Coalition recommends that the subcommittee consider certain additional steps, beyond the scope of the report, to foster legal certainty, reduce systemic risk and promote technological and financial innovation.
As background for the subcommittee's consideration of the report, the Coalition would like to make several general observations:
There is an urgent need for Congressional action during this session. The Working Group has characterized its recommendations as ''necessary'' and ''important.'' We agree.
The Working Group has presented Congress with valuable and constructive solutions to urgent problems. No solution, however, will be perfect from all perspectives. We must not allow perfection to be the enemy of that which can be achieved.
We must not be seduced by superficial allusions to asymmetrical regulation and allow these to prevent us from accomplishing what can be accomplished. Historically, progress on legal certainty has been held hostage to other legislative objectives. This strategy can no longer be tolerated.
ENHANCING LEGAL CERTAINTY FOR SWAPS
Page 162 PREV PAGE TOP OF DOC The Coalition strongly supports the working group's recommendation that bilateral swap agreements involving financial commodities between institutional counterparties be excluded from regulation under the CEA. This exclusion will enhance legal certainty and enhance the position of the United States as a major financial center.
In addition to the recommendations of the working group, the Coalition would support further relief for transactions involving non-financial commodities and a clarification that individually negotiated bilateral transactions, including those involving non-financial commodities, are not subject to regulation under the CEA.
ELECTRONIC TRADING SYSTEMS
The Coalition supports the working group's recommendation to exclude from regulation under the CEA electronic systems for trading financial derivatives which limit participation to institutional counterparties trading for their own accounts. This exclusion would remove a significant barrier to financial and technological innovation in the United States, eliminate legal uncertainty and improve the global competitive position of the U.S. financial sector.
Beyond the working group's recommendation, the Coalition would further encourage Congress to create an appropriate ''light-handed'' regulatory framework for those electronic trading systems that do not operate as exchanges and that would not otherwise qualify for exclusion from the CEA under the working group's recommendations. This new framework would create a legal basis for the future evolution of electronic trading systems, whether developed by exchanges or by other market participants. We would be happy to work with the subcommittee to develop such a framework.
The Coalition welcomes the working group's recommended clarification that qualifying swaps may be cleared without subjecting the underlying transaction to regulation under the CEA.
Page 163 PREV PAGE TOP OF DOC The Coalition also endorses the working group's recommendation that Congress provide a statutory basis for the oversight of clearing systems for OTC derivatives by the CFTC, Federal bank and securities regulators and appropriate foreign financial regulators. We believe that creating an appropriate regulatory regime will encourage the development of clearing facilities for OTC derivatives in the U.S. and, in turn, contribute to the stability of the financial system. We would also view the codification of CFTC authority to oversee clearing of OTC derivatives as a positive and useful development.
The Coalition welcomes the working group's recommendation to clarify the intent of the Treasury amendment by replacing the term ''board of trade'' with the term ''organized exchange.'' This clarification alone will eliminate a great deal of uncertainty and forestall much of the litigation that has arisen in this area in the past.
We also support the working group's recommendation that Congress provide the CFTC with authority to address potential abuses of retail customers by foreign currency ''bucket shops.''
In the area of hybrid instruments, the working group recommended that Congress clarify that the CEA's restriction on futures on non-exempt securities does not apply to hybrid instruments that would otherwise qualify for exemption from the CEA under the CFTC's current rules. The Coalition supports this recommendation. However, the Coalition urges Congress to take additional steps to codify an exemption for hybrid instruments, including those involving non-exempt securities, similar in scope to the CFTC's current exemption for hybrid instruments. We would be pleased to work with the subcommittee to accomplish that objective.
SINGLE-STOCK FUTURES; SHAD-JOHNSON ACCORD
The Coalition does not believe that single-stock futures should be unlawful per se. The Coalition welcomes the CFTC-SEC dialogue on this subject requested by the Chairman of this subcommittee, and referenced in the report, and stands ready to assist in any efforts to address the regulatory challenges posed by these products.
Page 164 PREV PAGE TOP OF DOC Congress must recognize that providing legal certainty for OTC derivative instruments and removing barriers to innovation are much more urgent matters for U.S. financial markets than creating a regulatory framework for single-stock futures. In the past, legislative efforts to provide legal certainty for OTC derivatives have been held political hostage to the single-stock futures issue. Congress should not allow this political strategy to undermine opportunities for concrete progress.
The Coalition agrees with the working group's conclusion that no current need has been demonstrated to regulate OTC derivatives dealers, most of whom are already subject to direct and indirect regulatory oversight.
The Coalition notes that the report reiterates the working group's earlier recommendation to expand the SEC's and CFTC's risk assessment authority with respect to broker-dealers and futures commission merchants. The Coalition fully supports the goal of improved risk reporting to financial regulators. The Coalition has some concerns, however, regarding the scope of the working group's recommendations in this area, and stands ready to engage in a dialogue on the relevant issues.
It is time for Congressional action to ensure legal certainty and remove the barriers to innovation posed by the CEA. The Working Group has unanimously urged the Congress to act and has provided Congress with a clear course of action. Moreover, the working group's recommendations have widespread support among financial market participants. We urge the subcommittee to take advantage of these rare conditions and move swiftly during this session to enactment of a bill incorporating the working group's recommendations.
Given the extraordinary consensus in the public and private sectors regarding the urgent need for legal certainty, market participants are carefully monitoring the reauthorization process for a signal that Congress will act on these important issues. As we have testified previously, and as financial market participants are acutely aware, the risks and obstacles to innovation posed by the CEA do not burden other major financial centers. If Congress continues to miss opportunities to modernize the CEA, the U.S. will jeopardize its position as the leading global financial center and the U.S. legislative and regulatory community will significantly diminish its own influence over the development of policy governing the global financial markets.
Page 165 PREV PAGE TOP OF DOC Congress must not allow less important issues to impede progress on these pressing matters.
The Coalition very much appreciates the subcommittee's interest in these issues and is committed to working with the subcommittee and other interested parties in an effort to solve these problems once and for all.
Testimony of William J. Brodsky
I am William J. Brodsky, chairman and chief executive officer of the Chicago Board Options Exchange. I appear today on behalf of CBOE and nine other securities markets that comprise the U.S. Securities Markets Coalition: the American Stock Exchange, the Boston Stock Exchange, the Chicago Stock Exchange, the Cincinnati Stock Exchange, the Nasdaq Stock Market, the National Securities Clearing Corporation, the Pacific Exchange, the Philadelphia Stock Exchange and The Options Clearing Corporation. The U.S. securities markets are vital to the health of the U.S. economy and serve as the investment vehicle or retirement savings choice for more than 80 million Americans. The Coalition welcomes this opportunity to provide its views on issues pertaining to the CFTC re-authorization. While the New York Stock Exchange is not officially a member of the Coalition, it supports the views presented in this testimony.
This committee and the Senate Committee on Agriculture, Nutrition, and Forestry are engaged in an exploration of various issues involving futures, over-the-counter derivatives, and the Commodity Futures Trading Commission in connection with the CFTC's re-authorization. As a part of the reauthorization, the Senate Committee on Agriculture, Nutrition, and Forestry held a hearing on February 10, 2000, on the recent report by the President's Work Group on Financial Markets on Over-the-Counter Derivatives and the Commodity Exchange Act (Working Group Report). The U.S. securities markets are most interested in two specific aspects of the CFTC re-authorization and the working group Reportthe treatment of futures on individual stocks and narrow-based stock indexes and the status of equity swapsthat are integrally related to the securities markets.
Page 166 PREV PAGE TOP OF DOC The Coalition's position on single stock futures rests on two principles. First in addressing whether to permit single stock futures, the Coalition strongly believes that any Congressional action should be guided by the need to ensure adequate investor protection to the 80 million Americans that participate in our nation's securities markets. Second, while the Coalition does not want to prevent competition from new products or new markets, the competition should take place on a level playing field. As a result, our essential message and plea is that Congress should not consider a repeal of the prohibition on futures on individual stocks and narrow-based indexes until it determines how to apply the securities laws protections to these stock surrogate products and necessary investor protection measures are in place. While we do not question the potential economic utility of single stock futures, our position arises from the fact that futures on single stocks are essentially surrogates for trading the stocks themselves. If the prohibition is to be lifted, the Coalition believes that these products must be subject to the securities laws and to oversight by the Securities and Exchange Commission, as are options on individual stocks. Otherwise, the integrated system of regulation for securities and securities derivatives could be weakened, the integrity of our equity markets endangered, investor confidence in those markets greatly reduced, and fair competition impaired.
EQUITIES ARE DIFFERENT
The U.S. equity securities markets are unique among equity markets around the world and are a pillar of strength in our economy. More than 80 million Americans are invested in the stock market, either directly or through mutual funds, and tens of millions more invest through their pension plans. The U.S. investor community is immense and spans not only the Nation geographically, but also spans a very broad segment of the economic spectrum. The United States is unique in the magnitude of public participation in our capital markets. We are the envy of the world in this regard and serve as the model that many foreign nations are now attempting to replicate. A contributing factor to people's participation in the U.S. equity markets is their confidence in the markets' integrity and fairness. Anything that could potentially jeopardize that confidence is a cause of great concern to us, and should be to Congress as well.
Page 167 PREV PAGE TOP OF DOC According to a survey by the Federal Reserve, 49 percent of American adults either own stock in individual companies or mutual funds. Money continues to be invested in equity securities at a brisk rate. This includes money from pension funds, IRAs, 401K plans and similar sources representing much of the accumulated wealth of our nation, and the savings and financial security of our workers. Indeed, the financial well-being of the nation, both short-term and long-term, is more and more directly linked to and dictated by the stock market. The stock market is a unique American strength, and the stability and integrity of this national asset are paramount concerns.
The broad public participation in the stock market attests to a basic observation, that stocks are different from any other interest on which futures contracts can be traded. We should be extremely cautious when considering modifications to the commodities laws that could affect the securities markets. Proposals to amend the commodities laws that affect the entire fabric of the regulatory system for stocks and related derivatives must not be undertaken lightly.
