[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW THE ROLE OF CREDIT DERIVATIVES IN THE U.S. ECONOMY
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HEARINGS
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
__________
OCTOBER 15, NOVEMBER 20, DECEMBER 8, 2008
__________
Serial No. 110-49
Printed for the use of the Committee on Agriculture
agriculture.house.gov
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COMMITTEE ON AGRICULTURE
COLLIN C. PETERSON, Minnesota, Chairman
TIM HOLDEN, Pennsylvania, BOB GOODLATTE, Virginia, Ranking
Vice Chairman Minority Member
MIKE McINTYRE, North Carolina TERRY EVERETT, Alabama
BOB ETHERIDGE, North Carolina FRANK D. LUCAS, Oklahoma
LEONARD L. BOSWELL, Iowa JERRY MORAN, Kansas
JOE BACA, California ROBIN HAYES, North Carolina
DENNIS A. CARDOZA, California TIMOTHY V. JOHNSON, Illinois
DAVID SCOTT, Georgia SAM GRAVES, Missouri
JIM MARSHALL, Georgia MIKE ROGERS, Alabama
STEPHANIE HERSETH SANDLIN, South STEVE KING, Iowa
Dakota MARILYN N. MUSGRAVE, Colorado
HENRY CUELLAR, Texas RANDY NEUGEBAUER, Texas
JIM COSTA, California CHARLES W. BOUSTANY, Jr.,
JOHN T. SALAZAR, Colorado Louisiana
BRAD ELLSWORTH, Indiana JOHN R. ``RANDY'' KUHL, Jr., New
NANCY E. BOYDA, Kansas York
ZACHARY T. SPACE, Ohio VIRGINIA FOXX, North Carolina
TIMOTHY J. WALZ, Minnesota K. MICHAEL CONAWAY, Texas
KIRSTEN E. GILLIBRAND, New York JEFF FORTENBERRY, Nebraska
STEVE KAGEN, Wisconsin JEAN SCHMIDT, Ohio
EARL POMEROY, North Dakota ADRIAN SMITH, Nebraska
LINCOLN DAVIS, Tennessee TIM WALBERG, Michigan
JOHN BARROW, Georgia BOB LATTA, Ohio
NICK LAMPSON, Texas
JOE DONNELLY, Indiana
TIM MAHONEY, Florida
TRAVIS W. CHILDERS, Mississippi
______
Professional Staff
Robert L. Larew, Chief of Staff
Andrew W. Baker, Chief Counsel
April Slayton, Communications Director
William E. O'Conner, Jr., Minority Staff Director
(ii)
C O N T E N T S
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Page
Wednesday, October 15, 2008
Etheridge, Hon. Bob, a Representative in Congress from North
Carolina, opening statement.................................... 3
Prepared statement........................................... 4
Goodlatte, Hon. Bob, a Representative in Congress from Virginia,
opening statement.............................................. 2
Prepared statement........................................... 3
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 1
Witnesses
Lukken, Hon. Walter, Acting Chairman, Commodity Futures Trading
Commission, Washington, D.C.................................... 5
Prepared statement........................................... 8
Sirri, Erik R., Director, Division of Trading and Markets, U.S.
Securities and Exchange Commission, Washington, D.C............ 11
Prepared statement........................................... 13
Pickel, Robert G., Executive Director and CEO, International
Swaps and Derivatives Association, Washington, D.C............. 35
Prepared statement........................................... 37
Hu, J.D., Henry T.C., Allan Shivers Chair in the Law of Banking
and Finance, University of Texas School of Law, Austin, TX..... 41
Prepared statement........................................... 42
Short, Johnathan H., Senior Vice President and General Counsel,
IntercontinentalExchange, Inc., Atlanta, GA.................... 47
Prepared statement........................................... 49
Taylor, Kimberly, Managing Director and President, Clearing
House, Chicago Mercantile Exchange, Inc., and CME Group, Inc.,
Chicago, IL.................................................... 52
Prepared statement........................................... 54
Submitted Material
Dinallo, J.D., Eric R., Superintendent, Insurance Department,
State Of New York, submitted statement......................... 79
Dunn, Hon. Michael V., Commissioner, Commodity Futures Trading
Commission, submitted statement................................ 73
Parkinson, Patrick M., Deputy Director, Division of Research and
Statistics, Board of Governors, Federal Reserve System,
submitted statement............................................ 73
Thursday, November 20, 2008
Goodlatte, Hon. Bob, a Representative in Congress from Virginia,
opening statement.............................................. 88
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 85
Prepared statement........................................... 87
Witnesses
Radhakrishnan, Ananda, Director, Division of Clearing and
Intermediary Oversight, Commodity Futures Trading Commission,
Washington, D.C................................................ 89
Prepared statement........................................... 90
Parkinson, Patrick M., Deputy Director, Division of Research and
Statistics, Board of Governors, Federal Reserve System,
Washington, D.C................................................ 92
Prepared statement........................................... 94
Sirri, Erik R., Director, Division of Trading and Markets, U.S.
Securities and Exchange Commission, Washington, D.C............ 96
Prepared statement........................................... 98
Dinallo, J.D., Eric R., Superintendent, Insurance Department,
State Of New York, New York, NY................................ 101
Prepared statement........................................... 103
Monday, December 8, 2008
King, Hon. Steve, a Representative in Congress from Iowa, opening
statement...................................................... 143
Prepared statement........................................... 144
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 141
Prepared statement........................................... 142
Witnesses
Duffy, Hon. Terrence A., Executive Chairman, CME Group Inc.,
Chicago, IL.................................................... 145
Prepared statement........................................... 147
Short, Johnathan H., Senior Vice President and General Counsel,
IntercontinentalExchange, Inc., Atlanta, GA.................... 150
Prepared statement........................................... 152
O'Neill, John, Manager, Fixed Income Derivatives, Liffe, NYSE
Euronext, London, United Kingdom............................... 156
Prepared statement........................................... 158
Book, Thomas, Member of the Executive Boards, Eurex and Eurex
Clearing AG, Frankfurt am Main, Germany........................ 166
Prepared statement........................................... 167
Damgard, John M., President, Futures Industry Association,
Washington, D.C................................................ 195
Prepared statement........................................... 197
Pickel, Robert G., Executive Director and CEO, International
Swaps and Derivatives Association, Washington, D.C............. 199
Prepared statement........................................... 201
Thompson, Don, Managing Director and Associate General Counsel,
J.P.Morgan, New York, NY; on behalf of Securities Industry and
Financial Markets Association.................................. 204
Prepared statement........................................... 205
Corrigan, Ph.D., E. Gerald, Managing Director, Goldman, Sachs &
Co., New York, NY.............................................. 208
Prepared statement........................................... 209
Murtagh, J.D., Bryan M., Managing Director, Fixed Income
Transaction Risk Management, UBS Securities LLC, Stamford, CT.. 220
Prepared statement........................................... 222
Supplemental material........................................ 252
Submitted Material
Citigroup Inc., submitted statement.............................. 250
Stupak, Hon. Bart, a Representative in Congress from Michigan,
submitted statement............................................ 249
HEARING TO REVIEW THE ROLE OF CREDIT DERIVATIVES IN THE U.S. ECONOMY
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WEDNESDAY, OCTOBER 15, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 11:05 a.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden,
Etheridge, Marshall, Ellsworth, Space, Walz, Pomeroy, and
Goodlatte.
Staff present: Adam Durand, John Konya, Scott Kuschmider,
Rob Larew, Merrick Munday, Clark Ogilvie, John Riley, Sharon
Rusnak, April Slayton, Debbie Smith, Bryan Dierlam, Tamara
Hinton, Kevin Kramp, and Bill O'Conner.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. I want to,
first of all, thank all the witnesses that have agreed to be
with us today, and also the Members for coming back from their
districts to be involved in this. This is an important issue. I
am going to just talk briefly about where I am coming from.
What I am interested in is getting a clearing situation set
up for these credit default swaps. As I understand it, there
are discussions going on between the different parties; the
SEC, the CFTC, the Fed, different groups that are working on
this. They would come under different regulation. There are
different proposals out there. Apparently, the different
parties are discussing this. We need to get these things in a
position where they are being able to be cleared, and by
bringing into it some kind of regulated situation we are going
to have some kind of capital requirements, which are very much
needed.
I believe that a lot of this financial problem and the
reason that people don't trust each other is, to some extent,
because of these swaps, because people don't know what is out
there. They have been put off by what happened with AIG,
Lehman, and Bear Stearns, and so forth. And so I think this is
a big part of the problem, and the sooner that we can get these
clearing mechanisms set up, the better we are going to be.
We have no idea what the $60 trillion is. Well, we have
some idea, but not much. From what I can tell, if you were able
to clear all this stuff out, it probably wouldn't be $60
trillion. It might be $15 trillion. But that is the problem.
Everybody is afraid to borrow because there might be something
out there that they don't know about, and within 3 days you can
see that your money could be gone. We saw it with Farmer Mac.
They had investments and all of a sudden they had a capital
problem.
So, this is a big part of this financial situation that we
are in. What I want to accomplish out of this hearing is to try
to figure out, or get some sense of how quick we can get this
clearing mechanism established, get some idea of what is going
on between the different parties.
We have Mr. Lukken here. We appreciate him being here. The
gentleman from the SEC, and people from the industry. So this
is a big problem. We have a big responsibility here to try to
get this right. I think that this Committee is more of an
impartial panel, if you will, because we are not as close to
Wall Street and all of these other folks that got us into this
mess. We can take a more open-minded view of what the solution
is going to be than maybe some other folks around this town.
So I appreciate you all being here. I recognize the Ranking
Member, and appreciate him coming back from his district and
rearranging his schedule to be with us. We will move on to the
panel.
OPENING STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN
CONGRESS FROM VIRGINIA
Mr. Goodlatte. Well, thank you, Mr. Chairman. I want to
thank you for calling today's hearing on the role of credit
derivatives in the U.S. economy. This is a critical time in our
nation's history when there is widespread doubt about the
stability of our financial system. This doubt is the result of
serious market failures where major institutions like Fannie
Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and AIG
have either defaulted, filed bankruptcy or experienced extreme
financial distress.
We should consider today's hearing as one part of an
aggressive fact-finding mission to determine the role credit
default swaps play in the marketplace and if they contributed
to the current economic crisis. The primary question for us
today is: Do credit default swaps serve a valid purpose in the
marketplace to manage risk and allow economic growth
opportunities for business expansion? Or, do credit default
swaps put businesses, and therefore, the entire economy in a
precarious position because they encourage risky behavior and
over-leveraging of assets? Is the current trouble with credit
default swaps just a symptom of a slowing economy or did their
unregulated existence help create the malaise? Do these
instruments require more oversight or is the current regulatory
system adequate to monitor these transactions? And if
transactions in the credit default swaps require additional
regulations, what should those regulations be, what should
those regulations require, and who would be responsible for
enforcement?
These are but a few questions that should be addressed to
ensure the marketplace works.
Today, we will hear testimony from those who recently have
been exploring those questions and examining this kind of
financial activity. As we move forward, it is important that we
protect the sanctity of the marketplace while at the same time
protect participants and limit any threat of systemic risk.
I look forward to hearing your comments. Thank you, Mr.
Chairman.
[The prepared statement of Mr. Goodlatte follows:]
Prepared Statement of Hon. Bob Goodlatte, a Representative in Congress
From Virginia
I would like to thank Chairman Peterson for calling today's hearing
on the role of credit derivatives in the U.S. economy.
This is a critical time in our nation's history when there is
widespread doubt about the stability of our financial system. This
doubt is the result of serious market failures where major institutions
like Fannie Mae, Freddie Mac, Lehman Brothers, Washington Mutual, and
AIG have either defaulted, filed bankruptcy, or experienced extreme
financial distress.
We should consider today's hearing as one part of an aggressive
fact-finding mission to determine the role credit default swaps play in
the marketplace, and if they contributed to the current economic
crisis.
The primary question for us today is do credit default swaps serve
a valid purpose in the marketplace to manage risk and allow economic
growth opportunities for business expansion? Or, do credit default
swaps put businesses, and therefore, the entire economy, in a
precarious position because they encourage risky behavior and over-
leveraging of assets.
Is the current trouble with credit default swaps just a symptom of
a slowing economy, or did their unregulated existence help create the
malaise? Do these instruments require more oversight, or is the current
regulatory system adequate to monitor these transactions?
And, if transactions in the credit default swaps require additional
regulations, what should those regulations be? What should those
regulations require, and who would be responsible for enforcement?
These are but a few questions that should be addressed to ensure the
marketplace works.
Today, we will hear testimony from those who, recently, have been
exploring those questions and examining this kind of financial
activity. As we move forward, it is important that we protect the
sanctity of the marketplace, while at the same time, protect
participants and limit any threat of systemic risk.
I look forward to hearing your comments.
The Chairman. I thank the gentleman from Virginia. I now
recognize the gentleman from North Carolina, the Chairman of
the Subcommittee that deals with this, Mr. Etheridge.
OPENING STATEMENT OF HON. BOB ETHERIDGE, A REPRESENTATIVE IN
CONGRESS FROM NORTH CAROLINA
Mr. Etheridge. Mr. Chairman, thank you. Let me thank you
for holding this hearing today. It may be one of the more
important ones we have held all year, other than the passage of
the farm bill.
I, like many of you here today, am here with mixed
emotions. I am glad we are holding the hearing, though I wish
our country were not experiencing the economic turmoil which
makes this hearing necessary.
My constituents have been asking me, ``How did we get in
this financial mess?'' They have heard and read some of my
colleagues on the Republican side theorizing that they blame
the Democrats. They have read that Democrats, theorizing, are
blaming the Republicans. I think the truth is there is a lot of
blame to go around, and a lot of people share some
responsibility in this mess.
The regulatory regime in operation today through all parts
of our financial system is a construct that was developed years
ago with bipartisan support, through bipartisan legislation.
Today, we are looking specifically at over-the-counter credit
derivatives, particularly credit default swaps, which
constitute the vast majority of these derivatives. Currently,
there is no specific regulation of these financial instruments,
as the Chairman has talked about. That wasn't by accident, as
he has also indicated. It was by design.
This Committee has jurisdiction over the Commodity Exchange
Act. In 2000, Congress passed legislation, the Commodity
Futures Modernization Act, which expressly stated that the CEA
would not apply to these derivatives. If the lack of oversight
of these derivatives and if the lack of these instruments is
the source of our financial difficulty, then both parties have
some responsibility.
We were told by the financial community and others that we
needed to modernize our regulatory structure to compete with
financial institutions in Europe and elsewhere. We were assured
that the parties to these financial instruments were
responsible and sophisticated enough to engage in these
transactions without the need for heavy government regulation
and oversight. To some extent, they were right, as they were
talking about the major players who did not need the government
to protect them from each other in the marketplace as opposed
to small retail customers who need greater protection from
fraud and manipulation.
Like trusting parents, we let the big boys and girls go out
in the financial playground, thinking we didn't have to watch
over them to keep them from hurting themselves. Little did we
know that they would end up trashing the playground instead. We
never guessed that the major players could grow up to be so
big, that the collapse of one of them would bring down the
financial system. Now we have a mess to clean up. Today's
hearing is the beginning of our role in that process.
Mr. Chairman, I applaud you for holding this hearing now as
opposed to waiting for the next Congress, because I think this
is important enough we have to get moving. Earlier this year,
the House passed the Commodity Market Transparency and
Accountability Act with wide bipartisan margins. It provided
for dramatic changes in the regulation of the physical
commodity derivatives. It looks like we must add financial
commodities to the reform effort. I look forward to working
with you and this full Committee in that effort.
Thank you.
[The prepared statement of Mr. Etheridge follows:]
Prepared Statement of Hon. Bob Etheridge, a Representative in Congress
From North Carolina
Thank you Mr. Chairman. I am here today with mixed emotions. I am
glad we are holding this hearing, though I wish our country was not
experiencing the economic turmoil which makes this hearing necessary.
My constituents have been asking me, how did we get into this
financial mess? They have heard and read Republican theories that place
the blame on Democrats and likewise Democratic theories that blame
Republicans.
The truth is that everyone, Republicans and Democrats alike, have a
share in the responsibility for this mess.
The regulatory regime in operation today for all parts of our
financial system is a construct that was developed years ago with
bipartisan support through bipartisan legislation.
Today, we are looking specifically at over-the-counter credit
derivatives, particularly credit default swaps, which constitute the
vast majority of these derivatives.
Currently, there is no significant regulation of these financial
instruments. That wasn't by accident, but by design.
This Committee has jurisdiction over the Commodity Exchange Act
(CEA).
In 2000, Congress passed legislation--the Commodity Futures
Modernization Act (CFMA)--which expressly stated that the CEA would not
apply to these derivatives. If the lack of oversight of these
instruments is the source of our financial difficulty, then both
parties are responsible.
We were told by, the financial community that we need to modernize
our regulatory structure to compete with financial institutions in
Europe and elsewhere.
We were assured that the parties to these financial instruments
were responsible and sophisticated enough to engage in these
transactions without the need for heavy government regulation and
oversight.
And to some extent they were right as they were talking about the
major players who did not need the government to protect them from each
other in the marketplace, as opposed to smaller retail customers who
need greater protection from fraud and manipulation.
And like trusting parents, we let the big boys and girls go play in
the financial playground thinking we didn't have to watch over them to
keep them from hurting themselves.
Little did we know that they would end up trashing the playground
instead. We never guessed that the major players could grow up to be so
big that the collapse of one of them could bring down the financial
system.
Now we have a mess to clean up. Today's hearing is the beginning of
our role in that process. Mr. Chairman, I applaud you for holding this
hearing now as opposed to waiting for the next Congress.
Earlier this year, the House passed the Commodity Market
Transparency and Accountability Act by a wide bipartisan margin.
It provided for dramatic changes in the regulation of physical
commodity derivatives.
It looks like we must add financial commodities to the reform
effort, and I look forward to working with you on that effort.
The Chairman. I thank the gentleman, and thank him for his
leadership on the Subcommittee. All Members' statements will be
made a part of the record, without objection.
We would now like to welcome our witnesses. I would like to
remind you that your full testimony will be made part of the
record. We want to get to questions so we would ask you to try
to--we won't hold you exactly to the 5 minutes, but try to
summarize your statements.
We very much appreciate you being with us. First, we have
Hon. Walter Lukken, the Acting Chairman of the CFTC, and Erik
Sirri, the Director of Division of Trading and Markets of the
SEC with us. So, gentlemen, welcome.
Mr. Lukken, you are up first. Welcome to the Committee.
STATEMENT OF THE HON. WALTER LUKKEN, ACTING
CHAIRMAN, COMMODITY FUTURES TRADING COMMISSION, WASHINGTON,
D.C.
Mr. Lukken. Thank you, Mr. Chairman. Good morning, Ranking
Member Goodlatte and other distinguished Members of the
Committee. Thank you for the invitation here today to discuss
credit default swaps.
The current financial crisis is requiring policymakers to
rethink the existing approach to market regulation and
oversight. Many observers have singled out the $58 trillion
credit default swap market as needing greater scrutiny and
transparency. These over-the-counter swap transactions are
largely unregulated and may have exacerbated the counterparty
and systematic risk in the financial system during this crisis.
With respect to the CFTC, the Commodity Exchange Act
excludes most over-the-counter financial derivatives, including
credit default swaps, from its regulatory and enforcement
jurisdiction. But if we are to avoid repeating the mistakes of
the past, we must strive to increase the transparency of these
transactions and find ways to mitigate the systemic risk
created by firms that offer and hold these off-exchange
instruments. While wholesale regulatory reform will require
careful consideration, centralized clearing is one immediate
and proven response that will help mitigate the current crisis.
Clearinghouses have been functioning for many years as a
means for mitigating the risks associated with exchange-traded
financial products. Whether securities, options, or futures,
centralized clearinghouses ensure that every buyer has a
guaranteed seller and every seller has a guaranteed buyer, thus
minimizing the risk that one counterparty's default will cause
a systemic ripple through the markets. The clearinghouse is
able to take on this role because it is backed by the
collective funds of its clearing members.
This clearing guarantee goes to the root of the problems we
are confronting today, the constriction of credit due to the
fear of default. Indeed, for futures contracts, the
standardized on-exchange predecessor of OTC derivatives,
clearing has worked extraordinarily well in managing credit
risk. For regulated futures exchanges, the clearing and
settlement mechanism serves to lessen the likelihood that large
losses by a trader will cause a contagion event. At least
twice-daily, futures clearinghouses collect payments from
traders with losing positions and credit traders with
profitable positions. This twice-daily mark-to-market prevents
the buildup of significant losses and effectively wipes clean
the credit risk inherent in the system. Importantly, no U.S.
futures clearinghouse has ever defaulted on its guarantee.
Just as significant, the clearing process provides
transparency to regulators. When transactions are cleared,
government and exchange regulators receive daily trading and
pricing information, which helps them police for manipulation
and fraud and to uphold the integrity of the market.
Clearing has been proven to work for OTC derivatives. After
Enron's demise in 2001, the OTC energy derivatives markets
locked up because many energy companies lacked the requisite
financial standing to back their off-exchange trades. In
response, the New York Mercantile Exchange sought and received
approval from the CFTC in 2002 to clear OTC energy products for
the first time. Today, a significant number of OTC energy
derivatives are cleared through regulated clearinghouses, which
has reduced systemic risk and allowed regulators a greater
window into this marketplace. Clearing for OTC products now
extends beyond energy products to financial products such as
forward rate agreements and foreign currency swaps.
Under existing law, any derivatives clearing organization
that is registered with the CFTC may clear OTC derivatives
without further registration or subjecting itself to any
additional regulatory requirements. Pursuant to the CEA, the
CFTC regulates DCOs and has the statutory mandate to ensure the
financial integrity of transactions subject to the CEA, and to
safeguard against systemic risk. The CFTC relies on the 14 core
principles for DCOs set forth by Congress in the CEA as a means
for evaluating whether DCOs comply with U.S. law.
The CFTC, in conjunction with other financial regulators,
will continue to seek ways to provide clearing solutions for
OTC derivatives. Last month, in its swap report to Congress,
the CFTC recommended the further use of clearing for OTC
derivatives. There are several private sector clearing
initiatives currently being considered by Federal regulators.
It is imperative that regulators work cooperatively and
expeditiously to conduct their due diligence and allow
appropriate programs to begin operations promptly. The CFTC
will continue to closely coordinate with the Federal Reserve
and SEC to further this important policy objective.
While the implementation of centralized clearing for OTC
products is a near-term solution that does not require
legislative changes, broader reform of the OTC derivatives
market is also needed and will require decisive Congressional
action. As Congress embarks on reform in the coming months,
there are several guiding objectives that should be pursued by
legislators to improve the oversight and prevent a similar
economic disturbance in the future.
First and foremost, regulatory reform should seek to
improve the transparency of these OTC markets, particularly
when their size reaches a critical mass where they play a
public pricing role and their failure might cause a systemic
event. Clearly, the CDS market has met this criteria. Enhanced
transparency through reporting or other means would enable
regulators to properly police these markets for misconduct and
the concentration of risk. In pursuing this objective, Congress
might look to the model adopted in the farm bill by this
Committee for the OTC energy swaps market, which triggers
additional oversight and transparency when a product begins to
serve a significant price discovery function.
Second, regulatory reform should incentivize and possibly
even mandate centralized clearing and settlement for certain
OTC derivatives. As mentioned, clearing brings enhanced
transparency, standardization, and risk management to these
products at a time when it is most needed.
Third, regulatory reform should revisit the amount of risk-
based capital held by dealer firms and large participants in
these OTC markets to better account for the interdependent
counterparty risk that now seems so evident and to prevent
these products from being held off balance sheet in unregulated
affiliates. As clearing begins for these products and trading
data improves, models for assessing risk will also progress, as
will the accuracy of the capital charges assigned to these
firms.
Fourth, regulatory reform should provide for clear
enforcement authority over these products to police against
fraud and manipulation. The CFTC is currently excluded by
statute from bringing enforcement cases against OTC financial
derivatives. Congress should rectify this by providing clear
enforcement powers regarding OTC products to the CFTC and other
appropriate regulators, such as the SEC.
Last, regulatory reform of OTC products should be globally
coordinated and non-exclusionary. As this financial crisis has
shown, the world financial system is highly intertwined,
leaving no country's banking system unscathed. We have also
learned that one country's actions to stem the crisis cannot be
effective without close cooperation among all nations. As this
crisis begins to wane and we turn to pursue long-term
adjustments to the global regulatory structure, world
legislators must work in close concert with each other to
ensure that steps taken by one nation to improve oversight are
not exploited by others in the global financial community. This
also means that domestic regulators should work in tandem and
not engage in the unproductive exercise of defending
jurisdictional lines at a time when a comprehensive and
coordinated response by regulators is most needed. The entire
regulatory community must continue to unite in seeking a
sensible and comprehensive solution to the global financial
crisis, which may require many of us to rethink our regulatory
approaches and jurisdictional biases. The CFTC is committed to
playing a constructive role in seeking a cooperative regulatory
solution that improves the global regulatory structure for
financial markets.
Mr. Chairman, I appreciate your leadership on the critical
issue we are talking about today, and I look forward to
participating fully in the Congressional and regulatory efforts
to implement policies and practices that best serve the public
interest. I look forward to your questions.
[The prepared statement of Mr. Lukken follows:]
Prepared Statement of Hon. Walter Lukken, Acting Chairman, Commodity
Futures Trading Commission, Washington, D.C.
Chairman Peterson, Ranking Member Goodlatte, and other
distinguished Members of the Committee, I am pleased to have this
opportunity to appear today to discuss risk management for credit
default swaps (CDS). The Commodity Futures Trading Commission (CFTC)
welcomes the opportunity to discuss over-the-counter (OTC) derivatives
and the benefits derived from clearing such products.
OTC Swaps and Regulated Futures Transactions
From the beginning of U.S. futures trading in the mid-1800s until
recently, regulated futures exchanges offered the primary means by
which commercial entities could manage their physical market price
risks. During the 1980s, however, financial institutions began to
develop non-exchange-traded derivatives contracts that offered similar
risk management benefits. In 1981, the World Bank and IBM entered into
what has become known as a currency swap. The swap essentially involved
a loan of Swiss francs by IBM to the World Bank and the loan of U.S.
dollars by the World Bank to IBM. The motivation for the transaction
was the ability of each party to borrow the funds they were loaning
more cheaply than the counterparty, thus reducing overall funding costs
for both parties. This structure of swapping cash flows ultimately
served as the template for swaps on any number of financial assets and
commodities.
The development of the OTC swap industry is related to the
exchange-traded futures and options industry in that a swap agreement
can function as a competitor or complement to futures and option
contracts. Market participants often use swap agreements because they
offer the ability to customize contracts to match particular hedging or
price exposure needs. Conversely, futures markets typically involve
standardized contracts that, while often traded in very liquid markets,
may not precisely meet the needs of a particular hedger or speculator.
The OTC swap market has grown significantly because, for many financial
entities, the OTC derivatives products offered by swap dealers have
distinct advantages relative to futures contracts.
Yet, these OTC swap transactions are largely unregulated. With
respect to the CFTC, the Commodity Exchange Act (CEA) excludes most OTC
financial derivatives, including CDS, from its regulatory and
enforcement jurisdiction.\1\
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\1\ See, e.g., CEA, 7 U.S.C. 2(d) and 2(g). Section 2(d)
excludes from CEA coverage transactions involving an ``excluded
commodity'' (a broad range of interest rate, currency, credit, equity,
weather, and other derivatives) that are not executed on a trading
facility and are entered into solely by eligible contract participants.
Section 2(g) excludes from CFTC regulation transactions involving a
commodity other than an agricultural commodity that are not executed on
a trading facility if they are entered into solely by eligible contract
participants and are subject to individual negotiation.
Section 2(d)(2) also excludes transactions involving an excluded
commodity that are executed through an electronic trading facility by
eligible contract participants trading on a principal-to-principal
basis, or by certain authorized fiduciaries or investment managers.
Finally, under Title IV of the Commodity Futures Modernization Act of
2000 (CFMA), an exclusion from the CEA was created for certain
individually-negotiated swap agreements offered by banks to eligible
contract participants.
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Credit Default Swaps
The current financial crisis is requiring policymakers to rethink
the existing approach to market regulation and oversight. Many
observers have singled out OTC credit derivatives, including CDS, as
needing greater scrutiny and transparency.
OTC credit derivatives emerged in the mid-1990s as a means for Wall
Street financial institutions to buy insurance against defaults on
corporate obligations. Specifically, OTC credit derivatives are
bilateral off-exchange instruments that allow one party (the protection
buyer) to transfer credit-related risks associated with the actual or
synthetic ownership of a ``reference asset'' to another party (the
protection seller) for a price.\2\ The reference asset associated with
an OTC credit derivative may be a corporate debt obligation (such as a
bond or a bank loan), a sovereign debt obligation, an asset-backed
security (such as commercial mortgage-backed securities), or any other
obligation or debt. Credit derivatives transfer the credit risks
attendant to the actual or synthetic ownership of a reference debt
obligation.
---------------------------------------------------------------------------
\2\ In the OTC market, the terminology ``protection seller'' and
``protection buyer'' is used to refer to the seller and the buyer of a
credit derivative.
---------------------------------------------------------------------------
The most common credit derivative product is the CDS. Under a CDS,
the protection seller promises to compensate the protection buyer for
the economic loss associated with a material decline in the value of a
reference asset that is triggered by the occurrence of a pre-determined
``credit event,'' such as a filing for bankruptcy or default on a debt
payment by the issuer of the reference asset. In some CDS contracts,
the protection buyer pays the protection seller a ``periodic premium''
for the protection.\3\ If a triggering credit event occurs, then the
protection buyer would receive a full lump-sum payment that is some
fraction of the par value of the reference asset, to compensate the
buyer for the asset's devaluation. In turn, the protection buyer would
deliver the devalued asset to the protection seller.
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\3\ CDS pricing is based on (i) the probability that the issuer of
the reference asset will experience a credit event, and (ii) the
expected recovery rate for the reference asset. Credit events are
defined in Article IV of the 2003 International Swaps & Derivatives
Association's (ISDA) Credit Derivatives Definitions. These definitions
and standards are well established, and they have been adopted for
widespread use in the OTC market.
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The estimated notional amount of CDS transactions has nearly
doubled every year since 2001 to reach an estimated peak of $62
trillion in 2007, before receding 12 percent to $54.6 trillion as of
June 30, 2008.\4\ In all likelihood, this number somewhat overstates
the actual size of the CDS market because many traders hold offsetting
positions that have not been netted against each other. Nevertheless,
the size of total CDS positions is substantial.
---------------------------------------------------------------------------
\4\ ISDA News Release, Sept. 24, 2008 (available at http://
www.isda.org/press/press092508.html).
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The Benefits of Clearing of OTC CDS Transactions
Recent events have uncovered the risks that certain CDS
transactions pose to the financial system. American International
Group, an insurance company, reportedly issued CDS transactions
covering more than $440 billion in bonds, leaving it with obligations
that it could not cover in the current market conditions. This CDS
exposure factored into the Federal Reserve's decision to provide an $85
billion conditioned loan to the ailing company to prevent its failure
and a possible contagion event in the broader economy.\5\ Clearly,
there are major risks associated with these products that need further
review.
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\5\ Indeed, it now appears that AIG may be the beneficiary of up to
an additional $37.8 billion in Federal aid.
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The dispersed and non-standardized nature of many OTC instruments
makes finding a regulatory solution a challenging task. But
policymakers must strive to increase the transparency of these
transactions and find ways to mitigate the systemic risk created by
firms that offer and hold these off-exchange instruments. While
wholesale regulatory reform will require careful consideration,
centralized clearing is one immediate and proven solution that could
help mitigate the risks associated with these products.
Clearing mitigates counterparty risk by substituting the credit of
the clearinghouse for the credit of the counterparty. In addition,
clearing: (1) addresses the assessment of market risk and price
transparency by publishing a settlement price each day for each
product; (2) increases liquidity by enabling participants to offset
positions against entities other than the original counterparty; and
(3) facilitates order processing by establishing standard procedures
and deadlines. For these reasons, this solution has been advocated by
CDS market participants and the President's Working Group on Financial
Markets (PWG). The PWG first recommended providing clearing solutions
for OTC derivatives in a 1999 report to Congress.\6\
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\6\ Over-the-Counter Derivatives Markets and the Commodity Exchange
Act, Report of the President's Working Group on Financial Markets,
November 1999.
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Clearinghouses have been available for many years as a means for
mitigating the risks associated with exchange-traded financial
products. Whether securities, options, or futures, centralized
clearinghouses ensure that every buyer has a guaranteed seller and
every seller has a guaranteed buyer, thus minimizing the risk that one
counterparty's default will cause a systemic ripple through the
markets. The clearinghouse is able to take on this role because it is
backed by the collective funds of its clearing members.
Clearing would enable parties to a CDS transaction to focus solely
on obtaining the best price for the transaction, without regard to
whether the parties executing opposite them are capable of performing
their obligations. Because the clearinghouse would serve as the central
counterparty to all transactions, parties could close out their
positions without having to seek out the original counterparties to
their trades.
Clearing would also strengthen the infrastructure of CDS trading by
facilitating more timely and accurate post-trade processing. For many
years, post-trade processing of OTC derivatives has been a
decentralized, paper-based process. As a result, the enormous growth in
trading volume led to massive backlogs in confirming trades. Various
initiatives have been undertaken to improve the trade processing of CDS
transactions, and progress is being made toward resolving the backlogs;
however, much work remains to be done. By contrast, as evidenced by the
performance of U.S. futures clearinghouses, efficient and accurate
trade processing is a hallmark of clearing. Adopting a clearing regime
for CDS would prevent such backlogs from developing in the future.
Centralized clearing addresses the root problems the markets are
confronting today--the constriction of credit due to fear of default.
Indeed, for futures contracts--the standardized on-exchange cousin of
OTC derivatives-clearing has worked extraordinarily well in managing
credit risk. The first independent U.S. futures clearinghouse was
established in 1925, and this model helped launch others. Today, the
world's largest derivatives clearing facility is located in the United
States and routinely moves billions of dollars per day in mark-to-
market settlements, including a record $12.7 billion on January 23,
2008, without any disruption. In 2007, that same facility traded a
record 2.2 billion derivative contracts valued at more than $1
quadrillion.
For regulated futures exchanges, the clearing and settlement
mechanism serves to lessen the likelihood that large losses by a trader
will cause a contagion event. At least twice daily, futures
clearinghouses collect payments from traders with losing positions and
credit traders with profitable positions. This twice-daily ``mark-to-
market'' prevents the buildup of significant losses. Importantly, no
U.S. futures clearinghouse has ever defaulted on its guarantee.
Just as significant, the clearing process provides transparency to
regulators. When transactions are cleared, government and exchange
regulators receive daily trader and pricing information, which helps
them to police for manipulation and fraud and to uphold the integrity
of the market.
Current Regulation of OTC Derivatives Clearing
Clearing has been proven to work for OTC derivatives. After Enron's
demise in 2001, the OTC energy derivatives markets ``locked up''
because many energy companies lacked the requisite financial standing
to back their off-exchange trades. In response, the New York Mercantile
Exchange (NYMEX) sought and received approval from the CFTC in 2002 to
clear OTC energy products for the first time. Today, a significant
number of OTC energy derivatives are cleared through regulated
clearinghouses, which has reduced systemic risk and allowed regulators
a greater window into this marketplace. Clearing for OTC products now
extends beyond just energy products to financial products such as
forward rate agreements and foreign currency swaps.
Under existing law, any derivatives clearing organization (DCO)
that is registered with the CFTC may clear all OTC derivatives without
further registration or subjecting itself to any additional regulatory
requirements.\7\ Pursuant to the CEA, the CFTC regulates DCOs and has
the statutory mandate to ensure the financial integrity of transactions
subject to the CEA and to avoid systemic risk. The CFTC relies on the
14 core principles for DCOs set forth by Congress in the CEA, 7 U.S.C.
7a-1, as a means of evaluating whether DCOs comply with U.S. law.
---------------------------------------------------------------------------
\7\ The CFMA added Section 409 to the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA), 12 U.S.C. 4422, which
governs the clearing of OTC derivative instruments by multilateral
clearing organizations (including DCOs). Section 409 of FDICIA
prohibits a person from operating a clearing organization for OTC
derivative instruments except if that person is registered with the
CFTC or the SEC, or is supervised by certain approved foreign financial
regulators, or unless that person is a type of banking organization.
---------------------------------------------------------------------------
In analyzing compliance with these principles, the CFTC looks to
the controls and tools utilized by a clearinghouse, including: (1)
appropriate membership standards and continuing oversight of members;
(2) collection of position reports from large traders; (3) daily mark-
to-market of all open positions; (4) collection of an appropriate
amount of performance bond (sometimes referred to as ``margin''), which
serves to cover any losses that cannot be met by the market
participant; (5) periodic stress-testing of open positions; (6) an
ability to liquidate all of a market participant's open positions
quickly; and (7) availability of other financial resources for use by
the clearinghouse to cover any member default. Any clearinghouse
seeking to clear CDS transactions will need to show in its proposal
that it can bring such tools to bear.
While DCOs do not need pre-approval from the CFTC to clear OTC
derivatives, any such initiative would be required to comply with the
relevant core principles set forth in the CEA, and the CFTC would
review it for compliance with those principles. In addition, the CFTC
would need to approve in advance any request by a DCO to commingle
funds associated with ``cleared-only'' OTC derivatives with the DCO's
customer segregated funds. The customer funds underlying exchange-
traded futures and options are required to be held in a separate
account and to be segregated from the funds of the clearing member and
of the DCO. The CEA and CFTC regulations prevent any other funds from
being held in the segregated account absent permission from the CFTC.
This is a critical customer protection feature that is designed to
ensure that customer funds for exchange-traded futures and options are
protected and available for withdrawal or transfer even if the clearing
firm in question experiences severe financial distress or goes into
bankruptcy. In appropriate circumstances, the CFTC has permitted DCOs
to commingle customer funds associated with ``cleared-only'' OTC
derivatives with customer funds associated with exchange-traded futures
and options in the segregated account. The CFTC has permitted such
treatment only when it has concluded that the benefits of permitting
such commingling outweigh the risks.
Separate from clearing, the creation of a trading platform for CDS
products also could be beneficial because it would enhance pricing
transparency, liquidity for the product, and order processing. However,
the utility of some of these customized off-exchange instruments might
be lost if they become sufficiently standardized to be listed on a
multilateral exchange trading facility. For example, two major U.S.
derivatives exchanges listed credit derivatives products in 2007, but
neither product was able to gain a significant market share.
In closing, the CFTC, in conjunction with other financial
regulators, will continue to seek ways to provide clearing solutions
for OTC derivatives. Last month, in its swaps report to Congress, the
CFTC recommended the further use of clearing for OTC derivatives. There
are several private sector clearing initiatives currently being
considered by Federal regulators, and it is imperative that
policymakers work cooperatively and expeditiously to conduct their due
diligence and allow appropriate programs to begin operations promptly.
While comprehensive financial reform might take time, encouraging
centralized clearing is one immediate step that can reduce risk in the
markets and benefit the U.S. economy.
Thank you for your leadership on this critical issue. We look
forward to participating fully in Congressional and regulatory efforts
to address these issues and to implement policies and practices that
serve the public interest.
The Chairman. Thank you, Mr. Lukken.
Welcome, Mr. Sirri. We look forward to your testimony.
STATEMENT OF ERIK R. SIRRI, DIRECTOR, DIVISION OF
TRADING AND MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION,
WASHINGTON, D.C.
Mr. Sirri. Thank you, Chairman Peterson, Ranking Member
Goodlatte, and Members of the House Committee on Agriculture. I
am pleased to have the opportunity today to testify regarding
the credit default swap market. As is widely noted, the CDS
market has experienced explosive growth in recent years. At the
end of the first half of 2008, the total notional value of CDS
is expected to be approximately $55 trillion, doubling its size
in only 2 years.
The SEC has a great interest in credit default swaps, in
part because of their impact on the market for debt net equity
securities and the Commission's responsibility to maintain
fair, orderly, and efficient markets. These markets are
directly affected by CDS because the credit protection is
written on the financial claims of the issuers that we
regulate. In addition, we have seen CDS spreads move in tandem
with falling stock prices, a correlation that suggests that
activities in the CDS market may be spilling over into the cash
securities markets.
The Commission's current authority with respect to OTC
CDSs, which are generally securities-based swap agreements
under the CFMA, is limited to enforcing the anti-fraud
prohibitions under the Federal securities laws, including
prohibitions against insider trading. I note, however, that if
CDS were standardized as a result of centralized clearing or
exchange trading, or other changes in the market, and no longer
individually negotiated, the swap exclusion from the securities
laws under the CFMA would be unavailable.
Under current law, however, the SEC is statutorily
prohibited from promulgating any rules regarding CDS trading in
the over-the-counter market. Thus, the tools necessary to
oversee the OTC CDS market effectively and efficiently do not
exist.
The SEC staff are actively participating with other
financial supervisors and industry members in efforts to
establish one or more central counterparties, or CCPs, for
credit default swaps. The SEC has regulated the clearance and
settlement of securities, including derivatives on securities,
since the Securities Acts Amendments of 1975. A CCP for credit
default swaps would be an important first step in reducing
systemic and operational risks in the CDS market, and
Commission staff fully support these efforts.
In addition to reducing counterparty and operational risks
inherent in the CDS market, and thereby helping to mitigate the
potential systemic impacts, a central counterparty may help to
reduce the negative effects of misinformation and rumors that
can occur during high volume periods. A CCP could be a source
of records regarding CDS transactions. Of course, to the extent
that participation in a CCP is voluntary, its value as a device
to protect manipulation and other fraud and abuse in the CDS
market may be greatly limited.
There is no guarantee, however, that efforts to establish a
central counterparty or other mechanisms would be successful or
that the OTC CDS market participants would avail themselves of
these services. Accordingly, one should not view a central
counterparty as a panacea for concerns about the management of
exposures related to credit derivatives. Even with a CCP,
dealers and other market participants must manage their
remaining bilateral exposures effectively under ongoing
regulatory oversight. Nonetheless, a central counterparty would
be an important step in addressing regulatory concerns.
Exchange trading of CDS would add efficiency to the market
for these instruments. It is not uncommon for derivative
contracts that are initially developed in the OTC market to
become exchange-traded as the product markets mature. While the
contracts traded in the OTC market are subject to individual
bilateral negotiation, an exchange is effectively a market for
a standardized form of a contract. These standardized exchange
contracts typically coexist with more varied and negotiated OTC
contracts.
Exchange trading of credit derivatives would enhance both
the pre- and post-trade transparency of the market, and that
would enhance efficient pricing of credit derivatives. Exchange
trading could also reduce liquidity risk by providing a
centralized market that allows participants to effectively
initiate and close out positions at the best available prices.
Credit default swaps serve important purposes as tools that
can be employed to closely calibrate risk exposure to a credit
or a sector. Yet, CDSs raise a number of regulatory concerns,
including the risks they pose, systemically, to financial
stability and the risk of manipulation.
With regard to financial stability, the default of one
major player affects not only the financial health of that
participant but also the market and operational risks borne by
parties distant to those transactions. In addition, there is a
risk of manipulation and fraud in the CDS market, in part
because trade reporting and disclosure are limited. One way to
guard against misinformation and fraud is to create a mandatory
system of record-keeping and the reporting of all CDS trades to
the SEC. Ready information on trades and positions of dealers
would also aid the SEC in its enforcement of its existing anti-
fraud and anti-manipulation rules.
Notwithstanding the lack of statutory authority to require
the reporting or record-keeping in the CDS market, the SEC is
doing what it can under existing statutory authority. Most
recently, the Commission announced a sweeping expansion of its
ongoing investigation into possible market manipulation
involving financial institutions. The expanded investigation
will require hedge fund managers and other persons with
positions in CDS to disclose those positions to the Commission
and to provide certain other information under oath.
Investigations of over-the-counter CDS transactions have
been far more difficult and time-consuming than those involved
in other markets because the information on CDS transactions
gathered from market participants has been incomplete and
inconsistent.
In crafting any regulatory solution, it is important to
keep in mind the significant role that CDS trading plays in
today's financial markets, as well as the truly global nature
of the CDS market. Further, the varied nature of the market
participants in credit default swaps and the breadth of this
market underscore the importance of cooperation amongst
financial supervisors at the Federal and state levels, as well
as supervisors internationally.
Thank you for the opportunity to discuss these important
questions, and I am happy to take your questions.
[The prepared statement of Mr. Sirri follows:]
Prepared Statement of Erik R. Sirri, Director, Division of Trading and
Markets, U.S. Securities and Exchange Commission, Washington, D.C.
Chairman Peterson, Ranking Member Goodlatte, and Members of the
House Committee on Agriculture:
I am pleased to have the opportunity today to testify regarding the
credit default swap (CDS) market. The over-the-counter (OTC) market for
CDSs has drawn together some of the world's important financial
institutions into a complex web. These institutions have diverse roles
in the market for CDSs, including as market makers, hedgers, and
speculators who take proprietary positions in the credit risk of the
underlying entity. The CDS market has experienced explosive growth in
recent years. As of the end of the first half of 2008, the total
notional value of CDSs is estimated to be approximately $55 trillion,
according to the International Swaps and Derivatives Association
(ISDA), doubling its size in only 2 years. AIG alone is reported to
have sold over $440 billion of CDS protection on a notional basis. It
is important, however, to keep in mind that notional value is not a
precise measure of the total risk exposure.
The SEC has a great interest in the CDS market because of its
impact on the debt and cash equity securities markets and the
Commission's responsibility to maintain fair, orderly, and efficient
securities markets. These markets are directly affected by CDSs due to
the interrelationship between the CDS market and the claims that
compose the capital structure of the underlying issuers on which the
protection is written. In addition, we have seen CDS spreads move in
tandem with falling stock prices, a correlation that suggests that
activities in the OTC CDS market may in fact be spilling over into the
cash securities markets.
The Commission's current authority with respect to OTC CDSs, which
are generally ``security-based swap agreements'' under the CFMA, is
limited to enforcing anti-fraud prohibitions under the Federal
securities laws, including prohibitions against insider trading. The
SEC, however, is statutorily prohibited under current law from
promulgating any rules regarding CDS trading in the over-the-counter
market. Thus, the tools necessary to oversee this market effectively
and efficiently do not exist.
SEC staff are actively participating with other financial
supervisors and industry members in efforts to establish one or more
central counterparties, or CCPs, for credit default swaps. Improving
market infrastructure and the ability to monitor the CDS market, for
example by establishing a CCP, would be an important first step in
reducing systemic and operational risks in the market. The Commission
staff fully supports these efforts.
In addition, when Chairman Cox spoke before the Senate Committee on
Banking, Housing, and Urban Affairs 3 weeks ago, he called the lack of
regulation of the CDS market a ``cause for great concern.'' The CDS
market's considerable size and importance to the financial system,
particularly during periods of significant market turbulence, compel
greater oversight. Recent credit market events, notably the default by
Lehman Brothers and the intervention by the Treasury with respect to
Fannie Mae and Freddie Mac, have required an ad hoc response by market
participants, generally under the auspices of industry groups such as
ISDA. In all three cases, the industry had to orchestrate an auction to
permit cash settlement of CDSs intended to be settled through physical
delivery of bonds as a means to reduce operational frictions. In fact,
the industry had to meet under the auspices of ISDA to even determine
with certainty that the Treasury actions with respect to Fannie Mae and
Freddie Mac were an event of default for purposes of credit default
swaps written on the debt securities of those two reference entities.
While ad hoc approaches have worked remarkably well to date, Chairman
Cox and others have questioned whether the size and importance of the
market make more oversight, including a more developed infrastructure,
prudent.
Background
As you know, CDSs, like other credit derivatives, are a type of
financial contract whose value is based on underlying debt obligations.
By their very nature, CDSs transfer risk rather than directly raise
capital in the way a bond or stock does. However, the transference of
risk can indirectly aid in raising capital. A CDS can be tied to the
performance of the debt obligations of a single entity or security,
or--with more complex CDSs--an index of several such entities or
securities. In a CDS, as in an insurance contract, the CDS ``buyer'' is
buying protection and the CDS ``seller'' is selling protection against
a default or other credit event with respect to the underlying debt
obligations. The buyer pays the seller a premium for this protection,
and the seller only pays the buyer if there is a default or other
credit event that triggers the CDS contract. The premium--cost of
protection for the buyer--increases as the risk associated with the
underlying obligation increases. In other words, as the
creditworthiness of the underlying entity goes down, the cost of
protection goes up.
CDSs are executed bilaterally with derivatives dealers in the OTC
market, which means that they are privately negotiated between two
sophisticated, institutional parties. They are not traded on an
exchange and there is no required record-keeping of who traded, how
much and when. The dealers include more than a dozen large, globally
active banks. London and New York are the centers of CDS trading. In
addition to the dealers, active participants in the CDS market include
hedge funds and registered investment companies, as well as insurance
companies, among others.
Although CDSs are frequently described as insurance (buying
protection against the risk of default), they, in fact, also are used
by investors for purposes other than hedging. Institutions can and do
buy and sell CDS protection without any ownership in the entity or
obligations underlying the CDS. In this way, CDSs can be used to create
synthetic long (or short) positions in the referenced entity. Because a
CDS transfers the risk of default on debt obligations from the buyer to
the seller, a CDS buyer is analogous to being ``short'' the bond
underlying the CDS. Whereas a person who owns a bond profits when its
issuer is in a position to repay the bond, a CDS buyer profits when,
among other things, the bond goes into default. Conversely, a CDS
seller can be said to be taking a ``long position'' on the underlying
credit. In other words CDSs may be used to replace cash bonds in
establishing trading positions in a credit.
Indeed, for a typical corporate debt issuer, the notional amount of
activity in OTC derivatives tied to its debt or credit can be
substantially larger than the outstanding balance (principal amount) or
trading in the issuer's actual debt securities. CDSs, therefore, can be
used to manage the risk of a portfolio of assets or to mitigate a
firm's exposure to an entire financial institution. Writers of CDSs can
develop concentrated exposures to particular credits, which if large
enough, could raise serious systemic issues for the global financial
system.
Establishing a Central Counterparty for the CDS Market
Although the clearance and settlement of CDSs are not currently
regulated, the SEC has regulated the clearance and settlement of
securities, including derivatives on securities, since the Securities
Acts Amendments of 1975. The SEC has registered approximately 20
clearing agencies under the Exchange Act, and SEC staff have performed
many compliance inspections and program reviews. During the more than
30 years the SEC has regulated clearing agencies, the SEC has continued
to develop expertise in this area, and no registered clearing agency
under the securities laws has failed to perform its obligations or
contributed to the failure of another institution through poor
performance.
As noted above, there are important relationships between the
securities markets and the market for CDSs. Accordingly, the SEC is
participating in discussions with the Federal Reserve Board (Fed), the
Federal Reserve Bank of New York, the Commodity Futures Trading
Commission (CFTC), and industry participants to create a central
counterparty (CCP) for credit default swaps. Last week, senior SEC
staff attended meetings with other regulators, hosted by the Federal
Reserve Bank of New York, at which industry members discussed their
proposed CCPs. There are currently four potential CDS central
counterparties: Eurex, NYSE Euronext, CME Group/Citadel, and
IntercontinentalExchange/The Clearing Corporation. The SEC staff will
continue to work in close cooperation with the Fed, the Federal Reserve
Bank of New York, and the CFTC to facilitate the creation of at least
one CCP.
As addressed in the testimony of my colleague, Dr. James Overdahl,
before the Senate Subcommittee on Securities, Insurance, and Investment
on July 9 of this year, a CCP could be an important step in reducing
the counterparty risks inherent in the CDS market, and thereby help to
mitigate the potential systemic impacts. As I noted earlier, CDS are
bilateral contracts between market participants. As is the case with
all contracts, each party to the transaction needs to be concerned
about the willingness and capacity of the party on the other side to
perform its obligations.
To illustrate how CDSs work, suppose that Dealer X sells protection
on ABC to Dealer Y. Dealer Y needs to be concerned about Dealer X's
ability and willingness to perform in the event of a default or other
credit event by ABC. While the risk being transferred from Dealer Y to
Dealer X relates to the credit quality of ABC, Dealer Y, while shedding
risk related to ABC, is taking on counterparty risk to Dealer X. Market
participants manage this counterparty risk using a variety of tools,
including marking positions to market and posting collateral, as well
as documentation that provides for other mitigants.
A central counterparty could further reduce systemic risk by
novating trades to the CCP, meaning that Dealers X and Y no longer are
exposed to each others' credit risk. In addition, the CCP could reduce
the risk of collateral flows by netting positions in similar
instruments, and by netting all gains and losses across different
instruments. So, instead of Dealer Y having a large volume of trades,
some offsetting, with many counterparties, Dealer Y could have a single
net position in ABC with the CCP. Likewise, Dealer X could have a
single net position in each underlying credit, perhaps related to a
large volume of individual trades, with the CCP. By replacing the
current ``web'' of CDS exposures with a ``hub and spokes''
architecture, a CCP could vastly simplify containing the failure of a
major market participant.
Moreover, a CCP could further reduce risk through uniform margining
and other robust risk controls over its exposures to its participants,
including specific controls on market-wide concentrations that cannot
be implemented effectively when counterparty risk management is
decentralized. A CCP also could aid in preventing the failure of a
single market participant from destabilizing other market participants
and, ultimately, the broader financial system.
A CCP also could help ensure that eligible trades are cleared and
settled in a timely manner, thereby reducing the operational risks
associated with significant volumes of unconfirmed and failed trades.
It may also help to reduce the negative effects of misinformation and
rumors that can occur during high volume periods, for example when one
market participant is rumored to ``not be taking the name'' or not
trading with another market participant because of concerns about its
financial condition and taking on incremental credit risk exposure to
the counterparty. Finally, a CCP could be a source of records regarding
CDS transactions, including, for each day, by underlying reference
entity, the identity of each party that engaged in one or more CDS
transactions. Of course, to the extent that participation in a CCP is
voluntary, its value as a device to prevent and detect manipulation and
other fraud and abuse in the CDS market may be greatly limited.
There is no guarantee, however, that efforts to establish CCPs or
other mechanisms would achieve success, or that OTC CDS market
participants would avail themselves of these services. Even if a dealer
does participate in the CCP, trades the dealer elects to do away from
the CCP would escape its risk management oversight. Accordingly, one
should not view a CCP as a panacea for concerns about the management of
exposures related to credit derivatives. Even with a CCP, preventing a
systemic risk buildup would require dealers and other market
participants to manage their remaining bilateral exposures effectively,
and the dealers' management of their bilateral exposures would require
ongoing supervisory oversight. Nonetheless, developing a CCP for
clearing CDSs would be an important step in accomplishing this goal.
Exchange Trading of CDSs
It is not uncommon for derivative contracts that are initially
developed in the OTC market to become exchange-traded as the market for
the product matures. While the contracts traded in the OTC market are
subject to individual bilateral negotiation, an exchange efficiently
creates a market for a standardized form of the contract that is not
subject to individual negotiation (other than price and quantity).
These standardized exchange-traded contracts typically coexist with the
more varied and negotiated OTC contracts. In this regard, we note that
last year the Commission approved a proposal by the Chicago Board
Options Exchange to list and trade Credit Default Options (``CDOs'')
and Credit Default Basket Options. The CDOs are modeled after CDSs and
structured as binary call options that settle in cash based on
confirmation of one or more specified adverse credit developments (such
as payment default) involving obligation(s) referenced in the CDO, such
as a debt security.
Some of the prospective central counterparties for CDSs also
propose offering some type of trading facility. Exchange trading of
credit derivatives could add both pre- and post-trade transparency to
the market that would enhance efficient pricing of credit derivatives.
Exchange trading also could reduce liquidity risk by providing a
centralized market that allows participants to efficiently initiate and
close out positions at the best available prices.
Primary Regulatory Concerns
CDSs serve important purposes as a tool that can be employed to
closely calibrate risk exposure to a credit or a sector. CDSs can be
especially useful for the business model of some financial institutions
that results in the institution making heavily directional bets, and
others--such as dealer banks--that take both long and short positions
through their market-making and proprietary trading activities. Through
CDSs, market participants can shift credit risk from one party to
another, and thus the CDS market may be an important element to a
particular firm's willingness to participate in an issuer's securities
offering.
CDSs also raise a number of regulatory concerns, including the
risks they pose systemically to financial stability and the risk of
manipulation.
With regard to financial stability, the OTC CDS market, together
with other derivative products, has drawn together the world's major
financial institutions and others into a deeply interconnected network.
Their activities in the CDS market generate significant market, credit,
and operational risk that extend beyond the willing counterparties to
the CDS transaction. As I described earlier, the buying and selling of
default protection through CDSs creates short and long exposures--
market risk--to the index, debt security, or other obligations
referenced in the CDS contract. At the same time, the buying and
selling of default protection creates credit risk exposure to
counterparties. The default of one major player therefore impacts not
only the financial health but also the market and operational risks
experienced by financial market participants distant to these
transactions.
In addition, like all financial instruments, there is the risk that
CDSs are used for manipulative purposes, and there is a risk of fraud
in the CDS market, in part because trade reporting and disclosure to
the SEC are limited. Further, very small trades in a relatively thin
market can be used to ``paint the tape'' and suggest that a credit is
viewed by the market as weak. The focus by current data providers in
CDS is on the spreads at which trades are concluded, rather than the
volume transacted at that price.
One way to guard against misinformation and fraud is to create a
mandatory system of record-keeping and reporting of all CDS trades to
the SEC. The information that would result from such a system would not
only reduce the potential for abuse of the market, but would aid the
SEC in detection of fraud in the market as quickly and efficiently as
possible. Given the interdependency of financial institutions and
financial products, it is crucial that we have a mechanism for promptly
obtaining CDS trading information--who traded, how much and when--that
is complete and accurate.
OTC market participants generally structure their activities in
CDSs to comply with the CFMA's ``swap exclusion'' from the Securities
Act and the Exchange Act. These CDSs are ``security-based swap
agreements'' under the CFMA, which means that the SEC currently has
authority to enforce anti-fraud prohibitions under the Federal
securities laws, including prohibitions against insider trading. If
CDSs were standardized as a result of centralized clearing or exchange
trading or other changes in the market, and no longer individually
negotiated, the ``swap exclusion'' from the securities laws under the
CFMA would be unavailable.
Notwithstanding the lack of statutory authority, the SEC is doing
what it can under its existing statutory authority to address concerns
regarding this market. Most recently, the Commission announced a
sweeping expansion of its ongoing investigation into possible market
manipulation involving certain financial institutions. The expanded
investigation will require hedge fund managers and other persons with
positions in CDSs to disclose those positions to the Commission and
provide certain other information under oath. This expanded
investigation should help to reveal the extent to which the risks I
have identified played a role in recent events. Depending on its
results, this investigation may lead to more specific policy
recommendations.
However, investigations of over-the-counter CDS transactions have
been far more difficult and time-consuming than those involving cash
equities and options. Although the SEC clearly has anti-fraud
jurisdiction over the CDS market, the SEC faces a much more difficult
task in investigating and taking effective action against fraud and
manipulation in the CDS market as compared to other markets. Because of
the lack of uniform record-keeping and reporting to the SEC, the
information on CDS transactions gathered from market participants has
been incomplete and inconsistent.
Recent private sector efforts may help to alleviate some of these
concerns. For example, Deriv/SERV, an unregulated subsidiary of DTCC,
provides automated matching and confirmation services for over-the-
counter derivatives trades, including CDSs. Deriv/SERV's customers
include dealers and buy-side firms from more than 30 countries.
According to Deriv/SERV, more than 80% of credit derivatives traded
globally are now confirmed through Deriv/SERV, up from 15% in 2004. Its
customer base includes 25 global dealers and more than 1,100 buy-side
firms in 31 countries. While programs like DerivSERV may aid the
Commission's efforts, from an enforcement perspective, such voluntary
programs would not be expected to take the place of mandatory record-
keeping and reporting requirements to the SEC.
In the future, Deriv/SERV and similar services may be a source of
reliable information about most CDS transactions. However,
participation in Deriv/SERV is elective at present, and the platform
does not support some of the most complex credit derivatives products.
Consequently, not all persons that engage in CDS transactions are
members of Deriv/SERV or similar platforms. Greater information on CDS
trades, maintained in consistent form, would be useful to financial
supervisors. In addition to better record-keeping by market
participants, ready information on trades and positions of dealers also
would aid the SEC in its enforcement of anti-fraud and anti-
manipulation rules. Finally, because Deriv/SERV is unregulated, the SEC
has no authority to view the information stored in this facility for
supervision of risk associated with the OTC CDS market.
In crafting any regulatory solution, it is important to keep in
mind the significant role CDS trading plays in today's financial
markets, as well as the truly global nature of the CDS market. Further,
the varied nature of market participants in CDSs and the breadth of
this market underscore the importance of cooperation among U.S.
financial supervisors at the Federal and state level, as well as
supervisors internationally.
Thank you for this opportunity to discuss these important issues. I
am happy to take your questions.
The Chairman. Thank you very much. I would like to note for
the record that the Federal Reserve was also invited, but they
claim to be too busy. I guess they are a little busy.
As I understand it, there are discussions going on, almost
daily, regarding these clearinghouses, and I guess now there
are different proposals out there involving CFTC, SEC, the Fed,
and the New York Fed or something. Would you give us a brief
description, each of you, of what your take on where that is at
and how soon we are going to see some action there?
Mr. Lukken. The law as, changed in 2000, allows over-the-
counter derivatives to be cleared through a variety of
different entities, including a CFTC-regulated clearinghouse,
but also an SEC-regulated clearinghouse and a bank-regulated
clearinghouse. And so the regulators have been cooperatively
meeting over the past several weeks to discuss private sector
solutions that may be developed to get a lot of the existing
over-the-counter credit default swap business on to a regulated
clearinghouse. As both our testimonies laid out, this manages
counterparty party risk, as well as providing transparency to
regulators and the people running the clearinghouse to see who
the participants are and what exposures they may have in the
system. Those are all beneficial public policy goals.
We have been meeting regularly to ensure that people are
moving forward with these proposals, to coordinate our
responses, and to ensure that all regulators involved in the
process have the information they need to carry out their
statutory mission of overseeing these clearinghouses we are
trying to ensure that this will happen according to, and that
it will help with the market situation that we are currently
facing.
We have been meeting, as you said, almost daily by phone
call, trying to talk with the private sector groups who are
involved in the clearing proposals and ensuring that they are
doing their due diligence to move forward as quickly as
possible.
Mr. Sirri. I agree with everything that Commissioner Lukken
said. The only thing I would add and emphasize is that this is
truly a cooperative effort between the various regulators that
are involved. For something like this to succeed, a central
counterparty, it has got to be that it is appropriately
designed and brings the private sector to that counterparty. It
may be that Congress chooses to act and makes working with such
a counterparty mandatory, but the work is proceeding as if it
is voluntary; that is, the counterparty will have to attract
market participants.
In that way, it has got to be appropriately designed to
reduce systemic risk and provide information and transparency
to regulators. Systemic risk issues are the ones that we both
talked about.
Chairman Peterson, you mentioned trust in your opening
statement. You pointed out that in times of stress, people
don't have trust in their counterparties, they don't have trust
in the system. The point of a central counterparty is to create
exactly that trust, where you don't have to worry who you have
traded with. A credible central entity has taken the place of
that counterparty you don't know.
So getting us all to work together to create that structure
that provides trust is exactly what we are all about as a
group.
The Chairman. I appreciate that. I appreciate the fact that
you regulators are working together. It seems to me like the
industry is into a deal to try to figure out who can get
control of this, and some people are trying to figure out how
to keep the current system going without being regulated. I
don't know--those folks that are trying to do that, I don't
know what planet they are living on.
Anyway, one of the questions is: Can we have more than one
clearing entity? The CME has got a proposal, ICE has a
proposal, somebody else has a proposal. Can we have two or
three of these, and will that work? As I understand it, I guess
the one that ICE is working on, they have tried to corral up
the broker dealers to get whatever control, or whatever they
are up to. They want to be regulated by the Fed. As I
understand it, the Fed has never done this. So what sense does
that make?
You guys are clearing it at the SEC. I guess you are doing
that. The CFTC clearly does that. I don't know what this is all
about. If they want to get away from this Committee where they
can get to a committee that has more friendly people on it, or
what they are up to. They are going to have a hell of a fight
with us if that is what they are up to.
Can more than one of these things exist, and what do you
think about the Fed getting, with all their other problems,
getting into something they have never done before?
Mr. Lukken. I will start. Yes, more than one of these
entities can exist. I think there are obviously efficiencies
having one central counterparty, but the law allows multiple
central counterparties to compete for this business. And the
market should allow these different entities to come to exist
based on who has the best model and risk management approach.
But when you have more than one potential central
counterparty, what is key for regulators is close information
sharing and cooperation, because I think all of us, if this is
outside of our jurisdiction, still have an interest in what is
going on, who the participants might be, because as we have
learned with this crisis, everything is interdependent and
intertwined.
Whatever happens in the coming weeks as these proposals
move forward, regulators have to closely cooperate with each
other and share information about what they are seeing on their
central counterparties so that all of us have the proper
oversight tools regarding these markets.
Mr. Sirri. The statutory framework for clearing for
securities provides explicitly that we encourage competition,
and in this setting I think we believe that competition will be
helpful. As Commissioner Lukken said, one might think if it
were all in one place, that would be optimal, but we found in
general that competition provides better services, better
pricing, and we think with appropriate supervision, can provide
good risk management.
I would point out also we have been addressing the question
of what exists in the United States; that is, is there one or
more than one central counterparty? But other parts of the
world, especially Europe, are extremely active in the over-the-
counter space. My expectation is they too will have a central
counterparty. So a truly global solution to this problem would
involve coordination and interoperability between central
counterparties located in the United States and central
counterparties located elsewhere in the world. That kind of
interoperability would be important to have a truly efficient
global setting for reduced risk management.
The firms that we are talking about are globally
incorporated firms. Subsidiaries of those firms operate in the
United States, London, and elsewhere in the world. If we don't
have such a framework, a firm such as that could easily move
business from one jurisdiction to the other to suit their
purposes.
It is incumbent on us regulators, both domestically and
internationally, to work together to eliminate that incentive.
The Chairman. Thank you for your answers. The gentleman
from Virginia, Mr. Goodlatte.
Mr. Goodlatte. Thank you, Mr. Chairman. Gentlemen, I
appreciate very much your testimony. You may recall that this
Committee spent a good deal of effort this year after the
completion of the farm bill on the issue of the oversight
authority of the Commodity Futures Trading Commission. The
Committee produced bipartisan legislation which ultimately
passed the House of Representatives just last month that
increased the oversight authority of the CFTC with regard to
over-the-counter trades of various kinds.
We were cautioned during hearings that were held during
that period, and in a letter that we received from the leading
financial officers of the Administration, including the
Treasury Secretary, the Chairman of the Federal Reserve Board,
the Chairman of the SEC, and CFTC--you, Mr. Lukken--cautioning
us that we not over-regulate the futures industry or that
business would be conducted overseas beyond the reach of our
regulators. Certainly, this is a legitimate concern. In fact,
in the other areas of our financial sector that are
experiencing great difficulties right now, I would say a major
part of that problem has been what I would call mis-regulation.
Some was over-regulation, some under-regulation, resulting in
the problems that we have.
Does your testimony today constitute a recognition that
there can be international cooperation here so that we don't
face that kind of concern about some other market somewhere
else attempting to draw away business from our U.S. markets if
we do what you have recommended here today.
I note the fourth recommendation that you have, Chairman
Lukken, is that regulatory reform should provide for clear
enforcement authority over these products to police against
fraud and manipulation. The CFTC is currently excluded by
statute from bringing enforcement cases against OTC financial
derivatives. Congress should rectify this by providing clear
enforcement powers regarding OTC products to the CFTC and other
appropriate regulators, including the SEC.
How would you characterize the current situation we are in
vis-a-vis where we were when we were working on that
legislation?
I will start with you, Mr. Lukken.
Mr. Lukken. I think you raise a very good point on the
international coordination issue. As I had mentioned, my fifth
point of my testimony, this has to be tightly coordinated among
global regulators for this to work. I think we all have to come
at this with a similar approach. You don't want to sort of
squeeze the balloon and have this go elsewhere around the
world. And so everybody is, I think, finding the same problems
in all jurisdictions around the world. Chairman Cox, as
Chairman of the Technical Committee of the International
Organization of Security Commissions, and the CFTC which is a
member, will work to address, internationally, how our
regulatory approaches should change to address a lot of the
issues that we have been seeing of late.
I would say on the enforcement side, and this is
enforcement, after-the-fact enforcement powers versus
regulation, we have that authority in regards to energy and
agricultural products. I don't see a large harm in extending
that to financial swaps. That if these financial swaps are
affecting our markets in some ways, our central financial
futures markets, that we should have the ability to take
enforcement action for manipulation or fraud against those
participants in those markets as well.
Mr. Goodlatte. I take it if more of these were required to
be cleared, that given what is going on in the financial
turmoil the world is facing right now, that many engaged in
these trades would find greater assurance in U.S. markets that
they could do so, and trade with greater safety, if that were
the case.
Let me in that regard ask you if credit default swaps were
required to be cleared a year ago, what activity would either
of your Commissions have taken?
Mr. Lukken. Well, if they were required to come on to a
U.S.-registered clearinghouse, we would have to ensure that
they continue to meet the core principles, the 14 core
principles that are stated in our Act for financial integrity,
that they are managing risk, all the things that we require of
clearinghouses, that these instruments were not in any way
jeopardizing the status of a clearinghouse and putting it at
greater risk.
And so we, under law, have to ensure that clearinghouses
meet those standards, and continue to meet those standards. So
we would run them through that stress testing and all the
things we do for clearinghouses to ensure that they were
meeting those standards.
Mr. Goodlatte. Mr. Sirri.
Mr. Sirri. Over-the-counter credit default swaps are
securities-based swaps. Because of that, the SEC currently has
anti-fraud authority over those swaps. So, for example, in
instances of market manipulation or insider trading, we have
the authority--we have enforcement authority in that space.
Now we cannot rule right in the area of over-the-counter
derivatives to regulate them. For example, one of the things we
have learned with respect to our ongoing enforcement
investigations is because we haven't been able to place
requirements on standardized record-keeping within these firms,
it becomes extremely difficult for our enforcement folks to go
into these firms and get the kind of information they need to
efficiently oversee this market.
If these contracts were to come on-exchange or to be
centrally cleared, they would become standardized, and they
would be securities. Once these instruments are securities, the
Commission has the power to require registration of the
clearinghouse, require registration of the exchange. They may
or may not choose to do that, but as a staff we would recommend
that they too, as Chairman Lukken said, enforce the core
provisions of the securities laws that pertain to securities in
these settings.
So, for example, when it comes to clearing, we believe it
is very important that clearinghouses have strong risk
management programs; they have to have strong internal controls
in business continuity procedures; they have to keep records
and provide those records to the Commission staff when they ask
for them. They have to be regularly inspected by regulators.
Mr. Goodlatte. Let me ask you a question about your
observation that these credit default swaps will need to become
more standardized if they are going to be cleared through
clearinghouses. What will that do in terms of their usefulness
to manage risk? I understood these swaps to be highly
negotiated instruments that are very specific to the
negotiating parties. Will that specificity make it difficult to
clear the instrument, and if they do become standardized, will
that reduce their purpose in terms of allowing the people who
trade in them to manage risk?
Mr. Sirri. It is a very perceptive question. I think it
will have a subtle effect. The over-the-counter markets will
continue to be the place and the source of innovation. There
will continue to be individually negotiated transactions there.
But, as on the futures markets, risk will be shifted into these
markets where there is standardization. That risk will move
efficiently and will in fact foster growth in the over-the-
counter markets. The best example I can think of is in the
interest rates swap markets. They are fairly standardized, but
can be somewhat individually negotiated in the over-the-counter
markets. But the Euro dollar futures markets, those markets
effectively shed and manage risk in a standardized way; the
point being that standardized markets and customized markets
can coexist, and they are in fact complementary.
The existence of a strongly regulated and standardized
market allows efficient risk sharing and the shedding of risk
that allows for strong growth in the customized market.
Mr. Goodlatte. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Pennsylvania, Mr. Holden.
Mr. Holden. Thank you, Mr. Chairman.
Chairman Lukken, according to Mr. Pickel's testimony, AIG's
defaults in the CDS market were actually its failure to post
additional collateral. Its CDS counterparties were entitled to
additional collateral because rating agencies suddenly and
drastically downgraded AIG's credit rating.
If AIG had been a participant in the CDS clearinghouse on
September 16 when this downgrade occurred, what action would
have been taken? Is it likely the clearinghouse would have
required that AIG post additional capital? If so, it clearly
would have been unable to comply; and what would have happened
then?
Mr. Lukken. The benefits of clearinghouses allow, as events
become more probable, for more margin to be held by those
participating firms. Again, as I mentioned, twice daily we
mark-to-market. As those probabilities change, as an entity
becomes closer to default, the amount of money changing hands
would increase. And so instead of a large systemic event that
we saw with the potential of AIG going into default, we would
have seen a more gradual changing of default standards and
margin to allow people, the winners to be paid by the losers
over a period of time. It becomes a more orderly way of
shifting the risk. Beyond that, we also have lots of guarantees
involved at the clearinghouse level, and segregation of funds.
We have lots of built-in safeguards at the clearinghouse to
prevent us having to go in and potentially bail out a large
participant because the clearing system, in essence, is backing
the guarantee behind the default.
Mr. Holden. Maybe you better elaborate a little bit. How
would you have gradual notice when the rating system happens
suddenly and dramatically, with AIG specifically?
Mr. Lukken. Well, just like credit default spreads change
on a daily basis based on market information, I think we would
have seen in the futures markets and the clearing markets
margin change as a result as well, as people start to get
closer to a rate change or not. Those rate changes are based on
events and underlying information about the firm's ability to
pay. And so that occurs over a period of time.
You are correct, the change by a rating firm of the firm's
rating occurs at a moment's notice, but the information leading
up to that change is gradual.
Mr. Holden. Thank you.
Mr. Sirri, last week, Lynn Turner, former SEC Chief
Accountant, testified before the Oversight and Government
Reform Committee that the SEC's Office of Risk Management has
been reduced to a single staffer this February. Can you tell us
what the responsibility of this office is and what role, if
any, it has in reviewing risk associated with the credit
default swaps, and is the statement about the staffing level
accurate?
Mr. Sirri. The Office of Risk Assessment is headed by
Jonathan Sokobin. At the moment, I don't know the exact
staffing. I believe it is on the order of six or seven at the
moment, on its way to nine, which is full staffing. So it is
staffed substantially above that level.
That office is used throughout the Commission by its staff
to aid in basic risk questions. So, for example, my division
works closely with the Office of Risk Assessment. When we have
questions that inherently involve risk in some way that we
can't handle we would engage them to do analytical work,
depending on what we want, to help us assess a particular risk
problem.
So it is fully staffed at the moment, as I understand it.
It may be shy one or two, but I think those offers have already
been made, and I think it performs a useful and practical
function within the Commission.
Mr. Holden. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
North Carolina, Mr. Etheridge.
Mr. Etheridge. Thank you, Mr. Chairman.
Mr. Sirri, the SEC's Inspector General report, which I have
a copy of here, and I think others have had an opportunity to
have, Report on the Oversight of Bear Stearns and the
Consolidated Supervised Entity, or CSE program, which came out
last month states, ``Thus, it is indisputable that the CSE
program failed to carry out its mission in the oversight of
Bear Stearns because under the Commission and the CSE program's
watch Bear Stearns suffered significant financial weakness.''
In the unedited version posted by Senator Grassley on the
Senate Finance Committee's website, it says your division
failed to follow up on red flags raised by Bear Stearns'
increasingly constant trading in market risk for mortgage
securities.
It is my understanding that Bear Stearns was also heavily
involved in credit default swaps, our topic today. I want to
give you an opportunity to respond to this IG's report and
answer two questions: What happened with SEC's oversight of
Bear Stearns that led to its collapse? Second, given your
inside view, can you answer a question that will come up likely
in the next panel, can the collapse of Bear Stearns be traced
back to credit default swaps or to the underlying obligations
like subprime mortgage securities to which they are linked?
Mr. Sirri. Thank you. There is a formal response from the
staff in that report, and it pretty much lays out our position
on these things. But I will address your question.
