SPEAKERS CONTENTS INSERTS
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H.R. 4541—THE COMMODITY FUTURES MODERNIZATION ACT
WEDNESDAY, JULY 19, 2000
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:10 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Bereuter, Baker, Bachus, King, Royce, Lucas, Kelly, Riley, Ryan, Biggert, Terry, Toomey, LaFalce, Kanjorski, C. Maloney of New York, Gutierrez, Watt, Ackerman, Bentsen, J. Maloney of Connecticut, Sherman, Meeks, Inslee, Schakowsky, Moore, Gonzalez, and Jones.
Chairman LEACH. The hearing will come to order.
Last year, after nearly two decades of work, Congress passed the Financial Modernization Act to bring our Nation's banking and securities laws in line with the realities of the marketplace. In the few days left for legislation in this Congress, an analogous opportunity presents itself to modernize the Commodity Exchange Act that governs the trading of futures and options.
At issue is the question of whether an appropriate regulatory framework can be established to deal not only with certain problems that confront today's risk management markets, but new dilemmas that appear to be on the horizon. Legislation of this nature involves different committees with different concerns, and sometimes competitive jurisdictional interests.
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From the Banking Committee's perspective, I would like to make clear my desire for constructive change and my respect for the initial Agriculture Committee effort on which this committee's review is premised. That committee's effort, led by Chairmen Combest and Ewing, reflects a credible way of dealing with a number of concerns that I have registered during much of the last decade as derivatives-related products have grown.
Nonetheless, I believe some modification in the Agriculture Committee approach is in order. The fact is that the CEA is an awkward legislative vehicle designed in an era in which financial products of a nature now in place were neither in existence, nor much contemplated. The CFTC was fundamentally designed to supervise agriculture and commodities markets, not banks.
Indeed, it is because of anachronistic constraints established under the Commodities Exchange Act that certain legal uncertainties exist for hundreds of billions of dollars of existing contractual obligations.
The goal of our committee is to ensure that as banks and other financial institutions continue to reinvent the risk management business, that the U.S. regulatory environment protects consumers and enhances the safety and soundness of the financial system without diminishing the competitiveness of the United States markets. To reach this goal, as we modernize the CEA we must provide clear and unmistakable legal certainty for off-exchange derivatives and other related products.
At this point I would recognize Mr. LaFalce.
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Mr. LAFALCE. I thank you very much, Mr. Chairman. By convening this hearing, you recognize that one of the most serious health care problems facing the United States today is sleeplessness, and you have come up with a cure for it, and that is why I was so pleased to join with you in introducing H.R. 4203, the Over-the-Counter Insomnia Reduction Act of 2000, which spoke to many of the topics that are before us today.
Also in April, our Banking Committee held hearings which covered not only the areas of H.R. 4203, but a number of other closely related matters. And today our primary subject is H.R. 4541, the Commodities Futures Modernization Act of 2000.
The bill was sparked by the unanimous conceptual recommendation of the President's Working Group on Financial Markets. When the report was published last year, perhaps its most compelling feature was this single-mindedness, a state which has been difficult to maintain as we have moved to draft legislation designed to incorporate those recommendations. While our committee must review, and if possible, improve on what it has received, my primary goal in considering this bill is not to design the world that I think ought to exist in the future and someday might, but rather, to effectively embody the recommendations of the President's Working Group into legislation. If we could do that in this Congress, we could declare victory and then consider in the future, based upon additional market experience, what additional improvements might be needed.
But before moving to H.R. 4541, I want to note that several of the witnesses are going to call for passage of the netting provisions which are otherwise pending in Title IX of the bankruptcy bill now in conference. Netting is directly related to H.R. 4541. The legal status of the expanded derivatives market is being clarified in both measures. Indeed, I am slightly hesitant to support the provisions of H.R. 4541, which will inevitably enlarge the already huge swaps market by clarifying its legal status until we have addressed what happens if a major swaps dealer financial institution were to go under.
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So I join the witnesses in calling for a very expeditious and, if need be, independent action on the netting provision. At the very least, the netting provision should be moved from the bankruptcy bill into another vehicle which is assured of passage. We don't want to get netting embroiled in a debate on abortion. We need to pass the netting provision. I think we could do it if we just took it up on the suspension calendar.
Currently, all obligations of all financial institutions cannot be netted in a receivership or bankruptcy proceeding with clarity and speed. If there is the failure of one large financial firm—as would have been threatened should Long-Term Capital Management have gone unsaved—then the possibility or probability of instability and contagion throughout the entire system would rise substantially. And without the netting provision, few would know who owes what to whom in the very short period available before mass confusion would set in.
During FIRREA and FDICIA, we made many adjustments to the overall liquidation statutes for financial institutions. But the market has evolved, and the evolution in that short period of time has rendered those provisions, if not obsolete, terribly inadequate. The netting provisions of Title IX are an effective and essential deterrent to guard the economy against such a calamity.
Going to H.R. 4541, the direct topic of the hearing, this is an extremely complex bill. It challenges the expertise of even the legal elite of the financial world, and so I am going to ask the witnesses to speak very slowly so I might comprehend you, at least a little bit better. Different rules are imposed for various instruments related to agriculture, metals, including gold, energy and finance. The entire panoply of regulatory authority for financial intermediaries is going to be affected and the roles of various regulators substantially changed.
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I have no doubt that legislation of this nature is needed since the many markets involved are altering so quickly. By the same token, I am concerned about the law of unintended consequences, and I believe we would be treading on particularly dangerous ground if we choose to open up the incredibly large and complex swaps market to the ordinary consumer, and so I think we should be very, very cautious before we embark on that road.
And Mr. Chairman, I could go on, but I will follow your lead, a little bit belatedly, and ask unanimous consent that the entirety of my statement now be included in the record.
Chairman LEACH. Without objection, of course, and the statements of all Members will be placed in the record as appropriate.
Mrs. Roukema.
Mrs. ROUKEMA. Excuse me, Mr. Chairman, I was going to ask for unanimous consent, and specifically related to the fact that I didn't want to add to Mr. LaFalce's sleep problem, whatever that may be, although I am not quite sure what he had in mind in this last statement, but be that as it may, be that as it may, I do think——
Mr. LAFALCE. Didn't you find it electrifying?
Mrs. ROUKEMA. Exactly. You stole most of the things I was going to say anyway, preempted me, but Mr. Chairman, I am unfortunately going to have to leave for an important markup in the Education and the Workforce Committee. But, I do want to say that, with my complete statement in the record, that I congratulate you for bringing this to our committee.
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As we all know, the Commerce Committee is also dealing with it, and I hope it can be expedited. Whether or not the netting question should be brought up in separate legislation and under suspension or not, I would just hope we could get this provision passed. But I would say that I am concerned about how a clearinghouse system for transacting swaps will be regulated. I think you quite effectively put more emphasis on it in your bill 4203, consistent with what the President's Working Group did. I certainly will be looking at this issue very, very closely to prevent any, you know, conflicts of interest and protect the status of those over-the-counter derivatives.
So with that having been said, I will put my full statement in the record, but I do hope that we can find a way to expedite consideration of this legislation. And I thank you, Mr. Chairman.
Chairman LEACH. Well, thank you, Mrs. Roukema.
Chairman LEACH. Mrs. Maloney.
Mrs. MALONEY. Mr. Chairman, I would just like to thank you for exerting the jurisdiction of the committee in taking a leadership role on this issue, and I will put my opening statement in the record.
Chairman LEACH. Thank you.
Yes, Mr. Baker.
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Mr. BAKER. Thank you, Mr. Chairman. I also appreciate the expedited consideration of this subject. Certainly the reauthorization should be considered on a timely basis and moved as expeditiously as possible. I, however, would like to express some small measure of concern about the manner in which the bill is currently constructed.
As originally constituted, the CFTC's mission in life was to regulate commodity-based transactions, and the futures market developed from those activities and clearly have served a valuable and important role for American agriculture. Today, however, some 97 percent of the futures contracts are financial in nature, and the market continues to develop rapidly. There are products yet to be developed and made available that this committee may not yet be able to even comprehend.
I point, for example, to just last month in response to market need, there was developed a new futures product relating to the ten-year benchmark for Fannie and Freddie. If I am understanding the current rule, it would mean that this futures contract, since it is traded on-exchange, would be regulated by the CFTC.
Now I don't know if the Members of this committee think we have had enough hearings on GSEs or not, or whether we fully understand the scope of their financial complexity, but I would only raise this point for the Members. Subject to the CEA proposal, GSE futures would now be regulated by the CFTC and not Treasury or not a financial regulator.
Further, there is some degree of uncertainty where the eligible contract participants are defined that their individuals of high net worth are institutions. If you don't meet that exemption, it would mean a small business wishing to take advantage of these risk management techniques must be regulated by the CFTC. Again, purely financial interest rate risk management issues.
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Mr. Chairman, I don't have amendments to propose later at this point, but I really fully think the committee should be very careful in moving forward without fully understanding the implications of these developments, not from a jurisdictional standpoint. It is not about whether banking or agriculture should be looking at financial transactions. It is with regards to who is the appropriate regulatory entity to ensure that individuals are properly protected and that markets remain stable. This is complex business. And I am afraid the proposal we have before us, although it moves the ball considerably down the track, does make significant progress, falls a bit short of the mark where we should be.
I thank you, Mr. Chairman.
Chairman LEACH. Thank you very much, Mr. Baker.
Yes, Mr. Sherman.
Mr. SHERMAN. I thank the Chairman for allowing me to make an opening statement.
Chairman LEACH. Of course.
Mr. SHERMAN. This bill addresses at least two issues. First, we ought to be allowing futures on stocks. The issue there seems to be whether the CFTC or the SEC should be the regulatory agency. Needless to say, the Agriculture Committee thinks that the CFTC, I would expect the Commerce Committee would think the SEC, and perhaps, Mr. Chairman, our committee is in the position to approach this completely unbiased between those two, unless there is a way to get those regulators that are under the jurisdiction of this committee involved in the process, as the last Member pointed out.
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What is at least as important to me is that we clarify the law with regard to swaps, to non-exchange-traded derivatives, and make it clear that the contracts that are out there now are legal and beyond question, and then clarify that when you have the truly accredited investors, that those swaps can continue and are not subject to CFTC regulation.
As to swaps in a retail arena where individuals or small businesses might be involved, perhaps we need to provide for some regulation, but it is unclear to me—but it seems to me that often the insurance regulators or the bank regulators that exist now would be fully sufficient, and the CFTC would not need to be involved in regulating swaps, even at the retail level.
I yield to the gentleman.
Mr. BAKER. I didn't want to disturb your opening statement, but I wish to further point out what I think the gentleman is referencing. The bill, as proposed, provides exclusions which may not be governed by the CFTC rather than going progressively and defining what a futures really is, and thereby establishing legal certainty, and I wholeheartedly agree with the gentleman. I don't know if we can get there in three days, but I think it is certainly something we should continue to discuss.
Mr. SHERMAN. I would like to define a future in the way that the vast majority of non-agriculture swaps are excluded from the definition. I thank the gentleman for that and I yield back.
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Chairman LEACH. Thank you. Yes.
Mr. BACHUS. Thank you, Mr. Chairman. I want to commend you for holding these hearings today, and I would like to welcome our distinguished panel of witnesses.
This legislation before us is the broadest reform of the Commodities Exchange Act that Congress has ever undertaken. Much like Glass-Steagall, the CEA is an Act that has been overtaken by the marketplace. Originally designed to deal with contracts involving agricultural commodities, the CEA now is the primary authority for the trillion dollar market in exchange-traded financial contracts. The CEA is badly in need of reform, and many of its customized derivative tools of modern finance do not fit neatly within its parameters.
I would like to commend the members of the President's Working Group and their representatives before us today for their work on CEA reform and the recommendations they have produced last year for the reform of these markets. The Agriculture Committee has now put these recommendations in legislative form, and it is now our job to review their work product.
The bill before us, H.R. 4541, for the first time in the long struggle for a CEA reform, has achieved the delicate balance of garnering support from each of the agencies involved in the President's Working Group, as well as support from virtually the entire financial industry, as well as the organized futures exchanges. Never before has a CEA proposal garnered such broad support, and as we approach this issue at the Banking Committee, I suggest that we need to be careful and not upsetting that balance.
Members of the banking industry are leading players in the derivatives markets. Therefore, it is appropriate that the Banking Committee play a role in this legislation and make certain improvements to it. I only caution that we need to be careful not to let the perfect be the enemy of the good when we consider amendments to the CEA. While we must be cognizant of our jurisdiction over these markets, we must also be pragmatic as we attempt to seize this window of opportunity and pass badly needed legislation to reform the CEA and to do it this year.
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On another note, Mr. Chairman, while the CEA is a fascinating topic, I would recommend to our audience today that an equally fascinating topic, dollarization, will be the subject of a markup after this hearing scheduled for 2:00. I welcome the audience to also attend the subcommittee markup on dollarization and would suggest to Treasury that they take a very close look at the bill the subcommittee reports out, which I believe will lead to greater financial stability in our hemisphere.
Thank you again, Mr. Chairman. I look forward to this morning's testimony.
Chairman LEACH. I am sorry, I passed over Mr. Gutierrez.
Mr. GUTIERREZ. That is all right, Mr. Chairman. I want to thank you, Chairman Leach, for holding this important hearing on legislation that is very critical to our Nation's financial markets.
As my colleagues know, I represent a city that is home to our Nation's preeminent futures and risk management market. The continued prosperity of these markets is extremely important, not only to the city of Chicago, but also to the economy of our entire region and Nation. The success of these markets has been one of the important engines of economic growth for the area I represent, and I strongly support efforts to assure that this growth continues.
I am encouraged, therefore, by the content of H.R. 4541. We should be working on this committee to support legislation that takes every step possible to provide safety and security to American investors while eliminating any unreasonable barriers to continued growth to our markets. I believe this bill is an important step toward reaching that goal. By providing legal certainty to our derivative markets and by reforming the regulatory structure in a sensible manner, I think the bill represents progress toward positive change, both for the markets and for investors, and I look forward to hearing our witnesses today and thank you and our very able Ranking Member, Mr. LaFalce.
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Chairman LEACH. Does anyone—yes, Mr. Toomey.
Mr. TOOMEY. Thank you, Mr. Chairman. Just for a moment, I would just like to emphasize the enormous importance of derivatives in our financial system, in our capital markets. I had the privilege of being involved in this industry for about seven years, and I struggle to find an analogy, and I will spare you my efforts there, but the fact is that the derivative industry has profoundly transformed the capital markets, international finance, the ability of American and foreign institutions to manage risk and has done enormous good and has been an enormous force for positive change in our economy generally.
So this bill that we have, I think, is a major step forward in that it provides certain improvements in the regulatory framework. First of all, the Shad-Johnson prohibition on single security contracts is clearly outdated, and it is a very major step forward to address that as we have done, and there is a great improvement in the whole question of the legal certainty, and that is very productive, and as my colleague, Mr. Bachus, pointed out earlier, these are very important and very good things, and we certainly want to see this advanced.