For over 60 years the securities markets have been subject to a regulatory oversight structure that promotes investor protection, market integrity, and fair competition. Yet, the futures exchanges are pushing for the elimination of the Shad-Johnson Accord's prohibition on futures on individual stocks and narrow based indexes without considering whether and how to extend the full panoply of securities market protections to these products. For the reasons discussed below, we believe a repeal of the prohibition without a full consideration of the securities market provisions that should apply to these products could prove very dangerous to the securities markets. We strongly urge Congress to refrain from repealing the prohibition unless the products are subject to the investor and market protections of the securities laws administered by the SEC.
THE SHAD JOHNSON ACCORD PROHIBITION SERVES IMPORTANT PUBLIC POLICY OBJECTIVES
Page 168 PREV PAGE TOP OF DOC The prohibition against futures on individual stocks and narrow-based stock indexes was the result of a jurisdictional accord between the SEC and CFTC in 1982, commonly referred to as the ''Shad-Johnson Accord.'' The accord treats options on securities and options on a group or index of securities as securities while regulating futures on a broad-based index of stocks as futures contracts under the Commodity Exchange Act. During negotiation of the accord, the SEC expressed serious concerns about the possibility of futures on individual stocks. The Federal securities laws were designed for different purposes than the Federal commodities laws. Consequently, unlike securities, including stock options, futures are not subject to the full panoply of key securities markets protections. The SEC and securities markets were concerned that if futures on stocks were regulated as futures and not as securities, the lack of securities market investor protections could cause stock futures to disrupt the market for the underlying stocks, impair market integrity, and become a tool for stock market manipulation.
Despite these concerns, the CFTC insisted that futures on individual stocks be regulated under the CEA while the SEC believed they should be regulated as securities. The two agencies failed to reach a final agreement on single stock futures. In light of the lack of interest in single stock futures at the time, the two agencies agreed to ban futures on individual stocks. They also agreed to prohibit futures on narrow-based indexes of stocks, which could easily be used as a surrogate for a future on an individual stock. Thus, futures on securities were limited to broad market indexes, where the breadth of the index would minimize the possibility of insider trading, manipulation, and market abuses involving the underlying stocks because the indexes could not be used as functional substitutes for individual stock. Indeed, in the SEC/CFTC Joint Explanatory Statement submitted to Congress to enact the accord, the SEC and CFTC stated that the requirement that a futures contract be based on a broad market index ''is intended to provide adequate flexibility for the market to respond to the needs of participants, while assuring that only broad-based securities index futures contracts that are not conducive to manipulation could be authorized.''
Page 169 PREV PAGE TOP OF DOCSECURITIES MARKET PROTECTIONS SHOULD APPLY TO SINGLE STOCK FUTURES
There continue to be significant differences between the regulatory schemes that apply to securities products and to futures products. In general, the securities laws are designed to protect investors, provide full disclosure of corporate and market information, and prevent fraud and manipulation. The commodities laws are designed to facilitate commercial and professional hedging and speculation and to oversee the price discovery process. Because of the different emphases of the two regulatory schemes, many of the basic regulatory protections that apply to each are also very different. There is nothing per se wrong about different regulatory schemes when comparing markets for securities to traditional commodity products. As noted above, however, stocks are different than other commodities or non-securities financial instruments underlying futures contracts. While we do not question the potential economic utility of single stock futures nor the futures regulatory regime, in general we believe that it would be a mistake to simply engraft the futures regulatory model onto a class of products that are the functional equivalent of products regulated under the U.S. securities model.
Congress designed the securities laws as an integrated scheme of regulation of transactions in stock in recognition of the securities markets' importance in our national economy. The securities laws provide for: (1)the regulation of the mechanisms of the securities markets to assure that those mechanisms are fair, competitive, and part of an integrated national system and that securities transactions are efficiently executed in the best market; (2)the regulation of securities clearance and settlement systems to assure the safeguarding of securities and funds, to facilitate the linkage or coordination of clearing systems into a national clearing system, and to unlink clearing systems from securities markets (so that participants in a particular stock market are not tied by rule to any particular clearing agency); (3)the regulation of the distribution of stock quotation and transaction price information to assure fairness, reliability, and promptness of that information and the transparency of market activity; (4)the prohibition of certain stock transactions, and the regulation of all transactions, to protect against manipulation, fraud, and insider trading in the securities markets; (5)the regulation of brokers and professional advisers to assure, among other things, that investors receive adequate disclosures and are fairly, honestly, and suitably dealt with and that their fiduciaries are adequately capitalized; (6)the regulation of margin levels to protect against excessive speculation and leverage, as well as to help protect the system from failures of market participants; (7)the regulation of stock transactions by directors, officers, and principal stockholders of issuers to prevent short-swing profits and misuse of corporate information and to inform the public of the holdings and transactions of insiders and other large stockholders; and (8)the regulation of transactions and reporting by issuers, persons involved in certain corporate transactions, and investment managers to assure adequate disclosure and fair dealing and to protect against fraud. This thorough system of regulation for securities transactions has worked very wellto the benefit of investors and the Nation as a whole.
Page 170 PREV PAGE TOP OF DOC If Congress were merely to repeal the accord's prohibition on single stock futures, regulation of these products would come within the CFTC's exclusive jurisdiction under the CEA. Although the CEA provides for regulation of some of the same conduct as is regulated under the securities laws, in most respects the details of its regulatory scheme are markedly different from the regulatory scheme of the securities laws. Since the exclusive jurisdiction provisions of the CEA would make regulation under the securities laws inapplicable to stock futures transactions, those transactions would be subject to different regulation from other types of stock transactions in virtually every detail and to different, potentially uncoordinated, oversight.
The differences between the securities and futures regulatory schemes raise fundamental questions about single stock futures, which must be answered before consideration of any modification to the accord. Namely, what securities laws and regulations will apply to a product that is essentially a surrogate for stocks? What regulations will apply to a product that is integrally linked to the stock market? What regulations will apply to a product that will likely be marketed to the same investors that participate in our nation's securities markets? The following examples are just some of the issues raised by these questions and that need to be answered before deciding whether to remove the accord's prohibition.
Leverage: Margin (the amount an investor has to put up to enter into a position in a financial instrument) for futures is consistently much lower than that applicable for securities. This greatly increases futures leverage, which is the amount of exposure an investor is subject to as a result of price movements. The high degree of leverage significantly raises the risk of stock manipulation and could lead to widespread customer losses in volatile stock markets. The futures exchanges have suggested that they might agree to subject single stock futures to similar margin as stock options. We are concerned as to the vagueness of this proposal. Would the futures exchanges agree to a 20 percent margin level for single stock futures with any changes approved by the SEC, as is the case for stock options? Anything less than this is a hollow offer.
Page 171 PREV PAGE TOP OF DOC Antifraud and Manipulation: Although the CEA contains general antifraud and antimanipulation provisions, many specific securities law provisions designed to prevent fraud and manipulation have no parallel in the CEA. Allowing single stock futures without applying these provisions would enable persons to effect manipulations or fraud by using futures and thus circumventing securities law prohibitions.
Insider Trading: There are no insider trading prohibitions under the futures laws as there are under the securities laws. The profound implications of this disparity are addressed later in this testimony.
Customer protection: The futures markets have no requirements similar to those in the securities markets to make certain that brokers do not place customers in unsuitable investments nor do they have the same account opening requirements as the securities markets. In addition, securities laws contain stringent requirements that brokers seek to obtain best execution of their customer orders where the same product trades on multiple markets. These requirements are lacking for futures.
Market Competition: Securities are permitted to trade on multiple exchanges and over-the-counter. In contrast, a futures contract is approved for a specific board of trade and can only be traded on a futures exchange. This ''exclusivity'' provision of the CEA is at odds with the freedom of competition embodied in the securities laws and would have to be addressed before permitting single stock futures.
Market Transparency: The futures markets are not subject to the strict transparency provisions mandated under the Federal securities laws. For example, the securities laws require the securities markets to consolidate last sale prices and quotations and to make that data available on a real-time basis. The CEA does not contain a similar requirement.
Market Linkages: Securities markets are linked by common clearing, a consolidated tape, and rules designed to prevent trade-throughs of customer orders. The futures markets have none of these linkages because identical products do not trade on more than one futures exchange or, where they do, the products are not fungible due to the lack of common clearing. If stock futures were permitted to trade on multiple exchanges, the lack of futures exchange linkages and common clearing would lead to fragmented markets.
Page 172 PREV PAGE TOP OF DOC Disclosure: Stock prospectus and disclosure documents reflect the heart of a securities disclosure scheme that provides investors with detailed information about their investments. By contrast, the futures industry only requires distribution of a very brief risk disclosure statement. In addition, the NASD has proposed rules to require members to provide special disclosure to customers about the risks of day trading. These rules would not cover day trading with stock futures if the futures were subject to the CEA.
Regulatory Fees: Securities exchanges are subject to transaction fees imposed under the Federal securities lawsthese fees help to fund the SECthey have no counterpart in the futures markets.
Tax: Futures and securities are subject to different tax treatment so that single stock futures transactions of customers would generally be taxed at a lower rate than customer transactions in stocks or stock options.
The Coalition believes that an in-depth examination of these and other issues is critical to any evaluation of the accord. It would be an extreme disservice to 80 million U.S. investors to repeal the accord prohibition on futures on individual stocks and narrow based indexes without first thoroughly addressing these issues. This is especially true given the expected marketing of single stock futures to retail investors.
A simple repeal of the accord's prohibition without a replacement beyond the existing futures requirements would completely undermine the carefully constructed securities regulatory system that is the backbone of investors' confidence in the securities markets. Several examples will demonstrate the potentially devastating consequences of a simple repeal. First, SEC Rule 10b18 places restrictions on corporate issuers of securities effecting purchases of their own stock in order to prevent the potential manipulation by an issuer of the price of its stock. The rule contains strict provisions on the manner, price, and volume of purchases by an issuer or an affiliate. For example, an issuer is allowed to purchase only up to 25 percent of the trading volume in its stock on any trading day. Permitting single stock futures to be regulated under the CEA would enable issuers to circumvent these restrictions by buying futures instead of the actual stock and would make it easier for an issuer to manipulate the price of its stock.
