SPEAKERS CONTENTS INSERTS
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RECOMMENDATIONS BY THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS
TUESDAY, APRIL 11, 2000
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Baker, Biggert, Terry, Toomey, LaFalce, Kanjorski, Waters, C. Maloney of New York, Watt, Bentsen, Sherman, and Lee.
Chairman LEACH. The hearing will come to order.
Today's hearings will address three areas—over-the-counter derivatives; hedge funds; and contract netting—where legislative proposals are pending to reduce systemic risk to the financial markets. The legislation, in each case, is based upon recommendations from the President's Working Group on Financial Markets. The Working Group, which consists of the Secretary of the Treasury and Chairmen of the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, has creatively examined system-wide issues across the legalistic and jurisdictional divides that normally separate one regulator's thinking from another's.
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The Working Group's newly established and long overdue consensus on OTC derivatives is momentous for the banking industry, banking regulators and this committee. An overwhelming majority of financial OTC derivatives transactions involve one or more banks. Not only do the largest commercial banks conduct most of the dealer activities for financial swaps or related derivatives, but banks and other financial institutions of all kinds and sizes are the largest-scale end-users of these contracts.
OTC derivatives, particularly interest-rate, foreign exchange, and credit derivatives, have become essential to risk management strategies, proprietary trading activities, international operations, and services to institutional customers. For these reasons, this committee has had a vigorous and sustained interest in derivatives issues for well over a decade.
In 1993, the then-committee Minority issued what remains the most comprehensive analysis of over-the-counter derivatives ever produced in Congress. Many of the issues addressed in the Working Group's 1999 report were raised in that report.
In the 6 1/2 years since, these markets have increased dramatically in size. According to recent OCC figures, the notional measure of U.S. commercial banks' derivatives transactions is almost $35 trillion; and, of this amount, $31 trillion represents OTC derivatives activities, yielding some $2.5 billion in revenues for the last quarter. The most recent total of banks' credit exposure from off-balance sheet derivatives contracts is $396 billion. In sum, banks are central to financial OTC derivatives markets, and these markets have become central to a wide range of banking activities.
At this point, I would like to ask unanimous consent to insert the rest of my opening statement in the record and turn to Mr. LaFalce and then to Mrs. Roukema, and then we will begin the hearing process.
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Chairman LEACH. Mr. LaFalce.
Mr. LAFALCE. Thank you very much, Mr. Chairman. I appreciate you scheduling these timely hearings. These may not be the most exotic or interesting topics for hearing discussion, debate and legislative enactment, but they are extremely important and an important part of our responsibilities.
Given the brevity of the legislative session this year, we have fewer days at our disposal than one might intuitively believe. So if we are to get legislation enacted, we would have to move very expeditiously.
Now, I realize that the most intense interest in recent days has been focused on the matter of OTC derivatives. You and I, Mr. Baker, and Mr. Kanjorski have introduced H.R. 4203 to deal with some aspects of that complex topic. However, prior to addressing that issue, I would like to turn to the matter of H.R. 1161, the Financial Contract Netting Improvement Act, which you, Mr. Chairman, Mrs. Roukema, the Chairperson of the Financial Institutions Subcommittee, and I introduced in 1999.
The netting bill is more than ready for expeditious enactment into law. If we do not seize the opportunity to move on it separately and quickly, we might create real risks that need not and should not exist.
This bill clarifies the manner in which banks and other financial institutions have quickly settled their gross obligations from and to each other at a net figure. In the case of a bank or other financial institution failure, establishing who owes what to whom quickly, within hours, is vital to prevent contagion and chaos throughout the system. The antiquity of present law, which does not square with the way markets now operate, makes this improbable, if not impossible.
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And, in slightly different form, this legislation is now incorporated in the House-passed version of the bankruptcy bill, H.R. 833. But that broader bill has been stalled in even getting to conference due to a number of reasons.
Our committee previously and unanimously reported a netting bill in the 105th Congress, which is little changed from the netting bill under discussion today. If the committee need act again—and I do not believe that essential at all—I would support simply cutting to the chase and passing out the relevant portions of the House bankruptcy bill as a substitute. The House has already agreed to these provisions. Frankly, however, I would much prefer moving immediately to the suspension calendar and not spending the committee's time on reworking old—and agreed-upon—ground.
Mr. Chairman, I would like to take the issue of netting and bring it to the floor on the suspension calendar as soon as possible, and I would encourage your consideration of that approach.
The huge amount of work that has been done to perfect this highly technical legislation has been overwhelming. The President's Working Group has given its input and its members have been fully consulted. All the major banks, brokers, trade associations and other industry parties have had their say. Both Chambers have passed and their products vary little. In short, the netting measures are ready for final adjudication and the President's desk.
On to H.R. 4203, the OTC derivatives bill. That is a somewhat different story. I was pleased to join in co-sponsoring this bill, and I very much appreciate the Chairman's timely effort to put issues of particular concern to this committee on the table. But, advancing legislation in this area will take considerable time and effort, and the bill does raise complex legal and policy issues and a number of committees will necessarily be involved. Even in its relatively narrow form, this bill has provoked sequential referrals to a number of other committees.
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Many are aware of the derivatives traded on well-known exchanges, such as the Chicago Merc, the Chicago Board of Trade, the New York Board of Trade, and so forth. These are standardized options and futures commonly quoted in the press. But the burgeoning area is what are known as over-the-counter derivatives, sophisticated financial arrangements tailored to the needs of large and knowledgeable investors, presumably knowledgeable investors. These have evolved here and abroad into what is nominally a multi-trillion dollar market.
Last November, the President's Working Group issued an important report on oversight of this market. Our consideration of modernizing derivatives law is further driven by Congress's need to reauthorize the Commodities Futures Trading Commission, which will otherwise sunset later this year.
I do not argue, or necessarily believe, that the OTC derivatives bill we have introduced adequately addresses all the issues raised by the President's Working Group. However, since banks or their affiliates generate most of the OTC instruments, it is essential that our committee put a product on the table and begin a thorough examination of the subject if for no other reason than the bank safety and soundness concerns these financial products generate. Nor do I argue that this bill most appropriately resolves those issues it does address.
For example, if swaps are to be totally excluded from the jurisdiction of the CFTC, a position of the President's Working Group I generally favor, and which H.R. 4203 attempts to execute, we must be certain the language is crafted properly. The CFTC exclusion must be truly effective, while leaving swaps clearly open to antifraud regulation from other quarters such as the bank agencies.
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Our bill focuses primarily on the security of clearing OTC derivatives. That is the system through which one party to a derivatives contract receives assurances that another party to the contract will perform directly or indirectly. The bill is not aimed at the fundamental structure of the Commodities Exchange Act. Moreover, we have not addressed the question of whether futures of the stock of the single companies should any longer be banned by specific statute.
These issues and others must be joined if we are to legislate successfully. Ultimately, any legislative product in this area must speak to a far greater array of issues than our bill addresses, including legal certainty, regulatory issues, and Shad-Johnson, and must incorporate not only the Banking Committee's concerns, but those of the Agriculture, Commerce and Judiciary Committees. It will be difficult to achieve consensus, and it will be time consuming.
Finally, with respect to H.R. 2924, the hedge fund disclosure measure I am also co-sponsoring, considering the origins of this bill—the failure of Long-Term Capital Management, which posed a systemic threat to the liquidity of the debt markets, this is a modest response as recommended by the President's Working Group. In the subcommittee, there was much discussion of whether this was a ''camel's nose under the tent,'' potentially leading to regulation of hedge funds by the Federal Reserve, instead of a mere quarterly disclosure of non-proprietary risk information for the 25 largest hedge funds. I believe it is no more than disclosure, centering on the public's need to be informed about risks in very key institutions.
For our part, I am also interested in the right of the Congress to know something about the sizes and types of risks that are arising. When problems present themselves, this institution then tends to hear about them rather quickly. Forewarned is forearmed. I favor the benefits this bill will bring to the public, but I believe that Congress will benefit from this information as well.
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Mr. Chairman, I thank you for your indulgence on a lengthy opening statement. I look forward to the testimony.
Chairman LEACH. Thank you very much, John, for your thoughtful comments.
Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I am very sensitive to the time constraints here, and we are very anxious to hear from our panelists, so I would ask unanimous consent that my full remarks be entered into the record.
I will simply observe that this hearing certainly is well devised, and it touches on very essential issues of systemic risk, and the approach seems to be a comprehensive one and that it is appropriate that we observe the systemic risk problems in a comprehensive form.
That having been said, I would also like to observe and associate myself with the remarks of the Ranking Member with respect to H.R. 1161, the netting bill. I do not know, Mr. Chairman, if we should be going into some sort of a conference, but I think that is a legitimate question as to whether or not the netting bill could be taken up in a separate context. At least that is something I believe that we should confer on.
With respect to the other questions, of course, I will save my questions and comments for both the regulators as well as the representatives of the financial industries which are here. But I will observe that, as a co-sponsor of Mr. Baker's hedge fund bill, I also recognize that there are legitimate questions that have to be raised regarding the reporting levels and whether or not they should be higher and a number of other questions, but I will save those questions for the regulators so that we can get advice of those that are dealing with the subjects on a regular basis and have that kind of experience.
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Thank you, Mr. Chairman. I look forward to the testimony.
Chairman LEACH. Thank you very much, Mrs. Roukema.
Let me just make one brief comment on the netting bill, because I know there is a lot of interest in it.
I am absolutely committed to getting this bill adopted in law in one fashion or another this year. I have been in contact with the Senate side on this issue. If it does not come to pass within the context of a bankruptcy bill, it will come to pass—at least every effort will be made to ensure that it comes to pass in the context of banking legislation.
We may bring a discrete bill of our own to the floor. It looks like on the Senate side there may be a minimum number of banking bills, whether it be one or two, or it could well be only one, in which case we could well have toward the end of the session a clutter of House-passed bills taken up in the context of a single Senate-passed bill. We will probably be doing some sort of sorting out of what has not happened and what has happened toward the end of the session. That is likely to be the order coming from the Senate.
I would be very happy to bring this particular netting bill to the floor at the earliest possible time, although I have no great sense of whether the leadership wants to do it in that fashion. But I certainly am convinced that the gentleman from New York is right in wanting to do this.