I do have some reservations, though, that we have kind of been forced into a very awkward construction in the process of coming up with this legislation, and along the way we have not provided as much legal certainty as perhaps we could, and perhaps we can't right now, but I would like to examine the question of whether or not, in particular, transactions that would be geared toward retail investors, transactions that might be very, very helpful and useful for small businesses—when you consider the power of these tools to reduce risk, to manage risk, I would like to see that power in the hands of as many people as possible.
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What this bill, as it is currently constructed does, is it leaves in place legal uncertainty with respect to how some of these transactions may evolve and may be used in a retail capacity, and I would like to just explore whether there is a way to do this so that we would absolutely minimize the inhibition on innovation that that remaining legal uncertainty might cause.
I suggest that I want to see a bill pass and I want to see this—I don't want the perfect to be the enemy of the good, but let us keep in mind if we don't do it now, and if we don't make this bill as good as it possibly can be, it becomes very difficult to go back and change it after we will have already addressed the Shad-Johnson issue. It becomes very difficult to go back and make changes, not necessarily impossible, but those are a couple of the things I hope we are able to explore at the hearing today.
Chairman LEACH. Well, thank you very much, Mr. Toomey.
Does anyone else seek recognition on the Democratic side? On the Republican side?
Yes, Mrs. Kelly.
Mrs. KELLY. Mr. Chairman, I request unanimous consent to insert my statement in the record.
Chairman LEACH. Of course, without objection.
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Mr. LaFalce.
Mr. LAFALCE. Very briefly. As I almost am very impressed with your remarks, Mr. Toomey, I think it is unfortunate that we are getting this bill on a referral that says we have to report it out by September 6th, which means we have to report it out next week. I think the issue that you raise is worthy of discussion. It rates a separate hearing unto itself. I have a lot of discomfort, though, in attempting to come to grips with it within the timeframe that has been established for our committee. That is all.
Chairman LEACH. If there are no further requests for opening statements, we will begin with our panel. We are fortunate today to have a very distinguished dual-panel approach. The first panel is composed of Lee Sachs, who is Assistant Secretary for Financial Markets at the Department of the Treasury; Mr. Patrick Parkinson, who is Associate Director of the Division of Research and Statistics of the Board of Governors of the Federal Reserve System; Ms. Annette L. Nazareth, who is Director, Division of Market Regulations of the United States Securities and Exchange Commission; and Mr. C. Robert Paul, who is the General Counsel of the Commodity Futures Trading Commission.
The committee would like to express great appreciation for the assistance of all of the above in putting us in the position we are now in. Let me begin with Secretary Sachs.
STATEMENT OF HON. LEWIS A. SACHS, ASSISTANT SECRETARY FOR FINANCIAL MARKETS, DEPARTMENT OF THE TREASURY
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Mr. SACHS. Thank you, Mr. Chairman.
Mr. Chairman and Ranking Member LaFalce and Members of the committee, I appreciate the opportunity to appear before you today on behalf of the Treasury Department to discuss H.R. 4541.
In deference to Congressman LaFalce's concerns regarding insomnia and in recognition of your full agenda today, I will keep my opening remarks brief and ask that my prepared statement be entered into the record as well.
I would like——
Chairman LEACH. Hold up for a second. Without objection, all statements of all witnesses will be placed in the record, and you may proceed as you see fit. Thank you. Go ahead.
Mr. SACHS. I would like to commend you, Mr. Chairman, and Mr. LaFalce, and the other Members of this committee for the interest and the leadership you have consistently demonstrated on the issues under discussion today. You have truly been, and often been at the forefront of these discussions.
When the President's Working Group on Financial Markets issued its report entitled ''Over-the-Counter Derivatives and the Commodity Exchange Act,'' the unanimous recommendations it set forth presented an unprecedented consensus on some of the more challenging regulatory issues facing the financial sector.
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With regard to the OTC derivatives market, the Working Group sought to reduce systemic risk, promote innovation, protect retail customers, maintain U.S. competitiveness and preserve the integrity of the underlying markets. This legislation provides an opportunity to achieve many of those objectives.
With regard to OTC derivatives, this bill strikes the appropriate balance between allowing the economy to realize more fully the benefits of derivatives, and at the same time, meeting each of the other of the Working Group's objectives. The Working Group recommendations take into account the underlying purposes of the Commodity Exchange Act and promote a sensible regulatory regime that excludes transactions that do not require the protection provided by the Commodity Exchange Act. More specifically, the CEA was designed primarily to address issues of fraud, manipulation and price discovery. Thus, H.R. 4541 would exclude transactions from the Act which involve instruments which are not readily susceptible to manipulation, which do not currently serve a price discovery function and which are traded by large sophisticated participants who do not need the protection provided under the Act.
In addition to providing legal certainty for OTC derivatives, the bill would provide for the development of appropriately regulated clearing systems and take important steps toward protecting retail customers. We strongly encourage the Congress to adopt these provisions.
With regard to the Shad-Johnson Accord, I would just reiterate that the members of the Working Group agreed that the current prohibition on single stock futures and narrow-based stock indices could be repealed if issues concerning the integrity of the underlying securities markets and regulatory arbitrage are resolved.
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The SEC and the CFTC have been working together to address these issues. However, there are still a number of concerns that have yet to be resolved. These are issues upon which both agencies must agree, and we are committed to working with them in an effort to further advance these discussions.
However, if these issues cannot be resolved on a timely basis, we believe that it is important to move forward with legislation designed to clarify the legal certainty for OTC derivatives and to implement the other recommendations of the Working Group.
With regard to regulatory relief for America's futures exchanges, the Treasury Department continues to support the view that it is appropriate to review from time to time existing regulatory structures to determine whether they continue to serve valid public policy functions. Like the OTC markets, exchange trading of derivatives should not be subject to regulations that do not have a public policy justification. We are broadly supportive of the CFTC's efforts to provide appropriate regulatory relief to the futures exchanges consistent with the public interest.
Before concluding, although I know it is not part of this bill, and a number of you referred to this in your opening remarks, I would like to take this opportunity to address another issue which is of concern to the Treasury Department, the Working Group and obviously to this committee, and on which the committee has shown tremendous leadership.
Earlier this year, Chairman Leach and Representative LaFalce introduced legislation that would clarify the treatment of OTC derivatives and certain other financial contracts in cases of bankruptcy or bank insolvency. We would like to urge Congress to adopt these provisions. Indeed, this committee may wish to consider the merits of attaching these provisions to this legislation. Rarely are there tangible steps the Government can take that can have a meaningful impact on the mitigation of systemic risk. Enacting these provisions would be one of those steps.
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In conclusion, Mr. Chairman, I believe we have a tremendous opportunity to advance legislation that will create a modern legal and regulatory framework for OTC derivatives. We look forward to working with the Members of the committee, our colleagues on the President's Working Group, and other Members of Congress in an effort to further advance these important objectives.
Thank you for having us here today.
Chairman LEACH. Thank you very much Mr. Sachs.
Mr. Parkinson.
STATEMENT OF PATRICK M. PARKINSON, ASSOCIATE DIRECTOR, DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS, FEDERAL RESERVE SYSTEM
Mr. PARKINSON. Thank you, Mr. Chairman.
Mr. Chairman, Ranking Member LaFalce, and other Members of the committee, I am pleased to be here to present the Federal Reserve Board's views on H.R. 4541, the Commodity Futures Modernization Act of 2000.
The Board continues to believe that legislation modernizing the Commodity Exchange Act is essential. In my remarks today, I shall focus primarily on three of the areas that the legislation covers: OTC derivatives, regulatory relief for U.S. futures exchanges, and repeal of the prohibition on single-stock futures. Before concluding, I shall also discuss the importance of legislation clarifying the treatment of derivatives and other financial contracts in bankruptcy.
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In its November 1999 report on OTC derivatives, the President's Working Group concluded that OTC derivatives transactions should be subject to the CEA only if necessary to achieve the public policy objectives of the Act—deterring market manipulation and protecting investors against fraud and other unfair practices. In the case of financial derivatives transactions involving professional counterparties, the Working Group concluded that regulation was unnecessary for these purposes because financial derivatives generally are not susceptible to manipulation and because professional counterparties can protect themselves against fraud and unfair practices. Consequently, the Working Group recommended that financial OTC derivatives transactions between professional counterparties be excluded from the coverage of the CEA.
The provisions of H.R. 4541 that address OTC derivatives are generally consistent with the Working Group's conclusions. Therefore, the Federal Reserve Board believes it would be appropriate to enact those provisions. In addition, the Board recommends incorporating into the legislation provisions that would enhance the Federal Reserve's enhancement authority with respect to derivatives clearing organizations that seek to organize as uninsured State member banks. Provisions should also be added that would clarify how clearing organizations organize either as uninsured State member banks or Edge Act corporations would be resolved in the event of their insolvency.
The Working Group called for the CFTC to review its regulation of exchange-traded futures, particularly financial futures, to ensure that they remain appropriate in light of the objectives of the CEA. The Federal Reserve Board supports the new approach to regulation that was outlined in the proposals issued by the CFTC last month. For some time the Board has been arguing that the regulatory framework for futures trading, which was designed for the trading of grain futures by the general public, is simply not appropriate for the trading of financial futures by large institutions. CFTC's proposals recognize that the current one-size-fits-all approach to regulation of futures exchanges is inappropriate, and they generally incorporate sound judgments regarding degree of regulation needed to achieve the CEA's purposes. Similarly, the Federal Reserve Board generally supports the regulatory relief provisions of H.R. 4541.
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The Working Group concluded that the current prohibition on single-stock futures can be repealed if issues about the integrity of the underlying securities market and the regulatory arbitrage are resolved. The Board believes that those issues can and should be resolved through negotiations between the CFTC and the SEC. The Congress should continue to urge the two agencies to settle their remaining differences. Whatever agreement they reach should then be incorporated through amendments to H.R. 4541. If it would facilitate repeal of the prohibition, the Federal Reserve Board is willing to accept regulatory authority over levels of margin on single-stock futures as provided in H.R. 4541 so long as the Board can delegate that authority to the CFTC, the SEC, or an intermarket margin board consisting of representatives of the three agencies.
The Federal Reserve continues to support the Working Group's recommendations for amendments to the U.S. Bankruptcy Code and the FDI Act to support financial contract netting. So I am adding the Board's voice to Lee's plea that this committee take the amendments which the committee introduced in H.R. 1161 and add them essentially to H.R. 4541.
H.R. 4541 reflects a remarkable consensus on the need for legal certainty for OTC derivatives and regulatory relief for U.S. futures exchanges, issues that have long eluded resolution. Likewise, the Working Group's recommendations for amendments to the bankruptcy code are the product of several years of consensus building. These provisions are vitally important to the soundness and competitiveness of our derivatives markets in what is an increasingly integrated and intensely competitive global economy.
The Federal Reserve Board trusts that the remaining differences regarding single-stock futures can be resolved swiftly. However, if those differences cannot be resolved, they should not be allowed to hold up passage by this Congress of these other critical provisions. Thank you.
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Chairman LEACH. Well, thank you very much, Mr. Parkinson.
Ms. Nazareth.
STATEMENT OF HON. ANNETTE L. NAZARETH, DIRECTOR, DIVISION OF MARKET REGULATION, U.S. SECURITIES AND EXCHANGE COMMISSION
Ms. NAZARETH. Thank you, Chairman Leach, Ranking Member LaFalce, and Members of this committee. I am pleased to testify today on behalf of the Securities and Exchange Commission as you consider H.R. 4541, the Commodities Futures Modernization Act of 2000.
My testimony addresses the desirability of legal certainty for the OTC derivatives markets and the need to assure that securities derivatives, such as single-stock futures, do not undermine investor protection and market integrity. As you know, the Working Group recommended last year that the Commodity Exchange Act should be amended to ensure legal certainty for OTC derivatives products. Given the critical role that OTC derivatives play in our capital markets, one can think of few more important issues for congressional consideration.
In making its recommendations for the OTC derivatives market, the Working Group balanced the needs of users with the risks of abuses. In particular, the Working Group limited its recommendations for regulatory relief to products traded by eligible contract participants. The Working Group drew these lines to reflect the sophistication of market participants who will use the exclusion. As a practical matter, institutions and other highly sophisticated investors are the main participations in the OTC derivatives market.
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Along the same lines, the Working Group concluded that regulatory relief for electronic derivatives trading systems should be limited to systems on which participants trade on a principal-to-principal basis. This distinction was intended to avoid concerns, such as conflicts of interest, that can arise with agency trading. In addition, the Working Group made recommendations with respect to hybrid products, those derivative products that have characteristics of both futures and either deposits or securities. Once again, care was taken to assure that appropriate legal protections would remain applicable to these products.
The Commission strongly supports the efforts made in H.R. 4541 to further these goals of the Working Group. Moreover, the Commission urges the committee to pass the much-needed provisions on legal certainty for OTC derivatives, regardless of whether consensus is reached on other issues in the bill.
In some important respects, H.R. 4541 differs from the Working Group's recommendations regarding legal certainty. We would be happy to discuss those differences with you and to provide technical assistance. I would also like to point out that the Working Group did not suggest that achieving legal certainty entailed removing all regulation over derivative products. Rather, the Working Group concluded that the Commodity Exchange Act was not the proper statute to govern certain derivatives. Some have suggested that in addition to being excluded from the Commodity Exchange Act, swap agreements should be excluded from the coverage of the securities laws in order to eliminate all legal certainty concerns. However, legal certainty concerns with respect to swaps have arisen only under the Commodity Exchange Act, because swaps could be illegal and voidable under the CEA if they were construed as futures and were traded off of an exchange.
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By contrast, similar issues of legal certainty do not arise under the securities laws. The SEC cannot simply choose to exercise authority over swaps or any other derivatives for that matter. In fact, the SEC may not assert jurisdiction over any financial product unless the product meets well-established tests of what a security is. Moreover, the Commission, by and large, has taken action with respect to swaps only in enforcement cases involving clear instances of fraud. Providing legal certainty for swaps under the CEA will have no impact whatsoever on the Commission's measured approach to swaps.
The Commission continues to strongly support the implementation of the Working Group's recommendations that are designed to provide legal certainty for the OTC derivatives markets, and we believe that these recommendations should be implemented immediately. We appreciate the committee's efforts in furtherance of this goal and we are committed to work with you.
In addition to providing legal certainty for OTC derivatives, H.R. 4541 would also lift the current ban on single-stock futures. The Commission supports lifting the Shad-Johnson ban on single-stock futures once the regulatory issues underlying that ban are resolved. Because a single-stock future would be a nearly perfect surrogate for the underlying security, the Commission believes that single-stock futures should be jointly regulated by the SEC and the CFTC as both securities and futures. In addition, because single-stock futures are fully expected to be retail products, the Commission believes that purchasers of single-stock futures should have the same legal protections that investors have in other securities. The SEC and the CFTC are working together to agree on a workable regulatory framework that will keep investor protection and market integrity in the forefront.
