SPEAKERS CONTENTS INSERTS
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REGULATION OF THE OVER-THE-COUNTER DERIVATIVES MARKET
WEDNESDAY, JUNE 10, 1998
House of Representatives,
Subcommittee on Risk Management
and Specialty Crops,
Committee on Agriculture,
Washington, DC.
The subcommittee met, pursuant to notice, at 1:35 p.m., in room 1302, Longworth House Office Building, Hon. Thomas W. Ewing (chairman of the subcommittee) presiding.
Present: Representatives Smith of Michigan, Bryant, Foley, Chambliss, Moran, Condit, Bishop, Pomeroy, Baldacci, McIntyre, Etheridge, and Boswell.
Staff present: Paul Unger, majority staff director; Dave Ebersole, senior professional staff; Ryan Weston, acting subcommittee staff director; Gregory Zerzan, associate counsel; Callista Bisek, assistant clerk; Kathleen Zeidler, legislative fellow, and John Riley, minority staff consultant.
OPENING STATEMENT OF HON. THOMAS W. EWING, A REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS
Mr. EWING. The Subcommittee on Risk Management and Specialty Crops will come to order. I'm going to try to do my opening statement before going to vote.
I would like to welcome the witnesses to today's subcommittee hearing to review the regulation of the over-the-counter derivatives market. It has been slightly over 1 year since this subcommittee held hearings on H.R. 467, the Commodity Exchange Act Amendments of 1997. Many of the issues that we discussed during that time will be major topics again today. We're glad to have you back to continue our discussions.
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Recent events provide evidence that the derivatives debate continues. According to a GAO report, the notional amount of OTC derivatives market was $47.5 trillion worldwide as of March 1995. With the market of such considerable magnitude, prudent action is necessary.
The SEC's Broker-Dealer Lite proposal is a regulatory attempt to encourage firms to return certain derivatives business to the U.S. by establishing a limited voluntary registration and regulatory process.
On May 7, the Commodity Futures Trading Commission issued a Concept Release on over-the-counter derivatives requesting public comment on the CFTC's regulatory approach toward this market. Caution must be taken in discussing Government regulation as if it were the ultimate solution to issues within the derivatives market or any market, for that matter. Regulation is not always the solution. However, government oversight, particularly with respect to anti-fraud and anti-manipulation measures, is certainly appropriate.
I commend the SEC and the CFTC for their involvement in the issue. The SEC clearly understands the need to allow U.S. firms to effectively compete for derivatives business that has moved offshore. This is a prevailing theme through last year's House and Senate debate on Commodity Exchange Act reform with respect to U.S. futures exchanges.
I also commend the CFTC for their strong interest and initiative in the OTC derivatives markets. The Commission's acknowledgment that the changing market has produced new products is evidence to the fact that the underlying statute may need modernization. Indeed, the President's Working Group needs to get to work on financial services reform generally.
What concerns me is that regulatory actions to regulate these markets or attempts to modify the regulations may undermine the intent of Congress to allow additional exemptions and innovations in the OTC market.
This subcommittee passed the most recent legislation amending the Commodity Exchange Act with the passage of the Commodity Futures Trading Commission Reauthorization in 1995—the CFTC's fifth and most expedited reauthorization in the Commission's history. At that time, it was made clear that the subcommittee would retain the right to review and debate issues such as the uncertainty of Treasury amendment jurisdiction, the authority for the CFTC to exempt products that might otherwise be subject to regulation, and the need to do business in a manner that retains the futures industry's competitiveness.
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The scope of the Commodity Exchange Act is considerable. As I stated at last year's subcommittee hearing, this committee does not take its oversight responsibility lightly. We will be thoughtful and thorough in today's hearing. The information we gather will not only be important for today's hearing, but also for the next year's reauthorization process.
I would like to emphasize that this hearing will be about the overall regulation of the over-the-counter derivatives market, not one particular idea, rule, proposed rule, or concept release paper.
In 1993, the CFTC voted and approved to exempt certain swap agreements and hybrid instruments as well as certain energy forwards from the Commodity Exchange Act and from all CFTC regulations except that anti-fraud and anti-manipulation provisions would still apply. The Commission found that limiting trading in the OTC market to professionals and institutions addressed concerns regarding financial integrity and consumer protection consistent with the public interest.
It was also clear that many regulators would continue to be involved in the OTC market because of the jurisdictional interest of the underlying instruments used in the OTC market.
It is my hope that we will be able to address today what changes have occurred in the OTC market and what action or inaction may be appropriate for the good of the market and the public interest in the future. I look forward to the hearing and to your testimony.
Thank you very much. We will recess for just a moment.
Mr. SMITH of Michigan. Mr. Chairman, I ask permission to enter a statement into the record. If it's in order, I would like to submit for the record some questions to be put in the record. Could I do that?
Mr. EWING. Without objection.
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[Recess.]
Mr. EWING. Due to the time constraints, we're going to ask the witnesses to go by the 5-minute rule today, and the members also. The Chair would ask the witnesses to help with our time constraints by meeting that request. The Chair would also like to ask the witnesses to remain and be available for questions throughout the balance of the hearing, if at all possible.
The Chair would note that the Board of Governors of the Federal Reserve System, and the New York Stock Exchange, and the National Grain and Feed Association have also submitted written testimony for the record.
[The statements appear at the conclusion of the hearing.]
Mr. EWING. The first panel is Ms. Brooksley Born, the Chairperson of the Commodity Futures Trading Commission.
Thank you for being patient and for waiting, and we would like to hear your testimony now.
STATEMENT OF BROOKSLEY BORN, CHAIRPERSON, COMMODITY FUTURES TRADING COMMISSION
Ms. BORN. Thank you very much, Mr. Chairman, and members of the subcommittee. I'm very pleased to represent the Commodity Futures Trading Commission here today to testify concerning the over-the-counter, or OTC, derivatives market. I ask that my written testimony be made part of the record.
Mr. EWING. Without objection.
Ms. BORN. It's particularly timely that this subcommittee has chosen to hold hearings on this subject. In recent years, the OTC derivatives market has grown dramatically in both volume and variety of products offered and has attracted many new end-users of varying degrees of sophistication. For these reasons, the Commission is currently examining the market and its own oversight to determine whether any adjustments of its regulations are necessary.
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Derivative instruments are contracts whose value depends upon, or derives from, the value of one or more underlying reference rates, indexes, or assets. Derivative contracts may be listed and traded on organized futures and options exchanges or privately negotiated between the parties. Derivatives executed off of an exchange or board of trade are referred to as OTC derivatives.
OTC derivatives are similar in structure and purpose to the exchange-traded futures and options. Like exchange-traded derivatives, OTC derivatives are used to perform a wide variety of important risk management functions. End-users employ OTC derivatives to hedge risks from volatility in interest rates, commodity prices, and other prices. OTC instruments can also be used to assume price risk in order to speculate on price changes. Participants in the OTC derivatives market include large institutions including mutual funds, pension funds, colleges and universities, government bodies, and individuals who have significant assets, as well as banks and other financial service providers.
The Commodity Exchange Act vests with the CFTC exclusive jurisdiction over futures and commodity option transactions. The reach of the act has extended to both exchanged-traded derivatives and derivatives that are sold over-the-counter. The act generally contemplates that futures and commodity options are to be sold through Commission-regulated exchanges which provide various kinds of safeguards.
Transactions in OTC futures and options, in contrast, generally have been prohibited except unless explicitly excluded or exempted from the exchange-trading requirements of the act. Throughout the years, the Commission's enforcement docket has included numerous proceedings against trading in OTC derivatives that were outside the scope of any exemption or exclusion.
The CEA specifically explicitly excludes certain types of OTC derivatives from the requirements of the act. The so-called Treasury amendment provides that the CEA does not apply to over-the-counter transactions in foreign currencies, government securities, and certain other financial instruments. Options on securities and options on securities indexes also are excluded from the act and are subject to the jurisdiction of the SEC.
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In addition, the Commission itself has exempted certain types of OTC derivative transactions from the act. For example, under 4(c) of the act, which was adopted in 1974, the Commission has the authority to allow options to be traded over-the-counter under such terms and conditions as the Commission may provide.
The Futures Trading Practices Act in 1992 added section 4(c) of the act, which gave the Commission authority to exempt futures transactions from certain provisions of the act including the requirement that they be traded on exchange. That section explicitly authorizes the Commission to exempt swap agreements and hybrid instruments either unconditionally or on stated terms or conditions.
Pursuant to that section, the Commission adopted regulations in 1993 exempting certain swap agreements and hybrid instruments from some, but not all, provisions of the act subject to specified terms and conditions. Part 35 of the Commission's Regulations exempt certain swaps from provisions of the act other than the anti-fraud and anti-manipulation provisions, and section 2(a)(1)(B), which is part of the Shad-Johnson Accord. To be eligible for exemptive treatment, the swap must be a swap agreement as defined by the rule: it must be entered into solely between certain defined eligible swap participants; it must not be part of a fungible class of agreements that are standardized in their terms; it must include as a material consideration the credit-worthiness of the parties to the obligation; and it must not be entered into or traded on or through a multilateral transaction execution facility.
The CFTC has been engaging in a comprehensive regulatory reform effort designed to update, to modernize, and to streamline its regulations and to eliminate undue regulatory burden. Our review of our regulatory system would be incomplete in an important respect if we did not address the Commission's rules on OTC derivatives.
The 5 years since the Commission adopted those rules have been characterized by dramatic growth in the volume and value of the transactions. Furthermore, the structure of the OTC derivatives market has changed significantly, creating a potential divergence between the Commission's regulations and the realities in the marketplace. For example, since 1993 the proliferation of OTC instruments has resulted in broader participation in the swaps market, encompassing new end-users of varying degrees of sophistication, and raising questions whether the Commission should broaden the definition of eligible swap participants contained in its current rule, and whether record keeping, sales practice, or other protections may now by appropriate.
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The swaps market also has experienced a proliferation of new products and proposed new trading systems. While the part 35 exemption does not extend to swap agreements that are part of a fungible class of agreements, swap agreements have been increasingly standardized, indicating a need to consider broadening the exemption under appropriate terms and conditions. The swaps exemption does not permit clearing of swaps or trading through exchange-like systems, but developments in the marketplace have indicated a significant demand for both. Clearing and execution facilities would pose regulatory issues concerning systemic risk and price discovery that are not involved in privately negotiated, bilateral off-exchange transactions. Moreover, any consideration of permitting clearing and execution facilities must take into account the need to promote even-handed regulation and fair competition between any such new facilities and the existing futures and option exchanges.
Another factor suggesting a need to review the Commission's rules is the number of large, well-publicized financial losses in the OTC derivatives market since the rules were adopted. Concerns have been raised concerning the effect of such losses on the investing public and on the financial system as a whole. Allegations of serious sales practice abuses by OTC derivatives dealers have been made in recent years in a number of cases involving major losses by derivatives end-users including Proctor and Gamble; Gibson Greeting Cards; Orange County, CA; and the State of Wisconsin Investment Board.
Obviously, regulation cannot eliminate market losses, but under the circumstances we thought it was appropriate to solicit information regarding industry practices to assess whether they merit a regulatory response.
To examine whether its regulatory framework relating to OTC derivatives remains appropriate in light of these recent market developments, the Commission issued a Concept Release on OTC derivatives a month ago.
The Concept Release seeks public comment on whether the Commission's current exemptions for swaps and hybrid instruments remain appropriate as to the definitions of eligible transactions and eligible participants and the prohibitions against fungible swaps, swaps clearing, and transaction execution facilities. It asks whether the current prohibitions on fraud and manipulation in swaps transactions are sufficient to protect the public, or whether the Commission should consider terms and conditions relating to registration, capital, internal controls, sales practices, record keeping, or reporting.
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The Concept Release does not propose any modification of the Commission's regulations, nor does it presuppose that any modification is needed. The Commission is open to evidence in support of broadening its exemptions, evidence indicating a need for additional safeguards, and evidence for maintaining the status quo.
In the event that the Commission determines that proposed regulatory changes are needed, such proposed changes would first be published for public comment before any final rules would be considered for adoption. Moreover, any evidential changes which impose new regulatory obligations would be applied prospectively only.
The Concept Release explicitly states that it does not, in any way, alter the current status of any instruments or transaction under the act. All currently applicable exemptions, interpretations, and policy statements issued by the Commission remain in effect and may be relied upon by market participants.
In sum, the Commission believes that the Concept Release is an appropriate and responsible regulatory step to assure that its regulations stay abreast of changes in the marketplace.
Thank you very much, Mr. Chairman. I would be happy to answer any questions.
[The prepared statement of Ms. Born appears at the conclusion of the hearing.]
Mr. EWING. Thank you for your testimony.
Your written testimony did not include any views on the joint legislative proposal sent to Congress last Friday by the Treasury and SEC, the Federal Reserve Board of Governors. Do you have any concerns about that proposal that the subcommittee should be made aware of?
Ms. BORN. I do. The Commission did not see that draft legislation until last Friday and, therefore, did not have time to include comments in our testimony which was filed on Monday. Nor had we been consulted about it prior to our having seen it. The Commission, therefore, has not had time yet to formulate its views as a Commission, but I can give you some preliminary personal views of my own.
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I am very concerned about section 3 of the draft legislation which would have the highly unusual effect of stopping all Commission regulatory action on swaps and hybrid instruments that are currently eligible for exemption for an extended period. I think the scope of section 3 is far from clear and might well create some legal uncertainty. However, I think that it could well be construed to have the following effects.
First of all, it obviously would tie our hands from reacting to a market crisis or financial emergency. As you are all aware, there have been some very big losses, for example, by U.S. institutions in connection with derivatives related to the Asian financial instability. If there were a crisis in this market, the Commission could not respond if this act were adopted with any meaningful action because our hands would be tied.
Moreover, as I read section 3, it would even prevent the Commission from enforcing the fraud and manipulation prohibitions that are applicable to exempted swaps. We would not be able to issue a cease and desist order relating to a case like the Bankers Trust case that involved fraud in over-the-counter derivatives. We would not be able to issue our order in the Sumitomo case which we recently did with respect to the over-the-counter derivatives that were part of that enormous manipulative scheme of the U.S. copper market.
I think that the draft legislation would also prevent the Commission from adjusting its regulations to reflect new developments in the market. For example, as I've said, the exemption currently prohibits clearing or exchange trading of swaps. The draft legislation might, as I read it, limit us from adopting a regulatory scheme under which swaps clearing or exchange trading would occur. The effect would be either that innovation in the marketplace would be stifled, or unregulated exchange trading in swaps would develop in competition with the regulated exchanges and in violation of our act.
These are some, but not all of my concerns. I'm also concerned that section 3 would change current law significantly as it applies to the prohibition against futures on equities securities. It would lift that ban for the over-the-counter market, but would not lift the ban for exchange trading. I think that consideration of both would be only equitable.
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Mr. EWING. I guess then it would be, I could summarize that you're very concerned about the impact this would have on your regulatory authority?
Ms. BORN. Indeed. I think it would eliminate a significant part of our authority.
Mr. EWING. The next question that it brings me to is what is happening in the President's Working Group? The President has set up a Working Group with yourself, with the SEC, with the Federal Reserve, with the Treasurer. Are you not communicating down there? Was there any conversation about your concept paper? What happened that such a serious rather rift between administrative agencies has occurred?
Ms. BORN. Well, as you may know, the President's Working Group was set up in 1988 by President Reagan to do a study on the 1987 market crash, which it did, and then fell into disuse until about 1994 when Secretary of the Treasury Lloyd Bentsen informally called the group together to discuss cross-jurisdictional issues.
In the 22 months since I've been a member of the Working Group, we've had five meetings of the Working Group; two of them focused on the legislation that was introduced last year by you, Mr. Chairman, and by Senator Lugar and others on the Senate side. And we had a third meeting that dealt with the CFTC's Concept Release. We had provided copies of the Concept Release before issuance to all the members of the Working Group. There had been discussion at both the staff level and the level of the principals on that.
Mr. EWING. Had concerns been raised, though, about the concept paper?
Ms. BORN. I was told that the CFTC did not have any statutory jurisdiction over the over-the-counter market, and that our jurisdiction was limited to exchange trading only. I then asked for any kind of legal authority to support that position, a legal memorandum that that opinion had been based upon. I never received one.
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Mr. EWING. Wouldn't it appear, though, that something as important as this type of regulatory activity should come out of a group like that with some continuity, with some agreement as to how to proceed?
Ms. BORN. Well, there has been no tradition of doing that in the Working Group. Earlier we had asked that the Working Group consider the SEC's proposed rule on OTC derivatives dealers, and there was no meeting ever held on that issue.
The Office of Thrift Supervision is considering comprehensive revisions of its rules on derivatives. There's been no meeting on that. There was no meeting on the FASB rules on derivatives reporting or accounting. There has not been a tradition of discussing those issues since I've been on the Commission.
Mr. EWING. I just want to ask one further question before I go to my colleagues.
And, you mentioned some of the losses that you felt your involvement, your oversight, had been able to identify and take some action on. Would it be fair to say that considering the size of the OTC market, that the amount of losses that we have experienced has been rather—percentage-wise—very low? And that there would always anticipate there would be some losses in business such as the over-the-counter markets conducts?
Ms. BORN. Well, of course, there are always losses in any derivatives market since it's a zero-sum game. For every dollar somebody makes, somebody else loses a dollar. So you expect enormous losses in an enormous market. Our concerns are more broadly when there are allegations that losses are occurring because of sales practice abuses, because institutions are being urged to go into transactions without a full understanding of the risks involved, and also whether losses may be so large because of lack of proper internal controls that the financial system may be, in some way, endangered.
There's been a history of some very, very large losses both on-exchange and off-exchange. And as our testimony states, in connection with the Asian instability, there have been reported some hundreds of millions of dollars of exposure on the parts of institutions like J.P. Morgan and Chase. And there are reports as recently as Monday's Financial Times that in Indonesia alone, there may be exposure by international banks who non-performing derivatives contracts in the range of $9 to $15 billion dollars.
