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H.R. 4062 — THE FINANCIAL DERIVATIVES SUPERVISORY IMPROVEMENT ACT OF 1998 AND H.R. 4239 — THE FINANCIAL CONTRACT NETTING IMPROVEMENT ACT
FRIDAY, JULY 17, 1998
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:15 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Bachus, Castle, Campbell, Kelly, Snowbarger, Riley, Foley, Fossella, LaFalce, Vento, Kennedy, C. Maloney of New York, Gutierrez, Hinchey, Bentsen, J. Maloney of Connecticut, Sherman, Lee, and Goode.
Chairman LEACH. The hearing will come to order.
The committee meets today as a result of the ongoing disagreement in the Executive Branch involving regulation of over-the-counter markets in derivative and hybrid financial instruments. This is the first of two hearings we will be having to review the situation.
Today we will hear from representatives of trading houses actively engaged in the derivatives market, from a panel of academics and from officials at three of the major exchanges. Next Friday, Federal Government regulators will appear before the committee.
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At the outset of these hearings it is important to underline that while seemingly narrow and obscure, this is an issue loaded with global economic consequences. A redefining of financial instruments by U.S. regulators could cause cascading market consequences, including the movement of business involving trillions of dollars of transactions annually out of the United States and, therefore, out from under U.S. oversight and supervision to other countries, often with less protective laws and regulations and less diligent regulators.
It is also noteworthy that we have a circumstance here in which three agencies of the United States Government are at significant disagreement with a fourth. At issue is a jurisdictional war, one with extraordinary policy and national interest ramifications. In the past decade, the derivatives market has grown dramatically as more and more financial institutions and commercial companies have included these products as part of their risk management strategies. Increasingly smaller companies, especially those that specialize in a few products, have found that derivatives are an excellent tool not only to mitigate risk, but to better compete with larger, more diversified companies.
At this point, I would like to review briefly this committee's involvement in the derivatives issue. Five years ago the then minority staff produced a landmark, 900-page study of derivatives markets, along with some 30 recommendations for improved regulatory oversight. In early 1995, I introduced a bill, H.R. 20, which would have provided a legal framework for implementing these recommendations and called for greater coordination among agencies with oversight responsibilities in these markets. While H.R. 20 was not adopted, industry and regulators have, on their own, implemented its major provisions, and as a result, derivatives markets are sturdier and more consistently supervised than they were several years ago.
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While market discipline and self-regulation are the most effective governors of an industry of this nature, there is a critical role for national and international oversight. In this regard, the derivatives policy group, which includes the world's major investment banks, has taken the lead in establishing what in effect are policing standards. In addition, accounting standards set by the Financial Accounting Standards Board have been toughened. Today's dealers and users, as well as regulators, have learned sometimes through bitter lessons a great deal about managing risk. They have also learned that there is a delicate balance between regulatory negligence and regulatory intrusiveness. Disregard can lead to institutional and systemic problems, unwarranted intrusiveness to counterproductive market reactions.
The balance was upset two months ago when the CFTC issued a ''Concept Release'' implying that it might reclassify certain OTC derivative products, thus bringing into question their legal status and regulatory treatment. The markets reacted skeptically.
Congress has never determined that swaps and hybrid instruments constitute futures contracts under the CEA and the rules, regulations, and CFTC pronouncements that determine which financial instruments are subject to or exempt from the CEA are among the most fragile areas of regulatory law, rent with conflicting court decisions and interpretations. A simple hint that a swap contract might be redefined could call into question the legality of thousands of swap contracts, with a notional value measured not in billions but trillions of dollars around the world. And the Concept Release, coated by suggestive, offhand remarks by CFTC officials, had the distinct flavor to participants in the market of costly new regulation.
The CFTC went ahead with its release despite requests to hold off by the Treasury, the Federal Reserve, the SEC and numerous industry representatives, including most agricultural interests. It appears to many that the CFTC has, in an abrupt policy shift, chosen to reexamine the swaps issue from a narrow legalistic perspective. Rather than interpreting the law in isolation, many market experts believe that the extraordinarily broad powers of the CFTC should be applied with great caution. The issue isn't whether the CFTC can find a legal rationale to act, but whether such action is in conformity with congressional intent, in harmony with other regulators and in step with realities of the market.
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By background, the CFTC is an agency that was established primarily to oversee the commodities markets, particularly the agricultural markets. As time has passed, the market for financial products has grown far larger than the market for ag commodities. While the CFTC has gained some expertise in these products, most of these financial products were developed by the banking and securities industries under regulators who have a preponderance of expertise in this area. Common sense would therefore suggest that when the CFTC considers regulations that would affect markets over which other regulators have greater expertise and oversight responsibility, it would not take actions without the input and consensus of these agencies.
Members of the committee, I have a substantially longer statement that I would like to ask unanimous consent to revise and extend in these opening remarks, and would turn to Mr. LaFalce for a statement.
[The prepared statement of Hon. James A. Leach can be found on page 138 in the appendix.]
Mr. LAFALCE. I thank the Chairman very much. I thank him for his excellent opening statement. But more than that I thank him for the very excellent work he has done on this issue over the years. As a cosponsor of the bill under discussion today, I welcome the corporation and academic witnesses that are here to discuss not just the bill, but the whole subject matter.
Experience leads me to perceive events pertaining to H.R. 4062 somewhat differently than the way they are typically characterized. The standard popular perspective is that this is a measure to quell a sort of legalistic duel over turf amongst regulators. Another common perspective is that H.R. 4062 aims to defer major public policy combat over new shadings in the derivatives market, perhaps important nuances, but only nuances nevertheless.
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Often the bill is also seen as a means to prevent participants in swaps from migrating offshore due to uncertainties over the direction of domestic regulation. However, I am concerned that the need to even consider H.R. 4062 may signal much more dangerous circumstances, the raising of barricades to cooperation and mutually beneficial action for all participants, the regulators and the regulated.
Think back to October 19, 1987. We had a devastating stock market crash; 31 percent of the market value of listed shares burned. Even more importantly, we had a looming payments gridlock amongst the Chicago markets, the New York markets and the main clearing banks. Chairman Greenspan and New York Fed President Corrigan salvaged the situation with a massive overdraft that kept our system liquid. Then, after the whole financial community underwent something like regulatory psychoanalysis, one cure, which Members of Congress hoped had become a learned lesson, was that the SEC, the bank regulators, the Treasury Department, the CFTC and the companies they regulate were going to iron out their differences on a regular, routine basis.
Various working groups were formed, reports prescribing cooperation were written and digested. A new spirit was supposed to inform how all participants were going to interact. The history of one of these working groups, the President's Working Group on Financial Markets, plays prominently in the development of H.R. 4062. But given the fact we even have H.R. 4062 in front of us, we must ask, is the President's Working Group really that, a working group?
In any case, the collaborative attitude amongst regulators was carried over from 1989 through 1993 in the context of the burgeoning, intricate and often very perplexing instruments we call ''swaps.'' These instruments allow firms to tailor their financial positions for interest income, currencies and many other stores of value. The substantial demand for such tailoring was obvious as the amount of swaps soared at that time and continues to rise tremendously today.
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The 1989 through 1993 period was capped with the passage of the Futures Trading Practices Act of 1992 and the satisfaction of most of the 30 swaps recommendations made by now Chairman Jim Leach when he was Ranking Member in November 1993. These recommendations were based on a massive study and an excellent study, which remains the definitive starting point for untangling the jurisdictional and legalistic web surrounding these instruments.
This period was not free from contention, but at bottom there was a joint, workable understanding. Yet today we find that comity amongst and between the swaps regulators and the regulated is stretched, some would say sorely. Clearly this is counterproductive, but I am fearful it is also dangerous in a global notional market of approximately $29 trillion, where the possible unraveling of contracts is an absolutely unacceptable risk, however remote it might be.
I don't think we should point fingers at anyone. I am not taking the tack that the CFTC's Concept Release of May of 1998 ignited the current feud over derivatives. I am not taking the tack that the SEC's proposal in December 1997 regarding brokers and dealers who might be involved in the swaps market lit the fuse and evoked CFTC retaliation. I am not taking the tack that anyone was being overly difficult in the negotiations which for weeks preceded this hearing exactly in order to try to avoid this hearing.
And Congress itself certainly cannot boast about jurisdictional clarity. Like the regulated and the regulators, we too have developed a tradition, for good or ill, of intricate internal boundaries regarding financial and securities matters. This is one reason the legislature prefers these issues remain, as much as possible, in the more fluid realm of joint effort by the regulated and the regulators. Should dangerous regulatory gaps exist, this approach provides the most artful way to bridge them. If the Congress is compelled to act, we would have to marshal the thoughts of three committees at least—Banking, Commerce and Agriculture—in the House alone. That has been done before; it could be done again. However, the reality is that we in Congress cannot, for a host of reasons, resolve this problem as effectively in my judgment as a joint venture by the regulators and regulated could or would. Moreover, as policymakers, I suspect that I would speak for majorities in all three of the House committees when I say we are much more concerned that the present controversy signals that the lessons of 1987 might become forgotten.
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This is a dangerous world where protecting America's economic interests as best we can must be a constant goal. The lessons we learned in 1987 are crucial to that protection. If Congress has to act to reinforce them, we will. Indeed, today is a first step on that road which, if not traveled in this session, will be traveled in the next, absent a less formal solution.
I think it would have been much better had it not come to this. I think it would be better if we could have a nonlegislative solution. When facing governmental situations like the present one, I am reminded of the General Omar Bradley story from World War II concerning when he and General Eisenhower left a joint meeting with the British imperial staff. It had been a contentious meeting. Bradley turned to Eisenhower and said, ''How naive of me. Here I thought the Germans were the enemy.''
As we proceed today, let's keep our eye on the target, the health of our country's economic structure which may someday again be tested by bad times, even though it thankfully flourishes today. I thank the Chair.
[The prepared statement of Hon. John J. LaFalce can be found on page 145 in the appendix.]
Chairman LEACH. Thank you, Mr. LaFalce.
Ms. Roukema, would you care to make an opening statement?
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Ms. ROUKEMA. I believe that Mr. Kennedy would like a few moments, and I would like to defer to Mr. Kennedy.
Chairman LEACH. Please, Mr. Kennedy.
Mr. KENNEDY. Thank you very much, both Ms. Roukema as well as the Chairman. As the Chairman knows and Members of this committee know, the HUD-VA bill is up on the House floor as we speak, and so I am going to have to run off and do my duties as the ranking Democrat on the housing committee. I unfortunately won't be able to stay for much of this stimulating and interesting testimony for the rest of the day. Oh, darn. But in any event, I do want to just briefly say how important I think this issue is, and the Chairman ought to be congratulated for holding this hearing.
I do want to be clear, however, that as we look at this issue, while the Government has a role to play in making certain that derivatives markets do not threaten the basic security of the banking industry or any of the markets themselves, we have to be very careful that we don't overreach or allow regulators to move in in a spirit of competition amongst themselves and end up hurting the very markets that they are trying to oversee, due to their own territorial battles. I am concerned, having run a company in the past and looking forward to returning to one that was actively involved in futures trading and the like, that there are currently, I believe, very strong regulators in the commodities markets that have been able to see these markets through difficult times in the past and have had, in fact, a better record than some other regulators in other industries, particularly having sat on this committee through the S&L crisis. I just would caution everyone from allowing turf fights to turn into regulatory battles which end up hurting markets.
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I know that the Chairman will make certain that we don't allow those turf wars to end up providing for bad legislation, and I look forward to working with Members of the committee as well as the people that have these concerns across our country as we try to work this out.
Thank you very much, Mr. Chairman. And, Marge, thank you very much as well.
Chairman LEACH. Thank you, Mr. Kennedy.
Ms. Roukema.
Ms. ROUKEMA. Mr. Chairman, I will keep my remarks very brief. I believe that you and the Ranking Member, Mr. LaFalce, have more than adequately outlined the pros and cons of the potential consequences of overregulation. At the same time, there are dangers, as have been outlined, to the regulatory lapses, and that is why these hearings this week and next week are so terribly important.
I do want to listen objectively to this, but I recognize that we have to not only become informed on the pros and cons of this question, but also, as we are educated, to take affirmative action rather than do it with hindsight. Therefore, I want to congratulate you for having this hearing today, and we recognize that both today and next week that we will be covering all the bases and hearing the pros and cons on all sides of this issue.
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I thank you and congratulate you for taking this initiative and for the new legislation which is about to be introduced.
Chairman LEACH. Thank you, Ms. Roukema.
Mr. Vento.
Mr. VENTO. Thank you, Mr. Chairman. I think it is a timely hearing and I look forward to the testimony of the witnesses.
I understand that there is concern about the Commodity Futures Trading Commission not cooperating as others—in coordinating their activities as much as others in the Administration and in positions of responsibility, including the Fed, would prefer. But I think that—one of the problems here, I think, is sometimes the issue of cooperation shouldn't mean that you are co-opted in terms of the independent judgment and responsibilities that an agency has.
As I read through this, I think most of us must recognize that large financial entities, private entities, in our mixed economy are not exactly friendly toward much of the regulation that takes place, whether it comes from the Fed or the Treasury or other independent agencies that have these special responsibilities. Obviously, the evolving circumstance with regards to new financial instruments and very creative financial instruments that seem to be evolving very quickly, it is clear, especially banks and financial institutions are probably stepping outside the bounds of law and outside the responsibility of the regulators that they normally have dealt with and into the area of responsibility—for instance, in this case, the Commodity Futures Trading Commission.
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We also, of course, I would remind my colleagues, have had the problem with the FASB rules and how these would be assessed and how the accounting standards and so forth should be put in place.
I think that both these examples serve as a clear indication of a necessity to probably address the law. In the meantime, the Commodity Futures Trading Commission has a responsibility under law, and as one who believes that there needs to be some monitoring and some Federal and even international agreements in terms of areas of regulation concerning these instruments, I look forward to trying to craft something that will be workable. But that, in the end, will in fact permit us to have a public policy voice in the nature of the instruments and the conduct of those that are engaged in utilizing those.
The Commodity Futures Trading Commission has obviously brought this to a conclusion rather than leave the issue adrift. So I think that their courage and their actions in this in terms of exercising their responsibilities and independence is something I respect. While I may not agree with them, I think we should respect the fact that they have in fact taken an aggressive posture with regard to this issue, and I think one that has some reason and judgment behind it, rather than permit this to drift.
I look forward to the response to the bill that the Chairman has introduced and to the problems and understanding the problems more fully that exist in terms of the international and domestic economies that we are trying to guide to a successful performance.
Thank you, Mr. Chairman.
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Chairman LEACH. Thank you very much, Mr. Vento.
Would the gentleman from California wish to make an opening?
Mr. CAMPBELL. Just that we ought to go on to the witnesses, Mr. Chairman.
Chairman LEACH. Thank you.
Does anyone else wish to make an opening statement?
Mrs. KELLY. Mr. Chairman.
Chairman LEACH. Yes, Mrs. Kelly.
Mrs. KELLY. Mr. Chairman, I have an opening statement, but in the interest of time, with unanimous consent, would just like to have it appear in the record.
Chairman LEACH. Without objection. Without objection, the statements of all Members will be placed in the record.
Mrs. KELLY. Thank you.
[The prepared statement of Hon. Sue W. Kelly can be found on page 144 in the appendix.]
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Chairman LEACH. Mr. Hinchey.
Mr. HINCHEY. Thank you very much, Mr. Chairman. I want to begin by thanking you for calling this hearing on the Financial Derivatives Supervisory Improvement Act of 1998. No one can dispute your leadership role on the issue of derivatives trading and supervision during the past several years, and I commend you for keeping such a watchful eye on the developments of this dynamic and complex market.
As you and others have noted, the market for both exchange-traded and over-the-counter derivatives has grown exponentially since we last visited this issue and is now estimated to be somewhere in the neighborhood of $25 to $30 trillion. This can be attributed as much to the soundness of our regulatory system as it can be to the ingenuity of our financial services industry. I don't think anyone here will dispute that our comprehensive regulatory regime deserves much of the credit for instilling the level of investor confidence necessary to make our financial markets the strongest in the world.
That being said, we should have as much information as possible about these markets. We know that over-the-counter derivatives are complex financial instruments that are tailored to the specific needs of end users. I do not doubt that they are important tools for managing the risks inherent in doing business on a global scale, but in the face of such explosive growth, I think there are a lot of things that we do not know about these largely unregulated instruments. For that reason, Mr. Chairman, the provision in your legislation that directs the President's Working Group on Financial Markets to study the derivatives market is to be commended. However, I have some concerns about anything that would tie the hands of an independent regulatory agency from doing its job.
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As you know, the Commodity Futures Trading Commission has issued a Concept Release that asks a number of questions about the over-the-counter derivatives market. The controversy sparked by this release is puzzling for a number of reasons. The CFTC's critics describe the agency's action as an aggressive grab for jurisdiction and are calling on Congress to shut them down before they disrupt a $30 trillion market. I don't understand this criticism.
In 1992, Congress authorized the CFTC to exempt over-the-counter derivatives from regulation, which of course they promptly did. In the ensuing five years, everyone acknowledges that much has changed in these markets. It seems to me that we would have much more cause for concern if the CFTC were not reevaluating the terms of its OTC exemptions in light of these changes.
I also am unable to understand the industry's fears that this Concept Release, which we all know was not a rule, not a regulation, will drive the derivatives market offshore. Mr. James in a few moments is going to tell us that the United States is the preeminent global center for financial risk management. Since I agree this is the case, then the industry should be eager to answer the CFTC's questions and prove that the evolution of the market is not a cause for concern.
Finally, I believe that Dr. Bies' testimony, in which she indicates the successful experience of large companies such as hers as end users of derivatives, will prompt smaller and less sophisticated entities to use these instruments illustrates another reason why we should be commending the CFTC for undertaking this review. When it is noted that legal and regulatory requirements are more burdensome for smaller companies that do not have large staffs to evaluate carefully all the risks inherent in OTC derivatives, this should give us all the more reason to take a look at what is going on in this market.
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It is one thing to say that General Motors or Microsoft do not need protection when negotiating a complex financial contract. It is entirely another thing to suggest that small companies without large staffs should be in the same position. Indeed, these exceptions are based on the assumption that the parties involved are large and sophisticated entities that are able to fend for themselves in the financial marketplace.
Again, Mr. Chairman, I commend you for calling this hearing and look forward to the testimony of the witnesses. I thank you.
Chairman LEACH. Thank you. Does any other Member wish to make an opening statement?
If not, let me just make one very quick aside. We have before us legislation. We also have the potential of nonlegislative remedies. I remain convinced a nonlegislative remedy is a preferable way to go and would only stress that I think at this point it is the responsibility of the CFTC to formally respond, something that it has not done to date, with written suggestions that may or may not be acceptable to the other parties.
In a helpful move, three Members of the Agriculture Committee made certain proposed changes in the approach that I set forth. I frankly differ with these, but I am prepared to accept any approach acceptable to the Fed, the Treasury and the SEC, which I have been informed these new modifications may not be. But I think it is time for the CFTC to step forward.
Let me now turn to Panel I, which is composed of Mr. Dennis Oakley, Managing Director of Global Markets for the Chase Manhattan Bank; Mr. Mark C. Brickell, Managing Director of J.P. Morgan & Co.; Mr. George M. James, Managing Director of Morgan Stanley Dean Witter & Co.; Mr. Charles Smithson, Managing Director, CIBC World Markets; and Dr. Susan S. Bies, Executive Vice President of Risk Management for the First Tennessee National Corporation.
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Chairman LEACH. Unless the panel objects, we will begin in the order of introduction, and I will turn to Mr. Oakley.
Before beginning, let me say, we may have a brief recess based on the fact that a bill on the House floor has a key component that involves this committee, and we may take a half-hour recess, perhaps even in the middle of this panel.
STATEMENT OF DENNIS OAKLEY, MANAGING DIRECTOR OF GLOBAL MARKETS, THE CHASE MANHATTAN BANK
Mr. OAKLEY. Thank you, Mr. Chairman. My name is Dennis Oakley, and I am a Managing Director of the Chase Manhattan Bank with responsibility for the mitigation of Chase's risk in foreign exchange and derivatives markets. Chase Manhattan, with $366 billion in assets, is the Nation's largest bank holding company. I am pleased to have this opportunity to be here today to discuss new legal risk to the derivatives market raised by recent actions of the Commodity Futures Trading Commission.
Derivatives are financial contracts that allow banks, corporations and other entities to hedge various risks, such as interest rate and currency risk, equity or commodity risk. To meet our customers' needs, we are a dealer of over-the-counter derivatives which are structured to precisely hedge those risks the customer does not wish to bear. We hold the world's largest portfolio of FX and derivatives measured by notional principal amount which, as of March 31, 1998, stood at $8.2 trillion.
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As I am sure you know, the notional principal amount, while eye-catching, is not really the right figure to look at when assessing risk. What I look at is the credit risk embedded in the notional principal amount. At Chase the credit exposure of our portfolio is $35.4 billion. Because of the size and global reach of our derivatives portfolio, we are on both sides of the market. If, for example, there is an increase in U.S. dollar interest rates, we will have some customers who have derivatives contracts that will make them winners and others who will be losers. But we at Chase are in the middle, having made a market between both customers. Our gains and losses will generally offset each other.