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Once again, the Commission appreciates the efforts that you have made in bringing derivatives issues to the forefront. Thank you.
Chairman LEACH. Well, thank you very much, Ms. Nazareth.
Mr. Paul.
STATEMENT OF C. ROBERT PAUL, GENERAL COUNSEL, COMMODITY FUTURES TRADING COMMISSION
Mr. PAUL. Thank you, Chairman Leach, Congressman LaFalce and Members of the committee. I am pleased to appear on behalf of the Commodity Futures Trading Commission to discuss the important issues addressed in H.R. 4541. The Commission commends the efforts of Chairman Combest, Chairman Ewing, and Congressman Stenholm to modernize the Commodity Exchange Act. The Commission welcomes many of the provisions of H.R. 4541, and in particular, supports the exclusions designed to enhance legal certainty for over-the-counter transactions.
Legal certainty is a crucial consideration when parties to OTC derivatives contracts decide with whom and where to transact business, and the President's Working Group recognized that legal certainty to OTC derivatives is vital to the continued competitiveness of U.S. markets.
Most OTC derivatives transactions, as we know them today, do not present regulatory concerns within the scope of the CEA. Congress has identified the overarching public mission of the CFTC as that of preventing price manipulation and ensuring price transparency. The President's Working Group determined, however, that most OTC derivatives are not susceptible to manipulation and do not serve a price discovery function. Therefore, excluding this activity from the CEA would not diminish the Commission's ability to carry out its statutory mandate.
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Moreover, OTC transactions are entered into by sophisticated institutional traders, and as the Working Group stated, the activities of most OTC derivatives dealers are already subject to direct or indirect Federal regulatory oversight. Accordingly, there is no manifest regulatory interest which warrants CFTC oversight of most OTC derivatives.
Congressional action to exclude OTC derivatives from the CEA would provide the legal certainty recommended by the Working Group. While the CFTC swap exemption has worked well, evolution in the OTC derivatives market has rendered the exemption inadequate for some purposes. Growth in swaps volume has led to the standardization of contracts and a demand for centralized clearing of these contracts. Public policy must meet these advances in the OTC market.
This bill permits clearing of OTC derivatives and authorizes a mechanism for the CFTC to regulate facilities that clear OTC derivative contracts. Again, the President's Working Group recommended removing legal obstacles to the development of appropriately regulated clearing systems for OTC derivatives to reduce systemic risks, and we support this recommendation with the following reservation: The bill would allow securities clearing facilities to clear a broader range of contracts than futures clearinghouses. We urge the committee to avoid placing futures clearing facilities at a competitive disadvantage.
One area, however, in which H.R. 4541 diverges from the recommendations of the President's Working Group, is energy products. This bill would codify an exemption for most provisions of the Commodities Exchange Act for transactions in energy commodities, and the Commission believes this exemption raises concerns that have yet to be resolved.
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Last month, the Commission published, for public comment, its comprehensive regulatory reform package which alters fundamentally the Commission's approach to regulation of markets and participants under its jurisdiction and transforms the Commission from a front line to an oversight regulatory. H.R. 4541 attempts to codify much of the Commission's regulatory reform proposal, and we welcome this support of the Commission's initiative.
To succeed as an oversight regulator, however, the Commission must be able to act quickly and effectively to address fraud and manipulation, as well as to protect the financial integrity of the markets. Section 15 of the legislation erects several barriers to enforcement action by the Commission that may allow registered entities to postpone and possibly avoid responsibility for violations of core principles.
H.R. 4541 addresses the issue of equity futures contracts and reflects efforts to develop a plan to amend the Shad-Johnson Accord. The CFTC and the SEC agree in principle that equity futures should be available to the marketplace, and the agency staffs have agreed on many specific conditions to lifting the ban.
We are continuing our effort to negotiate a resolution. Yesterday, in response to a congressional request, the agency sent a letter to Chairmen Bliley and Oxley to apprise them of the status of our discussions. We will be happy to share that information with this committee.
Again, the Commission appreciates this opportunity to present its views, and I will be happy to answer any questions you may have.
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Chairman LEACH. Well, thank you very much.
Let me just begin very briefly with a question to Secretary Sachs on netting. As you know, this committee is strongly committed to the netting provisions that have been worked out with the Executive Branch. To the frustration of the Chairman of this committee, and I am sure Mr. LaFalce and other Members, for a lot of reasons, netting has been put within the context of bankruptcy, in the bankruptcy bill. Is it your view that the Executive Branch will be affected in its determination of whether to sign or not a bankruptcy bill based on whether there is a netting provision in it?
Mr. SACHS. Mr. Chairman, the President, I believe, has been quite clear with respect to his intentions with respect to that bankruptcy bill. He has sent two letters to Congress, I believe one on June 9th, and I believe the most recent was on June 29th, indicating his intention to veto that bill, and that bill did indeed have those netting provisions contained in it. So I believe he has been quite clear with respect to that.
Chairman LEACH. The reason I raise it in this context is to put the Administration essentially on record in that regard and underscore that this committee wants to see netting achieved, and that can be done as an individual bill. It can also be done potentially in this context, and it's my view that we should be taking a shotgun approach and will attempt it in all contexts, including this one, and it will be my hope that the committee will look sympathetically on that particular amendment being added to this particular bill next week as we move to markup.
Mr. SACHS. We would wholeheartedly support that approach.
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Chairman LEACH. And I assume the Fed has the same position; is that right, Mr. Parkinson?
Mr. PARKINSON. Yes. We would favor you adding it to this bill, but if that is not possible, in any event, passing the financial netting provisions one way or another in this Congress.
Chairman LEACH. I have a number of questions, but what I would like to do is, because I have quite a few, turn to other Members, and then at the end, come back with more questions. Let me, at this point, turn to Mr. LaFalce.
Mr. LAFALCE. Thank you, Mr. Chairman. Let me follow up on the Chairman's netting questions in order to clarify it. I think what the Chairman had in mind was, in a sense, pleading in the alternative, referred to the shotgun approach, having the netting bill in the bankruptcy bill is fine, but if the bankruptcy bill is going to be vetoed despite that does no good. Having the netting provision in the derivatives bill is fine, but if it's not going anyplace in the Senate—I am not saying that is the case—but if it's not going to make to the President's desk for a signature, then that does no good. Then we must simultaneously have an independent, standing by itself netting bill. Is that basically your position, Mr. Sachs?
Mr. SACHS. Absolutely. We would be supportive of enactment of those provisions in any way you can do that, whether it is independently or as a part of this bill, or as something else that is going to move, frankly.
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Mr. LAFALCE. Mr. Parkinson.
Mr. PARKINSON. I agree with that.
Mr. LAFALCE. Ms. Nazareth.
Ms. NAZARETH. Yes.
Mr. LAFALCE. Mr. Paul.
Mr. PAUL. No objection.
Mr. LAFALCE. No objection or you support it?
Mr. PAUL. We would support it. We haven't taken an official position.
Mr. LAFALCE. Good. Let me go to another issue. A set of features in the bill is to allow the clearing of swaps, which is not now done, and for that matter I believe it is prohibited. But there is an outstanding issue of who would be the Federal regulator of the clearing mechanism for swaps. All versions of derivatives reforms recognize the legitimacy of existing clearinghouses for futures options and other securities, but at issue, who is going to be the regulator for new clearing operations? Sometimes we call that the default regulator. So if a new clearinghouse expressed no preference for its regulator, then some Federal regulator would step in. The bill from the Agriculture Committee makes the CFTC the default regulator. The bill that Chairman Leach and I have introduced would have the Federal Reserve as the default regulator. Does the Working Group have a preference between these two arrangements or some other arrangement?
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Mr. SACHS. At least as far as the Treasury is concerned, we believe that either of these two approaches is workable. Both are desirable. I believe I referred to this in my prepared remarks.
Mr. LAFALCE. You said either is workable and both are desirable. I don't know what you meant by both are desirable.
Mr. SACHS. Either one of these proposals is workable and would achieve the objectives I believe that we all share with respect to ensuring that clearinghouses are made available. If the Congress wishes to pursue the approach outlined in the bill that this committee has introduced, there are a couple of technical changes that we would recommend just to assure that there is fair competition, and that we make sure there is a level playing field with respect to clearing organizations, but your approach is certainly quite workable.
Chairman LEACH. Would the gentleman yield on that point?
Mr. LAFALCE. Sure.
Chairman LEACH. I appreciate you being equalitarian in your presentation, but I believe I am correct in saying that the Working Group recommendation itself is for the banking regulators to be the default point. Is that not valid?
Mr. SACHS. I am sorry, Mr. Chairman, I couldn't hear the end of your question.
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Chairman LEACH. In your response to Mr. LaFalce, you said either could work and you favor both on an equalitarian basis, but isn't it true that the Working Group itself concluded a little more strongly on the direction Mr. LaFalce was leaning, not toward equalitarianism, but for recommending that the banking regulator be the——
Mr. SACHS. That is correct.
Chairman LEACH. Thank you.
Mr. SACHS. That is correct.
Mr. LAFALCE. Mr. Parkinson, would you, using the materials in front of you, and Mr. Sachs, expand upon that answer, please.
Mr. PARKINSON. Chairman Leach is correct, that the Working Group report recommended the default regulator, as you used the term, would be a banking regulator. I don't think it says the Federal Reserve. As a practical matter——
Mr. LAFALCE. If there was a conflict between the Federal Reserve and the CFTC on the issue, we might want to go to the Treasury.
Mr. PARKINSON. I think the thrust of the Working Group's recommendations, though, that what is important is that clearing be regulated. It is less important who does it as long as some competent authority does it, and as a practical matter, I guess as I think about the concept of the default regulator, is it likely that the default is ever going to be relevant, is someone who is deciding to clear products going to fail to choose who the regulator is? I think not. I would add, too, I think if the Federal Reserve were made the default regulator, that would make it more important that the provisions we recommended clarifying our enforcement authority with respect to uninsured State member banks be added to the package.
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Mr. LAFALCE. Do either Ms. Nazareth or Mr. Paul wish to add to that at all? No?
Mr. PAUL. I would just agree with both Mr. Sachs and Mr. Parkinson. We still support the recommendation of the President's Working Group.
Mr. LAFALCE. All right. Very good. Thank you.
My last question, because I know the Chairman has been generous with time, suggestions have been made that consumers should be given access to the swaps market. Do you have any thoughts on that at this time?
Mr. SACHS. I have heard some of the suggestions, although I admittedly haven't seen proposals in this regard. The Working Group, when it studied the over-the-counter derivatives market, focused on the market as it exists now. This is an almost $90 trillion market, and it is almost entirely institutionally driven. There aren't published statistics as to whether there is retail participation, how much of this market is engaged in by retail.
My own experience, in having come from the business and in talking to participants in this market, is that it is not, to date, a statistically significant portion of the market. Having said that, the Working Group laid out a set of recommendations that was designed to clarify the legal certainty for that almost $90 trillion market. We did not study the numerous issues that are raised by the question of small investors participating in this market. We would be happy to study those if the Congress wishes us to do that. The issues are quite complex. I would imagine that——
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Mr. LAFALCE. How long would such a study by the Working Group take, do you think?
Mr. SACHS. I probably should consult with my colleagues at the table but——
Mr. LAFALCE. I mean, are we talking about six days, six months, a year, two?
Mr. SACHS. It took the Working Group a number of months to come to agreement on how to treat the institutional market with respect to these instruments. We haven't begun thinking yet about the implications for retail. It would not be measured in days, I am quite confident of that. It would be measured in months. I don't know how many, but I would say, and some of you suggested this in your opening remarks, there are significant issues that this bill focuses on with respect to this market. There is currently not a retail market for these products. I am sure you all could debate the desirability of that. One thing that is for sure is that there is no regulatory or legal framework in place that would address the complex issues that arise with discussion of retail participation. But, I would like to emphasize again the importance of addressing the legal certainty issues and the issues with respect to systemic risk that this bill would accomplish, and obviously, it is up to the committee, but I would encourage the committee to move forward on provisions that are dealing with the problems that are facing this market today, and if you wish to address issues that may become a factor in the future, we would be happy to work with you on that.
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Mr. LAFALCE. I thank the gentleman.
Chairman LEACH. Mr. Baker.
Mr. BAKER. Thank you, Mr. Chairman.
Mr. Sachs, again, I am just trying to make sure I am understanding properly in perspective, and one consequence of the Act as proposed is perhaps some regulatory arbitrage. For example, Section 31 fees apply on stock transactions under the SEC. There are no similar transactional costs on the CFTC side. On the SEC side you have tax based on income, whereas on the CFTC side you have a blended rate. There are some promotional distinctions, whereas with regard to futures, you can get a phone call at home and ''Boy, have I got a commodities futures deal for you in coffee beans.'' You can't do that in stocks.
The differential treatments in margin, I know the Fed has addressed this by saying this can be worked out, but you know that requires good faith effort by a lot of folks who may not have reason to want to work it out. There are clear market distinctions between the treatment of one transaction and the treatment of a very similar transaction under a differing regulator.
You know, a difference between an option on a stock future and a stock option from an economic perspective isn't dramatically different, but the consequences of that in expense, bottom line to market participants, can be pretty significant.
Having said that, just for the sake of establishing, I have got market concerns about where we are headed, why can't we deal just simply and focus on the issue of legal certainty in this bill and not upset the world? In fact, hasn't this authorization in past sessions not been timely authorized? We fund the operations of the CFTC, and the world goes on and nothing happens? I think the September 30th date that has been held out as the cataclysmic event may not be quite so cataclysmic. I am not suggesting the underlying product is defective. I am simply saying there are a few issues that are unresolved that ought to be addressed. We can do this in a timely way before we go home and what's the problem with dealing with legal certainty?
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Mr. SACHS. Congressman, you raise obviously some very important issues. To answer your last question first, we don't see any problem, obviously, in addressing issues of legal certainty, and we think that is terribly important. The issues you raised, I believe, are all contained in the sections of this bill regarding the Shad-Johnson Accord. And perhaps my colleagues from the CFTC and SEC will have more to add to this, but the concerns about regulatory arbitrage which you raised are obviously quite important. There are, I can tell you, having been witness to some of these discussions, there are intense discussions and negotiations occurring between the SEC and the CFTC in an effort to try and resolve these issues. I believe they are all negotiating in good faith and quite vigorously, and I believe are making progress on a number of the very important issues which you raise. I don't know that they are in a position at this time to say there is agreement on everything across the board, and I don't mean to belittle the challenge that they have in working these issues out, but we have some hope that there will be agreement on these issues in a timeframe sufficient to allow the Congress to move forward with respect to that part of this bill as well, and we are working as hard as we can to try and facilitate that progress.