Page 173 PREV PAGE TOP OF DOC Second, there are no suitability provisions for recommendations to customers in the futures laws comparable to those in the securities laws. The securities markets and SEC require that a broker-dealer determine for every transaction it recommends to a customer that the recommended transaction is suitable for the customer. In contrast, futures rules only require that a salesperson collect financial and other information on a new customer when approving the customer to open a futures account. There is no requirement that a salesperson recommending a futures transaction to a customer determine that the recommendation is suitable for the customer. Because of the lack of securities-like suitability provisions for futures, if futures on individual stocks and narrow-based indexes were permitted, they could be freely marketed to unsophisticated and unsuitable investors. The lack of suitability provisions would be particularly troubling given the recent increase in day trading by individual investors. Day trading raises unique investor protection concerns and is extremely risky. Those risks would potentially be increased exponentially if single stock futures were permitted under the CEA. The possibility that futures brokers would be able to recommend the day trading of futures on Internet stocks on 5 percent margin to their customers without making any suitability determination is a frightening prospect.
Third, section 13(d) of the Securities Exchange Act of 1934 requires a person acquiring 5 percent or more of the outstanding shares of a company's stock to file a notice with the SEC, issuer, and each exchange where the stock is traded. The requirement is intended to provide investors and the issuer with notice of the accumulation of a stock position that may have the potential to change or influence control of the issuer. If single stock futures were regulated under the CEA, it is unlikely that the SEC would have the authority to include these products within the 5 percent reporting requirements. Thus a corporate raider could circumvent the reporting requirement by using stock futures to acquire contracts representing more than 5 percent of a target's shares and, when the futures amounted to a controlling percentage of the company's stock, liquidate the futures and buy the stock. The raider would then have to make the required disclosure to the SEC because it was acquiring the actual shares, but it would be too late. The prophylactic purpose of the disclosure requirement of section 13(d) would be completely undermined.
Page 174 PREV PAGE TOP OF DOC Fourth, the Federal securities laws prohibit insider trading. Unlike securities, including stock options, futures are not subject to insider trading prohibitions. If single stock futures were regulated under the CEA, a person could trade on inside information with impunity using single stock futures.
These are only a few of the numerous examples of important securities regulations provisions that could be circumvented if the accord's prohibition were lifted. That is why it is critical that Congress and the regulatory agencies determine how to apply the securities regulatory structure to futures on individual stocks and narrow based indexes before deciding whether to remove the accord's prohibitions.
With the need to reauthorize the CEA this year, the futures exchanges are trying to repeal the accord's prohibitions as part of the CFTC's reauthorization legislation. The complex and difficult issues involved in an examination of the accord, however, should not be used to tie up the reauthorization process. Most importantly, the futures industry wants to overturn the accord's prohibition without agreeing to a comprehensive plan to address the important regulatory differences outlined above. Instead, they want to select only one or two securities law provisions and offer to apply these to single stock futures in an attempt to address concerns about the myriad securities law provisions that would be affected by single stock futures.
Amendments of the CEA in a few respects to meet discrete criticisms or shortcomings is an incomplete and inadequate solution. It ignores concerns about many fundamental securities laws provisions that have no parallel under the CEA. In addition, this approach will not be effective in resolving the specific concerns it targets. For example, the futures exchanges have suggested that the CEA could be amended to provide for regulation of insider trading, because the lack of insider trading provisions applicable to stocks is an obvious shortcoming of the CEA. However, even if the CEA were to be amended as proposed by the futures exchanges, to empower the SEC to apply insider trading rules to single stock futures, it would still be an inadequate response to the problems involved. In the first place, insider trading is only one aspect of the wide gamut of potential stock fraud and manipulation; if Congress wanted to make the two regulatory schemes congruent, it would need to enact all of the securities fraud and manipulation laws into the CEA and mandate the CFTC to adopt the anti-manipulation and anti-fraud rules established by the SEC. Second, even if Congress were to do this, the fraud and manipulation laws would be administered by two agencies, which could view the facts and importance of each matter differently, develop different precedents, and have different priorities. Third, even if there were exactly matching fraud and manipulation provisions, there would need to be perfect coordination by the two agencies and coordinated surveillance by the futures exchanges and securities markets. Finally, even if there were perfect matching of every provision and perfect coordination, the exclusive jurisdiction of the CFTC (and the safe harbor that jurisdiction gives commodity exchanges against other forms of competition) would still need to be addressed. Thus, if single stock futures are to be permitted and are to be regulated under the CEA it will be necessary to have a total overhaul of that Act to make it consistent with the securities laws to assure that there is adequate and appropriate oversight of all stock transactions and securities markets, including those involving stock futures, and to eliminate the exclusive jurisdiction provisions (and the prohibition against trading in other than a contract market) as they apply to stock futures.
Page 175 PREV PAGE TOP OF DOC Such a massive overhaul would be unwieldy and complicated. Instead, we strongly believe that the only effective way to modify the accord is to place futures on single stocks and narrow-based indexes under the aegis of the Federal securities laws administered by the SEC. This solution is simple, effective, comprehensive and pro-competition. We are not persuaded that any other approach makes sense or is workable. Indeed, three other approachessimply lifting the accord prohibition, applying one or two securities law provisions to the products, or trying to graft much of the securities laws into the CEA to cover stock futureswould be completely inadequate to address the problems that arise from permitting a stock surrogate product to trade outside of the securities laws. As we have demonstrated numerous times in this testimony, a failure to apply the same regulatory regime to single stock futures as is applied to securities would enable persons to engage in regulatory arbitrage by using futures to evade important securities market protections. Government policy makers should be concerned about the impact of regulatory arbitrage between futures and securities markets. Regulating single stock futures as securities is the best, and perhaps only way, to guarantee that these instruments do not fall outside of the system of oversight for stock and the stock markets. Consequently, the U.S. Securities Market Coalition opposes any repeal of the accord's prohibition on futures on single stocks or narrow-based indexes unless the products are regulated by the SEC under the Federal securities laws.
Working Group Report. The recent Working Group Report's examination of the single stock futures issue reinforces our position. In the report, the four Working Group agencies agreed that the regulatory disparities between the securities and futures markets must be addressed prior to any legislative action that would alter the accord. The report concluded that the SEC and CFTC, the two expert regulators in this area, should be given an adequate opportunity to work together to address these issues.
In response, the Chairmen of the House Agriculture and Commerce Committees recently requested that the SEC and CFTC work jointly to create and present to Congress a detailed report addressing the desirability of lifting the current ban on single stock futures together with any legislative proposals by February 21, 2000. As with Congress, we wait with anticipation for the SEC/CFTC report. We believe the issues involved are very important and deserve serious examination by the SEC, CFTC, and Congress.
Page 176 PREV PAGE TOP OF DOC The Coalition's Position is Pro-Competitive. In making our suggestions, we are not oblivious to the competitive concerns the futures exchanges raise about the accord's prohibition, but such concerns are misguided and overstated. For example, the futures exchanges point out that overseas markets trade single stock futures. In reality, there is no significant overseas market for single stock futures. The product trades on a handful of exchanges and garners only very small volume. The contracts on those exchanges generally cover local stocks, and none of those exchanges trade single stock futures on U.S. stocks. Hence, there is no looming overseas threat that justifies swift action on the accord. Just the oppositewe have a perfect opportunity to choose the right approach, which bolsters our recommendation that time be taken to ensure that these products are uniformly regulated as securities. Moreover, it is important to recognize that in overseas markets trading stock futures, ultimate oversight over the securities and futures markets lies with one regulator, unlike in the U.S. where we artificially separate regulation of securities from futures on securities.
The futures exchanges also suggest that the options exchanges trade so-called ''synthetic futures'' by using a combination of put and call series. While a single stock future can be created synthetically using options on a single stock, the options transactions constitute securities transactions. Hence, the synthetic product is still a package of securities regulated by the SECthe precise treatment we espouse for single stock futures.
We do not contend that traditional stock markets should be protected from new ways of buying and selling stocks. Indeed my exchangethe Chicago Board Options Exchange, which was conceived by a commodities exchange, the CBOTitself inaugurated a new form of trading under the regulatory supervision of the SEC. The U.S. stock markets have long been one of the strengths of our economy. The regulation of those markets since the enactment of the securities laws has, on the whole, added greatly to their transparency, efficiency and competitiveness. It would, in our view, be unwise and risky to allow a new form of buying and selling stocks to be governedperhaps exclusivelyby a different regulatory scheme or to permit those transactions to be less rigorously regulated.
Page 177 PREV PAGE TOP OF DOC Our recommended approach on the accord is the most pro-competitive. It would prevent an artificial regulatory division between securities options and futures on a single stock and create a level playing field. If other approaches are used in lifting the accord's prohibition, regulatory arbitrage, not the value of the product, could determine the success or failure of competing futures and securities products.
Finally, it is worth remembering why the prohibition exists (because the U.S. splits regulation of securities and futures on securities between two regulators. If the U.S. combined regulation of securities and futures on securities under one regulator, the regulatory and competitive disparities between the two product classes could be addressed by one ultimate source of authority. We recognize that a merger of the agencies may not be politically feasible to accomplish. If the regulation remains split, however, then the trading of single stock futures under the CEA would magnify tenfold the mistake of divided jurisdiction over related instruments. Hence, the only responsible way to lift the accord's prohibition without adopting our suggestion to regulate the products as securities would be to merge the SEC and CFTC.
Equity Swaps. Another issue that has received attention during the CFTC reauthorization process and in the working group Report has been the legal status of OTC derivatives. The attention devoted to this issue arises, in part, from issuance of a Concept Release on OTC Derivatives by the CFTC in 1998. The Concept Release raised questions as to the status of certain OTC derivatives in regard to the CEA. While the Coalition has refrained generally from becoming engaged in the debate stemming from the OTC Derivatives Concept Release, we do have a particular interest in matters pertaining to legal certainty for equity swaps because of the products' nexus to the equity markets.