What is our risk, then? In the example given above, our risk is that when U.S. interest rates increase, those customers who owe us money are unable to pay. For us to have a real problem, all of our customers who owe us money would have to default simultaneously. We feel confident, however, that while the portfolio is large, we have the management expertise and sophisticated systems to manage the inherent financial risk in an $8.2 trillion portfolio.
The portfolio is well diversified by every imaginable category—geography, currency, tenor, interest rate scenario and a deep customer base. But we have no way to manage this new legal risk. In our view, the root cause of the uncertainty created by the CFTC's actions is that the Commodity Exchange Act requires that all commodity futures contracts be traded on a board of trade and, since 1974, financial products have been considered to be commodity futures unless they fall within the exception of the Treasury amendment. If a product is deemed to be a future, and it is not traded on a board of trade, it is null and void.
Many of the products banks sell in the OTC derivatives market perform the same risk management functions as futures. To assure that these products are not deemed to be futures and, hence, null and void, several actions have occurred. In 1989, the CFTC issued a policy statement saying that most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as futures under the act. In 1992, Congress gave the CFTC specific authority to exempt certain derivatives from CFTC regulation.
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We have two problems with the current state of regulation. First, some of our fastest growing products, such as equity and credit derivatives, are not covered by the exemption. With the CFTC now raising the possibility that they are indeed futures, we have become concerned with a new level of legal risk for these nonexempted products. Furthermore, it is possible that the CFTC could change the terms of the exemption and cast doubt on the legality of our previously exempted products. Although they say they would only act prospectively, a plaintiff may argue that anything that the CFTC considers to be a future has always been a future.
Second, in order to reduce settlement risk in the foreign exchange markets, industry participants have begun to organize clearance and netting systems. Both the Concept Release and the CFTC's interpretation of the Treasury amendment raise the specter that adding clearing to a previously exempt product produces a future.
We are being pulled in two different directions. On the one hand, the bank regulators are demanding that we reduce the systemic risk involved in settling foreign exchange transactions; and Chase has been working on a variety of proposals to create multilateral clearing and netting systems that would accomplish that goal, including the G–20 Continuous Linked Settlement Bank. On the other hand, the CFTC thinks it has jurisdiction over multilateral netting facilities, even when the product being netted is foreign exchange.
The reason I am here today is that while we are confident of our ability to manage the financial risk of derivatives, actions taken by the CFTC have brought into question our ability to manage the legal risk in one of our primary booking locations, the United States. Chase, with a large portion of its derivatives portfolio booked in the United States, cannot remain complacent about new risk. We owe it to our depositors and shareholders to take any necessary action to minimize risk.
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Let me be frank. If the legal uncertainty posed by CFTC assertions of jurisdiction is not removed, Chase will be forced to move this business to another location, probably London, where we don't have the specter of legal jeopardy that has been raised by the CFTC. A substantial portion of this business is mobile. In the case of products done with individual customers, if the customers are in the U.S. and we can't avoid the legal uncertainty by booking the business outside the U.S., we may stop doing the business with U.S. customers. That will make certain risk management products unavailable to them. In the case of clearing systems, if U.S. law makes it unattractive to locate the facilities in the United States, we will support siting them in London and use them from our London branch.
We at Chase are pleased with the actions taken by the Chairman of the Federal Reserve, the Secretary of Treasury and the Chairman of the Securities and Exchange Commission on these issues. We supported their initial expression of concern and their proposed legislation when the CFTC first issued their Concept Release. We especially appreciate the approach taken by you, Mr. Chairman, in H.R. 4062 and your prior efforts attempting to avoid both this hearing today and the need for any legislation through a written agreement between the appropriate Federal agencies.
I understand that there are jurisdictional issues to be worked out between your committee and the House Agriculture Committee. While I am sure that there are legitimate issues, as the person at Chase responsible for managing credit risk in our derivatives portfolio, I have no position on which committee should have jurisdiction, although I do know that bank derivative dealers are heavily regulated. I do, however, care a great deal when the action of a Government agency raises new legal issues which have the effect of creating new risk to our large portfolio. This is unacceptable.
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It is the duty of both Congress and the Federal regulators to review the structure under which products like derivatives are regulated. We at Chase believe the appropriate context is the review, to be conducted next year, of the CFTC's enabling act, the Commodity Exchange Act.
Markets have developed very quickly in recent years, and U.S. firms like Chase have been in the leadership. If U.S. firms are to remain in their leadership role, then we must have the regulatory climate that promotes, not penalizes, innovation.
As Congress undertakes its comprehensive review next year, we at Chase will weigh in with our views. We will also work closely with our trade associations, like ISDA and the ABA, to guide policy decisions. But between now and the conclusion of this review, the markets need the type of standstill agreement on CFTC action supported by you, Mr. Chairman, and the principal financial regulators.
I am glad to have had this opportunity to provide Chase's views and will be glad to answer any questions.
[The prepared statement of Dennis Oakley can be found on page 150 in the appendix.]
Chairman LEACH. Thank you.
I feel compelled to insert at this point an aspect of your testimony, and let me be very clear in this. The Chairman of this committee has no jurisdictional concerns. This is an issue of policy and substance. I do not want an outside party to think that that is a factor in the consideration of this committee.
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Mr. Brickell.
STATEMENT OF MARK C. BRICKELL, MANAGING DIRECTOR, J.P. MORGAN SECURITIES, INC.
Mr. BRICKELL. Mr. Chairman, Members of the committee, thank you for inviting me here today to testify on behalf of J.P. Morgan.
We are deeply grateful for the initiative that you have taken, Mr. Chairman, to address the serious implications of recent actions by the CFTC. When the CFTC indicated that it may have regulatory authority over swaps activity, it sent a tremor through the marketplace and alarmed other Federal regulators. You, sir, by leading discussions among the financial institution regulators and their oversight committees, by scheduling this series of hearings, and by introducing essential legislation, have propelled this important issue into the spotlight where it belongs. Your actions give hope to financial market participants that these problems can be resolved before a financial crisis erupts.
J.P. Morgan is one of the world's largest dealers in privately negotiated derivatives. We are also among the largest users of exchange-traded futures. We know swaps, we know futures, and we know the difference. Our position and experience lead us to view the CFTC's recent actions with great concern.
Mr. Chairman, you have invited us here to discuss your bill, H.R. 4062, which would freeze the CFTC's regulatory authority where it stood at the beginning of 1998. Separately, you have also asked us to identify the strengths and weaknesses in derivatives regulation so that they can be addressed at some future time. We appreciate the way that you have framed these issues. The longer-term questions can be addressed in the future, but the legal risks created by the CFTC must be addressed immediately.
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I look at it this way. We have time to debate proper irrigation techniques tomorrow, but if the dam breaks tonight, the whole town will be flooded.
Privately negotiated swap transactions have become an essential part of risk management for American businesses. Each company, government body and bank faces financial risk the moment it opens its doors to do business, and each of those enterprises faces a unique mix of risks. Swaps are popular because they are custom tailored to meet the unique risks of each company. Because each swap is custom tailored, swaps differ substantially from futures contracts. Futures are standardized, exchange-traded contracts governed by the Commodity Exchange Act which was written to regulate standardized activity. But that statute is utterly inappropriate for the regulation of swaps.
Every swap transaction is unique, like a snowflake, and you can't make snowflakes with a cookie cutter like the Commodity Exchange Act. As a result, swap transactions simply don't fit within the regulatory framework administered by the CFTC. In fact, that regulatory framework is so inappropriate for the regulation of swap activity that if swaps were regulated under that act, the exchange trading requirement of the Commodity Exchange Act would instantly call into question the enforceability of thousands of swap transactions and undermine billions of dollars' worth of value on the books at American banks, brokers and corporations.
Recent actions and statements by the CFTC, including its Concept Release, raising questions about swap activity, have undermined the legal certainty that has been a foundation for swap activity. By law, futures must trade on an exchange; otherwise, they are illegal and unenforceable. If swaps are defined as futures, then many swaps would be subject to the exchange trading requirement. But these privately negotiated, custom-tailored deals aren't listed on any exchange. Therefore, if the CFTC successfully asserts jurisdiction, these swaps may no longer be valid, binding contracts.
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Everyone on the panel agrees about this. But you don't have to take our word for it. This problem is so grave that the Treasury, the Federal Reserve and the Securities and Exchange Commission have jointly called it a cause for serious concern. The Federal Reserve Board of Governors has testified that it is a potential systemic shock. Robert Rubin, Alan Greenspan, Arthur Levitt, the big three of financial markets, as you know, don't always agree, but on this issue they speak with one voice; and on behalf of the Clinton Administration, they are saying that this potential crisis must be addressed now.
We agree. That is why we support your initiative to legislate, which would require the CFTC to return to the status quo ante. We are not asking for a get-out; we are asking for a time-out. These are complicated issues, and Congress should have all the time it needs for a careful, deliberate look at the regulatory framework for swaps. And we can afford to take the time.
While many believe that the CFTC's actions may cause a financial crisis, no one believes that CFTC action is needed to solve one. There is no need for a new regulator to rush in. While the CFTC claims that it must protect investors, there is no evidence that swap participants need special protection. These contracts are not being signed by individual investors. As you will hear from other witnesses, participants in swap activity are businesses, banks, governments.
The real question is, what are the rules of the road for General Motors and J.P. Morgan and McDonald's? Do these large institutions need the CFTC to protect them from losses? This is a familiar question. Congress has already debated it many times. Again and again, the critics have contended that the high-profile losses reported by Orange County, by Barings, by Procter & Gamble justify CFTC involvement. But every one of those cases involved a violation of existing law or regulation. It is already illegal to commit fraud, it is already illegal to conceal losses; and appropriate sanctions were meted out in every one of those cases. Comprehensive CFTC regulation that increases costs and reduces flexibility for every participant in swaps activity won't make these illegal actions any more illegal.
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As Congress studies these issues in the future, we look forward to helping you with a long-term analysis. Your legislation, Mr. Chairman, proposes a study of swaps regulation which is consistent with the legislation that you have proposed in the past. We welcome the scrutiny such a study would entail, because we think we know what the conclusion will be. We believe that the regulatory framework for swaps is a source of strength for swap activity. It is consistent with a safe and sound financial system. It has contributed to the swaps success story.
The success of swaps activity shows the benefits of the existing regulatory approach, and it should be studied for its successes, not because of any failures. We should even consider, in my opinion, how the best features of swap regulation can be transported to the regulation of traditional financial activities to help foster safety and soundness and growth in those activities, too.
We look forward to working with you and other parts of the Congress, Mr. Chairman, on that long-term project. But now we must shore up the foundation of legal certainty that has been weakened by the CFTC's unilateral action.
We know that this session of Congress will soon draw to a close, and that it would be difficult to mark up and move a bill before Congress adjourns, but you can count on our support. None of us can prudently ignore the thoughtful conclusion of the Treasury, the Federal Reserve and the SEC that legislation is urgently needed. The competitiveness of American business, the safety and soundness of the financial system depend upon it.
Thank you.
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[The prepared statement of Mark C. Brickell can be found on page 156 in the appendix.]
Chairman LEACH. Thank you very much, Mr. Brickell, for that thoughtful statement.
Mr. James.
STATEMENT OF GEORGE M. JAMES, MANAGING DIRECTOR, MORGAN STANLEY DEAN WITTER & CO.
Mr. JAMES. Good morning, Chairman Leach, Congressman LaFalce and Members of the committee. I am George James, Managing Director of Morgan Stanley Dean Witter & Co. I welcome this opportunity to appear before the House Banking Committee to discuss H.R. 4062, the Financial Derivatives Supervisory Improvement Act of 1998 and the regulation of over-the-counter derivative transactions.
I have over 14 years of experience in the international derivatives arena. Most of my career was spent in the London office of Morgan Stanley Dean Witter & Co. I have been responsible for our international fixed income derivative business more or less since 1993. I am also a board member of the International Swaps and Derivatives Association.
Over the last 2 decades, over-the-counter derivatives and hybrid instruments have made the U.S. financial services industry the preeminent global leader in financial risk management. OTC derivative transactions, however, are not only important to U.S. financial services firms, but critical to the successful risk management of U.S. businesses, State and local government and institutional investors. Using these now common financial instruments, U.S. companies can lower costs of capital and maintain stable product prices by protecting against adverse movements in foreign currencies, interest rates and raw materials. Through the use of OTC derivatives, State and local governments can lower costs associated with borrowing money while pension and mutual fund managers can protect portfolios from various types of investment risk.
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In today's global financial markets, risk management within both corporate America and the public sector has taken on much greater importance. Sound risk management through the use of OTC derivatives has been instrumental in providing financial stability to market participants and facilitating strong economic growth.
A primary reason for the success of United States OTC derivatives is Congress' efforts over the last decade to reduce legal and regulatory uncertainty in the OTC derivatives market. Most recently, in 1992, the Congress enacted the Futures Trading Practices Act, which provided legal certainty to most OTC derivative instruments by authorizing the CFTC to exempt these instruments from the Commodity Exchange Act. The U.S. House and Senate conference report accompanying the FTPA stated that it was Congress' intent, quote, ''to give the CFTC a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development can proceed in an effective and competitive manner,'' unquote. Responding to Congress' mandate to provide legal certainty to these transactions, the CFTC exempted most swap agreements and hybrid instruments from the Commodity Exchange Act.
These important steps taken by Congress and the financial regulators have provided the legal certainty to the United States OTC derivative market that has allowed it to experience enormous growth and contributed to the U.S. becoming the preeminent global center for financial risk management. The CFTC's recent issuance of its Concept Release on OTC derivatives, however, has introduced new legal and regulatory uncertainty into the United States over-the-counter derivatives market.
The Concept Release represents an alarming shift in CFTC policy toward the regulation of OTC derivatives. The possibility of a new, more restrictive regulatory scheme for these financial instruments, or a ruling that some of these privately negotiated OTC instruments might be futures, as the Concept Release seems to contemplate, is unsettling. This action has U.S. and foreign market participants examining the validity of existing OTC derivatives and swap contracts executed under U.S. law.
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Morgan Stanley Dean Witter shares the concerns expressed by Federal Reserve Chairman Greenspan, Treasury Secretary Rubin and SEC Chairman Levitt regarding the impact of the Concept Release and potential subsequent CFTC action on these critically important markets. Were the CFTC Concept Release to evolve into a proposed rule-making, we believe the consequence of such action could be U.S. OTC derivative activity moving to offshore markets in Europe or Asia, detrimentally affecting the U.S. economy and diminishing the competitive position of the U.S. as the dominant financial center.
Morgan Stanley Dean Witter believes that the Congress is the proper forum in which to debate and determine the status and appropriate regulation of OTC derivatives. Congress will have the opportunity in the 106th Congress to explore these issues in connection with its consideration of the CFTC budget reauthorization. Failure by Congress to deal appropriately with the regulation of OTC derivatives could have serious ramifications for the U.S. market. Morgan Stanley Dean Witter would be pleased to provide Congress with any assistance in its discussion of these important market issues.
Morgan Stanley Dean Witter strongly commends the efforts by you, Chairman Leach, as well as the diligent efforts of the House Agriculture Committee Chairman Smith and House Commerce Committee Chairman Bliley to work with the CFTC and the other members of the President's Working Group to negotiate an agreement that the CFTC will take no action in this area until Congress has the opportunity to formulate appropriate policy.
Morgan Stanley Dean Witter supports the effort by the three House committees related to the joint statement of intentions regarding derivative regulation and legislation. However, we are disappointed that the CFTC could not reach agreement with the Chairman and the other financial regulators. As a result of the failure to reach a negotiated settlement, Morgan Stanley Dean Witter supports legislation to provide for, first, a temporary regulatory standstill that would prohibit the CFTC from restricting or regulating OTC derivatives; two, further study of U.S. and foreign OTC derivative activity by the President's Working Group; and three, clarification that certain securities-based derivatives do not violate the CEA.
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It is important to emphasize that this discussion today is not about regulatory turf. As the Federal Reserve Board of Governors stated in testimony submitted last month to the House subcommittee on risk management, quote, ''Considerably more is at stake—the safety and soundness of banks, the competitiveness of U.S. markets and institutions and possibly even the stability of the financial system—than would be the case if the issues were limited solely to regulatory turf,'' unquote.
We urge you, Chairman Leach and Members of the House Banking Committee, to continue to work closely with the House Agriculture and Commerce Committees and speak with one coordinated voice. Given the brief amount of time remaining in this legislative session, coordinated leadership from the committees, as well as Treasury, the Federal Reserve and SEC, is critical if legislation is to be achieved. Until the Congress has the opportunity next year to resolve the open questions concerning the regulation of OTC derivatives, it is important that the Congress take the necessary action that will reduce existing legal uncertainty and ensure corporate and governmental entity access and availability to these important financial risk management products.
Morgan Stanley Dean Witter appreciates the opportunity to offer its views on these important financial issues. I would be pleased to respond to any questions that you or the other committee Members have at the appropriate time.
[The prepared statement of George M. James can be found on page 171 in the appendix.]
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Chairman LEACH. Thank you, Mr. James.
Mr. Smithson.
STATEMENT OF CHARLES W. SMITHSON, MANAGING DIRECTOR, FINANCIAL PRODUCTS, CIBC WORLD MARKETS
Mr. SMITHSON. Mr. Chairman and Members of the committee, I am Charles Smithson, a Managing Director in the Financial Products Group of CIBC Oppenheimer. CIBC Oppenheimer is the U.S. securities subsidiary of Canadian Imperial Bank of Commerce and is a part of CIBC World Markets.
At CIBC World Markets, I am part of a group called the School of Financial Products; and it really is a ''school.'' My colleagues and I teach classes that deal with the way that derivatives work, how they are priced, how they can be used safely and effectively and how they have been misused, so that ''hard lessons'' need not be repeated. The ''students'' include CIBC's clients and prospects, as well as regulators and members of the press.
The faculty at the School of Financial Products are charged not only with disseminating existing information about derivatives and risk management, but also with discovering new information. To this end, we collaborate with several universities on surveys of the use or nonuse of derivatives. Today much of what I will tell you about comes from the most recent survey of U.S. industrial corporations done in collaboration with the Wharton School of the University of Pennsylvania.
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Of the questions posed to me in your invitation letter, the one that most caught my attention is whether current derivatives regulation is effective or whether it needs to be significantly changed. I believe the available data provides evidence that the current regulatory framework is indeed effective. Let me tell you what I see.
If you look at data on the OTC derivatives market, the thing that jumps out at you is the impressive growth this market has experienced. And the growth continues. In the first half of 1997, the most recent data that are available, the volume of new transactions grew at a rate of 46 percent. So we know that the existing regulation is conducive to growth.
But one might ask, what type of growth? The evidence indicates that the users of OTC derivatives are large and sophisticated and that they are entering into transactions to reduce the overall riskiness of their business. For the hearing today, we put together two figures from the 1997–1998 Wharton survey of industrial corporations in the United States. I am going to point to them over there on the easel.
[The figures referred to can be found on page 183 in the appendix.]
The top figure provides some evidence on the usage of derivatives and on the types of firms using them. The top section of the top figure indicates that derivatives usage is well established. Indeed, almost 85 percent of firms with sales over $1 billion reported that they used derivatives. Not shown in this figure is the change in derivatives used over time. Of the firms reporting that they used derivatives, 42 percent indicated that they increased their usage over the past year. The bottom section of the top figure shows that derivatives are used by service and manufacturing firms as well as primary product firms.
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The bottom figure is in many ways a place holder for a broad range of survey and empirical data indicating that industrial corporations are using derivatives to reduce the risk of their business.
The figure I brought with me shows that more than 90 percent of the users of derivatives identified risk reduction as their primary motivation for transacting in this market. And we need to note that this growth would not have occurred if end-users of OTC derivatives were dissatisfied with the sale practices of the dealers. On this point, the best source of data is the GAO's 1997 report on the OTC derivatives market in which they said, and I quote: ''Although sales practice requirements vary by product and dealer, according to the GAO's survey of a broad range of U.S. organizations, most end-users were generally satisfied with the sales practices of the dealers with whom they entered transactions.''
The success of the derivatives market is in large part the result of the successful efforts of Congress, bank regulators, the SEC and the CFTC to iron out differences in their jurisdictional regimes vis-a-vis derivatives, and to introduce regulatory solutions within their existing jurisdictional powers. For the firms that transact OTC derivatives, especially U.S. firms, it is important to establish clarity about how OTC derivatives transactions will be treated under U.S. law and laws of other jurisdictions, and certainty that OTC derivatives transactions will be legally enforceable.
Congress, the CFTC and the other financial regulatory agencies had provided this clarity and certainty by crafting a legislative and regulatory solution that avoided the implication that swaps are futures contracts and should be regulated as futures under the Commodity Exchange Act. However, the CFTC's recent actions threaten to jeopardize the legal certainty. By asserting jurisdiction over swaps, as it has implicitly by issuing its Concept Release, the CFTC has created an indelible implication that certain categories of swaps are futures contracts. Therefore, any OTC derivatives which do not fit cleanly under the existing CFTC Swaps Exemption should be deemed off-exchange future contracts and therefore illegal and unenforceable.
