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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.


    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.


    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.


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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.

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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.


    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. I think the financial institutions are getting much more information than this, much more frequently. So I don't think—and if someone disagrees, please explain. But I don't see how this enhances the understanding of the financial institutions of the credit that they are extending to hedge funds. I don't see how it does that a bit. I can see how it informs the public about the profile to some degree of the hedge funds, but I don't think it enhances the credit decision at all. Do you disagree with that?

    Mr. SACHS. I think again, this recommendation in isolation, we could certainly have that debate. We made this recommendation, and this bill is being contemplated, in the context of the full set of recommendations that the Working Group has made with respect to hedge funds and the other items we are discussing today. To the extent that individual institutions, as you point out, have more relevant and timely information, in fact, than is contemplated in this bill, there is not a broad sense in the market as to what this important segment of the market looks like.
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    For instance, at the beginning of this hearing, we were asked how many funds are out there, how big is this industry, what are we looking at here. It was very difficult for this group to give anything more than very general answers, because the information just simply is not available. So we think that that would be an important benefit as well.

    Mr. TOOMEY. OK. I take it that as an acknowledgment that it doesn't affect the individual institution as decisionmaking process, but rather has this sort of macro-exposure information value.

    Mr. SACHS. Not in and of it its own right, but as I believe Mr. Parkinson alluded to earlier, when one sees this information, it does serve as—and I don't know if he used these words, but as a flag to get you to ask more questions than you might otherwise have asked before. And as you correctly pointed out, Congressman, we do believe that counterparties, creditors, and so forth, do have better and more information today than they did then. That incident was within the last two years, it is fresh in everybody's mind, and as I believe we stated in the original Working Group report, that is what we would expect to happen so shortly after those events. But what markets have shown repeatedly throughout history is that after extended periods of calm, that that discipline at times tends to dissipate.

    Mr. TOOMEY. I understand this fear that the market might regress and fail to continue to recognize the information that it needs. But I find that surprising, because it seems to me that the market now, and the financial institutions and their credit-making decision process, goes so far beyond this, that the thought that they would regress to the point where this was the basis of their credit decisions is really not very credible.
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    And in fact, the regulators would be extremely remiss if they tolerated that kind of credit-making process on the part of the financial institutions. Don't you agree with that?

    Mr. SACHS. I am not a regulator. But I think if creditors and investors were making decisions solely on this information that would be disappointing.

    Mr. TOOMEY. It is incredible. It is so likely as not to be credible at all. If I could move on to another topic here. I would like to touch on the question of OTC derivatives and their regulation. If I could address this to Mr. Parkinson. I think you made the point earlier that it is the Fed's view that swaps are not futures contracts. That is my understanding. In fact, would it be fair to say that there is no swap that is a futures contract, that is the current understanding?

    Mr. PARKINSON. That has been our view.

    Mr. TOOMEY. OK. Am I correct in understanding that the President's Working Group nevertheless recommended that foreign exchange forward contracts be regulated by the CFTC, despite the fact that they would not be—that they have been considered swaps and therefore not futures contracts?

    Mr. PARKINSON. No. What the Working Group recommended was that the marketing of foreign exchange for contracts to retail investors by entities other than banks and broker-dealers and their affiliates be regulated by the CFTC, at least I don't read into that a conclusion that those instruments are futures. We are trying to make sure the CFTC has the authority when people are committing fraud in the marketing of foreign exchange futures that they can go after them without tripping over the Treasury amendment.
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    Mr. TOOMEY. So would that explicitly preclude having the CFTC have any supervision over financial institutions marketing of these products to retail customers?

    Mr. PARKINSON. I believe that the Working Group's recommendation is that if it is a bank, or a broker-dealer or an affiliate thereof, they would have no authority.

    Mr. TOOMEY. OK. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you, Pat.

    Before the panel breaks up, I would like to lay one issue on the table. One of the exchanges has expressed a lot of concern about Congress moving on the CEA issue, or the Banking Committee perspective on it, without attention being brought to some of the Shad-Johnson concerns about single stock trading. And a number of people have asked the CFTC and the SEC to come up with proposals in this area. Let me ask Mr. Paul, do you have any proposals? Have both of your institutions asked for some time to think about it? Have you reached any conclusions?

    Mr. PAUL. Well, Mr. Chairman, all I can say is that our staff has been working assiduously with the SEC staff to come up with solutions. We provided a progress report on March 2nd to the chairmen of the various committees of the Senate and the House indicating that we are making headway.
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    But these are very difficult regulatory issues that we are trying to meld two agencies and the two agency statutes together to come up with a regulatory scheme that imposes the least burden on the entities that want to sponsor and trade these products. So this has been an ongoing process for us and we continue to meet frequently to try and make headway, and we have every intention of trying to come up with a solution for Congress this session.

    Chairman LEACH. Ms. Nazareth.

    Ms. NAZARETH. I think that is a very fair summary of the deliberations.

    Chairman LEACH. Let me just add my voice to those that say I think encouragement is sought. But I will say, if the regulators cannot come up with a consensus approach, Congress might have to either ignore the subject or come up with its own. I am not convinced that you can hold up everything else because of an incapacity of the Executive Branch to reach a judgment on this issue. I would hope that consensus can be achieved. But it is possible that legislation in this area may spur some greater enthusiasm for reaching that consensus. But if no consensus can be achieved, I don't think Congress can be held accountable for inaction because the Executive Branch can't reach that consensus.

    In any regard, let me thank you all. You have provided very helpful testimony and it is very much appreciated.

    Mr. SACHS. Thank you, Mr. Chairman.
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    Mr. PARKINSON. Thank you.

    Chairman LEACH. Our next panel consists of Daniel P. Cunningham, a partner at Cravath, Swaine & Moore, on behalf of The International Swaps and Derivatives Association, Inc.; Shawn Dorsch, President and Chief Operating Officer and Co-Founder of DNI Holdings, Inc., or Blackbird; Mark D. Young, a partner with Kirkland & Ellis, on behalf of The Chicago Board of Trade; Terrence A. Duffy, Vice Chairman of the Chicago Mercantile Exchange; and Mark C. Brickell, Managing Director of J.P. Morgan & Company, Inc.

    Before turning to Mr. Cunningham, the Chair would like to announce a conflict of interest, and that is a former unpaid intern of the House Banking Committee, who is my niece, is a new member of your firm. Her name is Leslie Wells, and we welcome you with that in mind.

    Mr. Cunningham.


    Mr. CUNNINGHAM. Chairman Leach and Members of the committee, I am Dan Cunningham and I am here today on behalf of ISDA. I have worked with ISDA since 1984. ISDA has had the privilege of appearing before and working with this committee for many years, and we are pleased to be here again today.
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    ISDA's more than 460 members include the world's leading dealers in, as well as end-users of, off-exchange principal-to-principal derivatives transactions. These transactions are typically referred to as ''swaps'' and their status under the Commodity Exchange Act was a focal point of the November 19, 1999 report of the President's Working Group, and more recently, of the Over-the-Counter Derivative Systemic Risk Reduction Act of 2000. ISDA welcomes the recent introduction of this risk reduction bill.

    Swaps are powerful tools that enable American businesses and other end-users in each of the fifty States to manage their interest rate, currency commodity credit, and other related risks that are inherent in their underlying businesses. The United States has for many years been a leader in the development of swaps and American businesses were among the earliest to benefit from these risk management tools.

    In recent years, ISDA has witnessed the development of electronic communications and trading systems for swaps. We believe it is important that the United States provide an appropriate legal and regulatory environment for these new systems.

    The Working Group report embodied an unprecedented consensus among four key financial regulators that legislation should be enacted to provide legal certainty for swaps and for clearing and electronic trading systems for swaps as well. Simply put, financial transactions pose risks such as credit risk and market risk. These are all risks that a businessperson can evaluate, deal with, and hedge.

    The businessperson cannot do these things with legal risks. As you know, legal certainty simply means that parties must be certain that the provisions of the swap agreements they entered into are, in fact, enforceable. Any uncertainty with respect to the enforceability of swaps creates risk not only for the parties involved, but also for the financial system as a whole. These issues now have been carefully considered by the Working Group and proposed solutions have been incorporated in the risk reduction bill.
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    ISDA believes that the legal certainty provision of the risk reduction bill, and here I refer specifically to section 4 of the bill, that that provision covers an appropriately broad range of derivatives transactions entered into by any swaps dealer. ISDA applauds the clarity and breadth of this provision.

    ISDA also believes that the legal certainty provisions in the bill applicable to clearing and electronic trading represent an important first step. ISDA notes, however, that the multilateral clearing provisions and electronic trading provisions of the bill do not limit the applicability of the Commodity Exchange Act or CFTC jurisdiction in the case of transactions involving non-financial commodities with finance supplies. ISDA believes that these risk reduction provisions should be made applicable not only to swaps involving financial instruments, rates and indices, but also to swaps involving electricity, oil, gas, and other physical commodities having highly liquid cash markets.

    We note that Chairman Leach has stated his intention to work with the Committee on Agriculture to implement recommendations in the report that are primarily before that committee. ISDA looks forward to working with all concerned on a comprehensive solution.

    Electronic communications and trading systems clearly are an important part of the future of swaps activities in the United States and internationally. ISDA believes that the risk reduction bill is completely accurate when it finds that, and I quote now: ''Interpretations of Federal law suggesting that the use of certain electronic technologies in the trading of over-the-counter derivatives instruments might raise questions about their lawfulness have, in fact, hampered the development of more efficient trading systems and, therefore, more effective risk management for financial institutions.'' We agree with that finding. These uncertainties must be eliminated to prevent serious damage in the near future to the competitive position of the United States.
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    It is not clear to ISDA the extent to which clearing will be developed and utilized for swaps transactions. ISDA agrees, nevertheless, with the premise of both the report of the Working Group and the risk reduction bill that there is no reason to have a legal and regulatory structure that impedes the development of clearing for swaps.

    Let me turn briefly now to another important legal certainty issue. That issue is the enforceability of broad, closeout netting provisions such as those found in the widely used ISDA master agreements in bankruptcy proceedings. ISDA and the Bond Market Association have been actively advocating improved netting legislation in the United States since 1996. This very important legislation has come close to final enactment in the past. ISDA believes that there is no controversy concerning the benefits of this netting legislation. Rather, delay has been caused by the fact that the netting legislation has been included as part of a more comprehensive and, in parts, controversial bankruptcy reform proposal.

    If the more comprehensive proposal cannot be enacted this year, ISDA urges that the netting provisions embodied in H.R. 1161 should be enacted separately and without further delay.

    Let me conclude by saying again that ISDA applauds the introduction of the risk reduction bill. We have followed with great interest the regulatory initiatives being undertaken by the CFTC at the direction of its congressional authorizing committees. We appreciate the interest of Chairman Rainer and his colleagues, both in avoiding regulatory measures that increase legal uncertainty and in exploring opportunities to increase legal certainty in ways that are consistent with the Working Group report.
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    At the same time, however, we remain convinced that only Congress can provide a comprehensive solution to the legal certainty issue and that the time for Congress to do so is now, while our markets remain robust.

    We have seen repeatedly in the past that legal uncertainty is greatest at times of market turmoil, when counterparties try to avoid lawsuits. We look forward to working with this committee and other relevant committees to secure legislation that will provide needed legal certainty for all swaps transactions, including those that are cleared or entered into through electronic systems.

    Thank you, Mr. Chairman.

    Chairman LEACH. Mr. Dorsch.


    Mr. DORSCH. Thank you, Mr. Chairman.

    Good morning. My name is Shawn Dorsch and I am the President and Chief Operating Officer of DNI. DNI is very pleased to have been invited to deliver this statement to the Committee on Banking and Financial Services. Although the committee has three important topics before it, we have been asked to focus our testimony on rationalizing the legal and regulatory environment for the electronic trading of swaps and related financial derivatives.
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    DNI is a corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate a computerized communications and information system known as ''Blackbird.'' Blackbird helps major financial institutions find, negotiate, and agree to custom-tailored interest rate and currency derivative transactions, so-called swaps, directly with each other. The Blackbird system is now operational and successfully serving major swaps dealers in the United States. The Blackbird system serves only financial institutions; the public cannot access Blackbird.

    The fundamental goal of DNI is to provide its financial institution clients with a computerized system that will bring greater speed, precision, safety, and security and lower costs to the very same interest rate and currency risk management business activities that are now taking place every day in numerous U.S. financial institutions.

    In April 1999, when DNI was on the verge of making Blackbird operational, we received a letter from the CFTC asking DNI to provide certain information so that the CFTC could make an assessment of its own jurisdiction over Blackbird. Certainly, the CFTC is not to be faulted for making due inquiry to assure itself that it is fulfilling its regulatory responsibilities.

    This CFTC, however, was the same CFTC that had issued a concept release read by many as proposing that it take jurisdiction over the swaps community. This was the same CFTC which was at loggerheads with the Treasury, the SEC, and the Federal Reserve, and which was admonished by Congress not to take action following from its concept release. Fortunately, it is not the same CFTC today. If it were, we might now be speaking sadly of DNI as a U.S. entity in the past tense.
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    U.S. banks and investment banks which presently occupy a leadership role in providing interest rate and currency risk management products might have been deprived of access to leading edge technology that will help them compete.

    DNI recognized the potential difficulties in its situation with the CFTC. What followed, however, was a truly bewildering lesson in the very real, bottom-line effect of perceived legal uncertainty. DNI, a small North Carolina company, and its computer system were mentioned in multiple congressional hearings, only one of which DNI was invited to attend. The fact of the CFTC inquiry became general industry knowledge. Even our product name, Blackbird, was publicly ridiculed as an indication of evil and evasive intent.

    The details of the public controversy we faced are less interesting than some of the deeper effects of the controversy. Perhaps most importantly, senior DNI personnel had to shift their attention from building a business to explaining and defending that business. Obviously, substantial financial resources had to be focused on the regulatory situation. Potential clients needed to be reassured that transactions negotiated through Blackbird would not be void as illegal off-exchange futures. This, of course, is the central ''uncertainty'' concern arising from the Commodity Exchange Act with respect to swaps. Potential investors also needed to be helped to a level of comfort with the regulatory situation. The net effect was that the CFTC inquiry and attendant public attention significantly slowed our progress for a time.

