[Senate Hearing 109-]
[From the U.S. Government Publishing Office]



                                                      S. Hrg. 109 - 839
 
                         GROWTH AND DEVELOPMENT
                       OF THE DERIVATIVES MARKET

=======================================================================

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                    INTERNATIONAL TRADE AND FINANCE

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                       ONE HUNDRED NINTH CONGRESS

                             FIRST SESSION

                                   ON

 EXAMINATION OF THE GROWTH AND DEVELOPMENT OF THE DERIVATIVES MARKET, 
 FOCUSING ON THE ROLE OF DERIVATIVES AS A PART OF RISK MANAGEMENT FOR 
                  CORPORATIONS AND FINANCIAL ENTITIES

                               __________

                            OCTOBER 18, 2005

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


   Available at: http: //www.access.gpo.gov /senate /senate05sh.html





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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    THOMAS R. CARPER, Delaware
JOHN E. SUNUNU, New Hampshire        DEBBIE STABENOW, Michigan
ELIZABETH DOLE, North Carolina       JON S. CORZINE, New Jersey
MEL MARTINEZ, Florida

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                         Mark Oesterle, Counsel

                          Justin Daly, Counsel

             Alex Sternhell, Democratic Professional Staff

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                 ______

            Subcommittee on International Trade and Finance

                      MIKE CRAPO, Idaho, Chairman

                   EVAN BAYH, Indiana, Ranking Member

CHUCK HAGEL, Nebraska                TIM JOHNSON, South Dakota
MICHAEL B. ENZI, Wyoming             JON S. CORZINE, New Jersey
JOHN E. SUNUNU, New Hampshire
ELIZABETH DOLE, North Carolina

                     Gregg Richard, Staff Director

           Catherine Cruz Wojtasik, Democratic Staff Director

                                  (ii)


                            C O N T E N T S

                              ----------                              

                       TUESDAY, OCTOBER 18, 2005

                                                                   Page

Opening statement of Senator Crapo...............................     1

                               WITNESSES

James Newsome, President, New York Mercantile Exchange, Inc......     3
    Prepared statement...........................................    24
Joseph P. Bauman, CEO, JB Risk Consulting, LLC...................     5
    Prepared statement...........................................    27
Paul Bennett, Senior Vice President and Chief Economist, New York 
  Stock Exchange.................................................     7
    Prepared statement...........................................    30
Charles Smithson, Managing Partner, Rutter Associates LLC........     8
    Prepared statement...........................................    33

                                 (iii)


                         GROWTH AND DEVELOPMENT



                       OF THE DERIVATIVES MARKET

                              ----------                              


                       TUESDAY, OCTOBER 18, 2005

                               U.S. Senate,
   Subcommittee on International Trade and Finance,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Subcommittee met at 2:30 p.m., in room SD-538, Dirksen 
Senate Office Building, Senator Mike Crapo (Chairman of the 
Subcommittee) presiding.

            OPENING STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. The hearing will come to order.
    This afternoon, the Subcommittee on International Trade and 
Finance will examine the growth and development of derivatives 
markets.
    Derivatives have come to play an extremely important role 
in our financial system and our economy. As Chairman Alan 
Greenspan has said, ``derivatives have especially contributed, 
particularly over the past couple of stressful years, to the 
development of a far more flexible, efficient, and resilient 
financial system than existed just a quarter-century ago.'' 
Over the last three decades, the use of derivatives has grown 
rapidly. Some estimates of the current size of the market for 
derivatives exceed $200 trillion, an amount based on ``notional 
value'' or the underlying amount of all derivatives contracts, 
which is more than 100 times what it was 30 years ago. Congress 
played a role in the growth of this important market by first 
regulating commodity futures, then securities, including 
options on securities, and finally clarifying the law to allow 
the growth of newer and more complex OTC derivatives.
    The more common types of derivatives include: Forwards, 
futures, options, swaps, caps, collars, and swaptions to name a 
few. And I am not going to profess that I am capable of 
discussing those at a high level of sophistication, although I 
have had occasion, over the past few years, as we have battled 
out some of the issues around here, to dig into just how 
derivatives are utilized in the market. And that is the purpose 
of this hearing as well. Some are traded over-the-counter, such 
as forwards and swaps. Some types are traded both on and off 
exchange. Some products are regulated, such as commodity 
futures and securities options. Some are not regulated, such as 
the OTC interest rate swaps. Dealers and customers may be 
regulated or unregulated. Both institutions and persons may 
trade derivatives, through the OTC markets tend to be 
institutional.
    What all derivatives have in common, no matter what the 
label, how they are traded, or who regulates the trading, is 
that they are instruments designed to manage risk, allocating 
it to investors most able and willing to take it. Companies of 
all sizes use derivatives to manage all kinds of risk. 
Individuals use their derivatives primarily through options and 
futures exchanges. Financial institutions are major users of 
both exchange-traded and OTC derivatives. Energy companies, 
farmers, and hedge funds also represent some of the many 
diverse users of this multifaceted financial tool.
    Airlines may hedge a risk on jet fuel, and manufacturers 
may hedge a risk of the price of their raw materials going up. 
And there is no end to the list of those who use derivatives.
    One of the reasons for the growth of the derivatives market 
was the careful balance that was struck by the Commodity 
Futures Modernization Act of 2000, or what we all call the 
CFMA. Last month, the Banking Committee discussed issues 
relating to the pending reauthorization from 12 witnesses, 
including representatives from the agencies that make up the 
President's Working Group on Financial Markets. It is critical 
that we not undo the excellent work that was based largely on 
the President's Working Group back in 1999.
    The United States has been a leader in the innovation and 
growth of derivatives, and American businesses were among the 
earliest to benefit from these important management tools. We 
are fortunate to have a group of experts with us today who are 
going to help us understand first the growth of the derivatives 
market and their role in the U.S. economy; second, the 
regulatory developments and the role of market discipline; and, 
third, how historically agriculture commodity markets became 
the centers of financial product trading.
    Our witnesses today include James E. Newsome, who is the 
President of the New York Mercantile Exchange. Previously, Dr. 
Newsome served as the Chairman of the Commodity Futures Trading 
Commission from 2001 to 2004. In addition to his 
responsibilities at the CFTC, Dr. Newsome served as a Member of 
the President's Working Group on Financial Markets, and he was 
serving along with the Secretary of the Treasury, the Chairman 
of the Federal Reserve Board, and the Chairman of the SEC.
    We also have Joseph P. Bauman, who is the CEO of JB Risk 
Consulting. Mr. Bauman has been in the derivatives business for 
20 years. He served as the Chairman of ISDA from 1993 to 1994 
and was a Member of ISDA's Board of Directors from 1989 through 
1999. Mr. Bauman is also a founding Director of the 
International Association of Financial Engineers. He received 
his B.A. from Rutgers University and M.P.A. from the Wharton 
School of the University of Pennsylvania.
    Paul Bennett, who is also with us, is the Chief Economist 
and Senior Vice President of the New York Stock Exchange. Prior 
to joining the New York Stock Exchange in 2001, Dr. Bennett 
served for over 22 years in a variety of research and 
operational positions at the Federal Reserve Bank of New York. 
He holds a Ph.D. in economics from Princeton University and an 
A.B. in economics from the University of Chicago.
    And, finally, we have with us Charles Smithson, who is the 
Managing Partner of Rutter Associates. Dr. Smithson taught 
economics at Texas A&M University and is the author of numerous 
articles in professional and academic journals. Mr. Smithson is 
best known as the originator of the ``building block approach'' 
to financial products. He is the author of five books, 
including the best-selling text ``Managing Financial Risk and 
Credit Portfolio Management.'' Mr. Smithson served as a member 
of the working group for the Group of Thirty Global Derivatives 
Project, the output of which is often referred to as ``Sound 
Practices for Derivatives.''
    I want to thank each of you who will be here this afternoon 
testifying, and we look forward to your testimony and the help 
that you will give us on this Committee. I assume you have all 
been given the instructions. We like to ask you to try to keep 
your presentations to about 5 minutes, but as you can see, we 
are not going to have a full array of questioning from the 
Senators here. I think we do expect some to make it. But with 
the reconciliation battles going on and all the other fights 
going on right now in Congress, this is my fifth hearing today, 
and I think I am probably one of those with a smaller number. 
So what I am getting at is we may have time for you to slop 
over a little bit in your time. Now, that does not mean I want 
you to get carried away. So, I would like you to try to keep it 
to around 5 minutes, but if you are not done right at 5 
minutes, I will give you a couple of minutes to finish up 
rather than cutting you right off like I usually do.
    With that, why do not we start in the order I announced 
you, and, Dr. Newsome, you can begin.

                   STATEMENT OF JAMES NEWSOME

         PRESIDENT, NEW YORK MERCANTILE EXCHANGE, INC.

    Mr. Newsome. Thank you, Mr. Chairman. The New York 
Mercantile Exchange is the world's largest forum for trading 
and clearing physical-commodity-based futures contracts, 
including energy and metals products. We have been in the 
business for 135 years and are a federally chartered 
marketplace, fully regulated by the Commodity Futures Trading 
Commission.
    Futures markets provide important economic benefits. NYMEX 
energy futures are highly liquid and transparent, representing 
the views and expectations of a wide variety of participants 
from every sector of the energy marketplace. As derivatives of 
cash markets, they reflect cash market prices and as a result 
are used as a hedging and price discovery vehicle around the 
globe. The price agreed upon for sale of any futures contract 
trade is immediately transmitted to the Exchange's electronic 
price reporting system and to the news wires and information 
vendors who inform the world of accurate futures prices. In 
addition to continuously reporting prices during the trading 
session, NYMEX reports trading volume and open interest daily 
and deliveries against the futures contracts monthly. 
Transparent, fair, and orderly markets are critical to the 
NYMEX's success as the most reliable hedging vehicle for 
physical transactions and financially settled over-the-counter 
transactions.
    The Commodity Futures Modernization Act of 2000 was 
landmark Federal legislation that provided legal certainty, 
regulatory streamlining, flexibility, and modernization to U.S. 
futures and derivatives markets. It provided a reasonable, 
workable, and effective oversight regime for the regulated 
exchanges, while enhancing the abilities of exchanges to 
compete in a rapidly changing global business environment. 
Product innovation such as new platforms for trading futures 
and clearing OTC products are a direct result of the ability to 
respond to constantly changing industry demands. Market 
participants have benefited from more useful risk management 
tools, better use of technology, greater liquidity, more 
efficient pricing, and better customer service. Trading 
facilities have been able to provide more alternatives in 
trading platforms, products, and business models.
    The CFMA, contrary to some beliefs, did not diminish the 
regulatory oversight responsibilities of the CFTC. All exchange 
actions remain subject to CFTC review and oversight and 
enforcement action. It remains the CFTC's responsibility to 
assure that all futures exchanges are enforcing their rules and 
remain in compliance with the core principles. As intended, the 
level of regulation established for designated contract markets 
is appropriate for the nature and participants of the markets. 
Therefore, the CFMA effectively ensures the market and 
financial integrity of regulated futures exchanges.
    Volatility and high prices in crude oil, natural gas, and 
gasoline futures contracts have triggered unwarranted criticism 
of NYMEX. While a significant amount of energy trading occurs 
in other forums, such as in the OTC market, on electronic 
facilities, and on exempt markets, NYMEX is targeted largely 
due to its highly liquid and transparent markets. A new bill 
passed in the House 2 weeks ago calls for an investigation of 
NYMEX by the Federal Trade Commission. The General Accounting 
Office currently is studying the CFTC's oversight of NYMEX, and 
there is consideration of yet another independent study of 
NYMEX in the context of CFTC reauthorization. Misinformation 
spread by groups who do not understand the futures markets has 
led certain Members of Congress to draft legislation that 
potentially would roll back many of the significant 
advancements achieved under the CFMA. Generally, supporters of 
the legislation mistakenly believe that the bill will limit 
volatility and reduce prices of natural gas. A number of 
proposals have been discussed that would apply only to NYMEX 
natural gas futures contracts, including: Artificial price 
limits on natural gas futures contracts; a price limit that 
triggers an investigation of the market by the CFTC; and prior 
CFTC approval for NYMEX rule changes that expand price limits 
beyond 8 percent of the prior day's settlement price.
    Prices are market driven and must be allowed to find their 
true level consistent with market fundamentals. Artificial 
restrictions prevent futures markets from reflecting true 
market value and prevent the use of the market as a dependable 
hedge against price volatility. Without NYMEX or other 
exchanges as a price discovery market, conducting business in 
the cash market will be severely impaired. Higher costs to do 
business quickly translate into higher prices for consumers.
    The threat of investigative action each time a price limit 
is hit potentially would have a chilling effect on the markets. 
Moreover, and I think more importantly, the CFTC should have 
the flexibility to use its limited enforcement resources in the 
areas deemed most protective of the public interests.
    Finally, NYMEX does not believe that the rule amendment 
process established under the CFMA for futures exchange 
products, other than agricultural commodities, should be 
repealed for one commodity on one exchange. There is clear 
evidence that the self-certification process has been a huge 
benefit to exchange growth and development without indications 
to date of regulatory risks.
    Derivatives markets contribute to the efficient allocation 
of resources in the economy because the price, which is derived 
through a highly liquid, transparent, and competitive market, 
influences production, storage, and consumption decisions. 
These markets touch many aspects of the U.S. and global economy 
and, therefore consequently, our lives. They can only 
effectively serve their economic purpose if they are allowed to 
trade and respond to market fundamentals without artificial 
restraints.
    I thank you, Mr. Chairman, for the opportunity to share the 
viewpoint of the New York Mercantile Exchange.
    Senator Crapo. Thank you very much, Dr. Newsome.
    Mr. Bauman.