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Mr. LAFALCE. Mr. Chairman, there are many tactical approaches that can be taken, and you have to make a judgment based upon your knowledge and your leadership in the Senate. To me, though, I think we have nothing but pluses in taking the netting bill up on the suspension calendar immediately. There is no downside to it, and there are potential pluses. Thank you.
Chairman LEACH. Well, let me just say, from my perspective, I am in full agreement, but I have not had conversations with our leadership on it.
Does anyone else wish to make an opening statement?
Mrs. MALONEY. Mr. Chairman, I would just like my comments in full to be put in the record.
Chairman LEACH. Let me recognize Mrs. Maloney of New York.
Mrs. MALONEY. Thank you, Mr. Chairman.
As I stated in the subcommittee hearing on the Hedge Fund Disclosure Act, I am concerned with provisions in the hedge fund bill that charge the Federal Reserve with the role of collecting and disseminating information on the risk profiles of hedge funds. Given the Fed's unprecedented behavior in organizing the restructuring or bail-out of Long-Term Capital Management, I continue to be concerned that this provision sends the wrong signal to the markets and could increase moral hazard.
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As for OTC derivatives, I am pleased that the Chairman continues to lead on the issue and is appropriately asserting the jurisdiction of the committee. OTC derivatives play a critical role in risk management, and Congress should move quickly to resolve any uncertainty as to their legality.
Thank you very much, Mr. Chairman.
Chairman LEACH. Thank you.
Mr. Toomey, did you wish to seek recognition?
Mr. TOOMEY. Thank you, Mr. Chairman.
I would just briefly mention, with respect to the Hedge Fund Disclosure Act, that while I am glad to see that we have not moved in the direction of any kind of heavy-handed direct regulatory burdens, I will nevertheless reluctantly oppose the legislation.
I think there are a couple of problems that I look forward to discussing with the panelists today. One is, I don't think the bill would be able to accomplish its objective as a practical matter, which we will discuss.
I think it is also based on the flawed premise that markets do not work in the sense that the very sophisticated participants in this market are deemed to be incapable of determining the information that they need. Hence, the necessity of legislation requiring information.
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Third, I am concerned about the moral hazard scenario the concern that there will be an illusion of regulation where regulation would not exist.
Lastly, a mechanical thing that concerns me a great deal about this bill which is the requirement for meaningful and comprehensive analysis of risk is in the bill; however, it also says that no proprietary information need be disclosed. I think that is an internal contradiction in the bill. I don't see how you can accomplish the former without also committing the latter.
So these are issues that I think we need to look into; and, with that, I will yield the balance of my time.
Chairman LEACH. Thank you.
Ms. Schakowsky.
Ms. SCHAKOWSKY. Thank you, Mr. Chairman.
I just wanted to acknowledge the presence today of representatives of the Chicago Board of Trade and the Chicago Mercantile Exchange and say how much I look forward to their testimony and to underscore the important role that these exchanges have played in the overall economy, but also in particular in the vibrant economy in the City of Chicago and in our region and to just note that, from all of the discussions today, I will be looking at the impact on those exchanges with great interest and concern.
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Chairman LEACH. Thank you very much.
Does anyone else seek recognition?
If not, let me welcome Chairman Baker and say that I don't know anyone who has given more thoughtful attention to a whole host of extraordinary issues that are before our committee, particularly in the securities area, but not exclusively. There is no one who I have come to be fonder of, or more appreciative of his input, than Richard.
Please proceed.
STATEMENT OF HON. RICHARD H. BAKER, A MEMBER OF CONGRESS FROM THE STATE OF LOUISIANA; CHAIRMAN, SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES, AND GOVERNMENT SPONSORED ENTERPRISES
Mr. BAKER. Well, first, thank you very much, Mr. Chairman, for your kind remarks.
I am very appreciative of this opportunity to express my concerns relative to potential systemic risk at this hearing. In my capacity as subcommittee chair, I have strongly held opinions about three principal areas that I believe could warrant additional review by this committee.
I continue to commend you, Mr. Chairman, for your leadership in all areas of financial reform, specifically H.R. 4203 relative to swaps and derivatives products, and your interest in H.R. 2924 relative to enhancing transparency of hedge funds, and your co-sponsorship of H.R. 3703 relative to agency debt.
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First, what are the public policy concerns relating to systemic risk? Why should we care about counterparty obligations in a transaction involving an Italian currency swap or whether or not some well-heeled investor in a fancy hedge fund loses money?
The answer to both of these questions, in most cases, I believe, is that Congress should not. Only in rare circumstances, when the result of potential loss would trigger events far beyond the scope of the multimillionaire's portfolio, should regulators or the Congress be prompted to act. When the potential exists for innocent third parties to be impacted by turmoil that would reach far beyond the principals of the transaction, such as to other institutions or even in the case of my own mother's pension fund, the picture becomes more serious.
Over the years, there have been various studies regarding OTC derivatives recommending modification to the rules governing the OTC derivatives market. The most significant to us, however, are the most recent recommendations of the President's Working Group in their report of November of 1999 which constituted a very sound platform for beginning this discussion.
The recommendations contained in H.R. 4203, legislation sponsored by Chairman Leach, represent a forward-thinking legal framework for the dynamically growing derivatives industry. Historically, commodity futures contracts helped to provide stability primarily in the agriculture commodities market. During my four years on the House Agriculture Committee, I came to an understanding that today the OTC derivatives are largely centered in interest rate and foreign exchange contracts. In fact, 98 percent of all transactions account for interest rate and foreign exchange contracts. Tangible commodity transactions account for less than a fraction of 1 percent. In other words, this market is no longer about pork bellies.
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To state the importance of this industry to the overall economy, at the end of 1998, the total estimated notional amount of outstanding OTC derivatives contracts was $80 trillion. Needless to say, we should ensure as best we can this market does not experience any disruption.
But there is a problem. Legal uncertainty exists as to whether these contracts are subject to the Commodity Exchange Act and, therefore, under the supervisory jurisdiction of the CFTC. Other instruments operate under an exemption to the CEA, with no guarantee the exemption will not be withdrawn. By using new technology, some contracts move jurisdictions one more time. If this is confusing to you, that is because I believe that it really is confusing.
Chairman Leach's proposal remedies these uncertainties with the establishment of multilateral clearing organizations, clarifying that an over-the-counter derivative is an instrument contract with a financial institution that cannot be held unenforceable simply based on the regulatory status of the product. In addition, the bill allows electronic trading of OTC derivatives by a broad range of financial institutions as defined in the Gramm-Leach-Bliley Act. Accordingly, these provisions will provide markets assurance of the appropriate regulatory treatment of the products and remove significant concerns as to certainty of executing the contract.
Stated another way, this proposal, in my view, will ensure markets can operate as efficiently as possible. This is essential.
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Another area of dramatic growth, and subject of recent analysis by the President's Working Group, is the hedge fund industry. The Working Group has recommended several steps for legislative consideration. Although hedge funds secure their capital from high income individuals and invest in sophisticated markets, we are concerned with their scope of activity, particularly where there is potential for undisclosed, high levels of leverage. Such activity has the potential to bring harm to third parties when high leverage, market position and lack of disclosure result in the unfortunate events like those of September and October of 1998 when we all are aware LTCM had its problems.
To consider the Working Group's report, I do admit a certain bias. Since I am an advocate of free markets, I believe that markets can best regulate themselves. Nothing moves faster than an investor losing money. Regulators may look fossilized by comparison.
H.R. 2924 does nothing more than make financial statements of the large, unregulated hedge fund available to markets on a quarterly reporting basis. Keep in mind, too, that I want to ensure fair disclosure of such information. In fact, there is a clear specific prohibition to prevent the disclosure of proprietary information in H.R. 2924. In this bill, I hope that we create a fair and unbiased disclosure regime similar to other areas. For instance, the President's Working Group recommended the provisions of H.R. 2924 as a first step, with the recommendations that further action to directly regulate the industry could be taken at a later time should market conditions warrant.
In fact, I am in receipt of a letter from the Honorable Howard Davies, chair of the Financial Stability Forum, which is an organization comprised of the principal financial regulator from each of the G–10 countries which states as follows: ''The Working Group strongly supports efforts to require disclosure by large hedge funds. Both the Working Group, and the Forum as a whole, is therefore strongly supportive of the leadership you have shown in introducing H.R. 2924. I hope that other Members of Congress share your view that this is a vital measure to reduce risk in the global financial system.''
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That letter is dated April 7 of 2000, Mr. Chairman.
Let me make it very clear. I do not support regulating hedge funds directly. I do not want to take any action that would result in the relocation of this industry to an unregulated offshore domicile. This industry provides a valid and an important role in our economy, and it would be a significant loss if hedge funds left our capital markets.
But the message of the Financial Stability Forum cannot be ignored. The provisions of H.R. 2924 provide for minimal levels of enhanced transparency that should be taken to preserve the integrity of the international finance system.
I refer once again to comments by Mr. Davies: ''The Forum supported the use of market discipline as the primary means to reduce systemic risk posed by highly leveraged institutions. However, it also agreed that more interventionist measures, such as direct regulation of hedge funds, might have to be considered if the Financial Stability Forum report's recommendations to enhance market discipline were not adequately implemented.''
Recently, something profound occurred in the hedge fund industry which demonstrates the integrity of these markets. Mr. Julian Robertson, general partner of Tiger Management, announced his intention to liquidate his partner's portfolio. For twenty years Mr. Robertson was viewed as an icon of the industry. With initial capitalization of $8.8 million in 1980, the fund grew to $21 billion in size, an increase of 259,000 percent. The compounded annual rate of return after expenses was 31.7 percent. But, as he indicated, something significant in the broader markets has occurred.
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I quote from a letter to the partners: ''As you heard me say on many occasions, the key to Tiger's success over the years has been steady commitment to buying the best stocks and shorting the worst. In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much.''
While he chose to liquidate his fund, Mr. Robertson could have pursued another strategy. What if he had abandoned his commitment to his investment plan, given the obvious market pressures, and simply enhanced leverage, pursued a different and risky strategy, without disclosing to the market his reasoning? Given its size, we would not wish to know if this speculative strategy would have failed. Fortunately, Mr. Robertson's principled business judgment has resulted in the conclusion to a terrific business enterprise. Ideally, it is the way markets should work. But as we all know, that is not the way it happens every time. His decision highlights market discipline in its proper context and function.