    Perhaps there is little surprising in all of this until one stops to consider that most, if not all, of what the Blackbird system does is now done by ''voice brokers,'' human beings using telephones and squawk boxes.
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    In fact, Blackbird fulfills the same functions as the voice brokers, but with far greater efficiency and benefit to the financial system. Blackbird is not an exchange, nor is it a clearinghouse. Blackbird does not enter into transactions, it does not provide credit support or take or add credit risk. Blackbird does not change the individualized customized nature of swaps. Blackbird does not introduce preference or bias into the negotiations.

    Blackbird simply offers an improved electronic method for a dealer to identify other dealers who may, subject to the resolution of credit and many other terms, be willing to enter into a transaction having particular economic terms desired by the first dealer. The use of Blackbird promotes competition, improves transparency, recordkeeping and risk control, and reduces costs. Blackbird brings substantial private and public benefit, without changing any meaningful feature of custom-tailored swaps activities as they currently operate, and without creating any need for novel regulation.

    If Blackbird brings all of these benefits, why did it encounter the problems described above? It may be helpful for the committee to consider for a moment the underlying legislative and regulatory causes of DNI's predicament.

    First, there is the archaic language of the Commodity Exchange Act itself. It was stretched far beyond its original intended use even before the advent of new electronic technology as ''commodity'' exchange-traded contracts have moved from agricultural into the financial arena. Built on top of this obsolete legislative base is a statutory and regulatory exemptive structure constantly struggling to determine what might and might not be exempt. In DNI's case, the existing language of the relevant regulatory exemption was read by some to deny exempt status to Blackbird, essentially, because Blackbird is an electronic system. This is precisely the kind of dangerously confused thinking that the electronic trading section of the Over-the-Counter Derivatives Systemic Risk Reduction Act of 2000 is designed to forestall.
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    When words and reality no longer mesh, it is time to restore direction by returning to basic principles. Fortunately, in the Commodity Exchange Act context, we have seen this recognized on several fronts. First, the report of the President's Working Group on Financial Markets, entitled ''Over-the Counter Derivatives Markets and the Commodity Exchange Act,'' explicitly recognized that the ''method by which a transaction is executed has no obvious bearing on the need for regulation in markets, such as the markets for financial derivatives that are not used for price discovery.'' The report went on to note that there is no ''demonstrable need for regulation'' of certain electronic systems.

    Second, the new CFTC, reinventing itself under Chairman Rainer, has participated in the President's Working Group report and has put forth a new regulatory proposal that attempts to build afresh on positions of policy and principle, and that attempts to encourage use of electronic systems. We are encouraged by Chairman Rainer's very constructive attitude.

    Finally, Congress now seems to be well focused on the fact that existing statutory and regulatory regimes may not adapt readily to the promise and challenge of new technologies. The efforts of Chairman Leach, Congressmen LaFalce, Baker and Kanjorski in introducing H.R. 4203 should prove to be invaluable in establishing the proper direction for a redesign of our Nation's statutes and regulations governing the swaps business. We encourage Congress to watch closely to be sure that these new constructs are sufficiently resilient to weather changes in administration as well as changes in technology. In doing so, it is important to keep in mind the words of Federal Reserve Chairman Alan Greenspan which described the development of financial derivatives as ''by far the most significant event in finance during the past decade.''
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    Thank you, Mr. Chairman. We look forward to working with this committee and others in Congress and the relevant Federal agencies as this legislative effort proceeds.

    Chairman LEACH. Thank you, Mr. Dorsch.

    Mr. Young.


    Mr. YOUNG. Thank you, Mr. Chairman. My name is Mark Young. I am a partner in the law firm of Kirkland & Ellis. I am appearing today on behalf of the Board of Trade of the City of Chicago. Our Chairman, David Brennan, and our President and CEO, Tom Donavan, unfortunately could not be here today. They want to send their regrets and their continued interest in the subject matter of your legislation, H.R. 4203, and the issues that we will be discussing today.

    In my remarks this morning, I simply want to echo the prepared statement that has been submitted by the Chicago Board of Trade and make two additional points.

    The starting-off point for our analysis is that the Chicago Board of Trade today and other U.S. futures exchanges suffer from severe regulatory disparities. Mr. Dorsch's testimony has just illustrated one of them. Blackbird is a transaction execution facility, and so is the Chicago Board of Trade. Blackbird is not regulated at all under the Commodity Exchange Act, and the Chicago Board of Trade is regulated under the Commodity Exchange Act, and it bears a heavy burden of regulation under the Commodity Exchange Act.
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    To try to address that regulatory disparity and others, the Chicago Board of Trade, along with other U.S. futures exchanges, has supported comprehensive legislation for many years to reform the Commodity Exchange Act in three ways. First, we believe the Commodity Exchange Act should, like our friends at ISDA, define what is in the Commodity Exchange Act and what is out of the Commodity Exchange Act with absolute certainty. ISDA has stated in its prepared remarks that they remain convinced that only Congress can provide a comprehensive solution to the legal certainty issue and that the time to do so is now, and the Chicago Board of Trade completely agrees with that statement.

    The second of the three points that legislation must address is regulatory reform. Chairman Rainer and the staff at the CFTC are well on their way toward attempting to rationalize regulation under the Commodity Exchange Act and bring it into the modern age. We applaud them for their efforts. It is a start, but it is not a statutory or legislative solution, and that is the end point that we are looking for.

    Third, Mr. Chairman, you have already mentioned Shad-Johnson in this morning's hearing, and dealing with the inequity of equity derivatives is critical to the futures exchanges. In 1982, Congress passed what was called a temporary foreclosure of trading in single stock futures. It was designed as a temporary foreclosure, because the two agencies who proposed it to the Congress, the CFTC and the SEC, told the Congress, ''You don't have to resolve this issue right now, we are going to study it and come back with a recommendation to you.'' In my dictionary, eighteen years is not temporary, it is too long. We appreciate the encouragement that you gave the agencies today; we hope that they take that to heart and that maybe in eighteen days, we will have a legislative consensus that we can all support.
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    That is the three parts of the comprehensive legislation that we support.

    I would just like to make two additional points, Mr. Chairman. One relates to history and one relates to law. The historical point is this: In 1974, there were new businesses, some that had started, some that were in the offing, that came to Congress and said, ''We don't need regulation, we don't need additional Government oversight.'' Those businesses were started by the Chicago futures exchanges. The Chicago Mercantile Exchange led the way in the area of foreign currency futures. It was a new business, it started out and it was not subject to regulation under the Commodity Exchange Act.

    So we have a lot of sympathy with Mr. Dorsch's position when people come to you and say that a Federal statute applies to a new business enterprise, because that is exactly what happened to the Chicago exchanges in 1974. Congress expanded the definition of commodity to include everything but onions, granted the CFTC exclusive jurisdiction, and provided the CFTC with the regulatory tools for dealing with both agricultural derivatives and non-agricultural derivatives. So we find ourselves in a position where we are the, I guess the old regime looking at the new economy and saying, we would like to try and figure out how to rationalize regulation for both.

    That brings me to my second point. There has been some discussion today about what is a futures contract, and that is a critical issue under the Commodity Exchange Act, a critical definitional issue under the Commodity Exchange Act. It is true that there is no definition of a futures contract under the Commodity Exchange Act, but I would point out to the committee, the term that describes a futures contract in the Commodity Exchange Act is ''a contract of sale of a commodity for future delivery.'' If you look in the Commodity Exchange Act, there is a definition of ''contract of sale,'' there is a definition of ''commodity,'' and there is a definition that tells you what future delivery is not. So I would not want to say that the Congress completely dropped the definitional ball in figuring out what is a futures contract and what is not.
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    As decided by the courts over the years, however, a definition of futures contract has evolved. That definition does not turn on whether a transaction is subject to an electronic trading system or a clearing system. That is not critical to the legal inquiry of whether something is or is not a futures contract. In fact, the swaps exemption, which has been talked about this morning, either elliptically or explicitly, contains the phrase, ''multilateral transaction execution facility.'' That phrase does not say anything about electronic trading. It is neutral on electronic trading. It would apply whether it is electronic trading or non-electronic trading. So the notion that electronic trading somehow makes something a futures contract or in some way is inconsistent with the terms of the swaps exemption, it is just not so.

    In conclusion, again, I appreciate the opportunity to appear before you, and I look forward to any questions you have. We ask you to join us in supporting a comprehensive effort to reform the Commodity Exchange Act this year.

    Chairman LEACH. Thank you, Mr. Young.

    Mr. Duffy, you are the gentleman that is Mr. Latham's friend, is that correct?

    Mr. DUFFY. Yes, sir, that is true.

    Chairman LEACH. Good luck.

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    Mr. DUFFY. That was nice of the Congresswoman to come in and give a little shot for me.

    Chairman Leach, committee Members, ladies and gentlemen, my name is Terrence Duffy, Vice Chairman of the Chicago Mercantile Exchange. Our Chairman, Scott Gordon, asked that I express his regrets. He is unable to attend today. He is out of the country at this time.

    I have been a member of the exchange since 1982. I was first elected to the Board of Directors in 1994. I am currently serving my third term as vice chairman. I am the President of TDA Trading, Incorporated and an independent floor broker and trader. I have helped lead the CME's efforts to embrace new trading technologies. I appreciate the impact of technology on the future of the financial services industry and I am sensitive to the needs and expectations of the over-the-counter markets. I hope my testimony reflects that sensitivity.

    Chairman Leach asked that we focus on financial derivatives and state our view on the regulatory challenges and opportunities created for futures exchanges presented by the report of the President's Working Group on Financial Markets. I hope I can bring some perspective as an active trader and user of the futures industry.

    The current regulatory structure places U.S. regulated futures exchanges at a significant disadvantage to offshore competitors and the domestic OTC market. Overly detailed regulation of futures exchanges increases direct costs and time to market of innovative products. Our business space is constricted by the artificial constraints imposed by Shad-Johnson. Over-the-counter competitors are converging with futures markets in all respects other than the regulatory burdens. Although the CFTC exemption that permits over-the-counter markets to do swaps business was intended to preclude mimicking futures exchanges, we see auction markets for standardized futures contracts cloaking themselves in the mantle of the over-the-counter market and avoiding any regulatory response.
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    We realized at an early date that the Commodity Exchange Act should be amended to permit privately negotiated over-the-counter financial derivative transactions without fear that the contract would be invalidated as an illegal off-exchange futures contract. We supported the provision of the Futures Trading Practices Act of 1992, by which Congress granted the Commission power to exempt swaps and other derivatives from the exchange trading and other requirements of the CEA.

    We have responded to changing conditions in the over-the-counter market and are currently proposing amendments to the Commodity Exchange Act that would transform the exemption for over-the-counter market transactions into an exclusion and greatly expand its scope to permit clearing and electronic trading of financial derivatives among sophisticated parties without running afoul of the Commodity Exchange Act. In this we support the principles of the Working Group. While we support the goal of legal certainty for the OTC, we do not agree with the special interest provisions of the Working Group report that permit certain entities to run unregulated futures exchanges.

    We also are firmly of the view that enacting the Working Group suggestions in isolation will unbalance the financial services industry at the expense of most participants and their customers. We have proposed a holistic approach to the problem that will bring legal certainty to the over-the-counter market, regulatory release to the exchange markets, and resolve the Shad-Johnson restriction for the over-the-counter and the exchange markets at the same time.

    While we are critical of the special interest provisions in Treasury's proposal, the CME is exceptionally encouraged by the CFTC staff task force report, ''A New Regulatory Framework.'' The Commission has been both responsible and responsive to the concerns of all elements in the financial services industry. We are pleased by the tone of the proposal, which is consistent with a progressive regulatory philosophy that depends on oversight and competition among markets, rather than a prescriptive regulation of protected market spaces. The CFTC staff under Chairman Rainer has demonstrated a deepening understanding of the complex technological and competitive issue facing our markets and a commitment to providing much needed regulatory relief.
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    Another of CME's goals is freedom to list and trade futures contracts now forbidden by Shad-Johnson without being subjected to multiple regulators and without changing the fashion in which we have conducted our business for more than 100 years. Remember, we created a tremendously useful product in equity indexes in the face of overwhelming opposition. The SEC and its client exchanges opposed futures on indexes with all of the same arguments that they now raise against futures and individual securities. Nonetheless, equity indexes are the most popular contracts on securities exchanges as well as futures exchanges. Futures trading of equity indexes has enhanced customer opportunity with none of the consequences predicted by the OTC. In fact, their business has directly benefited.

    The division of responsibility between the SEC and CFTC, which I proposed in my written testimony, will eliminate the competitive barriers that injure public customers. It will not protect futures exchanges or securities exchanges against any legitimate competitive advantage of the other.

    In conclusion, Mr. Chairman, our goal was and remains equivalent regulatory treatment for functionally equivalent execution facilities, clearinghouses and intermediaries. We agree that clearing should have an appropriate regulatory framework, but cannot agree with any proposal that limits the range of clearing services that a clearinghouse can provide. The CME's clearinghouse has been a clear industry leader in risk management and technological innovation. It is inappropriate to limit the scope of its services by legislation.

    We continue to believe that the joint exchange proposal is the best formulation for regulation relief. However, we are well aware that legislative and industry consensus in favor of a good plan trumps our theoretically better plan. We are prepared to join the consensus and give up our plan in favor of the broad principles of the President's Working Group and the CFTC staff proposal if we can secure the Shad-Johnson relief.
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    The bottom line, I urge that the CFTC staff report be the basis for legislative overhaul of the Commodity Exchange Act and elimination of the Shad-Johnson prohibition against single stock futures be an integral part of that legislative package.

    Thank you, Mr. Chairman, for your clear focus on these important issues and your commitment to the success of the U.S. financial services industry.

    Chairman LEACH. Well, thank you for that testimony. That is the clearest expression of tradeoff that I have heard and I am appreciative of it.

    Mr. Brickell.


    Mr. BRICKELL. Misery loves company. That is what they say, Mr. Chairman, and it must be true. With one breath, the exchanges lament the burdens of regulation by the Commodity Futures Trading Commission, and with the next breath they insist that swaps are futures too, and swaps should be regulated by the CFTC.