                 STATEMENT OF JOSEPH P. BAUMAN

                  CEO, JB RISK CONSULTING, LLC

    Mr. Bauman. Thank you, Mr. Chairman. My name is Joseph 
Bauman, and I am honored to appear before the Subcommittee 
today. Throughout my career, I have been involved in the 
derivatives business and am currently a consultant to 
participants in the derivatives industry. In my career, I have 
worked for Chemical Bank, Citibank, and Bank of America, and I 
have also served as Chairman of the International Swaps and 
Derivatives Association, the global industry association that 
represents the privately negotiated industry, and was a Member 
of the ISDA Board for 10 years. Although this is my first 
testimony before this Subcommittee, I have testified previously 
on matters related to the derivatives market before other 
Congressional Committees and Subcommittees.
    In the many roles that I have played in the industry and in 
the several institutions for which I have worked, I have 
observed the phenomenal growth in the derivatives business. In 
my written remarks to the Subcommittee, I highlight the 
important role that the regulatory framework in the United 
States for swaps and other privately negotiated derivatives, 
with the components of market discipline and legal certainty, 
has played in that growth.
    In a way, market discipline and legal certainty are a check 
and balance on the effective functioning and growth of any 
market. In brief, market discipline provides an environment in 
which all parties to a transaction understand that they are 
accountable for both the profits and losses that result from 
their decisions, and legal certainty is the core principle by 
which participants to a transaction know that the terms of 
their agreement will be binding and enforceable under law. But 
it is the regulatory framework through which market discipline 
and legal certainty are reflected that could have the greatest 
impact on all market participants.
    In my remarks today, I would like to emphasize the need for 
this Subcommittee and other relevant Committees of Congress to 
ensure that when it comes to a regulatory framework for the 
derivatives markets, the Congressional intent as embodied in 
critical provisions of the Commodity Futures Modernization Act, 
continue to be carried out.
    OTC derivatives are built on a foundation of bilateral, 
privately negotiated, contractual relationships. Anything that 
calls into question any piece of that foundation can have 
serious adverse effects on the willingness of parties to engage 
in transactions. From the enforceability of essential 
contractual provisions to the essential right of two parties to 
engage in derivative transactions, ISDA's primary concern has 
been to ensure that when two parties agree to a transaction 
they have the certainty that their rights and obligations will 
be enforced.
    In the United States, a major focus of ISDA's efforts for 
over 15 years has been the recognition, confirmed in the 
Commodity Futures Modernization Act, that swaps are not 
appropriately regulated as futures under the Commodity Exchange 
Act. If swaps were futures, then swap transactions would be 
considered unenforceable as illegal, off-exchange futures. 
Throughout my tenure on the ISDA Board, which began at the time 
of the promulgation of the 1989 swaps statement by the CFTC and 
ended just prior to enactment of the CFMA, the potential of a 
court determination that swaps for futures was a significant 
concern for the industry. The substantial growth of the 
business during that period was, in no small part, due to the 
consistent view of regulators, including the CFTC, and the 
intent of Congress, as embodied in the 1992 Futures Trading 
Practices Act, that swaps were not appropriately regulated as 
futures contracts.
    It is worth highlighting that the only action inconsistent 
with those longstanding policies was the issuances of a CFTC 
concept release in 1998 which raised questions about the 
possible need to regulate the OTC derivatives market. Congress 
acted promptly to prevent the CFTC from proceeding with that 
initiative and directed the President's Working Group on 
Financial Markets to produce a report on OTC derivatives. That 
report, published in 1999, served as the basis for many 
achievements in the CFMA.
    But the experience of the 1998 CFTC concept release 
demonstrates that concerns about legal certainty are neither 
academic nor speculative. It is also instructive as an example 
of the need for Congress, regulators, and the industry to 
remain vigilant to ensure that Congressional intent continues 
to be carried out.
    The 5 years since the passage of the CFMA have proven the 
law's wisdom. In those 5 years, privately negotiated 
derivatives have continues to thrive and product innovation has 
proceeded unabated. Even more importantly, thanks in no small 
part to derivatives, the markets have been able to withstand 
significant shocks to the financial system. The legal certainty 
provided by the CFMA has been an important part of this 
success.
    The CFMA provided broad exclusions and exemptions from 
provisions of the CEA for many different types of OTC 
derivative products. Recently, significant concerns have been 
raised within the financial community regarding developments 
that threaten to set back that progress. These concerns arose 
in testimony before the Senate Banking Committee, in a recent 
report of the Senate Agriculture Committee in connection with 
the CFTC reauthorization legislation, and in a recent judicial 
decision, specifically the case of CFTC v. Bradley. These have 
raised questions regarding the scope of the exemptions and 
exclusions for over-the-counter derivatives enacted in the 
CFMA, suggesting that the relevant exemptions and exclusions 
are somehow limited in scope to the underlying transactions and 
do not cover the persons engaged in those transactions or their 
related conduct and activities.
    This view, which is clearly contrary, we believe, to the 
CFMA, if unaddressed, could resurrect the very legal concerns 
that led to enactment of the CFMA. Steps by the Subcommittee to 
clarify this issue should be prominent in the Subcommittee's 
consideration of CFTC reauthorization and related issues.
    I should also emphasize that the success of the CFMA is not 
limited to the legal certainty it provides to over-the-counter 
derivatives. By and large, the CFMA remains a crowning 
achievement of financial services law. By creating flexible 
rules for organized exchanges, providing legal certainty for 
sophisticated market participants, and encouraging the growth 
and development of new financial products, the CFMA has 
positioned the United States to remain a financial innovator 
for years to come.
    Thanks very much for allowing me to address the 
Subcommittee this afternoon. I appreciate your continued 
leadership in ensuring the legal certainty for privately 
negotiated transactions, and I look forward to answering any 
questions you may have.
    Senator Crapo. Thank you very much, Mr. Bauman.
    Mr. Bennett.

                   STATEMENT OF PAUL BENNETT

           SENIOR VICE PRESIDENT AND CHIEF ECONOMIST,

                    NEW YORK STOCK EXCHANGE

    Mr. Bennett. Thank you. I am Paul Bennett, Chief Economist 
of the New York Stock Exchange. On behalf of the NYSE and our 
Chief Executive John Thain, I want to thank you for inviting me 
to testify today before the Subcommittee. The NYSE greatly 
appreciates your leadership in overseeing the international 
aspects of our Nation's evolving financial markets and the 
ability of U.S. companies to successfully and fairly compete on 
a global basis. The NYSE is both a nationally and 
internationally focused organization. We list the stocks of 
U.S. companies valued at $12 trillion, plus we also list the 
stocks of non-United States companies valued at $9 trillion in 
Asia, Europe, Africa, and Latin America.
    Because we compete with stock exchanges around the world, 
many of which trade a variety of products, including financial 
derivatives, we believe strongly that to service our customers 
competitively in this environment we need to continue to have 
well thought out and effective regulation in the United States. 
This implies, among other things, regulatory parity between 
cash and derivatives markets, including an intelligent policy 
of portfolio margin requirements for a full range of 
instruments.
    Servicing our customers is also the driving force behind 
our new hybrid market which will give a greater range of 
choices about how to trade stocks than is offered by any other 
equity market in the world. In addition, our planned merger 
with Arca will provide our customers with another choice of 
trading platform, an opportunity to trade options in addition 
to cash equities, and the ability to expand the range of 
business activities we pursue as a newly public company, both 
domestically and internationally.
    Thank you.
    Senator Crapo. Thank you very much, Mr. Bennett.
    Dr. Smithson.

