[Senate Hearing 106-768]
[From the U.S. Government Publishing Office]
S. Hrg. 106-768
PRESIDENT'S WORKING GROUP REPORT OF OTC DERIVATIVES--CEA RE-
AUTHORIZATION
=======================================================================
HEARING
before the
COMMITTEE ON AGRICULTURE,
NUTRITION, AND FORESTRY
UNITED STATES SENATE
ONE HUNDRED SIXTH CONGRESS
SECOND SESSION
ON
PRESIDENT'S WORKING GROUP REPORT OF OTC DERIVATIVES--CEA RE-
AUTHORIZATION
__________
FEBRUARY 10, 2000
__________
Printed for the use of the
Committee on Agriculture, Nutrition, and Forestry
U.S. GOVERNMENT PRINTING OFFICE
67-569 CC WASHINGTON : 2000
_______________________________________________________________________
For sale by the U.S. Government Printing Office
Superintendent of Documents, Congressional Sales Office, Washington, DC
20402
COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY
RICHARD G. LUGAR, Indiana, Chairman
JESSE HELMS, North Carolina TOM HARKIN, Iowa
THAD COCHRAN, Mississippi PATRICK J. LEAHY, Vermont
MITCH McCONNELL, Kentucky KENT CONRAD, North Dakota
PAUL COVERDELL, Georgia THOMAS A. DASCHLE, South Dakota
PAT ROBERTS, Kansas MAX BAUCUS, Montana
PETER G. FITZGERALD, Illinois J. ROBERT KERREY, Nebraska
CHARLES E. GRASSLEY, Iowa TIM JOHNSON, South Dakota
LARRY E. CRAIG, Idaho BLANCHE L. LINCOLN, Arkansas
RICK SANTORUM, Pennsylvania
Keith Luse, Staff Director
David L. Johnson, Chief Counsel
Robert E. Sturm, Chief Clerk
Mark Halverson, Staff Director for the Minority
(ii)
C O N T E N T S
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Page
Hearing:
Thursday, February 10, 2000, President's Working Group Report of
OTC Derivatives--CEA Re-Authorization.......................... 1
Appendix:
Thursday, February 10, 2000...................................... 49
Document(s) submitted for the record:
Thursday, February 10, 2000...................................... 113
Questions and answers:
Thursday, February 10, 2000...................................... 135
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Thursday, February 10, 2000
STATEMENTS PRESENTED BY SENATORS
Lugar, Hon. Richard G., a U.S. Senator from Indiana, Chairman,
Committee on Agriculture, Nutrition, and Forestry.............. 1
Fitzgerald, Hon. Peter G., a U.S. Senator from Illinois.......... 3
Harkin, Hon. Tom, a U.S. Senator for Iowa, Ranking Member,
Committee on Agriculture, Nutrition, and Forestry.............. 4
Conrad, Hon. Kent, a U.S. Senator from North Dakota.............. 3
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WITNESSES
Panel 1: Head of the President's Working Group
Summers, Laurence, Secretary, U.S. Department of the Treasury,
accompanied by Lewis A. Sachs, Asst. Secretary for Financial
Markets, U.S. Department of Treasury........................... 5
Panel 2: Members of the President's Working Group
Greenspan, Alan, Chairman, Board of Governors of the Federal
Reserve System................................................. 13
Rainer, William, Chairman, Commodity Futures Trading Commission.. 14
Nazareth, Annette, Director of Market Regulations Securities and
Exchange Commission............................................ 17
Panel 3: Representatives of the Futures Exchange and OTC derivatives
community
Brennan, David, Chairman, Chicago Board of Trade................. 29
Salzman, Jerry, Chicago Mercantile Exchange...................... 32
Grove, Richard, Chief Executive Officer, International Swaps and
Derivatives Association (ISDA)................................. 34
Rappaport, Daniel, Chairman, New York Mercantile Exchange........ 30
Rosen, Edward, Counsel, Ad Hoc Coalition of Commercial and
Investment Banks............................................... 36
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APPENDIX
Prepared Statements:
Lugar, Hon. Richard G........................................ 50
Grassley, Hon. Charles E..................................... 52
Brennan, David............................................... 81
Greenspan, Alan.............................................. 61
Gordon, Scott................................................ 100
Grove, Richard............................................... 106
Nazareth, Annette............................................ 73
Rainer, William.............................................. 68
Rappaport, Daniel............................................ 92
Rosen, Edward................................................ 108
Summers, Laurence............................................ 54
Document(s) submitted for the record:
Statement of the International Swaps and Derivatives
Association, Inc........................................... 114
Statement submitted by Robert R. Champion, on behalf of
Champion Securities........................................ 128
PRESIDENT'S WORKING GROUP REPORT OF OTC DERIVATIVES--CEA RE-
AUTHORIZATION
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THURSDAY, FEBRUARY 10, 2000
U.S. Senate,
Committee on Agriculture, Nutrition, and Forestry,
Washington, DC.
The Committee met, pursuant to notice, at 9:05 a.m., in
room SH-216, Hart Senate Office Building, Hon. Richard G.
Lugar, (Chairman of the Committee), presiding.
Present or submitting a statement: Senators Lugar,
Fitzgerald, Grassley, Harkin, and Conrad.
OPENING STATEMENT OF HON. RICHARD G. LUGAR, A U.S. SENATOR FROM
INDIANA, CHAIRMAN, COMMITTEE ON AGRICULTURE, NUTRITION, AND
FORESTRY
The Chairman. This meeting of the Senate Agriculture
Committee is called to order. Today the Committee holds its
first hearing of this year on the reauthorization of the
Commodity Exchange Act. This hearing with its distinguished
list of witnesses will discuss the unanimous findings of the
President's Working Group regarding the proper treatment of
over-the-counter derivatives markets.
In late 1998, House Agriculture Committee Chairman Bob
Smith and I wrote Treasury Secretary Rubin requesting that the
President's Working Group study and make recommendations to
Congress regarding these instruments. Our request came on the
heels of an economically turbulent period which witnessed a
Russian default of debt, the devaluing of the ruble and the
near collapse of Long Term Capital Management Hedge Fund.
In addition, the CFTC was making overtures through its
concept release on the over-the-counter derivatives that it
might seek to unilaterally regulate these instruments. In
requesting this report, we sought to bring certainty to these
markets and to build a broad consensus on the Government's
role, if any, in regulating them. I have stated that one of my
goals for the Commodity Exchange Act reauthorization is to
provide legal and regulatory certainty to the over-the-counter
market. With its recommendations on the legal certainty of
swaps, the Treasury Amendment, and electronic trading, I am
confident this unanimous report will provide Congress with the
guidance it needs for achieving this important goal.
But the Working Group's recommendations cannot exist in a
vacuum. Another important goal of reauthorization is providing
regulatory relief for those entities that fall within the
Commodity Exchange Act. The Working Group recognized that its
recommendations regarding the over-the-counter market must be
implemented simultaneously with the lessening of regulation for
the futures exchanges.
Along with other members from the House and Senate
Agriculture Committees, I have requested the CFTC make its
recommendations on regulatory relief by February 14. I
understand that Chairman Rainer will meet this deadline and
intends to brief members on the proposal shortly.
Addressing the Shad-Johnson Accord is also a priority. The
President's Working Group agreed that the current prohibition
on single stock futures can be repealed if issues regarding the
integrity of the underlying securities market and regulatory
disparities can be resolved. Senate Banking Committee Chairman
Phil Gramm and I have written Securities and Exchange
Commission [SEC] Chairman Levitt and CFTC Chairman Rainer
requesting that the agencies study this issue and make
recommendations by February 21.
Senator Gramm and I have pledged to work together
throughout this process including the possibility of holding
joint hearings to ensure that both over-the-counter and on-
exchange instruments are appropriately and consistently treated
under our laws. Although it would be premature today to discuss
in detail the reform of Shad-Johnson Accord without the benefit
of the agencies' input, I would emphasize that this issue
remains a priority with the Committee.
Now this committee is finally faced with the daunting task
of drafting this complicated legislation in a year drastically
shortened by a full congressional calendar and a presidential
election. In my view, given at least the advice of our Senate
leadership on scheduling, we may have only a 3-month period to
pass this bill or to resign ourselves to the fact that it will
not get done until next year. However, the ramifications of
waiting until next year are considerable given the fact that we
will have a new administration, a new Congress, even possibly a
new chairman of this committee. The present time appears to be
most opportune and we are hopeful that we will have consensus
in the industry for comprehensive reauthorization legislation
promptly and I intend to actively promote passage this year.
Turning toward today's discussion, our first witness will
be the Treasury Secretary Lawrence Summers, head of the
President's Working Group, who will outline, first of all, the
unanimous findings of the commission.
Our second distinguished panel will consist of other
members of the Working Group including Chairman Alan Greenspan
of the Federal Reserve; Chairman Bill Rainer of the CFTC; and
Ms. Annette Nazareth, Director of Market Regulations of the
SEC.
Our final panel will contain members from the private
sector including representatives from the futures exchanges and
the over-the-counter derivatives community. I would say in
advance that we have been advised that a roll call vote will
occur at 11 o'clock. We will have a short recess so that
members may do their duty and then we will return so that we
can have a full hearing of all the witnesses and questions by
the Senators.
[The prepared statement of Senator Lugar, can be found in
the appendix on page 50.]
Before I ask for our distinguished first witness to
commence his testimony, I would turn to Senator Conrad for any
opening comment he might have.
STATEMENT OF HON. KENT CONRAD, A U.S. SENATOR FROM NORTH DAKOTA
Senator Conrad. Thank you, Mr. Chairman. Special thanks for
your leadership in this area. Obviously this is critically
important, important to our country, important to world
financial markets as well. This is something we simply have to
get right. The world is changing everyday around us. Last night
I was hooked up to my Web TV surfing the net and going to
various financial sites. It is just remarkable the information
and the access to markets that are now available to everybody
everywhere in the world that has access to the internet.
This changes everything and we have got to be very mindful
of two things. One, we have got to protect those who are
participants in the market and, second, we have got to make
certain that our industry can be fully competitive. We do not
want to do things unintentionally that will prevent our
companies from being able to compete on a global basis. I think
those of us who have passed around the book, The Lexus and the
Olive Tree, understand how globalization is altering the speed
with which everybody has to respond, those who are in the
private sector and those of us who are in government.
Government moves much more slowly than does the private sector
and we are going to have to speed up because things are
changing everyday in every way and if we do not respond
quickly, we are going to leave our people at a competitive
disadvantage.
So again, Mr. Chairman, we are going to have to strike a
balance. We are going to have to find how we balance the
competing interests of making certain that our companies are
competitive and at the same time protecting participants in the
market. I again want to thank you, Mr. Chairman. I look forward
to the panels that you have called before us.
The Chairman. I thank the Senator for his faithful work on
this issue as well as all other issues and his prompt
attendance at these nine o'clock hearings. I now call upon
Senator----
Senator Conrad. You know in North Dakota, we usually are up
by five so it is a little late to get started.
The Chairman. I understand. Senator Fitzgerald.
STATEMENT OF HON. PETER G. FITZGERALD, A U.S. SENATOR FROM
ILLINOIS
Senator Fitzgerald. Well, thank you, Mr. Chairman, and if I
could have leave of the Committee to introduce my remarks to
the record, I would appreciate that.
The Chairman. They will be published in full.
Senator Fitzgerald. Well, thank you, and I would just like
to make a couple of comments. Obviously, as the Senator from
Illinois who represents Chicago and LaSalle Street and the
futures business there, I have a great interest in these
particular hearings. I thought the Working Group's report was
very thorough and had many good elements and I was impressed
that it left open the possibility of a level regulatory playing
field for technically futures products and financial
derivatives that are not technically futures. It left open the
possibility of a level regulatory playing field where only
institutional counter parties were involved. That is an
interesting issue and we will want to pursue that more.
What I would be concerned of at the outset is fragmenting
the market between the retail and institutional customers. I
think we have to ask whether there is a public policy interest
sufficient to justify taking retail customers out of having
access to that large institutional market and that is something
that we need to focus on.
But as I read the Working Group's reports and some of the
testimony that has been submitted beforehand, there seemed to
be an openness on the part of most of the members of the
Working Group to have that level regulatory playing field
between traditional futures products and over-the-counter off-
exchange financial derivatives but only in the case of
institutional parties. I think we are going to have to pursue
that a little bit more, but with that, I would like to welcome
Secretary Summers to the Committee and thank the Chairman,
Senator Lugar, for holding these important hearings.
The Chairman. I thank the Senator for his special interest
in this subject and we look forward to working with you. Let me
ask that the first witness, Secretary Summers, attempt to
summarize remarks in a 10-minute period. We will not be overly
rigorous because the report is very important. Your testimony
will be published in full and it is an important statement.
Likewise with our second panel of those who have been working
with you as members, we will ask each to have a 10-minute
opportunity and that would allow for questions as members come
and go from the hearing, but we want to make certain that we
have plenty of dialogue with all of us. It is a pleasure to
have you, Secretary Summers. I see that you are accompanied by
a distinguished fellow alumni of mine at Denison University,
Lee Sachs, also a trustee of that institution, which gives him
special standing as you are sitting there.
[Laughter.]
We are grateful for your participation as always. Your
leadership in this has been extremely important and you have
been most forthcoming with members of the Committee. Senator
Harkin has arrived and I will ask, do you want to make a
comment now or maybe later?
Senator Harkin. Have others made remarks?
The Chairman. Yes. Senator Conrad made a comment.
Senator Harkin. Just briefly.
The Chairman. Very well. Go ahead.
STATEMENT OF HON. TOM HARKIN, A U.S. SENATOR FROM IOWA, RANKING
MEMBER, COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY
Senator Harkin. Thank you, Mr. Chairman. I am sorry. I just
had a previous engagement. I am sorry for being a little late,
but I want to thank you, Mr. Chairman, for holding this
important hearing on the report of the President's Working
Group on the over-the-counter derivatives markets. I, first of
all, take my hat off to you for chairing on three consecutive
days two hearings on dairy policy and one on financial
derivatives, two of the most esoteric and mystifying subjects
to ever come before this committee.
So I very much look forward to receiving the testimony from
Secretary Summers and others who are here and working with you,
Mr. Chairman, to craft legislation that we can enact this year.
We have made a good effort at it. Three years ago we worked
together in a bipartisan fashion toward a consensus bill, but
for some reason the stars were not quite aligned at that time.
I am optimistic now that the circumstances are more auspicious
that we can move ahead on new legislation. The report of the
President's Working Group should be very helpful to us in that
regard.
Again, with the rapid changes that we see in the technology
and in the financial markets, it is essential that the CEA is
updated to reflect these changes that have occurred and again
to just make sure that we accommodate some of the future
changes that are coming.
Any regulatory system becomes counterproductive if it
inhibits innovation and the creation of new and beneficial
products and services. So again I just want to underscore the
importance of avoiding action that would help the financial
markets but in any way damage the functioning of the
agricultural markets.
Finally I want to stress that when we pass legislation, we
take responsibility for its consequences. So as we work on
regulatory reform legislation, we have to be sure we do all we
can to guard against unforeseen risks, especially systemic
risks to the broader financial system that could come back to
haunt us later on. Thank you very much, Mr. Chairman.
The Chairman. Thank you very much, Senator Harkin.
Secretary Summers.