The Coalition believes that equity swaps should not be subject to the CEA. In general, the CEA is designed to regulate exchange-traded futures and is not equipped to cover privately negotiated bilateral instruments such as equity swaps. Clarifying the legal status of equity swaps would benefit dealers, end-users, and the markets generally. If Congress determines to provide clarification of the legal status of equity swaps it should do so by excluding equity swaps from the CEA. This approach generally is consistent with the working group Report. Further, this approach would make it possible for the SEC to exercise appropriate regulatory oversight over these products if it deems necessary
Page 178 PREV PAGE TOP OF DOCCONCLUSION
The U.S. securities markets have enjoyed a decade of unparalleled growth and success and are the envy of the world. They provide the vehicle for capital formation by U.S. enterprises and for investment and savings for over 80 million Americans. The maintenance of the integrity of these markets is an important national interest. Thus, the Coalition is very troubled by proposals to amend the accord to remove the prohibition on futures on individual stocks or narrow-based indexes without addressing how the protections of the Federal securities laws would apply to these products. As noted at the beginning of my testimony, the Coalition believes that the maintenance of investor protection should be the primary consideration for policymakers in examining the issue of single stock futures. Moreover, while the Coalition does not fear new competition from single stock futures, such competition must occur on a level playing field. As a result, the Coalition strongly believes the right result for addressing futures on single stocks and narrow based indexes, and indeed the only correct result, would be to require the products to be treated as securities under SEC regulation if the accord prohibition were to be lifted. For the sake of 80 million American investors, we can accept nothing less.
Testimony of David P. Brennan
Mr. Chairman and members of the committee, the Chicago Board of Trade welcomes the opportunity to discuss with you the ramifications of the November 1999 Report of the President's Working Group on Financial Markets, and thanks you for conducting this hearing.
The Report of the President's Working Group addressed a basic issue: whether the only Federal statute that is designed to regulate derivatives transactions B the Commodity Exchange Act B serves today's derivatives markets well. The Working Group concluded that the answer is ''no.'' Federal law has not kept up with the almost $100 trillion dollar derivatives markets. To that end, the report recommended a series of amendments to the Commodity Exchange Act which would allow that statute to serve better the objectives of enhanced market efficiency, innovation, and fair competition, while also preventing the negative market forces of legal uncertainty and systemic risk. The Working Group concluded that if these objectives are met, the U.S. derivatives markets would be able to maintain their global leadership position.
Page 179 PREV PAGE TOP OF DOC The Board of Trade strongly endorses each of these objectives and has long recognized the need for a sweeping overhaul of the Commodity Exchange Act. This overhaul should be the congressional mission as we approach CFTC Reauthorization this year. From our perspective, ''fair competition'' is the critical issue. Markets should be open so that all may compete. To the extent any government oversight is necessary, similar products offered to similar customers in similar circumstances should have similar oversight. The Working Group Report acknowledges these concerns and builds into its recommendations a framework for removing the current barriers to fair competition.
For the U.S. futures exchanges, a key ingredient to achieving this competitive balance is regulatory reform. The Working Group Report stated generally that ''Where regulation exists, it should serve valid public policy goals.'' In particular, the working group found that ''Exchange trading should not be subject to regulations that do not have a public policy justification.''
These principles have been embraced by CFTC Chairman William Rainer and his agency. Under his leadership, they are working on a plan to rationalize regulation under the CEA in a manner that would be consistent with the framework recommended in the working group report. While the details of the Commission's approach are not yet complete, the Board of Trade is very appreciative of the energy and creativity the Commission has devoted toward modernizing its regulatory stance. We look forward to learning more about the Commission's regulatory restructuring agenda and to working cooperatively with Chairman Rainer and the Commission in this effort.
In addition to encouraging the CFTC to rethink its regulatory approach, the working group report recommended the enactment of a series of amendments to redraw the boundaries of the Commodity Exchange Act. Drawing such lines is both a necessary and inherently dangerous practice. Every day as technology changes, derivatives markets change. Asking Federal law to anticipate or keep up with those changes is a tall order. For those reasons, the Board of Trade questions some of the jurisdictional lines the working group would draw. I will outline those areas in this testimony. But I do not want our observations to obscure the Board of Trade's support for the objectives identified by the working group or its recommendations to facilitate innovation and fair competition in derivatives markets. They have produced a starting point that will serve as a valuable catalyst to congressional consideration of the issues presented by CFTC Reauthorization this year.
Page 180 PREV PAGE TOP OF DOC Background
The Working Group frames its analysis by distilling the current derivatives market into two main typesswaps and futures. At their roots, swaps and futures have many similarities. Both markets are traded primarily by the same large sophisticated institutions. Both markets are used to hedge or assume the risk of changes in interest rates, currencies, stock or commodity prices. Both markets are large; as measured by the working group, the swaps market is at least $80 trillion is size and the futures markets is over $13 trillion. In both markets, the most popular types of transactions involve changes in interest rates.
The report notes that historically, futures and swaps also have had material differences. Futures were traded on exchanges. Swaps were not. Futures were standardized trading instruments. Swaps were customized and privately-negotiated. Futures were available to retail customers. Swaps were not. Futures were subject to the protection of clearing systems. Swaps were not. Futures were subject to regulation under the Commodity Exchange Act. Swaps were not.
The Working Group correctly understood that markets do not stand still, however. Today, some swaps are standardized, fungible, traded in centralized electronic markets or subject to clearing. And some futures are customized, or at least not standardized. This market convergence has substantially blurred the definitional lines between swaps and futures, as the working group acknowledges. Thus, in forming its recommendations, the working group report used the term ''derivative'' transactions B a term that covers both futures and swaps B in order to reflect the comprehensiveness of its recommendations.
That is a very healthy start to the debate. In the past, too much energy has been wasted trying to analyze whether swaps fit the legal definition of futures contracts. Both sides made persuasive arguments and no legal consensus has emerged. But that well-worn issue should now be beside the point. The questions framed for Congress by the working group wisely extend beyond those artificial labels and in the most simplified form are:
Page 181 PREV PAGE TOP OF DOC what derivatives should be excluded from the Commodity Exchange Act?
what derivatives should be subject to the Commodity Exchange Act?
what level of regulation or oversight should apply to those derivatives that are subject to the Commodity Exchange Act?
PRINCIPAL AREAS OF AGREEMENT
The Working Group's analysis started from the premise that not every derivatives transaction needs to be regulated. The Board of Trade completely agrees.
The Working Group then reasoned that regulation, if it exists at all, should serve valid public policy goals. The Board of Trade completely agrees.
The Working Group concluded that any clearing system for derivatives should be subject to separate oversight regulation at the Federal level, including under the Commodity Exchange Act. The Board of Trade completely agrees.
The Working Group determined that a large class of derivatives transactions should not be subject to the Commodity Exchange Act and found that the statute needs to be amended to provide those transactions with legal certainty. The Board of Trade completely agrees.
The Working Group recognized that excluding a large class of derivatives transactions from oversight under the CEA could remove those transactions from any form of Federal regulation and therefore has competitive implications for those transactions that remain subject to the CEA, including derivatives traded on organized futures exchanges. The Board of Trade completely agrees.
The Working Group stated that these competitive implications should cause the CFTC to reconsider its regulatory approach in an effort to transform itself into an oversight agency, rather than a front-line regulator. The Board of Trade completely agrees.
The Working Group acknowledged that the CFTC and the Securities and Exchange Commission should reassess whether the ban on single stock futures in the Shad-Johnson Accord should be lifted. The Board of Trade completely agreesand has for the past 18 years, while this self-described ''temporary foreclosure'' was serving as an absolute and unwarranted competitive barrier for exchange-traded futures in the United States.
Page 182 PREV PAGE TOP OF DOC The Working Group decided that a statutory line should be drawn so that the markets know with certainty what transactions are excluded from the CEA. The Board of Trade completely agrees. Our questions go to where that line should be drawn.
The Working Group's Factors: The Working Group would exclude from the CEA any
traded only among institutions;
on a ''principals only'' basis (no direct agency trades);
on a bilateral execution facility or an electronic multilateral execution facility; unless
the market serves a price discovery function.
Put another way, any financial derivative, even if standardized and fungible (like traditional exchange-traded derivatives), traded among institutions acting as principals on a centralized electronic execution facility would be removed from the statute's coverage. It should go without saying that this is a broad exclusion. Indeed, the working group conceded that the breadth of this exclusion blurs the historical distinctions between exchange-traded products that are subject to regulation under the CEA and those over-the-counter derivatives that are not.
In addition, the working group would even more broadly exclude from the CEA any derivative in or involving foreign currency or government securities, which is not traded on an ''organized exchange.'' To be excluded from the ''organized exchange'' category, an exchange would need to either (1) bar retail customers and agency trades for institutional customers or (2) Renounce its self-regulatory obligations.
The Working Group's revised Treasury amendment would change the landscape of Federal regulation drastically. It would mean that the Chicago Board of Trade's markets in Treasury Bond and Note futures and optionswhich account for about 75 percent of our businesscould be excluded from the ''organized exchange'' definition and the Commodity Exchange Act. How? We could enact a rule requiring all trades executed on the exchange floor to be on a principals only basis so that trading for any customer could be pursued off the exchange floor in a manner similar to dealer market practices. In the alternative, the Board of Trade could just disband its self-regulatory forces, including its Office of Investigations and Audits, thereby qualifying as a ''non-organized exchange'' in order to avoid regulation for three-quarters of our business. Thus, the ''organized exchange'' definition could lead to dramatic changes in derivative market regulation if enacted.
Page 183 PREV PAGE TOP OF DOC The underlying public policy rationale and logic for these exclusions is questionable. Let me summarize our concerns, one at a time.
The Working Group Report claimed that since financial derivatives pose less of a threat of manipulation than non-financial derivatives, financial derivatives should be eligible for exclusion from CEA regulation. We agree that the relative threat of manipulation of a type of derivative is a relevant consideration. We are less convinced that the right way to address that ''relativity'' is an ''all or none'' decision resulting in a selective regulatory exclusion for some financial derivatives, but not those traded on traditional exchanges, for example.