What is the Government's role in facilitating the efficient function of the markets? I submit that the appropriate role of Government is not just to impose regulation that will attempt to eliminate all risk. Only markets can determine what is too large, too volatile, too highly leveraged, too risky, and ultimately, what is excessive. This is what Mr. Robertson did, and this is what the market does on a daily basis.
However, what allows the market to make these decisions? I believe it is free access to accurate and timely information. Without information, the market simply cannot function effectively.
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Apart from hedge funds, particularly large and highly leveraged ones, does the committee have reason to examine the systemic risk in other vital sections of our capital markets? I believe so.
Over the past year, I have been asking questions of the prestigious group of highly qualified individuals from the Congressional Research Service, the General Accounting Office and the Congressional Budget Office and have come to the realization that the growth and size of the Government Sponsored Enterprises has been nothing short of enormous. Allow me to put this in perspective and discuss my findings when examined in the light of the Working Group's findings and recommendations.
GSEs now control a dominant position in the mortgage market. Fannie Mae and Freddie Mac have purchased, retained, or guaranteed over 70 percent of all of the conventional conforming mortgages outstanding. Furthermore, estimates are they will have more than $3 trillion in residential mortgages by the year of 2003, or almost 48 percent of all of the home mortgages in the United States. They now have a significant share of the U.S. debt market. The Treasury Department forecasts GSE debt may double to $3 trillion by 2003, surpassing Treasury debt. These facts alone may not be any cause for concern, but some review of the implications, I believe, is warranted.
Second, GSE debt has become a very significant part of the assets of the banking system. Mr. Chairman, I hope this point and the significance of it is not missed by the Members of this committee. I have learned that over 41 percent of all commercial banks and savings banks today have invested 100 percent or more of total capital, not tier 1, total capital in GSE, housing GSE and other GSE securities. The importance of this fact simply cannot be overstated.
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National banks may invest no more than 10 percent of their capital in the corporate bonds of one issuer and may not lend more than 15 percent of their capital to any one borrower. However, bank investments in GSE debt are not limited. Does this fact indicate there should be cause for concern? Probably not. But it is certainly reason to ask if such concentration of investment is prudent. Imagine the repercussions that might occur if one of the GSEs would happen to stumble in difficult market circumstances and the potential impact on the FDIC and even the Credit Union Insurance Fund.
I also raise the adequacy of risk measurements in these markets: The current ratings of agency securities are, in large part, influenced by the belief that the full faith and credit of the United States stands behind these instruments. This has clearly been confirmed by recent market reaction. I am concerned the market is not basing their valuation on underlying financials, but on the premise that these instruments are backed by the full faith and credit of the taxpayer.
As stated earlier, I believe market discipline, coupled with prudent supervision, is the best formula for mitigating systemic risk. However, in this instance, market discipline has become warped.
Does this fact by itself justify concern about market stability? No. But, again, it is an area where further inquiry, I believe, is warranted.
H.R. 3703 does much more than simply clarify the relationship of GSEs to taxpayer lines of credit. It establishes a regulatory system similar in authority and scope to the regulation applicable to every other financial institution. I continue to express the concern that the measurement tool needed to determine the risk-based capital adequacy of the GSEs, the Risk-Based Capital Rule, is not yet approved, much less implemented. Is this, by itself, a reason for concern? Perhaps not to some, but I believe the establishment of approved regulatory oversight would be a prudent step.
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In the late 1970's, no economist believed that unemployment and inflation could rise rapidly at the same time, yet it happened. The impossible occurrence created market conditions in the early 1980's that actually caused Fannie Mae, because of interest rate mismatch, to operate on an insolvent basis, on a mark-to-market basis, for almost five years.
In other words, there is a lack of transparency in the market. The GSEs' reputation, skewed by investor belief that they are Government-backed, could mean that investors are not exercising due diligence due to a lack of information.
To some, it might seem unfair that I would draw any comparison between LTCM and any housing GSE. Let me make this clear. I do not believe that any GSE is on the verge of failure. Quite the opposite. They are very healthy, very well managed and very profitable, which makes this discussion particularly relevant. Now is the time to address these issues.
Again, the hedge fund report encouraged me to make this connection. In fact, the report states, ''Although LTCM is a large hedge fund, this issue is not limited to hedge funds. Other financial institutions, including some banks and securities firms, are larger and generally more highly leveraged than hedge funds.''
Mr. Chairman, I would direct the committee's attention to the two charts at my left which make a graphic representation of the facts. In terms of assets-to-capital leverage ratio, Fannie Mae is more highly leveraged than not only the biggest bank, the biggest securities firm, but also more than LTCM was at its height. In reviewing the chart, we have picked one institution to represent each sector of the market, Citigroup being the largest bank, Merrill Lynch, the largest securities firm, LTCM and Fannie Mae. The chart to the right gives the functional relationship of assets to capital, again with Citigroup to the far right, Fannie Mae to the next left, Merrill Lynch, and then LTCM.
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The importance of these charts, Mr. Chairman, is only to present the committee with an overview of the facts in relation of capital-to-assets and the potential scope and size of the respective enterprises. Is this degree of leverage by the biggest housing GSE reason for alarm? Probably not. But it does present one more issue for the committee to consider.
To ignore the potential impact of a misstep by a GSE on our housing market and financial system I believe is to truly flirt with potential disaster. While economic times are prosperous, the GSEs are enjoying impressive earnings. Let's prepare for the day when the only thing standing between the losses of a GSE and your constituent's wallet is your good judgment.
I feel the committee should advocate market-based solutions to mitigate systemic risks. These solutions would include enhanced private sector risk management practices, improved transparency in the financial system, and risk-sensitive approaches to capital adequacy. Congress should do its part to facilitate this market discipline and act favorably on all three of the suggested proposals.
Mr. Chairman, I would be happy to answer any questions or provide any additional information or simply to pack my bags and quietly leave town.
Chairman LEACH. Let me thank you for your statement which I think is one of the most thoughtful that has been presented by a Member before this committee at any time.
Let me ask, does anyone have any questions for Mr. Baker?
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Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
First of all, I will tell you that I have yet to meet anybody from Louisiana who would leave anywhere quietly, and I am sure the same is true for the gentleman from Baton Rouge.
But I do have one comment. I know we talked about this in the hearing. First of all, I think your testimony was quite good. Of course, as you know, Richard, I don't always agree with everything that you say.
Mr. BAKER. I am shocked.
Mr. BENTSEN. I know. This came out before, but I can't let this go. With respect to the leverage ratio, I think for the record we need to be clear that in comparing the portfolios of Citigroup, Merrill Lynch, LTCM and Fannie Mae, they are very different portfolios. Arguably, Merrill Lynch and LTCM carry a much more risky portfolio, a less liquid portfolio in some instances, compared to Fannie Mae or Freddie Mac, and arguably Citigroup from time to time carries a less liquid portfolio. So I think that has to be taken into some consideration.
The other thing that I think we need to consider, and I know we discussed this the other day, but I don't think you are necessarily way off base in talking about the future of the GSEs, but I would hope that we would wait and allow OFHEO to do their job and let's see what they come up with. We may have a lot of questions for them in their final risk-based capital analysis, and we may not feel that it is sufficient. But before we get too far out in front, I would hope we would take a look at that.
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Mr. BAKER. Mr. Bentsen, if I may respond, I would concur with your observations. The underlying business profile of the various enterprises on the chart are dramatically different.
The one point I would make in the importance of this comparison is that all of the other participants, including LTCM, had active, fully competent regulatory oversight that was looking at them on a daily basis. You and I both know that we are now sitting here eight years after this committee directed OFHEO to implement a stress test to determine capital adequacy, a mission that has not yet been accomplished.
I would merely say that having someone of such large scope and sophistication—and I am not in any way implicating that they are not properly run today, but I am suggesting that we do not have a regulatory third party to whom we can turn and say tell us whether this profile is OK or not. It may be perfectly fine. How do we know?
You have triggered something in my mind, though, that I think would be helpful, I hope. I know the committee does not wish to move quickly. I just wish to make sure the committee continues to focus on these issues, and I would very much like to have the President's Working Group analyze this issue, if it would be helpful. They have certainly taken on the hedge fund industry and the over-the-counter derivatives question. If, in fact, this is an area that would be appropriate for review, I would love to have the Working Group analyze the relative degree of potential systemic risk that the GSEs might present to our economy if there would be a misstep. I just believe this is absolute due diligence that this committee must take. It is our responsibility.
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To that end, Mr. Chairman, I did not ask to make the letter of Mr. Davies part of the official record, which I would like to request.
Chairman LEACH. Without objection, that will be made a part of the record.
Mr. BENTSEN. Mr. Chairman, I would just say that having worked with the gentleman from Louisiana for the last almost six years, I am sure that he will continue to focus on this issue, and I look forward to working with him.
Thank you, Mr. Chairman.
Chairman LEACH. Mrs. Roukema.
Mrs. ROUKEMA. No questions.
Chairman LEACH. Any questions on this side of the aisle?
If not, let me thank the gentleman and simply raise the point that from time to time this committee deals with the question, are institutions too big to fail? And we all would hope the answer to that is no, but we recognize that, now and again, regulators look at systemic circumstances and reach other conclusions. But whether or not an institution is too big to fail, no institution should be above prudential regulation. No institution should be too big to be reigned in if it is in the competitive national interest.
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The good news that we are all confronted with is that these are wonderfully well-run institutions, Fannie and Freddie. The awkward news is that their powers are so great that markets have become skewed. So one of the great questions is, does the committee want to move at some point in time to a freer-market circumstance? That is a question of judgment, it is also a question of timing, and it is a very difficult one.
Mr. BAKER. Thank you, Mr. Chairman.
I just thought that when almost half of the financial institutions in this country—and given the committee's past focus on capital adequacy during all of the savings and loans days and our enhanced early intervention statutes when we see capital beginning to erode, that when we realize that almost half the banks in the country, a total of one-third of all bank capital is directly tied to the securities debt or equity, no bank can invest more than 24.9 percent in a domestic corporation, except when it comes to the Housing GSEs. I am not saying it is bad, but I am saying the concentration of investment in one area of our market would be probably advised against by any financial advisor telling you how to spread your risk in the current market.