STATEMENT OF HON. LAWRENCE SUMMERS, SECRETARY, U.S. DEPARTMENT
OF TREASURY, ACCOMPANIED BY LEWIS A. SACHS, ASSISTANT SECRETARY
FOR FINANCIAL MARKETS, U.S. DEPARTMENT OF TREASURY
Secretary Summers. Mr. Chairman, Senator Harkin, Senator
Fitzgerald, Senator Conrad, thank you very much for giving us
the opportunity to discuss the report of the President's
Working Group on Financial Markets on Over-the-Counter
Derivatives and the Commodity Exchange Act. Let me say that we
very much share your view on both the importance and the
urgency of these issues for the Nation's financial markets and
for the economy.
This report reflects a great deal of effort on the part of
the members of the President's Working Group including the
Chairmen of the Federal Reserve, CFTC and SEC. After a great
deal of effort, we were able to reach unanimous recommendations
and it is my very great hope that they can be enacted into law
this year.
Let me address three subjects in my remarks this morning.
First, the importance of OTC derivatives to the economy, then
the objectives that guided members of the Working Group in
formulating their recommendations, and third, the six
recommendations of the Working Group.
OTC derivatives now represent more than $80 trillion in
notional value. They perform a crucial function in helping to
share and allocate risk around our nation's economy. This
confers a number of benefits. It helps businesses and financial
institutions to hedge risks and lower their costs, thereby
reducing prices for American businesses and consumers. It
promotes more efficient allocation of capital across different
sectors of the economy. It encourages better information with
respect to the risks of various contingencies and promotes
transparency which leads to better planning, and it permits the
development of more imortive financial products by allowing for
wider sharing of risk.
The market is a valuable one and it can deliver many
benefits to those who make proper use of it. For example, the
agricultural sector benefits considerably from OTC derivatives
used by importers and exporters of agricultural commodities. By
using these products, they hedge their exposure to volatile
movements in foreign currency markets and can build on the
certainty to invest more in their businesses, allowing farmers
to export more of their products to overseas markets.
Mr. Chairman, I think we all have an obligation to work as
rapidly as possible to develop a legal framework that is as
modern as the market that it addresses. It is our judgment that
because the counter parties to OTC transactions are highly
sophisticated and because the issues involved are enormously
complex, government can best contribute by promoting a
framework for market discipline based on the principle of
transparency. The objective of government should not be to
protect individual institutions but to protect the system. And,
of course, government should have a continuing role with
respect to the protection of retail customers.
With these broad principles in mind, our report had four
objectives in developing a legal framework for this market:
First, the reduction of systemic risk; second, the promotion of
innovation; third, the protection of retail customers; and
fourth, ensuring U.S. competitiveness in an important industry
where there is a great deal of innovation taking place.
With these four considerations, systemic risk, innovation,
retail protection, and U.S. competitiveness, we developed six
recommendations. Let me highlight, Mr. Chairman, that a failure
to enact legislation along these lines would, in our judgment,
carry important risks with respect to each of our objectives:
the mitigation of systemic risk, the promotion of innovation,
the protection of retail customers, and the competitive of the
U.S. financial industry.
Our six recommendations. First, to create an exclusion from
the CEA for most swaps agreements. Because the combination of
the broad definition of commodity and the absence of any
definition of futures contracts implies that the CEA may apply
to transactions that no one anticipated in 1974, we believe
that the exclusion for certain swaps between sophisticated
counterparts is appropriate, consistent with market discipline,
and should be put into law. I would add that the enactment of
an exclusion promotes legal certainty that is essential for the
integrity of the market.
Second, to create an exclusion for electronic trading
systems. And third, to permit the use of appropriately
regulated clearing systems for OTC derivatives. These two
recommendations both go to the objective of allowing
sophisticated parties to organize together to trade OTC
derivatives in ways that are most efficient for them, in ways
that promote transparency to each other and in ways that permit
clearing arrangements which mitigate systemic risks in the
event of counter party default.
Fourth, to clarify the original intent of the Treasury
Amendment. As you will recall, Mr. Chairman, the Treasury
Amendment goes to the question of regulation of trading in
foreign exchange and government securities. The proposal here
would clarify their exclusion from regulation on an organized
exchange, but it would at the same time recognize the CFTC's
authority with respect to bucket shops and other practices
affecting retail customers.
The fifth and sixth recommendations are highly technical
with respect to the exempt status of hybrid securities. These
recommendations address some jurisdictional disputes, but I am
pleased to report that the jurisdictional disputes have been
resolved with the unanimous agreement of the parties involved.
Mr. Chairman, these are highly technical issues. But for
being highly technical, they are nonetheless very important
issues for the U.S. financial services industry and the
contribution that the financial sector can make to the
maintenance of a sound economy. We look forward to answering
your questions and speaking on behalf of all the members of the
Working Group hope it will be possible to enact these
recommendations this year. Thank you and thank you for your
leadership.
The Chairman. Thank you very much, Mr. Secretary. First, a
technical question. Has the Department of the Treasury been
working on any legislative language that reflects the findings
of this Working Group?
Secretary Summers. We do not have a full set of legislative
language to share, but we have been thinking through ways in
which various of these ideas can be expressed in legislative
language and we would be very pleased to have our staffs be in
touch regarding these issues.
The Chairman. I appreciate that because that will be a
great help in making certain that the Working Group's findings
and the conclusions you have reported today are appropriately
reflected when we finally get to the language. Mr. Secretary, a
broader question, and this was certainly a question before
initial hearings on this subject. Now, clearly not only the
financial markets but the public as a whole was intrigued and
correspondingly alarmed by the failure of the Long Term Capital
Management Hedge Fund and likewise the steps that were taken to
try to bring that situation into some balance. At one of our
hearings there was considerable argument over whether that
failure meant that there were a lack of proper credit
standards, a lack of appropriate regulation by someone.
Now, in essence, in the sophisticated ways in which the
financial community deals in an international way, as you
pointed out, are things simply at some point beyond our scope
and if so what kind of jeopardy does this bring to the American
economy, quite apart from financial markets, and to what extent
has your group, the Working Group, thought about all of that
and how are your recommendations appropriate, given those
risks?
Secretary Summers. I think you have raised a very important
set of issues, Chairman Lugar, and they are a set of issues we
gave a great deal of thought to in formulating our
recommendations. The Working Group, as you know, had prepared a
separate report on issues raised by highly leveraged
institutions. I would leave to others an attempt to fully
analyze the LTCM episode, but I think most would feel that it
represented a combination of leverage and illiquidity that led
to those very serious difficulties. The approach that we have
advocated in both the highly leveraged institutions report and
this one is one based on the principle of promoting market and
counter party discipline through greatly increased transparency
and that is the focus of our recommendations.
We believe that the best discipline, the most informed
discipline, on institutions can come from counter parties in
the context of transparent sharing of information. Some of the
recommendations that are contained in this report, though, to
some degree do go crucially to the objective of systemic risk,
including in particular the proposals to allow clearinghouses
to be set up with respect to over-the-counter derivatives that
will promote netting and therefore make large outstandings
smaller and contribute to systemic stability.
I believe that we do, and I think this was the tone of
several of the opening statements, do need to find a balance
between assuring a framework that protects against systemic
risk, on the one hand, and promoting innovation on the other,
but I would hasten to say that we need to be very careful of
establishing public regulation in a way that crowds out what is
potentially more effective private regulation by counter
parties.
The Chairman. Well, the private regulation idea is clearly
an important one and if there is a bias in the report or at
least a trend, it really moves toward more of that as opposed
to public regulation. This is an age-old dispute in our own
governmental system with the pendulum going backward and
forward; clearly I favor that move toward more private
regulation. This appears to be the way the CFTC and perhaps the
SEC are moving, but at the same time, let me just ask this
question.
Much of the Working Group's findings discuss what should
remain outside of the Commodity Exchange Act. What policies
should we focus on in determining instruments that should
remain within the Commodity Exchange Act? In other words, what
is sort of the core of that situation, as you see it, with
regard both to innovation and growth and international
competitiveness, but at the same time the basic public function
of regulation which that commission and our oversight try to
provide?
Secretary Summers. I think the core rationales for public
regulation in this area go to three things. They go to the
protection of retail customers. Where retail customers are
going to be substantially involved, there is certainly a case
for strong regulation. Where price manipulation is a
significant risk, particularly because of finiteness of supply,
there is a very strong case for regulation. There will be cases
where regulation can be constructive in terms of the promotion
of transparency and the price discovery function. The balance
that has to be struck involves a balance of recognizing when
the need for regulation with respect to those considerations
exceeds the costs, potential costs, in terms of reduction of
innovation and loss of international competitiveness.
In general, where it is highly sophisticated and
experienced parties trading with one another, we believe that
the promotion of market discipline based on counter party
scrutiny is likely to be most effective.
The Chairman. I thank you. I will ask each of our
colleagues to stay within a 5-minute time limit on a first
round. If there are additional questions, we will have a second
round. I call on the ranking member, Senator Harkin.
Senator Harkin. Thank you, Mr. Chairman. Mr. Secretary, you
know, you said it very aptly when you said that we should be
looking at the system itself and that government should not be
picking winners and losers within the system but look at the
system itself. I have been wrestling with this for a long time
on the derivatives market. You see--and this is a question I am
going to ask everyone that comes up here--right now we have an
exemption. CFTC gives exemptions. What the Working Group has
proposed is an exclusion.
What I wonder is if you have a problem that crops up, that
signals that some kind of regulation or action needs to be
taken? Something where you have tremendous leveraging, for
example, going on like we had in the hedge funds, if you have
an exclusion, then it would take an act of Congress to do
something about it. That takes a long time. If you have an
exemption, then the CFTC could respond more readily to
something like that, that cropped up. That is an issue that I
wrestle with a lot.
Now I understand the need for an exclusion, the certainty
of contracts. I understand that. But I am wondering if within
the framework of an exemption, you could not accomplish the
same thing? I just throw that out as a question for you to
ponder and if you have any response. In other words, with the
exemption, they could impose a regulation right away to stop
something that may be going out of control. With an exclusion,
you have to have an act of Congress.
Secretary Summers. Senator Harkin, I think in the latter
part of your remarks, you forecast correctly what would be my
response, which is you are clearly correct that an exemption
provides more flexibility than an exclusion, but it is
precisely the presence of that flexibility and the recognition
that it might be used that undermines legal certainty and
creates a greater possibility that these transactions will take
place and be booked abroad where they will not be subject to
American law. It is precisely that flexibility and the
expectation that it might be used that is potentially reducing
of confidence with respect to these transactions.
I do not think we would responsibly, nonetheless, favor
exclusion in areas where strong public regulation would confer
large benefits even despite that legal certainty consideration,
but it is our judgment and the judgment of the staffs whose
work went into this that in a range of financial transactions
between very large and sophisticated institutions, the impact
of public regulation in reducing the pressure for market
discipline might actually be counterproductive and therefore
the clear signal that an exclusion provides both would
contribute to legal certainty and would contribute to greater
pressure for the strongest possible market regulation.
Senator Harkin. Thank you, Mr. Secretary. Thank you, Mr.
Chairman.
The Chairman. Thank you very much, Senator Harkin. Senator
Fitzgerald.
Senator Fitzgerald. Thank you, Mr. Chairman. I want to
follow up on a question by Senator Lugar. He asked about where
you thought regulation was necessary. If I remember correctly,
you said essentially that you felt public regulation was
necessary where retail customers were involved and where you
are trading a product such as a commodity which theoretically
at least could be susceptible to market manipulation. Somebody
in theory could corner the market on grain. I took that to mean
that cornering the market on financial derivative products is
not as much of a possibility as where you have a finite
commodity.
If that is your test for the necessity of public
regulation, and we had a situation in which institutional
parties are trading a future on a financial product as opposed
to an agricultural commodity or some other commodity on an
exchange, would you support having no public regulation and
just allowing those counter parties in that case to police the
market?
Secretary Summers. Senator, I prefer not to comment in any
real detail on issues that fall within the CFTC and Chairman
Rainer's bailiwick. But I would say this. I think it is very
important that while this report has focused, in line with the
Chairman's request, on the OTC derivatives market, there are
obviously a set of issues that arise with respect to exchange-
traded products and that the same basic principles of
motivating innovation, protecting retail, avoiding systemic
risk, and being internationally competitive that we have
stressed with respect to OTC derivatives also arise with
respect to exchange-traded instruments and the same kind of
balances need to be struck.
As the Chairman indicated in his opening statement, this is
something that Chairman Rainer and the CFTC have been very much
involved in and will be reporting on soon, and I would
certainly support their efforts to remove any regulation which
proves to be unneeded.
I would say that I think the merits with respect to the OTC
derivatives market are very strong. The economic importance is
very great. I would hope that, that important issue would not
be held hostage to debates, whatever the merits on both sides
are, with respect to the proper regulation of the exchanges.
Senator Fitzgerald. Now with respect to the swaps exclusion
where institutional customers only are involved and retail
customers are not involved, would that exclusion operate to
deny retail customers access to the most liquid markets? Would
it not encourage the creation of markets with pools of
liquidity that are only available to the institutional
participants?
Secretary Summers. That clearly is a source of concern that
has to be balanced, Senator Fitzgerald, but while I have said a
number of things here that have suggested that in certain
circumstances, regulation may not be constructive, I think it
is important to remember that the premise of a view like the
one you described is that regulation is all an excessive
punitive burden, and in many cases, regulation can be a source
of strength and integrity to markets. Indeed if you look at
American financial markets, one of their strengths and one of
the reasons why companies, for example, come to list here is
the strength of our regulation. There has been some important
recent economic research comparing securities markets in a
number of the transition economies that have demonstrated that
in certain cases, proper regulation with respect to issues like
insider trading and the behavior by insiders can promote
integrity, encourage people to trade there and promote
liquidity.
So I think the conclusion that I would draw is that we need
everywhere to avoid unnecessary and unconstructive regulation
but that proper constructive regulation can strengthen a
market's integrity, confidence and thereby promote its
liquidity, and my hope, and I have great confidence that with
Chairman Rainer's leadership the CFTC will get there, would be
to take an approach of that kind with respect to the exchange-
traded markets.
Senator Fitzgerald. Well, thank you and I do agree with
your comment with respect to proper regulation. I think we have
the best capital formation markets here in the United States
because we have outstanding securities laws, and my hope would
be that we could come up with a similarly outstanding model to
cover our derivatives market. Thank you.
The Chairman. Thank you very much, Senator. Senator Conrad.
Senator Conrad. Thank you, Mr. Chairman. I would like to
follow up on the question by Senator Fitzgerald because I think
it really goes to the heart of the controversy here and the
questions that have to be answered by this committee. We had in
Long Term Capital a situation in which there was enormous risk.
There was huge leverage there and we saw a very fast action by
government to bring together private parties to stem the tide
there, to stop the hemorrhage. That could have become a very,
very serious situation for the financial market and the
confidence in financial markets.
Let me ask you this. You are talking about counter party
scrutiny as being what we should we look to for these large
sophisticated financial traders. What would you say to the
public who is listening here to give them comfort in light of
Long Term Capital? What happened to counter party scrutiny in
that case? Why did it fail? What is before us now that is going
to prevent a future failure?
Secretary Summers. No one can sensibly sit here and assure
you that there will not be more financial crises, that there
will not be problems in the future, Senator Conrad. The Working
Group's proposals, not with respect to OTC derivatives but with
respect to highly leveraged institutions, included a variety of
steps that were intended to reduce the risk of systemic risk
coming from a situation like Long Term Capital. Those involved
much greater requirement of transparency in their reporting to
their creditors.