                 STATEMENT OF CHARLES SMITHSON

            MANAGING PARTNER, RUTTER ASSOCIATES LLC

    Mr. Smithson. Chairman Crapo, thank you for the opportunity 
to testify about a market that is crucial to both industrial 
firms and financial institutions, but one that is widely 
misunderstood.
    Over the more than 20 years I have been involved in 
derivatives and risk management, I have been collecting 
empirical evidence generated by my academic colleagues on the 
impact of derivatives on the markets and on the firms that use 
them. The best way I know to share that evidence with you is 
through the answers to four important questions.
    The first question is: What happens to the volatility of 
financial prices when derivatives appear? I sometimes hear it 
said that the introduction of derivatives leads to increased 
price volatility. While the story has a ring of plausibility, 
the empirical evidence does not bear it out. The 39 academic 
studies on this topic that I was able to find indicate that the 
introduction of derivatives reduces price volatility in the 
underlying markets.
    Question two: What happens to the bid-ask spread and 
trading volume for the underlying assets? The academic studies 
indicate that the bid-ask spreads in the underlying markets 
decline after the introduction of derivatives and that the 
introduction of derivatives is associated with either no change 
or an increase in trading volumes in the underlying markets.
    Question three, shifting from the markets to the firms that 
use them: If a firm uses risk management, does the market 
regard the firm as being less risky? If a publicly traded firm 
is exposed to financial price risk, the returns to that firm's 
equity would be 
sensitive to changes in interest rates, foreign exchange rates, 
or commodity prices. Consequently, question number three could 
be rephrased as: If such a firm uses derivatives to manage one 
or more of those risks, do the exposures decline?
    As we reported in a recent article, Professor Simkins of 
Oklahoma State Univeristy and I found 15 studies that examined 
this question--6 focused on financial institutions and 9 
focused on industrial companies. Overwhelmingly, the studies 
indicated that the use of risk management led to a decrease in 
the perceived riskiness of the firm.
    Finally, we are to the payoff question, question four: What 
impact does the use of derivatives have on the value of the 
firm? This is the newest question to get examined by our 
academic colleagues. So far, there are only 10 studies, the 
oldest of which was published in 2001. Six of the studies 
examined the impact of managing interest rates and foreign 
exchange rates. The other four examined commodity price risk 
management, with one looking at commodity users and the others 
looking at commodity producers.
    What do they say? Managing interest rate and foreign 
exchange rate risk with derivatives is associated with higher 
firm values. Similarly, the study of commodity price risk 
management by commodity users found that fuel price hedging by 
airlines is associated with higher firm values. The three 
studies that looked at commodity price risk management by 
commodity producers found either no effect or a negative effect 
on equity values, which suggests that investors buy the equity 
of these commodity producers to gain exposure to the commodity 
price and, therefore, would not reward the firm for reducing 
that exposure.
    I believe the answers to the four questions are important 
enough that they bear repeating.
    Number one, the introduction of derivatives reduces price 
volatility.
    Number two, the introduction of derivatives decreases bid-
ask spreads and does not reduce volume in the underlying 
markets.
    Number three, firms that use risk management are perceived 
by the market to be less risky.
    Number four, the use of derivatives to manage interest rate 
risk, foreign exchange rate risk, and commodity price risk by 
commodity users is rewarded by the market with higher values.
    Derivatives have dramatically reduced the cost of 
transferring risk to market participants who have a comparative 
advantage in bearing them; that is, from individual firms to 
well-diversified institutional investors.
    Derivatives are often described as a ``zero sum game,'' and 
they are. But even though one party's gain is another's loss in 
an individual transaction, the more efficient risk sharing 
afforded by derivatives reduced total risk for all market 
participants.
    In order for derivatives to deliver the benefits that they 
are capable of providing, there must be a high degree of 
certainty as to their enforceability and their regulatory 
treatment. Congress made extraordinary progress in ensuring 
such certainty in 2000 with the enactment of the CFMA. The 
growth in the depth and breadth of the derivatives since 2000 
is a testament to the importance of legal certainty and the 
success of Congress' efforts.
    Mr. Chairman, thank you again for the opportunity to 
testify. As I began, I indicated that derivatives are widely 
misunderstood. Your Subcommittee is making progress toward 
removing those misunderstandings.
    Senator Crapo. Thank you very much, Dr. Smithson, and to 
the entire panel, I want to thank you.
    When I was elected to Congress, I did not know I was going 
to eventually become--I was going to say ``an expert.'' I am 
nowhere close to being an expert on derivatives, but become 
thrown into the business of learning about derivatives, because 
they are so important to our markets. I can still remember the 
first floor debate that we had on a critical battle we had over 
how to manage derivatives and how to regulate derivatives. And 
the training that I had tried to put myself through to even 
just talk lucidly about derivatives on the floor of the Senate 
was somewhat foreboding. I imagine it was like what Harriet 
Miers might be trying to go through right now to get ready to 
go before the Judiciary Committee.
    But my point is that when this issue first started becoming 
prominent just in the last couple of years--I know it was very 
prominent back in the late 1990's as the President's Working 
Group was working on it, but the public did not really pay a 
lot of attention to that. That was below the surface. After 
Enron and some of the other circumstances where derivatives 
were blamed as a part of the problem, it started to get more 
public attention. And as that developed, it became very evident 
to me that not only I and other Members of Congress but that 
the public in general needs to start learning a lot more about 
what derivatives are and how they work.
    The first time I asked Alan Greenspan a question about it 
to explain derivatives, he was in his gentlemanly way very 
succinct. He just said, ``Senator, I could probably go on a 
long time trying to answer that question, but the easiest way 
to think about it is that it is a way that markets allocate 
risk from those who can bear it least to those who can bear it 
most if they work efficiently.'' And it may be that that is how 
I am going to have to--that one level I have gotten 
internalized. It may be that I will have to just stick at that 
level of understanding, but I think that I and the rest of us 
can get a much better understanding, and we certainly need to 
as we go forward with this issue.
    To help a little bit on that, I would like to have the 
first part of our discussion just focus on kind of explanations 
of how derivatives work, and maybe I would ask each of you just 
in your own mind to maybe come up with an example of how a 
derivative could be used to manage a risk. And feel free to 
discuss this whole question in a little more broad terms than 
that if you want to in your answer, but could you each just by 
way of example help share with me how derivatives work? Do you 
want to start out, Dr. Newsome?
    Mr. Newsome. I would be more than glad to, Mr. Chairman. I 
will use an example from the energy sector, and Dr. Smithson 
made a comment about the airline industry and hedging the risk 
with regard to fuel prices.
    There was an article in Time magazine maybe 2 months ago 
that analyzed a number of the airlines, those who were using 
derivatives contracts to manage risk and those who were not. 
And I think it is a pure example of placing a hedge to create a 
floor for a price into the future.
    Southwest hedged 85 percent of their fuel costs and had a 
price per barrel locked in at $26. They had a breakeven price 
per barrel at $65.30.
    On the other side of the spectrum, you have Delta, who 
hedges 0 percent of their fuel. Prices at the time were $50 a 
barrel, so they had a breakeven price per barrel of $13.80. So, 
I think that is a pretty real-life example of how companies can 
use these markets to hedge risk.
    Senator Crapo. I read that same article, and the analysts, 
if I remember the article, were saying that you could buy 
Southwest stock safely--they were giving it a ``buy'' ranking. 
But they were not giving that to very many other airlines. And 
basically, if I understand it right, that is because Southwest 
was able to use--well, tell me, what did Southwest do?
    Mr. Newsome. I think when you look at particularly today's 
industry, where you have volatility in the energy markets and 
you have people complain about the level of volatility and the 
higher prices, the reality of the business is that the 
exchanges and other instruments are there to protect customers 
against the very price volatility that they are complaining 
about. So, I think this is a perfect example of Southwest 
having the feeling that fuel prices were probably going to go 
higher because of the political volatility in the Middle East, 
uncertainty in Venezuela, and other energy-producing areas, and 
the recognition that energy markets have become global. What 
happens in corners of the world does have a dramatic impact on 
energy prices here. Southwest saw the opportunity to lock in 
what they thought was a fair price with an upward trending 
market and certainly have benefited because of that now.
    Senator Crapo. And now somebody is losing in that 
transaction, if Southwest is buying gas at $26 a barrel.
    Mr. Newsome. Yes.
    Senator Crapo. Where is that playing out in the market?
    Mr. Newsome. As I think Dr. Smithson said, again, it is a 
zero sum game, so for every winner there is an equal and 
offsetting loser. But typically, as you would see a bank take 
the opposite position of, say, a Southwest Airline, then they 
would enter into other transactions to spread their risk. So, I 
think that is what Chairman Greenspan was referring to, when 
the risk gets allocated among those who are better able to 
stand it.
    Senator Crapo. Thank you.
    Mr. Bauman, do you want to weigh in?
    Mr. Bauman. I will take it back to my banking experience in 
the sense that banks around the country--and this is not the 
large banks, this is the thousands of community and even 
savings banks--generally are characterized by bearing interest 
rate risk in their activities. They generally are raising 
funds, paying depositors on the long-term basis, and maybe 
lending money on a short-term basis, meaning their interest 
rates that they will receive will vary over time. And that 
leaves them imbalanced and open to the risk of their income 
shrinking significantly if that interest rate gap reduces or 
reverses, and certainly if that occurs, it impinges on what 
those banks could do going forward with their customers.
    The interest rate swap market allows those banks to 
equalize to--as you started off this hearing pointing out, 
using these products as a risk management tool allows the banks 
to smooth out their imbalances and their interest rate 
exposures. And to the point of where that risk goes, there are 
certainly many corporations that are looking at essentially 
making investments in fixed cost plant and equipment, fixed 
cost assets, but borrow to produce those assets on a short-term 
basis from the point of interest rate exposure, and they too 
could benefit or be hurt by a change in that relationship. 
Their way of managing that risk is to try and eliminate it, and 
therefore, they have the opposite interest of many of the 
banks. And it is the matching of those two interests that the 
derivatives market facilitates.
    Senator Crapo. Thank you.
    Mr. Bennett.
    Mr. Bennett. Let me give you an example from the equities 
market. If I were a money manager managing a portfolio of 
equities on behalf of customers, and I received perhaps 
unexpectedly some cash to invest, if I had no derivative type 
instruments available to me, then I would either be sitting 
there with cash with the risk that the market would move up 
before I had a chance to invest it, which would harm my 
customers, or alternatively, I would have to try and hurry up 
and pick stocks very fast, faster than I was comfortable with, 
which would create an allocation of capital which was not 
optimal.
    By being able to hedge the cash with index futures, being 
long on index futures, that hedges me against fluctuations in 
the overall market, and then I can take a little bit more time 
and make a little bit more of a thoughtful selection of stocks 
to invest. I would still have risk in terms of how each of 
those stocks performs relative to the index while I am making 
the investments, and I also have to manage the purchase of 
those stocks in an orderly way.
    However, in a fundamental way in terms of the broader 
market risk, it hedges me against that and allows me to make a 
more efficient set of decisions.
    Senator Crapo. Thank you.
    Dr. Smithson.
    Mr. Smithson. Given that we have talked about managing 
commodity price risk, interest rate risk, and equity risk, I 
probably should talk about foreign exchange risk management. 
Instead, I am going to shift to a different dimension from 
those we talked about so far--asset liability managements or 
managing the ongoing operation of firm. Another place where 
firms find derivatives and risk management practices to be 
useful is in getting access to funds.
    My second favorite debt issue, of all I have ever seen, was 
issued in the late 1980's by Magma Copper Company. Magma was a 
new organization. They needed to borrow $200 million; but they 
knew that, if they issued a straight bond, nobody was going to 
buy it. The reason nobody was going to buy it is because 
everybody knew that they were making a ``copper play'': If 
copper prices went up, Magma would pay the coupon; if copper 
prices went down, Magma was going to tell you where ``they left 
the keys''--they were going to default. And so a straight bond 
was not going to work.
    What Magma did was issue ``copper interest index debt.'' 
What that means is that the coupon floated but, it did not 
float with LIBOR, it floated with the price of copper. If 
copper prices moved higher, Magma paid a higher coupon. If 
copper prices fell, the coupon went down.
    What Magma had done was use options. They had sold options 
as a paying way of part of the coupon on the debt.
    Everybody won on that issue. Magma's management credited 
that bond with getting them the breathing room that they needed 
to get the mine refitted and working. The investors won. I used 
to try to check the price on that bond and never could really 
get very firm quotes on it, because it went into investment 
portfolios and stayed. The investors liked it; and they kept 
it. As a matter of fact, when I said that Magma would have had 
trouble raising the $200 million with a straight bond, this 
``copper interest indexed'' bond was oversubscribed when it was 
issued. And the shareholders won. It turned out that Magma got 
their house in order--got that mine in Arizona working well. It 
was eventually bought by Broken Hill Properties, and I think 
the shareholders are still smiling about the price they 
received.
    Senator Crapo. Thank you. I think all of those examples are 
very good, and I note from the examples that--well, first of 
all, I think we all know that--you probably know if I am right 
about this, but it seems that agriculture was where all of this 
started, is that right? And we did not have an agriculture 
example, but that is obviously one area where it is a big 
issue.
    Dr. Smithson, you talked about metals. We have had energy, 
interest rates, equities, cash. Is there any commodity or 
industry in which derivatives are not now a very significant 
part of the industry? Can you think of any?
    Mr. Bauman. I do not think so, Senator. I think that 
derivatives are used in one context or another by all aspects, 
all industries.
    Senator Crapo. Just economy wide. I do not know why, it was 
hard for me to get my head around trading interest rates, but 
when I realized that it had expanded to the point where 
literally exchange rates, cash, interest rates, whatever, that 
these types of transactions could work in those arenas, it 
became evident to me that it could work anywhere. And it is 
working virtually everywhere. Would that be accurate?
    Mr. Newsome. Yes.
    Mr. Bauman. Correct.
    Mr. Bennett. Yes.
    Mr. Smithson. Yes.
    Senator Crapo. I would like to ask each of you if you agree 
with this. Again, back when we were having the Enron--in fact, 
I want to speak specifically about Enron. In fact, when the 
Enron debacle occurred, Enron used derivatives, as I think does 
virtually every major company these days. But some people were 
making the argument that Enron's collapse was because of its 
use of derivatives. I disagree with that then, disagree with it 
now, and I do not know the extent to which any of you 
understand the details of what happened at Enron.
    But do any of you disagree with that, and could any of you 
comment more specifically about that?
    Dr. Newsome.
    Mr. Newsome. Mr. Chairman, I was involved in a lot of the 
Enron situation.
    Senator Crapo. You were regulator at that time.
    Mr. Newsome. Yes. And I think it is important to look at 
not only Enron, but REFCO is a more current scenario.
    Senator Crapo. Right. I was going to get to that, so go 
right ahead.
    Mr. Newsome. And in many instances the derivatives 
industry, just because the company is involved in certain 
aspects of trading derivatives, gets painted with a black 
brush, and that is certainly not the case. I think particularly 
if you look at REFCO, which we brought up, certainly there is 
one aspect of the legal entity of REFCO, Inc. that has filed 
for bankruptcy, but when you look at other segments, both 
regulated and nonregulated, the company, at least those in the 
regulated divisions, have operated within the guidelines of the 
law. REFCO, LLC, which is the registered FCM for REFCO, 
continues to be a member in good standing of all the major 
exchanges, continues to be not only properly capitalized, but 
also has excess revenue on hand at NYMEX.
    When you start looking at the problems there, you go back 
to accounting fraud, regardless of what business the company 
may have been in. But certainly, specifically to your question, 
I do not think there is any evidence whatsoever that points to 
Enron's uses of derivatives as a cause to their collapse.
    Senator Crapo. Thank you. As I indicated to you at the 
beginning, there are critical things going on all over the 
Capitol right now, and I have just been given an urgent message 
that I have to make a communication right now. So, I am going 
to have to recess the Committee for just 5 minutes, slip out 
and get on the phone, and I will be right back. I apologize for 
this.
    This Committee will stand in recess for 5 minutes.
    [Recess.]
    This hearing will come to order. I want to thank everybody 
very much for that brief recess. We are trying to put together 
the reconciliation bill for this Congress, and it is one tough 
deal, and I happened to just end up sitting on three Committees 
that are in critical postures right now.
    Before I left I had just raised the issue of Enron, and I 
appreciated your answer, Dr. Newsome. I do not expect that any 
of the others, necessarily, because Dr. Newsome was the 
regulator at the time. But do any of the others of you want to 