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Mr. EWING. Thank you.
Now I'll go to Mr. Condit, our ranking member.
Mr. CONDIT. Thank you, Mr. Chairman, and thank you for holding this important hearing and collecting this information so, hopefully, we can at some point be sure to resolve this issue.
I do have a statement that I'd like to submit for the record, and then I'd like to ask a couple of questions.
[The prepared statement of Mr. Condit follows:]
Prepared Statement of Hon. Gary A. Condit
Mr. Chairman, thank you for holding this important hearing regarding the current state of Federal regulation of over-the-counter derivatives. Today's testimony will build on the excellent record complied by the Subcommittee last year and assist the Subcommittee in coming to an understanding of the state of derivatives markets in our Nation today.
Mr. Chairman, by any measure U.S. derivatives markets—both exchanges and over-the-counter—are tremendous assets to our economy. With all of its shortcomings, our regulatory system has allowed these markets to grow side-by-side, to be increasingly valuable as hedging and investment tools, and to serve as an important component of the system through which American firms and firms from around the world raise capital to do business.
Acknowledging these successes, we have the oversight responsibility to ensure that our laws and regulations facilitate a business atmosphere that provides appropriate protections to end-users without being unduly burdensome to those who provide market making services.
Mr. Chairman, the issues we consider today have their source in incremental changes made in the Commodity Exchange Act over many years, and in dramatic and significant changes which have occurred in the trading of derivative instruments. While both OTC and exchange markets have thrived, the Act itself does not necessarily accommodate every change in legitimate market practice. For these reasons, it is crucial that we on the Committee and the agencies which have charged with executing regulatory statutes engage in a constant practice of guaging the relevance of our laws and regulations to evolution in the marketplace.
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Mr. Chairman, taken by itself, the Concept Release issued by the CFTC appears to conform with the imperative for regulators educating themselves about market changes. The very agencies which are expressing concern with this information-gathering process each supported the Commission's action to exempt swaps and hybrids from the Commodity Exchange Act in 1992. From the start, the exemptive rules were made subject to conditions which proposed properly and subjected to the scrutiny of the public comment process. The Treasury, SEC, and Fed challenges to the comprehensive, measured request by the CFTC for comments on the continued relevance of the exemptive rules are puzzling. Clearly, to the extent that firms are now striving to comply with the terms of an exemption and find them overly restrictive, the Commission's information gathering process provides a forum to reveal those concerns and seek redress. To follow the wishes of their sister agencies, the Commission apparently must forever preclude itself from addressing such problems.
Mr. Chairman, the problem, of course, is more subtle and appears to be grounded in the inability of these agencies to communicate effectively with each other. I hope that our hearing today will awaken the government agencies represented to the real and important issues affecting our financial industries, and that they will resolve themselves to work together—given the statutes currently in place—to develop rational, efficient, and coordinated regulatory policies for our Nation's valuable financial services industry.
Mr. CONDIT. It seems to me the problems that we're now faced with is the appearance is that—be grounded in the ability—in the inability of the agencies to communicate with each other. And given that perception, I know that the Working Group asked you to sort of slow down or stop your study so that you could work together.
It seems to me, at a minimum, just as a practical matter, although you cited all the cases where it has not been done before, that you didn't need their approval to move on, it seems to me, given what's going on and the emotional involvement in this thing, is that you would have sort of run your study by the Working Group. Did you consider that, think about that? And why did you make a decision not to do that?
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Ms. BORN. We did discuss this at a staff level and at a principals level with the Working Group. We provided advance copies of the Concept Release and took comments from other members of the Working Group. Other members of the Working Group are, as I said, proceeding with their own regulatory changes. The SEC—which has jurisdiction over over-the-counter options on securities and options on securities indexes has been said by the GAO to have jurisdiction over approximately 1.4 percent of the over-the-counter derivatives market—proposed broad new rules for OTC derivatives dealers with very little advance consultation with us and no showing to us of an advance draft. The proposed rule which was issued over the Christmas holidays would adopt for the first time, a comprehensive regulation of over-the-counter derivatives dealers which would extend beyond the 1.4 percent of the transactions that the SEC has jurisdiction over to, for example, commodity options and commodity swaps and other instruments that we believe are within the exclusive authority of the Commodity Exchange Act.
We would not have been so concerned about that had the SEC acknowledged the applicability of our exemptions and the terms and conditions of our exemptions. However, they had provided in their proposed rules that their over-the-counter derivatives dealers would be able to trade in certain swaps and hybrid instruments that would not have complied with our exemptions' terms. They would have been able to trade by the terms of those proposed regulations in things that would have been illegal under our regulations and under the act.
As I've said, I'd ask that that be discussed before the President's Working Group, but it has never been put on the agenda.
Mr. CONDIT. You asked for it to be put on the agenda?
Ms. BORN. Yes, I did.
Mr. CONDIT. So, if they didn't get an opportunity to go through it thoroughly, it's no fault of yours. You've made a request for them to do it?
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Ms. BORN. That's correct.
Mr. CONDIT. Let me move on. And the Treasury Department has suggested that there's a need for emergency legislation based upon the publication of the CFTC, Concept Release, what emergency crisis is in the market? And what evidence do you have to substantiate such a finding?
Ms. BORN. None whatsoever. I am not aware of any kind of crisis. The Concept Release asks questions about the Commission's own regulations. It has no proposal in it. It takes no action by the Commission. It explicitly states that the legal status of each and every transaction is unchanged by the Concept Release and that all exemptions and previous statutory interpretations and policies continue to apply.
It also says that if, as a result of comments that we received from the public as we've requested, the Commission were to contemplate any proposed rules, such rules would go through a normal rule-making proceeding being put out for another public comment period. They would also, if they were at all restrictive as opposed to broadening, be applied prospectively only.
We see no kind of risk that would be posed here.
Mr. CONDIT. I was going to yield to the chairman, but I think you answered his question.
So you don't think this lack of legislation or the lack of a response in the short-term creates instability in the financial market?
Ms. BORN. We're not aware of any basis for that. This is a very large and a very robust and very dynamic market. We think that it will provide it with more legal certainty rather than less legal certainty if we examine whether or not our regulations remain relevant to the current state of the marketplace. And that this should be a healthy development for it. We do not think that it is so fragile that merely asking questions would disrupt or harm this market.
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Mr. CONDIT. OK, let me quickly ask you, the comment period expires the 13th of July; is that correct?
Ms. BORN. That's correct.
Mr. CONDIT. What is your next step?
Ms. BORN. Well, we have in a request, I should add, to extend the comment period another 60 days. I only saw it on Monday and have been busy preparing my testimony since then, so we haven't, as a Commission, addressed that request to extend the comment period another 60 days. Assuming that we do, that would take it into September to end the comment period. If we don't, the comment period would end in July.
There would then be a period of time during which the staff of the Commission, primarily our Division of Trading and Markets but probably other staff as well, would examine the comments and formulate a recommendation for the Commission as to whether any action is necessary, whether the comments confirm that our regulations are appropriate, whether they indicate a need for broadening the exemption, whether they indicate a need for any sales practice or other protections. And I would think that with that period of time and the vacation periods involved in late July and August, that it's unlikely that any kind of staff recommendation would come to the Commission until some time in September.
Mr. CONDIT. So, given September, it would be your opinion then as your relation to the CFTC authorization, that maybe we could get into the next Congress before we take that up if you're that late in the year?
Ms. BORN. To take up the legislation, you mean?
Mr. CONDIT. The reauthorization.
Ms. BORN. Yes, the reauthorization should be taken up next year.
Mr. CONDIT. I'm also incorporating this new rule in that. It just keeps——
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Ms. BORN. Well, I'm not at all sure that there will be a new rule. As we've said, this is merely asking questions about whether or not our current rules are adequate in light of all the dynamic changes in the marketplace. I think it's at least as likely that they are, as that they aren't.
Mr. CONDIT. It seems to me though, if it is likely that you're going to have a new rule that since you're going to do reauthorization, then the next Congress would be an appropriate time to sort of think about it putting it together, wouldn't it?
Ms. BORN. Well, we could certainly consider that.
Mr. CONDIT. Thank you for your time and your indulgence; I appreciate it.
Mr. EWING. Mr. Bryant.
Mr. BRYANT. Thank you, Mr. Chairman.
Madam Chairperson, thank you for appearing today and, Mr. Chairman, thank you for holding these hearings.
If I might just pick up at the end and follow my colleague's chain of questioning. I guess it's one of the concerns that I have in this, and I don't know that I have heard from you a clear commitment. But certainly with Congress moving toward recess and adjournment into the next Congress, there is some concern that action on the Commission's part might be taken during the time that we're away from Washington. And I think that is in part the reason for this bill, and perhaps even a condition that some might call a potential emergency situation. And so that's—I don't know, can you make that type of commitment to us today that the Commission would not take this up until Congress returns, or are you not comfortable doing that?
Ms. BORN. Well, of course, I can't commit for a four person Commission because it takes that vote, but certainly I don't think there is any intent at all to act without Congress being fully aware and being involved in this process. Indeed, I would welcome the comments of each and every member of this subcommittee and your constituents with respect to our Concept Release. And on an ongoing basis, we'll certainly keep this committee notified about our thinking.
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Mr. BRYANT. Well, I appreciate that courtesy. Again, the problem that we have is that the committee won't be here at the end of the year or the early part of next year. I am I guess from my standpoint, particularly impressed with the legislation and particularly those folks, the Secretary, Mr. Greenspan, and Mr. Levitt; all three are very supportive of this legislation. And I was here when you testified just a few moments ago about some of the—again, given you haven't had a long period of time to review the legislation thoroughly—but just two or three of the points that do cause some concern. Would it be your position today to actually, knowing what you know about this bill, to oppose it?
Ms. BORN. Personally, yes. Although as I said, the Commission has not had an opportunity to act as a Commission on it. Nor has our staff given us any kind of in-depth evaluation yet. I think it would be extremely dangerous and risky to tie the hands of any of the regulatory agencies about this market at this stage, because I think there are a lot of risks potentially out there that all the agencies involved may need to be able to respond quickly to. I would hate to think that we would be unable to act if there was a need.
I also think that to pass a bill that would prevent the Commission from going forward with the enforcement investigations and enforcement proceedings against massive manipulations or fraud in the over-the-counter derivatives market which has always been reserved by the Commission, would be extremely dangerous. Nobody else has jurisdiction over that among the Federal regulators.
Mr. BRYANT. Let me just close and thank you for your comment there by expressing or echoing what Chairman Ewing and Mr. Condit mentioned in terms of addressing an apparent lack of communication out there, again with the Working Group, because what this Concept Release has done, I think, has been the driving force behind this legislation. It certainly has the attention of Mr. Rubin, and Greenspan, and Mr. Levitt, Members of Congress, and certainly you've gotten our attention.
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So, that's our concern here, and couple that with the fact that we will be leaving Washington, that we are just—there are an awful lot of bright people out there who are concerned about this and the stability of the market. So, that's where we're coming from in this. And given your situation where you're not in a position to make a commitment, I think I will probably be in support of this at this point.
And with that, I will simply yield back my time. And thank you for coming once again.
Mr. EWING. Thank you very much, Mr. Bryant.
Mr. Pomeroy.
Mr. POMEROY. Madam Chair, I have great respect for you and your work. I think the Wall Street Journal article recently favorably captured what really is a very impressive track record of leadership in the CFTC before leaderships in the past for a good while, and I commend you for that.
I also have considerable respect, of course, for Secretary Rubin, Chairman Greenspan, Chairman Levitt. And so here we are in this quandary where you get a whole bunch of people you respect disagreeing with one another. I guess I'd think that the Concept Release document is overly broad and has raised questions beyond what you ever intended, provoking a bill that, in its own response, may be overly broad and having a reach that maybe goes beyond what the drafters intended as well.
It doesn't seem to me that all of this was necessary at all. While we have, perhaps, the legislative jurisdiction to resolve the dispute between the four of you, we certainly don't have even a smidgen of the expertise that the four of you represent, and it's regrettable that it would come to this forum for this kind of resolution.
The issues, I think, I just think this is very tantalizing little glimpse of what's going to come to the Agriculture Committee as the CFTC is up for reauthorization next year. I do think that that could be the optimal time to in-depth weigh-in to this whole matter.
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I am concerned about the Concept Release document being unnecessarily provocative. One of the—as an old insurance commissioner—one of the things we never, ever did was sit around in public forum and discuss the solvency of given insurance companies, because the raising of questions about the solvency of the insurance company indeed had an impact on the solvency of that insurance company.
I'm worried about the Concept Release document triggering the public discussion, which today's hearings represents, about the outer reach of over-the-counter derivatives that might raise question to whether they're appropriately an over-the-counter derivative or a future. And indeed, if they could be determined to be a future, whether or not the underlying legal obligation would be an enforceable one on that derivative. I'll try and say that again a little more clearly. Discussing this issue in public could cause ramifications for derivatives to the extent that it begins to be any kind of fuss, that maybe some of the derivatives are futures and, therefore, not enforceable.
Ms. BORN. Well, Mr. Pomeroy, the Commission acted in 1993 to exempt these transactions from the exchange-trading requirements of the act——
Mr. POMEROY. Under specified circumstances.
Ms. BORN. To the extent that it meets the terms and conditions of the exemption that's pursuant to a provision that was adopted in 1992 that explicitly says that the Commission may exempt non-fungible swaps transactions from the act pursuant to the terms and conditions that the Commission finds meet the public interest.
The Commission did that in 1993, and what we're trying to ascertain now is whether that exemption essentially still meets the needs in the marketplace or whether the marketplace has gone beyond that. For example, we are getting requests to permit swaps clearing or exchange trading of swaps. That's explicitly forbidden under our exemption. If a swaps clearing facility were created, for example, without broadening our exemption, would be illegal. One is going forward in London right now, and we don't want our people in the United States to have their hands tied in being able to go forward here as well.
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Mr. POMEROY. The fundamental question is, is this look by the CFTC about the evolution of the market and its ramifications for CFTC reauthorization in 1999? Or is it about some determination as to the status of existing agreements entered into under the assumption they were derivatives but potentially to be determined to be futures?
Ms. BORN. It's clearly not about the legality of current transactions, since we have said that all of our current exemptions and interpretations that provide safe harbors and that sort of thing are ongoing and applicable, and that any changes would be prospective. Mr. POMEROY. The rationale behind the other three in the Working Group, as I understand it, is as to if maybe any determinations that might have retroactive applicability. And I read here from the testimony that Chairman Greenspan submitted, if significant volumes of OTC derivatives were determined to be illegal and unenforceable under the CEA, potential losses to counterparties, including large U.S. banks that are leading derivatives dealers, could be so large as to pose a threat to the financial condition of those counterparties.
Now obviously that's alarming to us as we try to evaluate it.
Ms. BORN. Well, that certainly has nothing to do with the Commission's mission here. If we felt that there were large-scale illegal transactions, that might be appropriate for enforcement action, but that's not what's being proposed here. What's being proposed is a forward looking examination of whether our regulations are appropriate for the market of today and tomorrow.
Mr. POMEROY. Could that Concept Release document be written in such a way that made that more clear so we wouldn't have this——
Ms. BORN. That's explicitly stated in the Concept Release.
Mr. POMEROY. Thank you, Mr. Chairman.
Mr. EWING. Mr. Baldacci.
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Mr. BALDACCI. It seems to me there's a couple of questions. One, within your interpretation of the law, you feel that you are compelled under the law to take jurisdiction over what some have considered an expanded ruled in terms of what is a future or derivative action? Is that correct under what—you've been doing this for how long? Is there an official interpretation that you've accomplished?
Ms. BORN. Since the beginning of the act, it applied both to exchange trading and to over-the-counter instruments as well. And it started out as forbidding over-the-counter options and futures in an absolute way. And that existed for a number of years. In 1974 when the Commission was set up, the statute was amended. Prior to then, the USDA had been administering the statute. But in 1974, the statute was amended to give the Commission the power to permit OTC options to be traded subject to terms and conditions to be designed by the Commission. And we began to exempt certain limited types of OTC options.
Then in 1992, for the first time this Congress gave us the power to exempt futures from the exchange-trading requirement and other provisions of the act. And it was pursuant to the powers given to us in 1992 and 1974 that we adopted our exemptive rules in 1993 that permitted OTC derivatives to be traded.
Now prior to 1992, since we didn't have exemptive power with respect to futures, the Commission had entered into some policy statements saying that bilateral customized agreements between large institutional parties would not be as a practical matter regulated by the Commission under the full panoply of the requirements of the act, and we would put them into a safe harbor so that they could accrue. And it was pursuant to that safe harbor, I think, that the Congress realized we needed the exemptive power which we used.
Mr. BALDACCI. Madam Chairman, has there been set-down meetings with the Treasury, Federal Reserve, SEC, in terms of their suggestion that there might be a conflict with you and your committee?
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Ms. BORN. We shared copies of the Concept Release before it was issued with all of those agencies. There were various levels of meetings with staff and with the principals on the Concept Release.
Mr. BALDACCI. I'm familiar with the concern with currency devaluation or changes in currency and the need, if you will, for insurance dealing with the variable currency devaluation or possible changes in inflation. Or I suspect, you could even go into many other areas where eventually the market or some person is going to want to buy some assurance to, if you will, hedge variations that might affect any market whether it be monetary or a commodity market.
Ms. BORN. Let me just make clear that there are some aspects of the over-the-counter derivatives market that the act itself exempts, so that we haven't had to act to exempt it, and we've never had power over. That includes an exemption called the Treasury amendment which exempts all over-the-counter futures and options on foreign currency, Government securities, and certain other financial instruments specified by the Congress. So those are not being treated by the Concept Release whatsoever.