Having said that, as I did in my opening remarks and in my prepared remarks, if those issues cannot be resolved, and we are hopeful that they can, but if they can't be resolved, we believe it is important for the Congress to move forward with respect to the other provisions of this bill.
Mr. BAKER. Do you see any problem—and I am not saying necessarily in a regulatory sense. This is not alleging CFTC is inadequate or ill-prepared to manage these affairs. I am simply saying as a policy matter of having financial products treated in the same regulatory household as all other regulatory financial products, the development of the new futures on Fannie and Freddie that was developed last month, why is that logical to have that regulated by the CFTC? You guys seem to have a tough time with GSE issues, and you have a pretty good shop over there. Is it appropriate to throw that over the fence and say it is now a CFTC jurisdictional issue? That is very troubling.
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Mr. SACHS. The regulatory framework that has been established is the one that we all have to work with for the moment. I will say that there are a number of financial contracts that are traded on the futures exchanges which trade—which are overseen by the CFTC, apart from this GSE contract, and I am not entirely familiar with the specifics of that contract. For instance, one of the most active contracts on those exchanges is a contract involving Treasury securities, Treasury bond contracts and eurodollar futures contracts and instruments of that nature, which actually trade quite efficiently. It is a deep and liquid market. So it can work that way. There may be other ways to have those instruments regulated, but it has been working.
Mr. BAKER. My time has expired. My margin has been called, too.
Chairman LEACH. Thank you, Mr. Baker.
Mrs. Maloney.
Mrs. MALONEY. You raised a lot of interesting points, Mr. Baker. On the policy of regulating futures under financial regulation, certainly gave me something new to think about.
First of all, I would like to thank the Working Group for, again, coming before the committee and for coming to a consensus on some of the most important issues that you have considered. You have all commented on the effect of the lack of legal certainty for derivatives on contracts between large sophisticated entities. When properly employed, FX swaps, interest rates swaps and other instruments reduce risk of financial institutions and large corporations and make it much easier to conduct business around the world in multiple currencies. At the same time, we all know that many speculators participate in derivatives such as—and to mention the most spectacular of all, was the spectacular failure that was Long-Term Capital, and I would like to ask the Fed, was the lack of legal certainty about derivatives ever an issue in your dealing with Long-Term Capital?
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Mr. PARKINSON. I don't think any questions about the enforceability of individual contracts complicated that situation. There were some questions about how LTCM would have been wound up in the event that it had become insolvent, in particular, questions regarded the interaction between the laws of the Cayman Islands and the laws of the United States, and those issues would be addressed if the Congress enacted H.R. 1161, the financial netting legislation, which is just another reason why I think everyone at this table supports passing those provisions.
Mrs. MALONEY. So the hedge fund never suggested that it would challenge the legality of the contracts that it entered into which had moved against it?
Mr. PARKINSON. I am not aware of them doing so.
Mrs. MALONEY. And what will the impact of increased legal certainty be on derivatives speculators in general, and how does increased legal certainty provide additional protection for small investors from another spectacular near failure that could shake the world markets?
Mr. PARKINSON. I think that in terms of protecting small investors, by which I take it you mean public shareholders in firms who are using derivatives, there is simply no substitute for those corporate users understanding what they are doing, having proper internal controls, having knowledgeable staff, having a board of directors that sets appropriate policies and ensures that the management follows those policies. I think we certainly wouldn't want to try to make sure that investors are protected by perpetuating or increasing legal uncertainty. I think that is not the route. The route of good risk management and sound corporate governance is the route, I think, the public sector has been pursuing and should continue to pursue.
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Mrs. MALONEY. Why is energy exempted? Mr. Baker pointed out earlier that swaps markets are financial institutions, they are subject to supervision by bank regulatory agencies, and many of these transactions are also subject to bank or financial institution supervision. But why is energy exempted? We have been having many, many hearings on energy throughout this Congress and the increased costs, and so forth, and so forth. Well, who is regulating them? They are not under the financial institutions or under the banking regulation that Mr. Baker thought might clarify some of this, and yet it is exempted from this bill, energy. I am talking about the—does anyone want to comment?
Mr. PAUL. Well, Congresswoman Maloney, I will comment because we completely agree with you. That is one of our few objections—substantive objections to the bill in its current form is that we don't think that the case has been made to exempt energy commodities from the Commodity Exchange Act at this time. We have supported the President's Working Group's recommendations for an exclusion for financial over-the-counter derivatives. We currently have an exemption for certain energy products that has worked well for the industry, and because we don't think the case has yet been made that energy commodities are not manipulable, and also, because some of the major players in that market are not otherwise regulated by a Federal financial regulator, we believe that it is not appropriate at this time to provide for any of the statutory exemptions for energy commodities.
Mrs. MALONEY. Here we are making sure that the gray market isn't manipulated, yet throughout this period when there were high prices, there were all kinds of charges that there was energy manipulation. If it is not going to be regulated under the CFTC, who regulates energy? It is not under the banking regulators. So is it just out there hanging in limbo in either someplace—there's no regulation for it. So why in the world are we doing that?
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Mr. PAUL. Well, we would suggest that you don't do that.
Mrs. MALONEY. I think that is something we should try to correct. My time has expired.
Chairman LEACH. Well, thank you very much.
Mr. Riley.
Mr. RILEY. Thank you, Mr. Chairman.
Chairman LEACH. I apologize, Bob. Mr. Baker was hiding Mr. Bachus. Would you yield for Mr. Bachus? Is that all right?
Mr. RILEY. Reluctantly, I will yield to Mr. Bachus.
Mr. BACHUS. Thank you. It is my understanding that all the recommendations on legal certainty that the President's Working Group made are adopted in the bill; is that correct?
Mr. SACHS. Yes, I believe all of them, the vast majority of them are.
Mr. BACHUS. Are any left out?
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Mr. SACHS. Nothing substantial that I can think of.
Mr. BACHUS. Second, I think it actually goes beyond and puts additional legal certainty on some other non-financial commodities and hybrid instruments, too, does it not?
Mr. SACHS. Sorry, I missed that.
Mr. BACHUS. It actually goes beyond the President's Working Group recommendation and gives legal certainty to some other non-financial commodities of hybrid instruments.
Mr. SACHS. It does.
Mr. BACHUS. OK. Until I heard Mr. Paul's last statement about some non-financial commodities, whether or not—you know, that confused me a little bit. What I would like to do is let me ask you this, it is my understanding the bill in no way expands the jurisdiction or the power of the CFTC; is that right?
Mr. SACHS. Only in one area does it do that.
Mr. BACHUS. Where is that?
Mr. SACHS. That is in the area of a small part of the foreign exchange market dealing with retail customers. To the extent there is an entity which is currently unregulated, and is not affiliated with a regulated entity—often these are known as foreign exchange bucket shops—to the extent they are preying on unsuspecting retail customers, there have been problems that have arisen. There have been press reports and so forth, and this is a recognized problem. The bill does grant explicit authority for the CFTC to address those issues. But that is the only instance.
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Mr. BACHUS. Now, there actually is a provision that exempts qualifying derivatives from State regulation under bucket shop laws, though, isn't it—and gaming laws; is that correct?
Mr. SACHS. Yes.
Mr. PAUL. That is correct.
Mr. BACHUS. What I would like to do is maybe submit some questions in writing and so say, you know, is this regulated, is this not under CEA. Now it is my understanding that the so-called Treasury Amendment exclusion where CFTC—and there was a disagreement over whether certain of those financial instruments were regulated by the CEA, that has been resolved that the CEA—there's no——
Mr. SACHS. Yes, sir, those have been resolved.
Mr. BACHUS. And it was resolved by saying CFTC has no jurisdiction, or the CEA doesn't apply to those?
Mr. SACHS. There was a handful of different issues related to the Treasury amendment, and each of those has been resolved satisfactorily from our perspective.
Mr. BACHUS. But they were excluded from CFTC jurisdiction?
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Mr. SACHS. Yes.
Mr. BACHUS. OK. Thank you. I will just submit some written questions. Thank you.
Chairman LEACH. Thank you.
Mr. Riley.
Mr. RILEY. Thank you, Mr. Chairman. This bill is almost like Jason, it just keeps coming back, and I say that because I serve on the Ag Committee, and we have been dealing with this with most of our witnesses today for the last few months. There is one thing that still troubles me. It troubled me when we were in the Ag Committee hearings and it does today.
The way I understand the reasoning behind the legal certainty that you need for this country's needs is so that we don't force so many of these over-the-counter derivatives to be pushed offshore. And it seems to me like what Mr. Baker said a moment ago is absolutely correct, we need to give you legal certainty, we need to give that so we don't force some of these shops to move offshore and move them out of the United States. But I think what we are doing is we are developing a program here that becomes so complicated and so complex that we are going to end up defeating the express purpose of what the bill is supposed to do. If we dealt only with legal certainty, then I think we could do that and we could expand the markets at home, but as long as we continue to have different regulators where we have overlapping regulators, we have opt-outs for anyone over $10 million, we have sophisticated trader opt-outs.
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When we get to the point that we go back through these manipulations that we seem to be going through, I am not too sure that we are not going to end up incentivizing most of the trading groups to still go offshore or go to another country to do this. It seems to me like, again, that Mr. Baker is absolutely right, this bill should deal with the legal certainty, and then we take up any additions or subtractions from this bill individually, because the last thing that I want to see us do is spend this much time on something that becomes almost unworkable, and I think that we are about to.
Comments?
Mr. PARKINSON. I guess I would just comment that I don't think legal certainty or uncertainty is the only issue here. In fact, to remind you of the analysis the Working Group did, the question was, was regulation under the CEA necessary to deter fraud or manipulation, and the reason we have ended up with such a convoluted definition is we all recognize that in the case of fraud that there are a class of participants that don't need protection under the CEA. They can protect themselves. And there are another class of participants for whom there is not consensus as to whether they need protection. Then when it comes to drawing that line, it is inevitably an arbitrary line, and some of the complexity of that definition in turn reflects the complexity of our financial system and the many kind of financial intermediaries we have.
But, I think we have to take that as a given. If the Working Group tried to streamline its recommendations or streamline their translation into legislative language, it would be necessary to completely reform the financial system and simplify the array of financial intermediaries that are dealing with the American public. Those would be suggestions that would never make their way out of the Congress, and our goal was to try to come up with something on which there was consensus among four agencies which don't always find it easy to get to a consensus.
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And one of the virtues of that is, if we can agree on it, that makes it much more likely that the diverse interests in the Congress will be able to agree with it. When we try to extend beyond the Working Group consensus, to address other issues that admittedly the Working Group left unresolved, and I would agree that it would be very desirable to address some of these issues. I think you will find consensus is difficult.
Yes, it would be nice to address this, but what is the specific proposal, and can it attract a majority of votes in the Congress, and what really is the dilemma, do you try to make further improvements at the risk of losing passage of what we have here?
Mr. RILEY. And I appreciate that explanation, but again, I think we go back to the same point that we were originally making. If we ever get to the point where there are literally hundreds of trillions of dollars being in an arbitrage market and over-the-counter derivatives market, I do not see personally how that can be regulated by any regulator. If you want to make a sophisticated regulator go up to $50 million, I have got no problem with that, but as we discussed in the Ag Committee, I would like to bring it down to where it is under $10 million, because I think some of the most sophisticated players that I have known did not trade in the $10 and $20 million range, but when we have the amount of money that is being traded, when you have hybrids that involve financial instruments and commodities, I think it is going to be almost a nightmare to try to have any single regulator regulate this. And that is why I am saying I think you need legal certainty.
Let us pass that and let us get it out, but when we go back and try to make this as complicated as we have, I think Mr. Baker is absolutely right, we are going to—I think we are going to make it very, very difficult for American entrepreneurs, traders, arbitragers to remain here when they can go to other countries with far less hassle, with far less regulation, and I think if our ultimate goal is to streamline this process, I think we are going at it the wrong way. Thank you.
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Go ahead, Mr. Sachs.
Mr. SACHS. I would just add one thing. I concur with all the comments made by Mr. Parkinson. I would just add that although—trust me, I have read through this thing so many times that I share Congressman LaFalce's concerns on this and it is complex, but on one level it isn't that complex. What this bill does is it takes the market as it exists today, this vast almost $90 trillion market, and the vast majority of that under this bill would be excluded from the Commodity Exchange Act. This is not a retail market. What is being excluded in this bill are transactions among large counterparties trading instruments that cannot be readily manipulated and that do not serve a price discovery function. A lot of this boils down to that point. It is hard to get there, and it is hard to slog through the bill.
Mr. RILEY. I think you are absolutely right. I think we are trying to make a retail market out of something that should not be one, and I think that is the basic problem we have arrived at here. It seems to me to protect the United States interests, we should have a legal certainty for the traders to turn this into a retail market, which by your own statement there, says that this is not what it is intended for. I think that we are going to make something, again, more complex and more complicated than it should be, and ultimately it will be a disservice to those Americans or American businesses that try to use it in this country.
Chairman LEACH. Will the gentleman yield on that point?
Mr. RILEY. Yes.
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Chairman LEACH. There is a further complication. I mean, if one were to start all over looking at the markets instead of the law, wouldn't one devise this approach? It is conceivable one would, but I have a hard time believing one would. And to the degree that we are looking at a potential retail market, banks are in the retail business. The CFTC is not historically much of a retail regulator in the field of financial products. It is very tiny as an institution, has virtually no professionals outside of Washington. The banking regulators all do, and so suddenly we have decided that the protection of retail small people is something that should go to an organization of tiny dimension, centered in Washington, DC. instead of to the institutions that basically are designed to do retail supervision. It is the oddest, most awkward framework for protection of the consumer that I can envision.
And now we are all in the common framework of being stuck, because we have got a law that exists that comes from another committee of jurisdiction, but that does not mean that it is being very sensibly dealt with. And I think a good step is being made in this bill we have before us. But I think some of the concerns you are hearing from Mr. Riley, Mr. Baker and others are very simply, why do you posit this extraordinary authority in this institutionally insignificant institution as if it is going to protect where no one else is capable of protecting?
The other thing that this committee is so extraordinarily concerned with, and you have heard concerns reflected. It is a preeminently consumer protection issue. If you don't have legal certainty, you have no consumer protection, and so we think that this has to be dealt with to the maximum extent possible. I am personally afraid it can't be dealt with as much as I would like, but it can't be ignored. In your bill, you have legal certainty applied to, as you have explained, virtually all the current markets. That is a great plus, but for those of us that think new markets are going to develop, the question is how long do you want to wait to devise that again, and then do you want to deal with it again in the constraints of the current legal framework. Possibly a study is the way to go as we have discussed, but it is not a very happy answer to a question that basically this Working Group has, to date, refused to deal with.
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I say this very carefully, because when you say it will take months to think about, where have you been? Very many people in the private sector have done a lot of thinking about this, and so, in essence, you have come to this committee with a significant futures market without resolution and asked us to pass a bill based upon past markets, but not looking to the future, and that is something we have to wrestle with.