I think to get at the issue you raise, it is important to
understand the context of the program, the consolidated
supervised entity program. Firms like Bear Stearns, Goldman
Sachs, Morgan Stanley, the large security firms were, if you
will, a regulatory hole that was not covered under Gramm-Leach-
Bliley. These are institutions, large securities institutions
that do not have the traditional depository, so they are not
bank holding companies. There is no program for the supervision
of them as a holding company. It was a gap.
In 2004, the European Union had a financial conglomerates
directive. Because of that, these firms needed a single
consolidated supervisor. The SEC stepped into that gap and
provided such a program by rule. There was no statutory program
there. And so these firms opted into a rule-based program to
supervise these programs at the holding company level. The
supervision provided for oversight at the financial and
operational risk controls of those holding companies, as well
as reporting schemes for their capital and the requirement that
these firms keep a pool of liquidity at the holding company.
Now, absent us stepping into that, there would have been no
supervision of those holding companies at all. For us, the core
question is: Had we not stepped in, what would Bear Sterns,
Goldman Sachs, Morgan Stanley have looked like, because there
would have been no holding company supervision at all. I can't
answer that question for you today, but it is a point to which
our Chairman has spoken----
Mr. Etheridge. Let me interrupt. If you can't answer today,
can you get back to us in writing, because I think that is a
central point of what we are trying to get to?
Mr. Sirri. I would be happy to.
Mr. Etheridge. Just to talk and not give an answer is not
very helpful.
Mr. Sirri. Well, let me say that with respect to--you did
ask a very precise question about Bear Stearns, which is to
what extent were credit swaps responsible for the demise of
Bear Stearns. I don't think that credit default swaps were
causal in that sense. That firm was involved in a number of
activities. In particular, they had concentrated exposures to
the mortgage markets. These were one of the causes of that.
The real cause toward the end of that time, however, had to
deal with the behavior of counterparties and short-term funders
as liquidity ran out of that firm in the week of March 10th.
Mr. Etheridge. So you will get a written statement back.
Mr. Sirri. I will. Absolutely.
Mr. Etheridge. Thank you.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Georgia, Mr. Marshall.
Mr. Marshall. Mr. Sirri, just following up on Mr.
Etheridge's question concerning oversight of the big banks;
well, institutions; a couple of banks. Wouldn't you say that
had SEC appropriately measured the risk, it would have required
that greater reserves be held or that more liquidity be
present. In many instances, the CDSs that were being held as
insurance against underlying defaults on the underlying assets,
principal assets being CDOs, that those CDSs were lip gloss, at
best. Many came from Canada. They had triple A ratings from the
Canadian rating agency, but in fact there wasn't anything
substantial underlying it. And so really greater reserves
should have been held in these different banks against those
obligations. Wouldn't you say that the SEC should have required
that? I don't want to get into too much of a back-and-forth
here, but to suggest that the SEC is innocent in all this is a
bit of a stretch.
Mr. Sirri. It is a fair point. I wouldn't mean to suggest
that we were innocent, but I think I was just addressing
whether credit default swaps were the root cause of what was at
issue.
Mr. Marshall. It is argued that had those credit--as this
unfolded, in order to entice investment money in order to be
willing to take the risk, an awful lot of entities sought these
credit default swaps, many, I suppose, anticipating that they
were more than mere lip gloss, designed to fool people. And to
the extent that they were real, and provided real insurance, we
wouldn't be where we are at the moment, correct?
Mr. Sirri. Well, the important thing to realize with credit
default swaps is they are marked-to-market. So, in that
context, even over-the-counter collateral and funds move on a
daily basis. They shift in value. So, again, I think they are
an important risk-shifting market, but I don't think within
this context they were the essential element of what caused
problems here.
You are correct that there were problems with
counterparties who wrote those instruments. These are some of
the things that would be addressed by a central counterparty,
in the way that Chairman Lukken said.
Mr. Marshall. The concern that I think many of us probably
have is we are looking for more than just lip gloss. And if you
had multiple clearinghouses all competing with one another for
business worldwide, how is it that this clearinghouse process
would be any safer than the process the market devised and
relied upon, which is credit default swaps themselves? It would
potentially be another layer of lip gloss, and if we ran into
the systemic problem that we ran into this time around, the
same thing would occur.
Mr. Sirri. I understand your question better now, so let me
try and answer that.
Mr. Marshall. I started with an observation. The question
is multiple DCOs competing with one another.
Mr. Sirri. So one fair concern that one would have is if
these central counterparties do compete, one might have a fear
that you would have some type of a race to the bottom. I think
there are two things that mitigate against that. One is that
the customers of these folks are some of the people who are
most concerned about credit risk. So I don't mean the banks
themselves, I mean the customers of the banks. They may be
hedge funds, they may be investment companies. They are
concerned with the credit risk of their counterparties, the
banks.
Mr. Marshall. If I can interrupt, that is the same thing
that prompted the credit default system.
Mr. Sirri. But they would have an interest in not taking on
the credit risk of their counterparty.
Mr. Marshall. That is why credit default swaps were created
to begin with.
Mr. Sirri. They were created to adjust the credit risk of
the IBMs, of industrial corporations. Here I am talking about
the banks that write those swaps.
The second thing that would be important here is you would
have in some of these proposals an exchange. An exchange would
establish an arm's-length price. As that price was transparent
and moved, the market would see that a credit was
deteriorating. As you saw that credit deteriorate, you produce
public information. That could affect margin, that could
collect collateral flows, and reduce the systemic risk.
Mr. Marshall. There are two different things that we don't
want to conflate; one is the price discovery function that is
served by an exchange in exchange-traded standard contracts.
And the second problem that we are trying to address today is
with these OTC unique products, to what extent would multiple
DCOs clearing these products enhance world security from
another financial collapse. That is the real issue we are
dealing with today, not the price discovery issue.
Mr. Sirri. From my view, they are linking in the following
sense. The price discovery that comes out helps those clearing
organizations move the kind of collateral they need to move to
mark these things to market. So the price discovery says, well,
that swap was a 200 basis point swap. Now credit has gotten
worse, it has gone to a 300 point basis swap. That would
happen. An example was----
Mr. Marshall. You would pick whatever product was closest
on the exchange and use that to determine how to mark-to-market
the comparable OTC derivative that is just being cleared, not
on-exchange.
Mr. Sirri. It would be an important input. It is an input
that is absent today.
Mr. Marshall. Thank you, Mr. Chairman.
The Chairman. Thank you.
The gentleman from Indiana, Mr. Ellsworth.
Mr. Ellsworth. Thank you, Mr. Chairman.
Mr. Lukken, I think Mr. Sirri touched on this earlier, but
would you take a stab for me at what form you think the
clearinghouses should take or at least some components that you
think would make this successful, that we can understand, and
will stop this from occurring again.
Mr. Lukken. The Commodity Exchange Act requires that to be
a designated derivatives clearing organization, that you have
to meet 14 core principles. I encourage Members of this
Committee to look through them because they are very readable
in layman's terms. But they require the keeping of financial
safeguards; that there is proper membership, proper ownership
of the derivatives clearing organization; and they walk through
all the things that we as a regulator look to that entity to
have in place, all the controls in place to ensure that the
credit in the central counterparty is working.
Basically, how central counterparties work is people come
to these markets and they agree to--even though they have
potentially entered into a transaction with a third party, they
agree to allow the central counterparty to be the opposite
party of that transaction. And that central counterparty is a
guaranteed party. They always pay.
And so instead of me having to rely on, for example, Erik
and me entering into a transaction, I understand I will enter
in with a central counterparty, and that is guaranteed to pay
that transaction. It allows for money to flow without the
concern that somebody might default on that payment.
It works very well, and has worked since 1925. In the
futures industry we have never had a default on a guarantee by
a clearinghouse. It is a proven system. We do have over-the-
counter derivatives currently clearing in our clearinghouses
energy and other types of financial assets. So we think it is a
proven solution. It is not always guaranteed. It provides
safeguards, but there is always concern that somebody may--the
clearinghouse may default, and that is why we walk them through
these processes to ensure they are backing these transactions.
Mr. Ellsworth. Are there other things that we can do to
discourage the excessive speculation? I guess eliminating naked
swaps would be one way. Are there other ways that you can think
of that we would discourage that?
Mr. Lukken. As I mentioned in my testimony, and as touched
on by Erik, I think finding the appropriate capital charges for
these transactions, as they are being held by institutions, is
something we will have to revisit. I am not sure that we were
holding enough back in collateral for the risks that we are now
seeing in the system. I am not an expert in that area, but it
just seems to me that that is another area besides encouraging
central trading--or central clearing. Another area that we
might have to revisit is capital charges.
Mr. Ellsworth. Mr. Sirri, any response on that?
Mr. Sirri. I would agree with what Chairman Lukken said.
You may have personally sold stock on something like the New
York Stock Exchange or on NASDAQ, and you never worried about
whether you got paid nor did you worry about who bought the
stock that you sold. The reason is that there is a central
counterparty in there that a day after you trade locks that
trade in and stands between you and the person who bought that
stock from you.
The same thing is what happens here. By putting a central
counterparty in that central default space, you are no longer
subject to the kind of rumors, or to the kind of concerns, or
to the kind of manipulations that would be possible if you had
a pool of bilateral contracts. That counterparty's financial
fortunes may falter later on, but because the central
counterparty is in place instead of that original counterparty,
you are insulated from that risk.
Mr. Ellsworth. Thank you very much.
Mr. Chairman, I would yield back.
The Chairman. If I could take the rest of your time, would
the Members be all right with that?
One of the things that I have raised: If we go onto these
clearing exchanges, it is going to cost money, and it is going
to require capital requirements and margins, whatever, which we
do not have now, really, in the over-the-counter market.
So one of the things that concerns me is, what is going to
happen here? Are we going to have people just shift over to the
over-the-counter market so they do not have to pay that and so
that they do not have to be subject to that regulation and so
forth?
I guess it is kind of the same argument we had. Well, if
you regulate these guys, they are going to go overseas, and we
are not going to be able to do anything with them. Well, we saw
where that whole argument got us, along with the argument that
these guys are too big to regulate and so forth.
So is there some way that we could have an incentive to
move onto the regulated market; in other words, where it would
cost you more to be in the over-the-counter market than it
would cost you to go onto the regulated market in terms of what
the actual price is to go onto that regulated market? Is there
some way that we could put some kind of--I don't know--penalty
or tax or whatever on these people who are in the over-the-
counter market to try to encourage people to go into a clearing
situation so we can know what they are up to?
Mr. Lukken. I will take a stab at it.
Yes, I think that is what we should be doing, because there
is a public good in getting into a registered clearing
organization. We do not want to have reverse incentives where
we drive people out of that type of environment.
I think we are going to have a natural migration to a
central counterparty, though. We saw that with Enron. We saw
the energy markets looking for this solution. They wanted to
come to a guaranteed counterparty-type environment. So I think,
naturally, we are going to see migration there.
But, as policymakers think about this in the coming months,
they should think about what are the costs of each of these
things and whether they are being held by a firm in an
individual, negotiated-type fashion or cleared. The incentives
should be towards clearing and trading these on-exchange, so
that you may want to look, as we mentioned, at the capital
requirements of people holding these on their books versus
those who choose to come to a central clearinghouse.
The Chairman. Thank you.
The gentleman from Ohio, Mr. Space.
Mr. Space. Thank you, Mr. Chairman.
Mr. Lukken, you mentioned a few moments ago in response to
Mr. Ellsworth's questioning that no clearinghouse has ever
defaulted in these other fields. I understand the benefits of
clearinghouses in terms of risk management and internal
controls and regulations; but these CDSs and other exotic
mechanisms clearly caused the need to rescue AIG.
Is it conceivable that a U.S. futures clearinghouse would
ever default? If so, would not the effect of such default be
systemically catastrophic beyond anything we have seen thus
far?
Mr. Lukken. I think you are exactly right. I mean, that is
one concern, that it is a highly regulated entity and that
there is a significant concentration of risk in one entity. So,
when we walk through the regulations with these organizations,
we make sure that they have proper controls in place, that they
stress-test this environment, that there is a guaranty fund
involved in this, that the funds are segregated, that they are
mark-to-market daily--twice-daily in most instances.
So you are exactly right in that there is a concentration
of risk here, but I think the benefits outweigh the risks of
going to this type of a model.
I mean, what we have seen by going to clearing is that
regulators would see a greater window into these transactions.
We would be able to manage the credit and counterparty risk by
having some transparency in this area versus what we are seeing
today, which is, we do not know what is out there, and this is
unraveling on its own. Whereas, if we saw this in one location,
I think it would be a much better way to manage the risk of the
system.
Mr. Space. As I understand it, one of the differences
between you and Mr. Sirri's concerns is whether this should be
in one location versus in multiple central counterparties.
Is that a correct assessment?
Mr. Lukken. No. I think we have both said that there should
be and that there can be multiple clearinghouses of these types
of products, and that is what the law allows.
Mr. Space. Okay. I have another question.
Professor Hu will be testifying in the next panel. He
references some of the concerns and problems of the system. In
one of them he identifies, of the CDS process, how credit
default swaps can sometimes undermine the soundness of
corporations referenced in the swaps. Specifically, he talks
about decoupling the ownership of debt with economic exposure
to the risks associated with default--in other words, creditors
having no incentive to work with troubled debtors.
How does the presence of a large clearinghouse affect that
problem associated with the CDSs?
Mr. Sirri. I think those are really two different issues.
The purpose of a central clearinghouse is to be sure that
promised payments are made. When you and I enter into a
contract, you and I make the kind of payments that are
stipulated by that contract.
I have not read Professor Hu's testimony.
As I understand what he is saying, you have a situation
where someone who has exposure to an underlying credit through
a credit default swap has a different set of incentives than
someone who actually owns the bond. That might be true, but I
want to point out that that is true with any number of other
kinds of derivatives.
For instance, in the futures markets, I could own 500
individual stocks or I could buy an S&P 500 future in the
options market. I could buy a call on General Motors and have
an exposure that way, or I could own a share of General Motors
stock. Each of them creates similar economic exposures.
So that attribute of credit default swaps is similar to the
attribute of futures, and it is similar to the attribute of
options, contracts we have become comfortable with over the
years and whose issues, I think, we have learned how to manage.
Mr. Space. Mr. Lukken.
Mr. Lukken. I agree. I think his testimony is getting to
the fact that there is more incentive when you have skin in the
game to manage the risks associated with owning an underlying
asset.
As Erik said, in the regulated space, there are a lot of
people who are able to buy futures contracts in a variety of
different commodities, whether it is corn or wheat or financial
futures, without owning the underlying asset. So it is a
problem. But I think it is a separate issue than the clearing
issue, which is ensuring guaranteed payments on the credit risk
side.
Mr. Space. Okay. Thank you. I yield back.
Mr. Holden [presiding.] The gentleman from Minnesota, Mr.
Walz.
Mr. Walz. Well, thank you. Thank you to the Chairman and to
the Ranking Member for holding this hearing, and thank you to
our two witnesses. This has been very informative.
I would like to go back to, I think, put this into
perspective. Picture today that America is listening to this.
I just came from the plains of southern Minnesota. What are
they hearing? I heard this term ``trust'' being used. This is
fundamental, this crisis of confidence that is out there; and
if you cannot hear the rage, open the window. It is there, and
people are wondering what is going on and what is happening.
Now, I heard talk that there was going to be voluntary
cooperation. Well, please excuse the healthy skepticism from my
constituents when they are not buying that right now, so there
are a couple of things I want to ask.
First, Mr. Sirri, in listening to your testimony and in
listening to where we are, it seems like the consensus is large
that we may have a different opinion in the next panel in
moving toward the clearing of these.
A few weeks ago, Chairman Cox was very clear on the CDSs;
he said they should be regulated. Is that the Administration's
position?
Mr. Sirri. I believe Chairman Cox is clear in his view
there. As I understand it, his view is that there is a
regulatory hole in that these instruments are not appropriately
regulated and that there is sufficient importance that it would
be helpful if Congress were to act and would provide regulatory
authority.
Mr. Walz. So that is Chairman Cox's position. Is it the
Administration's position?
Mr. Sirri. I cannot speak for the Administration.
Mr. Walz. America would like to know, because what is
happening right now is that we are hearing conflicting issues
across the spectrum, and it changes day to day.
If we are talking about trust and a crisis of confidence,
that is what we need to get to, and that is why I am very
appreciative of our holding this hearing. But we have not heard
that yet. What we are hearing now are reasons and excuses, and
every one of us who is out there hearing this, if you happen to
be on the other side of the political spectrum, we hear Fannie
Mae and Freddie Mac and nothing else. I do not think anybody in
this room believes that is totally the issue or totally not the
issue.
So I think it is a concern in that we are hearing
conflicting messages from the key players in this, and that is
very frustrating for the public.
I would ask again the impact that it is making on that, and
the idea that they simply do not understand all of what is
happening here. This is too sophisticated for the people who
are out there working jobs that pay them $40,000 a year, who
are trying to save for retirement, who are trying to figure out
how to get their kids to college. It matters to them; it
matters to them what is happening here. So I think we are
getting at this, and I am glad that we are moving in the right
direction.
My question to both of you is this, and I think it gets at
the heart of this: Assuming that clearing is the way we go and
assuming we work out all of the details that happen there,
aren't we fighting the last war? What are we going to do in the
future to make sure this does not happen again?
I know, Mr. Lukken, you spoke of this, and I thought you
were passionate about it in your testimony, but you did not
flesh it out, really. What is going to be the next shadowy
world that emerges? Isn't it incumbent upon us to anticipate
what it is and to make sure that this does not happen again?
I would be glad to listen.
Mr. Lukken. I think in the modern regulatory financial
system information is key. We have to, as regulatory
authorities, make sure that we are getting the proper
information to make informed decisions. So that, I think, is
the path we have to pursue no matter what instruments are being
traded; and it has to be consistent and fair across all
products.
What we have tried to lay out, or what I have tried to lay
out, is that at times there is an event that should trigger our
getting additional information and regulatory oversight.
This Committee did an admirable job of looking at the
energy swaps market and in determining that at a certain point
in time there is a public interest that arises in wanting to
regulate these instruments. I think now we are looking at
financial derivatives in the same context and that at some
point there is a public interest, that a significant price
discovery function begins to happen. When people start quoting
these in policy papers and on CNBC and elsewhere that there is
a need for us to get in there and to get more information, and
to regulate these products.
So that is what we are going through today. As a
legislator, it takes time, but we are hopeful to do this as
quickly as possible.
Mr. Sirri. You made a very good point, and I think we are
always aware that we are solving yesterday's problem and that
we are playing catch-up. As a regulator and especially as a
financial regulator, I think that is something we are sensitive
to. It is a criticism that we hear.
I think the issue today is with credit default swaps,
although not yesterday's problem for two reasons: One, it is a
large, important and growing segment of the risk management
community. It is also a particular instance of securities-based
swaps, and I expect more novation to occur there. The second
and perhaps more important reason is that we are creating a
template, a template that allows for the contracts to exist,
but that provides for risk management and systemic risk control
over a portion of that market, the standardized portion. I
don't know if it can be replicated across other contracts, but
I am hopeful that this kind of process is a process that can be
replicated and that might be useful in other settings.
Mr. Walz. Well, I am very appreciative of both of you
coming here and taking the time to explain this.
I think the Chairman stepped out, but I do think it is
important to note that this issue, when it was in the oil
futures, as well as this, this is something that the Chairman
and that the other Members of this Committee have been talking
about and have been providing the foresight. I just hope we
have that ability to get that out there ahead of time, but I
appreciate both of you.
I yield back.
Mr. Holden. The gentleman from North Dakota, Mr. Pomeroy.
Mr. Pomeroy. I thank the Chairman.
I am interested in where we go from here, but I am also, as
part of that effort, interested in understanding precisely
where we are and how we got here relative to CDS exposure
throughout our economy at this hour. It just seems so
paradoxical to me.
As I have sat on this Committee over the years, I have
learned about these over-the-counter, unregulated activities
and about these wonderful financial innovations that were going
to alleviate risk. As an old insurance commissioner, I like
ways that you can shed risk, and I understand how that is going
to have a positive impact on growth.
In this utterly unregulated context where we were told,
essentially sophisticated players would be able to manage this
because obviously they would only want to shed risk to
creditworthy enterprises, we are seeing that no one really
knows. A lot of the CDS commitment out there is highly
questionable in terms of whether or not the risk-assuming party
can actually pay on the triggering event. So instead of
alleviating risk, we have compounded risk with false security
on the way up and aggravated uncertainty on the way down.
We have to get our hands around how in the world this
happened.
Now, the CFTC had no regulatory authority, and its interest
in what was occurring in the deregulated area went away at the
end of the last decade. Is that a fair statement, Mr. Lukken?
Mr. Lukken. As the over-the-counter market developed, the
CFTC really never had jurisdiction over it. It was exempted in
1994 by the CFTC. Then, in 2000, it was codified to exclude us
from regulating in this area.
Mr. Pomeroy. Okay. I am not going to argue; if that is
fact, that is fact. The SEC had no regulatory authority. This
Office of Risk Management, are they supposed to just look at
the regulated activity or are they supposed to look at broader
economic activity occurring that is going to impact regulated
activity?
Mr. Sirri. Their charge is actually not at all related to
this.
Mr. Pomeroy. What I am curious about is that the balance
sheets of lots of regulated enterprises have basically been
positively affected because they have shed risk on these CDSs;
is that correct?
Mr. Sirri. The credit default swaps are risk management
tools and do let you shed or take on risk.
Mr. Pomeroy. So we let them, in an unregulated sense, shed
risk to parties who may or may not be creditworthy; but the
regulator looks at a balance sheet that has been improved by
the shedding of risk. Is that correct?
Mr. Sirri. That could happen.
Mr. Pomeroy. Now, under that circumstance, is there no one
in the SEC looking at what is occurring in this unregulated
avenue as it may impact the regulated avenue?
You said that the credit default swaps have doubled in the
last 2 years. Now are you telling me nowhere in the SEC is
anyone evaluating, at least as kind of a--isn't there some
corner of the place where we have someone thinking, how is all
of this going to work in the end?
Mr. Sirri. Well, it is important to know what our authority
is. Our authority is only over fraud, so if there is fraud in
this market, we can step into it.
Mr. Pomeroy. You are absolutely limited from even exploring
the accumulation of systemic risk in an unregulated,
questionable context that might impact those regulated
enterprises, but the public interest of those enterprises is
under your jurisdiction?
Mr. Sirri. For example, these instruments that you are
talking about, credit default swaps, we regulate broker-
dealers, and we have strong authority over broker-dealers, but
large financial firms tend to hold these credit default swaps
outside of broker-dealers in unregulated affiliates over which
we have no authority.
Mr. Pomeroy. So, basically you have statutory blinders?
Nowhere in the SEC can you look at what is occurring in this
unregulated area as it may impact the regulated area; is that
correct?
Mr. Sirri. When the Chairman talked the other day about the
regulatory hole for these large securities firms, he in part
was referring to these kinds of situations where we do not have
the ability to oversee these affiliates.
Mr. Pomeroy. Have you been statutorily limited from
evaluating? I mean, it would seem to me, if I were at the SEC,
I would say, ``What is occurring here? We have had a doubling
in the last 2 years. What are we doing about it?''
Now, wouldn't that Office of Risk Management have an
ability to take a look at that?
Mr. Sirri. There is some amount of information that they
may be able to collect, but we do not even have the authority
to compel production of information to us outside of an
informant process.
Mr. Pomeroy. Correct. But is there an analytical capability
within the SEC to at least hypothesize about the danger to
regulated activity from this unregulated activity?
Mr. Sirri. We may be able to hypothesize, but we like to
work with data.
Mr. Pomeroy. Well, I would be happy with anything.
So, has anyone hypothesized?
Mr. Sirri. I cannot answer that question. I think what we
do understand is that these are important tools, that these are
large markets and that they are worthy of our attention. So
things like exchange trading----
Mr. Pomeroy. Okay. They are worthy of your attention. Is
anyone paying attention?
Mr. Sirri. I think we are. The way we are doing it, as a
group of regulators, is by the core efforts with the central
counterparty and exchange trading. They are the most efficient.
Mr. Pomeroy. Are you talking about the retroactive
application of that?
Mr. Sirri. Well, if these things were to be centrally
cleared and prices produced, those prices would be useful for
contracts.
Mr. Pomeroy. A prospective or retrospective?
Mr. Sirri. A contract that trades today would help inform
prices of contracts that already exist, so it would have a
retrospective component.
Mr. Pomeroy. I am out of time.
I am not quite sure I follow that. If we created a
clearinghouse and moved futures activity through it, would we
in the next few months be able to get a more clear sense of
basically how much risk has been shed that is unlikely to be
recovered?
Mr. Sirri. I understand what you are saying. I think in
many ways the answer to that is ``yes.'' There are processes in
place for the compression of these trades that would let
counterparties look and say, ``All right. I may have a whole
bundle of credit default swaps. Through an efficient process of
compressing them down, we can understand what those exposures
are, and we can compress and net them down to a much smaller
exposure.''
That is the kind of thing that can be facilitated by the
information produced by a central counterparty. So, yes, it
will have an effect on that issue.
Mr. Lukken. Congressman, one of the objectives of the
regulators--the SEC, the Federal Reserve and the CFTC--in this
process is to make sure that it is not just a central
counterparty for future business, but that it is getting at the
current holdings of credit default swaps that are on the books
today. We want to be able to get a lot of that potentially
risky business onto a clearinghouse and into view of regulators
and through a central counterparty.
Mr. Pomeroy. I am deeply alarmed that we have had this
doubling of the last 2 years, which has been a rough period of
time. So we are not on the way up anymore during the last 2
years; and you have CDSs doubling, and we do not have a refined
regulatory proposal in this area. I surely look forward to
working to develop one.
Thank you. I yield back.
The Chairman [presiding.] I thank the gentleman, and I
thank the panel for their being with us and for their answers.
And I thank the Members for their good questions. We will
dismiss this panel.
We would now like to invite our second and final panel to
the table: Mr. Robert Pickel, the Chief Executive Officer of
the International Swaps and Derivatives Association of
Washington, D.C.; Professor Henry Hu, the Allan Shivers Chair
in the Law of Banking and Finance of the University of Texas
School of Law at Austin; Mr. Johnathan Short, Vice President
and General Counsel of IntercontinentalExchange of Atlanta,
Georgia; and Ms. Kim Taylor, Managing Director and President of
the Clearing House of the Chicago Mercantile Exchange, Inc.,
Chicago, Illinois.
I welcome the members to the panel. We appreciate your
being with us.
Mr. Pickel, as soon as everyone gets organized here and
gets settled in, we would welcome your testimony.
All of the witnesses, your full statements will be made
part of the record. We will ask you to try to, potentially,
summarize your statements, and try to stay within the 5 minute
rule that we have for this Committee.
So, Mr. Pickel, if you are ready, we appreciate your being
with us. We look forward to your testimony.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CEO,
INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, WASHINGTON, D.C.
Mr. Pickel. Thank you, Mr. Chairman.
Chairman Peterson, Ranking Member Goodlatte and Members of
the House Agriculture Committee, thank you for inviting ISDA to
testify on the role of credit derivatives in the U.S. economy.
ISDA represents participants in the privately negotiated
derivatives business, and we have 830 member institutions from
56 countries around the world. These members include most of
the major institutions who deal in privately negotiated
derivatives. Among other types of documentation that we publish
for this market, ISDA produces definitions related to credit
default swaps.
Credit derivatives serve multiple uses. A CDS can be used
by the owner of a bond or loan to protect itself against the
risks that a borrower will not make good on its promises. A CDS
can also be used to hedge against other risks related to the
potential default of a borrower. Or, a CDS can be used to
express a view about the health of a particular company or of
the market as a whole.
An investment fund might believe that there will be a large
number of corporate bankruptcies in the future. In order to
meet its fiduciary duty to invest its clients' money prudently,
the fund might seek to generate returns during those
bankruptcies by purchasing credit protection on one or more
companies the fund believes are most likely to default. The use
of credit derivatives in this manner is similar to someone who
sells wheat futures or who buys put options on a security when
they do not own the underlying wheat or shares.
The last several weeks have seen major credit events in the
credit default swap market. Fannie Mae and Freddie Mac, two of
the world's largest issuers of debt, were taken into government
conservatorship. Shortly thereafter, Lehman Brothers, one of
the largest OTC derivatives dealers, filed for bankruptcy. Then
Washington Mutual, likewise, filed for bankruptcy protection.
All of the above companies were referenced under a large
number of credit default swaps. They also tended to be
counterparties to a large number of other types of derivative
trades. Despite defaults by these firms, the derivatives market
and, in particular, the credit default swap market have
continued to function and to remain liquid. This is true even
while other parts of the credit markets have seized up and
while the equity markets have declined. Credit derivatives
remain one of the few ways parties can continue to manage risk
and to express a view on market trends.
Under U.S. law, the counterparties to a failed firm like
Lehman Brothers are able to net out payments owing to and from
the bankrupt counterparty without having to wait for a
bankruptcy judge to resolve claims. The failure of this large
Wall Street firm has not caused the failure of its derivatives
counterparties. That risk was contained because of the prudent
structure of insolvency law in the United States and in the
apparently sensible collateral requirements of Lehman's
counterparties.
As has occurred in previous credit events, ISDA held an
auction to determine the cash price of the outstanding debt of
Fannie, Freddie and Lehman, and it will do so for Washington
Mutual as well. These auctions were done according to well-
established procedures, and they resulted in the successful
settlements of the outstanding CDS trades on those companies.
Participants in the CDS business have seen their trades settled
in an orderly fashion and according to swap participants'
expectations.
Regarding AIG, our observation is that AIG's situation was
a result of its overexposure to mortgage finance, primarily by
taking exposure to various tranches of CDOs, collateralized
debt obligations. Also, we believe that the collateral
practices of AIG, where they agreed to post collateral only
upon a downgrade, exacerbated their problems. If they had used
collateral extensively from the start of their trading
relationships, we believe that the situation would have been
far less, very similar to this mark-to-market situation that
exists generally in the derivatives business, as well as
through the clearinghouse functions. The regular use of
collateral provides credit protection and it also provides
trading discipline.
Before closing, I would like to address an issue that has
come up recently regarding credit default swaps. With respect
to exchange trading, by definition, OTC contracts--over-the-
counter, privately negotiated contracts--cannot be traded on an
exchange. They exist because there was and there will always be
a need for individualized, custom-tailored, private risk
management contracts. Anything that eliminates that risk
management option will not eliminate the need for these
contracts. They will simply be done elsewhere.
In conclusion, there is little dispute that ill-advised
mortgage lending, coupled with improperly understood securities
backed by those loans are the root cause of the present
financial problems.
We heard from Mr. Sirri earlier. And in Mr. Parkinson's
testimony, they both made clear that CDS did not cause the
faults of individual companies or the general economic crisis
that we are experiencing. It is also true, however, that recent
market events clearly demonstrate that the regulatory structure
for financial services has failed. Laws and regulations written
in the 20th century need to be changed to account for 21st
century markets and products. An in-depth examination of the
U.S. regulatory structure is self-evidently warranted.
In this examination, it is ISDA's hope that the facts
surrounding OTC derivatives and the role they continue to play
in helping to allocate risk and to express a view on market
activity will highlight the benefit of derivatives, of industry
responsibility, and of widely applied good practices. We at
ISDA look forward to working with this Committee and with other
Committees of Congress to address that overall regulatory
structure.
Thank you, Mr. Chairman. I look forward to your questions.
[The prepared statement of Mr. Pickel follows:]
Prepared Statement of Robert G. Pickel, Executive Director and CEO,
International Swaps and Derivatives Association, Washington, D.C.
About ISDA
ISDA, which represents participants in the privately negotiated
derivatives industry, is the largest global financial trade
association, by number of member firms. ISDA was chartered in 1985, and
today has over 850 member institutions from 56 countries on six
continents. These members include most of the world's major
institutions that deal in privately negotiated derivatives, as well as
many of the businesses, governmental entities and other end-users that
rely on over-the-counter derivatives to manage efficiently the
financial market risks inherent in their core economic activities.
Since its inception, ISDA has pioneered efforts to identify and
reduce the sources of risk in the derivatives and risk management
business. Among its most notable accomplishments are: developing the
ISDA Master Agreement; publishing a wide range of related documentation
materials and instruments covering a variety of transaction types;
producing legal opinions on the enforceability of netting and
collateral arrangements; securing recognition of the risk-reducing
effects of netting in determining capital requirements; promoting sound
risk management practices; and advancing the understanding and
treatment of derivatives and risk management from public policy and
regulatory capital perspectives. Among other types of documentation
ISDA produces definitions related to credit default swaps.
About Credit Default Swaps
Credit default swaps (CDS) are privately negotiated contracts which
require one party to pay another in the event a third party cannot pay
its obligations. To use an example, an investment fund that owns a
large number of bonds issued by a corporation may want to protect its
investors against the possibility that the corporation goes bankrupt.
The investment fund would then seek a counterparty, usually a
commercial bank, an investment bank or other financial institution,
that is willing to enter into a CDS contact. Under the terms of this
contract the investment fund agrees to periodically make payments to
the counterparty, usually every 6 months for a specified time period
such as 5 years. The counterparty (e.g., the bank, investment bank or
financial institution) agrees to pay the full amount on bonds or loans
issued by the corporation if there is a ``credit event''. Parties to a
CDS contract are free to choose what constitutes a ``credit event'';
under standard ISDA documentation credit events include an issuer's
bankruptcy, the acceleration of payments on its obligations, default on
its obligations, the failure to pay its obligations, the restructuring
of the issuer's debt or a repudiation or moratorium on payment on its
obligations.
Credit derivatives like CDS serve multiple uses. As in the example
above a CDS can be used by the owner of a bond or loan to protect
itself against the risk that the borrower won't make good on its
promises. A CDS can also be used to hedge against other risks related
to the potential default of a borrower. For instance, an auto parts
company that is heavily reliant on one auto manufacturer as its primary
customer might seek to protect itself against the risk that
manufacturer will go out of business. One way to do so would be to
purchase credit protection (through a CDS) on that company. Though not
a perfect hedge, such protection could at least help limit the fallout
from that customer's bankruptcy.
CDS can also be used to express a view about the health of a
particular company or the market as a whole. An investment fund might
believe that there will be a large number of corporate bankruptcies in
the future. In order to meet its fiduciary duty to invest its clients'
money prudently the fund might seek to generate returns during those
bankruptcies by purchasing credit protection on one or more companies
the fund believes are most likely to default. Use of credit derivatives
in this manner is similar to someone who sells wheat futures or buys
put options on a security when they don't own the underlying wheat or
shares. In each case the idea is to maximize profits from a decline in
prices.
Recent Market Turmoil
Beginning in the summer of 2007 investors became aware of growing
problems in certain securities backed by residential mortgages. In
particular, it appeared that home loans made to borrowers with lower
credit scores were experiencing higher-than-expected rates of default.
This occurred simultaneously with an increasingly steep drop in the
value of homes in the U.S. Thus mortgage loans were defaulting and the
value of the homes that secured the loans were falling below the value
of the loan itself.
Some of these mortgage loans had been sold by lending banks and
repackaged as securities called ``collateralized debt obligations,'' or
``CDOs''. Although CDO and CDS are similar abbreviations, they are very
different products. As described above a CDS is a privately negotiated
contract between two parties. A CDO, on the other hand, is an
investment security that can be bought and sold freely on the market.
Like other securities in the U.S., CDOs are subject to the disclosure
and other requirements of the securities laws; nevertheless it appears
that these CDOs, widely sold to investors throughout the U.S. and the
world, were fundamentally mis-priced. Worse, in some cases the
structures of the CDOs themselves were extremely complicated and
apparently not well understood.
As mortgage defaults increased and housing prices fell, the value
of these CDOs became increasingly unclear. The secondary market for
CDOs disappeared as buyers were unwilling to purchase securities backed
by assets which were declining in value. When markets lack buyers it
becomes difficult to determine the fair value of an asset; banks,
investment firms, institutional investors and others were required to
mark down the value of their portfolios. On paper these institutions
themselves appeared to be rapidly losing value.
The Role of CDS in the Market Turmoil
From ISDA's conversations with regulators and market participants
it appears that the role of CDS in the recent market turmoil can be
described as follows:
First, CDS make the pricing and extension of credit more efficient.
If a lender can be sure it will be repaid regardless of whether a
borrower defaults, it is more likely to lend. There are many reasons
that the last 10 years have seen a world flooded with cash: loose
monetary policy on the part of central banks; oil countries seeking to
invest wealth generated by high energy prices; tremendous economic
growth in emerging markets like India, China and Brazil. Experience
demonstrates that, in retrospect, many loans were made that never
should have been made.
Second, many credit derivatives require counterparties to post
collateral in order to guarantee payment. Under any derivative contract
both parties guarantee they will make payments to each other based on
the value of some other asset or index thus both parties face risk both
in terms of the price of that asset as well as the risk that their
counterparty will be able to make its required payment. It is because
of this last type of risk, called ``counterparty credit risk,'' that a
derivative contract counterparty may be required to increase the amount
of collateral it gives to the other party to the contract if the first
party experiences a change in its financial condition. For instance, a
triple A rated company will generally be required to post less
collateral than a single A rated company. But if that triple A rated
company faces a ratings downgrade, it may be required to post more
collateral.
In a typical situation a party that sells protection under a CDS
contact is guaranteeing that it will pay the value of bonds issued by a
third party. If that third party's financial condition worsens the
counterparty that bought protection will require that the protection
seller post more collateral. If this happens at the same time the
protection seller has also suffered a deterioration in financial
condition, it will be required to post still more collateral.
Improperly managed, a derivatives counterparty could face a situation
akin to a run-on-the-bank, where as its financial condition worsens it
becomes subject to more and more collateral calls until it can no
longer meet its obligations under its derivatives contracts. This risk
is not new or confined to derivatives markets; many financial contracts
have a ``material adverse change in condition'', or MAC, clause that
functions similarly. Swap participants have long been aware of this
risk; the need for careful management was highlighted 15 years ago in a
document outlining good risk management practices for the Group of
Thirty, the widely cited ``Derivatives: Practices and Principles.''
Nevertheless for counterparties that fail to follow good practices the
consequences can be significant.
This appears to be what happened in the case of AIG. AIG was one of
America's largest corporations, an insurance company regulated under
the laws of the State of New York as well as a thrift holding company
supervised by the Office of Thrift Supervision. AIG was highly rated by
SEC licensed rating agencies, who considered it well capitalized. Many
of AIG's derivatives counterparties apparently did not require it to
post collateral; in particular AIG Financial Products, a wholly owned
subsidiary of AIG active in the derivatives business, did not routinely
post collateral. When on September 16, 2008, AIG's credit rating was
downgraded, its creditors, including counterparties to derivatives
contracts, demanded the company post more collateral than it had
available. AIG was unable to meet its contractual obligations and
sought assistance from the U.S. Government.
While the market value of AIGs contracts has declined, and its
collateral requirements have increased, we are not aware that they have
been called upon to make payments following defaults on significant
numbers of obligations. An increase in the market value of mortgage
backed securities, or merely the performance of the mortgages
underlying the mortgage backed securities it has guaranteed, would
reduce AIG's difficulties substantially. To our knowledge AIG has
performed on all of its obligations.
The Performance of Credit Derivatives in the Current Market
The last several weeks have seen five major credit events. On
September 15 Tembec Inc., a Canadian forest products company, filed for
bankruptcy in the U.S. This filing was largely lost in the cavalcade of
bankruptcies and credit events that followed: Fannie Mae and Freddie
Mac, two of the world's largest issuers of debt, were taken into
government conservatorship. Shortly thereafter Lehman Bros., one of the
largest OTC derivatives dealers, filed for bankruptcy. Then Washington
Mutual likewise filed for bankruptcy protection.
All of the above companies were referenced under a large number of
CDS; with the exception of Tembec they also tended to be counterparties
to a large number of other types of derivatives trades. Despite
defaults by these firms, the derivatives markets, and in particular the
CDS market, has continued to function and remain liquid. This is true
even while the other parts of the credit markets have seized-up and the
equities markets continue to decline precipitously. Credit derivatives
remain one of the few ways parties can continue to manage risk and
express a view on market trends.
The failure of Lehman Bros. provided a test case for managing the
default of a major derivatives dealer. Despite dire predictions and
erroneous press reports, OTC derivatives transactions are designed to
deal with the failure of any market participant, even a major dealer.
Starting in the late 1980s, Congress acted to amend the bankruptcy and
banking insolvency statutes to ensure that the failure of a major
counterparty to a qualified financial contract, such as a swap
agreement, would not spread systemically and threaten other market
participants. Thus, under U.S. law the counterparties to a failed firm
like Lehman Bros. are able to net-out payments owing to and from the
bankrupt counterparty without having to wait for a bankruptcy judge to
resolve all claims. Additionally, counterparties are allowed to
foreclose on collateral the failed party posted. In this way a
derivatives counterparty is protected against suffering large losses
because the other party to the contract can't meet its obligations.
The bankruptcy of Lehman Bros. shows the strength and resiliency of
this system. The failure of this large Wall Street firm has not caused
the failure of its derivatives counterparties; that risk was contained
because of the prudent structure of insolvency law in the U.S. and the
apparently sensible collateral requirements of Lehman's counterparties.
In addition to the resiliency of the derivatives markets in the
face of the failure of a major counterparty, the credit events
involving Fannie and Freddie likewise demonstrate the strength of the
business. As noted above Fannie and Freddie were two of the world's
largest issuers of debt and likewise two of the largest objects of CDS
protection. When the U.S. Government decided to place these GSEs in
conservatorship, the credit event provisions of the standard ISDA
documents were triggered. That meant that thousands of CDS trades on
Fannie and Freddie needed to be settled. Likewise, Lehman was also the
object of thousands of CDS trades which needed to be settled in light
of that company's bankruptcy.
As has occurred in previous credit events ISDA held an auction to
determine the cash price of the outstanding debt of Fannie, Freddie and
Lehman. These auctions, occurring on October 8 (in the case of the
GSEs) and October 10 (in the case of Lehman) were done according to
well established procedures and resulted in the successful settlement
of the outstanding CDS trades on the three companies. As has occurred
in the case of previous credit events, participants in the CDS business
have seen their trades settled in an orderly fashion and according to
swap participants' expectations.
Conclusion
As this testimony makes clear, both the role and effects of CDS in
the current market turmoil have been greatly exaggerated. There is no
question that CDS facilitate lending and corporate finance and, as
such, have impacted and been impacted by recent events. However to say
that CDS were the cause, or even a large contributor, to that turmoil
is inaccurate and reflects an understandable confusion of the various
financial products that have been developed in recent years. There is
little dispute that ill advised mortgage lending, coupled with
improperly understood securities backed by those loans, are the root
cause of the present financial problems. It is also true, however, that
recent market events clearly demonstrate that the regulatory structure
for financial services has failed. Laws and regulations written in the
20th century, in many cases designed to address markets which existed
in the 18th century, need to be changed to account for 21st century
markets and products. An in-depth examination of U.S. regulatory
structure is self-evidently warranted.
In this examination it is ISDA's hope that the facts surrounding
OTC derivatives, and the role they continue to play in helping allocate
risk and express a view on market activity, will highlight the benefit
of derivatives and of industry responsibility and widely applied good
practices. Derivatives have continued to perform well during a greater
period of stress than the world financial system has witnessed in
decades. In the wake of failures of major market participants, both
counterparties and issuers of debt, CDS participants have settled
trades in an orderly way precisely according to the rules and
procedures established by Congress and market participants. In this
respect CDS activity has been a tremendous success. We are confident
that policymakers and market participants alike will find their prudent
efforts in helping build the infrastructure for derivatives over the
last 25 years have been rewarded.
The Chairman. Thank you, Mr. Pickel.
Professor Hu.
STATEMENT OF HENRY T.C. HU, J.D., ALLAN SHIVERS CHAIR IN THE
LAW OF BANKING AND FINANCE, UNIVERSITY OF TEXAS SCHOOL OF LAW,
AUSTIN, TX
Mr. Hu. Mr. Chairman and distinguished Members of the
Committee, thank you for this opportunity.
My name is Henry Hu. I teach at the University of Texas Law
School, and my testimony today reflects only preliminary
personal views. I ask that the written testimony I have
submitted also be included in the record.
The public and private efforts to improve the operational
infrastructure for credit default swaps of the sort just
discussed by Chairman Lukken and Director Sirri are extremely
valuable. Credit default swaps create a web of dependencies
among widely disparate, often very important participants in
the world capital markets. Possible clearinghouse arrangements
and ISDA's netting and other efforts can, indeed, help reduce
the systemic risks being created by such swaps.
However, I would like to briefly look beyond these
operational infrastructure matters. I will focus on three other
matters that I think are also important to consider: the
possible creation of a data clearinghouse, errors in financial
institution decision-making, and debt decoupling.
First is the matter of data. Each OTC derivatives contract
is individually negotiated and is not required to be disclosed
to any regulator. No one regulator knows on any sort of real-
time basis entity-specific exposures, the ultimate resting
places of the credit market and of other risks associated with
OTC derivatives, or some of the other facets of the web of
dependencies created by OTC derivatives.
The disclosure situation as to credit default swaps may be
particularly deficient. For instance, the best source of
statistical information as to OTC derivatives overall is the
BIS Triennial Survey issued by the Bank for International
Settlements. These periodic surveys are based on polls of
derivatives dealers that are conducted by 54 central banks and
monetary authorities. Yet those surveys do not even cover
turnover in credit derivatives.
There is likely a need for a data clearinghouse for credit
and for other OTC derivatives activities worldwide, as I have
argued for, for some time. That is the centralized,
comprehensive, near real-time disclosure of such transactions
in some standardized and retrievable computerized form. Such a
data clearinghouse may well help to provide advance notice to
regulators of possible problems. Should possible problems
arise, this data clearinghouse can contribute to the
informational predicate for proper regulatory responses.
Second is the matter of financial institution decision-
making. In a 1993 article, I suggested that there were a
variety of structural factors, perhaps, causing even
sophisticated financial institutions to make mistakes as to
complex financial products. For example, I refer to certain
psychological biases and to certain compensation incentive
structure problems.
One cognitive bias is the human tendency to ignore low-
probability, catastrophic events. One incentive structure
problem relates to the temptations posed by the highly
asymmetric nature of the payoffs often found in the derivatives
industry--huge wealth if the rocket scientist is perceived by
his superiors as doing well and typically, at most, simply
losing your job if you are not.
There is not enough public information as to whether these
structural factors undermined American International Group's
decision-making with respect to credit default swaps, but it
may be a matter worth looking into. For instance, I do point
out the psychological tendency to ignore low-probability,
catastrophic events. In August 2007, the head of the AIG unit
responsible for credit default swaps stated that it is hard for
us, without being flippant, to even see a scenario within any
kind of realm of reason that would see our losing $1 in any of
these transactions.
I do point out as to the asymmetric payoff issue in
derivatives that the head of that AIG unit apparently made $280
million over the last 8 ``good years'' and that, when he left
in February of this year, he was given, among other things, a
contract to consult for AIG at $1 million a month.
Third is the matter of how credit default swaps are
sometimes used by hedge funds or by others to engage in--thank
you, Congressman Space for referring to this issue--what can be
termed ``debt decoupling.'' That is that a creditor of a
company could enjoy the control rights given to him in the loan
agreement while simultaneously, through holding enough credit
default swaps, actually having a negative economic exposure to
the company. Such a creditor might well want its power to go
into bankruptcy and have incentives to use its control rights
to help grease the skids. This is quite different from simply
holding a contract on corn. You control the weather, in effect,
in terms of this situation; that is, having the control rights
on the loan agreement side and yet having, perhaps, incentives
to see the company not do well and certainly succeeding in
undermining the bankruptcy proceedings as well.
In conclusion, times are too interesting. It is difficult
to make public policy much less public policy that may be
foundational for the next several generations. As for credit
derivatives, I have touched briefly on three of the areas that
I think need more attention. Important strides can be made,
especially if coordinated worldwide, to avoid regulatory
arbitrage and if the steps can be taken with full respect for
the private and social value that both over-the-counter and
exchange-traded credit derivatives can offer.
Thank you very much.
[The prepared statement of Mr. Hu follows:]
Prepared Statement of Henry T.C. Hu, J.D., Allan Shivers Chair in the
Law of Banking and Finance, University of Texas School of Law, Austin,
TX
Credit Default Swaps and the Financial Crisis: ``Interconnectedness''
and Beyond *
I. Introduction
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* Copyright 2008 by Henry T.C. Hu. All rights reserved.
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Mr. Chairman and Members of the Committee, thank you for the
invitation of October 9 to testify before the Committee. My name is
Henry Hu and I hold the Allan Shivers Chair in the Law of Banking and
Finance at the University of Texas Law School. My testimony reflects
preliminary personal views and does not represent the views of my
employer or any other entity. I ask that my written testimony also be
included in the record.
At its economic core, the typical ``cash-settled'' credit default
swap involves a bet between two parties on the fortunes of some
referent third party. The ``protection buyer'' on the swap may be
concerned (e.g., if the buyer had lent money to the third party) or
simply skeptical (e.g., if the buyer wished to speculate) as to the
plight of the third party. For a fee (or stream of fees), the
``protection seller'' of the swap will pay the buyer cash upon a
specified disaster befalling the third party, the amount based on the
severity of the disaster and the size of the bet (i.e., the size being
measured by the ``notional amount''). A derivatives dealer (typically a
major financial institution) stands ready to enter into either side of
such bets--such privately negotiated two-party contracts--with its
customers. The customers are hedge funds, banks, insurance companies,
and others in the wholesale capital markets. Dealers may also enter
into such swaps with other dealers.
The market for these privately-negotiated contracts, for this
segment of the ``OTC derivatives'' market, has grown rapidly, at least
until recently. At mid-year 2008, the notional amount of credit default
swaps outstanding was $54.6 trillion.\1\ As with other OTC derivatives,
these contracts helped customers address their risk management and
other objectives in ways custom-tailored to each customer's specific
needs.
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\1\ See, e.g., Darrell Duffie & Henry T.C. Hu, Competing for a
Share of Global Derivatives Markets: Trends and Policy Choices for the
United States, draft available at http://ssrn.com/abstract=1140869;
ISDA Mid-Year 2008 Market Survey Shows Credit Derivatives at $54.6
Trillion, ISDA News Release, Sept. 24, 2008.
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The role of credit default swaps in the current financial crisis
has become a matter of public debate. The immediate responses have
largely focused on the substantive aspects of ``interconnectedness''
problems, through mechanisms such as clearinghouse arrangements to
limit credit exposures among the web of participants in this market.\2\
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\2\ I leave aside the Securities and Exchange Commission, with its
focus on fraud and manipulation, and New York State, with its focus on
the need to protect insurance policyholders. See Jesse Westbrook &
David Scheer, SEC chief demands credit swap regulation, Globe & Mail
(Canada), Sept. 24, 2008, at B14; Raymond J. Lehmann, New York Moves to
Define Some Swaps as Insurance, BestWire, Sept. 23, 2008.
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I would like to discuss three themes, albeit very briefly because
of time constraints and because the below-footnoted sources offer
closer analysis:
(1) While the substantive reduction of credit exposures is
worthwhile, there must also be independent measures to
significantly enhance disclosures as to the web of
relationships in credit default swap and other OTC derivatives
markets.\3\ A near-real-time ``data clearinghouse'' for OTC
derivatives activities may be needed. (Part II)
---------------------------------------------------------------------------
\3\ See, e.g., Henry T.C. Hu, Misunderstood Derivatives: The Causes
of Informational Failure and the Promise of Regulatory Incrementalism,
102 Yale Law Journal 1457, 1503-1509 (April 1993) [hereinafter Hu,
Misunderstood Derivatives]; Henry T.C. Hu & Bernard Black, Debt, Equity
and Hybrid Decoupling: Governance and Systemic Risk Implications, 14
European Financial Management 663, 693 (September 2008), draft
available at http://ssrn.com/abstract=1084075 [hereinafter Hu & Black,
EFM--Decoupling].
(2) There are structural reasons why ``sophisticated'' financial
institutions may misunderstand--or may act as if they
misunderstand--the risks of the derivatives they offer.\4\ If
such decision-making errors threaten the survival of the dealer
itself, a request for governmental intervention will not be far
behind. (Part III)
---------------------------------------------------------------------------
\4\ See, e.g., Hu, Misunderstood Derivatives, supra note 3 at 1476-
95; Hedge Fund Operations, Hearing Before the Committee on Banking and
Financial Services, U.S. House of Representatives, Oct. 1, 1998
(testimony of Henry T.C. Hu) (relating collapse of hedge fund Long Term
Capital Management to thesis of Misunderstood Derivatives).
(3) How credit default swaps are sometimes used can undermine the
soundness of the corporations referenced in the swaps and, if
bankruptcy occurs, proper reorganization.\5\ (This is even
after leaving aside entirely the fraud and manipulation issues
being investigated by the SEC.) What can be termed ``debt
decoupling,'' through such swaps and through securitization,
may not only undermine the health of individual corporations,
but affect the soundness of the financial system as a whole.
(Part IV)
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\5\ See, e.g., Henry T.C. Hu & Bernard Black, Equity and Debt
Decoupling and Empty Voting II: Importance and Extensions, 156
University of Pennsylvania Law Review 625 (January 2008), available at
http://ssrn.com/abstract=1030721; Hu & Black, EFM--Decoupling, supra
note 3.
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II. Interconnectedness: The Likely Need for a ``Data Clearinghouse''
``Interconnectedness'' issues related to credit default swaps
deserve the attention they are getting. A decline in a major
derivatives dealer's creditworthiness may undermine the financial
soundness of the counterparties relying on that dealer's swaps. The
deterioration in the creditworthiness of such ``first generation''
counterparties would affect their ability to meet their obligations on
the ``second generation'' credit default swaps they may have separately
entered into. And so on. Linkages among widely disparate participants
in the worldwide wholesale capital markets are created.
Regulatory and private responses have largely focused on the
substantive matter of reducing the exposures associated with this web
of transactions. The federal government did intervene as to Bear
Stearns Companies, Inc. (``Bear Stearns'') and American International
Group, Inc. (``AIG'') in large part because of the especially important
roles they had as dealers in credit default swap derivatives.\6\ With
the strong encouragement of the Federal Reserve Bank of New York,
various private efforts are on-going to try to centralize clearing and
reduce the web of dependencies among credit default swap
participants.\7\ The International Swaps and Derivatives Association,
the main industry trade association, has played an active risk-reducing
role as well, particularly with respect to the mechanics of settling
credit default swap payouts, including those associated with the Fannie
Mae and Lehman ``credit events.''
---------------------------------------------------------------------------
\6\ See, e.g., Nelson D. Schwartz, & Julie Creswell, What Created
This Monster?, N.Y. Times, Mar. 23, 2008, Bus. Sec., at 1 (quoting a
prominent securities analyst as saying that the Bear Stearns rescue
``was 100 percent related to credit default swaps''); Justin Fox, Why
the Government Wouldn't Let AIG Fail, at http://www.time.com/time/
printout/0,8816,1841699,00.html (Sept. 25, 2008) (noting government's
``biggest fears'' as to the consequences of AIG's failure had to do
with credit default swaps).
\7\ See, e.g., Serena Ng & Gregory Zuckerman, Electronic Exchange
For CDSs Is Proposed, Wall St. J., Oct. 7, 2008, at C2; Jeremy Grant
Anuj Gangahar, New attempt to set up swaps initiative, Fin. Times, Oct.
10, 2008, at 23.
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Independent, comprehensive measures to enhance disclosures as to
credit default swaps and other OTC derivatives, would be helpful. Each
OTC derivatives contract is individually negotiated and not required to
be disclosed to any regulator, much less to the public generally. No
one regulator knows, on a real-time basis or not, entity-specific
exposures, the ultimate resting places of the credit, market, and other
risks associated with OTC derivatives, or some of the other important
facets of the ``web of dependencies'' created by OTC derivatives.
The disclosure situation as to credit default swaps may be
particularly deficient. The best source of statistical information as
to OTC derivatives generally is the ``BIS Triennial Survey'' issued by
the Bank for International Settlements (BIS), based on polls of
derivatives dealers that are conducted by 54 central banks and monetary
authorities. These periodic surveys are available from 1998 to 2007.
However, the BIS Triennial Surveys do not even cover turnover in credit
derivatives, much less the far more detailed, real-time information
needed to properly assess the web of dependencies.
Other sources provide information at a granularity similar to the
BIS surveys. The best official U.S. statistics on credit derivatives
are probably those that come from the Office of the Comptroller of the
Currency. Those statistics focus on the activities of U.S. commercial
banks--a category that, for instance, excludes the activities of the
AIG. ISDA's market surveys of credit default swaps (and interest rate
derivatives and OTC equity derivatives) are conducted twice a year and
rely on voluntary participation--although, as to the June 30, 2008
survey, ISDA notes that ``all major derivatives houses provided
responses.''
Clearinghouse and/or any associated exchange trading of credit
derivatives will no doubt improve transparency as to transactions that
are comprehended by the applicable systems. I have not had the
opportunity to look at the limited public information as to these on-
going matters. However, there will still presumably remain an OTC
credit derivatives market and many transactions that are not funneled
into the systems. Moreover, I am not currently aware of other types of
OTC derivatives being subject to such proposed arrangements.
There is likely a need is for a ``data clearinghouse'' for OTC
derivatives: centralized, comprehensive, near-real-time disclosure of
OTC derivative transactions, in some standardized and retrievable
computerized form. Perhaps BIS would be an appropriate entity to serve
as such a data clearinghouse. But determining what details to precisely
require of OTC derivatives market participants as to the transactions
they enter into, how close to ``real-time'' such disclosures should be
made, what regulatory access and non-regulatory access there should be
to such disclosures, and what processing of the information submitted
to the data clearinghouse should be undertaken are some of the issues
that need to be subject to careful benefit/cost analysis. Such a data
clearinghouse may help provide advance notice to regulators of possible
entity-specific or system-wide problems and early remediation. Should
problems actually arise, this data clearinghouse can contribute
materially to the informational predicate for proper regulatory
responses to such problems.
III. Financial Institution Decisionmaking Errors
In my 1993 Yale Law Journal article ``Misunderstood Derivatives,''
I suggested that there were a variety of structural reasons to believe
that even sophisticated financial institutions will make mistakes with
respect to derivatives and other complex financial products. For
example, certain ``cognitive biases'' can undermine the models
developed by rocket scientists. Additionally, the compensation
structure in derivatives units, and the complexity of some products may
overwhelm normal ``internal'' and ``external'' corporate governance
mechanisms for deterring inappropriate behavior.
There is insufficient public information at the moment to determine
whether some of these structural reasons undermined AIG's
decisionmaking with respect to credit derivative swaps. But some of the
evidence available thus far suggests that these are matters worth
pursuing.
For instance, one of the cognitive biases undermining derivatives
models is the tendency to ignore low probability catastrophic events.
Psychologists theorize that individuals do not worry about an event
unless the probability of the event is perceived to be above some
critical threshold. The effect may be caused by individuals' inability
to comprehend and evaluate extreme probabilities, or by a lack of any
direct experience. This effect manifests itself in attitudes towards
tornados, safety belts, and earthquake insurance. My 1993 article
indicated that in the derivatives context, financial rocket scientists
are sometimes affirmatively encouraged, as a matter of model design, to
ignore low probability states of the world.
Certain public AIG statements are arguably consistent with the
operation of this cognitive bias, though they do not necessarily prove
the existence of the bias. For example, in August 2007, the head of the
AIG unit responsible for credit default swaps stated:
It is hard for us, without being flippant, to even see a
scenario within any kind of realm of reason that would see us
losing one dollar in any of those [credit default swap]
transactions.\8\
---------------------------------------------------------------------------
\8\ Gretchen Morgenson, Behind Insurer's Crisis, Blind Eye to a Web
of Risks, N.Y. Times, Sept. 28, 2008, at AI.
---------------------------------------------------------------------------
Similarly, AIG's Form 10-K for 2006 stated:
The threshold amount of credit losses that must be realized
before AIGFP has any payment obligation is negotiated by AIGFP
for each transaction to provide that the likelihood of any
payment obligation by AIGFP under each transaction is remote,
even in severe recessionary market scenarios.
In the derivatives industry, the incentive structure can be highly
asymmetric. True success--or the perception by superiors of success--
can lead to enormous wealth. Failure or perceived failure may normally
result, at most, in job and reputational losses. Thus, there may be
serious temptations for the rocket scientist to emphasize the rewards
and downplay the risks of particular derivatives activities to
superiors, especially as the superiors may sometimes not be as
financially sophisticated (and loathe to admit it). Moreover, the
material risk exposures on certain derivatives can sometimes occur
years after entering into the transaction--given the turnover in the
derivatives industry, the ``negatives'' may arise long after the rocket
scientist is gone. The rocket scientist may have an especially short-
term view of the risks and returns of his activities. Undesirable
behavior can be tempered by disclosure requirements; however but, among
other things, SEC and accounting disclosure requirements have not fully
kept up with the derivatives revolution.
I do not know if any of AIG's current or past employees succumbed
to any such behavior, by reason of the incentive structure or
otherwise. That said, it is a matter that would be worth looking into.
According to the testimony of Martin Sullivan, the former CEO of AIG,
until 2007, many employees at AIG Financial Products (AIGFP) (the
subsidiary generating the losses leading to the AIG bailout) were being
paid higher bonuses than he was. The head of AIGFP, Joseph Cassano,
apparently made $280 million over the last eight years. And when Mr.
Cassano left AIG in February 2008, he was given, among other things, a
contract to consult for AIG at $1 million a month.
IV. Uses of Credit Default Swaps Undermining the Health and
Reorganization of Corporations
There may be aggressive--but legal--uses of credit default swaps by
hedge funds and others that can undermine the soundness of the referent
third parties and, if bankruptcy occurs, the reorganization of such
parties. In August 2007, I began suggesting that the separation of
control rights and economic interest with respect to corporate debt
through swaps can cause such problems. This ``debt decoupling''
analysis has been further developed and I rely on this analysis to
illustrate these issues.\9\
---------------------------------------------------------------------------
\9\ For stories on the ``debt decoupling'' research referenced in
footnote 5, see, e.g., Bankruptcies in America--Waiting for Armageddon,
The Economist, March 27, 2008, at 81-82; Francesco Guerrera, Ben White,
& Aline van Duyn, Derivatives boom raises risk of bankruptcy, Fin.
Times, Jan. 28, 2008, at 13.
---------------------------------------------------------------------------
Ownership of debt usually conveys a package of economic rights (to
receive payment or principal and interest), contractual control rights
(to enforce, waive, or modify the terms of the debt contract), other
legal rights (including the rights to participate in bankruptcy
proceedings), and sometimes disclosure obligations. Traditionally, law
and real world practice assume that the elements of this package are
generally bundled together. One key assumption is that creditors
generally want to keep a solvent firm out of bankruptcy and (apart from
intercreditor matters) want to maximize the value of an insolvent firm.
These assumptions can no longer be relied on. Credit default swaps
and other credit derivatives now permit formal ownership of debt claims
to be ``decoupled'' from economic exposure to the risk of default or
credit deterioration. But formal ownership normally still conveys
control rights under the debt agreement and legal rights under
bankruptcy and other laws.
There could, for instance, be a situation involving an ``empty
creditor'': a creditor may have the control rights flowing from the
debt contract but, by simultaneously holding credit default swaps, have
little or no economic exposure to the debtor. The creditor would have
little incentive to work with a troubled corporation for it to avoid
bankruptcy. Indeed, if it holds enough credit default swaps, it may
simultaneously have control rights and a negative economic exposure. In
such a situation, the creditor would have incentives to cause the
firm's value to fall. Such ``debt decoupling'' could also cause
problems within bankruptcy proceedings, such as those relating to the
allocation of voting power among creditors, without consideration of
their true economic exposures.
Because many of the substantive and disclosure matters relating to
debt decoupling are beyond the scope of this Committee hearing, I have
been especially brief in discussing this aspect of credit defaults
swaps.
V. Conclusion
Times are too interesting. In such times, it is difficult to calmly
and rationally make public policy, much less public policy that may be
foundational for the next several generations.
As for credit derivatives, the issues are complex. They are
products that are valuable to corporations, investors, and financial
institutions worldwide. OTC credit derivatives, like other OTC
derivatives, allow for contracts customized to the individual customer
preferences. All derivatives are important to our financial services
sector, the third largest sector of the U.S. economy.
On the other hand, there are pressing needs for reform. I have
touched on three of the areas which I believe have not received enough
attention. Reform efforts in the U.S. generally need to be well-
coordinated with efforts in other countries, because of the nature of
the financial products and market participants and because of the
prospect of unwelcome regulatory arbitrage.
While we are in the early stages of sorting out the financial
crisis, including the role of credit default swaps, I think important
strides can be made.
Thank you.
The Chairman. Thank you, Professor. We appreciate your
being with us.
Mr. Short.
STATEMENT OF JOHNATHAN H. SHORT, SENIOR VICE
PRESIDENT AND GENERAL COUNSEL, IntercontinentalExchange, INC.,
ATLANTA, GA
Mr. Short. Thank you.
Chairman Peterson, Ranking Member Goodlatte, I am Johnathan
Short, Senior Vice President and General Counsel of
IntercontinentalExchange, or ICE. We very much appreciate the
opportunity to appear before you today to discuss the role of
credit derivatives in the financial markets and to discuss
ICE's efforts, along with those of other market participants,
to introduce transparency and risk intermediation into these
OTC credit derivative markets.
ICE is proud to be working with the Federal Reserve Bank,
with the Commodity Futures Trading Commission and with the
Securities and Exchange Commission on these efforts that are
vital to the health of our financial markets. We believe that
we have important domain expertise and knowledge to bring to
bear to that effort.
As background, ICE operates three regulated futures
exchanges--ICE Futures U.S., ICE Futures Europe and ICE Futures
Canada--together with three regulated clearinghouses--ICE Clear
U.S., ICE Clear Europe and ICE Clear Canada.
ICE recently acquired Creditex Group in August of 2008.
Founded in 1999, Creditex is a global market leader in the
execution and in the processing of credit derivatives. In the
last few years, Creditex has worked collaboratively with market
participants on a number of important initiatives which
directly address calls by regulators, most notably the Federal
Reserve Bank of New York, for improving operational efficiency
and for providing heightened transparency regarding risk
exposures in the credit derivatives market.
In 2005, Creditex helped to develop the ISDA cash
settlement auctions, which are the market standard for credit
derivative settlement. They have been used in recent weeks to
allow the orderly settlement of CDS contracts referencing,
among others, Fannie Mae, Freddie Mac and Lehman Brothers.
Creditex has also worked collaboratively with industry
participants to launch a platform to allow the efficient
compression of offsetting CDS portfolios of major dealers in
order to net down exposures, and to determine the real CDS
exposures of various market participants.
To be clear, however, more must be done. While credit
derivatives serve an important role in the broader financial
markets, improving the market structure pursuant to which
credit derivatives are traded and cleared is essential.
Candidly, this was an opportunity that I saw when we chose to
acquire Creditex.
Presently, the credit markets operate very similar to the
way that energy markets worked earlier this decade. Most
transactions are bilaterally executed between brokerage firms.
This is not a transparent or an efficient way for a market to
operate. Critically, the bilateral nature of the market leaves
participants exposed to counterparty risk. In times of great
financial distress, like the present, this risk can have
systemic implications. When financial counterparties do not
trust each other, they then stop lending to each other, and the
credit markets freeze. In addition, the failure of a large
counterparty can spread risk throughout markets, especially
where the market is opaque and where the true extent of risk is
not known.
The question before us today is how to bring appropriate
transparency to the CDS markets as well as how to appropriately
mitigate counterparty credit risk.
ICE believes that these mutual goals of transparency and
the mitigation of counterparty credit risk and systemic risk
can be achieved through the introduction of regulated clearing
and appropriate reporting obligations to regulators. This was
the solution that was referenced by Chairman Lukken in his
prior comments.
ICE's proposed solution: ICE has announced an agreement in
principle with The Clearing Corporation, leading credit market
participants, Markit, and Risk Metrics to introduce a clearing
solution to address the problem that is presently existing in
this market. To clear credit default swaps, ICE will form a
limited purpose bank, ICE U.S. Trust, for the sole purpose of
clearing credit default swaps.
ICE U.S. Trust will be a New York trust company that will
be a member of the Federal Reserve System. In other words, it
will be regulated both at the state and Federal levels; it will
be a bank clearinghouse, and it will be subject to the direct
regulatory and supervisory requirements of the Federal Reserve
System. ICE U.S. Trust will offer its clearing services to its
membership, and its membership will be open to market
participants meeting appropriate financial criteria, with third
parties unable to meet these criteria being able to trade
through the existing membership.
ICE U.S. Trust will review each member's financial
standing, operational capabilities, systems, and controls, and
the size and nature and the sophistication of its business in
order to meet comprehensive risk management standards with
respect to the operation of the clearinghouse. In addition, ICE
will make available its industry-leading T-Zero trade
processing platform as part of this effort.
Finally, and perhaps most importantly, a word about
regulation: The appropriate regulation of credit derivatives is
of the utmost importance to the financial system. Presently,
the credit derivatives market is largely exempt from regulation
from the Commodity Futures Trading Commission, or the
Securities and Exchange Commission. Also, as recent events
demonstrate, the credit markets are intricately tied to the
banking system with many credit derivative market participants
being banks that are subject to regulation by the Federal
Reserve.
As Chairman Peterson asked one of the earlier panelists, is
there an incentive to trade cleared products, I think the fact
that many of the largest market participants in this area are
being regulated directly by the Fed provides that incentive
through the Fed's ability to raise capital requirements.
Given the central role the Federal Reserve has played in
addressing both the current credit crisis and issues related to
credit derivatives within the broader market, ICE proactively
sought to ensure that its clearing model would be subject to
direct regulation by the Federal Reserve System. ICE shares its
model in order to ensure that its credit derivative markets
will be transparent and fully regulated from the inception of
its business by whomever we view as the regulator with the most
appropriate jurisdiction in the area. But to be clear, this
effort was not undertaken to avoid jurisdiction of the CFTC, of
the SEC or of any other relevant regulator; and ICE stands
ready to work with all regulators in this important industry
effort.
ICE understands that Congress may choose to enact
additional financial market reforms in the coming Congress,
including taking steps to broadly reform the financial
regulatory system as a whole. We would stand ready to work
within that framework as Congress evolves it.
Finally, ICE will be introducing a similar clearing model
in Europe through its ICE Clear Europe clearinghouse to address
European CDS, and would make information sharing and regulatory
dialogue a cornerstone of our clearing solution.
Mr. Chairman, thank you for this opportunity to share our
views with you, and I will be happy to answer any questions.
[The prepared statement of Mr. Short follows:]
Prepared Statement of Johnathan H. Short, Senior Vice President and
General Counsel, IntercontinentalExchange, Inc., Atlanta, GA
Introduction
Chairman Peterson, Ranking Member Goodlatte, I am Johnathan Short,
Senior Vice President and General Counsel of the
IntercontinentalExchange, Inc., or ``ICE.'' We very much appreciate the
opportunity to appear before you today to discuss the role of credit
derivatives in the financial markets and discuss ICE's efforts, along
with other market participants, to introduce transparency and risk
intermediation into the OTC credit markets. ICE is proud to be working
with the Federal Reserve Bank, the Commodity Futures Trading Commission
(``CFTC''), and the Securities Exchange Commission on these efforts
that are vital to the health of our financial markets. Importantly, ICE
has a history of working with OTC market participants to introduce
transparency and risk intermediation into markets, having been a
pioneer in the introduction of transparent electronic trading into the
energy markets and having introduced cleared OTC energy swap contracts
into its markets in 2002 in response to a market crisis in the energy
markets--a freezing of credit and transactions--much like the crisis
faced today in the broader financial markets.
Background
ICE was established in 2000 as an electronic over-the-counter (OTC)
market. Since that time, ICE has grown significantly, both through its
own market growth fostered by ICE's product, technology and trading
innovations, as well as by acquisition of other markets to broaden its
product offerings.
Since the launch of its electronic OTC energy marketplace in 2000,
ICE has acquired and now operates three regulated futures exchanges
through three separate subsidiaries, each with a separate governance
and regulatory infrastructure. The International Petroleum Exchange
(renamed ICE Futures Europe), was a 20 year old exchange specializing
in energy futures when acquired by ICE in 2001. Located in London, it
is a Recognized Investment Exchange, or RIE, operating under the
supervision of the UK Financial Services Authority (FSA). In early
2007, ICE acquired the 137 year old ``The Board of Trade of the City of
New York'' (renamed ICE Futures U.S.), a CFTC-regulated Designated
Contract Market (DCM) headquartered in New York specializing in
agricultural, foreign exchange, and equity index futures. In late 2007,
ICE acquired the Winnipeg Commodity Exchange (renamed ICE Futures
Canada), a 120 year old exchange specializing in agricultural futures,
regulated by the Manitoba Securities Commission, and headquartered in
Winnipeg, Manitoba.
ICE also owns and operates three clearinghouses: ICE Clear U.S., a
Derivatives Clearing Organization under the Commodity Exchange Act,
located in New York and serving the markets of ICE Clear U.S.; ICE
Clear Europe, a Recognised Clearing House located in London that will
serve ICE Futures Europe and ICE's OTC energy markets; and ICE Clear
Canada, a recognized clearing house located in Winnipeg, Manitoba that
serves the markets of ICE Futures Canada.
Finally, and of importance to this discussion, ICE recently
acquired Creditex Group. Founded in 1999, Creditex is a global market
leader and innovator in the execution and processing of credit
derivatives. Creditex operates a hybrid model of voice and electronic
execution, and was the first to successfully launch electronic trading
for credit default swaps in 2004. In the last few years, Creditex has
worked collaboratively with market participants on three important
initiatives which directly address calls by regulators, most notably
the Federal Reserve Bank of New York, for improved operational
efficiency and scalability in the credit derivatives market.
In 2005, Creditex helped to develop the ISDA Cash Settlement
Auctions which are the market standard for credit derivative settlement
and have been used in recent weeks to allow orderly settlement of CDS
contracts referencing Fannie Mae, Freddie Mac and Lehman Brothers. Also
in 2005, Creditex launched its subsidiary, T-Zero, which is now the
industry standard for trade transmission and same-day trade matching.
The platform addresses recommendations by the President's Working Group
earlier this year for flexible and open architecture, ambitious
standards for accuracy and timeliness of trade matching errors and
operationally reliable and scalable infrastructure. In recent months,
Creditex has also worked collaboratively with industry participants to
launch a platform to allow efficient compression of offsetting CDS
portfolios of major dealers. The platform reduces operational risk and
provides capital efficiency.
Credit Derivatives and the Importance of Credit Derivatives Clearing
ICE has earned a reputation as an innovator in introducing clearing
and transparency to the energy derivatives markets. ICE was the first
to introduce clearing to the power markets, which were the domain of
voice brokered, bilateral transactions. Voice brokered transactions
offer limited transparency and cater to the largest customers. Now, the
energy markets are predominately cleared with the attendant benefits of
mitigation counterparty credit risk and related systemic risk that can
flow from the failure of a large trading counterparty that has
bilateral agreements with a large number of market counterparties. Of
equal importance, regulators such as the CFTC and the Federal Energy
Regulatory Commission (``FERC'') were provided with important market
and individual trading information that has allowed each agency to
better understand, monitor, and discharge their respective regulatory
obligations with respect to these vital markets. In its last State of
the Markets Report, FERC remarked ICE ``provides the clearest view we
have into bilateral spot markets.'' \1\
---------------------------------------------------------------------------
\1\ Federal Energy Regulatory Commission, 2007 State of the Markets
Report, pg. 9 (Issued, March 20, 2008).
---------------------------------------------------------------------------
Like energy derivatives, credit derivatives serve an important role
in the broader financial markets, allowing parties to shift credit
risk, such as the downgrade in a company's debt, or insure against a
default in connection with a credit instrument. A common type of credit
derivative is the credit default swap, in which the buyer agrees to
make a payment or series of payments to the seller. In return, the
seller agrees to pay the buyer should a specified credit event occur.
Presently, the credit market is very similar to the way energy markets
worked earlier this decade; most transactions are bilaterally executed
through brokerage firms. This is not a transparent or efficient way for
a market to operate. Critically, the bilateral nature of the market
leaves participants exposed to counterparty risk. In times of great
financial distress, like the present, this risk can have systemic
implications. When financial counterparties do not trust each other,
and are unable to hedge their credit risk, they then stop lending to
each other and the credit markets freeze.