There's also a provision in the act that was adopted in 1982 as part of the Johnson-Shad Accord which was the jurisdictional division between the SEC and the CFTC that excludes from the act options on securities and options on securities indexes which are the derivatives areas that have been given to the SEC. So we also have no jurisdiction over OTC or exchange trading in options on securities or options on securities indexes. So those are not being discussed here at all by the Concept Release.
What the Concept Release is dealing with are the other kinds of derivative instruments which we have permitted through our exemptions subject to terms and conditions that we've imposed, and we're examining whether the terms and conditions remain relevant and appropriate.
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Mr. BALDACCI. Thank you.
Thank you, Mr. Chairman.
Mr. EWING. Mr. Bishop.
Mr. BISHOP. Thank you very much, Mr. Chairman, and I thank you, Chairperson Born.
And I, too, am somewhat scratching my head at the experts in this field who obviously are very reasonable men who are disagreeing at the Concept Release. And I'd just like to ask you, Chairman Born—it is my understanding that the Concept Release is merely a laundry list of questions about the over-the-counter market, and that it's an area over which the CFTC has jurisdiction. And in a prospective manner, I kind of want to know from your perspective if you can conceive of anything that is really wrong with the regulatory agency asking questions about an industry within its purview.
Ms. BORN. No, I think that, in fact, that is what the responsibility of a regulatory agency is. And it is part, as I said earlier, of an overall look by the Commission at its regulations as they apply to exchanges, as they apply to intermediaries, futures, commission merchants, and others, and as they apply to the over-the-counter markets to make sure that they're modern, in tune with the current markets, streamlined as much as we can, and we're making a real effort to try to alleviate any undue regulatory burdens that we find the protection of the public doesn't require.
Mr. BISHOP. Well, the legislation, I'm told, was born out of concerns for a crisis or an emergency. And in the area where I come from, emergencies or crises are generally considered very exigent circumstances such as floods, or tornadoes, or hurricanes, or train derailments, many of which we have experienced over the last few months in my area. And of course, the evidence would be obvious and incontrovertible that there is a crisis or an emergency. And even with those kinds of situations, it takes Congress sometimes an inordinate amount of time to respond in a way that can alleviate some of the real pain and suffering that our constituents and people across the country experience.
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In this particular situation, I frankly don't see an emergency of that type. What I see here is a regulatory debate, almost a pillow fight of turf concern. And I don't see the pain and suffering, and I'm wondering what the all of the hue and cry is about. Can you help me with that?
Ms. BORN. I'm afraid I'm as bewildered as you are. I am not aware of any emergency whatsoever in this market. If there were an emergency merely because a Government regulator asked questions about the market, you would think that the SEC's proposal to adopt a comprehensive regulatory scheme for over-the-counter derivatives dealers would have similarly caused a crisis. You would think that the Office of Thrift Supervision announced comprehensive revision of its regulations on derivatives would create that kind of an emergency, and that's never even been suggested, nor has there been a suggestion there's any need to delay those actions or put a moratorium on them.
Mr. BISHOP. Well, that was my next question. Isn't it true that most of the private sector supported issuance of the proposed SEC rule commonly known as the Broker-Dealer Lite which regulates the derivative product? My question is, do you have any indication as to why the industry would support the SEC regulation and yet have such a strong negative reaction to the possibility, and it's only the possibility then, from what I hear you saying. You know you've been talking enacting a regulation of CFTC regulation.
If the CFTC were to mirror a voluntary, incentive-driven type of proposed regulation that the SEC has already proposed, why wouldn't they be similarly supportive of such a concept? Do you have any opinion, indication——
Ms. BORN. I think part of the reason is as follows: unlike the CFTC, the SEC chose never up until now to deregulate the OTC derivatives trading that they had authority over. The General Accounting Office has said they have authority over about 1.4 percent of the transactions in this market. Those are options on securities and options on securities indexes.
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The SEC has, up until now, required those transactions to have the full panoply of protections including having a registered securities broker with all the requirements of a broker-dealer do the transactions. That's why that part of the market—not our part of the market, the commodities swaps and others—that's why that part of the market migrated in large part to England.
What the SEC is proposing now, and the reason they call it Broker-Dealer Lite is to lighten some of those regulations for OTC derivatives dealers who want to trade in securities options and securities index options who have a net worth of a $100 million dollars or more.
So this is a very small group of folks who would qualify for this reduced level. They could forego having to register as a full-fledged broker-dealer and instead register as an OTC derivatives dealer. They still would have net capital requirements; they still would have registration requirements. The sales practice requirements for the transactions within the SEC's jurisdiction would have all the same requirements as a security would, but it's slightly less than the broker-dealer. I think the important advantage is that they would go with a lesser standard of net capital. And they hope that that will bring back some of the business that was driven offshore.
I think the support for it is among the very large institutions which are only a handful—I think maybe less than 10—who might qualify for this kind of regulatory regime. And they approve it because it goes to our value at-risk type net capital approach, rather than the traditional net capital approach. And it would allow them to do these deals in this country without having to put it through their broker-dealer facility. All of them have affiliated broker dealers, I think.
Mr. BISHOP. But the essence of my question though, was, if the SEC was going to be allowed to propose and to mitigate these types of regulations without a declaration of emergency and the CFTC, on the other hand, was really raising some questions of the study for a prospective consideration, why would one be so supported and one would be so criticized? Especially the CFTC?
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Ms. BORN. I think that there is a large interest out there in not having the CFTC any longer have its traditional jurisdiction.
Mr. BISHOP. Well, would you adhere to the old adage that we had in Georgia when I was in the legislature that we ought to feed the SEC and the CFTC out of the same spoon?
Ms. BORN. Yes, and I would suggest at the same time, the Office of Thrift Supervision and the Federal Reserve Board and all the agencies who have rules regarding derivatives activity. You know there is a multi-agency interest here. Some of the players here are large securities broker-dealers. Some of them are large financial institutions, and obviously the banking regulators and the SEC have interest there.
Some of the OTC derivatives instruments are exempted from our act. The Treasury amendment transactions that are ceded to the Department of the Treasury and the two kinds of derivatives that are within the SEC's jurisdiction under our act are not within the scope of the CFTC's regulatory oversight so they have an interest in regulating those. So there's a lot of regulation by other Federal financial regulators.
I think it is important for the same rules to apply. I think it is important for there to be coordination. I think to apply a moratorium on one agency to tie its hands, while the other agencies go forward full-speed ahead to modernize their regulations and adapt them to the marketplace, is contrary to the kind of coordination and cooperation that should be going on.
Mr. BISHOP. Thank you very much.
Mr. EWING. Mr. Bishop, would you submit in writing the meaning of your Georgia saying so that all of us from the North will know how to interpret her answer. [Laughter.]
Mr. BISHOP. It's very simple. You just want to have a level playing field so that everybody's on the same ground.
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Mr. EWING. And that's what feeding out of the same spoon means.
Now we'll here from Mr. Foley.
Mr. FOLEY. Thank you, Mr. Chairman.
Madam Chair, you and Mr. Bishop elucidated that, ''what's all the fuss about?'', I think in part of your commentary. Now let me ask you, is it typical to ask 75 questions in the Federal Register as an informative point of view? Or is it something that would more indicate legislation on its way or rule-making about to take place?
Ms. BORN. We have in the last 2 years been engaged in a fairly comprehensive review of our regulations and have been trying to reach out to the participants in the market, to the other financial regulators, to Congress, and anybody who is interested for views on how we can best do that.
One of the mechanisms that we've been using on a fairly regular basis is the Concept Release. The Concept Release is a tool that is particularly useful for issues where the Commission has no preconceived notion as to whether regulations are needed, proposed rules were needed, whether changes in regulations are needed.
For example, we recently put out a Concept Release on what we called ''noncompetitive transactions.'' I get a lot of criticism for that term, but it is actually a statutory term as to whether we should expand the situations in which exchanges may allow off-exchange transaction to take place. For example, if big institutions want to place a very large trade that would be difficult to execute on the floor of the exchange and want to do it off exchange pursuant to exchange rules and then report it to the exchange, we've asked, ''Is that a good idea? Do we need to broaden existing limitations in our rules? Do we need to consider whether exchanges for physicals, which is a traditional kind of noncompetitive transaction that's been permitted, should be broadened, should have additional regulations, should be reconsidered in any event? And I think that may have had more than 75 questions.
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But we have other Concept Releases, and what they indicate is that the agency is far from ready, based on its own information, to propose anything or to even know whether it should propose anything.
Mr. FOLEY. Let me ask you to respond to testimony that we have not yet heard, but from the American Bankers Association. It says,
The ABA members are deeply troubled by the CFTC's Concept Release. It unilaterally disturbs the status quo of legal and regulatory certainty that has enabled the OTC derivatives market to thrive for the benefit of the United States economy. That status quo has been forged through the previous hard work of the CFTC, the committee, other regulatory agencies, and Members of Congress, and market participates. Now, however, by implicitly suggesting that it might reverse course on its own and treat the OTC derivatives as futures contracts, the CFTC has created the specter of unenforceable contracts, increased litigation, and burdensome new regulation. Our members believe that such unilateral action is fundamentally unwarranted, and they fear that the resulting specter will drive business and innovation away from the United States.
You said earlier in testimony, you did not want to tie their hands. We've heard that there's an emerging market in London for these types of transactions. Do you believe the statements as presented have validity?
Ms. BORN. No. I think it's a misunderstanding of the Concept Release. The Concept Release in no way changes the legal status of any of these instruments. In fact, it explicitly says that each and every statutory interpretation, exemption, and policy of the Commission is in place, and the participants in the market can continue to rely on that, that all we are doing is asking questions, and that if—but only if—we get to the point where the answers to those questions indicate a need for new regulation, then if the regulation was restrictive rather than exemptive—and we could certainly go either way—such new rules would go through a complete rule-making proceeding and would be prospective only. So I have no reason to believe that that interpretation of what we're doing has any validity.
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I should add that other regulators around the world have told me that they welcomed our Concept Release, that they think these are important questions, and it's an important time in this market that regulators around the world be asking these questions. And in at least three countries, since we issued the Concept Release, the regulators there have approached me and said that they hoped we could go forward and examine this market in a cooperative way to see whether or not regulators around the world are handling it appropriately.
Mr. FOLEY. Well, I would suggest there is obviously a changing dynamic around the globe in the way we handle our financial markets, so nobody is suggesting you shouldn't be exploring new avenues.
As Chair, do you have a personal view that more regulation is necessary in the OTC market?
Ms. BORN. I don't. I do feel that we may have to address swaps clearing and multilateral execution facilities which are currently forbidden. We have heard from a number of sources that there's a great deal of interest in having swaps clearing or some kind of exchange trading. That's currently forbidden.
I think that we mustn't be in a position where we are a block to developments in the market. On the other hand, I—and these are only my personal views; these aren't the views of the Commission as a whole—personally would be very concerned about just permitting swaps exchanges without any kind of regulatory regime to be created because I think they would be directly competitive with the futures and options exchanges. And I think they would pose exactly the same regulatory issues about price discovery, about the dangers of manipulation and fraud, about systemic financial risks from the marketplace, and so I feel that the time will come—it might be premature—when that issue is going to have to be addressed, one way or the other. I don't have a set notion as to how it should be. I think we need a lot of input on that.
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We know that the London Clearinghouse is planning a swaps clearing operation. I know that there are a number of U.S. entities that are interested in doing the same thing.
Mr. FOLEY. Thank you very much, Mr. Chairman.
Mr. EWING. Just a couple of closing matters, and we appreciate all the time you've given us. That there very likely will be some additional questions that we will submit in writing to you and to the other panels and ask for answers.
I do have to comment that I believe your concept paper has dominated the general discussion here today, and I had hoped for a broader discussion, but certainly it has created a lot of interest.
And just a couple of things in summary that come to me. I don't think we have shown the need for anybody—and you've said it in your own testimony—that there is a need for more regulation that we know of. I think that's a very important point. The second part is, while I believe that there is a lack of need at this point and that the concept paper has certainly caused a stir throughout the financial world here in the United States at least, that the legislation proposed could have devastating effects on your agency. And if we don't have a great need and we have legislation that might be more of a cure than we need, there must be some common ground, and I would like to think that when we're through here with this hearing, there will be certainty in the market, that we won't be concerned about regulations that maybe aren't addressing a need that we have identified, nor will we have legislation to hamper your agency. And that the Working Group should be brought in to play on this. And that probably we shouldn't have a new regulatory scheme here until either this committee has discussed it or the Working Group has come up with some type of agreement.
You know the Shad-Johnson agreement and the Treasury agreement were agreements. They weren't done by one agency over the other. They were controversial matters, and there was an agreement reached before it was put into affect.
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And I just think we'll see what the other panels say, but I hope that you will seriously consider that, Chairperson Born, because I think this is indeed a very grave situation that we don't want to get out of hand. And we want to see the CFTC move ahead with their regulatory duties, and we want to be sure that we're governing the market and watching it carefully. But we want to do it in a way that it is encouraging to the American market.
Thank you very much for being here.
Ms. BORN. Thank you very much, Mr. Chairman. And if I may, once the Commission has done an analysis of the Treasury Department's legislation, we would like to submit something in writing for the committee to consider.
Mr. EWING. Thank you very much.
Ms. BORN. Thank you.
Mr. EWING. The second panel, the Honorable John D. Hawke, Under Secretary of Domestic Finance, U.S. Department of Treasury; Mr. Richard Lindsey, Director of the Division of Market Regulations, Securities and Exchange Commission.
And we'll start with you, Mr. Hawke.
STATEMENT OF JOHN D. HAWKE, UNDER SECRETARY FOR DOMESTIC FINANCE, U.S. DEPARTMENT OF THE TREASURY
Mr. HAWKE. Thank you, Mr. Chairman. Mr. Chairman, if I may have my entire statement put in the record, I will summarize and try to address some of the key points that have been raised here today.
Let me say, first of all, that we don't underplay the importance of looking at these markets. We think it's an important thing to do. The question is, how and who should do it?
For the past 10 years, there's been an implicit consensus that the OTC derivatives market should be allowed to grow and evolve without deciding the difficult jurisdictional questions concerning the potential applicability of the Commodity Exchange Act to any of those transactions.
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Let me try to reduce this to what is probably an over-simplification, but the basic question that has hovered over this market for 10 years is whether swaps are futures. If swaps are not futures, again, this may be something of an over-simplification—but if swaps are not futures, the CFTC has no jurisdiction. If swaps are futures, the CFTC may have jurisdiction over part of the market, but they don't have jurisdiction to exempt another part of the market from the exchange-trading requirements of the Commodity Exchange Act.
So a lot turns on the decision as to whether swaps are futures or not. And for 10 years, there's been kind of an implicit agreement on the part of all parties not to resolve that question. The reason for the uncertainty that's caused today is that the CFTC's Concept Release implicitly decides that question, inescapably decides that question. They have asked 75 questions, the premise of which is that they believe that swaps are futures and, therefore, they have jurisdiction to regulate this market. They have decided that question. And that is what has caused uncertainty in the marketplace.
And it's caused uncertainty for two reasons. If swaps are futures and the CFTC has the kind of regulatory regime in mind that's implied by their questions, we are concerned that it's going to drive this market, or a good portion of this market, offshore. And if swaps are futures, and the CFTC does not have the authority to exempt swaps based on equities from the exchange trading requirements of the Commodity Exchange Act, it casts a cloud of illegality over that portion of the market. That's what has caused the problem.
Now this may not be an emergency in the terms that Mr. Bishop was describing, but we've canvassed the market, and we are extremely concerned about market reaction to the Concept Release. Let me just give a sampling of what we are being told. One attorney who advises a number of the major investment banks and commercial banks involved in OTC derivatives has advised us that he now routinely advises his clients to book OTC derivatives transaction with foreign clients that involve non-exempt securities in the banks' foreign affiliates where possible. All of these investment and commercial banks have non-U.S. affiliates or branches.
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We've also heard that the Concept Release is causing major derivatives firms to slow down or defer some new product development that raises questions in this area. We've heard that firms have put a hold on certain of their activities involving the use of OTC derivatives to provide U.S. institutional investors with exposure to foreign securities as well as OTC derivatives used to hedge investment risk in the United States.
We've heard that derivatives dealers that previously offered major agribusinesses with customized agricultural risk management products have begun to pull back from this line of business as a result of legal uncertainty created by recent statements by the CFTC interpreting the scope of the swap exemption.
We heard that the Concept Release has caused major U.S. corporations to delay or reconsider transactions involving OTC derivatives transactions on their own stock that they execute to hedge certain balance sheet risks.
We've been informed that a software company developing a product to support the OTC derivatives business has determined to organize its business in England because of what it perceives as an inhospitable and unstable regulatory environment in the United States.
We're told that clients of the derivatives dealers are concerned about these issues and that there is now a constant dialogue about the implications of the CFTC's Concept Release for contemplated transactions and the potential reactions to it. We've been informed that other major derivatives firms that have not yet curtailed their U.S. OTC derivatives activities would do so as soon as it became apparent that Congress was not willing to address this issue decisively.
Now these are all anecdotal bits of evidence to be sure, but this is the kind of feedback that we're getting from the marketplace, and I should say that it causes us tremendous concern. And it's caused by the fact that the CFTC has put out a release that is grounded on its inescapable conclusion that swaps are futures and can be regulated as such.
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Now, the legislation that we proposed was intended to try to bring some calm and certainty to this market while Congress has an opportunity to look at it. Chairperson Born has, I think in many respects, taken an over-broad reading of our proposal. We had absolutely no intention to interfere with enforcement actions or the granting of additional exemptions. We intended to try to bring calm and certainty to this market while the Congress has an opportunity to look at these issues.
And if the legislation that we've drafted has over-broad effects, we are very happy to sit down with the staff of this committee and the CFTC and work out language that will not have unintended effects.