In our view, tailoring the necessary surveillance of any publicly-traded derivative product to the actual threat of a manipulation is better than awarding a statutory exclusion to those products that are unlikely to be manipulated and traded other than on a traditional exchange. If no possible threat of manipulability exists for a particular type of publicly traded derivativewhether based on an agricultural commodity or a financial instrumentthen no trading surveillance should be needed. But other types of oversight may be appropriate for those publicly traded derivatives, including the fitness of the operator of the derivatives execution facility as well as fraud and financial integrity for intermediaries. In short, a reduced threat of manipulation does decrease the need for oversight, but it doesn't eliminate it in all areas. And all publicly traded derivatives transactions should be treated alike.
In addition, it will be difficult to decide what transactions are ''financial derivatives.'' Certainly the vibrant over-the-counter energy derivatives sector will contend that their instruments should be considered to be ''financial.'' And one could expect those that offer and trade over-the-counter equity swaps B derivatives tied to stock indexes or single stock prices B to claim that they fall within the term ''financial derivative.'' If so, the carve-out for qualifying financial derivatives plainly has implications for the Shad-Johnson ban on single stock futures and other related issues.
Page 184 PREV PAGE TOP OF DOC In the past, in the context of our ProMarket proposal, the Board of Trade itself has proposed treating financial and non-financial derivatives in a disparate manner. Some observers, including members of this committee, criticized us for that approach. To the extent those criticisms are valid, they are equally applicable to the working group's report B the nature of the ''commodity'' underlying a derivative may be a problematic criterion for determining a statutory exclusion.
INSTITUTIONS ONLY VS. INSTITUTIONS MOSTLY
The Working Group Report concluded that derivatives transactions entered into by and between only sophisticated institutional market participants may be excluded from the Commodity Exchange Act. The rationale is that institutions need less Federal-regulatory protections than non-institutional market participants do. That is true, but again a complete exclusion may not be the right answer. Today our exchange markets are not ''institutions only'' markets. We operate ''institutions mostly'' markets where 95 percent or more of the trades are for parties who would be considered to be institutions that are eligible to trade excluded derivatives under the working group's recommendation. So if our exchange markets barred the retail customer (no more than 5 percent of our market), fairness would dictate that exchange markets too should be eligible for the exclusion.
But why? The retail customer comes to our markets only when represented by a regulated intermediary who must act on behalf of the retail customer. That regulated intermediary makes sure that the customer understands the risks of trading and complies with the financial integrity protections. That regulated intermediary either executes the order itself acting as a broker or retains a regulated floor broker who will actually execute the customer's trade.
For purposes of executing a customer trade, the customer's identity is not relevant. It doesn't matter whether the customer order is for Donald Trump or Donald Duck, the IBM Pension Fund or Joe Q. Public. All the broker knows is that he or she represents a customer and is obliged to fill every customer order at the best price. For transaction execution purposes, retail customers are treated the same as institutional customers. So why exclude from the CEA ''institutions only'' execution facilities, but not ''institutions mostly'' execution facilities?
Page 185 PREV PAGE TOP OF DOC Enacting exclusionary standards that will encourage the creation of markets with pools of liquidity that will be the sole province of institutions will, in fact, disadvantage retail customers. Put simply, public customers are not likely to get the best prices available without access to the best pools of liquidity. We therefore question the wisdom of setting up a regime that could segregate the retail customer from the best markets, especially where a regulated intermediary is handling the execution of the customer's trades.
Again, our ProMarket proposal was criticized by some on just this ground. We like to think we have learned from that criticism. Congress should not adopt standards that could operate to deny retail customers access to the most liquid trading markets or execution facilities.
Principals Only vs. Agency and Principal Markets. Markets are made up of two types of tradesPrincipal and Agency. A Principal trade occurs when a party enters into a trade for its, his or her own account. An Agency trade occurs when one party enters into a trade for someone else (a customer).
The Working Group Report recommended that only Principal trades be eligible for exclusion from the CEA. The reasoning was that there is little Federal regulatory interest when two institutions trade with each other for their own account. On one level, we have no quarrel with that position. That is why the Board of Trade, along with the Chicago Mercantile Exchange and New York Mercantile Exchange, have endorsed an exclusion from the statute for privately negotiated transactions between two institutional parties.
But the working group report would go beyond that class of private transactions to exclude, for example, a centralized electronic ''dealers only'' market for trading derivatives. That would mean that in each dealer's back office, it could trade directly with its institutional customers at prices based upon, and reflecting a markup of, the centralized ''dealers only'' market price and still qualify for the exclusion. What the dealer could not do is try to get its institutional customers the best price by entering an order on behalf of the institution directly in the centralized electronic market.
Page 186 PREV PAGE TOP OF DOC Again, the working group report would encourage the creation of markets that are ''off limits'' to many market participants, at least directly. Fragmenting trading markets should be discouraged, not encouraged.
Electronic vs. Pit Trading. The Working Group Report would exclude from regulation under the CEA standardized, fungible derivatives traded on a principal basis among institutions if trading occurs on a multilateral electronic or computerized trading facility. This policy is followed to encourage the development of electronic trading mechanisms.
Under that recommendation, however, if that same derivatives contract is traded on the same basis by the same institutions in a pit trading or inter-dealer broker phone and fax environment, that trading activity would suffer full-scale regulation under the CEA. No basis exists for that disparity. We question whether it is fair or sensible to mandate that regulatory exclusions will turn on the nature of the execution mechanism selected. We would recommend, as a business that operates in both a pit trading and electronic trading environment, that regulatory coverage be based on market neutral concepts. Congress should not tip the competitive scales in one direction or another; if it decides to enact a regulatory exclusion for multilateral transaction execution facilities, that exclusion should treat electronic and physical trading environments alike.
In this regard, the working group's report is a bit inconsistent. In the Treasury amendment area of derivatives trading, the working group is willing to treat electronic and pit trading alike. For all other forms of financial derivatives, the working group would exclude only multilateral electronic execution facilities. Again, we would recommend that Congress adopt a neutral, even-handed approach to execution facilities. We also question whether Congress needs to add an extra and potentially confusing exclusion for Treasury amendment products. One exclusion that is well thought out and stated unambiguously is much better than two exclusions that could promote inconsistent policy outcomes.
Page 187 PREV PAGE TOP OF DOC Price Discovery. The Working Group Report suggested that in some instances excluded transactions could become subject to the CEA if those transactions resulted in or contributed to price discovery. The concept of price discovery requires careful definition, especially in an increasingly integrated, technologically linked global economy. Through the Internet, all sorts of disparate derivative and cash market pricing datafor financial and agricultural marketsare linked in ways never before possible, providing a new paradigm of price discovery. Even if that were not the case, to the extent price discovery is meant to include price basing, the report's exclusion may not provide the same measure of legal certainty to many market participants since certain plain vanilla OTC transactions have, or may, become the source for price basing in many financial areas.
It is true that the Commodity Exchange Act was enacted many decades ago in part to protect the integrity of the price discovery process. But that concern arose in an economic era where centralized markets frequently generated the only reliable pricing benchmark available by telegraph or telephone. In the markets of the 21st century, whether agricultural or financial, it is likely that technology will link together many disparate transaction execution facilities or other forms of markets, thereby providing market participants with a variety of pricing reference points. If regulatory coverage decisions turn on that kind of price discovery, again the goal of legal certainty will be seriously compromised.
Fair Competition. One objective of the working group report was to develop regulatory coverage principles that would promote fair competition. In two specific areas, the report's recommendations seem to fall short of that objective.
Clearing. The Working Group recommended that Congress enact legislation to provide a clear basis for the regulation of clearing systems for derivatives that are otherwise excluded from the Commodity Exchange Act. The Working Group believed that the clearing of otherwise excluded derivatives should be subject to oversight on a ''pick your regulator'' basis. The choices are the CFTC (but not for derivatives that are securities), the SEC (but not for non-financial derivatives) or the bank regulators. Up to here, the recommendation appears to be fair and even-handed.
Page 188 PREV PAGE TOP OF DOC The problem comes in when the class of excluded derivatives is considered. As we have seen, under the working group's recommendation, fungible and standardized financial derivatives identical to the futures and options now traded on the Board of Trade and Chicago Mercantile Exchange, and subject to their clearing mechanisms, could be excluded from the CEA. Those futures and options contracts by virtue of being considered to be excluded derivatives could now become subject to clearing by a SEC-regulated clearing agency. Yet a CFTC-regulated clearing agency could not clear derivatives, primarily options transactions, which are now subject to oversight by the SEC.
A balanced ''pick your regulator'' approach should provide a two way street for competition in clearing. Market participants are looking for centralized processing and clearing of all transactions. The Working Group recommendation gives a significant edge to SEC-regulated clearing agencies in this regard by expanding the range of instruments they could clear to cover those instruments now cleared by CFTC-regulated clearinghouses. Without reciprocity, futures clearinghouses will face a severe handicap and be forced to form separate securities clearing agency subject to SEC oversight in order to clear those derivatives that are securities. That is not fair and even-handed competition. Moreover, once such a securities clearing agency is formed by a futures clearinghouse, the operators of that facility may decide to put all its clearing business through the securities clearing affiliate since the securities affiliate will have the flexibility to clear all financial futures, options, securities and derivatives transactions. The futures clearing facility will lack the legal capability. Thus, the working group report offers a roadmap for expanding greatly the range of securities clearing and limiting dramatically the range of futures clearing.
Shad-Johnson. The Working Group did not indicate whether its definition of excluded financial derivatives included ''equity swaps'' and other forms of derivatives tied to securities prices. We have presumed that equity swaps were intended to be covered by the term ''financial derivatives'' because equity swaps are the class of instruments most in need of legal certainty under the CEA since they are not included in the CFTC's current swaps exemption. On the other hand, excluding equity swaps from the CEA would mean excluding those instruments from the Shad-Johnson product restrictions, leaving traditional exchange-trading of those instruments to be the only product offerings subject to the ban. That result signals a complete disregard for fair competition.