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Mr. Chairman, the interest you and your colleagues have shown in this issue is welcome. Jurisdictional disputes are extremely disruptive to the markets and their effects can linger long after the dispute is settled.
It is important to avert the current crisis to allow you and your colleagues in Congress the time to work with industry and regulators to arrive at a constructive solution to the present dispute.
[The prepared statement of Charles W. Smithson can be found on page 181 in the appendix.]
Chairman LEACH. Thank you very much, Mr. Smithson.
Dr. Bies.
STATEMENT OF DR. SUSAN S. BIES, EXECUTIVE VICE PRESIDENT, RISK MANAGEMENT, FIRST TENNESSEE NATIONAL CORP.
Dr. BIES. First Tennessee National Corporation appreciates this opportunity to testify on the Financial Derivatives Supervisory Improvement Act of 1998. As an end-user of financial derivatives, we are vitally concerned that the derivatives marketplace be competitive, innovative, efficient and sound.
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Chairman LEACH. Excuse me. If I can ask you to withhold for a second. We have on the floor coming up in about four or five minutes a principal banking provision of an appropriations bill. And at this point, I'd like to recess the committee for approximately 30 minutes. And then we will reconvene shortly thereafter.
Dr. BIES. OK.
Chairman LEACH. The hearing is in recess subject to the call of the Chair.
[Recess.]
Chairman LEACH. The hearing will reconvene, unfortunately, on a subject where there is a little more consensus in our committee then there was in the last four.
Dr. Bies, I would recommend that we begin at the beginning. I think it is fair to you and the flow of your statement, and so let me recognize you and ask you to begin at the beginning.
Mr. LAFALCE. Mr. Chairman, since we are beginning at the beginning, I would like to have the pleasure of welcoming Dr. Susan S. Bies of Buffalo, New York, North Tonawanda, New York, Niagara Falls, New York, and now Memphis, Tennessee to the panel. Welcome.
Dr. BIES. That is right. I am one of the Yankees down at First Tennessee.
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First Tennessee National Corporation appreciates the opportunity to testify on the Financial Derivatives Supervisory Improvement Act of 1998. As an end-user of financial derivatives, we are vitally concerned that the derivatives marketplace be competitive, innovative, efficient, and sound. We are pleased to see this proposal for an interagency review of the legal and regulatory framework to support this marketplace, which has been a vital risk management tool of end-users.
I am the Executive Vice President for Risk Management and Chairman of the Asset Liability Committee at First Tennessee, and, as such, I am responsible for ensuring that we identify and monitor all types of risks and ensure our risk management practices are appropriate for the types and amounts of risk we decide to accept. As part of our risk management practices, we are end-users of derivatives, and unlike the other four people who preceded me on panel, we are not dealers in derivatives.
The use of these derivatives is essential for us to meet the needs of our customers. Our financial services company can prosper only if we structure products to meet the requirements of businesses and consumers. We design products to give our customers the flexibility to choose the term, interest rate, and prepayment option best suited to their needs. But to give customers this versatility causes First Tennessee to accept exposure to the resulting risks.
Most of the derivatives we use to hedge our interest rate risks are over-the-counter derivatives, rather than exchange-traded derivatives, for several reasons. First, over-the-counter derivatives allow us to structure the transaction to the specific risk we are trying to hedge, including payment dates and indexes. We do not have to limit our choices to instruments traded on an exchange which have sufficient liquidity to support the size of the position we need to carry. We can choose the index to match our exposure and pass the basis risk on to the counterparty. We also find that over-the-counter derivatives enable us to enter into longer term agreements more efficiently than the liquidity in the exchange-traded instruments allow. This is particularly important when we hedge fixed rate mortgage loans that we service, and we service about $30 billion, and in our fixed rate consumer and business loans.
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Second, the breadth of the over-the-counter market allows us to get very competitive quotes from several dealers. This breadth also allows us to diversify and manage our counterparty risk. While we could avoid counterparty risk by using an exchange, we find that the market is broad enough that we do not have any problems with concentrations of risk above our internal credit risk limits with any one counterparty.
Risk management has developed into its own discipline over the last few years. Many companies have designated an executive officer to have responsibility for enterprise-wide risk management, credit, market and operating. As the techniques of risk identification, measurement and analysis have developed, risk managers like myself continue to seek new tools to hedge specific risks as we isolate them. And the most effective tools we found to hedge these isolated interest rate risks tend to be over-the-counter derivatives, precisely because they can be customized.
As our risk management techniques evolve, we can change new contracts to more closely affect risk as then defined. We do not want to see additional regulation that will stifle the development of risk management practices at end-users and thereby raise risks to our shareholders and increase our cost of capital.
We believe that the private market discipline and the existing legal and regulatory framework for derivatives have been effective. As an end-user, First Tennessee supports the proposal to conduct a comprehensive study of future derivatives regulation, especially since the review will encompass all the relevant regulatory agencies.
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We would hope that such a study would develop recommendations to accomplish a couple of things. First, to ensure that innovation and prompt response to emerging financial risk management practices, that the over-the-counter market has well served, will not be stifled as a result of any changes.
Second, recognize that as end-users continue to build their understanding of derivatives and see them as proven risk management tools, smaller companies will become end-users and adopt derivatives as part of their risk management strategies. While larger organizations have wider varieties of products, geography and customers that in many instances provide for some degree of self-hedging, regional and smaller organizations and those that specialize in a few products may find that derivatives are one of the best tools they can use to mitigate their enterprise risk and be able to compete effectively with larger organizations.
Third, we would hope we would be able to ensure that the legal and regulatory structure serves to limit compliance costs and reduce legal uncertainty by end-users. Legal uncertainty has recently been increased.
Fourth, to identify overlaps in regulatory authority that cause redundant compliance efforts. And we are pleased to see that there is an interagency working group that will look at this. We would hope that they would consider the scope of each agency's responsibility and keep to a bare minimum any areas that have oversight by multiple regulators.
Finally, we would hope that the group would continue to clarify the responsibilities of the both the end-users and the dealer in a transaction in terms of understanding the risks to be mitigated, risk exposures and reliance on statements.
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We have several suggestions we would like to make concerning the membership on the committees and the scope of the study. First, we feel very strongly that representatives of end-users should be included on all advisory committees and be encouraged to provide comments directly to the working group. End-users are the ultimate customers that provide the impetus for growth and innovation of derivative instruments, and their participation is vital to assess the current performance of the market and the regulatory framework, and address emerging concerns.
Second, we would like to see the inclusion of other end-users of financial derivatives that are not financial institutions. As risk management develops in more organizations, the appropriate use of derivatives will help reduce the volatility of earnings for many types of companies, reduce their cost of capital and encourage their growth.
Finally, carefully consider the definition of a financial derivative used to define the scope of the study. The market has introduced entirely new families of derivatives, such as credit derivatives. We are seeing new types of structured debt instruments that embed derivatives into cash instruments. Insurance products are being introduced to end-users that can be used to hedge financial risks similar to existing over-the-counter and exchange-traded derivatives. If a narrow definition of financial derivatives is adopted, the study will focus back to traditional products and increase the chance that the recommendations will be outdated before they can be implemented.
We encourage the Working Group on Financial Derivatives to complete their study and make their recommendation as soon as possible. The current debates among regulators have raised serious concerns among market participants about legal enforceability of over-the-counter instruments.
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Responses to this legal uncertainty include the use of offshore subsidiaries as our counterparty. We believe that the regulatory and legal framework in the United States provides the best protection to end-users. Designation of an offshore legal entity introduces new risk to the end-users in the forms of risks surrounding a foreign country's economic and legal conditions. These structures may also limit our ability to use master netting agreements with the counterparty's enterprise as a whole.
Since many over-the-counter derivatives agreements run for several years, we are also concerned about the legal standing of agreements that currently are outstanding or will be entered into before the working group study recommendations are implemented. We encourage this committee and the working group be as explicit as possible to enhance legal certainty in the derivatives market. Thank you.
[The prepared statement of Dr. Susan S. Bies can be found on page 188 in the appendix.]
Chairman LEACH. Thank you very much, Dr. Bies, and the panel.
Let me just begin with the dilemma that has been suggested to me by outside academics, and that is this word in public policy called ''counterproductivity.'' The argument is that if you change the status of swaps, the inevitable result will be that businesses such as yours will take your business offshore, which will have the effect of lack of legal certainty, which will also presumably have the effect of lack of economic growth in the United States in general and which will also have implications for legal consumer protection.
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Is that a valid observation? And so I would ask of you who are in the market, if we move in this direction, will you take increased business offshore?
Mr. Oakley.
Mr. OAKLEY. As I mentioned in my testimony, Mr. Chairman, if the legal uncertainty is not resolved, either through legislation or agreement among the regulators, that is one of the things that we have to seriously consider and most likely would start doing.
Chairman LEACH. Mr. Brickell.
Mr. BRICKELL. Yes, we would have to move some of our activity offshore. And while that would be a burden for us, I think there is an even greater concern for multinational institutions like ours with overseas branches, it is relatively easy to shift some activity offshore. For the American corporations, not all of which are multinational, who need these contracts to hedge their risks, it may not be possible to have access to the hedges by going abroad.
So a big concern is not only what happens to us, but what happens to American business. Will they even be able to hedge under this new CFTC regime?
Chairman LEACH. Mr. James.
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Mr. JAMES. I think it would be premature to say what our reaction would be to a proposed rulemaking that doesn't exist. So certainly if legal uncertainty is not resolved, then we will be looking at the overall structure of our business going forward. If there is a rulemaking from the CFTC which substantially impairs the attractiveness of the U.S. as a home for our business, then we will have to study, you know, potentially restructuring business.
Chairman LEACH. Mr. Smithson.
Mr. SMITHSON. Echoing what has just been said, the dealers of derivatives are always looking at the costs of doing business in different jurisdictions. And we would have to factor differences in costs associated with different regulations into our decision about where to locate an activity.
Chairman LEACH. Dr. Bies, do you have an offshore business in Iowa or only Tennessee?
Dr. BIES. I think New York State is our offshore business.
Chairman LEACH. OK.
Dr. BIES. I think we are a good example. We have just entered into our first offshore over-the-counter derivatives transaction that we have ever done. And to put it in perspective, our company has no offshore business; we do trade letters of credit for our domestic Tennessee area customers. We have just introduced a product where a new type of risk was identified. The only place we could find an effective hedge was an over-the-counter deritive and it was available through an offshore counterparty. It has raised a lot of issues with us. Are we just adding more country risk and legal risks than the exposure to the risk that we are trying to hedge to begin with? So we are actually experiencing our first offshore transaction.
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Chairman LEACH. Let me ask the second part of the question, then. If you put yourself in not only your shoes, but that of your customer, as one goes off shore is there more or less consumer protection for the United States consumer? Would you argue more or would you argue less?
Mr. Oakley.
Mr. OAKLEY. I am not really sure if I completely understand the question. But our customers would have the same amount of protection if we did a transaction, say, from our London office as they would if they had done the transaction from our New York office.
Chairman LEACH. What if you had a competitive other jurisdiction where the costs were lower? The point is not all countries have the same legal system we have. And from a customer point of view, even if you had the same legal protection, is there not less access and a cost for an American to go to London to sue?
Mr. OAKLEY. Yes, sir.
Chairman LEACH. And might one argue that a movement in the direction that is allegedly being contemplated by the CFTC may itself be counterproductive from a protection point of view of the consumer? This is the query that I am asking.
Mr. OAKLEY. Yes, sir.
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Chairman LEACH. Would you agree with that, Mr. Brickell?
Mr. OAKLEY. I would agree with that.
Mr. BRICKELL. Yes, if American firms have to meet offshore in order to write these contracts and have to do it under foreign law, clearly the protections available to them under U.S. law won't be available, and to the extent that those protections are better for consumers, they lose out.
Chairman LEACH. OK.
Mr. James.
Mr. JAMES. I would say that increased regulation in this area will probably result in increased costs to access the derivative market in the United States. And those costs will be passed on to consumers. To the extent that derivatives remain available overseas and U.S., if you will, wholesalers of derivatives remain in the marketplace, with access to the market as it is now and are able to translate risks back to the U.S. that are managed abroad, then I think the impact would be fairly marginal.
Chairman LEACH. Mr. Smithson.
Mr. SMITHSON. The locations to which I could envision us moving activities would provide U.S. users with the same kind of levels of protection. I think the change would be that the cost to the U.S. corporations of exercising their rights would be higher.
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Dr. BIES. I think, from our discussion, we are having to build a whole new knowledge base in order to go offshore. And it seems sort of silly since what we are hedging is exposure to movement in U.S. domestic markets. And we are just adding more complexity to what should be a straightforward transaction. So it raises our legal uncertainty in all of these transactions.
Chairman LEACH. Thank you very much.
Mr. LaFalce.
Mr. LAFALCE. Thank you, Mr. Chairman.
Dr. Bies, I believe, has said that more should be done to clarify what the dealer has to let the end-users know before the derivative is sold. And as I understand the CFTC Concept Release, one of their purposes was to probe the matter of openness and fairness in OTC's swamps. So putting aside jurisdictional issues and regulations, was the CFTC voicing a legitimate concern?
Has the market evolved so that more end-users means more displeasure by dealers early in the transaction, since there are now many, many more end-users and probably, therefore, less sophistication than there used to be?
Mr. OAKLEY. Chase believes that it is the responsibility of our counterparty to assess the risks of a transaction themselves. What we do——
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Mr. LAFALCE. Let the buyer beware?
Mr. OAKLEY. No. But at Chase, before we will do a transaction—that either through their own expertise in-house or through outside expertise that they hire, that they have the capability to understand these risks. If we determine that the customer does not have the ability to understand these risks, Chase will not do the transaction with them.
Mr. LAFALCE. Do you think there is anybody else that would do a transaction with someone who might not understand the fullness of the risk?
Mr. OAKLEY. There may be, I don't know.
Mr. LAFALCE. Well, if there might be, what are the chances that there might be, and would then the concerns expressed in the Concept Release be legitimate concerns, certainly not with respect to Chase, but to enough others to warrant concern?
Mr. OAKLEY. Perhaps someone else from another firm could answer that question.
Mr. LAFALCE. Well, the fact that someone can answer the question doesn't mean that another firm would be party to less than full disclosure information.
Mr. Brickell.
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Mr. BRICKELL. Well, we have established that Chase wouldn't be writing contracts with customers like that, and we can establish that J.P. Morgan wouldn't be either.
Mr. LAFALCE. I assume no one at the table here would be. But in the real world.
Mr. BRICKELL. There are two powerful reasons, compelling reasons for that, and I think they would affect every participant in the business. First of all, for those of us that are regulated by the banking authorities, we are already required under banking supervision to take these factors into account. And if we are failing to do that in the conduct of our swap business, we will be sanctioned by the banking supervisors. But there is a second and even more important factor——
Mr. LAFALCE. What about those that are not regulated by the bank supervisors?
Mr. BRICKELL. And this second factor affects all of us. When we write a swap contract with a counterparty, we are entering into a long-term contractual relationship in which we want the counterparty to perform on his obligations. If he can't do it, we may lose money. So we are very careful. And I think all swap dealers and their counterparties are careful to enter into the——
Mr. LAFALCE. That is sort of like of a bank not wanting to give a credit card to somebody who couldn't pay, so they couldn't lose money on it; right?
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Mr. BRICKELL. It is similar.
Mr. LAFALCE. Well, some people have told me that some banks give credit cards, knowing they will have a huge loss, because of the fact they give out willy nilly, and that is OK as long as they can charge high enough interest rates. Is there some similarity and concerns there?
Mr. BRICKELL. Well, the kinds of people that are involved in this business are very different from the consumers and the general public to whom credit cards are marketed. We are writing contracts with very large value, with large sophisticated counterparties. And we want to be sure that in every case, they understand the risks well enough to be able to meet their obligations.
Mr. LAFALCE. Let me jump to Dr. Schmidt Bies, or is it just Bies?
Dr. BIES. Bies.
Mr. LAFALCE. Was that correct, that you are concerned with adequate disclosure to end-users?
Dr. BIES. I think if you look at what happened in a lot of cases, end-users have had to rely on both legal documents and verbal representations when we end up battling against our counterparty as end-users. And this debate has been going on, you know, ever since the over-the-counter market has existed. It has been addressed by several studies before. The GAO looked at the sales practices issue in a study they released last year.
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I think we would like to see the evolution toward regulation by charter, with specific criteria, like the OCC's framework or the Federal Reserve's framework on derivatives that they recently released. That is the framework we have to look at as a bank. It is important to clearly state the responsibilities of the dealer and end-user of derivatives. It is our job as an end-user to really know what we are buying. I don't disagree with that.
But when there are new derivatives out there, we need to make sure that the bells and whistles are clearly explained to the end-users. And we believe the dealers who invent these new instruments day to day are the ones best able to explain that. But it is clearly understanding the expectations on both sides that reduces the risk and the cost.
Mr. LAFALCE. Anybody else wish to comment?
Mr. JAMES. I can just take a stab at that. I think I would echo Mr. Brickell's comments that the majority of our counterparties in this business are large, sophisticated corporations and financial institutions. They have access to, in some cases, more market information than we do.
Mr. LAFALCE. How large is the minority?
Mr. JAMES. Sorry?
Mr. LAFALCE. You said a majority of your counterparties are large sophisticated, which would mean a minority is not large or sophisticated. And I am wondering how large that minority is.
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Mr. JAMES. I would have to say it is very small. You know, 1 percent, half a percent, tiny. Therefore, one also needs to realize that the market is incredibly competitive, that for any given derivative transaction, there are 20 banks, 30 banks in the world, who will give roughly the same price for that transaction, will explain that transaction to the counterparty and so forth. So the available information to counterparties is absolutely huge, if they ask.
The third point that I would make is Morgan Stanley/Dean Witter is a relationship-oriented institution. We want to do a variety of business with counterparties. We want to do their merger business. We want to do their swap business. We want to do their bound business, their equity business, the foreign exchange business, to the extent they have it. There is absolutely no economic interest for us to do transactions with counterparties which are ill-explained and result in disputes after the fact.
Mr. BRICKELL. It may be helpful to point out that this question has been reviewed by the Government in the past with respect to these kinds of transactions in the General Accounting Office report on what they called the sales practices for derivatives. And they stipulated that even though there were cases where counterparties to contracts had gotten investment results that they hadn't sought, there still was no justification, in their view, for imposing additional regulatory burdens on the conduct of the activity.
In the course of the review that Chairman Leach and you and the bill, as you have cosponsored, have suggested, it is possible that you would come to a different conclusion and that there was a need for some sort of disclosure requirement. But it is, I think, important to remember that it is impossible that you would come to the conclusion that the CFTC should be the agency that administers that system partly, because if they were to have jurisdiction, it would only be because these contracts are futures and that brings with it a host of larger problems.
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Mr. LAFALCE. Dr. Bies, would a certain type of OTC contracts where you more fill in the blanks, fill in the price rather than tailor the product, do you think that you reach a point where banks and regular securities houses are conducting exchange-like activities without the regulatory oversight normally found in an exchange environment? And what percentage of these OTC contracts are basically just filling in the price as opposed to being custom tailor-made?
Dr. BIES. I can't speak for all end-users. But in our organization and other end-users that I am familiar with, the key reason we use over-the-counter derivatives is because we can customize them. We can take our debt issue that may have semiannual payments and perfectly match the hedge with the counterparty to give us cash on those same dates. As you know, the customization allows us to avoid all the other sort of noise that goes along with the hedge—like basis risk—we can't get on an exchange.
We can pick options, or swaps, settlement dates, strike prices, and so forth. And the versatility we get is invaluable to us. For each one of these chacteristics we negotiate. We can get a lot of bids, it is competitive; but for each transaction we specify our requirements and set our risks. So, to me, each one of these is a unique transaction.
Mr. LAFALCE. Thank you.
Chairman LEACH. Thank you, Mr. LaFalce.
Mr. Bachus.
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Mr. BACHUS. Thank you, Mr. Chairman. First of all, I want to commend you on your actions. As chairman of the oversight committee, I have your same concerns, and this has been an issue that we have been concerned about for some time. And so I am glad that we are discussing it.
Let me just sort of try to boil this right down to just sort of not third grade, but something that Members of Congress could understand, so maybe you are talking fifth grade. The Commodities Futures Trading Commission are discussing regulations of swaps. They are talking about restrictions on swaps. They are talking like they want oversight of swaps.
Is that pretty much—am I right about that?
Mr. BRICKELL. That is right.
Mr. OAKLEY. Yes.
Mr. BACHUS. Now, to do that, they would have to do so under the Commodities Exchange Act, would they not?
Mr. OAKLEY. Yes.
Mr. BRICKELL. That is right.
Mr. BACHUS. That would be their basis for doing it. They can't do something without some jurisdiction. And I notice, Mr. Brickell, you said, you made two statements: Swap transactions don't fit under CEA, and it is inappropriate to regulate them under CEA. I think maybe those statements are maybe the essence of whether or not we let this agency just assume jurisdiction or whether Congress should make those decisions.
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In that regard, the CEA, I know it was originally adopted in 1922 and it was amended in 1936, and I think the last time, was in 1970-what?