The question before us today is how to bring appropriate
transparency to the credit derivatives markets, as well as how to
appropriately mitigate counterparty credit risk and resulting
counterparty default risk that can have implications in the broader
financial markets when a large market counterparty defaults on its
obligations. ICE believes that the mutual goals of transparency and
mitigation of counterparty credit risk and systemic risk can be
achieved through the introduction of clearing and appropriate reporting
obligations to regulators.
ICE's Proposed Solution
ICE has announced an agreement in principle with leading credit
market participants, Markit, Risk Metrics and The Clearing Corporation
to introduce a clearing solution to address this problem. Founded in
1925, The Clearing Corporation is an independent clearinghouse, owned
by some of the largest derivatives dealers, including many of the
largest credit derivatives brokers. The Clearing Corporation has been a
leader in devising a credit derivatives clearing solution. With its
Creditex subsidiary and its partnership with The Clearing Corporation,
ICE believes it can offer a clearing solution uniquely tailored to the
credit derivatives market.
To clear credit default swaps, ICE will form a limited purpose
bank, ICE U.S. Trust. ICE U.S. Trust will be a New York trust company
that will be a member of the Federal Reserve System, and therefore will
be subject to regulatory and supervisory requirements of the Federal
Reserve System and the New York Banking Department. ICE U.S. Trust will
meet the statutory requirements for a multilateral clearing
organization, or MCO, as a state member bank. As an MCO, ICE Trust,
pursuant to section 409 of the FDIC Improvement Act, will be allowed to
be a clearinghouse for OTC derivatives.
ICE U.S. Trust will offer its clearing services to its membership.
Membership will be open to market participants that meet the
clearinghouse's financial criteria, and third parties unable to meet
membership criteria will be able to clear through members of the
clearinghouse. ICE U.S. Trust will review each member's financial
standing, operational capabilities (including technical competence),
systems and controls, and the size, nature and sophistication of its
business in order to meet comprehensive risk management standards with
respect to the operation of the clearinghouse. In order to supplement
ICE U.S. Trust's own monitoring processes, members will have a general
obligation to immediately notify ICE U.S. Trust of any infringement of
its rules or applicable laws or of any financial or commercial
difficulty on the part of themselves or any member and, as soon as
practicable thereafter, give the ICE U.S. Trust full particulars of the
infringement or difficulty.
Members of ICE U.S. Trust will be required to report various
specific other matters to the clearinghouse including: where the member
ceases to hold sufficient capital or breaches any applicable position
limit; if the capital of such member reduces by more than 10% from that
shown on the latest financial statement filed by it with the
clearinghouse for any reason; the failure to meet any obligation to
deposit or pay any Margin when and as required by any clearinghouse of
which it is a member; failure to be in compliance with any applicable
financial requirements of any regulatory authority, exchange, clearing
organization or delivery facility; the insolvency of the member or any
controller or affiliate of that member; any default affecting it; any
breach by it of the Rules; any breach by it of any applicable law; or
any action taken against it (including a fine, censure, warning,
default proceeding, disciplinary proceeding, investigation, suspension
or expulsion).
ICE U.S. Trust will adhere to the ``Recommendations for Central
Counterparties'' (``RCC'') developed jointly by the Committee on
Payment and Settlement Systems (CPSS) and the Technical Committee of
the International Organization of Securities Commissions (IOSCO) which
set out standards for Risk Management of a central counterparty (CCP).
These recommendations are broadly recognized and have been used by
national regulators and other firms for self assessment.
Following these guidelines, ICE U.S. Trust will establish a
Guaranty Fund sufficient to meet costs associated with the cost of
closing out a an insolvent member's liabilities that exceed the
financial resources (cash and collateral) held in the account of the
insolvent member. Each member will be required to contribute to the
Guaranty Fund in an amount which is adjusted to reflect the volume of
activity and risk they hold within the clearinghouse. The value of the
Guaranty Fund will be sufficient in aggregate to meet the largest
single modeled stress-test loss of a member in excess of the margin
requirement of that member. Portfolio stress-testing will use scenarios
to cover market risks exceeding a confidence level of 99.9%.
In addition, ICE will make available its T-Zero service to
facilitate same-day trade matching. T-Zero is a credit default swap
trade processing service launched by Creditex in 2005. T-Zero is the
market standard for CDS affirmation, novation consent, routing and
straight through processing. T-Zero's ability to deliver timely and
accurate trade information across the marketplace and to multiple users
will be leveraged to effectively support ICE U.S. Trust T-Zero
currently supports every major CDS trading house at some level as well
as three interdealer brokers.
Regulation of Credit Derivative Clearing
Appropriate regulation of credit derivatives is of utmost
importance to the financial system. Presently, credit default swaps are
largely exempt from regulation by the Commodity Futures Trading
Commission and the Securities Exchange Commission. Also, as recent
events demonstrate, the credit markets are intricately tied to the
banking system, with many credit derivative market participants being
banks that are subject to regulation by the Federal Reserve.
Given the central role that the Federal Reserve has played in
addressing both the current credit crisis and issues related to credit
derivatives within the broader market, ICE proactively sought to ensure
that it's clearing model would be subject to direct regulation by the
Federal Reserve. ICE chose its model in order to ensure that its credit
derivatives markets will be transparent and fully regulated from the
inception of its business. Regulatory requirements will include minimum
capital requirements, membership requirements, margin requirements, a
satisfactory guaranty fund, and operational safeguards, all with a view
to satisfying the internationally recognized clearing standards. As a
limited purpose bank, ICE U.S. Trust will be subject to examination by
the Federal Reserve and New York Banking Department in the normal
course of operations.
Finally, ICE understands that Congress may choose to enact
additional financial market reforms in the coming Congress to broaden
the purview of regulation of credit derivatives. In the event of such
reform, and any decision to vest jurisdiction of credit derivatives
with any particular regulator, ICE U.S. Trust will stand ready to work
with all appropriate regulators to ensure that its clearing operations
are robust, that the trading of credit derivatives through its clearing
house is transparent, and that each relevant regulator has all
information that it needs to carry out its mission. ICE is willing to
work towards any oversight solution that insures that these markets are
properly regulated.
Conclusion
ICE has always been and continues to be a strong proponent of open
and competitive markets in the derivatives markets, and of appropriate
regulatory oversight of those markets. As an operator of global futures
and OTC markets, and as a publicly-held company, ICE understands the
importance of ensuring the utmost confidence in its markets. To that
end, we have continuously worked with regulatory bodies in the U.S. and
abroad in order to ensure that they have access to all relevant
information available to ICE regarding trading activity on our markets.
We have also worked closely with Congress to address the regulatory
challenges presented by derivatives markets and will continue to work
cooperatively for solutions that promote the best marketplace possible.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
The Chairman. Thank you, Mr. Short, for your testimony.
Now we will hear from Ms. Taylor. Welcome to the Committee.
STATEMENT OF KIMBERLY TAYLOR, MANAGING DIRECTOR AND PRESIDENT,
CLEARING HOUSE, CHICAGO MERCANTILE EXCHANGE INC., AND CME
GROUP, INC., CHICAGO, IL
Ms. Taylor. I am Kim Taylor, Managing Director and
President of the Clearing House of CME Group, Inc. Thank you,
Chairman Peterson and Ranking Member Goodlatte, for inviting us
to testify today.
The credit default swap market has grown because credit
derivatives permit the dispersion and realignment of credit
risks. These instruments are tremendously valuable financial
tools in the right hands and if used properly. However, the
individual and systemic risks created by the exponential growth
of such contracts has not been properly managed. In some cases,
it appears not to have been understood by the managers, who are
highly compensated for promoting these instruments.
The lack of transparent pricing, of standardized contract
terms, of multilateral netting, and of all of the other
advantages that flow from an integrated trading and central
counterparty clearing system have compounded risk and
uncertainty in this market. We need to restore confidence in
this market.
There is a solution. The transparent price discovery and
multilateral trading and clearing mechanisms that have been
proposed by CME and by Citadel Investment Group offer a
systematic method to monitor and collateralize risk on a
current basis, reducing systemic risk and enhancing certainty
and fairness for all participants.
Our solution offers regulators the information and
transparency they need to assess risks and to prevent market
abuse. Our systematic, multilateral netting and well-conceived
collateralization standards will eliminate the risk of a
systemic impact when a jump to default of a major reference
entity might otherwise create a cascade of failure and
defaults. Let me provide a few examples of the problems and of
the solutions that our proposal offers.
First, credit default swap markets are opaque. Best-price
information is not readily available, as it is on an electronic
trading facility. Efficient and accurate mark-to-market prices
are hindered by this lack of transparency. Disagreements on
pricing are common, leading to subjective and inconsistent
marks-to-market and to potentially incomplete disclosure to
investors of the unrealized losses on open positions.
Currently, CME publishes official, independent prices for
over 800,000 instruments each day. The financial market trusts
those prices because they are independently and neutrally
determined. Over $45 trillion in direct market exposure is
marked to our prices on a daily basis with an untold amount of
related over-the-counter exposure also being marked based on
those prices.
Second, risk assessment information is inadequate, and risk
management procedures are inconsistent across the market.
Precise information on gross and net exposures is not
available. The true consequences of a default by one or more
participants cannot be measured, exactly the sort of systemic
risk brought to light by the Bear Stearns and AIG crises, which
caused major disruptions in the market. As Bear Stearns and AIG
faltered, credit spreads for most dealers widened, volatility
increased and liquidity declined. Intervention became
necessary.
Transparent market information, combined with risk
management protocols enforced by a neutral third-party
clearinghouse could have mitigated this outcome. The
clearinghouse and regulators would have seen and would have
been able to manage concentration risks within a particular
portfolio and would have been able to stress-test the
consequences of a major default.
Third, the gross exposures for bilateral CDS transactions
magnify systemic risk because a failure in the payment chain
can spiral out of control.
Our proposal goes beyond the plans of dealer-owned clearing
systems which only address the needs of the interdealer market.
As we understand it, nondealers, who may account for nearly
half of current trading volumes, would not benefit directly
from trade novation under the dealer-owned model. Excluded
market participants would also reap little benefit from the
clearinghouse's guarantee of performance. Settlement risk would
be mutualized for some, but not for all trades.
Our proposal, which is open to both dealers and to their
customers from day one, offers scalable, efficient trading and
clearing mechanisms to market participants, and it brings price
transparency to the entire market. Our systems include nearly
instantaneous trade confirmation, and they also take advantage
of multilateral netting to compress the portfolios that are
open at this time. We are in the process of running portfolio
compression exercises with market participants now so they can
gauge the effect, the benefit they will gain, from this
multilateral netting.
Our long experience is a tremendous asset in the fight
against systemic risk in the CDS market. The CME clearinghouse
currently holds more than $100 billion of collateral on deposit
and routinely moves mark-to-market payments exceeding $5
billion a day between market participants. We conduct the real-
time monitoring of market positions and of aggregate risk
exposures, twice-daily financial settlement cycles and advanced
portfolio-based risk calculations. We monitor large account
positions and perform daily stress testing. Our clearinghouse
has a proven ability to scale operations to meet the demands of
new markets and of unexpected volatility.
We have the scope and scale to protect against the risks of
the CDS market with our industry-leading financial safeguards
package of over $7 billion and in our long track record of
effectively managing high-risk scenarios such as the recent
failure of Lehman Brothers. Additionally, clearing credit
default swap products under the existing structures that we use
for our primary futures markets will protect customer funds in
segregated accounts that are afforded special protection under
the Bankruptcy Code.
The CDS market requires product structures, rules and
regulatory oversight that are suited to the needs of all market
participants. That may not occur if centrally traded and
cleared credit products must be fitted within regulatory
frameworks that were developed for different markets or to meet
different policy goals.
We are currently working with the New York Federal Reserve,
with the Commodity Futures Trading Commission and with the SEC
to find a way to quickly bring our solution to market. We are
encouraged that the regulators are highly motivated to contain
the problem without delay and that cooperation among them will
eliminate the jurisdictional and regulatory uncertainties that
might otherwise delay a solution.
I thank the Committee for the opportunity to share CME
Group's views, and I look forward to your questions.
Thank you.
[The prepared statement of Ms. Taylor follows:]
Prepared Statement of Kimberly Taylor, Managing Director and President,
Clearing House, Chicago Mercantile Exchange, Inc., and CME Group, Inc.,
Chicago, IL
I am Kimberly Taylor, Managing Director and President of the
Clearing House of CME Group Inc. Thank you Chairman Peterson and
Ranking Member Goodlatte for inviting us to testify today.
CME Group was formed by the 2007 merger of Chicago Mercantile
Exchange Holdings Inc. and CBOT Holdings Inc. CME Group is now the
parent of CME Inc., The Board of Trade of the City of Chicago Inc.,
NYMEX and COMEX (the ``CME Group Exchanges''). The CME Group Exchanges
are neutral market places. They serve the global risk management needs
of our customers and producers and processors who rely on price
discovery provided by our competitive markets to make important
economic decisions. We do not profit from higher food or energy prices.
Our Congressionally mandated role is to operate fair markets that
foster price discovery and the hedging of economic risks in a
transparent, efficient, self-regulated environment, overseen by the
CFTC.
The CME Group Exchanges offer a comprehensive selection of
benchmark products in all major asset classes, including futures and
options based on interest rates, equity indexes, foreign exchange,
agricultural commodities, energy, and alternative investment products
such as weather and real estate. We also offer order routing, execution
and clearing services to other exchanges as well as clearing services
for certain contracts traded off-exchange. CME Group is traded on
NASDAQ under the symbol ``CME.''
The Credit Default Swap market has grown because credit derivatives
permit dispersion and realignment of credit risks. These instruments
are a tremendously valuable financial tool in the right hands and used
properly. However, the individual and systemic risks created by the
exponential growth of such contracts has not been properly managed--in
some cases it appears not to have been understood by the managers who
were highly compensated for promoting these instruments. The lack of
transparent pricing, standardized contract terms, multilateral netting
and all of the other advantages that flow from an integrated trading
and central counterparty clearing system have compounded risk and
uncertainty in this market.
There is a solution. The transparent price discovery and
multilateral trading and clearing mechanisms that has been proposed by
CME and Citadel Investment Group offers a systematic method to monitor
and collateralize risk on a current basis--reducing systemic risk and
enhancing certainty and fairness for all participants. Our solution
offers regulators the information and transparency they need to assess
risks and prevent market abuse. Our systematic multilateral netting and
well conceived collateralization standards will eliminate the risk of a
death spiral when a jump to default of a major reference entity might
otherwise create a cascade of failures and defaults.
Let me provide a few examples of the problems, and the solutions
that our proposal offers:
First, CDS markets are opaque: best price information is not
readily available, as it is on electronic trading facility.
Efficient and accurate mark-to-market practices are hindered by
the lack of transparency. Disagreements are common, leading to
subjective and inconsistent marks and potentially incomplete
disclosure to investors of unrealized losses on open positions.
For example, earlier this year, Toronto Dominion Bank announced
a $94 million loss related to credit derivatives that had been
incorrectly priced by a senior trader. In an exchange model,
with transparent pricing and broad market data distribution,
such errors are much less likely to occur.
Second, risk assessment information is inadequate, and risk
management procedures are inconsistent across the market.
Precise information on gross and net exposures is not
available. The true consequences of a default by one or more
participants cannot be measured--exactly the sort of systemic
risk brought to light by the Bear Stearns and AIG crises, which
caused major disruptions in the market. As Bear Stearns and AIG
faltered, credit spreads for most dealers widened, volatility
increased and liquidity declined. Intervention became
necessary.
Transparent market information combined with risk management
protocols enforced by a neutral clearinghouse could have
mitigated this outcome. Risk managers would have had accurate
and timely information on their firms' positions, exposures and
collateral requirements. Collateral to cover future risks would
have been in place or positions would have been reduced. The
clearinghouse and regulators would have seen and been able to
manage concentration risks within a particular portfolio, and
stress-test the consequences of a major default.
Third, gross exposures for bilateral CDS transactions
magnify systemic risk because a failure in the payment chain
can spiral out of control.
Our proposal goes beyond the plans of dealer owned clearing
systems, which only address the needs of the inter-dealer
market. As we understand it, non-dealers, who may account for
nearly half of current trading volumes, would not directly
benefit from trade novation under the dealer-owned model.
Excluded participants also would reap little benefit from the
clearinghouse's guarantee of performance. Settlement risk would
be mutualized for some, but not all, trades.
Our proposal, which is open to both dealers and their customers,
offers scalable, efficient trading and clearing mechanisms to market
participants and brings price transparency to the entire market. Our
systems include nearly instantaneous trade confirmation.
Our long experience is a tremendous asset in the fight against
systemic risk in the CDS market. The CME Clearinghouse currently holds
more than $100 billion of collateral on deposit and routinely moves
more than $5 billion per day among market participants. We conduct
real-time monitoring of market positions and aggregate risk exposures,
twice-daily financial settlement cycles, advanced portfolio-based risk
calculations, monitor large account positions and perform daily stress
testing. Our clearinghouse has a proven ability to scale operations to
meet the demands of new markets and unexpected volatility. We have the
scope and scale to protect against the risks of the CDS market, with
our industry-leading financial safeguards package of over $7 billion
and our long track record of effectively managing high-risk scenarios,
such as the recent failure of Lehman Brothers. Additionally, clearing
CDS products under the existing structures that we use for our primary
futures markets will protect customer funds in segregated accounts that
are afforded special protection under the Bankruptcy Code.
The CDS market requires product structures, rules and regulatory
oversight that are suited to the needs of all participants. That may
not occur if centrally traded and cleared credit products must be
fitted within regulatory frameworks that were developed for different
markets or to meet different policy goals. We are working with the New
York Federal Reserve, the CFTC and the SEC to find a way quickly to
bring our solution to market. We are encouraged that the regulators are
highly motivated to contain the problem without delay and that
cooperation among them will eliminate the jurisdictional and regulatory
uncertainties that might otherwise delay a solution.
I thank the Committee for the opportunity to share CME Group's
views, and I look forward to your questions.
The Chairman. Thank you, Ms. Taylor.
Thank you, all members of the panel, for your testimony.
Ms. Taylor, the CFTC testified earlier that apparently a
designated clearing organization could start clearing credit
default swaps without prior approval from the CFTC.
Do you need any approval from the SEC or from the Federal
Reserve to begin to operate a clearinghouse for these
instruments?
Ms. Taylor. We are working with the SEC toward an exemption
from certain provisions of the Securities Acts that govern
securities, because the SEC is likely to view these as options
on securities; but they are working very effectively with us,
and I believe all other solutions that are trying to come to
market have the same issue with the SEC in needing an
exemption.
The Chairman. So that is going to happen shortly? I keep
hearing that something is going to happen by the end of the
month and that, if that happens, you can get started shortly
after that; is that all accurate?
Ms. Taylor. Yes. Subject to the appropriate regulatory
exemptions and from an operational point-of-view, we would be
ready to start by early November. It is unlikely that a
critical mass of market participants would be ready to start in
that time frame, and so we figure it would be more like January
before the facility would be fully up and running.
The Chairman. Now, you are talking about doing this under
the CFTC, and this competing deal is going to be under the
Federal Reserve. Do you think the regulation under the Fed will
be stricter or looser, or do you know? To your knowledge, has
the Fed ever exercised regulatory jurisdiction over a bank that
provides this type of clearing service?
Ms. Taylor. I do not believe that the Federal Reserve
currently is the official supervisor of any central
counterparty clearing entity. I would suggest that the
regulatory oversight that would be placed on a clearinghouse
for credit default swaps would probably be able to be effective
under different regulatory regimes.
The Chairman. So do you think it would be the same?
Ms. Taylor. I don't know that it would be the same, but I
think it would be able to be comparably effective.
The Chairman. Mr. Short, your company has three
clearinghouses that are currently under CFTC regulation. Yet,
apparently you are now proposing to set up this new deal under
the Federal Reserve. I guess you are going to become a bank or
a bank holding company or something?
Mr. Short. Correct, a limited purpose trust.
The Chairman. Is this because of their deep pockets, so if
you screw this up, they are going to bail you out like
everybody else?
Mr. Short. No, absolutely not.
To be clear, we chose to establish ICE U.S. Trust as a
limited purpose trust company and as a member of the Federal
Reserve because we viewed the Fed as one of the thought leaders
in this area. I can assure you it will be a fully regulated
solution. It will have all of the appropriate risk management
controls.
The Chairman. Well, with all due respect, these risk
management controls have not done a very good job in our
current situation. You know, I am one of those who does not
have a lot of confidence in what is going on; and I had more
confidence in the CFTC because I maybe understand it better and
so forth. But it just mystifies me why you would shift off in
this other direction. My skeptical nature leads me to believe
that something is going on here that is not apparent, so I just
do not have a lot of confidence in the fact that they have
these regulations and so forth.
Mr. Short. We would love to give you that confidence. As I
said, the reason we chose the Fed was in part because of the
jurisdictional hook that they have directly into the banks.
One of the prior panelists mentioned that one of the ways
you can incent somebody to clear through a clearinghouse would
be to make capital requirements more difficult for banks if
they were trading off-exchange. I think the Fed would likely
have that direct regulatory hook into many of the largest
market participants.
The Chairman. Well, they have never done this. Why would we
get them involved in something that they do not know anything
about? We have enough problems here without trying to teach
somebody something they do not know or do not have any
experience with.
Mr. Short. I think, unfortunately, we are in a situation
where the Fed is doing a lot of things that it has never done
before.
The Chairman. I understand that.
Mr. Short. Certainly not to dismiss the question, I think
the issue that ICE tried to address was bringing a clearing and
transparency solution to the market as it exists today to
mitigate the risk. In other words, to put out the fire with a
view that the new Congress will probably undertake systematic
financial market regulatory reform. As to whichever regulatory
bucket we end up in, we are more than happy to comply with what
Congress wishes in that regard. We just need to get a solution
to market quickly.
The Chairman. Well, if the Committee will indulge me for a
minute here, as I understand it, the CDSs that are held by the
banks are something like $16 trillion out of the $55 trillion,
$58 trillion, whatever it is. So are you saying that what you
are going to be doing is clearing these CDSs that are in the
banks, or is that what this is intended to do?
Mr. Short. It would be a solution for all market
participants, for all CDSs, not just for banks.
The Chairman. But they would have to be broker-dealers,
right?
Mr. Short. No.
The Chairman. I thought they had to be part of whatever
your group is.
Mr. Short. You would have members of the clearinghouse much
like there are members of the CME clearinghouse. To the extent
that a party was not a member of that clearinghouse, they could
trade through a member of the clearinghouse, so it would
address all market participants, and that is one of the
cornerstones of the Fed's regulatory requirements, that it not
just be a solution that is directed towards banks.
The Chairman. All right. Well, I have more questions.
The gentleman from Virginia, Mr. Goodlatte.
Mr. Goodlatte. Thank you, Mr. Chairman.
Mr. Pickel, what are your views on the clearing of credit
default swaps? Two models have been presented here today--one
using a derivative clearing organization under CFTC
jurisdiction, the other a clearing mechanism under the
jurisdiction of the Federal Reserve.
What are the pros and cons of each?
Mr. Pickel. Thank you for that question.
As far as ISDA, we have not specifically engaged in the
development of these clearing initiatives. We certainly are
well aware of them. They are being led by our members,
including ICE and CME, who are members of our organization.
What we have focused on is the need to continue to develop
the standardized documentation that supports the trading that
will be the basis for the trades that go into these
clearinghouses. In fact, the clearinghouses, I think, are
looking to rely upon our standardized documents, which are
definitions that we have published, as well as most likely the
settlement mechanism that we have developed and worked with
within Creditex and Markit, another company in the CDS base.
So we are following these developments closely. We want to
be supportive. I think the suggestion earlier on the first
panel is that several different approaches might be the right
way. That certainly makes sense to us, and it is also important
for us to make sure that the OTC product is robust.
Mr. Goodlatte. Well, let me ask you about that.
If you don't want to pick a winner here, would two
regulators for the same instrument solve the problem we have
been tasked with solving? Or does it create a fight for all of
the ICE supporters in Congress who line up to support Federal
Reserve regulation, and for all of the CME supporters who line
up to support the CFTC regulation, and where we end up with
gridlock while the market sorts it out?
What should we do? Should we pick one or should we let them
compete under two different regulatory schemes?
Mr. Pickel. I think the best approach is the focus on the
fundamental principles for any clearing mechanism, and Acting
Chairman Lukken referred to the 14 principles that they put in
place for DCOs following the CFMA.
I know that the Federal Reserve Bank of New York has also
been very clear that principles that have been developed at the
international level for clearing organizations should be
followed very closely. I think those international principles
are very consistent with the principles that apply for CFTC
DCOs.
So I think that it is important to focus on those
principles and make sure that whichever solution is developed
is consistent with those principles, like the guaranty funds
and the adequate collateral and those types of principles.
Mr. Goodlatte. Well, I hear you, but I am concerned that we
may set up a situation that opens up the process to regulatory
and political arbitrage. One that creates and propagates
uncertainty instead of ameliorating it if we do not come up
with one standard and one regulatory entity to oversee the
clearing of credit default swaps.
Mr. Pickel. It certainly cannot be ruled out. I think you
are making a very accurate observation.
I guess my reaction would be that we have an opportunity to
see how these two systems work. Keep in mind that there are
also two other organizations that are meeting with the New York
Fed to discuss clearing arrangements, so there are other
alternatives out there that are being discussed.
Mr. Goodlatte. All right. Well, let me ask Mr. Short.
You have elected to create an entity under the Federal
Reserve jurisdiction and to clear credit default swaps. Can you
give me the pros and cons of Federal Reserve jurisdiction and
why you elected not to follow the Chicago Mercantile Exchange
model where they elected to clear them under the CFTC
jurisdiction?
Mr. Short. Sure. Let me just take a step back and
reemphasize that what we are doing is establishing a special
purpose clearinghouse solely dedicated to clearing credit
default risk.
I think one of the broader questions that the Committee
might be interested in is whether these risks should be
intermingled with the risks of other futures customers in
another clearinghouse. I think Ms. Taylor will obviously have
views on that; but we thought, given the highly controversial
nature of these instruments, that it might not be the best idea
to have other risks combined with those risks.
The Federal Reserve Bank of New York, in our experience,
has been a thought leader in this area, and the law did provide
for establishing a clearing organization subject to its
jurisdiction. That was the sole reason we chose it, because we
thought it would be the most relevant regulator and, I guess,
also for the reason that it has a direct regulatory touch into
not all of it, but into a significant number of market
participants, which I think from a transparency perspective is
optimal.
Mr. Goodlatte. Well, thank you.
Let me ask Ms. Taylor if she can give me the pros and cons
of CFTC jurisdiction and why CME elected not to follow the ICE
model.
I would like you to respond to this question about its
being obvious that competitive forces are working to accomplish
what many have suggested for the credit derivatives market--
central clearing that creates transparency, that provides
protection against counterparty default and that minimizes
systemic risk.
In your opinion, why does CFTC accomplish those goals
better?
Ms. Taylor. Thank you. Some of the reasons that we chose
the CFTC regulatory regime included the fact that the
regulatory regime for derivatives clearing organizations is
already well developed and already has proven effective over a
range of circumstances over a long period of time. So, another
regulator could establish a comparable regime, but it is not
established yet. So we wanted to take advantage of the
groundwork that had already been laid with the effective CFTC
mechanism. We already are working with the CFTC to obtain
authority to allow the credit default swap funds and positions
to gain the protection of customer segregation of funds. That
is very important to users to the centrally cleared futures
markets.
In the Lehman example, most recently, I think that we have
found that futures customers were able to maintain their access
to the market, maintain their hedge or their market exposure,
and be able to transfer their positions and their funds,
supporting those positions fairly promptly to another clearing
member and not be at risk of loss of funds or access to the
market. That has not been the case with customers who faced the
nonregulated parts of Lehman.
So the futures regime's customer protection mechanism is
also very important. One of the other aspects that we have
found important--and we did look at the pros and cons of this
ourselves--is whether it was appropriate to include the credit
default swap products within the existing financial safeguards
package that protects all of the products that we clear.
And what we decided was that every time we have added more
product to that base, every time we have diversified the
products that we clear, we have been able to do so with
potentially some increase to the financial safeguards package,
but with an overall capital efficiency to the marketplace
compared to what the capital would be required if the two pools
of business were completely separate. And in these capital-
constrained times, we thought it would be very effective for
the dealers who are already large contributors to the financial
safeguards package to not have to duplicate the contribution in
order to be able to participate in the benefits of central
clearing of the credit default swaps.
The other side of that argument is, are we exposing the
other products within the financial safeguards package to some
newer undue risk by including the credit default swap products
in the same package? And our goal in making the decision to add
the credit default swap products to the existing financial
safeguards pool was to be able to equalize the risk profile via
other means. And the primary means that we are using to
equalize or make comparable--it won't be exactly equal but it
will be comparable, the risk profile that is posed to the
guaranty fund by the credit default swap products. We have a
very different way of calculating the risk associated with the
open position. So a very different margining regime that
margins these products to a higher standard and with a broader
kind of coverage period than the way we margin the futures
products, also subjects the products to very different stress-
testing related to the market conditions and the distinct risk
characteristics of the products. So by having increased
margining, that is a very large protection and it improves our
ability to make the risk comparable.
Mr. Goodlatte. Thank you. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
North Carolina, Mr. Etheridge.
Mr. Etheridge. Thank you, Mr. Chairman. Mr. Pickel,
Chairman Cox has called--the SEC has called for greater
regulation of the credit default swaps. And from your
testimony, it appears that ISDA doesn't really see a lot of
great need for greater regulatory oversight of these or other
financial derivatives. I would be interested in your comment on
his statement. And what do you think about greater regulation
of these instruments other than just transparency? Because in
your 60 Minutes interview, you stated that we need to design a
structure in the future that works more effectively. What kind
of structure were you talking about?
Mr. Pickel. Well, for instance, the legislation that was
passed for the rescue bill a couple of weeks ago called on the
Secretary of the Treasury to develop a report on a redesign of
the regulatory structure, including specifically focusing on
clearing and settlement of OTC derivatives. It is in that
context that we need to look at that and whether that is based
on the proposals earlier this year from Secretary Paulson or
perhaps something completely different. We are looking to be
engaged in that debate and we understand that in that
discussion there will clearly be a focus on derivatives. I
believe that the decisions that this Congress made or the
Congress in 2000 made given the existing regulatory landscape
of the securities world and the futures world remains the
correct decision.
Mr. Etheridge. You mean, the one where we don't do any
regulation?
Mr. Pickel. Under the existing structure of a securities
and futures world, yes, I believe----
Mr. Etheridge. So you would leave it up to the industry to
make the decision?
Mr. Pickel. Well, I think you have to also----
Mr. Etheridge. Look where it has gotten us.
Mr. Pickel. You have institutional regulation where banks
and, previously the SEC with their regulated entities, have
oversight and are able to understand the positions that their
firms--that their regulated entities are taking on. And that
supervisory role is very important for parties--for the
regulators to engage in. I think, as I say, if we are looking
at a new structure, a new regulatory structure, then we need to
look at a more comprehensive one.
Mr. Etheridge. Let me make sure I understand you. What we
are saying is, we should not be doing any regulatory scheme,
that the $700 billion we just pumped in, if it isn't enough, we
should put some more in with no regulatory schemes? Is that
what you are saying?
Mr. Pickel. No. On the contrary, I am saying that the
decision in--that is reflected in the bill to direct the
Secretary to report to Congress for a new regulatory regime is
a very important step forward and the Congress should be----
Mr. Etheridge. You are saying Congress is out to just sit
around, wait around until the Secretary comes back and tells us
what we ought to do?
Mr. Pickel. Well, I think that that is what the legislation
from Congress instructed the Secretary to do. So I think that
that is the----
Mr. Etheridge. With all due respect, sir, I happen to
disagree. Last time I checked, I put my name on the ballot, the
Secretary is appointed. Thank you.
Professor Hu, let me ask you a question. You mentioned in
your testimony the SEC and the accounting disclosure
requirements have not fully kept up with the derivatives
revolution. What specific changes are needed in this area given
that they have really outpaced the regulatory schemes of--that
is what you are talking about. And you may be aware that in the
context of Congressional consideration, as has just been talked
about here, of the financial rescue package that had
considerable debate about the appropriateness of current
standards for mark-to-market accounting of financial
derivatives. Are you familiar with this discussion? And do you
have any comments regarding the appropriateness of the current
standards of what we ought to be looking at?
Mr. Hu. Woody Allen once said, ``I took a speed reading
course. Read War and Peace in 20 minutes. It involves Russia.''
In the 2 minutes I have, I can only touch very, very lightly on
some of these issues. In terms of the kinds of disclosures, I
am concerned about the move against mark-to-market. Yes, it
causes some instability in terms of--to the extent that people
put credence on those numbers. But the mark-to-market is an
effort to provide information beyond historical information.
And so, I would think that the general idea of hiding, in a
sense, mark-to-market novation, or hiding attempts at valuation
generally is not a good thing, that it is counter to the kinds
of disclosures that we want.
Similarly, for instance, one of the issues has been this
move towards internationally accepted accounting standards. As
a general idea, it does make sense to move to internationally
recognized standards. But there are material differences. So
that for instance, under our current U.S. rules, we have a
categorization of level one versus level two versus level three
assets. The level three being the most difficult to value
portion. I think that that kind of--and that is not required
under international standards. I think that that kind of
information is very useful, in general, in terms of sunlight
disclosure. I am concerned about this kind of--some of these
calls in terms of getting rid of mark-to-market or in terms of
racing towards internationally accepted standards without
recognizing the differences.
In terms of SEC--in terms of some SEC disclosures, getting
back to the AIG situation, I guess, if you really read very
carefully the AIG disclosures, there are 10-Ks and things like
that. You can find some statements in terms of problems at AIG
Financial Products. But certainly they don't jump out at you.
And I am wondering whether, for instance, as you know, after
Enron, the SEC took many steps to increase disclosure
requirements as to off balance sheet liabilities and other
things that kind of relate to derivatives. I am wondering
whether, in effect, we have to--we ought to re-examine these
SEC disclosures requirements in light of AIG and some of these
other companies. So that is the 2 minute version.
Mr. Etheridge. Thank you. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. Mr. Pickel, that we
have directed the Secretary to give us a report, making
recommendations concerning whether additional regulation is
appropriate doesn't mean that we are sort of abdicating our
traditional role of trying to figure that out for ourselves.
Ms. Taylor, in your testimony, I was a little confused about
whether you were talking about transparency to the clearing
house and the regulators or some greater transparency, some--
your system would serve some function that exchanges serve
where price discovery is concerned. So you would be publishing
information about OTC transactions that are cleared on your
clearing--on whatever your platform is?
Ms. Taylor. That is correct. We would be publishing--from
the clearing house point-of-view, we would be publishing
primarily the official marking prices that we used which would
be able to be used for market participants to base other marks
off of. From the trading systems, we would also be publishing
real-time trade data and the prices associated with that.
Mr. Marshall. How would you go about telling people what
you were describing? Many of these transactions are very
specific custom transactions.
Ms. Taylor. The transactions that will be listed for
trading on the trading platform will be in fairly standardized
contracts.
Mr. Marshall. Okay. Let me go to you, Professor Hu. I
enjoyed your preliminary thoughts here on the subject. I would
love to hear more thoughts. If you don't mind, I might even
call you up after just so the two of us can talk.
Mr. Hu. Absolutely.
Mr. Marshall. There has been a lot of concern lately that
some of the problems have been caused, at least some of the
downside has been ushered in by naked short selling and a lot
of criticism of that, temporary suspension of that. We have in
the insurance area, typically, prohibitions on taking insurance
on somebody else's life unless you have a direct interest in
that person's life. And we are very careful to try to make sure
that there not be moral hazard that encourages people to cause
the death of another or the failure of another, the accident of
another, that sort of thing. In your preliminary thoughts here,
you made reference to the availability of CDSs to individuals
who were merely skeptical about the performance on the
underlying instrument or entity or what have you. Have you
wondered whether or not there isn't some unacceptable moral
hazard presented by merely the availability of CDSs or other
derivatives to individuals who are just betting that there is
going to be a collapse?
Mr. Hu. I think there is actual real value to being able to
speculate. That is that I think that short sellers who, in a
sense, bet on the fate of----
Mr. Marshall. If I could interrupt. I am talking about OTC.
I am not talking about price discovery being served by people
on both sides of the transaction.
Mr. Hu. Oh. But it is so hard to separate, in a sense, the
ability to sell short and the role of short sellers from people
buying credit default swaps. So that, in a sense, they are
substitutes for each other now. So that for instance, if you
ban short selling, well you can go into the credit default
swaps market. So, in terms of the role of short sellers and in
terms of credit default--people who buy credit default swaps,
to some extent they do play a social role, a valuable social
role. Now that said, to the extent for instance that they
spread false rumors and things like that, of course the SEC
should go after----
Mr. Marshall. Would it be helpful to all of us if we
required that short selling and--whether it is buying an
insurance policy or what have you, and we have concluded that
this is useful. That it needs to be public, that it needs to be
totally transparent; this just can't be done secretly.
Mr. Hu. Indeed. One of the articles--one of the underlying
articles cited in the written testimony, the article calls for
much greater disclosure of these kinds of issues, precisely for
these kind of issues.
Mr. Marshall. Mr. Short--and Ms. Taylor, I am sorry. I only
have 5 minutes here. We are all concerned that this could just
be lip gloss, that, in fact, a great deal of additional
protection wouldn't be provided. I understand how clearing does
enhance the likelihood that the counterparties are
appropriately collateralized, that they have the appropriate
reserves, that mark-to-market would have good effects in that
regard. But suppose you did business with AIG. The two of you
are competing. One of you won the business. In part, you got
the business with the AIG Financial Products because you
weren't really requiring a whole lot. It was good for you
financially. Then AIG collapses, what happens then? Who steps
up and makes good on those products that AIG has been trading,
clearing in your operations so that the parties are essentially
made whole?
Mr. Short. It is the clearinghouse through comprehensive
margining and risk management controls.
Mr. Marshall. With regard to your counterparts in this
transaction. But I am saying that failed. And all of a sudden
there is this massive failure. So the clearing house itself has
to step up. Ms. Taylor, if I understood you correctly, you have
about $6 billion that is available to cover----
Ms. Taylor. A little over $7 billion.
Mr. Marshall. A little over $7 billion. And if it is a $100
billion problem, we are just out of luck, right? There is $7
billion to cover part of it. We have an $85 billion problem.
Ms. Taylor. Actually I take your point. But I think that
the size of our fund is governed by the size of the exposure
that we anticipate having to face in a worst case. So the other
piece of this that everybody needs to think about with adding a
clearing house, the open notional exposure that exists in the
over-the-counter CDS markets right now is very exaggerated
based on the fact that there is no multilateral netting. So we
would actually expect probably a ten fold decrease in the size
of the open notional exposure and therefore the size of any
potential issues.
Mr. Marshall. Are you effectively saying that the open
notional exposure is probably about ten times less than the
$60-some-odd trillion figure?
Ms. Taylor. We would expect a very significant benefit
from--on a real risk basis that would be true. It would come
down significantly, probably at the 80 to 90 percent level.
Mr. Marshall. My time is up. Thank you.
The Chairman. I thank the gentleman. The gentleman from
Ohio, Mr. Space.
Mr. Space. Thank you, Mr. Chairman. Professor Hu, in Mr.
Pickel's testimony, he concludes, in reference to the current
market conditions, that credit default swaps were the cause, or
were even a large contributor to that turmoil, is inaccurate.
Given your testimony and regarding the interconnectedness of
credit default swaps, do you agree with that statement?
Mr. Hu. I think that it is always difficult to separate
causation from correlation. But in terms of, for instance, the
AIG situation, it is their activities relating to the credit
default swaps and perhaps mistakes they made in pricing those
credit default swaps that led to one of the largest bailouts in
history; and a continuing bailout, it seems, in terms of
additional moneys. And so I think that in terms of in some--it
is unfair to make--to exaggerate the role of credit default
swaps. But in terms of the AIG situation, I think that it is
hard to disentangle credit derivatives from the failure of the
entity itself. And very quickly, in terms of Congressman
Marshall's comment about moral hazard, it is interesting,
ironic that the moral hazard is especially great when it is not
naked in the sense of credit default swaps but when the person
actually has a loan agreement, a credit agreement because he
has the control rights plus bad incentives. So it is kind of an
ironic twist to this whole kind of debt decoupling issue.
Mr. Space. Right. Mr. Pickel, I will give you a chance to
respond. I think everyone understands that credit default swaps
were not the only reason for the turmoil we are in. Certainly
ill-advised lending practices is at the very root of it. But I
find it somewhat disturbing that you minimize the role that
credit default swaps have played in this contagion which has
infested the market. I find equally disserving your statement
that your association is not engaged in clearing initiatives as
if to suggest that they are not important or that regulation is
not called for. Can you offer your response to Mr. Hu's or
Professor Hu's assessment of the AIG situation and the role
that CDS has played in that failure?
Mr. Pickel. Well, there is no--obviously there was
significant seller of protection, roughly about $440 billion
notional, according to their financial statements. What they
were doing via those contracts was taking on exposure to
mortgage obligations, principally super senior tranches of
collateralized debt obligations that had been written
ultimately on mortgages that were extended by banks. So those
mortgages were put into mortgage-backed securities. These
collateralized debt obligations were created. And at that point
in time the holders of those obligations decided that it would
be prudent to purchase some protection which they purchased
from AIG. AIG was willing to take on that risk to those
underlying mortgage exposure.
A couple of other factors clearly played into the situation
there. Professor Hu mentioned the mark-to-market situation.
Keep in mind that in the AIG situation, they have had mark-to-
market losses, so losses on the books. But those actual
tranches that they have written protection on were highly rated
and have declined in value. But there has not been an actual
default on those as far as I am aware.
The other thing was, as I mentioned in my oral testimony,
they had agreed to only provide collateral in the event of a
downgrade in rating. And when they had the mark-to-market
losses, the rating agencies downgraded them, that led them to
having to post collateral, led to a liquidity problem. We
feel--and this is very much the clearing model--that it is far
more effective to be utilizing collateral regularly in your
trading relationship, partly because of the credit protection
that provides, but also it provides discipline in that
relationship.
So I think those are some of the things that we would focus
on in terms of lessons learned from AIG. As far as our
involvement with clearing initiatives, again, our association
focuses on the infrastructure that exists for the OTC
derivatives business. We are certainly supportive of the
clearing initiatives, but there is enough effort and work being
put into those initiatives that we are not in a position to
endorse those specifically.
Mr. Space. Thank you. My time has expired.
The Chairman. I thank the gentleman. The gentleman from
Minnesota, Mr. Walz.
Mr. Walz. Well, thank you, Mr. Chairman. And I would like
to take just a few minutes to look at this. I think it is an
intriguing point being brought up by Professor Hu on this
interconnectedness. Because it still comes back to the issue--
and I am not going to leave this analogy alone--open the
window. I am going to let the voices of the country come back
in on this interconnectedness. As we talk here, it cannot be
removed from their reality. Because in that case, no matter
what happens, their perceived reality is reality. Professor Hu,
could you restate that little tidbit of wisdom from the AIG
manager, the CDS back in 2007? I want to hear exactly what that
person said.
Mr. Hu. Okay. And he said--let's see here. ``It is hard for
us, without being flippant, to even see a scenario within any
kind of realm of reason that would see us losing $1''--well, he
was correct in that. He didn't lose just $1--``in any of
those,'' referring to credit fault transactions.
Mr. Walz. And what was his compensation?
Mr. Hu. Over the 8 years, the last 8 years, $280 million in
compensation. And on his leaving, apparently he got a
consulting contract of $1 million a month.
Mr. Walz. Is he still receiving that?
Mr. Hu. No. I think it ended shortly before the House
Oversight hearing.
Mr. Walz. At this point, it would be hard for me to not be
flippant. So what is at stake here and the issue I come to
again is its trusting confidence. And Mr. Pickel, I am going to
stay away from it because quite honestly, I am having a hard
time understanding the position you are coming from. I am
listening to this. But this resistance to coming forward on
this just seems so out-of-sync. The image in my mind is the
band continuing to play on the Titanic. It is hard for me to
shake that because this issue and the destruction that it has
brought to the confidence in the American economy is so great,
and I will be the first one. And this is what I want to
explore, the interconnectedness issue. Because lord knows,
there are others that are fiddling with you on this one. The
point that I think is interesting, and we have to be, I think,
very aware of.
Professor Hu, you brought this up and just re-stressed it.
The issue of bond ownership and credit default swaps can have
that perverse situation where the creditor is going to benefit
from the failure. How do we avoid that?
Mr. Hu. I think as a first step disclosure--and let me
illustrate in terms of this issue, and that is that this issue
not only comes up--may come up outside of bankruptcy, but in
bankruptcy proceedings. That is, normally in bankruptcy
proceedings, the bankruptcy judge basically allocates voting
power in terms of reorganization plans based on how much they
have lent to the company. But if that person, that person who
has lent the money in a sense has reduced its economic exposure
because of credit default swaps or other means, you end up with
a person who may have very low true economic exposure to a
debtor having a humongous number of votes.
So there is a mis-allocation, if you will, of votes in
terms of reorganization. So that just as you might want to give
more votes to shareholders in corporations when they have more
shares, they have more of an incentive to see the company do
well; that kind of presumption that is in bankruptcy
proceedings, that if you have lent more, then you have more of
an incentive to see a successful reorganization might not hold.
Bankruptcy judges, right, as they get--hopefully as they get
more sophisticated about these issues, and we insist on
disclosure, right, could in a sense make the right allocations
in terms of voting power. But that is just a first step.
Mr. Walz. Well it has been brought up several times, this
issue of moral hazard; those of us who want to believe the
market is working. I am still having a hard time seeing where
that manager had a moral hazard in this; with having such a
clearly--either incompetent, inept, or blinded--view of what
was happening in his area of expertise and yet the payoff
appears to have been tremendous. And anything that we do, I am
just curious what the framework is going to look like.
Mr. Hu. Well, for instance, this relates to the disclosure
point as well. And you can tell, one of the reasons I have
focused on disclosure is that disclosure is the most kind of
incremental step one can take in terms of regulation; that is,
as opposed to substantive regulation. And in terms of
disclosure--and at fairly low cost--so that if you had a better
sense in terms of how exactly various--key rocket scientists--
key people within AIG Financial Products, what the incentive
structure would look like, that is that you would see very
conspicuously, hey you could make a fortune if X, that that may
in a sense cause capital markets to look more closely or in
terms of the payoff structure for the CEO. To what extent do
the results of AIG Financial Products figure in to the overall
compensation; those kinds of measures.
Mr. Walz. Well, I thank you. I yield back. Thank you, Mr.
Chairman.
The Chairman. I thank the gentleman. The gentleman from
North Dakota, Mr. Pomeroy.
Mr. Pomeroy. Thank you, Mr. Chairman. I want to follow up
with Professor Hu. I find your testimony very interesting. And
it raises questions in my own mind about whether or not a
clearing house is going to adequately deal with this. Needless
to say, I have had my confidence in sophisticated market
participants severely shaken by the times we are in. It made
sense to me at an earlier point that--well, these folks know
what they are doing. And yet clearly they didn't. I note you
quoting AIG's form 10-K, the threshold amount of credit--on
page 5 of your testimony. Threshold amount of credit losses
must be realized before AIG Financial Products has any payment
obligation, is negotiated by AIGFP for each transaction, to
provide a likelihood of any payment obligation by AIGFP under
each transaction is remote even in severe recessionary market
scenarios. I mean, they could not have been more mistaken. I
would vote right now for a law that makes people put on their
fancy Mercedes ``I wrecked the economy'' bumper stickers, for
all those responsible in this kind of gross misjudgment. And
the anger as referenced earlier by my friend, Mr. Walz, is
absolutely palpable.
You indicate that--and apparently you have written an
article about cognitive biases undermining derivative models,
the tendency to ignore low probability catastrophic events.
Now, if I understand how that relates to this situation,
you had product pricing based not on any underwriting of
transactions, but based on basically a formula applied to a
tranche of transactions whose character was evaluated by a
rating agency.
Mr. Hu. Indeed. In that 1993 piece, 5 years before long-
term capital, when genius failed, I was basically pointing out
in terms of like--in terms of the--this particular cognitive
bias, you actually saw that in terms of what some people
considered good principles of financial modelling when it came
to derivatives. So that I cited--I quoted one person as saying
that in designing a financial model, you ought to ignore
marginally relevant states of the world. Sure sounds like a
first cousin to that comment from the 10-K report that I cited,
that you just referred to. So the issue is that when you
design--when rocket scientists design these models, they
basically--it basically works most of the time.
So the analogy that I have used is, it is like a safety
belt that works except in serious crashes. So that precisely
when you want the model to work best, it is most likely to
fail. So for instance, assumptions like the usual financial
model in terms of--assume continuous liquidity, for instance.
Well, we all know, markets seize up. The pricing doesn't work.
The hedging strategies you have used don't work. So that there
is a--when people think in terms of rocket scientists, because
all of the Greek letters that they are constantly referring to,
the Ph.D.s in astrophysics and that sort of stuff, in fact, you
have to kind of take those models with some skepticism in terms
of----
Mr. Pomeroy. Warren Buffett apparently has been quoted as
saying, ``Beware of mathematicians bearing formulas.''
Mr. Hu. Beware of geeks bearing gifts.
Mr. Pomeroy. Tom Friedman in today's column writes, the
Y.B.G. and I.B.G. lending. ``You will be gone, and I will be
gone,'' the parties doing the transaction. They still get their
bonuses. They are far from the scene. They have no ultimate
stake in the consequences. Is this what we have seen in this
marketplace?
Mr. Hu. This is one of the concerns I talked about in that
1993 piece. That is, that the rocket scientist may be three
banks away by the time the risks show up. That often with these
products, the profits--``profits are immediately obvious.'' But
the risks lurk and may pop up later on and often in high
magnitude. And the trick is--the problem is, it is a real
difficult problem of incentive structure. You do want----
Mr. Pomeroy. Professor, I get that. But it seems to me, any
system response that doesn't ultimately look at the solvency of
the risk-acquiring party on a risk-reserving basis or look at
the credibility of the credit-triggering party, a third party
like a rating agency. You know if you don't get your hands
around those, you basically have simply a kind of a collective
operation of a system, but it can go off-track without
anticipating a catastrophic meltdown.
Mr. Hu. That is a very good point. In terms of that risk
reserving idea that you have talked about, one of the things I
have looked at a couple of weeks ago in connection with AIG's
10-K and proxy and so forth. I was looking at what they said
about, in the sense, how they designed their incentive
structure. And basically, they made the right noises, that is,
looking at the long-term performance and that sort of thing,
balancing short-term risk with long term and so forth. But it
clearly is a very difficult issue in terms of institutional
design for any corporation, not just AIG. I think that what
that leads to, because it is so difficult, is that we may need
in a sense, for instance, higher capital adequacy requirements.
We may need to be a little bit worried about relying too much
on the internal models that these financial institutions use in
terms of capital adequacy. So that I think that in terms of--so
that one of their possible responses is to perhaps rethink a
little bit some of the capital adequacy rules that we are
moving to.
Mr. Pomeroy. May I ask one more question? I see my time is
just about up. This is of Ms. Taylor. Can a clearing house deal
with the valuation of solvency of the risk-acquiring party? Is
that an essential part of a clearing house function or not?
Ms. Taylor. I am sorry. I didn't quite follow the question.
Mr. Pomeroy. Okay. The clearing house requires
transparency, the scoring of trades.
Ms. Taylor. Yes.
Mr. Pomeroy. Is there an evaluation of whether or not the
ultimate risk-acquiring party is solvent for the cumulative
risks they are acquiring?
Ms. Taylor. Yes. We have a number of ways of gauging the--
the clearing house would do that in a very real and very real-
time sense for the members of the clearing house. We do it on a
once-removed basis for the customers of clearing members. But
we monitor the financial health of the clearing members and the
exposure that they pose versus their capital resources and
versus stress testing the----
Mr. Pomeroy. You are able to do that because of the
standardized nature of the contracts traded?
Ms. Taylor. We are helped by the standardized nature of the
contracts traded. We are helped by the mark-to-market. We are
helped by the transparency of the prices. We are helped by our
ability to access the books and records of the clearing member
entities. So we are helped in a number of ways.
Mr. Pomeroy. Thank you.
The Chairman. I thank the gentleman. I don't know,
Professor, anybody can answer. I was reading a story yesterday
or the day before in the Financial Times or someplace where
they were criticizing the SEC ban on short selling. Well, they
were saying that by leaving the credit default swaps out there,
they actually enhance their position to accomplish kind of the
same thing through these swaps. And that it was very short-
sighted to stop the short selling in securities and not stop it
over here on the swaps; is that true? And can you explain that?
Mr. Hu. I think that clearly there were interrelationships
in terms of selling--you know the ban on short selling and the
other markets. And I think that that points out the
interdependence of markets and the need for comprehensive
rethinking in terms of equities versus equity derivatives, or
in terms of loans versus credit derivatives. I think that that
is called for at this point. The kind of structure we set up
was set up in the 1930s before a lot of these products really
took off. In particular, in terms of the OTC derivatives market
as opposed to the exchange rate.
The OTC derivatives market is the financial laboratory in a
very important sector of our economy, the third most important
sector of our economy. I think that at this point with the
derivatives revolution, that kind of fundamental rethinking is
necessary. I don't know whether we ought to go for the Treasury
plan, Treasury Secretary Paulson's ideas. But certainly a
rethinking, a comprehensive look. In the meantime, there are a
number of incremental steps that can be taken, such as in terms
of disclosure.
The Chairman. I thank the gentleman. And I thank all the
Members.
Mr. Pickel. Mr. Chairman, just to comment briefly on that.
I think Mr. Sirri, in the first panel, talked about, they were
looking at the interconnectedness between the equity prices and
the trading in CDS. I think that to the extent that one is
influencing the other, clearly the SEC is overlooking the
securities markets there, the stock markets and needs to
understand how parties may be utilizing other instruments if
they are truly manipulating the price of equities.
So I think that that kind of interconnectedness is
something that is appropriate to look at. And similarly, even
if it is just related to CDS, the authorities that they have
regarding fraud and manipulation under the CFMA are there and
he alluded to those in his----
The Chairman. Well, that is illusory. I mean, I was reading
this other story about how somebody used these swaps to force a
city in California into bankruptcy. And now they claim that
they are going after counties and cities because their
justification is that their books are inadequate and they are
not telling the truth and they are not taxing people enough,
whatever. So they are driving these people into the ground.
There is a lot of stuff going on here. You know, and I mean
your folks need to get real. If they don't do that, they are
going to get regulated.
You know, we will keep them from trying to screw this up.
There are going to be people that are going to do things that
would be very bad in terms of--they would be the wrong
solution. And we are going to, in this Committee, try to help
get the right solution. But by God, we are going to know what
is going on with this stuff out in the open. We, in the farm
bill, put in real-time price reporting for livestock so our
farmers can find out every morning what is going on, who is
doing what and what the big guys are up to. If we can do that
with livestock, we can sure as heck do it with this. And we
should. So, we will be doing more hearings. I thank the
Members. I thank the members of the panel. And this Committee
is adjourned.
[Whereupon, at 1:51 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement of Hon. Michael V. Dunn, Commissioner, Commodity
Futures Trading Commission
I support the testimony being given today. Clearing has proven an
efficient, effective method for addressing both counterparty and
systemic risk. It provides greater transparency and accountability for
financial risks. Clearing, however, is not enough. It does not address
a central problem that is a significant cause of our current crisis,
the lack of Federal authority to adopt regulations necessary to address
financial risks related to swaps.
Our current crisis has laid bare the flaw at the heart of the
Commodity Future Modernization Act of 2000's exclusion of swaps from
the CFTC's jurisdiction. Current events have proven categorically that
relying on investors and institutions to monitor their own counterparty
risk as a method to guard against systemic financial risks for our
country is not sufficient.
Congress must revisit its determination to exclude swaps markets
from regulation and make sure that Federal regulators are in a position
to see and assess systemic financial risks. The CFTC's model of
principle-based regulation combined with rigorous market surveillance
and stringent capital requirements has fostered innovation while at the
same time ensuring market integrity.
The diversity and complexity of over-the-counter markets provides a
serious regulatory challenge. How do you ensure that market
participants have access to effective, efficient, innovative risk
management tools while also ensuring those tools do not jeopardize
market integrity?
Clearing swap transactions is central to managing systemic
financial risk related to swaps. The larger and more standardized the
markets, the more vital it is that those markets have centralized
clearing.
No agency is in a position to extend oversight into the over-the-
counter markets without additional resources, and the Commission is no
different. But the costs of those additional resources are perhaps the
best bargain the public will ever get in terms of the enhanced
financial security they can provide.
______
Submitted Statement of Patrick M. Parkinson, Deputy Director, Division
of Research and Statistics, Board of Governors, Federal Reserve System
Chairman Peterson, Ranking Member Goodlatte, and Members of the
Committee, I am pleased to offer this statement on the over-the-counter
(OTC) credit derivatives market, particularly credit default swaps
(CDS). First, I will provide some information on credit derivatives,
the markets in which those instruments are traded, the risks that their
use entails, and some key practices for managing those risks. Then I
will discuss the oversight of the credit derivatives markets and joint
efforts by supervisors and market participants to strengthen the
infrastructure of those markets, including efforts to foster central
counterparty (CCP) clearing and exchange trading of credit derivatives.
Finally, I will discuss the public policy objectives that should guide
consideration of regulatory changes for these markets.
The OTC Credit Derivatives Market
Background
A credit derivative is a financial contract whose value is derived
from the value of debt obligations issued by one or more reference
entities. The predominant type of credit derivative is a CDS. In a CDS,
a ``protection buyer'' pays premiums to a ``protection seller.'' In
return, in the event of a default or other specified credit event, the
protection seller is obligated to pay the protection buyer the
notional, or par, value for the debt, thereby transferring the risk of
default from the buyer to the seller. Most reference entities are
corporations, including corporations rated investment-grade as well as
those with lower ratings. Over the last few years, CDS referencing
mortgage-backed securities and other asset-backed securities (CDS on
ABS) also have been actively traded. A single-name CDS references a
single corporation or ABS, while a multi-name CDS references a basket
of reference entities or, more commonly, an index composed of many
single-name CDS.
Markets in Which Credit Derivatives Are Traded
Although credit derivatives have been listed on exchanges, to date,
the vast majority of credit derivatives have been executed bilaterally
with derivatives dealers in OTC markets. The dealers include about 12
to 15 large, globally active commercial and investment banks. The
principal centers for trading are in London and New York. Trades are
typically executed over the telephone or through voice brokers. Use of
various electronic trading platforms to facilitate bilateral execution
of CDS has been growing, especially in Europe, but remains fairly
limited. Other than dealers, the most active participants in CDS
markets are asset managers, including both hedge fund managers and
managers of regulated investment companies.
Estimates of the size of the global market for CDS indicate that
the market was growing very rapidly through year-end 2007. Global
market estimates published by the Bank for International Settlements
(BIS) show that the notional amount outstanding at that time was $58
trillion, about twice the level just a year earlier. The gross
replacement cost of those contracts, which measures the current market
value of the protection against credit events that this $58 trillion of
contracts represents, was about $2 trillion at year-end. Growth of
index and other multi-name CDS has been especially rapid in recent
years, and those instruments now account for more than 40 percent of
both the notional amount and the current market value of all CDS. More
recent data on CDS are available from the Depository Trust and Clearing
Corporation's (DTCC) Trade Information Warehouse, which was put in
place in 2006 and now contains an electronic copy of the vast majority
of CDS trades. CDS registered in the warehouse totaled $35 trillion in
early October, down significantly from $44 trillion in April.
The very rapid growth of the credit derivatives market reflected
their perceived value for transferring credit risks. The single-name
CDS markets typically are far more liquid than the underlying bond or
loan markets, in large measure because the cost of taking short
positions is much lower. Fixed-income asset managers use credit
derivatives to obtain or adjust their credit exposures. Portfolio
managers at banks use single-name CDS to manage concentrations of risk
to their largest borrowers. Furthermore, the very liquid markets for
CDS indexes allow asset managers to adjust the risk profile of their
entire debt portfolios much more quickly and at much lower cost than
was possible before these instruments were available. The availability
of CDS also facilitates underwriting and making markets in the
underlying debt markets.
Risks of Using Credit Derivatives
The use of credit derivatives entails risks as well as benefits.
The types of risk are essentially the same as those associated with
financial activity generally--market risk, credit risk, operational
risk, legal risk, and reputational risk. Of particular importance is
counterparty credit risk--that is, the risk that a counterparty to a
credit derivatives contract could fail to perform its contractual
obligations, resulting in losses to the nondefaulting counterparty. For
example, in the case of a CDS, if the protection seller itself becomes
insolvent, the protection buyer would lose the value of that protection
and would need to replace it by purchasing protection from another
seller. If the premiums required by the market for protection against
default by the reference entity had risen since the protection had been
purchased from the insolvent seller, the protection buyer would be
exposed to a loss equal to the present value of the difference between
the premiums paid on the new contract and the premiums paid on the
original contract.
Key Practices for Managing Risks
Participants in the credit derivatives market and other OTC
derivatives markets seek to mitigate the inherent counterparty credit
risks by carefully selecting and monitoring their counterparties, by
documenting their transactions under standard legal agreements that
permit them to net gains and losses across contracts with a defaulting
counterparty, and by entering into agreements that require counterparty
exposures to be collateralized. Market participants effectively
preclude firms from acting as dealers if they are not rated A or
higher. Dealers evaluate the credit worthiness of their counterparties
and assign them internal credit ratings. Those who are rated equivalent
to below investment grade by their counterparties usually are required
to enter into collateral agreements that include initial margin
requirements as well as variation margin requirements. Transactions
with hedge funds typically are supported by collateral agreements, as
are transactions between dealers. Laws in the United States and many
other jurisdictions have been amended in recent years to clarify that
netting and collateral agreements are legally enforceable. Still, the
measurement and management of counterparty credit risks on credit
derivatives are challenging.
Oversight of the OTC Credit Derivatives Market
Prudential Supervision of Derivatives Dealers
Oversight of the credit derivatives market comes through the
prudential supervision of the market's dealers. Most transactions in
the market are intermediated by dealers, and all major dealers are
banks that are subject to prudential regulation by U.S. or foreign
banking regulators. Over the last 10 years, the prudential supervisors
have devoted considerable attention to the dealers' management of the
risks associated with activities in the credit derivatives market and
other OTC derivatives markets. A major focus has been management of
dealers' exposures to each other and to hedge funds, with more limited
attention until recently to exposures to insurance companies, which
also were writing significant amounts of protection purchased by
dealers.
The volatility and illiquidity in financial markets over the past
year have provided a severe test of major dealers' counterparty risk-
management practices. Thus far, the results with respect to hedge fund
exposures have been remarkably good. Although quite a few hedge funds
have performed very poorly, counterparty credit losses to their dealer
counterparties have been negligible. By contrast, the financial
difficulties of some monoline financial guarantors have forced some of
the firms that act as dealers to write down substantially the value of
credit protection on residential mortgage-backed securities and other
structured securities that the dealers had purchased. Because the
guarantors had been considered highly creditworthy and because the
exposures against which they sold protection were considered to pose
very little credit risk, their CDS counterparties had not required most
of the monoline guarantors to enter into collateral agreements.
For the monoline insurers and more recently for AIG, losses on
credit derivatives reflect a failure to understand and manage the risks
associated with complex financial products effectively. Similar issues
have been evident at some very large commercial banks, which assumed
some of the same exposures, but usually through holding structured
securities rather than writing CDS on such securities. As emphasized in
the report of the Senior Supervisors Group, financial institutions need
to make appropriate changes in their risk-management practices, improve
internal incentives and controls, and ensure that traditional credit
risk management disciplines are in place for such complex products.\1\
Their supervisors need to strengthen supervisory oversight in these and
other relevant areas. Practices with respect to management of exposures
to complex instruments need to cover all such exposures, whether
assumed through holding structured securities or through selling CDS on
such securities.
---------------------------------------------------------------------------
\1\ Senior Supervisors Group (2008), ``Observations on Risk
Management Practices during the Recent Market Turbulence,'' March 6,
www.newyorkfed.org/newsevents/news/banking/2008/
SSG_Risk_Mgt_doc_final.pdf.
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Supervisory Efforts To Strengthen the Infrastructure of the OTC Credit
Derivatives Market
In addition to their efforts to ensure that individual derivatives
dealers manage the risks associated with credit derivatives and other
OTC derivatives effectively, prudential supervisors, under the
leadership of the Federal Reserve Bank of New York (FRBNY), have been
working with dealers and other market participants since September 2005
to strengthen arrangements for clearing and settling OTC derivatives
transactions. For too many years, post-trade processing of OTC
derivatives transactions remained decentralized and paper-based despite
enormous growth in transactions volumes. Among other problems, dealers
reported large backlogs of unconfirmed trades, a significant portion of
which had been outstanding for 30 days or more. The failure to confirm
trades promptly can exacerbate counterparty credit risks by allowing
errors in counterparties' records of their transactions to go
undetected, which could lead them to underestimate exposures or to fail
to collect margin when due. Such backlogs also could significantly
complicate and delay the close-out and replacement of trades with a
defaulting counterparty.
By 2005, backlogs of unconfirmed trades were especially large in
the credit derivatives market. With encouragement and close monitoring
by their prudential supervisors, the dealers worked with market
participants to address these weaknesses. By making greater use of
available platforms for electronic confirmation of CDS trades, they
quickly reduced the backlogs. By September 2006, the dealers reported
that, in the aggregate, they had reduced confirmations outstanding more
than 30 days by 85 percent. In 2006, the dealers agreed to expand their
efforts to tackle backlogs in the equity derivatives market, again by
making greater use of electronic confirmation services.
Although these achievements were impressive, the financial turmoil
during the summer of 2007 convinced prudential supervisors and other
policymakers that further improvements in the market infrastructure
were needed. Specifically, CDS backlogs grew almost fivefold from June
to August 2007, reversing much of the previous improvement. Although
the backlogs subsequently receded, this episode demonstrated that
backlog reductions were not sustainable during volume spikes. Moreover,
it underscored that, in many respects, the post-trade processing
performance of the OTC derivatives markets still lags significantly the
performance of more mature markets and still has the potential to
compromise market participants' management of counterparty credit risks
and other risks.
In their reports on the financial market turmoil, both the
President's Working Group on Financial Markets (PWG) and the Financial
Stability Forum (FSF) asked prudential supervisors, under the
leadership of the FRBNY, to take further actions to strengthen the OTC
derivatives market infrastructure.\2\ Specifically, they asked the
supervisors to insist that the industry set ambitious standards for
trade data submission and resolution of trade-matching errors. More
timely and accurate submission of trade data is critical to avoiding
the buildup of backlogs following volume spikes. They also asked
supervisors to ensure that the industry promptly incorporates into
standard CDS documentation a protocol that would permit cash settlement
of obligations following a default or other credit event involving a
reference entity, based on the results of an auction. Adoption of the
cash settlement protocol is intended to address concerns that a
physical settlement process for CDS could be disorderly in the event of
large-scale or multiple contemporaneous defaults. Finally, the PWG and
FSF also recommended that the supervisors ask the industry to develop a
longer-term plan for an integrated operational infrastructure for OTC
derivatives that covers all major asset classes and product types and
addresses the needs of other market participants as well as dealers.
---------------------------------------------------------------------------
\2\ President's Working Group on Financial Markets (2008), ``Policy
Statement on Financial Market Developments,'' March, www.treasury.gov/
press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf; Financial
Stability Forum (2008), ``Report of the Financial Stability Forum on
Enhancing Market and Institutional Resilience,'' April 7,
www.fsforum.org/publications/r_0804.pdf.
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The FRBNY convened a meeting of supervisors and market participants
on June 9 to discuss how to address the PWG and FSF recommendations.
They agreed on an agenda for bringing about further improvements in the
OTC derivatives market infrastructure. With respect to credit
derivatives, this agenda included: (1) further increasing
standardization and automation, with the ultimate objective of matching
trades on the date of execution; (2) incorporating an auction-based
cash settlement mechanism into standard documentation; (3) reducing the
volume of outstanding CDS contracts via greater use of services that
orchestrate multilateral terminations; and (4) developing well-designed
central counterparty services to reduce systemic risks. Dealers already
have made progress in multilaterally terminating CDS contracts, as
reflected in the significant drop between April and October of this
year in the value of contracts registered in the Trade Information
Warehouse, and they have committed to accelerating those efforts.
Dealers also agreed to extend the infrastructure improvements in the
credit derivatives market over time to encompass the markets for OTC
equity, interest rates, foreign exchange, and commodity derivatives.
Potential Changes in Market Infrastructure
Central Counterparty Clearing of Credit Derivatives
A central counterparty (CCP) is an entity that offers to interpose
itself between counterparties to financial contracts, becoming the
buyer to the seller and the seller to the buyer. Trades on derivatives
exchanges routinely are cleared through a CCP, in part so that market
participants can accept the best bids or offers without considering the
creditworthiness of the party making the bid or offer. Indeed, in
electronic exchanges, the use of a CCP permits anonymous trading. CCP
services also have been offered to counterparties in OTC derivatives
markets. For example, since September 1999, LCH.Clearnet Limited has
operated SwapClear, a London-based CCP for interest rate swaps between
dealers. SwapClear provides clearing for almost 50 percent of global
single-currency swaps between dealers.
A CCP has the potential to reduce counterparty risks to OTC
derivatives market participants and risks to the financial system by
achieving multilateral netting of trades and by imposing more-robust
risk controls on market participants. However, a CCP concentrates risks
and responsibility for risk management in the CCP. Consequently, the
effectiveness of a CCP's risk controls and the adequacy of its
financial resources are critical. If its controls are weak or it lacks
adequate financial resources, introduction of its services to the
credit derivatives market could actually increase systemic risk. In the
first significant test of the effectiveness of a CCP for OTC
derivatives' default procedures, SwapClear recently wound down $9
trillion of OTC interest rate contracts when Lehman Brothers, one of
its clearing members, defaulted. The collateral Lehman Brothers had
posted covered all losses on its positions, and thus the clearinghouse
did not have to use any of its other financial resources.
Several plans are now under development to provide CCP services to
the credit derivatives market. A CCP that seeks to offer its services
in the United States would need to obtain regulatory approval. The
Commodity Futures Modernization Act of 2000 included provisions that
permit CCP clearing of OTC derivatives and require that a CCP be
supervised by an appropriate authority, such as a Federal banking
agency, the Commodity Futures Trading Commission (CFTC), the Securities
and Exchange Commission (SEC), or a foreign financial regulator that
one of the U.S. authorities has determined to satisfy appropriate
standards. A CCP for credit derivatives with standardized terms that
was not regulated by the SEC would need an exemption from securities
clearing agency registration requirements.
If a CCP for credit derivatives sought to organize as a bank
subject to regulation by the Federal Reserve or if we were consulted by
any other regulator of a proposed CCP, we would evaluate the proposal
against the ``Recommendations for Central Counterparties,'' a set of
international standards that were agreed to in November 2004 by the
Committee on Payment and Settlement Systems (CPSS) of the central banks
of the Group of Ten countries and the Technical Committee of the
International Organization of Securities Commissions (IOSCO).\3\
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\3\ Committee on Payment and Settlement Systems and Technical
Committee of the International Organization of Securities Commissions,
Bank for International Settlements (2004), ``Recommendations for
Central Counterparties,'' November, www.bis.org/publ/cpss64.htm.
---------------------------------------------------------------------------
If one or more CCPs for credit derivatives that meet the CPSS-IOSCO
standards are introduced, the Federal Reserve will encourage market
participants to use those services to the fullest extent possible. We
hope to see developers of CCPs move expeditiously in order that CDS
market participants can quickly realize the risk management benefits of
a CCP. We also strongly encourage such CCPs to clear trades for a broad
range of active market participants, either directly or through
intermediaries. Active market participants, including asset managers as
well as dealers, should be excluded from participating only if not
doing so would entail risks to the CCP that it cannot mitigate
effectively.
The CFTC, SEC, and the Federal Reserve recognize their mutual
interests in ensuring that a CCP for credit derivatives is organized
and managed prudently. We are working on a Memorandum of Understanding
(MOU) to ensure that we all will have the information necessary for
carrying out our different responsibilities with respect to these
markets regardless of the form in which a CCP is organized and
regardless of which agency is the primary regulator.
Exchange Trading of Credit Derivatives
An exchange is a mechanism for executing trades that allows
multiple parties to accept bids or offers from other participants.
Trades on an exchange usually are intermediated by a CCP. Exchange
trading requires a significant degree of standardization of contracts.
In many cases, counterparties to OTC derivatives trades seek to
customize the terms of trades to meet very specific risk-management
needs, so many OTC trades are not amenable to exchange trading.
However, many OTC derivatives, including many credit derivatives have
become sufficiently standardized that exchange trading is feasible and
the scope for exchange trading probably could be expanded by further
standardization of contracts while still meeting risk-management needs.
Where exchange trading of OTC credit derivatives is feasible, it
can produce several benefits. First, trades executed on an exchange
usually are intermediated by a CCP, and a well-designed CCP can reduce
risks to counterparties and the financial system. Second, an electronic
exchange can be designed so that trades are locked in at execution,
essentially achieving trade matching in real time and eliminating
confirmation backlogs. Third, exchange trading has the potential to
increase market liquidity by allowing participants to directly trade
against bids and offers posted by a broad range of parties, including
asset managers as well as derivatives dealers. Finally, exchange
trading has the potential to significantly increase transparency with
respect to bids and offers and the depth of markets at those bids and
offers. For these reasons, policymakers should encourage trading of
credit derivatives on exchanges if the terms of the contracts are
sufficiently standardized to make exchange trading feasible. However,
they should not lose sight of the fact that one of the main reasons the
credit derivatives market and other OTC markets have grown so rapidly
is that market participants have seen substantial benefit to
customizing contract terms to meet their individual risk-management
needs. They should continue to be allowed to bilaterally negotiate
customized contracts where they see benefits to doing so, subject to
continued oversight of the dealers by their prudential supervisors.
Policy Issues in Considering Regulatory Changes
In considering potential regulatory changes for credit derivatives
or CDS, policymakers should carefully review the source of problems to
date. Thus far, the most significant problems with CDS have arisen with
management of counterparty exposures on credit protection on highly
rated structured credit products purchased from monoline insurance
companies. It is important to note that the financial difficulties of
Bear Stearns were not associated with CDS activity, and concerns about
losses to the firm's derivatives counterparties were not the primary
factor motivating the Federal Reserve's decision to extend credit to
facilitate the firm's acquisition. That decision was driven primarily
by the fear that the collapse of Bear Stearns would have caused other
dealers to lose access to critical funding from the triparty repurchase
agreement markets. Similarly, Lehman Brothers did not fail because of
CDS activity. Furthermore, closeout of contracts with Lehman Brothers
by its counterparties provided the first major test of procedures to
handle a default by a significant counterparty, and evidence to date
suggests that those procedures were very effective at mitigating losses
to Lehman's counterparties.
Any discussion of changes to the regulatory framework for credit
derivatives should clearly specify the public policy objectives of
regulation and how particular regulatory changes would contribute to
achieving them. The objectives that have provided the foundation for
regulation of derivative markets in the United States can be summarized
as: deterring market manipulation, protecting any unsophisticated
market participants from fraud and counterparty losses, promoting
transparency, containing systemic risks, and promoting product
innovation that facilitates risk management. In light of recent
experience, the objectives most often cited in discussions about
shoring up our regulatory regime are manipulation, transparency, and
systemic risk.
Clearly, there are concerns about manipulation involving CDS. These
concerns can be addressed by clarifying the SEC's authority with
respect to CDS. Policing manipulation requires information, however.
Mandating participation in DTCC's trade warehouse for credit
derivatives and giving the SEC access to that data would seem the
fastest, most effective, and least costly means of bolstering its
ability to police manipulation.