So it is just a fact that was alarming and surprising; and I again appreciate your courtesies in allowing me to offer this testimony, Mr. Chairman.
Chairman LEACH. Thank you very much, Mr. Baker.
Our second panel is composed of Mr. Lewis A. Sachs, who is the Assistant Secretary for Financial Markets at the Department of the Treasury; Mr. Patrick M. Parkinson, Associate Director, Division of Research and Statistics of the Board of Governors of the Federal Reserve System; Ms. Annette L. Nazareth, Director of the Division of Market Regulation, U.S. Securities and Exchange Commission; and C. Robert Paul, General Counsel, Commodity Futures Trading Commission.
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We will proceed in the order in which I have recognized the witnesses. Let me say, without objection, all opening statements of all of the panelists will be placed in the record. Hearing no objection, that is so ordered. The panelists may proceed to summarize or as they see fit.
Secretary Sachs, we will begin with you.
STATEMENT OF HON. LEWIS A. SACHS, ASSISTANT SECRETARY FOR FINANCIAL MARKETS, DEPARTMENT OF THE TREASURY
Mr. SACHS. Thank you, Mr. Chairman and Ranking Member LaFalce and Members of the committee. I appreciate the opportunity to appear before you today. I do understand there is a full agenda, and I will keep my opening remarks brief. Thank you for entering my prepared statement in the record.
Today, my testimony will focus on four topics: first, the Working Group's recommendations on the over-the-counter derivatives markets; second, the implementation of our recommendations on hedge funds; third, H.R. 2924; and, fourth, our recommendations on financial contract netting and H.R. 1161.
With regard to OTC derivatives, the members of the Working Group believe that a strengthened OTC derivatives market can contribute to the greater efficiency of the U.S. financial markets and the economy as a whole. As OTC derivatives have grown in importance to our economy, however, the legal and regulatory framework for these markets has significantly lagged behind the development of the markets themselves. It is within our grasp to reduce systemic risk, enhance the competitiveness of these markets and increase retail customer protection by providing an updated legal and regulatory framework.
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The Working Group issued a number of unanimous recommendations which included proposals designed to enhance legal certainty, remove impediments to the development of electronic trading systems, and facilitate the development of appropriately regulated clearing systems for OTC derivatives.
The legislation that has been introduced by Chairman Leach and Ranking Member LaFalce, H.R. 4203, would address some of the concerns that are the subject of the Working Group's recommendations. We are broadly supportive of the objectives which underlie this bill designed to mitigate systemic risk and to promote legal certainty, innovation and competitiveness in the OTC derivatives markets.
At the same time, we believe that a comprehensive approach, encompassing amendments to the Commodity Exchange Act, is important to fully accomplish all of the objectives outlined in the Working Group's report. We look forward to continuing to work with this committee and others to ensure the advancement of these objectives.
Let me now focus on the second subject of this hearing, which is the Working Group's recommendations from its April, 1999, report on hedge funds. In this report, the Working Group set forth a series of recommendations designed to promote private market discipline in order to best constrain excessive leverage and thereby reduce the likelihood that future failures of individual institutions could pose a threat to our financial markets more broadly. The Working Group's recommendations emphasized the promotion of sound risk management practices by all market participants and improvements in transparency designed to allow individual market participants to make more informed investment and credit decisions.
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Since the Working Group's report was issued, important progress has been made toward implementing the report's recommendations by bank regulators, the private sector, and key international groups. I have outlined this progress in my prepared remarks and earlier testimony before the subcommittee.
We will continue to work with Congress and others to ensure that all of the Working Group's recommendations are implemented. In this regard, H.R. 2924, which was introduced by Representatives Baker and Kanjorski, would implement one of the Working Group's recommendations requiring that the largest unregulated hedge funds disclose publicly certain summary, non-proprietary financial information, including meaningful measures of risk.
One of the primary areas of concern expressed by the private sector has been the challenge of balancing the disclosure necessary to enhance market discipline with a need for protection of information essential to the firm's ability to engage competitively in proprietary trading. The members of the Working Group are quite sensitive to this concern and believe that H.R. 2924 strikes the appropriate balance by providing for a rulemaking process through which the concerns of all relevant parties could be voiced in determining what information is both relevant and useful without compromising the firm's ability to engage in business transactions.
Consistent with the findings of the Working Group, this bill does not call for direct regulation of hedge funds. H.R. 2924 instead provides for enhanced public disclosure only by those hedge funds that are large enough such that, if one were to fail, that failure could potentially pose risk to the financial system more broadly. Clearly, providing information to market participants does not guarantee that those participants will process or use the information effectively. It is equally true, however, that if certain basic information is not made available to market participants, it cannot be processed or used at all.
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Finally, the Working Group's reports both included strong recommendations for adoption of legislative proposals designed to improve the closeout netting regime for derivatives and other financial instruments under the bankruptcy code and bank and solvency law. These proposals would enhance market stability, limit counterparty exposure, and could help to preserve market stability in the event of a failure of a financial institution. H.R. 1161, introduced by Chairman Leach and Representatives LaFalce and Roukema, would implement these recommendations. We strongly urge Congress to adopt these contract netting provisions as soon as possible.
Mr. Chairman, Ranking Member LaFalce, we commend you and the other Members of this committee for your attention to these important and extremely complex issues. We look forward to working with you and others in this Congress to advance legislation that will strengthen the competitiveness and stability of the U.S. financial markets.
That concludes my prepared remarks, and I look forward to your questions.
Chairman LEACH. Thank you very much, Mr. Sachs.
Mr. Parkinson.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
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Mr. PARKINSON. Thank you, Mr. Chairman.
I am pleased to be here today to discuss efforts to implement recommendations contained in the Working Group's report on hedge funds and OTC derivatives. Your letter of invitation requested the Board's testimony to focus on three issues: financial netting legislation, public disclosure requirements for hedge funds, and the regulation of OTC derivatives.
The Board strongly supports the Working Group's recommendations for amendments to the U.S. Bankruptcy Code and the FDI Act to support financial contracting netting. Enactment of H.R. 1161, the bill pending before this committee, would reduce uncertainty for market participants about the disposition of their financial market contracts in the event of the default of one of the counterparties. This reduced uncertainty should limit market disruptions in the event of an insolvency, limit risk to federally-supervised market participants, including insured depositories, and limit systemic risk.
The Board also supports the Working Group's recommendation that the very largest hedge funds be required to publicly disclose information about their financial activities, including meaningful and comprehensive measures of market risk, but excluding proprietary information on their strategies or positions. The recommendation is one of a larger set of recommendations by the Working Group intended to constrain excessive leverage in the financial system by making private market discipline more effective.
The Board has been following the progress of Representative Richard Baker's Hedge Fund Disclosure Act. The Board had been concerned about provisions of an earlier version of the bill that would have permitted collection and sequestration of proprietary information on hedge funds' strategies and provisions. Such provisions could have created the perception that hedge funds were subject to prudential oversight, even though the bill provided no explicit authority for such oversight. Such a perception would be fraught with moral hazard that would weaken moral discipline, contrary to the Working Group's goal in recommending public disclosure.
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The Board welcomes the manager's amendments to the earlier bill that deleted these troublesome provisions and thereby made clear that public disclosure, not prudential oversight, is the objective of the legislation. The Board supports the substantive provisions of the amended bill and commends this committee for its efforts to move this legislation forward.
In the Board's judgment, however, the bill could be further improved by an amendment providing that the information be collected and disseminated by the SEC instead of by the Board. Because of the SEC's broader responsibilities for public disclosure, such an amendment would underscore the purpose of this legislation.
The Board strongly supports modernizing the Commodity Exchange Act by implementing the recommendations contained in the Working Group's November 1999 report. It is essential that Congress address the legal uncertainties created by the possibility that courts could construe OTC derivatives to be futures contracts subject to the CEA. These legal uncertainties create risk to counterparties and, indeed, to our financial system that simply are unacceptable. They have also impeded initiatives to centralize the trading and clearing of OTC contracts, developments that have the potential to increase efficiency and reduce risks in OTC transactions.
To address these concerns, the Working Group recommended that financial OTC derivatives transactions between professional counterparties be excluded from the coverage of the CEA. Furthermore, it recommended that such transactions between such counterparties should be excluded, even if they were executed through electronic trading systems. Finally, the Working Group recommended that transactions that were otherwise excluded from the CEA should not fall within the ambit of the Act simply because they are cleared. While the Working Group concluded that clearing should be subject to Government oversight, that oversight need not be provided by the Commodities Futures Trading Commission. Instead, for many types of derivatives, oversight could be provided by the SEC, the Office of the Comptroller of the Currency, the Federal Reserve, or by a foreign financial regulator that the appropriate U.S. regulator determines to have established appropriate standards.
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The Working Group envisioned that these recommendations would be implemented through amendments to the CEA. Chairman Leach recently introduced a bill that takes a different approach to implementing some, but not all, of the Working Group's recommendations. The bill also includes provisions that would enhance the Federal Reserve's authority to oversee clearing organizations that seek to organize as uninsured State member banks and would clarify the treatment of such clearing organizations in bankruptcy.
The Board appreciates the efforts of this committee and believes that they enhance prospects for implementation of the Working Group's recommendations. Nonetheless, it believes that many of those recommendations can be fully implemented only through amendments to the CEA. The Board does support enactment of the provisions of Chairman Leach's bill that relate to clearing organizations that choose to organize as banks, which would complement the necessary modernization of the CEA.
Mr. Chairman, that concludes my prepared remarks. I would be happy to answer any questions you might have.
Chairman LEACH. Thank you.
Ms. Nazareth.
STATEMENT OF HON. ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION
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Ms. NAZARETH. Thank you, Chairman Leach.
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission as you consider recommendations by the President's Working Group on Financial Markets that are currently the subject of legislative action before the committee.
My testimony will address three topics that have been the subject of Working Group reports. First, I will discuss the netting of financial contracts. Next, I will focus on the public disclosure of leverage and risk information by hedge funds. Finally, I will address the regulatory structure affecting over-the-counter derivatives transactions.