Senator Conrad. When you use--I am sorry to interrupt, but
when you say transparency, what do you mean by that? What is
provided for here that makes these transactions more
transparent for those who are involved? Is there more reporting
of what a company's positions are so that others could see how
highly leveraged they were?
Secretary Summers. Yes. Yes, and, in particular, there is
more reporting at two levels, both with respect to the
expectation of the information that will be shared between
leveraged institutions and banks or other institutions that
provide them with credit, and as those institutions that are
regulated by the Government are supervised, there is much
closer scrutiny of their exposure to highly leveraged
institutions such as hedge funds. Is this going to be totally
satisfactory? I am sure there will be problems at some points
in the future, but I think the concern, and I think it is a
legitimate one, is that we need to act in a way that ensures
that the maximum degree of responsibility is felt by counter
parties who inherently will be much closer to these situations
and better able to judge them than any set of regulators are
ever likely to be.
There is a second type of policy response that is
appropriate and one area where we get into it here is the
Working Group's second recommendation with respect to
clearinghouses which provides for arrangements in which there
is some sharing of obligation and so credit can be extended
with confidence that it will be repaid. And, greater reliance
on clearinghouses, greater reliance on netting arrangements,
more rapid settlements procedures, these are all very intricate
issues, but if you look back to the time after LTCM, I think
most would feel that better netting, faster settlements, more
transparency, improved contractual relations in a variety of
ways that reduce the pressure for forced liquidations are all
constructive steps. With the support of those of us in the
official sector, there have been a number of groups in the
private sector that have come together to devise procedures and
move forward along those directions.
But I would hasten to distinguish somewhat the issues that
we have just been discussing, which are very important, from
the issues that are the primary focus of this hearing. It is
possible to leverage a position heavily and lose most or all of
an institution's capital whether you are trading on an over-
the-counter market or an exchange market. A substantial amount
of the LTCM positions were actually on exchange-traded markets
and the overwhelming preponderance of the Barings positions
which had some similarity were traded on exchange markets. So,
I think the set of issues involved in LTCM risk type problems
is a somewhat different set of issues than the set of issues
that are involved with respect to what type of markets we
should have.
The Chairman. Thank you very much, Senator Conrad. Senator
Grassley.
Senator Grassley. Mr. Chairman, I do not have any questions
but I would like permission to put an opening statement in the
record.
The Chairman. It will be published in full.
[The prepared statement of Senator Grassley can be found in
the appendix on page 52.]
Senator Grassley. And I hope before I have to leave for the
Finance Committee I get a chance to hear the next panel.
The Chairman. Very well. Are there other questions of
senators of our distinguished witness? If not, we thank you
very much, Secretary Summers, for your testimony and for your
chairmanship.
[The prepared statement of Secretary Summers can be found
in the appendix on page 54.]
The Chairman. The chair would like to call now a panel
consisting of Chairman Alan Greenspan, Board of Governors of
the Federal Reserve System; Chairman William Rainer of the
Commodity Futures Trading Commission; and Ms. Annette Nazareth,
Director of Market Regulations, Securities and Exchange
Commission.
I welcome the panel and I will ask that you testify in the
order that I introduced you and that will be first of all
Chairman Greenspan, then Chairman Rainer, and Ms. Nazareth.
Each of you hopefully can give us 10-minutes or so of testimony
and then as you noticed with the previous witness, we will have
a round of questions by senators. Chairman Greenspan, it is
always a privilege to have you before the Committee and we
welcome you again today.
STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS OF
THE FEDERAL RESERVE SYSTEM
Mr. Greenspan. Thank you very much, Mr. Chairman. I shall
endeavor to be somewhat more brief than 10-minutes, but I tend
sometimes to ramble on so I may end up in that particular area.
I am particularly pleased to be here today before you and your
committee members to underscore the importance of this
committee's efforts to modernize the Commodity Exchange Act and
to express my support for the Working Group's recommendations.
Over-the-counter derivatives have come to play an
exceptionally important role in our financial system and in our
economy. These instruments allow users to unbundle risks and
allocate them to the investors most willing and able to assume
them. A growing number of financial and non-financial
institutions have embraced derivatives as an integral part of
their capital allocation and profit maximization.
In considering regulation of derivatives under the CEA, we
need to keep in mind that imposing government regulation on a
market can impair its efficiency. Thus, when evaluating the
need for government regulation, it is essential that the public
policy objectives be identified clearly. As the Working Group's
report discusses, the primary public policy purposes of the CEA
are to deter market manipulation and to protect investors
against fraud and other unfair practices. We must, of course,
assess whether government regulation is necessary to achieve
those objectives.
As Secretary Summers has already testified, in the case of
financial OTC derivatives transactions between professional
counter parties, the Working Group has agreed that such
regulation is unnecessary and that such transactions should be
excluded from coverage of the act. Furthermore, the exclusion
should extend to the electronic trading of such contracts by
such participants.
The rationale for these positions is straightforward. OTC
transactions in financial derivatives are not susceptible to
manipulation, and professional counter parties simply do not
require the protections that the CEA provides for retail
investors.
The Working Group has also concluded that government
oversight of clearing systems for over-the-counter derivatives
is appropriate. However, provided such government oversight is
in place, OTC transactions that would otherwise be excluded
from the CEA should not fall within the ambit of the act
because they are cleared. If market participants conclude that
clearing would reduce counter party risks in OTC transactions,
concerns about legal risks associated with the potential
application of the CEA should not stand in their way.
The Working Group's report does not make specific
recommendations about the regulation of traditional exchange
traded futures markets. Nevertheless, it calls for a review of
the existing regulatory structures, particularly those
applicable to financial futures, to ensure that they are
appropriate in light of the objectives of the act. Consistent
with the principles of regulation I identified earlier, the
report notes that exchange-traded futures should not be subject
to regulations that are unnecessary to achieve the CEA's
objectives. The report also concludes that the current
prohibition on single stock futures can be repealed if issues
about the integrity of the underlying securities markets and
regulatory arbitrage are resolved.
Mr. Chairman, I want to underscore how important it is for
us to address these issues promptly. I cannot claim to speak
with certainty as to how our complex and rapidly moving markets
will evolve, but I see a real risk that if we fail to
rationalize our regulation of centralized trading mechanisms
for financial instruments, these markets and related profits
and employment opportunities will be lost to foreign
jurisdictions that maintain the confidence of global investors
without imposing so many regulatory constraints.
My concerns on this score stem from the dramatic advances
in information technology that we see all around us. In markets
in which there are significant economies of scale and scope,
like those for standardized financial instruments, there is a
tendency toward consolidation or even natural monopoly.
Throughout much of our history, this tendency has been
restrained by an inability to communicate information
sufficiently quickly, cheaply, and accurately. In recent years,
however, this constraint is being essentially eliminated by
advances in telecommunications. We have not yet seen clear
evidence of the trend toward natural monopoly, but the
diffusion of technology often traces a so-called S-shaped
curve, first diffusing slowly but then rapidly picking up
speed. Once we reach the steep segment of that S-curve, it may
be too late to rationalize our regulatory structure.
Already the largest futures exchange in the world is no
longer in the American heartland; instead, it is now in the
heart of Europe. To be sure, no U.S. exchange has yet to lose a
major contract to a foreign competitor. But it would be a
serious mistake for us to wait for such unmistakable evidence
of a loss of international competitiveness before acting. As
our experience with the vast eurodollar markets demonstrates,
once markets with scale and scope economies are lost, they are
very difficult if not impossible to recapture.
Thank you, Mr. Chairman. I look forward to your questions.
[The prepared statement of Mr. Greenspan can be found in
the appendix on page 61.]
The Chairman. Thank you very much, Chairman Greenspan.
Chairman Rainer.
STATEMENT OF WILLIAM J. RAINER, CHAIRMAN, COMMODITY FUTURES
TRADING COMMISSION
Mr. Rainer. Thank you, Chairman Lugar, Senator Harkin,
Senator Fitzgerald. I appreciate the opportunity to come here
and discuss these recommendations. The goals of the Working
Group report have already been mentioned and the ability to
achieve these goals will be enhanced through greater legal
certainty for the OTC market. Congressional action to exclude
OTC financial derivatives from the act would provide such
certainty. I can advocate this step because OTC financial
derivatives, as we know them today, do not present regulatory
concerns within the scope of the act. Also, excluding this
activity will not diminish the CFTC's ability to carry out the
statutory mission it is charged to fulfill.
When the Commodity Exchange Act was written, Congress
articulated the rationale for regulating futures transactions.
First, the act establishes the economic utility of futures
trading, stating that futures prices are generally quoted and
disseminated throughout the United States and in foreign
countries as a basis for determining prices to the producer and
the consumer of commodities.
In addition to their price discovery function, futures
transactions are used by commercial handlers as a means of
hedging themselves against possible loss through fluctuations
in price.
The second prong of Congress' rationale for regulation is
that the transactions and prices of commodities are susceptible
to excessive speculation and can be manipulated, controlled,
cornered or squeezed. The risks of price distortion and
manipulation are the factors rendering regulation of these
markets imperative. Congress thus identified the overarching
public mission of the CFTC as that of preventing price
manipulation and ensuring price transparency.
Like exchange-traded futures, OTC derivatives are risk
shifting instruments. The Working Group, however, has
determined that prices established in OTC derivatives
transactions do not serve a significant price discovery role.
The Working Group has also concluded that most OTC derivatives
are not susceptible to manipulation. Moreover, OTC transactions
are entered into and traded by sophisticated institutional
traders who are able to look out for themselves in these
markets, and as has been pointed out the activities of most
derivatives dealers already are subject to direct or indirect
Federal oversight.
Because there is no manifest regulatory interest warranting
CFTC oversight of OTC derivatives, I support the exclusion
proposed by the Working Group. Congress and the CFTC have acted
before to resolve legal uncertainty affecting OTC derivatives.
In 1992, amid strong signals that swap market participants
feared their contracts could be declared unenforceable,
Congress responded decisively instructing the CFTC not to
regulate swaps entered into by sophisticated parties. Congress
authorized the CFTC to provide exemptive relief for swaps
without requiring the Agency to make a threshold determination
that particular exempted transactions fell within its
jurisdiction.
CFTC promptly issued a rule exempting swap agreements from
all provisions of the act except prohibitions against fraud and
manipulation provided the swaps meet certain conditions. This
exemption worked relatively well. Lately, however, evolution in
the OTC derivatives market has rendered the exemption
inadequate. The exemptive rule does not apply to OTC contracts
that are standardized, cleared or executed under conditions
that approximate those of an organized exchange.
Technology, however, is dramatically changing the structure
and nature of many aspects of the financial services industry.
The rise of electronic screen-based trading has blurred the
line drawn in our swaps exemption between bilateral and
multilateral trading. The growth in swaps volume and the
acceptance of these contracts by a wider range of users has led
to their standardization. Public policy must meet these
advances in the OTC market.
I also believe that development of regulated clearing
systems should be encouraged. Clearing systems can employ a
variety of risk management tools such as mutualizing risks and
offsetting multiple obligations. Consequently, clearing systems
can help to reduce systemic risk.
Finally, the commission's rule, the swap exemption rule,
exempts bilateral swaps from all provisions of the CEA except
those provisions prohibiting manipulation and fraud. The CFTC
thought it prudent to retain its jurisdiction to act in the
event the Agency learned that participants were engaging in
fraudulent or manipulative conduct and that the transactions
executed under the exemption were, in fact, futures.
The swaps exemption does not alter the CFTC's
responsibility to take action against this misconduct. In a
given set of circumstances, however, the Agency's ability to
act may be contingent upon proving that transactions are
futures or options. This is a critical point to remember. At no
time has Congress or the CFTC made the definitive judgment that
swap transactions are, in fact, subject to the CEA's
jurisdiction. The combination of responsibility with no more
than contingent authority is simply bad public policy because
as a practical matter the CFTC cannot exercise its residual
enforcement authority under the swaps exemption without
exacerbating the existing legal uncertainty in this area.
While examining the applicability of the act to OTC
markets, we also have conducted an inquiry into whether our
current regulatory scheme is appropriately tailored to today's
environment for exchange-traded futures. Since November, the
Agency has undertaken a serious effort to answer the question
what degree of exchange-traded regulation is necessary to serve
the public interest entrusted to us?
This inquiry is at the heart of the process that the CFTC
has engaged in over the last several months. Impending
technological and other changes require the CFTC to scrutinize
the continued vitality and viability of its one-size-fits-all
regulatory structure that currently applies to all futures
transactions. While that process is not yet complete, certain
clear principles have emerged.
One, the historic needs of traditional physical commodities
should not be the basis for regulating every futures contract
traded today and, two, institutional market participants do not
require all of the protections designed for retail traders.
The key policy elements will include a move from direct to
oversight regulation, a move from prescriptive rules to
flexible performance standards, and the increased use of
disclosure based regulation. This plan will not impair the
Agency's ability to assure the fundamental market integrity
expected when conducting futures exchange transactions in the
United States or when relying upon the prices set in U.S.
exchange-traded markets. The commission will continue to
exercise its authority to assure this integrity.
In conclusion, Mr. Chairman, time is not our ally in
establishing a framework that achieves our national economic
priorities with respect to derivatives trading. Technology has
made it increasingly easy to establish rival markets in foreign
jurisdictions. Technology has also increased the speed with
which new innovations are introduced and widely used by market
participants. Because of these realities, I ask Congress to act
expeditiously on the recommendations of the Working Group.
Thank you again for the opportunity to testify and I will look
forward to our continued collaboration with the Working Group
and members of this committee and look forward to your
questions. Thank you.
[The prepared statement of Mr. Rainer can be found in the
appendix on page 68.]
The Chairman. Thank you very much, Chairman Rainer. Ms.
Nazareth.
STATEMENT OF ANNETTE NAZARETH, DIRECTOR OF MARKET REGULATIONS,
SECURITIES AND EXCHANGE COMMISSION
Ms. Nazareth. Thank you, Senator Lugar, Senator Harkin,
Senator Fitzgerald. I am pleased today to appear to testify on
behalf of the Securities and Exchange Commission as you
consider issues pertaining to the reauthorization of the
Commodity Futures Trading Commission. In my oral testimony, I
will focus on the Report on Over-the-Counter Derivatives
Markets and the Commodity Exchange Act, which the President's
Working Group on Financial Markets submitted to Congress last
November.
In preparing the Report, the Working Group's task was
fairly specific: to focus on how the CEA might be modified to
address issues related to OTC derivatives markets. Accordingly,
the Report makes recommendations in several areas. First, the
report recommends that Congress amend the CEA to exclude
bilateral swap agreements among eligible swap participants
acting on a principal basis. This exclusion would not apply to
transactions involving non-financial commodities with finite
supplies.
It would also not apply to transactions that are conducted
on a multilateral transaction execution facility, as that term
is defined by the CFTC. The Commission believes that excluding
qualifying instruments from the CEA should create greater legal
certainty than the current approach that merely provides for
the possibility of exemption, thus leaving open the question of
whether such instruments are futures.
Second, the Report explores questions raised when
electronic systems facilitate the trading of OTC derivatives.
The Report recommends, among other things, that Congress amend
the CEA to exclude electronic systems that are clearly not
multilateral transaction execution facilities. It also
recommends excluding electronic systems that limit their
participants to sophisticated counter parties trading for their
own accounts, as long as the systems are not used to trade
contracts that involve non-financial commodities with finite
supplies.