Page 189 PREV PAGE TOP OF DOC Consider this. The report's recommendations would exclude from the Shad-Johnson ban a swap tied to the value of IBM stock, where that swap was standardized, fungible, cleared, traded only by institutions and subject to a multi-lateral electronic trading facility (just like the Board of Trade's Project A). At the same time, the report also suggested that the ''current prohibition on single-stock futures (for example, futures tied to the value of IBM stock) can be repealed if issues about the integrity of the underlying securities market and regulatory arbitrage are resolved.'' Does that mean that if an IBM future was traded only among institutions and was standardized, fungible, cleared and traded only on an electronic trading facility like Project A it would not present any issues relating to the integrity of the underlying securities market and regulatory arbitrage? The report doesn't say, but it suggests the answer is ''no.'' Otherwise its discussion on Shad-Johnson would be superfluous since it seeks merely to initiate reconsideration of the Shad-Johnson issue, not resolve it.
In summary, the working group report appears to be excluding equity swaps from Shad-Johnson. To reach that result, the working group is elevating form over economic substance by treating an instrument labeled a ''swap'' as excluded from Shad-Johnson and the same instrument labeled a ''futures contract'' as banned under Shad-Johnson. Labels should not be determinative of these important issues of regulatory policy, as the working group makes clear in the other areas of its report.
The U.S. futures exchanges have been urging Congress to reconsider and lift the Shad-Johnson ban since 1982. We have agreed that the same kind of margin and insider trading rules should apply to stock futures as apply to stock options. We don't want a regulatory advantage. We just want an opportunity to compete.
The Shad-Johnson ban places U.S. markets at a serious competitive disadvantage to our foreign competitors as well. They can, and many do, offer single stock futures. We can't.
Page 190 PREV PAGE TOP OF DOC That anomalous result is best illustrated by this example. As you know, the Board of Trade has entered into a joint venture with the German-Swiss exchange EUREX to develop an electronic trading platform. As part of that agreement, EUREX may not list futures on U.S. stocks without the Board of Trade's consent. If the Shad-Johnson ban on single stock futures is not lifted, the Board of Trade could have no choice but to consent to the listing of futures on U.S. stocks on EUREX allowing investors all over the world, except in the U.S. where Shad-Johnson applies, to trade those instruments. The Board of Trade could share in the transaction fee for each execution, an important consideration as we move to a for-profit environment. But no U.S. investors could trade in that global market in single stock futures on U.S. stocks. That makes no sense.
The Working Group Report deserves considerable credit for trying to jump-start a meaningful dialogue that should lead to allowing single stock derivatives, including futures, to be traded in the U.S. A main purpose of the working group report is to open up markets for healthy competition by removing unneeded regulatory barriers. The Shad-Johnson ban is such a barrier; Congress should repeal the Shad-Johnson product restrictions.
The Working Group Report has outlined the principal elements of a CFTC reauthorization bill. Congress must enact clear lines of demarcation for those derivatives that are not, and are, subject to the CEA. Regulatory modernization for those transactions that are subject to the CEA must be codified to provide for oversight, not micro-management, designed to serve valid public policy goals. Finally, Congress must repeal all unwarranted barriers to competition, like the Shad-Johnson product restrictions.
As always, filling out that outline with the details of specific legislative solutions will be a challenge. But a seemingly strong consensus has emerged that the working group has identified the correct ingredients for a successful legislative package. As we say often in the context of restructuring the Chicago Board of Trade, the status quo is not an acceptable alternative. We need to move and move quickly to restructure Federal regulation to enable all derivatives markets to benefit from the forces of full and fair competition. The Board of Trade looks forward to working with you, Mr. Chairman, and this committee to get the work done to help create legislation that will accomplish the important national goals the working group has set out.
Page 191 PREV PAGE TOP OF DOC
Statement of Robert R. Champion
Twice in the past (on June 10, 1998 and on May 18, 1999), I have submitted written testimony to this subcommittee on the history of my firm, Champion Securities, and the serious roadblocks to financial innovation that we have encountered as a result of the outmoded provisions of the Commodity Exchange Act. Rather than repeat all that was contained those statements, I will summarize a few key points and conclude with my recommendations on what Congress should do to foster financial innovation and bring legal certainty to the over-the-counter derivatives market, particularly with respect to hybrid instruments.
Champion Securities was formed to develop and market a single over-the-counter derivative instrument, now called MarketPlus. The instrument by its nature is not amenable to exchange trading and cannot be regulated under the regulatory scheme established under the CEA without an exemption from most of its provisions. Many financial-market professionals, including some within the CFTC, believe that the instrument is simply not subject to the CEA because it is not a futures contract. Yet it can be regarded as having some of the characteristics of futures. Therefore, we have been working with the CFTC for over 10 years to obtain an exemption from the CEA.
The story of MarketPlus exposes the failures and shortcomings of current commodity law.
OVERVIEW OF THE MARKETPLUS INSTRUMENT
MarketPlus is a debt security within the meaning of section 2(1) of the Securities Act of 1933. It is a variable-return debt obligation that pays interest at a money-market rate and that can be linked directly or inversely to the performance of one or more asset categories, as represented by a securities or commodity index. The instrument is fully paid for by the holder, who cannot be required to make additional payments to the issuer at any time. It is issued and sold subject to applicable Federal and state securities laws to those permitted under those laws to purchase the instrument.
Page 192 PREV PAGE TOP OF DOC Investors can allocate all or a portion of their MarketPlus investment to the total return of an index and specify a multiple of that return ranging from 3.00 (short) to +3.00 (long). At a zero multiple, they earn a money-market rate of return. The combination of the interest earned on the principal and the return earned on the index exposure results in an overall return comparable to allocating funds between a money-market instrument and long or short positions in one or more asset categories.
Our obligations to holders are backed by a credit-support arrangement. We maintain asset backing of no less than 103 percent of those obligations. This cover is in the form of short-term Treasury securities, other investment-grade money-market instruments, and positions in futures contracts that mirror the aggregate of the indexed positions of the holdersall pledged to a trustee on behalf of the holders.
MarketPlus affords active investment managers greater liquidity and risk-management flexibility than switching among mutual funds by allowing them to use a touch-tone telephone (and, eventually, the Internet) to specify an exact market exposure at any hour or half hour during the trading day. When holders change their asset allocations, we hedge the net change in our aggregate liability to those holders by buying or selling futures contracts on that asset category.
The cost of using MarketPlus is competitive with mutual funds that accommodate active managers and levels the playing field for individual and smaller institutional investors. With MarketPlus, these investors now have an alternative designed specifically to meet their needs regardless of portfolio size. Just as the mutual fund enabled a large number of small investors who individually selected stocks to band together and have a professional select stocks on their behalf, passing on the cost savings to them, MarketPlus enables small investors who implement asset allocation and portfolio trading strategies to band together and have an institutional portfolio trader implement their aggregate decisions for them, enabling them to benefit from the issuer's expertise and cost savings.
Page 193 PREV PAGE TOP OF DOCCHAMPION'S 10-YEAR HISTORY
In June 1990, after we redesigned our original concept of MarketPlus so that it would comply with the CFTC's Statutory Interpretation Concerning Certain Hybrid Instruments (the Statutory Interpretation), the CFTC staff gave us a no-action letter. The changes that the CFTC required made MarketPlus considerably more complicated and costly to use, and less attractive to tax-exempt investors. Nevertheless, at least, MarketPlus could be offered.
In January 1992 we began the offering, in a private-placement to accredited investors (as defined in SEC regulation D). Unfortunately, the negative tax consequences for tax-exempt investors severely restricted our market. (Most accredited investors have their holdings in tax-exempt accounts.) Since then we have sold approximately $90 million of MarketPlus to over 200 holders, almost all of whom relied upon registered investment advisors to make their allocation decisions. The maximum amount invested in MarketPlus at any one time was $23 million.
Over this 10-year period, we have successfully administered MarketPlus in accordance with all agreements, satisfied all redemption and termination requests, and executed almost 6,000 hedging trades totaling in excess of $20 billion in notional value of futures contracts. Virtually all of these trades were new business for U.S. futures exchanges, business thatin the absence of MarketPluswould have gone to mutual funds or to other investment vehicles outside of the futures markets. Significantly, from a public-policy viewpoint, MarketPlus takes active trading activity that most mutual funds do not want and redirects it to the futures exchanges where it belongsand where it enhances the price-discovery process.
The issuer of MarketPlus and its affiliated broker-dealer have had six routine audits by the SEC, the NASD, and the California Department of Corporations, and have not received any complaints from holders or their advisers.
To demonstrate that MarketPlus meets a market need, we asked a number of registered investment advisors who have used it to write to the CFTC. Here is what some of them said:
Page 194 PREV PAGE TOP OF DOC The president of the Society of Asset Allocators and Fund Timers, Inc., a professional trade organization with 170 members who collectively manage over $14 billion, wrote:
''MarketPlus makes the low cost and many of the benefits of modern institutional index trading technology available to the average retail investorour customer. Many of our members believe that this innovative new financial instrument will provide them with risk management capabilities that are unavailable through mutual fund timing.''
John S. Lyons, president of J. Lyons Fund Management, wrote:
''MarketPlus has not only been an outstanding vehicle but also one that has functioned operationally without the slightest problem. In 26 years [as an investment advisor], I do not recall seeing such a well-conceived investment product developed.''
Paul A. Merriman, President of Paul A. Merriman & Associates, an investment manager, wrote:
''Admittedly there are many products available to timers, but Champion's MarketPlus is the only one that delivers what we wantaccurate pricing and intraday trading. With Champion, you get precise results, and with [(mutual funds] you get approximate results. There is no way to know in advance whether this difference will be meaningful or insignificant.''
Don M. Chance, Ph.D., CFA, Professor of Finance, wrote:
''MarketPlus is a significant financial innovation and is, I believe, in the spirit, if not the letter, of the [Futures Trading Practices Act of 1992].''