Mr. Sachs.
Mr. SACHS. Mr. Chairman, I only have one comment on this. Clearly these are important issues that you and the other Members have raised with respect to retail participation in this market, and it does warrant further study. We did not address this issue for a couple of reasons. And I would like to share those with the committee. One, because as you have all recognized, this is an institutional market currently, and we saw some real problems that needed to be addressed in the near term. Second, maybe we could have thought further into the future as to how these markets might develop, but we have not gotten input from the private sector that there is substantial demand for development of a retail market for these products.
Obviously, if the Congress wishes us to study these issues, or there is demand from the private sector to move into this area, I don't want to speak for all my colleagues on the Working Group, but I am sure we would be happy to study the issues that arise as a result of that. But this is an area that is developing quite rapidly. None of us can say what this market will look like in the future. We could only address what we can see and anticipate, and this is an issue that if there's going to be interest from the private sector and/or the Congress, we will be happy to look at it, but it has not been a pressing matter as far as we have been able to tell.
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Chairman LEACH. We have other people who want to talk, and I don't mean to insert myself at this time, but let me just stress, when you have legal uncertainty, you preclude the development of a market, and the only thing you have for sure is the prospect that the market will go elsewhere. And so I think it is a matter of some concern, and I hope all of you will listen to the testimony of the following panel on these kinds of issues.
Mr. Kanjorski.
Mr. KANJORSKI. Thank you, Mr. Chairman.
Mr. Sachs, as I understand your testimony and your response to some of the prior questions, it is basically that you have not gone where other men have not gone before, simply because no men have gone there before. Furthermore, you have contemporary problems with the law that you want us to solve. Is that correct?
Mr. SACHS. That is correct.
Mr. KANJORSKI. And in the best of all worlds, we certainly would not be dealing with something out of the Agriculture Committee if we were to reconstitute this law today. However, that is where the jurisdiction on futures lies. They have just naturally carried on, and we will have to wrestle our Agriculture Committee for jurisdiction over the entire issue, if that should happen sometime in the 23rd Century, correct?
Mr. SACHS. Yes.
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Mr. KANJORSKI. In your honest estimation, how fast is this market evolving? And if you could project out three to five years in the short term, what do you think it is really going to look like here, provided that we do not have to come back in that period of time and make substantial changes?
Mr. SACHS. Boy, Congressman Kanjorski, I would love to be able to tell you what the market would look like in several years. I can tell you it is one of the fastest growing markets that we have seen. What you are doing in this bill, if I may, is providing for that growth in a balanced manner. One of the developments that we can anticipate is the development of electronic trading systems for these instruments. The development of those systems would represent a substantial improvement in the areas of transparency and efficiency. It would reduce costs. It may add to liquidity and would represent quite a substantial improvement from today's market. So, if you ask what I think things may look like in the future, I believe people will take advantage of these electronic trading systems, if indeed the Congress moves forward in passing this legislation.
As far as other developments in this market, it is very difficult to say what other changes we may see. I will say, one other thing that this bill will accomplish is, it will provide for the development of not only electronic trading systems, but clearing systems, and that would be also a very positive development, and although the bill does not mandate that these instruments have to be cleared, it provides the private sector with the opportunity to take advantage of all the benefits of clearing systems. So I believe you have the opportunity here to shape a part of this market.
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Mr. KANJORSKI. Mr. Chairman, that is sufficient for me. I yield back the balance of my time.
Chairman LEACH. Yes, Mr. Toomey.
Mr. TOOMEY. Thank you, Mr. Chairman. I would like to make one observation before I get on to a question, and that is we have talked as though retail use of derivatives is a distant hypothetical possibility at some point and doesn't exist, but I would suggest quite to the contrary, that every day in America there are retail customers, individual mom and pops and folks using effectively over-the-counter derivatives. It is in the form of interest rate caps on variable rate mortgages, whether we call it or market it as such. The fact is that is a derivative product that is used in an extremely constructive fashion where an unsophisticated home buyer, I should say unsophisticated in the sense we usually use that term, is making a conscious decision to pay a little extra in terms of a mortgage rate in order to have the security of knowing the rate will never exceed a certain level. That is an optional feature. It is quite complex in terms of pricing and trading them, but it is very, very useful and easy to comprehend for a homeowner, and so I would just suggest that a broader application of these products may come much more quickly than we seem to be discussing, especially given that they are already there.
My question, if I could direct first to Mr. Sachs, and I want to acknowledge that I know you guys wrestled with this and I know it wasn't easy, if it were I think there would be perhaps a different approach, but it seems to me there is a certain logic and there would be a certain elegance in approaching the question of legal certainty with respect to the derivatives, over-the-counter derivatives, if instead of the exclusion approach that we have taken we instead said this is what a futures contract is and this comes under the purview of the CEA, and if something doesn't meet this definition it is not. Is that an approach that is something that you would be conceptually opposed to or is there some other reason why that is not the approach that this legislation or that you recommend?
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Mr. SACHS. Congressman Toomey, to address the second part of your question, it is actually a concept that we considered as a Working Group in the early stages of our discussions, and as far as elegance goes, it on a relative basis could be considered to be a more elegant approach. The difficulty arises in actually trying to arrive at what that definition of a future, or swaps, or even an exchange, might be these days. We could come up with a definition, we might be able to come up with a definition that would work today, although I am not sure we could, but the way this market is developing, in a week or a month or six months, that definition would no longer be relevant.
I think someone referred to the ''Jason'' aspect of this, in that it keeps coming back. If you take that approach, you may end up having to revisit this time and time again, but as a conceptual matter, no, we don't have a problem with that approach. It is very challenging though, and we did try to do that and decided to recommend the approach that we did as a result of that attempt.
Mr. TOOMEY. Is there anybody else in the Working Group who is opposed to that approach conceptually or does everybody agree that it is a matter of a difficulty of agreeing on definitions?
Mr. PARKINSON. I don't think it is simply a matter of agreeing on definitions. I think if we took the approach that some are advocating and define futures as contracts on enumerated agricultural products and anything else traded on a designated contract market, that would be perfectly clear and that would create legal certainty. But as I remarked earlier, we are not simply trying to deal solely and exclusively with legal certainty issues. There are questions as to whether you need protections against fraud and manipulation, and if you adopted that definition and left everything in the over-the-counter markets except agricultural products outside the Commodity Exchange Act you would be left with the question of how to deal with public policy concerns about fraud and manipulation. It may be possible to come up with solutions to those issues, but I think no one has come up with solutions yet and you might find as you went down that path that you ended up dealing with the same kinds of complex issues and definitions that you run into when you take the Working Group's approach.
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So I don't think it is simply a matter of coming up with a definition. It is coming up with a definition and a set of alternative solutions to the concerns about fraud and manipulation.
Mr. SACHS. I would agree with Pat's comments as well.
Mr. PAUL. Let me address that as well. We do see problems if we try to define futures at this point. We really don't know what the implication of that would be. We have undertaken no studies as to what effect that would have. We have seen our futures markets grow exponentially over the last twenty-five years, the entire time the CFTC has been in existence, to where they have become the leading futures markets in the world. I think the worst thing we could do would be to create uncertainty on the futures exchanges in an attempt to bring greater legal certainty to the over-the-counter markets.
To borrow Congressman Riley's Jason analogy, just like the Hydra in ''Jason and the Argonauts,'' you cut off one head, three grow back, I would be very wary as to what multiplicity of problems we might encounter if we were to try to define futures at that point rather than, as I think a number of the Members have pointed out, the need to focus on what we can do to bring legal certainty as quickly as possible to the over-the-counter markets.
The other point I think that is important that Mr. Sachs made is that as these products develop and with greater innovation we might find ourselves locked into a definition that doesn't work as these markets continue to develop. I think that one thing that we have learned and I think one thing that is one of the underpinnings of the Working Group recommendations is we have tried to steer away from labels. Labels don't work well in these markets, the lines blurring between what is a swap and what is a future and what is on-exchange, what is over-the-counter, whether an electronic trading facility is an exchange or not, and what is a multilateral trading facility. We think that when you begin to come up with a statutory definition of futures you are going to find yourself backed into a corner, and we would suggest that this is probably not the appropriate time to undertake that huge task.
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Mr. TOOMEY. Well, I would just respond by saying it is not clear to me why the reverse approach avoids all those same problems. When you try to define what should be excluded versus what should be in, it is not clear to me why one approach introduces all of these problems and the other avoids them. It seems both approaches have these problems.
With that, I would yield the balance of my time.
Chairman LEACH. Well, thank you and I will only add one footnote to what the gentleman has said. I think if one were to start from scratch in this whole area it is inconceivable that you would have an exemption approach. I mean it is just not the way rational minds rationally work. I mean we are dealing with a convoluted logic as well as an awkward set of bills that relate in partial measure to jurisdictions of institutions of Government as well as institutions of the Congress, and so, because of this governmental awkwardness we are skewing markets to the disadvantage of United States commerce.
Yes, of course, under Mr. Toomey's time. Mr. Toomey will be glad to yield to you.
Mr. TOOMEY. I will be happy to yield.
Mr. RILEY. Thank you. I just can't let this opportunity pass. Can any of you tell me the difference between a swap and a future? Would you try?
Mr. PARKINSON. I think we didn't try in this report, because even if you write down a definition it turns out to be more or less irrelevant to the underlying public policy purposes of the Act.
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Mr. RILEY. I think that points up the basic problem that we have in doing something other than legal certainty. If we can't even define the difference between the two products, I think it is going to be inconceivable that we can come up with regulations to govern two products that we can't define.
Chairman LEACH. Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman. I think a swap starts with an S and a futures starts with an F.
Mr. RILEY. Spoken like a guy from Texas.
Mr. BENTSEN. I want to go back to the—first of all, I apologize for not being here for your testimony. There was a bill on the floor that I wanted to speak on and so I had to wait for that.
I want to go back to a little bit of what Mr. Toomey was talking about, and then I have some other questions. I think Mr. Toomey is right from the standpoint that retail in the derivatives market is not something far off in the future. I think I disagree with him a little bit that it is not as simplistic as interest rate caps on adjustable rate mortgages. I think we should have a little more concern than that. And I hope I am not mischaracterizing his comments on this.
And I understand the Chairman's concern that the CFTC ends up being a retail regulator of last resort in some instances, that they may be illogical, but it concerns me that the alternative might be to have no regulator in some instances in the derivatives market.
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We went through this during the Gramm-Leach-Bliley, when we considered the Gramm-Leach-Bliley bill in its various stages, whether derivatives were a bank product or not a bank product, and Mr. Toomey and Mr. Baker were involved in that, at what level is a sophisticated investor, a sophisticated investor or not, at what level should there be somebody looking over the shoulder of the broker-dealer or of the seller, and I think that we should still have that concern in this instance, because what concerns me as this market moves forward, and we don't know where it is going, we are always playing catch-up on it, what concerns me is that somewhere there may be a regulatory black hole, and so I think that in that respect you are on the right track.
Maybe in the future CFTC is not the place to be and maybe we have to address that, but I would hope we wouldn't say there is no retail market, we don't need to worry about that, because I think there is a retail market for derivatives and I think there is going to be a bigger retail market for derivatives, and that is both good and that also leads to potential risk to retail purchasers and we ought to be concerned about that.
With respect to the underlying bill, I have two questions. One is one related to the—both related to single stock futures. One is, from reading through your testimony it would seem to me that the underlying bill allows for single stock futures, but presumes that the CFTC and the SEC are going to get together and work out issues related to margin requirements and differences, because you do end up with in effect two ways to purchase stock and it seems from your testimony that that has not happened. Do you all think that that will happen any time soon or would it be better for us to not repeal Shad-Johnson at this point in time until the commissions can get together on this issue?
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Second of all, an issue that was raised in a meeting yesterday, and I don't know if this is necessarily, would occur in the underlying bill, but it has to do with single-stock swaps and is there progress on ensuring—if you allow for single-stock swaps that language could be crafted that would ensure that it is not used as an artifice to evade securities laws through a swap, which it would otherwise have to abide by with an actual purchase as it relates to insider trading and disclosure of certain percentages that are held, parking rules and things like that?
Mr. PAUL. Well, Congressman Bentsen, I will address the first issue on single-stock futures and I will defer to my colleagues on the single-stock swaps. We are negotiating very diligently with the SEC to try to resolve the remaining issues. We have reached agreement on an awful lot of these specifics so far. We are doing our level best to try to do it within a timeframe, reach resolution within a timeframe that would provide comfort to the congressional committees that we have a way to regulate it if you lift the Shad-Johnson ban on single-stock futures. We believe that it is important that we proceed with making the statutory change to permit single stock futures, because they are available on at least foreign equities and other markets. We think the time is right now based on what the industry tells us, and there is a demand for it, and we also think, based on a very good working relationship that the CFTC has with the SEC, both at the staff level and at the chairman level, that this is probably a propitious time to try to get this thing accomplished.
I can't begin to prognosticate any better than Mr. Sachs can about where the market is going in five years as to whether or not the SEC and the CFTC can reach final resolution on these things, but we are certainly doing the best we can, and I think we have made substantial progress and will continue to try to close the remaining gaps. We agree that there are a lot of issues that need to be addressed to make sure that the futures markets cannot be used to circumvent securities laws and we are in complete agreement in principle with the SEC on that. We have even agreed on a lot of the specific issues on how we might harmonize margins, addressing some of the concerns that Congressman Baker mentioned earlier, customer suitability, you know, the cold calls in the night, we agree that we should have similar rules there. With respect to transaction fees and tax treatment, that is out of our control.
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But I think that we are very close on a number of the issues, and we would encourage Congress as well as our colleagues at the SEC to join us and try to get these remaining issues resolved, because we think it is important to try to lift that ban and let the markets develop.
Ms. NAZARETH. I agree with much of what Bob said. We obviously feel that it is essential that we have an appropriate regulatory framework for the trading of single-stock futures. We don't believe that our goals are achieved with the Shad-Johnson provisions of this bill. In fact, I believe that the progress that the agencies have made in formulating an appropriate regulatory framework goes well beyond where this bill is. Unfortunately we find ourselves with a problem of timing. I believe that we would ultimately be able to come to a resolution on these issues. Whether or not we could do it in the very tight timeframe that we have is uncertain, and for that reason that we would prefer that if we don't reach resolution by the appropriate time that this part of the bill be separated out from the rest, because we support the legal certainty provisions, but feel it is essential that we have the right regulatory framework for trading of these products.
Mr. BENTSEN. With the Chairman's indulgence, it would then be the SEC's intent that if an agreement were worked out, that the bill would be amended to reflect that agreement, otherwise you want to strip the Shad-Johnson bill?
Ms. NAZARETH. Yes.
Mr. BENTSEN. And can you provide for the record, and the CFTC, you raised the issue of foreign equities of futures, single equity futures and swaps. Do they have similar requirements as it relates between the futures market and the real-time market?