Electronic systems that assist eligible swap participants
in communicating about or negotiating bilateral agreements
would also be excluded. Moreover, to avoid disadvantaging
existing futures exchanges, the Report specifically states that
those exchanges would be permitted to establish these kinds of
electronic systems for swaps as well.
Third, the Report addresses systems for clearing OTC
derivatives. Like electronic trading systems, clearance systems
for OTC derivatives are subject to legal uncertainty. Because
of their importance, the Report urges Congress to permit
regulated clearing systems used for OTC derivatives. The Report
clarifies, however, that a clearing system subject to
regulation by one agency should not become subject to
regulation by another agency simply because it also clears OTC
derivatives.
Fourth, the Report focuses on providing greater legal
certainty for instruments covered by the Treasury Amendment.
The Treasury proposed this amendment in 1974 out of concern
that the broad statutory definition of ``commodity'' would
subject OTC markets in government securities and foreign
currency to CEA regulation. As a result, the amendment excludes
a list of instruments from the definition of commodity. These
listed instruments, however, still may be subject to CEA
regulation when traded on a ``board of trade.''
By proposing to replace ``board of trade'' with ``organized
exchange,'' the Report seeks to clearly delineate the
limitation on the exclusion. The Report also recommends
clarifying the Treasury Amendment to permit the CFTC to address
problems associated with foreign currency ``bucket shops.''
Fifth, the CFTC's ``exclusive jurisdiction'' over certain
matters has caused confusion over the appropriate regulator and
regulatory scheme for complex derivative instruments that
possess attributes of both securities and futures contracts. In
order to provide legal certainty for these hybrid instruments,
the CFTC has agreed that it will not propose any new rule that
would cover these instruments without the concurrence of the
other Working Group members. The Report recommended modifying
the CEA's exclusive jurisdiction in order to eliminate
questions regarding the authority of the SEC and bank
regulators with respect to hybrid instruments. The report also
urges Congress to clarify that the Shad-Johnson Accord should
not be construed to apply to hybrid instruments that have been
exempted from the CEA.
Finally, the unanimous findings of the Report reiterated
the commission's position that although single stock futures
may possess elements of traditional futures contracts, they
also have characteristics of traditional securities.
Accordingly, when considering the Shad-Johnson Accord's ban on
single stock futures, it is clear that regulatory issues
associated with the introduction of such products would be
complex. Indeed, the members of the Working Group agree that
numerous issues would have to be resolved before the ban could
be reconsidered. These issues include, but are not limited to:
margin levels; insider trading; sales practices; real time
trade reporting; floor broker activities; and CFTC exclusive
jurisdiction.
As you know, Chairman Lugar and Senator Gramm have asked
the SEC and the CFTC to report back to their respective
committees later this month on issues associated with modifying
the Shad-Johnson Accord. The Commission staff has been working
diligently with their counterparts at the CFTC to consider the
relevant issues. We look forward to sharing our views with the
Committee on these issues when our report is submitted.
In conclusion, I would like to note that the Report only
represents a beginning. In addition to implementing the
Report's recommendations, we must all continue to study the
rapidly evolving markets for OTC derivatives. With input from
Congress and industry participants, we are confident that we
may meet any regulatory challenges while permitting this
important market to continue to develop efficiently. Thank you.
[The prepared statement of Ms. Nazareth can be found in the
appendix on page 73.]
The Chairman. Thank you very much, Ms. Nazareth. Let me
just comment because your very thoughtful testimony touches
upon a couple of thoughts. In those you mentioned in one
passage that the CFTC would not attempt to act arbitrarily
where there are at least arguably issues that face the SEC or
other Working Group members and that I like that idea.
As you recall, during the last 2-years as we have come
together, there was some question as to whether the CFTC
unilaterally would take jurisdiction feeling that it was doing
its duty in behalf of the American public and the integrity of
the financial system with some dispute of other persons who
have come together in this Working Group. Individual members of
the Working Group approached this chairman to indicate their
distress about that from time to time. So it is important--you
know we are all one country, we have one administration, one
president who makes appointments--to work together on this.
Then the fact that this team effort has come together is
significant and that it might be of some value.
Second, each of you have pointed out that time is not our
ally in this. When I mentioned in my opening comment that we
need to act in the next 3-months, this strikes fear and panic
into the hearts of legislators, drafters, all the parties that
are involved, to want to approach this in a much more leisurely
pace, sort of having several bites at the apple, but I think we
all understand I hope the urgency of this. This is why we set
some arbitrary deadlines for reports which we are hoping that
each of the groups will come back to us.
The third point touched upon by Chairman Greenspan and then
amplified by Chairman Rainer, we had during one hearing in this
room--in fact, someone sitting about where you are, Ms.
Nazareth, demonstrated with a screen here a trade. He actually
made a trade in a foreign country from this committee room. I
think he sold a contract of corn and got confirmation. That was
certainly interesting for all of us who are not involved in day
trading here or elsewhere hopefully in the building, but
nevertheless it demonstrated the fact that we really do not
know all that is occurring. As Chairman Greenspan said, there
is an S-curve here. Once you go over the curve, it may be
beside the point to deal with all of this with the certainty
that we had hoped with regulation. We still have a
responsibility to do our best.
But our confidence level probably diminishes rapidly.
But in that respect, do we live in a world, and Chairman
Greenspan, I ask you this philosophically, in which it is
anticipated by the public that we will all be wise enough to
have a regulatory mechanism that brings confidence to our
markets and we do our very best to do that? But as I listen to
your testimony and sort of read anecdotally the other material,
is this a situation that is getting really beyond our abilities
to do this? And to what extent, as we approach this, do we do
so with some modesty that we do our best but at the same time
not give the impression that I think some of us have given in
the past that almost like the Food and Drug Administration
pinning down safe food and after endless hearings and years of
study we get it right? I am not certain this is applicable in
this area, but would you give some philosophical perspective to
this?
Mr. Greenspan. Well, Mr. Chairman, I think you are raising
a very important concern. We have been very fortunate in this
country that the regulatory structure we have put in place has
been generally accepted by the American public. They have
exhibited confidence in it, and even though you periodically
hear of breakdowns in the system that the press goes a little
berserk on in certain areas, what is really quite remarkable is
how little of that there is. I do think that we are confronting
a broader challenge to continue that level of integrity of our
system largely because, as I point out in my prepared remarks,
the technology of financial innovation has become so
extraordinary, and, in many respects, almost discontinuous.
We have seen quantum jumps in information technology in the
nature of financial products, and as a consequence, the need
for financial regulation to adjust itself to the rapidly
altering financial structure which confronts us. I think the
Working Group has endeavored in this particular area to
recognize that a number of our definitions and our concepts
with respect to financial instruments generally, and
derivatives particularly, have got to be understood in a
rapidly changing environment.
I cannot promise you nor do I believe any of our colleagues
can that we will get this all right. But I do say, and I think
it should be emphasized, that the Working Group works very
effectively. I am myself impressed at the interaction that has
occurred and our ability to reach consensus. We do that not
because each and every member of the group agrees
wholeheartedly with each and every recommendation, but we
recognize the need for consensus above the specific solutions
that each of us would prefer, other things equal, and I take
that as a very good sign.
The Chairman. I can remember just anecdotally, Chairman
Greenspan, your coming along with Secretary Rubin to Senator
Dole's office at the beginning of the Mexican crisis, now I
guess 4-years ago or so--five--time goes by rapidly.
Mr. Greenspan. But memories do not fade.
The Chairman. I know. The thing that I remember about the
meeting, however, is the description of billions of dollars
being electronically transferred, not just with regard to
Mexico and the United States, but as you were pointing out at
that time from Southeast Asia and strange places that we would
not have thought were necessarily involved in a bilateral
crisis but at the same time seeking safety presumably. I think
this was impressive that unlike most types of protectionism,
where you can try to keep out something or keep it in, with
regard to money and electronics, even at that point, and as you
say quantum leaps have occurred in that 5-year period. So that
this is something to say the least that is very difficult, but
it is reassuring and I like your comment that the Working Group
has gotten together. Hopefully without knowing this is a
permanent institution, there at least is enough tradition of
your working together which is extremely helpful to the
relevant committees.
In that point, I am trying to work together, and I made
explicit this morning, with Chairman Gramm of the Banking
Committee. As we have gotten through the CFTC's situations
during the last two decades or so in which I have been involved
in this, frequently we have been in loggerheads with the
Banking Committee or we have gone through several years in
which nothing happened because there was sufficient stymie
either way. I think Chairman Gramm is determined, and I am,
that we have oversight over different institutions, but
nevertheless we have a working group in which you have bridged
those gaps in the administration, and I know the distinguished
ranking member joins me in our attempts to bridge them in this
Senate, bipartisan and by committee or whoever else we need to
work with.
In that respect, Chairman Rainer, let me ask you, you have
talked, and Senator Harkin asked a very pertinent question
about the difference between exemption and exclusion, but you
have said exclusion, and you have said it because this gets to
the heart of the legal certainty problem. You talked about a
regulatory scheme that really did not seem to be quite focused.
It never quite had the authority. It was out there, however,
and a part of the crisis that brought us all together a couple
of years ago was that suddenly CFTC, vague or not, decided it
was in the public interest that unilaterally it would deal with
this problem.
So this then threw markets into potential turmoil. I do not
want to put too fine a point on it, but this is a very
important juncture in the legislation and would you just
underline again the need for either certainty, exclusion as
opposed to exemption, how this fits after all the studies and
compromises that you may have made?
Mr. Rainer. That is a very important question, Chairman
Lugar, and not one that I have not spent a considerable amount
of time thinking about. The first thing I did was to determine
whether I agreed with everyone else in the Working Group
whether or not the instruments of the over-the-counter
derivatives were not manipulable, did not serve a price
discovery role, and the impact of the types of participants
with respect to regulation. I have satisfied myself that these
instruments are not readily susceptible to manipulation and do
not serve a meaningful price discovery role. As a result of
that and given the sort of collision that the CEA and the over-
the-counter derivatives market has more or less been on for a
long time, I thought it was time to resolve this matter, to
resolve the issue. I thought it was in the public interest to
get this cleared up and I did not see the benefits of the
Commodity Exchange Act superimposed over this market.
The Chairman. Those are the two major criteria,
manipulation and----
Mr. Rainer. Serving a price discovery role.
The Chairman. And price discovery.
Mr. Rainer. Since those two elements are not material with
this market, I thought that the public interest would be best
served if I agreed that we exclude this market from the
Commodity Exchange Act. Exclusion versus exemption--that is not
a complicated answer for me. I was seeking the greatest clarity
for legal certainty and an exemption would provide clarity. A
codified exemption would probably provide a little more
clarity, but the greatest clarity would be an exclusion, and I
support that.
The Chairman. Thank you. Senator Harkin.
Senator Harkin. Thank you, Mr. Chairman. I had three
questions. That was one of them, and that is can we provide the
same kind of legal certainty--after all, we write laws--and to
provide the same kind of legal certainty under an exemption
that we can under exclusions? I do not know why we cannot do
that. Again, I get back to what I asked Secretary Summers in
the beginning. That with an exclusion we have washed our hands
of it. If anything happens, again, you say I do not know what
is going to happen out there. I mean you say there is a
notional value of about $83 trillion or something like that
worldwide. I mean that is a lot of risk out there. These are
risk instruments. That is a lot of risk.
And so if you have this exclusion and something unforeseen
happens, who does something about it? You cannot, Mr. Chairman.
You cannot. You cannot. It has got to come back to us and we do
not act that fast around here. So I am wondering that within
the framework of an exemption, can you provide the legal
certainty which I understand has to be done, and this is what I
wrestle with, the legal certainty of these contracts, but
keeping the hammer--I do not know--hammer may be the wrong
word--but keeping the possibility that one of you or all of you
can act rapidly to intervene at some point? I ask all of you
that. I will start with you.
Mr. Rainer. I will defer on some of these matters to
Chairman Greenspan, but one of my answers is that I think we
have to keep in mind that most of these participants are either
involved in the banking system or investment banking industry
and so there is regulation along those lines. I am not a lawyer
and I cannot slice the differences very well between codified
swap exemption and exclusion, but I have been assured that
exclusion does provide the greatest clarity for legal
certainty. And, if that is the case, that is what I am
supporting.
Senator Harkin. Well, I have been told that, too, but I am
not certain I am buying it right now. I may. Chairman
Greenspan.
Mr. Greenspan. Senator, let me repeat what Secretary
Summers says because I do agree with him on this. The problem
would be less immediate if the CFTC had 20-year terms for
Commission members, and the people in the CFTC stayed very long
periods of time and did not change their philosophy
particularly. Then the issue would be pretty much irrelevant, I
would think. That is not the case. We have changing CFTCs.
Indeed, the difference between the current CFTC and the one
immediately preceding it with respect to how the CFTC viewed
the markets is really quite significantly different.
The result of that is that you have a situation where the
uncertainty owing to the turnover of the commission does create
a significant diminution of the degree of legal certainty, and
I think that a major concern is that it is a critical issue
which unless appropriately resolved can very readily move a
very substantial part of this market, and it is a huge market,
as you point out, overseas. There is virtually no reason why a
lot of these transactions that are made by larger investors
cannot be struck in London under a different set of laws.
So I would just say basically that because of the easy
ability to move abroad, it means that the sensitivity or the
particular barrier which we have to cross with respect to
degrees of uncertainty has been lowered, and I am fearful that
unless we get legal certainty, and indeed it is the view of all
of the Working Group members, we are fearful that we may end up
with another eurodollar market.
Senator Harkin. I try to interpret in my own words. Maybe I
just wanted clarification of this, Mr. Chairman. It almost
sounded to my ears like you were saying that if we were--if in
the wisdom of Congress, we were to provide some kind of legal
certainty to these derivatives and do it under an exemption
basis, that the regulatory body that would be best able to
oversee that would not be something like the CFTC, which as you
say changes more rapidly, but perhaps something like the
Federal Reserve System which is more stable and long term.
Mr. Greenspan. I would say that even we do not, in my
judgment, fall into the category which would create the same
degree of legal certainty that a statute would do. I----
Senator Harkin. Are my fears unfounded then that if
something happens out there, there is no one that can do
anything and we have to act here in Congress? Is that just an
unfounded fear or----
Mr. Greenspan. Senator, no, you are certainly raising a
legitimate question which really is far broader than the
question of the issue we are discussing today because all of
government regulation is either discretionary with respect to
various regulatory agencies or prohibitive. There is no
capability of any element within this government, for example,
to regulate home heating oil prices, to my knowledge. When we
had this recent very sharp run-up in prices, there indeed was
no authority to deal with it. It is a market adjustment process
which will eventually deal with it and, as I think we have all
argued, in the derivatives area, it is largely counterparty
surveillance which is our primary source of regulation.
I think that we have to recognize that regulation is a very
difficult operation. I mean you point out that the LTCM episode
was one over which we had no particular regulatory capability,
yet the supervisory structure of this government worked. We had
an ad hoc approach. The Federal Reserve Bank of New York
brought together numbers of private parties because in our
judgment it was to their interest to resolve the question.
There is a great deal of that going on.