I was trying to think of a way to dramatize the point about the effect of the Concept Release, but one only has to look at the Concept Release to see what is implied in the questions that it asks. On one hand, it's represented that the Concept Release simply asks questions, but these are not academic or neutral questions. The questions include, should the CFTC oversee OTC derivatives clearinghouses? Should it regulate multilateral transaction execution facilities for OTC derivatives? Should it require registration by OTC derivative dealers and perhaps other market participants? Should it impose capital requirements for OTC derivative dealers? Should it prescribe internal control requirements? Should it establish extensive sales practice rules and disclosure requirements? Should it adopt record keeping and reporting requirements? Should it require mandatory membership in a self-regulatory organization?
These are questions that are asked presumably not only to get information but to serve some notice as to the kind of regulatory regime that might be coming down the pike. And that regulatory regime can only be based on a conclusion that swaps are futures. And that is an issue that is not only hotly debated, but has been the subject of a consensus over the last 10 years at least that it would not be resolved because of the kinds of uncertainty it would bring to this market.
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It's as if the CFTC put out 75 questions asking whether they should regulate interstate trucking. One would not put out those questions unless one had made some preliminary determination that the agency has jurisdiction to do what it's asking questions about.
The legislation that we have proposed does not intend to decide any of these issues permanently. We simply would propose to direct a study by the Working Group with a report to this committee. We would put a standstill on further rule making in this area by the Commission, and we would try to bring legal certainty to that portion of the swaps market which is not presently eligible for the CFTC's exemption. And as I say, if those have been drawn too broadly, we are happy to work to draw them to achieve the intended result.
Mr. Chairman, let me just say one final word about the processes of the President's Working Group on Financial Markets, because I've participated in the Working Group for 3 years now, and I think for the most part, it has worked extremely well.
The issue about the Concept Release was brought up in a Working Group meeting. The members of the Working Group did not have copies of the Concept Release. Staff had been permitted to read a draft of the release at the Commission's offices, but the members of the Working Group did not have the release.
At that meeting, both Chairman Greenspan and Secretary Rubin expressed in very strong terms their views that: (a) swaps are not futures, and (b) the CFTC does not have jurisdiction to impose the kind of regulatory requirements that were implied by the draft release as it had been reported to them. They urged that the Commission not go forward with the Concept Release, and that this be the subject of further Working Group inquiry.
But the Working Group only works to the extent that its members are willing to pay deference or accommodate the views of the majority of the members of the Working Group. And I think the CFTC, recognizing that an independent agency with independent authority, made a decision to go ahead and issue the Concept Release. And it did that, I think, with the recognition based on things that were said at the meeting that the other members of the Working Group might propose remedial measures to deal with the kind of fallout that would come from doing that. And that's why we're here today. Our legislation is simply a proposal to try to bring some calm to this market, to have these entirely appropriate questions looked into by a body that has not prejudged the jurisdictional question, and to bring calm to that segment of the market that's not presently eligible for the exemption from the Commodity Exchange Act.
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Thank you, Mr. Chairman.
[The prepared statement of Mr. Hawke appears at the conclusion of the hearing.]
Mr. EWING. Mr. Lindsey.
STATEMENT OF RICHARD LINDSEY, DIRECTOR, DIVISION OF MARKET REGULATION, SECURITIES AND EXCHANGE COMMISSION
Mr. LINDSEY. Chairman Ewing and members of the subcommittee: I'm pleased to be here in front of this subcommittee again. And I appreciate the opportunity to appear on behalf of the Securities and Exchange Commission to discuss the regulation of transactions involving over-the-counter derivatives and hybrid instruments.
These issues involve significant questions of public policy that require the attention of Congress, members of the financial regulatory community, and interested industry participants.
The Commission has prepared a written statement and asks that it be included in the record of these hearings.
Mr. EWING. Without objection.
Mr. LINDSEY. My remarks this afternoon will address the Commission's concerns raised by the recent CFTC Concept Release. OTC derivative instruments are important financial management tools that reflect the unique strength and innovation of American capital markets. The growth of this market has come, in part, as a result of the careful approach taken by Congress and U.S. financial regulators. That approach has focused on promoting legal certainty for OTC derivative transactions and building consensus among regulators through the President's Working Group on Financial Markets. Unfortunately, the CFTC's recent Concept Release on OTC derivative instruments represents a significant departure from this approach. In it, the CFTC suggests creating a new, comprehensive regulatory scheme for transactions involving swaps and hybrid instruments. Ironically, compliance with extensive, new regulations would become a condition for exempting swaps and hybrids from the requirements of the CEA.
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Last month, Chairman Levitt, Secretary Rubin, and Chairman Greenspan all objected to the issuance of the CFTC's Concept Release. In a joint statement, they cited their concern that the CFTC's action may increase legal uncertainty for swaps, destabilizing a significant global financial market.
Regulators and market participants, alike, are asking why the CFTC has suggested a radically new approach to the treatment of OTC derivatives and hybrids. After all, no convincing argument has been made that recent developments in the OTC derivatives market would merit the CFTC's consideration of a new regulatory scheme.
The CFTC's Concept Release is particularly troubling by setting out a broad regulatory agenda under the guise of exercising exemptive authority. We strongly disagree with this approach.
First, this would appear to be based on the CFTC's erroneous conclusion that swaps are futures. As the SEC has said before, traditional swaps that are not traded through a multilateral transaction execution facility are not futures and are, therefore, not subject to regulation under the CEA. This is also the prevailing industry view.
Second, we have doubts as to the CFTC's authority to regulate OTC markets. The CEA provides for the regulation only of exchange-traded futures, making off-exchange futures transactions illegal. Nowhere in the CEA has Congress articulated an intent that the CFTC regulate off-exchange markets.
Third, we disagree with any plan by the CFTC to regulate through exemption. In enacting the Futures Trading Practices Act of 1992, Congress gave the CFTC broad exemptive, not regulatory, authority concerning swap transactions. The conference report for the act states that the purpose for giving the CFTC those exemptive powers was to provide certainty and stability to existing and emerging markets so financial innovation and market development could proceed. The objective was legal certainty for swaps, not extensive regulation of an evolving market.
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CFTC's Concept Release also raises significant concerns regarding its current hybrid exemption. Hybrid instruments are, first and foremost, depository instruments or securities products. They also have some payment features similar to commodity contracts. All hybrids satisfying the current exemption are already regulated as banking or securities products. There is no need for adding another layer of regulation under the CEA.
It seems the CFTC is proposing to substantially narrow the scope of the current exemption, making its availability dependent upon compliance with a new regulatory scheme. As with swaps, we object.
Last week, Chairman Levitt joined Secretary Rubin and Chairman Greenspan in proposing legislation that would give Congress and financial regulators time to consider the public policy issues discussed here today. It also calls for a study of these issues by the Working Group. The Commission recognizes that this is an unprecedented step which underscores our concern with the CFTC's action. For that reason, we urge quick passage of this legislation.
We welcome any questions on these issues that you may have and look forward to continued discussions with the subcommittee, the Working Group, and the industry on these important issues.
Thank you.
[The prepared statement of Mr. Lindsey appears at the conclusion of the hearing.]
Mr. EWING. Thank you both for your testimony.
The first thing that comes to mind that I'd like to address with you is that setting the responsibility for regulation. Some of the issues that have been put on the table here today do, in fact, come back to the Congress. Would you agree?
Mr. HAWKE. Yes, very much so.
Mr. EWING. And it should be the Congress' decision as to who should and when should these parts of the market be regulated. Do you both agree with that?
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Mr. HAWKE. Yes, sir.
Mr. LINDSEY. Yes.
Mr. EWING. Is there an opportunity, though, for your agencies to work through the President's Working Group to try and address the current disagreement on regulations in the market?
Mr. HAWKE. Well, Mr. Chairman, to the extent that this fundamental question lies at the heart of the disagreement, I'm not sure that discussion and argument within the Working Group is going to be able to resolve it. The fundamental question is whether swaps are futures.
There is a strong body of opinion on both sides of that issue. I don't know that extended discussion in the Working Group is going to resolve that, particularly since the CFTC has already reached the conclusion, apparently, that swaps are futures and, therefore, they have jurisdiction to do what they're proposing to do.
Mr. EWING. But you have indicated that there is strong opinions on both sides?
Mr. HAWKE. That's right. That's why we think that it is a particularly appropriate issue for Congress to decide.
Mr. EWING. Do you know of any major problems in the market arising from the Asian crisis, or otherwise in the world? In the world market for over-the-counter trading of derivatives?
Mr. HAWKE. I think Mr. Lindsey probably has a better perspective on that than I do.
Mr. LINDSEY. Well, there are a large number of OTC derivatives transactions that are outstanding that are entered into primarily with banks to various Asian nations or counterparties of various Asian nations. There have been some discussions associated with how those contracts should be administered.
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Mr. HAWKE. I should say, Mr. Chairman, if I could just add to that, that one of the reasons that we're concerned about the uncertainty is that to the extent that the CFTC has given currency to the conclusion that swaps are futures, it certainly provides an incentive for a private party that's on the losing end of the swap to challenge the legality of that swap and try to avoid performance. That's one of the things that our legislation is intended to put to rest until Congress has a chance to deal further with that issue.
Mr. EWING. Chairperson Born, I think, indicated that the concept paper was not issued because of any particular emergency or problem in the market. Would you agree that there is no emergency or major problem in the market that has come to your agency's attention?
Mr. HAWKE. I'm not aware of any emergency in the market that of a sort that would call for regulation. We are concerned about market disruption being caused by——
Mr. EWING. Well, I understand, but I'm talking about an emergency or a problem in the market that would require additional regulatory efforts by the CFTC or any other agency.
Mr. LINDSEY. We're not aware of any pending emergency associated with the market for these products.
Mr. EWING. Would you also agree that if there was no effort to extend additional regulations to this market that your legislation would not be necessary?
Mr. HAWKE. Well, we think the legislation is necessary for a couple of reasons, Mr. Chairman. One, we think the legislation would direct the kind of study we think is appropriate. Two, the legislation would bring legal certainty to those particular types of transactions—swaps involving equities to oversimplify it—that are put under a cloud of possible illegality as a result of the CFTC's conclusion that swaps are futures, because those are the kinds of instruments that they can't exempt from the requirements of the act.
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Mr. LINDSEY. It strikes me that the question is one of immediacy. Is there a need for something to be done today if nothing else changes? And I think that the question here really is, what are the future implications for what happens in this market?
As Under Secretary Hawke has already stated, there are a number of types of things that are beginning to happen in the market in terms of how people are advising their clients and where contracts are starting to be executed.
There are two real issues, I think, that underpin this. One is the issue that Under Secretary Hawke has brought up several times about the potential enforceability of these contracts arising from a potential illegality of these contracts and whether or not somebody chooses the litigation route to try to get out of the contract.
The second point is that many of these contracts are very easy to move abroad. This is not like a manufacturing facility where you construct a plant and you sink roots into the earth. Instead, this is something where you run a book very easily. And you can put three people on the plane, and you could run the book out of London tomorrow.
The question is: How much uncertainty has been introduced into the market? I think that we've all heard quite a lot of concern about this. And what I would remember back to is the Eurobond experience where a very simple law change moved the Eurobond market from the United States, where it was a vibrant market, abroad virtually overnight. And that market has never returned.
Mr. EWING. The point that at I'm trying to make with you is, if there was no effort to extend regulations at this time without congressional action or reauthorization, then there might not be the need for this legislation? You know anybody can get up in a crowd and yell, ''fire,'' and you can start a wave. I mean we're talking about a pretty sophisticated market; I don't think you can come here and say that just anything puts a wave through that market that requires a Congress act.
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Mr. HAWKE. No, Mr. Chairman, I think you're entirely correct, and I would agree with that. But here we have something very specific that goes to the heart of the legality of hundreds of millions of dollars worth of transactions. Are swaps futures? If they are not, then the CFTC does not have the jurisdiction to do what its threatening. If they are, then a problem of legality is posed, and the threat of a regulatory regime is imposed that may induce companies to take transactions overseas in a way that will—as Mr. Lindsey says—may cause them never return to the United States.
Mr. EWING. Well, one final question: if there's been controversy for years and no one is changing the status quo, is there a need for your legislation?
Mr. HAWKE. I don't think there has been controversy for years, Mr. Chairman, because I think that for the last 10 years with the exemptive rule that the Congress authorized the Commission to adopt, and with a general implicit consensus not to resolve the question of whether swaps are futures, there's been relative calm in the market. Sure, that question may have always hovered over the market, but nobody was proposing to resolve it.
What's different today, is that the CFTC, an agency that has tremendous potential involvement in this market, has decided that swaps are futures. And that has changed—that has abrogated the consensus that has existed for a long time.
Mr. EWING. I think your answer is a little out of sync with your testimony in regard to the fact that there is disagreement on that issue.
My parting comment is that if we're going to work this out without causing a great deal of controversy in the market, it will take cooperation from both of your agencies as well as the CFTC.
Mr. Condit.
Mr. CONDIT. Thank you, Mr. Chairman. With your permission, Mr. Chairman, Mr. Baldacci from Maine was here earlier, and he wanted to ask a question to Mr. Lindsey. It's a very lengthy question; I would like to submit it for the record, and submit it in writing, and have you respond directly to Mr. Baldacci. Would you agree to do that, sir?
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Mr. LINDSEY. Yes, I would.
Mr. CONDIT. And I will proceed with my questions, but he has a great deal of concern about this issue, and I promised him that I would do that.
I would like to ask both of you, what do you think the CFTC or the chairperson is going to do with the concept paper?
Mr. HAWKE. Well, we would certainly hope—and this view was expressed in the Working Group—that the Commission would not move forward. They presumably will be getting a lot of information and views in, in response to the release. And since Chairperson Born says this is part of a regulatory streamlining program that they have, I would assume that the next step would be to formulate a proposed rule, and put it out for comment, and move ahead with the normal rulemaking process.
Mr. CONDIT. Mr. Lindsey, do you concur with that?
Mr. LINDSEY. Well, I think I would concur with the fact that we would hope to not see anything move forward associated with this particular Concept Release.
If you ask in a reading of the Concept Release, what is it that we think are the underlying intentions associated with that? I think Under Secretary Hawke's testimony kind of covered that in very specific terms. There appears to be an approach to a very broad regulatory scheme using exemptive authority here.
Mr. CONDIT. Is the Concept Release the genesis for your legislation?
Mr. HAWKE. Yes, Mr. Condit. The Concept Release asks I think more than 75 questions, probably more than 100 questions, the implication of which is that the CFTC is considering a regulatory regime for the OTC derivatives market based on its conclusion that swaps are futures and that, therefore, they have jurisdiction to regulate.
It was the potential threat to the movement of this market offshore that was the genesis for our proposal, as well as the legality for that portion of the swaps markets that they don't have the authority to exempt.
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Mr. CONDIT. But for all these agencies to kind of get cross-ways with each other, it seems to me that both of you and some of the other heads of the agencies seem to think that they may want to pass a rule, have a rule meeting. And that response would be the end-response. You get to talk to the legislation; I mean that's a pretty serious thing. I mean we've got agencies that ought to be working together but are not working together like they're coming out sort of conflicting thing? Does that—I mean am I putting words in your mouth?
Mr. HAWKE. Well, again, one of the reasons why the Working Group exists is to try to work these problems out. But the Working Group doesn't have the power to bind its members by majority vote.
Mr. CONDIT. Thanks for bringing that out. In May 1993 you folks did a Concept Release seeking comments regarding changes in capital requirements applicable to swaps contracts. I'd just ask you what the status of that action in response to the comments received? And to what degree did you work with the other agencies that relates to your Concept Release?
Mr. LINDSEY. Well, remember that the SEC is also a prudential regulator, which means that for those entities that are under our responsibility, we have a responsibility for setting the capital requirements associated with those entities.
Now typically what we do is we regulate securities products; we don't regulate other products. But sometimes more than securities products are held within a broker-dealer. To the extent that more than securities products are held within broker-dealers, we do set capital requirements associated with those broker-dealers. I mean as to a wide variety of things.
For example, there have been broker-dealers that have held oil and gas producing businesses within the broker-dealer. So, while we regulate the securities business, we don't regulate the oil and gas business. But when those two are merged together, we are going to set prudent capital standards so we can make sure that we protect the safety and soundness of the institution.
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Mr. CONDIT. Do you have a response to that?
Mr. HAWKE. No, I have no comment on that.
Mr. CONDIT. Well, then tell me, Mr. Lindsey, did you work with the other regulatory agencies; yes or no?
Mr. LINDSEY. In 1993 I wasn't there, but my understanding is that we've long coordinated our capital regime with, for instance, the CFTC. And in the many cases, if you look at the CFTC's capital regime over FCM's and the capital regime of the SEC over broker-dealers, you will find very much in common associated with those two capital regimes.
Mr. CONDIT. What is the consequence if we go silent on the legislation, on the Concept Release, on any rule change until we get into the next legislative cycle, which would be next year, when we get a reauthorization to take this up when we reauthorize the whole thing. What is the consequences of a 5- or 6-month period of being silent?
Mr. HAWKE. Mr. Condit, I read a list of anecdotal evidence that we've had from the marketplace about the uncertainty that's been created and what it's doing with respect to the inhibition with respect to innovative new products, with transactions moving offshore, other transactions just not getting done. We continue to think that if the uncertainty is not resolved, if there isn't some interim kind of relief, that that will continue, that the markets will continue to reflect that uncertainty by moving transactions offshore, by not doing transactions that might otherwise be done and that would be useful, and potentially by encouraging parties to transactions to raise legal questions while deliberations are going forward.
Mr. CONDIT. I thought when you read your information, that was with the assumption that there would be a rule change? Is that not correct that the fact that this floating out there that's——
Mr. HAWKE. This is the market perception at the present time. This is what people in the marketplace are telling us is happening because of the Concept Release and——
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Mr. CONDIT. Is it your impression, then, that if we had a hard, clad agreement that we go silent on this until we reauthorize this and take it up at that time, that that would not be of help?
Mr. HAWKE. I think that would be of help. There's no question that that would be of help, but it still doesn't resolve the question about the potential illegality of some transactions.