The Commission supports H.R. 1161, the Financial Contract Netting Improvement Act of 1999, which includes a number of proposed amendments to the laws that govern the insolvency proceedings for a broker-dealer, bank, or other financial institution.
For several years, the Working Group has been developing proposals to improve the U.S. insolvency regime in an effort to address inconsistencies among the laws and to reduce systemic risk. Many of the provisions of H.R. 1161 incorporate or are based on amendments to statutes that were endorsed by the Working Group in 1998. We believe H.R. 1161 will help to reduce systemic risk and strengthen investor confidence in the U.S. financial markets. The Commission looks forward to the enactment of this important legislation.
Turning to hedge fund disclosure, as you know, hedge funds generally operate outside the existing framework of U.S. banking securities and futures laws. Consequently, limited information about their activities is currently available. The Working Group, in its April, 1999 Hedge Fund Report, found that the scope and timeliness of available information on the activities of unregulated hedge funds was too limited and concluded that they should be required to disclose additional and more up-to-date information to the public.
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The Commission supports the principles underlying H.R. 2924, which are consistent with the Working Group's findings. That is, that market forces are the most effective means of constraining excessive leverage and that increased disclosure to the public by unregulated hedge funds about their financial activities should enhance market discipline. We offer the committee our assistance in its efforts to implement the Working Group's recommendations in this area.
I would also like to take a brief moment to update the Committee on the Commission's progress in implementing another Working Group recommendation that is included in H.R. 2924; namely, public company disclosure. As you know, neither SEC rules nor generally accepted accounting principles currently require public companies to disclose material exposures to hedge funds and other significantly leveraged financial institutions. The Working Group recommended that public companies be required to disclose such material exposures in order to reinforce private market discipline. Commission staff has been working on proposed guidance that would require responsive disclosure in periodic reports filed with the Commission.
The idea is that public companies would disclose exposures to hedge funds and other highly leveraged institutions that are material to their financial statements or could have a material effect on their financial statements as a result of possible future losses. We plan to work with our counterparts on the Working Group on this matter, with the expectation of issuing a proposed rule for public comment in the near future.
Finally, I will focus on the Working Group's October, 1999, over-the-counter derivatives report. In preparing that report, the Working Group's task was fairly specific: to focus on how the Commodities Exchange Act might be modified to address issues relating to OTC derivatives markets. To that end, the report made recommendations in several areas.
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First, the report recommends that Congress create greater legal certainty for swap agreements by providing for an exclusion from the Commodities Exchange Act for bilateral contracts between eligible swap participants where the underlying is other than a non-financial commodity with a finite supply.
Second, the report recommends permitting the development of electronic systems that facilitate the trading of OTC derivatives among eligible swap participants on a principal-to-principal basis.
The report also focuses on providing greater legal certainty for instruments covered by the Treasury amendment, in particular, by further clarifying that the OTC markets in Government securities and foreign currency generally are excluded from CEA regulation.
In addition, the report recommends that the Treasury amendment be clarified to allow the CFTC to address problems associated with foreign currency bucket shops.
With respect to hybrid products, that is, instruments that possess attributes of futures contracts and securities or bank products, the report makes proposals for improving legal certainty for these products as well.
Finally, the report addresses systems for clearing OTC derivatives. Because of their importance, the report urges Congress to permit regulated clearing systems to be used for OTC derivatives. The report clarifies, however, that a clearing system subject to regulation by one agency should not become subject to regulation by another agency merely because it also clears OTC derivatives.
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Last week, Chairman Leach introduced a bill that seeks to address clearance and electronic trading issues raised by the OTC derivatives report. We note that the savings clause in the bill preserves the SEC's authority over securities clearing agencies that clear OTC derivatives that are securities. As the Working Group recognizes, however, OTC derivatives legislation should clarify SEC jurisdiction over securities clearing agencies as they extend their businesses to OTC derivatives that are not securities as well. We look forward to working with the committee as we study Chairman Leach's bill in greater detail.
In conclusion, the Commission appreciates the efforts of this committee in responding to the recommendations of the Working Group in the areas of netting, hedge fund disclosure, and OTC derivatives. We look forward to interacting with the Working Group, your committee and other legislators as they consider the implementation of changes in these areas.
Thank you.
Chairman LEACH. Thank you, Ms. Nazareth.
Mr. Paul.
STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION
Mr. PAUL. Thank you, Chairman Leach, and Members of the committee. I am pleased to be here to testify before you today on behalf of Chairman Rainer and appreciate the opportunity to discuss the recommendations of the President's Working Group and its last two reports and the commission's proposed new Rule 4.27 enhancing the reporting requirements of certain commodity pool operators managing hedge funds.
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In its report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act last November, the President's Working Group determined that most OTC derivatives transactions, unlike futures, do not serve a significant price discovery role nor are they susceptible to manipulation. Furthermore, OTC transactions are entered into and traded by sophisticated institutional traders who are able to look out for themselves in these markets.
Consequently, Chairman Rainer agrees with the other members of the Working Group that there is no manifest regulatory interest that warrants CFTC regulation of most OTC derivatives, and he supports the exclusion from the Commodity Exchange Act proposed by the report.
In 1992, Congress authorized the CFTC to issue a rule exempting swap agreements from most provisions of the Commodity Exchange Act. Lately, however, evolution in the technology and trading practices of the OTC derivatives markets have rendered the exemption inadequate. The swaps exemption does not apply to OTC contracts that are standardized, cleared or executed under conditions that approximate those of an organized exchange. The rise of electronic, screen-based trading has blurred the line drawn in the Commission's swaps exemption between bilateral and multilateral trading.
The growth in swaps volume and the acceptance of these contracts by a wider range of users have led to their standardization. Public policy must meet these advances in the OTC market. One year ago, the President's Working Group issued its report on hedge funds leverage and the lessons of Long-Term Capital Management. The report noted that the primary mechanism that regulates risk-taking in a market economy is the market discipline provided by creditors, counterparties and investors. This market discipline can only be effective, however, when other market participants have sufficient and timely information available with which to evaluate the creditworthiness of a hedge fund.
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Financial information by itself does not provide an adequate measure of risk exposure. So the President's Working Group report recommended that financial regulators should require hedge funds to disclose financial information to the public on a quarterly basis and to supplement such information with more meaningful descriptions of the fund's risk exposure and leverage.
Consistent with the Working Group's recommendation, the commission staff in consultation with the other members of the Working Group has drafted proposed new Rule 4.27, which the commission has approved for publication for public comment this week. The rule would require any commodity pool operator managing funds with either $3 billion in total assets or $1 billion in net assets to provide quarterly financial statements and summary measures of the aggregate risk exposures of the pools under its control. Each such commodity pool operator would also be required initially to provide a summary description of its risk management practices.
Although the commodity pool operators would file these reports with the commission, the proposed rule does not require or contemplate that the CFTC would analyze or evaluate them. The rule is intended to give the marketplace an enhanced level of information. The CFTC, under this proposal, would act only as the conduit of that information by making it publicly available on the internet. The proposed rule does not require commodity pool operators to report any information that would reveal positions or trading strategies proprietary to those funds.
The President's Working Group report noted that Congress would need to enact legislation if similar disclosures were to be required by hedge funds managed by entities other than those registered with the CFTC as commodity pool operators. And H.R. 2924 would do that. The dollar threshold set forth in proposed Rule 4.27 and its approach to reporting are consistent with those of H.R. 2924.
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In conclusion, Mr. Chairman, we support the recommendations contained in the Working Group's report on the OTC derivatives markets and the Commodity Exchange Act. And we look forward to cooperating with the Working Group and with Congress to see these recommendations enacted into law this year.
In addition, we support the recommendations contained in the Working Group report on hedge funds, and we believe proposed Rule 4.27 is consistent with those recommendations. Thank you again for the opportunity to testify before you today.
Chairman LEACH. Well, thank you all very much. And let me just make one reference to the background of H.R. 4203, which is the over-the-counter derivatives, the Systemic Risk Reduction Act. And that is that simply we had a number of approaches that were on the table, including a comprehensive bill. But we reached the judgment from our committee's perspective that it was only appropriate within a legislative setting to deal with the issues principally under the banking committee jurisdiction.
It is our belief that this bill contains a number of the most important principles to reduce systemic risk, and by the same token that it can stand alone. And as a stand-alone, it would be helpful to the current circumstance. But it would be vastly preferable to be part of a wider effort, either complementary to or intertwined into an effort coming from principally the Agriculture Committee, which has basic jurisdiction over the CEA. And it is my hope to work as constructively as possible with the Ag Committee as well as the Commerce Committee in this endeavor.
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So I want to say that what the committee did was basically take out of the Working Group recommendations those areas that were principally the Banking Committee's jurisdiction, and then attempt to put them in a format which made the most legislative sense for the future. And it is my hope that the bill that we have introduced can stand either alone or as a complement to the work of others.
That is the background for its introduction. My sense is that the panelists in general support the thrust of this legislation. Is that correct?
Mr. Sachs.
Mr. SACHS. Yes, sir. We, without question, support the thrust of the legislation and concur with your other comments.
Chairman LEACH. Mr. Parkinson.
Mr. PARKINSON. Yes, I would agree.
Chairman LEACH. Ms. Nazareth.
Ms. NAZARETH. I agree.
Chairman LEACH. Mr. Paul.
Mr. PAUL. We are studying the bill. We haven't reached any conclusions yet.
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Chairman LEACH. Fair enough. That is understandable, because there are sensitivities within the various regulatory bodies. I must say that there are areas here that I think we ignore at risk to the system as we go along. And I am pleased that the Working Group has developed a relationship that seems to be more cohesive between the regulatory bodies than at any time in the last decade. I think that is very important. And it is my goal in a congressional setting to have as collegial a circumstance as humanly possible. There is no intent here to lay down gauntlets for anybody. This is simply an effort to try to achieve as credible a bipartisan, bi-institutional tri-committee effort as possible on the House side and look to the future with that in mind.
Let me, at this point, ask Mr. Kanjorski if he has any questions.
Mr. KANJORSKI. Just a few questions. Mr. Chairman, I would like to have my opening remarks entered in the record.
Chairman LEACH. Without objection, the opening statements of all Members will be placed in the record. Please proceed.
