[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
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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.
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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.
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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.