Mr. CONDIT. I appreciate both of you being here today, and I appreciate your responses.
Thank you.
Mr. EWING. Mr. Moran.
Mr. MORAN. Mr. Chairman, thank you.
As I understood your testimony, that the question that we're trying to resolve, or ultimately need to resolve is whether swaps are futures? And around that question, revolves the question of who has jurisdiction? Why is that an important question? Why do I care whether CFTC or the SEC has jurisdiction over this issue?
Mr. HAWKE. I don't think that jurisdictional choice is presently on the table, Mr. Moran. I think that is certainly one of things that Congress could consider if it was taking a comprehensive look at this area.
The question right now is just the uncertainty that's caused by that question not being definitively resolved.
Mr. MORAN. So, the question right now is whether the CFTC has jurisdiction or no one has jurisdiction?
Mr. HAWKE. Well, if the CFTC—I'll let Mr. Lindsey speak to what the SEC's jurisdiction would be—but the problem is that if the CFTC does not have jurisdiction to exempt transactions from the Commodity Exchange Act, and those transactions are deemed to be futures, they are illegal. That's really one of the principal consequences of this question not being resolved.
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Mr. MORAN. So it's not really a question of who regulates, but what the effect of that jurisdiction is on the legality of the instruments?
Mr. HAWKE. That's right.
Mr. LINDSEY. I think, in part, I agree that that's it. I would expand on that a little bit further in terms of saying it's not just a matter of who regulates it. That's not the issue. What is an issue is whether or not this is an activity that needs regulation at all. And then if so, what should be the appropriate regulation?
At this point in time, Congress has never given guidance to any agency associated with how that type of market should be regulated.
Mr. MORAN. And if we were discussing that issue, would we hear how the CFTC would regulate versus how the SEC would regulate?
Mr. LINDSEY. Well, I think that from our perspective we regulate securities products. Many swaps are not securities products; some are, some aren't. It depends on the type of instrument that's there. It's not a matter of the type of regulatory scheme. Remember under the CEA, the CFTC has regulatory authority over futures that are traded on boards of trade. And any future that's not traded on a board of trade is illegal. And that's where the uncertainty comes from.
Mr. MORAN. In your proposed bill, it appears to me that you deal with the Shad-Johnson language in the last part of, I think, section 3. Why is that important? It seems to me you're answering the question that we've yet to answer, at least for a certain period of time?
Mr. HAWKE. Well, the statutory language is enormously complex, but that is the provision that deals with the illegality question that I was describing. If those transactions that are—again, to simplify—based on equity securities are considered to be swaps, then the CFTC does not have the authority to exempt them from the exchange-trading requirement, and they are illegal. And that provision that alludes to Shad-Johnson is just the lawyers' way of embodying the legal protection for those transactions.
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Mr. LINDSEY. The provision from our reading is not meant to change Shad-Johnson at all. But what it does do is resolve uncertainty as whether or not swaps are futures. And remember a future on an individual equity security would be illegal under the act under the accord.
Mr. MORAN. The attempt, then, is to clear up the uncertainty created by the CFTC's actions in regard to the securities issues that are traded in this particular period of time? Is that not a fair statement?
Mr. HAWKE. Yes. The transactions that came into being during this period of time, up until the Congress decides on the reauthorization of the CFTC.
Mr. MORAN. But that uncertainty is there now? Regardless of what the CFTC did?
Mr. HAWKE. That uncertainty is there now, and it has been there ever since. But the scab has been pulled off the wound. For 10 years, everybody has, in effect, agreed not to make an issue of whether swaps are futures or not, and the market has proceeded with relative calm because of that.
What's changed is the CFTC having determined, or having made clear, that in their view swaps are futures. And that raises the illegality issue and gives aid and comfort to those parties to the transactions that might want to repudiate them.
Mr. MORAN. Thank you.
Mr. EWING. Thank you, Mr. Moran.
Mr. Pomeroy.
Mr. POMEROY. Thank you, Mr. Chairman. Thank you, each of you, for excellent testimony.
I find myself as a committee member wanting to preserve the status quo but very unused to the notion, we've got to pass a law to keep things the same. [Laughter.]
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The uncertainty that you speak of seems to be coming up on the CFTC reauthorization, bringing the inevitable look at what has transpired relative to growth in the off-exchange versus on-exchange market was going to create some uncertainty. And as, again, as an old regulator, I've heard Chicken Little cries before, just about taking a look. And if the question before us is really one of imminent financial institutions by fundamental uncertainties created in these instruments, that's a serious issue that we need to respond to. But anecdotal reports of people raising anxieties about what really were going to be inevitable in light of Congress taking a look at all of this anyway. So I've got to have a little less sympathy for them.
Under Secretary Hawke, you indicate that, basically, the fundamental premise of the CFTC being able to ask questions is that these are futures. And I'm not sure I agree with you. It seems like to me there's a relationship between futures and swaps. One stops somewhere and the other starts beyond that point and, therefore, they would have certain license to ask questions relative to trends in both areas.
So it seems to me the Treasury Department would certainly have license; I would hope you would be asking and doing your own analysis in terms of what's happening in this area, as I would hope the SEC is. And I gather from your proposed rule, you are. It would seem to me that all of you—I mean, Mr. Greenspan, and I hope he's looking at this too.
And as a result of your respective analyses, we're going to be better off when we have to make some policy judgments as a congressional committee, and ultimately as Congress.
For us to do the workup, well let me tell you; we're not as well-positioned to do the workup. You might has well have a chimpanzee write a novel. I mean, you know, it just is totally different to have a group of generalists try and sort this one out. We need your analysis. We need the CFTC's analysis, Treasury's analysis, SEC's analysis, the chairman's analysis.
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And so, really, can't we study this without taking a look at—that doesn't mean I'm prejudging the ultimate issue. I mean, clearly, the fact that we're here trying to sort this out tell me maybe the CFTC kind of stomped into this in a way that all of this might have been avoided, but here we are. And the fundamental question is, can't we ask questions? Can't each of the players of the Presidential Working Group ask these questions leading up to some important decisions that will be naturally attendant to the CFTC reauthorization?
Mr. HAWKE. Well, that's been our proposal. The proposed legislation would require the Working Group to do that kind of study. We suggested earlier in the game at the Working Group, that the Working Group ask these questions, because the Working Group can ask the questions in a way that doesn't prejudge some of the fundamental conclusions. The Working Group can ask the public, for example, for comment on the issue of whether swaps are futures. And it can make certain assumptions. But the way the Concept Release was put out, it implicitly decides that question, and that's what's caused the problem.
Mr. POMEROY. But does the Working Group, as a collective entity, undertake studies?
Mr. HAWKE. The Working Group, through the collective staffs of the agencies—the Working Group has no staff of its own as such, but uses the staffs of the participating agencies—done studies in the past.
Mr. POMEROY. There's a difference. I mean in terms of what—for example, I've got a preoccupation of functional regulations and financial services, but I wouldn't want to be hooked into a Working Group with the OCC, Treasury, and me to try and sort it out, because I'd lose 2 to 1 on State functional regulation of insurance.
So, I'm wondering if basically that's the position you're putting CFTC in; they got a 3 to 1 vote. If you've got to do it collective, maybe that's why each of them ought to do it prospectively, and you bring your work forth.
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Mr. HAWKE. Well, I think that our legislation contemplated that prospect. The Working Group, we think, would be an effective means of collecting information and data. Our proposal makes clear that any member of the Working Group could express separate views about conclusions. This is not something that would be decided by a vote of the Working Group The members of the Working Group would be able to express their views based on the fruits of the study.
Mr. POMEROY. And that the unilateral action of the CFTC even raises a prospect that there might be either a determination of some swaps or futures or give some legal grounds to people who want to get out of this——
Mr. HAWKE. Well, I think that's the problem. When an agency asks 75 or 100 questions about whether it should regulate in certain ways, it, to my mind, inescapably suggests that the agency has concluded that if it should resolve those questions in the affirmative, that it's already determined that it has jurisdiction to do what it's asked about. And that's what's caused the problem.
Mr. POMEROY. Final question, Mr. Secretary. Can't you all get this worked all, with dependency of this Congress, without us having to pass a bill?
Mr. HAWKE. We would certainly like to try.
Mr. POMEROY. I would certainly like you to try.
Mr. EWING. Thank you, Mr. Pomeroy.
I'd just like to leave maybe two thoughts with this panel, and I do appreciate your time.
The Working Group is the President's Working Group. You serve at his pleasure from his administration. I think it's important that you work together.
Had your agencies worked a little closer with this committee last year, we could have addressed some of these problems in legislation we had before this committee. And maybe this just foretells the challenge of reauthorization next year.
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But I just leave those two ideas with you in hopes that maybe it will spur additional cooperation and effort in the future.
Thank you very much.
The third panel is now Mr. Pat Arbor, chairman of the Chicago Board of Trade, accompanied by Thomas R. Donovan; Mr. Scott Gordon, chairman of the Chicago Mercantile Exchange, accompanied by Eric Kilcollin; Mr. Daniel Rappaport, chairman of the New York Mercantile Exchange, accompanied by R. Patrick Thompson. If the gentlemen would all come to the front.
Thank you, gentlemen, for coming and for your patience in waiting. We are going to start with you, Mr. Arbor.
STATEMENT OF PATRICK ARBOR, CHAIRMAN, CHICAGO BOARD OF TRADE, ACCOMPANIED BY THOMAS DONOVAN, PRESIDENT AND CEO
Mr. ARBOR. Thank you and good afternoon, Mr. Chairman, and members of this subcommittee.
I am Patrick Arbor, chairman of the Chicago Board of Trade, and I am joined today by Thomas Donovan, our president and chief executive officer. We are pleased to appear before this committee at this critical oversight hearing.
In today's technology-driven global markets, over-the-counter derivatives and exchange-traded derivatives are closely intertwined and converging. The Chicago Board of Trade, therefore, has testified many times about the over-the-counter derivatives market over the years. Our views, by now, should be well known.
Like exchange-traded instruments, over-the-counter derivatives offer market participants an opportunity to manage or assume the risk of price changes. Like exchange-traded instruments, over-the-counter derivatives transactions are entered into mostly by highly sophisticated professionals and financial institutions. Although both over-the-counter markets and exchange-traded instruments serve the same purpose and involve the same market participants, today both markets are regulated in a very different manner. Very simply, exchange markets are heavily regulated, and over-the-counter derivatives face little regulation.
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Over-the-counter markets have thrived under this minimalist approach to Government oversight. The Chicago Board of Trade is not asking for changes in that approach or to ratchet up regulation of over-the-counter markets. Instead, the Board of Trade is simply asking for what Congressman Bishop described as ''eating out of the same spoon,'' regulatory parity, so that we can fairly compete with and effectively complement the over-the-counter markets. That has been our consistent message for a number of years. We still believe that regulatory parity is the only fair way for Congress to allow competition based upon merit in the marketplace, not regulatory arbitrage.
And from that perspective, Mr. Chairman, the CFTC's Concept Release is disappointing, but certainly not improper. We do believe the CFTC has jurisdiction to regulate over-the-counter derivatives transactions that are futures and options. We don't believe that only transactions traded on exchanges are subject to CFTC jurisdiction. We do believe the CFTC should reassess its past exemptive actions as changing market conditions warrant.
Our major problem, however, with the CFTC's release is this: rather than narrowing the existing regulatory disparity, the CFTC is contemplating widening that disparity. According to the release, the CFTC is considering whether to expand the scope of its swaps exemption to include even standardized and fungible swaps, which today would not qualify for that exemption. Yet the CFTC does not suggest it would consider comparable new exemptive relief for standardized and fungible instruments when traded on our exchanges. In fact, the Concept Release barely mentions exchanges and their need for regulatory parity.
The release, therefore, typifies the recurring out-trade we have with the CFTC. The Commission's operating premise is that only exchanges need regulation because of the price discovery and clearing services they provide. That kind of thinking is dangerously and outdated. Exchanges have every incentive to adopt effective safeguards against threats to market or financial integrity. And exchange clearing systems disperse risk, not concentrate it. In the computer age, price discovery is a 24-hour global process that is not bounded in any way by our trading pits.
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The motivation for the legislation submitted last Friday by the Treasury, Federal Reserve Board, and the Securities and Exchange Commission is most understandable. But again, that proposal does not contemplate a study of all derivatives markets, whether on-exchange or off-exchange, in an attempt to fashion a comprehensive, modernized regulatory policy that's needed. Neither the legislation's proposed study nor its moratorium would address the fast-moving changes in exchange markets, changes that have caused the exchange markets and over-the-counter markets to converge in many important respects. Certainly the recent proposal to establish the Cantor Financial Futures Exchange is a disturbing and unsettling example of that convergence and the difficult policy issues it embodies. Yet unless the study and moratorium applies to those as yet unexplored issues as well as over-the-counter markets, we would be concerned that the proposed bill, like the CFTC's Concept Release would not reduce regulatory disparities, but actually could increase them.
A comprehensive study also makes sense given the proposed array of Federal regulatory perspectives involved in the study. With the CFTC, the SEC, the Federal Reserve, and the Treasury analyzing these issues collectively and independently, nothing should be taken off the table, including any necessary changes to the Shad-Johnson Accord. Only that kind of top-to-bottom reform could hope to cover all of the multi-faceted and interrelated issues that must be addressed to allow U.S. exchanges and other to compete in the global marketplace where technology has and will overcome antiquated market systems and barriers.
Mr. Chairman, last year you attempted to stimulate discussion of these issues and rectify the regulatory disparity we face by introducing legislation that would have treated exchanges and over-the-counter transactions in a substantially comparable manner. We strongly supported that legislation and your efforts. Unfortunately, those that prefer the status quo were able to derail that legislation, at least hopefully only for the time being.
But the current controversy surrounding the issuance of the CFTC's Concept Release shows that maintaining the statutory status quo is not a long-term solution. Congress must consider comprehensive reforms of the Commodity Exchange Act sooner rather than later. Hopefully, this hearing will rekindle that debate on the issues, and the next Congress will have meaningful modernization and reform on the agenda.
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Thank you very much.
[The prepared statement of Mr. Arbor appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Arbor.
Mr. Gordon.
STATEMENT OF M. SCOTT GORDON, CHAIRMAN, CHICAGO MERCANTILE EXCHANGE, ACCOMPANIED BY T. ERIC KILCOLLIN, PRESIDENT AND CEO
Mr. GORDON. Mr. Chairman, my name is Scott Gordon. I'm the chairman of the Board of the Chicago Mercantile Exchange, and I'm accompanied by Rick Kilcollin, our president and CEO. I'd like to ask that my written testimony be submitted for the record, and I'll try and condense my remarks.
Mr. EWING. Without objection.
Mr. GORDON. The OTC derivative market has mushroomed in size and scope since the CFTC's swaps policy statement in 1989. The Commission's adoption of the part 35 exemption of swap transactions in 1993 reconfirmed and solidified its policy statement.
It is an understandable response to radically altered conditions that the agency responsible for the regulation, part 35, reevaluate the terms of its exemption. The CME agrees that the CFTC is the correct agency to exercise that responsibility. The OTC derivatives business has been conducted pursuant to CFTC exemption. THE CFTC has exclusive jurisdiction over the bulk of the U.S. OTC market.
The CME's support of the Commission's jurisdiction to issue the Concept Release may not, however, be taken as support of any change in the scope of the swaps exemption. Obviously, the OTC market has grown exponentially despite well-publicized losses. It must be providing the service that its customers value. CME does not believe that a case has been made or will be made for imposing more CFTC regulation on that market.
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However, CME is certain that a strong case can be made against the weakening of those provisions of part 35 that preclude the OTC market from retaining the advantages of its unregulated status while replicating the functions and features of exchanged-traded futures contracts. In particular, the CME opposes any effort to eliminate those provisions of part 35 that limit the exemption to non-standardized, privately negotiated transactions that are not executed by means of an electronic trading system or settled through a clearinghouse.
Documents have circulated asserting that the Commission called for a comprehensive regulatory regime for oversight of the OTC derivative market. No one who has read the Commission's release could properly suggest that conclusion.
The proposed bill to stop the CFTC, which was circulated on June 5, purports to be a standstill proposal. In fact, it is much more. The bill is a clear first step in the transfer of jurisdiction for futures contracts that are not traded on CFTC regulated exchanges from the FTC to other regulators. The bill also amends the Shad-Johnson Accord without explicitly disclosing that result. The bill provides that futures contracts on equities may be traded over-the-counter without either CFTC or SEC approval. In effect, the bill permits futures on individual stocks to be traded over-the-counter without the supervision of any regulator. It is preposterous to continue the prohibition on such transactions on a regulated marketplace while passing special legislation to permit them in a market with no financial safeguards and no effective regulation.
A Concept Release is a far cry from a proposed rule change. We have asked the Commission to extend the commend period until the second week of September so that everyone will have time to read the release and respond. It is clear that a substantial period of study is in the offing before the Commission offers any proposal to change the status quo. Moreover, a Commission proposal for change will be published for comment and permit opponents, if any, ample time for emergency legislation or any other protective response. If the Commission eventually proposes any increase in regulation, the CME will very carefully review such proposal based on its well-founded concern that excess regulation does far more harm than good.
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The CME will be in the forefront of opposing any new regulation of OTC markets and is categorically opposed to any rule that would jeopardize the legality of swaps that have been executed in reliance on part 35.
The CME urges this subcommittee to look at the actual effect and implication of the proposed emergency bill. Any fair reading demonstrates that that bill has enormous jurisdictional and regulatory consequences that should not be adopted without a clear understanding of the long-term consequences on all the impacted parties. CME urges that the proposal be rejected.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Gordon appears at the conclusion of the hearing.]
Mr. EWING. Thank you.
Mr. Rappaport.
STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK MERCANTILE EXCHANGE, ACCOMPANIED BY R. PATRICK THOMPSON, PRESIDENT
Mr. RAPPAPORT. Thank you, Mr. Chairman.