Mr. KANJORSKI. Thank you, Mr. Chairman. I want to clarify some of the questions that we are always getting. Can the panelists tell us the rough number of entities that are covered by H.R. 2924? That way, we can get the parameters of the facts and establish that we are not nitpicking with this bill.
Mr. PAUL. Well, with respect to proposed Rule 4.27, which the CFTC has tailored to the same dollar thresholds as 2924, we believe that that would capture approximately 25 of the largest commodity pool operators, and although they represent roughly only 1 percent of the number of hedge funds out there, they represent something approaching 30 percent of the assets under management by those funds.
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Mr. KANJORSKI. But, is it only 1 percent of the total number of funds that are in existence?
Mr. PAUL. The idea was we want to capture only the largest operators that would have, or could pose systemic risk to the system. So we have tried to try to take as light a regulatory approach as possible without unduly interfering with the business of the hedge funds.
Mr. KANJORSKI. In covering these entities, do we also cover any banks or their affiliates?
Mr. SACHS. We don't believe that the provisions in the bill as drafted would capture any such institutions.
Mr. KANJORSKI. Do we cover any funds that are subject to the reporting of the Commodity Futures Trading Commission?
Mr. PAUL. Well, there are already reporting requirements for the commodity pool operators under the Commodity Exchange Act and regulations generated thereunder. What our proposed rule would do is increase the frequency of that information filed from an annual to a quarterly basis and also provide for supplemental information that would give counterparties and creditors a better idea of the risk profile for those funds.
Mr. KANJORSKI. Do any of you view H.R. 2924 as a substitute for a rigorous risk management system by the lenders on the counterparties?
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Mr. SACHS. Mr. Kanjorski, without question, we do not view 2924 as a substitute. If anything, we view it as an enhancement of those practices.
Mr. KANJORSKI. Some claim that we are rushing to legislate when we are considering H.R. 2924. Yet, the Long-Term Capital Management crisis occurred in September of 1998, and the Working Group issued its recommendations on which this legislation is based in April of 1999. And we did not have the markup in the Capital Markets Subcommittee until March of 2000. Is this a rush to judgment, in anyone's opinion?
Mr. SACHS. Is H.R. 2924 a rush to judgment? Let me say this: The President's Working Group spent a great deal of time looking into the situation surrounding Long-Term Capital, we considered our recommendations quite carefully, and we do not believe that the members of the Working Group rushed to judgment in making any of the eight of our recommendations with respect to hedge funds.
Mr. KANJORSKI. Do any of you believe that we are imposing significant costs on the unregulated hedge funds by legislating in this matter?
Mr. PARKINSON. No.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Chairman LEACH. Thank you very much.
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Mrs. Roukema.
Mrs. ROUKEMA. I will have to go over the record on that. I didn't quite hear that last question, but I won't take my time. I think I have heard you, but let me clarify for anyone that wants to make the comment now, when I made my inductory remarks, I referenced as to why we shouldn't be raising the level at which disclosure occurs. Can you address not the disclosure level, but the question of systemic risk and whether or not that hedge fund level should be higher, the reporting levels, that is what I mean, whether the reporting levels should be higher. Can you very succinctly explain to me why you do not believe that they should be any higher. Why you believe that they are adequate in this legislation?
Ms. NAZARETH. I think, as you know, Mr. Paul indicated that the CFTC legislation is only going to pick up about 20 commodity pool trade operators. I think we thought the additional requirement for disclosure for those who were not——
Mrs. ROUKEMA. As it relates to systemic risk you think the $1 billion is more than enough.
Mr. PAUL. Well, Congresswoman, let me try to answer that. At least with respect to our proposed Rule 4.27 which, as I said, has the same threshold as H.R. 2924, we have just approved that for publication for public comment. And we hope during the public comment period to get feedback from market participants.
Mrs. ROUKEMA. Do you not have any further comment here now? The Department of the Treasury or the Commodities Futures Trading Commission?
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Mr. SACHS. I guess I can make a couple of comments on this. There is no magic to that number, a billion dollars in net asset value. As we have all indicated it is—we arrived at that number based on the consensus judgment of staff of the various agencies you see represented here based on data that the CFTC has at its disposal. It does capture only the very largest hedge funds. It is fewer than 1 percent. There is a provision, and I believe it is adopted in the manager's amendment of the bill, to allow for the Federal Reserve to, in effect, raise that bar if it determines after consulting with the other members of the Working Group that that number is, in fact, too low and that it is capturing too many funds. I believe that was adopted in the manager's amendment.
Mrs. ROUKEMA. If it was, it was probably something I introduced, but we will go back and look at that. But perhaps more useful to the point, right at this point in time, is the question of whether or not the information which will be reported to the public will be stale or out-of-date. I believe there was something that Ms. Nazareth alluded to with respect to that issue—or maybe I misunderstood the context in which you made your statement about needing information that is more up-to-date. How can we address the staleness issue and would it be more appropriate for the regulators to identify and address the systemic problems as they arise rather than our having to address them perhaps, after the fact, or at too late a date or that that information will be stale for anybody's determination?
Ms. NAZARETH. I think the reference to obtaining more up-to-date information was a reference to the fact that currently some version of this information, although not as full information, is obtained annually and the Working Group's recommendation was that the information be obtained quarterly.
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Mrs. ROUKEMA. I understand that. But even in that context——
Ms. NAZARETH. I think information on a more timely basis than that would likely be obtained by the private sector through the counterparty relationships. But to require through regulation that the disclosure be more timely than quarterly, probably, at this point, would be too much.
Mrs. ROUKEMA. Does anyone have a further comment or observation on that issue from their own division's or agency's observations or experience, I should say?
Mr. SACHS. Congresswoman, I would just add that as someone had asked a question earlier whether or not we think this is a substitute for counterparty discipline risk management, and I don't think anyone at this table would suggest to you that this information being disclosed publicly, in and of itself, is a substitute for those sound practices. We do believe that a certain minimum amount of information being publicly disclosed is useful to enhance market discipline. As Ms. Nazareth was indicating before, the major counterparties and creditors and lenders and investors in these institutions by virtue of their own sound practices hopefully would ask for more frequent information.
Mrs. ROUKEMA. Well, except that you are saying in the interest of their own sound practices, except we found in the past that under other circumstances, they don't always necessarily act in interest of their own sound practices or for the larger public good. Yes.
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So therefore, I think we have to address this for those that are not using sound practices. Did you want to make a further comments? No. All right.
Mr. SACHS. I can. I would just say that is indeed why we recommended that this minimum amount of information be disclosed publicly so that the information is available whether or not they ask for it.
Mrs. ROUKEMA. And that is as up-to-date as we can make it, you are suggesting, as current and as usable as we can make it in the real world.
Mr. PARKINSON. In terms of the counterparties of the hedge funds and, in particular, the banks that are subject to supervision by the Fed or the OCC, we have already issued supervisory guidance that has underscored the importance of ongoing monitoring of the financial condition of the hedge fund counterparties. To be frank, they really cannot rely on the quarterly reports for that purpose. We expect much more timely and detailed information they are going to get from those reports. But while I don't think that is a suitable topic to address through legislation, it has been addressed through supervisory guidance. It is certainly something that our examiners are monitoring and assessing on an ongoing basis.
Mrs. ROUKEMA. Well, I would like for you to think about it as to whether or not there should be some more precise reference in the legislation or whether your discretionary authority here is adequate, if you will.
Yes. Mr. Paul.
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Mr. PAUL. I want to support what Mr. Parkinson had to say, first of all, and also what Mr. Sachs said with respect to providing the information to the counterparties, which is really the role that the regulators envisioned for ourselves at this point. But I also want to mention that with respect to the quarterly reports even though that might not give up-to-date information up to the day, it may be able to provide counterparties with the ability to discern certain trends for those reporting entities. And so if they were to watch a deterioration in the financial profile or an increase in the risk exposure of those funds over successive quarters, we believe that it would be helpful to make a more meaningful determination as to the creditworthiness.
Mrs. ROUKEMA. Thank you. If any of the panelists have more to add, you know that the record will be open for your additional comments. Thank you.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you, Mrs. Roukema.
Mrs. Maloney.
Mrs. MALONEY. I would like to ask Mr. Parkinson if you move to the SEC, like you said in your comments, wouldn't there still be a danger of moral hazard?
Mr. PARKINSON. Well, I think we are concerned about that danger. That is why we were so strongly urging that you be very clear in the legislation that the purpose here is public disclosure, it is not prudential oversight. That is why it is important that the information collected be limited to non-proprietary information, and that anything that is collected is released to the public. And yes, at the margin, we think that this concern about moral hazard would be diminished if the SEC were doing this, not the Fed. Will it ever go away? No. But I think that the various steps that have been taken and could be taken in this context would make us comfortable that it ought not be a serious concern.
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Mrs. MALONEY. We heard the Chairman testify at various times that he thinks the market is the best regulator if it is transparent. What about just reporting publicly and having somebody certify that it is accurate in some way and not having it collected by either entity?
Mr. PARKINSON. I don't think we envision ourselves as anything other than—or whoever collects this—as serving as anything other than a conduit to place the information in the hands of the public. The agency specified would have some initial role in deciding who should report and what should be reported. But having made those decisions, we envision it as a fairly mechanical process of collecting the reports, and putting them out on the website or wherever for the public to take a look at.
And we are trying to avoid any hint that we are doing anything other than trying to make private market discipline more effective. To the extent we fail in the task of communicating that clearly and acting consistently with those sentiments, then the danger you put your finger on—moral hazard—would be become a serious one.
Mrs. MALONEY. Maybe we could stamp a statement on each release. I would like to ask the members of the panel, the report of the President's Working Group on OTC derivatives concluded that non-financial commodities with finite supplies should continue to fall under the Commodity Exchange Act and be regulated by the CEA. The argument for this approach is that commodities with finite supplies are susceptible to manipulation. And the Chairman's bill also follows this approach.
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Some commentators have argued that certain non-financial commodities should receive the same exclusion from the CEA, that the Working Group subjected for financial figures. They have suggested that some non-financial products such as energy products and oil should receive the exclusion. Can the panel comment on why this would or would not be a good idea?