Mr. BRICKELL. 1974. The last time in 1992, I guess.
Mr. BACHUS. But I mean substantially, 1972 or 1974?
Mr. BRICKELL. 1974, rewritten.
Mr. BACHUS. Were swaps around then?
Mr. BRICKELL. They weren't around in the form that they exist today. There were some primitive precursors, but not the kind of business that we have now.
Mr. BACHUS. When you tried to determine whether an act anticipated that an agency would oversee the regulation of a swap—but those swaps didn't exist when the act was adopted or when it was revised in 1936 or 1974?
I had my oversight committee look into this, and they can't really find any evidence of these transactions before the 1980's, which was, I mean, maybe late, you know, it takes a little time. So I mean, if swaps weren't in existence when the CEA was adopted or revised, it is not surprising that the regulatory scheme in CEA doesn't really fit the swap business. I mean, it would be hard to do that. Am I right about that?
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Mr. BRICKELL. Yes.
Mr. BACHUS. Which to me sort of confirms what you are saying, I mean.
Mr. BRICKELL. I think that conclusion is not only accurate, it is reinforced by the actions of the Congress. In 1992, after swaps had become a large activity, the Congress looked at this question. And they were very careful not to reach the conclusion that swap contracts could be characterized as futures. And I think it was for the reasons I have mentioned in the testimony that these contracts simply cannot be appropriately regulated under this act. Swaps are custom tailored and futures are standardized and this doesn't work.
Mr. BACHUS. You know, to me the history of the act and the history of swaps tells you that the legislative purpose could not have been to regulate these activities because they didn't exist. So to argue that they do is—I mean the court often looks at that at their interpreting and people look at the legislative intent.
Can any of the witnesses give me an example of a legal risk arising out of CFTC actions that has become a reality? In other words, just how real is this risk that we are—I am concerned about as you are concerned about it—but how real is this risk?
Mr. BRICKELL. Well, I think we have experience from recent history that tells us how real it is. It can be confirmed by some of the witnesses on the next panel. In 1987, the Commission first promulgated a document which raised the question that possibly swaps were futures. It was an advanced notice of proposed rulemaking issued in December of 1987. At the same time, they were rumored to have commenced enforcement actions against a couple of banks for some of their activities in the banking business involving commodity prices and bank deposits that were linked to the prices of commodities.
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When the marketplace realized that the CFTC thought that these kinds of transactions might be futures, we shut down our nascent commodity swap business. We continued to write interest rate and current swaps, but the innovative activity which had been singled out by the CFTC for scrutiny ended in the United States. And we either ceased completely to develop those transactions, which are quite helpful to our customers, or sent the activity offshore where it could be safe.
After that, after those events occurred, the CFTC came under the chairmanship of Wendy Gramm, and Dr. Gramm looked at the situation with her staff, which included Dr. Robert Mackay, one of the next witnesses, and concluded that swaps were not appropriately regulated as futures. That was the conclusion of the Commission.
Much of the activity came back after that, but not all of it. When you have these eruptions of legal risk, it is costly to American competitiveness. And there was a clear example.
Mr. OAKLEY. It is my understanding that a London clearinghouse, the exchange clearinghouse for foreign exchange transactions, has recently decided not to do business in the United States to help American banks reduce their foreign exchange settlement risks.
Mr. BACHUS. Pretty real.
Mr. JAMES. The last time we had this discussion in 1992, numerous transactions which would have reduced the cost of borrowing to American business were canceled as a result of increased legal risk promulgated by CFTC discussion.
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Mr. BACHUS. OK. These legal risks that have arisen surrounding these swap transactions—and I think the question was sort of asked in a little different way—but does this have really any effect on our status as a world financial center? That may be a pretty obvious question, but I want it in the record.
Mr. OAKLEY. In my view it does. When you have legal uncertainty, it has to bring question to foreign jurisdictions or foreign companies wanting to do business in the United States.
Mr. BACHUS. In other words—OK. So would you say that people are more likely to take swap transactions somewhere else in the world if they are worried about the legal enforceability of their swap transactions here?
Mr. JAMES. Absolutely.
Mr. BACHUS. I am just trying to say that in sort of a——
Mr. JAMES. Absolutely, legal enforceability is the fundamental support for contractual obligations between two counterparties. And without legal uncertainty, the way our institution operates, we wouldn't have a business in the U.S. without legal certainty.
Mr. BACHUS. I think one thing that we have all learned from being on this committee is uncertainty is a real poison to the markets and to creating a stable atmosphere for transactions. Let me go back—and this will be my last question—but I made this comment, but I didn't want to presuppose that you agree with me.
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I said that I think that Congress should consider whether swaps should be subject to additional regulations, rather than letting the CFTC make that decision arbitrarily. Would you all agree with that?
Mr. BRICKELL. Yes, definitely.
Mr. OAKLEY. Yes.
Mr. JAMES. Yes.
Mr. BACHUS. OK, all members of the panel. Do you think in that regard what the Chairman has proposed, and that is a regulatory standstill or a moratorium, is appropriate?
Mr. BRICKELL. That is consistent with the proposals from Treasury, Federal Reserve, the SEC the Clinton Administration, we think it makes sense for the CFTC to stand still until Congress has a chance to consider this question more carefully.
Mr. BACHUS. Well, I will tell you all as one of the subcommittee chairs, I hope we move decisively on this and decisively send a message that if there is to be any change of regulations, that it ought to come from Congress and not from a commission which, in my opinion, doesn't have jurisdiction over this subject. Thank you.
Chairman LEACH. Thank you, Mr. Bachus.
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I would like to turn to Mr. Bentsen. But let me say, I think we will go just two minutes and then we will break, and then I will come back to you, if that is all right.
Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
To follow up a little bit on Mr. Bachus—and I would guess that it is a question of legal enforceability, not the regulatory scheme that is your concern—that at some point in time when the book is written on what the regulatory scheme is with respect to swaps and derivatives—which I think the book has not been written at this point in time—that you are not necessarily going to be back up here saying that that would drive you offshore, that it is more of a question of the exerting of CEA over the swaps market; is that correct?
Mr. BRICKELL. There is no question that under the present circumstances, the principal cause for concern is the legal uncertainty created by the CFTC's attempt to assert jurisdiction over these activities. The exchange trade requirement is a threat to the enforceability of swap contracts. It is hard to respond to the question of what the impact of regulation would be, if a different scheme were suggested, without knowing.
Mr. BENTSEN. Granted. And I reserve judgment on that to a future date, because, as you know, Congress has wrestled with this issue for many years and we will probably for many more years. I do think that there is a difference here. We are generally, I believe, talking about institutional clients, really the private placement market; what we would call, I guess, probably not the politically correct term of art, but ''big boys'' and ''big persons,'' I guess now, who know what they are doing.
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There is a third item, I think, in controlling the market as well that we have learned from Gibson and from Procter & Gamble, and that is liability—that if disclosure is inadequate or fraudulent, that liability does come into play although—and Orange County, for that matter, although it takes some time.
Could you tell me from your perspective—and the end-users may not have a position on this, although I do agree end-users should have some representation particularly as it relates to disclosure and liquidity—but what is the dealers' position with respect to amending the CEA to allow the commodity exchanges the ability to offer derivative-type products and swap products for smaller baskets, and individual assets or stocks or securities or whatever?
Mr. BRICKELL. I will speak for myself. I would be supportive of giving the futures exchanges the ability to do things to offer transactions which they are today statutorily prohibited from doing. We are free to offer swaps on the value of single shares of stock and on the value of small portfolios of stock. And we do it every day, and our customers are helped by it. And if our clients had another alternative, another way to hedge those risks by going to the futures exchanges, I think that would be good for the economy.
Mr. BENTSEN. Any others care to comment on that?
Mr. SMITHSON. I also agree. The actions proposed are another way of trying to get more competition in the markets and that would definitely be beneficial.
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Mr. BENTSEN. My experience has been that most people are in favor of competition up here, except when it affects them personally, and then there is another issue brought to light.
Chairman LEACH. Ken, if I can suggest, we have a vote on the floor and that is to be followed by a vote. And because of the hour, I thought we would recess to a time certain to allow each of you, if you want, to get a sandwich. There is a snack bar down below, and so forth. So why don't we recess until 1:25, and then we will return to Mr. Bentsen. So the committee is in recess until 1:25.
[Recess.]
Chairman LEACH. The hearing will reconvene.
Mrs. Maloney.
Mrs. MALONEY. I really don't have a great understanding of derivatives. But I just want to know who is regulating derivatives now? Are you being regulated now, and if so, how and in what way?
Mr. OAKLEY. At Chase, our supervisor is the Federal Reserve Bank of New York and the New York State Banking Department. During the annual examinations of Chase Manhattan, they do a thorough review of our derivatives business—the way that we measure risk, the way we conduct our business and operational risk. So I would say that our primary supervisor would be the Federal Reserve Bank but we are also supervised by the New York State Banking Department.
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Mrs. MALONEY. Does anyone else want to add or have a different regulator?
Dr. BIES. I do. First Tennessee is an end user; our primary regulator is the Comptroller of the Currency because our lead bank is a national bank, so we have both the Comptroller of the Currency and then the Federal Reserve for the holding company at large.
Mrs. MALONEY. Are there any derivatives that are not regulated in our banking, securities, futures industry that have no regulation? Is there any area not regulated?
Mr. BRICKELL. One reason I think we are slow to respond is that all of us are regulated, but perhaps not in the sense that you are thinking of. All of us are subject to the strict discipline of the marketplace. Each of us has to satisfy his counterparty that he is of, for example, sufficient credit quality to be able to meet his obligations under the contract. So when we deal with each other or when we deal with others, we are very careful to analyze carefully the risks that we are taking on.
Mrs. MALONEY. And you are representing?
Mr. BRICKELL. I am from J.P. Morgan.
Mrs. MALONEY. From J.P. Morgan. So in other words, banks such as Chase are regulated, but J.P. Morgan in securities is not regulated, is that what you are telling me, except by the market? Banks are regulated by the market, too, I would say. Is that not a fair statement in a sense?
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Mr. BRICKELL. That is certainly true. And my bank, J.P. Morgan, is a bank holding company, owns Morgan Guaranty Trust Company of New York. It also owns a securities firm, J.P. Morgan Securities, Inc. And each of the business enterprises, our futures commission merchant, each of them is regulated by some Federal regulator in addition to being regulated by the marketplace. The whole group of businesses is regulated by the Federal Reserve.
Mrs. MALONEY. So everybody is regulated. As a consumer, why would I care about this proposed change of jurisdiction over to the CFTC, the questionnaire that more or less thought it should be shifted there. As a consumer buying derivatives, do I care who is regulating me? Does it mean anything to me at the bottom line, as a consumer, either in safety incentives or in dollars in my pocket?
Mr. BRICKELL. The first thing we probably should clarify is that this is not a business where Ward and June Cleaver are signing the contracts. This is not a consumer activity. Our counterparties are big corporations, government bodies, the World Bank, large institutions.
Mrs. MALONEY. In this case, they are my consumers. Take Orange County. Orange County, although it was a municipality buying derivatives, it was really representing the taxpayers of Orange County. So what I am saying, whether you are an Orange County municipality buying it or the Treasury Department or whoever is buying them, ultimately you are representing people.
My question is, what does it mean to people where it is located either—do you understand what I am saying?
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Mr. BRICKELL. Yes. Two comments. The first is, I am glad you raised the Orange County question, because it is important for us to emphasize that the kinds of derivatives that we are here talking about today, privately negotiated swap contracts, did not exist in the portfolio of Orange County. Orange County got into trouble by buying bonds, borrowing money to finance the purchase—borrowing money, using those bonds as collateral, then buying more bonds. So they took on financial risk with a completely different kind of product, not the things we are here discussing.
But the second response and much more important, you would care as a consumer, any kind of a consumer, in Orange County or as Ward and June Cleaver, about the CFTC's assertion of jurisdiction over swaps, because if swaps are futures, then swaps which have not been exempted from the CFTC's exchange trading requirement will be potentially illegal, unenforceable contracts. If that is true, then billions of dollars of transactions that are on the books of Chase, J.P. Morgan and Morgan Stanley and the companies that we help hedge risk, billions of dollars' worth of contracts will be potentially unenforceable. It is such a serious problem that the Federal Reserve Board has testified that it constitutes a potential systemic shock; and for consumers, that would be a very serious event.
Mrs. MALONEY. Can you go over again why changing to the CFTC would make some swaps illegal and unenforceable? When everybody just testified that everybody is being regulated.
What gets me on this Banking Committee, everyone complains about being regulated, but then you keep seeing these Orange Counties and other types of problems that we are called in to bail out. So you wonder, something is going wrong someplace that we are not doing our jobs right, that we are not stopping problems before they start. But—maybe that is another question, but it certainly would be causing a problem if you had unenforceable contracts.
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So go over that. Why would that do that?
Mr. BRICKELL. Under the Commodity Exchange Act, the authorizing statute for the CFTC, futures contracts are required by the statute to trade on a futures exchange. So if you have written a futures contract and it isn't listed on a designated contract market, isn't listed on a futures exchange, it could be challenged in court as an illegal, unenforceable transaction. Now, that is potentially a very big problem when we are talking about billions of dollars worth of contracts.
Mrs. MALONEY. But it is not, if you then took all your derivatives that you are selling in your Chase or your Morgan Stanley holding bank or whatever and shifted it to the commodities exchange, am I right, because then it would be covered? Am I right or wrong?
Dr. BIES. Let me speak from an end user, why I would be very troubled with that. I would compare it to the way we would make home mortgage loans or the way we make small business loans.
Mrs. MALONEY. But would it be covered if it went to the exchange, or not, is my question.
Mr. BRICKELL. If they were futures contracts and they were traded on the exchange, then they would be enforceable.
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Mrs. MALONEY. Right now—I am just trying to understand the basis of it. Right now you don't have to do that. I see. So in other words, you could continue selling, it would be unenforceable unless you switched over to the commodities?
Mr. BRICKELL. The contracts which we have already written, which are very valuable to ourselves and to our customers, would be potentially destroyed if the CFTC——
Mrs. MALONEY. But couldn't you transfer them over? Or not? You could not transfer them over?
Mr. BRICKELL. No, they couldn't be listed on the exchange unless the CFTC had approved in advance the listing of the particular contract. As we have indicated earlier today, the very nature of the business, with each contract being custom tailored and individually negotiated, doesn't lend itself to exchange trading. The business could not exist in the form it exists today on a futures exchange.
You raised the question of past episodes of financial distress where people have come to the Banking Committee after the fact and sought assistance. This is not such a case. The legislation that has been introduced by the Chairman and cosponsored by Congressman LaFalce and others is designed to anticipate a serious financial problem that would exist if the CFTC's assertion of jurisdiction were successful.
Mrs. MALONEY. I thank you. That clears it up for me. I am sorry I interrupted you, but I had a train of thought I wanted clarified and he clarified it for me. Thank you.
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Dr. BIES. And I guess the point I want to make is, when you put something on the exchange, the only way you can get the liquidity in the marketplace is for you to have enough volume of buyers and sellers for the identical type of derivative you would want to sell.
What makes the over-the-counter market so important to all of us is that, for example, when we customize a loan to a small business or to an individual, we want to do it the way the customer wants it and we do a lot of unique transactions. By using over-the-counter derivatives we are able to customize and match the risks that we end up with because we are dealing with consumers and small businesses. If we have to stick with an exchange-traded instrument, we are going to have some real problems in meeting the business needs financially of small businesses and consumers, so we are very concerned about forcing the standardization of the derivatives market that an exchange would require.
Mrs. MALONEY. I would like to ask one final question before I defer back to our distinguished Chairman. And other Members have come, and I do not want to take up their time. As a Representative that represents the great State of New York, I am concerned about a lot of activity moving banking services, banking jobs, banking transactions offshore. I want to know how this would impact on that.
And, second, if the transaction is offshore, then it no longer is under United States regulation or enforcement, and so forth, and so forth. Am I right or wrong, if it is offshore?
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I think a lot of people come to New York or, rather, to our country because they trust the transparency of our system and the record really of our banks and securities and commodities exchange and everything else. I am concerned about all this shift.
Maybe this is off the subject, but there is a lot of shift; every time I pick up the paper, somebody is moving offshore. Would someone like to comment on that? It seems to me that it would be a little bit of a problem, but I open it up to your comments.
Mr. JAMES. I think there are two relevant points there. The first relates to legal uncertainty. If Congress does not address the issue of legal uncertainty, then banks like ourselves and end users will feel uncomfortable that hedges they have put in place to hedge economic risk will not be enforceable. Therefore, if a contract is performing because the specified risk has gone against the counterparty, for example say Morgan Stanley owes the counterparty money, all of a sudden the contract is not enforceable and, therefore, is not a hedge.
That is an absolute minimum that must be addressed by the Congress. That exists now. It has been supported by the Congress in the past, and it must continue to be supported.
The second issue is a bit more gray. The costs of regulation vary dramatically with what comes out of the study, the CFTC discussion and so forth. To the extent that high costs of regulation are imposed on the market, I think we all feel that the market would tend to migrate offshore. It is a question of how high those costs are and just exactly what happens going forward in terms of regulation for the market.
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Mrs. MALONEY. Would anybody else like to comment on the offshore?
Mr. OAKLEY. I would agree with what George said, that the certainty of contracts, given the volume that Chase has booked, is very important to us. If we cannot achieve that legal certainty here in the United States, then we would have to seriously consider moving the business to a jurisdiction where we could get that legal certainty.
Mrs. MALONEY. Thank you. I yield back my time.
Chairman LEACH. Thank you very much, Mrs. Maloney.
Mr. Campbell.
Mr. CAMPBELL. Thanks, Mr. Chairman. My question would be directed to Jack Coffee, and I am not going to be here after 2:00. But it could be that members of this panel would have something to say on it, as well, so with the Chairman's permission, what I would like to do is ask Professor Coffee and then allow the other members to follow if that is agreeable with the Chairman.
Chairman LEACH. That is thoroughly agreeable to the Chairman.
Mr. CAMPBELL. There is a professorial courtesy involved here, you see. It is a subtle subtext. But in order to be recorded, the professor will have to find a seat at the table. Make a seat for the professor. It is a good rule to follow generally.
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My question deals with a parallel between the Securities Exchange Act and the Commodity Exchange Act insofar as extra territorial jurisdiction applies.
Mr. Chairman and colleague, we are talking about the business going offshore. I don't think it can go completely offshore because of the long-arm reach if the Commodity Exchange Act is interpreted the way the Securities Exchange Act has been interpreted.
Here is what I understand, and then I would like Jack to correct me if I am wrong, and the others, to tell me.
Yes, as to registration, it has to be an American exchange. But as to the antifraud provisions of the Securities Act—and you know that is what the other party is going to allege; you know they are going to try to make use of all of their remedies in the statute—the Second Circuit has held that all you need to have take place in America is a constituent element. It can be two Bahamian corporations putting it together in the Bahamas with a stopover at Kennedy Airport, at which point a document was signed. I believe that is pretty close to the actual facts of the case.
So it is not simply that you drive business offshore. You would incapacitate American businesses from taking part in swaps without the long-arm reach of the CEA, the Commodity Exchange Act, whereas truly foreign national concerns—French, English and so forth—would operate without that regime; that is, if my leap is correct, namely that the extra territoriality application of the antifraud provisions that we know from the Securities Exchange Act would be followed to the commodities side as well.
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Professor.
Mr. COFFEE. With regard to the antifraud elements, I think you are correct, that the Federal courts have developed a dual conduct or effect test. Any act, any mailing into the United States, even phone calls into the United States, could give an American court jurisdiction. This often happens in insider trading cases where someone trades from Lebanon, but winds up trading the stock on the New York Stock Exchange.
What we should be very clear about, though, is that the exemptions we are talking about today, which are in Parts 34 and 35 of the CFTC's regulations, are not exemptions from the antifraud rules. Today, the antifraud rules fully apply to both swap contracts and hybrid instruments if they are at bottom futures. All that is being talked about is the withdrawal of the exemptions which, per se, ban the trading of a futures contract off an exchange.
Mr. CAMPBELL. Will you allow me to interrupt for a second? You said, if they are determined to be futures. That of course is the whole debate here, whether a swap is a future as defined under the Commodity Exchange Act.
Mr. COFFEE. That is not a fraud debate.
Mr. CAMPBELL. Absolutely. But if it is a future, it is reached.
Mr. COFFEE. Let me take this in two steps, actually, if I can.
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Mr. CAMPBELL. Try it again. Sure.
Mr. COFFEE. If the exemption were withdrawn, then you would have a question as to whether that exemption was a nonexclusive safe harbor or whether it was a necessary exemption, and there is a huge debate over those two elements. Everyone agrees that withdrawing the exemption creates some uncertainty. They don't concede that it is therefore a futures contract, but if it were, then the conclusions are fatal.
Mr. CAMPBELL. I think then, with the risk of oversimplifying, that the answer to my question is yes, which is—and if I will put the question again, maybe you would agree that if the Commodity Exchange Act definition of ''future'' is held to apply to a swap, then insofar as any constituent element of the transaction happened in America, even if these firms attempted to go overseas to the maximum extent they could, they would still be brought in under the CFTC's jurisdiction as the court would interpret the CEA.