My name is Daniel Rappaport; I'm chairman and chief executive officer of the New York Mercantile Exchange. With me today is Patrick Thompson, president of the exchange.
I'd like my written comments to be submitted for the record, please.
Mr. EWING. Without objection.
Mr. RAPPAPORT. On behalf of NYMEX, I wish to thank you for the opportunity to participate in today's hearings on regulatory oversight of the risk management marketplace with emphasis on over-the-counter derivatives. Congress has repeatedly, and we believe correctly, delegated legislative jurisdiction over the commodities futures marketplace to this committee and through the Commodity Exchange Act, regulatory authority to the Commodity Futures Trading Commission.
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In section 4(c) of the 1992 Futures Trading Practices Act, Congress gave the CFTC the authority to exempt transactions between appropriate persons from any provision of the act. In 1993, the CFTC swiftly exercised its new exemptive authority by adopting part 35 of its regulations.
We are unaware of any suggestion made by anyone at any time that the CFTC lacked the authority to grant such exemptions. We find it extremely unfortunate that some large trading entities and even sister agencies are attempting to use the occasion of the CFTC's reasonable and prudent review of its prior exercise of exemptive authority to try to create jurisdiction ambiguity regarding the CFTC's regulatory role. No such ambiguity exists.
Congress has already clearly spoken on this issue. If Congress did not intend for the CFTC to have jurisdiction on this matter, why would it have granted the CFTC exemptive authority?
We commend the CFTC for its recent Concept Release seeking input to determine the appropriate balance of regulation in the OTC market. Periodic review of the form and function of the regulatory environment, especially in view of the explosive growth that the unregulated OTC market has experienced over the last 5 years, is a prudent and reasonable course of action for the CFTC to take.
The regulated exchanges have been treated as second-class citizens in the comprehensive regulatory structure. The SEC and Treasury seem to be very comfortable with the status quo. Finally, we have a regulatory agency that is willing to ask the hard questions to resolve the critical open issues. And Treasury presents anecdotal comments of market users and an unspoken consensus of regulators over the last 10 years to support its position. Treasury says that CFTC has already made up its mind on the issue. Apparently Treasury has done so as well. If the best evidence the Treasury has is this anecdotal and unspoken consensus over the last 10 years, it's obvious why it's come out with its desperate attempt at the last hour for legislative relief.
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To paraphrase Mr. Greenspan, the bill seems like evidence of irrational regulatory—what was his quote? Exuberance, right—irrational regulatory exuberance, it seems like.
During the period of explosive growth of the OTC market, many OTC-traded instruments have matured and evolved into ''plain vanilla'' standardized contracts that are indistinguishable from regulated exchanged-traded contracts.
What is the rationale for having no regulation on those instruments while maintaining heavy-handed regulation for the exchange-traded products. Logic and reason dictate that the exact opposite should be Congress' objective.
Contrary to exchange-traded products, OTC trading in not transparent and does not appear on any regulatory radar screen. OTC trading is, therefore, difficult to monitor and virtually impossible to manage in a crisis environment. An appropriate regulatory regime that serves the greater public interest should seek to provide the exchanges with the regulatory flexibility to make the regulated exchanges the markets of choice rather than the markets of last resort.
Groups of OTC traders and other OTC entities have even requested that CFTC extend its exemptive authority to permit them to open clearing operations. Such operations, sometimes referred to a multilateral transaction execution facilities, are specifically prohibited under part 35. We strongly believe that this prohibition should continue.
If OTC traders are permitted to participate in central clearing operations that mitigate counterparty credit risk and remain exempt from the regulatory burden that the exchanges are compelled to operate under, such action would be the straw that breaks the regulated exchanges back.
Having said all that, NYMEX believes that an important lesson can be learned from the CFTC's exercise of exemptive authority over OTC markets. Light-handed but prudent regulation is the revealed preference of the marketplace. The domestic OTC market is the most dynamic, fastest growing marketplace in the world.
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In this regard, the grant to the CFTC of exemptive authority under section 4(c) does not distinguish between exchange and off-exchange products. In other words, in 1992 Congress not only gave the CFTC its authority to exempt OTC transactions, but also provided it with expressed statutory authority to exempt exchange-traded products for relevant reasons of the act.
We believe that a major, if not central, unfinished challenge that remains to be met by the CFTC is to apply the exemptive authority granted by Congress to exchange traded transactions with the same creativity and vision that it displayed for OTC products. The CFTC's prior efforts in this area have been so limited in scope that they have never been used by any of the regulated exchanges.
We respectfully suggest that the CFTC show the same level of confidence in the regulated exchanges as it did to the OTC traders 5 years ago. As you know, exchanged-traded futures and options are in many ways economically indistinguishable and clearly are offered for the very similar economic purposes as OTC derivatives. A regulatory regime for exchange-traded products that ignores the reality of the marketplace is a disservice to the derivatives industry and to the public interest.
Mr. Chairman, we believe that the public interest is well served by an open, constructive discussion of the issues including those raised by the CFTC's Concept Release.
We are grateful for the opportunity to offer our testimony before the committee.
[The prepared statement of Mr. Rappaport appears at the conclusion of the hearing.]
Mr. EWING. Thank you very much. Thank you to all of you, gentleman.
Mr. Rappaport, when you were quoting Chairman Greenspan, were those his comments about the concept paper or about the legislative correction of the concept paper? [Laughter.]
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Mr. RAPPAPORT. Well, I was sort of, I guess you know, paraphrasing.
Mr. EWING. Or neither? [Laughter.]
Mr. RAPPAPORT. I guess our position is that the proposed bill is an overreaction and from our perspective would be an unmitigated disaster.
Mr. EWING. To all of you, is there a problem in the market today because of the concept paper in the over-the-counter market?
Mr. Arbor.
Mr. ARBOR. Mr. Chairman, I don't believe there's a problem in the market, but there's certainly a problem with the regulation. It's clear that this blurring of lines and this convergence that's going on between the over-the-counter markets presents unique problems that have to be addressed in a very comprehensive manner. I'll just give you an example; there's a proposal to form an exchange by a private company called Cantor-Fitzgerald. They're basically operating in the over-the-counter environment. This firm acts as both the broker and the dealer for transactions to bring together buyers and sellers without the benefits of an exchange. Cantor acts that way in the over-the-counter markets for Treasury securities and proposes to marry that type of operation, that over-the-counter activity, with a so-called pseudo exchange and call it the Cantor Financial Futures Exchange.
Now in this particular case, we think it's very, very flawed. This whole concept is very flawed because we don't believe any firm should control an exchange. Certainly at our exchanges in New York and in Chicago—the Chicago Mercantile Exchange, and the Chicago Board of Trade, and the New York Mercantile Exchange—there's no one firm that controls our exchanges.
Furthermore, no firm should be able to appoint a majority of an exchange's board of directors in control, in this particular case, 8 out of 13. I will certainly speak for Chairman Rappaport and Chairman Gordon that we, as chairmen, don't have a firm that controls our Board. Now, I am sure they'll confirm that.
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Also, no firm, we think, should enjoy a monopoly on floor brokerage execution at an exchange. Member firms should be able to compete for floor brokerage business. We went through, back in the 1970's, a suit by the Government to stop fixed commission rates in our industry. Now it looks like there's an attempt to reinstate that policy. So, we don't think any firm should be able to fix brokerage commission rates. And no firm should be able to mandate that an exchange use non-competitive trading practices, being able to trade for themselves and also do business for their customers.
And certainly no firm with a dominant position in the cash market, in this case with Cantor-Fitzgerald, 85 percent should be able to conduct an exchange, and control an exchange, and appoint the board members, and monopolize floor practices, and fix brokerage commission rates, and mandate particularly non-competitive trading practices. But it's issues like this, we think, that face the Commission that do demand some kind of addressing of this issue.
Mr. RAPPAPORT. Mr. Chairman, can I respond to the question?
Mr. EWING. Please do.
Mr. RAPPAPORT. I don't think there's any market emergency out there. Are people nervous as the result of the Concept Release? I'd have to say, yes. If I were in their position, I'd be a little nervous as well. Not having been subject to any regulation over all these years and the market thriving, growing at dramatic levels. And now the CFTC asking the hard questions, at what is the appropriate level of regulation? Yes; they are a little nervous, but there's no market emergency out there. And nobody's running overseas tomorrow. A lot is going to depend about how this works out.
In the end, I think it would be a big mistake to exercise heavy-handed regulation over the OTC market. But from our perspective, that's what we've been living with for years. And we've had to contend with the enviable flexibility that the OTC market enjoys. And what we would like, what we're hoping for, is that this Concept Release creates a debate that will look at the OTC market and the regulated exchange market as one, and that the heavy-handed regulation that's been imposed on the regulated exchanges over these last 5 years as the OTC market has flourished, will be lightened up to some extent.
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Mr. GORDON. Mr. Chairman, I know the hour is late; I'll give you a very brief response to your question.
I'm not aware of any specific problems caused by the release of the Concept Release and, therefore, I don't think there's an emergency.
Mr. DONOVAN. Mr. Chairman, can I just add something to Chairman Arbor's remarks about the proposed Cantor proprietary exchange?
Ron Hersch, who will be on the next panel, is chairman of the Futures Industry Association. He also happens to be an elected member of the board of the Chicago Board of Trade; he's 1 of 27. He's also on the FCM of Bear-Stearns and Company. If Cantor was to be approved, conceivably, we could have the Bear-Stearns Financial Futures Exchange. We could have the Merrill Lynch Financial Futures Exchange. We could have the Cargill Agricultural Exchange. We'd have a proliferation of exchanges and having lived through the legislation in 1992, I don't think that's what this committee intended.
And I know that you've submitted a letter to the CFTC, and I hope that they will heed the concerns of the members of this committee and the Senate Agriculture Committee who have expressed this in letters to the Commission.
Mr. EWING. Thank you. I think in following up on the comments from the board about the Cantor application, and indeed about the concept paper, would you say that the exchanges believe that that kind of change in direction, in regulation, of the organized markets has to be approached very cautiously?
Mr. ARBOR. Yes.
Mr. RAPPAPORT. Sorry.
Mr. ARBOR. Yes. Mr. Chairman, we think that certainly would be the subject of the reauthorization next year. But we certainly think that the Concept Release doesn't go far enough. It's a very narrow focus and does not address the exchange aspects.
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Mr. EWING. Anybody else?
Mr. RAPPAPORT. Yes, to the extent that any action is taken in response to the market survey, which it really is. Yes, I would say that the approach has to be very, very cautious. The OTC market—and we all go through our own debates as to whether or not it's complementary or competitive to our markets—and to a large extent, it's complementary, and to some extent, it's competitive. We would not like to see the outcome of this to be strong regulation on the OTC market. Nor do we think that that's the CFTC's intent.
Mr. GORDON. Again, Mr. Chairman, given that we see no emergency, the idea that a study is being done and we're going to go into next year and talk about reauthorization, and have all the relative parties be able to respond and go forward. I'll say, once again, the idea of an emergency piece of legislation I believe is problematic, because it is something that should be discussed over a period of time, and does it very quickly, and I don't think it's to anybody's best interest.
Mr. EWING. I assume it would go without saying that all of you on the organized exchanges would find it helpful if the President's Working Group was more cohesive in their response to regulatory matters?
Mr. ARBOR. Well, why certainly, absolutely. That's exactly what should happen. And again, both the proposed legislation and the Concept Release only addressed the over-the-counter markets and not the exchange markets. So we think it should be a total, comprehensive, top-to-bottom reform-type approach to the whole problem, not just part of the problem.
Mr. GORDON. Mr. Chairman, you know, again, as I said in my testimony, the CFTC is the appropriate regulator in this respect. The fact that the other members of the Working Group should be able to contribute, I totally agree with this. I believe in the concept of what that Working Group is, but it still lies within the agency that's given statutory authority over these products to be able to develop a policy and then bring it forward to Congress.
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Mr. RAPPAPORT. I think it was Representative Pomeroy before who actually did the math, 2 to 1, 3 to 1, whatever it happens to be. And I think the outcome was sort of obvious, and that may be the reason why the CFTC may have come out with this. In a sense, anything coming out of that Working Group looked like it was going to come out 3 to 1 against the CFTC and probably exercise jurisdiction in areas where it felt it had jurisdiction, and I think creating this forum highlights the issue, to the extent that at least we hope that's no longer possible.
Mr. EWING. Mr. Chambliss, do you have some questions?
Mr. CHAMBLISS. Mr. Chairman, I think probably anything I'd ask would be repetitive. I apologize to the chairman for not being here earlier. It's been an unusual afternoon.
Just in what you said and what I've learned earlier from what has been going on, with respect to this issue, that I understand that you gentlemen may not necessarily be opposed in the end to having some review of these types of transactions. But that it's kind of ridiculous to take this complicated an issue on short notice and try to do any major regulating. Basically, what we need to do is deal with this issue next year in our CFTC reauthorizing bill. Am I hearing that right?
Mr. ARBOR. That's exactly right. We feel it should be a comprehensive review, and probably the proper forum for that would be in the reauthorization, you know, next session. But it should include not only the over-the-counter markets but a review of the exchanges with the aim and direction to try to achieve some kind of regulatory parity. Eating out of the same spoon, as Congressman Bishop referred to before, is the motto that we would prefer.
Mr. CHAMBLISS. That's all I have, Mr. Chairman.
Mr. EWING. Mr. Chambliss, do you know what eating out of the same spoon means?
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Mr. CHAMBLISS. I've eaten out of the same spoon as Mr. Bishop several times but——
Mr. EWING. Well, he explained it to us. It's a level playing field, and he says that's a Georgia saying. And it's become part of our hearing here today.
Gentlemen, I guess in parting here I would have a questions that the one thing that probably the exchanges which you represent need as much as anything is certainty and eating out of the same spoon, the level playing field, certainly to know what you have to deal with and what your competition is going to have to deal with. And I assume that's what you would ask from this oversight committee?
Mr. ARBOR. That's correct, Mr. Chairman.
Mr. RAPPAPORT. Mr. Chairman, we've been living with certainty. Our position in terms of the degree of regulatory relief that we would seek has been pretty clear over time. And as we've said on a number of occasions, it's been relatively heavy compared to that which has been given to the over-the-counter market.
We're not the ones that are going to be living with uncertainty as this moves forward. The only possible outcomes here are, we hope, perhaps slightly more regulation OTC and substantially less on the regulated exchanges so that the CFTC and Congress can get more global trading onto the regulatory radar screen, so that in the event that there is some crisis, we can see it coming, and we can manage it in the event that we're forced to.
Mr. GORDON. Mr. Chairman, just a brief remark. You know, we support rational legislation and regulation that give parity between markets. If it looks like something else, they should be regulated in like fashion.
Mr. EWING. Well, I think you all are aware that I have legislation that is still pending that would try and lighten that regulatory load and put us in a very, hopefully, as good a competitive position in the world markets as possible.
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We certainly need your continued input and advice as this committee moves along as we try and find the right pattern for this country and for our markets. And I appreciate very much your input and your being here today.
Thank you very much.
Mr. ARBOR. Thank you, Mr. Chairman.
Mr. RAPPAPORT. Thank you.
Mr. GORDON. Thank you.
Mr. EWING. The fourth panel will be Mr. John Damgard, president of the Futures Industry Association; Mr. Joseph Bauman, senior vice-president, Bank of America, representing the International Swaps and Derivatives Association; Mr. Marc Lackritz, president in Securities Industry Association; Mr. John C. Dugan, counsel, American Banking Association; and Mr. William P. Miller, chairman of the End-Users Derivatives.
If those gentlemen would come forward, appreciate it.
Thank you, gentlemen, for your patience in waiting. And the chairman expects you to bring great clarity to all of the issues that have been put on the table today. And that's why you were saved until the last panel.
And we'll start with my constituent, Mr. Damgard.
STATEMENT OF JOHN DAMGARD, PRESIDENT, FUTURES INDUSTRY ASSOCIATION
Mr. DAMGARD. Mr. Chairman, it's a great pleasure to be here.
I'll ask that my written testimony be submitted for the record.
And before I begin, I'd like to introduce Ron Hersch of Bear-Stearns who is the chairman of the Futures Industry Association and will be responding to any questions that the members might have, along with myself.
Mr. Chairman, members of the subcommittee, my name is John Damgard. I'm president of the Futures Industry Association, and the FIA is the national trade association of the commodity futures and options industry. Our regular membership is comprised of approximately 70 of the largest futures brokerage firms, known as futures commission merchants or FCMs, in the United States. Among our associate members are representatives from virtually all other segments of the futures industry, both national and international. Reflecting the scope and diversity of our membership, FIA estimates that our members effect more than 85 percent of all customer transactions executed on U.S. contract markets.
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We are pleased to be here today to discuss the Concept Release on over-the-counter derivatives instruments issued by the Commodity Futures Trading Commission on May 7, 1998. The Commission has emphasized that it has issued the release for the purpose of collecting information, that it's made no decision regarding the possible regulation of these instruments. Nevertheless, the Concept Release goes well beyond the simple request for information on the nature of the OTC derivatives markets today. It has the distinct flavor of an advanced notice of proposed rule-making.
To many in the financial community, even the threat of additional regulation of the OTC derivatives markets by the CFTC is misguided as a matter of public policy. The CFTC's charge in 1992 was simple and straightforward. The Commission was to use the exemptive powers granted under this section to act swiftly, to bring certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner.
FIA shares many of the concerns that have been expressed by the various representatives of the financial community in this regard.
FIA has a critical interest in a stable OTC derivative market. FIA's members effect more than 80 percent of all customer transactions executed on U.S. futures exchange. The economic success of our members, therefore, is tied directly to the success of the futures markets in the United States and around the world. In this regard, it must be emphasized that the OTC derivatives markets and the regulated futures markets are very closely lined.