    Not since the LaBrea Tar Pits filled up with fossils has one group howled so loudly that the others ought to ''come on down.'' We swappers will take a pass, Mr. Chairman. We are not going for a swim in that pond; we will stay up here on the bank. We remember who went under at LaBrea. It was a ''D'' word, all right, but it was not ''derivatives.''
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    Mr. Chairman and Members of the committee, that is why we are so grateful to you for holding this hearing today and giving us the opportunity to testify on behalf of J.P. Morgan. There is too much at stake. Swaps are too important to the economy and too much would be lost if swaps somehow became futures contracts subject to the Commodity Exchange Act. We are deeply grateful to you, Mr. Chairman, for your thoughtful critique of the recent staff draft proposal from the CFTC and for your legislative initiative, and we are glad that Ranking Member LaFalce, Congressman Baker and Congressman Kanjorski have joined you as co-sponsors of H.R. 4203, the Over-the-Counter Derivatives Systemic Risk Reduction Act. If the four of you had been the lifeguard squad at the LaBrea Tar Pits, there would have been far less damage.

    J.P. Morgan is one of the world's largest dealers in privately negotiated derivatives. We are also among the largest users of exchange-traded futures. We know swaps, we know futures, and we know the difference. We do not know of a single swap transaction that should be regulated as a futures contract by the CFTC.

    We are not the only U.S. bank with a large swap business. According to Chairman Greenspan, U.S. banks are the leading players in global derivatives markets and BIS statistics indicate that as much as 85 percent of all swap transactions include a bank participant. So there is no doubt that swaps are of central importance to the House Banking Committee.

    Swaps are important for American business as well. They have become an essential part of risk management. Each company, Government body and bank faces financial risk the moment it opens its doors to do business, and every one of those enterprises faces a unique mix of risks. Swaps are popular and their use has grown by over 40 percent per annum since 1987, because each swap is custom-tailored, and swaps differ substantially from futures contracts. Futures are standardized exchange-traded contracts written and governed by the Commodity Exchange Act, which was written to regulate standardized activity. But that statute is utterly inappropriate for the regulation of swaps.
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    Every swap transaction is unique, like a snowflake, and you cannot make snowflakes with a cookie-cutter like the Commodity Exchange Act. As a result, swap transactions simply do not fit within the regulatory framework administered by the CFTC.

    The Commission itself has known this since at least 1989. That year, the CFTC, under Chairman Wendy Lee Gramm, issued a swaps policy statement saying that swaps are not appropriately regulated as futures.

    Subsequently, in 1993, the Commission issued a swaps exemption. The Commission took great advantage of the new powers granted by Congress to reassure swap participants that their deals would be enforced. But change is so rapid in the swap business that the exemption is out-of-date today. Now it serves as a constraint on innovation. Reducing the credit risk of swaps, negotiating them electronically, making their benefits available to small business, any of these useful activities could call into question the enforceability of a swap, because they go beyond the boundaries of the 1993 swap exemption.

    In short, useful activities are barred today by an antiquated Commodity Exchange Act with its roots in the 1920's. It is time to bring the CEA into the internet age. If we do not, the CEA may do even more damage than inhibiting useful innovation by banks and by futures exchanges.

    Despite the CFTC's best efforts to provide exemptive relief, we all know that the CEA is so inappropriate for the regulation of swap activity that if swaps were regulated under the Act, the exchange trading requirement of the Act would instantly call into question the enforceability of thousands of deals and undermine billions of dollars worth of value on the books of American banks, brokers and corporations. Everyone on the panel knows that this is true, but you do not have to take our word for it. The problem is so grave that the Treasury, the Fed, the SEC and the CFTC itself have jointly called for legislation to address the problem.
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    We agree, and that is why we support your initiative to legislate. It would modernize the banking laws in a manner generally consistent with the recommendation of the Working Group report.

    What principles should guide Congress as you legislate? A bill should achieve three essential goals. It should establish with clarity that swaps are outside the scope of the CEA and not regulated by the CFTC. It should achieve statutory deregulation of the futures exchanges. We support their goal of regulatory parity, but by making their regulatory framework better, not by making our framework worse.

    Third, it is time to repeal the outdated Shad-Johnson prohibition on futures on single securities. Bank customers benefit every day when banks write equity swaps without SEC regulation as a result of the Toomey-Campbell amendment passed in this committee and included in the Gramm-Leach-Bliley Act. Futures exchanges should be free to offer similar products to their customers.

    Mr. Chairman, this is not the first time that you have patrolled the CEA shoreline. The work this committee did in 1998 was remarkably effective in guiding the CFTC after the initial issuance of its concept release on swaps. We know that it will take legislation to make it clear that swaps are not regulated by the CFTC, and we applaud the introduction of your bill and your leadership of this committee. The bill will help to save swaps and it throws a lifeline to the futures exchanges. You can count on our support as you clarify once and for all that the CEA does not apply to swaps transactions.

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    Thank you.

    Chairman LEACH. Well, thank you very much, Mr. Brickell.

    Taking up your last point, it seems to me that Mr. Parkinson from the Fed testified earlier that swaps should not be considered under the CEA. Mr. Cunningham, Mr. Dorsch, Mr. Brickell seem to echo that. On the other hand, Mr. Young and Mr. Duffy seem to say swaps are futures. Is this a fair assessment? Mr. Young and Mr. Duffy, you have a different perspective, is that valid?

    Mr. YOUNG. I don't think, Mr. Chairman, that it is completely fair, and if we left that impression with you, let me try and correct the record.

    Chairman LEACH. Please.

    Mr. YOUNG. Glib slogans do not equal legal certainty. Snowflakes and cookie-cutters do not equal legal certainty. There needs to be a specific and clear line drawn that goes beyond labels of what is in the Commodity Exchange Act and what is out of the Commodity Exchange Act. That is what we have supported for many, many years. That is what we continue to support as a way to remove systemic risk from the financial markets today, which does exist because of legal uncertainty. And the more people talk about the labels rather than the substance of the transactions.

    Chairman LEACH. Right, but I am a little concerned. Are you differing with Mr. Brickell only on the fact that you want to define CEA exemptions under law, or are you differing with the concept itself?
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    Mr. YOUNG. I am differing with, I think, both.

    Chairman LEACH. All right.

    Mr. YOUNG. Let's take snowflakes and cookie-cutters. We could actually agree.

    Chairman LEACH. They are futurist contracts, are they? .

    Mr. YOUNG. Snowflakes are not futures contracts, but cookie-cutters are. Mr. Brickell used the term ''standardization,'' and he said swaps are not standardized instruments. If they are not standardized, they are not tradable, they are not executable, and they are probably not clearable, and therefore, they are outside the Commodity Exchange Act. That is what our proposal has been for a long time. We have said if it is a privately negotiated snowflake it is outside the Commodity Exchange Act.

    Chairman LEACH. Mr. Brickell, do you want to respond to this snowflakes/cookie-cutter analogy?

    Mr. YOUNG. They are his analogies.

    Mr. BRICKELL. We have said that swaps are different from futures, because swaps are custom tailored. Every swap is unique in some way from the other swaps. The problem that the exchanges face is not that electronic trading permits us to efficiently trade standardized, fungible transactions, although that is what they suggest in their testimony. Technology has advanced so far that we know how to electronically trade custom-tailored deals. These custom-tailored deals may be more useful to customers, to corporations and Government bodies than the standardized deals that trade on exchanges. So the exchanges seem to be especially sensitive to the burdens of regulation in this commercial environment.
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    How do you resolve a problem like this fairly? We have given this a lot of thought, and our proposal is that futures exchanges should be regulated more like swap dealers are regulated. That principle underlies the President's Working Group report; that principle underlies your bill and your bill is less burdensome for electronic trading of futures than anything the CFTC could write, since you are able to change the law and they are not.

    So we think you found the way.

    Chairman LEACH. Let me just ask Mr. Duffy, are you snowed by Mr. Young, or do you like this sugary cookie offered by Mr. Brickell?

    Mr. DUFFY. Being on the trading end for nineteen years, I have heard a lot of analogies, but I have never heard anything about snowflakes or cookie-cutters. But I will say one quick thing, and that is that we support legal certainty for the swaps and I think we have said that quite clearly in our testimony, and I think we will stay with that position.

    Chairman LEACH. Well, thank you very much.

    What I would like to do is go on for about five more minutes and then we will break for the vote. I believe it is Mr. Watt's turn, if you would like to proceed now.

    Mr. WATT. Mr. Chairman, I think I can be very brief. I actually wanted to welcome Mr. Dorsch, who is from my region of the country, and Mr. Watkins on the next panel, who is from my region of the country.
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    Chairman LEACH. If the gentleman will yield, your region of the country is awfully well represented.

    Mr. WATT. Well, we always think that we are, and try to make sure that that is true both on the legislative side and on the private side. I don't know whether the Chairman will agree with that or not.

    Chairman LEACH. That was the intent of the Chairman's remarks.

    Mr. WATT. Oh, OK. In that case, maybe I should stop while I am ahead.

    I am having a little trouble understanding. It sounds like everybody on this panel endorses H.R. 4203; is that right?

    Mr. YOUNG. I think from our perspective there is a lot of good in H.R. 4203. We just think that it is better that that good be addressed in a comprehensive piece of legislation coming out of the Agriculture Committee that will deal with all three issues and all three areas of legislative concern to the exchanges.

    Mr. WATT. But we do not have that bill before us, so I am trying to figure out if I were called upon to vote in this committee on this bill in its current form, would you be supportive of it, or would you be opposed to it?

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    Mr. YOUNG. We would not be supportive of it.

    Mr. WATT. And Mr. Duffy, what is your response to that question?

    Mr. DUFFY. I suppose I would echo Mr. Young's sentiments.

    Mr. WATT. So all the positive comments you all were making about the bill, you would vote against it in its current form?

    Mr. DUFFY. I believe that we need to put all of our concerns into one legislative package, and I think that would be to our benefit to do so, and to have bits and pieces it would not be to our benefit. So as I do support Chairman Leach's bill to an extent, I think that we need to address it, like Mr. Young said, in the Agriculture Committee to help put everything that we are looking for to get in the bill.

    Mr. WATT. Of course, this bill, I assume, will go to the Agriculture Committee. So I am still uncertain what you are saying. Are you saying that you oppose provisions in this bill, or are you saying you oppose provisions—you are opposed to this because there are not other provisions included in the bill?

    Mr. DORSCH. It is really that we are more in favor of a comprehensive bill. Some of the provisions of this bill, when they try to address legal certainty, we do not believe can fully do the job, because the bill is not amending the Commodity Exchange Act. It is suggesting rules of construction for courts or agencies under the Commodity Exchange Act without amending the Commodity Exchange Act. We believe it is better, and apparently as a matter of degree, it is necessary for a legislative comprehensive solution to address legal certainty under the Commodity Exchange Act.
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    Mr. WATT. And the comprehensive legislative solution, the amendment to the Commodity Exchange Act would be something that defines at least the cookie-cutter swaps as something that should be regulated? Is that where you are?

    Mr. YOUNG. Potentially the line that is drawn in this legislation is not very far from where we would like to see the line drawn in the comprehensive legislation, but the problem is this is not a comprehensive piece of legislation and it is stating a rule of construction relating to another statute rather than amending that statute. Those are the two off-hand objections we have with the statute.

    Chairman LEACH. Would the gentleman yield?

    Mr. WATT. Happy to yield.

    Chairman LEACH. First, the Chair has laid on the table that he would be—his first preference is for this to be part of a bill that does modify the Commodity Exchange Act, and second, I think it fair to ask if—I don't want to presume the gentleman, but I will give him more time, that Mr. Duffy seems to suggest that he can support large movements in this area if there is change in the Shad-Johnson issue.

    Mr. Brickell, can you accept that change? If there is consensus in the Executive Branch in that direction, could you accept that as a tradeoff for acceptance for the rest of that approach?

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    Mr. BRICKELL. Could we accept Shad-Johnson repeal?

    Chairman LEACH. Sure.

    Mr. BRICKELL. We would strongly support it.

    Chairman LEACH. So what I am getting at is I think there is a little more consensus here than the wording might indicate from this last exchange. But please proceed.

    Mr. WATT. Mr. Dorsch and Mr. Cunningham, we have everybody else I think on record here and I am trying to make sure I get the last two on record and then I will stop.

    Mr. CUNNINGHAM. I think it is fair to say that it is this preference, our first priority has always been a comprehensive solution, including regulatory relief for the exchanges, legal certainty and certain other matters. However, if that road to Mecca does not work, we would be forced to look at others, and this bill would be something we would be seriously interested in pursuing if the comprehensive solution is not doable.

    Chairman LEACH. If I could interrupt briefly, I am afraid we have three minutes until a vote. So what I would like to do is recess at this time and I will return to the gentleman if he so wishes.

    Mr. WATT. Actually, I was about to yield back if Mr. Dorsch would just say yes or no.
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    Mr. DORSCH. I concur with Mr. Watt.

    Chairman LEACH. The gentleman's time has expired.

    Mr. NEY. I just have one second, if I could.

    Chairman LEACH. If you can do it in one second.

    Mr. NEY. I would just like to ask Mr. Duffy, if I could, on the Shad-Johnson Accord, revise it, review it or discard it?

    Mr. DUFFY. Well, obviously we want to have the Shad-Johnson Accord repealed. We feel that—in 1982, if I may, Mr. Chairman, for one quick second make this comment, in 1982 we had—we started a financial index on stock indexes and we are one of two exchanges basically in the country now and also on the Board of Trade that are not permitted to trade.

    Chairman LEACH. If I could just interrupt for a second, we will return to this after the recess. I will ask him to fill this out, whether or not you are able to return or not.

    At this point, we will recess pending the vote. So that there is a little bit of certitude, why don't we make it until 1:30. We will recess until 1:30.

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    Chairman LEACH. The hearing will reconvene.

    Before turning to the next witness, I would like to see if Mr. Duffy would like to expand briefly on his last answer, or do you think you sufficiently covered it, for Mr. Watt? No, actually, Mr. Ney; you were in the middle of a response when we had to recess.