comment on the Enron situation?
    Mr. Bauman. Senator, the only additional comment I would 
add is maybe on the other side of the question is how the 
markets themselves were able to react to situations such as 
Enron, and there I would point to in my remarks focused on the 
CFMA and the strength of legal certainty that was provided by 
that Act.
    Even in an Enron situation, where a company is on the 
ropes, what the CFMA allowed is a very orderly understanding of 
market participants of what transactions, what exposures they 
had with that company that was in difficulty. And, really, the 
markets were able to absorb that much better than they could 
have or might have before the CFMA was enacted.
    Senator Crapo. Mr. Bauman, you actually just led right in 
to what my next line of questioning was going to be. And the 
reason I brought up Enron was to kind of set the stage for a 
question that I asked back then to Chairman Greenspan at a 
hearing like this, where I asked him, about Enron, and then 
about derivatives. His response was that--in fact, this 
response I think was not only in the context of Enron but the 
stock market collapse and a lot of the economic downturn that 
we had seen in the turbulent times there.
    I do not recall if this was before or after September 11, 
but we had had a number of serious shocks to the economy and we 
were in a tailspin and were starting to stabilize and grow 
back. And Chairman Greenspan's remark with regard to 
derivatives was that had we not had a strong, stable 
derivatives market and a good regulatory climate relating to 
it, that we would not have had as strong a build-back in the 
economy. We were able to stabilize quicker and recover better 
because of it.
    Any comment on that from the witnesses?
    Dr. Smithson.
    Mr. Smithson. I think the analogy that most comes to mind 
to me is to think about dropping a rock into a pond of water 
and watching the ripples as they hit the shore. If you can make 
the pond bigger, by the time the ripples get to the shore, they 
are smaller than they were.
    Senator Crapo. Good example.
    Mr. Smithson. That is what derivatives do. They make the 
``pond'' bigger.
    Senator Crapo. I appreciate that, because like I say, I 
think just in a very basic way we, as a public, need to begin 
understanding how derivatives work a little better because they 
are so significant, and because we are more and more getting 
into policy issues relating to how we manage and regulate--
hopefully not overregulate--these important parts of our 
economy.
    Many, if not all of you, have mentioned the CFMA. It is my 
opinion that in order--first of all, it is my opinion that the 
work that the President's Working Group and then Congress, 
following the recommendations of it, did in passing the CFMA 
was extremely valuable, and actually helped to facilitate the 
strong growth in the utilization of derivatives. Anybody 
disagree with that on the panel?
    [No response.]
    Everybody seems to agree. It is also my belief that in 
order that we not undo the significant achievements of the 
CFMA, as we are now looking at its reauthorization, that the 
reauthorization should be very limited, and should be 
formulated to avoid creating barriers or undue burdens for 
legitimate business, undermining legal certainty or creating 
any unintended consequences.
    I would appreciate it if each of you would discuss with me, 
in your mind, are there issues outstanding with regard to the 
CFMA that we need to address?
    In one sense, I think that we could just have a straight 
reauthorization as is, but I think Mr. Bauman and some others, 
you may have raised some questions about some improvements, and 
certainly we want to look at the improvement, if we can, 
without creating any additional problems.
    So the question I have is what is the scope, what should we 
be looking at as we look a reauthorization of the CFMA?
    Dr. Newsome.
    Mr. Newsome. I will start first, Mr. Chairman, and admit to 
the Committee that I am somewhat biased in my view of the CFMA. 
Bill Rainer as Chairman of the CFTC at the time, had the 
opportunity to work with numerous committees to develop the 
legislation, and I had the honor of implementing the CFMA, and 
worked very closely with the Congress to make sure that we 
implemented the Act following the intent of the Congress.
    I think a couple of the primary segments of the CFMA have 
been brought out in earlier discussion. Certainly legal 
certainty for over-the-counter markets was a critical point of 
the CFMA. Flexibility for the exchanges to operate outside the 
old traditional regulatory box was also another important part. 
But clarifying the CFTC oversight of the off-exchange forex 
fraud was also an important part of the Act.
    I had the opportunity to utilize that authority very 
aggressively. I think during my tenure we brought actions 
against some 40 forex bucket shops, and even after I left, the 
Agency continued to use that authority aggressively.
    As I think everyone knows, a Federal court has thrown some 
uncertainty into whether or not the CFTC maintains that 
authority, and there has been a big discussion over how to 
clarify that authority to the Agency, and whether that 
authority should be expanded to go beyond forex. I have not 
been involved in a lot of those discussions that have been held 
by the Congress, but I do feel that clarifying the Agency's 
authority over that type of fraud was important. Whether the 
Congress chooses to specifically look at that type of fraud and 
try to find a way to reclarify the Agency's authority or 
whether it gets broadened, I guess is less important to me, but 
simply that without that kind of authority, you have some major 
fraud activity that is basically going to go unchallenged just 
because of resources by the Justice Department or others who do 
not have the expertise to dig in.
    So, I guess the only thing I would look at in terms of 
primary changes would be to make sure that we, if anything, 
enhance and strengthen the enforcement abilities of the Agency 
to go after those who are involved in fraud.
    Senator Crapo. Thank you.
    Mr. Bauman, did you have any thoughts?
    Mr. Bauman. I guess the one thought I would have would be 
that--not that I see reason to change. I think that there is a 
very good bill there, and probably all other things being 
equal, I would not recommend any changes to it.
    But to the extent that we are seeing, either through policy 
or through court decisions, some either erosion around the 
edges of loosening of what were thought to be the standard set 
up by the CFMA and the legislative history behind it, the only 
changes I would see would be things that would close down those 
frayed edges, to make sure that legal certainty stays the goals 
of the system.
    Senator Crapo. Thank you.
    Mr. Bennett.
    Mr. Bennett. I agree. I think that the CFMA has set up a 
very productive and balanced regulatory process, and so at the 
most it would need to be just tweaked and looked at like any 
other piece of legislation. I think that the President's 
Working Group, if there were going to be any changes, I would 
seek their advice on them because they were obviously very 
valuable in the initial legislation, and they have a very well-
informed set of views.
    I think that on particular issues that are I think on the 
table now, the margin rules for single-stock futures, I think 
that it is important that they stay harmonized with the margin 
rules in the cash market, so that there is no inequality there. 
I also think that the portfolio margining is a very sound 
concept, and it is very workable, and I think it should be 
extended to the broader range of financial assets.
    Senator Crapo. Thank you. I appreciate that very much and 
you may know, I also believe we have to be very careful to let 
the President's Working Group do its job today and weigh in on 
these issues, and they are working on those issues.
    Dr. Smithson.
    Mr. Smithson. I defer to Dr. Newsome on the fraud aspects 
that he brought up. The aspect that keeps coming to mind for me 
is how well the Act has worked since 2000--it has been tested 
since 2000--and how much effort went into getting us to this 
point. I guess I have to come back to the point that it would 
be marvelous to have a one-sentence reauthorization.
    Senator Crapo. Thank you very much.
    One of the battlegrounds that I--I was going to say ``I 
think.'' I do not even need to think this, it is already 
developing. One of the developing battlegrounds is going to be 
energy, and with all of the recent market activity in both the 
cash and futures markets for energy commodities, crude oil, 
gasoline, and natural gas in particular, there are some who 
have suggested that narrow price limits be applied to futures 
markets as a way to decrease volatility.
    Now, that reminds me of one of your points, Dr. Smithson, 
that the derivatives can actually accomplish that on their own, 
but can you--and this is open to the panel--can you tell us 
what the likely effects of mandating a price limit for energies 
futures products would be, and probably for NYMEX. You might 
want to start out on that, Dr. Newsome.
    Mr. Newsome. Again, I would probably be a bit biased in my 
answer, so I will make a few comments and then turn it over to 
my colleagues. But I think putting on the old CFTC hat, the 
CFTC itself is not even supportive of narrow price limits. In 
fact, there are no Federal rules that require price limits. The 
only directive from the CFTC is that if the exchanges choose to 
use price limits, that they not set those price limits so 
tightly that it disallows the market to function and to 
operate.
    Certainly, from my personal standpoint, I am not a big 
proponent of price limits. I think that the role of the markets 
is to discover the true price, and if that is your goal, then 
you have to allow the markets the flexibility to move based 
upon fundamentals.
    I think the reality is, even if, say, the Congress chose to 
put tight price limits on contracts and NYMEX, that action will 
have no effect on energy volatility or energy prices. It will 
simply drive that activity to over-the-counter or to exempt 
markets to operate and to take place outside of the regulated 
exchange.
    Senator Crapo. Thank you. Any other input on that?
    Mr. Bauman. I would certainly agree with Dr. Newsome's 
comments, particularly the last part of it. I would analogize 
it to the balloon that you are squeezing in one sector, and it 
is going to expand out in another sector. Trading will either 
go offshore or to other markets or find other ways of being 
reflective of the true price.
    Mr. Bennett. I agree with that except just to add a point, 
is that if there are certain types of transactions that really 
are more comfortable in the futures markets, if you put an 
abrupt end to the trading in those markets, it may actually 
generate more volatility than would have otherwise happened 
outside in the overall market and for the underlying market. 
And it depends on which commodity we are talking about.
    Senator Crapo. Right.
    Dr. Smithson.
    Mr. Smithson. So far, I have told you about empirical 
evidence. There are some of my colleagues who do experimental 
economics, which is an interesting area. As they have told me 
about their experiment, and they have actually looked at what 
happens, when you try limits where prices could only move in a 
certain range during a certain period of time. It turns out 
that the price followed the same pattern that would have 
existed in their absence.
    What I am trying to say in a long-winded way is that the 
evidence, so far, is that they do not do a very good job. If 
anything, they kick a little extra volatility in instead of 
taking it out.
    Senator Crapo. Thank you. Last month before the Banking 
Committee, the witnesses representing the agencies that make up 
the President's Working Group, said that it was unnecessary to 
offer any kind of additional regulation of the energy and 
natural gas derivatives, as we look at reauthorization of the 
CFMA. How would you respond to those who think that we should 
expand the regulatory reach of the CFMA and extend and create 
additional regulation of energy and gas derivatives?
    Mr. Newsome. Mr. Chairman, I think those who are wanting to 
add layers of regulation, particularly in energy, are trying to 
do two things, and both are misguided. They are trying to 
decrease volatility and trying to decrease prices. All the 
proposals that have been laid on the table that I am aware of 
to this point would do neither.
    Senator Crapo. Any disagreement?
    [No response.]
    Certainly, there are lots of people looking to try to 
figure out how to reduce the price of petroleum or gas 
products, but I tend to be one who believes--and I think your 
previous answers indicate this--that the price is going to be 
reached by a world economy, and neither this Congress, nor the 
CFTC is going to be able to dictate what the price of oil is 
going to be. We need to look to better energy policy maybe to 
deal with that issue.
    How do each of you--and I know Dr. Smithson's answer here, 
but you are welcome to amplify on it--respond to the suggestion 
that the CFMA somehow contributes to price spikes and 
volatility in markets? There are those who are making that 
claim.
    Mr. Newsome. You know, sometimes when you have a comment 
that is made so off base, it is hard to come back with a 
logical explanation. I find myself in that situation now. I 
think when you look at the exchanges, you look at the CFMA, the 
CFTC, they are all price neutral. The goal is to provide the 
marketplace and the regulation around that marketplace to allow 
true prices to be discovered. So how anyone can say that the 
regulatory scheme adds volatility is beyond me.
    I would have to assume that they are referring to the 
Agency not creating position limits tight enough or price 
limits tight enough that it allows this volatility to take 
place, but we discussed that just a moment ago.
    Mr. Bauman. I was hesitating I think for many of the same 
reasons as Dr. Newsome. It is a hard idea to get one's mind 
around from our side of the table. But maybe a practical 
example of why I hesitate on it is that for the last couple of 
years I have actually gotten close to the credit derivatives 
market, as opposed to the interest rate and currency markets of 
old. When I started, when I left working for the banks in 2000, 
there were what we would call maybe 15 individual credits that 
were actively quoted in the market. And if a bank wanted to 
hedge its risk against a specific credit exposure, it really 
had to search around for somebody who could provide them with 
that hedge, and prices were very far disbursed, not very 
visible, transparent, and few transactions were done. A good 
deal of that uncertainty related by the marketplace on what a 
credit derivative was in a legal context.
    With the CFMA making clear that credit derivatives fell 
into the regime of over-the-counter derivative contracts, the 
activity built up, the liquidity built up, many more names were 
quoted, bid offer spreads became narrower, and it became very 
easy for a bank to hedge its position in an individual credit. 
So just the opposite, I think actions such as the CFMA have 
contributed to the transparency and liquidity of the markets, 
and not made them more volatile as such.
    Senator Crapo. Thank you.
    Mr. Bennett.
    Mr. Bennett. I would agree with that assessment also. I 
think that these good rules help coordinate the markets, makes 
it much more likely that you are not going to have spikes and 
volatility for that particular reason. You will have volatility 
for other reasons, but I think you just have to say that it 
reduces the likelihood of spikes and excessive volatility.
    Senator Crapo. Anything else, Dr. Smithson?
    Mr. Smithson. I think it has all been said.
    Senator Crapo. I want to come back for a moment now to the 
REFCO case, and I do not expect that any or all of you will be 
experts on this, but to the extent that you do understand what 
has been happening with regard to REFCO, some of the press 
accounts regarding the recent events at REFCO have suggested 
that the unreported related transaction between REFCO's CEO and 
its unregulated entity, REFCO Capital Markets, may have been 
more difficult to detect because over-the-counter derivatives 
trading is exempt from Federal regulation. I personally think 
that this is--when we have problems like Enron or REFCO or some 
of these things, and they are engaging in derivatives 
transactions, which as we have indicated, any major company is 
going to be doing, and people do not quite understand what 
derivatives are, then all of a sudden they tend to become the 
culprit.
    It is important to note that this kind of trading is 
subject to very rigorous market discipline, and there is also 
the various antifraud aspects of the regulatory regime we have 
in place.
    But that having been said, the question I raise to you, to 
the extent that you may know enough about it to express an 
opinion, is, does the issue, failure to disclose between 
REFCO's CEO and its trading entity, have anything to do with 
derivatives trading?
    Mr. Newsome. Not at all. In fact, we are talking about two 
separate legal entities within the umbrella of REFCO, REFCO, 
Incorporated, REFCO Capital Markets, versus REFCO, LLC, which 
was the futures commission merchant, or the regulated entity of 
the CFTC and of all the exchanges in which they traded. We have 
no indication that any of the fraudulent activity was related 
to over-the-counter markets, certainly not the futures markets, 
and that it looks like a serious case of accounting fraud.
    Senator Crapo. We are not necessarily prejudging anything 
here, but let us say that the problem here is accounting fraud, 
which is what the early indications are. That is illegal 
already and heavily regulated, is it not?
    Mr. Newsome. Correct.
    Senator Crapo. So the fact that the fraud occurred in an 
arena in which derivatives were being utilized does not mean 
that the derivatives caused the fraud or that there was 
anything with regard to derivatives regulations that would have 
changed it, am I correct?
    Mr. Newsome. I think not only are you correct, Mr. 
Chairman, but I also think there is argument to be made that 
the accounting fraud did not even occur within the derivatives 
regulated entity of REFCO, so even more separation.
    Senator Crapo. We had the same point under Enron, if I 
remember correctly. When we ultimately got into the bottom of 
it, it was not even the derivatives which were at issue, 
although they were blamed. I just think it is important that we 
start getting into these kinds of things, because we are going 
to face these kinds of questions as we move forward.
    Another question: Have REFCO's difficulties caused any 
broader disruptions in financial markets?
    Mr. Newsome. I will only speak specifically to NYMEX, and I 
would say that in terms of REFCO, LLC, the registered entity, 
that they currently are in a good member status standing as a 
member at NYMEX and all the other future exchanges, that they 
are not only appropriately margined, but they have excess 
capital on hand at the exchanges. So we have seen no activity 
in terms of REFCO, LLC or their trading that has created 
concern.
    I think the credibility issue of the parent company has 
created enough uncertainty that a number of their customers 
have started unwinding positions on the exchanges, a number of 
their customers have started leaving REFCO as their clearing 
member, transferring their accounts to other clearing members 
on the exchange, but all of those have occurred in a very 
orderly manner and certainly have had no negative impact on the 
markets themselves.
    Senator Crapo. Any difference there? It seems to me that 
what you just described is a good example of market discipline 
helping to be a part of the ultimate resolution of these kinds 
of issues.
    Mr. Newsome. Correct.
    Senator Crapo. Let me turn to the international situation. 