In spite of the wide acceptance of MarketPlus, we are still struggling to find a regulatory solution that will permit a public offering of this innovative instrument to those for whom it was created. The variable nature of its indexing, and its linkage to a securities indexwhich implicates the ''except for section 2(a)(1)(B)'' constraint in the CFTC's CEA section 4(c) exemptive authority, have caused it to be a regulatory outcast.
The regulatory solution that we negotiated with the CFTC under Chairman Wendy Gramm, an exemption from the CEA under the Statutory Interpretation (the only exemptive avenue available to the Commission at that time), was unacceptable to Chairman Gramm's successor, Mary Schapiro. And the regulatory solution that we negotiated with Chairman Schapiro, to be regulated as an OTC futures contract, was unacceptable to Chairperson Born. The Commission under Chairperson Born offered no alternative regulatory solution. Now, under Chairman Rainer, the Commission is once again studying how MarketPlus should be regulated.
Page 195 PREV PAGE TOP OF DOC Our experience in attempting to find a way in which MarketPlus can be brought to market underscores the serious deficiencies in current law as it relates to OTC derivatives, especially hybrid instruments. At no time have we attempted to avoid regulation; we only have sought to find a regulatory solution that worked for us, the regulators, and potential MarketPlus investors.
As I will describe next, it is extremely important for Congress to realize that it is not just the big banks, brokers, and exchanges who are hurt by out-dated commodity regulations. Small firms like mine that are attempting to create new financial instruments for the growing individual investor market are hurt as well.
IMPROVING THE CURRENT REGULATORY ENVIRONMENT FOR FINANCIAL INNOVATION
The regulatory difficulties that MarketPlus has faced are solely the result of its being at the cutting edge of financial innovation in the 1990's, which involves new products that:
Are designed to meet a growing demand from individual, as opposed to institutional, investors;
Provide these investors with the ability to customize and change an instrument in order to fine-tune their investment strategies and risk-reward exposure;
Allow investors to use advanced computer and communication capabilities, such as the Internet, to manage their investments and react quickly to changing market conditions; and,
Are designed to have the lowest possible cost of ownership and use.
Because future financial innovation will occur primarily in the area of OTC derivatives, especially in new forms of hybrid instruments, current law now puts the CFTC in charge of deciding what will be allowed and who wins and who loses. This is too much power to give to a single regulator.
Page 196 PREV PAGE TOP OF DOC The following are my firm's recommendations on what is needed to improve the regulatory environment for financial innovation in the over-the-counter derivatives market, particularly with respect to hybrid instruments.
1. Clarify, simplify, and codify part 34: The requirements of the current hybrid instrument exemption, as contained in part 34 of the Code of Federal Regulations, are generally well-conceived and with clarification and modification could satisfy Congress's intent to foster financial innovation. While we favor simply excluding all hybrid instruments from the CEA, we do have two specific recommendations that would provide greater legal certainty and correct certain shortcomings in the current exemption without excluding all hybrids from the CEA.
First, and most important, in accordance with the unanimous recommendation contained in the report by the President's Working Group on Financial Markets entitled Over-The-Counter Derivatives Markets and the Commodity Exchange Act, Congress should enact a provision to clarify that section 2(a)(1)(B), the Shad-Johnson Accord, should not be construed to prevent swaps and hybrid instruments linked to securities indexes from being exempted from the CEA. We have submitted a specific proposal to staff on how to accomplish this result.
Second, the CFTC's 1998 Over-The-Counter Derivatives Concept Release stated that the definition of a hybrid instrument under part 34 is ''extremely complex and difficult to understand and to apply.'' It is clear from this and other Commission statements in that release that the primary cause of these problems is the so-called predominance test. We suggest that, in practice, the predominance test is an unnecessary requirement that can be eliminated. Doing so will result in an improved hybrid exemption that is easy to understand, straightforward in application, and legally certain.
The reason the predominance test can be eliminated is that part 34s requirements that a hybrid instrument be fully paid and that the maximum loss be limited to the amount invested are, in combination, more than sufficient to ensure that an exempted hybrid instrument is more securities-like than futures-like. The maximum-loss provision alone makes it unattractive to issue a highly leveraged, futures-like, instrument. With high leverage, a sudden small price decline could cause holders to lose more than their investment. The issuer either must hedge this possibility, passing the cost on in pricing the instrument, or fully disclose that there is a good chance that the issuer could suffer significant losses. Either alternative results in such an instrument being unattractive in the marketplace. Reputable experts on part 34 agree with this view.
Page 197 PREV PAGE TOP OF DOC We urge Congress to codify such a new and improved part 34 hybrid exemption.
2. Do not impose additional suitability requirements on hybrid instruments: Because so much attention is being focussed on swaps and professional markets, we are concerned that a qualified person, or eligible participant, standard appropriate for those markets might be applied to hybrids as well, forgetting that unlike swaps hybrid instruments that are exempt under the current part 34 exemption must be initially issued or sold subject to applicable Federal or state securities or banking laws to persons permitted thereunder to purchase or enter into the hybrid instrument.
It therefore is unnecessary to impose additional suitability requirements on hybrid instruments. To do so not only is unwarranted but would cripple the development of innovative hybrid instruments for the rapidly growing individual investor market.
3. Have Federal regulation preempt state regulation: Just as states are precluded from having jurisdiction over futures contracts regulated by the CFTC, Federal regulation of OTC derivatives should preempt state regulation. It is our experience that state securities regulators often are ill-equipped to evaluate a new OTC derivative or to set appropriate suitability standards. Unlike the traditional securities with which state regulators have experience, OTC derivatives often contain complex, on-going payment streams that do not yield to simple risk assessment.
When a state regulator does not understand a financial instrument, he or she simply sets a high, often inappropriate, and inflexible suitability standard based on the net worth of a potential investor. A flexible standard that takes knowledge, sophistication, and experience into consideration as applied by brokers under the NASD Conduct Rules would be far more appropriate. In other words, the know your customer standard provides adequate protection.
4. Mandate institutional continuity: The CFTC should be bound to a greater degree than it is under current law and practice by decisions made by previous incumbents. Under current practice, an applicant can be forced back to square one each time leadership changes (which can be quite frequent). This situation makes business planning and, when necessary, raising venture capital impossible, thereby stifling financial innovation.
Page 198 PREV PAGE TOP OF DOC 5. Allow a majority of CFTC commissioners to bring a matter to a vote: Under current CFTC rules, only the chair is able to do so. Thus, as was our experience, whenever the chair did not have the votes to support her position on an issue, she simply did not allow it to be voted upon.
6. Have only the issuer be ''on the hook'' if a hybrid instrument violates the CEA: Current CEA section 4(a) is so broad that a registered investment adviser with a client owning such an instrument and in theory the client as well are both exposed to the harsh penalties of the CEA. This makes it difficult or impossible for an issuer faced with ambiguities in the statute to offer an instrument in good faith and to allow the courts to decide whatever questions regulators or private litigants might wish to raise.
7. Have an inter-agency decision-maker to resolve regulatory disputes: A group, similar to the President's Working Group on Financial Markets, which would include senior officials of the SEC, CFTC, Treasury, and the Federal Reserve should in cases of regulatory uncertainty receive applications for new financial instruments and have the authority to decide how they should be regulated. No single agency should have a veto power over financial innovation in the United States.
8. Define ''futures contract'': Lastly, it is long overdue for Congress to define the concept of ''futures.'' Until recently, such a proposal seemed unrealistic. Now, there may be a consensus that the lack of any statutory definition, coupled with the small number of incomplete, unclear, and conflicting judicial pronouncements on the definition of futures, has created an unworkable situation that demands a legislative solution.
Drafting the complicated legislation necessary to bring U.S. commodities law into the new millennium is a daunting and challenging task. Nevertheless, it would be tragic if Congress did not seize this unique opportunity to take action. My firm, and whatever resources we can marshal, will be more than happy to suggest specific legislative language. Meanwhile, I will continue to find solace in Funds Law:
Page 199 PREV PAGE TOP OF DOC Governments will always do the right thing after they have exhausted all other possibilities.
Statement of Marc Lackritz
I am Marc Lackritz, president of the Securities Industry Association. I appreciate the opportunity to offer you SIA's views on a subject critically important to our membership: over the counter derivatives, specifically the recommendations contained in the November 1999 Report of the President's Working Group on Financial Markets entitled ''Over-the Counter Derivatives Markets and the Commodity Exchange Act''
When I last testified before this subcommittee in June 1998, the subcommittee was considering the appropriate response to the publication of then-CFTC Chairwoman Born's concept release on OTC derivatives (the Concept Release). Published over the objection of the other members of the President's Working Group, the Concept Release called into question the legal status of OTC derivatives, and threatened to destabilize financial markets and undermine a decade of Congressional efforts to promote financial innovation and enhance the competitiveness of the U.S. financial sector. As SIA and others recommended, Congress averted a potential disaster by enacting emergency legislation imposing a moratorium on further CFTC action.
In sharp contrast to the Concept Release, the President's Working Group Report represents a constructive, responsible and practical set of solutions designed to resolve longstanding uncertainties associated with the Commodity Exchange Act that would ensure that U.S. markets remain at the vanguard of financial innovation for years to come. Importantly, its policy recommendations are supported by all the Federal financial regulators, and enjoy overwhelming support by market participants. SIA congratulates the President's Working Group for its efforts and enthusiastically endorses its recommendations.
However, the report will be of little value if Congress fails to act on its recommendations. A failure to do so would impair the competitiveness of the U.S. financial sector and reduce the attractiveness of the U.S. as a financial center. Congress has the power to maintain this country's preeminent leadership position in the global financial markets by moving promptly to enact the report's recommendations, and SIA would be pleased to assist that effort in any way within our power.
Page 200 PREV PAGE TOP OF DOCI. SIA ENDORSES THE PRESIDENT'S WORKING GROUP RECOMMENDATIONS TO ENHANCE LEGAL CERTAINTY FOR OTC DERIVATIVES.
A. Qualifying bilateral swap agreements involving financial commodities, including transactions based on non-exempt securities, should be excluded from regulation under the CEA.