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Mr. PAUL. Well, in the case of the foreign markets where these products are beginning to develop, in general they don't have the same regulatory structure that we do with futures and securities.
Mr. BENTSEN. That is another question. We may not want to go there.
Mr. PAUL. I prefer not to go there. So those issues haven't come up, but those are fledgling markets that are developing. We understand there is a real desire to develop them here, and if we can reach resolution on the regulatory approach, we think that they probably would.
Chairman LEACH. Will the gentleman yield?
Mr. BENTSEN. I will be glad to yield.
Chairman LEACH. Let me just say, because I am not impressed with the statement of the SEC on this subject, that the time is now for you and the CFTC to reach resolution of this issue. As you know, I indicated in our April hearing on this subject that if the two of you don't, Congress is likely to, and I will tell you that even though there is a distinction in judgment between the two principal committees of jurisdiction, which are Agriculture and Commerce, to the degree that the Banking Committee will play a balancing role, it is my view that the issue should be resolved, and if the two of you don't want to reach agreement, we will resolve it in a congressional way.
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Now I think there are some legitimate securities concerns that I would like to see the prospect of these single securities futures being traded on the exchanges as well, and if you don't reach agreement Congress will, and so this concern about timeframe is not compelling.
I don't know of any less compelling statement that has been made in this hearing than that one, Ms. Nazareth, with the exception of a statement made by your boss last week that you just—you would feel fine if markets went offshore. I will tell you I am a very strong advocate of your boss and of the SEC, but I think you are going to have to get in step with the markets if you are going to have an influence on congressional consideration and that means in a timely fashion.
And so with the strongest possible recommendation, I think you are going to have to move forward, and I am hopeful you will reach agreement with your head of the agency, and I can assure you that if you reach agreement Congress may embrace it. We may not, but the strong likelihood is we would.
Ms. NAZARETH. If I could clarify two points. I didn't mean to imply by my statement that significant progress hasn't been made, and in fact, as Bob Paul stated earlier, we have now shed a bit more transparency on the progress of our deliberations by actually having produced a joint document on where we have agreement and where we have disagreement. I think that it would be helpful for others to take a look at that, because obviously, it will inform your decision as to where the bill currently stands. I think you will see that it takes a somewhat different approach from the approach this bill takes and the Congress can certainly make decisions on those aspects of the bill where we haven't come to agreement. However, I think there is far more consensus between the agencies than may previously have been understood.
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On the other point, in defense of my boss as you say, I am familiar with the statement that you are referring to and I would like to clarify it. I think ultimately Chairman Levitt's point was not that he wants to see U.S. investors trading single-stock futures with offshore counterparties, thereby not having our domestic exchanges and intermediaries——
Chairman LEACH. And law.
Ms. NAZARETH. And law. That is not the case at all.
I think that what we are looking for is an appropriate framework for investors in this country to be able to trade these products with U.S. intermediaries and you know U.S. counterparties.
Chairman LEACH. You are retracting your boss' statement.
Ms. NAZARETH. I am clarifying his statement.
Chairman LEACH. Did you have anything more?
Mr. BENTSEN. One other thing, Mr. Chairman, that Mr. Paul, you said with respect to other markets, fledgling markets abroad, but what about markets, the London markets, the Frankfort markets, are they engaged in single-stock futures? And I realize not every nation comports to U.S. securities laws and futures laws, but I would hardly call those fledgling markets as well, and I don't know whether they provide that or not.
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You don't have to answer that right now. You can provide it for the record, but what other nations in mature markets are doing to bridge this gap of single stock futures and how you treat it in the futures side and the securities side.
Mr. PAUL. Congressman Bentsen, if I can just take a second, thank you for helping me correct the record, because I did not mean that the markets where they are trading are fledgling. These products are relatively new to these markets and they have been introduced in some of the most developed markets outside of the United States, such as Australia, and I will be happy to submit to the committee data that we have managed to accumulate, there is not a lot, but what data we have accumulated on the volume and the experience to date in those markets. I believe there are about five or six countries that currently permit it.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman LEACH. First, Mr. Ryan, it is your turn if you want to ask a question. OK.
Yes, Mr. Maloney.
Mr. MALONEY. Thank you, Mr. Chairman. I do not have a statement or a question, but I do have a unanimous consent request. I have a letter from Richard Grasso, who is the Chairman of the New York Stock Exchange, which I would like to submit for the record.
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Chairman LEACH. Excuse me, it is without objection.
Mr. MALONEY. I have a unanimous consent request I would like to submit for the record.
Chairman LEACH. You may submit it, and I assume all of you will be open to responding to written questions. Is that a fair assumption?
Mr. SACHS. Of course.
Mr. MALONEY. Thank you, Mr. Chairman.
Chairman LEACH. Does anyone else wish to ask questions of this panel?
Let me, before concluding though, indicate on this single securities futures issue that it underscores the difficulty in the way we currently have management of our supervisory function. As some of you on this panel know, five or six years ago I introduced a bill to merge the SEC and the CFTC. That may or may not be a very wise approach and it is certainly not going to be considered in the context of this legislation other than possibly a study, but I will tell you for those that would have liked to see these single-stock futures authorized, I am confident they would have been if you would have had merged institutions, and so ironically those that most objected to the merger of the institutions are now being disadvantaged by them not being merged.
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But I see a real question in the long term whether the SEC and the CFTC should be individual institutions or should be merged. Let me point out in this statute, for example—and I don't know if the Federal Reserve has focused on this, Mr. Parkinson, or the Treasury—we have changed the purpose, according to the Agriculture Committee statute, of the CFTC. It is no longer a purpose that is at supervising markets. It is a purpose that goes to looking at systemic risk, which is normally considered in this country the Federal Reserve's function and we have also gone under the purposes of this Act into certain fraud areas, which is normally the SEC's function, and those are new purposes of the CFTC. Now I will tell you logically to say the CFTC or any Government agency shouldn't be concerned with both of those would be a mistake. On the other hand, it underscores this problem of duplication of function.
And let me ask, would any of you object to a study in this bill or do you think it would be helpful or hurtful on the question of whether the CFTC and the SEC should be merged?
Mr. Sachs.
Mr. SACHS. I don't believe we would be opposed to such a study. I cannot assure the Chairman or the committee that the result would reflect the unanimity that was reflected in our last study. However, we would have no objections to conducting such an exercise.
Chairman LEACH. Mr. Parkinson.
Mr. PARKINSON. I guess I agree with Mr. Sachs. We certainly would conduct the study if we were asked. But, achieving consensus is likely to prove difficult.
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Chairman LEACH. Ms. Nazareth.
Ms. NAZARETH. We would have no objection. I would just point out that, and I am sure you know this, it is more complex than just merging the agencies. It is really a question of thoughtfully thinking through how you would adjust the whole framework in which these products trade. It is not a question of taking two buildings and putting people together. Rightly or wrongly, we are subject to two very different statutes with very different purposes. Ultimately, that is what we are going to have to focus on reconciling.
Chairman LEACH. Mr. Paul.
Mr. PAUL. Mr. Chairman, if there were such a study I can assure you we would want to participate in it. However, as I understand—I am relatively new to the agency. I have only been there since October, and I understand some studies have been conducted in the past and that the conclusions were there would be no real cost savings or personnel savings and that as Ms. Nazareth pointed out, our statutes take slightly different approaches. We focus more on manipulation and the way the markets operate. The SEC focuses more on disclosure of capital formation, protecting the shareholders, and although a lot of our functions overlap, we think that this current system has worked rather well, even in spite of all the innovation, and has been relatively flexible and we would suggest that what our agency has been able to do with both financial derivatives, electronic trading systems that have grown up under our auspices going back to 1988, cash settled futures, a lot of other things like that we, I guess, don't see a pressing need for it. But as I said, we would certainly participate and be willing to participate in any such study.
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Chairman LEACH. Ms. Nazareth, you referenced earlier that you had worked out some sort of joint agreement, implied, with the CFTC, where you have mutually reached certain areas of agreement versus disagreement, and that this is in writing and when things are in writing that is designed to help people. It is my understanding talking to Majority and Minority staff that you haven't deigned it significant enough to transfer it to us.
Ms. NAZARETH. I thought we had. If you haven't yet received it, you certainly will.
Chairman LEACH. We would really respect your respect in that regard.
Ms. NAZARETH. Absolutely.
Mr. PAUL. I understand from my colleagues that we are preparing it as we speak and you will get it.
Chairman LEACH. This is a study under preparation?
Ms. NAZARETH. Yes.
Chairman LEACH. That clarification is helpful, too. So is this a clarification of the SEC, a second clarification of the SEC position today? Thank you. Well, we want to thank you all. We will be groping with these issues as we go forward. Thank you very much.
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Our second panel is composed of Mr. Hal S. Scott, Nomura Professor of International Financial Systems and Director of the International Financial Systems Program, Harvard Law School; Mr. Shawn Dorsch, President, Chief Operating Officer and Co-founder, DNI Holdings, Incorporated; Mr. Mark C. Brickell, Managing Director of J.P. Morgan & Company; Mr. Richard E. Grove, Jr., who is Executive Director and CEO of International Swaps and Derivatives Association; Mr. Dennis Oakley, who is Managing Partner of the Chase Manhattan Bank; and Mr. Mark D Young, of Kirkland & Ellis, on behalf of the Chicago Board of Trade and the Chicago Mercantile Exchange.
Chairman LEACH. We will begin in the order of introduction. Mr. Scott.
STATEMENT OF HAL S. SCOTT, NOMURA PROFESSOR OF INTERNATIONAL FINANCIAL SYSTEMS, DIRECTOR OF THE INTERNATIONAL FINANCIAL SYSTEMS PROGRAM, HARVARD LAW SCHOOL
Mr. SCOTT. Thank you, Mr. Chairman and Members of the committee, for permitting me to testify before you today on H.R. 4541.
The financial institutions, and particularly banks, are the major counterparties to OTC derivatives, primarily swaps. If these transactions were to be declared null and void due to the failure of the parties to comply with the CEA, significant losses could arise for financial institutions, and the mere threat of such transactions being nullified or being subject to costly regulation under the CEA could deter parties from engaging in them, at least in the United States. As of today the legal status of swaps under the CEA is determined by the CFTC swap exemption of 1993.
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This exemption presents three problems. There is the continuing possibility that the CFTC might significantly change or retract the swap exemption. There is a concern with the lack of clarity of the conditions for exemption, and finally, there is a lack of persuasive justification for the conditions that must be met to obtain an exemption. For example, why shouldn't standardized swaps qualify for the exemption?
I do not believe Section 5 of H.R. 4541 improves the situation. Indeed, I believe it makes matters worse. Section 5 of H.R. 4541 is replete with new terms and concepts that will create more legal uncertainty than exists under the swaps exemption. Let me just give an example. Others are in my written testimony.
To qualify for exclusion from CEA, trading on an electronic facility can be done on a ''principal-to-principal'' basis, but not on an agency basis. Whether or not a particular party is acting as agent or principal is a difficult one under the general law of agency. Or whether the transaction takes place on an electronic trading facility will be difficult to determine in particular cases given the complex definition of such a trading facility. These uncertainties cannot be easily fixed by better drafting.
The result will be that the CFTC will have to clarify these matters by interpretations and regulation. The CFTC will thereby acquire substantial discretionary authority over whether certain swaps transactions are excluded or are not excluded from CEA coverage.
Finally, the conditions for exclusion in H.R. 4541 in my view are much too narrow and cannot be justified by public policy. For example, it is completely unclear to me why the electronic trading of OTC derivatives should be limited to principal transactions whereas non-traded transactions can be engaged in on an agency basis. A billionaire can enter into a traditional swaps transaction through a financial institution agent, but could not use the same agent to enter into a transaction on an electronic trading facility. This makes no sense to me.
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I agree with the Chairman and Congressman, I believe, Mr. Riley, who spoke to the question of what was driving this complexity. And in my view, enormous complications have been introduced in this bill to protect OTC derivative retail customers who simply do not exist, and I do not think that we should pursue the goal of protecting people who are not participating in a market at the expense of creating legal uncertainty for those who do participate in the market, and that is the basic problem I see in the draft as it stands.
Three options would be preferable to the approach taken by H.R. 4541. I want to just address one, that derivatives based on non-agricultural products, including all financial derivatives, would be outside the CEA unless transactors in such derivatives specifically requested to be regulated under this CEA. So CEA jurisdiction over these transactions would depend on whether the party or trading systems voluntarily submitted to this jurisdiction.
This option would mean the transactors would have the choice of entering into financial derivative transactions, futures, options or swaps, either over-the-counter or on a regulated exchange. This would remove the CFTC from any regulatory role unless the parties to transaction consent to the jurisdiction. This provides complete legal certainty. If the parties have not consented to CFTC jurisdiction a transaction would not be subject to the CEA. On the other hand, the exchanges would be free to set up trading facilities unregulated by the CEA just the way any other transactors would. The result would not necessarily mean—I will quickly conclude—that all financial derivatives would be traded outside the jurisdiction of the CFTC.
If people thought CFTC jurisdiction or regulation was optimal, they would submit to it. This happens in the securities markets. You have two exchanges that trade the same stock. One is regulated, the other is less regulated. People commonly submit to the more regulated regime, because they think it has more integrity.
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If there is a problem with retail fraud, it should be addressed if that becomes a concern. It seems to me that existing regulators of financial institutions can deal with the fraud of their regulatees. If there is a loophole there for non-regulated entities, that jurisdiction could be given to some agency like the FTC to deal with.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you, Professor.
Mr. Brickell.
STATEMENT OF MARK C. BRICKELL, MANAGING DIRECTOR, J.P. MORGAN & CO., INC.
Mr. BRICKELL. Mr. Chairman, Ranking Member LaFalce, thank you for holding this hearing and for giving J.P. Morgan the opportunity to testify today. We are deeply concerned about this legislation and we hope that this committee will amend H.R. 4541 to ensure that swaps remain what they are today, a banking product. That is not likely with this bill. Nowhere in this legislation is it made clear that swaps are not futures. Nowhere in this legislation does a definition of a futures contract appear. Too much would be lost if we missed this opportunity to make it clear that swaps are not futures contracts subject to the Commodity Exchange Act.
Mr. Chairman, your personal attention to this issue has been a source of reassurance to the markets for many years now. In 1998, it was your leadership that led the Congress to deal with the CFTC concept release and this year, together with Ranking Member LaFalce and other cosponsors, you were the first to introduce a legal certainty bill in this Congress. We are grateful for all that you have done to enhance legal certainty for this essential business, and it is an essential business.
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Swaps are part of the warp and woof of the financial fabric. They are used by companies and Government institutions to manage the unique risks that each faces when it opens its doors to do business, and the swaps business is a banking business. According to Federal Reserve Chairman Greenspan, U.S. banks are the leading players in global derivatives markets. It is the bank for international settlements that keeps the statistics on swaps activities worldwide, and they say that a bank is a participant in up to 85 percent of all swaps transactions. And the most recent legislation on this subject, last year's Gramm-Leach-Bliley Act, swaps are identified by name as a banking product. The swaps business is not a securities business and it is not a futures business.