    Mr. DUFFY. Yes. Mr. Ney asked me how I felt about Shad-Johnson and should it be revisited.

    Chairman LEACH. Repealed or modified.

    Mr. DUFFY. My answer was going to be in 1982 when we created equity indexes, we struggled to get people even to get into pits to trade these products. Then they became quite successful over the years, obviously, and now we are one of two exchanges that do not have the opportunity to trade individual issues on securities, the Chicago Board of Trade. They trade them overseas, they trade them over-the-counter, and it is kind of a crazy twist that we are the ones that created equity indexes and we are two of the exchanges that can't trade the individual issues.

    So that was going to be my response to the Congressman.

    Chairman LEACH. That is fair.

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    The gentleman from Louisiana.

    Mr. BAKER. It may have been clarified, because I stepped out in the course of the questioning, but I just want to make sure I was understanding Mr. Young and Mr. Duffy's concerns about the Chairman's proposal in that it does not statutorily affect CEA. Therefore, it could not address in a proper context the concerns you have about certainty.

    Going beyond that, to make sure I am understanding your point, are you suggesting that there should be a clear identification of each product type as to its designation, or are you suggesting that the cookie-cutter be more clearly defined? If you are saying we ought to have clarity of current market product by type, statutorily, what happens the next time the new products develop?

    Mr. Young.

    Mr. YOUNG. I am not saying that we should have clarity by type. Type to me suggests definition by labeling, and that I do not think will result in legal certainty. I think it will result in people moving to the label that conveys the least level of regulation or no regulation. So I don't think that will work. I think that you have to identify what economic function do you think should be regulated, and then apply a rational level of regulation to that, no more and no less. That is what we have been asking for.

    The cookie-cutter and snowflake analogy was not something that we created. I believe Mr. Brickell has a copyright on it, and I don't want to attempt to infringe.

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    Mr. BAKER. I don't think he minds.

    Mr. YOUNG. But the notion has always been in the law in the Commodity Exchange Act that instruments that are standardized and offsetable that are entered into, not in order to result in delivery of a product, but in order to shift risk, those are futures contracts, and that legal definition of futures contract has created considerable legal uncertainty in the over-the-counter derivatives world. We are very sensitive to that and we would like to see something better come along.

    What we have proposed is a system where you would look at how something is executed, not what the underlying transaction is, whether it is a future or not a future, because we think that getting into the legal debate of what is a future and what is not a future is not a recipe for legal certainty, it is a recipe for continued legal uncertainty. Even with the dialogue we have had today, when you use the term ''swaps'' and you use the term ''futures'' and you consider them mutually exclusive, I think legally that is a very difficult case to make.

    Mr. BAKER. So you are really arguing for a different set of labels as opposed to the ones the Chairman is proposing?

    Mr. YOUNG. I am arguing for a different set of demarcation points that would identify the economic function that should be regulated under the Commodity Exchange Act, and only that function.

    Mr. BAKER. But whether you call it a swap or a future, you have to, even in your world, I think, describe some elements that constitute an end product. Are we really just debating to some extent whether we have a word, ''swap,'' or whether we have a set of criteria that determines how you are measured?
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    Mr. YOUNG. I am not going to get into a debate about the debate, but the point we are trying to make, and let me say it this way, there will have to be, for there to be legal certainty under the Commodity Exchange Act, there will have to be a definition of what is in and what is out. How you structure that definition is what the debate is really about, not the label swaps versus futures. That is the only point I was making.

    What we have supported is a definition that says privately negotiated derivative transactions are out of the Commodity Exchange Act. Publicly executed transactions are in the Commodity Exchange Act. We drew that line because the commodity exchanges, the futures exchanges, are subject to the Commodity Exchange Act and we offer public execution facilities. Other execution facilities we think should be subject to similar rules to the rules that we will be required to follow, and those rules we are very hopeful will not be the rules that apply today, but will be the rules that will come out of the CFTC, led by Chairman Rainer, who is ratcheting down regulation and modernizing so that it can apply in a rational basis to all execution facilities.

    Mr. BAKER. One further quick question. Doesn't the provision of the Chairman's mark that stipulates that regardless of the jurisdictional field in which you find your product being located, that the contract is enforceable, doesn't that enhance the certainty in the market? If the bill were to pass in its current form, that element alone, isn't that an improvement in your current circumstance?

    Mr. YOUNG. It would—to the extent that people cannot renege on contractual obligations, it would assist in legal certainty.
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    Mr. BAKER. In using the jurisdictional claims, is my point. I don't have the quote cite in front of me, but regardless of the jurisdictional regulatory field in which a product may rely, it is not unenforceable simply because of a dispute over jurisdiction.

    Mr. YOUNG. Right. I don't believe that that would materially help the legal certainty issue, because a disgruntled losing trader in an over-the-counter transaction wouldn't really be asserting jurisdiction, they would be asserting that the contract is illegal, and unless we are going to change the way our jurisprudence works, illegal contracts are not enforceable. That is what the nature of the dispute would be, not a jurisdictional one.

    Mr. BAKER. Thanks.

    Mr. Cunningham, do you share that view with regard to legal certainty and the statements in the Chairman's mark relative to jurisdictional concerns?

    Mr. CUNNINGHAM. With respect—I don't, given the uncertainty faced. With regard to the—any uncertainty that may exist in this proposal is so far less that I would much rather be there.

    Mr. BAKER. Thank you very much.

    Mr. WATT. Will the gentleman yield?

    Mr. BAKER. Certainly.
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    Mr. WATT. I wanted to ask Mr. Young, given this distinction between private and public that you just made, based on your understanding of what Mr. Dorsch's company does, are there any things that he would be doing that you would think would come under the regulations in either private or public—in the private or public side of what you just described? I don't know what the distinction is you are making, but I just wanted to make sure whether you thought anything he was doing should be under your board's jurisdiction.

    Mr. YOUNG. OK. The way I would describe it is that the Blackbird business is operating a transaction execution facility. That is the same business that the Chicago Board of Trade is in. What we would like is comparable treatment for our respective businesses. We are not asking—we would be delighted to be regulated like Mr. Dorsch's business. That would turn back the clock to 1974 and say, only with respect to financial derivatives, ''You are completely outside the Commodity Exchange Act and no one else can regulate you.'' If that is going to be the will of the Congress, we could accept that, turning back the clock. But all we are saying is, each transaction execution facility should be regulated in a comparable manner. We think that is fair and that will lead to fair competition.

    Mr. WATT. You think his business is a transaction execution facility.

    Mr. YOUNG. Yes, I do.

    Mr. BAKER. Unless Mr. Watt has a further question, I yield.

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    Mr. WATT. Mr. Dorsch might want to respond.

    Mr. DORSCH. I think there are very significant differences between Blackbird and the Chicago exchanges. First of all, Blackbird is not doing anything differently than what voice brokers have been doing for about seventeen years. As for the voice brokers, the Government and the regulatory agencies have never seen fit to regulate the voice brokers as an ''execution facility.'' Blackbird, the only difference is that instead of doing it on a telephone, we let people do it electronically, and the voice brokers are unregulated and we are not doing anything differently than them.

    But going beyond that, I would actually like to point out some specific differences between Blackbird and the exchanges, and in particular, it has to do with the clearinghouse and the extension of credit that the exchanges provide to those that trade there, and the fact that when an entity trades at the exchanges, their actual counterparty is the exchange, or exchange clearinghouse. In our world, all of the transactions which are done on Blackbird are exactly as they are with the voice brokers and they are bilateral transactions where the two counterparties are the two counterparties that negotiated the transaction and Blackbird is not a counterparty to such a transaction and is not involved in any way, shape or form.

    Mr. WATT. I thank the gentleman for yielding.

    Chairman LEACH. Mrs. Biggert.

    Mrs. BIGGERT. Thank you, Mr. Chairman.

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    My question is for Mr. Duffy, who is from my district in Illinois, and I believe is my first constituent to appear before this committee. I might have had a constituent before I was elected from the district, but anyway, I would like to welcome Mr. Duffy here.

    Chairman LEACH. Well, Mr. Duffy, you are extraordinarily well represented by Mrs. Biggert, and the gentleman from Iowa claims your friendship too.

    Mrs. BIGGERT. Thank you.

    First of all, I would like to ask whether—do you think that this bill will attempt to foreclose your clearinghouse from clearing OTC products, and is this a problem?

    Mr. DUFFY. Yes, I would say it would be a problem. I think that our clearinghouse should not be limited to any restrictions of clearing of OTC products. As long as the bill is going to allow the over-the-counter markets, we should have the same boundaries that they would have to clear any type of business that we see fit. So yes, I do think it would limit us.

    Mrs. BIGGERT. Do you take it from the language that says in the rule of construction that transactions subject to the CEA that such instruments are excluded from the CEA?

    Mr. DUFFY. If you wouldn't mind repeating that one more time.

    Mrs. BIGGERT. I didn't make that very clear.
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    The bill has a rule of construction saying that clearing of an OTC derivative instrument shall not be construed to mean that such transaction is subject to the CEA, so that is kind of a reserves saying therefore, it is not?

    Mr. DUFFY. Yes.

    Mrs. BIGGERT. OK. Also, you included in your testimony, you mentioned a need to level the regulatory playing field. Do you think that this bill achieves the regulatory fairness, or would it be able to achieve the regulatory fairness if it was combined with what might be proposed in the Agriculture Committee?

    Mr. DUFFY. Yes. I think that if we were to combine the two bills that we would get the regulatory relief and the parity of the playing field that we would need to compete.

    Mrs. BIGGERT. What would happen if this bill passed and then suddenly Congress does not get around to passing the agricultural bill?

    Mr. DUFFY. I don't know if I can foretell the future, but I do know that if we don't have—we feel very strongly that we need all the elements of our—of Shad-Johnson and everything else in a bill to make us be competitive in the years to come.

    Mrs. BIGGERT. OK.

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    Would you agree with that, Mr. Young?

    Mr. YOUNG. Yes, I would.

    Mrs. BIGGERT. OK. One of the things, Mr. Young, that you talked about really is that the bill really is changing the jurisdiction of the CFTC and the coverage of CEA in areas, except for derivatives involving non-financial commodities with finite supplies. That was in your testimony.

    What does that mean? Is it just the derivatives with non-financial, so again you would be foreclosed from any financial commodities?

    Mr. YOUNG. The bill attempts to leave in place the CFTC's jurisdiction with respect to derivatives on non-financial commodities like metals and energy and agricultural products, and I think the testimony earlier today indicated that there are some folks who would be interested in expanding the list of financial commodities to pick up some of the commodities I just identified as non-financial with finite supply.

    So there would be a balance of, what I would like to think of as commodities that are in and commodities that are out, and there would be an expansion, according to some who testified here today, of those commodities that are out, leaving it primarily with I think metals and agriculture.

    Mrs. BIGGERT. OK. Would you agree that the determination by the CEA, we really—you mentioned about relies on asking the question of is it a futures contract. Do you see a distinction from what has been testified to by other members on how to determine what is a futures contract?
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    Mr. YOUNG. I probably do. I don't think labels should govern, I think the economic reality and the economic substance of the transaction is critical to that determination. There is a statutory description of what a futures contract is. There is case law and agency precedent defining what a futures contract is, and what we found is that that precedent is not particularly helpful, given today's markets, because of the use of the very creative financial engineering that you see arrayed at this table and in this room. As a result, a lot of those lines have been blurred, and that is why we are in favor of drawing a new line.

    A good example of the lines being blurred is Mr. Dorsch suggested a few minutes ago that Blackbird is not like the Chicago Board of Trade, because Blackbird does not have a clearinghouse. Well, the Chicago Board of Trade doesn't own a clearinghouse. It is served by an independent clearinghouse called the Board of Trade Clearing Corporation, and the reason that clearing exists is because the CFTC has required an execution facility called a board of trade to have a clearing system before it will approve it for trading. So it is not definitional, it is a regulatory requirement.

    So as far as the Chicago Board of Trade is concerned, its business is executing trades and providing liquidity. I believe that is the same business plan that Blackbird has, and there is nothing wrong with that.

    Mrs. BIGGERT. It seems like we have lots of rules and regulations and people always find a way, not really to get around them, but they are very innovative and creative in finding new markets, and I don't think we want to hold that back; I think even in talking about hedge funds, probably some of the most creative and innovative ideas that have come along. So it seems like rather than go back to regulation, that what we should be doing is going toward less regulation in all fields, not only for something like Blackbird, but for something like the exchanges. Thank you.
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    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you very much, Mrs. Biggert.

    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman.

    My first question is for Messrs. Young and Duffy. I understand your position that you would like to see less regulation of the exchanges and, frankly, I share that concern and would like to see that also. In the meantime, it seems to me that we should not force privately negotiated derivatives transactions such as the kinds that Blackbird executes into the jurisdiction of a CEA simply because they are being executed through an electronic mechanism. As such, I think section 5 of H.R. 4203 addresses that and is beneficial.

    Would you support section 5 of this bill that would legislate that, or no?

    Mr. YOUNG. No.

    Mr. TOOMEY. OK. Do you contend that Blackbird does anything that is not currently done by voice brokers?

    Mr. YOUNG. I am not as familiar with voice brokers or frankly with Blackbird's system as I probably should be, because Blackbird's system, as far as I know, is not something that is open to public scrutiny or has been the subject of considerable public discussion. But, what I was trying to say before is, and the reason I answered no to your question, is that the fact that something is electronically traded or not doesn't make it a futures contract or not make it a futures contract. What makes it a futures contract, according to the law that exists today, is whether the instrument is sufficiently standardized and fungible so that multiple parties can trade it.
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    Now, if Blackbird's trades are all customized and all unique, if they are all such beautiful snowflakes that no one else can trade them, then they are not futures contracts. But at the last congressional hearing I attended that Mr. Dorsch testified at, he indicated in response to Senator Fitzgerald's questions, I believe, that some of those contracts can be offset among each other, so they can't be snowflakes, they have to be cookie-cutters. That is why I am having trouble with the boxes that we are developing in this dialogue just sorting things into one box versus the other.