Mr. COFFEE. If there was fraud alleged, there is a good chance that a transaction that would be overseas for some purposes would still be a domestic transaction within the subject matter jurisdiction of U.S. Federal courts for CEA purposes.
We really should understand the distinction here that is in Regulation S of the securities laws, which says, for all of the prophylactic rules, the registration requirements, and so forth, a transaction can be considered offshore and beyond the SEC's jurisdiction, but it still is within the jurisdiction for antifraud purposes. And in both industries, the securities industry and the OTC derivatives industry, there has been great growth and considerable contentment within the industry if they are deregulated for purposes of the registration and substantive requirements, and there has not been a problem with there being some potential fraud liability. That has only come up in the fairly rare case.
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Mr. CAMPBELL. But if it is not a future, if a swap is not a future, then none of this applies?
Mr. COFFEE. That is correct.
Mr. CAMPBELL. Thank you. I think you have answered what I anticipated you might.
Now, the other witnesses, if you would like to speak to this. To me, it is a big deal. It is not just that we will drive business overseas; it is that we will forever be at a competitive disadvantage because there is an American component and CFTC would have a long-arm reach.
Mr. BRICKELL. I want to support that interpretation. As I think I mentioned earlier—and I don't know if you were in the room at the time—the burdens of driving business offshore are borne most heavily by American firms who may no longer have access to these contracts as a way to manage risk. And if their offshore competitors can use such contracts to manage risk and they can't, you have hurt American competitiveness not only in the financial sector, but in the rest of American industry as well.
This is not a hypothetical problem. In 1991, I should—full disclosure for Congressman LaFalce and others, I am not a lawyer, but we cared a lot about the outcome of this case. In 1991, in the Transnor decision, Judge Connor in the Southern District Court in New York decided that Brent oil forward contracts, forwards, traded on the price of North Sea oil out of London, were U.S. futures contracts subject to the Exchange Act and illegal, unenforceable off-exchange futures. He did that in response to a request by a private litigant.
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The immediate impact on American firms was that foreign firms ceased doing business with them in these types of contracts, and the situation was ultimately remedied by the CFTC, which was chaired at the time by Dr. Gramm, when they issued a statutory interpretation that clarified the issue and made it clear that they, as primary interpreters of the act, did not believe that these contracts were futures.
But that problem has come to pass in the recent past.
Mr. CAMPBELL. Thank you.
Mr. Chairman, I probably do this every so often, but I need to do it again. I need to put disclosures on the record. For three years I was the director of a subsidiary of Dean Witter. Professor Coffee and I served on the Stanford faculty together for one year. And Mark Brickell succeeded me as president of the student body of the University of Chicago.
Chairman LEACH. Two of the three sound as if they are conflicts.
Mr. CAMPBELL. Mark, you will have to leave.
Thank you, Mr. Chairman.
Chairman LEACH. Thank you very much. Let me thank this panel very much. You have presented very thoughtful testimony, and I think underscored the seriousness of the issue before us.
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My own view is that this is an extraordinary consumer issue and that one of the modest differences in the panel between Mr. Brickell and Mr. James, who pointed out the large users of these products—Dr. Bies has pointed out that, increasingly, smaller consumers are using it, and companies like her own in Tennessee are serving smaller consumers—but if you disrupt contracts, if you cause markets to go overseas, this is particularly devastating to those with the least access to the judicial system in a highly expensive arena.
Therefore, I do not view this issue as principally a battle between regulators or between titans of industry. I view this as a macroeconomic issue of enormous concern to the American public and to the consumers of products who desire certitude and want to see their markets at home; where if there is a problem, they know how to go to court and they have the capacity to go to court; where if there is a problem, they have a remedy within a governmental landscape where complaint can be lodged and an actor can act.
I think this has been made very clear by this panel. Let me thank you all. I appreciate your attendance. Thank you.
Chairman LEACH. Our second panel consists of Dr. Wendy Gramm, who is a Distinguished Senior Fellow at the James Buchanan Center, George Mason University, and a former CFTC chairperson. I might also add, and I think far more significantly, is a former member, I believe, of the board of advisers of the University of Iowa Business School.
Mr. John C. Coffee, Jr., is the Adolf A. Berle Professor at Columbia University Law School; Dr. Robert Mackay is Vice President of National Economic Research Associates; and Dr. Martin Regalia is Vice President for Economic Policy and Chief Economist at the United States Chamber of Commerce.
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We will begin with Dr. Gramm.
STATEMENT OF DR. WENDY L. GRAMM, DISTINGUISHED SENIOR FELLOW, JAMES BUCHANAN CENTER, GEORGE MASON UNIVERSITY, FAIRFAX, VA
Dr. GRAMM. Thank you very much, Mr. Chairman, and thank you for inviting me here to testify. I want to summarize my testimony and provide what I hope will be some historical perspective on the issue at hand.
The observations I have come from two perspectives. As former Chairman of the CFTC, when the regulations, laws and policy statements concerning swaps, hybrids and other derivatives were written, and currently as Director of the Public Interest Comment Program at the James Buchanan Center for Political Economy, whose objective is to provide policymakers with information about the impact of regulations on society. The first point I want to make today is that regulations impose costs, in the form of the added costs of doing business or in indirect form by creating uncertainty, inhibiting legitimate and beneficial activity, or stifling innovation. If these regulatory costs exceed the benefits, firms will be less able to compete effectively on world markets.
Financial markets, especially derivatives markets, are extremely sensitive to unnecessary regulatory cost since technology and competition have made it easy for firms anywhere in the world to develop and offer products and services to customers regardless of national boundaries. There are many good examples of how regulatory uncertainty can and has affected the derivatives business, and my written testimony gives some. One example also provides some important history for the current debate.
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In December 1987, the CFTC issued an advance notice of proposed rule-making suggesting that the Commodity Exchange Act applied to swaps and hybrid instruments. As a result of this release and an accompanying enforcement case concerning oil swaps, the U.S. commodities swap business went overseas.
There was also much uncertainty in the interest rate swap market which prevailed until the CFTC published its swaps policy statement in July of 1989 that removed some of the regulatory uncertainty by establishing a safe harbor for swaps. The uncertainty was further reduced with rule-makings, statutory interpretations and, of course, reauthorization—the Futures Trading Practices Act of 1992 and its implementing regulations. This set the stage for the return of the commodity swaps business back to the United States and to further development of the over-the-counter derivatives and swaps markets in the U.S.
Now, much has been said about the growth of the OTC swaps market since 1993, and the CFTC has stated in its recent Concept Release that it is reviewing all these regulations in part because of the rapid growth and changes in this market during the past five years. But the growth in this market is not surprising; it is what was expected to happen. The whole point of all the rule-makings and the law was to provide regulatory certainty through safe harbors within which these markets could develop. Indeed, we would have been surprised if these markets had not grown.
And as for change, of course markets and conditions change. That is a fact of life in a competitive and dynamic world. I thus question why the CFTC feels the need to raise questions concerning the regulation of swaps.
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So much effort went into the Futures Trading Practices Act of 1992 about these issues. Furthermore, the discussion involved all the relevant regulatory bodies, all the relevant congressional committees, and all the different interested parties from industry. In my opinion, it is premature to raise all these issues again after a relatively short period of time without a very good reason to do so. I believe it is unwise for regulatory agencies to change or threaten to change regulatory regimes often unless there is a good reason. Unnecessary changes impose costs and create uncertainty.
Instead, agencies should try to provide stability in rules, policies and procedures. Businesses and individuals need predictability and stability and some certainty. In my opinion, taxpayers dollars would be better spent if the CFTC were to focus its effort, instead, on implementing the rest of the Futures Trading Practices Act, especially using its exemptive and other authorities to reduce the regulatory burdens on its own regulatees, especially the exchanges that it oversees.
While I do not agree with the timing or substance of CFTC's Concept Release, I am also not terribly enthusiastic about bills to micromanage agencies. Elections do have consequences, after all. However, I do believe that H.R. 4062 helps to reduce the uncertainty and the fear that the CFTC will rescind or significantly alter the swaps policy statement and other regulatory safe harbors that have been created. And while I don't agree with all the premises of the bill, and I don't think that CFTC action should be subject to any approval of the Treasury, I do believe that the benefits of the bill that you propose, Mr. Chairman, outweigh my reservations.
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Finally, you asked about my views concerning regulatory structure as it relates to derivatives. This is not a new issue. I have some of the same questions I have had in the past when I have testified on this issue. What will be different? How will decisions be made? And will better decisions be made? And by ''better,'' I mean that laws are implemented without unduly burdening industry or consumers and without unnecessarily stifling freedoms or innovation. Better regulatory decisions also mean that regulations generate net benefits, benefits exceed the costs and address a systemic problem that cannot be remedied by market or other alternatives to regulation.
The problem I have is that no agency has been exempt from bad decisions, especially as they affect derivatives markets. My testimony provides some examples. While I am not yet prepared to suggest a change in regulatory structure, I am troubled by the uncertainty that has occurred in the over-the-counter markets. But before changes in either regulatory structure or the Commodity Exchange Act are made, I believe three things should be done.
One, the questions I have raised earlier should be answered; two, the CFTC should make a good-faith effort to use its exemptive authorities to provide more clarity for these markets, along with careful analysis of what regulations are truly necessary and what regulations can be removed from their regulatees; and three, existing mechanisms for resolving disputes among the regulatory agencies regarding jurisdictional issues as described in my testimony should also be used to provide greater certainty.
I would like to close with a reminder that not all products, not every single transaction nor all aspects of business have to be regulated by the Federal Government. I do not see a regulatory gap if some transaction is not regulated. Regulation should be written only if there is a systemic market failure that cannot be remedied by alternative mechanisms, including the private regulation of the market.
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The market is a stern disciplinarian, and Government is generally not as efficient or effective as a regulator. Furthermore, there are many avenues for discipline and regulation beyond Federal regulators or even financial market regulators. State level securities and fraud laws, even the Federal Trade Commission, have authorities that aid in enforcing against fraud. Besides, businesses, institutions and individuals should be free to conduct business without unnecessary regulatory burdens.
Thus, instead of looking for regulatory gaps to fill with more regulations, our markets, consumers and the economy would fare better if efforts were spent looking for unnecessary regulatory burdens to eliminate. Thank you very much.
[The prepared statement of Dr. Wendy L. Gramm can be found on page 198 in the appendix.]
Chairman LEACH. Thank you very much, Dr. Gramm.
Our next witness carries a title of extraordinary dimensions. Adolf Berle was one of the great statesmen of the century. We welcome you, sir.
STATEMENT OF JOHN C. COFFEE, JR., ADOLPH A. BERLE PROFESSOR OF LAW, COLUMBIA UNIVERSITY LAW SCHOOL
Mr. COFFEE. Thank you, Mr. Chairman, and thank you, Members, for inviting me. I agree with much of what has been said before, but I am going to give a somewhat more focused message.
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My message is very simple. The controversy that has provoked today's hearings has occurred before, and probably will occur again. Much of what Congress needs to know about it, it learned in kindergarten. Essentially this controversy is the product of two indisputable facts. One, the lines between securities, commodities and derivatives are hazy, probably involve some degree of at least arguable overlap, although the statutes say otherwise, and have rarely been interpreted by courts. Thus, there is some already prevailing uncertainty about the boundaries.
Second, our fragmented system of financial regulation gives independent regulatory agencies considerable incentive to compete for regulatory jurisdiction.
Sometimes competition is a good thing, but today's hearings are about the dark side of regulatory competition, namely, the potential ability of an agency to hold an industry captive, indeed, as a hostage, in order to cause changes that it wants from another agency. I think that that is the backdrop or at least that is the looming possibility in the regulatory conflict that we are seeing.
In my written testimony, I go on at much too——
Chairman LEACH. Excuse me, if I could interrupt for a second. I am trying to find the kindergarten analogy.
Mr. COFFEE. I think when you see certain kinds of conflicts in the sand box what you have to do is try to work out a truce and a modus operandi of living together by any means that will work. I very much concur with the Chairman's opening remarks that said legislation should be the last resort. The first resort should be a negotiated solution between contending agencies.
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I think we are seeing something of a regulatory turf war which you will see discussed at more length next week. I want to put this in perspective because your first panel has looked at this only from the perspective of the banks and the banking agencies. I think the long-standing conflicts that have existed between the SEC and the CFTC explain some of what has gone on and explain in considerable detail what some of the motives may have been behind the Concept Release that the CFTC issued in May.
Chairman LEACH. I did not mean to interrupt, but I think we have got an analogy that is fitting. At the risk of presumption, are you suggesting that any of the players in the sand box should be sent to a corner and a pointed cap put on their head?
Mr. COFFEE. I think that teachers deal with sand boxes in their own way and they know how to get the pupils in line. But I do think that the best solution is one in which two participants in the sand box quarrel are forced to work out an understanding that doesn't sacrifice the core interests of either of them.
Chairman LEACH. Very well.
Mr. BENTSEN. Mr. Chairman, perhaps the motive of your legislation would be what we do in our household with kindergartners is to call a time-out for a period.
Mr. COFFEE. I agree with the philosophy of time-outs, also. Anyway, let me get back on track.
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I have a very long memorandum here that goes through the history of some of the border wars that have occurred between both the CFTC and the banking agencies and the CFTC and the SEC. I don't want to bore you by going over that, but it is a fairly tangled history. It reads almost like a marital squabble in that there is no clear beginning; I don't think there is an end in sight. And I don't really mean to say that there are either heroes or villains in the past quarrels that have existed, but as a result, I think that the CFTC, as a fairly small agency by Washington terms, had become fairly hypersensitive to the prospect of encroachments upon its jurisdiction, because it had been the subject of raids in the past that sought to take over very significant aspects of its jurisdiction.
In that light, I think to examine what has gone on recently, we have to start with what I think was the precipitating event in the current crisis, namely, the 1997, December 1997 issuance by the SEC of a rule-making proposal which has become known to almost everyone as Broker-Dealer Lite.
I think that proposal had two very sensible purposes, one, to give regulatory relief to dealers who are somewhat more comparatively heavily regulated than banks. You didn't hear about this from the first panel because they were primarily banking affiliated persons.
Second, it had the gall, which you have heard a good deal about already today, to stem the cost-driven flow of OTC transactions abroad by reducing regulatory costs. Basically the SEC's proposal would permit a broker-dealer to set up an affiliate company in which it could combine both derivatives that were securities and derivatives that were not securities, run them as a joint lower-cost business and receive some regulatory relief. It was warmly greeted by the industry. However, this proposal clearly and possibly understandably raised the hackles of the CFTC, which saw this as an attempt by the SEC to invade an area which they had just deregulated five years earlier in 1993 in the belief that it wouldn't be regulated at all. In May, and I believe probably in response, the CFTC responded with its Concept Release.
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There are signs in that release that it was intended as a kind of regulatory shot across the bow to the SEC and to others, because typically regulatory releases are written in a way that soft pedals the amount of regulation that is contemplated.
No one wants to say there are major changes coming. They said, there is just a teensy-weensy little change we are going to make in the law. They talked about massive repeal of exemptions that had been relied upon by large industry for five or 6 years. I think there was some institutional jockeying for position going on here, because you don't normally, as a regulator, seek to be quite that provocative in talking about what you might do.
Removing these exemptions, as you have already heard, would wreak significant legal uncertainty because any kind of transaction that qualifies as a futures contract created off an exchange is, per se, invalid; and there are also some problems under State law which have a number of gaming and bucket shop provisions that apply to those kinds of contracts that are not exempted from the CEA statute.
Now, both agencies have taken a position. I think it is important to say that there is a major difference between what the CFTC has done and the SEC has recently done. The SEC has proposed to deregulate and to make things easier for dealers who otherwise have an incentive to take business abroad. The CFTC has threatened to withdraw exemptions that had been relied upon by a very large industry which has doubled in size based on those exemptions.
Before the Concept Release, there was not a hint from the CFTC over the last four or five years that it saw developing problems that made it skeptical about the wisdom of the exemptions that it granted in 1993. I, thus, have some doubt that the CFTC will ultimately, when push comes to shove, ever withdraw Parts 34 and 35.
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It may be in part their game plan that enough pressure, enough pain being caused to all, will lead the SEC to back down and withdraw their deregulatory proposals in their Broker Lite rule. If that happens, a tactic that I think is unfair will have worked, and it will probably be used again in what I think are the likelihood of continuing border wars between agencies that have somewhat overlapping jurisdiction.
Now, against that backdrop, let me say very briefly what I think should be done. Again, I agree with the proposals announced by the Chairman and the Ranking Member that a truce would be preferable to legislation. As an academic, I am a little too far removed from the inside baseball aspects of these negotiations to know just how feasible a truce is. I think a truce could take the form of a joint SEC-CFTC Broker Lite proposal which both agencies could join in and promulgate together and that would, I think, do less damage to the pride and institutional prerogatives of the CFTC.
But if a truce is not available, cannot be negotiated, then I do think that H.R. 4062 is justified, but I want to suggest just two modifications under the statute you proposed very briefly. Congressman Campbell is gone, but he knows that no law professor can look at a statute without getting an itchy feeling in his fingers and thinking just a few changes here and a few changes there and the Mona Lisa would be improved upon.
Point one that I would make to you is that the CFTC's antifraud jurisdiction would be infringed by some of the language in this statute, particularly Section 6–1. It says that the CFTC would lack authority to grant any order with respect to formally qualifying swaps or hybrid instruments. The problem there is that the word ''order'' includes cease and desist orders, which are probably one of the primary enforcement mechanisms that an agency uses to combat fraud.
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Today, Parts 34 and 35 do not in any way repeal the antifraud rules in the CEA. The danger is that 6–1 as it is currently drafted could be read to deny the CEA the authority to grant cease and desist orders solely on antifraud grounds.
In my memorandum at page 37 I suggest a fairly modest legislative fix that would say that nothing in this section would limit the ability of the CFTC to issue cease and desist orders or to pursue other antifraud remedies or seek restitution. I put some limits on it. I am sure more polishing could improve on that, but I don't think that anything that has been said today about the current crisis necessitates a reduction in the agency's antifraud authority.
The second point—again, I will be very brief—6–2 is, I think, a little bit more controversial than the rest of the statute; 6–2 would significantly change the Shad-Johnson accord. I think that the rationale for this statute is that it is essentially a moratorium, a time-out. A time-out does not include changing the Shad-Johnson accord, which is sort of the constitutional law in a loose sense of this area of securities versus commodities. In particular, the provision would disallow the provisions in one section of the CEA that require any index to meet what is called the ''substantial segment criterion.'' I explain this at more length in my memorandum.
But the problem with repealing it in one area is that it would reduce it only with regard to the OTC market, and it would not change it with regard to the exchange-traded futures contracts, and that does unlevel the playing field. You are giving an additional kind of exemptive relief not currently set forth in Parts 34 and 35, which are the rules that constitute the status quo that everyone wants to protect.
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This would go beyond protecting the status quo. It would expand the exemption, and it would not give it to the exchange-traded dealers on, say, the board of trade. I think that does unlevel the playing field.
My simple suggestion is that this legislation will look fairer and probably be easier to explain to others if it can legitimately be said that it only involves a moratorium, that it doesn't significantly go beyond what the existing status quo is under the rules that the CFTC has had in force for the last five years.
At this point, I have clearly used up my time, and I really have just those two basic suggestions if you go forward with the legislation. Thank you.
[The prepared statement of John C. Coffee Jr. can be found on page 204 in the appendix.]
Chairman LEACH. Thank you, Professor. You can be assured we will look at your provisions very carefully and vet them. This will be in partial measure a ''Coffee accord.''
Professor Mackay.
STATEMENT OF DR. ROBERT J. MACKAY, VICE PRESIDENT, NATIONAL ECONOMIC RESEARCH ASSOCIATES
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Dr. MACKAY. Mr. Chairman, Members of the committee, my name is Robert Mackay, I am Vice President at National Economic Research Associates. I appreciate the opportunity to appear to provide my views regarding H.R. 4062 and the regulation of over-the-counter derivative transactions and hybrid instruments. I should point out that this testimony reflects my own views and not necessarily those of NERA or its other officers.
As a result of the extensive scrutiny and study of OTC derivatives, a significant part of which was done by this committee over the past decade, there is now broad agreement that derivatives provide substantial benefits to end users, dealers and the U.S. economy as a whole. Moreover, as a result of the hard work and cooperation of supervisors, regulators, Congress and industry participants, there had been, at least until recently, a consensus that the current regulatory structure was adequate to address the risk and other public policy concerns raised by OTC derivatives.
Unfortunately, the regulatory compromise hammered out between 1988 and 1993 that facilitated the striking success of OTC derivatives activities has now been shattered. This hard-wrought compromise provided enhanced legal certainty and a stable regulatory framework for swaps and hybrids, but compromise now has been replaced by the loud clashing of divergent and potentially irreconcilable views of OTC derivatives. In my view, to understand what all the shouting and the associated anxiety is about, it is helpful to lay out these opposing views in as clear and straightforward a manner as possible, even at the risk of oversimplifying or possibly characterizing the views.