Can I envisage a problem that will emerge in which if there
had been regulatory authority, it would have been readily
resolved and that we in the event did not have that authority
and would be presumably worse off? Absolutely. I mean those are
going to happen. I think that there is a very fundamental
tradeoff of what type of economy you wish to have. I mean you
can have huge amount of regulation and I will guarantee nothing
will go wrong, but nothing will go right either.
Senator Harkin. My time has run out. I do not know if Ms.
Nazareth wanted to wade into this or not.
Ms. Nazareth. Well, just briefly. I certainly agree with
Chairman Greenspan and Chairman Rainer that there are very
strong benefits to the legal certainty. I also think that
there, in fact, have been a number of improvements and private
sector initiatives in addressing the risks associated with this
business. The improved transparency initiatives that came out
of the President's Working Group Report on Highly Leveraged
Institutions I think was very important. I do think that market
discipline has been and will continue to improve significantly.
I think credit standards have improved and, you know, as a
result of the Working Group's Report on Highly Leveraged
Institutions, we will probably see greater transparency of
exposure to highly leveraged institutions and also the SEC
asked for increased risk assessment authority. So there are
other initiatives going on that I think will go to improving
the issues of the systemic risk.
Senator Harkin. Thank you. Mr. Chairman, I had two other,
but obviously I have used up my time. The other two, and I may
just write these in a letter to you all, number one, the
exchanges are concerned about parity. In other words, they are
looking for some regulatory relief, too, and if we do this and
we do not do the other one, they are worried about the
disconnect. I think that is a fair, rational concern on their
part, and I wanted to ask you about that, but maybe I will in a
letter.
The other one was just on the clearinghouse concept. I am
not certain how that works in this regime. I know how it works
on the exchanges where you settle up and you make your marks
everyday and you clear it at the end of the day. I do not know
how it works in this setting and, again, perhaps in a letter
you could outline it for me how this clearinghouse concept
might work. Thank you, Mr. Chairman.
The Chairman. Let me just respond for a moment. Senator, in
my opening comment I mentioned that, just taking up this parity
situation comparable problems with SEC or others. Chairman
Gramm and other members of the Banking Committee have suggested
and I think this may be a good idea that we may have joint
hearings of the two committees.
Senator Harkin. That would be good.
The Chairman. To try to take a look at the level of
regulation so that things do not get too disparate. We do not
have a comparable situations entirely, but some members of the
Banking Committee including the Chairman are much interested in
this question, too. So this may be a way on our side at least
of trying to do work that is comparably done by the Working
Group. Senator Fitzgerald.
Senator Fitzgerald. Thank you, Mr. Chairman. I have a
question for Ms. Nazareth. I appreciate your being here and I
gather you are the Director of Market Regulation at the SEC.
Ms. Nazareth. That is right.
Senator Fitzgerald. We talked with Secretary Summers about
how well our securities laws have worked in this country and I
think we have a wonderful regime that has held up well even
though it was drafted in the 1930s. It has held up well even in
this modern world. One feature of our securities laws in this
country is that the basic core statutes apply to all securities
traded everywhere. There are some minor exceptions to that
general rule. One can sell stock to sophisticated parties
without filing a registration statement. However, in general,
if there were ever any fraud, you would come in under your
authority under section 10(b)(5) and wherever that market
trading occurred, whether it occurred on an exchange or out in
the parking lot, you would have the authority to act.
Furthermore, the definition of securities in the securities
laws of this country is very, very broad. It is hard to create
a financial product that does not have characteristics of a
security. In fact, stocks, bonds, promissory notes can be
classified as securities, and the scope of the securities laws
is enormously broad, very hard to escape. The laws apply
everywhere.
In talking about how we are going to redo the CEA, we are
talking about something completely different. Instead of having
a CEA that applies to all financial derivatives everywhere and
equally and having a broad definition of what is encompassed by
the act, we are really carving out a little narrow area of
financial derivatives that are going to bear the whole brunt of
full-scale regulation; namely financial derivatives that are
called futures contracts and traded on an exchange.
Anything that is slightly different that can be called a
swap as opposed to a future. An interest rate swap, if we call
it a swap, even if it is fungible, standardized, and not traded
on an exchange, it will not be subject to regulation. I am just
wondering if that makes sense. Do you not think there is a
possibility that all financial derivatives the business is
going to migrate to the swaps area very easily because you can
escape the definition of what is covered by the act?
In fact, what is covered by the act is left really to
something that is labeled a future and traded on an official
board of trade. Do you not think a lot of that business is just
going to go to where it is unregulated? In addition do you
think our securities laws should have such kind of gaping
exemptions and just apply in little narrow areas?
Ms. Nazareth. I would not think that it would all migrate
to the over-the-counter derivatives markets because those are--
they are really not standardized products. They are bilateral
contracts. They are not fungible. They are used really for very
specific financial purposes.
Senator Fitzgerald. You do not think there is any
standardization of interest rate swaps out there? I mean----
Ms. Nazareth. Well, I think given the large market for
them, there certainly has become somewhat more of a
standardization in the sense that there obviously are
agreements that people use, but they do negotiate the terms of
those agreements on a bilateral basis.
Senator Fitzgerald. How would you describe the difference
in economic terms between an interest rate swap between
institutional parties and institutional parties buying interest
rate futures? What is the economic difference between those two
transactions?
Ms. Nazareth. Well, there are differences in--again, I
think there are differences in the fungibility, the closeout
procedures. Currently certainly there were differences in the
ability to net. There will be some more--they will become----
Senator Fitzgerald. But what are the economic differences?
Suppose we have a different futures contract for every interest
rate swap. We change the contract in some regard so it is no
longer fungible. What would be the economic difference?
Ms. Nazareth. Well, I think in some cases they may serve a
similar economic function. I think that is one of the
challenges that we all have as regulators today is that you
have a number of these products that start to resemble each
other.
Senator Fitzgerald. What would be the public policy
rationale for giving disparate treatment to similar instruments
traded by similarly situated institutions, but just happen to
be trading in different venues?
Ms. Nazareth. Well, I am not here to sort of argue what I
believe is, you know, Chairman Rainer's jurisdiction with
respect to what should the commodities laws cover, but I do
think that there are differences in that what we have done for
purposes of this report is simply address over-the-counter
derivatives and defined them, defined these swap transactions
in a narrow way of just talking about counter parties with $25
million in investments, bilateral contracts, contracts that are
done purely on a principal basis. So it is a smaller subset.
Certainly it does not cover, you know, retail products and
things of that nature.But again I think----
Senator Fitzgerald. Would anybody else care to address this
issue? It seems to be a distinction without a difference.
Mr. Rainer. Senator Fitzgerald, you raise very good points
and I think it is very consistent with what is actually in the
Working Group set of recommendations because there is
difference paid to the fact that these recommendations may have
an impact on our exchange-traded futures with differences in
regulation for similar products. One of the reasons I think we
have such a good strategy here is because this is not a one-
part recommendation, it is a two-part recommendation.
The first part is to enact the recommendations with respect
to the over-the-counter derivatives and the other part is for
the CFTC with assistance from this committee and others to
devise a regulatory framework that is more rational than the
one that we have today. With your example, if I were to say
eurodollar contracts, I would argue, although we have not made
this judgment officially, I would say there is a good case to
be made that the eurodollar contract is also a contract that is
not readily susceptible to manipulation. Our challenge is to
come up with a comprehensive framework that deals with the very
issues that you were talking about.
Senator Fitzgerald. Thank you. Mr. Greenspan, the Federal
Reserve Board regulates the banks in this country and I am sure
you have been looking very carefully at----
Mr. Greenspan. Some of the banks.
[Laughter.]
Senator Fitzgerald. Well, all bank holding companies.
Mr. Greenspan. Correct.
Senator Fitzgerald. You do look at the derivatives on the
balance sheets, the derivative exposures of our banks. A lot of
banks have purchased interest rate swap contracts. In fact, I
saw that of that 80-trillion on OTC financial derivative
markets, a large percentage of that are simply interest rate
swaps, I would imagine most of those swaps are between
financial institutions laying off interest rate risks that they
may have. Have many banks bought interest rate futures on a
board of trade or are they all interest rate swaps?
Mr. Greenspan. There is both involved, but I think the
point you are making, which I would agree with, is the fact
that the proportion of derivatives which are exchange traded
has been declining, and the reason they have been declining is
that the market participants perceive that the costs of
exchange-traded derivatives exceed the benefits that they
create over and above over-the-counter derivatives. And, they
do. I mean there are certain advantages in the settlement and
clearing processes in exchanges which are not replicable in the
over-the-counter markets and as a consequence the exchanges do
have certain benefits which the OTC markets do not have.
If, however, we see, as we do, a decline in the share of
exchange-traded instruments, it presumably means that the
markets generally perceive that the costs involved, essentially
regulatory costs, are excessive relative to the benefits that
are achieved. I think that it clearly is an issue that ought to
be addressed. We at the Working Group certainly are aware of
this problem and have been looking at it. And, precisely how to
come at it, I think is an issue which does require efforts on
our part and I would presume that we will be moving in that
direction as best we can.
Senator Fitzgerald. Would you be in favor of exempting
exchange-traded transactions wherein the counterparties are
strictly institutional?
Mr. Greenspan. There has been a considerable amount of
discussion and indeed certain efforts beginning to be directed
in that particular area. Obviously, the concerns that a number
of people have is that if you bifurcate the market, you will
create a significant spread in at least part of the residual.
That, is the bid-asked spreads will open up because the volumes
will be substantially less.
I do think we have an issue here that has got to be
resolved and I would suspect that it is not so much an exchange
issue as it is between retail customers and institutional
customers. There is no question that if you have a very large
volume market, the liquidity of that market will essentially
create a very significantly lower per unit cost of transaction
than you will get in a retail market, which by its nature is
much smaller.
The question is whether or not you want to do cross-
subsidization between these various types of markets. My own
impression is that if you were concerned about this issue, one
vehicle which we used to have, I guess, was in the grain pits.
We used to have, I remember, thousand bushel wheat contracts. A
thousand bushel wheat contract had a bid-asked spread which was
significantly wider than the conventional 5,000-bushel wheat
contract. But you had a considerable volume of retail business
in the thousand bushel contract and what would happen would be
is that the exchange traders would arbitrage the difference and
effectively, significantly reduce the difference in the
spreads, but not completely.
In other words, they did not effectively cross-subsidize
because that was not their business, but their arbitrage did
bring down the differences quite considerably and I think what
the issue here is not that we do not perceive of the necessity
of making certain that retail markets are as efficient and
liquid as they can be, but how do we do it without impairing
the important competitive efficiencies of the large
institutional markets. That is where the issue lies as far as I
can see.
Senator Fitzgerald. We have not bifurcated our securities
market like that.
Mr. Greenspan. Well, we used to have odd lots, remember. It
was the same issue.
Senator Fitzgerald. OK.
Mr. Greenspan. I as a kid used to buy odd lots and some of
them were very odd stocks, I must say.
[Laughter.]
Senator Fitzgerald. Well, thank you very much. I appreciate
that testimony. I have just one question on the Treasury
Amendment, if I may? I know we have run over, but the report
adopts a definition of organized exchange that has two parts.
One, it permits retailer agency trades and, two, it provides
for self-regulation. Under the proposed amendment to the
Treasury Amendment, could an exchange which is open to retail
customers and which trades Treasury Amendment products other
than foreign currencies opt out of the CEA simply by either
dropping its self-regulatory functions or barring the retail
customers?
Mr. Rainer. Is that to me, Senator?
Senator Fitzgerald. Yes.
Mr. Rainer. That is a very complicated question and I would
like to answer it this way. The Treasury Amendment is in need
of repair. The CFTC has a mission where it should and does find
and prosecute and convict entities involved with foreign
exchange on retail. This is a large problem in our country. The
way it works is that for the CFTC successfully to prosecute
such an entity, it must prove that entity is a board of trade.
And the way it proves, at least one way it proves that it is a
board of trade, is define the board of trade under the category
called ``association of persons.'' If it is an association of
persons, it is easier to establish that this bucket shop is a
board of trade. That very act if successful has the Catch-22
effect of potentially looping in legitimate bond dealers into
the CEA, an unintended circumstance.
So I think what the PWG is trying to solve is this problem
by converting the definition to organized exchange with retail
and SRO. I do not care to give full validity to your example,
but it is not intended, I do not think, to allow your example
to happen, and this is one of these technical details that we
will be happy to work with the Committee on.
Senator Fitzgerald. Once you write the legislation, will
you come up with the way of solving it?
Mr. Rainer. Yes.
Senator Fitzgerald. Well, thank you all very much.
Appreciate your time.
The Chairman. Thank you very much, Senator Fitzgerald, for
comprehensive questions and we thank each of you for giving us
your testimony and your service. This panel is dismissed.
The Chairman. We will proceed on to the final panel which
will include Mr. David Brennan, Chicago Board of Trade;
Chairman Daniel Rappaport of the New York Mercantile Exchange;
Mr. Jerry Salzman of the Chicago Mercantile Exchange; Mr.
Richard Grove, Chief Executive Officer of the International
Swaps and Derivatives Association; and Mr. Edward Rosen,
counsel, Ad Hoc Coalition of Commercial and Investment Banks.
The Committee will come to order. It is a privilege to have
each of you gentlemen here this morning for your testimony and
I will ask that you testify in the order that I introduced you
and that would be, first of all, Chairman Brennan, then
Chairman Rappaport, Mr. Salzman, Mr. Grove and Mr. Rosen. If
you can, try to summarize your testimony in 5-minutes and all
of your statements will be made a part of the record so it will
not be necessary for you to ask that, that occur. It will occur
because we want a complete record of your views and the entire
hearing. Chairman Brennan, good to have you again before the
Committee.
STATEMENT OF DAVID P. BRENNAN, CHAIRMAN, CHICAGO BOARD OF TRADE
ACCOMPANIED BY THOMAS R. DONOVAN, CHIEF EXECUTIVE OFFICER AND
PRESIDENT, CHICAGO BOARD OF TRADE
Mr. Brennan. Thank you, Senator, and thank you for having
me. Mr. Chairman and members of the Committee, I am David
Brennan, Chairman of the Chicago Board of Trade. With me today
is our President and CEO Tom Donovan. We thank you for the
opportunity to discuss with you the Working Group's report on
derivatives markets.
Before I begin, I would like to mention that the new
leadership at the CFTC, Chairman Bill Rainer, has been a breath
of fresh air. He has brought market experience and creativity
to the Agency. As you have already heard this morning, under
Chairman Rainer, the CFTC is looking to transform and modernize
its regulatory approach. We applaud his efforts and look
forward to working with him.
We have submitted to this committee a written statement
that describes in detail where we agree and disagree with the
Working Group's report. Sometimes in all that detail the big
picture does get lost. I want to make sure that I emphasize
that picture today.
The Working Group's recommendations add up to a
comprehensive overhaul of the Commodity Exchange Act. Broadly
stated, the Working Group's framework would do three things:
give legal certainty to over-the-counter derivatives; transform
the CFTC into an oversight agency for execution and clearing
facilities; and reconsider the single stock futures ban in
Shad-Johnson and its competitive implications.
Chicago Board of Trade fully endorses the need to reform
the CEA and the Working Group's three-part framework. That
should not be too surprising. Restructuring Federal regulation
is driven by the same market forces-technology, globalization,
innovation and competition-which have caused exchanges to
restructure themselves. The Board of Trade is no exception.