Some market observers have expressed concern about the opaqueness
of OTC derivatives markets generally. Market transparency has several
dimensions--the stock of trades outstanding, trade volumes, and
pricing. Data on outstanding trades in the global market currently are
available from the BIS, and these data could be enhanced through more
frequent and detailed reporting. As noted above, the vast majority of
CDS trades are registered in DTCC's trade warehouse, and this warehouse
is a possible vehicle for more detailed and timely data than are
available through the periodic BIS survey. Creation of a CCP also
offers the potential for detailed and timely data on volumes and
positions outstanding for the contracts cleared by the CCP. Pricing
data is meaningful only for standardized products. Greater
standardization will come through exchange trading, in turn
facilitating price transparency both on the terms at which traders are
willing to deal and on the ultimate transaction price. The economic
benefits of transparency are well known, and policymakers should
promote transparency more vigorously. We should not, however, limit
derivatives activity to contracts that can be exchange-traded and
cleared. Promotion of innovation in risk management products remains an
important policy objective, and much of that innovation will always
occur away from the more standardized products that are exchange-traded
and cleared.
Finally, there are concerns that our regulatory regime must be
changed to better contain systemic risk. Work by prudential supervisors
is already underway that addresses the weaknesses of major market
participants in measuring and managing their counterparty credit risk;
as recent experience with market participants' monoline counterparties
has shown, there is room for substantial improvement. This step is
fundamental to containing systemic risk because it limits the potential
for any large market participant to be the catalyst for such risk. In
addition, U.S. authorities are coordinating with counterparts in other
jurisdictions through the group organized by the FRBNY to ensure that
the clearance and settlement of OTC derivative trades occurs in a sound
and prudent manner and that this activity is not a source of systemic
risk.
OTC derivative markets are global markets requiring global
coordination of regulation to address systemic risk. Available evidence
suggests that more trading of CDS occurs in London than in the United
States. Regulatory remedies that focus only on the United States will
not address perceived problems. U.S. authorities and their foreign
counterparts have an established mechanism through the FRBNY group to
foster domestic and international cooperation. Domestic authorities
also are hardening their cooperation through creation of a MOU related
to a CCP for credit derivatives. Uncoordinated, unilateral regulatory
efforts, by U.S. authorities or other authorities, simply cannot
achieve the public policy objectives of regulation.
Conclusions
The credit derivatives market is an important innovation that
provides significant benefits to the banks and asset managers that use
these instruments and to the financial system generally. However, their
use entails risks, including counterparty credit risks, that market
participants need to manage effectively. Supervisors need to continue
to pay dose attention to individual dealers' management of the risks
associated with intermediating the credit derivatives market and other
derivatives markets. In addition, they need to address the weaknesses
in dealers' management of risks from complex financial instruments,
whether CDS or securities, identified by the Senior Supervisors Group.
Supervisors also need to continue to foster collective actions by
dealers and other market participants to move rapidly toward the goal
of implementing a clearing and settlement infrastructure for the credit
derivatives market and other OTC derivatives markets that is as
efficient as the infrastructure for more mature markets. Supervisors
and other policymakers should encourage the introduction and use of
well-designed CCP clearing services for credit derivatives, greater
standardization of contracts, and the trading of standardized contracts
on exchanges. These steps will address concerns about containment of
systemic risk as well as produce ancillary benefits with respect to
deterring market manipulation and enhancing transparency.
______
Submitted Statement of Eric R. Dinallo, J.D., Superintendent, Insurance
Department, State of New York
Testimony to the United States Senate Committee on Agriculture,
Nutrition, and Forestry Hearing on ``The Role of Financial
Derivatives in the Current Financial Crisis''
By Superintendent Eric Dinallo New York State Insurance Department
Tuesday, October 14, 2008, Dirksen Senate Office Building, Room 106
I would like to thank Chairman Tom Harkin, Ranking Member Saxby
Chambliss and the Members of the Senate Committee on Agriculture,
Nutrition, and Forestry for inviting me to testify today at this
hearing on the role of financial derivatives in the current financial
crisis.
My name is Eric Dinallo and I am Insurance Superintendent for New
York State.
I have been asked to discuss with you today one particular kind of
derivative--credit default swaps--which have played a major role in the
financial problems we now face.
Let me first establish why the New York State Insurance Department
is a relevant authority on credit default swaps. I will expand on
theses issues at greater length, but to provide a context, I will start
with a brief summary.
As credit default swaps were developed, there was a question about
whether or not they were insurance. Since initially they were used by
owners of bonds to hedge their risk or seek protection or insurance in
the case of a default by the issuer of the bonds, this was a reasonable
question. In 2000, under a prior Administration, the New York Insurance
Department was asked to determine if certain credit default swaps were
insurance and said no. That is a decision we have since revisited and
reversed as incomplete. I will provide more detail on these important
decisions shortly.
In addition, since I took office in January 2007, the impact of
credit default swaps has been one of the major issues we have had to
confront. First, we tackled the problems of the financial guaranty
companies, also known as bond insurers or monolines. Credit default
swaps were a major factor in their problems. More recently, we have
been involved in the bailout of AIG. Again, management of credit
default swaps was the biggest source of that company's problems.
Through these experiences, we have needed to carefully study the
history and issues surrounding credit default swaps. And we have
learned the hard way about their impact on markets and companies.
I am honored to have this opportunity to share with you what we
have learned from this experience.
First, let's discuss what a credit default swap is and the
different kinds of credit default swaps. A credit default swap is a
contract under which the seller, for a fee, agrees to make a payment to
the protection buyer in the event that the referenced entity, usually a
company or other issuer of some kind of bond, experiences any number of
various ``credit events'', such as bankruptcy, default, or
reorganization. If something goes wrong with the referenced entity, the
protection buyer can put the bond to the protection seller and be made
whole, or a net payment can be made by the seller to the buyer.
Originally, credit default swaps were used to transfer and thus
reduce or mitigate risk for the owners of bonds. If you owned a bond in
company X and were concerned that the company might default, you bought
the swap to protect yourself. Literally the buyer ``swaps'' risk of
default with someone else. That is why it is called a credit default
swap. The swaps could also be used by banks who loaned money to a
company. This type of swap is still used for hedging purposes.
Over time, however, swaps came to be used not to reduce risk, but
to create or assume it. This second type of swap is little more than a
gamble on the value of a particular reference obligation. Institutions
that did not own the obligation bought and sold credit default swaps to
place a directional bet on a company's credit worthiness. In early May,
we began to use the term ``naked credit default swaps'' to describe
swaps bought by speculators because in that case the swap purchasers do
not own the underlying obligation. The protection becomes more valuable
as the company becomes less creditworthy. This is similar to naked
shorting of stocks.
I have argued that these naked credit default swaps should not be
called swaps because there is no transfer or swap of risk. Instead,
risk is created by the transaction. Indeed, you have no risk on the
outcome of the day's third race at Belmont until you place a bet on
horse number five to win.
We believe that the first type of swap, let's call it the covered
or ``sartorial'' swap, is insurance. The essence of an insurance
contract is that the buyer has to have a material interest in the asset
or obligation that is the subject of the contract. That means the buyer
owns property or a security and can suffer a loss from damage to or the
loss of value of that property. With insurance, the buyer only has a
claim after actually suffering a loss.
With the covered swaps, if the issuer of a bond defaults, then the
owner of the bond has suffered a loss and the swap provides some
recovery for that loss. The second type of swap contains none of these
features.
Because the credit default swap market is not regulated, we do not
have valid data on the number of swaps outstanding, how many are naked,
who bought, who sold and on which issuers they have been written.
Estimates of the market were as high as $62 trillion, though lately the
market has been reduced to an estimated $55 trillion. By comparison, as
of the second half of this year, there was only about $6 trillion in
corporate debt outstanding, $7.5 trillion in mortgage-backed debt and
$2.5 trillion in asset-backed debt, according to data from the
Securities Industry and Financial Markets Association. That's a total
of about $16 trillion in private sector debt. So it appears that swaps
on that debt could total at least three times as much as the actual
debt outstanding.
When we were dealing with finding a solution for AIG, we knew the
company had written almost half a trillion dollars in swaps, but we had
no idea how much in swaps had been written on AIG itself or by whom.
That meant we did not know what the broader effect of an AIG bankruptcy
would be. Also, in our work on the bond insurers, we could not
determine the total credit default swaps written on companies such as
MBIA and Ambac.
As one of the efforts to stop the current financial crisis, the SEC
suspended shorting the stock of 700 companies and all naked shorting of
stocks. But nothing was done about the shorting of credit through
credit default swaps, though there are much larger numbers involved.
Now, I think it would be useful for your purposes to go into some
of the history, including important legislative decisions.
Gambling, betting or speculating on movements in securities or
commodities prices without actually owning the referenced security or
commodity is nothing new. As early as 1829, ``stock jobbing'', an early
version of short selling, was outlawed in New York. The Stock Jobbing
Act was ultimately repealed in 1858 because it was overly broad and
captured legitimate forms of speculation. However, the question of
whether to allow bets on security and commodity prices outside of
organized exchanges continued to be an issue.
``Bucket shops'' arose in the late nineteenth century. Customers
``bought'' securities or commodities on these unauthorized exchanges,
but in reality the bucket shop was simply booking the customer's order
without executing on an exchange. In fact, they were simply throwing
the trade ticket in the bucket, which is where the name comes from, and
tearing it up when an opposite trade came in. The bucket shop would
agree to take the other side of the customer's ``bet'' on the
performance of the security or commodity. Bucket shops sometimes
survived for a time by balancing their books, but were wiped out by
extreme bull or bear markets. When their books failed, the bucketeers
simply closed up shop and left town, leaving the ``investors'' holding
worthless tickets.
The Bank Panic of 1907 is famous for J.P. Morgan, the leading
banker of the time, calling all the other bankers to a meeting and
keeping them there until they agreed to form a consortium of bankers to
create an emergency backstop for the banking system. At the time there
was no Federal Reserve. But a more lasting result was passage of New
York's anti-bucket shop law in 1909. The law, General Business Law
Section 351, made it a felony to operate or be connected with a bucket
shop or ``fake exchange.'' Because of the specificity and severity of
the much-anticipated legislation virtually all bucket shops shut down
before the law came into effect, and little enforcement was necessary.
Other states passed similar gaming or bucket shop laws. Interestingly,
to this day, companies wishing to use the world ``exchange'' must
receive permission from New York State.
Thus, the various bucket shop laws essentially prohibit the making
or offering of a purchase or sale of security, commodity, debt,
property, options, bonds, etc., upon credit or margin, without
intending a bona fide purchase or sale of the security, commodity,
debt, property, options, bonds, etc. If you think that sounds exactly
like a naked credit default swap, you are right. What this tells us is
that back in 1909, 100 years ago, people understood the risks and
potential instability that comes from gambling on securities prices.
With the growth of various kinds of derivatives in the late 20th
Century, there was legal uncertainty as to whether certain derivatives,
including credit default swaps, violated state bucket shop and gambling
laws.
The Commodity Futures Modernization Act of 2000 (``CFMA''), signed
by President Clinton on December 21, 2000, therefore created a ``safe
harbor'' by (1) preempting state and local gaming and bucket shop laws
except for general anti-fraud provisions, and (2) exempting certain
derivative transaction on commodities and swap agreements, including
credit default swaps, from CFTC regulation.
Thus CFMA stated: ``This Act shall supersede and preempt the
application of any state or local law that prohibits or regulates
gaming or the operation of bucket shops.''
CFMA also amended the Securities and Exchange Acts of 1933 and 1934
to make it clear that the definition of ``security'' does not include
certain swap agreements, including credit default swaps, and that the
SEC is prohibited from regulating those swap agreements, except for its
anti-fraud enforcement authority.
Therefore, by ruling that credit default swaps were not gaming and
not a security, the way was cleared for the growth of the market. But
there was one other issue. If some swaps--covered swaps--were
considered insurance, then they would be regulated by state insurance
departments. The capital and underwriting limits in insurance
regulation could have threatened the rapid growth in the market for
these derivatives.
So at the same time, in 2000, the New York Insurance Department was
asked a very carefully crafted question. ``Does a credit default swap
transaction, wherein the seller will make payment to the buyer upon the
happening of a negative credit event and such payment is not dependent
upon the buyer having suffered a loss, constitute a contract of
insurance under the insurance law?''
Clearly, the question was framed to ask only about naked credit
default swaps with no proof of loss. Under the facts we were given, the
swap was not ``a contract of insurance'', because the buyer had no
material interest and the filing of claim does not require a loss. But
the entities involved were careful not to ask about covered credit
default swaps. Nonetheless, the market took the Department's opinion on
a subset of credit default swaps as a ruling on all swaps and, to be
fair, the Department did nothing to the contrary.
In sum, in 2000 as a society we chose not to regulate credit
default swaps, whether as insurance, as a security or gaming.
Why did that matter? As we have seen, the financial system has been
placed in peril because there was no comprehensive management of
counterparty risk. Deals were made privately between two parties. These
bilateral arrangements mean that there are no standards for the
solvency of counterparties, who can assign the credit default swaps to
other parties. The buyer does not know how much risk the seller is
taking on. There are no requirements for the seller to hold reserves or
capital against the risks it is taking on by selling swaps. And no one
knows who owns or where the credit default swaps ultimately reside.
None of this was a problem as long as the value of everything was
going up and defaults were rare. But the problem with this sort of
unregulated protection scheme is that when everyone needs to be paid at
once, the market is not strong enough to provide the protection
everyone suddenly needs.
Unlike insurance, credit default swaps are marked-to-market. That
means, the value of the swap reflects the current market value, which
can swing sharply and suddenly. Value changes require the sellers to
post collateral. Sudden and sharp changes in the credit rating of the
issuer of the bonds or of the bonds themselves can produce large swings
in the value of the swaps and thus the need to post large and
increasing amounts of collateral. That capital strain can produce
sudden liquidity problems for sellers. The seller may own enough assets
to provide collateral, but the assets may not be liquid and thus not
immediately accessible. When many sellers are forced to sell assets,
the price of those assets falls and sellers are faced with taking large
losses just to meet collateral requirements. As the prices of the
assets are driven down by forced sales, mark-to-market losses increase
and the collateral posting cycle continues. Meanwhile, the underlying
assets may continue to perform--paying interest and principal in full.
The above was a substantial part of the problem at AIG. A ratings
downgrade on September 15 produced immediate collateral calls. The
company did not have sufficient liquid assets.
In addition, chains of counterparty exposures mean that if any one
link in the chain--any one counterparty--fails, others with exposure to
that counterparty may also fail setting off a chain reaction. Many
financial institutions bought protection from AIG, and there was great
uncertainty as to whether all of these institutions could survive AIG's
failure.
Was the AIG bailout necessary? I believe it was. Thanks to the
protective moat created by state regulation, AIG's insurance operations
were insulated from the problems in other AIG subsidiaries and are
solid, profitable companies. Many of AIG's companies are leaders in
their markets. They have substantial value. But that value could not be
realized over a weekend. The bailout will provide time for an orderly
restructuring of AIG's operations. It is possible that AIG will
survive, as a smaller but much stronger insurance-focused enterprise.
At least some of its operations will be sold.
Some argue that the company should have been filed for bankruptcy,
as Lehman did. AIG has business relations with just about every major
bank in the world. At a time when the financial system and in
particular the credit markets are already deeply troubled, the risks of
allowing AIG to file for bankruptcy were, in my opinion, just too
great. The New York Federal Reserve Bank and the Treasury appear to
share that view.
But that systemic risk does underline the need for us to heed New
York Governor David Paterson's call to regulate the credit default swap
market. In a recent statement, Governor Paterson said, ``The absence of
regulatory oversight is the principal cause of the Wall Street meltdown
we are currently witnessing. This is why New York took the crucial next
step of planning to regulate an area of the market which had previously
lacked appropriate oversight, but that is indisputably as regulatable
as insurance. I strongly encourage the Federal Government to follow our
approach and bring stronger regulatory oversight to these markets. New
York stands ready to work expeditiously with all concerned to find a
workable solution to this problem.''
In an interview with The New York Times, Governor Paterson called
credit default swaps ``gambling'' and noted that they were a major
cause of AIG's problems. He told the paper that ``when we peeled back
the onion, we found out that AIG had so many credit default swaps that
we couldn't calculate how much money they probably had'' lost.
On September 22, Governor Paterson announced that New York State is
prepared, beginning in January, to regulate part of the credit default
swap market which has to date been unregulated. The state is prepared
to provide clear regulatory guidance where credit default swaps are
used as ``insurance'' to protect or ``hedge'' the value of investments
held by the purchaser. These transactions are, both functionally and
legally, financial guaranty insurance policies.
As I noted, the 2000 decision by the Insurance Department only
considered naked credit default swaps. Last month, we determined that
covered credit default swaps are insurance and therefore potentially
subject to state regulation.
What would be the benefit of treating covered credit default swaps
as insurance? Insurers must hold capital and reserves against risks.
Insurers are subject to underwriting restrictions that ensure
diversification. Insurers are not permitted to write policies with
acceleration events, downgrade triggers or collateral calls. While
financial guaranty insurance companies have been downgraded, they have
maintained their solvency and liquidity. In short, if they were
regulated as insurance, buyers of covered credit default swaps would be
assured that they could actually have protection when they need it.
What New York State is doing fits our role as insurance regulators.
We are providing an appropriate way for those with an insurable
interest to protect themselves. Our goal is to ensure the terms of
credit default swaps are written as a mechanism for protecting buyers
against actual losses and not for betting on the credit quality of a
third party. We will also ensure that whoever sells protection is
solvent, in other words, can actually pay the claims. There is
currently no such protection for parties to credit default swaps that
use them as insurance.
The primary goal of insurance regulation is to protect
policyholders by ensuring that providers of insurance are solvent and
able to pay claims on policies they issue. The goal of regulating these
swaps is not to stop sensible economic transactions, but to ensure that
sellers have sufficient capital and risk management policies in place
to protect the buyers, who are in effect policyholders and to ensure
stable markets.
However, we recognize that carving up the credit default swap
market is not the ideal solution. And we recognize that there are some
valid uses of naked swaps to provide liquidity in the market for risk
transfer. There may be different valid ways of having a material
interest besides directly owning a bond, such as being long a stock,
owning part of a syndicated loan or having a receivable. Also, it may
be valid to use the swaps for various sophisticated trading strategies.
Governor Paterson's announcement that New York was ready to
regulate part of the market starting January 1 framed the dialogue and
pushed forward the discussion of regulating the entire market. The day
after Governor Paterson's announcement, SEC Chairman Cox asked for the
power to regulate the credit default swap market. And shortly
afterward, the New York Federal Reserve began a series of meetings to
discuss how to proceed.
There are a number of possible effective means of regulating the
entire market, including an exchange, a clearing corporation or a
centralized counterparty. Properly designed and operated, any solution
would include margin requirements to ensure that there is sufficient
capital and liquidity. There should be security funds and other
mechanisms to manage counterparty default equitably and predictably. It
should provide transparency, both with regard to prices and with regard
to the amount of exposure by all counterparties. These measures would
ensure that credit default swaps could be a tool for managing risk,
without becoming a risk to the entire financial system. We support this
effort to find and implement an effective holistic solution.
Credit default swaps played a major role in the financial problems
at AIG, Bear Stearns, Lehman and the bond insurance companies. One of
the major causes of this financial crisis was not how lax or tight we
regulated or how easy or hard we enforced, but what we chose not to
regulate. Clearly, it is time to start regulating credit default swaps.
As Governor Paterson said on September 22, New York stands ready to
work expeditiously with all concerned to find a workable solution to
the problem of how to regulate credit default swaps.
Thank you and I would be happy to answer any questions.
HEARING TO REVIEW THE ROLE OF CREDIT DERIVATIVES IN THE U.S. ECONOMY
----------
THURSDAY, NOVEMBER 20, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:35 a.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden,
McIntyre, Etheridge, Boswell, Baca, Scott, Marshall, Herseth
Sandlin, Cuellar, Costa, Salazar, Space, Walz, Gillibrand,
Kagen, Pomeroy, Barrow, Donnelly, Mahoney, Childers, Goodlatte,
Lucas, Moran, King, Neugebauer, Foxx, Conaway, and Latta.
Staff present: Adam Durand, John Konya, Scott Kuschmider,
Rob Larew, Clark Ogilvie, John Riley, Rebekah Solem, Kristin
Sosanie, Bryan Dierlam, Tamara Hinton, Kevin Kramp, and Jamie
Mitchell.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee on Agriculture hearing to
review the role of credit derivatives in the U.S. economy will
come to order.
Mr. Goodlatte is on his way, so I am going to start with my
opening statement, and we think by the time I am finished he
will be here, and we can proceed.
I thank the Members and the witnesses for being with us
today, and I want to welcome everyone to today's hearing, the
second in as many months that this Committee has called to
review the role of credit derivatives in the U.S. economy.
Today, this Committee will hear about the recent events in
the credit default swap market, the possibility of establishing
over-the-counter clearing of such contracts, and the Memorandum
of Understanding that was recently signed by the CFTC, the SEC
and the Federal Reserve Board.
One thing we learned at the October hearing is that very
few people know much about the credit default swaps market and
even fewer people know the significant role that they have
played in the financial and credit crisis that has threatened
the stability of our economy.
The market for these products has risen a thousand percent
over the last 7 years, with contracts becoming more specialized
and complicated over time. Although I would say the more I look
at these contracts, I am not sure they are as complicated as
people make them out to be. That may be a myth that is out
there. I think it is complicated in terms of trying to price
them and so forth.
Anyway, as we have seen, the changes in the price of a
credit default swaps contract outstanding against a particular
firm can have real effects in the financial health of the
company itself. The sudden collapse and gradual fallout of the
insurance giant AIG and the difficulties experienced by other
financial firms in recent months have served to demonstrate
that the CDS market is extremely opaque and market positions as
a result are nearly impossible to value during times of stress.
We need our regulators to have a clear view of the market.
The most promising development appears to be the commitment of
regulators and the industry to establish clearinghouses along
the lines of those the commodity futures markets use to provide
transparency and greater assurance of counterparty performance.
I think one of the things we can do right away to start
opening up and cleaning up the swaps market is to use the CFTC
model of a transparent and aboveboard central clearing process.
To that end, there has been recent discussion among Federal
regulators about combining forces to oversee the central
clearing of swaps trades.
In the recent MOUs signed by the CFTC, SEC, and Federal
Reserve, the three agencies committed to cooperate in the
establishment and oversight of clearing platforms in the swaps
market. As is noted in testimony submitted today, there are
proposals under consideration that would lead to a
clearinghouse regulated by the Fed and another by the CFTC.
While the Fed has no experience in regulating the type of
central clearing counterparty under consideration, the CFTC has
long experience in just that area. I am not aware of any
allegation that the CFTC has failed as a clearinghouse
regulator, and I hope in the course of this hearing to
understand better why there is consideration of giving the Fed
this new job in an area where they have no history, while the
CFTC can take over that function within their existing mission.
As I understand it, the CFTC has a statute, they have law,
they have a long history, but with the Fed, there is no
statute, there is no underlying law; and it looks to me like
either people are trying to look like they are being regulated
when they are not, or it is going to take a long time to get
that put together. So that is part of what we want to try to
figure out here today.
Unfortunately, the debate over the risk these swaps and
their disentanglement posed to the economy was completely
missing from the bailout bill that was pushed by Treasury
Secretary Henry Paulson and passed by this Congress. It took,
in my opinion, the wrong approach and does not begin to get at
the problems caused by these unregulated financial sectors.
Furthermore, recent comments by Secretary Paulson would
seem to acknowledge that the TARP now in place is now going
nowhere. He already acknowledged that the asset purchase plan
he was pushing will not work because very few, if any, holders
of the toxic debt are interested in selling at a loss, no
matter what the stakes. Instead, we have exposed taxpayers to
hundreds of billions of dollars more in debt that will be paid
off by our children and grandchildren and probably borrowed
from China.
At some point, our regulators in the next Congress will
have to get to the root of the problem before it is too late
and allow for some real oversight of these markets to provide
transparency and accountability for both buyers and sellers,
and to reduce systemic risk.
So I again welcome everybody to the Committee.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
Good morning. I want to welcome everyone to today's hearing, the
second in as many months that this Committee has called to review the
role of credit derivatives in the U.S. economy. Today, this Committee
will hear about the recent events in the credit default swaps market,
the possibility of establishing over-the-counter clearing of such
contracts, and the Memorandum of Understanding that was recently signed
by the Commodity Futures Trading Commission, the Securities and
Exchange Commission, and the Federal Reserve Board.
One thing we learned at October's hearing is that very few people
know much about the credit default swaps market and even fewer people
know the significant role they have played in the financial and credit
crisis that has threatened the stability of our economy.
The market for these products has risen a thousand percent over the
last 7 years with contracts becoming more specialized and complicated
over time. And as we have seen, the changes in price of a credit
default swaps contract outstanding against a particular firm can have
real effects in the financial health of the company itself.
The sudden collapse and gradual fallout of the insurance giant AIG
and the difficulties experienced by other financial firms in recent
months have served to demonstrate that the CDS market is extremely
opaque and that market positions, as a result, are nearly impossible to
value during times of stress.
We need our regulators to have a clear view of the market. The most
promising development at this time appears to be the commitment of
regulators and the industry to establish clearing houses along the
lines of those the commodity futures markets use, to provide
transparency and greater assurance of counterparty performance. I think
one of the things we can do right away to start opening up and cleaning
up the swaps markets is to use the CFTC model of transparent and above-
board central clearing process.
To that end, there has been recent discussion among Federal
regulators about combining forces to oversee central clearing of swaps
trades.
In a recent Memorandum of Understanding signed by the CFTC, SEC,
and Federal Reserve, the three agencies commit to cooperate in the
establishment and oversight of clearing platforms in the swaps market.
As is noted in testimony submitted today, there are proposals under
consideration that could lead to a clearinghouse regulated by the Fed
and another by the CFTC. While the Fed has no experience in regulating
the type of central clearing counterparty under consideration, the CFTC
has long experience in just that area. I'm not aware of any allegation
that the CFTC has failed as a clearinghouse regulator and I hope in the
course of this hearing to understand better why there is consideration
of giving the Fed this new job in an area in which it has no history,
while the CFTC can take over that function within its existing mission.
Unfortunately, the debate over the risk these swaps and their
disentanglement pose to the economy was completely missing from the
bailout bill that was pushed by Treasury Secretary Henry Paulson and
passed by Congress. It took the wrong approach and does not begin to
get at the problems caused by these unregulated financial sectors.
Furthermore, recent comments by Secretary Paulson would seem to
acknowledge that the Troubled Asset Relief Plan now in place is going
nowhere. He's already acknowledged that the asset purchase plan he was
pushing will not work because very few, if any, holders of the toxic
debt are interested in selling at a loss, no matter what the stakes.
Instead, we have exposed taxpayers to hundreds of billions more in debt
that will be paid off by our children and grandchildren.
At some point, our regulators and the next Congress will have to
get to the root of the problem before it is too late and allow for some
real oversight of these markets, to provide transparency and
accountability for both buyers and sellers, and to reduce systemic
risk.
At this time I would yield to my friend and colleague, the Ranking
Member from Virginia, Mr. Goodlatte, for an opening statement.
The Chairman. At this time, I would yield to my friend and
colleague, the Ranking Member from Virginia, Mr. Goodlatte, for
an opening statement.
OPENING STATEMENT OF HON. BOB GOODLATTE, A REPRESENTATIVE IN
CONGRESS FROM VIRGINIA
Mr. Goodlatte. Well, thank you, Mr. Chairman.
I want to thank you for calling today's hearing on the role
of credit derivatives in the U.S. economy. Today's hearing is
part of a continued effort by this Committee to further gain
information and insight into the complex nature of credit
default swaps and how they should be regulated.
Credit default swaps do serve a valid purpose in the
marketplace. They are essential for managing risk. The
financial problems that we have seen in recent months are not
the result of their mere existence but rather because, right
now, no one can confidently price them or measure their true
performance, or know the depth and breadth of this market, or
be assured of the creditworthiness of its counterparty. There
should be appropriate regulation, but it should be done in such
a way that respects the nature of the marketplace and considers
the real limits of government intervention.
Recently, Federal regulatory bodies established a
Memorandum of Understanding regarding credit default swaps. I
support this measure which will allow for information sharing
and will encourage cooperation among regulatory authorities.
Also, there is a consensus among regulators that there is a
need for a clearing mechanism for credit default swaps. This
will provide the transparency needed to understand the market,
as well as measure counterparty performance.
I am encouraged that we are collectively moving forward
with this idea of a clearing mechanism. This will provide a
number of benefits to all parties involved. It will improve the
transparency of the credit default swaps market, it will
improve risk management, and it will create a method for price
discovery.
However, as we move forward, it is important to make clear
that it is no solution to the problems to merge the Commodity
Futures Trading Commission with the Securities and Exchange
Commission. This is not going to solve anything, and it is not
an approach that we should pursue.
I look forward to your testimony and your answers to the
questions posed by the Committee Members, Mr. Chairman. Thank
you, and I yield back.
The Chairman. I thank the gentleman.
All Members' statements will be made part of the record.
Again, we welcome the witnesses to the table: Mr. Ananda
Radhakrishnan, Director of the Division of Clearing and
Intermediary Oversight of the CFTC; Patrick Parkinson, Deputy
Director, Division of Research and Statistics for the Board of
Governors of the Federal Reserve; Erik Sirri, Director of the
Division of Trading and Markets for the SEC; and Mr. Eric
Dinallo, Superintendent, State of New York Insurance
Department.
So, gentleman, welcome to the Committee.
We will start with you, Mr. Radhakrishnan. Am I right on
that?
Mr. Radhakrishnan. Yes, sir.
The Chairman. Your statements will be made part of the
record. We would encourage you to summarize and try to stay
within the 5 minutes because we've got a lot of stuff going on
today. So welcome to the Committee.
STATEMENT OF ANANDA RADHAKRISHNAN, DIRECTOR,
DIVISION OF CLEARING AND INTERMEDIARY OVERSIGHT, COMMODITY
FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Radhakrishnan. Thank you, Chairman Peterson and Ranking
Member Goodlatte and the other distinguished Members of this
Committee. I am pleased to appear here today to discuss risk
management for credit default swaps.
I will focus my remarks on the ongoing process to develop a
clearing solution for CDS products and the recent MOU that was
signed by the CFTC, the Federal Reserve and the SEC. This
Committee may be aware that there are two entities that are
being seriously considered to provide a clearing solution for
credit default swaps. One of them is the Chicago Mercantile
Exchange, and the other is the IntercontinentalExchange. There
are other entities that are also seeking to provide a solution,
but it is my understanding that these two entities are furthest
along.
As the Chairman pointed out, the Federal regulator for the
Chicago Mercantile Exchange is the CFTC, and the ICE proposal
has been structured to my understanding as a limited public
trust company under the auspices of the State of New York. They
will be seeking to join the Federal Reserve; and, therefore,
the Board of Governors will be the regulator for that entity.
During the past several weeks, staff of the CFTC, the Fed
and SEC have engaged in a collaborative review of these
entities to evaluate their proposals for compliance with
applicable statutory regulatory requirements, and specifically
for the CME, the core principles that Congress gave us in the
CFMA for derivatives clearing organization.
As the gentleman alluded to, there was an MOU signed by the
CFTC, the Fed and the SEC. Generally speaking, the MOU is a
statement of the intent of the three agencies to cooperate,
coordinate and share information in connection with the
respective oversight responsibilities of each agency regarding
central counterparties for CDS products.
The MOU also explicitly recognized that a central
counterparty for CDSs may be one or more of the following: a
state-chartered bank that is a member of the Fed, a DCO that is
under the jurisdiction of the CFTC, or a clearing agency that
is under the jurisdiction of the SEC. This reflects the
statutory scheme that was set up by Congress with the passage
of the CFMA.
Specifically, section 409 of the Federal Deposit Insurance
Corporation Improvement Act of 1991, also known as FDICIA,
which was enacted as part of the CFMA, provided for over-the-
counter derivative instruments to be cleared by what is known
as a Multilateral Clearing Organization, or an MCO, that is
either regulated by the CFTC, the SEC, the Federal Reserve, or,
in some cases, by a foreign clearing organization.
In that same statute, OTC derivative instruments are
defined, in my opinion, quite expansively to include, among
other things, any agreement, contract or transaction that is a
credit spread, or credit swap, or that is a swap on one or more
occurrences of any event, equity security or other equity
instrument, debt security or other debt instruments. In short,
instruments known as CDSs fall under the FDICIA's definition of
over-the-counter derivative instruments.
We believe Congress intended to bring the benefits of
multilateral clearing to the over-the-counter credit markets
without imposing legal ambiguity or regulatory redundancy that
would create a disincentive to clearing these unregulated
instruments. So over the years, through the supervision of
DCOs, the CFTC has developed extensive institutional knowledge
and regulatory expertise regarding derivatives clearing.
Further, the clearing model used by DCOs has worked well for
many years for a wide variety of products without a single
clearinghouse default.
DCOs process millions of transactions per day using fully
automated clearing systems that reduce the likelihood of
processing delay and error, and we believe that this model
should work equally well for CDS transactions.
I thank you for your leadership on this critical issue and
am pleased to answer any questions that you may have.
[The prepared statement of Mr. Radhakrishnan follows:]
Prepared Statement of Ananda Radhakrishnan, Director, Division of
Clearing and Intermediary Oversight, Commodity Futures Trading
Commission, Washington, D.C.
Chairman Peterson, Ranking Member Goodlatte, and other
distinguished Members of the Committee, I am pleased to have this
opportunity to appear today to discuss risk management for over-the-
counter credit default swaps (CDS). My name is Ananda Radhakrishnan and
I serve as the Director of the Division of Clearing and Intermediary
Oversight at the CFTC. I am here today testifying in that capacity and
not on behalf of the Commission.
Acting Chairman Lukken testified before the Committee on October 15
on this subject, so I will try not to be redundant, but rather focus on
recent events related to the CDS markets, including the ongoing process
to develop a clearing solution for CDS products and the Memorandum of
Understanding (MOU) recently signed by the CFTC, the Federal Reserve
(Fed), and the Securities and Exchange Commission (SEC).
As the Committee is aware, concerns have been raised regarding the
role that over-the-counter CDS products may have played in contributing
to the recent credit crisis. Staff of the CFTC, the Fed, and the SEC
believes that centralized clearing of CDS instruments would bring
transparency and financial integrity to the CDS market, which would be
an important step in resolving the current crisis and restoring the
strength and integrity of the U.S. financial markets as a whole. As
such, the agencies have been working together to identify potential
clearing solutions for CDS products.
Several entities--most prominently, the Chicago Mercantile Exchange
(CME) and the IntercontinentalExchange (ICE)--recently have submitted
proposals to clear CDS. The primary Federal regulator for these
entities will be the CFTC (for the CME proposal) and the Fed (for the
ICE proposal). In addition, the entities plan to obtain exemptions from
the SEC from certain securities law provisions. During the past several
weeks, staff of the CFTC, Fed, and SEC have engaged in a collaborative
review of these entities to evaluate their proposals for compliance
with applicable statutory and regulatory requirements, such as the core
principles for derivatives clearing organizations (DCOs) established by
the Commodity Futures Modernization Act of 2000 (CFMA).
Another example of agency cooperation is the MOU entered into by
the CFTC, Fed, and SEC. Generally speaking, the MOU is a statement of
intent to cooperate, coordinate and share information in connection
with the respective oversight responsibilities of each agency regarding
central counterparties for CDS.
Among its specific provisions, the MOU provides that the agencies
will consult with each other and share information regarding matters
such as: (i) the review and approval of any proposed central
counterparty; (ii) material proposed changes to the rules, policies or
procedures of a central counterparty; and (iii) the financial
condition, risk management systems, internal controls, liquidity and
financial resources, operations, and governance of central
counterparties. The MOU also contains provisions regarding permissible
uses of information exchanged under the MOU and confidentiality of that
information.
The MOU deliberately does not address the specifics of any
particular clearing proposal for CDS, nor does it commit any of the
agencies to take any action (or refrain from any action) with respect
to any particular clearing proposal or central counterparty. It
recognizes the importance of efficient supervision and regulation of
central counterparties to reduce duplicative efforts. It avoids,
however, addressing any issues respecting the jurisdictional authority
of the agencies over various central counterparties.
However, as the MOU expressly recognizes, a central counterparty
for CDS may be one or more of the following: a state-chartered bank
that is a member of the Fed, a DCO under the jurisdiction of the CFTC,
or a Clearing Agency under the jurisdiction of the SEC. This reflects
the statutory scheme set up by Congress with the passage of the CFMA.
Pursuant to Section 409 of the Federal Deposit Insurance
Corporation Improvement Act of 1991 (FDICIA), which was enacted as part
of the CFMA, over-the-counter derivative instruments may be cleared by
any multilateral clearing organization (MCO) that is regulated by the
CFTC, the SEC or the Fed (or by foreign clearing organizations under
certain circumstances). Over-the-counter derivative instruments are
defined expansively in Section 408(2) of FDICIA to include, among other
things, any agreement, contract, or transaction that is a credit spread
or credit swap or that is a swap on one or more occurrences of any
event, equity security, or other equity instrument, debt security or
other debt instrument. In short, instruments known as CDS fall under
FDICIA's definition of over-the-counter derivative instruments.
Contemporaneously with authorizing the clearing of over-the-counter
derivative instruments by any MCO, Congress excluded the trading of
over-the-counter financial derivative instruments from CFTC and SEC
jurisdiction. However, there remains legal uncertainty whether the act
of clearing changes the legal status of an OTC derivative. We believe
Congress intended to bring the benefits of multilateral clearing to the
over-the-counter credit markets without imposing legal ambiguity and
regulatory redundancy that would create a disincentive to clearing
these unregulated instruments. That principle is recognized in the MOU
that was entered into last week, which emphasized the importance of
promoting the effective and efficient supervision and regulation of
central counterparties and reducing duplication of effort by the
agencies.
Over the years, through supervision of the DCOs, the CFTC has
developed extensive institutional knowledge and regulatory expertise
regarding derivatives clearing. Further, the clearing model used by
DCOs has worked well for many years for a wide variety of products,
without a single clearinghouse default. DCOs process millions of
transactions per day, using fully automated clearing systems that
reduce the likelihood of processing delay and error. This model should
work equally well for CDS transactions.
We at the CFTC will continue to work collaboratively and
cooperatively with our colleagues at the Fed and the SEC, and with
international regulators, to bring transparency and financial integrity
to the CDS market through clearing and infrastructure improvements, and
to enhance and improve effective risk management and market oversight.
It is our hope that these efforts will help restore the strength and
integrity of the U.S. financial markets.
Thank you for your leadership on this critical issue. I am pleased
to answer any questions you may have.
The Chairman. Thank you very much.
Mr. Parkinson, welcome to the Committee.
STATEMENT OF PATRICK M. PARKINSON, DEPUTY DIRECTOR, DIVISION OF
RESEARCH AND STATISTICS, BOARD OF
GOVERNORS, FEDERAL RESERVE SYSTEM, WASHINGTON, D.C.
Mr. Parkinson. Thank you, Chairman Peterson, Ranking Member
Goodlatte and Members of the Committee. I appreciate the
opportunity to provide an update on recent initiatives by the
Federal Reserve to enhance the markets in which credit default
swaps and other over-the-counter derivatives trades are
settled.
I would like to emphasize that the Federal Reserve has
taken these actions in coordination with the President's
Working Group on Financial Markets and other domestic and
international supervisors of key market participants.
In March, the PWG made recommendations to enhance the
market infrastructure for CDS and other OTC derivatives. In
light of recent developments, last week the PWG announced a
broader set of public policy objectives to guide efforts to
address the full range of challenges associated with OTC
derivatives, including risk management of OTC derivatives and
the transparency and integrity of CDS markets, as well as
further measures to strengthen the market infrastructure.
The PWG's top near-term priority is to oversee the
implementation of CCP clearing for CDS. In the past month,
authorities in the United States and abroad have sought to
speed the development of CCPs for CDS. Four organizations plan
to offer clearing for CDS. The primary Federal regulators for
two of those organizations would be U.S. authorities, in one
case, the Commodity Futures Trading Commission and, in the
other case, the Federal Reserve Board. The primary regulators
for the other two would be authorities in the United Kingdom
and Germany.
In addition, the two U.S. CCPs, for credit derivatives to
obtain an exemption from the SEC from securities clearing
agency registration requirements. The CFTC, SEC and Federal
Reserve recognize their mutual interests in ensuring that all
CCPs for credit derivatives are organized and managed
prudently.
We have been jointly examining the risk management and
financial resources of the two organizations that will be
supervised by U.S. authorities against the Recommendations for
Central Counterparties, a set of international standards that
were agreed to in 2004 by the Committee on Payment and
Settlement Systems of the central banks of the Group of 10
countries and the Technical Committee of the International
Organization of Securities Commissions.
Last week, the CFTC, SEC, and Federal Reserve signed a
Memorandum of Understanding that established a framework for
ongoing consultation and information sharing relating to CCPs
for CDS. The MOU is particularly important because it created a
mechanism to ensure that we all have the information necessary
for carrying out our respective responsibilities related to the
markets regardless of the form in which the CCP is organized
and regardless of which agency is the primary regulator.
Numerous other efforts are under way to build a more
resilient infrastructure for OTC derivatives. Major dealers
recently committed to broad improvements in back office
processes for equity, interest rate, commodity and foreign
exchange products as well as credit products. These commitments
include greater use of electronic processing of trades,
speedier confirmation of trades, and expanded use of central
trade repositories, in part to enhance market transparency.
Dealers as well as other large market participants also
have redoubled their efforts to terminate economically
redundant trades that contribute to operational risks. To date
in 2008, more than $24 trillion of the notional amount of the
CDS trades has been terminated.
Although the creation of the CCPs for CDS will provide an
important new tool for managing counterparty credit risk,
enhancements to the risk-management policies and procedures for
market participants will continue to be a high priority for
supervisors. Many transactions that transfer credit risk
between market participants will continue to be executed and
managed on a bilateral, decentralized basis because they are
not sufficiently standardized to be cleared through a CCP.
Supervisors recognize financial institutions need to make
changes to their risk-management practices for OTC derivatives
to ensure the traditional credit risk management disciplines
are in place for complex products, regardless of whether they
take the form of CDS or of securities. Efforts to implement
these changes continue through the Senior Supervisors Group, in
which supervisors from the jurisdictions with major OTC
derivatives dealers are represented. Such cooperative groups
have offered an important tool for ensuring that supervisors
set consistent standards for all participants in these global
markets.
Many market observers have expressed concern about the
opaqueness of OTC derivatives markets generally, not just of
the CDS markets. The Depository Trust Clearing Corporation's
Trade Information Warehouse, a contract repository, contains an
electronic record of a large and growing share of CDS trades.
DTCC recently began publishing aggregate market data based upon
these reports. However, these data currently are not
comprehensive. The PWG has called for a record of all CDS that
are not cleared through a CCP to be retained in the DTCC
warehouse or a similar repository and for regulators to have
access to the data on CDS housed at the CCPs and repositories.
Furthermore, the PWG has called for public reporting of prices,
trading volumes, and aggregate open interest.
In conclusion, credit derivatives and other OTC derivatives
are integral to the smooth functioning of today's financial
market. With appropriate oversight and prudent risk management
by users of these products, derivatives can provide significant
benefits to financial market participants and to the financial
system generally. The Federal Reserve is working cooperatively
with other domestic and international authorities to strengthen
the infrastructure through which CDS trades are cleared and
settled, and to address weaknesses that have been identified in
the risk management practices of major participants. Efforts to
strengthen the infrastructure also will help support
significant improvements in transparency, which in turn can
enhance efficiency in market integrity.
Thank you.
[The prepared statement of Mr. Parkinson follows:]
Prepared Statement of Patrick M. Parkinson, Deputy Director, Division
of Research and Statistics, Board of Governors, Federal Reserve System,
Washington, D.C.
Chairman Peterson, Ranking Member Goodlatte, and Members of the
Committee, I appreciate this opportunity to provide an update on recent
initiatives by policymakers to enhance the markets in which credit
default swaps (CDS) and other over-the-counter (OTC) derivatives trade
and are settled. On October 15, I provided the Committee with a more
extensive statement about the nature of OTC credit derivatives markets,
prudential oversight of those markets, potential changes in market
infrastructure, and the policy issues that should be considered in
evaluating regulatory changes. Today, I will briefly review the key
conclusions of that statement and then discuss the Federal Reserve's
recent actions to strengthen market infrastructure, enhance risk
management, and increase transparency for these products. I would like
to emphasize at the outset that the Federal Reserve has taken these
actions in coordination with the President's Working Group on Financial
Markets (PWG) and other domestic and international supervisors of key
market participants.
Summary of October 15 Statement
As noted in my earlier statement, supervisors have worked with
market participants since 2005 to strengthen the infrastructure of
credit derivatives markets through such steps as greater use of
electronic confirmation platforms, adoption of a protocol that requires
participants to request counterparty consent before assigning trades to
a third party, and creation of a contract repository, which maintains
an electronic record of CDS trades. Looking forward, the most important
potential change in the infrastructure for credit derivatives is the
creation of one or more central counterparties (CCPs) for CDS. The
Federal Reserve supports CCP clearing of CDS because, if properly
designed and managed, CCPs can reduce risks to market participants and
to the financial system. In addition to clearing of CDS through CCPs,
the Federal Reserve believes that exchange trading of sufficiently
standardized contracts by banks and other market participants can
increase market liquidity and transparency and thus should be
encouraged.
Policy discussions of potential regulatory changes for CDS have
focused on preventing market manipulation, improving transparency, and
mitigating systemic risk. Manipulation concerns can be addressed by
clarifying the Securities and Exchange Commission's (SEC) authority
with respect to CDS. Data from a contract repository provide a means
for enhancing transparency, a topic I will discuss in greater depth
later. To better contain systemic risk, prudential supervisors already
have begun to address the weaknesses of major market participants in
measuring and managing their counterparty credit risks. This step is
fundamental to containing systemic risk because it helps limit the
potential for any single large market participant to be the catalyst
for transmission of such risk.
Strengthening Infrastructure, Enhancing Risk Management, and Increasing
Transparency
PWG's Policy Objectives for OTC Derivatives
In March, the PWG made recommendations to enhance the market
infrastructure for CDS and other OTC derivatives. In light of recent
developments, last week the PWG announced a broader set of policy
objectives to guide efforts to address the full range of challenges
associated with OTC derivatives, including risk management of OTC
derivatives and the transparency and integrity of CDS markets, as well
as further measures to strengthen market infrastructure.\1\
---------------------------------------------------------------------------
\1\ President's Working Group on Financial Markets (2008), ``Policy
Statement on Financial Market Developments,'' March, www.treas.gov/
press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf;
President's Working Group on Financial Markets (2008), ``PWG Policy
Objectives,'' November 14, www.treasury.gov/press/releases/reports/
policyobjectives.pdf.
---------------------------------------------------------------------------
Central Counterparties for CDS and Other Infrastructure Issues
The PWG's top near-term priority is to oversee the implementation
of CCP clearing for CDS. In the past month, authorities in the United
States and abroad have sought to speed the development of CCPs for CDS.
Four organizations plan to offer clearing for CDS. The primary Federal
regulators for two of these organizations would be U.S. authorities--in
one case, the Commodity Futures Trading Commission (CFTC), and in the
other case, the Federal Reserve Board (and its supervisory delegee, the
Federal Reserve Bank of New York). The primary regulators for the two
others would be authorities in the United Kingdom and Germany. In
addition, the two U.S. CCPs for credit derivatives plan to obtain an
exemption from the SEC from securities clearing agency registration
requirements. The CFTC, SEC, and Federal Reserve recognize their mutual
interests in ensuring that all CCPs for credit derivatives are
organized and managed prudently. We have been jointly examining the
risk management and financial resources of the two organizations that
will be supervised by U.S. authorities against the ``Recommendations
for Central Counterparties,'' a set of international standards that
were agreed to in 2004 by the Committee on Payment and Settlement
Systems (CPSS) of the central banks of the Group of 10 countries and
the Technical Committee of the International Organization of Securities
Commissions.\2\
---------------------------------------------------------------------------
\2\ Committee on Payment and Settlement Systems and Technical
Committee of the International Organization of Securities Commissions,
Bank for International Settlements (2004), ``Recommendations for
Central Counterparties,'' November, www.bis.org/publ/cpss64.pdf.
---------------------------------------------------------------------------
Last week, the CFTC, SEC, and Federal Reserve signed a Memorandum
of Understanding (MOU) that established a framework for ongoing
consultation and information sharing related to CCPs for CDS. The MOU
is particularly important because it created a mechanism to ensure that
we all will have the information necessary for carrying out our
respective responsibilities related to these markets regardless of the
form in which a CCP is organized and regardless of which agency is the
primary regulator.
As outlined in my October statement, numerous other efforts are
under way to build a more resilient infrastructure for OTC derivatives
in addition to the development of a CCP for CDS. Major dealers recently
committed to broader improvements in back-office processes for equity,
interest rate, commodity, and foreign exchange products as well as
credit products. These commitments include greater use of electronic
processing of trades, speedier confirmation of trades, and expanded use
of central trade repositories, in part to enhance market transparency.
Dealers as well as other large market participants also have redoubled
their efforts to terminate economically redundant trades that
contribute to operational risk. To date in 2008, more than $24 trillion
of the notional amount of CDS trades has been terminated.
Risk Management
Although the creation of CCPs for CDS will provide an important new
tool for managing counterparty credit risk, enhancements to the risk-
management policies and procedures for market participants will
continue to be a high priority for supervisors. Many transactions that
transfer credit risk between market participants will continue to be
executed and managed on a bilateral, decentralized basis because they
are not sufficiently standardized to be cleared through a CCP. Such OTC
transactions are integral to the functioning of today's financial
markets. Supervisors recognize, however, that financial institutions
need to make changes in their risk-management practices for OTC
derivatives by improving internal incentives and controls and by
ensuring that traditional credit risk-management disciplines are in
place for complex products, regardless of whether they take the form of
CDS or of securities. Efforts to implement these changes continue
through the Senior Supervisors Group, in which supervisors from the
jurisdictions with major OTC derivatives dealers are represented.\3\
Such cooperative groups offer an important tool for ensuring that
supervisors set consistent standards for all participants in these
global markets.
---------------------------------------------------------------------------
\3\ Senior Supervisors Group (2008), ``Observations on Risk
Management Practices during the Recent Market Turbulence,'' March 6,
www.newyorkfed.org/newsevents/news/banking/2008/
SSG_Risk_Mgt_doc_final.pdf.
---------------------------------------------------------------------------
Transparency
Many market observers have expressed concern about the opaqueness
of OTC derivatives markets generally. The Depository Trust Clearing
Corporation's (DTCC) Trade Information Warehouse, a contract
repository, contains an electronic record of a large and growing share
of CDS trades. DTCC recently began publishing aggregate market data
based upon these records each week. Information is provided, for
example, on index, versus single-name, contracts; reference entities on
which the contracts are written; and maturities of contracts. However,
these data currently are not comprehensive. The PWG has called for a
record of all CDS that are not cleared through a CCP to be retained in
the DTCC warehouse or a similar repository and for regulators to have
access to the data on CDS housed at CCPs and repositories. Furthermore,
the PWG has called for public reporting of prices, trading volumes, and
aggregate open interest.
Conclusion
Credit derivatives and other OTC derivatives are integral to the
smooth functioning of today's financial markets. With appropriate
oversight and prudent risk management by users of these products,
derivatives can provide significant benefits to financial market
participants and to the financial system generally. The Federal Reserve
is working cooperatively with other domestic and international
authorities to strengthen the infrastructure through which CDS trades
are cleared and settled and to address weaknesses that have been
identified in the risk-management practices of major market
participants. Efforts to strengthen the infrastructure also will help
support significant improvements in transparency, which in turn can
enhance efficiency and market integrity.
The Chairman. Thank you very much.
Mr. Sirri, welcome to the Committee.
STATEMENT OF ERIK R. SIRRI, DIRECTOR, DIVISION OF
TRADING AND MARKETS, U.S. SECURITIES AND EXCHANGE COMMISSION,
WASHINGTON, D.C.
Mr. Sirri. Thank you, Chairman Peterson, Ranking Member
Goodlatte and Members of the House Committee on Agriculture. I
am pleased to have the opportunity to be here again, today to
testify regarding credit default swaps.
As you know, the CDS market has experienced explosive
growth in recent years. I think it is important to note that
the CDS can serve important economic purposes, including the
management of risk exposure to a particular credit or to an
entire sector.
The current CDS market operates solely on a bilateral
basis, an over-the-counter system that has grown many times the
size of the market for the underlying credit derivatives.
Recent events have focused attention on the systemic risks that
are posed by CDS. Moreover, the deterioration of credit markets
generally has increased the likelihood of CDS payouts, which
are prompting CDS buyers to seek additional margin from their
counterparties. These margin calls have strained
counterparties' balance sheets and may be forcing asset sales
that contribute to a downward pressure on the cash securities
market.
In addition to this risk that CDS poses systemically to
financial stability, CDS also presents risks of manipulation
and fraud for our markets.
The SEC has great interest in credit default swaps in part
because of their impact on securities markets and the
Commission's responsibility to maintain fair, orderly and
efficient markets. These markets are directly affected by CDS
because the credit protection is written on the financial
claims of issuers, which we regulate.
The Commission's current authority with respect to OTC CDS,
which generally are securities-based swap agreements under the
CFMA, is limited to enforcing anti-fraud prohibitions under the
Federal securities laws, including prohibitions on insider
trading. I note, however, that if CDS were standardized as a
result of central clearing or exchange trading or other changes
in the market and no longer subject to individual negotiation,
the swap exclusion from the securities laws under the CFMA
would be unavailable.
Under current law, however, the SEC is statutorily
prohibited from promulgating any rules regarding CDS trading in
the over-the-counter market. Thus, the tools necessary to
oversee OTC CDS markets effectively and efficiently do not
exist.
In addition, there is a risk of manipulation and fraud in
the CDS market in part because trade reporting and disclosure
are limited. One way to guard against mis-information and fraud
is to create mandatory systems of record-keeping and the
reporting of all CDS trades to the SEC. Ready information on
trades and positions of dealers would also aid the SEC in its
enforcement of anti-fraud and anti-manipulation rules.
Notwithstanding the lack of statutory authority to require
the reporting of record-keeping in the CDS market, the SEC is
doing what it can under existing statutory authority. Most
recently, the Commission announced a sweeping expansion of its
ongoing investigation into possible market manipulation
involving certain financial institutions. The expanded
investigation will require hedge fund managers and other
persons with positions in CDSs to expose their positions in the
Commission and provide certain information under oath.
Investigations of over-the-counter CDS transactions have
been far more difficult and time-consuming than those involving
other markets because information on CDS transactions gathered
from market participants have been incomplete and inconsistent.
SEC staff is actively participating with other financial
supervisors and industry members in efforts to establish one or
more central counterparties for credit default swaps. This
would be an important first step in reducing systemic and
operational risks in the CDS market, and the Commission staff
fully support these efforts.
The Commission staff, along with Fed and CFTC staff, have
been evaluating proposals to establish CCPs for the CDS. SEC
staff has participated in on-site assessments of these Federal
counterparty proposals, including review of the risk management
systems.
The SEC brings to this exercise its experience of more than
30 years in regulating the clearance and settlement of
securities, including derivatives on securities. The Commission
will use this expertise in its regulatory and supervisory
authority over any CCPs for CDS that may be established to
strengthen the market infrastructures and to protect investors.
To facilitate the speedy establishment of one or more CCPs
for these credit default swaps and to encourage market
participants to voluntarily submit their CDS trades to a
central counterparty, the Commission staff is preparing
conditional exceptions from the requirements of the securities
laws for Commission consideration. SEC staff has been
discussing the potential scope and condition of these draft
exemptions with each prospective CCP and has been coordinating
with relevant U.S. and foreign regulators.
In addition, last Friday, Chairman Cox signed a Memorandum
of Understanding with the Fed and CFTC. This MOU establishes a
framework for consultation and information sharing on issues
related to central counterparties for CDS. Cooperation and
coordination under the MOU will enhance each agency's ability
to effectively carry out its respective regulatory
responsibilities, minimize the burden on CCPs, and reduce
duplicative efforts.
In addition to reducing counterparty and operational risk
inherent in the CDS market and thereby helping to mitigate the
potential systemic impacts, a CCP may also help reduce negative
effects and misinformation and rumors that can occur during
high-volume periods. A CCP would be a source of records
regarding CDS transactions. Of course, to the extent that
participation in a CCP is voluntary, its value is a device to
prevent and detect manipulation and other fraud and abuse in
the CDS market may be greatly limited.
Exchange trading of CDS would also add efficiency to the
market for these instruments. It is not uncommon for derivative
contracts that are initially developed in the OTC market to
become exchange traded as the market for the product matures.
While the contracts traded in the OTC market are subject to
individual bilateral negotiation, on-exchange it efficiently
creates a market for a standardized form of the contract.
These standardized exchange traded contracts typically
coexist with more varied and negotiated OTC contracts. Exchange
trading of credit derivatives could enhance both pre- and post-
trade transparency to the market that would enhance efficient
pricing of credit derivatives. Exchange trading could reduce
liquidity risk by providing a centralized marketplace that
allows participants to efficiently initiate and close out
positions at the best available prices.
In crafting any regulatory solution, it is important to
keep in mind the significant role that CDS trading plays in
today's financial markets, as well as the truly global nature
of the CDS market. Further, the varied nature of market
participants in CDS and the breadth of this market underscore
the importance of cooperation among U.S. financial supervisors
at the Federal and state levels, as well as supervisors
internationally.
Thank you for this opportunity to discuss these important
issues, and I am happy to take any questions.
[The prepared statement of Mr. Sirri follows:]
Prepared Statement of Erik R. Sirri, Director, Division of Trading and
Markets, U.S. Securities and Exchange Commission, Washington, D.C.
Chairman Peterson, Ranking Member Goodlatte, and Members of the
House Committee on Agriculture:
I am pleased to have the opportunity today to again testify
regarding the credit default swaps (CDS) market. My testimony today
summarizes the key points from my testimony before this Committee 5
weeks ago and updates it to reflect the Commission's activities since
then.
CDS can serve important purposes. They can be employed to closely
calibrate risk exposure to a credit or a sector. CDS can be especially
useful for the business model of some financial institutions that
results in the institution making heavily directional bets, and
others--such as dealer banks--that take both long and short positions
through their market-making and proprietary trading activities. Through
CDS, market participants can shift credit risk from one party to
another, and thus the CDS market may be an important element to a
particular firm's willingness to participate in an issuer's securities
offering.
The current CDS market operates solely on a bilateral, over-the-
counter basis and has grown to many times the size of the market for
the underlying credit instruments. In light of the problems involving
AIG, Lehman, Fannie, Freddie, and others, attention has focused on the
systemic risks posed by CDS. The ability of protection sellers (such as
AIG and Lehman) to meet their CDS obligations has raised questions
about the potentially destabilizing effects of the CDS market on other
markets. Also, the deterioration of credit markets generally has
increased the likelihood of CDS payouts, thus prompting protection
buyers to seek additional margin from protection sellers. These margin
calls have strained protection sellers' balance sheets and may be
forcing asset sales that contribute to downward pressure on the cash
securities markets.
In addition to the risks that CDS pose systemically to financial
stability, CDS also present the risk of manipulation. Like all
financial instruments, there is the risk that CDS are used for
manipulative purposes, and there is a risk of fraud in the CDS market.
The SEC has a great interest in the CDS market because of its
impact on the securities markets and the Commission's responsibility to
maintain fair, orderly, and efficient securities markets. These markets
are directly affected by CDS due to the interrelationship between the
CDS market and the securities that compose the capital structure of the
underlying issuers on which the protection is written. In addition, we
have seen CDS spreads move in tandem with falling stock prices, a
correlation that suggests that activities in the OTC CDS market may in
fact be spilling over into the cash securities markets.
OTC market participants generally structure their activities in CDS
to comply with the CFMA's swap exclusion from the Securities Act and
the Exchange Act. These CDS are ``security-based swap agreements''
under the CFMA, which means that the SEC currently has limited
authority to enforce anti-fraud prohibitions under the Federal
securities laws, including prohibitions against insider trading. If CDS
were standardized as a result of centralized clearing or exchange
trading or other changes in the market, and no longer subject to
individual negotiation, the ``swap exclusion'' from the securities laws
under the CFMA would be unavailable.
Progress on Establishing a Central Counterparty for CDS
As announced on November 14th, a top priority for The President's
Working Group on Financial Markets, in which the SEC Chairman is a
member, is to oversee the implementation of central counterparty
services for CDS. A central counterparty (``CCP'') for CDS could be an
important step in reducing the counterparty risks inherent in the CDS
market, and thereby help mitigate potential systemic impacts.
By clearing and settling CDS contracts submitted by participants in
the CCP, the CCP could substitute itself as the purchaser to the CDS
seller and the seller to the CDS buyer. This novation process by a CCP
would mean that the two counterparties to a CDS would no longer be
exposed to each others' credit risk. A single, well-managed, regulated
CCP could vastly simplify the containment of the failure of a major
market participant. In addition, the CCP could net positions in similar
instruments, thereby reducing the risk of collateral flows.
Moreover, a CCP could further reduce risk through carefully
regulated uniform margining and other robust risk controls over its
exposures to its participants, including specific controls on market-
wide concentrations that cannot be implemented effectively when
counterparty risk management is uncoordinated. A CCP also could aid in
preventing the failure of a single market participant from
destabilizing other market participants and, ultimately, the broader
financial system.
A CCP also could help ensure that eligible trades are cleared and
settled in a timely manner, thereby reducing the operational risks
associated with significant volumes of unconfirmed and failed trades.
It may also help to reduce the negative effects of misinformation and
rumors that can occur during high volume periods, for example when one
market participant is rumored to ``not be taking the name'' or not
trading with another market participant because of concerns about its
financial condition and taking on incremental credit risk exposure to
the counterparty. Finally, a CCP could be a source of records regarding
CDS transactions, including the identity of each party that engaged in
one or more CDS transactions. Of course, to the extent that
participation in a CCP is voluntary, its value as a device to prevent
and detect manipulation and other fraud and abuse in the CDS market may
be limited.
The Commission staff, together with Federal Reserve and CFTC staff,
has been evaluating proposals to establish CCPs for CDS. SEC staff has
participated in on-site assessments of these CCP proposals, including
review of their risk management systems. The SEC brings to this
exercise its experience over more than 30 years of regulating the
clearance and settlement of securities, including derivatives on
securities. The Commission will use this expertise, and its regulatory
and supervisory authorities over any CCPs for CDS that may be
established, to strengthen the market infrastructure and protect
investors.
To facilitate the speedy establishment of one or more CCPs for CDS
and to encourage market participants to voluntarily submit their CDS
trades to the CCP, Commission staff are preparing conditional
exemptions from the requirements of the securities laws for Commission
consideration. SEC staff have been discussing the potential scope and
conditions of these draft exemptions with each prospective CCP and have
been coordinating with relevant U.S. and foreign regulators.
In addition, last Friday, Chairman Cox, on behalf of the SEC,
signed a Memorandum of Understanding (MOU) with the Federal Reserve
Board and the Commodity Futures Trading Commission. This MOU
establishes a framework for consultation and information sharing on
issues related to CCPs for CDS. Cooperation and coordination under the
MOU will enhance each agency's ability to effectively carry out its
respective regulatory responsibilities, minimize the burden on CCPs,
and reduce duplicative efforts.
Other Potential Improvements to OTC Derivatives Market
As explained above, the SEC has limited authority over the current
OTC CDS market. The SEC, however, is statutorily prohibited under
current law from promulgating any rules regarding CDS trading in the
over-the-counter market. Thus, the tools necessary to oversee this
market effectively and efficiently do not exist. Chairman Cox has urged
Congress to repeal this swap exclusion, which specifically prohibits
the SEC from regulating the OTC swaps market.
Recordkeeping and Reporting to the SEC
The repeal of this swap exclusion would allow the SEC to promulgate
record-keeping requirements and require reporting of CDS trades to the
SEC. As I discussed in my earlier testimony, a mandatory system of
record-keeping and reporting of all CDS trades to the SEC, is essential
to guarding against misinformation and fraud. The information that
would result from such a system would not only reduce the potential for
abuse of the market, but would aid the SEC in detection of fraud in the
market quickly and efficiently.
Investigations of over-the-counter CDS transactions have been far
more difficult and time-consuming than those involving cash equities
and options. Because these markets lack a central clearing house and
are not exchange traded, audit trail data is not readily available and
must be reconstructed manually. The SEC has used its anti-fraud
authority over security-based swaps, including the CDS market, to
expand its investigation of possible market manipulation involving
certain financial institutions. The expanded investigation required
hedge fund managers and other persons with positions in CDS and other
derivative instruments to disclose those positions to the Commission
and provide certain other information under oath. This expanded
investigation is ongoing and should help to reveal the extent to which
the risks I have identified played a role in recent events. Depending
on its results, this investigation may lead to more specific policy
recommendations.
However, because of the lack of uniform record-keeping and
reporting to the SEC, the information on security-based CDS
transactions gathered from market participants has been incomplete and
inconsistent. Given the interdependency of financial institutions and
financial products, it is crucial for our enforcement efforts that we
have a mechanism for promptly obtaining CDS trading information--who
traded, how much and when--that is complete and accurate.
Recent private sector efforts may help to alleviate some of these
concerns. For example, Deriv/SERV, an unregulated subsidiary of DTCC,
provides automated matching and confirmation services for over-the-
counter derivatives trades, including CDS. Deriv/SERV's customers
include dealers and buy-side firms from more than 30 countries.
According to Deriv/SERV, more than 80% of credit derivatives traded
globally are now confirmed through Deriv/SERV, up from 15% in 2004. Its
customer base includes 25 global dealers and more than 1,100 buy-side
firms in 31 countries. While programs like Deriv/SERV may aid the
Commission's efforts, from an enforcement perspective, such voluntary
programs would not be expected to take the place of mandatory record-
keeping and reporting requirements to the SEC.
In the future, Deriv/SERV and similar services may be a source of
reliable information about most CDS transactions. However,
participation in Deriv/SERV is elective at present, and the platform
does not support some of the most complex credit derivatives products.
Consequently, not all persons that engage in CDS transactions are
members of Deriv/SERV or similar platforms. Greater information on CDS
trades, maintained in consistent form, would be useful to financial
supervisors. In addition to better record-keeping by market
participants, ready information on trades and positions of dealers also
would aid the SEC in its enforcement of anti-fraud and anti-
manipulation rules. Finally, because Deriv/SERV is unregulated, the SEC
has no authority to obtain the information stored in this facility for
supervision of risk associated with the OTC CDS market and can only
obtain it if given voluntarily or by subpoena.
Market Transparency
Market transparency is another improvement to the CDS market that
the Commission supports. The development of a CCP could facilitate
greater market transparency, including the reporting of prices for CDS,
trading volumes, and aggregate open interest. The availability of
pricing information can improve the fairness, efficiency, and
competitiveness of markets--all of which enhance investor protection
and facilitate capital formation. The degree of transparency, of
course, depends on participation in the CCP, which currently is not
mandatory.
Exchange Trading
A CCP also could facilitate the exchange trading of CDS because the
CDS would be in standardized form. Exchange trading of credit
derivatives could add both pre- and post-trade transparency to the
market that would enhance efficient pricing of credit derivatives.
Exchange trading also could reduce liquidity risk by providing a
centralized market that allows participants to efficiently initiate and
close out positions at the best available prices.
Some of the prospective CCPs for CDS are proposing to offer some
type of trading facility. In addition, we anticipate that other
entities may develop trading platforms for CDS. The SEC believes it is
important that the CCPs be open to clearing trades in eligible CDS from
any participant that meets a fair and objective set of access criteria,
including a participant that operates an exchange or other trading
facility.
In crafting any regulatory solution, it is important to keep in
mind the significant role CDS play in today's financial markets, as
well as the truly global nature of the CDS market. Further, the varied
nature of market participants in CDS and the breadth of this market
underscore the importance of cooperation among U.S. financial
regulators and supervisors at the Federal and state level, as well as
regulators and supervisors internationally.
Thank you for this opportunity to discuss these important issues. I
am happy to take your questions.
The Chairman. I thank the gentleman.
Mr. Dinallo, welcome to the Committee.
STATEMENT OF ERIC R. DINALLO, J.D., SUPERINTENDENT,
INSURANCE DEPARTMENT, STATE OF NEW YORK, NEW YORK, NY
Mr. Dinallo. Thank you, Mr. Chairman, Ranking Member
Goodlatte, and Members of the Committee.
I think we can all agree that credit default swaps have
played a major role in the economic meltdown that we are going
through at this time. The market grew to in excess of $60
trillion, which I am sure some of you have heard is larger than
the entire economic output of the globe on an annual basis.
Indeed, you could buy probably all of the stock in the world
for far less than that amount. It is surprising that we got to
a point where the largest financial services mechanism in the
globe that humankind had ever invented was essentially
unregulated.
I have not said, as the Ranking Member said, which I agree
with, that this was the causation of all that we are going
through. I do think it was, in fact, a catastrophic enabler for
what we went through. Because at the end of the chain of CDOs
and other arcana of our securities industry there was this
belief that we had this backstop of some sort of insurance
product, which to a large extent we really didn't have.
You often hear CDS referred to as insurance. It is offered
as insurance in the sense it is a credit default guarantee,
but, as you've said, only about 20 or 30 percent of the market
actually performs that function, the hedge, the valuable
hedging instrument.
I agree we need to basically deal with risk on the bond and
credit market. But at least 80 percent grew into what Wall
Street calls a directional bet or a situation where you have
absolutely no exposure to the underlying credit event, because
you don't hold the bonds or you don't hold the CDO.
I think it is important as you go forward to keep that
distinction in mind. Because as you decide upon the regulatory
mechanism that you want to put in place, at least from an
insurance perspective, capitalization, solvency, and surplus
are usually the earmarks of making a guarantee against a future
outcome.
The essential difference, which I just sort of thought
about today, between investments, which aren't guaranteed and
generally are not promised, as insurance is, essentially,
insurance is a certain guarantee or promise against an outcome
and a payment upon that event; which is how, to a large extent,
CDSs were appropriately held out and were appropriately
necessary. We didn't have a mechanism to short or be negative
on the credit market, which is far in excess of the equity
market.
It is sort of interesting that we did stop the shorting of,
I think, 800 financial stocks for a long time and all naked
shorting, but we really didn't do much about a much larger part
of the market, which goes to how we deal with the credit and
the bond side.
So, in some way it is the first time in history, sadly,
that you don't have all the participants lined up against the
bankruptcy. In other words, usually all members of a
transaction want to avoid the worst-case scenario; and they
tend to line up and pull on the same rope against an
insolvency. But here you have more people rooting for
insolvency and failures of institutions than you have actually
on the other side. Because there is the 80/20 rule that I
described where you have more people holding the naked credit
default swaps than what I would call the sartorial credit
default swaps. I think that creates a drama that to a large
extent has been somewhat self-fulfilling.
When you place a bet on a football game, you can't really
actually have an impact on the outcome of the game. You sit
there, and you may hope one team wins, and you have a bet with
your friend or a bookie. But the credit default swaps actually
impact the outcome of the game. Because, as those rates
increase, the rating agencies and other participants in the
market take keen interest in them and, in fact, cite them for
the actions, including rating down grades. So, there is a real
cyclical feedback nature to them that has to be considered.
From a regulatory point of view, the frustration that some
of us have had is that we have no idea how much CDS was written
on the institutions that we were regulating over--in other
words Ambak, MBIA, AIG. When you think about what you are going
to do with those institutions, whether you are going to let
them go into insolvency or not, we still don't know how much
credit default swaps were written on them as a reference
instrument. We know how much they had written, how much AIG had
written but not how much was written on them as a target.
So, a lot of this is why we went to the position that we
went in September where we announced we are going to regulate
part of the market, that insurance part of the market, that
sartorial part as insurance product. As we said on January 1st,
because it had all the hallmarks of insurance and fit our
history, we are going to start to regulate that.
But I want to tell you, I want to sort of announce today I
think it is very important that everyone should know that,
because of the great progress that has been made--it was our
hope that we would both make sure there was solvency behind the
insurance type transactions and cause a robust debate about
this--and because of the great progress that has been made on
the Federal side, the formation of it looks like at least two
solutions and the MOU. I am here to tell you that at least for
now we are suspending that January 1st date because we don't
want a segmented market. We have always wanted a holistic
solution, and it looks like we are headed towards a holistic
outcome. So I am happy about that.
I would urge, again, to have five indicia behind that
solution; and I will conclude that we are suspending it because
it looks like we are heading towards a solution that will have,
I hope, these five clear margin rules: some sort of guaranty
fund or ultimate solvency behind these commitments, rules of
event determination that everyone agrees on so there is no
dispute when there has been a default or insolvency, rules of
dispute resolution so everyone agrees how to resolve disputes
about that topic, and, finally, although this one is somewhat
controversial, some kind of central counterparty or some kind
of central counterparty enumeration of exactly who has how much
risk in this market so one can decide whether someone is
overburdened or dangerously exposed.
The Department and I think those five indicia are
essential, but it looks like the solutions that we're talking
about are going to embody something remarkably like that.
Progress is such that we think it is worth waiting for a whole
solution, because we never purported to be able to offer that.
Thank you very much.
[The prepared statement of Mr. Dinallo follows:]
Prepared Statement of Eric R. Dinallo, J.D., Superintendent, Insurance
Department, State of New York, New York, NY
I would like to thank Chairman Collin C. Peterson, Ranking Member
Bob Goodlatte and the Members of the House Agriculture Committee for
inviting me to testify today at this hearing to review the role of
credit derivatives in the U.S. economy.
My name is Eric Dinallo and I am Insurance Superintendent for New
York State.
What I would like to discuss with you today is one particular kind
of derivative--credit default swaps--which have played a major role in
the financial problems we now face.
Let me first establish why the insurance regulator for New York is
a relevant authority on credit default swaps. I will expand on theses
issues at greater length, but to provide a context, I will start with a
brief summary.
As credit default swaps were developed, there was a question about
whether or not they were insurance. Since initially they were used by
owners of bonds to seek protection or insurance in the case of a
default by the issuer of the bonds, this was a reasonable question. In
2000, under a prior Administration, the New York Insurance Department
was asked to determine if swaps were insurance and said no. That is a
decision we have since revisited and reversed as incomplete. I will
provide more detail on these important decisions shortly.
In addition, since I took office in January 2007, the impact of
credit default swaps has been one of the major issues we have had to
confront. First, we tackled the problems of the financial guaranty
companies, also known as bond insurers. Credit default swaps were a
major factor in their problems. More recently, we have been involved in
the rescue of AIG. Again, credit default swaps were the biggest source
of that company's problems.
Through these experiences, we have needed to carefully study the
history and issues surrounding credit default swaps. And we have
learned the hard way their impact on markets and companies.
I am honored to have this opportunity to share with you what we
have learned from this hard won experience.
First, let's discuss what a credit default swap is and the
different kinds of credit default swaps. A credit default swap is a
contract under which the seller, for a fee, agrees to make a payment to
the protection buyer in the event that the referenced security, usually
some kind of bond, experiences any number of various ``credit events'',
such as bankruptcy, default, or reorganization. If something goes wrong
with the referenced entity, the protection buyer can put the bond to
the protection seller and be made whole. Or a net payment can be made
by the seller to the buyer.
Originally, credit default swaps were used to transfer and thus
reduce risk for the owners of bonds. If you owned a bond in company X
and were concerned that the company might default, you bought the swap
to protect yourself. The swaps could also be used by banks who loaned
money to a company. This type of swap is still used for hedging
purposes.
Over time, however, swaps came to be used not to reduce risk, but
to assume it. Institutions that did not own the obligation bought and
sold credit default swaps to place what Wall Street calls a directional
bet on a company's credit worthiness. Swaps bought by speculators are
sometimes known as ``naked credit default swaps'' because the swap
purchasers do not own the underlying obligation. The protection becomes
more valuable as the company becomes less creditworthy. This is similar
to naked shorting of stocks.
I have argued that these naked credit default swaps should not be
called swaps because there is no transfer or swap of risk. Instead,
risk is created by the transaction. For example, you have no risk on
the outcome of the third race until you place a bet on horse number
five to win.
We believe that the first type of swap, let's call it the covered
swap, is insurance. The essence of an insurance contract is that the
buyer has to have a material interest in the asset or obligation that
is the subject of the contract. That means the buyer owns property or a
security and can suffer a loss from damage to or the loss of value of
that property. With insurance, the buyer only has a claim after
actually suffering a loss.
With the covered swaps, if the issuer of a bond defaults, then the
owner of the bond has suffered a loss and the swap provides some
recovery for that loss. The second type of swap contains none of these
features.