If the volume of OTC derivatives transactions is significantly reduced, or OTC derivative participants are compelled by Government action to effect these transactions overseas, the volume of U.S. exchange-traded futures and options transactions will be reduced accordingly, to the detriment of our markets and to our members. By calling into question the legal enforceability of OTC derivative transactions, the CFTC's Concept Release could have just that effect.
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Moreover, it is appropriate to note that many of the FIA's member firms have affiliates that are OTC derivative dealers and end-users. Consequently, any action by the CFTC, or any other Government agency, that casts doubt on the legal enforceability of the transactions these entities enter into may have a substantial, though indirect adverse effect on our member firms.
Our position is simply that this review cannot be conducted, and any decisions with respect to the appropriate scope of regulation of these markets cannot be made by the CFTC alone. The Commission, itself, recommended the creation of an interagency council to consider common approaches to such issues as market information access, transparency, internal management controls, and the development of clearing facilities of OTC derivatives.
The legislative history of section 4(c) confirms our belief that Congress reserved to itself the decision with respect to the appropriate regulation, if any, of the OTC derivative markets.
In adopting this amendment, Congress made no determination that swaps and similar OTC derivative instruments are subject to the CFTC's jurisdiction. To the contrary, the Conferees noted that section 4(c), quote, ''provides flexibility for the Commission to provide legal certainty to novel instruments where the determination as to jurisdiction is not straightforward.''
In issuing the Concept Release, the Commission, again, did not address its own statutory authority over swap transactions. However, by this omission, the Commission nonetheless has implied that swap and hybrid transactions are within the scope of its jurisdiction. Moreover, in a comment letter to the Securities and Exchange Commission earlier this year, the Commission explicitly stated that certain swap transactions are subject to its statutory jurisdiction.
We believe the committee needs to give some direction to the Commission in this regard. FIA respectfully suggests that any review of the OTC derivatives market be conducted by the Working Group. To the extend that the group determines that additional oversight or regulation of these markets is warranted, the Working Group can submit a report to the Agriculture Committee for your consideration.
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We note that the CFTC reauthorization hearings may well begin next year and would provide an excellent opportunity to address this issue.
Thank you for your consideration, and I'm pleased to answer any questions.
[The prepared statement of Mr. Damgard appears at the conclusion of the hearing.]
Mr. EWING. Thank you, Mr. Damgard.
Mr. Bauman.
STATEMENT OF JOSEPH BAUMAN, SENIOR VICE-PRESIDENT, BANK OF AMERICA, REPRESENTING INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
Mr. BAUMAN. Mr. Chairman, and members of the subcommittee, I am Joseph Bauman, managing director of Bank of America. At the bank, I have the responsibility for providing risk management products such as swaps to the bank's clients. However, I am here today in my capacity as a member of the Board of Directors of the International Swaps and Derivatives Association, widely known as ISDA.
ISDA has more than 350 members including most swap dealers, many of the large end-users of swaps, and many of the principal customers of the futures exchange. We have on several occasions appeared before this subcommittee to support proposals to modernize the Commodity Exchange Act by reducing the regulatory burden on the futures exchanges and by providing greater legal certainty that the act does not apply to privately negotiated swaps transactions.
Mr. Chairman, the most significant issue we, as businesses, face is the legal certainty that our contracts will be enforced. Without it, we would be nowhere.
But, unfortunately, Mr. Chairman, recent actions and statements of the CFTC culminating in its Concept Release concerning privately-negotiated swaps have undercut and imperiled the legal certainty that has until now existed for swaps through in large measure, the foresight and efforts of Congress. Moreover, the CFTC has sent a chill through this business by raising the specter that it may seek to impose new restrictions on privately-negotiated swap transactions.
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For these reasons, ISDA wholeheartedly supports the proposal of the Treasury, Federal Reserve, and SEC that emergency legislation be enacted to preserve the current legal framework for swap transactions and the stability of these financial markets until you and your colleagues in the next Congress have the opportunity to renew your efforts to modernize the act.
In these brief remarks, I'd like to explain why this action is imperative. Swap transactions are custom tailored to manage the unique risks of each firm. These custom-tailored swaps are very different from the standardized futures contracts traded on organized exchanges. Both Congress and the CFTC have for many years recognized that swaps are not—and I repeat not—appropriately regulated as futures under the CEA.
By writing the 1989 Swaps Policy Statement enacting the 1992 Futures Trading Practices Act and issuing the 1993 Swaps Exemption, Congress and the CFTC have created an umbrella of legal certainty which covers a broad array of transactions including transactions such as swaps on securities prices which are not, and often cannot be, covered by the Swaps Exemption itself.
This environment has encouraged innovation in risk management and contributed to the Nation's economic growth and stability. But all of this is now in jeopardy because the CFTC has broken from the pack and reversed course. By issuing its Concept Release on swaps, the CFTC has ignored the goal of legal certainty established by this subcommittee.
Treasury Secretary Rubin, Federal Reserve Chairman Greenspan, and SEC Chairman Levitt put it best in their joint statement that said, quote, ''We seriously question the scope of the CFTC's jurisdiction in this area and we are very concerned about reports that the CFTC's actions may increase the legal uncertainty concerning certain types of OTC derivatives.'' Secretary Rubin and his colleagues are not crying wolf.
When the CFTC asserts jurisdiction over swaps as it has by issuing the Concept Release, it implies that certain categories of swaps are futures contracts. If so, swaps that don't fit within the four corners of the Swaps Exemption could be deemed illegal, because under CEA off-exchange futures contracts are illegal and unenforceable.
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This way, the CFTC has called into question the enforceability of thousands of swap transactions and put at risk tens of billions of dollars of value on the books of American banks, brokers, and corporations.
The CFTC can't calm the markets by saying that any new regulations will only be prospective. The CFTC assertion of jurisdiction over swaps will encourage private litigants to challenge their agreements in the courts as unenforceable, off-exchange futures. This legal risk is undermining market confidence. Markets are fragile. Market confidence can be lost quickly, and once lost, market confidence cannot easily be regained.
The growth of swap activities is evidence of the extent to which American businesses have embraced swaps as tools that allow them to hedge financial market and commodity risks and to focus on their core business.
The increase in legal risk that is occurring as a result of the CFTC's actions represents an unfortunate and unnecessary deterrent to firms like mine that offer swaps and is an equally unwelcome deterrent to end-users that can continue to benefit from these competition enhancing risk management tools. This is clearly not in the public interest.
As I said, ISDA represents both dealers and end-users of the swaps business, and I can assure you that just like our dealer members, end-users are very concerned about the CFTC's course of action.
Mr. Chairman, in conclusion we recognize that this session of the Congress will rapidly draw to a close and that the proposed legislation asks much of you and your colleagues. Unfortunately, the CFTC has made it necessary for us to ask for your help to preserve the umbrella of legal certainty that all of us have worked so diligently to create, and as others have pointed out, for which Congress has preserved for itself the right to change.
None of us can prudently ignore the considered judgment of the Treasury, the Federal Reserve, and the SEC that legislation is needed this year to assure continued stability in the financial markets and continued confidence by U.S. business in that their contractual rights under their risk management transactions.
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[The prepared statement of Mr. Bauman appears at the conclusion of the hearing.]
Mr. EWING. Thank you.
Mr. Lackritz.
STATEMENT OF MARC LACKRITZ, PRESIDENT, SECURITIES INDUSTRY ASSOCIATION
Mr. LACKRITZ. Thank you, Mr. Chairman.
My name is Marc Lackritz. I'm the president of the Securities Industry Association. With the Trade Association of the Securities Industry, we have about 800 members ranging from broker-dealers to investment banks, very large firms to very small firms, and many of them are very active in the over-the-counter derivatives market. And that's why it's a pleasure to testify before you today about this issue.
Let me just begin by saying that the over-the-counter derivatives market, which is to say individually-negotiated contracts between and among sophisticated parties, is one of the great financial success stories we've had in the last 20 years. It's made our national financial services industry an international leader, has provided enormous benefits to all the users of these new products and services.
Specifically, cities and towns that use over-the-counter derivatives have saved significant dollars and been able to hold their taxes down by the money they save. Pension fund managers managing the assets of future retirees have been able to help save and preserve the retirement assets of countless workers. Airlines, for example, use over-the-counter derivatives contracts to help keep airline prices down and ticket prices down.
In fact, the result of over-the-counter derivatives has really been to help reduce the cost of capital to every single manufacturer and economic entity in the United States, so much so that I think they actually have helped to contribute as well to the increased of productivity growth in the country that has helped led to our economic expansions of the last number of years.
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It's been a terribly successful—very, very hugely successful—innovation that's been the result of a number of factors. One of them's been the advancement of portfolio theory and hedging theory. Second, it's been the new advent of technology that's enabled computers to compute, analyze, or synthesize vast amounts of the data that makes these products profitable. And third, and very importantly, has been the legal certainty that your committee, Mr. Chairman, and the Congress, who working together with independent regulatory agencies, has been able to provide to this marketplace. That's been a critical building block to the success of this marketplace.
The CFTC's Concept Release that was just released recently unilaterally, by its actions, threatens to undermine this progress on all fronts. It implicitly reverses the 10-year consensus among the Congress and all these regulatory agencies that swaps should not be regulated as futures. It already has escalated legal uncertainty in this marketplace, as you've heard before from Under Secretary Hawke and Richard Lindsey.
In addition, it has already pushed some business offshore, and it threatens our status of innovation and leadership that we've built up in the last 20 years because of the movement offshore to other financial centers. And it threatens our status as a global financial center.
Now the problem here is the Congress did not tell the CFTC to do. What Congress specifically did was to tell the CFTC, urge the CFTC, to exempt certain classifications of transactions encumbered that's covered under the act. And what's happened here in a unusual sort of regulatory jujitsu is that the direction of Congress to the regulatory agency to exempt transactions has now been used by that regulatory agency as justification to impose a regulatory structure on these same transactions.
And as a result, it's sort of like an Alice in Wonderland mummification of what your original intent was. It also basically arrogates to an independent agency a task which the committee and the Congress clearly have responsibility for.
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So there's been a dramatic change here. In fact, what I suggest to you is that the CFTC's action here really will create a problem that's far worse—and already has created a problem—far worse than any of the problems that we've heard about that they are alleging that they are trying to solve.
I might add that only Congress can really fix this problem. You are the only body here that can really deal with issue effectively without creating market disruption.
We've already heard from a couple of the witnesses as to how this release does undermine, how this unilateral agency action undermines the legal certainty that's been built up. It's ascent and it's a building block of the success in this industry.
Only you have the power and the authority really to look in this issue, to deal with the public policy questions, and to resolve it without creating market disruption and legal uncertainty that have already resulted. And so we really strongly urge you to do that.
Now the CFTC has offered a number of reasons for why it is doing what it's doing. And I would submit to you, with all due respect, that none of these reasons really ''wash'' and have much merit. They said, for example, that they have the regulatory responsibility to do that, but it's clear that Congress reserved this responsibility to itself. It's talked about the losses in the market. The losses, in and of themselves, are no reasons for regulatory intervention in the marketplace. Every single day, individuals and institutions make money and lose money in the market; that's not a reason to regulate the market.
They talk about the enormous growth in this market as a rationale for getting into it. The growth in this market is a sign of its success, not a sign of its problems. And I think one of the things that's unusual here is that the very success of this marketplace has caused this new inquiry to come forth.
The bottom line, Mr. Chairman, is that these individually-negotiated transactions and hybrid instruments perform a very vital role in our economy. Until the CFTC's Concept Release came out, the legal certainty had fostered the growth in this activity. And now this action has threatened to undo all the success and dump it back into a swamp of litigation.
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So we urge you in the strongest possible terms to support the legislative proposal because we think that the risks from not acting here in this circumstance are far greater than the risks of acting and moving forward. We think it's critical to do that, because it's important that the markets aren't disrupted, that we don't have a diminished leadership position of financial leadership in the world.
And as the Congress, it's your responsibility that formulates legislative policy, not the actions of an unilateral independent agency.
Thank you very much, Mr. Chairman.
[The prepared statement of Mr. Lackritz appears at the conclusion of the hearing.]
Mr. EWING. Thank you.
Mr. Dugan.
STATEMENT OF JOHN DUGAN, COUNSEL, AMERICAN BANKERS ASSOCIATION AND AMERICAN BANKERS ASSOCIATION SECURITIES ASSOCIATION
Mr. DUGAN. Mr. Chairman, and members of the committee, my name is John Dugan, and I am a partner in the law firm of Covington and Burling. I am appearing today in my capacity as outside counsel for the American Bankers Association, otherwise known as the ABA, as well as the ABA Securities Association, otherwise known as ABASA.
The ABA is the largest bank trade association in the country representing all types and all sizes of depository institutions, from community banks to regional and money center banks. ABASA is a separately-chartered subsidiary of the ABA representing those banking organizations that are most actively engaged in capital markets activities, including derivatives transactions.
I appreciate the opportunity to provide the views of the ABA and ABASA regarding policy developments affecting derivatives, especially the Concept Release recently issued by the CFTC. I have been involved in legislative and regulatory developments affecting derivatives since 1992, when I served as Assistant Secretary of the Treasury for Domestic Finance and when Congress directed the CFTC to promulgate the so-called Swaps Exemption in the Futures Trading Practices Act of 1992.
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Mr. Chairman, the members of the ABA and ABASA are deeply troubled by the CFTC's Concept Release. It unilaterally disturbs the status quo of legal and regulatory certainty that has enabled privately-negotiated derivatives activities to thrive for the benefit of the United States economy. That status quo had been forged through the previous hard work of the CFTC, this committee, other financial regulators, other Members of Congress, and market participants.
Now, however, by implicitly suggesting that it might reverse course on its own and treat privately-negotiated derivatives as futures contracts, the CFTC has created the specter of unenforceable contracts, increased litigation, and burdensome new regulation. ABASA and ABA's members believe that such unilateral action is fundamentally unwarranted, and they fear that the resulting specter will drive business and innovation away from the United States.
The critical point is this: privately-negotiated derivatives affect many different parts of the financial marketplace and are affected by the decisions of many different financial policy makers. All the participants in this process helped create the 1992 legislation that established the status quo of legal and regulatory certainty that you've heard about today, which was based fundamentally on the concept that privately-negotiated derivatives ought not to be regulated as exchange-traded futures contracts. Any notion of departing from this status quo, if the departure is thought to be necessary, should only be accomplished through coordinated action by the same spectrum of policy makers, and only after careful study with input from market participants.
That's why the ABA and ABASA support the recent proposal by the Treasury Department, the Federal Reserve, and the SEC to postpone any changes to the status quo until Congress and the regulators have worked through this issue together. The ABA and ABASA believe that a process which fosters such consensus before acting, as opposed to a go-it-alone effort to break from the status quo, constitutes sound and sensible policy. Indeed, the ABA and ABASA would welcome the opportunity to participate in such a process.
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Thank you very much. I'd be happy to answer any questions you may have.
[The prepared statement of Mr. Dugan appears at the conclusion of the hearing.]
Mr. EWING. Thank you.
Mr. Miller.
STATEMENT OF WILLIAM MILLER, CHAIRMAN, END-USERS OF DERIVATIVES
Mr. MILLER. Thank you, and good afternoon.
I'm William Miller; I'm testifying on behalf of the End-Users of Derivatives Association.
I would ask that our written testimony be included the record.
Mr. EWING. Without objection.
Mr. MILLER. Thank you.
Let me highlight portions of our written testimony.
Derivatives are important to global economies. American firms and regulators built a U.S. leadership role in global derivative markets estimated to be valued at $70 trillion dollars.
Derivatives are global and complex; the market is robust and vibrant. The products vary from the simple to the complex, and user expertise varies from the unsophisticated to the sophisticated. So does the dealer expertise. There are multiple regulatory regimes worldwide, and the legal environment varies from those which are derivatives-oriented to those which are not.
Now within this complex environment, the CFTC has issued a Concept Release in order to better quantify, or define, this market. The CFTC reviewed the OTC market about 5 years ago and these are the reports. They were good, helpful reports. We as end-users and many of us investors liked these reports. They give us a better understanding of the markets, and they give us greater comfort when we participate and understand what's going on.
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Over the past 5 years, derivatives have grown six-fold in outstanding value. A private industry group, the Group of 30, in 1993 issued an excellent report providing recommendations for good risk management of derivatives. There have been some losses. They have highlighted the need for effective risk management by the market participants. The SEC required greater disclosure recently of derivatives by corporations in their financial reports improving information to shareholders and assuring greater awareness of derivatives by top management.
The GAO reviewed a narrow aspect of derivative activities, and 9 months ago recommended additional regulatory oversight by the Presidential Working Group, which then referred it back to each of the underlying Government agencies. The FASB recently revised accounting standards for reporting on derivatives.
Recognizing the size, a six-fold growth over the past 5 years, changes, and added complexity of the derivatives market, the End-Users of Derivatives Association supports U.S. regulators updating and making public their assessment of exchange-traded and OTC derivative markets and regulatory structures.
Our written testimony also lays out parameters and considerations for regulatory change.
And with that I'd like to thank you, and I'm pleased to respond to any questions.
[The prepared statement of Mr. Miller appears at the conclusion of the hearing.]
Mr. EWING. Thank you, each of you participants.
Mr. Miller, does your organization support the concept paper?
Mr. MILLER. We have no objection to any U.S. regulator or whether it be the Federal Reserve, the Treasury, the CFTC getting a better understanding of the market and the regulation associated with it.
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Mr. EWING. To all of you on the panel, is there or have you identified a problem there that you believe further regulation could address in the over-the-counter market?
Mr. LACKRITZ. Let me start, Mr. Chairman. No, there is not a problem in the markets that any future regulation could address. As I've tried to summarize in my oral testimony, the very rationale being offer by the CFTC for moving forward don't really include any problems in the market. But the issues they focus on concern the rapid growth in the market to the fact that some of the participants have lost money, and the fact that they have a regulatory responsible somehow made up out of the exemption that was mandated out of the 1992 legislation that this committee passed.