This last month our board of directors overwhelmingly adopted a
bold strategy to restructure our exchange by creating two
independent for-profit companies. One will focus on pit
trading; the other will focus on trading electronically. Both
will try to attract business by providing liquid trading
markets. Both will innovate and invest in technology to provide
customers the best service. Both will provide customers with a
market that they can trust.
What our plan does is give both companies a fair chance to
compete, and no business should really ask for more. Federal
regulation is part of that fair chance. We believe in open
markets and fair competition. To us, similar products traded in
similar circumstances should have similar government oversight.
That means privately negotiated transactions may be excluded,
but all public execution facilities should be treated alike.
That is our ``golden'' rule of fair competition.
Today that rule is not being met. After almost 80-years,
the Commodity Exchange Act has become unworkable. Over-the-
counter derivatives, especially in the area of equity swaps,
are plagued by legal uncertainty, as the Working Group
describes. Exchange markets suffer from extreme regulatory
arbitrage, as the Working Group acknowledges. For single stock
futures, it is even worse. We are barred from competing at all
under a statutory provision that we were told 18-years ago
would be ``temporary'' until a regulatory impasse could be
resolved.
The Working Group recommendations cover each of these
areas. Some of those recommendations are specific statutory
changes. Some involve working with the CFTC and the SEC. We
know that many details need to be worked out and are likely to
be controversial, but we are eager to help bring these issues
to closure. Mr. Chairman and members of the Committee, all we
have ever asked for is a fair chance to compete. This year's
CFTC reauthorization may present us with our best chance to
achieve that goal. We look forward to working with you and this
committee to make sure that, that common objective becomes a
legislative reality. Thank you very much.
The Chairman. Well, thank you very much, Mr. Brennan, and
we look forward to working with you and your associates in the
Chicago Board of Trade. We noted with interest the developments
that you described there in your organization which are
indicative of some of the issues that have been a part of this
hearing today.
[The prepared statement of Mr. Brennan can be found in the
appendix on page 81.]
Chairman Rappaport.
STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK MERCANTILE
EXCHANGE
Mr. Rappaport. Thank you, Mr. Chairman. Thank you, Senator
Fitzgerald. I had a number of comments that I was going to make
but I will not make, and I think I will keep my comments
relatively brief because I cannot tell you how encouraged I was
sitting out in the audience listening to your questions to the
other panels and after coming and going to these hearings over
the last 7-years for the time that I have been chairman of the
New York Mercantile Exchange, I see that finally we have gotten
our point across because you are asking the questions that we
were asking years ago coming to you trying to make you aware of
this disparity of regulation, this inequitable disparity of
regulation that did not put us on a level playing field with a
marketplace that was selling the same product to the same
customers at the same exact time, and we really appreciate the
fact that you are beginning and clearly now understand this
issue.
We think that while the Working Group report begins to
address some of the issues associated with legal certainty and
some of the other related issues, I was very glad to hear your
comments in terms of this is really only half the puzzle and
that the other half of the puzzle needs to be resolved and that
you have an interest in resolving it in more of a simultaneous
manner than some other people are discussing, not permitting
our side to be held hostage to resolution of this other issue
because, as you recall, when Congress passed the Futures
Trading Practices Act in 1992, they also encouraged that the
commission use its exemptive authority to take care of the
exchange issue. Here we sit 8-years later not having got any
real relief, although I will echo Chairman Brennan's remarks
that Chairman Rainer's initiatives in this area in a very short
time have made incredible accomplishments and we look forward
to more.
But even the report itself says that U.S. futures
exchanges, on page 21, are at a competitive disadvantage to OTC
derivative markets as a result of the Commodity Exchange Act
observing what major market participants have said and the
report itself goes on to say that if the recommendations in the
report are implemented that they hold out a good possibility
that it will only exacerbate that perceived balance. And, that
is really where we are today. We are here to say that we agree
with some of the recommendations in the report. We are looking
forward to seeing the commission's response to the rest of the
puzzle and I look forward to being here again to talk to you
more about that. Thank you.
The Chairman. Well, thank you very much, Chairman
Rappaport. As you know, we have asked for specific comments on
issues that we are not taking up in great detail today from the
chairmen of CFTC and the SEC and in a fairly short time frame
because these are relevant clearly and I have stressed again
the potential cooperation with Chairman Gramm and the Banking
Committee. You cite correctly the 1992 act is one in which some
cooperation came only have a long stretch and so we are back,
at least----
Mr. Rappaport. It did not really come to us though.
The Chairman.--into a different report at that point.
[The prepared statement of Mr. Rappaport can be found in
the appendix on page 92.]
Mr. Salzman.
STATEMENT OF JERRY SALZMAN, CHICAGO MERCANTILE EXCHANGE
Mr. Salzman. Chairman Lugar and Senator Fitzgerald, I am
honored to represent the CME's Chairman Scott Gordon who was
unfortunately too ill to get on the plane last night or this
morning. He sends his regrets to this committee. I am going to
essentially present his remarks, if I may, and, of course, as
usual I may add something of my own. I want to begin by
unequivocally expressing the CME's support for the efforts of
the CFTC under Chairman Rainer to reexamine and reassess the
regulatory structure of our industry. The commission has made
valiant initial revisions to its very thick white book of
regulations. We think that demonstrates the commitment to bring
regulatory burdens into line with regulatory needs. We are
extremely happy about that.
That said and without criticism of our Regulator's
endorsement of the President's Working Group's Report, it is
fair to say that the CME is extremely concerned about the focus
of that Report. We are, of course, heartened by Senator Lugar's
remarks that he is going to ensure that we get some parity when
legislation is put into place. But it is clear to us that the
Report itself unjustifiably tilts the playing field against the
existing exchanges.
Our goal, the goal of the exchanges, has been equivalent
regulatory treatment for functionally equivalent execution
facilities, clearinghouses, and intermediaries. That is, if an
execution facility is performing a function, all execution
facilities performing the same function in an equivalent manner
should be treated equally. Same for clearinghouses and the same
for intermediaries. We have carefully assessed the Report and
we do not think that the Report endorses this principle. The
Working Group has recognized the regulatory disparities and
blurred product distinctions that handcuff U.S. futures
exchanges in today's competitive global markets. I think
Senator Fitzgerald's questions have been very pointed in saying
what is the difference between these products? What are the
differences between the intermediaries? What are the
differences between these end users in these two markets? That
has really called the issue into a clear perspective.
We consider that omission in the Report a serious flaw. Now
the Report does call for some changes that are in accord with
our principles. But it's recommendations for regulatory relief
and legal certainty we think are only going to bring immediate
benefits to the over-the-counter market and to enterprises that
are now springing up all over this country intending to operate
or operating unregulated exchanges at this very point in time.
All you have to do is look on the internet or look in the
newspaper clips everyday. There is a new one every morning.
The Report itself begins with what I think we would all
agree is a conservative call for legal certainty for the over-
the-counter swaps market. We agreed with that call and we
sponsored and have made proposals to that effect beginning
early last year. The Report, however, veers from that simple
principle to a more radical realignment of markets and
regulators by essentially redefining what a swap is to include
standardized, cleared, financial futures contracts that are
traded on electronic exchanges. So effectively, while calling
for legal certainty for a swap, they then redefine swap and
call for special treatment for special kinds of exchanges that
essentially duplicate what our exchanges are doing.
The call for legal certainty for a bilaterally negotiated
swap contract, which we support, is effectively converted into
a demand for exclusion from the CEA for exchange traded and
cleared financial futures. Now this creates two problems.
Senators Harkin and Fitzgerald have pointed out that the
exclusion may cripple somebody at a later point in time when
action needs to be taken and it is not clear why you need an
exclusion.
There is another problem that I do not think has been
raised, except in our testimony, which is that the exclusion
may not lead to the legal certainty. Legal certainty has been
code for avoidance of CFTC regulation and risks of equities or
derivatives that have underlying securities from the CEA. Given
the public statements of the SEC and the statements and briefs
that they filed in many courts, there becomes a serious
question as to whether these excluded derivatives are or are
not securities. As Senator Fitzgerald has noted, given the
broad scope of that definition and given court decisions that
the only reason they are not securities is because of the
CFTC's exclusive jurisdiction.
My concern is that we are not creating legal certainty but
transferring uncertainty from one regulator to another
regulator. I think this issue has to be faced at a very early
stage in this process. I see my red light is on. I have a
little more, but I do not want to hog time up here so I will
just stop.
The Chairman. Proceed if you can summarize.
Mr. Salzman. OK. I want to draw special attention to a
discrepancy between the treatment that the OTC market gets in
the Report and exchanges that is in respect to equity
derivatives. As we all know, the Shad-Johnson accord raises
questions as to legality of both exchange-traded single
security futures and over-the-counter single security futures
or derivatives. The President's Working Group proposes to
exclude swap agreements that ``reference non-exempt securities
from the CEA.'' Non-exempt securities, I believe, is a term of
art for equity securities and certain kinds of other municipals
and things like that.
In fact, the Presidential Working Group urges that single
stock futures and all stock indexes be permitted both over-the-
counter and on the unregulated exchanges it describes. If that
reccomendation were enacted, we would be in this strange
situation where the places to trade derivatives on single-stock
futures are either over-the-counter or unregulated markets. A
regulated market with transparent pricing and careful
protection of ultimate customers is the only place left where
you cannot trade the instrument. That proposal is made without
any suggestion that we have to work out regulatory issues,
where we have to work out margins, where we have to work out
anything.
In fact, it is just carte blanche for unregulated exchanges
and over-the-counter markets and the same old story for the
existing regulated markets. This to us does not seem reasonable
or fair. And with that, I will stop. Thank you very much,
Senator.
[The prepared statement of Mr. Gordon, submitted by Mr.
Salzman can be found in the appendix on page 100.]
The Chairman. Well, thank you, Mr. Salzman. Let me mention
at this point two things. First of all, I should have mentioned
that Commissioners David Spears and Jim Newsome have come to
the hearing today from CFTC and we appreciate their presence in
addition to the distinguished chairman.
The other thing is that Senator Fitzgerald and I will need
to go to vote. There are 5-minutes left in the roll call on the
bill that is on the floor. Fortunately, it is a single vote and
so I will ask the patience of Mr. Grove and Mr. Rosen because
we will both want to hear the testimony from the beginning.
Senator Fitzgerald. We will be right back.
The Chairman. We will be right back. The hearing is
recessed for a moment.
[Recess.]
The hearing is called to order. We look forward now to the
testimony of Mr. Grove. Will you please proceed?
STATEMENT OF RICHARD GROVE, CHIEF EXECUTIVE OFFICER,
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
Mr. Grove. Thank you very much, Mr. Chairman. I am the CEO
of ISDA, the International Swaps and Derivatives Association,
and before joining ISDA, I was actively engaged for many years
in sales and trading of OTC derivatives and other financial
products. ISDA has had the privilege of appearing before and
working with this committee for more than a decade and we are
pleased to be here again today. ISDA's more than 450-members
include the world's leading dealers in off-exchange principal-
to-principal derivatives transactions. These transactions are
typically referred to as swaps and their status under the CEA
is the focal point of the report of the President's Working
Group.
Swaps, as you know, Mr. Chairman, are powerful tools that
enable American businesses and other end users in each of the
50-states to manage the interest rate, currency, commodity,
credit and other related risks that are inherent in their
activities. In this way, businesses and other users of swaps
are able to lower their cost of capital, manage their credit
exposures and increase their competitiveness both here and
abroad by focusing on their core areas of expertise.
The United States has been a leader in the development of
swaps and American businesses were among the earliest to
benefit from these risk management tools. The dramatic growth
in the volume and diversity of swaps is probably the best
evidence of their importance to, and acceptance by, end users.
It is no coincidence that the U.S. economy and the volume of
swaps both grew dramatically during the last decade. Let me add
at this point that ISDA's membership includes many of the
businesses, financial institutions, government entities and
other end users that rely on swaps to manage their financial
and commodity market risks with a degree of efficiency and
effectiveness that would not otherwise be possible.
The Working Group report is the product of a great deal of
effort by each of the members of the group and their
colleagues. It reflects a solid understanding of, and
sensitivity to, the factors that enable the U.S. financial
markets to so efficiently allocate capital and so effectively
sustain economic growth. The report embodies an unprecedented
consensus among four key financial regulators that legislation
should be enacted to provide legal certainty for swaps.
As you know, legal certainty simply means that parties,
both dealers and end users, must be certain that the provisions
of the swaps agreements they enter into are enforceable. Any
uncertainty with respect to the enforceability of swaps creates
risks not only for parties involved but for the financial
system as a whole. For example, when unilateral actions by the
CFTC in 1998 suggested that the CFTC might treat some swaps as
futures contracts, congressional action was required to
preserve legal certainty for swaps and thus ensure continued
market stability.
The underlying policy considerations were not addressed by
Congress in 1998, but they have now been carefully considered
by the Working Group. The Working Group concluded that
financial swaps do not present public policy concerns of the
sort that the CEA is intended to address and that legal
certainty can therefore best be provided by an exclusion from
the CEA.
In one respect ISDA believes that Congress should go
further than the Working Group by excluding from the CEA swaps
involving commodities with deep and liquid markets such as
various energy products. Indeed, the failure to do so may
stifle the continued development of innovative energy risk
management tools in the United States to the detriment of
American businesses and other end users. That having been said,
ISDA agrees with the thrust of the Working Group's
recommendations. There is broad consensus on the merits of the
issue and I cannot emphasize too strongly ISDA's belief that
the time for congressional action to provide legal certainty is
now.
I would also stress that legal certainty should be provided
in a manner that does not restrict financial innovation. As you
know, Mr. Chairman, U.S. financial institutions and U.S.
technology companies are world leaders in their respective
fields. From the broad perspective of our national interest, we
should not compromise these leadership positions by creating or
maintaining regulatory structures that discourage financial
institutions from using and benefiting from the most efficient
and innovative electronic technology available.
To summarize, ISDA hopes that the Working Group's report
will serve as the catalyst for the enactment of bipartisan
legislation this year to provide legal certainty for swaps. As
described more fully in our written statement, ISDA believes
that this legislation should also provide appropriate
regulatory relief for the futures exchanges.
Let me conclude with the promise that ISDA will remain
committed to working with this committee on a cooperative and
constructive basis to ensure that the key objective of legal
certainty for swaps as well as appropriate regulatory relief
for the futures exchanges is translated into legislative
reality this year. Thank you, Mr. Chairman.
[The prepared statement of Mr. Grove can be found in the
appendix on page 106.]
The Chairman. Thank you very much, Mr. Grove. Mr. Rosen.
STATEMENT OF EDWARD ROSEN, COUNSEL, AD HOC COALITION OF
COMMERCIAL AND INVESTMENT BANKS
Mr. Rosen. Thank you, Mr. Chairman, and thank you for the
continued leadership role that you have played in this issue
over the years. The coalition believes that the most important
attribute of the President's Working Group report is the
consensus. In reaching any consensus obviously all individual
views succumb to the weight where agreement meets. Undoubtedly,
left to their own devices, each of these agencies would have
produced a different report, but we have something better than
four different views on this subject. We have one view. Whoever
it was that first said that less is more I think had something
like this in mind.
We should not really overlook the importance of this
consensus because when we look back to the not too distant
past, it was clear that we nearly compromised the vitality of
our financial markets as a result of interagency jurisdictional
competition. But we now for the first time have four agencies
who are all rowing in the same direction.