These two views could be summarized quite simply as, on the one hand, swaps are OTC futures; on the other, swaps are not OTC futures. I would like to briefly consider each of these views in turn; but keep in mind as I go through this, I am not a lawyer, I am just a former regulator and economist trying to make sense of the different views of an arcane and complex statute and its nexus with the latest financial innovations.
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The first view, swaps are OTC futures, appears to be the current view that is now held by the CFTC. Putting that question aside for the moment, though, in my opinion, this view of OTC derivatives and, importantly, its critical public policy implications can be briefly summarized as follows. First, swaps are OTC futures and/or commodity options. Why? Because they bear economic characteristics and perform economic functions indistinguishable from exchange-traded futures or options contracts. Second, when Congress gave the CFTC the authority to permit and regulate trading in OTC futures under this view, it did that when it enacted Section 4(c) of the Futures Trading Practices Act of 1992.
The CFTC used this authority in 1993 when it adopted the swaps exemption and exempted certain swaps from some, but not all provisions of the act subject to specified terms and conditions. So under this view, the swap exemption should be viewed as an exemption and a regulatory scheme for certain OTC futures, since it is conditional on these specified terms and conditions.
Importantly, unlike what Chairman Gramm was saying in her view, that Part 35 the swaps exemption is not a nonexclusive safe harbor, in this context, nonexclusive means if you are in, you are definitely OK, but if you are out, you may still be OK. Instead, the swaps exemption is a strict exemption with specified terms and conditions. If a swap falls outside the four corners of that exemption, unless otherwise exempted or excluded, then it is subject to the act and, in particular, subject to 4(a) the exchange trading requirement. Without another safe harbor, the swap is illegal and unenforceable.
Since swaps, in this view, are OTC futures, there is an important implication for part of this market. Equity swaps are just OTC futures on equity indices. If the swaps involve nonexempt securities, then they are not eligible for exemptions under Part 35 because of the ''. . . except for 2(a)(1)(b)'' clause in the Futures Trading Practices Act. Unless otherwise exempted or excluded, they are illegal, and unenforceable OTC futures and losing counterparties with savvy counsel, sufficient resources to sue and no fear of reputational loss can walk away from the transactions. But—for what it is worth, equity swap counterparties can continue to rely on the swap policy statement, but I think under this view that swaps are futures; the policy statement is simply a statement of the commission's enforcement priorities. So while swap counterparties don't have to worry about being sued by the CFTC for dealing in illegal OTC futures so long as their swaps fit the policy statement, they still have to worry about private litigants.
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Since 1993, the structure of the OTC market supposedly has changed significantly with swap agreements becoming increasingly standardized. Those swaps, then, that the current commission now views as being sufficiently standardized—and I should say, part of a fungible class of agreements would no longer fall within the four corners of the existing swaps exemption since they are OTC futures and are subject to the act, including the exchange trading requirement, they would be illegal and unenforceable, at least until the commission broadens the exemption under appropriate terms and conditions.
Finally, in issuing the Concept Release, the commission is just reevaluating its regulatory scheme. And if you accept this view of the world, the Concept Release does not in any way alter the current status of any instrument or transaction under the CFTC; or to put it differently, swaps were already futures and they are still futures.
Now, this view of OTC derivatives and swaps stands in sharp contrast to the view articulated by the swap industry and members of the President's Working Group on Financial Markets—other, of course, than the chairman of the CFTC. The alternative view of CFTC derivatives and its critical public policy implications are quite different and can be summarized fairly I think as follows.
First, swaps are not futures, although some swaps may be commodity options. Why not? Because swaps, while containing some elements of futures, are economically distinguishable from exchange-traded futures—and we heard some of the reasons why earlier today—and while used for risk management purposes, are also integrally related to capital-raising activities.
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Also, in this view, the exemptive authority in Section 4(c) was the result of a carefully crafted political compromise. The swaps industry and its allies, instead of holding out for a statutory exclusion, accepted the exemptive provision since there was no requirement that an instrument or transaction first be found to be a futures in order to be exempted, and no negative inference was to be drawn from not being exempted.
The compromise, in effect, provided legal certainty by sidestepping definitional and jurisdictional issues. In this view, the swaps exemption exempted certain swaps without the CFTC finding that they were futures, and it increased legal certainty for these instruments. This was important because, as generally accepted swaps possess certain elements of futures and, therefore, bore some risk of being successfully challenged in court as illegal OTC futures, for those swaps falling under the exemption, this risk was eliminated. In this view, though, the swap exemption did not establish a regulatory scheme for swaps since they are not futures and they are not appropriately regulated as futures.
Part 35, in this view, is a nonexclusive safe harbor for swaps. A swap can fall outside the exemption; for example, an electricity swap with a commercial counterparty that fails to meet the appropriate persons test might still be legal since swaps aren't necessarily OTC futures. Equity swaps are not OTC futures, and while they do not enjoy the legal certainty provided by the swaps exemption, they do have the protection of the swap policy statement which, in this view, is more than just a statement of enforcement priorities.
While not drafted as a statutory interpretation, the commission was nevertheless interpreting the proper scope and application of its scheme. Since swaps are not OTC futures and are not appropriately regulated as futures under this view, the current commission's recent Concept Release can only increase legal uncertainty since it signals a fundamental change in the commission's historical view of swaps.
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Faced with a choice between these widely divergent and contending views of OTC derivatives, what are we to do? Compromise is of course one answer, but this appears to have been tried, to the credit of the chairman of this committee, and apparently hasn't worked. Litigate is of course another answer, but whatever the outcome of that, the policy decision is likely to end up right back in Congress. We seem then, in my view, to be left with legislate as the only answer.
In my opinion, this is the correct answer both in the near term and the long term. I reach this conclusion for two reasons. First, my view of OTC derivatives is close to the swaps-are-not-futures view; and second, the public policy consequences of the other view that swaps are OTC futures are simply too adverse to be accepted. As a result, I would support a legislatively mandated standstill or time-out for any additional regulation of swap transactions and hybrid instruments by the CFTC. This standstill is essential as a short-term fix to allow Congress, the relevant regulators and the derivatives industry an opportunity to address and resolve the critical public policy questions without disrupting markets and increasing legal uncertainty.
In the long run, at the next session of Congress, Congress should take up and in my view pass a statutory exclusion from the CEA for swaps. The precise form of the exclusion, whether through the Treasury amendment or a separate provision, or even as proposed as Senator Lugar last year, a statutory exemption, is not as important as finally clarifying that swaps are not appropriately regulated as futures. Congressional action is necessary since moving to a regime where swaps are viewed as OTC futures, in my view, will have the following consequences. It will expose equity swap activity to significant legal risk with a potential for substantial market disruptions. It will expose other nonexempt swaps to additional legal risk and impede financial innovation. It will expose swaps that counterparties had legimately thought were exempt, the more standardized plain-vanilla swaps, to unanticipated legal risk as the commission snatches the four corners of the swap exemption from under these transactions and, in the process, threatens the safety and soundness of the banking system.
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Finally, it will increase the regulatory burden on swaps activity without offsetting benefits as the CFTC restructures its regulatory scheme along the implicit, yet transparent and, in my view, unwarranted lines drawn in the Concept Release.
Thank you for the opportunity to testify. I am happy to answer your questions.
[The prepared statement of Dr. Robert J. Mackay can be found on page 246 in the appendix.]
Chairman LEACH. Thank you, Professor Mackay.
Professor Regalia.
STATEMENT OF DR. MARTIN A. REGALIA, VICE PRESIDENT FOR ECONOMIC POLICY AND CHIEF ECONOMIST, U.S. CHAMBER OF COMMERCE
Dr. REGALIA. Chairman Leach, my name is Martin Regalia, and I am Vice President for Economic Policy and the Chief Economist for the U.S. Chamber of Commerce. I am here today representing our members on an issue of great importance. And we appreciate the opportunity to comment on the recent CFTC Concept Release and on the proposed legislation to reduce the market uncertainty caused by this action.
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For many years, participants in privately negotiated derivative contracts have been concerned about the uncertainty over whether these transactions come under the purview of the Commodities Exchange Act and its general requirement that transactions covered under the act be traded on an exchange or be deemed illegal and unenforceable.
A series of policy statements, findings, exemption letters involving virtually all Federal financial regulators and the Congress over the past ten years had established the view that such contracts, particularly swaps, should not be regulated as futures contracts under the CEA. The recent Concept Release by the CFTC has shattered this uneasy peace and once again raised the question of whether privately negotiated derivative contracts are futures and should be subject to the CEA requirement that they be traded on an exchange.
While the CFTC claims to have done nothing but raise questions, the heightened level of uncertainty precipitated by its action can have a significantly negative result of driving these activities offshore, to the detriment of current and future users of swaps contracts.
Other financial market regulators, the Federal Reserve Board, the Securities and Exchange Commission, and the U.S. Treasury, as well as market participants, have voiced strong concerns at the unilateral action of the CFTC and proposed standstill legislation until such differences can be sorted out.
The U.S. Chamber shares the concerns of these groups and supports legislation to return to the stability of the status quo until all interested parties can be brought together to address this issue. Now, clearly we would support a nonlegislative solution to this problem as preferable, but if that is not available, legislation is warranted.
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One might wonder why the Chamber would become involved in what some might see as only a financial market issue or a regulatory turf fight among financial market regulators. We see this issue as much more than that.
Our members operate in all facets of this business as end-users and as dealers. The CFTC action places them at increased risk of loss and encourages them to operate offshore. Furthermore, the CFTC action is a clear example of a rush to regulate before the fundamental questions such as the need to regulate, how to regulate and who should regulate, have been answered. The Chamber does not purport to have answers to these questions, but we strongly believe that they should be addressed before action is taken that can cause more harm than good.
Legislation such as that proposed by yourself, the SEC, the Fed, and the Treasury will allow for that much needed discussion. Thank you.
[The prepared statement of Dr. Martin A. Regalia can be found on page 257 in the appendix.]
Chairman LEACH. Thank you very much.
Personally to say to Professor Coffee, staff looked over your testimony in advance and has spoken with the Fed, the Treasury, and the SEC and they are not attracted by your principal suggestion, and they argue that your fix for antifraud would again allow the CFTC to call a swap a future in order to take an enforcement or a cease and desist order, and this would then have the effect of disrupting the market. Would you concur in that assessment?.
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Mr. COFFEE. No. I mean what we have been talking about all along is a status quo under which the OTC market has doubled in size in the last three years. It has doubled with, apparently under the statute, antifraud liability being at least latent. There is nothing that exempted the ability of the CFTC to go to court or to seek a cease and desist order if it believes there was fraud in a situation not unlike the Procter & Gamble situation.
Chairman LEACH. In the Procter & Gamble situation, we should be very clear, it was the Fed that acted first, and very strongly.
Mr. COFFEE. All three agencies took action, actually.
Chairman LEACH. They did, but it was led by the banking regulators.
Mr. COFFEE. There are non-banks that are dealers and swaps.
Chairman LEACH. Of course. But all I am getting at is that it isn't as if there is no fraud regime that can come into play without the CFTC asserting jurisdiction.
Mr. COFFEE. Well, let me make a basic generalization. I would regard the SEC and the CFTC as having some comparative advantage as antifraud regulators, where I think the banking agencies may well have some comparative advantages in terms of solvency regulation. Their historic focus has been on the protection of the safety and soundness of the banking system.
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Chairman LEACH. But to interrupt you there, the banking statutes and practices go way beyond fraud; that is, they in many ways have higher standards; that is, they can cause banks to cease and desist if they think they are damaged, if their reputation is being damaged, for a whole spectrum of reasons that aren't only fraud. They also can act in fraud.
Mr. COFFEE. I do not think you can compare the history of banking regulation with the history of either SEC or CFT regulation and say that the banking agencies have done more in terms of protection of the end-users. The concern of bank regulators has essentially been to ensure that the banking agency, including as a swap dealer, not get itself in such trouble that it could begin to jeopardize the financial system.
When we talk about fraud agencies, I think the SEC has always led the way, but I think, particularly in recent years, the CFTC has done significant work in the area of antifraud regulation. And I don't think the basic thrust of today's hearings, which is that there is a need for a moratorium to protect the status quo, needs any action that takes us beyond the status quo and cuts back the antifraud rules.
Essentially, this entire proceeding is brought about because of the threat that Parts 34 and 35 might be rescinded or modified. They have never said a thing about cutting back on antifraud liability. So I am just suggesting that if you protect Parts 34 and 35, you have done the minimum thing necessary, and it is easiest to justify this as emergency moratorium legislation.
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Dr. MACKAY. Can I just add, Mr. Chairman?
Chairman LEACH. Yes, of course.
Dr. MACKAY. In my reading of the P&G case in particular, the Commission did not say they had committed fraud in the transaction of futures contracts. They listed a set of contracts in the back, some of which refer, obviously, to commodity option contracts. P&G was charged with fraud as a commodity trading adviser. In fact, one can read the swaps exception, such that the fraud, the retention of fraud authority only applies if the transaction is a futures. If swaps aren't futures, the fraud authority has no application.
And so it is not clear that your interpretation of the status quo is the status quo as I was laying out, for those people that believe swaps are not futures, that retention of fraud authority is not there. There is other fraud authority, as the chairman mentioned, but that is not one. And so whether the status quo involves that or doesn't I think is open to issue.
Mr. COFFEE. If I can, maybe just a one-sentence response. I am not trying to argue who is right and who is wrong on the particular issue that was presented or whether or not it is an exclusive or a nonexclusive safe harbor. But that issue is there. That is why there is uncertainty. If it was perfectly clear that swaps were not going to be future contracts, then the threat to repel chapter 35 would be meaningless, because it is only the possibility that it might be at least seen by some courts as a futures contract makes it important to keep chapter 35 in place.
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So there is this tension. And I think the status quo probably has to recognize that there is some tension and simply make sure that it not be changed in any significant period of time until the working committee comes back with its long-term proposals.
Chairman LEACH. Dr. Gramm, would you like to comment on this?
Dr. GRAMM. I think we should get back to the issue at hand, and that is that if there is fraud going on in a particular market, there are a lot of enforcement agencies, not only at the Federal level, that can be brought into play. Very often in real cases, you might not know at the beginning of an investigation exactly what that instrument is to begin with. And agencies very often work together, along with the State and local fraud authorities, especially as it deals with securities or other financial types of transactions.
I would argue that this whole discussion about whether or not fraud ought to be in or out of your legislation is really beside the point. That is, if there is something fraudulent going on, what typically happens in enforcement cases is that as you begin to investigate, if the CFTC looks at it, and determines that it is not in their jurisdiction or they can't tell, they can very easily pass that case off to other regulators and enforcement officials that do have jurisdiction. So I think it is really a nonissue.
With regard to some of the cases that have been mentioned concerning derivatives losses, I would like to point out that, in fact, the private sector and private market discipline worked quite well. In fact, as you know, cases were brought between the market participants themselves. So I think the fact that people get hung up on this issue is just a way to raise potential problems with the bill.
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I don't see this as a real issue. If we have a standstill and the CFTC were not able to do fraud at all for any kind of swap and they think there is something going on in an area, they can certainly do what we always do through working groups. We have fraud task forces, and so forth, to share that information with other authorities, including the State and local fraud authorities as well.
Chairman LEACH. Thank you.
Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman.
It is true, I guess, that the Gibson case and the BT case ultimately were settled through litigation and regulatory authorities. But, Dr. Gramm, are you of the belief that there is no gap, and this is getting a little off the subject of why we are here today, but that there is no regulatory gap in the derivatives market today? I think there are two or three markets really, as with all securities. There is the institutional market, the private placement market, which are almost one and the same it would appear, but there is still some concern in the retail market.
And there have been some less high-profile cases, both with public entities, some in our home State, and as well as some retail buyers of various Ginnie Mae and Fannie Mae derivatives. And again I think the book is still out on that. But I would be interested in your opinion.
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Dr. GRAMM. The points that I think are very important is that I don't look at every single transaction and say who is looking at that particular transaction or monitoring business between an individual and their counterparty or the person who is selling them that product. The market regulates that, and there are a lot of opportunities for the markets to work, including to discipline bad behavior.
So, if you look across the board at a lot of the so-called losses that have occurred, some of them have not even involved derivatives. Derivatives is such a broad term these days, but some of the losses haven't involved derivatives. Some of the problems would not have been prevented by any further regulations. Some of them were due to internal mechanisms that were simply avoided or were weak.
Mr. BENTSEN. I guess my concern is only—and I don't disagree that there is a market, there is a market issue that a dealer who is selling product that they cannot stand behind or make a futures market in, or is not properly structured, ultimately will have no buyers. But on the other hand, a dealer that is using fraudulent sales practices or sales pitches ultimately may be caught. But the buyer at the other end may suffer great financial harm.
Dr. GRAMM. Well, my point, though, is that if there is a sale that has been made that has been due to either misrepresentations or fraud, that there are a lot of authorities to deal with that, not only the Federal Trade Commission, but the law enforcement authorities, be it at the State level—district attorney-type offices, the securities regulators—working together.
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As a matter of fact, there used to be fraud task force working groups, because very often when you have or identify a fraud, you know people might have been hurt, but you don't often know what is the underlying product. And so there is an awful lot of general authority by other regulators as well as State and local enforcement officials.
Mr. BENTSEN. I read Mr. Coffee's statement, I didn't read the whole thing, I was scanning it. I believe he said that the SEC determined in the Gibson case that 10(b)(5) would not apply. Did I misread that and the purpose——
Dr. COFFEE. In the Procter & Gamble case, they did assert a 10(b)(5) theory, and it was settled with the defendant.
Mr. BENTSEN. With a 10(b)(5).
Dr. MACKAY. If I could pick up on your point, because you raised the retail issue and it is one we tended to slight a bit today in terms of—we focused on the swap side of this issue rather than the hybrids, and I think it is important to recognize that these instruments do have, in my opinion, an important role to play at the retail level. To have a certificate of deposit in which the return is indexed to the upside on the S&P can be a fairly attractive product. To have one that it is indexed on the upside to the index of housing prices in central Florida, if you are trying to save the down payment on your home, that is a nice product.
So I think there is an important role here for these derivative products, even at the retail level. Under the hybrid release, they are going to be offered subject to banking regulation or securities regulation. And I think that is appropriate, and those benefits can then flow down to the retail level. And I think that is probably an important issue we are going to have to face in the future on the swaps side also.
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Mr. BENTSEN. If the Chairman will bear with me, because I do have some pertinent questions to the issue, but this is such a stimulating hearing today that it has piqued my interest. But your testimony got me to one of my favorite subjects, which is, I guess, the point that the SEC provided the exception under 10(b)(5) for OTC dealers not to be broker dealers under the requirement.
Does that then create some regulatory gap, in your opinion, in the OTC swaps market?
Mr. COFFEE. Well, I don't think by giving that exemption, it did. What happened in the Procter & Gamble case, which you were correct to point to, was although the SEC had earlier said in the Gibson's Greetings/Bankers Trust case that an interest rate swap was subject to 10(b)(5), the Procter & Gamble court found that an interest rate swap was not subject to 10(b)(5) and that would mean that the only agency with the practicability to monitor would be the CFTC. And that is why I am a little concerned about carving away its antifraud authority through cease and desist orders.
I am not trying to say that this market has endemic fraud. I think it is one of the best and soundest markets that we have, because it is a wholesale sophisticated marketplace.
Mr. BENTSEN. I want to associate myself with your remarks. I agree with you. I think it is a very sophisticated, a very efficient market. But I think there are concerns both in the high-profile institutional cases as well as in the retail case, of disclosure, I guess, more than anything else, and what is and what isn't proper disclosure, which is true in all markets and very hard to define.
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Let me ask if I might, Dr. Gramm, from your previous experience—I had asked the earlier panel about this—what would be the problem of opening up the swaps market to the commodity exchanges. I don't know whether there would be a broad enough market for them to actually list a single stock swap or a single rate swap of some sort. But would you see a particular problem in that?
And as a follow-up to that, to the others perhaps, or to Dr. Gramm, would that potentially open up—if you gave the exchanges that authority, where of course they under CEA, the CFTC, would have some regulatory authority, at least on the actions of the exchanges, would they then again be opening the door to the CFTC moving on to other swaps?
Dr. GRAMM. As I understand your question, I would not be opposed to the ability of the exchanges to propose a futures contract for trading on their exchanges—a contract that might even look like a swap or a contract that would be for a single security. That is an issue that as you know is quite controversial, especially with regard to the securities community. But as I understand the Shad Johnson Accord that goes way back to 1982, that, in fact, when the Shad Johnson Accord was agreed upon, there was an understanding—and the exchanges could probably help you with this—there was an understanding that there would be consideration in the not too distant future of allowing futures on individual stock.
And I think we have moved away from that agreement in the subsequent years. So I think it is something that had been contemplated as early as 1981 and 1982, and it is something that I think is definitely worth contemplating again. And it should be, again, on an even footing, to the extent that the futures exchanges would be given the authority to do this.
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Mr. BENTSEN. Is that a potential kindergarten-like approach to give that authority to the exchanges in return for the CFTC not trying to exert its authority, in defining what its authority is with respect to swaps, in order to ensure that the OTC market is not under CFTC; but if the CFTC market wants to do it, they can do it; or are there problems inherent in that?