    Mr. TOOMEY. Mr. Dorsch, would you like to comment on that?

    Mr. DORSCH. I would like to just state for the record that Blackbird has had extensive discussions with the Federal Reserve, the Office of the Comptroller of the Currency, the Department of Treasury, and the CFTC. We have met with each and every one of the commissioners, we have given Chairman Rainer live demonstrations of the system, and it has been open to extensive scrutiny by Federal regulatory authorities. Blackbird trades fully negotiated, customized swaps. None of the products which are traded in Blackbird are offset. We don't have any type of exchange-style offset in the transactions that we do within Blackbird.

    Mr. TOOMEY. I would just make a further comment. I traded swaps for seven years and we used exclusive—well, we traded directly amongst other financial institutions, but we often used brokers as well, and I have become fairly familiar with what the Blackbird system does and how it works, and I don't see how it provides anything, any service or any practical effect that is different from what the brokers provide, except for use of execution and greater information and that sort of thing. So I don't understand why we shouldn't simply say, as section 5 of this bill does, that the mere existence of electronic execution should not force these transactions into the scope of the CEA. I don't understand that. Maybe we should just move on.
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    I have a question for Mr. Brickell. Mr. Brickell, on the question of the hedge funds, you are, I believe, the only member of this panel who works for a bank. Your bank extends credit to hedge funds on a routine basis, is that correct?

    Mr. BRICKELL. That is correct. We do business with hedge funds, and a substantial business at that.

    Mr. TOOMEY. OK. There was some discussion in the prior panel as to the merits of the Hedge Fund Disclosure Act and it was suggested, I believe, and I think part of the basis of this bill is that it would ensure that there is a certain, at least minimum, amount of information that is disclosed. It seems to me that financial institutions, banks that extend credit to hedge funds systematically require far more information, far more frequently in far greater detail than the legislation contemplates or could realistically entertain.

    Would that be safe to say that about your institution and your credit practices?

    Mr. BRICKELL. Yes. It is certainly true that at our bank, we make credit judgments based on more detailed information than is available through the types of public disclosure contemplated in the bill we are discussing today. I could give you examples.

    Mr. TOOMEY. Well, could I ask the question, when your credit department is looking at extending credit to a hedge fund, would you say that it would be a normal course of practice to require proprietary information from the hedge fund in order that the credit department can effectively evaluate that, and that the hedge fund would provide that with the assurance, with the knowledge that it is part of the bank's business to get this information and to safeguard it from the trading floor to create a firewall that would prevent that information from being shared inappropriately?
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    Mr. BRICKELL. Yes. It is true that the types of information we collect are so proprietary, they go so deeply into the question of the kinds of positions that the hedge fund has taken, that we sometimes need to assure the hedge fund operator that the information will not be made available to the personnel on our trading desks.

    For example, we will have the ability to call once a month for a report from the hedge fund about its three largest positions or its five most concentrated positions, and naturally, the hedge fund would rather that information remains with the credit department and is not available to the trading floor because it is proprietary, and information of that type would clearly be more detailed than the information that would be publicly disclosed under the bill.

    Mr. TOOMEY. Would it be your opinion that in order for a risk analysis to be comprehensive and meaningful with respect to a hedge fund, it has to be proprietary?

    Mr. BRICKELL. There is no question but that we would not be comfortable taking credit exposure to hedge funds without obtaining this kind of detailed information. And, in fact, that is not just true for our business with hedge funds. That is the business of banking. Bankers receive information that is not available in public financial statements from virtually all of their customers. That is a specialty of being a banker, and we do it for hedge funds like we do for other customers.

    Mr. TOOMEY. My last question. Some have suggested that while maybe that is a good practice that the bank engages in today, but perhaps memories will be short and there will be a regression in the discipline of the credit department. So I guess two questions.
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    Do you think that—could you address the nature of the systematic effort by credit departments, your credit department in particular, to ensure that that does not happen? And second, if it were to happen, would this legislation provide a useful backstop that would at least ensure safe credit extension should that day come?

    Mr. BRICKELL. Well, if you back away from the question of hedge funds themselves and look at the ability of firms to compile financial information, it has grown enormously over the last two decades, because technology, the cost of computing power has dropped, and because we have created markets where we can price the forward curve, price volatility in the markets that the Chicago exchanges operate and the derivatives trading that we do at the banks have all contributed to greater transparency about risk.

    So the kinds of information we are getting across the board are more detailed, more informative than they have been. We are even disclosing some of those things that the banks—even their own public disclosure statements. That is the trend. We are not going back. We are going to get more detailed and more meaningful information about risk as time passes.

    Would this bill provide a meaningful backstop if we slipped? The answer is no. It does not call for the kinds of detailed information that we are able to get today and that we ask for today when we are extending credit, not only to hedge funds, but to other customers as well.

    Mr. TOOMEY. Thank you.

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    Thank you, Mr. Chairman.

    Chairman LEACH. Well, thank you very much, Pat, for those thoughtful queries.

    Let me just conclude with this panel by stressing that comparable as well as simplified in certain regulations is the intent of H.R. 4203, and I raise this particularly for Mr. Young and Mr. Duffy in this context. The two of you have testified that you want regulatory parity with OTC markets. H.R. 4203 is drafted to allow futures exchanges to trade in swaps and OTC derivatives outside the CFTC framework, just like the OTC community would move into electronic trading of the same products. Isn't this parity approach, or doesn't this parity approach make sense for your institutions?

    Then let me also say we have drafted the bill to allow exchanges to apply their clearing expertise to swaps transactions with the option of being under the same regulators that would regulate swaps clearing by OTC participants, and doesn't this approach also create opportunity for both of your exchanges? The reason I stress this is that all of us want to see your exchanges succeed. I mean there is nothing designed to undercut as much as there is a design to try to open up competitive markets.

    Now, is this appreciated? Do you agree with this premise that I have just made, or does it strike you as invalid?

    Mr. YOUNG. We agree with the premise. It is appreciated. Our concern is that for our business where we are today, it is not necessarily the best vehicle to achieve those two objectives.
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    Since we are already subject to the Commodity Exchange Act, I don't know that we would be allowed through the escape hatch door of being outside the Commodity Exchange Act and not subject to any other regulation if we were to undertake the activities described in your bill. That is our off-exchange concern.

    Chairman LEACH. Well, let me say, I mean I share part of that concern, because I think the CEA has to be modified and it is a far preferable way to go. I would prefer to have the approach we have laid on the table integrated into a larger, more comprehensive approach that deals with a number of issues you have raised. I might believe that absent that, this is a signal to step forward, but I share your preference for moving in a comprehensive or complementary fashion.

    But let me end with a question to the whole panel, because I think this is a critical question that applies to your two exchanges, applies to American commerce, and that is, to fail to move in this direction strikes me as an invitation to take business offshore massively and quickly. Is that a premise that you would agree with? First, Mr. Cunningham.

    Mr. CUNNINGHAM. I do. Without going into details, I think in my career thus far I have seen commodity derivatives transactions in the late 1980's and equity derivatives since they were invented done offshore, because of the concerns about the U.S. regulatory system, and I believe if we don't straighten out the situation for electronic trading we will see that develop in London. It is easy to do in London, and I think you are correct.

    Mr. DORSCH. I totally agree with that. I think we are seeing it already.
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    Chairman LEACH. Mr. Young, would you agree with that?

    Mr. YOUNG. I think it is a little bit more complicated than that. First of all, the over-the-counter market is operating today under this notion of legal uncertainty which we believe is real, believe it is a burden on the market, but the market is very successful, people are being able to innovate in that market and their growth rates are the growth rates that are the envy of the futures exchanges, so I would be happy to make that trade any day I could.

    At the same time, we are very strongly in favor of comprehensive reform in this area. We have been working hard to achieve that by getting all of the pieces of the puzzle in place over the last several years.

    We are very optimistic people by nature. We are not willing to throw in the towel now and say let's just take one little piece at this time. I don't believe that taking that piece would cure the legal certainty problem to the extent it exists and is going to send business overseas, it will still exist unless you deal with the Commodity Exchange Act frontally, amend it and decide what is in and what is out in a clear, unmistakable fashion.

    Chairman LEACH. Mr. Duffy.

    Mr. DUFFY. I would just like to say that we appreciate the legal certainty and we want to see legal certainty happen, but as far as the business going offshore, this is an $80 trillion a year business that obviously we do not want to see go offshore, so I appreciate the Chairman's comments on that. Thank you.
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    Chairman LEACH. I appreciate that.

    Mr. Brickell.

    Mr. BRICKELL. Mr. Chairman, the President's Working Group has said that this is a matter of national priority and the legislation is needed in this area, and needed now. We agree completely with that. I recall that in 1998, your leadership on a similar issue and the convening of discussion groups, including people from the other committees in the House of Representatives, led to spectacular results and we hope that you will push ahead in much the same way that you did then to help lead our groups to a common vision of how to proceed on this issue and a successful legislative effort.

    Chairman LEACH. Well, I appreciate that. I want to make it very clear, as this panel concludes, that we have certain jurisdiction, we have certain philosophical views. The larger jurisdiction, however, is within another committee of Congress, and we wish to work constructively with it. I am in full support of the perspective of Mr. Young and Mr. Duffy that it is better to have a comprehensive bill, and I am very hopeful in that. Absent that, we may have to do some piecemeal things, but I vastly prefer a comprehensive approach. I think that would be the best for the American system at this time.

    Anyway, I want to thank all of you and I appreciate very much your testimony. Thank you.

    Chairman LEACH. Our final panel consists of Michael A. Watkins, Deputy General Counsel, First Union Corporation, on behalf of the ABA Securities Association; William P. Miller II, Chairman of the Executive Committee, the End-Users of Derivatives Council of the Association for Financial Professionals; George Crapple, Chairman, The Managed Funds Association; and Garrett Glass, Chief Market Risk Officer, Bank One Corporation, on behalf of The Financial Services Roundtable.
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    We will go in the order in which people have been introduced. We will begin with you, Mr. Watkins.


    Mr. WATKINS. Thank you, Mr. Chairman.

    Mr. Chairman and Members of the committee, my name is Michael Watkins. I am Deputy General Counsel of First Union Corporation. First Union, the Nation's sixth largest banking company, is active in the global derivatives markets both as a dealer and an end-user. First Union makes markets and derivatives related to the interest rate, foreign exchange, equity, commodity and credit markets.

    I appear here today on behalf of the ABA Securities Association. ABASA is a separately chartered subsidiary of the American Bankers Association charged with policy development for major bank and financial holding companies involved in securities, underwriting and dealing and derivatives activities. My testimony today also reflects the views of the ABA.

    I have nearly twenty years experience with derivatives and have watched with great interest the developments in these markets. The issues raised in this hearing are very important to First Union, to the membership of ABASA and the ABA, and to the capital markets as a whole.
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    We have submitted a formal statement which the committee has entered into the record. The statement expresses our strong support for H.R. 1161, which addresses the subject of netting, and I will not dwell on that subject further.

    Instead, I would like to convey a few specific suggestions about H.R. 2924 and some more general thoughts about the Over-the-Counter Derivative Systemic Risk Reduction Act of 2000 that was introduced just last week.

    H.R. 2924, introduced by Congressman Baker and co-sponsored by many Members of this committee, including yourself, Mr. Chairman, implements some of the recommendations issued by the President's Working Group on Financial Markets. To limit the use of excessive leverage among market participants, the bill would implement the Working Group's recommendations regarding enhanced disclosure. Large unregulated hedge funds would be required to make additional public disclosure regarding the use of leverage.

    It is our fundamental belief that market forces should provide the necessary discipline to limit the use of excessive leverage by financial institutions, including unregulated hedge funds. Nevertheless, the provisions of this bill seem to have accommodated many of our Members' legitimate concerns.

    For example, amendments by the Subcommittee on Capital Markets make clear that information to be shared publicly regarding an unregulated hedge fund will not involve any proprietary or trade secret information. Moreover, the hedge fund disclosure requirements apply to only the largest of hedge funds or families of hedge funds. Only those funds or fund families with aggregate total assets of $3 billion or net assets of $1 billion or more would be required to submit reports. This cutoff is appropriate and smaller funds would not have a significant economic impact.
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    We do have several additional suggestions, however. The definition of unregulated hedge fund should be expanded to include pooled funds operated by both registered broker-dealers and affiliates of such broker-dealers. This could be accomplished by adding to the list of excluded firms both broker-dealers registered with the SEC, and their affiliates subject to section 17(h) of the Securities Exchange Act of 1934.

    Other technical amendments would also be appropriate. For example, it should be made clear that defined benefit and defined contribution plans such as 401(k) plans do not come within the meaning of unregulated hedge funds. After all, these plans are subject to extensive regulation under ERISA and examination by the Department of Labor. Private equity funds and common and collective trust funds used by banks to manage trust accounts should also be excluded. The legislation should make clear that these and other similar pooled funds are not covered by this bill.

    The bill would also express the sense of the Congress that public companies should be required to disclose additional information about their material financial exposures to significantly leveraged institutions. ABASA would respectfully suggest that the committee not include this provision at this time while the Financial Accounting Standards Board is considering the effectiveness of financial disclosures generally. It may be wiser for the Congress to refrain from adding more until FASB has completed its review of this issue.

    We would urge the committee to amend section 5 to provide for appeal of district court orders. Hedge funds should be entitled to appeal a lower court ruling, especially if there is a dispute as to whether a fund is unregulated, meets the prescribed asset size, has made the requisite disclosure, or has done business with U.S. residents.
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    Finally, Mr. Chairman, a few comments about regulation of over-the-counter derivative transactions. Over-the-counter derivatives are custom-made contracts whose terms can be individually tailored to fit a specific customer's needs. Because these contracts are not standardized, that is, they often contain unique terms reflecting a specific transaction, these instruments have not been traded on exchanges. However, many transactions use terminology and forms developed during the last fifteen years by the International Swaps and Derivatives Association. As swap transactions involving institutions and sophisticated individuals become more common, our members anticipate that some categories of swaps may become sufficiently standardized to permit trading on exchanges and some by clearing organizations, much like their financial cousins, exchange-traded futures and options, are today. Trading and settlement of these instruments through electronic networks are also likely to develop.