Because each swap is custom tailored swaps differ substantially from futures. Those futures are governed by the Commodity Exchange Act, which was written to regulate exchange trading of standardized products. That statute is utterly inappropriate for the regulation of swaps. Swaps just don't fit within the regulatory framework administered by the CFTC.
We all know about the most important symptom of this problem. It is the question of enforceability that arises if the CFTC ever asserts that swaps are futures, a question about the enforceability of swaps on securities prices and others that don't fit within the CFTC's swaps exemption. But this is one important symptom of the problem of CFTC regulation. It is not the only problem.
Today there is a general consensus that supports the idea that swaps aren't futures. From the CFTC's own 1989 policy statement that says swaps aren't appropriately regulated as futures, to the Supreme Court decision in the Dunn case, to the 1998 appropriations rider to the report of the President's Working Group, no agency, no Congress and no court has ever found that swaps are futures. As a result the CFTC has never regulated swaps.
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But concerns about CFTC attempts to regulate erupt periodically and, because the CEA gives the CFTC authority to regulate all futures contracts, but contains no definition of futures, there is confusion about the boundaries of CFTC authority. So we have these periodic events where a ripple of concern appears in Washington, a temporary fix is applied and then we begin the cycle all over again.
Some of us have been working on this issue for twelve years now, and it is time to break that cycle. But we can't do it with temporary halfway measures. It is time to create clear, unmistakable and lasting legal certainty that swaps as a banking product are outside the CEA.
The House Agriculture Committee has made a tremendous effort over the last eighteen months to tackle this problem. We commend them for what they have been able to achieve thus far. Their bill would bar the CFTC from regulating many kinds of swaps, but the bill does not provide legal certainty. Somehow in 110 pages of legislation there was not room in the bill to include four short words: ''swaps are not futures.'' instead, the bill creates a complex scheme of exclusions and partial exemptions from the Commodity Exchange Act that overlap, but don't ultimately cover all swaps.
The result in this Ag Committee version is that some types of swaps, including swaps done by banks, will be vulnerable to CFTC regulation and legal uncertainty. Even bank swaps that the banking authorities believe are safe and sound will face this threat. Swaps that are negotiated electronically but fail to meet the principal-to-principal test, swaps with small business customers, swaps with most individuals will be illegal and unenforceable unless the CFTC provides exemptive relief to the bank.
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The power to exempt is the power to regulate. It is hard to believe that the House Banking Committee will hand over to the House Agriculture Committee the authority to supervise regulation of swaps done by banks with their small business and depositor customers. It is not good for banks or the customers.
We ask the committee to fix these flaws. We believe that the surest way to do so is to insert the definition of a futures contract into the Commodity Exchange Act. That definition should make it clear that futures are the contracts traded on futures exchanges. Those contracts will be regulated by the Commodity Futures Trading Commission. We should point out that the same problem that exists in this bill for banks exists for brokerage firms, insurance companies, energy companies and many others in the economy. Instead of piecemeal solutions by the Banking Committee and the Commerce Committee to address these flaws, the bill you report out of this committee and send to Rules should create clear, unmistakable legal certainty for all of us.
Mr. Chairman, some firms may be so worried about the problems of CFTC regulation that they say H.R. 4541 is already good enough. That short-term approach attempts only to treat the worst symptom of this disease, the enforceability question, but in the long term it simply means that we will have to come back to Congress and especially to the House Agriculture Committee to fix the next problem caused by CFTC regulation.
The Banking Committee shouldn't have to horse trade its way to legal certainty, giving the CFTC new regulatory authority over banks in return for enforceable swap contracts. Swaps are a banking product and the Banking Committee should be able to provide legal certainty. That is why we support the efforts of this committee, Mr. Chairman, to amend and improve H.R. 4541. The competitiveness of American business and the safety and soundness of the financial system depend upon it.
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Thank you.
Chairman LEACH. Thank you, Mr. Brickell.
Mr. Oakley.
STATEMENT OF DENNIS OAKLEY, MANAGING DIRECTOR, GLOBAL CREDIT CAPITAL MANAGEMENT DEPARTMENT, CHASE MANHATTAN BANK
Mr. OAKLEY. Thank you, Mr. Chairman, and Mr. Chairman and Members of the committee, my name is Dennis Oakley, and I work at the Chase Manhattan Bank. Chase greatly appreciates the opportunity to testify today on behalf of this important legislation. Although I am here testifying on behalf of Chase, my testimony is endorsed by the following commercial and investment banks: Citigroup, Credit Suisse First Boston, Goldman Sachs & Company, Merrill Lynch & Company, Incorporated, Morgan Stanley Dean Witter & Company.
At Chase I am a Managing Director in the Global Credit Capital Management Department. This department is charged with the management of Chase's wholesale credit risk globally.
At the June 30, 2000, aggregate wholesale credit risk at that date stood at $122 billion, and my group is responsible for the management of it. The derivatives business is an important business at Chase. As of June 30th, 2000, the aggregate outstanding notional amount of Chase's foreign exchange and derivative contracts stood at approximately $14 trillion. Of this amount $13 trillion is associated with over-the-counter derivatives and $1 trillion with exchange trading estimates. However, $13 trillion is not the amount that we have at risk. The amount that we have at risk and that is on our balance sheet as of June 30 was $29.6 billion, which is about one quarter of 1 percent of the total notional amount. Foreign exchange and derivatives credit risk is approximately 25 percent of Chase's global wholesale credit risk, and I am responsible for the management and distribution of this credit risk.
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At Chase we believe we have a good risk management regime, from credit officers approving extensions of credit to our group who manages the risk once it is on our balance sheet. We have good credit underwriting skills. We have superior MIS. And we have portfolio analytics that help us understand our risk. We are aggressive in managing our risk and our credit exposures to minimize our risk and to maximize return for our shareholders.
Unfortunately, I do not have any tools that can help me manage the legal risk in the United States associated with the $29.6 billion of credit risk associated with FX and derivatives transactions. Having those transactions declared null and void would be like having all of our counterparties default simultaneously. This event would have a material adverse impact on the financial condition of Chase.
The only way I know how to manage this risk, short of not doing business in the United States, is to come to Washington and ask you to fix the laws. In my view as a risk manager at Chase, the proposed legislation would provide the legal certainty Chase and other market participants need, and it would also promote the innovation and the use of electronic trading and clearing mechanisms.
The Commodity Futures Modernization Act of 2000 would codify numerous unanimous recommendations of the President's Working Group designed to promote legal certainty, mitigate systemic risk and foster innovation in the U.S. markets for financial derivatives. Not only would the bill codify the legal certainty recommendations of the President's Working Group, the bill includes no compromises on any of these recommendations. In fact the bill goes beyond the recommendations to provide additional legal certainty for non-financial commodities, hybrid instruments that combine the economic features of futures contracts and traditional securities and banking products, and promote regulated clearing of OTC derivatives.
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Significantly, the bill would not vest with the CFTC with new jurisdiction over OTC derivatives that are not futures contracts or commodity options except in the case of clearing.
Chase would recommend that the committee consider certain additional provisions that would further advance the goal of legal certainty. Contracts between eligible contract participants that are subject to individual negotiation should be excluded from the Commodity Exchange Act regardless of the underlying commodity except for agricultural commodities.
Two, the bill should expressly state that nothing in the bill would create any presumption that an excluded or exempt transaction or a transaction not eligible for an exclusion or exemption is or otherwise would be subject to the CFTC.
Three, Chase would have no objection to including in the bill the financial netting improvements currently part of the pending bankruptcy reform legislation.
And lastly, Chase would also recommend that certain conforming amendments to the Bankruptcy Code to extend the existing protections to derivative clearing organizations and other registered entities.
In sum, Mr. Chairman, while not perfect, the bill would provide critical protections for the OTC derivatives markets and market participants against legal uncertainty, and it would promote innovation in U.S. markets in the use of electronic trading and clearing mechanisms. There is a lot at stake for the U.S. banking community. Market participants are carefully monitoring the Commodity Exchange Act reauthorization for a signal that Congress will act on this important legislation. This bill does no harm. In my view, it would be unconscionable for us to miss this opportunity when we have such consensus with the President's Working Group, the financial industry, the firms that I mentioned in my testimony, we all have consensus that this bill will meet our needs and I encourage Congress to pass the legislation.
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Thank you.
Chairman LEACH. Thank you very much, Mr. Oakley.
Mr. Grove.
STATEMENT OF RICHARD E. GROVE, JR., EXECUTIVE DIRECTOR AND CEO, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC.
Mr. GROVE. Thank you, Mr. Chairman, Members of the committee. We very much appreciate the opportunity to testify here today.
My name is Rick Grove. For the past ten years I have been an investment banker involved in the sales and trading of OTC derivatives and related products, and it has been my privilege for the past three years to serve as the Chief Executive Officer of ISDA, an organization that includes 480 of the world's leading dealers and users of these transactions.
All of us, whether we are dealers or users in this market, believe that there is a need for legislation this year to solve the legal certainty problems that exist in our business. Dealers and users cannot tolerate legal risk, the risk that a party to a contract entered into in good faith can walk away from that contract.
As dealers we can manage all sorts of risks. We can manage market risk and credit risk, and that is what we get paid for, but none of us, whether we are users or whether we are dealers, can manage legal risk. If legal uncertainty exists, at best, transactions that should be done in the United States will be done offshore. At worst, transactions that should be done because they make economic sense for U.S. corporations or U.S. financial institutions or U.S. Government agencies will not be done, and even worse, outstanding transactions that have been done for good economic reasons may be unenforceable, causing losses and instability in the financial markets.
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The OTC derivatives markets have faced a degree of legal uncertainty that has grown over the past few years. If the United States is to retain its financial market leadership and if the U.S. financial markets are to continue to provide the foundation for unprecedented growth in this country, we need to fix the legal certainty problem and we need to fix it now.
H.R. 4541 will do this to a very large extent. Is it perfect? No, it is not perfect. But let me say, Mr. Chairman, we very much appreciate the interest that you are taking in exercising your committee's jurisdiction to improve this bill where possible and we welcome the invitation that you extended to us to submit changes that we would propose to the bill and we have done so. We have proposed a number of changes to the bill that we believe will both improve the bill and at the same time maintain the consensus upon which passage of this legislation depends.
And let me note that the consensus that exists right now with respect to the legal certainty provisions is unprecedented. The four members of the President's Working Group on Financial Markets have all testified in support of the legislation. There is bipartisan support that has been expressed in both Houses of Congress. There is unanimity among the members of our organization with respect to the need for legislation and we have been happy to have received the support of nine other financial markets associations in a statement that was released yesterday indicating broad financial market support for these provisions. At the same time, other sectors of the financial markets, most notably the Chicago futures exchanges, have also indicated their support for the legal certainty provisions of this legislation.
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The consensus on the need for this legislation also includes a consensus on the need for this legislation to occur this year. Waiting until next year, waiting until the next Congress is simply not a viable option. If we do so, transactions that might have been done in the U.S. will continue to migrate offshore. Transactions that make sense for U.S. corporations and for U.S. Government agencies and for U.S. financial institutions, that should be done, may not be done. And if the relatively benign markets that we have enjoyed the past few years turn volatile in the meantime, we could see significant losses and financial market instability should these contracts not be enforceable.
The consensus that exists with respect to the legislation, both with respect to the need for legislation and with respect to the need to achieve legislation this year, presents us with an opportunity that we should not pass up. We have a major problem that exists in the market now, and we shouldn't fail to move forward simply because the solution is less than perfect. We should not fail to move forward simply because this legislation may not anticipate every innovation that we will be working on in the coming years. We can't possibly anticipate everything now, but we do have a significant problem now. Let us solve that problem now and let us deal with other issues as they arise in the future.
So as you consider this bill we urge you to do all that you can to improve and strengthen the legislation, but at the same time we urge you to maintain the consensus upon which passage of this legislation depends.
Thank you very much.
Chairman LEACH. Thank you very much, Mr. Grove.
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Mr. Young.
STATEMENT OF MARK D. YOUNG, PARTNER, KIRKLAND & ELLIS, ON BEHALF OF THE CHICAGO BOARD OF TRADE AND THE CHICAGO MERCANTILE EXCHANGE
Mr. YOUNG. Thank you, Mr. Chairman. My name is Mark Young. I am a partner in the law firm of Kirkland & Ellis and I am appearing today on behalf of both the Chicago Board of Trade and the Chicago Mercantile Exchange. If from time to time in my testimony I lapse into a reference to the Chicago exchanges I would like it to be clear at the outset I am not including the Chicago Options Exchange in that reference.
Mr. LAFALCE. Mr. Brodsky so notes.
Mr. YOUNG. I had him specifically in mind. The Chicago futures exchanges strongly support a comprehensive legislative package that we ask Congress to enact this year. That package would have three essential elements: Legal certainty for the over-the-counter market; regulatory reform for the U.S. futures exchanges; and the lifting of the Shad-Johnson temporary eighteen-year-old ban on single stock futures. We would support only comprehensive reform, and like Mr. Grove, we believe that waiting until next year is not a viable option.
Today I would like to talk about three elements of this debate that puts some to sleep, but for some bizarre reason tends to incite some passion into folks at the other end of the table. The three things are history, Shad-Johnson and regulatory arbitrage.
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First, some brief history. Today I heard in this room proposals that we define futures contracts and what is a futures contract. It was but, I think, eight or nine years ago that, in the Agriculture Committee, a gentleman by the name of Glenn English had a very similar idea. He offered a proposal and that proposal was based on a definition of futures contracts that came straight out of the case law. It wasn't embellished. It wasn't lawyered. It was copied. And that definition caused great consternation among many in the financial world and even many in other sectors of the economy, because it captured far too much commerce to make everybody happy.
So as a result of the failure to go forward with the definition of future, a decision was made in 1992 that a better approach would be to exempt instruments from the Commodity Exchange Act. At the time that exemption was championed, if I am not mistaken, by ISDA, among other groups. No one at the time suggested that the power to exempt was the power to regulate, and if we are going to turn back the clock today and try and define futures contracts, I suggest that what we have really done is said to the President's Working Group, thank you very much for all your work and thank you very much for your consensus, but we can't really work with that now, we are going to have to go back to the way things were, where we thought we could try to get things to be, nine or ten years ago. That was not a fruitful exercise at the time, and I urge this committee to avoid going down that path and instead to take the approach that the President's Working Group has worked out, that has achieved this broad consensus on legal certainty.