Because the credit default swap market is not regulated, we do not
have valid data on the number of swaps outstanding and how many are
naked. Estimates of the market were as high as $62 trillion. By
comparison, there is only about $6 trillion in corporate debt
outstanding, $7.5 trillion in mortgage-backed debt and $2.5 trillion in
asset-backed debt. That's a total of about $16 trillion in debt private
sector debt.
Now, I think it would be useful to go into some of the history.
Betting or speculating on movements in securities or commodities
prices without actually owning the referenced security or commodity is
nothing new. As early as 1829, ``stock jobbing'', an early version of
short selling, was outlawed in New York. The Stock Jobbing Act was
ultimately repealed in 1858 because it was overly broad and captured
legitimate forms of speculation. However, the issue of whether to allow
bets on security and commodity prices outside of organized exchanges
continued to be an issue.
``Bucket shops'' arose in the late nineteenth century. Customers
``bought'' securities or commodities on these unauthorized exchanges,
but in reality the bucket shop was simply booking the customer's order
without executing on an exchange. In fact, they were simply throwing
the trade ticket in the bucket, which is where the name comes from, and
tearing it up when an opposite trade came in. The bucket shop would
agree to take the other side of the customer's ``bet'' on the
performance of the security or commodity. Bucket shops sometimes
survived for a time by balancing their books, but were wiped out by
extreme bull or bear markets. When their books failed, the bucketeers
simply closed up shop and left town, leaving the ``investors'' holding
worthless tickets.
The Bank Panic of 1907 is famous for J.P. Morgan, the leading
banker of the time, calling all the other bankers to a meeting and
keeping them there until they agreed to form a consortium of bankers to
create an emergency backstop for the banking system. At the time there
was no Federal Reserve. But a more lasting result was passage of New
York's anti-bucket shop law in 1909. The law, General Business Law
Section 351, made it a felony to operate or be connected with a bucket
shop or ``fake exchange.'' Because of the specificity and severity of
the much-anticipated legislation virtually all bucket shops shut down
before the law came into effect, and little enforcement was necessary.
Other states passed similar laws.
Section 351 prohibits the making or offering of a purchase or sale
of security, commodity, debt, property, options, bonds, etc. without
intending a bona fide purchase or sale of the security, commodity,
debt, property, options, bonds, etc. If you think that sounds exactly
like a naked credit default swap, you are right. What this tells us is
that back in 1909, 100 years ago, people understood the risks and
potential instability that comes from betting on securities prices and
outlawed it.
With the growth of various kinds of derivatives in the late 20th
Century, there was legal uncertainty as to whether certain derivatives,
including credit default swaps, violated state bucket shop and gambling
laws.
The Commodity Futures Modernization Act of 2000 (``CFMA''), signed
by President Clinton on December 21, 2000, created a ``safe harbor'' by
(1) preempting state and local gaming and bucket shop laws except for
general anti-fraud provisions, and (2) exempting certain derivative
transaction on commodities and swap agreements, including credit
default swaps, from CFTC regulation.
CFMA also amended the Securities and Exchange Acts of 1933 and 1934
to make it clear that the definition of ``security'' does not include
certain swap agreements, including credit default swaps, and that the
SEC is prohibited from regulating those swap agreements, except for its
anti-fraud enforcement authority.
So by ruling that credit default swaps were not subject to state
laws or SEC regulation, the way was cleared for the growth of the
market. But there was one other issue. If the swaps were considered
insurance, then they would be regulated by state insurance departments.
The capital and underwriting limits in insurance regulation would
threaten the rapid growth in the market for these derivatives.
So at the same time, in 2000, the New York Insurance Department was
asked a very carefully crafted question. ``Does a credit default swap
transaction, wherein the seller will make payment to the buyer upon the
happening of a negative credit event and such payment is not dependent
upon the buyer having suffered a loss, constitute a contract of
insurance under the insurance law?''
Clearly, the question was framed to ask only about naked credit
default swaps. Under the facts we were given, the swap was not
insurance, because the buyer had no material interest and the filing of
claim does not require a loss. But the entities involved were careful
not to ask about covered credit default swaps. Nonetheless, the market
took the Department's opinion on a subset of credit default swaps as a
ruling on all swaps.
In sum, in 2000 as a society we chose not to regulate credit
default swaps.
Why did that matter? As we have seen, the financial system has been
placed in peril because there was no comprehensive management of
counterparty risk. Deals were made privately between two parties. These
bilateral arrangements mean that there are no standards for the
solvency of counterparties. The buyer does not know how much risk the
seller is taking on. And there are no requirements for the seller to
hold reserves or capital against the risks it is taking on by selling
swaps.
None of this was a problem as long as the value of everything was
going up and defaults were rare. But the problem with this sort of
unregulated protection scheme is that when everyone needs to be paid at
once, the market is not strong enough to provide the protection
everyone suddenly needs.
Unlike insurance, credit default swaps are marked-to-market. That
means, the value of the swap reflects the current market value, which
can swing sharply and suddenly. Value changes require the sellers to
post collateral. Sudden and sharp changes in the credit rating of the
issuer of the bonds or of the bonds themselves can produce large swings
in the value of the swaps and thus the need to post large and
increasing amounts of collateral. That capital strain can produce
sudden liquidity problems for sellers. The seller may own enough assets
to provide collateral, but the assets may not be liquid and thus not
immediately accessible. When many sellers are forced to sell assets,
the price of those assets falls and sellers are faced with taking large
losses just to meet collateral requirements. As the prices of the
assets are driven down by forced sales, mark-to-market losses increase
and the collateral posting cycle continues. Meanwhile, the underlying
assets may continue to perform; paying interest and principal in full.
The above is a substantial part of the problem at AIG. A ratings
downgrade on September 15 produced immediate collateral calls. The
company did not have sufficient liquid assets.
In addition, chains of counterparty exposures mean that if one
counterparty fails, others with exposure to that counterparty may also
fail, setting off a chain reaction. Many financial institutions bought
protection from AIG, and there was great uncertainty as to whether all
of these institutions could survive AIG's failure.
Was the AIG rescue necessary? I believe it was. Thanks to the
protective moat created by state regulation, AIG's insurance operations
were insulated from the problems in other AIG subsidiaries and are
solid, profitable companies. Many of AIG's companies are leaders in
their markets. They have substantial value. But that value could not be
realized over a weekend. The rescue will provide time for an orderly
restructuring of AIG's operations. It is possible that AIG will
survive, as a smaller but much stronger insurance-focused enterprise.
At least some of its operations will be sold.
Some argue that the company should have been filed for bankruptcy,
as Lehman did. AIG is a ``systemically important company.'' It has
business relations with just about every major bank in the world. At a
time when the financial system and in particular the credit markets are
already deeply troubled, the risks of allowing AIG to file for
bankruptcy were, in my opinion, just too great. The New York Federal
Reserve Bank and the Treasury appear to share that view.
On September 22, we announced that New York State would, beginning
in January, regulate the insurance part of the credit default swap
market which has to date been unregulated--the part which the Insurance
Department has jurisdiction to regulate.
That announcement played an important role in spurring national
discussion about a comprehensive regulatory structure for the CDS
market. The result has been exactly what was envisioned--a broad debate
and discussion about the best way to bring controls and oversight to
this huge and important market and concrete progress toward a
centralized risk management, trading and clearing system. After our
announcement, SEC Chairman Cox asked for the power to regulate the
credit default swap market. The New York Federal Reserve began a series
of meetings with the dealer community to discuss how to proceed.
We believe that there are appropriate uses for credit default
swaps. We acknowledge that some amount of speculation can provide
useful information and market liquidity. We also recognize that the
best route to a healthy market in credit default swaps is not to divide
it up among regulators. It would not be effective or efficient for New
York to regulate some transactions under the insurance law, while other
transactions are either not regulated or regulated under some other
law. The best outcome is a holistic solution for the entire credit
default swap market.
Last Friday the Presidents Working Group, which the New York
Insurance Department has advised on insurance-related matters,
announced a Memorandum of Understanding among the Federal Reserve, the
SEC and CFTC to cooperatively implement a central counterparty plan for
CDS transactions. While these plans have not been finalized, we are
hopeful that this will be the first step toward comprehensive Federal
oversight.
The New York Federal Reserve Bank and the New York Banking
Department are working with one of the proposed central counterparties
to establish a New York trust company to serve as a clearing house for
credit default swaps. Processing this application is a top priority of
the Superintendent of Banks and the Banking Department.
Effective regulation of credit default swaps should include the
following provisions:
All sellers must maintain adequate capital and post
sufficient trading margins to minimize counterparty risk.
A guaranty fund should be created that ensures that a
failure of one seller will not create a cascade of failures in
the market.
There must be clear and inclusive dispute resolution
mechanisms.
To ensure transparency and permit monitoring, comprehensive
market data should be collected and made available to
regulatory authorities.
The market must have comprehensive regulatory oversight, and
regulation cannot be voluntary.
Based on the developments reported on by the President's Working
Group, it is clear they are committed to comprehensive and effective
Federal oversight of credit default swaps. My conversations with your
Members and the Members of the Senate have also persuaded me that
Congress is committed to producing a complementary legislative
framework. As this process unfolds during the next Congress, my office
will be actively following and assisting the Federal Government's
efforts. Accordingly, New York will delay indefinitely our plan to
regulate part of this market.
We understand that the market for credit default swaps is large and
complex and it will take time to complete a holistic solution. But
while we support these beginning efforts, we also recognize that they
do not yet constitute a completely transparent and fully regulated
market. We urge the industry, Federal agencies and Congress to continue
working until that essential goal is reached. At that point, we will be
prepared to consider any necessary changes in state law to prevent
problems that might arise from the fact that some swaps are insurance.
The unregulated marketplace in credit derivatives was a central
cause of a near systemic collapse of our financial system. Credit
default swaps played a major role in the financial problems at AIG,
Bear Stearns, Lehman and the bond insurance companies. A major cause of
our current financial crisis is not the effectiveness of current
regulation, but what we chose not to regulate. This lack of regulation
has been devastating for thousands of New Yorkers and every taxpayer in
the United States. We must see that this does not happen again.
New York stands ready to work expeditiously with all concerned to
find a workable solution to the problem of how to regulate credit
default swaps.
Thank you and I would be happy to answer any questions.
The Chairman. I thank the gentleman.
I have a lot of questions and I think a lot of Members do.
What I am trying to understand is why this thing is bogged
down here. Apparently, the SEC is requiring that in order to
give their go-ahead we have to accede to the fact that these
things are securities or something; or you are going to reserve
the right or something. Could you clarify?
I had a discussion with your boss, Mr. Cox, a month ago. He
indicated they were going to try to move. I keep being told
that this is going to get done, and it keeps dragging out. So
how soon is this going to get resolved that the SEC is going to
agree in a way that these things can move ahead as soon as
possible?
At the G20 summit last weekend, the only thing of any
substance that came out of there that everybody agreed on was
that we needed to get this clearing in place as soon as
possible. That seemed like everybody agreed to that, but it is
not happening.
Now this Committee is going to Europe a week from Sunday,
and we are going to meet with the London people, and we are
going to meet with the people in Germany. So we are going to
talk to the other two who are potentially involved in this. But
I have become convinced that this needs to get done as soon as
possible. So what is holding this up, and how soon is this
going to get done?
Mr. Sirri.
Mr. Sirri. Thank you for the question.
I think each of the regulators are committed to getting
this done as soon as possible. We are working constructively
together. We are working with the applicants. Right now, we are
at a stage where we are processing their applications. They
come to us with exemptive applications, in the case of the SEC.
Our Chairman, Chairman Cox, has been very clear with the
staff that he wants to be sure we are not standing in the way
of expeditious process to get these going. We have internal
schedules we are trying to work through to get these done. As
far as I know, those schedules are proceeding apace. I think we
expect to be finished with this work in mid-December.
The Chairman. Okay.
Why is it that the SEC thinks that once you put these swaps
on a regulated clearing situation that that turns them into a
security? Am I wrong about that?
This seems to be the bone of contention, that somehow or
another it turns them into a security and, therefore, the SEC
is going to get involved in regulating areas that they never
have before. What is that all about?
Mr. Sirri. It is interesting. With regard to over-the-
counter instruments, the SEC over-the-counter securities-based
swaps, the SEC is the only agency that has authority in that
market.
The Chairman. That is only manipulation and fraud.
Mr. Sirri. Anti-fraud and anti-manipulation------
The Chairman. That is not what the issue is, in my opinion,
frankly.
Mr. Sirri. No, that is exactly right. The reason why we
don't have any broader authority there is because the CFMA
specifies that, as long as the swap is subject to individual
negotiation, we don't have authority. So the key phrase is
whether or not it is subject to individual negotiation.
When a swap is brought onto a central counterparty or onto
an exchange, it is no longer subject to individual negotiation
as far as its material terms, anymore than a share of equity of
IBM is subject to individual negotiation on the New York Stock
Exchange. Once that is true, then that exclusion no longer
applies and our authority kicks in.
Now, that said, it is very clear that we want to offer
exemptions, exemptions from clearing agency registration,
exemptions from exchange registration, from broker/dealer
registration and such to expeditiously get these central
counterparties up and running. We think it is important for
systemic and other risk-management purposes to get going, and
we intend to offer those exemptions quickly.
The Chairman. If that is the case, then wouldn't the
thousands of energy over-the-counter swaps that are being
cleared by ICE and NYMEX as we speak become future contracts by
that reasoning?
Mr. Sirri. In this country, we do not have the central
counterparty for clearing over-the-counter derivatives yet.
This would be our first set of organized counterparties.
The Chairman. We will get into this more.
The other thing I want to understand, Mr. Parkinson, where
this deal came from, ICE, how they came to decide that they
were going to become a bank, apparently, so they could get
under your regulation and what that is all about.
I may be paranoid, but is that what is going on here? Are
they trying to become a bank so that they can have access to
the $700 billion, or are they just trying to not be regulated
by the CFTC? Did they come to you and ask for this, or did you
go to them? How did this all transpire? Do you know?
Mr. Parkinson. Yes. I will start by saying, since they made
this decision in advance of Congress passing the TARP
legislation, I don't think it had anything to do with that. The
background here is that particular effort has changed its
structure when Clearing Corp was acquired by ICE, but when it
was first begun it was through this Clearing Corp vehicle; and
Clearing Corp substantially is owned by a number of the major
OTC derivatives dealers. Those dealers today are all organized
as banks. So they have a long experience, number one, dealing
with the Federal Reserve as a supervisor.
The Chairman. Well, they weren't all organized as banks,
right? Didn't some of them become banks after------
Mr. Parkinson. Yes, yes. Some of them were investment banks
prior to recent events.
The Chairman. They didn't have a history.
Mr. Parkinson. I think, nonetheless, they had a history of
relationship with the Fed.
In particular, the other thing is that since 2005, our New
York Reserve Bank has been leading this effort of domestic and
international supervisors of the dealers working together with
the dealers and with buy-side participants to strengthen the
infrastructure of the CDS markets. That goes back to 2005. So
they had a history of working with us in that area.
Finally, as Ananda indicated, the Commodity Futures
Modernization Act tried to facilitate clearing. It required the
regulation of clearing, but it allowed them to decide how they
would be organized and effectively who would regulate them,
with the choices being the CFTC, SEC or a banking regulator. So
there were statutory provisions out there that facilitated
their making that choice and gave them the option.
The Chairman. Have you ever done this within the Fed? Is
there any clearing mechanism like this that you have ever done
in the Fed?
Mr. Parkinson. We have never been the primary regulator of
a central counterparty clearing service. However, I think we
have a wealth of related experience. I would cite four things.
First, as I noted, today, all of the major dealers are
organizers, banks subject to our supervisor and a------
The Chairman. These are the same dealers that had this
backroom operation that is 2 years behind the times and all
screwed up. I don't have a lot of confidence in them, frankly.
So, you don't even have a statute to base this on, do you?
What are you going to use as the regulation or the base for
what you are going to do? You are going to, supposedly, use
these international standards which are a guideline so these
guys can keep doing what they have been doing? That is what it
looks like to me, that they want to keep doing what they have
been doing. They don't want to change, so they want to set up
something where they can write their own rules. Frankly, I am
not going to go along with that, at least for this Member. I
don't trust them as far as I can throw them.
Mr. Parkinson. Well, they are not going to be allowed to
write their own rules. They will have to conform to both
international standards you mentioned.
The Chairman. Is that in the statute? How do we know that
that is going to be done?
Mr. Parkinson. If they want to organize as a bank and
become a member of the Federal Reserve system, they have to
file an application with the Federal Reserve. We are not
obligated to accept that application. We will accept that
application only if, after discussing with the SEC and the CFTC
their proposal in evaluating against those standards and other
applicable standards, we think it has been designed and will be
operated in a manner that is safe and sound and generally
reduces system risk. So they will have to conform to those
standards, or they will not be able to avail themselves of the
organizational option.
The Chairman. How do we know? What control do we have as
Members of Congress? There is not a statute there that we have
written. We are basically taking your word that you are
following some kind of a standard. That is my concern. Are you
going to come to Congress and ask that this be put in the
statute and there be clear regulation like we have with the
CFTC, or are you going to do this however you decide to do it
in the Fed?
Mr. Parkinson. I think we think we have adequate authority
to discharge this responsibility and make sure that they do
meet the high standards we are going to set.
But I think Chairman Bernanke, in talking about regulatory
restructuring, there has really been only one thing where we
have been clear about a need for new authority; and that is we
would like more formal powers to conduct the operations we are
already conducting as overseer of the payment system, and as
overseer and regulator of a variety of clearing and settlement
systems, including this idea of organizing as a limited purpose
trust company is not at all novel. The depository trust
company, which the major repository and settlement system for
equities and corporate debt in the United States, is organized
in the same way; and there we have been coordinating and
cooperating with the SEC in oversight of that since it was
formed, I believe, in 1970.
The Chairman. Well, I have gone way over my time, but I
need to know a lot more about this, and I am concerned why we
are getting another entity that has no experience into this.
Ananda, you look like you want to say something, or are you
just paying attention?
Mr. Radhakrishnan. Just paying attention. Thank you, sir.
The Chairman. The gentleman from Virginia, Mr. Goodlatte.
Mr. Goodlatte. Well, thank you, Mr. Chairman.
I am going to get Mr. Radhakrishnan involved here. Because
what I am hearing so far--and I want to follow up on the
Chairman's questions--are a lot of legalistic arguments about
something that there is growing consensus that we need to do,
that we don't have transparency, we don't have easy ways to
value these complex transactions. And yet, instead of figuring
out the most logical way to move forward and create that
transparency to create a clearinghouse mechanism, we are having
a jurisdictional fight amongst bureaucracies.
So let me ask each one of the bureaucracies to tell us what
your organization's experience is in overseeing central
counterparties for derivatives transactions. Please provide
some details as to how you would design an effective credit
default swap oversight program.
Mr. Radhakrishnan, we will start with you.
Mr. Radhakrishnan. Thank you, sir.
As this Committee is aware, the CFTC has some 33 years of
experience in overseeing clearinghouses for exchanges since the
inception of the CFTC.
Mr. Goodlatte. And how long ago was that?
Mr. Radhakrishnan. The CFTC was formed in 1975. Until 2000,
my understanding is that the oversight of clearinghouses was
part and parcel of the oversight of exchanges because the
Commodity Exchange Act did not have specific provisions for the
oversight of a clearinghouse. However, that changed in 2000
when Congress passed the CFMA and specifically provided for 14
core principles for derivatives clearing organizations, or
DCOs, or clearinghouses; and the Commission has promulgated
regulations to amplify those statutory provisions. So------
Mr. Goodlatte. In other words, you are close to being ready
to go, if you got consensus on being able it to do this?
Mr. Radhakrishnan. Yes, sir. Because we believe we have the
statutory scheme and we have the experience to regulate the
Chicago Mercantile Exchange as the CCP for credit default
swaps.
Mr. Goodlatte. Let me ask, Mr. Parkinson, what your
organization's experience is in overseeing central
counterparties for derivative transactions.
Mr. Parkinson. Well, as I already stated, we have no
experience as primary regulator of the CCP, but we have a
wealth of related experience in term of oversight of the major
dealer counterparties and the credit derivatives markets in
terms of oversight of payment systems, because payment systems
are integral to any clearance insolvent system, including a
CCP.
In the oversight and security settlement system, as I
mentioned a moment ago, the depository trust company, a key
part of the infrastructure, is organized as a member bank. In
that context, because the National Securities Clearing
Corporation is so intertwined with DTCC, we have worked with
the SEC who is the primary regulator of the National Securities
Clearing Corporation in looking at the operations of that CCP.
Finally, I would say we played a very leading role in the
development of the international standards in this area, the
recommendations for central counterparties that central banks
and securities and commodities regulators jointly developed
back in 2004, and I think we are ready to go.
In terms of the question that has been raised several
times, why hasn't this happened already, we are all being very
careful evaluating these proposals against existing standards
because we want to make sure they are designed and operating
prudently before allowing them to go into operation. But as
soon as we are convinced that they are so designed and
operated, we will give them approval to begin operations.
Mr. Goodlatte. Do you have a written, detailed plan, as the
CFTC has, on how you would move forward? Is this something that
is immediately implementable?
Mr. Parkinson. I think it is implementable as soon as the
three authorities at the table have reached agreement that the
design of the proposal to organize it as a member bank meets
applicable standards.
Mr. Goodlatte. Mr. Sirri.
Mr. Sirri. The SEC has a comprehensive statutory authority
to regulate clearing and settlement for securities. So, on the
securities side, with respect to cash instruments, as Pat said,
DTCC is a custodian, NSCC is a central counterparty there, we
are the primary regulator. On the derivatives side, as you
asked, we regulate the options clearing corporation which
serves as a central counterparty for a number of listed options
exchanges. So we have been doing this since 1975, regulating
central counterparties clearing and settlement for both
derivatives that are struck on securities as well as those
securities themselves.
Mr. Goodlatte. Mr. Dinallo, shed some light on this
dispute. How would you proceed from here? If you were Chairman
of the panel of the three entities that are seated next to you
and you had to find a way to move forward, what would you do?
Mr. Dinallo. I think there is nothing inherently wrong with
permitting two solutions, actually, to arise and letting market
participants begin to engage in sort of a decision process
around that, as long as it has the indicia that I ticked off. I
think that there is some benefit to that, and I think this may
in fact be the better way to go than having to decide on
either.
There is the case that you will inevitably have a situation
where the banks--which have had their issues, to be sure, as
the Chairman pointed out--will end up becoming the counterparty
to almost all of the CDSs. There has to be a way to put upon
them the proper capital requirements to have you be certain, as
Members of Congress, that the right money, so to speak, is set
aside against those commitments.
The Fed is going to become, essentially, the regulator for
all of those; and that is a participation that one should not
underestimate in making sure that we don't have a systemic risk
in this particular market again. But I will concede that the
history as to this kind of a futures type market is clearly
with the experience of the CFTC just on the historical record.
But, the new kind of regulatory regime you see coming and the
fact that every investment bank has become a Fed supervised
entity creates a tension that you may not want to break quite
yet as you see how it works out.
Mr. Goodlatte. In other words, instead of breaking the tie
amongst the three, we could break the log jamb by taking action
to enable one or more of them to move forward and then let the
marketplace determine what would happen.
Mr. Dinallo. Well, I think the market is so avid to get
this right; and one reason why New York is stepping back from
this, at least for now, is to help, not have additional,
although I thought well-intended and helpful complication but
also a helpful instigator. I think that speed counts and if the
CFTC can be first in class, because it is first, there is a
merit there, and then you will see other participants try to
compete with that.
Mr. Goodlatte. Thank you.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Pennsylvania, Mr. Holden.
Mr. Holden. Thank you, Mr. Chairman.
Mr. Sirri, you stated that the review process will be
completed in mid-December?
Mr. Sirri. Those are our goals, yes.
Mr. Holden. Operations, I assume, would be able to take
effect shortly thereafter?
Mr. Sirri. [Nonverbal response.]
Mr. Holden. Will this clearinghouse be required to meet
certain standards and be prepared to continue operating during
the stresses related to natural or man-made disaster? Who will
decide how much margin should be reserved for these products
and at what level the margin should be set? Can you describe
the guaranteed fund process and how much will be held in this
fund?
Mr. Sirri. Sure. There are multiple parts to your question.
Let me answer each one.
The first point you raised, I think, was natural disasters,
something we would group generally in the issue of business
continuity. Business continuity, the ability to withstand
various kinds of shocks from natural disasters, power outages,
retention of data, all sorts of things, are a standard part of
robustness and planning that go through oversight of a central
counterpart or a clearing process. I think all three of these
agencies working together understand how important that is.
So as we speak today, we are working with the various
applicants who have come to us to ask for the ability to
operate a central counterparty for a number of risk management
issues. You have raised an operational risk management issue,
and that is one of the ones that we are dealing with.
The second portion of your question related to margin and
to the size of the central counterparty. Our subjects have
active discussion. All three agencies sent staff to Chicago to
meet with the counterparties. We went in and examined them. We
looked at the financial, the risk models. Reports have come
back.
We are working now to establish just those kind of
parameters you are talking about: What are the appropriate
levels of margin? What are the appropriate sizes for the
clearing fund? Those two quantities interact, depending on the
risk management, depending on the margin; and that will affect
the size of the clearing fund and so forth.
I don't have firm answers for those, because those are
actively the things that we are discussing. Those are core to
the point of this question. Because central counterparties'
purpose, or one of their primary purposes for us, is to reduce
systemic risk. So getting business continuity right and
financial risk management right is right at the heart of what
we are after.
Mr. Holden. Mr. Radhakrishnan, Mr. Parkinson, do you want
to add anything to that?
Mr. Radhakrishnan. I would agree with Mr. Sirri.
In the core principles that we have, we do have specific
core principles to take care of system safeguard issues. We do
have a core principle that looks at financial resources. We do
have a core principle that requires clearinghouses to have risk
management systems to adequately manage the risk they are
taking.
The CFTC's approach has always been to review the proposal
that a clearinghouse has to set margin and to create the
guaranty fund. In other words, we don't have a prescriptive
regime, and we believe that is what Congress intended when they
passed the CFMA, and it has worked well so far. So our job is
to look at the proposal that a clearinghouse would have to set
the margin and then determine whether it is reasonable. In the
case of this particular initiative, we are requiring each of
the participants to get a validation of their margining model.
As far as the guaranty fund is concerned, usually in the
futures' world a guaranty fund is a function of the amount of
risk, so the more risks the clearinghouse takes the larger the
guaranty fund will be, and that makes sense as well.
Mr. Holden. Mr. Parkinson.
Mr. Parkinson. Thanks.
I agree with everything that has been said by Erik and
Ananda; and I would just note that those standards we apply,
the recommendations for central counterparty, address both the
business continuity issues, the margin issues, and the issues
relating to the size of the guaranty fund.
Mr. Holden. Mr. Parkinson's testimony states that the
President's Working Group is calling for a record of all credit
default swaps that are not cleared to be retained in the
Depository Trust and Clearing Corporation Trade Information
Warehouse. Should there be a mandatory reporting requirement
for CDS and/or over-the-counter derivatives that market
participants might elect not to clear? Is there any danger of
such a disclosure requirement driving transactions to a less
transparent shore?
Mr. Parkinson. I think what we called for will not all
necessarily be in the Depository Trust and Clearing
Corporation's repository, but, in general, for all the OTC
derivatives markets, not just the CDS markets, that OTC trades
be reported in trade repository and that regulators have access
to the information in those repositories.
Mr. Holden. Anyone else care to comment at all?
Mr. Dinallo. I would only comment that I think, after what
we have gone through, regulators and Congress should not be shy
about demanding some sort of accountability around these
instruments, and that there is not a tremendous amount of off-
exchange activity here. There are certain bespoke transactions
that might be so complicated that they would be off-exchange,
but those could receive no action, so to speak, moments in safe
harbors. But I think it is no longer the right way to go to be
afraid of offshore activity when we just went through what we
did largely through the decision of what we chose not to
regulate.
Mr. Holden. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Texas, Mr. Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman.
You said you are very close to having everything in place
to providing and overseeing a central clearinghouse. I think
you mentioned CME was close to that; is that correct?
Mr. Radhakrishnan. That is correct, sir.
As my colleagues have pointed out, a joint team has been
looking at the proposal of ICE as well as the CME. Once the
team comes to the conclusion that both organizations are ready
to go, then as far as we are concerned the CME can offer these
services; and we will be ready to regulate.
Mr. Neugebauer. So you are waiting for the Federal Reserve
and the SEC to sign off on that because of this agreement that
you entered into; is that correct?
Mr. Radhakrishnan. I wouldn't call it a ``sign-off
process,'' sir. To me, that would be ceding the jurisdiction of
the CFTC to another, which I suspect Congress will not like. We
are collaborating on this, and I think we all have a joint
interest in making sure that the bodies that are ultimately to
provide the service have in fact, what I would call, passed
muster.
Mr. Radhakrishnan. So it is more of a collaborative process
to review the proposals, but once we all agree that they have
reviewed the proposals, then, as the regulator of the CME, it
would be up to us to tell the CME that they can go ahead and
provide the service.
Mr. Neugebauer. Do you do this on any other kinds of
securities or financial instruments?
Mr. Radhakrishnan. Normally, we do not. Normally, under the
statute, the CME has the right to self-certify that it is going
to clear a particular product; and they have exercised that
many times. But I guess, given the unique nature of this
venture, and given the importance that it has for the economy,
and given the fact that nobody has provided the service yet,
the CME believes that it is also in its interest to make sure
that all of the Federal regulators who are interested in this
subject agree that they can go ahead and offer their service.
Mr. Neugebauer. Maybe I did not understand, but I am still
trying to figure out who is going to be in control here or who
is the primary regulator. Or are we going to submit, to check
these securities, to multiple regulatory authorities? How has
that been worked out?
Mr. Radhakrishnan. In my view, sir, the only regulator for
the CME is the CFTC, because the CME has chosen to offer its
service in its capacity as a derivatives clearing organization.
Mr. Neugebauer. So, if you are the primary regulator, why
are you getting a sign-off from these other entities if they
are not going to have jurisdictional------
Mr. Radhakrishnan. I think what we have decided to do,
because of the critical nature of this venture, we have decided
that it does make sense to cooperate with our fellow
regulators. Also, we might learn something from them, and I
think we have learned a lot of things from our discussions. So
I would look upon this as a collaborative venture and not as a
situation where we have basically ceded our authority to the
other regulators that are represented at this table.
Mr. Neugebauer. Mr. Parkinson, it has been mentioned that
the Federal Reserve Bank of New York might be a clearinghouse
as well, for these transactions.
Mr. Parkinson. No. I think what you are referring to is,
again, the ICE proposal. They proposed to get a charter from
New York State as a limited purpose trust company, which is a
kind of bank, and then apply to be a member of the Federal
Reserve system, specifically of the Federal Reserve Bank of New
York. So that is where the Federal Reserve Bank of New York
comes in.
Mr. Neugebauer. So they would be under your jurisdiction?
Mr. Parkinson. Yes. Yes.
Just to sort of answer the question you gave to Ananda,
again, we are the ones that decide whether it is appropriate to
grant that bank membership in the Federal Reserve System; and
also New York State plays an important role because they have
to decide whether to give it a charter. But we are evaluating
these proposals jointly and collaboratively, and I think we
would be very reluctant to proceed if we thought that either of
the other agencies had serious concerns. We certainly would
want to hear them out very thoroughly as to what those concerns
would be, and would want to try to address those concerns
before going forward.
I do not sense that we look at the issues of risk
management with respect to CCP in significantly different ways.
I am not expecting that there will be big differences of
opinion as to the robustness of these proposals.
Mr. Neugebauer. Mr. Sirri.
Mr. Sirri. I think, with regard to the SEC's interest, a
distinction needs to be made here.
In the organizational form of the central counterparties,
in the choice by that central counterparty, they could choose
to organize as a derivatives clearing organization, in which
case the CFTC comes into play. Instead, they could choose to
organize as a New York bank, in which case the Fed comes into
play.
In each of those instances, as to the instrument that is
traded, we believe there are strong arguments that it is a
security. That is what triggers our coming into play.
Our authority is based on the attributes of the instrument
that is traded. The CDS that is novated into a central
counterparty, we believe there is a strong argument that it
becomes a security, one even stronger when it becomes exchange-
traded.
Mr. Neugebauer. So your position is, whichever route that
one would choose, you are going to have jurisdiction
regardless?
Mr. Sirri. Our jurisdiction comes from the attributes of
the instrument that is traded. As we understand it, the
attributes of that instrument would likely make them
securities.
Mr. Holden [presiding.] The chair thanks the gentleman.
The gentleman from Iowa.
Mr. Boswell. Thank you, Mr. Chairman.
I am just going to say this: This is a learning process for
quite a few of us. We do not have your expertise. When we go
back to the people on the streets in our districts, they are
saying, ``Where has the Reserve been? Where has the SEC been?
Where has the CFTC been?'' They are getting pretty angry about
it; they are pretty upset, as you could probably appreciate.
So I would like for you to give me some assurance that we
are on top of this. I think that is where Chairman Peterson was
kind of going. I would like to know just a little bit more
about the clearinghouse.
Whenever you create a clearinghouse for any financial
instrument, you are concentrating risk away from holders of the
instruments into the clearinghouse. It would appear there is
obviously a great deal of risk associated with those credit
default swaps. So how does your agency test the financial
security of the clearinghouse under your jurisdiction to ensure
it can meet stress events like defaults of clearing members,
even if such an event is considered a low-probability scenario?
How do you deal with that, any of the three of you?
Mr. Radhakrishnan. Let me take a crack at that,
Congressman. Thank you for that question.
You are correct. Whenever there is a clearing solution to a
group of financial instruments for which there is none, it does
concentrate the risk in one party, but the key is how well that
central counterparty manages the risk. As we have seen in the
regulated futures arena, Congress has decided that it is
essential that every exchange be cleared by a DCO, and that is
what the law provides.
So, in this instance, the key elements are the methodology
for managing the risk. In this respect, as I had mentioned in
an answer to an earlier question, the CFTC has traditionally
looked at the methodology to see whether it is reasonable. The
CFTC has not prescribed the methodology by which risks should
be managed purely because, prior to 2000, we did not have the
authority to do that. But, it makes a lot of sense because the
question is: Why should we substitute our judgment for that of
the professionals whose job it is to do this? Now, our job is
to see that it is reasonable.
The other thing that we look at is the financial resources
that a clearinghouse will have in case a clearing participant
defaults. The financial resources can take many forms; the
primary form is margin. How much margin do you collect from the
clearing participants?
Then the secondary form is, what other resources does the
clearinghouse have that it can resort to in the event that it
has to perform because one of its clearing participants cannot
perform? Usually, that takes the form of a clearing fund or a
guaranty fund. It may take the form of a certain amount of the
capital of the clearinghouse itself. It may take the form of an
insurance policy. Sometimes, to make sure that there is
sufficient liquidity, it may also take the form of a committed
line of credit so that the clearinghouse has the ability to get
funds right away, so that it can pay on the other side.
What we do is monitor the ongoing operations of a
clearinghouse. We conduct periodic reviews of the
clearinghouse.
The CFTC has a unit called the Risk Surveillance Unit, and
we are in the position of looking at significant positions of
every customer on all of our regulated exchanges, and we are
able to look at the risk that significant customers pose to
clearing firms.
Then the next step is the risk that a clearing firm can
pose to a clearinghouse. This is a fairly new capability that
we have developed, but we will continue to develop it and will,
hopefully, learn more from our experiences.
Mr. Boswell. Would anybody else like to comment?
Okay. I will wait until the next round. I have other
questions, but my time is about up.
Mr. Holden. The chair thanks the gentleman.
The gentleman from Texas.
Mr. Conaway. Thank you, Mr. Chairman.
My good friend, Mr. Boswell, is correct. There is a lot of
learning going on here this morning, we hope.
It is illogical to have $60-plus trillion in notional value
of derivatives based on actual debt of, say, $16 trillion,
because it is so inverted like that. If your clearinghouse
captures all $60 trillion in this activity and you have your
margins or whatever your capital requirements are, will that,
in effect, limit, in the future at least, this inverted
circumstance where you have four times the notional value of
derivatives versus the actual underlying assets or debt? Can
somebody come up with $60 trillion worth of capital to be the
counterparty? How does that work mechanically?
Mr. Sirri. Let me take a stab at that one.
I think what you are observing is that the amount of cover
that is written on a group of underlying instruments is much
larger than those instruments themselves. Thus, people, whether
they are side bets or are risk management, are taking risk
management positions on those. The central counterparty will
help in that way because the concern, of course, is that you
get some kind of a large flow resulting from a default of one
of the underlying reference entities.
The point of margin is to create a system so that along the
way, each day, capital is shifted; funds are shifted from
someone who lost to someone who gained.
So the idea is, yes, a central counterparty would help in
such a situation. It would reduce systemic risk from the large
number of notional values of CDSs that are out there.
Mr. Conaway. But is it realistic to hold out the premise
that, on the fifth day of business, they will have captured all
of this $60 trillion worth of activity? Just from a volume
standpoint of going from 0 to 100 miles an hour does not make a
lot of sense.
Mr. Sirri. Look, the framework that we have been talking
about here for the central counterparties we are talking about
is optional in that the central counterparty will hold itself
out as being open for business, and the dealers will need to
bring their business there.
Mr. Conaway. So how long do you think it will take to
migrate?
Mr. Sirri. I think it is anybody's guess. It remains to be
seen. There are reasons to do it.
In particular, the customers of the dealers, many of them
hedge funds, are concerned about the credit risk posed by the
dealers themselves. They are forced to bring it on. The force
to keep it off is that there are economic reasons not to
standardize a contract. People will make more money in the
over-the-counter markets for a given transaction than in the
standardized. Those two forces will have to balance.
As regulators, I think we are trying to craft a system that
is not so burdensome as to drive people away, but that is
sufficiently robust so we accomplish our goals.
Mr. Conaway. Mr. Dinallo, the underlying credit default
swap, in my view, is an insurance contract. As an insurance
regulator, how did we get to a circumstance where we let
companies like AIG write insurance contracts without the
traditional reserve circumstances? If you are writing life
insurance, you have to put them up.
Did that, in fact, happen, and was AIG writing these
insurance contracts without reserve requirements? If that is
the case, starting at that level and requiring a reserve, like
balances for folks who are writing the original credit default
swap, is that a part of the regulatory scheme that states ought
to be doing?
Mr. Dinallo. Yes, I think my answer is very complementary
to Mr. Sirri's, and it actually goes to this inversion
observation that you have made.
It is true, as I said in my opening, that what we would
call a covered CDS, where you actually have exposure to the
referenced entity, is clearly an insurance transaction. AIG,
out of its unregulated, non-insurance entity--essentially, the
hedge fund that was bolted onto AIG at the holding company
level--wrote $460 billion worth of that; and there was not
nearly the solvency and capital requirements that are
associated with a normal insurance undertaking.
Mr. Conaway. Is that something the states ought to be
working on?
Mr. Dinallo. What I did say earlier was that we had said
that we were going to regulate those covered ones as insurance
products. The problem is that you create a segmented market
when you do that, because there are probably always going to be
some naked CDSs out there, and there are appropriate reasons
for that. So what we have done in New York, announced today, is
to put that in abeyance against the January date until we see
how this more holistic solution works out.
I will just say that I think it is very important, your
point about inversion. The way you stop inversion is, if you
basically put everyone onto one of these exchanges, it becomes
more expensive, and the sort of flyers that everybody took on
the future and/or demise of our companies and of our credit
vehicles goes down a lot because it becomes too expensive just
to take these free------
Mr. Conaway. Mr. Chairman, if I might follow up on one
other question.
If I am relying on an AIG in contract, if I am buying a
security and I am looking at it to say, ``Well, that has got an
AIG guarantee on it and that is backed by reserves and I know
it actually can collect.'' Why is that a bad thing versus
someone who chose naked CDSs? Why does it diminish that market?
Because the reason I am buying a security is that it has
got a AAA rating from some folks who did not know what they
were doing, and it has got AIG guarantees which were obviously
worthless. Why is it not requiring the insurance companies or
the writers of these insurance contracts to have the standard
reserve requirements that you have actuarially determined? Why
is that a bad thing?
Mr. Dinallo. In my opening, I think I politely implored the
Committee to make sure that whatever solution we ended up with,
that there were sufficient capitalization surplus reserves,
too. Because I think what I said was that CDSs in their covered
form, the ones that you are talking about, are really more akin
to insurance, and therefore, they are a guarantee. You are
basically guaranteeing against the adverse outcome. They are
not investments in the sense that investments are not
guaranteed. Securities are not guaranteed; they are merely a
reflection of an investment position.
So I think you are wholly correct that we have to look at
the tilt of capitalization behind CDSs more like insurance and
less like other forms of financial services.
Mr. Conaway. All right.
Thank you, Mr. Chairman.
Mr. Holden. The chair thanks the gentleman.
The gentleman from Georgia.
Mr. Marshall. Thank you, Mr. Chairman.
Mr. Sirri, it seems to me that the SEC's argument for
having jurisdiction simply because over-the-counter swaps have
been cleared is a bit of a stretch. It is also clear that it
adds a layer of regulation that could discourage people from
wanting to clear. So I am kind of curious to know what you
think the SEC brings to the table that is worthwhile if, in
fact, it asserts jurisdiction just as a policy matter.
I guess I would like to hear from Mr. Radhakrishnan as to
what his view is of the added value that the SEC might bring to
the table. A sort of dual regulation problem seems to me to be
potentially problematic.
Mr. Sirri. Sure. It is a good question.
I think the SEC has a set of basic charges that it has had
since its inception in 1934. Amongst those are the maintenance
of fair, orderly and efficient markets, investor protection,
anti-manipulation authority, and protections against insider
trading.
Mr. Marshall. You have both of those now, the latter, too,
and you would not lose that with regard to OTC swaps that are
cleared.
Mr. Sirri. If they were no longer subject to individual
negotiation, we would lose our anti-fraud authority, so that is
a curiosity. You could actually have a situation where we would
have over-the-counter anti-fraud authority, but if it is no
longer subject to individual negotiation, that authority would
vanish.
Mr. Marshall. And part of your concern here is that you
would no longer have the authority to investigate fraud?
Mr. Sirri. I think the point you have raised is a good one.
It does not go to the fine legal point. I think we police
markets. We are fundamentally a market regulator. That is one
of the things we do. There are investor protection issues that
are out there.
Mr. Marshall. The CFTC, though, is also a market regulator.
That is what we have charged them with the responsibility of
doing, so you are sort of piling on, it seems to me, from the
perspective of the market, if you have two regulators.
Mr. Sirri. We have a unique charge, which is explicitly
investor protection. That sits, I think, uniquely with us. It
is a mandate we have had. Because these instruments are------
Mr. Marshall. If I can interrupt, the investors we are
talking about here are these over-the-counter characters that
we for a long time had decided that we were going to exempt
from that kind of protection. We thought they were big boys and
were able to take care of themselves.
So here we want to encourage them to clear because it is in
our best interest societally that they clear, and we have never
thought they needed your protection in trying to do their
deals.
Mr. Sirri. That is only a portion of the investment
protection. You are right; those are the direct counterparties
to the trade. But because these instruments are struck on other
financial claims--debt, bonds, things like that--they drive the
pricing of those bonds just as, as you know, futures contracts
struck on equities can drive the pricing of equities.
So the point is that, in this space, we have an interest. I
think something we bring that is unique is our ability--in this
case, they would be an exchange trader or centrally cleared
markets--to police with respect to insider trading, investor
protection, anti-fraud. Those are things that we have a long
history of.
Mr. Marshall. If we clean the statute up and simply make it
clear that you continue to have that kind of authority, you
would not feel the necessity to otherwise have to approve the
use of a clearing operation under the Fed or a clearing
operation under the CFTC?
Mr. Sirri. I could not answer that question for the
Commission. I think such a thing would be helpful, but you are
asking me, would that be enough to satisfy the interests of the
Commission. I just could not answer that for the Commission.
Mr. Marshall. Actually, Mr. Radhakrishnan, I am not going
to go to you because I am not going to have much time left.
Mr. Parkinson, in your testimony, or, in response to
questions, you noted that the Fed will be regulating these
banks, these institutions of investment banks that have now
decided to become full-fledged banks, and that the lion's share
of credit default swaps will involve one of these banks as a
counterparty.
What do you anticipate will wind up being the relationship
between the Fed's regulation of these institutions as
counterparties and their decision to use either ICE or CME as
the clearing agency? Don't you think that the Fed is going to
want all of this business to go through the clearing agency
that it is regulating?
Mr. Parkinson. I think we are going to want the banks we
supervise to take advantage of the central counterparty
services that are offered. I do not believe we will be giving
them advice as to which of a number of competing services they
should be utilizing. That will be their decision.
Mr. Marshall. Mr. Radhakrishnan, what impact do you think
it has on the decision of a bank to choose a clearing party in
that, if it chooses CME, it is now subject to not only Federal
Reserve regulation but also to CFTC regulation?
Mr. Radhakrishnan. Well, as Mr. Parkinson has said, I hope
that the banks will choose the clearinghouse that they believe
best fits their needs and also that they believe has the best
solution. If it chooses CME, then it would fall within, first
of all, the jurisdiction of the CME itself and then within our
jurisdiction.
As part of the MOU, I think, if the Fed should need any
information to aid it in its supervision of its regulators,
then we will be willing to provide that information as part of
the MOU.
Mr. Marshall. My time is up, Mr. Chairman. There are,
obviously, a lot of questions we could ask about this subject.
Mr. Holden. The chair thanks the gentleman.
The gentleman from Kansas.
Mr. Moran. Mr. Chairman, thank you very much.
As I understand the testimony, we have a general belief
that these instruments need to be cleared. Is that true, that
there is no disagreement in regard to that?
Mr. Radhakrishnan. Yes, sir, there is no disagreement.
Mr. Moran. Then the question becomes whose jurisdiction and
whether or not there is a security aspect that the SEC involves
itself in once there is clearing in place. I would like to hear
an explanation for why the SEC believes that these are
securities when they behave much more like a commodity.
Mr. Sirri. I will be happy to answer that.
When these instruments are over-the-counter, they are
securities-based swaps. Under the CFMA, they are explicitly
excluded from the definition of ``security.'' Our authority
only runs to anti-fraud, as we have discussed.
An important part of that determination is that these
contracts, their material terms, be subject to individual
negotiation. The key phrase is ``subject to individual
negotiation.'' When these instruments come on to a central
counterparty and are novated to that central counterparty--in
other words, I give up this bilateral contract that you and I
struck, and I give it to the central counterparty--within that
comes, if you will, a standard, plain vanilla credit default
swap that is the form that that entity produces. That
standardized credit default swap is no longer subject to
individual negotiation.
More to the point, as some of these central counterparty
proposals will be the case for them, they will have appended
onto the exchanges; those exchanges, by definition, create
standardized forms for trade. You do not negotiate the terms of
a CDS on an exchange. You buy one or you do not. The question
is the reference entity that you choose, the price and the
quantity.
Because of those things, we believe they fall outside the
exclusion in the CFMA, and they become securities, and our
authority is triggered. But more importantly than our authority
being triggered, we have interests in the issues that are being
implicated.
Mr. Moran. Let me first ask, are there those who disagree
with that interpretation, which I assume is directed at the
CFTC?
Mr. Radhakrishnan. I will speak for myself, Congressman.
I think the statutory scheme is fairly clear, specifically
section 409 of FDICIA. I believe what Congress decided in 2000
was that a clearinghouse for OTC derivatives can take various
forms. The form that it takes dictates who the regulator is.
I defer to my friend on his interpretation of the
securities laws, but I do not see how the very act of clearing
changes the nature of the instrument. In fact, I think it is
clear that a lot of these instruments are already standardized
to begin with when they trade. So, if something is already
standardized, I do not know how clearing makes it even more
standardized.
Mr. Moran. I certainly do not claim to be an expert,
particularly of the law in this regard, and would love to have
a greater level of expertise. But just my common sense tells me
that the act of clearing does not change the nature of the
instrument, so I am confused how the SEC reaches the conclusion
that it reaches.
What you just answered may answer my next question, which
is: What is the belief by CME and ICE for applying for an
exemption from the SEC? Is this the same theory or are they
just overly cautious? Do they believe that they need an
exemption from the SEC, or do they just believe they want to
avoid any question?
I do not know that you can answer what their motivation is.
What is the basis for which the ICE and CME seek an exemption
from the SEC?
Mr. Sirri. The exemptions that we are contemplating are
four, and it depends on the particular entity. But there is an
exemption from registration as a clearing agency; there is an
exemption from registration of being a broker-dealer if you
deal in these instruments or they be securities; there is an
exemption from registration as an exchange if part of the
package of what you are offering is an exchange; there is an
exemption from the requirement if they are securities, that
they are offered as securities. So there are four places where
we believe we have to offer relief.
To the question of why they are coming to us, which is what
you really asked, obviously, we believe that there are
authority issues implicated. More to that, if you were to ask
them, I think that others believe that there is a serious
question, and were they not to come to us, then the status of
those instruments would be sufficiently in question in that
they would not be successful financial products.
So I think it is important. Regardless, I think, of where
you come on the technical issue that is being discussed here, I
think the provision of exemptions is important for success
here.
Mr. Moran. Will this be resolved absent a court
determination? If so, what kind of time frame is the SEC and
others on in resolving this legal dispute?
Mr. Sirri. Well, I am not sure I would characterize it as a
dispute. I think we are very much of one mind on what we need
to get done here. I can only speak for my Chairman's
instructions to me as a staff member, who said, ``I want you to
facilitate this happening.'' We decided that, process-wise, the
way we can get this done most quickly, rather than registering
as a clearing agency or registering as an exchange, is to
exempt them from those requirements because we can do that
quickly. That is a process that we have in place, and I think
all of us are aiming to get this done sometime roughly in the
middle of December. That is what I understand our time frame to
be. I think that comports very well with what I understand the
timetables of these counterparties to be.
Mr. Moran. Thank you very much.
Thank you, Mr. Chairman, for allowing me to go beyond my
time.
The Chairman [presiding.] I thank the gentleman.
The gentleman from North Carolina.
Mr. Etheridge. Thank you, Mr. Chairman.
Mr. Sirri, I was not here earlier, but I want to follow up
on what my friend from Kansas has touched on. He has touched on
it, and I want to follow it a little further because I am sure
you are familiar with section 409 of the Federal Deposit
Insurance Corporation Improvement Act of 1991, which was added
in the Commodity Futures Modernization Act.
This section authorizes multilateral clearing
organizations, whether under the CFTC, the SEC or the Fed
oversight, to clear over-the-counter derivatives. If over-the-
counter derivatives magically become securities through
clearing, why did Congress enact this provision into law? What
is it for if that was not what it was about?
Mr. Sirri. I am not sure I can answer why Congress did
something, so I will not try to, but I can offer a comment on
what I understand that to be. Again, I am not an authority on
FDICIA, but I understand a DCO to be able, for example, under
its terms, to clear securities and derivatives on securities. I
understand that that is something that is permitted under it.
We clearly have authority to regulate clearance of
securities. That is something that we have been doing for a
long, long time--for decades and decades and decades.
So the entity, the provision of the DCO itself, because it
allows that regime--the point is, that it can do it does not
mean it requires that other agencies not be a part of the
process. Were someone to elect to clear a security, an equity,
it would be unusual for us to say we will not do it. I am not
sure--and this would be something for Congress to answer. I
could not answer it.
Did Congress intend for equities to be cleared under the
DCO regime? From the understanding of my staff members, who
understand this a lot better than I, their answer to me was
``no.''
Mr. Etheridge. That may be a place we need to revisit.
Given that explanation, it seems to me you would have to
agree that other swaps can be standardized through the clearing
process in the same manner. Therefore, if counterparty credit
risk is removed through clearing, wouldn't the thousands of
energy over-the-counter swaps that are being cleared by ICE and
by NYMEX, as we spoke about before, in fact, be futures
contracts?
By your reason, these energy swaps become standardized
contracts for future delivery. Hence, they are now subject to
the full regulatory authority of the CFTC. Doesn't this
analysis regarding credit default swaps result in this
conclusion? If not, why not?
Mr. Sirri. I cannot answer as to the question of whether
they would come under the CFTC authority. That would not be a
question for us.
Mr. Etheridge. But given your last conclusion to your last
answer, that is why I asked the question of you.
Mr. Sirri. I can come back to you after the fact and answer
that, but that is too fine a question for me to parse right
here.
Mr. Etheridge. Would you be kind enough to give us a
written explanation of that, please?
Mr. Sirri. I would be happy to do that.
Mr. Etheridge. Because I think that gets to the heart of
the question we have been dealing with, would you not agree?
Mr. Sirri. Well, I would think the one thing that I would
observe here is that the instruments which we are discussing
are securities base-wise. In other words, my point was only to
them. The point I was making was not to other things that do
not implicate the securities--energy, as you brought up.
Mr. Etheridge. That gets to part of that issue. So, if you
would be kind enough to give us a written explanation of that
prior to the 15th, that would be great.
Mr. Sirri. I would be happy to do that.
Mr. Etheridge. Thank you.
I yield back, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Wisconsin.
Mr. Kagen. Thank you, Mr. Chairman.
I would like to say it is a pleasure being here. It just
feels a bit outrageous that we have to be here because perhaps
somebody at some institution, at some regulatory agency, had
their eye off the ball or was asleep at the switch as this
problem grew and grew.
What really matters to people now is that we prevent this
from ever happening again. I think the best medicine for that
is to provide the most transparency possible in that all
derivatives, perhaps, should be completely transparent and
cleared on existing exchanges. So let me first direct a few
questions to Mr. Sirri.
Which types of credit derivatives constitute security-based
swap agreements under securities laws and which do not?
Mr. Sirri. I would have to go back to the statute to be
precise, but the main point is that they are referencing
instruments that fundamentally are securities.
Mr. Kagen. I would appreciate it if you would give me a
written response at your earliest convenience.
Mr. Sirri. Sure.
Mr. Kagen. How frequently has the SEC used its authority
over security-based swap agreements to pursue fraud cases?
Mr. Sirri. Right now, as I said in my opening statement, we
have an active effort in that area. We have issued subpoenas.
We have required entities to respond to us under oath exactly
on that issue, to look at fraud in the securities-based swap
area.
Mr. Kagen. So your activity in that area just started? Is
this new activity for you?
Mr. Sirri. I think it is probably fair to say we have
become increasingly focused on it as the market has grown. The
market early on was small. It did not apparently warrant that
kind of oversight. We have now seen that the market is larger;
its effect on underlying instruments is larger.
Mr. Kagen. It is certainly difficult to monitor something
that you cannot see and that you cannot measure.
To what extent, then, can and does the SEC force any
disclosure of risk exposures for reporting companies or
entities to derivative contracts?
Mr. Sirri. So you are talking about disclosure requirements
for listed companies. Those companies have basic reporting
requirements about their exposures to various categories of
risk--counterparty risk, credit risk, equity market risk,
interest rate risk. There are basic requirements for
disclosures of risk for publicly reported companies.
What we do not have with regard to CDS is the ability for
record-keeping for financial intermediaries, for example, with
respect to their positions there. So, if there were a hedge
fund that had positions in CDS, we would not have the ability
to force any kind of record-keeping for that adviser with
respect to those CDSs or to promulgate the rules.
Mr. Kagen. This morning's discussion has primarily focused
on the credit default swaps.
Aren't there other products that you might be interested in
overseeing--the interest rate swaps and the currency swaps? Are
you reaching out there as well? Do you oversee those now?
Mr. Sirri. I am not aware that the Commission has a
particular interest there. I mean, they aren't securities-based
instruments.
Mr. Kagen. But then I am not sure; I thought you told me
you did not know exactly which credit default, security swap
instruments you were going to regulate.
Mr. Sirri. We have an interest over things that are
securities-based. So, for example, equity swaps where the
underlying instruments are equities. But if you point to
something like currency swaps where the underlying entity is a
currency and is not a security, we would not have the authority
or the interest there for a currency swap or for a LIBOR swap,
or for whatever it might be.
Mr. Kagen. This question goes to the entire panel, if you
would give me a brief response. If you need to extend it in
writing later, I would appreciate it.
I am really interested in knowing to what level you believe
your agency or your interest is in allowing for the complete
revelation and transparency of all derivatives and of all
swaps, whether they be public or private.
Mr. Parkinson. I guess I would call your attention to a
number of key provisions of the policy objectives for OTC
derivatives markets at the President's Working Group at which
all of our Chairmen are represented, released last Friday.
Those are, first, the details of all credit default swaps
that are not cleared through a CCP should be retained in a
central contract repository. Then going to your point about
other types of OTC derivatives, it also stated that central
contract repositories should be encouraged for other OTC
derivatives' asset classes. Then finally, with respect to a
regulator's ability to oversee these markets, it indicated that
regulators should have access to trade and position information
housed at those central trade repositories.
So I think the conclusion has been reached that we need
greater transparency, and we have identified a mechanism for
providing that level of transparency.
Mr. Kagen. Is there a trigger point economically or a
dollar amount that would trigger it? In other words, you are
saying that every single swap and that every single CDS, no
matter its nominal value, would be reportable and transparently
available to the public?
Mr. Parkinson. Yes. I think the goal is to get all of the
CDS contracts into that trade repository. So, in a sense, it
would go beyond the degree of transparency you have in the
futures markets, and it would include not only the large
positions, but indeed, all of the positions that were in the
warehouse.
Mr. Kagen. Thank you, Mr. Chairman. I yield back.
The Chairman. The gentlewoman from New York.
Mrs. Gillibrand. Thank you, Mr. Chairman. Since I was not
here at the beginning of the hearing, I do want to welcome New
York State Insurance Department Superintendent Eric Dinallo.
Thank you, Eric, for being here. You have obviously tried
to take a leadership role on the issue of credit default swaps.
I have read your testimony, and I have read letters you have
submitted to this body on the issue. Having been the chief of
the Investment Protection Bureau under the New York Attorney
General, investigating conflicts of interest in financial
services, you have had an interest in this area.
I read your letter with interest where you really made the
difference between naked credit default swaps and covered
credit default swaps. You made your views known that you
thought the covered credit default swaps should indeed be
regulated as insurance, but you did not have a view as to what
to do with the naked version. You implied that they should be
regulated under some gambling rules, which has not been
discussed in this forum, but I do want to have you address that
briefly.
I am concerned that, obviously, if we did regulate as
insurance--and it did make sense in the way you framed it--you
would have the problem of states being now the regulators of
insurance, and you cannot have 50 different regulations for
credit default swaps. So I would like you to address that
issue. Then give me your views on the naked variety, where you
think they would best be regulated.
Mr. Dinallo. Thank you for the warm introduction and for
that question.
The first part that I would answer is that in 1907 we had a
banking crisis in this country that was largely caused by
securities and other speculation where there was--remarkably,
like where we are now--a lack of capital behind the commitments
and a lack of actual transactions in the underlying purchases.
People were buying what you now would probably call
``futures,'' but they were not actually having any transactions
other than the actual securities. These were called ``bucket
shops,'' and they were all up and down the streets of New York.
They were also prominent in Boston and in Chicago.
People would go in there and would essentially wager on the
future of a security or of an exchange; and they had a huge
impact on the crisis in 1907, which led to J.P.Morgan's pulling
everyone into a room, saying, we had better form a central bank
today, which they successfully did. As of 1908, there were laws
against these sorts of bucket shops, saying that you had to
actually engage in the transaction if you were going to be
buying on credit or margin.
As for the CFMA, which has been discussed today, one of its
other features, besides taking away jurisdiction from the CFTC
and from the SEC, is, it also took away jurisdiction under the
bucket shop or gaming laws of the various states. That would
have been the oversight for what I just described, to the
extent that there are naked CDSs where there is actually no
actual exposure in the referenced transaction.
So the testimony and the approach that we took was that
there is about 10 to 20 percent of this market which looks
remarkably like insurance. People call it insurance. They think
they have insurance, arguably.
Mrs. Gillibrand. And they use it, in fact, as an insurance
mechanism?
Mr. Dinallo. Yes. Thank you, Congresswoman.
They, in fact, kind of touted--I do not mean that in a bad
way, but they said, we have this protection against our trading
book. So we went forth in mid-September and said we would offer
to regulate that.
I think it caused some distress to do that because it could
have segmented the markets, and it also had the 50 states issue
that you have discussed. Because Chairman Cox, the very next
day, came out and said that the SEC was asking for jurisdiction
again; and there has been this really protective activity since
that time. On reflection, we think it is better to hold this in
abeyance so we do not cause more dislocation in the market and
so that we can see what comes out of it.
It looks like any of the solutions that we have discussed
today would go a long way to both giving the ultimate
transparency that the markets need, the counterparty repose
that is very important, and the solvency and capital behind it.
It may not be quite as much as you would have in an insurance
contract, but it is far, far better than where we are today.
We concede that it is not good to have a segmented market,
so I would rather have them all regulated than sort of have
them half as insurance--or \1/3\ as insurance and \2/3\, or
whatever it would be--as not.
Mrs. Gillibrand. Thank you.
With my remaining time, Mr. Sirri, you obviously would like
to regulate credit default swaps. I think, early on in the
early 2000s, the SEC said they did not want to regulate it, and
they said it was not necessary. I am gravely concerned that you
have just started now to regulate fraud and deception in the
market when we have such a high volume of $50 trillion worth
out there.
How are you possibly going to now regulate this market with
your current resources and with your current staffing levels? I
do not think it could conceivably be possible. I would like
your views on that.
Mr. Sirri. Sure. It is a good question.
I think one of the things I would point to is the rapid
growth of the CDS market. This market, as everyone has been
saying, has grown astronomically over the last few years, the
point being, when you go back in time to earlier in this
decade, the market was much, much smaller. It did not have as
much place, and it did not have as much effect on other
financial instruments.
The numbers that are cited for the credit default swap
market are large, but these are notional numbers; this is the
amount of insurance covered, if you will, that is written. Our
resources are the resources that we have with respect to our
Enforcement Division.
To that point, I think one of the things that the Chairman
has pointed out is, as a mechanism to use those resources more
efficiently, the SEC would like legislation passed; and the
Chairman has called for it to promote things like record-
keeping and the making and the retention of certain records.
The point of that is, it allows the fixed resources of the SEC
to more efficiently be brought to bear on those entities that
either write or purchase coverage in this market, and allows us
to more efficiently police and surveil that market.
Mrs. Gillibrand. Do you think you can accomplish that with
your current resources?
Mr. Sirri. That is a difficult question.
What I do know is that it is a very difficult market to
oversee today, given this current state of play. We have
limited authority in the over-the-counter markets, but we
cannot make any rules.
I think what we really need to do is to enhance what can be
done. This is why the Chairman has asked for legislation in
this area, to cause that to be more efficient.
I do believe in this case. I am probably the wrong person
to ask because it is not the division I oversee for the precise
level of staffing for that.
Mrs. Gillibrand. Thank you, panel.
The Chairman. I thank the gentlelady.
The gentleman from California.
Mr. Costa. Yes. I will follow up on the gentlewoman's line
of questioning as it relates to the enforcement of the SEC.
It just seems to me, as we are contemplating changing the
authority and the supervision and the oversight, that part and
parcel of that, you have to come with recommendations to us as
to what level of enforcement you are going to need.
I found your answer to the gentlewoman's question
unsatisfactory. Just because it is not in your division, I
think that the Chairman, Mr. Cox, needs to make an evaluation;
and they need to make a recommendation to the Committee as we
look at legislation. Furthermore, I would say that we need to
figure out not only what you need, but what it is going to cost
and how we are going to pay for it.
Mr. Sirri. I would be happy to come back to you and do
that. All I meant by my answer was that, having not talked to
the Chairman about that, I could not presume to offer an answer
on behalf of the Commission.
Mr. Costa. In your response to one of the earlier
questions, I thought you commented on the fact that it was
bringing into question the credibility of the financial
instruments, i.e., the derivatives.
Did you not say that?
Mr. Sirri. I did not mean to imply anything about their
credibility. I believe derivatives are incredibly important.
Mr. Costa. No. I mean the viability of those instruments
today.
Mr. Sirri. I am not sure I recall the context of my remark.
Mr. Costa. With the whole question currently surrounding
the issue of these derivatives, how would you describe the
current health, given the current financial meltdown we are
experiencing at this point in time?
Mr. Sirri. The financial health of the derivatives markets?
Well, I think it is a good question, but a difficult one to
answer because the derivatives markets are so varied. There are
exchange-traded derivatives which have been, as far as I know,
going on as they have been. The over-the-counter instruments
have been growing rapidly.
I think we have learned through this experience that there
is, perhaps, additional regulation that is needed. Pat went
through some of the things that we and the President's Working
Group recommended. The central counterparty is part of it.
I think my summary point would be that there is clearly an
economic need that is served by the over-the-counter
derivatives markets, and that is a good thing; but as they have
grown. It is for Congress to determine whether additional
oversight is needed for all or for parts of that market.
Mr. Costa. I think there is a sense that we believe there
is greater oversight that is necessary. We are trying to grasp,
as we get more understanding of how it operates, what the
appropriate level of oversight is and how we protect, through
transparency, the financial foundations, on how they interplay
with the current financial mess we are in.
In part, we are playing catch-up. We are looking for not
just the SEC, but for the other regulatory agencies to make
recommendations. In listening to the four of you opine to us on
your level of oversight, it sounds to me at best confusing, and
at worst as though there was a total lack of ability to provide
the proper regulation for this industry.
Mr. Sirri. Well, I think all I can say to that point is,
our authority is very circumscribed at the moment. It goes to
exchange-traded instruments. In the over-the-counter markets,
there is only, as I have said, anti-fraud authority. After
that, we have no authority.
So there are large portions of this market, of the over-
the-counter derivatives markets, whether in the case of
securities-based swaps for other issues that we have talked
about beyond fraud or for other kinds of commodities such as
energy or other things, for which we have no authority and do
not have a remit.
Mr. Costa. I think, on that point, that many of us feel
that actually no one is in control. I mean, it is totally
unregulated, it seems to me.
Mr. Dinallo, you give a state perspective on this. You
talked historically about the bucket shops and about the early
turn of the 20th century; and you talked about trying to create
some uniformity here.
From a state perspective, which--from New York, obviously,
major players--would you recommend in terms of a Congressional
change the way this whole regulatory framework is considered?
What is your bottom line in terms of the areas that we need to
change?
Mr. Dinallo. Well, having been here today and having the
honor to sit through this, I would observe that it sounds like
there are a lot of round pegs in sort of square holes going on
in the sense that one could step back and try to rewrite it
holistically. The CFMA left a dangerous and tremendous
regulatory gap, but still left enough jurisdiction that there
are appropriate arguments going both ways.
My advice, I think, from the beginning, starting this
morning, is to just make sure that the Committee and that
Congress understands what you are dealing with to the extent
you are dealing with guaranteeing outcomes, which is different
than a mere investment or security product. Those generally
have with them higher levels of solvency and capital
requirements because they are much more like, if not identical
to, insurance. They have a certain amount of confidence and
promise behind them that insurance companies tend to be usually
very good at.
There is an entirely different approach in those
situations. From a state perspective, from a regulatory state
perspective, I found it, as I said earlier, very difficult to
very frustrating that we did not have any idea how much CDS was
written on the companies that we were regulating, to the extent
that some of them could have gone insolvent. We did not know if
that was the right or wrong decision because we did not know
what the systemic impact was going to be.
So to the extent people think about that, to the extent
that they also go around saying, ``I have insurance,'' when, in
fact, we are trying to be cooperative here by stepping back and
not segmenting the markets, I would make sure that there is
adequate solvency, tremendous transparency and some kind of
aggregation function so that you know how much risk you have at
each entity.
Mr. Costa. My time has expired, but I have one final
question, if I might, Mr. Chairman.
Mr. Dinallo, I do not know that you are the appropriate
person to answer this question, but I am not so sure the other
gentlemen want to opine.
Part of the argument we get about suggesting we be cautious
about how we make the changes in transparency, in regulatory
oversight, and in the ability to bring some curbs or
protections, some boundaries, is that we will lose this entire
market and that we will go overseas, whether it be London or
wherever.
What is your feeling on that?
Mr. Dinallo. I do not have a lot of faith, or I am not
particularly impressed, with that argument after what we just
went through. I think the markets will actually reward
transparency on this point, and the capital will come to the
most transparent, efficient markets. There will be some more
capital intensity on these solutions, but people will actually
believe there is capital behind their counterparty
transactions, which is exactly why we are in a credit freeze
right now, because they have no idea what the ultimate
obligations and risks of cliff events are on the other side.
So I actually believe that we, to some extent, went through
a time when we sort of fell in love with the European model--
the CFMA reflects this modernization going toward solvency--and
Basel II. When, in fact, a sort of less capital-intensive, sort
of capital-looser models of the holding company level are not
good when you are dealing with credit crises.
That is where we are now, and I would not be swayed by that
very much.
Mr. Costa. Mr. Parkinson, you look pained.
Mr. Parkinson. No, I am not pained. I would add a different
point.
We have to be conscious that this is a global market, and
indeed, the majority of the activity is conducted not in the
United States, but in London. But that is not an argument if we
see a need for change to achieve specific policy objectives, as
in the case of various series that have been outlined in the
PWG statement that--we hesitate to do that for fear of the
activity going offshore. Rather, it suggests we should be
coordinating and cooperating with the foreign authorities. In
fact, that is what we have done at least with respect to the
infrastructure issues.
I think, going forward on the broad range of issues, we
will work through something called the Financial Stability
Forum, which includes representatives of all of the major
jurisdictions, including London, which is the other important
jurisdiction in terms of CDS activity.
Mr. Costa. Well, the Chairman is taking the Committee over
there in a week or so, so I guess we will get a better
understanding as to the level of collaboration that they
believe is taking place.
The Chairman. I thank the gentleman.
I have a number of questions that I want to get on the
record. I do not know exactly how the other Members want to
proceed, but if it is all right, I would like to go through
these and ask the other Members if they want to jump in at any
point on any of these things that I am asking about and further
expand on it.
We will proceed in that manner. Would that be okay?
Then, after that, if there are any more questions, have you
gentlemen a few more minutes to be with us? Okay.
First of all, Representative Gillibrand just asked me a
question. I recognize everybody is trying to create more credit
and is trying to get people to buy more stuff, and to keep
going into debt apparently, so the economy can be good, which I
have a real problem with. I think we have to start paying our
bills, not only as people but as a government.
So what would happen if we made credit default swaps
illegal? Does anybody want to answer that? Could we make them
illegal?
Mr. Sirri. Well, one thing I might point to is something
that was alluded to in the last set of questions, which is,
where does the business get done? I think these are financial
instruments that exist. Were they to be illegal here, somehow,
given that they have some economic use, I would suspect they
would be done outside the jurisdictional reach of the United
States.
The Chairman. Does anybody disagree with that?
Mr. Dinallo. No. The point of my submitted testimony was
some section of them used to be, arguably, illegal under the
bucket shop laws. The naked versions were essentially illegal
or at least they were prosecutable or pursuitable as illegal
prior to 2000. There is a real hedging need for the cover.
There is a perfectly appropriate reason to want to hedge
your risk of true default of your counterparty. It is harder to
articulate on a purely naked credit default swap what is the
economic reason behind it. There are gray areas where you do
not actually own the bump, but where you have some exposure;
but in a pure naked situation, it is harder to defend.
The Chairman. Do each of you currently have jurisdiction
over any clearinghouse that clears OTC swaps? I just want you
to answer for the record.
Mr. Radhakrishnan. Mr. Chairman, yes, we do.
The CFTC has jurisdiction over the CME clearinghouse, which
has now taken over the clearing of energy swaps on NYMEX. The
London clearinghouse, which has a swap clearing program, is
actually registered with the CFTC as a DCO; although I will not
claim that we exercise jurisdiction over it because the FSA
does.
The Chairman. Mr. Parkinson?
Mr. Parkinson. No.
The Chairman. Mr. Sirri?
Mr. Sirri. If the CDS instruments are novated to a central
counterparty, depending on the nature of how that is done, then
it may be that we have authority. It would have to be specific.
We would have to see what the actual specifics are to answer
that question.
The Chairman. How important is it--and we talked a little
bit about this--to find a CDS solution that works on both sides
of the Atlantic? Is that an important thing?
Mr. Dinallo. I would like to just amend the answer, because
I think that Mr. Parkinson made a really good point about
overseas and London.
I did not mean to imply that we should disregard Europe and
overseas. But I did speak at the Financial Stability Forum a
month ago, and I can tell you that what I came away with was a
real disappointment, a dejection bordering on anger, that our
markets had produced these very opaque instruments. The CDOs
and the CDO squares kind of came, from their point of view,
from our markets; whether they are right or wrong, that is the
perception.
I was simply arguing that enhanced transparency would bring
capital from abroad, not the opposite.
I think it is very important. Increasingly, there was a
belief, at least when I was there, that we need to work
together on this. There is the possibility that it goes
completely overseas, but there are basic policy decisions here
that Congress and others have to make about whether that is
appropriate or inappropriate depending upon if you think the
activity should be done or not.
The Chairman. Well, that is part of why we are going over
there.
Do you all agree that this is important that we have
regulation on both sides, or not?
Mr. Parkinson. Yes.
Mr. Radhakrishnan. I agree with that, too.
Mr. Sirri. So would I.
The Chairman. Okay. Are there any actions Congress could
take to clarify the jurisdiction or authority of the various
agencies with regard to the oversight of the OTC derivatives
products?
Mr. Parkinson. I don't think the Federal Reserve needs any
additional authority to discharge the activities we are
currently discharging. I think we did indicate support in our
statement for clarifying the authority of the SEC to impose
record-keeping and reporting requirements so they would be able
to effectively police manipulation or fraud in these markets.
Mr. Sirri. I think our Chairman has gone on record as
saying that there is a regulatory hole associated with certain
over-the-counter derivatives, and he feels that some
Congressional authority could be granted in either some
regulator or, in certain instances, right to the SEC for that
market.
The Chairman. Ananda, do you think you need any additional
authorities?
Mr. Radhakrishnan. I think, Mr. Chairman, that it is clear
that any DCO could do this, but to the extent that there is
some uncertainty, perhaps it may not be a bad thing for
Congress to clarify what it meant when it promulgated sections
408 and 409 of FDICIA.
I would add that there is also a provision in the Commodity
Exchange Act, which is section 5(b). If you will indulge me,
Mr. Chairman, it says, ``A DCO that clears a grievance contract
or transaction excluded from this chapter or other over-the-
counter derivative instruments may register with the Commission
as a DCO.''
So, apart from the provisions of FDICIA, I believe it is
clear from the provisions in the Commodity Exchange Act that
Congress contemplated a DCO clearing OTC derivative
instruments.
The Chairman. We might want to clarify that.
Now, if we have four people that end up doing this, is this
going to work? Is there going to be enough business for four
people; or is this going to, somehow or another, inhibit a good
outcome? Is that a danger, that we are going to split this up
so much that it may not work?
Mr. Sirri. I think the point of the MOU that our agency
signed was to ensure that that didn't happen. It highlighted
our singleness of purpose, our common goals, that we intended
to work together to cooperate, to consult, to achieve this
common goal of getting these CCPs up and running. I think it
indicates that the leadership of our agencies wants that to
happen, and I think we expect that to work.
The Chairman. So you are not going to let this one group
have an advantage over another. In other words, one can do it
cheaper or one has less onerous regulations, and somehow or
another we skew where the thing goes, and the other ones don't
work, and we end up with something someplace where we don't
have good regulation.
I am just concerned about this whole area because of things
I have heard from different people that are involved in this.
So you are going to have that under control, and you are going
to make sure that this is really a level playing field, or not?
Mr. Parkinson. I think, domestically, we have the MOU, and
that is one of the principal purposes of entering into that
MOU, is to make sure------
The Chairman. So we can be assured that it will be a level
playing field?
Mr. Parkinson.--that we are committed to establishing a
level playing field within the U.S. And then, on the
international front, again, I point to the existence of
international standards for risk management under the CCP,
which I believe certainly will be used in the U.K. as well as
the U.S.
The Chairman. Anybody else?
Should there be a reporting requirement for OTC derivatives
that market participants might elect not to clear? Should there
be a reporting requirement if there are derivatives that the
people in the market decide not to clear? Should there be a
requirement that they report that?