    Our members use derivative instruments as both end-users and as dealers. As end-users, commercial banks, much like other corporations, use derivatives to manage their risks and reduce funding costs, thereby enabling them to make credit more widely available in their local communities. As of year end 1999, approximately 400 commercial banks held derivative contracts for purposes other than trading.

    As derivative dealers, many of ABASA's members, including my own organization, capitalize on their ability to understand the financial needs and risk management objectives of their many customers, which typically include other banks, financial services firms, corporations and other sophisticated capital markets participants. OTC derivatives allow these customers to better manage their own particular risks and they permit greater product innovation in response to changing customer needs.
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    The President's Working Group recommended a series of changes to the Commodity Exchange Act that would, among other things, increase the legal certainty for swaps, clarify that certain electronic trading systems for excluding swap agreements are not covered by the CEA, and provide a comprehensive regulatory framework for OTC derivative clearing systems. ABASA strongly supports the Working Group's general recommendation that legal certainty for swaps should be increased.

    For several years now, ABASA, along with other affected market participants, has consistently advised financial regulators to refrain from taking any action that would jeopardize legal certainty for OTC derivatives. Legal certainty for swap transactions will, we believe, solidify market confidence and stem the migration of transactions to offshore jurisdictions.

    ABASA's members are still studying the other recommendations of the Working Group, many of which appear to be incorporated into the legislation introduced last week. For this reason, we respectfully request the opportunity to discuss this important bill with the committee and its staff more fully at a later date. For now, we note that the bill only addresses recommendations most suited to implementation under the banking laws and does not address those that require modifications to the CEA or the Federal securities laws, including the key issue of whether swap transactions are to be excluded from the CEA.

    We recognize, however, that the Chairman has pledged to work with Chairmen Combest and Bliley in drafting wider, more comprehensive OTC derivatives legislation.

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    In conclusion, Mr. Chairman, we strongly support enactment of legislation permitting netting among financial contracts. We urge the committee to revise H.R. 2924 as suggested, and we heartily endorse the concept of enhanced legal certainty for derivatives and plan to work closely with the Chairman and the committee toward passage of meaningful legislation to that effect. I also wish to commend Chairman Rainer's most recent regulatory relief proposal which the ABA and ABASA have provided a letter in support of, and which is a clear step in the right direction.

    Thank you.

    Chairman LEACH. Thank you very much, sir.

    Mr. Miller.


    Mr. MILLER. Thank you, and good afternoon.

    Mr. Chairman and Members of the committee, my name is Bill Miller. I am here today to provide testimony on behalf of the End-Users and Derivatives Council of the Association for Financial Professionals which represents over 12,000 members and over 5,000 corporations. We are significant participants in the Nation's payment systems, credit and capital markets. Our 1999 survey of OTC Derivatives Use and Risk Management Practices is included in our testimony.
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    As end-users, important criteria and factors that we look for with derivatives are the widest possible array of choices of products and delivery alternatives: liquidity, transparency and ability to customize; protections in the form of anti-manipulation, anti-fraud and counterparty performance assurances; a seamless, cost-effective, global environment; and a legal regulatory tax framework across multiple jurisdictions. We prefer the U.S. environment.

    Against this backdrop, as described in our written testimony, we support the Hedge Fund Disclosure Act, H.R. 2924, which seeks to promote disclosure. We think it is a step in the right direction, and it is a good first step. However, we believe that further clarification of significant leveraged institutions and direct material exposures appears in order as it relates to public funds before we can opine further on that. As you can appreciate, how this is interpreted can have far-ranging impacts and costs beyond the intent of this bill.

    We share the view embodied in the President's Working Group report to modernize the legal and regulatory structure of the derivatives market, including the Commodity Exchange Act, with the objective of one, to give greater legal certainty to privately negotiated bilateral swap transactions; two, encourage innovation and growth of appropriately regulated electronic trading systems and clearing facilities; three, to not impose on fair competitive disadvantages on regulated exchanges. Futures play a critical role in the growth and use of risk management instruments for us. Four, encourage the establishment of an alternative to the OTC market to less sophisticated end-users; and five, reconsider the restrictions on futures on securities contained in the Shad-Johnson Accord.

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    On a separate matter, our derivative markets and activities of major firms continue to evolve and grow in complexity, making the oversight role of regulators more difficult. We recently performed a survey of our members. I will read just a part of it.

    We asked our respondents whether they use now or plan to use the internet to negotiate loans, OTC derivatives or foreign exchange. Currently, only a small percentage of respondents use the internet for foreign exchange services, 9 percent; loans, 3 percent; and OTC derivatives, 2 percent. The use of the internet is expected to quadruple within the next few years. Negotiating loans on the internet may increase from 3 percent to 36 percent, OTC derivatives from 2 percent to 28 percent, and foreign exchange services from 7 percent to 45 percent. This survey reinforces this change in this environment.

    Our testimony urges Congress to consider charging an interagency committee with aggregating and disbursing derivative-related information in conjunction with the underlying financial positions across each regulator in a systematic and timely manner that each regulator and regulators in total have a more complete picture of the overall market.

    Thank you.

    Chairman LEACH. Well, thank you very much, Mr. Miller.

    Mr. Crapple.

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    Mr. CRAPPLE. Mr. Chairman, thank you for the opportunity to testify today. I appear here as the Chairman of the Managed Funds Association, a trade association representing more than 700 participants in the hedge fund and managed fund industry. I am also the Co-Chairman and Co-Chief Executive Officer of Millburn Ridgefield Corporation, a money manager and sponsor of hedge funds and other funds since 1971. My testimony is addressed to H.R. 2924, the Hedge Fund Disclosure Act.

    In the year-and-a-half since the LTCM events of September 1998, this committee and other committees of Congress, regulators, the lending community and the public have been fully briefed on the deficiencies in credit risk management which virtually all informed observers have concluded were the cause of the LTCM crisis. Based upon this record, we believe that H.R. 2924 does not represent a way forward toward preventing future LTCMs but, rather, is a costly form of bureaucratic windowdressing, likely to obscure rather than illuminate important risk management issues raised by LTCM.

    The rationale for this proposed legislation seems to be simply that tossing isolated and inherently out-of-date financial data concerning large hedge funds into the public domain will somehow reduce systemic risk. Not even the proponents of this proposal have been able to explain how it would reduce systemic risk or any other risk, and clearly advocates of the legislation concede it is not calculated to correct or improve the lending practices at the root of LTCM's problems.

    Mr. Chairman, our organization represents major users of the derivatives and securities markets. As such, we would be the first to rise in support of measures meaningfully designed to reduce risks in the financial markets.
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    For example, we support H.R. 4230 and legal certainty for swaps. We would support measures which could reasonably be expected to prevent future LTCM blowups. However, based on our review of the LTCM situation, we do not believe that a case for the creation of an elaborate new public reporting structure envisioned by H.R. 2924 has been made. In fact, the legislative proposal appears to rest largely on wishful thinking and its likely product will be, at best, an illusion of protection, one from which neither regulators nor the public should draw comfort.

    We appreciate that legislators and regulators are eager to respond to financial crises and to mend apparent rents in the regulatory fabric. However, as we all know, the zealous pursuit of cures may at times result in an impulse for some form of Government response, without careful assessment of the likely benefits and costs of that action. This type of well-intentioned urge to react to a crisis, without careful scrutiny of likely consequences, is the essence of H.R. 2924.

    What are the lessons of LTCM?

    In the eighteen months since the LTCM events, real advances have been made in understanding the causes of the LTCM problems and in improving the ability of market participants to prevent such problems in the future. The multiple reports issued by the banking supervisors, international organizations, the Counterparty Risk Management Policy Group, which I would point out calls for extensive disclosure by hedge funds to their lenders and to the lenders' regulators, and the recently issued report of certain large hedge funds on sound practices for hedge fund managers, exemplify these valuable efforts.
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    Based upon the analyses that have been made of the causes and possible cures for LTCM-type problems, we believe that the following conclusions are clear.

    First, LTCM is an extreme illustration of the weaknesses inherent in credit practices at that time. It is not typical of hedge funds, nor are hedge funds the largest or most leveraged institutions or those that may be most affected by credit risk lapses. Nonetheless, the lessons LTCM has to teach about credit risk management are extremely important.

    Second, no substitute exists for rigorous risk management by lenders and counterparties. As has been noted by members of the President's Working Group and others, the primary responsibility for addressing the weaknesses in risk management practices that were evident in the LTCM episode rests with private financial institutions. In the case of LTCM, a relatively small number of U.S. and foreign banks and broker-dealers were critical to the establishment of LTCM's leveraged trading positions. Consequently, regulators and supervisors have a responsibility to help to ensure that banks and securities firms employ systems to manage risks that are commensurate with the size and complexity of their portfolios and responsible to changes in financial conditions. We submit that this is the crux of the LTCM problem and the only place to look for solutions: responsible behavior by lenders and counterparties and their regulators.

    Third, the need for timely information concerning rapidly changing risk profiles means that lenders and other counterparties cannot expect to rely on public disclosure mechanisms to meet their requirements. Thus, for example, the exhaustive reviews of lending practices by bank regulators and private sector groups have agreed that lenders must obtain comprehensive data concerning the risk profiles of leveraged institutions, perform careful and frequent stress testing of credit and market risk profiles, and develop meaningful measures by which they can continuously monitor potential future exposures. It is therefore clear that the snapshot quarterly disclosure which H.R. 2924 would require would not in any way suffice to address the credit risk management deficiencies associated with LTCM, and it would be very misleading to suggest that the disclosures called for by the bill would in any way suffice for proper risk assessment by other members of the public. The information it calls for is simply too little and too late to do the job of sound credit management, and it is not directed toward the financial institutions whose day-to-day scrutiny of leveraged borrowers is the system's only defense against future LTCMs.
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    Fourth, if the reporting requirements of H.R. 2924 had been in effect in 1998, no coherent picture leading to a conclusion of systemic risk would have been uncovered. Numerous, much larger and equally highly leveraged institutions would not have reported under the proposal, because they are not hedge funds. Nor would non-U.S. hedge funds have reported. H.R. 2924 would illuminate a few pixels and leave the rest of the TV screen blank.

    The rationale for the proposed new requirement for public disclosure by hedge funds cannot conceivably be to increase the data available to lenders and counterparties, who need far more and far more timely data than that called for, but rather to provide some level of increased information to investors or the public at large. With respect to investors, we do not believe that any of the regulatory studies or analyses of LTCM have suggested any need to reexamine the established rules governing private securities offerings to sophisticated investors. No suggestion has been proffered that the Congress or the SEC change the current local structure for private securities offerings.

    As you know, under the current structure, privately offered investment funds such as hedge funds are offered to sophisticated investors whose ability to make informed investment decisions and to impose their own demands for information generally obviate federally-imposed disclosure requirements. But what the proponents of H.R. 2924 seem to have in mind is a form of vaporous diffusion of information to the public at large, apparently in the belief that dispersion of some type of risk data, no matter how stale or incomplete or unexplained, will somehow create a more informed market environment.

    The Department of the Treasury, for example, in supporting H.R. 2924, has spoken of enhancing market discipline by creating an environment of greater transparency and disclosure.
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    The case for H.R. 2924 thus depends upon a leap of faith, not a plan or even reasoned expectation of what benefits may reasonably be anticipated if this elaborate new disclosure framework were implemented. In making its recommendations for actions in response to LTCM, the President's Working Group on Financial Markets stated that, ''Government regulation should have a clear purpose and should be carefully evaluated in order to avoid unintended outcomes.'' This is a reasonable, indeed an essential standard if our financial markets are to remain sound and competitive.

    H.R. 2924 falls far short of satisfying this standard. In the course of the hearings before this committee, key proponents of the legislation have, in fact, raised questions which call into question the very essence of the bill. Representative Baker, for example, has stated as to the public reporting requirement initially proposed in the President's Working Group report and which would be codified in H.R. 2924, ''As to the reporting requirement, it would seem to me that anything that is timely released verges on proprietary. Anything that is not timely released and is retrospective in its view is of little value to a person trying to judge current day risk positions.''

    H.R. 2924 calls for disclosure of a snapshot financial data after the close of the quarter it relates to and of some unspecified measure of risk. In addition to lack of timeliness, the information that would be publicly disclosed under H.R. 2924's requirements is inherently too limited to provide a workable basis for evaluating a hedge fund's riskiness. As a representative of the Federal Reserve Board testified before this committee: ''The fact of the matter is, there is no simple, reliable methodology boiling down into a single number what the riskiness of a portfolio is.'' And he noted that this is particularly true with respect to the kind of complex portfolios that not only hedge funds, but many other financial institutions, have today. Given the liquidity of those markets, hedge funds and other highly-leveraged institutions can alter their risk profiles significantly within days or even hours. These facts cast great doubt on the usefulness of H.R. 2924's disclosures to lenders and regulators, much less to the general public.
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    So we must ask, Mr. Chairman, if the information that would be required to be disclosed is of little value, because it is out-of-date and because there is no single snapshot or capsule to capture the risk propensities of a complex hedge fund portfolio, why is there a push to enact legislation calling for the mandatory public disclosure of such data. We can only conclude that good intentions have resulted in a rush to legislate, causing well-intentioned persons to refrain from close scrutiny of costs and benefits in order to provide the comfort of a legislative response, one which will close the book with an emphatic legislative flourish on a highly publicized financial problem.

    But what are the potential adverse consequences of H.R. 2924? We must remind this committee that there is a price to be paid for creating the type of reporting regime envisioned by H.R. 2924. This is not a case in which a proposed new requirement can be accepted as benign, albeit ineffective. Required public dissemination of information that is purportedly material to risk when it is, in fact, likely to be both stale and incomplete, is far more likely to be inimical than beneficial to public understanding of the risks of hedge funds.

    Astute commentators, including regulators, have noted that a false impression that the regulatory agency operating the reporting system is actually overseeing the activities of hedge funds can be dangerous, because it reduces private market discipline without any actual Government oversight to make up for that loss. I think we saw a little of that in the testimony of Mr. Parkinson from the Fed earlier today. They didn't want to be the ones that were the repository of this information and giving the impression that they were actually doing something with it.