Second, in terms of Shad-Johnson, there was some discussion earlier today about the provisions of H.R. 4541. I would like to just summarize what has happened in the Shad-Johnson area. The House Agriculture Committee has attempted to be responsive to the views of the Securities and Exchange Commission and the securities exchanges by developing a hybrid form of regulation for single stock futures that borrows from many of the important components of Federal securities law and would have those components, borrowed pieces, apply to single stock futures traded on U.S. Future exchanges. There are in fact, if you take the House bill and the Senate bill, 10 special principles that would apply to the trading of single stock futures. To me that shows good faith, that shows an effort to try and work things out. That shows a way of doing, I think, Mr. Chairman, what you had in mind earlier today of bridging the gap between futures regulation and securities regulation to come up with an appropriate solution to the single stock futures problem. I would be happy to discuss each of those principles in detail if any Member of the committee would like to go in that direction.
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Finally, we have heard a lot about regulatory arbitrage, and I can't help but wonder what that term really means. At least for purposes of today, I represent the Chicago Mercantile Exchange, and the Chicago Mercantile Exchange trades futures contracts on currencies and futures contracts on eurodollars and the Mercantile Exchange offers those contracts in electronic as well as open outcry trading facilities. Under this bill, the currency and eurodollar contracts can be traded among 95 percent of our client base, completely outside the Commodity Exchange Act, without any regulation whatsoever. They are traded electronically on a principal-to-principal basis. You compare no regulation to the regulation that the Chicago Mercantile Exchange would be subject to under the Commodity Exchange Act, even with the regulatory relief provisions that are in this bill, and I submit to you, Mr. Chairman, you have some real regulatory arbitrage.
So what is our answer to that? Why are we supporting this? Because people have come to us and said the world is never going to be perfect, but you are going to have to compete in it, get the best you can and then do your best in the marketplace, and that is what the Chicago exchanges have decided to do and that is why we support H.R. 4541.
Thank you very much.
Chairman LEACH. Mr. Dorsch.
STATEMENT OF SHAWN A. DORSCH, PRESIDENT, CHIEF OPERATING OFFICER, AND CO-FOUNDER, DNI HOLDINGS, INC. (BLACKBIRD)
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Mr. DORSCH. Thank you, Mr. Chairman, Members of the committee. My name is Shawn Dorsch, and I am the President and Chief Operating Officer of DNI Holdings.
I am very pleased to have been invited to appear before the committee today. Much has happened since DNI testified on this subject in April, and we commend your continued leadership on behalf of the legislative effort to effectuate the goals set forth in the President's Working Group report on over-the-counter derivatives and the Commodity Exchange Act.
In addition to the legislative progress achieved to date, the CFTC has published for comment a substantial set of proposed revisions to its rules for both exchange-traded and privately negotiated derivatives. We continue to be encouraged by the market-oriented attitude of the CFTC, but there is only so much that can be accomplished under existing law. Therefore, legislation remains the key to meaningful CEA reform.
On June 29th, the Committee on Agriculture approved H.R. 4541. The electronic trading system provisions of that bill represent a substantial improvement over earlier drafts of the legislation and in our view are adequate for today's technology. We very much hope that legislation will be passed this year, but we do remain concerned that the bill is needlessly complex and will not accommodate the further innovation which is sure to come.
As you know, DNI is a corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate a computerized communication and information system, which is known as Blackbird. This system helps major financial institutions find, negotiate and agree to custom-tailored interest rate and currency derivative transactions directly with one another. The Blackbird system is the first of its kind and the only electronic system for swaps dealers that is currently operational.
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Our business is growing and after years of development and initial deployment has now reached the revenue generating stage. I would like to stress here that the Blackbird system serves only financial institutions, and the public cannot access the Blackbird.
I am also pleased to report that on June 29th, DNI was notified that its application for a patent on the Blackbird's symbol methodology was granted by the U.S. Patent and Trademark Office. This patent covers the methodologies used in the Blackbird system to express all the terms and conditions of a complex swaps or derivatives transaction which would be necessary for straight-through processing. This will result in significant cost savings for banks and other dealers who do swaps.
In the next few weeks, Blackbird will commence operations in London to serve swaps dealers in Europe, and we have an office in Tokyo and we are planning to commence activities there later this year. Many foreign countries have an approach to supervision that does not impede the development of our business, but we want to maintain our headquarters here in the United States and most of our job growth here as well. This is why this legislative undertaking is so important to us.
Under the version of H.R. 4541 approved by the Committee on Agriculture, Blackbird is subject to CFTC regulation as a trading facility, unlike the situation that pertains today. As we understand it, Blackbird is then excluded by the first of three exclusions. The exclusion relevant to Blackbird provides as follows: ''The term 'trading facility' does not include an electronic facility or system that enables participants to negotiate the terms of and enter into bilateral transactions as a result of communications exchanged by the parties and not from the interaction of multiple orders within a predetermined non-discretionary automated trade-matching algorithm.'' As noted, this exclusion appears to do a good job of describing today's technology, but what about three years from now when major swaps dealers start using computers to do some of their trading for them? What if systems like the Blackbird do start to use ''non-discretionary trade-matching algorithms''? I am not really sure what such an algorithm is.
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As long as the resulting transactions are, one, truly bilateral and, two, between sophisticated parties that have preapproved each other for credit purposes, why should there be potential adverse regulatory consequences turning on the use of such an algorithm? In short, this provision is unnecessarily complicated, vague and will threaten innovation. At the same time, it does not advance the public policy goals of protecting price discovery or guarding against manipulation.
In another section of the legislation we could be required to limit transactions authorized to be entered into on the Blackbird to transactions which are between eligible contract participants and that are entered into on a principal-to-principal basis between parties trading for their own accounts. The first requirement is sensible; Blackbird is used by dealers and only dealers and all of them are more than clearly eligible contract participants.
The second requirement however is very troubling for several reasons. In the first place, why is there a principal-to-principal requirement at all? If the eligible contract participants are trading on an electronic facility for their own account or for the account of another sophisticated party, are not all the parties involved able to protect their own interests? Why should it make a difference if a dealer is acting as a principal or as an agent so long as all the parties involved are eligible contract participants? What does it mean to trade for your own account when you are engaged in back-to-back transactions?
DNI urges this committee to eliminate the requirement that transactions entered into on an electronic trading facility must be principal-to-principal in order to qualify as excluded transactions, especially since this is not a requirement if the transaction was done over the telephone or by smoke signals or by a fax machine or any other method of communication. Again, this requirement, in our view, advances no legitimate public policy goal.
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In conclusion, Mr. Chairman and Members of the committee, the Commodity Exchange Act is amended significantly once only every ten or twenty years. For this reason, Congress should not adopt the definition of a trading facility that accommodates today's technology, but not tomorrow's. The legislation before this committee should be passed this year, and we urge that, but it needs to be modified or adjusted to foster and not impede improvements in technology and to not be unnecessarily complicated or confusing.
Thank you, Mr. Chairman.
Chairman LEACH. Well, thank you very much, Mr. Dorsch. For a while I thought I had invited you to advertise your company, but let me say what you have suggested is you have patented the definition of some of these financial products, which is something that the Government can't define, but you have patented. That is an interesting aspect, but I would also say that to me the most interesting aspect of your testimony is that you have defined new market arrangements that are arising and you have also said, in essence, that as a company you can headquarter in a number of jurisdictions, and the question is which country will have the adequate law to apply, and you are going to do these products, whatever American law is going to do, as I see it. So the question is, can American law catch up with Blackbird and keep you located in North Carolina instead of Tokyo or London or the Caymans for that matter? And I think that is something we ought to bear very much in mind.
We are going to have a vote coming up, and so let me turn to other panelists and give them a chance to the degree they can before the vote, and then I have some questions afterwards.
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Mr. LaFalce.
Mr. LAFALCE. Thank you, Mr. Chairman, and thank you all for your excellent testimony on a very difficult, complex subject.
Mr. Brickell, you say that nowhere in the bill does it say a swap is not a future. Are you calling for us to define a future or are you calling for us to define a swap and then say that a swap is not a future? Is that question even relevant? Does it make a difference? I would think that it might make a difference. If we are talking about a future, the definitional responsibility might well go to CFTC. If we are talking about the definition of a swap, Gramm-Leach-Bliley already says that swaps are banking products, but it also doesn't exclude swaps from any coverage under SEC or CFTC. Am I correct in my analysis? So, Mr. Brickell, without asking you to comment on it, because I want——
Mr. BRICKELL. Please go ahead.
Mr. LAFALCE. It is the others, other than Mr. Dorsch, that I would like to ask this question. Would it be inappropriate if we were to say give the Working Group or the Treasury the ability to define a swap as opposed to a future and then say a product defined as a swap as opposed to a future shall not be subject to the jurisdiction of the CFTC or SEC or to the banking regulators? That is my first question of four of you, other than Mr. Brickell and Mr. Dorsch. And then, if the answer to that is yes, my second question would be to Mr. Brickell and Mr. Dorsch, shouldn't we have a Truth in Swaps Act to accompany that? So for the first question we go to the other four, other than Mr. Brickell.
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Professor Scott.
Mr. SCOTT. Congressman LaFalce, I would define a swap or any other financial derivative as something traded on an exchange, but the choice of whether it was traded on an exchange would be left to participants. So it wouldn't—you wouldn't—I am not sure I am differing from Mr. Brickell's position here, but I think it needs to be made clear that at least my position on this is that the parties would decide whether they want to trade these instruments on an exchange. If they did, obviously they would be regulated by the CEA. If they didn't, they wouldn't.
Mr. LAFALCE. Parties, too, that is a separate question, what type of parties are we talking about, sophisticated or unsophisticated parties? And another question, when we talk about exchanges, what exchange are we talking about? Are we talking about single equity swaps, are we talking about the New York Stock Exchange or are we excluding them as the present bill would do?
Mr. SCOTT. Well, I would say to your first question any parties, and then the question arises what if unsophisticated parties are trading swaps off an exchange? Who is going to regulate them; who is going to protect them? There is an issue of consumer protection there. I don't think we have to invoke the mechanism of the CEA with all of its market manipulation concerns in this area. It is a consumer protection issue, people being defrauded in swaps transactions. Give authority to deal with that to the Justice Department, the FTC or agencies that are generally concerned with consumer protection. That is the way I would handle that, recognizing of course that retail participation in this market is minuscule at the moment, and I really believe that what has happened in this bill is we have sort of created this incredible complex structure to deal with the problem we don't have, and if we have the problem there are better ways to deal with it.
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Mr. LAFALCE. Anybody else wish to comment on the two questions I posed?
Mr. GROVE. If I could I would like to comment, Congressman. I would say that there are a lot of ways, in theory, that we could achieve the objectives we have set out to achieve in H.R. 4541, and your suggestion might be one and there certainly have been others. Professor Scott has made some suggestions and others today have made some suggestions about how to achieve that result. Fundamentally what we care about is achieving the result, and we don't care as much about how we get there. Ideally we would like a solution that will work not just today, but in the future. It has to work today and it has to be a solution that is achievable today. I think that in one of the last questions that was posed to the Working Group, a question posed by Congressman Toomey about an alternative approach to achieving legal certainty, we learned that there is a great deal of concern on the part of the members of the Working Group about whether that is an approach that would work.
So 4541 contains an approach on which there is widespread agreement at this point. We certainly would welcome and in fact have made some suggestions for ways in which you might improve that legislation.
Mr. LAFALCE. Is it fair to say you do not object to Mr. Brickell's or Mr. Dorsch's position except that it is not ripe for judgment now and that there are other issues that are clearly ripe for judgment now and you don't want a resolution of their issues to stand in the way of immediate judgment?
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Mr. GROVE. Well, Congressman, I wouldn't go that far. I think they have got some interesting ideas without a doubt. I wouldn't go so far to say I would endorse those ideas. But we certainly have a problem with ideas that would set back the progress of legislation and prevent it from being achieved this year.
Mr. LAFALCE. Mr. Young.
Mr. YOUNG. If I can answer your question, I think the Working Group has already done what you are suggesting they might do. I think that is exactly the question that they answered in their report. Let me tell you why. The simple question that the Working Group tried to resolve was what should be excluded from the Commodity Exchange Act. They didn't want to put a label on what should be excluded from the Commodity Exchange Act for good reason. Labels don't make good law. I have litigated cases for years over what is a security; is an option on an exempt security a security? I have litigated for five years whether something is an exchange. That is a very interesting question. Might be lucrative for lawyers, it is not a particularly good way of doing business. I have litigated what is a futures contract. That takes a while to get through.
So I think what the Working Group tried to do was a better approach than looking at a label and putting a definition on a label, and that was simply to say what should be excluded from the Commodity Exchange Act, and they came up with their answer, and that is what is in the bill that is before you.
Mr. LAFALCE. Let me come at it from the opposite perspective now. Mr. Brodsky and Mr. Grasso might be in a similar position and that would differ from the perspective of Mr. Dorsch and Mr. Brickell. They might think that the bill before us goes too far in limiting the exchanges and inadequately protecting potential consumers. Any comments on that?
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Mr. YOUNG. Let me make two comments on that. There are, as I understand it, two parts of the bill that Mr. Brodsky and Mr. Grasso may be concerned about. The first part is the legal certainty part, because it allows electronic trading of single stock equity swaps that look an awful lot like single stock futures and allows them outside the Commodity Exchange Act ban which exists today under current law and therefore could create a new market where the regulatory arbitrage concerns that Mr. Brodsky and Mr. Grasso have expressed serious reservations with would be substantial and would be very pronounced.
Chairman LEACH. If I could interrupt, we have a problem with the vote on the floor and we have got a double problem. I have been advised by staff and looked into that, this is going to be followed by a fifteen-minute vote and followed by another vote with the motion to recommit. So that looks like an hour. We also have a subcommittee markup at two o'clock. So we are under a little bit of constraint, and so I am seeking advice. My sense is to submit questions in writing, but I would like the gentleman from North Carolina.
Mr. WATT. Mr. Chairman, I certainly will waive my right to ask any questions and be happy to submit them in writing or discuss individually with the members of the panel the questions that I wanted to ask.
Chairman LEACH. Let me at this point then thank you all. Let me also indicate that we welcome any, and I particularly want to stress this to the most independent person here, Professor Scott, any suggestions of amendments in writing. We would be very appreciative. Then we will submit some questions in writing that I hope you will be responsive to.
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Second, let me announce that I have a goal and this is not a commitment. Staff is on a full time effort to come up with various amendment approaches, some of which I will consider in the consensus variety, some of which will be perhaps of the debate variety. I am going to try to be in a position by the close of business Friday to have some amendments that we will be able to circulate to people who may be interested in them for comment. Mr. LaFalce and I have agreed that we will work on the consensus variety together and that we will think through those that might be of a more philosophically different approach.
I will tell you all that my own sense is one of great frustration working within the constraints of this particular Act. On the other hand, we have no choice but to do so and that is a difficulty that we all are living under.
In any regard, thank you all very much, I appreciate very much your testimony. The hearing is adjourned.
[Whereupon, at 1:10 p.m., the hearing was adjourned.]