Mr. Parkinson. I think as I indicated earlier, the PWG has
concluded that all CDSs that are not cleared by CCP should be
reported to a trade repository and that regulators should have
access to the information in that repository.
The Chairman. I just wanted to clarify.
What lessons has your organization learned from its
oversight of firms that failed or have required government
support this year?
Mr. Parkinson. I think, with respect to CDSs, although one
can read in the press that CDSs were the cause of the demise of
Bear Stearns or of Lehman Brothers, and in fact that is not
true. They failed not because of the activities in CDSs, but
because of their holdings of various types of securities--
residential mortgage securities, commercial mortgage-backed
securities, et cetera. Indeed, to the extent they use CDSs,
they use them to hedge some of those exposures. But, obviously,
they didn't fully hedge them, or they wouldn't have run into
the problems that they did.
Mr. Sirri. I think another lesson that we learned, again,
related to CDS, is that a central counterparty can have an
important role to play here because of the information flow. As
firms got into trouble, their counterparties sought to novate
various over-the-counter derivatives away from the troubled
firm. When that happened and they took those swaps to better-
performing counterparties, some financially healthy firms,
those firms would often reject those novations, creating a set
of rumors in the market where people believed that a name was
no good, whether it was Bear Stearns or Lehman at the time,
whoever it was, that that name wasn't a name that people would
take and trade.
Had those been novated to a central counterparty, that set
of uncertainties, that rumor mill, if you will, would not have
occurred because there would have been a better counterparty to
all those swaps. They would have no longer been bilateral
contracts. So I think a central counterparty could have helped
in that situation.
The Chairman. Well, you are talking about here like when
they use these credit default swaps to actually move against
the company or move against the city and basically take them
down, just like a short sale almost? Is that what you are
talking about?
Mr. Sirri. No, I was actually meaning that we might have a
set of contracts, I might have a book of business, as just an
intermediary. If I get in trouble, then my counterparties would
no longer want to just have my exposure, my credit exposure,
for the book of business. They might, in turn, look at Pat and
say, ``I would rather novate those contracts to Pat and have
Pat step in in my place.'' Pat may or may not choose to do
that. When he doesn't choose to do it, say, for his own
business reasons, people say, ``Oh, Parkinson won't trade with
Sirri; he must be afraid of Sirri.'' And that set of rumors is
not helpful.
The Chairman. And there were the instances where those kind
of rumors actually--it was like some city I read about in
California that got taken down, basically, because of rumors
that were started by one of these deals.
Before the current crisis erupted, what steps did your
organizations take to attempt to identify and forestall the
sort of problems that we are seeing?
Mr. Parkinson. I think all of our agencies have been
involved since 2005 in these efforts to strengthen the
infrastructure of the markets. I think we have made substantial
progress along those lines. But, as we have indicated, I think,
in the ambitious agenda we have going forward, there is more to
do. But the infrastructure, clearly, was something that has
been on our radar at least since 2005.
The Chairman. Anybody else?
At the risk of further raising a jurisdictional fight, Mr.
Sirri, are you saying that the CDS transactions would be
securities subject to SEC jurisdiction but for the fact that
the CFMA provided the swaps exclusion?
Mr. Sirri. What we are saying is that we think there is a
very strong argument that our authority is triggered by the
novation to a central counterparty. That is the key issue.
Whether the clearing agency is a New York bank or any bank or a
DCO, that is not the key issue for us. The key issue is the
nature of those instruments once they are novated to a central
counterparty.
The Chairman. I still wonder about that.
But anyway, Mr. Parkinson, do you think a clearinghouse
needs to be a banking entity to clear a CDS?
Mr. Parkinson. No. The law allows, in the United States,
either to be organized as a bank or as a CFTC-regulated DCO or
as an SEC-regulated clearing agency. And, as Mr. Radhakrishnan
and I and all of us have testified, one of the existing
proposals is for the CME to do it through a DCO. That is
allowed under the law, and it is a perfectly legitimate choice.
The Chairman. Lynn Turner, a former Chief Economist at the
SEC, was quoted yesterday as saying, ``The Federal Reserve was
supposed to supervise the lending of many of the banks now in
trouble, and yet seemingly they did nothing,'' I am quoting her
now, ``I wonder why, when they didn't do the job they were
supposed to be doing, one would give them even more
responsibility.''
Could you comment on that?
Mr. Parkinson. Well, obviously, some of the banks that we
supervise have suffered losses and are in one degree or another
of difficulty. I would note that that essentially can be said
of anybody that is a prudential supervisor of a large global
institution at this point, whether the SEC was supervising some
of those entities--there are U.K. entities, there are European
entities.
None of us has been completely successful in ensuring the
safety and soundness of the institutions that we oversee. But I
guess it is only people like Mr. Turner, who don't have the
responsibility, that feel free to make those kinds of charges.
The Chairman. As I understand it, the CFTC has been
operating a long time, and I don't think anybody has lost any
money on any of your deals, have they?
Mr. Radhakrishnan. No, Mr. Chairman. In this specific
instance, if you look at the one insolvency, which is Lehman
Brothers, the entity that filed the bankruptcy was a holding
company, and then they also had a regulated entity, which was
both registered as a broker dealer with the SEC and as an SCM
with the CFTC. That entity went through what I would call a
planned bankruptcy. There was an arrangement for another firm,
Barclays, to buy over the accounts. All of the futures accounts
and the funds associated with the futures accounts were
successfully transferred with no loss to customer funds.
The Chairman. Do any other Members have questions?
Mr. Moran?
Mr. Moran. Mr. Chairman, thank you.
This is for the SEC. One of the things I had read someplace
was--you told me earlier that, by mid-December, the plan is to
have an exemption from the securities laws for the clearing
operations. Is that accurate?
Mr. Sirri. Those are our goals, yes.
Mr. Moran. That is the goal. But I read someplace in which
your plan is only to have a temporary exemption from security
laws, somewhere between 9 and 18 months. My question is, why;
and what does that mean for the regulatory certainty?
One of the answers to my question about why they are
seeking this exemption, I assume the answer to that is because
we want to know that the process we are going through is legal,
the underlying securities will not be suspect to legal
challenge. And yet, if you have a very short-term exemption--
let me take the pejorative word out--if you have an exemption
of 9 to 18 months, does that not then defeat the certainty that
they are seeking?
Mr. Sirri. Well, our goal is not to have it not defeat that
uncertainty. We do want to provide regulatory certainty here,
because that is what will make the central counterparty
successful. So I think we internalize that.
The reason for it being a temporary exemption is our goal
was to get this work done as quickly as possible. So using that
process was the quickest process that we had available to us to
cause these entities to come to fruition. There may remain to
be a few other issues that we have to think about--the
registration question and such. But, in the intervening months,
we hope to settle those points.
So this was the fastest way that we could get these
entities up and running while discharging our responsibilities.
Mr. Moran. The process that you used to grant the exemption
is a shorter, more immediate process if you grant a temporary
exemption than a permanent exemption?
Mr. Sirri. No, the exemptive process is the same; we have
to make a set of findings about our action being in the public
interest. The reason for it being temporary is we are exempting
these entities from registration as broker dealers, clearing
agencies, exchanges, and such. What I am saying is that we are
doing this rapidly enough that the Commission may want to
consider, for example, in the spring, are they comfortable with
all the choices that were made in November, December; do they
want to modify them at all? So that is the reason for the
temporary------
Mr. Moran. Easier to reach a temporary decision than a
permanent decision, just greater level of comfort with that
decision. I think that is what you are saying. Thank you.
Mr. Chairman, one other thing, and this is somewhat
unrelated to the topic of today's discussion, but I rarely get
an opportunity to speak to someone from the Federal Reserve
system.
Just for the record--and you are certainly not the person
to which I can deliver the message very well, but you are the
Fed, in my world this morning.
One of the things we experience in Kansas is that our
banking system has generally been sound. We have few of the
problems that are associated with what is going on elsewhere in
the country. I find it ironic or self-defeating when the
Federal Reserve announces a reduction in interest rates, I
assume with the goal of stimulating the economy, stimulating
borrowing and putting economic activity back into play. And
yet, every time I turn around, my bankers tell me that the
regulators are cracking down on any ability to make a loan. My
farm lenders can't make loans to farmers because their
portfolio is agriculture. My commercial developers can't make
loans to commercial developers because their portfolio is
already commercial developers.
So the things that our banks do, the bread and butter of
our lending institutions, more and more is off-limits. It seems
to me that there is a somewhat counterproductive effort at the
Fed to lower interest rates to encourage people to borrow
money, at the same time telling the people who lend money,
``You can't loan money because of additional regulations and
restrictions.''
If you would deliver that message to someone at the Federal
Reserve, I would be grateful. I would be happy to hear back
from somebody about why this is not counterintuitive.
Mr. Parkinson. Thank you.
Mr. Moran. Thank you.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from North Carolina, Mr. Etheridge.
Mr. Etheridge. Thank you, Mr. Chairman. I will be brief
with mine, as well.
Mr. Radhakrishnan and Mr. Parkinson, from your testimony,
it appears that you both agree that a banking entity could
clear default swaps under Federal Reserve oversight and a
designated clearing organization to do the same under CFTC
oversight. Is that correct?
Mr. Radhakrishnan. That is correct, sir.
Mr. Parkinson. Yes.
Mr. Etheridge. That being said then, what would your
reaction be if a bank entity tried to form a DCO to clear CDS
under CFTC oversight or a DCO tried to become a banking entity
to clear CDS under Federal Reserve oversight?
Mr. Radhakrishnan. I think we would not have an opinion on
that; we would say that that would be fine. In fact, if you
look at the ICE-TCC proposal, the TCC, before it decided to
apply to become a New York State limited purpose trust company,
is a designated clearing organization.
I think what is happening is a separate entity is going to
become the New York State banking authority. But as long as the
banking authorities do not mind accepting a DCO as one of their
regulatees, I don't think the Commission has any objections to
an entity that is already regulated by another regulator
becoming regulated by us. In fact, we have two examples: One is
the Options Clearing Corporation, which is regulated both by
the SEC and us, and the other is the London Clearing House.
Mr. Parkinson. I am not aware of anything that would
prohibit a banking organization from forming a CCP and
registering with the CFTC. Although it is not exactly the same
situation, I would note that, under the Gramm-Leach-Bliley Act,
we have many banks who have subsidiaries that are futures
commission--or bank holding companies whose subsidiaries are
futures commission merchants, and they are regulated by the
CFTC. There are various provisions of Gramm-Leach-Bliley that
direct us to rely primarily on the CFTC in the oversight of
those entities. So, philosophically, I think I would be very
comfortable with that approach.
Mr. Etheridge. Okay, thank you.
Let me associate myself, if I could, Mr. Parkinson, with my
good friend Mr. Moran's statement from Kansas, as it relates to
the ability to loan and the regulatory schemes. I know we are
going through some tough times right now, but I am hearing from
a number of folks, not only just my farm community, who are
losing jobs, going out of business, small-business people, car
dealers and others. We are saying we are going to help them,
and they are seeing no relief at the local level. We are still
having problems with the bigger banks still not letting those
dollars flow. I hope you will take that message back.
As we approach the winter season now, if we don't get some
of those funds flowing, we are going to have some real problems
across America in small towns and rural communities.
Thank you, Mr. Chairman. I yield back.
The Chairman. I thank the gentleman.
Any further questions?
If not, I want to thank the panel for their patience and
their hanging in there and putting up with us for this period
of time. We appreciate you coming before the Committee, and we
look forward to working with you as we go through this process.
Hopefully you can get this thing resolved by the 15th of
December, because, as you know, I think the sooner we can do
this, the better.
Thank you.
The Committee on Agriculture is adjourned, subject to the
call of the chair.
[Whereupon, at 12:58 p.m., the Committee was adjourned.]
HEARING TO REVIEW THE ROLE OF CREDIT DERIVATIVES IN THE U.S. ECONOMY
----------
MONDAY, DECEMBER 8, 2008
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 1:07 p.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden,
Etheridge, Marshall, Herseth Sandlin, Cuellar, Costa, Salazar,
Ellsworth, Space, Gillibrand, Pomeroy, King, Neugebauer,
Boustany, Conaway, and Smith.
Staff present: Adam Durand, John Konya, Scott Kuschmider,
Rob Larew, Clark Ogilvie, John Riley, Rebekah Solem, Bryan
Dierlam, Tamara Hinton, Kevin Kramp, and Jamie Mitchell.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. Good
afternoon, everybody. I want to welcome you to today's hearing.
Today marks the third hearing this Committee has held on credit
derivatives in the recent months. We have had two good hearings
to this point, and we will save everyone the time and not
rehash what has been said about these complex--actually not
that complex, largely unregulated financial products. This
afternoon we have two panels of industry stakeholders before us
to discuss recent movement in the industry and among
regulators.
In the wake of the unwinding of billions of dollars of
obligations in this extremely opaque, and at times hard-to-
value credit default swaps market, several companies have
stepped forward and are seeking approval to operate
clearinghouses for credit derivatives. Such clearinghouses
could reduce the bilateral risk of swaps transactions and
increase transparency of these products not just for the
public, but for all the players in the industry.
Given the possibility of central clearing, I would hope our
panelists can shed some light on how this would work given the
often complex, specialized nature of many of these products.
Issues like margin requirements, the standardization of
contracts, exchange operating standards, financial security of
the clearinghouses in times of stress, and the creditworthiness
of the participants would also need to be addressed if these
products were brought out of the dark and onto regulated
exchanges.
Our panelists also may have views on the recent Memorandum
of Understanding signed by the Federal Reserve, the SEC, the
CFTC on sharing of information and coordinating oversight of
swaps and new clearinghouses. As was discussed before this
Committee last November, proposals in that Memorandum of
Understanding could lead to a clearinghouse regulated by the
Fed and another by the CFTC, leaving open the possibility that
clearinghouses could choose between a regulator with no
experience in this area and a regulator with long experience in
this area. Moving towards a dual or even tripartite structure,
if you include the Fed, it looks like it would create a divided
regulatory problem among the largest banks that allowed the
biggest players to essentially choose their regulator based on
experience or lack thereof.
Last week I lead a Congressional delegation to Europe to
meet with regulators and clearing providers. We spent time in
London, Brussels and Frankfort discussing with our counterparts
across the Atlantic the same issues this Committee has examined
over the last several months.
One thing that is clear is that in today's world, any
regulatory answer to the lack of transparency in the market for
credit derivatives has to be a global one. We hear often of the
threats that implementing certain kinds of regulation on
certain tradable products will just drive those products
overseas to less transparent markets. Domestic exchanges
already have a long history as counterparts for derivative
trades, taking on market participants' trading and settlement
risk. In fact, no CFTC-regulated exchange has had a default. So
I would be interested in hearing from some of other panelists
on how such a track record here would encourage the movement of
credit derivatives to other markets.
Our hearings to this point have been very informative,
thorough and bipartisan, and with two full panels today, I
expect we will get a wide range of views from industry
stakeholders.
I again welcome today's witnesses and welcome the Members
for their participation and look forward to members of the
panel's testimony.
[The prepared statement of Mr. Peterson follows:]
Prepared Statement of Hon. Collin C. Peterson, a Representative in
Congress From Minnesota
Good afternoon. I want to welcome everyone to today's hearing.
Today marks the third hearing this Committee has held on credit
derivatives in recent months. We have had two good hearings to this
point and I will save everyone the time and not rehash what has been
said about these complex and largely unregulated financial products.
This afternoon we have two panels of industry stakeholders before us to
discuss recent movement in the industry and among regulators.
In the wake of the unwinding of billions of dollars of obligations
in this extremely opaque and, at times, hard to value credit default
swaps market, several companies have stepped forward and are seeking
approval to operate clearinghouses for credit derivatives. Such
clearinghouses could reduce the bilateral risk of swaps transactions
and increase transparency of these products, not just for the public,
but for all the players in the industry.
Given the possibility of central clearing, I would hope our
panelists can shed some light on how this could work given the often
complex, specialized nature of many of these products. Issues like
margin requirements, the standardization of contracts, exchange
operating standards, the financial security of clearinghouses in times
of stress, and the creditworthiness of participants would also need to
be addressed if these products were brought out of the dark and onto
regulated exchanges.
Our panelists also may have views on the recent Memorandum of
Understanding signed by the Federal Reserve, the Securities and
Exchange Commission and the Commodity Futures Trading Commission on
sharing information and coordinating oversight of swaps and new
clearinghouses.
As was discussed before this Committee last November, proposals in
that Memorandum of Understanding could lead to a clearinghouse
regulated by the Fed and another by the CFTC, leaving open the
possibility that clearing houses could choose between a regulator with
no experience in this area and a regulator with long experience in this
area.
Moving towards a dual, or even tripartite structure, if you include
the Fed, looks like it would recreate the same divided regulatory
problem we have already seen on Wall Street and among the largest banks
that allowed the biggest players to essentially choose their regulator
based on experience, or lack thereof.
Last week, I led a Congressional delegation to Europe to meet with
regulators and clearing providers. We spent time in London, Brussels,
and Frankfurt, discussing with our counterparts across the Atlantic the
same issues this Committee has examined over the past several months.
One thing that is clear is that in today's world, any regulatory
answer to the lack of transparency in the market for credit derivatives
has to be a global one. We hear often of the threats that implementing
certain kinds of regulation on certain tradable products will just
drive those products overseas to less transparent markets. Domestic
exchanges already have a long history as counterparties for derivatives
trades, taking on market participants' trading and settlement risks. In
fact, no CFTC-regulated exchange has had a default. So I would be
interested in hearing from some of our panelists on how such a track
record here would encourage the movement of credit derivatives to other
markets.
Our hearings to this point have been very informative, thorough,
and bipartisan, and with two full panels today, I expect we will get a
wide range of views from industry stakeholders. I welcome today's
witnesses and I look forward to their testimony.
The Chairman. And with that I would yield to the Ranking
Member, for today, of the Committee, my good friend, the
distinguished Member from Iowa, Mr. King.
OPENING STATEMENT OF HON. STEVE KING, A REPRESENTATIVE IN
CONGRESS FROM IOWA
Mr. King. Thank you, Mr. Chairman. I thank you for calling
today's hearing, and also for continuing this Committee's
efforts in gaining further insight into the role of credit
default swaps in our economy and how they should be regulated.
I also would like to thank the participants on our two
panels today. We appreciate your time and commitment to the
public policy process as we learn more about credit default
swaps and move forward with an appropriate regulatory approach
for this financial instrument.
This is the third hearing in the Agricultural Committee
that has been held on the role of credit default swaps in our
economy. Since our first hearing in October, there have been a
number of developments with respect to this financial
instrument and our economy as a whole. Credit default swaps do
serve a valid purpose in the marketplace. They are an important
risk-management tool necessary for successful functioning of
our financial markets. However, we have learned that these
financial instruments need appropriate oversight.
Credit default swap products have grown exponentially over
a relatively short amount of time without proper regulation and
transparency. This has created systemic risk and uncertainty in
our marketplace. Credit default swaps need a regulatory
approach that will provide greater transparency and risk
management, and that will create a method for price discovery.
Last month Federal regulatory bodies established a
Memorandum of Understanding regarding credit default swaps.
This measure will allow for information sharing, will encourage
cooperation among regulatory authorities. It will create a
method for clearing credit default swaps. This approach should
ultimately provide transparency needed to understand the market
as well as measure counterparty performance.
However, as we move forward with developing a clearing
mechanism, what remains uncertain is how exactly this clearing
mechanism will reduce counterparty credit risk. What standards
in relation to reporting, pricing and assessing risk before a
credit event are needed for clearing these financial
instruments? How will various regulatory authorities work
together to achieve the broad goals of the Memorandum of
Understanding? How will those efforts promote regulatory
consistency rather than a duplication of efforts or, worse,
further mismanagement?
Today we hope to advance our knowledge in respect to these
questions to create the appropriate regulation that respects
the nature of the marketplace and considers the limits of
government intervention.
Again I thank you for your participation in today's
hearing. I thank the Chairman and look forward to your
testimony.
Mr. Chairman, I yield back.
[The prepared statement of Mr. King follows:]
Prepared Statement of Hon. Steve King, a Representative in Congress
From Iowa
I would like to thank Chairman Peterson for calling today's
hearing. And, for continuing this Committee's efforts in gaining
further insight into the role of credit default swaps in our economy
and how they should be regulated.
I would also like to thank the participants of our two panels
today. We appreciate your time and commitment to the public policy
process as we learn more about credit default swaps and move forward
with an appropriate regulatory scheme for this financial instrument.
This is the third hearing the Agriculture Committee has held on the
role of credit default swaps in our economy. Since our first hearing in
October there have been a number of developments with respect to this
financial instrument and our economy as a whole.
Credit default swaps do serve a valid purpose in the marketplace.
They are an important risk management tool necessary for the successful
functioning of our financial markets.
However, we have learned that these financial instruments need
appropriate oversight. CDS products have grown exponentially over a
relatively short amount of time without proper management. This has
created systemic risk and uncertainty in our marketplace. CDS products
need a regulatory scheme that will provide greater transparency and
risk management, and will create a method for price discovery.
Last month, Federal regulatory bodies established a Memorandum of
Understanding regarding credit default swaps. This measure will allow
for information sharing, will encourage cooperation among regulatory
authorities, and will create a method for clearing credit default
swaps. This approach should ultimately provide transparency needed to
understand the market, as well as measure counterparty performance.
However, as we move forward with developing a clearing mechanism,
what remains uncertain is how exactly this clearing mechanism will
reduce counterparty credit risk. What standards, in relation to
reporting, pricing and assessing risk before a credit event, are needed
for clearing these financial instruments? How will various regulatory
authorities work together to achieve the broad goals of the Memorandum
of Understanding? How will those efforts promote regulatory consistency
rather than a duplication of efforts or worse further mismanagement?
Today, we hope to advance our knowledge in respect to these
questions so that we can create the appropriate regulation that
respects the nature of the marketplace and considers the limits of
government intervention.
Again, I thank you for your participation in today's hearing, and I
look forward to your testimony.
The Chairman. I thank the gentleman.
The other Members, if you have opening statements, they
will be made part of the record, but we are going to move ahead
to the witnesses to proceed with the hearing.
Our first panel we welcome today, we have Mr. Terrence
Duffy, Executive Chairman of the CME Group from Chicago;
Johnathan Short, Senior Vice President and General Counsel of
the International Exchange of Atlanta, ICE; Mr. John O'Neill,
Manager of Fixed Income Derivatives for Liffe, New York Stock
Exchange Euronext, London; Mr. Thomas Book, a Member of the
Executive Board of Eurex Clearing AG in Frankfort, Germany.
Mr. Duffy, we will start with you. You have 5 minutes. Your
statements will be made in full part of the record, so we would
encourage you to stay within the time, although we will give
you a little latitude. Welcome, and we look forward to your
testimony.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME
GROUP, INC., CHICAGO, IL
Mr. Duffy. Thank you, Mr. Chairman. Again, I am Terry
Duffy, the Executive Chairman of the CME Group, and I want to
thank you, Mr. Chairman, and Mr. Goodlatte for inviting us to
testify today.
You asked us to discuss the role of credit default swaps
and the regulatory framework that governs. You also asked for
our suggestions for modifications of the current regulatory
framework to facilitate efficient clearing of credit default
swaps.
At the outset I would like to applaud the efforts of New
York Fed President Timothy Geithner, SEC Chairman Chris Cox and
CFTC Chairman Walt Lukken. They worked with market participants
to reduce gross open CDS exposures by more than 25 percent,
from $67 trillion to $44 trillion. They also worked together to
facilitate regulatory review and approval of industry efforts,
including CME Group's effort.
Credit default swaps serve an important economic purpose,
but unfortunately the way they do it is not perfect. Ideally
credit default swaps are designed to permit investors to hedge
specific risk that a particular enterprise will fail or the
rate of failure of a defined group of firms will exceed
expectations. Credit default swaps are also an excellent device
to short corporate bonds, which otherwise could not be shorted.
In an uncontrolled environment, however, credit default
swaps can pose serious problems to the efficient functioning of
our capital markets, and as has been well documented, the
incentives to sell credit default swaps has led to unfortunate
outcomes. Firms have sold credit default swaps that bear risks
akin to hurricane insurance, but no regulator required that a
firm maintain sufficient capital to fund the disaster that was
being covered.
Volatile pricing of credit default swaps has had a severe
adverse impact on companies whose credit ratings, loan
covenants and stock prices were impaired by reported changes in
their credit spreads. We understand that some pricing conduct
is under investigation, but it is too late for the companies
that were most impacted. Regulators have been unable to judge
the market impact of allowing a firm to fail. This is because
it is hard to determine what the consequences of the failure
would be with the respect to their obligations to others and
the credit default swaps that would mature. This is a short
list of common problems.
While some characterized credit default swaps as gambling
devices or instruments of mass destruction, we do not take that
view. We believe that they can serve an important role in our
economy without imposing undue systemic risks if such swaps are
marked-to-market to prices that are independently and
objectively determined; if the regulators responsible for
controlling systemic risk can easily keep track of the
obligations of the banks, brokers and other participants in the
markets; and if the well capitalized and regulated
clearinghouses act as a counterparty for such swaps.
The current regulatory regime does not make it easy to
achieve these aims. If credit default swaps are traded between
sophisticated parties, and the transaction is subject to
negotiation, the transaction is excluded from regulation by the
CFTC by section 2(g) of the Commodity Exchange Act and excluded
from regulation by the SEC by section 206(a) of the Gramm-
Leach-Bliley Act. In consequence, efforts to enhance this
market with product standardization and central counterparty
clearing services have necessitated collaboration among
regulators with uncertain statutory authority.
Although the CDS market has historically had some notable
shortcomings, it is important to also recognize recent market
structure enhancements. These include significant reductions in
the confirmation backlog, the increased rate at which
counterparties are pursuing bilateral tear-up and compression
agreements, and the DTCC's efforts to release information on
the aggregated gross credit default swaps exposure held in the
Trade Information Warehouse.
Also, with the leadership of the New York Fed, the industry
has been moving toward the adoption of central counterparty
claim facilities. These innovations improve the risk-management
capabilities of market participants. CME Group has an immediate
operational capacity to offer a compression facility and
clearinghouse for standardized credit default swaps. We will
also be able to migrate a high percentage of previously traded
swaps into standardized, cleared environment. This in turn will
provide regulators with the information they need and give
customers a more efficient market with lower costs and lower
risk.
CME Group has the ability to reduce risk now. We have
presented our plan to the Federal Reserve, CFTC and the SEC. We
also have addressed regulatory uncertainty in this area. We
have urged the SEC to advance the ball by immediately retaining
authority to prosecute for insider trading and manipulation
that affects securities markets. This should include exempting
the trading and clearing of credit default swaps that are
cleared by the CFTC-regulated clearinghouse. We remain hopeful
that the SEC will take the steps necessary to achieve these
important regulatory and systemic risk-reduction goals. We are
working with, and will continue to work with, the SEC, the CFTC
to secure a workable set of exemptions that will give the
solution a chance to succeed.
I thank you for your time, and I look forward to answering
your questions.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME
Group Inc., Chicago, IL
I am Terrence A. Duffy, executive Chairman of CME Group Inc. Thank
you Chairman Peterson and Ranking Member Goodlatte for inviting us to
testify today. You asked us to discuss the role of credit default swaps
and the regulatory framework that governs. You also asked for our
suggestions for modifications of the current regulatory framework to
facilitate efficient clearing of credit default swaps. At the outset, I
would like to applaud the efforts of New York Fed President Timothy
Geithner, SEC Chairman Chris Cox and CFTC Chairman Walt Lukken in
working with market participants to reduce gross open CDS exposures by
more than 25% from $67 trillion to $44 trillion and in working together
to facilitate regulatory review and approval of industry efforts,
including CME Group's efforts, to enhance the CDS market through
central counterparty clearing services.
Introduction
Credit default swaps serve an important economic purpose in an
unfortunately imperfect manner. At the ideal level, credit default
swaps permit investors to hedge specific risk that a particular
enterprise will fail or that the rate of failure of a defined group of
firms will exceed expectations. However, because credit default swaps
are not insurance, investors who are not subject to any specific risk
can assume default risk to enhance yield or buy protection against a
default to speculate on the fate of a company or the economy generally.
Credit default swaps are also an excellent device to short corporate
bonds, which otherwise could not be shorted.
In an uncontrolled environment, credit default swaps can pose
serious problems to the efficient functioning of our capital markets.
As has been well documented, the incentives to sell credit default
swaps have led to unfortunate outcomes. Firms have sold credit default
swaps that bear risks akin to hurricane insurance, but no regulator
required that the firm maintained sufficient capital to fund the
disaster that was being covered. Volatile pricing of credit default
swaps has had direct and severe adverse impacts on companies whose
credit ratings, loan covenants and stock prices were impaired by
reported changes in their credit spreads. We understand that some
pricing conduct is under investigation, but it is too late for the
companies that were most impacted. Regulators have been unable to judge
the market impact of allowing a firm to fail because the consequences
of the failure with respect to their obligations to others and the
credit default swaps that would mature have not been immediately
discernable. This is the short list of common problems.
While some have characterized credit default swaps as gambling
devices or instruments of mass destruction, we do not take that view.
If such swaps are marked-to-market to independently and objectively
determined prices, if the regulators responsible for controlling
systemic risk can easily keep track of the obligations of the banks,
brokers and other participants in the market and if a well-capitalized
and regulated clearing house acts as the central counterparty for such
swaps, we believe that they can serve an important role in our economy
without imposing undue systemic risks.
The current regulatory regime does not make it easy to achieve
these aims. If credit default swaps are traded between sophisticated
parties and the transaction is subject to negotiation, the transaction
is excluded from regulation by the CFTC by section 2(g) of the
Commodity Exchange Act and excluded from regulation by the SEC by
section 206A of the Gramm-Leach-Bliley Act. In consequence, efforts to
enhance this market with product standardization and central
counterparty clearing services have necessitated collaboration among
regulators with uncertain statutory authority. Although the CDS market
has historically had some notable shortcomings, it is important to also
recognize recent market structure enhancements, including significant
reductions in the confirmation backlog, the increased rate at which
counterparties are pursuing bilateral tear up and compression
arrangements, as well as DTCC's efforts to release information on the
aggregate gross CDS exposures held in the Trade Information Warehouse.
Also, with the leadership of the New York Fed, the industry has been
moving toward the adoption of central counterparty clearing facilities.
These innovations improve the risk management capabilities of market
participants.
We have formed a joint venture with the Citadel Investment Group
and have immediate operational capacity to offer a compression facility
and clearing house for standardized credit default swaps and to migrate
a high percentage of previously traded swaps into a standardized,
cleared environment that will provide regulators with the information
they need and customers with a lower cost, lower risk and more
efficient market. CME Group has the ability to reduce risk now. We have
presented our plan to the Federal Reserve, the CFTC and the SEC. We
have addressed regulatory uncertainty in this area by urging the SEC to
immediately advance the ball by retaining authority to prosecute for
insider trading and manipulation that affects securities markets and
otherwise exempting the trading and clearing of credit default swaps
that are cleared by a CFTC regulated clearing house. We remain hopeful
that the SEC will take this step necessary to achieve these important
regulatory and systemic risk reduction goals. We are working with, and
will continue to work with, the SEC and CFTC to secure a workable set
of exemptions that will give this solution a chance to succeed.
Discussion
Trading of financial futures on regulated futures markets, subject
to the oversight of the Commodity Futures Trading Commission, has been
a net positive to the economy, has caused no stress to the financial
system and has easily endured the collapse of one and near collapse of
two firms that were very active in our markets. This is a record of
which this Committee, the CFTC and our industry can be justifiably
proud.
When Lehman Brothers filed for bankruptcy, no futures customer lost
a penny or suffered any interruption to its ability to trade. The
massive proprietary positions of Lehman were liquidated or sold, with
no loss to the clearing house and no disruption of the market. This
tells us that the margining, financial safeguards and customer
protection mechanisms of the futures industry work in times of immense
stress to the financial system.
Fourteen years ago, on June 14, 1994, we testified before the
Subcommittee on Environment, Credit, and Rural Development of the
Committee on Agriculture of the House of Representatives on the topic
of regulatory issues for OTC derivatives.\1\ At that time, OTC swaps
were in their infancy--the market had grown from approximately $2
trillion in 1989 to less than $8 trillion in 1994. We sounded a number
of very clear warnings respecting the steps that would be necessary to
assure that this rapidly growing market did not result in systemic
problems to our economy.
---------------------------------------------------------------------------
\1\ Testimony of CME's then Chairman John F. Sandner.
``There are common themes in the recent stories, beyond the
obvious ones of massive financial losses and attempts to shift
the blame to others . . . In almost all cases of unexpected
losses, properly linked to derivative instruments, three
elements are present, to varying degrees: (1) the accuracy of
pricing the instruments involved; (2) the assessment of risk
before the fact; (3) and the rapidity with which small losses
---------------------------------------------------------------------------
became huge.''
Interestingly, what was true of the nascent OTC interest rate swaps
market in 1994 is just a true with the nascent CDS market in 2008. By
contrast to the elements that contribute to significant loss events in
OTC derivatives markets, centrally cleared derivatives are subject to
daily mark-to-market, risk management and stress testing via the
margining process. Both of these critical risk management functions
prevent small losses from accumulating unnoticed.
Since at least the early 1990s, CME has had a consistent philosophy
respecting the regulation of OTC derivative trading and the superiority
of regulated exchanges with central counterparty clearing. We have not
sought to ban all OTC trading, we have urged that OTC trading be
limited to truly sophisticated investors trading contracts that are too
individualized or too thinly traded to be brought onto a trading
platform for standardized products. We were right then and we are right
now.
On September 26, 2007, I testified before the House Agriculture
Subcommittee on General Farm Commodities and Risk Management and
discussed our view of the success of the Commodity Futures
Modernization Act and the amendments that we believed were necessary to
extend the benefits of central counterparty clearing to OTC
derivatives.
I do not intend to repeat that testimony, which was detailed and
extensive. I will only note that we suggested that Congress look to
``first principles,'' which means the findings and purposes adopted by
Congress to guide the Commission's exercise of its jurisdiction.
Section 5(b) of the Commodity Exchange Act charged the Commission with
a duty to oversee ``a system of effective self-regulation of trading
facilities, clearing systems, market participants and market
professionals'' and to ``deter and prevent price manipulation or any
other disruptions to market integrity; to ensure the financial
integrity of all transactions subject to this chapter and the avoidance
of systemic risk; to protect all market participants from fraudulent or
other abusive sales practices.''
We suggested that there is a growing conflict between these
``purposes'' and the statutory exemptions for unregulated markets that
had been inserted into the CEA by various special interests. It is
clear to us that all of the key purposes mandated by Congress in
Section 5(b) are jeopardized if trading facilities for contracts in
exempt commodities are permitted to coexist with regulated futures
exchanges that list those same commodities.
Rather than looking back and trying to assess blame, we want to
move forward and explain what CME Group is offering and planning to
offer to alleviate the risks to the economy currently represented by
the almost $600 trillion in outstanding notional value of OTC swaps. We
are in the process of offering a means to convert a significant
proportion of outstanding OTC interest rate swaps into centrally-
cleared instruments subject to the high risk management standards and
regulatory requirements of the CME Clearing House as a Derivatives
Clearing Organization supervised by the CFTC. If customers accept this
program, we expect that standardization of these outstanding contracts
and submission to our clearing system will permit a multilateral
netting process that will reduce the outstanding exposure on the
current open exposures submitted to our clearing system by a factor of
at least five.
I want to particularly focus on our plans to play a role in the CDS
market. CME Group's goal is to respect the value and importance these
markets provide to managing risks in corporate debt portfolios and to
work with the dealer community and buy-side participants to facilitate
their current hedging, trading, and dealing activities while providing
them with netting, risk management and other central counterparty
clearing services that reduce their costs and risk and increase
investor confidence in these markets. It is also our goal to provide
counterparty credit risk intermediation, reduction in gross exposures,
and transparency around aggregate open exposures in a manner that
reduces the potential need for regulatory intervention in distressed
credit situations going forward.
The CDS market has grown because credit derivatives permit
dispersion and realignment of credit risks. These instruments are a
tremendously valuable financial tool in the right hands and used
properly. However, the individual and systemic risks created by the
exponential growth of such contracts has not been properly managed--in
some cases it appears not to have been well understood. The lack of
transparent mark-to-market, standardized contract terms, multilateral
netting and all of the other advantages that flow from a comprehensive
and open central counterparty clearing system have compounded risk and
uncertainty in this market. The gross notional exposure in that market
is about $44 trillion. It is estimated that portfolio compression by
netting could reduce that exposure by a factor of five to ten.
There is a solution. The compression facility and multilateral
clearing mechanisms that have been proposed by CME and Citadel
Investment Group offer a systematic method to monitor and collateralize
risk on a current basis reducing systemic risk and enhancing certainty
and fairness for all participants. Our solution offers regulators the
information and transparency they need to assess risks and prevent
market abuse. Our systematic multilateral netting and well-conceived
collateralization standards will eliminate the risk of a death spiral
when a jump to default of a major reference entity might otherwise
create a cascade of failures and defaults.
Let me provide a few examples of the problems, and the solutions
that our proposal offers:
First, best price information in CDS markets is not always
readily available. Disagreements are common, leading to
subjective and inconsistent marks and potentially incomplete
disclosure to investors of unrealized losses on open positions.
For example, earlier this year, Toronto Dominion Bank announced
a $94 million loss related to credit derivatives that had been
incorrectly priced by a senior trader. In a centrally cleared
model, with independently determined, broadly disseminated
mark-to-market prices such errors are much less likely to
occur.
Second, risk assessment information is inadequate, and risk
management procedures are inconsistent across the market.
Precise information on gross and net exposures is not
available. The true consequences of a default by one or more
participants cannot be measured--exactly the sort of systemic
risk brought to light by the Bear Stearns and AIG crises, which
caused major disruptions in the market. As Bear Stearns and AIG
faltered, credit spreads for most dealers widened, volatility
increased and liquidity declined. Intervention became
necessary.
Transparent mark-to-market price information combined with risk
management protocols enforced by a neutral clearing house could
have mitigated this outcome. Risk managers would have had
accurate and timely information on their firms' positions,
exposures and collateral requirements. Collateral to cover
future risks would have been in place or positions would have
been reduced. The clearing house and regulators would have seen
and been able to manage concentration risks within a particular
portfolio, and stress-test the consequences of a major default.
Our long experience is a tremendous asset in efforts to reduce
systemic risk in the CDS market. The CME Clearing House currently holds
more than $100 billion of collateral on deposit and routinely moves
more than $3 billion per day among market participants. We conduct
real-time monitoring of market positions and aggregate risk exposures,
twice-daily financial settlement cycles, advanced portfolio-based risk
calculations, monitor large account positions and perform daily stress
testing. Our clearing house has a proven ability to scale operations to
meet the demands of new markets and unexpected volatility.
CME Clearing also brings significant scale with risk management
expertise and default protections. You may have seen press questioning
our decision to include CDS clearing in a consolidated guaranty fund
with our existing futures and energy and commodity OTC business. To
clarify the record, we want to say the following.
A CCP guaranty fund is similar to a mutualized insurance or loss
sharing vehicle. As such, the risk profile to the pool is reduced
whenever the risks covered by the pool are diversified. We have seen
very real evidence of this diversification benefit whenever we have
added large pools of business to our guaranty fund--whether the
products are correlated or uncorrelated to the existing product set.
The London Clearing House has also successfully pursued a consolidated
guaranty fund approach across its futures and OTC business since the
mid-1990s.
In evaluating this approach, we took great care to ensure that the
risk profile faced by non-CDS participants who contribute to the
guaranty fund--traditional futures participants--is not adversely
affected. We effectively risk manage the CDS products--via
participation restrictions, margining techniques and risk monitoring
practices--such that the risk profile to the guaranty fund posed by a
CDS product is comparable to that posed by a traditional futures
product. The CDS market requires product structures, rules and
regulatory oversight that are suited to the needs of all participants.
That may not occur if centrally traded and cleared credit products must
be fitted within regulatory frameworks that were developed for
different markets or to meet different policy goals. We are working
with the New York Fed, the CFTC and the SEC to find a way quickly to
bring our solution to market.
We are in ongoing negotiations with the SEC and do not believe that
it is appropriate to comment publicly on the pending proposals and our
mutual efforts to reach a satisfactory accommodation that will permit
our venture to provide a valuable service to the industry, the economy
and the regulators.
I thank the Committee for the opportunity to share CME Group's
views, and I look forward to your questions.
The Chairman. Thank you very much, Mr. Duffy. We appreciate
that.
Mr. Short, welcome to the Committee.
STATEMENT OF JOHNATHAN H. SHORT, SENIOR VICE
PRESIDENT AND GENERAL COUNSEL, IntercontinentalExchange, INC.,
ATLANTA, GA
Mr. Short. Thank you. Chairman Peterson, Members of the
Committee, I am Johnathan Short, Senior Vice President and
General Counsel of IntercontinentalExchange, or ICE. We
appreciate the opportunity to discuss the role of the credit
derivatives in the financial markets and ICE's efforts, along
with the efforts of other market participants, to introduce
transparency and risk intermediation into the OTC credit
markets. I will begin with a brief update regarding the status
of our efforts in this regard.
As I previously testified before this Committee, ICE will
form a limited-purpose bank, ICE U.S. Trust, to clear credit
default swaps. ICE U.S. Trust will be a New York trust company
and a member of the Federal Reserve System. It will therefore
be subject to the regulatory and supervisory requirements of
the Federal Reserve System and the New York Banking Department.
I am pleased to report that ICE's application and charter
were approved by the New York Banking Department last Thursday,
December 4th. The Federal Reserve Bank of New York is currently
reviewing ICE Trust's application, and we believe we are in the
final stages of that review. When approved, ICE Trust will
immediately begin clearing current backlogs of CDS trades
before moving on to accepting newly executed CDS transactions.
ICE Trust will be an open platform. Other suitable trading
platforms will be able to use our clearing facilities. Because
of existing agreements with the Depository Trust and Clearing
Corporation Warehouse, our solution will support the
cataloguing of existing and future CDS trades regardless of
whether they are cleared or not. Ultimately the goal is to
ensure that the greatest amount of trades are centrally cleared
in order to decrease counterparty risk and increase
transparency.
One of the things that we were asked to do was to respond
to the President's Working Group's recommendations, and I will
try to do so briefly. Effective regulation of credit
derivatives is essential for the efficient operation of capital
markets in the financial system. To address these issues, on
November 14th the President's Working Group on Financial
Markets outlined four important objectives for OTC derivatives
markets. Those objectives were to improve market transparency
and the integrity of credit default swaps, to enhance risk
management of OTC derivatives, to strengthen OTC derivatives
market infrastructure, and to continue cooperation among
regulatory authorities.
I support PWG's policy objectives, and, as I will outline
here, we believe that our credit default swaps clearing
solution will help regulators achieve each of these important
objectives.
The first policy objective of the PWG is improving market
transparency and the integrity of the credit default swaps
market. Specifically, the PWG calls for public reporting of
prices, trading volumes and aggregated open interest. Further,
the PWG states that regulators should have access to trade and
position information housed at central counterparties and
central trade repositories. ICE will satisfy these objectives
by direct regulation by the Federal Reserve and through
adoption of appropriate clearinghouse rules requiring the
reporting of this information.
As the Federal Reserve reviews our membership application,
we will work with it and other regulators to provide requested
data including public reporting.
The second policy objective of the PWG is enhanced risk
management of OTC derivatives. Among the specific objectives,
the PWG calls for specific risk-management standards for
regulated entities that transact OTC derivative instruments,
best practices for market participants with respect to risk
management. To meet the objectives, the Federal Reserve
regulatory requirements include minimum capital requirements,
governance requirements, membership requirements, margin
requirements, a satisfactory guaranty fund, and other
operational safeguards all with a view to satisfying
internationally recognized clearing standards. Importantly, we
were very pleased to see in the Memorandum of Understanding
between the Fed, the SEC and the CFTC that there has been a
commitment between these three important regulators to meet the
highest and best standards.
ICE Trust membership will be open to all market
participants who meet the clearinghouse's financial criteria.
And importantly, third parties who do not care to join the
clearinghouse will be able to clear through members of the
clearinghouse. Like other clearinghouses, ICE Trust will review
each member's financial standing, operational capabilities,
systems and controls, and the size, nature and sophistication
of its business in order to meet comprehensive risk-management
standards.
The third policy goal that PWG is to strengthen OTC
derivatives markets infrastructure, including open access to
key infrastructure components and standardization of CDS
contracts.
Finally, the PWG states that regulators should encourage
improvements to operational infrastructure, including
improvements of post-trade automation, frequent portfolio
compression and enhanced standardized documentation.
ICE's clearing solution squarely addresses this objective
by addressing the OTC CDS market as it exists today. By
bringing a CDS clearing solution to the existing market
structure, ICE's solution can quickly address the existing
systemic risk that is resident in the market. Of equal
importance, ICE has critical domain knowledge and expertise to
bring to its clearing solution as a result of its acquisition
of Creditex Group in August of this year; its development of
the ISDA cash settlement auctions in 2005 in which it was a
participant; and in recent weeks its efforts in the orderly
settlement of CDS contract referencing Fannie Mae, Freddie Mac,
Lehman Brothers and many others.
The final policy objective of the President's Working Group
is to continue cooperation amongst regulators. Specifically,
the PWG states that regulators that have jurisdiction over OTC
markets should cooperate and ensure they have adequate
enforcement authority. I fully support this recommendation and
believe that CDS clearing will achieve this goal.
Importantly, as the Chairman himself noted, I think this
needs to be taken to the next step, and there needs to be a
facilitation of international cooperation to bring transparency
to these truly global markets.
Mr. Chairman, thank you for the opportunity to share our
views with you, and I will be happy to answer any questions
that you or the Committee have.
[The prepared statement of Mr. Short follows:]
Prepared Statement of Johnathan H. Short, Senior Vice President and
General Counsel, IntercontinentalExchange, Inc., Atlanta, GA
Introduction
Chairman Peterson, Ranking Member Goodlatte, I am Johnathan Short,
Senior Vice President and General Counsel of the
IntercontinentalExchange, Inc., or ``ICE.'' We very much appreciate the
opportunity to appear before you today to discuss the role of credit
derivatives in the financial markets and ICE's efforts, along with
other market participants, to introduce transparency and risk
intermediation into the OTC credit markets.
ICE is proud to be working with the Federal Reserve System, the
Commodity Futures Trading Commission (``CFTC''), and the Securities
Exchange Commission (``SEC'') on these efforts that are vital to the
health of our financial markets. Importantly, ICE has a history of
working with over-the-counter (``OTC'') market participants to
introduce transparency and risk intermediation into markets. We
pioneered the introduction of transparent OTC energy markets nearly a
decade ago, moving trading from telephones to screens. In 2002, we
introduced clearing into the OTC energy markets in response to the
credit and counterparty risk crisis that were then gripping the energy
markets--much like the crisis confronting global financial markets
today. With the formation and launch of ICE Trust (``ICE Trust''),
which I will detail in a few minutes, ICE is leveraging its expertise
in OTC clearing and making significant investments to transform the OTC
credit derivatives market into a regulated, centrally cleared
marketplace that will be open, independent, transparent and efficient.
Background and Progress Report
As outlined in previous testimony, to clear credit default swaps
(``CDS''), ICE will form a limited purpose bank, ICE Trust. ICE Trust
will be a New York trust company and a member of the Federal Reserve
System. It will therefore be subject to regulatory and supervisory
requirements of the Federal Reserve System and the New York Banking
Department.
ICE has agreed to purchase The Clearing Corporation (``TCC'') and
has garnered the support of nine banks: Bank of America, Citigroup,
Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase Bank,
Merrill Lynch, Morgan Stanley and UBS. Currently TCC provides clearing
services for global futures exchanges and OTC markets and since early
2007 has been working with leading industry participants, regulators
and industry associations on a global initiative to clear CDS indices,
tranches and single name instruments.
The nine banks using the ICE CDS clearinghouse will novate and
capitalize their positions with a new and completely separate bulk
fund. The guaranty fund for index contracts alone has been estimated to
be in excess of $1 billion. The total level of funding and collateral
could rise considerably as initial and variation margin levels are
determined and as new types of credit transactions move into the
clearinghouse.
It is important to note that one of the defining features of the
ICE Trust CDS clearing solution--and one that we believe is import to
its success over the long term--is the independence of ICE Trust
management from its clearing membership. The management of ICE Trust
will be vested in an independent Board of Directors. Initially, the
Board of Directors of ICE Trust will consist of seven members, four of
whom are independent in accordance with the requirements of the New
York Stock Exchange listing standards, the Exchange Act, and ICE's
Board of Director Governance Principles. Within 6 months of its initial
constitution, the Board of Directors will increase to nine with the
addition of two new independent directors.
In this vein, ICE Trust has also been holding regular meetings with
buy-side participants to insure their representation in the
clearinghouse solution. Feedback from these meetings has allowed ICE
Trust to tailor its governance to allow buy-side participants to have a
voice in the management of the clearing house through an advisory
board. ICE Trust believes it is very important that its clearing
solution be open to all participants, and thus obtaining buy-side
support is very important.
ICE Trust will also be an open platform: other suitable trading
platforms will be able to use ICE Trust's clearing facilities. Because
TCC and Creditex are integrated with the Depository Trust and Clearing
Corporation (DTCC) warehouse, our solution will have the ability to
support all existing and future CDS trades, regardless of when or where
the trades were executed. Ultimately, the goal is to insure that the
greatest amount of trades are centrally cleared in order to decreased
counterparty risk and increase transparency.
Regulation of Credit Derivatives Clearing
As stated in our earlier testimony, appropriate, effective
regulation of credit derivatives is essential for the efficient
operation of capital markets and the financial system. Presently,
credit default swaps are largely exempt from regulation by the CFTC and
the SEC. Since the beginning of the credit crisis in 2007, however, the
Federal Reserve Bank of New York (``New York Fed'') has progressively
taken steps to address the unique market structure and systemic risks
inherent in the credit market. As recent events demonstrate, the credit
markets are intricately tied to the banking system, and many of the
largest credit derivative market participants are banks subject to
regulation by the Federal Reserve.
To address these issues, on November 14, the President's Working
Group on Financial Markets (``PWG'') announced its policy objectives
for the OTC Derivatives Market. In the policy statement, the PWG
outlined four objectives for OTC derivatives markets: (1) Improve
Market Transparency and Integrity for Credit Default Swaps, (2) Enhance
Risk Management of OTC Derivatives, (3) Strengthen OTC Derivatives
Market Infrastructure, and (4) Continue Cooperation among Regulatory
Authorities. ICE supports the PWG's policy objectives, and as outlined
below, ICE believes its credit default swaps clearing solution, ICE
Trust, will help regulators achieve these objectives.
Improving Market Transparency and Integrity for Credit Default Swaps
The first policy objective of the PWG is to improve market
transparency and integrity for credit default swaps. Specifically, the
PWG calls for public reporting of prices, trading volumes, and
aggregated open interest. Further, the PWG states that regulators
should have access to trade and position information housed at central
counterparties and central trade repositories. ICE will satisfy these
objectives through direct regulation by the Federal Reserve, and
through adoption of appropriate clearing house rules.
The Federal Reserve Act authorizes the Federal Reserve System and
the New York Federal Reserve to require reporting from ICE Trust, and
to conduct examinations of ICE Trust as it sees fit. The Federal
Reserve has this authority because it establishes the terms under which
ICE Trust will become a member bank. The Federal Reserve also has
statutory authority to require reports and conduct examinations of any
affiliate of ICE Trust. We expect that the Federal Reserve will require
detailed reports on a regular basis concerning all aspects of the
operations of ICE Trust. As the Federal Reserve reviews our membership
application, we will work with the agency, as well as other regulators,
to ensure that we provide requested and required data, including public
reporting.
In the case of the current market structure for credit default
swaps, the absence of this kind of information has contributed to
uncertainty in the credit derivatives marketplace. ICE fully supports
reporting of consolidated CDS market information because we know
transparency will improve public confidence and market effectiveness.
Our experience has taught us that central clearing combined with timely
and appropriate information disclosure will substantially improve
market safety and soundness, while preserving OTC market participants'
ability to innovate and create new risk management products.
Oversight by the Federal Reserve System will ensure that ICE's
cleared credit derivatives model is transparent and fully regulated
from the inception of its operation. The Federal Reserve System has
played a central role in addressing both the current credit crisis and
issues related to credit derivatives within the broader market. Indeed,
since its founding in 1913, the U.S. central bank has had primary
responsibility for maintaining the stability of the financial system
and containing systemic risk in financial markets.
Enhanced Risk Management of OTC Derivatives
The second policy objective of the PWG is to enhanced risk
management of OTC derivatives. Among the specific objectives, the PWG
calls for consistent risk management standards for regulated entities
that transact OTC derivatives instruments, including best practices for
market participants with respect to risk management.
To meet these objectives, Federal Reserve regulatory requirements
include minimum capital requirements, governance requirements,
membership requirements, margin requirements, a satisfactory guaranty
fund, and operational safeguards, all with a view to satisfying
internationally recognized clearing standards. As a limited purpose
bank, ICE Trust will be subject to regular examination by the Federal
Reserve and the New York Banking Department, among other regulatory
bodies as appropriate in the normal course of operations and will be
required to satisfy reporting requirements.
ICE Trust will offer clearing services to its membership.
Membership will be open to all market participants that meet the
clearinghouse's financial criteria, and, importantly, third parties
unable to meet membership criteria will be able to clear through
members of the clearinghouse. Like other clearinghouses, ICE Trust will
review each member's financial standing, operational capabilities
(including technical competence), systems and controls, and the size,
nature and sophistication of its business in order to meet
comprehensive risk management standards with respect to the operation
of the clearinghouse.
ICE Trust will require members to report various specific other
matters to the clearinghouse including: where the member ceases to hold
sufficient capital or breaches any applicable position limit; if the
net worth of such member reduces by more than 20% from that shown on
the latest financial statement filed by it with the clearinghouse for
any reason; the failure to meet any obligation to deposit or pay any
margin when and as required by any clearinghouse of which it is a
member; failure to be in compliance with any applicable financial
requirements of any regulatory authority, exchange, clearing
organization or delivery facility; the insolvency of the member or any
controller or affiliate of that member; any default affecting it.
ICE Trust will adhere to the ``Recommendations for Central
Counterparties'' (``RCC'') developed jointly by the Committee on
Payment and Settlement Systems (``CPSS'') and the Technical Committee
of the International Organization of Securities Commissions (``IOSCO'')
which set out standards for Risk Management of a central counterparty
(``CCP''). These recommendations are broadly recognized and have been
used by national regulators and other clearinghouses for self-
assessment.
Following these guidelines, ICE Trust will establish a guaranty
fund sufficient to meet costs associated with the cost of closing out
an insolvent member's liabilities that exceed the financial resources
(cash and collateral) held in the account of the insolvent member. Each
member will be required to contribute to the guaranty fund in an amount
which is adjusted to reflect the volume of activity and risk they hold
within the clearinghouse. The value of the guaranty fund will be
sufficient in aggregate to meet the largest single modeled stress-test
loss of the largest two members in excess of the margin requirement of
that member. Portfolio stress-testing will use scenarios to cover
market risks exceeding a confidence level of 99.9%.
The ICE Trust guaranty fund will be for CDS positions only and will
not serve as a collateral deposit for any other commodity contracts. We
believe the best solution for containing the financial risks associated
with credit derivative markets is to completely separate them from
other derivative markets.
Strengthened OTC Derivatives Market Infrastructure
The third policy goal of the PWG is to strengthen the OTC
derivatives market infrastructure. This objective includes ensuring
that all market participants have open and fair access to key
infrastructure components and that exchange or similar platforms for
standardized CDS contracts should be encouraged. Finally, the PWG
states that regulators should encourage improvements to operational
infrastructure, including improvements to post-trade automation,
frequent portfolio compression and enhanced standardized documentation.
ICE's clearing solution squarely addresses this objective by
addressing the OTC CDS market as it exists today. By bringing a CDS
clearing solution to the existing market structure, ICE's solution can
quickly address the existing systemic risk that is resident in the
market. Of equal importance, ICE has critical domain knowledge and
expertise to bring to its clearing solution as a result of its
acquisition of Creditex Group, Inc. (``Creditex''). Creditex is the
global market leader and innovator in providing infrastructure to the
credit default swap markets. In the last few years, Creditex has worked
collaboratively with market participants on three important initiatives
to improve operational efficiency and scalability in the credit
derivatives market.
In 2005, Creditex helped to develop the ISDA Cash Settlement
Auctions, which are the market standard for credit derivative
settlement and have been used in recent weeks to facilitate the orderly
settlement of CDS contracts referencing Fannie Mae, Freddie Mac, Lehman
Brothers, Landsbanki (Europe's first credit event auction) and many
others. In addition, Creditex and Markit, a credit derivative pricing
service, designed a compression solution to reduce the overall notional
size and the number of outstanding contracts in credit derivative
portfolios. Since August, Creditex and Markit have completed the
compression of $1.036 trillion in notional value of CDS transactions,
greatly reducing the risk to the financial system.
Finally, Creditex's subsidiary, T-Zero, is provides critical
infrastructure for trade transmission and same-day trade matching. The
platform addresses recommendations by the PWG earlier this year for
flexible and open architecture, ambitious standards for accuracy and
timeliness of trade matching errors and operationally reliable and
scalable infrastructure.
Importantly, ICE U.S. Trust will be open to other appropriate
market ``front end'' and ``back end'' solutions that fit the needs of
market participants. As noted earlier, other suitable trading platforms
will be able to use ICE Trust's clearing facilities. Because TCC and
Creditex are working with the Depository Trust and Clearing Corporation
(``DTCC'') warehouse, our solution will have the ability to support all
existing and future CDS trades, regardless of when or where the trades
were executed.
Cooperation Among Regulators
The final policy objective of the President's Working Group is
continued cooperation among regulators. Specifically, the PWG states
that regulators that have jurisdiction over OTC markets should
cooperate and ensure that they have adequate enforcement authority. ICE
fully supports this recommendation and believes that CDS clearing will
help achieve its goal. ICE Trust's principal regulator will be the
Federal Reserve, but it stands willing to work with any regulator to
make sure that the CDS market is open, transparent and regulated.
Conclusion
ICE has always been and continues to be a strong proponent of open
and competitive derivatives markets, and of appropriate regulatory
oversight of those markets. As an operator of global futures and OTC
markets, and as a publicly-held company, ICE understands the importance
of ensuring the utmost confidence in its markets. To that end, we have
continuously worked with regulatory bodies in the U.S. and abroad in
order to ensure that they have access to all relevant information
available to ICE regarding trading activity on our markets. We have
also worked closely with Congress to address the regulatory challenges
presented by derivatives markets and will continue to work
cooperatively for solutions that promote the best marketplace possible.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
The Chairman. Thank you, Mr. Short.
Mr. O'Neill, welcome to the Committee.
STATEMENT OF JOHN O'NEILL, MANAGER, FIXED INCOME
DERIVATIVES, LIFFE, NYSE EURONEXT, LONDON, UNITED KINGDOM
Mr. O'Neill. Good afternoon, Chairman Peterson, Ranking
Member King and all Members of the Committee. My name is John
O'Neill. I am the Manager of CDS at Liffe, which is part of
NYSE Euronext. It was very good to meet many Members of the
Committee in your recent visit to London. I thank you all for
the opportunity to testify here today.
I would like to begin my testimony by saying a few brief
words about the current CDS market, and then highlight to the
Committee some important principles which we have used in
developing the CDS clearing service which will be launching in
London 2 weeks from today. I then would like to end by making
brief observations concerning regulation of these markets.
First of all, as mentioned by the Committee already,
despite recent difficulties, we believe that CDS contracts
remain important tools for the management of risk. The
Committee has also noted some of the historical difficulties of
the CDS market particularly associated with rapid growth of
these transactions.
We believe that there are three key points the market still
needs to address. The first is same-day confirmation for
virtually all trades, so-called ``T+0'' settlement. The second
is accurate and timely marked-to-market pricing. And the third
is introduction of strong and proven central counterparties for
these products. The solution we are launching will address all
these points. We strongly agree with policy leaders in the
U.S., and elsewhere, that strong and experienced counterparties
are required for the CDS market.
NYSE Euronext, through our Liffe derivatives business,
already has a proven system for clearing OTC products. It is
called Bclear. Bclear has processed OTC transactions with a
value of over $8 trillion, and it is widely used by all
sections of the industry, banks, brokers and the buy side.
Bclear's products have so far been restricted to OTC equity
derivatives. On the 22nd of December, we also will be making
credit default swap contracts available on Bclear. This is a
longstanding product for us and has been developed in
cooperation with the market.
There are four guiding principals we have used in
developing CDS for Bclear. I would like to briefly mention
those to the Committee. The first is the CDS clearing solution
must be global in nature to reflect the global nature of this
market. All business in Bclear clears into LCH.Clearnet in
London, which is perhaps the most respected and experienced OTC
clearer in the world. U.S. dealers are among the largest users
of LCH.Clearnet both for their U.S. domestic business and their
wider global operations.
Particularly relevant for this market is LCH's experience
at the sole interbank interest rate swap clearer. Again, U.S.
firms are large users of this service.
The Committee will also be aware that LCH has recently
entered into a proposed merger agreement with the U.S.-based
DTCC, which, as noted, is an important player in this market.
We are starting in London, but we are working with U.S.
authorities to make sure U.S. parties have access to this
solution.
Our second principle is that we believe the CDS market
requires proven and safe solutions. We believe central
counterparties of CDS should be absolutely proven, and this is
no time for experimentation. In June this year, the notional
value of interest rate swaps held within LCH was valued at
approximately $60 trillion. That is even larger than the total
CDS market.
LCH has experience of handling major dealer defaults, most
recently Lehman Brothers. In that period of extreme stress, LCH
unwound a portfolio of equities, commodities, energy and
interest rate swaps held by Lehman's worth $9 trillion. Our
written testimony contains more details.
CDS clearing requires well capitalized and experienced
clearinghouses, specifically with experience in clearing OTC
products, we believe.
Our third principle is that the solution should be open to
the whole market. That includes buy-side, sell-side and
interdealer brokers. We have designed our approach to
accommodate this. Significantly for the Committee, our approach
allows buy-side customers to hold segregated business with
clearers. This means that counterparties who would have held
business with Lehman's when Lehman Brothers collapsed would
have been quickly assured of segregated business and quickly
assured of safety. That is an important point for the
Committee.
The fourth and final point is that we believe solutions
should be non-disruptive. The market can get all the security
of clearing and processing without asking parties to completely
change their business models. Bclear provides this by allowing
business to be pre-negotiated, entered to Liffe, accepted, and
then confirmed. It will increase the efficient use of capital
and will reduce stress on financial institutions. It will also
allow regulators to gain transparency concerning the size of
positions, which is particularly important in times of extreme
stress.
Finally, I would like to end by saying a few quick words
about regulation of this market. Both Bclear and LCH.Clearnet
are regulated by the FSA in London. LCH.Clearnet is also
regulated by the CFTC as part--given its status as the U.S.
derivative clearing organization. Both SEC and CFTC have
existing Memoranda of Understanding with the FSA. And the
British Government has had an information-sharing agreement
with U.S. authorities since 1991. We have been working with
U.S. regulators as well as the FSA in order to make the
solution available to U.S. customers.
Finally, from a policy perspective, if the U.S. chooses to
regulate CDS clearing in a greatly more restrictive manner than
other jurisdictions, there may be a risk that business will
move elsewhere.
We ask for concerted efforts among all regulators to
regulate this market. We support the policy and the principles
of the President's Working Group on Financial Markets and hope
for extensive cooperation between regulators. We stand ready to
help Congress to achieve this goal.
Thank you very much for the opportunity to testify.
[The prepared statement of Mr. O'Neill follows:]
Prepared Statement of John O'Neill, Manager, Fixed Income Derivatives,
Liffe, NYSE Euronext, London, United Kingdom
Introduction
Good Afternoon Chairman Peterson, Ranking Member Goodlatte and
Members of the Committee. My name is John O'Neill and I am the Manager
of CDS at Liffe, NYSE Euronext. I have headed up our initiative on
credit default swap clearing since the beginning of this year. I thank
you and the Committee for the opportunity to testify today.
The evolution of NYSE Euronext as a global company, as well as the
similar evolution of several other exchanges internationally, reflects
the global nature of financial and commodity markets. As the latest
financial crisis has shown, our markets and economies are more
connected than ever. NYSE Euronext's geographic and product diversity
has helped to inform our efforts in the area of credit derivatives, as
we work to bring transparency to, and mitigate the risks associated
with, products like credit default swaps.
I. Our CDS clearing solution
a. The CDS market
Credit default swaps are vitally important tools to facilitate the
management of risk. They allow the owners of bonds or loans to protect
themselves when they fear that borrowers will not honor their promises.
They also allow corporations to protect themselves against the risk
that partners or suppliers may go into bankruptcy. In difficult
economic times, this diversification of risk, if used properly, will
continue to add value to the marketplace.
During the past decade, the market for credit default swaps has
grown exponentially--from a relatively small derivative product to a
global industry of approximately $57 trillion in notional value at the
end of June 2008.\1\ At this time, the CDS market represented as much
as 8% of the total over-the-counter derivatives market of $684
trillion.\2\ The size of the CDS market may well diminish somewhat by
the end of 2008, as activity has slowed and the industry has
implemented programs to reduce the amount of contracts outstanding.
However, credit default swaps will continue to be one of the most
active global derivative products.
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\1\ The Bank for International Settlements estimated that the
notional amount of outstanding CDSs in 1998 was approximately $108
billion. By 2007, that number had grown to approximately $58 trillion.
Bank for International Settlements, Press Release, The Global
Derivatives Market at End-June 2001, December 20, 2001, and Bank for
International Settlements Monetary and Economic Department, OTC
Derivatives Market Activity in the Second Half of 2007, May 2008.
\2\ Bank for International Settlements semi-annual OTC derivatives
statistics as of June 2008.
---------------------------------------------------------------------------
This rapid growth in CDS transactions initially led to serious
processing inefficiencies. Most trades were confirmed manually, and
large backlogs developed. Although regulatory pressure from global
authorities has improved this situation significantly, inefficiencies
remain. The market needs to continue to strive for same day
confirmation (so called ``T+0'') to be the standard for virtually all
trades.
The clearing solution that we will launch in 2 weeks will provide
exactly that.
We strongly agree with by policy leaders in the U.S. and abroad
that it is essential that these instruments be cleared through central
counterparties.
b. Bclear: NYSE Euronext's CDS Clearing Solution
Since 2005, NYSE Euronext (through its subsidiary LIFFE
Administration and Management (``LIFFE A&M'')) has developed and
currently makes available to its members an OTC derivatives processing
service, called ``Bclear.''
Bclear is a simple, efficient and low cost way to register, process
and clear OTC derivative trades. It brings the flexibility of over-the-
counter trading to a centrally cleared exchange environment. Bclear has
processed OTC transactions with a notional value of over $8 trillion
since launch, and has been widely adopted by dealers, brokers and buy-
side firms. Previously, Bclear's products have been limited to equity
derivatives, but this will shortly be extended to other asset classes.
Importantly, on December 22, NYSE Euronext plans to add credit
default swaps to Bclear's portfolio of cleared OTC derivatives. This
will provide a mechanism for the processing and centralized clearing of
CDSs based on credit default swap indices. This is a longstanding
project developed in cooperation with the current market. This is an
extremely viable solution for several reasons:
(1) Bclear is part of a global solution. Clearing solutions for
credit default swaps must address the global market. In that
regard, Bclear's partnership with our clearing firm,
LCH.Clearnet Ltd. (``LCH.Clearnet'') is recognized as global in
nature. Today, U.S. dealers are among the largest users of
LCH.Clearnet, for both their U.S.-based and global operations.
LCH.Clearnet Group recently signed a non-binding heads of terms
regarding a proposed merger with the U.S.-based Depository
Trust & Clearing Corporation (DTCC).
From a regulatory perspective, if the U.S. chooses to regulate CDS
clearing in a greatly different or more restrictive manner than
regulators abroad, a situation may be created that will cause
products to move elsewhere. A concerted effort among regulators
and market participants is necessary in order to coordinate
policies governing the CDS market and strengthen the integrity
of that market. While NYSE Euronext is starting in London, we
are also working with U.S. regulators to enable us to make this
or a similar service available to market participants in the
United States.
(2) Bclear is a proven solution. As noted above, since 2005,
Bclear has processed OTC equity derivatives transactions with a
notional value in excess of $8 trillion.\3\ All Bclear business
is cleared by LCH.Clearnet, a highly experienced clearer of
global OTC derivative products, including repos, freight and
energy products. LCH.Clearnet is also the world's only
interbank interest rate swaps clearer. LCH.Clearnet is the
leading independent central counterparty group (CCP), serving
major international exchanges and platforms, as well as a range
of OTC markets. LCH.Clearnet a subsidiary of LCH.Clearnet Group
Ltd., which is owned 73.3% by users, 10.9% by exchanges and
15.8% by Euroclear (the leading European settlement operator);
LCH.Clearnet Ltd has a total of 109 members internationally
across all our services. The notional value of interest rate
swaps held within LCH.Clearnet stood at $60 trillion,
accounting for approximately 46% of the inter-dealer interest
rate swap market as of June 2008, larger even than the total
value of the CDS market.
---------------------------------------------------------------------------
\3\ As of December 1, 2008.
As the counterparty to every clearing member, LCH.Clearnet reduces
the scope for counterparty risk between market participants.
LCH.Clearnet is legally responsible for the financial
performance of the contracts that it has registered and any
resulting delivery contracts. All clearing members deposit
margin with LCH.Clearnet to cover the risk on their net
---------------------------------------------------------------------------
positions.
LCH.Clearnet has unrivalled experience handling dealer and market
participant defaults, including the recent collapse of Lehman
Brothers. In this period of extreme financial stress,
LCH.Clearnet successfully unwound the Lehman Brothers portfolio
of equities, commodities (softs and metals), energy (oil, power
and gas), repos and interest rate swaps in five major
currencies of $9 trillion notional value. This major unwind was
completed well within the margin Lehman Brothers held at
LCH.Clearnet, and without any recourse to LCH.Clearnet's
default fund or other protections. The total value of margin
held by LCH.Clearnet is typically in the vicinity of $60
billion, and the total size of LCH.Clearnet's Default Fund is
approximately $890 million.\4\
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\4\ As of December 4, 2008.
Working closely with its members, LCH.Clearnet has successfully
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managed not only the Lehman default but also the defaults of:
Drexel Burnham Lambert Ltd (1990).
Woodhouse Drake and Carey (1991).
Baring Brothers & Co. Ltd (1995).
Griffin Trading Company (1998).
In addition, LCH.Clearnet was heavily involved in managing down of
the positions of:
Yamaichi International (Europe) Ltd (1997).
Enron Metals Ltd (2001).
Refco Securities and Overseas Ltd (2005)
The default fund contributions of Members have never been drawn
upon in any default managed by LCH.Clearnet.
This is a well capitalized and highly experienced clearinghouse,
with unique experience in clearing OTC products. These are
exactly the criteria that regulators should consider when
assessing the credibility of CDS clearing solutions.
(3) Bclear is an open solution. Unlike other proposed solutions,
Bclear does not limit the participants who can benefit from its
clearing service. It facilitates sell-side, buy-side, and
interdealer broker interaction. Significantly, it allows buy-
side participants to use an account structure that will isolate
their positions from their clearing member. In the Lehman
Brothers default, this allowed those customers holding these
segregated positions with Lehman to be quickly assured of
safety.
(4) Bclear is a transparent, non-disruptive solution. Bclear allows
the flexible style of negotiation of the OTC market, but with
many of the benefits of exchange processing and central
counterparty clearing. With Bclear, deals are still pre-
negotiated, typically via phone, just as they are in today's
OTC market. There is electronic confirmation between the
clearing member and LCH.Clearnet, which stands as the central
counterparty to all transactions processed through Bclear.\5\
Mark to market valuations are provided via NYSE Euronext
systems on the same day.
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\5\ On October 31, 2008 LIFFE announced changes to its clearing
arrangements which, subject to regulatory approval, will be implemented
in the first quarter of 2009. These will involve LIFFE A&M becoming the
central counterparty to all transactions entered into on the LIFFE
market and all transactions which are accepted by LIFFE A&M through
Bclear, including CDS transactions. Under these arrangements, LIFFE A&M
will outsource certain functions to LCH.Clearnet, including those
concerning the management of clearing member defaults. At this time, we
are not seeking exemptive relief for LIFFE A&M to act as the central
counterparty to CDS transactions.
This fully cleared approach will reduce the total size of the
outstanding market even further, while increasing the
confidence that will allow participants to trade. This more
efficient use of capital will reduce stress on financial
institutions. It will also allow regulators to see clearly the
size of outstanding CDS positions, particularly important in
situations of extreme stress. U.S. regulators will be able to
access this information from the U.K. Financial Services
Authority (the ``FSA'') under existing Memoranda of
Understanding (MOU).
II. Regulation of the CDS market
The importance of international regulatory cooperation is
underscored by the regulatory arrangements under which we operate.
Bclear is a service operated by LIFFE A&M, which is a Recognized
Investment Exchange, regulated by the FSA. As part of the market
operated by LIFFE A&M, the Bclear service is subject to FSA oversight.
LCH.Clearnet is also subject to FSA oversight, and is also subject
to the regulatory oversight of the U.S. Commodity Futures Trading
Commission pursuant to that agency's recognition of LCH.Clearnet as a
Derivatives Clearing Organization.
In addition, we believe that as of today, LCH.Clearnet meets all 15
of the CPSS-IOSCO Recommendations.\6\ The CPSS-IOSCO Recommendations
for Securities Settlement Systems and for Central Counterparties
establish the types and level of risk mitigation that should be
exhibited by safe and efficient infrastructure providers. They provide
a benchmark against which to consider the major types of risk that such
organizations are likely to face. These recommendations represent an
internationally developed and agreed minimum standard of good practice
that systemically important CCPs should seek to achieve.
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\6\ LCH.Clearnet Ltd was assessed in June 2006 by the FSA and Bank
of England against the CPSS-IOSCO recommendations for CCPs. The
findings of the FSA/BoE review are publicly available; LCH.Clearnet Ltd
was deemed to observe fully 14 of the 15 recommendations and to broadly
observe the remaining one. Today we believe that LCH.Clearnet fully
meets all 15 of the recommendations.
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The U.K. Government has had information-sharing and cooperation
arrangements with the U.S. Securities and Exchange Commission and the
CFTC in place since 1991. These arrangements were updated most recently
in 2006, when the FSA entered into Memoranda of Understanding pursuant
to which the FSA and the respective Commission have agreed to cooperate
and share information in connection with the oversight of financial
services firms.\7\ These agreements provide the means by which the
relevant Commission may access information regarding Liffe business,
including transactions processed by the Bclear service and cleared by
LCH.Clearnet, to address any potential issues, such as insider trading,
manipulation and similar matters.
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\7\ In 2006, the FSA entered into two Memoranda of Understanding
Concerning Consultation, Cooperation and the Exchange of Information
related to Market Oversight and the Supervision of Financial Services
Firms, one with the Securities and Exchange Commission (signed on 14th
March 2006) and one with the Commodity Futures Trading Authority
(signed on 17th November 2006).
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We strongly support the policy objectives announced by the
President's Working Group on Financial Markets (PWG) on November 14,
2008, particularly the PWG's support for the use of central
counterparty arrangements for OTC derivatives including credit default
swaps and other OTC derivatives asset classes. We believe this policy
can significantly strengthen the OTC derivatives market and reduce
systemic risks.
We have been working with U.S. regulators, as well as the FSA, in
connection with our efforts to make our CDS clearing solution available
to U.S. market participants. The extensive cooperation we have seen
among these regulators is essential to developing a strong global
structure for the OTC derivatives market, and we stand ready to help
regulators and Congress to achieve that goal.
Attachment
Thank you, Mr. O'Neill.And last, Mr. Book. Welcome.
STATEMENT OF THOMAS BOOK, MEMBER OF THE EXECUTIVE BOARDS, EUREX AND
EUREX CLEARING AG, FRANKFURT AM MAIN, GERMANY
Mr. Book. Chairman Peterson, Ranking Member King and Members of the
Committee, I appreciate this opportunity to testify before you today.
And I thank the Committee for calling this hearing on measures to
improve the market structure for credit default swap transactions. I am
Thomas Book a Member of the Executive Boards of Eurex and Eurex
Clearing, and I have responsibility for the management of the clearing
business.