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    Of course, if lenders or counterparties were to rely upon such plainly inadequate information, the results are likely to be devastating and would increase, not decrease, the chances of another LTCM.

    Creating a new governmental reporting burden also has negative consequences for those who are subject to or face the prospect of being subject to those duties. Disclosure to the public of financial information about private investment vehicles is likely to raise serious concerns about the ability to preserve the confidentiality of trading strategies, positions and other proprietary data.

    As drafted, H.R. 2924's public reporting provisions are likely to create extraordinary practical disadvantages for hedge funds within its reach. H.R. 2924 calls for disclosure of financial information such as financial statements prepared in accordance with Generally Accepted Accounting Principles. GAAP requires disclosure of all material portfolio positions, with positions in which 5 percent or more of portfolio assets are invested commonly viewed as material, disclosure of proprietary trading information is, therefore, implied. Moreover, investment banks, banks and insurance companies which are larger and maybe equally highly leveraged are under no such requirement. In addition, the requirement to produce such financial data and other disclosure within fifteen days after the end of each calendar quarter is, to the best of our knowledge, virtually unprecedented and would be very difficult, if not impossible, to satisfy.

    As has often been noted, hedge funds are highly portable businesses and the offshore market is in a high growth phase. Government reporting requirements can present a significant disincentive to conducting business in the U.S. In fact, H.R. 2924 would impose its reporting requirements on foreign funds doing business with U.S. entities such as borrowing from U.S. banks, so the bill could cause U.S. firms to lose business from foreign funds.
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    Chairman LEACH. If I could interrupt for a second, Mr. Crapple. First, let me just ask unanimous consent that all statements be placed in the record, and without objection, so ordered. Second, let me just express concern. We have a major bill on the floor from our committee in about an hour, and so we are going to have to try to bring this to some completion. You have gone about double the length of everyone else so far.

    Mr. CRAPPLE. I beg your pardon. I conclude, I am done.

    Chairman LEACH. Well, if you want to conclude.

    Mr. CRAPPLE. No, really I was at the end, I was going to wind up.

    Chairman LEACH. I apologize. I didn't realize that. Do you have another paragraph you want to get through? I especially didn't mean to cut you off, because you are expressing some dissent with committee views and the committee welcomes dissent. I want you to know that dissent is a welcome commodity, not a preferred one.

    Mr. CRAPPLE. I will just say that we welcome the opportunity to work further with the committee as we very much wish to have our views on the record on this matter and related matters.

    Chairman LEACH. This is an educable group.

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    Mr. Glass, please proceed.


    Mr. GLASS. Mr. Chairman, thank you.

    My name is Garrett Glass, and I am the Chief Market Risk Officer with Bank One Corporation in Chicago. I am pleased to have the opportunity today to speak on behalf of the Financial Services Roundtable, a national association open to the Nation's major diversified financial services firms. Many Roundtable members are market makers or end-users in the derivatives market. My background at Bank One includes participation as a trader and manager in the derivatives market when it was developing in the early 1980's. As the Chief Market Risk Officer for Bank One, I am responsible for independent oversight of trading and proprietary investment activities of the corporation.

    First, let me express the Roundtable's support for H.R. 1161, the Financial Contract Netting Improvement Act of 1999, introduced by Chairman Leach, Ranking Member LaFalce, and Financial Services Subcommittee Chairwoman Roukema.

    The purpose of this Act is to strengthen the provisions of the Federal Deposit Insurance Act and bankruptcy laws that protect the enforceability of contractual rights to terminate and close out certain capital markets transactions, net the amounts payable by each party and foreclose on any collateral.
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    Let me explain why this bill is so important. There are a number of beneficial effects when the bankruptcy law governing a defaulting party allows the enforcement of closeout and netting provisions of a master agreement and doesn't make them subject to any stays, or doesn't allow the conservator or reliever to ''cherry pick.'' Cherry picking enforces transactions that are favorable to the defaulting financial institution, but repudiates transactions that are favorable to the non-defaulting party.

    In regards to H.R. 4203, the Roundtable wishes to commend Chairman Leach, Representative LaFalce and Capital Markets Subcommittee Chairman Baker and Representative Kanjorski for introducing H.R. 4203. This legislation is an important step in reducing systemic risk and does much to resolve a number of issues of concern to the OTC derivatives market.

    The Roundtable generally supports the recommendations included in the report by the President's Working Group on Financial Markets entitled ''Over-the-Counter Derivatives Markets and the Commodity Exchange Act'' and urges Congress to pass legislation during this session. The OTC derivatives market has for too long a period of time been subject to uncertainty over the role of the Commodity Futures Trading Commission in regulating OTC derivatives.

    Arguably, the current approach of the Commodity Exchange Act to allow the CFTC to exempt certain OTC derivatives could be improved, in particular by a legislative approach. We believe it is important that Congress move quickly to enact these proposals, since today's markets are evolving at an increasingly rapid pace. At the same time, we believe a competitive and innovative futures industry is important for the continued growth of the derivatives market. In this regard, the efforts of CFTC Chairman Rainer to reform the regulatory focus of the CFTC into more of an oversight approach is to be commended.
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    The Roundtable agrees with the Working Group that bilateral swap agreements involving financial commodities between institutional counterparties be excluded from regulation under the CEA. This exclusion will enhance legal certainty and enhance the position of the United States as a major financial center.

    The President's Working Group report cites the price discovery function as an element that distinguishes a futures exchange from an OTC electronic trading system. In our view, the price discovery function of a futures exchange is important inasmuch as it helps prevent market manipulation. An OTC derivative trading system may serve a price discovery function for the professional market, but this characteristic should not entail CEA inclusion or CFTC supervision. The swap market, for example, may conceivably serve as a bench-mark pricing mechanism for the United States debt markets, given the current plans of the Treasury Department to retire Federal Government debt. It would be unfortunate if legal or regulatory uncertainty prevented the markets from exploring this possibility.

    We support the efforts of this committee to clarify the regulatory environment governing derivatives and related trading and clearing entities, and we believe that by working together these recommendations can be implemented.

    Now let me turn to the hedge fund legislation. The Roundtable suggests several clarifying and technical changes that we believe will conform with the stated intent of this legislation. For example, we suggest that the definition section be adjusted to reflect that hedge funds or private equity funds affiliated with institutions already subject to supervision or examination of a Federal banking agency be exempt from the additional reporting requirements of the bill.
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    Mr. Chairman and Members of the committee, on behalf of the Financial Services Roundtable, I appreciate the opportunity to appear before you today and to have the opportunity to express our support for speedy action on the recommendations of the President's Working Group. I and the Roundtable stand ready to assist you in your endeavors.

    Chairman LEACH. Well, thank you very much, each of you. You presented very reasonable perspectives, although some of them critical, Mr. Crapple. Each of you also represents users of derivatives, and Mr. Watkins and Mr. Glass additionally represent derivatives dealers. Since you have extensive business in the derivatives area, can any of you cite for the record examples of problems created by the legal uncertainty for OTC derivatives? In this regard, can you describe the types of circumstances where bilateral clearing of OTC derivatives could help you do business? And finally, as users, do you believe that you will see or you will yourself take business offshore if the legal uncertainties are not clarified? Does anyone want to respond to that?

    Mr. Glass.

    Mr. GLASS. Mr. Chairman, about six or so years ago, our bank joined with several other commercial banks in the United States and Canada to form a multilateral clearing organization devoted to foreign exchange netting. It was known as Multinet International Bank. It was registered as a trust company under the Federal Reserve regulations, and it had significant difficulties attracting business from the market to the point where we eventually sold this bank to a company in London, that is CLS Services, which is still operating. We basically had to join forces with them, in part because some of the constituents in the market we thought would join us were saying specifically there was too much uncertainty in the environment over whether there would be another regulatory regime applied, and even uncertainty about the legality of the netting.
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    So I have had personal experience with it. That is not the only reason this decision was made to move the operation ultimately to London, but it is certainly an example I have lived through.

    Chairman LEACH. Mr. Crapple.

    Mr. CRAPPLE. There have been a number of lawsuits between customers and dealers where the customers have attempted to avoid liability on contracts by claiming that they were illegal futures contracts, so this is not any sort of a moot issue; it is an issue that does come up fairly often.

    Chairman LEACH. Mr. Miller.

    Mr. MILLER. We have. None of our end-users have any of their OTC contracts entailing legal uncertainty. I was just thinking of George's comment about the claim in any defense, whenever you wish to contest a transaction, you can fall back on any of those, and as I understand it, the legal uncertainty was—none of the courts ruled that the claim of legal uncertainty, that the CFTC would have jurisdiction, actually helped. Is that correct?

    Mr. CRAPPLE. That is correct.

    Mr. MILLER. So that would tend to I guess answer the question from our perspective. Our end-users believe that each of our OTC transactions are legally certain. We have no examples to answer your question.
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    Chairman LEACH. Well, that is fair enough.

    Mr. Watkins.

    Mr. WATKINS. Mr. Chairman, legal uncertainty does cast a significant cloud over our business, and we spend quite a bit of time at First Union, particularly in our capacity as a dealer, trying to both educate our customers and confirm for ourselves to the best we possibly can the legal sufficiency of the contracts that we enter into with our customers.

    Our view is that this is less of an issue concerning our institutional customers, because we feel that we and our institutional customers are all in the same boat together anyway. With respect to the major investment banks and corporate banks we deal with, we have already subjected them to significant levels of counterparty credit review. We know from a financial perspective where each counterparty stands day-to-day. So legal certainty is less of an issue in those circumstances. But I would have to say that legal certainty is something that consumes a great deal of our time. It does place a cloud over OTC products.

    Also, looking forward into the future, if this is an issue which cannot be resolved, I would expect, in my personal opinion, to find more of these contracts migrating offshore. I think on the earlier panel, some of the views that Mr. Dorsch mentioned are views that I also personally support and I believe that others at First Union would also.

    Chairman LEACH. Thank you very much.

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    Mr. Baker.

    Mr. BAKER. Thank you, Mr. Chairman.

    Mr. Crapple, I understand that the CFTC has now proposed a regulatory requirement on commodity pool operators that would implement a quarterly reporting mechanism that is now annual in scope that would put their reporting requirements similar in conformance to the irresponsible legislation I proposed. Are you supportive of that, or not?

    Mr. CRAPPLE. No, I am not supportive of that either. I think that—my understanding is the same as yours, that it would be very similar to your bill. It is a bigger change than just going from annually to quarterly, because the CFTC has not heretofore publicly disseminated that information, so it would also add the public disclosure of that information. That would apply only to commodity pool operators who, it turns out that some of the more highly-leveraged hedge funds were commodity pool operators, because of their use of derivatives.

    Mr. BAKER. Do you know how many firms with certainty the legislation would impact?

    Mr. CRAPPLE. I don't know the answer to that. I have heard numbers like 20, but I am not sure that there are that many.

    Mr. BAKER. And what is the nature of the organization you represent today? Is it a hedge fund operation?
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    Mr. CRAPPLE. We are the Managed Funds Association and we have approximately 700 members who are individuals who are affiliated with most of the major futures trading funds and many of the larger hedge funds.

    Mr. BAKER. So that I understand your constituency properly, if we assume that the bill would apply to perhaps 20, let's say on the outside 25 hedge fund operations in the country, I am told 15 to 17 of those would be commodity pool operators already subject to the other disclosure requirements; it would mean net six, eight folks who don't disclose now might have to disclose after the legislation would be passed. I assume all of those would be members of your organization and hedge fund management individuals?

    Mr. CRAPPLE. Not necessarily, but a number of them would be.

    Mr. BAKER. Generally speaking.

    Mr. Miller, your testimony seems to contradict, to some extent, that of Mr. Crapple's with regard to the advisability of H.R. 2924. Tell me what an end user is as compared to Mr. Crapple's constituency, so I am understanding who within the market is saying this looks like it might be advisable and who is saying it might not be.

    Mr. MILLER. Our members are principally corporate members of financial institutions.

    Mr. BAKER. You would basically use the services of a hedge fund product to hedge risk for your corporate members?
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    Mr. MILLER. Actually, our corporate members through their pension funds may invest if they felt it appropriate, and I am not sure of the extent of our hedge fund investing.

    Mr. BAKER. I am just trying to get my arms around this. Are you the consumer of Mr. Crapple's organization's product?

    Mr. MILLER. Yes. To a limited extent.

    Mr. BAKER. So from a very simple congressional perspective, which I am all too often accused of having, it would seem that on the one hand we have the provider of the product saying our regulatory disclosure is perfectly adequate and the consumer of the product saying we really don't know enough in all cases to make appropriate judgments. Is that an unfair characterization?

    Mr. MILLER. No.

    Mr. BAKER. Thank you.

    I just want for the record, Mr. Chairman, to outline that the President's Working Group recommendations were disclosed to the Congress in 1998. We had a hearing in September of 1999 in which we did hear from the various parties who had differing opinions about the proposal, and the markup did not occur until March 16 of this year. As was noted in an earlier panel, this is hardly a congressional rush to judgment, and I want to make it clear, at least from my perspective, Mr. Chairman, if there are informed opinions that could suggest modifications, as in the example of Mr. Watkins who wanted to make it clear that 401(k)s would not be subject to disclosure, we certainly would want to make sure that we do not do anything to further make markets uncertain. That would not be our intent.
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    I do take some comfort in the fact of the Financial Stability Forum and the President's Working Group both have endorsed the approach and the Financial Stability Forum has gone somewhat further in saying, if this approach is not adopted, direct regulation may be next.

    Now, I will get on the same table with you, Mr. Crapple. That is not where I would like to see this go at all. But respected financial regulators from around the globe are now saying that enhanced transparency in hedge fund operations is a fully warranted action for the Congress to take.

    Thank you, Mr. Chairman.

    Chairman LEACH. Would you yield on this last point?

    Mr. BAKER. Yes, sir.

    Chairman LEACH. I read recently that Howard Davies, whose regulatory function in Britain is far more comprehensive than any of our regulators, because he is the regulator of insurance, securities and banking, has not only indicated support for your approach, but very definitively warned that much firmer action may be undertaken if approaches on the transparency side aren't taken. Isn't that valid?