Now I think the exchanges really have it right when they
say that to some extent this is about drawing lines, and as we
noted in our written testimony, the coalition believes that
there is more that can be done in certain areas in establishing
a regulatory framework within the Commodity Exchange Act for
electronic trading systems that are not eligible for one of
these exclusions in the area of hybrid instruments and legal
certainty for non-financial derivatives. We also support
modernization of the regulatory regime for exchanges and we
also support the trading of single stock futures.
Even though we might have drawn the line somewhat
differently had we had the luxury of drafting a report like the
President's Working Group report, we think that it is
nonetheless a very valuable starting point of departure for
this legislative effort. Confirming the recommendations in the
President's Working Group alone will be a very important step
in providing legal certainty and ensuring financial innovation
going forward in the U.S. financial markets, but we must
maintain our perspective on what is most important in this
process and what is less important in this process.
It is most important in this process to resolve the issues
of legal uncertainty and barriers to innovation that hold back
the United States financial markets and it is very important to
provide a framework for the exchanges that allows them to
compete on an appropriate basis both domestically and
internationally. But there are other issues that are somewhat
less important in this debate, issues that it would be nice to
address, but it may be very difficult to address. For too long,
accomplishing the legal certainty agenda has been held hostage
to some of these other issues like the trading of single stock
futures.
This is, I think, the fourth appearance I have made before
this committee on these issues. I think we have been talking
about these issues now for 10-years. We really need to resolve
these issues. It is nice to see a general recognition that time
is not our ally on them, and I want to confirm to the Committee
that the coalition is committed to participating in a process
that will result in successful legislation, but we must not
allow our inability to achieve a perfect result to interfere
with our ability to accomplish what can be accomplished.
I had some longer remarks prepared, but I candidly think
that the debate and discussion that has occurred prior to this
panel on issues of exemption versus exclusion, analogies to the
securities law regulatory structure, comparability of
economically similar products, has really raised the level of
the debate on these issues and I look forward to an opportunity
to addressing those issues.
[The prepared statement of Mr. Rosen can be found in the
appendix on page 108.]
The Chairman. Well, thank you very much. Let me commence
the questioning and I will call upon my colleague, Senator
Fitzgerald. Let me address this to Chairman Brennan and
Chairman Rappaport and Mr. Salzman. The Working Group report
goes out of its way to state that futures exchanges are
eligible to qualify for both the over-the-counter derivatives
exclusion and the electronic trading system exclusion if they
meet proper criteria. I am wondering has this been discussed at
your exchange and what are your general conclusions with regard
to that part of the report? Do you have a comment on that, Mr.
Brennan?
Mr. Brennan. Yes, Senator. I think we have discussed this
and I think to crystalize it, I think we are concerned about
the fragmentation when you split off either pit versus
electronic or retail versus institutional. We are very
concerned about the fragmentation issue that has been discussed
and maybe the ag versus the financial, you know, the finite
supply versus the infinite supply, and we are wrestling with
that, but that is the framework which we have been discussing
it.
The Chairman. Do you have any comment on that, Chairman
Rappaport?
Mr. Rappaport. Yes. I think we agree in that sense that we
are very concerned about what seems to be an effort to create
what some people have referred to as the two-tier market, the
retail versus the institutional, and we wonder why a similar
structure in the securities law could not be created for the
commodities. I think one of the problems that we have all been
struggling with, and I agree with Ed Rosen before, I think the
debate here, I think, is somewhat elevated from some of the
ones we have had in the past years, is that we continue to
struggle with this Commodity Exchange Act, trying to make it
work within this environment. That is a very difficult thing to
do because the simple question is, as Senator Fitzgerald
pointed out, why is it that I can buy one share of a tech stock
that has daily volatility of 500-percent, not unlike and
perhaps a lot more than a lot of the commodities that we trade,
and I can trade that right next to Goldman Sachs and Morgan
Stanley and the most sophisticated investors in the world and
there is no issue with that. And it is one marketplace, price
discovery, transparency, everybody knows where it is, and I
cannot do that with bond futures or I cannot do that with crude
oil or gold, real global commodities? I think that is a very
simple question that needs to be answered, and if it is, I
think that will drive us to the solution. So in response to the
simple question, we are very concerned about the fragmentation
of the retail versus the institutional market.
The Chairman. Mr. Salzman.
Mr. Salzman. In addition to that fragmentation, I think we
are also concerned about the notion of whether you need a
disinter mediated market or an intermediated market and why
should that make a difference. We have customers out there
entering orders through the internet, but they do not go
directly to our market. They first stop at an FCM's computer,
if you could call it stopping, to have a credit check performed
in a tenth of a second or even less, and then they come into
our market. It seems to us that there is no good reason why
that sort of a market ought to be treated differently than one
where the customer comes in directly and his own credit is
checked.
We actually think that there are very good reasons why
intermediaries should exist in these markets, why they are the
ones best suited to actually give customers information and to
deal with customer credit, why it makes the market easier, more
efficient to operate and why it makes clearinghouses work
better. Until we fully understand why we would distinguish
between those two markets, it does not seem to us we should be
forced into the paradigm adopted by the Working Group in order
to get the exemption or exclusion even. It just does not--we
have not seen the reason behind it.
The Chairman. Mr. Grove and Mr. Rosen, I ask these
questions of you. How important is clearing to the over-the-
counter community? Most of the users of the over-the-counter
derivatives market are large institutions that perhaps do not
need clearing, may actually perceive clearing as an added
expense. If OTC derivatives were allowed to clear outside the
CEA, would there be a demand for those services?
Mr. Grove. Clearing is an option that would be desirable
for us to have but not necessarily one that dealers would take
advantage of, at least not initially. There are other
mechanisms that exist now, such as bilateral netting, and
increasing the use of collateral, that serve some of the same
purposes. But to prevent clearing for reasons that are not
compelling, in our view, would be a mistake, and to the extent
that clearing mechanisms evolve, we would certainly like the
option to be able to take advantage of those mechanisms going
forward.
The Chairman. Do you have a further comment on that, Mr.
Rosen?
Mr. Rosen. No. I would just note that there are different
forms of clearing and there are different needs in different
industry sectors. So, that informs the appetite for clearing,
but I think it is clearly something which ought to be there
because it does provide a benefit to the market and there ought
to be a framework for it if it is going to exist.
The Chairman. Senator Fitzgerald.
Senator Fitzgerald. Thank you, Mr. Chairman. Mr. Grove, Do
you believe that futures between sophisticated parties on non-
agricultural or non-commodities, say on financial futures,
between sophisticated parties on futures exchanges should be
exempt from the CEA? Would you support legislation to exempt
them from the CEA?
Mr. Grove. Well, Senator, I support exclusion from the CEA
of OTC derivatives products that, as the Working Group report
concludes, are not susceptible to manipulation, do not serve a
price discovery mechanism and do not involve retail investors.
With respect to the issue of competition, which is raised
in Chairman Lugar's initial question to my colleagues from the
exchanges and which I think follows on what from in the
direction that you are going, the OTC derivatives market is one
of the most competitive segments of the financial markets.
There are no barriers to entry other than the competence of the
dealers, the competence of their staffs, their reputation and
their credit standing. My end user members would welcome even
more competition, including from the exchanges, and our dealer
members at this point face significant competition. It would
not matter to them. We certainly welcome greater competition
for financial derivatives.
Senator Fitzgerald. So you could support legislation that
would exempt exchange-trades futures transactions involving an
underlying financial instrument, as opposed to a commodity that
could be manipulated or susceptible to manipulation? Could you
support legislation to exempt them from the CEA?
Mr. Grove. I would support legislation that would exempt
those types of financial OTC derivatives products.
Senator Fitzgerald. You are saying OTC products. Futures by
definition are not OTC products. They are traded on a futures
exchange. I am talking about an exchange-trade financial
futures contract, an interest rate futures contract, where the
trading is between institutional parties.
Mr. Grove. Senator, if Congress is of the view that those
products can be appropriately deregulated, I would not oppose
that legislation.
Senator Fitzgerald. OK.
Mr. Rosen. Senator, may I chime in here?
Senator Fitzgerald. Sure.
Mr. Rosen. Because I think you are asking an excellent
question, and candidly I think if you strip away all of the
different perspectives that people bring to the President's
Working Group report, it is a wonderful catalyst for this
debate because what it is really trying to do is strip away the
labels, on exchange, off exchange, swap, future, and for the
first time it is trying to say let us look at what is
happening. Let us calibrate the level of regulation to the
policy concerns that are raised. So when you say trading on an
exchange, one wonders what do you mean by that? But I think the
question is fair whether it is in an exchange environment or a
non-exchange environment, if the nature of the participants,
the way they interact with each other, the nature of the risks
presented by the trading and the contract are identical to what
they would be in an OTC context, there is not a legitimate
basis for regulating them.
And candidly, I think this also answers the exemption
versus exclusion question because if you believe that the basis
for this treatment, whether you call it exemption or exclusion,
is because you have analyzed the products and concluded that
they do not raise policy issues of the type that this statutory
framework was designed to address, then the question is what
are you leaving for somebody to exercise their exemptive
authority to do? There is no congressional directive or
guidance for the execution or implementation of that
administrative authority and you have sort of a free-floating
you can step into any crisis authority or you have a
meaningless authority, and that is why the truth of the matter
is that Congress cannot escape the need if a situation arose
that raised a different set of concerns than are currently
addressed under the Commodity Exchange Act to establish the
framework for addressing it. I think as a practical matter,
though, there are other considerations that it is important to
focus on.
These markets are populated mostly by regulated entities or
affiliates of regulated entities who live in a regulated
culture of shared risk management and direct and indirect
oversight. If you look back at the LTCM event, what was of
concern was not that LTCM got a leverage and blew itself up. I
mean who really cares? What people really care about is what is
the spillover effect to the people in the marketplace and the
financial community who might be indirectly affected by that?
If you look at that landscape, the parties that were
dealing with LTCM were regulated. They were comprehensively
supervised. But we have all learned very important lessons from
LTCM which will contribute to preventing a reoccurrence from
that and I do not think we can escape responsibility for
understanding that these are markets that are maturing and
there are some things that regulators can do in addressing
these problems and there are some things that they cannot do.
Senator Fitzgerald. I noted, Mr. Grove, in your testimony
you said that the ISDA has developed master documentation
templates for swaps transactions that are today used in the
United States and around the world by the vast majority of
swaps participants for their transactions. That sounds to me
like these are pretty standard contracts and that they are
fungible. And yet historically, the justification for disparate
regulatory treatment between OTC swaps and futures traded on an
exchange has been, well, the futures, they are fungible, they
are the same contract, but right in your testimony you seem to
indicate that really they are just a word processed document
and you are changing the names of parties and maybe the terms
of whatever interest rate flow is being swapped; is that
correct?
Mr. Grove. Most of my colleagues on the legal side wish it
were so, but I can assure you, Senator, that those agreements
are heavily negotiated, sometimes for periods of many months
and on into years. The important point, though, is that those
templates, those master agreements, allow market participants
to engage in, an infinite variety of OTC derivatives
transactions. The economic terms of each transaction differ
from trade to trade and that is the important point.
Senator Fitzgerald. So if you had contracts where the
economic terms did not differ, say you are right now selling
five banks interest rate swaps and they all want the same deal
right now, then there might be justification for some
regulation there because they would all be the same agreement?
Theoretically, at least 5 banks could get the same swap
agreement if they are coming in the same interest rate
environment trying to hedge their current interest rate
exposure?
Mr. Grove. The volumes are such that it could occur that
there would be identical transactions, but, it would be
coincidental that there would be identical transactions, and if
there were five identical transactions, there would be tens of
thousands of transactions executed during that period of time
that would be very different.
Senator Fitzgerald. So you would have no objection to
putting into this exclusion that would apply to interest rate
swaps, for example, that the exclusion would not apply if the
contracts were identical, that some prohibitions so no two
contracts be the same?
Mr. Grove. Senator, that would not be workable because as a
party to a transaction, I would not know what other
transactions existed in the market. So it might be that two
other banks or two other parties were engaging in that same
transaction or a transaction with the same exact notional
amount, the same exact interest rate and the same exact
maturity, but I would not know that and it would be pure
coincidence. It would be an unworkable----
Senator Fitzgerald. But the underlying legal documentation
is pretty standardized; isn't it? We are really just talking
about you attach immense importance to changing these little
things like exactly how much is the notional amount and exactly
when the contract is going to end. I mean that is where you
hang all this importance on those little tiny differences?
Mr. Grove. That is because the contract deals with issues
like bankruptcy; what happens if a counterparts goes into
bankruptcy? Credit-type terms are dealt with in the master
agreement. The economic terms vary from trade to trade and, not
the credit terms are not important, they are, But economic
terms are quite important as well.
Senator Fitzgerald. I notice that you also request that
there be some provision in the bankruptcy code and I take it to
mean that you would like something in the bankruptcy code that
a defaulted party under one of these swap transactions could
not discharge that debt in bankruptcy? Is that what you are
looking for?
Mr. Grove. No, what we are looking for--in fact, this
provision is included in the bankruptcy bill that has just
recently passed the Senate for which we are very appreciative.
We are looking for provisions that further solidify the law as
it now exists in the United States which recognizes that swap
transactions between two counter parties in a bankruptcy
situation could be netted down to a single amount. This has the
effect of reducing systemic risk. What we are looking to do is
bring more transactions within that umbrella so that again if a
bankruptcy does occur, more transactions can be netted down to
a single number, thereby reducing the exposure of the financial
system as a whole to the bankruptcy of that one entity.
Senator Fitzgerald. Throughout your testimony or in your
paper that you have submitted, you talk about the importance of
legal certainty and you say that there are three things you
need: clarity concerning how swap transactions will be treated
under U.S. law, certainty that they will be legally
enforceable, and certainty that key provisions in swap
transactions will be enforceable even in the case of bankruptcy
of one of those parties. So you keep focusing on legal
certainty, but is there not one thing, one other thing that you
want that you have not mentioned? You do not just want legal
certainty. We could give you legal certainty within the ambit
of CEA in their regulation. You might not like it, but you
would have legal certainty. You want complete exemption from
the CEA in addition to legal certainty; is that correct?
Mr. Grove. We support the Working Group's recommendations
that an exclusion is the best way to achieve the objectives
that the Working Group has set out in its report. We think that
as Secretary Summers said earlier and as Chairman Greenspan
said earlier, that bright line distinctions, absolute
certainty, is important in the financial markets. We need to
know in good times and in bad that contracts will be enforced,
that the agreements that we enter into in good faith, whether
we are end users or whether we are dealers, that those
agreements will be enforced in accordance with their terms.
We are skilled, particularly on the dealing side, skilled
at managing market risk and we are skilled at managing credit
risk. That is our business. But legal risk is not a risk that
we can manage in any way. And, legal uncertainty, particularly
in a time of market volatility and market crisis, can undermine
the confidence of the public in the financial system of the
United States and lead to systemic implications.
Senator Fitzgerald. Let me--I understand your position on
that--I want to pursue this area a little bit more on the
exemption. The report recommends that only principal trades be
eligible for exclusions from the CEA and frequently refers to
markets where quote ``principals are trading for their own
account.'' Is it always easy to tell when somebody is a quote
``principal trading for their own account''? If a firm acts as
a buyer to customer one and turns around and acts as a seller
to customer two, has it really acted as a principal or as an
intermediary? What would be your position on such transactions?