For years, market participants have been troubled by the legal uncertainties that have clouded the status of OTC derivatives. This problem is most acute in the context of swaps involving non-exempt securities, because the CFTC lacks statutory authority to exempt these
contracts from prohibitions contained in the CEA. This situation has increased legal risk to parties using these otherwise desirable and legitimate products and encouraged them, where feasible, to execute such transactions outside the United States.
The President's Working Group recommendation to exclude qualifying bilateral swap agreements involving financial commodities from regulation under the CEA is a practical, common sense solution to the legal certainty issue that is consistent with the broader policy framework for financial market regulation. The exclusion for bilateral swaps is consistent with the Treasury amendment exclusion of certain financial products from regulation under the CEA, and will enable the OTC derivatives markets to flourish and foster financial innovation in the United States. Transactions by institutional market participants in these products do not generally give rise to the price discovery, manipulation and public customer protection concerns addressed under the CEA.
B. SIA agrees that the CFTC's authority to exempt hybrid instruments that reference non-exempt securities should be clarified.
Hybrid instruments are exempt under current CFTC regulations only if they are predominantly securities or bank products. Because these instruments should be and are regulated by other regulators, their status under the CEA should be clear. However, in the case of hybrid instruments involving non-exempt securities, the CFTC lacks the authority to provide comprehensive exemptive relief. SIA agrees with the President's Working Group that the CFTC's authority to exempt from the CEA hybrid instruments involving all securities should be clarified.
Page 201 PREV PAGE TOP OF DOC In addition, SIA recommends that Congress codify an exclusion from the CEA similar in scope to the CFTC's current exemption for hybrid instruments. The Hybrid Exemption has been in effect for 7 years and has worked well. We are aware of no evidence of abuse or regulatory problems presented by these instruments. We believe that a Congressional codification of this exemption is the appropriate means for establishing the jurisdictional status of these instruments. We would be pleased to work with the President's Working Group and the committee in assisting that process.
C. SIA agrees that the electronic trading of qualifying OTC derivatives should be excluded from the CEA.
Despite the numerous advantages of electronic trading systems, four market participants in the United States cannot take full advantage of these technological innovations. An attempt to make use of some of these newer, more efficient systems may transform a perfectly legitimate OTC derivatives transaction into an illegal off-exchange futures contract. This fear has severely inhibited the use of such systems in the United States, even as their use overseas proliferates.
As the President's Working Group recommends, given their manifest benefits Congress should encourage the use of electronic trading of OTC derivatives and eliminate the impediments to such trading arising from the CEA. As the world's leader in technology, it is surely ironic that U.S. market participants are inhibited by the CEA from making use of innovative trading platforms. Failure to adopt the President's Working Group recommendation on electronic trading will materially disadvantage the U.S. financial community.
D. The use of clearing should not subject otherwise excluded OTC derivatives to CEA regulation; Clearing should be appropriately regulated.
Clearing of OTC transactions should be encouraged since it allows mutualization of counter-party credit risk, which in turn reduces systemic risk. However, the CEA currently discourages clearing, because arranging to have a trade cleared may subject an otherwise excluded or exempt transaction to regulation under the CEA. SIA agrees with the President's Working Group that clearing should not alter the legal status of the transaction being cleared.
Page 202 PREV PAGE TOP OF DOC Further, SIA welcomes clarification of the CFTC's authority to regulate clearing independent of the regulatory status of the product being cleared. SIA believes clearing of OTC products should be regulated by an appropriate domestic or foreign authority.
E. Treasury amendment products should be excluded from regulation under the CEA unless conducted on an ''organized exchange.''
The President's Working Group report affirms Congress's original intent in enacting the Treasury amendment in 1974, specifically that the banks, broker-dealers, and well-capitalized institutions that comprise the foreign exchange and government securities markets do not require and would not be benefited by the protections afforded under the CEA.
By replacing the term ''board of trade'' with ''organized exchange'' as the President's Working Group recommends, Congress will go a long way toward minimizing legal disputes and preempting future litigation in this area. Treasury amendment products are now among the deepest, most efficient, most liquid, and most important financial markets in the world, and should not be subject to constraints or legal uncertainty under the CEA.
II. SIA SUPPORTS THE SEC/CFTC DIALOG ON SHAD-JOHNSON
SIA continues to believe that the most important issue for Congress to resolve in this area is the legal uncertainty affecting OTC derivatives and hybrid instruments involving non-exempt securities. Accordingly, we do not believe that resolving that issue should be postponed until all of the issues involving the trading of single stock futures have been decided. SIA does not believe single-stock futures should be prohibited by law. However, before these products could be permitted to trade, an examination of the appropriate regulatory infrastructure for them would have to undertaken, addressing many important issues, such as the integrity of the underlying securities market and questions of regulatory arbitrage. SIA agrees with the President's Working Group that an interagency dialogue, including the other members of the President's Working Group, is the appropriate process for resolving the complex regulatory issues presented by these products. SIA looks forward to the results of that dialogue and stands ready to provide whatever assistance it can in resolving the issues involved.
Page 203 PREV PAGE TOP OF DOCIII. CONGRESS SHOULD ENACT LEGISLATION IN ACCORD WITH THE PRESIDENT'S WORKING GROUP REPORT'S RECOMMENDATIONS THIS YEAR
SIA concurs with the President's Working Group Report's conclusion that the need for changes in the CEA to enhance legal certainty for OTC derivatives and remove barriers to innovation posed by the CEA is compelling. The problems engendered by the CEA are real and are exacerbated by the increasing globalization of financial markets. Now that the agencies with the relevant expertise have recommended a prudent course of action, Congress should not delay in enacting those recommendations into law. Markets can migrate overnight, and once gone
from our shores and ensconced in a new, more hospitable legal environment, may not return. SIA urges the subcommittee to take the lead in moving Congress to resolve these long standing issues this year.
Conclusion. SIA is greatly encouraged by the President's Working Group Report. The fact that the constituent members of the working group, notwithstanding historical differences in views, could reach such a broad consensus on so many important issues is a testament to the seriousness with which they undertook their work. We respectfully request that Congress now move in the same cooperative spirit to enact the report's recommendations. SIA stands ready to assist the Agriculture Committee in any way we can in moving to the enactment of responsive and responsible legislation this year. Thank you for the opportunity to be heard on this important issue.
Statement of the Managed Funds Association
Managed Funds Association (MFA) appreciates the opportunity to submit its views concerning the recent report of the President's Working Group on Financial Markets on Over the Counter Derivatives Markets and the Commodity Exchange Act (PWG Report). MFA commends the subcommittee for its interest in this critical and timely subject and looks forward to working with the subcommittee as it proceeds with its consideration of issues relevant to the reauthorization of the Commodity Futures Trading Commission.
Page 204 PREV PAGE TOP OF DOC MFA is the nonprofit trade association for the managed funds and derivatives industry, representing more than 700 participants in the hedge fund and managed futures industry. MFA's members are sophisticated investment managers and traders who, as intermediaries for the investing public, use domestic contract markets, foreign futures markets, the over-the-counter derivatives markets and cash markets. As substantial end-users of derivative products, MFA's members favor regulatory reform measures that foster access to the fullest range of markets, reduce transaction costs, and assure efficiency and fairness.
In brief, MFA is generally supportive of the recommendations of the PWG Report but believes that care must be taken in implementing these recommendations to assure that regulatory reform is not undertaken in a manner that diminishes access to or reduces the preeminence of United States derivatives markets as the largest and most liquid in the world.
Legal Certainty for OTC Derivatives. MFA endorses the recommendations of the PWG concerning legislation to exclude OTC financial derivatives from the Commodity Exchange Act. Establishment of a statutory exclusion from CEA regulation would, in our view, represent a major step forward in increasing the efficiency and competitiveness of the U.S. financial markets by creating, a clear statutory foundation for the legal status of these instruments. In defining the scope of such a statutory exclusion, MFA believes that the existing criteria defining eligible swaps participants for purposes of the CFTC's swaps exemption generally have worked well and should be carried forward into any statutory exclusion. In this connection, we note that PWG's suggestion that consideration be given to further restricting the extent to which individuals qualify for the exclusion by increasing the financial requirement for natural persons to $25 million in discretionary investments (from the existing $10 million in total assets) does not appear to be supported by any evidence or public policy rationale and would unduly restrict access to these important products. MFA strongly opposes the imposition of further restrictions to access to swaps transactions.
Page 205 PREV PAGE TOP OF DOC Regulatory Reform for Exchange Futures Markets. MFA also strongly supports the recommendations of the PWG for close review of the current regime for regulation of exchange traded futures transactions to eliminate requirements that do not serve a sound public policy purpose. Consistent with its concurrence in the recommendations of the PWG, the CFTC has undertaken a comprehensive regulatory reform initiative which would advance the objectives of the PWG both as to OTC and exchange-traded derivative products. MFA strongly endorses the PWG recommendation for regulatory modernization and applauds the CFTC's vigorous and creative efforts in that connection under the leadership of CFTC Chairman William Rainer.
MFA strongly supports these efforts to create a regulatory framework designed to serve the current marketplace and foster continued innovation in the 21st century. However, MFA believes that it is critical that regulatory reform be undertaken in a manner that promotes efficiency and liquidity in U.S. derivative markets and that does not compartmentalize market activity or result in subdivisions of existing or future marketplaces in order to achieve modernization of the regulatory structure. MFA believes that the goal of maximizing access to efficient and liquid markets should guide efforts to streamline regulation and that regulatory modernization does not require that U.S. markets pay the price of fragmentation into multiple markets defined by regulators rather than by the needs and interests of market participants.
In conclusion, MFA strongly supports the goals articulated in the PWG report and of the CFTC as articulated by Chairman Rainer and stands ready to assist in the effort to recreate the CEA and the CFTC to foster the competitiveness, efficiency and fairness of the U.S. futures markets. MFA appreciates the opportunity to submit its views and would be pleased to respond to any questions you may have and to assist the subcommittee in any way that it believes helpful during the conduct of its reauthorization hearings.