Mr. PAUL. Well, I guess I should start it off. Although the President's Working Group agreed that non-financial commodities with finite supplies would remain under the jurisdiction of the CFTC and the Commodity Exchange Act, we did point out in the report that the commission can continue to exercise its exemptive authority under section 4(c) of the Act to provide regulatory relief with respect to certain products, traded by certain markets. And in fact, we have provided that relief to certain segments of the energy markets and will continue to keep our doors open to do that. We also have no intention of withdrawing any of those exemptions that we have already issued.
Mrs. MALONEY. Would anyone else like to comment? No. OK. Thank you.
Chairman LEACH. Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
Mr. Sachs, I just wanted to thank you for your professional and responsible testimony here today on behalf of the Treasury Department. And thank you for your courtesy.
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Mr. SACHS. Thank you, Mr. Chairman.
Mr. BAKER. Mr. Parkinson, in looking at the Financial Stability Forum construction—and I am doing this for the record—it is composed of approximately 40 members: three from each G7 country, of which the United States is listed; international financial institutions, including the International Monetary Fund; international regulatory groupings, including the Basel committee and committees on central bank experts. My point being that this is a very respected group of international regulators who have taken the following position. My purpose for reading this will be to ask if this does reflect the Fed's position as well.
On page 1 of the recent correspondence dated April 7th, ''However, it is also agreed that more interventions to measures such as direct regulation of hedge funds might have to be reconsidered if the report's recommendations to enhance market discipline were not adequately implemented.'' Is that statement reflective of the position of the Federal Reserve on this matter or not?
Mr. PARKINSON. I think it echoes a statement in the President's Working Group on hedge funds that what we have done is, as I think several witnesses have emphasized, recommended things that are intended to make private market discipline more effective. We believe that is the best way to address concerns about excessive leverage. We believe, or at least, I would agree with the statement I recently heard Secretary Summers make that the problem with Government regulation of hedge funds is that Government regulation tends to crowd out the more effective private market regulation, and that is something we very much wish to avoid. But I think the Working Group report indicated, and the Financial Stability Forum indicated, that we will be monitoring progress in implementing the various recommendations that the Working Group and the Financial Stability Forum have made.
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And again, particularly with respect to recommendations addressing excessive leverage, I think the Financial Stability Forum report is entirely consistent with the Working Group's report. So we will be monitoring whether those recommendations are implemented, and if indeed they are not being implemented, and we sense that private market discipline is not improving, being strengthened the way we want to see it, then we will have to consider other options.
But again, our view very strongly is that those other options are not the best options. The best options are the ones that were recommended by the Working Group and by the Forum. There may be greater sympathy for some of the more direct interventions by some other countries represented on the Forum, but I think the U.S. position, held by all agencies involved in that Forum, was basically the position espoused in the President's Working Group report.
Mr. BAKER. In summation, let's try this, see how it works, if it doesn't give us the results we hope for, additional steps may be warranted.
Mr. Parkinson, I read over a Federal Reserve staff report that was issued March of this year, number 173 relative to market discipline and Government's role in supervisory capacity. At the conclusion of it—I am paraphrasing a very lengthy report—is that governmental supervisory actions should almost be intented to support market discipline as opposed to the primary lines of defense, which I have also read comments of Secretary Summers, much to the same effect.
This would necessitate the ability of the private market to have access not only to accurate, but timely information, which I believe I still have concerns about the quarterly reporting mechanism that is suggested by 2924. Had 2924 been in effect prior to the events of the fall of 1998, it is my judgment, but I am asking your opinion, that the events surrounding LTCM's demise would not have been prevented, but perhaps the scope, perhaps the timing of intervention might have been earlier, perhaps this knowledge over the three-year trading history of LTCM would have indicated a change in risk position that markets may have responded to.
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Can you look back to those events and determine what effect, if any, this might have had on the market?
Mr. PARKINSON. Well, I think, again, one of the big problems in the LTCM episode was that some of those counterparties and creditors did not have adequate information about the risk profile of LTCM, not timely information, even not necessarily the right information with a lag. I do believe that most of them had the annual audited financial statements that LTCM prepared.
So again, I think quarterly information would have been better, but even quarterly information is not good enough in our view. They really have to engage in a dialogue with the hedge fund and establish early on in their relationship what information is going to be provided on an ongoing and timely basis, where ''timely,'' I think, means, given the capacity of hedge funds to change their risk profiles in days, if not hours, weekly or even daily updates when things are changing rapidly. And that remains the most important recommendation with respect to transparency.
That said, I think what you have been proposing usefully complements that, although I see it not as much as being the benefit of the counterparties, because they have to do much better than that, but helping the public and the Congress and regulators make sensible decisions, understand better the role that hedge funds are playing and make sensible public policies. I know in the opening remarks Ranking Member LaFalce indicated that Congress would like to know this information. And the counterparties are not going to give it to the Congress. There has to be another mechanism, and this seems to be a sensible mechanism that has been developed to collect it and disseminate it to the public.
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Mr. BAKER. Just one more quick question. I don't know how long the answer will be.
Chairman LEACH. Sure. You may have as much time as you wish.
Mr. BAKER. The report went on to indicate matters of concern in analyzing hedge fund activities, citing specifically leverage as a principle issue as well as market position. And that there was a conclusion reached or at least a recommendation, observation, indicating that LTCM's position in its market and leverage ratios were not necessarily unique in the scope of financial activities, that there were other businesses which engaged in that level of leverage, may or may not be reason for concern, but it left unidentified those market participants that may be similar in business operation.
With regard to the issue of systemic risk only, leverage and market position seem to be the regulator's principal concern and not necessarily the underlying business portfolio and the risk associated with it.
Mr. PARKINSON. I think it is a question of what you mean by ''leverage.'' I would mean by ''leverage,'' really, the inverse of a risk-based capital ratio. So the question is, how much exposure to loss is there, and how does that relate to the resources, the capital, available to absorb those losses.
Mr. BAKER. As well as diversification of portfolios. As opposed to a single line of business and being spread across the market.
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Mr. PARKINSON. Right. But again, we quoted some figures on simple leverage ratios. I think when you see a very high simple leverage ratio that should lead you to ask further questions. But until you get the answers to those further questions, it doesn't really allow you to reach a conclusion as to whether firm A with a leverage ratio of 25 is, in fact, riskier than firm B with a leverage ratio of 20.
Mr. BAKER. It is an indicator that somebody ought to at least take—maybe make an analysis particularly where market position is large, where regulatory capacity may be weak, it certainly warrants someone simply asking the questions. That was my point. Thank you very much.
Chairman LEACH. Mr. Watt.
Mr. WATT. Mr. Chairman, I think I will pass. Thank you.
Chairman LEACH. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
Mr. Sachs, and the others, you know the subcommittee marked this bill a week or two ago, and I supported the Chairman of the subcommittee on it, although I remained a little perplexed about whether or not the hedge fund bill is accomplishing the goal or whether or not we have the right goal in mind. And the comments by Mr. Parkinson regarding the Fed's position, which appears to be saying that the Fed doesn't think: A, that it ought to be collecting this information, that the SEC ought to be collecting this information, because they are more in line or in the business of doing this. Second of all, that some form of quarterly disclosure is not necessarily sufficient to creating an effective transparency for the market.
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I continue to wonder, though, who we are trying to disclose to and what the result is going to be. And both you and Mr. Parkinson talked about new rules with respect to banks and other entities which you regulate and what their counterparty agreements are. I think we are concerned about the systemic risk to those institutions. In the testimony from Ms. Nazareth with the SEC it appears that the SEC is now proposing a rule that hedge fund exposure, I believe if I read this right, you are proposing a rule that hedge fund exposure would be a material item for public companies, which I think also gets to the point.
And I guess my question is, goes back to what we talked about in subcommittee, aren't we trying to ensure that hedge fund operators are sufficiently disclosing to their counterparties and to their clients and that there is not systemic risk within the banking system as a result of failure to disclose, and do we have the regulatory apparatus in place today through the bank regulators to do it. And now if the Securities and Exchange Commission makes this a material item for disclosure, does that add to the regulatory realm, and isn't that possibly more effective than this quarterly disclosure?
Second of all, and I would ask this of the Fed and of the SEC, because I am still not quite sure how this works, how do you divide the information that you were provided between market information and proprietary information? How do you make that determination? And in doing so, how are you sure that the final product that is disclosed to the public is effective if it just says that hedge fund X has certain holdings in these types of mortgages and these types of equities, are you able to do that without giving away their investment strategy, or are you able to give them any information that is at all useful that the market may not otherwise already know.
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Ms. NAZARETH. I could start by speaking a little bit about the public company disclosure that you alluded to. That disclosure is different from the quarterly reporting that we were speaking about.
Mr. BENTSEN. I understand that.
Ms. NAZARETH. So what the public company disclosure would achieve is that it would require public companies in their quarterly reports to, in some fashion, indicate the exposures that they have to highly leveraged institutions. It would be material; it would be exposures that are either material or could be material if a loss were incurred with respect to the portfolio. And you know the expectation there is that, again, we would be enhancing market discipline by increasing the amount of transparency with respect to the exposures that public companies have, so that in all likelihood, when the marketplace in general and shareholders, you know, review these financial statements, if we have gotten the type of disclosure right so that people can comprehend it and compare exposures across different companies, the investing public can determine for itself whether it believes that public companies are incurring too much exposure to these types.
Mr. BENTSEN. But you would also be putting burden on public companies to investigate and explore their own exposure and their arrangements whether a counterparty arrangement or whatever or investment arrangement with the hedge fund, because they would also be incurring liability to their shareholders.
Doesn't that use an existing regulatory regime that is in place that is not already applied, and does that help achieve the goal that the bill is trying to achieve?
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Ms. NAZARETH. Well, it is one part of it. Again, it is one of the proposals in the Working Group report. One of the expectations is that we can sort of improve market discipline by increasing the amount of reporting that public companies currently do with respect to their exposures to highly leveraged institutions.
On the other hand, as Mr. Parkinson indicated, we are also trying to improve market discipline by increasing the transparency with respect to the activities of the hedge funds themselves. And that is the second part of the recommendation in the report that we, on the one hand, we are relying on the industry best practices to improve the types of information that counterparties obtain from hedge funds, but as a backstop measure, we would at least be obtaining quarterly information that would give the public at large a better sense of the kinds of activities that the hedge funds, and the kinds of risks that the hedge funds are undertaking.