Eurex Clearing is the largest central counterparty in Europe and is
the guarantor of all Eurex transactions. It is licensed and supervised
by the German Federal Supervisory Authority. It is also recognized by
the U.K.'s Financial Services Authority. It is critically important to
provide the CCP with respect to over-the-counter CDS contracts in order
to improve transparency and for effective risk controls and increased
operational efficiency, thereby reducing systemic risks for financial
markets.
The benefits of central counterparty clearing to the OTC market and
CDS contracts include, one, reduction of gross credit exposures and
mitigation of counterparty risk through the effect of multilateral
netting and collateralization of remaining net credit exposures; two,
valuation of risk exposure by an independent, market-neutral entity;
three, transparency in collateralization, including the discipline of
daily marking-to-market of exposures; and four, automated back-office
processes resolving current operational weaknesses.
An almost equivalent amount of CDS transactions are traded in
Europe during European business hours and denominated in Euros as is
traded in the U.S. denominated in dollars. Accordingly, Eurex Clearing
strongly believes that there are unmistakable benefits for U.S. market
participants for having a European clearing organization serving the
global market. These are greater efficiencies by using existing
European clearing infrastructures for these European transactions,
greater efficiencies with respect to settlement of CDS contracts,
enhanced financial surveillance as well as market surveillance, and
greater innovation resulting from increased competition.
Our new CDS clearing service will begin with iTraxx' and
CDX' indices, followed by single name CDS. Its key features
are a link with DTCC's Deriv/SERV Trade Information Warehouse, ensuring
full comparability with existing CDS back-office infrastructure, and
enabling automated backloading of existing transactions. The guarantee
fund for CDS transactions will be segregated to avoid commingling of
risks, and the margining system is specifically designed to address the
asymmetric nature of the CDS buyer and seller risk profile. Clearing
will be operated by Eurex Clearing with open access to all eligible
credit institutions. And Eurex Clearing will establish a separate
entity to share governance and control with market participants.
With respect to our recommendations for an appropriate regulatory
framework, we notice that several witnesses to this Committee have
identified areas of the current U.S. legal framework that are subject
to differing interpretation. Clarification with respect to these issues
would provide greater legal certainty and would facilitate both
domestic and non-U.S. CCPs with understanding and compliance with these
legal requirements.
We further note that the current regulatory framework which applies
to following multilateral clearing organizations offering clearing
services in the United States provides a successful template for
addressing this global market. This regulatory framework exists under
the provisions of current law, which this Committee was instrumental in
enacting in 2000. This existing requirement ensures that there is
regulatory comparability between U.S. and non-U.S. clearing
organizations and removes the possibility of regulatory arbitrage.
Finally, it should be noted that although the benefits of clearing
are significant for the integrity of financial markets, it cannot be
assumed that centralized clearing will be automatically and broadly
accepted by current OTC market participants. As a consequence, Congress
should take into account whether the regulatory enhancements that it is
considering will reinforce and be supportive of the migration of CDS
transactions from the current bilateral structure to regulated and
transparent CCPs.
Eurex Clearing understands the importance of public confidence in
the regulatory oversight of listed and OTC derivatives, and we
appreciate the opportunity to work with the U.S. regulatory authorities
with respect to our plans to offer clearing services for CDS
transactions.
Eurex Clearing is honored to have been invited to present its views
to this Committee and appreciates the opportunity to discuss these
critically important issues. I am happy to answer any questions.
[The prepared statement of Mr. Book follows:]
Prepared Statement of Thomas Book, Member of the Executive Boards,
Eurex and Eurex Clearing AG, Frankfurt am Main, Germany
I am Thomas Book, a Member of the Executive Boards of Eurex
andEurex Clearing. Chairman Peterson, Ranking Member Goodlatte and
Members of the Committee, I appreciate this opportunity to testify
before you today and I thank the Committee for calling this hearing on
the important subject of over-the-counter (``OTC'') derivatives,
particularly credit default swap (``CDS'') contracts, the role that
they play in the United States and international economies, and the
appropriate regulatory framework going forward, particularly as it
relates to clearing of CDS contracts. As a Member of the Executive
Boards of Eurex as well as Eurex Clearing, I have overall
responsibility for the management of the clearing business.
1. Eurex and Eurex Clearing
Eurex is one of the largest derivatives exchanges in the world
today and is, in fact, the largest exchange for Euro-denominated
futures and options contracts. While it is headquartered in Frankfurt,
Germany, Eurex has 398 members located in 22 countries around the
world, including 76 in the United States. Eurex, and its subsidiary the
International Securities Exchange, a stock options exchange located in
New York City, is part of the Deutsche Borse Group which also includes
the Frankfurt Stock Exchange and Clearstream.
Eurex Clearing was formed in 1997 to function as the clearinghouse
for the Eurex exchanges.\1\ Eurex Clearing acts as the central
counterparty (``CCP'') for all Eurex transactions and guarantees the
fulfillment of all transactions in futures and options traded on Eurex.
Eurex Clearing does not currently operate directly in the United
States.\2\ Eurex Clearing is directly connected with various national
and international central securities depositories, thereby simplifying
the settlement processes for its clearing members. As Europe's largest
and one of the world's leading clearing houses, Eurex Clearing clears
more than two billion transactions each year.
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\1\ Eurex Clearing AG is a stock corporation formed and
incorporated under the laws of Germany and is a wholly owned subsidiary
of Eurex Frankfurt AG, a German stock corporation which is itself
wholly owned by Eurex Zurich AG, a Swiss stock corporation. Eurex
Zurich has two 50% parents, Deutsche Borse AG, a German stock
corporation listed on the Frankfurt Stock Exchange, and the SIX Swiss
Exchange.
Eurex Clearing exists as a separate corporate legal entity from its
affiliates for which it functions as CCP and has its own Board of
Directors. As provided under German corporate law, Eurex Clearing has
an Executive Board which is responsible for the day-to-day management
and operations of Eurex Clearing, and a Supervisory Board.
Eurex Clearing also acts as the central counterparty for and
guarantees transactions on Eurex Bonds (a cash market for bonds), Eurex
Repo (repurchase agreements), for equities on the Frankfurt Stock
Exchange and the Irish Stock Exchange and for certain contracts
executed on the European Energy Exchange. Transactions on the ISE, a
wholly owned U.S. subsidiary of Eurex (through its U.S. subsidiary,
U.S. Exchange Holdings, Inc.) are cleared by the Options Clearing
Corporation.
\2\ Eurex Clearing does, however, have an agreement with The
Clearing Corporation relating to the operation of a clearing link
between Germany and the United States.
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Members of Eurex Clearing are categorized as either Direct Clearing
Members or General Clearing Members. General Clearing Members, which
number 58 firms, are the only clearing members who may clear
transactions on behalf of nonaffiliated non-clearing members and most
Eurex members in the U.S. clear their trades through them. General
Clearing Members must have at least =125 million (approximately $156
million) in equity capital. Credit institutions, banks, and other
financial institutions that are regulated by a country in the European
Union or Switzerland may become clearing members. Accordingly, Eurex
Clearing has no clearing members located in the United States.
Eurex Clearing provides fully automated and straight-through post
trade services for derivatives, equities, repo, and fixed income
transactions with a track record of 99.99% availability of its
electronic clearing platform. It also has strong financial safeguards
and industry leading risk management, including in particular its
unique risk functionalities and processes for derivatives such as
intra-day risk margining in real-time based on actual positions and
prices throughout the trading day and its integrated pre-trade risk
validation functionality. It has a deep and experienced risk management
team with in-depth knowledge of the latest risk models and techniques,
including Value-at Risk Valuation models. Eurex Clearing has very
strong lines of defense, including an overall collateral pool as of
November 2008 of more than =70 billion and the highest collateral
standards. It requires that overnight margin payments be made through
central bank money.
Eurex Clearing has already established clearing and risk management
procedures for credit futures based on iTraxx indices. These contracts
were launched on Eurex in March 2007, making Eurex the first regulated
market globally to offer credit derivatives. Eurex Clearing is
currently working to expand its clearing services to include OTC CDS
contracts that are registered in the DTCC Trade Information Warehouse.
As explained more fully below, Eurex Clearing believes that providing
for a CCP with respect to such transactions will increase transparency
in these markets, enforce strict risk controls and increase efficiency,
thereby greatly reducing systemic risk for financial markets as a
whole.
2. Regulation of Eurex Clearing
As required, Eurex Clearing is licensed as a CCP by the German
Federal Financial Supervisory Authority (``BaFin''). In addition, on
January 16, 2007, Eurex Clearing was recognized by the United Kingdom's
Financial Services Authority (``FSA'') as a Recognized Overseas
Clearing House (``ROCH''), on the basis that the regulatory framework
and oversight of Eurex Clearing in its home jurisdiction is comparable
to that of the FSA.
The German Banking Act (``Banking Act'') provides the legal basis
for the supervision of banking business, financial services and the
services of a CCP. The activity of credit and financial services
institutions is restricted by the Banking Act's qualitative and
quantitative general provisions. These broad, general obligations are
similar to the Core Principles of the Commodity Exchange Act which
apply to U.S. Derivatives Clearing Organizations (``DCOs''). A
fundamental principle of the Banking Act is that supervised entities
must maintain complete books and records of their activities and keep
them open to supervisory authorities. BaFin approaches its supervisory
role using a risk-based philosophy, adjusting the intensity of
supervision depending on the nature of the institution and the type and
scale of the financial services provided.
BaFin may grant a clearing license subject to conditions consistent
with the Banking Act's general provisions and may limit the scope of
the license to certain types of business. When licensing an
institution, BaFin issues guidelines to the institution with respect to
capital adequacy and risk management and subsequently, it monitors
compliance with the conditions for granting the license.
The Banking Act requires that a CCP must have in place suitable
arrangements for managing, monitoring and controlling risks and
appropriate arrangements by means of which its financial situation can
be accurately gauged at all times. In addition a CCP must have a proper
business organization, an appropriate internal control system and
adequate security precautions for the deployment of electronic data
processing. Furthermore, the institution must ensure that the records
of executed business transactions permit full and unbroken supervision
by BaFin for its area of responsibility.
BaFin has the authority to take various sovereign measures in
carrying out its supervisory responsibilities. Among other things,
BaFin may issue orders to a CCP and its Executive Board to stop or
prevent breaches of regulatory provisions or to prevent or overcome
undesirable developments that could endanger the safety of the assets
entrusted to the institution or that could impair the proper conduct of
the Cap's banking or financial services business. BaFin may also impose
sanctions to enforce compliance. BaFin has the authority to remove
members of the Executive Board of an institution or, ultimately, to
withdraw the institution's authorization to do business.
In addition, the German Federal Bank (``Deutsche Bundesbank'')
coordinates and cooperates, with BaFin, the primary regulator, in the
supervision of Eurex Clearing. Deutsche Bundesbank plays an important
role in virtually all areas of financial services and banking
supervision, including the supervision of Eurex Clearing. Under the
Banking Act, Deutsche Bundesbank exercises continuing supervision over
such institutions, including evaluating auditors' reports, annual
financial statements and other documents and auditing banking
operations. Deutsche Bundesbank also assesses the adequacy of capital
and risk management procedures and examines market risk models and
systems. Deutsche Bundesbank adheres to the guidelines issued by BaFin.
As appropriate, Deutsche Bundesbank also plays an important role in
crisis management.
Both supervisory authorities use a risk-based approach to
oversight. Under this risk-based approach, the supervisory authority
must review the supervised institutions' risk management at least once
a year, to evaluate current and potential risks and, in so doing, to
take account of the scale and importance of the risks for the
institution and of the importance of the institution for the financial
system. Institutions classified as of systemic importance, including
Eurex Clearing, are subject to intensified supervision by both
supervisory authorities.
3. Benefits of CCP Clearing for CDS Transactions
In previous hearings \3\ this Committee heard witnesses express
concerns about the role that credit derivatives have played in the
recent market turmoil. In this regard, witnesses cited the difficulties
experienced by CDS contract writers that did not have adequate
collateral to support their positions,\4\ the lack of transparency with
respect to such transactions,\5\ the operational weaknesses in the
current market structure,\6\ and the systemic risk arising from these
transactions and from interconnections between the market for CDS
transactions and other markets.\7\
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\3\ Hearing To Review the Role of Credit Derivatives in the U.S.
Economy: Hearing before the House Committee on Agriculture, 110th
Cong., 2d Sess. (October 15, 2008) and Hearing To Review the Role of
Credit Derivatives in the U.S. Economy: Hearing before the House
Committee on Agriculture, 110th Cong., 2d Sess. (November 20, 2008).
\4\ Hearing To Review the Role of Credit Derivatives in the U.S.
Economy: Hearing before the House Committee on Agriculture, 110th
Cong., 2d Sess. (October 15, 2008) (statement of Robert Pickel, CEO,
International Swaps and Derivatives Association, at p. 3).
\5\ Id. (statement of Erik Sirri, Director of Trading and Markets,
U.S. Securities and Exchange Commission, at p. 6).
\6\ Id. (statement of Walter Lukken, Acting Chairman, U.S.
Commodity Futures Trading Commission, at p. 3).
\7\ Id. (statement of Erik Sirri, at p. 2).
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Eurex Clearing, like many of the witnesses before this Committee,
believes that CCP services for CDS contracts will address the concerns
identified before this Committee with respect to counterparty risk,
lack of transparency regarding exposures and the sufficiency of risk
coverage and operational weaknesses, thereby ameliorating systemic risk
for the financial market. Given the huge exposure in CDS contracts and
the systemic relevance of CDS clearing services in mitigating these
concerns, a robust, proven clearing house is required to act as the
central counterparty to these trades.
First, clearing of OTC CDS contracts by a CCP will reduce risk. The
specific risks of CDS contracts with contingent liabilities that arise
only upon the default of the contract's reference entity and the dual
risks of a default of the reference entity and the subsequent default
of the protection writer before settlement, require an independent,
neutral and strongly collateralized CCP with a proven risk management
capability.
Specifically, multilateral netting by the CCP would reduce the huge
bilateral credit exposures arising from the current market structure. A
central clearing house replaces multiple bilateral credit risks with
the standard and transparent credit risk of the CCP. Moreover, and
perhaps most critically, a CCP provides post-default backing, and by
mutualising potential counterparty default risk, central counterparty
clearing will ameliorate one of the most glaring systemic risks raised
by the current market turmoil. Mutualising counterparty risk results in
enhanced certainty with respect to legal enforceability and lines of
defense in case of a default by a clearing member.
Second, clearing of OTC CDS contracts by a CCP will increase the
transparency of position risk. Valuation of the risk of the netted
positions is made by the CCP, an independent and market neutral party.
The CCP requires that this risk be collateralized under a fully
transparent and robust framework. Moreover, the collateralization
framework, which includes daily mark-to-market of risk, provides an
early warning mechanism with respect to the overall ability of parties
to carry the risk of their positions.
Finally, central counterparty clearing addresses current
operational weaknesses through standardized, straight-through
processing. In this regard, multilateral netting of transactions
reduces the complexity of back office processes and the number of fails
and the CCP will simplify trade assignments.
Novation and netting procedures are already an integral and proven
service of Eurex Clearing. Eurex Clearing believes that offering these
services, which have a proven track record with respect to listed
derivatives, will bring significant benefits to the OTC market in CDS
transactions and, for the reasons discussed above, reduce systemic risk
to the financial market and increase market integrity.
4. Description of Eurex Clearing's Initiative for CDS Clearing
Eurex Clearing's new clearing service for OTC CDS contracts will
address a significant part of global trades that exist bilaterally
today and are registered in the DTCC Trade Information Warehouse, with
the first priority on CDS index contracts. Highlights of this clearing
service are:
Product scope includes iTraxx' and
CDX' indices, to be followed by iTraxx/CDX tranches
and single name CDS;
Link with DTCC's Deriv/SERV Trade Information Warehouse,
ensuring full compatibility with existing CDS back-office
infrastructure and allowing automated backloading of existing
transactions;
Credit event handling and settlement based on ISDA dispute
resolution language and auction results;
Segregated guarantee fund for CDS to avoid commingling of
risks and a separate clearing license;
Product specific, asymmetric margining concept designed
especially to address CDS risk profile; and
CDS risk management operated by Eurex Clearing with open
access to eligible credit institutions; a separate entity to
share governance and control with respect to product scope will
be established.
For the clearing of CDS, a new clearing license from Eurex Clearing
will be required. Only CDS clearing members will be permitted to submit
CDS trades for their own account as well as their clients' accounts for
clearing. Eurex Clearing will provide, among other things, the
following services--corresponding to its clearing of non-CDS
contracts--to its clearing members:
Position keeping, separated for clearing members and their
customers;
Daily position valuation;
Performance guarantees; and
``Margin'' requirements to cover members' potential losses.
Finally, in the case of a credit event, Eurex Clearing will execute
cash settlements in accordance with ISDA-approved protocols subject to
ISDA providing access to the results of credit event auctions, which is
critical for effective risk management in CDS products and ensure
market integrity.
5. Suggestions for Future Regulatory Proposals
The Commodity Futures Modernization Act of 2000 (``CFMA'') provides
a successful template for any future regulatory enhancements to address
the concerns raised during the hearings before this Committee. For
example, Section 112 of the CFMA added a new provision establishing the
regulatory oversight that would apply to a clearing house operating as
a Multilateral Clearing Organization (``MCO'') with respect to OTC
derivatives transactions. It authorizes: (1) banks; (2) clearing
agencies registered under the Securities Exchange Act of 1934; (3) DCOs
registered under the Commodity Exchange Act; and (4) clearing
organizations supervised by a foreign financial regulator that a U.S.
financial regulator has determined satisfies appropriate standards, to
operate as an MCO.
The market in OTC CDS transactions is global in scope, with roughly
half of all traded volumes deriving from Europe. Eurex Clearing
believes that any regulatory proposal must be measured against the
effect that it might have on the global nature of the market and should
take into account the following factors:
Does the regulatory proposal recognize, and is it premised
on, cross border regulatory cooperation to avoid ``regulatory
arbitrage''?
Does it take into account global regulatory standards and
business practices?
Does it provide an appropriate level of flexibility in
implementation?
Does it erect artificial legal barriers or does it encourage
competition?
Section 112 of the CFMA is quite forward thinking in that it
recognizes that in a global market, clearing organizations regulated by
a foreign regulator satisfying appropriate standards should be able to
be authorized to clear OTC derivative transactions for U.S. persons and
in the U.S. In fact, using that authority and measuring the foreign
regulatory framework against the Core Principles for DCOs of the
Commodity Exchange Act, the CFTC has recognized several foreign
regulatory authorities as meeting appropriate standards in connection
with the foreign regulator's oversight of particular CCPs.\8\
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\8\ Most recently, the CFTC recognized the U.K. FSA in connection
with its oversight of ICE Clear Europe, See http://services.cftc.gov/
SIRT/SIRT.aspx?Topic=ClearingOrganizations&
implicit=true&type=MCO&CustomColumn Display=TTTTTTTT.
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The Core Principles for U.S. DCOs found in section 5(b) of the
Commodity Exchange Act lend themselves to comparison to the regulatory
regimes that apply in other national jurisdictions in a way that
prescriptive regulatory provisions can not. By way of example, the Core
Principles for DCOs are broadly consistent with the recommendations for
CCPs of the International Organization of Securities Commissions and
the Bank for International Settlements.\9\ Moreover, many of the broad
requirements in the Banking Act parallel Core Principles which apply to
U.S. DCOs.
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\9\ Compare section 5(b) of the Commodity Exchange Act, 7 U.S.C.
7b and ``Recommendations for Central Counterparties,'' Report of the
Committee on Payment and Settlement Systems, Technical Committee of the
International Organization of Securities Commissions, (``CCP Report'')
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD176.pdf.
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Of course, coupled with broad international acceptance of
appropriate regulatory standards must be robust arrangements for
cooperation by international regulatory authorities and a ready
framework for information sharing.\10\ The current framework,
incorporated in Section 112 of the CFMA is based upon broadly accepted
regulatory standards and permits reliance by U.S. regulatory
authorities on those standards being enforced by the regulatory
authority of the CCP's home jurisdiction. It provides a sound
regulatory foundation for clearing of OTC CDS transactions in a global
market.
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\10\ In addition to the broad acceptance by international
regulators of the IOSCO recommendations in the CCP Report, many
regulatory authorities, including the U.S. CFTC, U.S. SEC and BaFin are
signatories to the IOSCO Multilateral Memorandum of Understanding
Concerning Consultation and Cooperation and the Exchange Of
Information.
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Eurex Clearing strongly believes that there are unmistakable
benefits, even for U.S. market participants, to having a European
clearing solution serving the global market, as currently being
implemented by Eurex Clearing for the CDS market. A large percentage of
international trading is priced in Euro and access to a European CCP
facilitates these transactions. In this respect, many U.S. market
participants seek to diversify their portfolios through exposure to
European-based securities and trade CDS related to them. Moreover, a
large percentage--perhaps a third--of the global trading in CDS focuses
on the credit of sovereign European governments and European businesses
the economics of which are driven primarily by local, contemporaneous
European market developments. For example, corporate actions which may
directly affect the values of such CDS occur, by and large, during the
European business day. Furthermore, because the determination of credit
events underlying CDS, particularly those referring to the
restructuring, is subject to practices specific to the jurisdiction of
the reference entity, ISDA's European offices would likely make
determinations about what constitutes a credit event for a CDS with a
European reference entity.
Moreover, Eurex Clearing believes that financial surveillance as
well as market surveillance is crucial to the clearinghouse's proper
supervision and that these functions are enhanced by knowledgeable
experts who have access to up-to-date information and are operating in
real time along with the reference markets, thereby providing enhanced
protection for all market participants. For these reasons, global
participants in the European CDS market, which includes a sizable
number of U.S. participants, will benefit from access to a European OTC
CCP.
In addition, CCPs that serve global markets, if permitted under
this framework to operate in the U.S. as MCOs, stand to offer U.S.
markets the benefits of increased competition. This has the potential
to offer U.S. market participants with alternative methods of doing
business and access to clearing services for innovative products that
may not otherwise be available. In this regard, as noted above, Eurex
was the first exchange to list credit futures contracts when it listed
futures on Euro-denominated iTraxx CDS indexes.
Accordingly, if Congress determines to enact regulatory
enhancements, it should consider clarifying any perceived legal
uncertainty with respect to the operation of the legal framework and
whether other legal requirements apply to certain CDS transactions and
not others. Such clarity would facilitate both domestic and non-U.S.
CCPs with understanding and complying with the legal requirements.
6. Conclusion
Eurex Clearing supports fully appropriate regulatory oversight of
listed and OTC derivatives. Eurex Clearing understands the importance
of public confidence in these markets and is committed to the utmost
level of cooperation with the regulatory authorities of those nations
that have an interest in our clearing operations. In this regard, we
appreciate the opportunity to work with the U.S. regulatory authorities
with respect to our plans to offer central clearing services for CDS
transactions. Eurex Clearing would note that the U.S. financial market
regulators have been inclusive, cooperative and open.
Eurex Clearing also believes that the existing treatment of CCPs
that are subject to oversight by a non-U.S. regulatory authority that
satisfies appropriate regulatory standards is the right framework and
we urge Congress to maintain and extend that approach in any future
regulatory proposal, particularly proposals to address any perceived
legal uncertainty with respect to the law which may apply to clearing
of CDS transactions.
Finally, Eurex Clearing is honored to have been invited to present
its views to this Committee and appreciates the opportunity to discuss
these critically important issues. I am happy to answer your questions.
The Chairman. Thank you very much, Mr. Book.
I thank all of you on the panel. We appreciate again your
willingness to be with us today.
There have been proposals to mandate the clearing of the
CDS instruments. Do you, each of you, believe such a mandate is
necessary? Starting with you, Mr. Duffy.
Mr. Duffy. Mr. Chairman, are you referring to mandating the
clearing of these------
The Chairman. Credit default swaps.
Mr. Duffy. Yes, we do believe that there should be a
mandate to the clearing of credit default swaps. We understand
that all OTC products cannot be traded on a central limit order
book like we have at the CME Group today, although we will
offer a central limit order book for credit default swaps and
clearing of the ones that don't trade on the central limit
order book. But, yes, we do believe they should be regulated by
a clearing entity.
The Chairman. Mr. Short.
Mr. Short. We likewise believe that clearing should be
mandated for most CDS instruments. My understanding is that
there are certain CDS instruments that are more difficult to
clear than others and are particularly liquid. So we are not of
the view that every CDS instrument should be cleared, but
certainly any instrument that is widely traded that has
systemic risk implications should be subject to clearing.
The Chairman. Mr. O'Neill.
Mr. O'Neill. Certainly we support a policy of encouraging
clearing of CDS contracts; I would note that the most
standardized contracts, initially those most suitable for
clearing, particularly index contracts, then standardized
single name and charge contracts, for instance. I also agree
with other speakers that certain contracts may be difficult to
clear even in the medium term, particularly if they are
nonstandardized. So I would encourage policymakers to consider
that to make------
The Chairman. Mr. Book.
Mr. Book. Currently there is a lot of focus on creating
clearing solutions for this market. I think it is very
important that the migration path after those solutions have
come to launch is clear. That there is a clear user commitment
in transporting, in the phased approach, the different CDS
products to such central clearing mechanisms. And obviously the
standardized index segment is the one to start with and most
suitable to discuss the benefits of central clearing.
The Chairman. Thank you.
Assuming that such a mandate was imposed, how much time
would the industry and you need to meet such a mandate? And
should certain kinds of CDSs be cleared earlier than others? In
other words, if we are going to set that up, should we have
some kind of structure to phase it in, if you will, from the
easiest to the hardest? How much time would it take; what time
frames should we be looking at if we did have a mandate?
Mr. Duffy.
Mr. Duffy. Mr. Chairman, the CME Group is prepared now at
this time to go forward with its solution to meet any mandates
for cleared credit default swaps contracts. And just to make
myself clear, I agree with my colleagues that index products
and standardized products are the most easily mandated to
clear, and those would be the first that you would see going
forward. Some of the ones that pose the most risk are the
illiquid ones that I referred to as toxic.
The Chairman. Say that we were going to mandate even those
to be cleared, how much time should we give to get that process
set up; 6 months, 9 months, a year? Do you have any view on
that?
Mr. Duffy. Well, I think some of these illiquid CDS
contracts are--some of the clearinghouses, and I will speak for
myself, probably wouldn't want to clear any of them at any time
because of the illiquidity associated with them, and just the
nature in which they trade. So there are some of these that
just are not clearable.
The Chairman. Well, what if we mandated that they be
cleared?
Mr. Duffy. Then we would probably need a little bit more
time, obviously, on some of these products to make sure we have
the risk management tools in place for these illiquid
securities.
The Chairman. You don't have an estimate of that? If you
could talk to your folks and give us some kind of an estimate.
Mr. Duffy. Sure.
The Chairman. Mr. Short.
Mr. Short. Likewise, ICE is operationally ready to begin
clearing, and like some of my colleagues have suggested, we
similarly believe that the order should probably be indexes,
then single names, then tranches.
We would begin by addressing the current backlog of trades
that exists by inputting those into the clearinghouse, and,
hopefully, addressing some of the systemic risk concerns that
exist in the marketplace, and then transition to clearing new
trades after that. But we could be ready to begin that process
by year's end. We don't need a significant lead time.
The Chairman. Mr. O'Neill.
Mr. O'Neill. Yes. For our part, as I mentioned in my
testimony, we will be clearing index contracts on the 22nd of
December. We will be moving on to single names shortly
afterwards in the new year. And as per the comments of other
members of the panel, I think there are certain contracts,
particularly nonstandardized or potentially toxic contracts,
which may not be suitable for clearing. I think if that is
mandated, then possibly that market will no longer be viable.
The Chairman. Mr. Book.
Mr. Book. I think the process has to start, as the other
witnesses have also said, with the standardized index segment.
And I believe it is crucial to have a phased approach in
avoiding stress to market participants by avoiding that there
is a single launch for all mandated clearing. And that that
process will actually take some time and should go--start with
index contracts first and probably tranches and single name for
those liquid ones that are suitable for clearing. There might
be other products that are very illiquid. Also for central
clearing organizations, there will be issues in pricing and
determining settlement prices for those.
The Chairman. Thank you. My time is expired. I now
recognize the gentleman from Iowa for 5 minutes of questions.
Mr. King. Thank you, Mr. Chairman.
I thank all the witnesses for your testimony and for your
willingness to be here and help share with us your experience
and your viewpoints on this.
I think it is a fact that counterparty risk has contributed
to the credit freeze to some degree; however, we might disagree
on the level of that. Let us submit if there is not a mandate--
and I would ask first Mr. Duffy and then go on down the line--
will there be enough business migration to clearing to mitigate
those concerns about counterparty risk that would go
voluntarily, short of a mandate?
Mr. Duffy. On the credit default swaps, sir, yes. We do
believe there will be enough business that will come on in the
clearing to still keep it a very viable and sustainable market.
And the counterparty risks, we have already estimated that we
can net down those exposures probably by a factor of five to
seven. So if you are looking at a $50 trillion notional market,
we feel we can net that down by a factor of five to six. So we
do think it is sustainable.
Mr. King. Mr. Short, do you agree?
Mr. Short. I do agree with that. Part of ICE's solution, we
have reached out to the major dealers in the industry, many of
whom are now bank holding companies that are directly regulated
by the Fed, which would be our primary regulator. I think there
will be a strong incentive on the part of the market
participants to use clearing, and I think the buy-side and
other parts of the market are definitely interested in
clearing.
Mr. King. Mr. O'Neill.
Mr. O'Neill. Yes, absolutely we think this market is liquid
enough to filtrate central clearing. Further, we think the
reduction in notional outstanding which central clearing will
bring, and the assurance it will give counterparties, will
actually possibly increase the volume traded within the market,
allowing people to hedge their risk better, also in a more
efficient manner. So we definitely think it is viable.
Mr. King. Mr. Book, do you agree?
Mr. Book. I think the financial turmoil that we have seen
over the past month and year has highlighted the benefits of
central clearing and the necessity to urgently address many of
the issues in market integrity in the OTC derivatives base. I
still think there needs to be a clear migration path and time
line to address those issues and bring them onto centralized
clearing organizations. I would not believe that this is an
automatic process since we have not seen that business come to
central clearing organizations even though there were offerings
over the past years.
Mr. King. If there were offerings, though, would you think
there would be enough voluntary migration that we wouldn't need
to mandate?
Mr. Book. I think a mandate would certainly help to
facilitate that migration process.
Mr. King. Thank you.
Should there be a mandate for exchange trading of any type
or all types of credit default swaps, Mr. Duffy?
Mr. Duffy. Well, trading in credit default swaps, mandating
and clearing them would be two different things. We will offer
both, sir. We believe that by putting them in a central order
book, you get more transparency, which makes the product--when
you clear it, you have better risk management associated it. We
will not make it mandatory to trade on our central limit order
book in order to clear at the CME Group, but I think that is an
important distinction.
Mr. King. Thank you.
Mr. Short.
Mr. Short. I don't believe that CDS needs to be traded on
an exchange, although that is certainly something that we will
offer as part of our solution eventually. The current market
trades OTC will bring our solution to that current market, but
we will have an open clearinghouse infrastructure that
electronic platforms can connect to and facilitate electronic
trading of these instruments.
Mr. King. Thank you.
Mr. O'Neill.
Mr. O'Neill. Yes. As I said in my testimony, we believe
that all the processing and clearing efficiencies the markets
require can be delivered without necessarily mandating a
central limit order book, and that is why our approach reflects
that.
The Chairman. Mr. Book.
Mr. Book. I think the focus should be on addressing the
systemic risks and the risk exposures in that market. First of
all, this is currently a bilateral, unregulated market, and
establishing central clearinghouses should be the focus to
address the issues in that market.
Mr. King. Thank you, Mr. Book.
Now I will re-ask this question a little bit differently
and try to move down the panel again. Let us just assume that
there is no clearing mandate in place for credit default swaps,
and you testified that you believe for most of you there would
be sufficient voluntary participation. But how much of that
market do you think would come in? You gave me a little bit of
a measure. Can you restate that a little bit, please, Mr.
Duffy?
Mr. Duffy. Well, if there is no mandate, sir, obviously
this--as we said before, this has not been a cleared solution.
This product has been around roughly 10, 11 years, and it has
grown exponentially throughout that time period and is a
bilateral transaction with a counterparty risk to both parties.
So to put a percentage if it is not mandated, in current
circumstances you have already seen the market shrink or
compress from $60-some-odd trillion to $40-some-odd trillion
since this crisis began, so I would assume a percentage of
that, sir, so maybe 20 to 30 percent of that if there is no
mandate.
Mr. King. Thank you.
Mr. Short, I will phrase it a little differently. If we
don't mandate, and if that judgment is incorrect, and the
participation is so low that there isn't confidence in the
marketplace, then what is our next alternative?
Mr. Short. To be clear, I was not suggesting that a mandate
wasn't needed. I do think you will see significant uptake. If
you deem a mandate appropriate, that would certainly be
welcome.
I think one of the hooks, if you will, in the ICE
clearinghouse is it is part of the Fed system, and a lot of its
members will be a part of the Fed system. So to the extent that
there is concern about major dealers participating in the
solution, I think there is a natural regulatory nexus to
encourage them to put their business into the clearinghouse.
And I think we found that if you get a major segment of the
market into the clearinghouse, the rest of the market will
follow.
Mr. King. Thank you, Mr. Short.
Mr. Chairman, I see my time has expired, and I yield back.
Mr. Holden [presiding.] The chair thanks the gentleman from
Iowa.
Following the line of the questions of the gentleman from
Iowa, first, if there is no mandatory clearing in place, should
there be mandatory reporting requirements for parties in CDS
who decide not to clear those agreements? And second, should
there be a mandatory reporting requirement for parties in any
over-the-counter transaction?
Mr. Duffy. Well, sir, we are a highly regulated business
which believes in transparency. We believe that is what best
serves the product. So it would be disingenuous for me to say
anything other than yes. I do believe there should be some kind
of mandatory reporting to pricing because it brings more
transparency to the market, which in return brings better
benefits to the users of those products. They can actually see
it. We are big believers in the transparency, especially when
it comes to reporting of pricing of products.
Mr. Holden. Mr. Short.
Mr. Short. ICE advocates transparency in reporting. The
answer is maybe a little more nuanced. These instruments really
reside along a spectrum from being highly standardized to being
nonstandardized. The farther you move along that spectrum, and
the more liquidity and the more standardized they are, they
should certainly be reported, even if they are not cleared. You
could posit a case where something was so tailored and
specialized that it didn't really have--wasn't a liquid
instrument, didn't have any systemic implications. You might
suggest that those need not be reported.
Mr. Holden. Mr. O'Neill.
Mr. O'Neill. Yes. We believe the most important form of
transparency is reporting of cleared positions and prices to
regulators. And as I said in my testimony, U.S. authorities
will have access to that solution. As to the wide-range market
outside clearing, I don't think we have a policy beyond that at
this time.
Mr. Book. I think it was one of the main lessons learned
out of the financial trauma that transparency is required, also
in the opaque OTC markets, and therefore the mandatory
reporting requirement would certainly help us. They are
standard for regulated futures exchanges or clearinghouses
already.
Mr. Holden. Mr. Short, why is ICE engaging in this
clearinghouse proposal? And did your company approach the
banks; did the banks approach you? Did the Fed ask you to work
with the banks or become involved?
Mr. Short. ICE first began a dialogue with the Fed in the
summer of this year in connection with their acquisition of
Creditex, which is an interdealer broker in the CDS space. Our
plan had been to introduce clearing on a more leisurely
timetable, probably in the spring of this coming year. But
market events have quickly overtaken us.
We did not work with the dealers initially. In fact, we
hired independent transactional counsel rather than our normal
counsel who had relationships with the dealers, so that we
could maintain the independence of our proposal and work with
the Fed in the background on this issue.
The first dialogue, I believe, was voluntary where we
reached out to the dealers, asking them to back our solution,
because they are a significant part of the market. As I said
earlier, once you get a certain part of the market to move, you
can typically move the rest of the market.
Mr. Holden. Again, Mr. Short, why did you decide to form a
limited purpose trust company as opposed to using the existing
infrastructure under ICE Futures U.S., which is regulated by
the CFTC, or ICE Futures Europe, which is regulated by the FSA?
Why did you seek an avenue of regulation by the Federal
Reserve?
Mr. Short. We chose that avenue for two reasons. The first
was the Fed had been the thought leader in the CDS space. It
has been working with market participants for quite some time
to address the lack of transparency in the CDS space. Under
existing law the Fed is an appropriate regulator for a
clearinghouse under existing law.
In addition, the current framework under which the CFTC and
SEC operate, CDS, for whatever reason, right, wrong or
indifferent, is exempted largely from CFTC and SEC oversight.
The reason we decided to do it pursuant to a limited purpose
trust company was to segregate that risk and make sure that
Wall Street's risk remained Wall Street's risk and not Main
Street's risk in terms of mixing those risks with other risks
that are in our other clearinghouses.
Mr. Holden. Thank you.
The Chairman [presiding.] The gentleman from Texas Mr.
Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Short and Mr. Duffy, do you believe the Securities and
Exchange Commission will still have ongoing oversight of your
clearinghouse, even if it should get an exemption from them?
Mr. Short. My belief is that they will maintain a
regulatory touch. We have been working with the SEC on
appropriate exemptive relief. My understanding is that they
will maintain a position these are securities and maintain
their enforcement authority, and mandate certain concerns that
the clearinghouse has to meet.
Mr. Duffy. Yes, I agree with that. Right now, obviously,
the CFTC has oversight of the clearinghouse of our futures
business, but we believe that the SEC's oversight would be
appropriate on clearing if we were to do these products.
Mr. Neugebauer. CME's proposal would be overseen by the
CFTC?
Mr. Duffy. Right.
Mr. Neugebauer. And under the principles established by the
Commodity Exchange Act, a Euronext Liffe proposal would be
overseen by FSA under the principles established by the
Financial Services Markets Act of 2000. Eurex would be overseen
by BaFin under the German Banking Act. But all three of these
regulators have their own regulatory schemes authorized by
their appropriate legislatures.
As I understood it, the Federal Code proposes overseeing
ICE using standards developed by the International Organization
of Security Commissions, IOSCO, which, to my understanding, has
never been adopted by any national legislature. Is it
appropriate that we would start using standards that have
actually never been adopted by any governmental institution?
Mr. Short. I believe the IOSCO standards are widely
respected and recognized as appropriate international standards
for clearinghouses. I think that importantly when you step back
and look at this question and look at the Fed's appropriateness
or ability to properly run a clearinghouse here, I think you
have to step back and look at our current regulatory system.
The Fed, of all the three regulators that we named domestically
here, the CFTC, the SEC and the Federal Reserve, is the only
regulator that is responsible for addressing systemic risk
issues. I think that puts it uniquely in a position to oversee
this space.
I was also very encouraged by the Memorandum of
Understanding, because I do think this is a situation where
each Branch of the government should learn from fellow
regulators, and my reading of that proposal was that those
three regulators would work to impose the highest level of
standards between the three of them no matter which was the
primary regulator.
Mr. Neugebauer. For the panel, I am having a hard time
understanding if we are going to bring consistency and
transparency where we would have--I understand the concept of
multiple clearinghouses. I believe that is appropriate. The
question I have is how do we reconcile multiple regulatory
authorities where you have different regulators for different
entities, and how that would bring consistency to the market.
How that could, in fact, push business to one clearinghouse or
the other depending on what standards that that particular
regulator had established for that clearinghouse.
Mr. Duffy.
Mr. Duffy. Well, first we have the ability from the 2000
Act that we have dual regulation on certain products. And we
think with a couple small tweaks, we could make that work
again. It was never really enacted. That was in the single
stock futures that we introduced back then.
So as far as the oversight, we do believe that the CFTC is
the right authority to have oversight of these products. And as
I said in my testimony, we believe that the SEC should still
have the ability to deal with market manipulations or
infractions such as that. So we do believe that there can be a
place for both regulators in the credit default swaps area.
Mr. Neugebauer. And the Federal Reserve, I notice you named
two, but------
Mr. Duffy. I think the Federal Reserve has said that they
are not an oversight agency to these products. So whether or
not they want to get into that right now, the two prime
regulators are CFTC and the SEC. We have worked with the Fed as
close as IntercontinentalExchange has. They have taken a lead
on these products. So we have worked with them, but I don't
believe they are looking to become a regulator of them.
Mr. Neugebauer. Who would be the regulator for ICE?
Mr. Short. It would be the Fed. Clearly we would be a
member of the Federal Reserve System, and the Fed would have
direct regulatory oversight of our clearinghouse, as well as
the New York State Banking Department as well.
Mr. Duffy. I believe that is due to the bank holdings that
they are going to have, and that is not what the CME has, as a
bank trust.
Mr. Short. That is correct.
Mr. Neugebauer. I think my time is over.
The Chairman. Go ahead.
Mr. O'Neill. May I make a statement on behalf of NYSE
Euronext? As noted by the Committee, our product is FSA
regulated. We have engaged with the CFTC, the SEC and the Fed
regarding U.S. access for our product. I believe the situation
is that we have CFTC and Fed approval, and we should have SEC
approval, I think, in the coming days.
As a general position I would agree that any form of
regulatory arbitrage of these products is something to be
avoided. We think solutions should stand or fail on their
merits rather than on their regulatory regimes. That is just a
general statement.
Mr. Book. I would add to that, for these products are
global in nature, and the market participants operating on a
global basis, it is very important that the international
authorities operate. Also, if you see a mandated clearing
requirement, for instance, that should be in a coordinated way,
both in the United States and in Europe.
We at Eurex Clearing are very open with working with all
the regulators involved. As being regulated in Germany, we are
also working with U.K. FSA, and we are in discussion with the
CFTC on operating on an MCO status in the United States for the
OTC clearing that we would offer.
The Chairman. All right. The gentleman's time has expired.
With the Committee's indulgence, I would like to make one
final inquiry in this area.
Mr. Short, it troubles me that you are going to be
regulated by someone who doesn't have an underlying authority
from us. They have a lot of authority, that is one thing, but
what I am wondering about is because you are regulated by the
Fed, if something goes wrong, and one of the counterparty
fails, and it is beyond the ability to deal with it, does your
scheme mean the Fed would then step in and take over that loss,
given the authority that they have? Is that part of what is
going on here? And maybe they can even use this bailout money
to cover this? Is that part of what is going on here?
Mr. Short. The Fed has not offered us that------
The Chairman. Well, they haven't offered it, but isn't it
true that they would be able to do this?
Mr. Short. Whether they would be able to, I wouldn't want
to speculate on the Fed's intention. That certainly hasn't been
any element of our discussions with the Fed at all.
The Chairman. Well, for people's information, I wrote a
letter to the Fed asking them this very question. I have not
gotten an answer back, so--somehow or another we will get to
the bottom of this, but it does make me wonder. So, anyway----
--
The gentleman from North Carolina, the Chairman of the
Subcommittee that has jurisdiction over this, and someone who
has spent a lot of time on this issue, Mr. Etheridge, for 5
minutes.
Mr. Etheridge. Mr. Chairman, thank you. Let me follow that
line of questioning for just a moment.
My question, I guess for each of you, and following that,
is it possible, given what we have heard so far and what we
see, that the Fed could design a regime that remains completely
consistent and in compliance with IOSCO standards, but more
favorable than it would be under the CFTC or FSA oversight?
Mr. Short. I don't believe--well, first of all, I would
say--I would agree with my colleague that there should be no
room for creating a system where there is regulatory arbitrage
full stop. And I read the Memorandum of Understanding that was
recently executed between the CFTC, the SEC, and the Fed
addressing that very issue, basically saying that those three
regulators would work together to make sure that standards were
consistent so that you didn't have that type of regulatory
arbitrage.
Mr. Etheridge. Anyone else want to comment on that one?
Okay, let me move to the next question, because I think the
public is asking the same question that this Committee's trying
to get to, and that is, as we talk about the operation of
proposed clearinghouses, would anyone be allowed to become a
clearing member, assuming that they met the financial
requirements? Or is it within your plans to have a limited
membership?
Mr. O'Neill. I can speak on behalf of NYSE Euronext, sir.
The requirements are clear on this product--are as per
existing products. There are stringent requirements. We can
certainly provide the Committee with exactly the standards
required to be a clearer member of LCH.Clearnet, but we do not
propose any additional standards for clear and CDS transaction,
certainly not CDS index transactions.
Mr. Etheridge. Mr. Book.
Mr. Book. Eurex Clearing will look at requiring the
clearers for this business to fulfill additional requirements
in terms of their financial strength, so, for instance,
required equity capital because we believe that the exposure is
very significant in this business. So it will not be
automatically available for all our current clearing
participants, but there will be a separate registration with
Eurex Clearing required, and we will have the detailed
requirements for that business.
Mr. Etheridge. Mr. Short.
Mr. Short. The ICE system would likewise be open, subject
to meeting the appropriate standards for joining the
clearinghouse. There are certainly financial requirements
imposed because these are the ultimate underwriters of the
risk, and it would be imprudent to allow anybody that didn't
meet the financial standards to join.
Mr. Etheridge. Okay. Let me move through one more question.
I guess all of us are concerned about safeguards. So what
safeguards are in place to ensure that there can be no price
manipulation as we are setting up all these pieces? And I will
start with Mr. Book again, and we will go from right to left.
Mr. Book. I think what is really important for a
clearinghouse is to come with a settlement price mechanism to
do the mark-to-market for these products which will be based on
several sources. So this is very important to have here, free
of manipulation settlement prices. At Eurex Clearing, we can
rely on our existing market surveillance that we have, also for
the existing business in Europe, and therefore oversee that
business.
Mr. Etheridge. Mr. O'Neill.
Mr. O'Neill. Yes, absolutely. Mark-to-market settlement
prices are vital for this market. But with relation to market
surveillance, we already have a very active program of market
surveillance for our market, as I outlined in my testimony,
shared entirely with the U.S. authorities. So we will be using
the same approaches that we apply for all our existing
products, which have proved very successful today.
Mr. Etheridge. Thank you.
Mr. Short.
Mr. Short. I agree with my colleagues. Mark-to-market is
vitally important. It is one of the clearinghouse's most
important functions. We would look to a variety of market
sources to establish comprehensive and trustworthy settlement
prices.
Mr. Etheridge. Mr. Duffy.
Mr. Duffy. And I would agree. But the only thing I would
just add is that the CME Group is a neutral institution, and so
we don't benefit by the market going up or down; we are
completely neutral in that position. And that would also apply
to credit default swaps, as it does all our products.
Mr. Etheridge. Thank you. One final question with the
Chairman's indulgence:
Will each of you commit to making prices for cleared items
available publicly? Starting with you, Mr. Duffy and down the
line. Whoever wants to go first.
Mr. Duffy. I am sorry, Mr. Chairman. I didn't hear the
question.
Mr. Etheridge. Will you commit to making prices for cleared
items available publicly?
Mr. Duffy. Yes, sir.
Mr. Short. Yes.
Mr. O'Neill. Our current approach to the European market
reports prices to regulators rather than publicly. But we can
consider additional requirements for the U.S. market.
Mr. Book. Yes, we will publish prices.
Mr. Etheridge. Thank you very much, gentlemen.
Thank you, Mr. Chairman. I yield back.
The Chairman. I thank the gentleman.
The gentleman from Louisiana, Mr. Boustany, for 5 minutes.
Mr. Boustany. Thank you, Mr. Chairman.
I believe each of you addressed this issue in your
testimony to some degree about the timeline for when you expect
to be operational. Could you each kind of go through that again
for clarification? Let me start with you, Mr. Duffy.
Mr. Duffy. We are prepared today, Congressman Boustany, to
move forward. So our timeline is strictly in the hands of the
regulators and the approving regulators to move forward. So we
are operationally prepared to move forward today.
Mr. Boustany. Okay.
Mr. Short.
Mr. Short. We are in the same position, operationally
ready. We have received our bank charter. We are still waiting
for the Fed's final approval.
Mr. O'Neill. As I said in my testimony, we will be planning
on being live on the 22nd of December for index contracts. You
may be aware that currently within Europe, the European
Commission level, there are discussions concerning CDS
clearing, so that is subject to no final requirements emerging
from that process.
In terms of single names and other contracts we will be
live next year. We don't yet have a date to announce for that.
Mr. Boustany. Mr. Book.
Mr. Book. We will be operational the end of Q1 2009. And
one of the core pieces in creating that offering is to create
the automated link into the DTCC Deriv/SERV Warehouse. There is
obviously the dependency on bringing that offering out. And the
scope will be initially iTraxx' indices from the
start and then we will expand it from there.
Mr. Boustany. Thank you. There are those who have wondered
why we don't have clearinghouses as of this time for credit
default swaps. Why do you think a clearing solution for CDS
hasn't been implemented in the past?
Mr. Duffy.
Mr. Duffy. We have announced as of 2 years ago a new
clearing initiative for over-the-counter called Clearing 360.
So the CME Group has already made announcements that they are
going to clear over-the-counter products. It has been a
reluctance among the dealers, sir, to put these into a
clearinghouse. They have been transacted as bilateral
agreements versus central counterparty cleared agreements. That
really has been the reluctance of the dealers, and the buy-
siders just had to go along with that. I think you are seeing a
move afoot from the larger buy-side community, what you
actually heard there through the testimony that they are
looking for the central cleared solution. They are getting more
and more concerned with bilateral risk from not only the buy
side, but the sell side.
Mr. Boustany. Mr. Short, do you want to add to that?
Mr. Short. I agree pretty much with what Mr. Duffy said. I
think these markets historically start out as nonstandardized
OTC instruments, and they become standardized over time. There
has been a reluctance, I think, to date, by maybe some of the
dealers to embrace clearing. But I think that is firmly changed
now.
Mr. Boustany. Mr. O'Neill.
Mr. O'Neill. Yes. Absolutely, I think there is a maturity
lifecycle to products, which starts with innovation, then moves
on to standardization, and then gives the possibility of
clearing.
We have been working on the CDS initiative since 2007, so
it is quite a long-standing project for us. And we have also
had Bclear in place since 2005 for more standardized asset
classes such as equity derivatives. So we think the moment has
come for CDS clearing.
Mr. Book. Let me add to this that Eurex already launched in
March 2007 iTraxx' futures contract that will also
open for clearing only as standardized futures because we
believe there is a lot of value for those, for that huge
marketplace. However, they did not get any liquidity so far. It
is also believed that now focusing on the clearing to address
the existing exposure incentives an immigration path is
required.
Mr. Boustany. One last question: What significant hurdles
have you encountered in trying to develop a CDS solution? In
other words, licensing agreements, have you had problems with
that?
What other hurdles have you encountered, Mr. Duffy?
Mr. Duffy. You know, it is kind of all of the above. The
licensing agreements are one thing that are necessary to get,
especially for the index products which everyone talks about,
the index products and credit default swaps, and just getting
people to change their habits. I mean, it is a product that has
been around 10, 11 years now. It has been trading one way the
whole time. So these are some of the hurdles that you need to
get to get people to buy into the central counterparty clearing
which we offer.
I think there is some concern that on a central limited
order book, with some of these products being illiquid and not
trading very frequently, that that is what the exchange model
has always presented. But as counter to that, we are not--we
are willing to clear these products without trading them also.
So those are some of the hurdles that we have had.
Mr. Boustany. Thank you.
Mr. Short.
Mr. Short. It is quite a large undertaking. It involves
outreach to a number of market participants, and we have
developed a comprehensive rule set and a set of standards that
will govern the clearinghouse. And there have been challenges,
but we think we have gotten through most of the big issues.
Mr. Boustany. Mr. O'Neill.
Mr. O'Neill. I wouldn't say actually we have faced any
difficult hurdles. We typically have quite a cooperative
attitude towards product development. We work with existing
markets, within existing standards.
For instance, on this project, we have a good relationship
with ISDA, good relationships with the index provider market
for valuations. So I think the key point is, we are not asking
people to change their business models. We are providing
services to them. And we find that if we take that approach,
typically the existing market is actually very cooperative.
Mr. Boustany. Mr. Book.
Mr. Book. There are obviously several dependencies in
rolling out such a service. The core to it is to create a
robust and sophisticated risk mechanism together with the
users. In terms of dependencies, as obviously, licensing
requirements, Eurex has a licensing arrangement for the
iTraxx' in place. And we are reaching out to expand
that for CDX'. And there are, of course, also
efforts on creating the link into the Deriv/SERV Warehouse that
I mentioned earlier.
Mr. Boustany. Thank you.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman.
Gentlemen, do all of you, representing your individual
organizations, feel that you have been treated fairly and
evenly by U.S. regulators? Does anybody have a complaint about
regulators and how you have been treated? I take it from all
the shaking heads here and the lack of response, the answer is
no?
Mr. Short. No.
Mr. Duffy. No.
Mr. Marshall. Are there actions that Congress should take
to clarify the current regulatory structure? We have a number
of different agencies, and we are wondering whether or not it
would be helpful if we introduced legislation that would
clarify jurisdiction or authority for these different agencies
with regard to CDSs, and the over-the-counter market generally.
Mr. Duffy, I guess we will start with you, as we always
have.
Mr. Duffy. Well, I think with the Modernization Act of 2000
for the CFTC, it has obviously been a model for the regulatory
framework here in the United States. We have not had the
problems under this agency that we have maybe seen in other
product lines that are not under its jurisdiction. So we
commend the CFTC for all they have done.
In order to facilitate to get these products up and moving,
it may be unfortunate, but we may have to bifurcate some of the
regulation, which may not be a bad thing for starters. This is
a highly contentious product around, and I don't think people
understand it quite well. So it is not surprising that some are
looking at these as securities, some are looking at these as
futures, and then the Fed is looking at it in a different way
also.
So to have bifurcation of regulation in this particular
product, I don't think is going to inhibit the growth of it.
But it does need regulation, sir.
Mr. Marshall. Are you saying--is your comment that it would
be helpful not to have bifurcation?
Mr. Duffy. My comment would be that I would love to see
this under the jurisdiction of the Commodity Futures Trading
Commission, but I don't believe that to be realistic.
I think that the SEC has got a part in this because they
consider these bonds to be securitized contracts which fall
under their jurisdiction. So I don't think that is realistic.
I would love to see modernization of the Securities and
Exchange Commission like we had with the CFTC in 2000, and
streamline the whole process.
Mr. Marshall. Your view, I suspect, is that the statute is
not clear concerning whether or not the SEC has authority. And
if in legislation Congress clarified that the SEC does not have
authority, in essence saying that once a swap has cleared, that
does not necessarily mean that it is a security.
Are you troubled by the fact that the SEC would then be on
the sidelines and not have regulatory oversight?
Mr. Duffy. No, I am not troubled by it, sir.
Mr. Marshall. Mr. Short.
Mr. Short. I think one of the challenges for Congress in
the coming session is to take a look at the overall financial
regulatory scheme that we have, and consider what improvements
need to be made.
It is a little bit troubling to me that we have a system
that has essentially silos where, if you view a product one way
or another way, it could be subject to different ultimate
regulatory regimes. I think there needs to be a harmonization.
I would echo what Mr. Duffy said, that the CFTC has done a
fantastic job with the CFMA and the Modernization Act being a
principles-based regulatory regime, and having some of those
principles exported to other regulators and a harmonization of
regulation, I think, would be appropriate.
Mr. Marshall. Mr. O'Neill.
Mr. O'Neill. Generally speaking, we absolutely would
welcome clarity. We have engaged with the CFTC, the SEC and the
Fed for this product, all with good results, we believe. We
think, yes, the CFTC has done an excellent job of regulating
the U.S. futures market.
I would also note that the SEC has had responsibility for
monitoring for insider trading and market manipulation which is
important for CDS. I would also say that the NY Fed has a
considerable range of knowledge in this area. So we hope,
however the U.S. regulatory situation is clarified, all that
knowledge and all that skill can be brought to bear for the
highest possible standards.
Mr. Marshall. Mr. Book.
Mr. Book. I would agree with that, for the clarification
would certainly help. Also, from the perspective of a foreign
entity, we believe that the MCO is a good template. We have,
with all the regulators involved here, very good constructive
dialogue. But certainly certainty and clarification here would
help.
Mr. Marshall. We have been concerned about regulatory
arbitrage here, in essence, that we live in a ``lowest common
denominator'' world with different jurisdictions offering less
regulation in order to entice business. And it would be very
helpful if across the Atlantic at least and hopefully globally
we can come up with some fundamental principles that everybody
can abide by so that we do not continue to have this phenomenon
that leads ultimately to lax regulation and problems like the
ones that we have today that are affecting so many ordinary
folks all over the United States.
I yield back. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Texas, Mr. Conaway.
Mr. Conaway. Thank you, Mr. Chairman. And following up with
that great lead-in from my colleague from Georgia, European
regulators are considering schemes that might have such
requirements that if both parties are European, they would have
to clear through a European clearinghouse. If one party is
European and the other is not, but it is denominated in Euros,
you could clear through that entity. Or if the representative
itself is a European entity that all of that activity would
have to go through a European clearinghouse.
Can I get some sense from all of you as to the pros and
cons on that group getting ahead of the U.S. regulatory scheme
and what impacts it might have?
Mr. Short. My own sense is that that is not particularly
helpful. It would seem that there needs to be regulatory
information sharing between international regulators, but I am
not sure why somebody should have to clear, for example,
through a European clearinghouse if it was a European entity or
a contract was denominated in Euros. It seems to be going in
the wrong direction of having regulatory cooperation and
openness in markets.
Mr. Book. If I might add to that, I think, first of all, it
was earlier asked, the question, of whether there is a benefit
in mandating clearing. I think it is urgently required that if
there is such requirement considered, that that takes place on
an international cooperative level. Therefore, I think it is
good that both from a European Central Bank perspective, also
from an EU perspective, the issue of market integrity for CDS
transactions taking place in Europe have also been recognized.
I think there are benefits of using existing European
market infrastructures that are well sustained to address
business in Europe, and there are certain benefits and
efficiencies coming out of that. But in the end, it is
essential that there is international cooperation on all the
measures that are undertaken to improve market integrity in the
OTC derivatives markets since these markets are global in
nature and the open positions can just move where the least
regulatory requirements are.
Mr. O'Neill. I would certainly echo some of those
sentiments. We don't support regulatory arbitrage for these
products.
I think we have seen an unusually high level of cooperation
for CDS clearing between U.S., European and other authorities;
and in general, as a principle, we support competition in
clearing. I said earlier, we believe solutions should stand or
fail on their integrity, on their merits, rather than
regulatory advantage.
Mr. Duffy. I would agree completely with that.
Roughly 15 to 25 percent of our core business today comes
from outside the United States, and I think that is important
because we believe it is a global market in nature. And that is
what the CME understands, and that is the way we operate our
business. So we don't see that any different in credit default
swaps. So we would not like to see a regulatory arbitrage or an
advantage because of the denomination of currency.
Mr. Conaway. There has been this idea of conflicts of
interest between clearinghouses owned and run by the dealer
banks who have the largest position in credit swaps.
Can you speak to us briefly about your stance on these
conflicts of interest and how we ought to view them, and what
may be some of the solutions for that problem?
Mr. Short. In terms of ICE Trust solution I think it is a
matter of having the appropriate governance. We will have an
independent Board of Directors. And I certainly believe that as
long as you have the appropriate governance structure in place,
having the dealer segment as part of the solution is a benefit,
not a hindrance. I think it is just a matter of getting the
governance right.
Mr. Conaway. Terry.
Mr. Duffy. Yes. I don't disagree on conflicts of interest.
You know, you need to have a neutral party and that is what the
CME Group is. We are truly a neutral party. So I think--I just
would agree with my colleague, Mr. Short. I wouldn't add to
that.
Mr. Conaway. Europeans sometimes have a different opinion
of conflicts of interest. Any comments, Mr. O'Neill?
Mr. O'Neill. I just echo Terry's statements really. We
think an independent organization, particularly independence of
mark-to-market pricing is vital, and clearly we meet those
requirements.
Mr. Book. I would agree with that. I think the call to the
challenge here is to create a robust risk mechanism, and this
risk management task should be run on a neutral, independent
basis because it just should serve first and foremost market
integrity.
Mr. Conaway. Thank you, Mr. Chairman. I yield back.
The Chairman. If I could have the Committee's indulgence,
if I could just refine that a little bit.
This independent board, who is going to pick them? I mean,
aren't they going to, in reality, be picked by the folks that
set this up?
Mr. Short. No. Our Board presently under our application
consists of our internal management as well as a majority of
our independent directors from our main Board of Directors at
IntercontinentalExchange, Inc.
The Chairman. But, we have heard this with a lot of our big
corporations, and they are all interconnected and they all know
each other, and they are all buddies. So when you say they are
independent, at least for me, I am a little skeptical because I
think------
Mr. Short. I think above all, ICE, if you look at
IntercontinentalExchange's governance model, we have had the
most independence perhaps of any exchange to the point where we
don't really even have major market participants sitting on our
Board of Directors. We believe in independence that much.
The Chairman. Thank you.
The gentlelady from South Dakota, Ms. Herseth Sandlin.
Ms. Herseth Sandlin. Thank you, Mr. Chairman. I would just
like to follow up for Mr. Duffy and Mr. Short on a couple of
questions that Mr. Neugebauer and Mr. Marshall were trying to
get at in terms of our concern about the number of different
regulators.
And, Mr. Duffy, I hear you loud and clear, that you would
prefer that these clearinghouses be regulated by the CFTC. But
we have had the SEC in here testifying previously. We have had
the Federal Reserve--members of the Federal Reserve Board in
here. We can't even get them to agree when they come in and
testify that we should mandate regulation of credit default
swaps.
So can you clarify your earlier comments--and both of you,
this is for both Mr. Short and Mr. Duffy--because it is still
unclear to me why, Mr. Short, you have--ICE has pursued sort of
a separate infrastructure, whereby you are seemingly seeking an
avenue of regulation by the Federal Reserve.
And, Mr. Duffy, what are your concerns based on what--I
think you are probably familiar with testimony from the SEC
that we have taken before this Committee before--where you see
having multiple regulators isn't going to be a problem with the
growth of an instrument that can be useful to the economy.
Mr. Duffy. Congresswoman, first of all, I think that there
could be potential growth inhibitors when you have multiple
regulators. But I am just trying to be realistic on a product
line that we have debated now, especially in this body of
Congress, for several months just to get it up and cleared. I
believe that you have even had the largest sell-side
participants.
The banks say they need a cleared solution to credit
default swaps. So we really have been kind of stuck trying to
get it up and listed. So from my realistic standpoint, we know
that there could be multiple jurisdictions on credit default
swaps. Our concern with that, would it ever bleed over into
other core product businesses, and that--we think that would be
a real detriment to our business.
So, we are willing to participate in multi-regulation to
get this product up and listed. We believe we have a good
solution that makes sense for the marketplace. So we would like
to bring that as quick as possible.
I think we are just trying to be more realistic when it
goes to being with our regulator. As far as setting up a bank
trust similar to what the IntercontinentalExchange did, we
certainly could have gone down that path. We entertained that a
couple years back, but we saw best not to do it. So we have not
gone down that path, but--we are not prohibited from doing
that, though.
Ms. Herseth Sandlin. Can you explain why you thought it was
best not to?
Mr. Duffy. Well, we just didn't see any benefits or reasons
to go doing that. We already have regulation under the CFTC and
the SEC as a publicly traded company, so we didn't think we
needed to add additional layers.
Ms. Herseth Sandlin. Mr. Short.
Mr. Short. ICE's view in terms of why it pursued the path
with the Fed again was because we viewed the Fed as a thought
leader in this area. Certainly, the New York Fed and Tim
Geithner have been pushing in this area for quite some time.
In terms of forming a limited purpose trust company and
becoming a state member of the Fed, we wanted to create a
separate clearinghouse to isolate this risk, keep it as Wall
Street's risk. And separate and apart from that, we viewed this
as, perhaps, the best way to get to market quickly. We wanted
to propose a solution that would address the existing market
problems; because we think that the most important thing to do
is to address systemic risk in the system, bring transparency
to the marketplace. And then Congress, in a thoughtful manner,
can decide ultimately who needs to regulate what products.
Ms. Herseth Sandlin. Okay. So it wasn't necessarily any
sense on ICE's part that the existing infrastructure of the
CFTC or FSA would be inadequate?
Mr. Short. Not at all. Both are fine regulators and have
the appropriate infrastructure to oversee clearinghouses in
this market space.
Ms. Herseth Sandlin. But isn't it also possible that, as
you say, then Congress can determine who the appropriate
regulators should be, that Congress may very well determine
that the Federal Reserve shouldn't exercise regulatory
authority in this area, that it should be existing entities
such as the CFTC? And then where does that leave you in terms
of how you have set up your clearinghouse?
Mr. Short. We would obviously avail ourselves of whatever
regulatory regime Congress thought best to impose in terms of
rationalizing the overall market structure. We could operate
under any of those regimes.
Ms. Herseth Sandlin. Okay.
Thank you, Mr. Chairman. I yield back.
The Chairman. I thank the gentlelady.
The gentleman from California Mr. Costa.
Mr. Costa. Mr. Duffy, I am concerned about the issue that
was raised earlier with potential conflicts of interest. If, in
fact, you are providing clearinghouse functions and at the same
time the dealer banks in fact have the largest positions on
some of these default swaps, what can you tell me that is going
to convince me otherwise?
Mr. Duffy. Well, the same thing that we have in our core
business today, sir. Some of the largest dealers in the world
have some of the largest positions on the CME Group. And we
have obviously everything put in place today internally and
operationally to make certain that there are no conflicts of
interest, because if we had conflicts of interest, we would not
have a core business today. We wouldn't be able to become a
public company or any of that.
So I think the same assurances that we have on our core
business today, sir, are the same assurances that you can have
on our credit default swaps offering for the future.
Mr. Costa. I assume, Mr. Short, you have a similar answer?
Mr. Short. Yes. It is a matter of having the right
governance. The only additional point I would make is that many
of the larger dealers are now bank holding companies or have
foreign office--or even if they are foreign, have domestic
offices that are subject to Fed regulation. Having that direct
Fed insight into their operations, into their balance sheets, I
think is particularly helpful in terms of managing risk.
Mr. Costa. Aren't you concerned that there is not only a
lack of credibility among the general public as it relates to
everything that has taken place over the last several months,
as it relates to the whole CDS issue and the lack of knowledge
that the general public really has about what has taken place
and what level of exposure is out there?
And it just seems to me that the--and then Members of
Congress, we have to figure out a better way to do things. I
wouldn't suggest at this point in time that you have a high
level of credibility, would you?
Mr. Duffy. I think the CME Group has a very high level of
credibility, sir. We have been in the business for 160 years.
We have had zero default. We have never had a customer lose a
penny of funds due to a default of one of our clearing member
firms. I don't think there are too many businesses in the
United States or abroad that can say that they have had that
type of credibility in its history as a company.
So, I think that when you look at the credibility of credit
default swaps themselves, I think they are widely misunderstood
because they are very complicated products. But I would not say
that the company of CME Group is not credible because of the
things that I outlined, sir.
Mr. Costa. So you are on record as supporting a regulatory
scheme, and you are in the process of pursuing the efforts you
have explained to us. But if the Congress agrees in the next
year to put together such a scheme, you will follow that lead?
Mr. Duffy. We have been a regulated exchange since our
existence, sir. And we have no interest in being anything other
than a highly regulated entity to protect the interests of the
participants of our marketplace.
Mr. Costa. With all that history that you just stated, do
you believe it is possible that we can come together with our
friends in Europe and elsewhere and set up a standardization
and a transparency? I hope a call that will allow the
marketplace to work and at the same time provide a level
playing field.
Mr. Duffy. As I said earlier, I think it is imperative that
we work hard with our European friends to come up with a
standard that we can all abide by. The world has gotten
smaller, and it is a global marketplace, so I think it is
essential.
At the same time, sir, I think it is essential for the
United States to give approval for exchanges such as ours that
are neutral parties to go ahead and start to execute and
facilitate this business to eliminate some of the systemic
risks that have already been in the system.
Mr. Costa. My time is getting short, but Mr. O'Neill and
Mr. Book, my sense is that there is a different view from the
folks in a European exchange or clearinghouse and what
currently is taking place in London.
Do you see eventually multiple clearinghouses?
Mr. O'Neill. Sir, I think the statement of the European
Commission is to support one or more European CCPs so they
would like to see those brought into existence. However, I
think actually our policy, as I said, is that there is no
regulatory arbitrage, that European or U.S. solutions compete
according to their merits. So I think in that respect, we are
very much in line with the sentiments expressed here today.
Mr. Costa. Mr. Book.
Mr. Book. I think in general we very much would support,
have competition in this field rather than a monopoly, so
competing providers that would provide for innovation--also for
high standards in the services that are offered. I think that
is key. And the requirement for having those multiple providers
is to have a level playing field for those in offering their
services on a global basis.
Mr. Costa. With your indulgence, Mr. Chairman; my time has
expired. But I have one other question I wanted to raise.
Mr. Duffy, I have a concern as I look across, and we
haven't raised the subject here today, but the potential
exposure and risk involved in the area of the monolining
efforts that have participated in this. We have municipalities
throughout the country. Some have filed, sadly, bankruptcy, and
are at significant risk.
I don't know if this is an area that you have expertise in.
But would you care to comment?
Mr. Duffy. I think, Congressman, this is not actually an
area I have expertise in as far as municipalities and the
viability of those municipalities.
Mr. Costa. I am talking about as it relates to the monoline
underwriting on their bonds.
Mr. Duffy. Well, I mean, their bonds have gone down in
value, as have everyone's. So, in all honesty, sir, I am not an
expert on the municipality of bonds. So I would not comment.
Mr. Costa. Would any of the other three gentlemen care to
comment?
Mr. Short. I am afraid I am not an expert either, sir.
Mr. Costa. We will find someone who is.
Thank you very much, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Indiana, Mr. Ellsworth.
Mr. Ellsworth. Thank you, Mr. Chairman. Thank you,
gentlemen. My question is for Mr. Duffy and Mr. Short.
Based on what you know, do you think that any exemption
granted by the SEC for organizations seeking to establish
credit default swaps central counterparties will be temporary?
And what is your reaction to the SEC exemption requirements for
these central counterparties?
And the second part of the question would be, do you think
that these temporary exemptions have created an uncertainty in
the market?
Mr. Short. I think the SEC, as part of its exemptive
relief, has suggested that it might grant temporary exemptive
status. I think that part of that might be driven by the speed
with which they have had to react to the situation. They have
really been working along with the CFTC and the Fed to make
sure that a solution comes to market to address some of the
systemic risk. It does create a little bit of uncertainty out
there that the SEC would be very cautious in withdrawing that
exemptive relief in a precarious fashion once a situation was
up and running. It may just be waiting and biding its time to
see what Congress does with broader market reform.
Mr. Ellsworth. Should they define ``temporary'' or leave it
open-ended? Would it be more beneficial to define what the
``temporary'' is? Or------
Mr. Short. It might help.
Mr. Duffy. I agree with Mr. Short. Uncertainty is never
good for any marketplace.
At the same time, I think that the community would look at
this and try to bypass the temporary part of the exemption,
especially if the solution is successful, sir. If the solution
is not successful, I am assuming it is going to be temporary
and eliminated or modified. If the solution is successful, I am
assuming that the industry, the Street and the participants
will bypass the word ``temporary,'' and I am assuming the SEC
eventually will make it part of their makeup.
Mr. Ellsworth. Thank you. Mr. Chairman, I don't have
anything further.
The Chairman. I thank the gentleman.
The gentleman from Ohio, Mr. Space.
Mr. Space. Thank you, Mr. Chairman. This question will be
directed to Mr. Duffy and Mr. Short.
Clearinghouses for any financial instrument concentrate
risk away from the holders of the instruments into the
clearinghouse itself, and there is obviously a great deal of
risk associated with these credit default swaps. How would the
financial security of the clearinghouse itself be tested to
ensure that it can meet the stress of defaulting members, even
if such a potentially catastrophic event would be unlikely?
Mr. Short. It is all part of the risk management system
within the clearinghouse. Positions are margined appropriately.
There is a guaranty fund behind those positions, and there is a
comprehensive set of stress tests that the clearinghouse
undertakes to demonstrate, based upon historical data and
projections, what would happen in the event of a significant
move in the market.
The comprehensive risk management systems--having
comprehensive risk management systems is really what the
clearing business is about. And the Fed has been very
inquisitive about the amount of stress testing that we are
doing, and they are very much on the ball in that regard.
Mr. Duffy. I would agree.
And I would just add on a stress test, which is critically
important, sir, we stress-tested both after the fact Lehman and
Bear and the way our risk management capabilities are put into
place; the CME Group and its participants all would have been
made whole.
There is no question it is a stress on the system. But at
the same time our tests all show we would have withstood such
an event such as those two large institutions going down.
So I think it is a testament to the risk management
capabilities that the CME Group has, and also to the people and
experience, which are critically important to making certain
that these debts are paid.
Mr. Space. Thank you.
I yield back, Mr. Chairman. Thank you.
The Chairman. I thank the gentleman.
The gentleman from North Dakota, Mr. Pomeroy.
Mr. Pomeroy. I didn't quite hear the thrust of what you
said when you indicated that--who had been on the ball? I am
sorry. Mr. Short, who had been on the ball?
Mr. Short. As part of our Fed application process, we have
had teams from the Fed, along with the New York City Banking
Department, along with representatives of the CFTC and SEC,
looking at various aspects of our proposed clearing operations.
And part of that review is to walk through the risk management
systems and to assure the Fed as part of its approval process
that we have the appropriate risk management systems in place.
And part of that is running stress tests.
I should have clarified my response.
Mr. Pomeroy. Well, I am highly frustrated as a Member of
this Committee--participated in the earlier referenced law, the
Commodity Futures Modernization Act, and during all the time
since, seeing the financial interests represented, exchanges,
market participants, regulators. And it was all, what a great
piece of work we had done while the biggest financial calamity
in 50 years hits Wall Street, largely because of flaws relative
to what was regulated, what wasn't regulated.
I mean, I just think--I feel that there was so much that we
didn't know that we needed to know, and it is a very
regrettable situation. I don't think anyone has been on the
ball.
One of the things that worries me about this Memorandum of
Understanding in several different sources, potentially hosts
for regulatory oversight of exchanges, is that, do we have a
capacity in this scheme to keep track of, on the aggregate, the
amount of liabilities being assumed by market participants on
these credit default swaps?
And, Mr. Short, we will start there and go up and down, if
my question is clear.
Mr. Short. I believe we do. I think the Memorandum of
Understanding provides a framework for inter-regulator
dialogue. And there should be dialogue, because what you have
seen ultimately is the convergence of financial instruments
over time that are subject to different regulatory regimes. But
I think the capacity exists in place to look at that.
Mr. Pomeroy. Well, regulators can talk to one another.
That, to me, seems a little short of what I would like, which
is an ongoing tally kept somewhere in terms of what some of us
are exposed to on credit default swaps of various characters.
Could we achieve that within a regulatory regime? And can
we achieve it within one where you have various exchanges
regulated by various parties?
Mr. Short. I think some of that would be handled through
the transactional reporting that would occur from the
clearinghouse both under our solution and CME's solution. And
certainly to the extent that you were dealing with any of the
entities that were directly regulated by the Fed, which many of
the dealers currently are, I think the Fed would be looking at
those tallies very closely going forward.
Mr. Pomeroy. We must make sure--it seemed to me, for the
same interests you just spoke to, that we are capturing on a
comprehensive basis every participant in every credit default
swap, and we are keeping a tally in terms of their accumulating
exposure. I don't know how else we are going to get our hands
around this thing.
Mr. Book, do you have an opinion on that?
Mr. Book. I think probably it is not so much the focus on
the regulation of exchanges and clearinghouses.
I think, first of all, one has to acknowledge the fact that
based on these numbers of 2007, 84 percent of derivatives were
traded outside of regulated markets in the over-the-counter
segment and only 16 percent were traded on regulated markets or
clearinghouses, which highlights how big the task is to get all
those transactions done on regulated markets or clearinghouses.
And I think the first step is to have reporting requirements
to, first of all, clarify what is the outstanding exposure that
which market participants hold and which instruments. And that
it is also a prerequisite. For instance, like the confirmation
that has been established with the DTCC Warehouse to have that
clarity to establish centralized clearing organization for
those businesses and for those highly opaque OTC markets.
Mr. Pomeroy. Mr. Duffy.