This is a situation, Mr. Chairman, I think where the old adage of ''if it ain't broke, don't fix it,'' has sort of been stood on its test. We've got a regulatory agency saying, ''I'm going to fix it,'' and what we we're saying is that might break it.
Mr. DAMGARD. I would just add that I think that the Concept Release does smack of a seeking to impose regulation on a market that is not now regulated and has shown no need to be regulated. The CFTC's own statement they talk about examining their own regulatory role in this new market.
And I think the question that we have—and this is third time that I've been up testifying on this subject—is what does Congress want to do with respect to giving responsibility to the CFTC or any other agency? With respect to regulating these products?
The marketplace is ultimately going to decide, in my view. I think that competition and innovation are what this industry is all about, and if we try to protect any one element of this industry, there is a risk of running this business offshore.
We have exchanged-traded products versus OTC products; we have open outcry versus electronic trading, and we have the question of United States versus the rest of the world. And I think exchanges and Congress have very, very important decisions to make with respect to all of those questions, because otherwise I see our business going away.
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Mr. BAUMAN. Mr. Chairman, if I could address it, I'd say the key phrase in your question is, obviously, what problems could new regulations cause? I would agree with Mr. Lackritz that while there are issues and to a certain degree problems that always arise in the conduct of any business there are none that are demanding the attention of regulators. I'd say that the biggest problem, that we may face is the effect that the Concept Release could have on the market in general.
Mr. DUGAN. I would just second what's already been said. I think that one of the fundamental premises about the need for the Concept Release was this notion of losses. Congress and the regulatory agencies took a very thorough, very hard look at that in the last 3 to 4 years, and there's certainly nothing recent that would suggest that those problems have been reoccurring. And so I would agree that there isn't anything in the marketplace that would warrant this going forward at this time.
Mr. MILLER. We have issues related to global derivative regulation or customer protections and safeguards. Our approach is to deal with those issues directly with our particular counterparties, the broker-dealers, and then weigh from there whether it's appropriate to go to regulators. So our approach does not cause us at this point to be wanting to bring anything to the attention of this committee.
Mr. EWING. The SEC has broker-dealer license approval. Would this new regulation bother that——
Mr. LACKRITZ. Maybe I can address that, Mr. Chairman.
The SEC's proposal for this Broker-Dealer Lite idea was really—the industry has urged this option because of so much, particularly in the options area, has moved offshore because there wasn't an adequate and appropriate regulatory—there wasn't an appropriate body to do that business onshore. And, in fact, in working with the SEC to try and craft an opportunity for voluntary use of sort of a regulatory structure, a light regulatory structure, in the United States, it would help to bring some of that business back to the United States. It would create an option to do that. It's not in any way, shape, or form comparable to what the Concept Release has brought forth.
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In fact, I might add, Mr. Chairman, that in this area of over-the-counter derivatives, about 90 percent of them are being done by banks, which in fact are overseen by bank regulators. The remaining 10 percent of them are being done by about six large investment banks firms which, in fact, have voluntarily proposed a—they're called a Derivatives Policy Group—and they, in fact, have a voluntary reporting regime to the SEC and to CFTC which in fact has discloses a lot of the information already, so that those regulatory concerns are in fact addressed.
Mr. EWING. Gentlemen, most of you are suggesting that the Treasury legislation would be attached to a appropriation bill and passed down to the Congress impacting the CFTC in probably some very significant ways is the way to handle this situation? I mean where is the congressional discussion and debate of the issue?
Mr. DAMGARD. I think procedurally none of us favor the appropriations route. It's just that at this particular time in a very busy congressional season there weren't any other ideas. I have not yet studied the legislation, and I'm not an expert with respect to whether or not it creates problems for the CFTC that can't be rectified.
But I do believe that the markets need the assurance that nothing is going to happen in terms of greater regulation in OTC products because of the amount of business that's out there. I mean the concern, Mr. Chairman, comes from those who have taken Congress' word and taken the previous CFTC position that they can enter into these contracts knowing full well they're accepting risks. And I might add that most of the dealers that are in this business are laying those risks off on regulated exchanges.
So it's good for my members. I mean Mr. Hersch's largest customer is his OTC derivatives subsidiary whose business he brings to the Chicago marketplace.
What we're concerned about is whether a U-turn on the part of the CFTC allows losers or people who owe a lot of money in the derivatives market—and I'm told that there are many of those particularly in Asia—to avoid paying what they owe. And I think that the examples that were offered by the Treasury Department, Deputy Secretary Hawke, are probably very, very accurate examples.
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We believe that sending a signal that assures the status quo is very, very important for the markets, and right now. And I don't know how else that would be done, but we would be amenable to other solutions beside the legislation if Congress had other remedies. We do believe it has to be addressed.
Mr. LACKRITZ. Mr. Chairman, can I just talk about your question about where is the congressional discussion here?
Congress is really the only body that has the authority and is in a position to actually settle these issues. This is legislative public policy. And what we've always done is to have Congress set the policy and independent agencies carry it out. We don't have independent agencies setting legislative policy and then coming back to Congress to say, ''I've done your job for you. You know, don't worry; I've got it all under control. I've done your job.''
So that's really, here, the legislation that we all support and we strongly support, and we really urge you to enact. It really is necessary to preserve a congressional role here, because if in fact the status quo has been altered, it wasn't altered by the Congress, and it wasn't altered by the President's Working Group. The status quo was altered by only one body here, CFTC.
And the only way to get that status quo back is for Congress to legislate to get that status quo back.
Mr. EWING. Well, thank you for protecting our congressional prerogatives. [Laughter.]
We find that people are always interested in us acting when they agree with us. [Laughter.]
When they don't, we get the little other response.
But I'll just lay out for you that you don't take something quite as controversial. We've heard a lot of testimony here today on both sides of whether there should be action, and put it on a rider of an appropriation bill and have any debate on the issue. There are already powerful people in this Congress coming down on both sides of that issue. What will that do to your markets?
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I mean I'm very interested in knowing whether that kind of strong debate in the Congress, and maybe no action, is going to improve your markets.
Mr. BAUMAN. I would defer to my colleagues in Washington on the best way for this bill to be approached in Congress. From my seat, it is the imperative for action that is important. It's not in any way an attempt to reduce the debate on the issues. What we are asking for is a bit of the calendar, so that the issues can be brought out and debated, and if this is a good forum for that, we are very happy to do it.
But what we do feel is that, with the limited number of days that Congress will be in session for the remainder of this year, and the obvious agenda that Congress faces, that this is not an issue that we really feel comfortable allowing pass to the next Congress.
Mr. DAMGARD. And I would just add that I'm unaware of any strong support for greater regulation of the OTC market, even the exchanges are saying they recognize that the strong OTC markets and growing OTC markets brings business to them. And they're their best customers. So what they're saying, or at least what I heard them say is, let the OTC markets continue to grow in a relatively unfettered environment. And look long and hard at what sort of relief you might be able to provide the exchanges. That was the message that I heard.
And my sense is that the damage that's been done is the threat of a regulatory scheme being imposed in a market that currently is growing and is very successful, where contracts go out many, many years that could very well be violated and set aside by the courts.
Mr. EWING. Well, from this chairman's standpoint, I want to make it very clear that I don't know of anybody who is suggesting more regulation either. But I do know that there are powerful forces involved in this issue who don't believe that the Treasury's legislation is the right way to address the problem. So that creates the controversy, and will certainly create the debate which may or may not lead to the passage of your legislation.
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I have suggested that if there is no regulation proposed and if this is indeed held until next year, that this debate would much better be a part of reauthorization. And hopefully, that would not destabilize the markets.
Are there comments on that?
Mr. BAUMAN. Well, I think that, in general, I would, and my association would, agree with that. The qualifier is that there needs to be something that will hold the playing field as it is today. And that is what we would like to come out of the legislation, simply to hold the playing field for that and to delay any actions until there could be thorough debate on it.
Mr. DAMGARD. I mean there's a sense that markets are moving offshore as we speak; so how do we stop the bleeding? And I'm not saying that an amendment to the appropriations bill as drafted by the Treasury is the only way. We would be very interested in hearing from those who might provide other solutions. I think what my colleagues are saying is to sit back and wait for next year's reauthorization may cause irreparable harm to a market that quite honestly is very important to the U.S. economy, and I might add very important to my industry.
Mr. EWING. Well, I think my assessment of this is that if rule-making is going to proceed, then there will be a legislative discussion and maybe a legislative battle over the issue in the Congress. I wonder if that's productive for any of these parties in this debate?
Mr. LACKRITZ. Well, Mr. Chairman, if I could address your previous question?
We strongly support your committee taking up this question in the reauthorization legislation next year. I think there is broad agreement that you certainly have the prerogative and the responsibility for that, and we don't dispute that.
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But the real question is between now and then, how do we get back to the status quo prior to being altered unilaterally by this Concept Release? The Treasury, Fed, and SEC legislation that's been suggested, we thought was a very effective way of getting there and we think that will do it.
If there are other ways of getting back the status quo so we can keep the status quo until you have an opportunity to make those kinds of decisions, we'd obviously want to explore them.
Mr. EWING. Well, this is certainly where we have to go. And we have all be responsible as we try and get to that status quo and be willing to look at the options out there in my opinion.
Mr. Chambliss, I didn't mean to take so much time.
Mr. CHAMBLISS. Thank you, Mr. Chairman, and I don't have very many questions.
But I was appreciative of your characterization, Mr. Bauman, of the these products as being custom-tailored because in my limited knowledge of them, that's kind of the way I think of them. I think that's a very appropriate term to describe them in.
And you all have great success stories about the way that this particular is working, and my guess is that if the Government had interfered previously there would not be those success stories out there. That's kind of the way I perceive Government interference, very honestly.
And because it is such a narrow limited market from the standpoint of being able to—the only participants in that market, as I understand it, are pretty sophisticated investors. That means that if we're going to regulate this through CFTC, we're going to virtually have to create a whole new bureaucracy to be involved in this on a daily basis, which is absolutely not the direction that the current Congress wants to go, and I'm a little bit bothered by that.
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At that the same time, though, I don't understand enough about these products to know whether or not the world financial market is going to be in jeopardy if all of a sudden we have a number of these things failing for whatever. Because obviously, as one of you testified to, you have successes and you have failures out there but—I mean is that a possibility or a likelihood of these things? Do they have the capability of creating a financial crisis worldwide if all of a sudden we have a number of losses in these particular products?
Mr. BAUMAN. I'll start and try to address the Congressman. As was said, there are losses; there are going to be losses in all financial markets. Some might say that for as many losses there are, there are going to be people who gained.
Mr. CHAMBLISS. Is that true with these products?
Mr. BAUMAN. Yes, it is.
Mr. CHAMBLISS. Okay.
Mr. BAUMAN. I think the key from a public policy perspective should be, is there an imbalance when it comes to the effects that those gainers or losers would have on the structure of the financial system or the advancement of business? And I think that history has borne out over the last 10 years that, while there are going to be losses and some of them may be for reasons that, with the benefit of hindsight, we would say people should have known better and might have acted differently; that none of them have really resulted in a systemwide concern. That was raised as a concern 7 to 10 years ago. It has just not materialized, has not happened.
In many ways I think that is because the product set that we tend to call swaps is a very diversified set of products with a very diversified end-user group, and that the fact is that no one problem in today's world would probably be large enough to bring the system itself to the point of strain.
Mr. CHAMBLISS. Are these treated as capital assets?
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Mr. BAUMAN. Technically, they are off balance sheet instruments. The FASB has recently come out with rules that standardize the treatment of these instruments and the reporting of them. They are disclosed in virtually all firms' financial statements or footnotes, and in a variety of different ways, depending on their use, will appear as balance sheet values to all viewers of the public statement.
Mr. DUGAN. And if I could just add, in the banking world and banking industry there are particular capital requirements that do apply to banks that hold these instruments. Similar capital requirements apply in other contexts as well.
Mr. BAUMAN. I had taken your term ''capital'' to mean something else. Yes, certainly, they are instruments that bear capital haircuts, if you're a securities firm, or are a part of the risk-based capital ratio, as in the banking industry, in calculating our capital adequacy.
Mr. CHAMBLISS. Does FDIC exercise any jurisdiction over these products?
Mr. DUGAN. Yes, they do. As you may know, this market grew up originally as a bank-created market, involving credit judgments made on a bilateral basis. All of the banking regulators have paid a great deal of attention to these particular products, and have adopted risk management techniques to make sure that these are managed in a safe and sound manner. It's a very constant focus of the banking regulators on the banking industry—of all the banking regulators, including the FDIC.
Mr. CHAMBLISS. If I understood what Chairman Ewing was driving at a while ago with his question regarding the Treasury legislation, I'm not sure I ever heard the answer to what I thought was the question. And that is, let's suppose that this Treasury legislation moves forward and it doesn't pass. Is that going to put you in a worse position or put this market in a worse position than if we do nothing? I mean it looks to me like it would.
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Mr. LACKRITZ. Well, there are always risks to action and risks to inaction, I think. Here in this particular case, unilateral actions by one agency have thrown legal certainty to the wind and created additional uncertainty.
So right now, what we're trying to figure out is how to get the genie back in the bottle. And legislation from Treasury really is one attempt to try and do that. Now if it doesn't pass, there are others ways I suspect of doing it. We think this is the cleanest, most efficient, and most effective way of restoring the status quo and providing for the legal certainty that the market really depends.
Mr. MILLER. Will the uncertainly go away? I mean I haven't seen this Treasury amendment, but does it have a life of to it of about 6 months? Once it expires, are we then going to have further uncertainty when Congress or anyone else wishes to raise questions?
Mr. LACKRITZ. Congressman, I didn't realize you'd recognize us to ask questions of each other, but we're happy to respond to each other. [Laughter.]
Mr. CHAMBLISS. When you know as little about this as we do, we appreciate those questions. [Laughter.]
Mr. DAMGARD. I think it was designed to correspond with reauthorization of the CFTC, so that Congress, you know, the enabling committee has the opportunity to address this subject. And you know, if the enabling——
Mr. LACKRITZ. That's exactly correct.
Mr. DAMGARD. If Congress doesn't act, then we are back to an expired provision and the uncertainty would then be reinstated.
Mr. BAUMAN. The bill, I believe, also calls for a study to be conducted by the Working Group and reported back within, I believe, one year.
Mr. MILLER. I would just ask that the study also include other regulators beyond just the Working Group. Because I think one thing we've learned is that this is so broad that there are other regulators, like insurance agencies and foreign regulators——
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Mr. LACKRITZ. Can I just interject? This issue has been so complicated, as you've gotten a taste of today, with all of the different participants in the marketplace, the different exchanges, the different regulators. We have a Working Group of only four financial services regulators, and apparently has one agency that's a bit of a renegade from the other three. And the notion of now expanding it to include more—I mean we could obviously rent out RFK Stadium and have a study done, too, but, frankly, we'd like to get this problem resolved and get legal certainty back into the marketplace, Mr. Chairman. That's really what or interest is.
Mr. DAMGARD. I mean, if there are flaws to the Treasury amendment—and there was one that was raised yesterday which I now find is not accurate—and that is, would this freeze the CFTC's ability to, you know, to provide flexibility in the ag trade option area? And there were certain agricultural groups that were opposed to this solution on the basis that they need greater flexibility, and they are not content with what they currently have received out of the CFTC.
We don't want to do that. We are not attempting to tie the CFTC's hands in any kind of emergency activity, but we are looking for ways in which to totally renounce what most of the marketplace seems to believe that this Concept Release has conveyed.
Mr. CHAMBLISS. Well, I don't think there's—based on what I have heard in conversation—I don't think there's any chance that that legislation might not prevail during the appropriation process. But if I'm hearing you, if it should there are other options out there that will allow you to stop the bleeding, as you say, until the reauthorization process can be completed?
Mr. LACKRITZ. Well, we would urge you to adopt this legislation. We think it's the most effective, and quickest, and most efficient way of solving a very significant problem that we have now.
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But if the question is, are there no other ways without this legislation? No, there are other ways, but we haven't seen any yet. It really requires an independent agency to basically renounce or backtrack or withdraw and explicitly make statements, so that we can restore the legal certainty of this marketplace that has operated under beforehand
Mr. CHAMBLISS. I'm sure somebody has asked this question earlier and I apologize for asking you to repeat it, but what is the total dollar volume in this industry right now?
Mr. BAUMAN. Yes. The notional value will be reported in the press as a variety of numbers, depending on what is included under that umbrella. At its largest, I believe if you include all outstanding swaps, futures, forwards, related contracts, the notional value would be absolutely huge. It would be over $70 trillion. But that value is not a true representation of the risks in the market.
Most studies have shown that the risks of the activities boil down to about 1 percent of the notional amount in the aggregate, across all market participants in all parts of the world, not just in the United States. And while those still represent very large numbers, they are not numbers that are unusual or maybe even out of line relative to the risks in the financial system from loans, public bond markets, equity markets, and other similar financial instruments with current value.
Mr. CHAMBLISS. Thank you, Mr. Chairman.
Mr. EWING. Well I am pleased to see after several hours of some of the most interesting testimony, although somewhat technical, that there's still a lot of life in this last panel. And I would want you to be assured that I believe this committee is interested in stability in our markets and in seeing this situation resolved in a amicable way.
Your message has come through in other testimony here today. And we intend to follow up on what you have told us and work with the agencies. I can assure Ms. Born is not a rogue—no it was a rogue agency. I just wanted to clarify that. [Laughter.]
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And she's been very patient and set through it all and listened. And I always appreciate that whenever we have a hearing.
And I thank all of you for your testimony and for waiting to appear on our last panel.
If there are no other questions, I will adjourn this meeting and indicate that the record will remain open for 10 days to accept statements and any additional information.
The hearing is adjourned.
[Whereupon, at 5:43 p.m., the subcommittee adjourned subject to the call of the Chair.]
[Material submitted for inclusion in the record follows:]