Dr. GRAMM. I am not sure I understand your question. But if I understand what you are referring to about what happened in the subsequent period—I do think that there is concern, and appropriate concern, that there should be some equity in the treatment with regard to these instruments.
Mr. BENTSEN. Well, maybe a more simplistic way if we decided to do that, and then CEA, and then——
Dr. GRAMM. To allow them.
Mr. BENTSEN. To allow them to do that, and then the CFTC then had regulatory authority, at least for the operational functions of the exchanges, could then CFTC attempt to extend its regulatory authority beyond the exchanges to the OTC market?
Dr. GRAMM. Not on the basis of that one action alone, I don't think. I mean the point is that unless you really deal with the other problems, which from time to time allows them to go out and create this kind of uncertainty, which is a separate issue from that one alone.
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Mr. COFFEE. Just to clarify. There is one legislative obstacle today, which I think I agree with Dr. Gramm is probably out of date and probably doesn't need to exist; that is, the CEA would not allow any of the contract exchanges, any of the futures markets to trade either a future, a swap or any other instrument on a small stock index; for example, the 25 leading Internet stocks or the 25 leading software stocks.
There probably would be a market for that kind of instrument, because we see it in the world of equity swaps. And I do not know if that is the kind of provision that needs to remain, it may be a little anachronistic. It was inserted originally at the time of the Shad Johnson Accord because of concerns about that kind of instrument being a vehicle for insider trading and there not being an insider trading prohibition at that time in the CEA.
I think you can cure that. You can make sure that inside trading is prohibited under both statutes with regard to those instruments. But I don't see any reason why we should bar the Chicago exchanges from being able to trade instruments on relatively small indexes.
Dr. MACKAY. Could I just triple that? The SEC just recently turned down the Board of Trade's application to trade futures on the Dow Jones Industrial or Dow Jones Transportational Index. I should disclose I was the Board of Trade's expert in that case, given that they were appropriate indices. But I think that sort of action, I totally agree with your sentiment, I think the market should be the test in that case in whether or not those products——
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Mr. BENTSEN. Did they turn it down on the basis of the CEA?
Dr. MACKAY. Yes, that they were not sufficiently broad-based indices to be allowed to trade.
Mr. BENTSEN. Thank you, Mr. Chairman.
Chairman LEACH. As some of you may know, the most innovative trading index in America is in Iowa City, Iowa. It is a political trading circumstance. You can bet on the candidate of your choice, and it ends up that investors have had better judgments than political pundits. Anyway, let me thank this panel. You have been exceptional, and I appreciate very much your comments.
Our third panel is composed of Mr. Scott Gordon, who is Chairman of the Board of Directors of the Chicago Mercentile Exchange; Mr. Patrick H. Arbor, who is Chairman of the Chicago Board of Trade, and Mr. Daniel Rappaport who is Chairman of the New York Mercantile Exchange.
Let me apologize to all the witnesses for the tardiness of the hour, as well as the fact that Congress has adjourned, and therefore many Members have left for the weekend.
But I very much appreciate your attendance. And I assure you that the transcript will be widely shared. Unless there is an agreement to the contrary, I will go in the order in which you have been introduced. Would you prefer to change the order, I am happy to do that too.
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Then we will begin with Mr. Gordon.
STATEMENT OF M. SCOTT GORDON, CHAIRMAN OF THE BOARD OF DIRECTORS, CHICAGO MERCANTILE EXCHANGE
Mr. GORDON. Thank you, Mr. Chairman, and, Mr. Bentsen. My name is Scott Gordon. I am Chairman of the Chicago Mercantile Exchange. We welcome this opportunity to comment on H.R. 4062 and the CFTC's Concept Release respecting over-the-counter derivatives. The OTC derivative market has mushroomed in size and scope since the CFTC's swaps policy statement in 1989.
During this period of rapid market change and growth, the types of contracts traded, the customers participating, and the means by which trading is conducted have all changed. It is an understandable response to radically altered conditions that the agency responsible for the regulation, Part 35, reevaluate the terms of its exemption. The CME believes that the CFTC is the correct agency to exercise that responsibility.
The OTC derivatives business has been conducted pursuant to CFTC exemption. Many of the instruments traded in the OTC market are clearly contracts of sale of a commodity for future delivery governed by the CEA, Commodity Exchange Act. The CFTC is the agency most familiar with the derivative trading issue.
The CME's support of the Commission's jurisdiction to issue the Concept Release may not, however, be taken as support of any change in the scope of this swaps exemption. Obviously, the OTC has grown exponentially despite well-publicized losses. It must be providing a service that its customers value. CME does not believe that a case has been or will be made for imposing more CFTC regulation on that market.
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However, CME is certain that a strong case may be made against weakening those provisions of Part 35 that preclude the OTC market from retaining the advantages of its unregulated status while replicating the fundamental functions and features of exchange-traded furtures contracts. In particular, the CME opposes any effort to eliminate those provisions of Part 35 that limit the exemption to nonstandardized, privately negotiated transactions that are not executed by means of an electronic trading system or settled through a clearinghouse, if such trading or clearing system is not subject to appropriate CFTC regulation.
At the time the Commission crafted its swaps exception, swaps contracts were individually negotiated in face-to-face transactions between end-users and banks or dealers. A substantial segment of the market now consists of standardized contracts known as plain vanilla swaps, traded by means of electronic systems or formally organized broker markets. Those contracts are indistinguishable from standardized futures contracts, and the trading systems are beginning to look exactly like organized exchanges. The instruments are futures contracts equivalents; the trading is done through exchange-like facilities.
H.R. 4062 appears to be a response to the strong reactions against the CFTC's Concept Release, rather than to the substance of that release. The findings section calls for bringing regulation up to date, but the bill precludes the CFTC from taking steps to propose any rule, regulation, or policy statement that is necessary to accomplish that goal.
The bill does nothing to restrain the SEC's efforts to adopt its proposed ''broker/dealer-lite'' rules that are designed to take over regulation of certain nonbroker-dealer participants in the OTC derivatives markets. Instead H.R. 4062 establishes a Working Group on Financial Derivatives that is dominated by bank regulators, rather than market regulators.
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Section—and this is something that Professor Coffee had stated earlier—Section 62 alters the provisions of the Shad Johnson Accord and the CEA, the Commodity Exchange Act, that prohibit OTC equity swaps that are contracts of sale or a commodity for future delivery. The CME objects to any alteration of the Shad Johnson Accord that does not provide equal treatment to the exchanges. In this case, evenhandedness would exempt any exchange-traded instrument for which application has been made prior to enactment of H.R. 4062 to the same extent as OTC equity-based derivatives are exempted.
The CME is not, though, opposed to the relief proposed in H.R. 4062 for transactions entered into in good faith prior to the enactment of the bill. The CME objects to relief for the OTC market that is not coupled with equal treatment for exchange-based transactions. H.R. 4062 has been cast as a standstill proposal in response to the emergency created by the CFTC's Concept Release. The bill is not a standstill proposed zone. We don't believe that there is an emergency.
We think that the bill impairs the CFTC's enforcement activities and expands the existing exemptions. In addition, H.R. 4062 appears to be a first step in the transfer of jurisdiction for futures contracts that are not traded on CFTC's regulated exchanges from the CFTC to other regulators.
The CME urges the committee to look at the actual effect and implication of H.R. 4062. A fair reading demonstrates that the bill has enormous jurisdictional, or may have enormous jurisdictional and regulatory consequences that should not be adopted without a clear understanding of the long-term after-effects on all of the impacted parties.
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Thank you, Mr. Chairman.
[The prepared statement of M. Scott Gordon can be found on page 262 in the appendix.]
Chairman LEACH. Well, thank you very much for your dissent.
Mr. Arbor.
STATEMENT OF PATRICK H. ARBOR, CHAIRMAN OF THE BOARD, CHICAGO BOARD OF TRADE, ACCOMPANIED BY THOMAS R. DONOVAN, PRESIDENT AND CHIEF EXECUTIVE OFFICER
Mr. ARBOR. Good morning, Mr. Chairman, and Members of this committee. I am Patrick H. Arbor, Chairman of the Chicago Board of Trade, and I am joined today by Thomas R. Donovan, the Board of Trade's President and Chief Executive Officer. We are certainly pleased to appear before you on this important topic. In today's technology-driven global markets, over-the-counter derivatives and exchange-traded derivatives are closely intertwined and converging.
Like exchange-traded instruments, these over-the-counter derivatives offer market participants an opportunity to manage or assume the risk of price changes. And like exchange instruments, over-the-counter derivatives transactions are entered into mostly by highly sophisticated professionals and financial institutions.
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Although both the over-the-counter products and exchange-traded products serve the same purpose, involve the same market participants, today both markets are regulated in a very, very different manner. Very simply, the exchange markets are heavily regulated, and over-the-counter markets face very little regulation.
Now, over-the-counter markets have thrived under this minimalist approach to Government oversight. The Board of Trade is not asking for changes in that approach or to ratchet up regulation of over-the-counter markets. Instead, we are simply asking for regulatory parity so that we can fairly compete with and effectively complement these over-the-counter markets. That has been our consistent message for a number of years.
We still believe that regulatory parity is the only fair way for Congress to foster competition based upon the merit in the marketplace, not regulatory arbitrage.
Now, the CFTC's Concept Release is not aimed at achieving regulatory parity for exchange markets. To that extent, it is very disappointing to us. On the other hand, we disagree with those who believe the CFTC's release is improper.
We do believe that the CFTC has jurisdiction to regulate over-the-counter derivatives transactions that our futures and options. We do believe that transactions traded off exchanges may be subject to CFTC jurisdiction. And we do believe that the CFTC should reassess its past exemptive actions as changing market conditions warrant.
Our major problem with the CFTC's release is this: that rather than narrowing regulatory disparity, the CFTC is contemplating widening that gap. According to the release, the CFTC is considering whether to expand the scope of its swaps exemption to include even off-exchange swaps that are standard and fungible; for example, today those instruments would not qualify for regulatory exception. Yet, the CFTC did not ask us, the exchanges, for any comment on any comparable new exemptive relief for identical standardized and fungible products when they are traded on our already regulated exchanges.
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So the release, therefore, typifies the recurrent ''out-trade'' that we have with the CFTC. The Commission's operating premise is that only exchanges need regulation because of the price discovery and clearing services they provide. That kind of thinking is seriously outdated and fosters unfair competition. We have adopted strong and effective safeguards against threats to market or financial integrity. We have every incentive to maintain those safeguards. Exchange clearing systems disperse risk, rather than concentrate it. In the computer age, price discovery is a 24-hour global process that is not constrained in any way by a trading pit.
Mr. Chairman, your legislation, H.R. 4062, recognizes that. It recognizes that technology and other innovations have altered many traditional distinctions between exchange and over-the-counter markets. We agree with you that a comprehensive review and overhaul is needed to bring derivative regulations up to speed with developments in all derivative markets.
That review and accompanying moratorium should include the pending application of the Cantor Financial Futures Exchange. Many in the exchange community, both securities and futures exchanges, oppose that application, because it would be contrary to the public interests. It would allow Cantor Fitzgerald, a firm with a dominant position in the over-the-counter Government securities brokerage, to control a futures exchange. The Cantor Financial Futures Exchange would use the same trading mechanisms, the same trading models and personnel for its futures exchange that they use to broker over-the-counter transactions in the cash Treasury securities market.
That proposed convergence of over-the-counter and exchange operations is exactly and precisely the kind of development that your legislation's comprehensive approach is designed to handle in a rational, prudent, and orderly fashion. The current framework for derivatives regulation promotes blatantly unfair competition, as events this week have demonstrated.
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Just yesterday—and I would like to submit this as Exhibit 1—as Dr. Coffee and Dr. Gramm mentioned before me, the Securities and Exchange Commission issued its final decision rejecting the Board of Trade's application to trade futures contracts on the Dow Jones Utility Index Average and the Dow Jones Transportation Index Average.
Both stock indexes are well known and have been used by market participants for many years to gauge stock price movements in these important and substantial market sectors. Both stock indexes also are the subject of options trading; in fact, the SEC approved those options just last year. At that time, the SEC concluded that options trading on these indexes would be in the public interest and would not be susceptible to manipulation. Now the SEC says that the futures trading on the exact same indexes could be subject to manipulation and should be banned. Well, if they are not subject to manipulation and should not be banned south of Van Buren Street, it is hard to conceive why they should be banned and subject to manipulation north of Van Buren Street in Chicago.
The reason for that ban—the SEC says that the Dow Jones Utility and Transportation Indexes do not reflect and measure the utilities and transportation sectors of the stock market. But the real reason, the actual reason is that the SEC regulates options but not futures. Now, that kind of Government decisionmaking, based on turf and not the merits, is exactly what needs to be eradicated from our system. Preventing market participants from getting access to important risk management products because of jurisdictional prejudices should simply not be tolerated any longer. In a global marketplace, those kinds of petty disputes will hurt U.S. markets and only benefit our competitors overseas.
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We are concerned, furthermore, Mr. Chairman, that Section 6 of H.R. 4062 would also further the competitive disparity that the SEC's recent action has created; because under that section, any dealer in the over-the-counter derivatives would have been free to offer a swap on the Dow Jones Utility or Transportation Index and not have to worry about the same Shad Johnson provisions the SEC invoked just yesterday against the Chicago Board of Trade.
Now, we know and appreciate the equity swaps dealers' need for legal certainty, and we have no problem with their objective. We simply would like to have the same exemption from Shad Johnson to apply to the exchange-traded futures as well. And I think that was buttressed and supported by Dr. Coffee and Dr. Gramm before me. In short, the regulatory status quo is simply unacceptable.
We would welcome the study your legislation contemplates, particularly since it calls for specific recommendations to modernize and harmonize our current regulatory framework. We would urge you to include a balanced, fair, and complete moratorium as part of that legislation. But even if no legislation is enacted, the Board of Trade believes that the study and recommendations your bill contemplates are important work that should get done by the President's Working Group, even if it means that each agency independently would offer its own views for public debate and discussion. Indeed, one of the benefits of a comprehensive study would be the breadth of Federal regulatory perspective involved.
With the CFTC, the SEC, the Fed, and the Treasury analyzing these issues, nothing should be off the table, including the necessary changes to the unfair Shad Johnson Accord restrictions. Only a thorough, top-to-bottom inquiry could hope to cover all the multifaceted and interrelated issues that must be addressed. U.S. exchanges and others must be allowed to compete in the global marketplace where, every day, technology is overcoming antiquated market systems and barriers.
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The current controversies surrounding the issuance of the CFTC's Concept Release shows that maintaining the statutory status quo is not a long-term solution. Congress must consider dramatic reforms of the Commodity Exchange Act sooner rather than later. Thank you.
[The prepared statement of Patrick H. Arbor can be found on page 267 in the appendix.]
Chairman LEACH. Thank you very much, Mr. Arbor.
Mr. Rappaport.
This is one of the first times New Yorkers have been outnumbered by Midwesterners.
STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK MERCANTILE EXCHANGE, ACCOMPANIED BY PATRICK THOMPSON, PRESIDENT
Mr. RAPPAPORT. With me today is Patrick Thompson, President of the Exchange. Five years ago when the CFTC exercised its exemptive authority under Section 4C of the Futures Trading and Practices Act, there was virtually unanimity that the CFTC had acted reasonably and had done the right thing for the marketplace. Five years later after, witnessing explosive growth and material changes in the OTC market, we think that in issuing its Concept Release, seeking input on the OTC market, the CFTC is acting reasonably and in the long term is once again doing the right thing for the overall marketplace.
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Over the last five years, OTC trading has matured and evolved. A high percentage of OTC trading is not the exotic customized products it once was. Products traded OTC have become very standardized, and in most cases they are identical to the products traded on the regulated exchanges.
What is the rationale or what is the justification for having a heavy-handed level of regulation on the exchanges while having virtually no regulation on the OTC markets when the products traded are identical?
Mr. Chairman, I have been looking for an answer to that question for the last three years. And if I could get an answer to it, I would stop my comments here. However, I don't expect you to answer it, it is a very difficult question to answer, but we are happy that you are holding these hearings today to make an effort to address those issues. But the CFTC, we believe, has correctly recognized that one marketplace requires harmony of regulation.
We think it is unfair that they are being the object of severe criticism because they have had the courage to ask the difficult questions and raise the difficult issues. Our fear is that if regulatory jurisdiction is fragmented, OTC will wind up with a light-handed level of regulation and a regulator with a liberal laissez-faire perspective, while the exchanges will continue to be compelled to fight a battle with one hand tied behind our back.
Our greatest fear is that in this fragmented regulatory environment, the more liberal regulator will permit the creation of an OTC clearing entity. If that happens, Congress and the regulators will have selected the winner, and the exchanges will be out of business. In addition, it would be very difficult for Congress and the regulators to manage a derivative crisis in an emergency. All of the relevant information will have disappeared from the regulatory radar screen.
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Mr. Chairman, we support a nonlegislative solution to this issue. We have read all of the various correspondence that have been exchanged between the agencies and the various committees. We have even read the most recent correspondence from Chairman Smith to the respective regulators. We understand that some of the regulators don't even support that. We don't think that it is appropriate that standstill legislation applies only to the CFTC. It is our fear that if that occurs, as we said before, more liberal regulators or unregulated markets will make encroachments upon our marketplace, and we think that could be devastating to our marketplace.
We think that a nonlegislative standstill is the appropriate solution for now, until Congress has had the time to consider this matter. But we firmly believe that such standstill should apply to all the regulators and that the CFTC shouldn't necessarily have to get the Treasury's consent before it exercises its proper regulatory authority.
Thank you, Mr. Chairman.
[The prepared statement of Daniel Rappaport can be found on page 272 in the appendix.]
Chairman LEACH. Though you have read the correspondence, what did you think of the suggestions of the CFTC and how to modify the agreement to fit their needs?
Mr. RAPPAPORT. We thought that CFTC's suggestions were actually reasonable, in a sense——
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Chairman LEACH. Can you read blank paper?
Mr. RAPPAPORT. They haven't proposed any?
Chairman LEACH. The CFTC has not proposed any changes to this committee.
Mr. RAPPAPORT. Well, actually, Mr. Chairman, I have a copy of the CFTC's response to, I think, your letter; CFTC's response, dated June 23rd.
Chairman LEACH. They say they are seeking advice from other committees of the Congress and outside parties.
Mr. RAPPAPORT. But it also makes specific recommendations as to how your original compromise should be modified in order to satisfy them. And we think those compromises——
Chairman LEACH. That was to draft one.
Mr. RAPPAPORT. Sorry?
Chairman LEACH. That was to draft one, not draft two.
Mr. RAPPAPORT. It is dated June 22nd. Draft one is dated the 19th, draft two is dated the 22nd. So I would expect that the CFTC's correspondence dated June 23rd responds to both draft one and draft two.
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Chairman LEACH. I apologize. It is draft four they haven't responded to.
Mr. RAPPAPORT. So I do think, though, that their response in draft one and draft two presents a reasonable compromise, in that it says that the standstill should apply to all of the agencies, not just the CFTC.
Chairman LEACH. Let me just tell you where I think the dilemma that you have is. There are equalities that can be achieved in two different ways in your world; one is to increase costs on others to equal yours; the other is to decrease costs on you. Costs are, in this case, regulation. And you are in the position of your analogy as to taxes. one person might be taxed at one rate and have some advantages, and another at a different rate because of other changes or other circumstances in the Tax Code, and there is always an inequality.
The question is: Is it right to increase costs, or decrease? And you want to go either way. But the case for increasing regulation on one person because another has a given amount is not always a compelling case.
Mr. RAPPAPORT. Mr. Chairman, we would like to be clear. We are not in favor of increased regulation on the OTC market. I think that goes across the board. All we want is the opportunity to compete on that same playing field.
Chairman LEACH. You may want that, but you are suggesting that similar standstills be applied to people that have not caused any reason for a standstill to be applied to them that I can see? Now, we have had a prior witness who suggested that some of this might have been precipitated by an SEC action. But the fact of the matter is that the three other regulators have done nothing to upend the markets, they have done nothing that puts a potential systemic risk into the system. It is the CFTC that has.
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And as the Federal Reserve has asserted very strongly, under what reason in daylights is there to put a constraint on them because somebody else has acted capriciously? And the case for that is nonexistent. Now I totally sympathize with that perspective.
But your dilemma is the obvious one, that your exchanges are tied to CFTC judgments and then an increase in regulation that is applied with the change in definitions puts more work on your exchanges, but it also puts more costs in the system. And I think if you got a case to reduce costs, that certainly should be looked at in the context of governmental recommendations in the CFTC authorization.
But I am not sure that there is a case that others should have the additional costs imposed upon them simply because your exchanges might get more work out of the system. I don't see how that is compelling.
Can you explain how it could be?
Mr. RAPPAPORT. Yes. I think that characterizing this issue only in terms of costs way underestimates it. It is not really costs; that is not the issue. I think from our perspective, it is strategic flexibility. There are costs associated with more regulation and, yes, it is a greater burden. But the greater burden that we carry is not the added costs of our marketplace, it is the strategic flexibility to respond to the changing marketplace.