Mr. BENTSEN. I know my time is up with you. If this rule and the new bank rules had been in place, say, with Long-Term Capital, do you believe that would have helped in any way where the counterparties, the various counterparties in arrangements with Long-Term Capital, may have taken a broader look, or deeper look, at what Long-Term Capital is up to in order to protect themselves from liability they might incur from shareholders or liability they might incur from regulators? And doesn't that do a great deal, perhaps more than some sort of muted public disclosure to the market in trying to achieve our ends?
Mr. PARKINSON. Again, you started out with the question of whom are we trying to disclose to. And if you really want to know information about the hedge funds and you mean the general public and the Congress, the kind of disclosure requirements that the SEC would be promulgating, I don't think would get you there. They would get you fragments of the picture from the perspective of individual creditors, but you couldn't aggregate that into a picture what was the hedge fund's balance sheet or its risk profile as a whole.
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Ms. NAZARETH. I might also point out most of these hedge funds, virtually all of them, are not public companies. So the public company disclosure element that the SEC is working on really wouldn't——
Mr. BENTSEN. I understand that. I mean, I think that the fear of the hedge fund industry, though, is that they are one step away from being public companies and having to disclose. And that is a whole other issue for discussion. If I could—my time is up, but if you could answer for me perhaps the gentleman from the Fed, how would you divide between proprietary and non-proprietary information, and what will we end up with?
Mr. PARKINSON. I would define proprietary information as information which, if it were disclosed to the competitors of the hedge fund, they could trade against the hedge fund's positions and strategies in ways that would cause the hedge fund to be less profitable, or even to incur losses. And we don't want that to happen, not simply because of the adverse implications for the hedge fund's profitability and for its investors, but because hedge funds play an important role in our financial system providing liquidity to markets. If they can't make money doing that, they are going to cease doing it.
So as a practical matter, the Working Group called for comprehensive and meaningful measures of market risk, such as VAR or stress testing results. I think VAR is the simplest thing that could be disclosed. That is comprehensive—a VAR measure ought to be over all of your positions in your portfolio. And it is meaningful in the sense that it does tell you something about the distribution of potential profits and losses on the portfolio. It doesn't tell you everything you might want to know, but it tells you something. It is helpful. And it does not disclose any proprietary information.
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I don't understand the theory by which someone could take your VAR measure, and from that infer what your positions were and trade against them. I would point out all of our major banks and securities firms disclose VAR measures in their public reports, and I don't think they would do that if they thought that that was proprietary information that their competitors could trade against.
Mr. SACHS. That is voluntary.
Mr. BENTSEN. Could you define for me, and the others may know this, I am not sure I understand this completely, VAR is the value of what the current value of the asset is. Are you talking about defining what the specific assets are that are being held or are you talking about a more of a broad balance sheet approach that just says they have certain holding in equities in X amount or is it certain types of mortgages they have holdings that are currently valued at X or Y?
Mr. PARKINSON. It is a single number. You just take the entire portfolio and you endeavor to estimate the potential profits and losses. It is a forward looking measure. How much could I gain or lose on this portfolio? It can be defined in various ways. But it may ask: what is the number that the likelihood of my losing more than that amount in a single day is less than 1 percent?
Mr. BENTSEN. But it doesn't define the underlying asset. Just the dollar value of that.
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Mr. PARKINSON. Now you may want to complement that with some kind of balance sheet information, of what granularity I don't know. And again, obviously if it got too fine, it would stray into the area of proprietary information. But asking them how much is Government securities versus equity versus bonds, again, public companies tend to report these things and it is not regarded as proprietary. It is not creating problems of people trading against the disclosure of that information.
Mr. BENTSEN. But again, public companies fall under different rules.
Mr. PARKINSON. But again, those rules, we would have concerns about those rules if, in fact, they were disclosing proprietary information and discouraging banks and broker-dealers from providing liquidity to the markets. We don't think those kinds of disclosures, whether they are by public companies or non-public companies, raise that set of concerns.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman LEACH. Mrs. Biggert.
Mrs. BIGGERT. Thank you, Mr. Chairman.
Mr. Parkinson, in your testimony you stated that the Working Group recognizes that implementation of these recommendations regarding OTC derivatives would blur some of the distinctions between OTC derivatives and exchange-traded futures, and this would aggravate existing concerns about regulatory disparities and resulting competitive imbalances between the OTC markets and the exchanges. Could you expand a little bit on that?
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Mr. PARKINSON. Well, while I don't believe there has ever been a statutory definition of a futures contract, certainly decentralized trading and clearing of OTC contracts has been a fact, whereas an exchange is a centralized market. All of our futures markets in the United States always have had either a department of the exchange, or an affiliated corporation clears those contracts. And historically, OTC derivatives contracts have neither been centrally traded nor cleared for the most part. So that if we remove the regulatory impediments, the impediments in the Commodity Exchange Act that currently exist that discourage electronic trading and clearing of OTC derivatives the markets may move in that direction.
So that the characteristics, the economic characteristics of OTC contracts and exchange contracts would not be as different as they have been historically.
We are recommending that for a broad range of OTC contracts, we rely on market discipline to meet public policy objectives. I think given the blurring of distinctions between exchange-traded and OTC, it raises questions why you are not taking the same strategy with respect to exchange trading. The Working Group's report didn't try to address those issues in any thorough fashion, but did indicate that it was appropriate that the CFTC conduct a review of its existing regulatory regime, particularly, with regard to financial futures and study whether all the existing regulations really are necessary. And, in fact, the CFTC has done such a review and already released a staff report on that. So I think that elaborates on that one sentence of my remarks.
Mrs. BIGGERT. I think one of my concerns with the exchange, which exchanges which have been regulated and then the other private groups that have come in, it is not a level playing field. And yet there seems to be, in H.R. 4203, changing the CEA without really doing that legislatively, but with exclusions that by this Act. And I wonder if that is a problem.
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Mr. PARKINSON. Well, again, I think in my testimony and some of the other testimonies, we indicated that really we saw the bill originating in this committee as complementing what needed to be done in the CEA. And in the Working Group's report, having noted that there was this blurring and these issues of competitive equity, the Working Group stated that enactment of its recommendations with respect to OTC derivatives should be accompanied by explicit authority for the CFTC to provide appropriate regulatory relief for exchange-traded financial futures, if deemed by CFTC to be consistent with the public interest. That is where still there is a job to be done in the Agriculture Committee to give the CFTC the authority it thinks it needs to provide the right kind of regulatory framework for the exchanges that addresses these competitive issues.
Mrs. BIGGERT. Do you think that there should be amendments to the CEA as well as what is in H.R. 4203 to take care of this and would be proposed for the Agriculture Committee?
Mr. PARKINSON. Yes. We think, and in fact, the Working Group has not only made proposals, but presented statutory language implementing those proposals to the Ag committees which we hope they will act on.
Mrs. BIGGERT. Will they be dealing with this CEA?
Mr. PARKINSON. Yes, they are the only ones that can deal with the CEA, and that is their piece of legislation.
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Mrs. BIGGERT. Well, it seems like there is a question as far as definition of futures and what would be a financial future. Do you think that the exchanges under H.R. 4203 would still be able to deal in financial futures?
Mr. PARKINSON. I sure would hope so. I certainly didn't read anything in H.R. 4203 that would preclude a futures exchange from trading financial futures. I can't believe that would have been the intent.
Mrs. BIGGERT. It seems like there is a—it seems like who can deal with something is—has been changed maybe from what it is as to who it is, whether it is the OTC or a futures contract or the exchange that is dealing with it. Is there a change in that?
Mr. PARKINSON. No, I don't think there is a change. This gets down to the question of whether swaps really are futures that fall within the ambit of the CEA. And there are different opinions on that matter. But at least the Fed's view has been that swaps are not futures, so it has always been the case that the authority, the statutes that apply to exchange-rated futures and swaps are, in fact, different statutes. And I think that is why we think that in trying to move forward to a more appropriate regulatory framework, you need to be acting on both fronts. You need to be doing something with respect to the CEA, and you need to be doing something with respect to the banking laws.
Mrs. BIGGERT. Thank you.
Thank you, Mr. Chairman.
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Chairman LEACH. Mr. Toomey.
Mr. TOOMEY. Thank you, Mr. Chairman. I would like to——
Chairman LEACH. Excuse me, let me say Pat, I want to give you extra time if you want, because I know you have some concerns. I think it is fair.
Mr. TOOMEY. Thank you, Mr. Chairman. I might actually consume the normally allotted time. So I appreciate that. And I appreciate the testimony of the witnesses today. In particular, Mr. Sachs, I appreciate the ongoing discussion we are having about this. And I was hoping you would confirm something which I think one of the panelists mentioned earlier, which is simply, and I am sure you agree with this, that hedge funds, per se, do provide a very useful function in the financial markets, especially the liquidity that they provide, and I guess I would just ask does everyone agree with that on the panel?
Mr. SACHS. I certainly would agree with that and refer to that in my prepared remarks.
Mr. TOOMEY. Thank you. As far as the question of the information that this bill would require hedge funds to disclose, I would like to get back to the question of to whom we are providing this and for what purpose. Wouldn't it be fair to say that the financial institutions, which extend credit to hedge funds already, all of them, demand far more information, far more qualitative information with a greater frequency and more timeliness than this legislation contemplates? Don't you think that is the systemic routine of the credit departments of the big financial institutions?
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Mr. SACHS. I guess I will address this. The short answer, Congressman, is yes, we do. However, on the heels of the Long-Term Capital episode, it did become evident, based on comments we had heard from private sector institutions, that at that point in time, many of them were unaware of the broad risks that that particular fund was taking on and of the size of the fund. And we believe that if this information were out there, and the markets in general, the press, and so forth, were focused on just the basic items that are discussed in Congressman Baker's bill, that that would have, at the least, served as a flag to those institutions that just did not have the information available.
Mr. TOOMEY. So even if we assume that at the time of Long-Term Capital's problems this information was not obtained, are we in agreement that financial institutions routinely obtain far more information, again, with far more frequency than—I mean, the question in my mind is does this really enhance anything, and I think the answer is clearly no