How best can we--this is a broad question, I just want to get a 
discussion going on the international context here. How best 
can we position the U.S. markets to compete internationally in 
the context of derivatives? That should be open-ended enough 
for you to jump in any way you want.
    Mr. Newsome. Certainly, the CFMA gave the CFTC the 
flexibility that it needed to embrace international companies 
to do business in the United States. We do not quite have the 
same amount of flexibility for U.S. companies trying to do 
business offshore. The NYMEX just opened a fully regulated 
entity in London to participate in the European marketplace. It 
was a matter of months before we received that regulatory 
approval. We are currently seeking approval in Dubai to develop 
a crude benchmark to openly and transparently trade Middle 
Eastern crude, and we have yet to experience that process, but 
certainly I can tell you it is not quite as easy going offshore 
as it is welcoming participants onshore.
    Mr. Bauman. I think there are probably two things, one of 
which we have talked a good deal about, which is legal 
certainty, which continues I think to be a reason for 
companies, for trading firms to look to trade in the United 
States under its legal regime.
    But one we have not talked too much about--I am sure any of 
us could--is innovation, and that we want to maintain an 
environment that encourages innovation in financial products, 
and that in and of itself is something that is a competitive 
tool for the U.S. economy to exercise.
    Senator Crapo. Thank you.
    Mr. Bennett. What I would add to that is that having a good 
regulatory environment in the United States and a level playing 
field is one very important thing. Also U.S. companies have to 
go out and expand aggressively globally. The stock exchange is 
in the middle of changing over our trading systems to our 
hybrid market to merging with Arca, and this will create a 
public company, and I think these will give us the tools to 
compete domestically much better, but also internationally, 
because the stock exchange business is becoming a lot more 
international as well, not only in trading stocks but also in 
trading various types of equity-linked derivatives or other 
derivatives.
    Senator Crapo. Dr. Smithson.
    Mr. Smithson. Coming back to the question you posed--how 
could the U.S. markets be able to compete more effectively 
internationally? If you look back to see where we have been 
successful, you find that we have been successful as 
innovators, and so I echo what Joe Bauman just said: Make sure 
that nothing is done that blocks innovation, and that we keep 
in mind that the innovators should enjoy the fruits of that 
innovation.
    Senator Crapo. Would it be fair to say that right now the 
United States is, as far as policy with regard to derivatives, 
that the United States is not over regulating to the extent 
that we are pushing derivatives business or businesses that are 
derivatives related out of the country or pushing them 
offshore? Is that fair to say, we have not overdone it?
    [All nod.]
    Senator Crapo. Let me ask the other side of that. Is it 
fair to say that we have a better climate here? I mean are we 
at the cutting edge in the derivatives arena so that we are a 
desired place to do business globally?
    Mr. Newsome. I think that is exactly the case, Mr. 
Chairman. The CFMA was the right legislation at the right time. 
Not only did it create the environment for the flexibility that 
my colleagues at the table have mentioned, but it also created 
a regulatory environment in which global banks and global 
businesses want to do business. I mean we just signed on a 
clearing member that is one of the largest Japanese banks 
because they want to increase business in the United States. 
They want to do it as clearing member of exchanges. I think we 
are going to continue to see more and more of that type of 
activity.
    Senator Crapo. Anybody else want to add anything there?
    I just have one more question, and again, it is going to be 
a broad open-ended question, maybe so broad that there is no 
answer to it. But the question is: Where do you see the 
derivatives market, the derivatives issue going in the next 4 
or 5 years? Any prescient thoughts as to where you think we are 
headed with this? Feel free anybody to jump in if you would 
like.
    Mr. Newsome. I think it is a hard question to answer 
because probably 5 years ago, no one would have envisioned that 
the business would have exploded as much as it has during that 
time period. I do not think it is an accident that the 
tremendous growth in the derivatives business and the passage 
and implementation of the CFMA occurred at relatively the same 
time. I think in fact the two are very connected.
    As long as the flexibility and the certainty provided for 
in the CFMA is maintained, we are going to continue to see 
tremendous innovation, tremendous usage of the markets. Even 
though the markets have grown two- and three-fold since the 
passage of the CFMA, there is still a lot of cash market 
participants who do not utilize the derivatives industry, and I 
think we have a lot of opportunity to expand and reach those 
type of customers.
    Senator Crapo. Okay.
    Mr. Bauman. I certainly agree with that. In fact, I 
probably would have said it a little bit differently. I have 
observed that all of the statistics about online retailing show 
phenomenal rates of growth, yet it is still only a very small 
percentage of retailing in general. I think there is still 
growth in the risk management disciplines that could take the 
use of these instruments far above levels that we think are 
quite high today.
    Senator Crapo. Good.
    Mr. Bennett.
    Mr. Bennett. I would add to that that I think the 
integration of the cash and the derivatives markets will 
probably continue, so 5 years from now they will be much more 
integrated in terms of the way people use them.
    I also think that this will show up as we move to more 
electronic platforms, which really unify the trading of those 
two types of assets in a more integrated fashion. They will 
move very quickly and be very tightly linked.
    Senator Crapo. Dr. Smithson, we will give you the last word 
if you want to take it.
    Mr. Smithson. Thank you. It is clear that derivatives use 
is becoming standard operating procedures inside firms. No 
longer will we ask a firm, ``Do you use them,'' rather we will 
ask questions about ``How do you use them?'' and ``How do you 
track them?''
    It is clear that we are going to see new applications of 
derivatives technology. Since I did not predict credit 
derivatives, I am probably the wrong one to ask what the new 
applications will be, but the technology will move to the next 
step.
    So most of what I would see for the next 5 years is very 
positive, but I will also add a little leavening: I am afraid 
that over the next 5 years we will still see The Wall Street 
Journal, every time they mention the word ``derivatives'' put 
``complex'' in front of it.
    Senator Crapo. I probably contribute to that a little bit 
myself. When I read that list at the beginning, that was a 
complex list, and I bet if we have this hearing in 5 years, it 
will be a longer list. That list that I just read was forwards, 
futures, options, swaps, caps, collars, and swaptions.
    [Laughter.]
    I am going to learn what a swaption is before the next 
hearing. These guys know over here already.
    [Laughter.]
    I think we have accomplished a lot of the objectives of 
this hearing. This obviously is a very critical issue with 
immense potential for our economy, and the decisions that we 
are embarking upon making here in Congress with regard to the 
regulatory policy which we will adopt relating to them is 
critical. I think that you have helped significantly not just 
the Committee, but the public, to understand a little better 
what this issue is all about, and hopefully help us make the 
right policy decision.
    I would like to thank again all of the witnesses for the 
time that you put in to preparing your testimony and coming 
here and sharing your wisdom with us.
    And without anything further, this hearing is adjourned.
    [Whereupon, at 3:53 p.m., the hearing was adjourned.]
    [Prepared statements, response to written questions, and 
additional material supplied for the record follow:]
                  PREPARED STATEMENT OF JAMES NEWSOME
             President, New York Mercantile Exchange, Inc.
                            October 18, 2005
    Mr. Chairman and Members of the Committee, my name is Jim Newsome 
and I am the President of the New York Mercantile Exchange (NYMEX or 
Exchange). NYMEX is the world's largest forum for trading and clearing 
physical-commodity based futures contracts, including energy and metals 
products. We have been in the business for 135 years and are a 
federally chartered marketplace, fully regulated by the Commodity 
Futures Trading Commission (CFTC).
    On behalf of the Exchange, its Board of Directors and shareholders, 
I thank you and the Members of the Committee for the opportunity to 
participate in today's hearing on ``Growth and Development of the 
Derivatives Market.''
Introduction
    Futures markets provide important economic benefits. NYMEX energy 
futures are highly liquid and transparent, representing the views and 
expectations of a wide variety of participants from every sector of the 
energy marketplace. As derivatives of cash markets, they reflect cash 
market prices and as a result are used as a hedging and price discovery 
vehicle around the globe. The price agreed upon for sale of any futures 
contract trade is immediately transmitted to the Exchange's electronic 
price reporting system and to the news wires and information vendors 
who inform the world of accurate futures prices. In addition to 
continuously reporting prices during the trading session, NYMEX reports 
trading volume and open interest daily and deliveries against the 
futures contracts monthly. Transparent, fair, and orderly markets are 
critical to the NYMEX's success as the most reliable hedging vehicle 
for physical transactions and financially settled over-the-counter 
(OTC) transactions.
    A key attribute of these products is their leverage. For a fraction 
of the cost of buying the underlying asset, they create a price 
exposure similar to that of physical ownership. As a result, they 
provide an efficient means of offsetting exposures among hedgers or 
transferring risk from hedgers to speculators. The leverage and low 
trading costs in these markets attract speculators, who play a valuable 
role as liquidity providers enabling commercial traders to get in and 
out of the market as needed. As liquidity increases, so does the amount 
of information absorbed into the market price, leading to a more 
broadly based market in which the current price corresponds more 
closely to its true value.
Impact of the Commodity Futures Modernization Act
    The Commodity Futures Modernization Act of 2000 (CFMA) was landmark 
Federal legislation that provided legal certainty, regulatory 
streamlining, flexibility, and modernization to U.S. futures and 
derivatives markets. It provided a reasonable, workable, and effective 
oversight regime for the regulated exchanges, while enhancing the 
abilities of exchanges to compete in a rapidly changing global business 
environment. Product innovations such as new platforms for trading 
futures and clearing OTC products are a direct result of the ability to 
respond to constantly changing industry demands. Market participants 
have benefited from more useful risk management tools, better use of 
technology, greater liquidity, more efficient pricing, and better 
customer service. Trading facilities have been able to provide more 
alternatives in trading platforms, products, and business models.
    Most importantly, these major changes to the regulatory landscape 
have not compromised the integrity of the marketplace in any respect. 
Support for this notion is demonstrated by the routine reviews of 
NYMEX's self-regulatory programs conducted by the CFTC. Exchanges 
remain at the top-tier of CFTC regulation, subject to 18 core 
principles covering all aspects of exchange operations, including 
customer protection, financial integrity, market integrity, 
recordkeeping, and conflicts of interest. Moreover, the NYMEX's 
Derivatives Clearing Organization is subject to 14 additional core 
principles. The core principles establish broad performance standards 
that must be met by the regulated entity, but gives the entity the 
flexibility as to how it complies with these standards.
    NYMEX's Compliance Department ensures that the core principles are 
enforced and the Exchange disciplines violative activity by its 
members. The Department is staffed with highly experienced individuals 
and equipped with cutting edge technology to conduct market 
surveillance, trade surveillance, and financial surveillance to monitor 
market activity for abusive behavior. Automated surveillance systems 
are used to detect market manipulation, wash trading, prearranged 
trading, trading ahead of customer orders and violations of position 
limits. Staff also monitors trading activity during volatile markets to 
determine if a participant's activity is disruptive or manipulative.
    The CFMA did not diminish the regulatory oversight responsibilities 
of the CFTC. All exchange actions remain subject to CFTC review and 
oversight and enforcement action. It is the CFTC's responsibility to 
assure that all futures exchanges are enforcing their rules and remain 
in compliance with the core principles. As intended, the level of 
regulation established for designated contract markets is appropriate 
for the nature and participants of the markets. Therefore, the CFMA 
effectively insures the market and financial integrity of regulated 
futures exchanges.
Growth and Development of Energy Derivatives
    It is well-documented that, beginning in the late 1970's, the 
introduction of deregulation dramatically increased the level of 
competition in the energy markets. This competition prompted the 
development of the first-ever exchange-traded energy derivative 
products. The success and growth of these new contracts attracted a 
broad range of new participants to the energy markets. The addition of 
new participants to the markets also led to the introduction of new and 
wider varieties of energy derivatives. Today, the NYMEX, other 
exchanges and over-the-counter markets worldwide offer futures, futures 
options, swap contracts, and exotic options on a broad range of energy 
products, including crude oil, fuel oil, coal, heating oil, unleaded 
gasoline, and natural gas.
    The futures industry has experienced tremendous growth since the 
adoption of the CFMA in December 2000, a clear sign that the current 
regulatory regime is appropriate for these markets at this time. 
Trading volumes in 2004 for futures and options globally increased 300 
percent over the 2000 volume levels. U.S. futures and options volume 
for the same timeframe increased over 200 percent. NYMEX's futures and 
options volume alone as of 2004 had increased over 50 percent since 
year 2000 volume levels. Individually, NYMEX's flagship futures 
contracts showed significant volume increases as well, including crude 
oil--up 43 percent, heating oil--up 34 percent, and gasoline--up 48 
percent.
    NYMEX keeps its markets available for trading after the close of 
the open outcry trading session through the internet-based NYMEX 
ACCESS' electronic trading system. With NYMEX 
ACCESS', NYMEX is open virtually around the clock. Traders 
can log on from any internet-enabled computer almost anywhere in the 
world. The after hours electronic trading session allows traders to 
protect themselves against exposure to price risk overnight. Total 
annual volume for NYMEX ACCESS' in 2004 was a record 
8,239,700 contracts, breaking the previous record of 5,880,455 
contracts set in 2003.
    The CFMA, in addressing legal certainty for OTC derivatives, also 
permitted the clearing of OTC derivatives transactions by regulated 
futures exchanges. End-users and merchant energy companies that were 
existing customers of the NYMEX asked the Exchange to develop the 
clearing of standardized OTC energy products. NYMEX 
ClearPort' was the result of this request. During the 
initial period, 25 contracts were launched and currently the NYMEX 
ClearPort' program comprises over 175 products in the 
electricity, coal, NatGas, oil and emissions markets. Today, over 30 
per cent of total NYMEX volume comes through the NYMEX 
ClearPort' system. This sustained growth can be linked to 
the addition of OTC clearing to NYMEX's range of services offered, 
which allows energy companies to mitigate their credit risks.
    Additionally, NYMEX's global expansion has recently included the 
addition of cleared futures contracts for Singapore Fuel Oil and clean 
petroleum products, and European Fuel Oil, Naptha, and Gasoline. This 
new clearing service has restored confidence, transparency, and 
liquidity to the marketplace and has once again allowed the economic 
benefits of derivatives to benefit the marketplace as a whole.
    Off-exchange contracts submitted to NYMEX for clearing are afforded 
the same protections available to other futures contracts. The 
clearinghouse provides market participants with protection against 
counterparty default and is backed by a $130 million guarantee fund and 
a $100 million default insurance policy. The advantages of doing 
business on a regulated market are now available to any business entity 
with credit or price exposure in the energy markets. The ability of 
energy companies to now mitigate their credit risk with cleared 
derivatives brings liquidity, transparency, and market confidence back 
to the trading community.
    As a result of the demand by customers to mitigate their counter-
party risk through new clearing products, the parent holding company of 
NYMEX has recently launched a new exchange in London to trade Brent 
Crude oil via open outcry. Additionally, the Exchange has announced the 
creation of the Dubai Mercantile Exchange--DME. The DME will bring the 
mitigation of counter-party risk to new contracts that will be traded 
in the Middle East region. In Singapore, the NYMEX has begun to add 
liquidity to regional Fuel Oil contracts through the use of the 
existing NYMEX ClearPort' Clearing system. Combined, the 
global expansion of the NYMEX brings the ultimate level of counterparty 
protection, liquidity, and transparency to derivatives and regulated 
futures contracts.
    New investment opportunities in the form of mini energy futures are 
offered by NYMEX for its highly liquid crude oil and natural gas 
futures contracts. The contracts are 50 percent of the size of the 
standard contracts and are financially settled at the settlement price 
of the physical commodity futures contracts on NYMEX.
Recent Legislative Proposals
    Volatility and high prices in crude oil, natural gas, and gasoline 
futures contracts have triggered unwarranted criticism of NYMEX. While 
a significant amount of energy trading occurs in other forums, such as 
in the OTC market, on electronic facilities and on exempt markets, 
NYMEX is targeted largely due to its highly liquid and transparent 
markets. A new bill passed in the House 2 weeks ago, calls for an 
investigation of NYMEX by the Federal Trade Commission. The General 
Accounting 
Office currently is studying the CFTC's oversight of NYMEX and there is 
consideration of yet another independent study of NYMEX in the context 
of CFTC reauthorization. Misinformation spread by groups who do not 
understand the futures markets has led certain Members of Congress to 
draft legislation that potentially would roll back many of the 
significant advancements achieved under the CFMA. Generally, supporters 
of the legislation mistakenly believe that the bill will stop 
volatility and reduce prices of natural gas. A number of proposals have 
been discussed that would apply to only the NYMEX natural gas futures 
contract, including:

 Artificial price limits on natural gas futures contracts;
 A price limit that triggers an investigation of the market by 
    the CFTC; and
 Prior CFTC approval for NYMEX rule changes that expand price 
    limits beyond 8 percent of the prior day's settlement price.

    Prices are market driven and must be allowed to find their true 
level consistent with market fundamentals. Artificial restrictions 
prevent futures markets from reflecting true market value and prevent 
the use of the market as a dependable hedge against price volatility. 
In addition, artificial restrictions in the marketplace would result 
in:

 Greatly reduced (if not completely eliminated) price 
    transparency;
 Higher costs;
 Higher price volatility--in the off-exchange market where 
    price transparency is at the discretion of market participants 
    subject to their parochial business interests; and
 Other classic symptoms of artificial price controls, such as 
    government-induced shortages.

    Without NYMEX as a price discovery market, conducting business in 
the cash market will be severely impaired. Higher costs to do business 
quickly translate into higher prices for consumers.
    The threat of investigative action each time a price limit is hit 
potentially would have a chilling effect on the markets. Moreover, the 
CFTC should have the flexibility to use its limited enforcement 
resources in the areas deemed most protective of the public interests.
    Finally, NYMEX does not believe that the rule amendment process 
established under the CFMA for futures exchange products, other than 
agricultural commodities, should be repealed for one commodity on one 
exchange. There is clear evidence that the rule self-certification 
process has been a huge benefit to exchange growth and development 
without indications to date of regulatory risks.
Conclusion
    Five years ago, Congress took a giant step in revising the 
regulatory framework for futures trading. NYMEX has experienced first 
hand the business opportunities provided by that extraordinary law and 
would urge that the major provisions of that law remain unchanged, 
including the rule self-certification process and the ability of the 
futures exchange to determine the best terms and conditions of a 
futures 
contract listed on its exchange. Derivatives markets contribute to the 
efficient allocation of resources in the economy because the price, 
which is derived through a highly liquid, transparent and competitive 
market, influences production, storage, and consumption decisions. 
These markets touch many aspects of the U.S. and global economy and, 
consequently, our lives. They can only effectively serve their economic 
purpose if they are allowed to trade and respond to market fundamentals 
without artificial restraints.
    I thank you for the opportunity to share the viewpoint of the New 
York Mercantile Exchange with you today.
                 PREPARED STATEMENT OF JOSEPH P. BAUMAN
                      CEO, JB Risk Consulting, LLC
                            October 18, 2005
    Mr. Chairman and Members of the Subcommittee, my name is Joseph 
Bauman. Throughout my career I have been involved in the derivatives 
business, and I am currently a consultant to participants in the 
derivatives industry. In my career I have worked for Chemical Bank, 
Citibank, and Bank of America. I also served as Chairman of the 
International Swaps and Derivatives Association and was a Member of its 
Board for 10 years. Although this is my first testimony before this 
Subcommittee, I have testified previously on matters related to the 
derivatives markets before other Congressional Committees and 
Subcommittees.
    In the many roles I have played in the industry and in the several 
institutions for which I have worked, I have observed the phenomenal 
growth in the derivatives business. While there are many reasons for 
that growth, I believe that the regulatory framework in the United 
States for swaps and other privately negotiated derivatives, with the 
components of market discipline and legal certainty, has been among the 
most significant factors contributing to that growth. It is those 
factors that I would like to highlight for the committee.
Role of Derivatives in the Economy
    Derivatives play a critical role in our economy. By allowing 
corporations to take certain types of risk out of their operations, 
derivatives allow those businesses to plan with greater certainty and 
to better withstand unexpected economic developments. As Federal 
Reserve Chairman Alan Greenspan noted in testimony before this 
Committee 3 years ago, ``on balance they [financial derivatives] have 
contributed to the development of a far more flexible and efficient 
financial system--both domestically and internationally--than we had 
just 20 or 30 years ago.'' Derivatives afford a means for a company, 
say an airline, to manage risks not intrinsic to the business itself, 
such as jet fuel price fluctuations. The airline can hedge the risks to 
those price fluctuations by entering into swaps or options which ensure 
that, regardless of developments in the oil or jet fuel markets, the 
manufacturer is guaranteed a certain price for its jet fuel needs or 
limits its exposure to rising prices. In other words, derivatives allow 
a business to focus on its core operations (in this example, flying 
planes and running an airline) while minimizing the chance that 
something completely outside of its control (fluctuations in jet fuel 
prices) will undermine its planning. Airlines, such as Southwest, 
actively manage this risk, which is, in part, a reason for their 
ability to thrive in the current difficult climate for airlines. In 
fact, an article in this past Sunday's New York Times highlighted that 
Southwest Airlines' fuel cost hedging contracts had protected it from 
spikes in the price of fuel and contributed to its profitability.
Growth of the OTC Derivatives Business
    Derivatives (and in particular, privately negotiated derivatives) 
have become an indispensable part of most large and medium-sized 
businesses' financial management in the last 20 years. ISDA has 
published figures on outstanding notional amounts in the interest rate 
and currency derivatives business since 1987 and in recent years has 
published similar information for credit derivatives and equity 
derivative. The chart below shows the growth in that business. I should 
emphasize that these figures demonstrate the growth in trading 
activity. It is important to keep in mind that the notional amounts 
reported are not a reflection of outstanding exposures or risk. Figures 
published by the Bank for International Settlements indicate that, on a 
net basis, outstanding counterparty credit exposures on interest rate 
and currency products are less than 1 percent of notional amounts 
outstanding.