    Mr. BAKER. I am going through my vast system of filing here. You are correct, Mr. Chairman. On April 7 of 2000 I am in receipt of a letter from Mr. Davies which indicates that should the Congress not adopt the provisions of H.R. 2924, the Financial Services Authority agreed that more interventionist measures such as direct regulation of hedge funds might have to be reconsidered if the report's initial recommendations to enhance market discipline were not adequately implemented. This authority is one on which the regulators from the G-10 nations, as well as many other interests are represented, and apparently to my surprise received a great deal more interest and enthusiastic support from the international market as opposed to domestic regulators here.
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    Chairman LEACH. Thank you.

    Mr. BAKER. Thank you, Mr. Chairman.

    Chairman LEACH. Mr. Toomey. Oh, excuse me.

    Mr. Watt.

    Mr. WATT. Thank you, Mr. Chairman. I just wanted to welcome my good friend and neighbor from Charlotte, Mr. Watkins, and commend him for his testimony.

    Mr. Crapple, it came through loud and clear that you don't like this bill very much, H.R. 2924, and I think I understand which side of this you are on, but let me be absolutely clear. I assume that what you are saying is, we should not be doing anything rather than saying that this bill doesn't do enough.

    Mr. CRAPPLE. With respect to hedge fund disclosure, I am saying it would be better to do nothing. With respect to the bulk of the recommendations by the President's Working Group, we think it is highly desirable that there be much greater transparency between highly leveraged hedge funds and their lenders, and the lenders' regulators, and these are points that were made extremely strongly in the Counterparty Risk Management Policy Group, which produced a telephone book-sized group of regulations on how the lenders basically had slipped up and what they should be doing better to prevent Long-Term Capital situations.

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    Our only point is that disclosure of hedge fund positions to the public isn't going to head off Long-Term Capital; it has to be done down in the trenches with the lenders and the regulators and the hedge funds themselves, and that is where the transparency should really be.

    Mr. WATT. Well, you have surprised me then. I thought you were saying we should not be doing anything.

    Let me be clear on what it is you think we should be doing. I am reading what you are saying now to be that Mr. Baker's bill doesn't go far enough; that it really, if we want to get the transparency, we have to do more regulation at lower levels, and am I mistaken in what you are saying? Maybe I shouldn't put words in your mouth. Tell us what you would do in response to the Working Group's recommendations?

    Mr. CRAPPLE. You are not mistaken in what I was trying to say, but it doesn't require any legislation. What really is required, and I think what has prevented a Long-Term Capital situation, would have been, for example, greater scrutiny by the banking regulators of the credit procedures that were being followed by the banks in extending credit to institutions like Long-Term Capital.

    So I think it is really something of a slip-up both by the private sector and by the regulators that allowed this to happen. It doesn't necessarily take a new law to remedy that situation. I mean the Fed and the Comptroller of the Currency have put out a number of pronouncements—and the SEC—to the broker-dealer community about tightening up all of these gaps and the looseness that gave rise to this unusual case of Long-Term Capital.
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    Mr. WATT. So we should be doing nothing, but the regulators should be doing more or have done more already, is what you are saying?

    Mr. CRAPPLE. From the point of view of a new law on this particular point, yes, that is our position. A new law is not necessary, because it doesn't—this particular law does not go to the essence of what caused the problem.

    Mr. WATT. Thank you.

    I yield back, Mr. Chairman.

    Chairman LEACH. Thank you.

    Mr. Toomey.

    Mr. TOOMEY. Thank you, Mr. Chairman.

    I would like to go back very briefly to a topic that Mr. Baker brought up in a question. As for the relationship between the hedge fund industry and the End-Users of the Derivatives Council of the Association of Financial Professionals, I wouldn't have guessed that that relationship is one of producer to consumer so much as two different groups that consume the same product, and I would guess that the hedge fund's counterparties to derivative transactions are primarily other hedge funds and very large financial institutions. Would that be more accurate than to suggest that this is a producer-consumer relationship, if both of you could comment on that?
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    Mr. MILLER. I would agree that it is a softer relationship between producer and consumer, because if you look at our membership and then, just as George broke his down, and said 400 members, maybe 15 or 20 might be affected by this, we have 12,000, most are corporates. A small fraction of those are going to have investable funds. They are going to place assets in hedge funds and have direct relationships.

    Mr. TOOMEY. A very small percentage?

    Mr. MILLER. I would say less than 10 percent, yes.

    Mr. CRAPPLE. I agree with that. I didn't want to speak out on that topic, but I don't think that as a matter of their group being customers of hedge funds, it is a very, very minor part of the customer base of hedge funds. If anything, we probably do share the great desire to avoid systemic risk in the financial markets and to have good, functioning, efficient markets.

    Mr. MILLER. Where the significant linkage will occur, I believe, is that many of our members have significant relationships with the banking and financial community, and they have significant relationships with the hedge funds, and that is where you will see that linkage.

    Mr. TOOMEY. Thank you.

    Now, Mr. Crapple, I think in your testimony, as well as that of the regulators that we had on an earlier panel, and for that matter a banker earlier, all I think testified and would agree that currently lenders, those extending credit to hedge funds, already require far more rigorous, far more regular, far more frequent analysis of risk as a standard systematic part of their credit analysis than this bill would contemplate with its quarterly release of information. But nevertheless, the bill has been described by some as a supplement to that information, and it is not clear to me that it supplements information to sort of be providing it, and alternatively it has been described as sort of a stopgap in the event that the lending institutions should become remiss in the rigorousness of their credit analysis, at least this would be there as a stopgap.
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    Could you comment on whether you see it playing that role?

    Mr. CRAPPLE. I think virtually all of the testimony that spoke to that point today was unanimous in that the information that will be supplied pursuant to this bill would really have very little usefulness, and probably no usefulness and should have no usefulness to people extending credit to highly-leveraged organizations. It appeared to be considered inconceivable by the various bankers that spoke that they would ever be falling back to a position where this would be the only information that they could make very large lending decisions on. So basically, I don't think much of a case has been made at all that you will advantage the creditor-debtor part of the Long-Term Capital problem through this legislation, and what you are really left is whether some benefit to the system will occur by publishing this information publicly, and that is where we sort of fall off the bandwagon here. We don't see what that benefit is of publication of this information.

    Mr. TOOMEY. One of my concerns is that the legislation asks for meaningful and comprehensive analysis, and it seems to me that for that kind of a risk analysis to be meaningful and comprehensive, it must necessarily be proprietary. Do you agree with that?

    Mr. CRAPPLE. I agree that in order to come up with that information—for example, value-at-risk is often mentioned as a single number that might be used to show the riskiness of any portfolio; and to compute value-at-risk, every position in a portfolio has to be analyzed and the volatility of every component in the portfolio has to be studied. So this could be done by a third party and not involve disclosing confidential information.
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    But if all you end up with is a single number of a loss, there is a 5 percent risk of taking on a one-day basis, this isn't going to tell you how big the hedge fund is. So you can have a risk number, but until you get down to things such as what positions are actually there, what is their liquidity, how long would it take to get rid of them in a crisis, it is this kind of thing that is inherently proprietary and, as someone testified earlier, it is the kind of thing that banks have to look at in making their credit decisions, but would not be appropriate for public disclosure without giving away all of the proprietary information.

    Mr. TOOMEY. One of my concerns is regarding this shift to overseas venues for hedge fund activity. It strikes me that the calculation itself, the disclosure itself is not necessarily terribly onerous, but the revelation of proprietary information could be seen that way. Do you see that leading to a loss of market share of American firms or American firms dealing with hedge funds?

    Mr. CRAPPLE. It is an interesting question. Because the U.S. has a handle on a foreign hedge fund that has U.S. investors, and some do. But to the extent that the regulatory environment is more onerous, there certainly is some push toward getting rid of U.S. investors, and certain managers have done that, and having only non-U.S. investors. I think this is an undesirable thing. I alluded in my testimony to the fact that the bill would draw into its orbit foreign funds who did business with U.S. banks. I think that would have a chilling effect on, say, foreign hedge funds doing business with U.S. businesses.

    Now, nonetheless, if I believed that the bill would solve a problem like Long-Term Capital, which we believe is a serious problem, we would be for it. We just don't see that it would solve the problem, and it would create a burden.
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    Mr. MILLER. We see the raw data being useful to the regulators in getting a complete picture. But we would be hesitant—actually, we would be opposed to having that raw data go out to the public. I think there has to be some care and sensitivity in terms of how it is disclosed, which I think our regulators have demonstrated in the past.

    Mr. TOOMEY. Thank you.

    Thank you, Mr. Chairman.

    Chairman LEACH. Let me just throw out a possibility here and comment on some earlier testimony.

    Mark Brickell, who is still with us, laid out that his bank is very careful as they look at their lending to hedge funds. We all know in the LTCM issue it didn't look as if a number of banks were as careful as Mark's description of what the current policy of his bank is. In fact, it looked as if in the LTCM issue that LTCM winked at the banks and said, ''You really don't want to know. It is so proprietary to us, you will be disadvantaged if this is known.'' And the banks accepted their brilliance as reasoning for choosing not to know what, in retrospect, appears to be a number of things that financial institutions should have taken into consideration. It looked as if all of the major banks that lent to Long-Term Capital didn't know how much lending other banks had made to Long-Term Capital, among other things.

    Coming back to disclosure as well as appropriate approaches, clearly, there are pluses and minuses to Mr. Baker's bill which I have co-sponsored. And just trying to think through alternatives, if one were to have a bill that would mandate that the regulators insist that the banks and the credit extenders that they regulate have a grasp of their lending to hedge funds and that this be reviewed as part of a bank examination and that information that was garnered might be made available to the regulator and to the degree there is disclosure, it could be aggregate statistics to a regulator of all industry activity or guesstimates of such. That would be one type of approach to be considered. But does that seem to have more disadvantages or more advantages as a broad approach?
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    Mr. BAKER. May I add on?

    Chairman LEACH. Of course.

    Mr. BAKER. There is an article which appeared in Barron's in February of this year which is almost exactly the point you are making about enhanced informational management and regulation or transparency of hedge funds. The description is benign transparency. That is, investors can see second-to-second changes in the value of the portfolio, but actual trading positions aren't disclosed. It is a firm which has started what they call a free market solution to the transparency problem using the internet to provide investors with real-time, tick-by-tick valuations of hedge fund assets and an analysis of the risk embedded in the portfolio.

    So if you engage in some activity which deteriorates asset value, that is reflected in an up-to-the-moment tracking. This apparently has 43 funds of assets of $20 billion already subscribed and appears to be the direction of where technology could take us, but I am not sure that anybody at the table is willing to have that type of transparency or insight into their moment-by-moment trading activities.

    Where are you on the scale of things, Mr. Crapple, on this?

    Mr. CRAPPLE. Actually, I believe we are subscribers to this particular platform that you are referring to.

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    Mr. BAKER. It is all offshore funds. I don't think that you are offshore, open only to foreign investors and tax-exempt U.S. institutions. That is the description that they have given us here.

    Mr. CRAPPLE. I believe we are talking about the same thing. I think it is a wonderful idea. I don't know about minute-by-minute, I think that is impossible, but it is going to be day-by-day fluctuations in net asset value compiled by a third party to give it an objective measure.

    Mr. BAKER. Right.

    Mr. CRAPPLE. I think that on a voluntary basis this may be the wave of the future, and they are going to calculate value and risk on a daily basis.

    Going back to Mr. Leach's point, which I think is an excellent one, I think the bank regulatory authority should be requiring careful scrutiny of the bank's lending to hedge funds. This could easily be compiled in some way.

    Interestingly enough, if you take the 15 largest banks and securities dealers, you will have most of the highly-leveraged counterparties in that picture, and that would be a way to get a more complete picture than a handful of U.S. domiciled large hedge funds. The data would be going to someone who could be reasonably expected to do something intelligent with it, that is the bank examiners, as opposed to going out to the general public.

    Chairman LEACH. This approach also envisions a camera in this room that will be focused on Fort Knox, and it will show the gold at any given moment in time in each of the rooms so we will have a real sense for the stability of the economy, Mr. Crapple.
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    Did you have anything that you wanted to add?

    Mr. TOOMEY. Nothing except to say that I think your suggestion is a very intriguing one. We ought to think about that.

    Mr. GLASS. Having been a credit officer for hedge funds in our bank, the two difficulties we had were first, knowing how much they were dealing outside of our institution. Our regulator was the OCC, so they saw only what the OCC could see with the banks under their regulatory authority, and the Fed didn't see our sort of exposure. So in the industry you would have to be careful about that split.

    The other important question——

    Chairman LEACH. I'm sorry, you mean one would know and one wouldn't?

    Mr. GLASS. The Federal Reserve would not have access to our information from our bank because we were regulated by the OCC. You would have to get those two organizations to share that information.

    Second, it is important to know the situation with your collateral and whether the collateral you have been given is the same collateral everybody else has been given and whether you are going to be in line to dispose of that with a lot of other people. That is one of the questions that you need to ask the hedge funds directly. It is not as easy to find that out.
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    Mr. MILLER. Garrett's comments relate a little to our proposal that we are urging you to consider to pull this altogether. Part of the basis for that was also in reading the GAO report which focused on the same thing Garrett is pointing out.

    Chairman LEACH. Mr. Watkins, would you like to add anything?

    Mr. WATKINS. I just wanted to respond to what Mr. Glass mentioned. I would agree that the exposures are not seen by both Federal regulators, at the Fed and at the OCC. I would agree there is a disfunction there.

    Chairman LEACH. Let me thank you all. We are in an extraordinary new world in which we are all trying to wend our way through with appropriate judgments, and we take your views seriously, and we also say that the contrast with the legislative body vis-a-vis a market participant, that first and foremost concern has to be with systemic issues and protection of the public. These are not at total odds with your concerns, because you have a vested interest in systemic interests and protection of your clients. So we are all, I think, have a little different perspective, but the end concern is rather similar. So we take your views with great respect. We will mull them over.

    Thank you all very much.

    The hearing is adjourned.

    [Whereupon, at 4:22 p.m., the hearing was adjourned.]
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