Mr. Grove. Senator, when counter parties transact, they
know who they are transacting with. They cannot always know
what their counter party is then doing with the position and
what other trading that counter party is engaging in. And I
think to suggest that it should be the obligation of Party A to
know what Party B will do next or what other transactions Party
B is entering into would be inappropriate.
However, should there be a transaction between Party B and
Party C that raises different regulatory implications, then
perhaps a different regulatory regime should apply. In other
words, if we have an institutional transaction here and a
retail transaction there, I take your point that perhaps a
different regulatory regime ought to apply, but it is not the
obligation of Party A to know what Party B does.
Senator Fitzgerald. But put the Working Group's report into
law, I mean it looks like there would really be nobody policing
that to make sure it is really principals trading between
principals. That one of those apparent principals is really not
just an intermediary.
Mr. Grove. Take the example of retail foreign exchange,
Senator. In that case, I assume that if those recommendations
of the Working Group report were enacted into law that there
would be some mechanism in place for policing whether those
transactions were being done in accordance with the law. I
would believe that, that would be part of legislation or
regulatory enactment following legislation.
Senator Fitzgerald. Because then it would be governed by
the CEA?
Mr. Grove. Because then you are into a different part of
the statute and it would be governed perhaps by CEA.
Senator Fitzgerald. But in this case, leaving aside foreign
currency and so we are out of the Treasury Amendment, and you
have an interest rate swap, and you have a trade between what
you think are two principals. One of them turns around and
sells to a retail person. Who would come in to the regulate
that?
Mr. Rosen. Senator, if an exemption of an exclusion were
crafted that depended upon transactions actually being
conducted as principal transactions and they were not, the CFTC
has the authority to investigate that the act is, in fact,
being complied with or not. And, if those are, in fact, not
principal trades, the CFTC can take action. The focus on the
principal character of the relationship is extremely important
because there is relatively little opportunity for abuse when
you and I do not have a transaction with each other until we
have looked each other in the eye and agreed on the terms as
opposed to a situation where I ask you to represent me in a
market that is opaque to me and you come back and tell me what
you have done at the end of the day after the order has been
passed through three other hands.
If you look at the history of CFTC reparations and
enforcement and abuses, I am sure the vast majority of those
problems have resided in situations where agents were
representing parties and not dealing directly with them as
principal.
Senator Fitzgerald. Now this vast OTC unregulated
environment that exists now and that you anticipate would
continue in the future under new legislation, I mean the
exclusion would have the effect of denying retail customers
access to that market, which is very liquid. What do you think
about that? I mean what is the policy behind setting up a
regime that keeps retail customers away from that market and
having no access to those available pools of liquidity?
Mr. Grove. Senator, this is a market, the OTC derivatives
market, that is most appropriate for institutional
participants. It does involve in most cases two-way credit
exposure so that if you were a bank and I am a retail person,
you would not enter into an interest rate swap with me because
of my credit standing. You want to enter into these types of
transactions with entities that have a fair degree of credit
worthiness because at any given point in time the value of the
obligations could run either way.
So in that sense, it is not a market that is likely to
expand into the retail arena. But I appreciate your point about
bifurcation between retail and institutional markets. Let me
say, though, that to deny the benefits of this market to
American businesses, to American financial institutions, to
American governmental entities, and to prevent them from
hedging their financial market and commodity market exposures
in the most efficient and most effective way possible simply to
put them on a parity with individuals like me would be an
inappropriate costly step. It would deny the benefits----
Senator Fitzgerald. Now you know how the exchanges feel.
Mr. Grove. It would deny the benefits of these transactions
and that would clearly have an impact on the profitability of
those companies, and those financial institutions, and on the
ability of governments to deliver services as efficiently, and
would obviously have an impact on the U.S. economy.
Senator Fitzgerald. Would you guys like to comment,
Chairman Brennan or Chairman Rappaport, Mr. Salzman, from the
exchange perspective on the bifurcation of the market? Would
you like to elaborate on that a little bit more? Would you be
opposed if the Chicago Board of Trade, say the new legislation
would allow you to set up an exchange where only institutional
parties could trade financial derivatives and there would be no
application of the CEA? Would you be opposed to that?
Mr. Brennan. Separating out the retail from the
institutional?
Senator Fitzgerald. Yes.
Mr. Brennan. I think we would, yes, because what drives
liquidity in these markets is not only the big players, but it
is all the players I do not think that we want to get into a
situation where we exclude a certain segment of the players;
everybody should have access to that liquidity. I would be
troubled by the bifurcation because some of these markets are
very deep and liquid and some are not. It depends on the
product. It also depends on volatile times and sometimes it is
not always that transparent to the marketplace who is providing
that liquidity.
Senator Fitzgerald. I mean if we were to bifurcate this, I
mean you could end up just with a place for trading for
institutional people or ways for institutional parties to trade
and really no market for the retail investors potentially. I
mean does anybody on the panel care to comment on that? Yes.
Mr. Rappaport. Can I make an analogy that is related to the
securities analogy that I made before? I mean how do you think
the securities industry would feel if the rules were that you
could not really trade stocks unless you traded above 100,000-
shares and anybody who traded less than 100,000-shares had to
go through some sophisticated entity that had good credit
worthiness to trade that? You can imagine that the price, that
if you were trading 1,000-shares instead of 100,000 is not
going to be as good and it is not going to be as competitive. I
think that is the situation that we are talking about. What
would happen in that situation is exactly the scenario that you
laid out before is that the parties that did not have the
credit worthiness, parties like myself and Mr. Grove, would
have to go a credit worthy party and say buy this for me.
If the marketplace were transparent enough that the price
would be readily available that we could all look at it and
say, okay, buy it for me at that price, then they would do it
and then they would do their transaction with me. How that
lesser transaction would be regulated would probably be under
some more onerous level of regulation because the philosophical
approach to the market would be the retail customer has to be
protected, whereas the other market would be in this relatively
unregulated environment, which by the way we support. There are
a lot of things that we disagree with here, but it is mostly
because we are at this and have historically been at this
regulatory disadvantage and while we understand why the OTC
marketplace is seeking this regulatory certainty and some other
advantages, clearing and some other, which I have a lot of
questions on clearing that I would like to address, you know,
here or at some other time, we understand why they are seeking
that. It is just the fact that we have never been able to get
there ourselves to get that regulatory parity that sort of
brings us here today.
Mr. Salzman. Could I just explain? The Chicago Mercantile
Exchange now operates electronic markets for its stock index
products, its S&P and its Nasdaq. They are the most
tremendously successful markets in terms of the time to
maturity that we have ever seen. And the great thing about
these markets is that a public customer with an internet access
can get the price he sees in the market by pushing a button. He
can get to the front of the line by pushing a button sooner
than an institutional customer. He is exactly on a par with
that customer. He sees the market equally. He has equal access
to all the prices in the market.
The only difference between him and a futures commission
merchant is, as I said, his order flows through somebody else's
computer to have its credit check before it gets to our market.
I think we would be very reluctant to all of a sudden say to
the retail customer you cannot have access to the same market
in which the institutional people are playing because you have
to have your credit checked by somebody else's computer or
because you do not have $10 million in net assets. So long as
the person has had appropriate risk disclosure and so long as
the futures commission merchant is setting a credit limit on
the positions he can take, which they do for their own
protection, we do not want to see these markets fractionated.
We just do not want to see them divided up. We have nothing
against what they want, I assure you.
Senator Fitzgerald. That would be much different than what
we do in the area of regular securities trading where everybody
is treated pretty much the same.
Mr. Rosen. All of these references to the securities
markets remind me of the admonition ``Be careful what you wish
for.'' I think that if the principle of securities law
regulation were applied to futures, people would be very
surprised with the results. Again I go back to the President's
Working Group report, if you analyze what the purpose of this
statutory framework is, it is a different, very, very different
framework than the securities laws.
Securities laws are protective of the capital formation
process. Commodities do not give rise to information
disparities in the same way that the securities markets do and
the integrity of the capital formation process and the
securities markets depends upon regulation of the informational
disparities in the marketplace whoever you are. If you go back
to the history of the Commodity Exchange Act----
Senator Fitzgerald. Well, basically inside information is
legal in trading commodities. It is legal in trading real
estate. They may know the state is going to put a new
interstate right next to where you want to put this office
building. It is legal there, but we have said it is not legal
in securities.
Mr. Rosen. Right. But because the essence of the use of
futures as hedging devices is trading on inside information.
The very purpose of the market and the regulatory regime was to
ensure that the prices that were being discovered on the boards
of trade were accurately reflected market conditions because
businesses were relying on them and the reason speculation was
permitted in those markets at all was because it contributed to
the liquidity that make those markets more vibrant, but there
is a very, very great disparity between basically commercial
risk shifting transactions and investment opportunities.
I think we have to also bear in mind that the President's
Working Group report does not require you to bifurcate the
model. It allows you to build your business model. It allows
you to build your business model and says when you build your
model, if you introduce factors that give rise to a legitimate
public interest and regulation, then you will live with the
regulatory consequences. So nobody has to drive toward that,
and if the regulatory regime for the exchange markets is
rational and appropriately calibrated to the risks and not
overly burdensome, there should not be an inducement for
someone to shed their traditional market participants in order
to survive.
I think that is the goal to ultimately be hoped for is that
at the end, each level of activity is appropriately regulated
because as you know, if you look at on the international
dimension, you cannot get exactly the same trade terms with
every country or the same economic conditions, and if your
predicate was to make all of this playing field level, you
would never have anything to do. So we have to get focused on
what the right issues are which is to make sure that legitimate
activity can be conducted with an appropriate level of
regulation that does not hold the participants back and harm
this country's economy.
Senator Fitzgerald. I think I have gone on long enough,
Chairman Lugar. So I yield to you.
The Chairman. Well, you have, I think, conducted a really
very important dialogue that has occurred I suppose behind the
scenes. It has occurred now in front of the scenes. Let me just
say, and I do not mean to diminish the importance of anything
that has been said, but some who are in the room, many of you
who are participating in this hearing, will recall that about
4-years ago we attempted much more modest type of reforms
principally with the CFTC. We were not as global as the
President's Working Group, which arose largely because of the
over-the-counter difficulties that our country and the world
was facing. Of course, that was 4-years ago. Chairman Greenspan
corrected me that the Mexican was 5-years ago--time goes by
rapidly. One reason we did not progress maybe as we should have
was that, first of all, we did not have Senator Fitzgerald who
has an intense interest in the whole subject.
[Laughter.]
There was at that time, and there were other disputes, but
the board of trade and the Merc even in Chicago had very
diverse views on many of the issues, in fact, so diverse and so
embattled that most of the members of our committee were simply
exhausted by the process. They said finally our constituents
are hog farmers and people that are in cotton and so forth, and
this is all very interesting, but by and large--this is not
withstanding, Senator Fitzgerald, who is deeply interested in
this--simply lost interest. They moved on to a different
agenda, but say life moves on.
Now lots of things have happened in the world subsequently,
and one of the four points of the Working Group, which is not
necessarily definitive with regard to all the rest of them, is
just simply the problem of all of our markets vis-a-vis the
world. In other words, we could have a situation, I can
envision, in which we are deeply concerned defensively about
who does what business on which floor and in which way, but
most if not all of it diminishes, and as a matter of fact, we
are left dealing with a smaller and smaller pie which would be
unfortunate.
Now, at this particular stage, each of you appreciate the
gravity of the issues. Everything seems to be up for grabs
again, and I understand that, and Senator Fitzgerald's
questions have offered an opportunity for advocacy and
defensiveness and what have you, as the case may be. What I
hope at the end of the day might be possible, and we will hear
from Chairman Rainer soon, in terms of his recommendations, but
if he has a substantial proposal that brings significant
regulatory relief to everybody that deals with CFTC,
conceivably this will be attractive.
Now other parts of the bill may be unattractive. Each of
you finally have to decide at the end of the day what the
pluses and minuses are of this business because having heard
this all today and having heard it other times, I cannot find
at least a path that you weave through all of the mine fields
here that will leave everybody excited about the product.
But I do think it is important to have one and so I in a
general way will say that I am determined to proceed to try to
get one and so we really appreciate the testimony you have
given today as well as very important answers on details and
very specific, very technical questions. Because whether the
Senate as a whole is interested in this question or not, at
least the two of us are, and there are other members, and
ultimately that will probably guide whether we have a bill or
not.
Now if we do not have a bill, many people would say time is
not in our favor. Maybe some of you would say, well, that is
not true of my situation, but in a way I think it probably is.
Leaving aside the jurisdiction we are talking about today, it
was my privilege to open up the New York Stock Exchange in
December one day. After I did my duty, I went down on the floor
and visited with traders and other people who are involved in
that sort of thing and very quickly they were making an
argument of why what they do there is unique and important as
opposed to where else it could be done, namely maybe on the
commodity exchanges with single stock trading, for example, why
New York Stock Exchange can do this better than somebody else.
I understand. I listened to their argument. Likewise, why that
stock exchange as it is important.
Now at the same time, you know, you visit, as I did the
same day, barely off the floor with people who already are
envisioning plans for handling it in a very different way. Mr.
Grasso and others understand that and they have been busy as
all of you have in managing your situations. This is changing
rapidly with major players who sort of pay the bread and butter
of all of this and the upkeep and so forth, but suddenly have
decided the way the world works some other way may be better.
Maybe some other country. And, that is serious.
So I take that seriously and this is why we are in the
urgent time frame of this and asking, subjecting you to all
these questions. But I appreciate your coming. Senator, do you
have another comment or question?
Senator Fitzgerald. I guess we were not supposed to talk
about Shad-Johnson today. Was that the----
The Chairman. The thought was that we would take that up
after we get a report from both the SEC and the CFTC who were
asked by Senator Gramm and me and others to sort of come
together jointly and they are supposed to do that I think by
the 21st of February.
Senator Fitzgerald. Well, without discussing it here, could
I ask Mr. Grove and Mr. Rosen to maybe give the Committee in
writing what their views would be on the possibility of futures
on individual stocks?
Mr. Grove. Sure.
Mr. Rappaport. Be happy to do that.
The Chairman. For that matter, any of you may offer
thoughts about that. This is obviously----
Senator Fitzgerald. They like the idea.
The Chairman.--a very big issue.
Senator Fitzgerald. They do.
The Chairman. Yes. Clearly, Senator Fitzgerald points
toward a demarcation point. I know Secretary Summers asked
prior to the hearing the extent to which we would get into that
and we did mention. I mentioned in the opening statement that
this is an issue out there, but we are trying very hard once
again to work on a parallel with the Banking Committee, the SEC
and the CFTC in the spirit of this Working Group, see what we
can find. We have had comments by Phil Johnson, one of the
authors of the accord. My service in the Committee and in this
particular area even goes back to visiting with Phil Johnson
when he was working with John Shad on the agreement they came
up with.
Those of you who participated in our round table last year,
and Senator Fitzgerald was here, will recall some historians
sort of recalling their thoughts about how permanent, how
temporary, what the conditions were, but all of this is to be
revisited soon.
Well, gentlemen, I thank you very much for giving us your
time and we appreciate the attendance of all the audience that
listened in today. Thank you very much.
Mr. Grove. Thank you, Senator.
[Whereupon, at 12:12 p.m., the Committee was adjourned.]
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A P P E N D I X
February 10, 2000
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DOCUMENTS SUBMITTED FOR THE RECORD
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QUESTIONS AND ANSWERS SUBMITED FOR THE RECORD
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