Role of Market Discipline
    Market discipline is the most important factor influencing how 
derivatives activity functions, and is beneficial from the standpoint 
of both market stability and providing a high quality of service to 
end-users. First, market discipline benefits market stability because 
firms operate in an environment in which they understand that they are 
accountable for both the profits and the losses that result from their 
decisions. The result is sound risk management practice and high credit 
quality. Second, market discipline benefits end-users because of the 
importance of competition and reputation. Competition among dealers 
ensures that, if end-user concerns are not addressed, another dealer 
stands ready to step in and do so. And reputation--which takes years to 
build but can be destroyed in seconds-- is of great importance because 
it provides clients a means of quality assurance in an environment when 
you only have one chance to get a deal right.
    It is also worth pointing out that, since the privately negotiated 
market is limited to firms qualifying as ``eligible contract 
participants'' on the basis of either asset size or income, there is no 
``market regulator'' for over-the-counter derivatives activity in the 
same sense as there is in the United States for securities (Securities 
and Exchange Commission) or futures (Commodity Futures Trading 
Commission). At the same time, the majority of the derivative dealers 
are regulated, most of them as banks or as securities firms, either in 
the United States or across a large number of other jurisdictions. 
Since the vast majority of transactions are either between two dealers 
or a dealer and an end user, this ensures that those major institutions 
are subject to the appropriate oversight for their business focus.
The Importance of Legal Certainty
    OTC derivatives are built on a foundation of bilateral, privately 
negotiated contractual relationships. Anything that calls into question 
any piece of that foundation can have serious adverse effects on the 
willingness of parties to engage in transactions. One of ISDA's 
principal achievements has been the establishment of a sound 
contractual and documentation framework that facilitates the ability of 
parties to engage in these transactions. ISDA's Master Agreement, 
supported by legal opinions from over 40 countries on the 
enforceability of its core provisions, is the global standard for 
documenting OTC derivatives transactions. ISDA has worked with 
legislatures and regulators around the world to enact laws that 
recognize the enforceability of these core provisions. Efforts here in 
the United States have led to several significant changes in laws 
relating to these core provisions, including most recently the changes 
to the Bankruptcy Code and bank insolvency laws that became effective 
on October 17 of this year.
    ISDA's efforts on the contractual framework would be for naught if 
the fundamental right of parties to enter into these privately 
negotiated transactions was thrown into question by the legal or 
regulatory framework in which the parties operate. For example, ISDA 
has worked to change laws in various countries that were it not for 
these changes, would treat these transactions as unenforceable gaming 
contracts and not the legitimate hedging tools that they are.
    In the United States, a major focus of ISDA's efforts has been the 
recognition, confirmed in the Commodity Futures Modernization Act 
(CFMA), that swaps are not appropriately regulated as futures under the 
Commodity Exchange Act (CEA). If swaps were futures then swap 
transactions would be considered unenforceable as illegal off-exchange 
futures. Throughout my tenure on the ISDA Board, which ended just prior 
to enact of the CFMA, the potential of a court determination that swaps 
were futures was a significant concern for the industry. The 
substantial growth of the business during that time period was, in no 
small part, due to the consistent view of regulators, including the 
CFTC, and the intent of Congress, as embodied in the 1992 Futures 
Trading Practices Act (FTPA), that swaps were not appropriately 
regulated as futures.
    It is worth highlighting that the only action inconsistent with 
those longstanding policies was the release of a CFTC Concept Release 
in 1998 raising questions about the possible need to regulate OTC 
derivatives. Congress acted promptly to prevent the CFTC from 
proceeding with that initiative and directed the President's Working 
Group on Financial Markets to produce a report on OTC derivatives. That 
report, published in 1999, served as the basis for the many 
achievements in the CFMA.
    The experience of the 1998 CFTC concept release demonstrates that 
concerns about legal certainty are neither academic nor speculative. It 
is also instructive as an example of the need for Congress, regulators, 
and the industry to remain vigilant to ensure that Congressional intent 
continues to be carried out. Despite the policies embodied in the FTPA 
and the position of the CFTC over the 10 years preceding the concept 
release, suggestions that the CFTC might consider changes in that 
regulatory treatment through administrative action raised alarm bells 
throughout the industry, the President's Working Group, and Congress.
    Because of the continuing potential for an adverse court ruling or 
a change in administrative determination creating legal uncertainty of 
the status of swaps and other privately negotiated derivative 
transactions, participants in these transactions, both dealers and end 
users and both U.S. and foreign firms, welcomed the 1999 Report of the 
President's Working Group and the efforts of Congress in 2000 to 
provide clarity on this issue.
Experience Under the CFMA
    Recognizing the peril presented by a broad interpretation of the 
reach and scope of the CEA, Congress in 2000 undertook to ensure that 
privately negotiated derivatives contracts between sophisticated 
counterparties would be legally enforceable and subject to the normal 
rules of contract law, rather than forced into an ill-fitting Federal 
statutory regime originally designed for agriculture producers. The 
CFMA created the means by which financially sophisticated parties, 
called ``eligible contract participants,'' could continue to engage in 
risk management without fear that their privately negotiated contracts 
would be unenforceable. ISDA was privileged to help play a role in 
achieving this historic legislation, and is dedicated to ensuring that 
the legal certainty created by the law is not undermined.
    The 5 years since the passage of the CFMA have proven the law's 
wisdom. In those 5 years privately negotiated derivatives have 
continued to thrive and product innovation has proceeded unabated. Even 
more importantly, thanks in no small part to derivatives; the markets 
have been able to withstand significant shocks to the financial system. 
The bursting of the dot.com bubble, the terror attacks of September 11, 
and the financial scandals and bankruptcies at Enron, WorldCom, 
Adelphia, and others would, in the past, have created serious economic 
dislocation and threatened long term prospects for growth. However, 
through the use of derivatives major market participants have been able 
to limit their exposure to losses from these types of events, passing 
on the risks that in the past would have potentially been concentrated 
in a few institutions and possibly driven one or more of them out of 
business. While the events creating these shocks may have occurred in 
any circumstance, modern risk management practices, and in particular 
the use of derivatives, have saved countless businesses and jobs over 
the last 5 tumultuous years by limiting the consequences of these 
events or spreading the effects to a broader category of risk takers in 
amounts that, while possibly painful, did not threaten their existence. 
The legal certainty provided by the CFMA has been an important part of 
this success.
    At various times since enactment of the CFMA, and currently in the 
CFTC reauthorization debate, there have been efforts to modify the 
provisions of the CFMA that have provided the fundamental legal 
certainty intended by Congress. While these efforts have been primarily 
focused on energy trading, the implications of those efforts go beyond 
energy trading into other OTC derivative products. The President's 
Working Group on Financial Markets has consistently opposed attempts to 
roll back the legal certainty created by the CFMA, much as it did in 
1998 in response to efforts to erode the protections provided by 
Congress and the CFTC at that time. The opposition of America's top 
financial regulators, evidenced by letters going back to 2002, clearly 
shows a consensus view that privately negotiated derivatives 
transactions, far from adding to upheavals in certain commodity 
markets, in fact help to alleviate problems caused by dislocations and 
disruptions in those markets.
    The CFMA provided clear guidance regarding the scope of 
transactions subject to regulation under the CEA and, as a corollary, 
certainty as to the legal status of the institutional over-the-counter 
derivatives market. And the listed and OTC derivatives markets have 
each flourished in the aftermath of the CFMA--a testament to the 
importance of regulatory efficiency and legal certainty.
    The CFMA provided broad exclusions and exemptions from provisions 
of the CEA for many different types of OTC derivative products. 
Recently, significant concerns have been raised within the financial 
community regarding developments that threaten to set back this 
progress. These concerns appear to have been raised by testimony by the 
former CFTC General Counsel before the Senate Committee on Banking, a 
recent Report of the Senate Agriculture Committee in connection with 
CFTC reauthorization legislation and a recent judicial decision (in the 
case of CFTC v. Bradley). As I understand it, these have raised 
questions regarding the scope of the exemptions and exclusions for 
over-the-counter derivatives enacted in the CFMA--suggesting that the 
relevant exemptions and exclusions are somehow limited in scope to the 
underlying transactions and do not cover the persons engaged in those 
transactions or their related conduct and activities.
    This view, which is clearly contrary to the CFMA, if unaddressed, 
could resurrect the very legal certainty concerns that led to enactment 
of the CFMA. Steps by the Subcommittee to clarify this issue should be 
prominent in the Subcommittee's consideration of CFTC reauthorization 
and related issues.
    The past few years have seen tremendous upheavals in the energy 
sector, from the California energy crisis to the collapse of Enron to 
the current price volatility in petroleum-based products. There has 
been little evidence that shocks in one market have spilled over into 
others. Where in the past shortages and anticompetitive behavior could 
be expected in the wake of these upheavals, properly functioning 
markets, reinforced through effective risk transfer made possible by 
derivatives, have allowed the United States to weather the current 
period of difficulty more effectively than was the case previously. It 
would be a grave mistake to tamper with the regulatory framework, 
including the legal certainty created by the CFMA, in light of the 
success it has brought in difficult times.
    The success of the CFMA is not limited to the legal certainty it 
provided for OTC derivatives; by and large the CFMA remains a crowning 
achievement of financial services law. By creating flexible rules for 
organized exchanges, providing legal certainty for sophisticated market 
participants and encouraging the growth and development of new 
financial products, the CFMA has positioned the United States to remain 
a financial innovator for years to come.
                              ------------
                   PREPARED STATEMENT OF PAUL BENNETT
               Senior Vice President and Chief Economist,
                        New York Stock Exchange
                            October 18, 2005
    Mr. Chairman, Ranking Member Bayh, and Members of the Committee, I 
am Paul Bennett, Senior Vice President and Chief Economist at the New 
York Stock Exchange (NYSE or Exchange). On behalf of the New York Stock 
Exchange and our Chief Executive Office John Thain, thank you for 
inviting me to testify today before the Subcommittee. The NYSE greatly 
appreciates your leadership in overseeing the international aspects of 
our nation's evolving financial markets. We find ourselves at a 
critical point in that evolution, and your attention to these issues 
could not be more timely as we seek to maintain the competitive 
leadership of U.S. financial markets in the world and to protect the 
interests of investors, both individual and institutional.
Evolution of Today's Financial Markets
    The New York Stock Exchange is the world's largest cash equities 
market. We serve 90 million investors, the institutional community and 
over 2,700 of the world's leading corporations. The companies listed on 
the NYSE have a total global market capitalization of $21 trillion. 
During the first 9 months of 2005, our average daily trading volume was 
1.61 billion shares, worth over $55 billion a day. We are an important 
cog in the capital formation engine, helping to provide companies and 
investors with opportunities that translate into job creation and 
economic growth.
    You have asked us to speak about the growth of the derivatives 
market and its role in the U.S. economy. While the NYSE does not run a 
derivatives market today, the importance and growth of that market have 
had a significant impact on the NYSE, and have helped shape our 
strategy for the future.
Equity Market
    The U.S. equity market has grown steadily in the past decade. The 
consolidated daily volume in the U.S. equity market, including both the 
listed market and OTC market, has reached about 4 to 5 billion shares a 
day representing $80 to $100 billion traded daily.
    Decimalization and technological innovation have continuously 
decreased costs for investors on the U.S. equity market. According to 
the GAO's 2005 study on the Securities Market, costs for institutional 
investors have decreased by 30 percent to 53 percent overall, and by 90 
percent for individual investors.
    Today, there are more buyers and sellers than ever before. Forty-
two percent of adults in the United States today own shares; moreover, 
since 1990, the portion of U.S. households' assets in equities and 
mutual funds has nearly doubled, from 9.6 percent to 16.8 percent at 
the end of the second quarter in 2005.
    The NYSE is committed to providing those investors the highest 
value proposition. And to do so, we must recognize the new realities of 
financial services. Today's market differs greatly from that of a 
generation ago. The diversified products, the rise in electronic 
trading, and the globalization of our capital markets have utterly 
transformed the way our markets work.
Derivatives Markets
    The biggest financial story of this era may be the bold and 
imaginative new ways we are creating to manage risk, reduce the costs 
of hedging, and make markets more efficient. For investors, the result 
is an explosion of new opportunities to invest in new products on new 
platforms.
    A derivatives market that started with futures contracts on 
agricultural commodities, like butter, milk, and live cattle, in the 
19th century, has turned into the principal means for investors to 
manage their risk no matter what the investment. Today, options, 
futures, swaps, and other innovations have become widely used and even 
required risk management tools for sophisticated investors and 
financial intermediaries. While the $100 billion daily trading is an 
impressive figure in the equities market, it has not escaped our 
attention that the value of contracts traded on the Chicago Mercantile 
Exchange (CME) averaged over $2 trillion a day for the first 6 months 
of 2004.
    And while volume on the NYSE remained relatively flat in 2004, 
total volume in equity options, both in the United States and abroad, 
soared by nearly 30 percent. From 1995 to 2004, options volume has 
increased by 400 percent. Over that same period, the total number of 
options contracts traded in the United States has risen from 288 
million to 1.2 billion.
    For futures, the CME's 2004 annual volume was more than 787 million 
contracts, representing double-digit volume gains for the fifth 
consecutive year. The Chicago Board of Trade's (CBOT) 2004 annual 
volume reached nearly 600 million contracts, a record high for the CBOT 
and the third consecutive record-breaking year for the CBOT.
Competitive Landscape
    In addition to the growth in new products and platforms, today's 
financial markets are facing a new global challenge to the traditional 
leadership of U.S. capital markets.
    There is now greater mobility of capital, greater international 
participation in local markets, and greater competition among markets 
in different geographical areas. Financial institutions, investment 
firms, and other financial intermediaries have increased their trading 
across national boundaries, in numerous different markets, outside 
traditional exchanges, and even directly among themselves.
    Today, traditional rivals like the Deutsche Borse are becoming 
better capitalized, and better competitors. While this is true for the 
equities market, it is especially true in the derivatives market. 
Eurex, which is jointly owned by Deutsche Borse and SWX Swiss Exchange, 
is the world's largest future and options market for euro denominated 
derivative instruments. In addition, according to Eurex's monthly 
statistics from third quarter 2005, it has the largest market share in 
terms of contract turnover for the entire international options and 
futures markets--12.84 percent. The next four biggest players are CME 
(11.28 percent), CBOT (7.69 percent), Chicago Board of Options Exchange 
(CBOE) (5.44 percent), and the International Securities Exchange (ISE) 
(4.88 percent).
    And investors are responding to these opportunities. An increasing 
portion of U.S. portfolios is going overseas into non-U.S. investments. 
Since 1990, in U.S. investors' portfolios, the equity portion alone of 
non-U.S. stocks has nearly tripled, from 6.0 percent to 16.8 percent.
    In addition, the NYSE's competitors have become stronger through 
demutu-
alization and consolidation. In response to growing competition, many 
marketplaces in both Europe and the United States, such as the London 
Stock Exchange plc and Nasdaq, have demutualized to free themselves 
from the constraints of their membership structures and to provide 
greater flexibility for future growth. In recent years, the number of 
new market entrants, the need to respond to the globalization of 
capital markets, and the desire to provide global, cross-border 
services to clients has also led to a wave of consolidation, both in 
the United States and abroad.
    In order to compete effectively in this global climate, and in 
order to provide investors and issuers with the best possible 
marketplace, we must become a multiproduct, global competitor.
    We are looking at the possibility of expanding or adding new 
platforms in areas that can benefit from increased transparency. We are 
currently seeking an SEC exemption to expand our investor friendly 
corporate bond platform to trading unregistered bonds of our listed 
companies.
    We are also making great progress in one fast-growing asset class, 
U.S. Exchange Traded Funds (ETF's), whose total funds have soared over 
50 percent last year to $227 billion. ETF's provide investors an 
excellent way to manage risk and diversify by trading a portfolio of 
stocks in a designated area such as gold, natural resources, the S&P, 
or Chinese-based equities.
    But ETF's represent only a single star within the giant 
constellation of financial markets. We need to expand our universe much 
more broadly in order to compete successfully.
    NYSE is becoming a public, for-profit company to give us improved 
access to capital, and the ability to use stock as acquisition 
currency. We are merging with Archipelago, an outstanding, 
entrepreneurial company that is pioneering leading-edge trading 
platforms and customer focus.
    That is also why we are building the Hybrid Market; we are 
responding to the demand of many of our customers for greater ability 
to trade electronically. The Hybrid Market will give customers the 
choice of two investor-friendly paths: Either the sub-second speed of 
automatic execution, or the price improvement and best value that 
distinguish the auction market.
    Ten years ago, these changes at the NYSE would have been 
unthinkable. But today, moving forward without these changes is what 
would be unthinkable. We must respond to investors' needs and thereby 
preserve the position of the United States as the leader in our global 
financial marketplace.
Regulatory Developments
    As you can imagine, there are also regulatory considerations that 
affect not only the competitive landscape but also dictate where and 
how individuals and their representatives invest their money. Two such 
examples are capital requirements for broker-dealers and margin rules 
for brokerage accounts.
Capital Requirements
    For years, U.S. broker-dealers have moved much of their derivatives 
business overseas because of stringent capital requirements that make 
conducting such business in the United States less attractive.
    In August 2004, the SEC adopted rule amendments that established a 
voluntary, alternative method for broker-dealers to compute net 
capital. This rule allows them to use internal models to calculate net 
capital requirements for market and derivatives related credit risk. 
One condition to using this alternative method is that the broker-
dealer's ultimate holding company and affiliates become consolidated 
supervised entities and consent to group wide oversight (consolidated 
supervision) from the SEC. Another condition is that the broker-dealer 
must maintain $5 billion of tentative net capital in order to 
participate, which limits the number of broker-dealers who are able to 
take advantage of this rule.
    The Exchange currently has rule proposals before the SEC to modify 
its capital rules to reflect a different level of capital and to change 
its margin rules to accommodate derivatives business that may come back 
into the United States. To date, five internationally active firms, 
including Goldman Sachs, Merrill Lynch, Bear Stearns, Lehman Brothers, 
and Morgan Stanley, have either applied or been approved for CSE 
(consolidated supervised entity) status.
    Relaxation of the capital rules by allowing firms to use internal 
models to compute charges has encouraged the firms using this 
alternative method to study whether to bring their OTC derivative 
dealers back into the U.S. broker-dealer. There is significant benefit 
to the firms from a legal netting standpoint to have all transactions 
with a single counterparty in one legal entity. They are studying the 
technology issues as well as other regulations that might be applicable 
before reaching a final decision.
Portfolio Margining
    Another regulatory development that affects derivatives concerns 
potential changes to portfolio margining.
    The evolution of the equities and derivatives markets puts into 
focus the need to ensure a sensible regulatory approach that will 
foster competition among markets and strengthen the U.S. position in 
the global marketplace.
    As the Banking Committee's hearing last month on Commodity Futures 
Trading Commission (CFTC) reauthorization highlighted, it is essential 
that regulation of the security futures and equities markets maintain 
the competitive balance that was established by Congress in 2000 in the 
Commodity Futures Modernization Act (CFMA).
    One aspect of that regulation that has been under scrutiny is the 
margin rules that apply to different products. We strongly agree with 
the many participants in the financial markets, several of whom 
testified before the Committee, that portfolio margin rules should be 
developed not just for select sectors of the marketplace, but for all 
equity products. Currently, margins for security futures customers are 
calculated using a strategy-based approach, which computes margin 
requirements for each individual position or strategy in a portfolio. 
Portfolio margining, used for all futures contracts and for security 
options at the clearing level, is risk-based, and more accurately 
reflects economic exposure to the marketplace.
    The NYSE is working with the NASD, CBOE, CFTC, and other 
commodities exchanges and market participants to develop a portfolio 
margin rule that would apply to all equities. We consider this 
initiative a top priority and will be working with our fellow 
regulators to produce a rule for SEC consideration by year-end.
Conclusion
    Today's financial markets have evolved significantly over a 
relatively short period of time. Technological changes have increased 
the speed of transactions and reduced the costs of those transactions. 
The equity market has grown steadily, while the derivatives market has 
grown exponentially with the introduction of new products. The 
international competitive landscape has forced U.S. markets and market 
participants to think globally.
    While some may see this change as a threat, the NYSE sees 
opportunity. Investors will increasingly need platforms that can meet 
all of their investment needs, including equities, futures, options, or 
swaps. As the NYSE proceeds with its plans to become a publicly traded 
company and merge with Archipelago, thereby increasing our 
capitalization and diversifying our product offering, we are looking to 
take advantage of the opportunities that this new competitive landscape 
will present.
    Mr. Chairman, and Ranking Member Bayh, and Members of the 
Committee, thank you for the opportunity to present this testimony. I 
look forward to answering your questions.
                              ------------
                 PREPARED STATEMENT OF CHARLES SMITHSON
                Managing Partner, Rutter Associates LLC
                            October 18, 2005
    Chairman Crapo and Members of the Subcommittee, I am pleased to 
have the opportunity to testify before the Subcommittee today about a 
market that is crucial to the effect functioning of both industrial 
firms and financial institutions, but one that is widely misunderstood.
    I am Charles Smithson. I am the Managing Partner of Rutter 
Associates, an advisory firm that specializes in financial risk 
management. My colleagues and I assist banks, insurance companies, and 
industrial companies in measuring and managing their exposures to 
financial price risks (that is, interest rate risk, foreign exchange 
rate risk, commodity price risk, and equity price risk), credit risk, 
and liquidity risk.
    While the benefits of freely functioning markets are without 
question, the interaction of willing buyers and sellers can lead to 
price volatility. Since derivatives provide market participants with a 
means of dealing with that price volatility, the derivatives market we 
are discussing here today is a consequence of the increased price 
volatility we witnessed in the 1970's and 1980's--increased volatility 
in foreign exchange rates resulting from the move to floating exchange 
rates, increased volatility in interest rates associated with the move 
to damp inflation in the late 1970's, and increased volatility in 
commodity prices associated with deregulation of those markets.
    What can be said about the consequences of derivatives? Over the 
more than 20 years, I have been involved in derivatives and risk 
management, I have been collecting empirical evidence, which today I 
will share with you in the form of answers to four important questions.
    Question #1: What happens to the volatility of financial prices 
when the financial risk management products appear?
    Some argue that the introduction of derivatives leads to increased 
volatility. John Shad (former Chairman, Securities and Exchange 
Commission), one of the more outspoken proponents of this view, saw 
derivatives as ``the tail wagging the dog,'' escalating price 
volatility to ``precipitous, unacceptable levels.'' Others suggest that 
there is no reason for the introduction of derivatives to have any 
effect on the volatility of underlying assets. Derivatives are 
``created assets'' (for every long there is a 
corresponding short). Thus the introduction of these contracts would 
have no predictable effect on trading in the underlying security. Still 
others argue that the introduction of derivatives should lead the 
volatility of the underlying assets to fall, not rise. After all, the 
newly created trading opportunity in this derivative security should 
increase market liquidity for an underlying asset.
    This question has been extensively examined by academics. When we 
searched the academic journals, my colleagues and I found 39 empirical 
analyses, starting with the Holbrook Working's classic 1960 study of 
the impact of the introduction of futures on onion prices through a 
2000 study of the impact of the introduction of options on share 
prices. While the ``derivatives increase volatility'' story seems 
plausible, the empirical evidence supports the contention that the 
introduction of derivatives reduces price volatility in the underlying 
markets.
    Question #2: What happens to the bid-ask spread and trading volume 
for the underlying assets?
    My colleagues and I found 5 academic studies that examined the 
impact of the introduction of derivatives on the bid/ask spread in the 
underlying market. These studies indicate overwhelmingly that the bid/
ask spreads in the underlying market declines after the introduction of 
derivatives.
    Some have suggested that the introduction of derivatives reduces 
volumes in the underlying markets. Finance theory suggests that the 
reduced bid-ask spread noted above and the ability to arbitrage one 
market against the other should increase volumes in the underlying 
markets. My colleagues and I found 6 published studies in which 
academics looked at what happens to the trading volumes in the 
underlying asset when derivatives on the asset are introduced. These 
studies indicate that the introduction of derivatives is associated 
with increases in unadjusted volumes in the underlying and either an 
increase or no change in market-adjusted trading volumes.
    Question #3: If a firm uses risk management, does the market regard 
the firm as being less risky?
    Over the years, most of my interest has been focused on this 
question and on the ``payoff'' Question #4 to follow. After all, if I 
am going to suggest that firms should manage financial price risk, I 
should have a pretty good idea that the market will reward them for 
doing so. What I am going to tell you about today come from an article 
Professor Betty Simkins (Oklahoma State University) and I published in 
the most recent issue of The Journal of Applied Corporate Finance.
    In the context of Question #3, if a publicly traded firm is 
``exposed'' to financial price risk, the returns to the firm's equity 
would be sensitive to changes in interest rates, foreign exchange 
rates, or commodity prices. Consequently, Question #3 could be 
rephrased as: If such a firm uses derivatives to manage one or more of 
those exposures, does the exposure decline?
    Professor Simkins and I found 15 studies that examined this 
question, 6 that focused on financial institutions and 9 on industrial 
companies. Overwhelmingly, the studies indicated that the use of risk 
management led to a decline in the perceived riskiness of the firm:

 In the case of financial institutions, all 6 of the studies 
    reported that the use of derivatives reduced the sensitivity of the 
    equity returns to interest rates;
 In the case of industrial companies, 8 of the 9 studies 
    reported that the use of derivatives reduced the sensitivity of 
    their equity returns to financial price risks.

    Question 4: What impact does the use of derivatives have on the 
value of the firm?
    All of the empirical evidence on this question is very recent. 
Professor Simkins and I found only 10 studies that focused on this 
question, the ``oldest'' of which was published in 2001.
    Six of the studies examined the impact of interest rate and FX risk 
management (one looking at banks and 5 looking at industrial 
corporations). The other 4 studies examined commodity price risk 
management, with one looking at commodity users and three looking at 
commodity producers.

 Managing interest rate and foreign exchange rate risk with 
    derivatives is associated with higher firm values.
 Similarly, the study of commodity price risk management by 
    commodity users found that fuel price hedging by airlines was 
    associated with higher firm values.
 In contrast, the three studies of commodity price risk 
    management by commodity producers found either no effect or a 
    negative effect on equity values--If investors take positions in 
    commodity producers as a way to gain exposure to the commodity 
    price, the firm should not necessarily benefit from hedging the 
    commodity price risk.
Summary & Conclusions
    We have answered four questions about risk management using 
empirical evidence provided by the academic community:

    1. What happens to the volatility of financial prices when the 
financial risk management products appear?
    The introduction of derivatives has reduced price volatility in the 
underlying market.

    2. What happens to the bid-ask spread and trading volume for the 
underlying assets?
    The introduction of derivatives has decreased bid/ask spreads and 
has had little effect on trading volume in the underlying market.

    3. If a firm uses risk management, does the market regard the firm 
as being less risky?
    Yes--Firms that use risk management are perceived to be less risky.

    4. Does the use of derivatives increase, leave-unchanged, or 
decrease the value of the firm?
    The use of derivatives to manage interest rate risk, foreign 
exchange rate risk and commodity price risk by users of commodities is 
associated with higher firm values.

    Perhaps the principal benefit from the innovations over the last 
two decades has been the improvement in the allocation of risk within 
the financial system. Derivatives have dramatically reduced the cost of 
transferring risks to those market participants who have a comparative 
advantage in bearing them. As Merton Miller said: ``Efficient risk-
sharing is what much of the futures and options revolution has been all 
about.''
    Derivatives markets provide corporations the ability to hedge 
against currency, interest rate, and commodity price risks far more 
quickly and cheaply than was possible before. Derivatives have 
permitted the transfers of risk from individual firms to well-
diversified institutional investors. This transfer has not only lowered 
mortgage rates for homebuyers, but it also should help protect the 
financial system from another disaster like the one experienced by the 
savings and loan industry.
    Derivatives are often described as a ``zero sum game;'' and they 
are. But, even though one party's gain is another's loss in an 
individual transaction, the more efficient risk sharing afforded by 
derivatives can reduce total risk for all market participants.
    Derivatives have expanded the technology available to firms and 
individuals to manage risk. They have reduced the costs of managing 
exposures, thereby increasing liquidity and efficiency.
    In order for derivatives to deliver the benefits that they are 
capable of providing, there must, of course, be a high degree of 
certainty as to their enforceability and regulatory treatment. Congress 
made extraordinary progress in ensuring such certainty in 2000 with its 
enactment of the Commodity Futures Modernization Act of 2000. The 
substantial growth in the depth and breadth of the listed and OTC 
markets for derivative products in nearly all asset categories since 
2000 is a testament to the importance of legal certainty and the 
success of Congress's efforts.
    Mr. Chairman, Members of the Subcommittee, thank you once again for 
the 
opportunity to testify before the Subcommittee on these important 
subjects. Our economic success depends on a clear understanding of the 
relationship between financial instruments, their use and their 
regulation, on the one hand, and the market consequences of their use 
and regulation, on the other hand. I would be pleased to assist the 
Subcommittee and its staff going forward in connection with the 
Subcommittee's efforts to understand these relationships.
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