And I think that while you have had three different panels up here today representing three different significant constituencies in the marketplace, I think one thing that all the panels will agree upon is that since the CFTC granted exempted authority under Section 4(c) of the Futures Trading and Practices Act, the OTC market has changed dramatically over these last five years. Whereas the original contracts traded OTC were exotic customized products, they now have evolved into the same products that we trade. So if I were sitting in their shoes, I would say, you know, the world looks fine to me; no change is needed, no problem here.
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But the problem is that those contracts have evolved into the same contracts we trade, and we have been having to live with this burden for five years, and now the CFTC has recognized, hey, you know, the same thing that the exchanges are trading is being traded OTC.
Chairman LEACH. Let me interrupt you there. Then what areas would you ease regulations on your exchanges?
Mr. RAPPAPORT. I think the exchanges——
Chairman LEACH. By the way, it seems to be reasonable to me that the New York Exchange would want to move to Chicago. Is that it? Would that be a cost saver?
Mr. RAPPAPORT. No. With all due respect to our friends in Chicago, we like it just where we were.
Chairman LEACH. We won't impose that, nor will we seek a nonlegislative solution. In what areas would you suggest that regulations might be?
Mr. RAPPAPORT. We would like to see—and actually we had a conversation with Dr. Wendy Gramm, who was chairman of the CFTC when that exemptive authority was pursued for the OTC market. Well, she said, You know, the second step is just what you say in your testimony, that the CFTC needs to be giving serious consideration to granting 4(c) exemptions to the regulated exchanges.
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The regulated exchanges have all the information on our radar screen. Without the regulated exchanges, the CFTC nor Congress have any idea what is taking place in the marketplace, because OTC information is just not recorded.
Chairman LEACH. Let me stop you and ask, what would you recommend, what areas would you think should be eased?
Mr. Arbor.
Mr. ARBOR. It is clear that swaps that are standardized and fungible look like, walk like, talk like, and in fact are futures contracts. Those swaps, those derivatives are not subject, for example, to the stringent audit trail requirements that our exchanges in Chicago and New York are required to comply with. Our members of our exchange have turned into virtual bookkeepers on our floor, trying to document every single trait, that it is very cost-intensive, very time-intensive and requires compliance departments in all the firms in Chicago and New York to monitor the exact procedure that is required.
The audit trail requirement that we are subject to in the exchange community is not required in the over-the-counter market. That is one big strong example. The other example, of course, would be the documentation requirements, compliance and suitability requirements that are required of our customers that are not required in the over-the-counter markets. And that is why we at the Chicago Board of Trade and the other exchanges have talked continuously about a professional market exemption category for us, recognized that our customers are professional, are sophisticated, and should not be subject to these regulatory costs that the CFTC has imposed upon us.
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Chairman LEACH. Mr. Gordon, would you agree with that?
Mr. GORDON. I would. And if I can just add one thing, it might be slightly off point but I didn't get a chance to answer earlier, I want to make very clear we are not looking for increased regulation on the OTC markets. I think that would be—it is ludicrous to think that they should be regulated more. I think the problem though is——
Chairman LEACH. The difficulty is if you change the definition, that is what you are causing.
Mr. GORDON. Well, I don't know what is going through, you know, what motivated the CFTC to bring out their Concept Release.
Chairman LEACH. Would you have advised them to do that?
Mr. GORDON. They wouldn't have asked me. And I would have to think about that.
Chairman LEACH. Would any of you advise them to do that?
Mr. Rappaport, would you have advised the CFTC to bring out the Concept Release?
Mr. RAPPAPORT. We had a number of philosophical discussions in that area before, and when there were some discussions about that, we were kind of surprised in that we think it is difficult to put the genie back in the bottle.
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Chairman LEACH. Mr. Arbor, would you agree with that?
Mr. ARBOR. We think the Concept Release——
Mr. RAPPAPORT. I am sorry, I should be clear. We are happy that they released it, and we would have advised them to release it, and that Concept Release has got us here today and has put this issue on the table. And I think that we would rather face the debate in these and other hearings on this issue than sit with the status quo, where we just slowly fade away and bleed to death.
Chairman LEACH. Should I call the nurse?
Mr. RAPPAPORT. I may be overstating my point, but we get just a short time to speak and interact, that I have to try to make it as dramatic as possible.
Mr. ARBOR. The CFTC has not gotten into the habit of asking the Chicago Board of Trade for advice on what they are going to do or not do, but we think that the Concept Release could certainly be a good thing as far as prospecting and trying to discover information about these critical changes in our industry caused by technology and innovation and product development. So to that extent, the Concept Release is something that we would probably support, because it does provide a process to gather information.
Mr. GORDON. Mr. Chairman, if I can just make a comment just to focus on a core issue for us and why I think we are having problems with this, at least from the CME's standpoint. Now that the Concept Release is out and we are faced with what you said would be the best solution, which we would agree with—which is a nonlegislative solution—for us to go into the next Congress and debate all of these issues in the context of CFTC reauthorization, I think that would be a positive thing. I think we all take a deep breath, we come back in the next Congress, and we debate every single issue that is out there.
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And I think we can do that in various venues, and I think it will be very, very healthy. The problem that we have is that we are now taking elements, specific elements, somewhat out of context, not necessarily today, but it is very difficult to debate these specific elements without taking it in the larger context of what the CFTC does and what effect it has on us.
So our concern with a moratorium or a standstill or anything else, going into next Congress' debate, is that it not put us at a disadvantage and that we can all take a deep breath and wait until next year and debate all of these issues. And I think that would be our major concern, that nothing happens in terms of products that are traded, or regulation or anything else, until we can all come back together next Congress and have this debate. I think that would be preferable.
Chairman LEACH. I am sorry to take so much time. Mr. Bentsen has been here, but he has asked a number of questions.
Why don't I go to Mr. Kennedy; is that all right?
Mr. Kennedy.
Mr. KENNEDY. Ken, if you have been waiting here a long time and want to ask, you can go ahead. I just have a couple of quick questions. First of all, I just want to welcome the panel and say that I do believe, as I have said in my opening statement, that the mercantile exchanges, what were new instruments just a short time ago, provided I think not only people that had been traditionally in the markets that had to function without futures capability with a tremendous stabilizing force and have enabled the country's economy to grow substantially. And so I think that all three of you should be commended and the people that have brought such a tremendous market force to bear in so many different products ought to take great pride in the accomplishments of your industry, number one; number two, that unlike other much more regulated industries, we have not had anywhere near the taxpayer bailouts that others have had in the past.
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I think we should start with the premise that the markets are working well, that they have not required tremendous Government intervention, and it is that very lack of intervention that has in many cases led to their success. I do think that the Chairman is right and that this—having sat on this committee and had to vote on billions and billions of dollars' worth of bailouts because of the S&L crisis in particular, that there is a fundamental responsibility once we see these larger institutions beginning to play in large fashion in some of these derivative markets, that the Banking Committee in particular has the responsibility to make sure that that hasn't gone too far.
You have got sort of two different aspects of this regulation. It seems to me that you don't want, rightfully so, to be having a market divided between two regulators, one of which is stricter on you and less strict on another group that is trading the same instruments, because that is unfair and will drive people out of your market and into theirs.
On the other hand, we have to make certain that we are not going to allow the big boys to move in and grab market share, which they would be inclined to do. They have their own regulators, their own regulators would be pushing to grab your pot, and that is something that we have to be careful to not let them push into as well.
Now, the real question, it seems to me, the challenge that you have got to sort of explain, or that I would like to try to understand better, is how do we accomplish through your current regulatory structure the ability to make sure that the big banks and others that we have responsibility for are not going to end up being able to abuse the process? Because if you can figure out a way to accomplish that, then it seems to me that we are able to stay out of your business and your backyard, and we can act more as sort of a fair-handed overseer of the process without having to take up the ultimate responsibility we have, which is to protect the taxpayer and to make sure that if there is an imbalance in the market that the taxpayers have to pick up the tab, which is ultimately our responsibility.
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I don't know, Mr. Arbor, if you have a response, or whoever would like to.
Mr. ARBOR. I will be happy to respond. We certainly think that a lot has changed. I think the bill recognizes, and the Chairman is right when he says that the changes in technology and innovation have certainly altered many traditional distinctions between these different marketplaces. We think the approach is for a comprehensive, thorough, top-to-bottom review of the marketplace, considering these technology changes and innovations. It should be done by the Working Group, which is the Treasury, the Fed, the SEC and the CFTC, and possibly the Comptroller and the FDIC representative, also, and hopefully with input from the exchange community and the banking community to develop a comprehensive plan.
I think you point out very well, Mr. Kennedy, the problem we have at the Chicago Board of Trade. The Shad-Johnson agreement was used by the SEC to reject a product at the Chicago Board of Trade yesterday and that very same product with the same indices is being traded in the exchange right across the street from us; but because it is under the SEC jurisdiction, it is OK. But because it is a futures product, the SEC had the ability under the Shad-Johnson agreement to reject that contract, and they exercised that yesterday. That kind of disparity in regulatory treatment just isn't conducive for the fostering of these markets, and if it continues, it is going to damage the growth of these great futures markets, which are very valuable risk management tools, as you pointed out, for the development of our economy in North America.
Mr. KENNEDY. Mr. Gordon or Mr. Rappaport, do you want to add any thoughts to that?
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Mr. RAPPAPORT. I think that where you draw the line to achieve that objective will always be subject to debate, but I think that the conceptual road that you need to go down in order to achieve that objective is very clear. At least it is to me. I think that if you go down that road, it will reduce the likelihood of you ever having to face an S&L debacle in the derivatives industry, and the conceptual road that you need to go down is to open up our marketplace.
The regulated exchanges and the OTC marketplace, for the most part, are chasing the same customers because we sell the same product. So from a regulatory perspective, you need to open up our marketplaces or permit us, give us the rule environment to open up the regulated exchange marketplace so that more customer trading takes place in those marketplaces so that we have the strategic flexibility to offer products that attract those customers, so that more customer trading takes place in our marketplace, you get to see it, we get to see it.
Mr. KENNEDY. I appreciate that, then, but I think that ultimately what I am trying to drive at here, which I was trying to see if you might want to address, is that you have forces that the Chairman and everybody on this committee can let you know, that when a regulator has an industry that it regulates, they end up wanting to expand their jurisdiction, and under that premise, in this city, they will try to push that OTC market under their umbrella, thereby making an unfair—what I am concerned about is that you are going to end up, which is why I assume you are here—you are going to end up getting the short end of the stick on the regulatory issue because it will not be your CFTC regulator; it will end up being somebody else in this town who will end up taking over this function. Isn't that basically what you are concerned about?
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Mr. RAPPAPORT. Yes, it is. It is close. The fear is that we and the CFTC will go down the road we are on right now, which is heavy-handed regulation, whereas the rest of the world will be permitted to trade freely. So it is not so much that we will be saddled with a new regulator; it is that we will be stuck in our existing regulatory environment whereas the rest of the world that is basically operating in the same marketplace will be able to do as they please.
Mr. GORDON. Mr. Kennedy, I think one thing that might be helpful in going back to the Chairman's comment that a nonlegislative solution is probably the best one. I think probably what has to happen is everybody has got to take a deep breath and then have all of us in the industries, the private sector, sit down and see if we can craft something.
Now, it might be silly to suggest that—maybe that can't come to fruition—but for us not to do that, for all of these parties not to sit down, what we are faced with is a possibility that we all end up with the short end of the stick. I think that is the biggest problem we have.
Mr. ARBOR. I would like to submit to Congressman Kennedy that we are on the short end of the stick right now. We labor under more regulatory burdens than the over-the-counter market. I can go through a litany, a list of the regulatory burdens that we have to encounter relative to the over-the-counter markets. The biggest right now for us is the audit trail requirements that we are under where our members, I have said this before, are turned into virtual bookkeepers, instead of traders, because they have to document every trade.
That same audit trail requirement is not required in the over-the-counter market. It is causing us to hire more compliance people, more people to develop systems at the Chicago Board of Trade to comply with it.
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We are not against audit trails. All we are saying is, we want a fair, level, equal playing field so that we can compete with the over-the-counter markets. Right now, the playing field is tilted against us. We are not calling for more regulation upon them; all we are talking about is equality, parity, a leveling of the playing field.
Mr. KENNEDY. Mr. Chairman, I appreciate all the time you have given me. I just want to again reiterate, I think that the function that your exchanges and the board of trade have played in terms of the overall market development have been phenomenal. I have firsthand knowledge of just how important these instruments can be in allowing a small business to be able to compete with a lot bigger players in a whole range of different markets. I think we need to keep you independent; we need to make certain we don't end up with inadvertently allowing an unfair playing field to develop. But I think you have done an excellent job. I would hope that we can find a way to allow either a voluntary—but even without a voluntary, to make certain that the freedoms that you have had in the past are not going to be infringed upon.
Thank you very much, Mr. Chairman.
Chairman LEACH. Thank you, Mr. Kennedy.
Mr. Bentsen.
Mr. BENTSEN. Thank you, Mr. Chairman. First of all, I think we need to clarify having sat here when Mr. Rappaport was talking about a liberal regulator, he was talking about in the John Locke sense of the liberal.
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Mr. Gordon, one thing in your testimony—and I think some others may have mentioned this—that I have to take some issue with, and I may be wrong and there may be some empirical evidence to state otherwise, but I think it is hard to make the case that the dramatic growth in the derivatives market, in the product variation, can be tied directly to the 1989 accords. I think that we have seen tremendous product development in all markets, including in the exchange market, certainly during the 1980's and subsequent to the 1980's. I know in my own experience prior to coming to Congress, there are products that we were using in the early 1990's that didn't exist in 1989, that were developed. So I do have some question with that.
That being said—go ahead.
Mr. GORDON. I meant it as a temporal reference, not that it regrew because of it—just a frame of reference.
Mr. BENTSEN. Fair enough.
That being said, I think you also said in your testimony that you would be willing—I don't know if you speak for the entire industry, but you would be willing to correct or agree that the CFTC proposal would not apply to existing product or existing contractual agreements, but only to future or prospective products. Right?
Mr. GORDON. Correct. I had that as a reference to this bill, but that is the point. I mean, the confusion or the apparent confusion that is created or has been created by the Concept Release shouldn't jeopardize existing product. So I don't know what the vehicle is to be able to do that, but the point is that from some period, let's just say today on back, that you just grandfather all that product, it is not a question, so we are not debating things that have already happened, at least not from our standpoint.
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Mr. BENTSEN. And so you all appreciate the fact that the CFTC proposal does create some problems with respect to existing product?
Mr. GORDON. I am not saying that. It is merely a response to comments from people who say that there is a problem. I don't think there is an emergency, at least from our standpoint. Maybe it is narrow based and just a Midwestern view, but we don't see from our vantage point that there is an emergency.
Having said that, there are people that say that this has created some uncertainty. I understand that comment, and we are just trying to respond to it.
Mr. BENTSEN. The concern that has been brought to us, which I think is a legitimate concern if it pans out, is that the CFTC jurisdiction and, thus, the CEA jurisdiction over the products could in fact result in making some contracts null and void, which would be disruptive to the market, I think we would all agree. And if that is the case, then I don't think we have much choice but to take some action if the agency will not step back.
Would you disagree with that?
Mr. GORDON. The basis for our comment was that we don't want that to be the case. So whether it is or not, if we just say these contracts are not subject to review, I think that is the proper way to do it.
Having said that, I don't know what the vehicle to do that is. My frame of reference was this particular bill, meaning we would agree that you grandfather in the product that is outstanding. I am not clear on, if this bill doesn't go forward, how you would do that. But it should happen; one way or the other, we believe it should happen.
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Mr. BENTSEN. Let me step forward. You and the others said that you don't want to impose an additional regulatory burden on the OTC market; what you want is a fair playing field. I appreciate that. By that, would you mean that you would want the ability to offer product-based and small-indices-based products on the exchange like that which was denied by the SEC; and even more minute, singular asset swaps and instruments, being able to list those on the exchange under your current regulatory scheme? Would that be sufficient? Or would you be looking for the ability to offer such type of instruments outside your regulatory scheme?
Mr. GORDON. Let me answer. I don't know if ''sufficient'' is the right word, but we would certainly be interested in looking at doing that product.
The second part of your question, which is outside the regulatory framework or scope of what we have right now, I think that is something we have to debate in the whole context of CFTC reauthorization. That is why I didn't want to pull things out of context. But with respect to the question of whether we would like to trade narrow-based indices or more product, absolutely. The board of trade was just denied their application. We had actually made application a number of years ago for what was deemed at that point a narrow-based index, so we would certainly want to trade that.
Mr. BENTSEN. If you were given that authority, if the CEA were changed to give the exchanges the authority to list those types of products, you would be fairly well satisfied as it relates to your competitive position vis-a-vis the OTC?
Mr. GORDON. No, I would not agree with that. I think it is one component of what we would look for. So if you ask the question, would we be interested in doing it, the answer would be, absolutely yes. If you ask, is it sufficient to solve whatever disparity we see out there, I would say absolutely not because it is out of context and it is a specific item.
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Mr. BENTSEN. I would appreciate the comment of the others on this, but you would still have the concern that these types of products or all products that are listed on your exchanges are at a competitive disadvantage from a regulatory standpoint?
Mr. RAPPAPORT. We can't even list those products now.
Mr. BENTSEN. But assuming you had that authority.
Mr. RAPPAPORT. I think that your question and this little conversation is illustrative of our point.
You had a panelist here before, an OTC panelist, who sat up here and said, ''Hey, we're trading single share futures all day.'' That is what you are talking about.
He is doing it. He is offering it to the marketplace. He is unregulated. Why shouldn't we be in that environment? Why shouldn't we be able to offer that same product to the marketplace and then let the market trade it wherever they choose to?
Mr. BENTSEN. My question is this. I would argue they are not completely unregulated, but I do have some questions about it.
But my question is this: If you are given the standing authority——
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Mr. RAPPAPORT. Why didn't he have to come here and ask you or somebody whether or not he can trade it and we do? And even if we do, the answer is no.
Mr. BENTSEN. I am suggesting, if you have that authority, that deals with part of your problem. But the other part of your problem is the regulatory scheme that you have. But is that OTC-related totally, or is it your total regulatory scheme that you have a problem as it relates to all your products?
Mr. ARBOR. Let me see if I can have a go at answering your question. As far as the Concept Release is concerned, we would support it for information gathering purposes only. We are not suggesting that the Concept Release would lead to anything meaningful at this point, but we think information is needed to be gathered about the disparity between the regulatory environments.
We certainly would like to trade these products. We submitted products to the CFTC and the SEC, and the SEC had jurisdiction because of the Shad-Johnson agreement. We think that is wrong, we think it is restrictive, and we think it certainly should be revisited. We certainly would like to have less regulation or comparable regulation compared to our competition.
Section 6 of H.R. 4062, we think would provide certainty to an area that is uncertain right now for the trading of swaps, not futures, so that you have got this section allowing the same instruments to be given legal certainty, to be traded in the over-the-counter market. You have got the SEC allowing these instruments to be traded in a securities environment, but we, the futures industry, are denied that. We think there is a need for a comprehensive top-to-bottom, thorough review of the regulatory environment. It is as simple as that.
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Mr. BENTSEN. I appreciate that. I don't necessarily disagree with the idea of revising the CEA to give you that authority. It seems to make relatively good sense.
I am sure, Mr. Chairman, there is somebody in this town who is opposed to that. We haven't heard from them yet, but I am sure I will hear from them next week.
With that, I will yield back the balance of my time.
Chairman LEACH. Thank you, Mr. Bentsen.
Mr. Sherman.
Mr. SHERMAN. Thank you, Mr. Chairman. I want to commend you for holding these hearings. I look forward to moving forward in this area. I don't want to delay the conclusion of them any further. Thank you.
Chairman LEACH. Thank you.
Let me just say in conclusion, it seems to me when you talk about derivatives and you are talking about management of risk—and abstractly there are a number of kind of risks; there is legal risk, there is a country risk, systemic risk, which leads me to think that maybe you ought to start a new contract on the futures on future regulation, which strikes me as a fairly risky proposition.
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The other thing that seems clear to me, that I had not focused on as intently until the last month, this committee has worked for three years now on a financial system modernization approach which, at the moment, is tied up in H.R. 10. Of all the enormously contrasting perspectives that has taken on disproportionate influence, it has been the battle of regulators. I had no idea how intense this was in a banking regulatory circumstance, but we are seeing a real analogy here with regard to the markets that you deal with.
In the private sector, there is always the issue of maximization of profit and differing perspectives, and you are certainly protecting, or advocating, the views of your institutions. In the public sector, there seems to be a maximization of power concern that sometimes enters this. I am just sometimes perplexed by it.
I just would like to conclude by saying, I am hopeful we can come up with a nonlegislative remedy. But unless it is very precise, unless it has the agreement of all the parties, it is my intent to continue on a timely basis to pursue a legislative remedy. I think there are imperfections in that route and disadvantages to it. I see little alternative at this point. Anyway, I realize there is a difference of judgment in this panel in particular.
It is not inconceivable that some of the issues that have come to the floor will play a larger role as we move, presumably next year, to CFTC reauthorization. We may change the landscape of both the regulated and unregulated market over time.
Thank you all. The hearing is adjourned.
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[Whereupon, at 4 p.m., the hearing was adjourned.]
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