Mr. Duffy. Well, I think the reporting part is critically
important. You look at the size of the overall market, sir. And
I think when we were here a couple of months ago, everybody was
trying to determine how big this market really is, because none
of us really knew. And that was because of a lack of
information associated with it.
I think that you have seen, as I said in my testimony
earlier, the Fed, the CFTC and the SEC come together to
hopefully net some of these CDSs down. Now we have seen the
concentration of this market down to roughly around $46
trillion, down from around $60-some-odd trillion.
I think it goes to show you that we need to have a
regulator involved to constantly keep on an eye on this,
because that was half the problem: Nobody knew where these
credit defaults were, who had them, how much they were worth.
Mr. Pomeroy. My concern is, can several regulators
concurrently, doing essentially the same thing, achieve that
end?
Mr. Duffy. Our hope is, yes, sir.
As I said earlier, we are very large proponents of the
Commodity Futures Trading Commission. We think they have done a
remarkable job, especially over the last several years with the
growth of our industry. But we do believe multiple regulators
can work on the credit default swaps to bring harmonization and
bring some compression to this market so we know exactly what
it is worth.
Mr. Pomeroy. Would one regulator be better?
Mr. Duffy. Again, I think that that is going to be a little
bit unrealistic. But obviously a streamline of any regulation
is always a benefit to the product, in my opinion.
Mr. Pomeroy. Thanks. I yield back.
The Chairman. I thank the gentleman.
Anybody else have any further questions? I don't think so.
So we again want to thank this panel for being so generous
with your time in answering our questions. We appreciate your
being before the Committee. And I am sure we will have more
discussion before this is all over with.
So the panel is excused.
Mr. Duffy. Thank you.
The Chairman. We will call up the next panel once we get
the logistics cleared out here so we can make it happen.
All right. Welcome to the Committee.
This is a distinguished panel: Mr. John Damgard, President
of the Futures Industry Association of Washington; Mr. Robert
Pickel, CEO of International Swaps and Derivatives
Association--he has been with us before; Mr. Don Thompson, the
of J.P.Morgan on behalf of the J.P.Morgan and the Securities
Industry and Financial Markets Association; Mr. Gerald
Corrigan, the Managing Director of Goldman Sachs in New York;
and Mr. Brian Murtagh, the Managing Director of Fixed Income
Transaction Risk Management, UBS Securities LLC of Stamford
Connecticut.
Gentlemen, welcome to the Committee. And you will each be
given 5 minutes to summarize your testimony. Your full
testimony will be made a part of the record.
So Mr. Damgard, if you will proceed. Again, welcome to the
Committee.
STATEMENT OF JOHN M. DAMGARD, PRESIDENT, FUTURES INDUSTRY
ASSOCIATION, WASHINGTON, D.C.
Mr. Damgard. Thank you much, Mr. Chairman, Members of the
Committee. I am John Damgard, President of the Futures Industry
Association. And I thank you for inviting the FIA to this
hearing on the current plans to clear credit default swaps.
We know this Committee has been actively involved in this
issue for many months. FIA greatly appreciates the leadership
that you have shown, Mr. Chairman, along with Ranking Member
Goodlatte and the other Members of the Committee.
FIA believes credit default swaps add real value to our
economy. We also believe that a system for clearing credit
default swaps would enhance that value. As this Committee
appreciates, clearing would remove counterparty performance
risk, increase transparency and, most importantly, reduce
systemic risk. FIA therefore supports plans to clear these
instruments.
Today, the FIA would like to make three basic points.
First, the vital interest of clearing firms must be recognized
in the structure of any clearing system for credit default
swaps. Second, government agencies should not make clearing of
credit default swaps a jurisdictional football. And third,
merging the CFTC and the SEC will not answer the financial
market regulatory concerns raised in recent months.
As this Committee is aware, the futures clearing firms are
FIA's predominant members. Some may overlook the role these
firms play, but the simple truth is the clearing firms are the
lifeblood of any clearing system. The clearing firm is
financially responsible to the clearinghouse for every trade it
clears. Each clearing firm puts its capital at risk at the
clearing organization to guarantee performance on the firm's
trades and its customers' trades. In effect, the clearing firm
is financially underwriting its customers' performance.
Each clearing firm knows that its capital is standing
behind other clearing firms in the system and may be called
upon if another clearing firm fails. That is why clearing
systems are known as mutualized risk systems. In any system for
credit default swaps, FIA would expect the clearing firms to
play a similar role.
No clearing firm should be asked to commit its capital to a
clearing system unless the firm is comfortable that its capital
will be well protected. The U.S. futures industry is proud of
its unparalleled record in this regard. We assure this
Committee will want to make sure that any of the CDS clearing
systems now being considered will meet that high standard of
excellence including appropriate capital standards for any new
clearing members.
FIA strongly believes that the clearing of credit default
swaps would serve the public interest. FIA appreciates that
existing law is not crystal clear on what is the right
regulatory home for credit default swaps that are cleared. No
one doubts that the SEC has fraud and manipulation enforcement
powers over individually negotiated credit default swaps, and
no one doubts that Congress gave the operators of clearing
systems for OTC derivatives a choice of regulators--CFTC, SEC
or the Fed. The question is, did the CFTC and SEC retain some
residual jurisdiction over credit default swaps even when they
are being cleared by an entity subject to another regulator's
oversight?
FIA believes either the CFTC or SEC or both could state a
legal claim to jurisdiction over these instruments. We would
ask these agencies to resist the urge to assert their authority
to regulate through exemption orders. Instead, all members of
the PWG should work cooperatively as a team to put in place a
strong and effective, coordinated oversight system for cleared
credit default swaps. That is the best approach to serve the
public interest as the PWG's recent MOU demonstrates.
Last, throughout the current credit crisis the U.S. futures
markets have continued to provide liquid, fair and financially
secure trading venues for managing or assuming price risk. The
CFTC has achieved an exemplary regulatory record that is cited
throughout the world as the gold standard. That record
illustrates the wisdom of this Committee's decision almost 45
years ago to give birth to the CFTC with exclusive jurisdiction
over all facets of futures trading. That judgment is as sound
today as it was then.
We understand that reforming financial market regulation is
on the agenda of the new Administration and the new Congress.
Many different suggestions have been offered for changing the
regulatory status quo. FIA welcomes a healthy debate on how
best to strengthen both our regulatory systems and our markets
nationally and internationally. All options should be on the
table and fully explored.
Through this process, we are confident Congress will agree
simply folding the CFTC into the SEC is not the answer. And we
look forward to answering any questions the Committee may have.
[The prepared statement of Mr. Damgard follows:]
Prepared Statement of John M., Damgard, President, Futures Industry
Association, Washington, D.C.
Mr. Chairman and Members of the Committee, I am John Damgard,
President of the Futures Industry Association. FIA is pleased to be
asked to discuss some of the issues raised by plans to clear credit
default swaps. We know this Committee has been actively involved in
these issues for many months. FIA greatly appreciates the leadership
you have shown, Mr. Chairman, along with Ranking Member Goodlatte and
the other Members of this Committee.
Just to establish some common vocabulary, credit default swaps are
derivatives designed to manage the risk that a credit event will occur
in the future. Those credit events are defined by contract and range
from a corporation's failure to make an interest payment to its
corporate restructuring. Credit default swaps may involve indexes of
credit events for many companies or credit events for a single
corporation. That is why you hear discussion of indexed CDS instruments
and single name CDS instruments.
FIA is not here today to debate the value of credit default swaps
or to champion one clearing proposal over another. We believe credit
default swaps add value to our economy. We also believe that an
appropriately-structured and regulated CDS clearing system would
enhance that value. As this Committee appreciates, clearing would
remove counterparty performance risk, reduce systemic risk and increase
price transparency for eligible CDS transactions.
FIA has three basic points. First, the vital interests of clearing
firms must be recognized in the proper structure of any successful CDS
clearing operation. Second, government agencies should not make CDS
clearing a jurisdictional football. Third, merging the CFTC and the SEC
will not answer the financial market regulatory concerns Congress has
raised in recent months.
As this Committee is aware, FIA's regular members are the clearing
firms. Many may overlook the role these firms play in any clearing
system. But the simple truth is the clearing firms are the lifeblood of
clearing. The clearing firm is financially responsible to the clearing
house for every trade it clears. Each clearing firm puts its capital at
risk at the clearing organization to guarantee performance on the
firm's trades and its customers' trades. In effect, the clearing firm
is financially underwriting its customers' performance. Each clearing
firm knows that its capital is standing behind the other clearing firms
in the system and may be called upon if another clearing firm fails.
That is why clearing systems are known as mutualized-risk systems.
In any clearing system for CDS instruments, FIA would expect the
clearing firms to play a similar role. No clearing firm should be asked
to commit its capital to a clearing system unless the firm is
comfortable that its capital will be well-protected. The U.S. futures
industry is proud of its unparalleled record in this regard. We are
sure this Committee will want to make certain that any of the CDS
clearing systems now being considered will meet that high standard of
excellence, including the capital standards for any new clearing
members.
One structural issue that has been raised concerns whether to
commingle the risk pool that already exists for futures clearing with
the CDS risk pool. An alternative clearing approach would treat the CDS
clearing pool as a separate, self-contained structure. FIA does not
have a view now on which approach would be preferable from the
perspective of the clearing firms. We do believe the Committee and the
relevant agencies should pay particular attention to developments in
this area to make certain that the strongest possible CDS clearing
solution will be allowed to develop.
Another structural issue is often referred to as interoperability.
As CDS clearing evolves, it is unclear whether one clearing system will
predominate or whether multiple systems will thrive. In the event more
than one system is successfully launched, the regulators should
consider a plan to allow an appropriate linkage for the clearing
systems that would meet the related challenges of protecting against
systemic risk through the most efficient use of a clearing firm's
capital.
We suspect the Committee has heard about the interoperability
issue, and others, in its recent fact-finding trip overseas and that
you will monitor carefully any developments in the U.S. on this issue.
Your trip underscores that we can not develop CDS clearing policy in a
vacuum. The CDS market is international in scope and our policies must
work both domestically and internationally. The CDS clearing issue
highlights that today national borders are becoming less meaningful for
financial markets. We have one global financial market with global
issues that require global cooperation and solutions.
These international issues also serve to remind us that domestic
regulatory jurisdictional politics should not become a barrier to
forging an appropriate CDS clearing policy. As the CDS market has
evolved, it has become clear that it would serve the public interest to
make a clearing system available for many of these credit derivatives.
Given the current tightening of the credit markets, no agency's
jurisdictional claims should be considered to be more important than
the national economic interest. Current law provides a choice to those
who want to try to clear OTC derivatives in the U.S.--the clearing
entity could choose to be regulated by the SEC, the CFTC or the Federal
Reserve Board. Each regulatory body has had experience with the kind of
prudential, safety and soundness regulatory judgments that clearing
operations necessarily involve. And each regulator has pledged to
follow the established guidelines, whether adopted by IOSCO or the
Commodity Exchange Act, for the operation of an effective CDS clearing
system.
Once a clearing system operator has chosen its regulator, that
regulatory body should communicate and coordinate with its regulatory
colleagues. The recent MOU adopted by President's Working Group rightly
adopts this strategy. By emphasizing a process of interagency
consultation, the MOU should lead to sharing information and regulatory
suggestions among the PWG members with a view toward adopting a
streamlined and unified set of oversight principles for CDS clearing in
the U.S.
FIA understands the need for legal certainty and that the two U.S.
clearing platforms have applied to the SEC for exemptions to provide
that clarity. We would hope that those exemptions will not turn into an
excuse to regulate CDS transactions or to prescribe additional
requirements for clearing. If so, that would undermine the cooperative
process the MOU structure has put in place. Congress has found the CFTC
and the Fed to be qualified to oversee CDS clearing operations. They
should be allowed to perform their statutory functions without
interference from the SEC or other regulatory bodies.
In past hearings, the Committee has expressed concern about the
basis for the SEC's apparent claim that once a CDS is cleared it
becomes a security. In FIA's view, many CDS instruments are just as
likely to be considered commodity options subject to CFTC jurisdiction
under current law. Jurisdictional flag-planting seems short-sighted
given the crisis facing our financial markets. The PWG's MOU process
tries to keep that counter-productive activity to a minimum. We would
urge the Committee to make certain that neither the SEC nor the CFTC
attempts to use its exemption powers and the interest in legal
certainty as an excuse to impose regulatory restrictions on CDS
transactions that serve the agency's jurisdictional interests, but not
the public interest.
Last, as I have testified for decades, no compelling case has been
made to merge the CFTC and the SEC. Throughout the current credit
crisis, the U.S. futures markets have continued to provide liquid, fair
and financially secure trading venues for managing or assuming price
risks. The CFTC's vigorous, expert and efficient oversight of our
nation's futures markets has achieved an exemplary regulatory record
that is cited throughout the world as the gold standard. That record
illustrates the wisdom of this Committee's decision almost 45 years ago
to give birth to the CFTC with exclusive jurisdiction over all facets
of futures trading. That judgment is as sound today as it was then.
We understand that reforming financial market regulation is on the
agenda of the new Administration and the new Congress. Many different
suggestions have been offered for changing the regulatory status quo.
FIA welcomes a healthy debate on how best to strengthen both our
regulatory systems and our markets, nationally and internationally. All
options should be on the table and explored fully. Through that
process, we are confident Congress will agree that simply folding the
CFTC into the SEC is not the answer.
We look forward to answering any questions this Committee may have.
The Chairman. Thank you very much, Mr. Damgard.
Mr. Pickel, welcome to the Committee.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CEO,
INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, WASHINGTON, D.C.
Mr. Pickel. Thank you, Mr. Chairman and Members of the
Committee. Thank you for inviting ISDA to testify today at this
follow-up hearing regarding credit derivatives.
As you know from our previous meeting, ISDA and the OTC
derivatives industry are proud of the strength of the OTC
derivatives infrastructure and what it has demonstrated during
the recent turmoil, while at the same time being committed to
working with Congress, regulators and within the industry to
strengthen these markets still further.
Credit default swaps benefit the broader economy by
facilitating lending and corporate finance activity, which is
especially crucial in today's tight credit environment. They
perform a valuable signaling function and allow investors to
express a view on the market. CDSs have remained the only
credit product consistently available to allow companies and
investors to transfer credit risk and express a view on credit
performance. While cash securities and money markets have
seized up, CDSs have continued to function. Illiquidity in the
financial markets would likely be worse if companies and
investors did not have a healthy CDS business available to
them.
Furthermore, the causes of the financial crisis are rooted
in poor lending decisions, particularly in the residential real
estate market. For more than 2 decades, ISDA has maintained an
active and collaborative dialogue with public policymakers and
supervisors, including financial regulators, legislators and
governments around the globe to establish a sound policy
framework for swaps activity. Since 2005, market participants
have been working towards implementing a central clearinghouse
for credit derivative transactions. Building on these efforts,
ISDA and its members have worked together with the President's
Working Group and other regulators towards achieving this
objective.
A well-regulated and prudently managed central counterparty
can provide benefits to the market by reducing the systemic
risk associated with counterparty credit exposures and
providing enhanced liquidity and price discovery by means of
standardization and centralized trading.
In addition to the ongoing efforts on the central
counterparty front, market participants, along with The
Depository Trust & Clearing Corporation, have taken a
significant step towards addressing market concerns about
transparency by publishing on a weekly basis aggregate market
data through DTCC's Trade Information Warehouse.
On November 14 the PWG announced a series of policy
objectives for the OTC industry, and that has been referenced
in the prior panel. ISDA agrees that the four objectives laid
out in the PWG statement and believes that continuing to pursue
the improvements industry and regulators have worked on over
the last several years is key to ensuring the OTC derivatives
industry in the U.S. remains healthy and competitive.
Within these four broader objectives, the PWG lists a
number of specific recommendations for the industry, for
policymakers, and recommendations of an operational nature. Of
particular importance from ISDA's perspective is the PWG
statement acknowledging the continued need for bilateral,
custom-tailored risk management contracts. While some have
posited that all OTC derivatives contracts should be made to
trade on-exchange, as the PWG notes, there will continue to be
the need for customized OTC derivatives transactions.
As Members of the Committee well know from their recent
fact-finding mission to Europe, the European Commission is very
interested in these very same issues. In both public and
private conversations, they have stated their belief in the
need for a European clearing solution regardless of what is
done here in the United States. Given that Europe is currently
the largest global center for OTC derivative activities,
actions taken by regulatory officials there will likewise have
a tremendous impact on market participants here in the United
States.
As policymakers on both sides of the Atlantic debate how to
address clearing and OTC operational issues, it is important to
bear in mind the global nature of these products. Policymakers
should consider various approaches to addressing and
facilitating clearing. It would be beneficial to maintain
maximum flexibility in terms of where and how firms choose to
clear.
The current stress which the global economy is facing has
placed severe burdens on market participants in the operational
infrastructure of the entire financial services industry as
well as spreading harm to businesses, workers and consumers.
While the roots of the market turmoil lie in imprudent lending
decisions, there are lessons to be learned across markets and
products.
With respect to CDS in general, the market has held up
extremely well under the strains of multiple failures of large
market participants and issuers of debt. Thus far, the auction
and settlement process that we have run together with market
and Creditex have performed effectively and the collateral and
netting arrangements among market participants has likewise
operated as intended. Nevertheless the turmoil has exposed the
need for market participants to increase the speed with which
they implement operational improvements to which they have
already committed; as well as to commit to examining what
further improvements might be necessary. ICE looks forward to
continuing to work with the Committee, the Congress and
regulators to help ensure that the strength and liquidity of
the CDS market that it has shown to date in this environment
continues in the future. Thank you and I look forward to your
questions.
[The prepared statement of Mr. Pickel follows:]
Prepared Statement of Robert G. Pickel, Executive Director and CEO,
International Swaps and Derivatives Association, Washington, D.C.
Mr. Chairman and Members of the Committee:
Thank you very much for inviting ISDA to testify at this follow-up
hearing regarding credit derivatives. As you know from our previous
meeting ISDA and the OTC derivatives industry are proud of the strength
the OTC infrastructure has demonstrated during the recent turmoil,
while at the same time being committed to working with Congress,
regulators and within the industry to strengthen these markets still
further.
About ISDA
ISDA, which represents participants in the privately negotiated
derivatives industry, is the largest global financial trade
association, by number of member firms. ISDA was chartered in 1985, and
today has over 850 member institutions from 56 countries on six
continents. These members include most of the world's major
institutions that deal in privately negotiated derivatives, as well as
many of the businesses, governmental entities and other end-users that
rely on over-the-counter derivatives to manage efficiently the
financial market risks inherent in their core economic activities.
Since its inception, ISDA has pioneered efforts to identify and
reduce the sources of risk in the derivatives and risk management
business. Among its most notable accomplishments are: developing the
ISDA Master Agreement; publishing a wide range of related documentation
materials and instruments covering a variety of transaction types;
producing legal opinions on the enforceability of netting and
collateral arrangements; securing recognition of the risk-reducing
effects of netting in determining capital requirements; promoting sound
risk management practices; and advancing the understanding and
treatment of derivatives and risk management from public policy and
regulatory capital perspectives. Among other types of documentation
ISDA produces definitions related to credit default swaps.
The Role CDS Play in the Credit Markets
Credit default swaps (CDS) benefit the broader economy by
facilitating lending and corporate finance activity, which is
especially crucial in today's tight credit environment. They perform a
valuable signaling function and allowing investors to express a view on
the market.
CDS provide a simple device for banks and other lenders to hedge
the risks associated with lending to a particular company, group of
companies or industry. Generally speaking, CDS hedge the risk that a
borrower will default. Fundamentally, if a lender can be sure it will
be made whole regardless of whether a borrower defaults, it is more
likely to lend. CDS also free capital for further lending activity by,
among other things, enabling lenders to effectively manage its
regulatory capital requirements or by increasing a lender's credit
limit with respect to a specific borrower or industry. Ultimately, CDS
increase liquidity in the banking industry because they enable banks to
manage the credit risk inherent in lending. Because CDS limit the
bank's downside risk by passing it on to parties that seek such
exposure, banks are able to lend more money to many more businesses.
CDS thus significantly expand companies' access to capital from bank
lending; indeed, without this risk management option credit markets
might be even more tightly constricted than they presently are.
CDS also serve a valuable signaling function. CDS prices produce
better and more timely information about the companies for whom a CDS
market develops because CDS prices, unlike the credit ratings published
by rating agencies, rely on market-based information about a company's
financial health. CDS prices reveal changes in credit conditions,
giving insight to bankers, policymakers, investors and others about
credit in real-time, making it easier to manage and supervise
traditional banking activities. The recent trend of basing term loan
pricing on CDS spreads as opposed to credit ratings illustrates the
increasing value lenders place on CDS pricing information.
CDS has remained the only credit products consistently available to
allow companies and investors to transfer credit risk and express a
view on credit performance; while cash, securities and money markets
have seized up, CDS have continued to function. Illiquidity in the
financial markets would likely be worse if companies and investors did
not have a healthy CDS business available.
CDS are an efficient means of hedging risk or adjusting positions;
they remain an accurate indicator of credit quality, are highly liquid,
and have been the best way to express a view on credit in troubled
times when cash and securities markets have seized up.
Central Counterparty Clearing and DTCC Trade Information Warehouse
For more than 2 decades, ISDA has maintained an active and
collaborative dialogue with public policymakers and supervisors
including financial regulators, legislators, and governments around the
globe to establish a sound policy framework for swaps activity. Since
2005, market participants have been working towards implementing a
central clearing house for credit derivative transactions. Building on
these efforts, ISDA and its members have worked together with the
President's Working Group and other regulators towards achieving this
objective. As a result of these efforts, central counterparty clearing
of CDS (CDS CCP) is near, with the goal of commencing operations before
the end of 2008.
A well-regulated and prudently managed CDS CCP can provide benefits
to the market by reducing the systemic risk associated with
counterparty credit exposures and providing enhanced liquidity and
price discovery by means of standardization and centralized trading.
Additionally, there is the probable reduction of economic and
regulatory capital and likely increased transparency.
In addition to the ongoing efforts on the CDS CCP front, market
participants along with the Depository Trust & Clearing Corporation
(DTCC) have taken a significant step towards addressing market concerns
about transparency by publishing, on a weekly basis, aggregate market
data from DTCC's Trade Information Warehouse (Warehouse). The market
data consists of outstanding gross and net notional values of CDS
contracts registered in the Warehouse for the top 1,000 underlying
single-name reference entities and all indices, as well as certain
aggregates of this data on a gross notional basis only.
ISDA continues to support the development of options for
participants in CDS to undertake their business in the most prudent and
efficient manner and to the highest standards of commercial conduct. We
welcome the development of clearing and settlement arrangements which
would provide the benefits of choice and flexibility to participants
within the sound industry framework developed by ISDA over 20 years
ago; a framework that benefits from the significant counterparty credit
risk mitigation of legally enforceable netting and collateral
arrangements.
Recommendations of the President's Working Group
On November 14 the PWG announced a series of policy objectives for
the OTC industry. The PWG broke their recommendations into four broad
categories: (1) improve the transparency and integrity of the credit
default swaps market; (2) enhance risk management of OTC derivatives;
(3) further strengthen the OTC derivatives market infrastructure; and
(4) strengthen cooperation among regulatory authorities. ISDA agrees
with these four objectives, and believes that continuing to pursue the
improvements industry and regulators have worked on over the last
several years is key to ensuring the OTC derivatives industry in the
U.S. remains healthy and competitive.
Within those four broader objectives the PWG lists a number of
specific recommendations. These can be separated into recommendations
for policymakers (e.g., ``Regulators should establish consistent policy
standards and risk management expectations for CCPs or other
systemically important derivatives market infrastructures and apply
those standards consistently''); recommendations for industry (e.g.,
``Market participants should adopt best practices with respect to risk
management for OTC derivatives activities, including public reporting,
liquidity management, senior management oversight and counterparty
credit risk management''); as well as recommendations of an operational
nature (e.g., ``Details of all credit default swaps that are not
cleared through a CCP should be retained in a central contract
repository''). These recommendations provide a helpful framework for
policymakers and industry alike to discuss while reviewing and
reforming the current regulatory structure. Of particular importance
from ISDA's perspective is the PWG's statement acknowledging the
continued need for bilateral, custom tailored risk management
contracts. As the PWG states: ``Participants should also be able to
bilaterally negotiate customized contracts where there are benefits in
doing so, subject to continued oversight by their prudential
supervisors.'' While some have posited that all OTC derivatives
contracts should be made to trade on-exchange, as the PWG notes there
will continue to be the need for customized OTC transactions.
On the same day the PWG announced its policy objectives, it also
released a Memorandum of Understanding among the Federal Reserve, the
Commodity Futures Trading Commission and the Securities and Exchange
Commission related to regulation of central counterparties. This
Memorandum is an important step in ensuring that regulators do not work
at cross-purposes while working to facilitate the creation of a central
clearinghouse. It would be unfortunate were the creation of a CDS
clearinghouse to be unnecessarily delayed because of a lack of
agreement among Federal regulators.
Other Industry Developments
According to ISDA's semi-annual survey at mid-year 2008, the
notional amount outstanding of CDS decreased by 12 percent in the first
6 months of the year to $54.6 trillion from $62.2 trillion. This
reduction represents the efforts of the industry to clean up
outstanding trades through a process known as ``tear-ups'', whereby
trades between counterparties which are still on the books but
effectively cancel one another out are removed, or ``torn up''. This
reduction in outstanding trades represents a significant achievement
for the industry in addressing operational issues, and is but one
example of efforts being undertaken, in coordination with regulators,
to help ensure the operational infrastructure of the OTC industry is
sound and able to withstand any challenges.
It may also be useful at this point to speak for a moment about
``notional'' amounts. These figures are inevitably cited to promote
unease about the size of the OTC market. It is helpful to note that the
notional amount of a derivative contract refers to an underlying
quantity upon which payment obligations are calculated. Notional
amounts are an approximate measure of derivatives activity and reflect
the size of the field of existing transactions. For CDS this represents
the face value of bonds and loans on which participants have written
protection; the exposure under a CDS contract is in fact a fraction of
the notional. For example, according to the DTCC (a private
organization which processes payments under derivatives contracts) when
Lehman Bros. failed the ``notional'' amount of CDS which referenced
Lehman was roughly $72 billion. However the actual money that exchanged
hands was 7% of that total, or a little over $5 billion.
As the Lehman settlement illustrates the transfer of payments under
CDS contracts is nowhere near the jaw dropping amounts often popularly
portrayed. And the Lehman settlement further illustrates the ability of
the market to settle payments even when the failure occurs at a very
large and important market participant. While work remains in
addressing operational issues within the industry the Lehman settlement
has reassured many about the ability of the OTC market to handle a very
large and systemically significant credit event.
Issues Related to the Global Nature of CDS
As the Members of this Committee well know from your recent fact-
finding mission, the European Commission is very interested in these
same issues. In both public and private conversations they have stated
their belief in the need for a ``European clearing solution,''
regardless of what is done in the United States. Given that Europe is
the largest global center for OTC derivatives activity actions taken by
regulatory officials there will likewise have a tremendous impact on
market participants in the United States.
As policymakers on both sides of the Atlantic debate how to address
clearing and OTC operational issues it is important to bear in mind the
global nature of these products. If a multi-national financial
institution is required to clear OTC contracts in each jurisdiction in
which it enters into CDS contracts it is likely to incur significant
costs. Depending on how great these costs are, onerous requirements in
one jurisdiction could lead to a multinational choosing to book all of
its derivatives business in just one jurisdiction. Thus for cost-
effectiveness purposes there exists the possibility that only one
jurisdiction will become the center for a ``global clearing solution''.
Alternatively, firms may find they can clear in each jurisdiction
provided there is linked clearing across platforms. As policymakers
consider various approaches to addressing and facilitating clearing it
would be beneficial to maintain maximum flexibility in terms of where
and how firms choose to clear. In this regard the efforts undertaken to
date by the NY Federal Reserve and other regulators to encourage
clearing should serve as a model. This process has encouraged industry
initiative while at the same time working to remove unnecessary
obstacles to the development of clearing options. Further, it builds
upon the flexibility already extant in U.S. law which provides that a
clearinghouse may be regulated by the CFTC, SEC or a Federal banking
regulator. Having multiple clearing options, across jurisdictions and
regulatory bodies, will allow the market to choose any ultimate
``global clearing solution''. This result is likely to be best in terms
of operational efficiency, cost effectiveness and ensuring the
continued health of the CDS market.
Conclusion
The current stress which the global economy is facing has placed
severe burdens on market participants and the operational
infrastructure of the entire financial services industry, as well as
spreading harm to businesses, workers and consumers. While the roots of
the market turmoil lie in imprudent lending decisions there are lessons
to be learned across markets and products. With respect to CDS, in
general the market has held up extremely well under the strains of
multiple failures of large market participants and issuers of debt.
Thus far the auction and settlement process have performed effectively,
and the collateral and netting arrangements among market participants
have likewise operated as intended. Nevertheless the current turmoil
has exposed the need for market participants to increase the speed with
which they implement operational improvements to which they have
already committed, as well as to commit to examining what further
improvements might be necessary. ISDA looks forward to continuing to
work with this Committee, the Congress and regulators to help ensure
that the strength and liquidity the CDS market has shown in this
environment continues in the future. Thank you.
The Chairman. Thank you, Mr. Pickel.
Mr. Thompson, welcome to the Committee.
STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND ASSOCIATE
GENERAL COUNSEL, J.P.MORGAN, NEW YORK, NY; ON BEHALF OF
SECURITIES INDUSTRY AND FINANCIAL MARKETS ASSOCIATION
Mr. Thompson. Thank you, Mr. Chairman. The credit default
swap market has experienced significant growth in recent years
because credit default swaps are useful tools for managing and
investing in credit risk, and they provide significant and
economic benefits. For example, credit default swaps have
increased the availability of credit. Because they enable banks
and other lenders to efficiently manage credit exposure, credit
default swaps increase lenders ability to extend credit to
their customers. Incidentally, credit default swaps spreads
also provide a convenient and accurate measure of the relative
riskiness of companies and other economic entities.
The mainstream financial press frequently cites increases
in credit default swap spreads as evidence that particular
companies are in financial distress. Although the derivatives
business is sometimes described as unregulated, that is
inaccurate. Virtually all of the significant participants in
the CDS market are U.S. and foreign banks or bank holding
company subsidiaries.
Banks are subject to extensive regulation by state and
Federal regulators and bank holding companies are regulated by
the Federal Reserve. The broad authority given to these
regulators includes the authority to obtain information about
bank and bank holding company business activities, transactions
and asset portfolios, and also the authority to prohibit
activities that might threaten the safety and the soundness of
a bank.
Bank regulators establish minimal capital requirements,
review risk management and control practices, and conduct
ongoing examinations of the institutions they regulate. Credit
default swap market participants are also subject to the SEC's
anti-fraud and anti-manipulation authority under the 1934 Act.
The Commission has broad authority to investigate whether any
person has violated the Act, including authorities that require
the production of books and records.
Even though most swap dealers that engage in credit default
swap transactions already are subject to comprehensive
oversight and regulation, we strongly support efforts to
improve systemic stability, in particular by using a
clearinghouse to reduce counterparty credit risk. We also
strongly support enhanced regulatory oversight of credit
default swap markets and market participants. Recent events
have shown that a poorly managed credit default swap business
can threaten not only the financial condition of the firm
engaged in that business, but also the stability of other firms
and financial markets generally.
Additional steps that should be included; giving a single
Federal regulator additional information gathering authority
with respect to clearinghouse facilities and significant market
participants, and empowering that regulator to adopt
regulations to ensure prudent business practices and to
minimize systemic risk.
Because the credit default swap market is global, we
believe that regulation at the Federal level with international
consultation and cooperation is the correct approach.
Participants in the credit default swap market generally
support the OTC derivatives initiatives announced by the
President's Working Group on financial markets on November
14th, 2008. In particular, we strongly support implementation
of central counterparty services for credit default swaps.
My bank, J.P.Morgan, is working with other market
participants to establish a clearinghouse for credit default
swap transactions. We believe the clearinghouses will be in
operation shortly, although full implementation will be phased
in over time. We believe that the development of the
clearinghouse with credit derivatives with a central
counterparty is an effective way to reduce and mutualize
counterparty credit risk, which, in turn, will help promote
market stability.
The clearinghouse, also, will facilitate regulatory
oversight by providing a single location for access to
information about the credit default swap transactions it
processes. We also generally support the PWG's policy objective
of improving the transparency and integrity of the credit
default swap market. Although care should be taken to protect
information that might adversely effect the competitive
positions of market participants.
In summary, Mr. Chairman, credit default swaps are
financial instruments that are useful tools for managing credit
risk. Their importance in our economy is demonstrated by the
tremendous growth in the credit defaults swap market in recent
years. We recognize, however, that the credit defaults swaps,
like any finance instrument, can be misused or mismanaged. We
believe that the industry's implementation of a credit default
swap clearinghouse will reduce risk. And we appreciate the
encouragement and support regulators have given to our efforts.
Additional steps to improve regulatory oversight of credit
default swap activities will further reduce risk. And we look
forward to working with Members of Congress and other
governmental official on initiatives to enhance the
effectiveness of regulation without imposing unnecessary
limitations on the markets or its participants. Thank you.
[The prepared statement of Mr. Thompson follows.]
Prepared Statement of Don Thompson, Managing Director and Associate
General Counsel, J.P.Morgan, New York, NY; on Behalf of Securities
Industry and Financial Markets Association
Introduction
Chairman Peterson, Ranking Member Goodlatte, and Members of the
Committee:
My name is Don Thompson and I am the co-head of the derivatives
legal practice group at J.P.Morgan. I am appearing on behalf of
J.P.Morgan and the Securities Industry and Financial Markets
Association.\1\ Thank you for inviting both organizations to testify at
today's hearing.
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\1\ The Securities Industry and Financial Markets Association
brings together the shared interests of more than 650 securities firms,
banks and asset managers locally and globally through offices in New
York, Washington, D.C., and London. Its associated firm, the Asia
Securities Industry and Financial Markets Association, is based in Hong
Kong. SIFMA's mission is to champion policies and practices that
benefit investors and issuers, expand and perfect global capital
markets, and foster the development of new products and services.
Fundamental to achieving this mission is earning, inspiring and
upholding the public's trust in the industry and the markets. (More
information about SIFMA is available at http://www.sifma.org.)
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The Role of Credit Default Swaps in Our Economy
Credit derivatives were developed in the mid-1990s and have
experienced significant growth \2\ due to their usefulness for purposes
of managing and investing in credit risk. Among the various types of
credit derivatives, credit default swaps (CDS) are the most widely used
product and they play an important role in our economy.
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\2\ The International Swaps and Derivatives Association estimates
the total notional amount of outstanding CDS grew from $8.42 trillion
at the end of 2004, to $34.4 trillion at the end of 2006, and to $54.6
trillion as of June 30, 2008. Although these statistics provide an
indication of growth in the use of CDS, they greatly overstate net CDS
exposure.
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For example, the availability and use of CDS has increased
liquidity in credit markets. Because they enable banks and other
institutional lenders to efficiently manage credit exposure in their
portfolios, CDS make it possible for these lenders to provide more
liquidity to particular companies than they otherwise would if they did
not have the option to hedge in the CDS market. CDS also provide a
convenient and accurate measure of the relative riskiness of companies
and other economic entities. CDS represent pure credit risk, isolated
from the other risks that are inherent in bonds and other financial
instruments, such as interest rate risk. As such, CDS spreads, the
prices quoted by swap dealers for CDS covering a particular company's
obligations, send prompt and clear signals to the market when the
company's credit risk changes. The mainstream financial press
frequently cites increases in CDS spreads as evidence that particular
companies are in financial distress.
Regulation of Credit Default Swaps
Although derivatives markets and products are sometimes described
as unregulated or not subject to regulatory oversight, that is
inaccurate and misleading. Virtually all of the significant
participants in the CDS market are U.S. and foreign banks or bank
holding company subsidiaries. (One notable exception, of course, is the
AIG affiliate that was an active CDS market participant, but not a bank
or bank holding company subsidiary.) \3\ Banks are subject to extensive
regulation by state and Federal bank regulators, and bank holding
companies are regulated by the Federal Reserve. The broad authority
given to these regulators includes the authority to obtain information
about bank and bank holding company business activities, transactions
and asset portfolios and also the authority to prohibit activities that
might threaten the safety and soundness of a bank. The banking
regulators establish minimum capital requirements, review risk
management and control practices, and conduct ongoing examinations of
the institutions they regulate. CDS market participants also are
subject to the SEC's anti-fraud and anti-market manipulation authority
under the Securities Exchange Act of 1934 and the Commission has broad
investigatory authority to determine whether any person has violated
the Act, including the authority to require the production of books and
records.
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\3\ This AIG affiliate, which has incurred significant losses in
connection with its CDS business, was not subject to regulatory
oversight in the manner that banks are, nor was it regulated by any
insurance regulator.
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Even though most swap dealers that engage in CDS transactions
already are subject to comprehensive oversight and regulation, we
strongly support efforts to improve systemic stability, in particular
by using a clearinghouse to reduce counterparty risk. We also strongly
support enhanced regulatory oversight of CDS markets and market
participants. Recent events have shown that a poorly managed CDS
business can threaten not only the financial condition of the firm
engaged in that business (e.g., AIG), but also the stability of other
firms and financial markets generally. Additional steps that should be
considered include giving a single Federal financial regulator
additional information gathering authority with respect to
clearinghouse facilities and significant market participants, and
empowering that regulator to adopt such regulations as might be
appropriate to ensure prudent business practices and minimize systemic
risk. Because the CDS market is global, we believe that regulation at
the Federal level, with international consultation and cooperation, is
the right approach. Vesting authority in a single regulator would
promote consistency in the application of regulations and provide
comprehensive oversight of markets and market activity.
President's Working Group Initiatives
Participants in the CDS market generally support the OTC
derivatives oversight and infrastructure initiatives announced by the
President's Working Group on Financial Markets (PWG) on November 14,
2008. In particular, we strongly support implementation of central
counterparty services for CDS. My bank, J.P.Morgan, is an active member
of the group of CDS market participants that have been working to
establish a clearinghouse for CDS transactions and I believe it will be
in operation in a matter of weeks, although full implementation will be
phased in over a period of several months. We believe that the
development of a clearinghouse for credit derivatives with a central
counterparty is an effective way to reduce and mutualize counterparty
credit risk, which in turn will help promote market stability. In
addition to reducing counterparty credit risk and operational risk, the
clearinghouse will facilitate regulatory oversight by providing a
single location for access to information about the CDS transactions it
processes.
We also generally support the PWG's policy objective of improving
the transparency and integrity of the CDS market, although care should
be taken to protect information that might adversely affect the
competitive positions of market participants. We agree with the steps
outlined by the PWG to enhance risk management of OTC derivatives and
would emphasize the importance of consistent standards being adopted by
different regulatory bodies. The objective of further strengthening OTC
derivatives market infrastructure is advisable, although we do not
believe that the use of an exchange for standardized CDS contracts \4\
should be mandated. We believe that the OTC markets and exhange-traded
markets can coexist and that market conditions should determine which
market is used in a particular circumstance. We agree that the ability
to negotiate customized contracts should be maintained.
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\4\ An example of a standardized CDS contract is an index-based CDS
that references a common group of firms and covers a fixed 5 year
period.
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We believe the objective of strengthening cooperation among
regulatory authorities is important, particularly insofar as it
promotes regulatory consistency and efficiency through information
sharing. Minimizing regulatory overlap and duplication results in more
effective regulation without the imposition of unnecessary burdens.
Memorandum of Understanding Between Federal Reserve, CFTC, and SEC
We support the objectives of the Memorandum of Understanding
between the Federal Reserve Board, the CFTC, and the SEC regarding
central counterparties for CDS. Its provisions are designed to confirm
that information can be shared by the agencies without waiving
confidentiality, that information about customers shared among the
agencies is exempt from notice requirements under the Right to
Financial Privacy Act, and that the CFTC can keep private any
information that would disclose confidential business information. We
believe these provisions are appropriate.
Conclusion
Credit default swaps are financial instruments that are useful
tools for managing credit risk. Their importance in our economy is
demonstrated by the tremendous growth in the CDS market in recent
years. We recognize, however, that CDS, like any financial instrument,
can be misused or mismanaged. We believe that the industry's
implementation of a CDS clearinghouse will reduce risk and we
appreciate the encouragement and support that financial regulators have
given to our efforts. Additional steps to improve regulatory oversight
of CDS activities will further reduce risk and we look forward to
working with Members of Congress and regulatory authorities on
initiatives that will enhance the effectiveness of regulation without
imposing unnecessary limitations on the market or its participants.
The Chairman. Thank you, Mr. Thompson. We appreciate your
being with us.
Dr. Corrigan, welcome to the Committee.
STATEMENT OF E. GERALD CORRIGAN, Ph.D., MANAGING DIRECTOR,
GOLDMAN, SACHS & CO., NEW YORK, NY
Dr. Corrigan. Thank you, Mr. Chairman and Members of the
Committee I submitted a rather lengthy statement I will not go
through in any detail. I want to focus specifically on the end
of my statement that focuses on what I call enhanced official
oversight of the CDS-related markets. Here I am suggesting, for
your consideration, five guiding principals and five
suggestions, all of which are focused on enhanced financial
stability, and all of which I believe are consistent with the
spirit of the MOU between the Fed, SEC and CFTC.
The first of those guiding principals, Mr. Chairman, simply
stresses the point that the leadership of major financial
institutions across the board must understand that further
financial commitments of resources are needed to enhance the
stability of these CDS and related markets.
The second principle suggests that regulators, legislators
and market participants alike should exercise great care in
this effort so as not to fall victim to the laws of unintended
consequences.
The third principle suggests that even in face of the
substantial write-downs experience in the CDS base, they must
recognize that subflaws probably reflect flaws in risk
management as much, if not more, than they did in flaws in the
design of the instrument.
Fourth from the viewpoint of financial stability, whether
or not, or to what extent, CDS trades occur on organized
exchanges is not a matter of overriding importance so as long
as the details of such trades are made available on trade date
to the DTCC Warehouse.
And finally, the prompt implementation of a CCP for credit
default swaps will constitute a necessary, but in my judgment,
not sufficient condition to facilitate the orderly wind down of
seriously troubled and highly interconnected financial
institutions.
To get the conditions of both, necessary and sufficiently,
requires in my judgment the following. First, regardless of
which CCP emerges as the industry standard, the authorities
must satisfy themselves that the risk mitigation features of
the CCP will have virtually failsafe operational and financial
integrity, including the capacity to absorb the default of two
of its largest members. Consistent with this philosophy, I
believe there should be a single dedicated global CCP for CDS
transactions, and that any approach that commingles CDS
settlement funds with other funds for other financial
instruments would be unwise.
Second, I think we need to continue to believe on the
leadership of the New York Fed and other regulators to
strengthen and sustain the public-private cooperation that has
been so successful in the last 3 years in dealing with some of
those issues.
Third, I believe the prudential supervisors should be a
part of regular inspections and examinations to ensure that
individual institutions are doing their part in meeting best
practices to deal with these conditions.
Fourth, prudential supervisors should on a case-by-case
basis, make inquiries regarding highly concentrated positions
and crowded trades. And where necessary, encourage or require
individual institutions to moderate the risk of such positions.
And finally, major American participants and their
supervisors must ensure that risk monitoring, risk management
and of special importance corporate governance regarding
practices in the marketplace are subject of continuing and
intense oversight by the private and the official community.
Thank you, Mr. Chairman. I will complete my remarks with that.
[The prepared statement of Dr. Corrigan follows.]
Prepared Statement of E. Gerald Corrigan, Ph.D., Managing Director,
Goldman, Sachs & Co., New York, NY
Chairman Peterson, Ranking Minority Member Goodlatte, and Members
of the Committee, I appreciate the opportunity to appear before you
this afternoon in order to share with you my observations on the
workings of the marketplace for credit default swaps (CDS). My remarks
emphasize the further steps which I believe should be taken to enhance
the efficiency, resiliency and the stability of that marketplace.
Needless to say, the CDS market is widely cited as a significant
contributing factor to the volatility and uncertainty that has been at
the center of the financial market crisis that has gripped the U.S. and
the global financial system for the last 16 months. Having said that, I
want to emphasize at the outset that despite the events of the recent
past, a great deal of effort has, over the past 3 years, been devoted
to enhancing market practices in the CDS space on the part of both the
public and private sectors. Accordingly, I have attached to this
statement two Appendices drawn from the July 27, 2005 and the August 6,
2008 Reports of the Counterparty Risk Management Policy Group (CRMPG)
which contain valuable information on the subject of this hearing
including an imposing list of Recommendations from the 2008 Report for
further strengthening the CDS and related markets.
A number of these Recommendations have been, or are in the process
of being, implemented. Indeed, I would respectfully suggest that had it
not been for the improvements in market practices over the past 3
years, the events of recent months probably would have been even more
damaging as difficult as it is to imagine such an outcome. But, we
should make no mistake about the future reform agenda which remains
formidable.
My written statement covers four subjects that are relevant to the
purpose of the hearing as follows:
Section I: The Nature of the Credit Default Swap Instrument
Section II: The Structure of the Credit Default Swap Market
Section III: Risk Monitoring and Risk Management for CDS Users
Section IV: Enhanced Official Oversight
Section I: The Nature of the Credit Default Swap Instrument \1\
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\1\ For a detailed description of the CDS see Appendix A.
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In essence, the CDS is a deceptively simple financial instrument in
which counterparty A (the seller of credit protection) receives a fee
from counterparty B (the buyer of credit protection) in exchange for
protecting counterparty B against a decline in credit worthiness or a
``credit event'' of a so-called ``reference entity.'' The reference
entity may be a credit claim (a loan or a bond) against a particular
company or country (a single name CDS) or it may be a basket of single
names (an index CDS). The reference entity may also be a specific
asset-backed security or a structured credit product such as a
collateralized debt obligation (CDO).
If the creditworthiness of the reference entity declines--the buyer
of protection (counterparty B in the above example)--gains and the
seller of protection (counterparty A above)--loses. In the extreme case
in which the reference entity experiences a ``credit event'' (such as a
default), the buyer of protection (counterparty B) delivers the
defaulted instrument to the seller of protection (counterparty A) and
receives the par amount of the CDS contract. Needless to say, in a
volatile financial market environment in which credit quality is
falling and the risk of default is rising, the counterparty risk
management process in the CDS market becomes very challenging--to put
it mildly (see Section III below).
Section II: The Structure of the Credit Default Swap Market
The CDS market is comprised largely of sophisticated financial
institutions. There are about 16 so-called ``dealers'' at the center of
the CDS market. These dealers--all of which are owned and controlled by
major U.S. and foreign banking institutions--play the vital role of
market makers in a wide array of financial instruments including CDS.
They also take proprietary positions in these instruments, in part, as
a natural extension of their market making activities. While precise
estimates of activity levels in the CDS market are not easy to compile,
most observers would suggest that something approximating 90 percent of
overall activity in the CDS market can be attributed to the dealer
community. Whatever the precise number, it necessarily follows that the
bilateral and multilateral counterparty risk exposures among the
dealers to each other are very large.
The balance of the CDS market is comprised of several other classes
of institutions including corporates, insurers (including monolines)
and, in particular, hedge funds. As described in Appendix A, the
rationale as to why individual institutions and classes of institutions
choose to participate in the CDS market varies considerably across
classes of institutions and over the credit cycle. At the risk of
considerable oversimplification, however, the motivation for
participation centers around a few key factors including (1) satisfying
the needs of clients; (2) an explicit decision to be either long or
short credit risk; and (3) an explicit decision to hedge credit risk.
Reflecting in part the huge structural changes in financial markets
over the past decade or so and the even larger changes in the macro-
economic and the macro-financial environment over the past 5 years, the
growth of the CDS market has been explosive--and then some. Over
roughly the last decade, the CDS market also experienced a radical
transformation from a market that was, in large part, designed to
mitigate relatively infrequent events (defaults) to a market that is
dominated by trading activity in which very large trades with short
durations are commonplace.
It is these patterns of trading activity that produce the headline
news items about the $60 trillion plus notional size of the CDS market
even as we all know that notional amounts tell us very little about
risk factors for the marketplace and its participants.
Unfortunately, the industry itself contributed to the focus on the
gross notional sizes of the CDS market. That is, until recently when
new trades were put in place to offset existing trades the existing
trades typically were not closed out, thus swelling the gross notional
size of the market. In recent weeks, and months, joint public-private
efforts aimed at ``trade compression'' have resulted in dramatic
declines in the gross notional amounts of CDS outstanding. For example,
information released recently indicates that trade compression efforts
have eliminated the notional value of CDS outstanding by $27 trillion.
Further reductions are expected in the period ahead such that even with
new transactions growing rapidly, the notional amount of CDS will soon
fall below $30 trillion and will trend still lower over time.
There is one other feature of the CDS market that should be
highlighted; namely, while in trade count terms a significant fraction
of CDS trades are straight-forward in design and structure, a
relatively small number of high value trades are highly structured and
highly complex. These so-called ``bespoke'' trades are often initiated
by clients of financial intermediaries and require quite complex and
unique documentation. These bespoke trades are a very important source
of the value added provided by the CDS market. Thus, efforts aimed at
reform must not be so rigid and mechanical so as to undercut the
ability of the market to forge unique solutions to unique problems.
Section III: Risk Monitoring and Risk Management for CDS Users
With the benefit of hindsight it is quite obvious that a number of
large and sophisticated financial institutions experienced shortcomings
in their risk monitoring and risk management activities before and
during the crisis and that some such shortcomings occurred in the CDS
space. The mere presence of a small number of highly concentrated CDS
risk exposures across the financial landscape tells us in unmistaken
terms that some market participants were quite slow in recognizing that
these exposures risked material write-downs and very sizeable
collateral calls. It is also true that the more complex the reference
entity (e.g., CDO's), the more difficult it is to anticipate credit
problems and the more likely it is that collateral disputes between
counterparties will arise. Having said that, failures in risk
monitoring and risk management were by no means limited to the CDS
space in a context in which hedging opportunities made possible by the
CDS surely did help many institutions to mitigate credit exposures.
All of this raises the very difficult analytical question of
whether, on balance, the CDS tempered or amplified the credit crisis.
While I believe that we will gravitate toward an informed answer to
that question only with the passage of time, based on what we now know
I see the CDS as a net plus. In saying that, I must acknowledge that
the CDS and other segments of the financial markets have benefited
greatly from large scale central bank and governmental interventions.
It is also true that the CDS market has benefited from a handful of
recently implemented critical reforms as follows:
(1) The prohibition against novation of trades without the consent
of the initial counterparty;
(2) huge reductions in unsigned trade confirmations;
(3) major advances in automation covering all steps in the trade
processing cycles;
(4) the building of a consensus approach to cash settlement in the
event of a reference entity default which proved extremely
valuable in the credit events at the housing GSE's and Lehman;
(5) the agreement among the dealers on the use of a common close
out methodology which, fortunately, was put in place only weeks
before the Lehman bankruptcy. Had this agreement not been in
place the very challenging aftermath of the Lehman bankruptcy
would been an even greater blow to market confidence; and
(6) important strides have been made in increasing the transparency
of the CDS market.
Turning to the subject of risk management more generally, Appendix
A explains, in straight-forward terms, the nature of the risks
associated with the CDS instrument. In examining the events leading up
to and including the crisis it is quite clear that the very large
write-downs and losses witnessed in the CDS space were importantly
driven by either or both ``basis'' risk and ``counterparty'' risk.
To a considerable degree the basis risk problem arose because
efforts to hedge risks did not always perform as expected due to
sometimes very large disparities in the absolute and relative movements
in the prices of position being hedged and the CDS designed to provide
the hedge. In a few cases even the algebraic sign of the hedge was
wrong; that is the price of the underlying asset and the hedging
instrument actually moved in the same direction!
With regard to counterparty risk, it has been widely recognized in
the press and elsewhere that highly concentrated positions at a
relatively small number of institutions--particularly sellers of
protection involving complex reference entities--resulted in massive
collateral calls which caused large write-downs and impaired the
liquidity position of the institutions in question. Even worse, there
were situations in which basis risk, counterparty risk, and the
embedded leverage in certain classes of structured credit products
interacted with each other in ways that amplified contagion and
volatility, and multiplied the size of margin calls and write-downs.
The legacy of these events in the CDS space will be with us for a
long time. However, as we seek to draw lessons from these events we
must proceed with care. Indeed, as discussed in the next section of
this statement, I believe that the agenda for further reform in the CDS
space is reasonably clear even if full implementation of the agenda
will be challenging and time consuming.
Section IV: Enhanced Official Oversight
Given all that has occurred on the financial front over the past 16
months, it is only natural that this Committee, the Congress as a whole
and the public at large are focused on enhanced official oversight of
financial markets and institutions. Fortunately, the Memorandum of
Understanding entered into by the FED, the SEC and the CFTC on November
14, 2008 regarding ``Central Counterparties for Credit Default Swaps''
provides something of an anchor for such focus as it applies to CDS and
OTC derivatives more generally.
As I see it, the approach to enhance official oversight should be
based on five guiding principles and five suggestions, all of which are
focused on financial stability, as follows:
Guiding Principles
First; the financial industry, broadly defined, must recognize at
the highest levels of management that a substantial further
commitment of leadership and resources must be devoted to
necessary enhancements in the efficiency, resiliency, stability
and integrity of the OTC markets with specific emphasis on the
CDS.
Second; in shaping the reform agenda, the regulators, legislators
and market participants should exercise great care so as not to
fall victim to the laws of unintended consequences. As an
example, even the hint of an approach that would raise
questions about the legal standing of existing contracts could
materially worsen the already badly shaken confidence in
financial markets and institutions.
Third; even in the face of substantial write-downs experienced by
some institutions in the CDS space, we must recognize that such
losses probably reflect flaws in risk management much more than
they reflect flaws in the instrument.
Fourth; from the viewpoint of financial stability, whether or to
what extent CDS trades occur on organized exchanges is not a
matter of overriding concern so long as the details of all such
trades are made available on trade date to the DTCC warehouse.
Finally; the prompt implementation of a CCP for credit default
swaps will constitute a necessary, but not sufficient,
condition to facilitate the orderly wind-down of seriously
troubled and highly inter-connected financial institutions.
With those guiding principles in mind, I would offer the following
specific suggestions as to official initiatives that would further
strengthen the CDS and related OTC derivatives markets. These
suggestions are all focused on measures to further mitigate systemic
risk. As such they complement the CCP and bring us closer to the goals
of achieving the necessary and sufficient conditions of containing
systemic risk arising from these markets.
Suggestions To Mitigate Systemic Risk
First; regardless of which CCP emerges as the industry standard,
the authorities must satisfy themselves that the risk
mitigation features of the CCP have virtually failsafe
operational and financial integrity including the capacity to
absorb the default of two of its largest members. Consistent
with this philosophy, I also believe that there should be a
single dedicated global CCP for CDS and that any approach that
co-mingles CDS settlement funds with settlement funds for other
financial instruments is unwise.
Second; building on the highly effective leadership of the New York
Fed and the community of domestic and international
supervisors, we must sustain and strengthen the public-private
cooperative efforts to ensure that the necessary steps to
strengthen the industry wide infrastructure surrounding the OTC
markets are implemented in a timely fashion. These necessary
initiatives are outlined in Appendix B.
Third; prudential supervisors should, as a part of their regular
inspections and examinations, insure that individual
institutions are doing their part to insure that such
institutions' policies, practices, procedures and operating
systems regarding the needed infrastructure improvements are in
line with industry best practices.
Fourth; prudential supervisors should, on a case by case basis,
make inquiries regarding highly concentrated positions and
crowded trades and, where necessary, encourage or require
individual institution to moderate the risks of such positions.
On a voluntary basis, hedge funds and other unregulated
financial institutions should be willing to respond to similar
inquiries or face the prospects of greater direct regulation.
Finally; major market participants and their supervisors must
ensure that risk monitoring, risk management and, of special
importance, corporate governance practices are in line with
best practices with particular emphasis on monitoring exposures
and the application of rigorous valuation and price
verification practices to complex transactions. Among other
things, such best practices will play a constructive role in
quickly resolving collateral disputes.
These five guiding principles and five suggestions to enhance
official oversight of the OTC derivatives markets are, I believe, very
much consistent with the spirit of the FED, SEC and CFTC Memorandum of
Understanding. More importantly, they are also consistent with the
broader objective of enhancing our shared vision of greater financial
stability while striking a constructive and modest re-balancing of the
role of marketplace and the role of public policy in fostering a more
disciplined approach to financial intermediation, which of course, is
essential to economic growth and rising standards of living.
Appendix A
The following is an extract from the July 27, 2005 Report of the
Counterparty Risk Management Policy Group II entitled ``Toward Greater
Financial Stability: A Private Sector Perspective.''
The credit default swap (CDS) is the cornerstone of the
credit derivatives market. A credit default swap is an
agreement between two parties to exchange the credit risk of an
issuer (reference entity). The buyer of the credit default swap
is said to buy protection. The buyer usually pays a periodic
fee and profits if the reference entity has a credit event, or
if the credit worsens while the swap is outstanding. A credit
event includes bankruptcy, failing to pay outstanding debt
obligations or, in some CDS contracts, a restructuring of a
bond or loan. Buying protection has a similar credit risk
position to selling a bond short, or ``going short risk.''
The seller of the credit default swap is said to sell
protection. The seller collects the periodic fee and profits if
the credit of the reference entity remains stable or improves
while the swap is outstanding. Selling protection has a similar
credit risk position to owning a bond or loan, or ``going long
risk.''
Other noteworthy aspects of the credit default swap market
include:
The most commonly traded and therefore the most liquid
tenors for credit
default swap contracts are 5 and 10 years. Historically,
volumes are con-
centrated in the 5 year maturity. One large financial
intermediary esti-
mates that 70% of the CDS volume is in this tenor, with
20% in longer ma-
turities and 10% in shorter maturities. Liquidity across
the maturity curve
continues to develop, however, demonstrated by CDX
indices, which are
quoted in the 1, 2, 3, 4, 5, 7, and 10 year tenors.
Standard trading sizes vary depending on the reference
entity. For exam-
ple, in the U.S., $10 million-$20 million notional is
typical for investment
grade credits, and $2 million-$5 million notional is
typical for high yield
credits. In Europe, =10 million notional is typical for
investment grade cred-
its, and =2 million-=5 million notional is typical for
high yield credits.
Credit default swap indices provide investors with a single,
liquid vehicle through which to take diversified long or short
exposure to a specific credit market or market segment. The
first index product was the High Yield Debt Index (HYDI),
created by JPMorgan in 2001. Like the S&P 500 and other market
benchmarks, the credit default indices reflect the performance
of a basket of credits, namely a basket of single-name credit
default swaps (credit default swaps on individual credits). CDS
indices exist for the U.S. investment-grade and high-yield
markets, the European investment-grade and high-yield markets,
the Asian markets and global emerging markets.
Unlike a perpetual index like the S&P 500, CDS indices have a
fixed composition and fixed maturities. New indices with an
updated basket of underlying credits are launched periodically,
at least twice a year. New indices are launched in order to
reflect changes in the credit market and to give the index more
consistent duration and liquidity. When a new index is launched
(dubbed the ``on-the-run index''), the existing indices
continue to trade (as ``off-the-run'') and will continue to
trade until maturity. The on-the-run indices tend to be more
liquid than the off-the-run indices.
Probably the most important event in the CDS market in 2004
was the establishment of one credit derivative index family.
The establishment of the Dow Jones CDX index family in the U.S.
and the Dow Jones iTraxx' index family in Europe and
Asia in the second quarter has led to increased liquidity in
index products and the growth of other products (volatility,
correlation) that require a standard, liquid underlying market.
In DJ CDX Investment Grade and High Yield, bid/offer spreads
have halved due to the liquidity benefit of having one single
index family, and transaction volumes have increased.
1. Forces Driving Market Activity
Credit derivatives have been widely adopted by credit market
participants as a tool for managing exposure to, or investing
in, credit. The rapid growth of this market is largely
attributable to the following features of credit derivatives:
1.1. Credit derivatives allow the disaggregation of
credit risk from other risks inherent in traditional
credit instruments
A corporate bond represents a bundle of risks
including interest rate, currency (potentially) and
credit risk (constituting both the risk of default and
the risk of volatility in credit spreads). Before the
advent of credit default swaps, the primary way for a
bond investor to adjust his credit risk position was to
buy or sell that bond, consequently affecting his
positions across the entire bundle of risks. Credit
derivatives provide the ability to independently manage
default risk.
1.2. Credit derivatives provide an efficient way to
short a credit
While it can be difficult to borrow corporate bonds
on a term basis or enter into a short sale of a bank
loan, a short position can be easily achieved by
purchasing credit protection. Consequently, risk
managers can short specific credits or a broad index of
credits, either as a hedge of existing exposures or to
profit from a negative credit view.
1.3. Credit derivatives create a market for ``pure''
credit risk that allows the market to transfer credit
risk to the most efficient holder of risk
Credit default swaps represent the cost to assume
``pure'' credit risk. Bond, loan, equity and equity-
linked market participants may transact in the credit
default swap market. Because of this central position,
the credit default swap market will often react faster
than the bond or loan markets to news affecting credit
prices. For example, investors buying newly issued
convertible debt are exposed to the credit risk in the
bond component of the convertible instrument, and may
seek to hedge this risk using credit default swaps. As
buyers of the convertible bond purchase protection,
spreads in the CDS market widen. This spread change may
occur before the pricing implications of the
convertible debt are reflected in bond market spreads.
However, the change in CDS spreads may cause bond
spreads to widen as investors seek to maintain the
value relationship between bonds and CDS. Thus, the CDS
market can serve as a link between structurally
separate markets. This has led to more awareness of and
participation from different types of investors.
1.4. Credit derivatives can provide additional
liquidity in times of turbulence in the credit markets
The credit derivative market can provide additional
liquidity during periods of market distress (high
default rates). Before the credit default swap market,
a holder of a distressed or defaulted bond often had
difficulty selling the bond, even at reduced prices.
This is because cash bond desks are typically long risk
as they own an inventory of bonds. As a result, they
are often unwilling to purchase bonds and assume more
risk in times of market stress. In contrast, credit
derivative desks typically hold an inventory of
protection (short risk), having bought protection
through credit default swaps. In distressed markets,
investors may be able to reduce long risk positions by
purchasing protection from credit derivative desks,
which may be better positioned to sell protection (long
risk) and change their inventory position from short
risk to neutral. Furthermore, the CDS market creates
natural buyers of defaulted bonds, as protection
holders (short risk) buy bonds to deliver to the
protection sellers (long risk). CDS markets, therefore,
have tended to increase liquidity across many credit
market segments.
As the chart below illustrates, CDS volumes as a
percentage of cash volumes increased steadily during
the distressed spring and summer of 2002 in the face of
credit-spread volatility and corporate defaults.
1.5. Credit derivative transactions are confidential
As with the trading of a bond in the secondary
market, the reference entity whose credit risk is being
transferred is neither a party to a credit derivative
transaction nor is even aware of it. This
confidentiality enables risk managers to isolate and
transfer credit risk discreetly, without affecting
business relationships. In contrast, a loan assignment
through the secondary loan market may require borrower
notification and may require the participating bank to
assume as much credit risk to the selling bank as to
the borrower itself. Because the reference entity is
not a party to the negotiation, the terms of the credit
derivative transaction (tenor, seniority and
compensation structure) can be customized to meet the
needs of the buyer and seller, rather than the
particular liquidity or term needs of a borrower.
2. Long and Short Users
The following is a brief summary of strategies employed by
the key players in the credit derivatives market:
2.1. Banks and loan portfolio managers
Banks were once the primary players in the credit
derivatives market. They developed the CDS market in
order to reduce their risk exposure to companies to
whom they lent money, thereby reducing the amount of
capital needed to satisfy regulatory requirements.
Banks continue to use credit derivatives for hedging
both single-name and broad market credit exposure.
2.2. Market makers
In the past, market markers in the credit markets
were constrained in their ability to provide liquidity
because of limits on the amount of credit exposure they
could have on one company or sector. The use of more
efficient hedging strategies, including credit
derivatives, has helped market makers trade more
efficiently while employing less capital. Credit
derivatives allow market makers to hold their inventory
of bonds during a downturn in the credit cycle while
remaining neutral in terms of credit risk. To this end,
a number of dealers have integrated their CDS trading
and cash trading businesses.
2.3. Hedge funds
Since their early participation in the credit
derivatives market, hedge funds have continued to
increase their presence and have helped to increase the
variety of trading strategies in the market. While
hedge fund activity was once primarily driven by
convertible bond arbitrage, many funds now use credit
default swaps as the most efficient method to buy and
sell credit risk. Additionally, hedge funds have been
the primary users of relative value trading
opportunities and new products that facilitate the
trading of credit spread volatility, correlation and
recovery rates.
2.4. Asset managers
Asset managers have significantly increased their
participation in the credit derivatives market in
recent years. Asset managers are typically end users of
risk that use the CDS market as a relative value tool,
or to provide a structural feature they cannot find in
the bond market, such as a particular maturity. Also,
the ability to use the CDS market to express a bearish
view is an attractive proposition for many asset
managers. Prior to the availability of CDS, an asset
manager would generally be flat or underweight in a
credit they did not like, as most were unable to short
bonds in their portfolios. Now, many asset managers may
also buy credit protection as a way to take a short-
term neutral stance on a credit while taking a bullish
longer term view. For example, an asset manager might
purchase 3 year protection to hedge a 10 year bond
position on an entity where the credit is under stress
but is expected to perform well if it survives the next
3 years. Finally, the emergence of a liquid CDS index
market has provided asset managers with a vehicle to
efficiently express macro views on the credit markets.
2.5. Insurance companies
The participation of insurance companies in the
credit default swap market can be separated into two
distinct groups: (1) life insurance and property &
casualty (P&C) companies and (2) monolines and
reinsurers. Life insurance and P&C companies typically
use credit default swaps to sell protection to enhance
the return on their asset portfolio either through
Replication (Synthetic Asset) Transactions (``RSATs''
or the regulatory framework that allows some insurance
companies to enter into credit default swaps) or
credit-linked notes. Monolines and reinsurers often
sell protection as a source of additional premium and
to diversify their portfolios to include credit risk.
2.6. Corporations
Corporations are recent entrants to the credit
derivatives market and promise to be an area of growth.
Most corporations focus on the use of credit
derivatives for risk management purposes, though some
invest in CDS indices and structured credit products as
a way to increase returns on pension assets or balance
sheet cash positions.
Recent default experiences have made corporate risk
managers more aware of the amount of credit exposure
they have to third parties and have caused many to
explore alternatives for managing this risk. Many
corporate treasury and credit officers find the use of
CDS appealing as an alternative to credit insurance or
factoring arrangements due to the greater liquidity,
transparency of pricing and structural flexibility
afforded by the CDS market. Corporations are also
focused on managing funding costs; to this end, many
corporate treasurers monitor their own CDS spreads as a
benchmark for pricing new bank and bond deals and are
exploring how the CDS market can be used to hedge
future issuance.
3. Risk Management Issues
The risk profile of a credit default swap is essentially
equivalent to the credit risk profile of a bond or loan, with
some additional risks, namely counterparty risk, basis risk,
legal risk and operational risk.
3.1. Counterparty risk
Recall that in a credit event, the buyer of
protection (short risk) delivers bonds of the defaulted
reference entity, or other eligible assets, and
receives par from the seller (long risk). Therefore, an
additional risk to the protection buyer is that the
protection seller may not be able to pay the full par
amount upon default. This risk, referred to as
counterparty credit risk, is a maximum of par less the
recovery rate, in the event that both the reference
entity and the counterparty default. While the
likelihood of suffering this loss is remote, the
magnitude of the loss given default can be material.
Counterparties typically mitigate this risk through the
posting of collateral (as defined in a credit support
annex (CSA) to the ISDA Master Agreement) rather than
through the adjustment of the price of protection.
3.2. Basis risk
Basis refers to the difference, in basis points,
between a credit default swap spread and a bond's par
equivalent CDS spread with the same maturity dates.
Basis is either zero, positive or negative.
If the basis is negative, then the credit default
swap spread is lower than the bond's spread. This
occurs when there is excess protection selling
(investors looking to go long risk and receive periodic
payments), reducing the CDS coupon. Excess protection
selling may come from structured credit issuers (or CDO
issuers), for example, who sell protection in order to
fund coupon payments to the buyers of structured credit
products. Protection selling may also come from
investors who lend at rates above LIBOR. For these
investors, it may be more economical to sell protection
and invest at spreads above LIBOR rather than borrow
money and purchase a bond.
If the basis is positive, then the credit default
spread is greater than the bond's spread. Positive
basis occurs for technical and fundamental reasons. The
technical reasons are primarily due to imperfections in
the repo market for borrowing bonds. Specifically, if
cash bonds could be borrowed for extended periods of
time at fixed costs, then there would not be a reason
for bonds to trade ``expensive'' relative to credit
default swaps. If a positive basis situation arises,
investors would borrow the bonds and sell them short,
eliminating the spread discrepancy. In practice, there
are significant costs and uncertainties in borrowing
bonds. Therefore, if the market becomes more bearish on
a credit, rather than selling bonds short, investors
may buy default protection. This may cause credit
default swap spreads to widen compared with bond
spreads.
Another technical factor that causes positive basis
is that there is, to some degree, a segmented market
between bonds and credit default swaps. Regulatory,
legal and other factors prevent some holders of bonds
from switching between the bond and credit default swap
markets. These investors are unable to sell a bond and
then sell protection when the credit default swap
market offers better value. Along this vein of
segmented markets, sometimes there are market
participants, particularly coming from the convertible
bond market, who wish to short a credit (buy default
swap protection) because it makes another transaction
profitable. These investors may pay more for the
protection than investors who are comparing the bonds
and credit default swap markets. This is another
manifestation of the undeveloped repo market.
A fundamental factor that creates positive basis is
the cheapest-to-deliver option. A short CDS position
(long risk) is short the cheapest-to-deliver option. If
there is a credit event, the protection buyer (short
risk) is contractually allowed to choose which bond to
deliver in exchange for the notional amount. This
investor will generally deliver the cheapest bond in
the market. When there is a credit event, bonds at the
same level of the capital structure generally trade at
the same price (except for potential differences in
accrued interest) as they will be treated similarly in
a restructuring. Still, there is the potential for
price disparity. Thus, protection sellers may expect to
receive additional spread compared to bonds for bearing
this risk. This would lead to CDS spreads trading wider
than bond spreads and therefore contribute to positive
basis. Thus, when investors invest in credit default
swaps, they risk entering into a position that is
relatively expensive as compared to entering into a
similar risk position with bonds or loans.
3.3. Legal risk
Credit default swaps investors may face legal risk if
there is a credit event and the legality of the CDS
contract is challenged. Although not without specific
disputes, as previously stated, ISDA's standard
contract has generally proven effective in the face of
significant credit market stress. The large majority of
contracts have tended to settle without disputes or
litigation. As discussed in Section IV of the main
CRMPG II Report, legal issues can and do arise in this
market from time to time. Most of these disputes have
involved contractual claims related to whether there
was a credit event under the terms of the contract, the
identity of the reference entity, the timeliness of
notices delivered under the contract, the nature of the
assets deliverable into the contract and the timeliness
of the delivery of assets for settlement purposes.
3.4. Operational risk
With limited straight through processing,
confirmation backlogs, and a clearing service in
relatively early stages of operation, back offices have
tended to feel the strain of handling a rapidly growing
volume of activity. The recent credit event in which
gross positions in the reference entity exceeded the
available deliverable assets highlighted the potential
difficulty for market participants in settling
transactions in a timely and efficient manner. Section
IV of the main CRMPG II Report addresses these issues
more fully.
Other risk considerations:
Credit default swaps are leveraged transactions.
Unlike a transaction
related to floating rate notes or corporate bonds
with a similar amount
of credit risk, principal amount is not exchanged
upfront in a CDS.
As noted above, large and/or sophisticated
counterparties typically
mitigate the risk of non-performance by the daily
updating of collat-
eral accounts reflecting gains or losses on
positions.
Credit default swaps are over-the-counter
transactions between two
parties and it is difficult to estimate the amount
of default swaps
which are outstanding. While the net amount of all
credit default
swaps is zero, as the amount of long protection
positions must be
equal to the short protection position, there may be
market partici-
pants who are very long or short exposure to
specific credits.
In marking the value of an open credit default swap
to market, invest-
ors must estimate a recovery rate. If investors
deviate from industry
standard recovery rates, they can calculate
different values for their
open contracts.
Appendix B
CRMPG III Recommendations
The following is an extract from the August 6, 2008 Report of the
Counterparty Risk Management Policy Group III entitled ``Containing
Systemic Risk: The Road to Reform.''
Recommendation
Number
V-1. The Policy Group recommends trade date (T+0)
matching for electronically eligible transactions.
Goal: End 2009.
V-5. The Policy Group recommends that market participants
should seek to streamline their methods for trade
execution and confirmation/affirmation, which
should facilitate an end-to-end process flow
consistent with same-day matching and legal
confirmation.
V-6. The Policy Group recommends that senior leaders of
trading support functions should clearly articulate
to senior management the resource requirements
necessary to achieve the same-day standards.
Recognizing the expense management imperatives
driven by recent market conditions, senior
management should make every effort to help support
functions achieve these standards for the
overarching benefit of enhancing market resilience.
Goal: Ongoing.
V-10. The Policy Group further recommends frequent
portfolio reconciliations and mark-to-market
comparisons, including on collateralized
instruments.
Goal: Weekly end 2008, moving to daily for
electronically eligible trades mid 2009.
V-11. ISDA Credit Support Annex documents spell out the
bilateral terms of the margin process. While the
process is generally standardized, the Policy Group
recommends that the industry needs to find an
effective means to resolve valuations disputes,
particularly for illiquid products. Doing so is
likely to be a difficult and demanding matter and
therefore an industry-wide approach may have to be
considered.
Goal: End of 2009.
V-12. The Policy Group recommends that, as mark-to-market
disputes inevitably surface through the collateral
portfolio reconciliation process, the information
should be passed to the executing trading desks on
a real-time basis to allow for research and
resolution. This should, of course, be done with
appropriate anonymity of the counterparty's
identity, positions, and broader portfolio. A close
alignment of the collateral team with trading
desks--without violating the fire walls and
controls that are critically important to the
integrity of the financial system--would facilitate
such information sharing. As necessary, significant
and large value collateral disputes should promptly
be escalated to the appropriate senior officers.
Goal: Immediate.
V-14. The Policy Group recommends that market participants
actively engage in single name and index CDS trade
compression. ISDA has agreed on a mechanism to
facilitate single name trade compression with
Creditex and Mark-it Partners. Established vendor
platforms exist for termination of offsetting index
trades, and we urge major market participants to
aggressively pursue their use.
V-15. Based on the considerations above, the Policy Group
recommends that the industry, under the auspices of
the current ISDA Portfolio Compression Working
Group, commit immediately and with all due speed to
achieve consistency of the current product,
including potentially:
V-16. The Policy Group recommends that ISDA should update
its Credit Derivative Definitions to incorporate
the auction mechanism so that counterparties to new
credit default swap trades commit to utilize the
auction mechanism in connection with future credit
events.
V-18. The Policy Group recommends that all large
integrated financial intermediaries (e.g., the
major dealers) should promptly adopt the Close-out
Amount approach for early termination upon default
in their counterparty relationships with each
other. We note that this can be agreed and suitably
documented without making any other changes to the
ISDA Master. The Policy Group expects that these
arrangements will be in place in the very near
term.
V-20. The Policy Group recommends that all major market
participants should periodically conduct
hypothetical simulations of close-out situations,
including a comprehensive review of key
documentation, identification of legal risks and
issues, establishing the speed and accuracy with
which comprehensive counterparty exposure data and
net cash outflows can be compiled, and ascertaining
the sequencing of critical tasks and decision-
making responsibilities associated with events
leading up to and including the execution of a
close-out event.
V-21. The Policy Group recommends that all market
participants should both promptly and periodically
review their existing documentation covering
counterparty terminations and ensure that they have
in place appropriate and current agreements
including the definition of events of default and
the termination methodology that will be used.
Where such documents are not current, market
participants should take immediate steps to update
them. Moreover, each market participant should make
explicit judgments about the risks of trading with
counterparties who are unwilling or unable to
maintain appropriate and current documentation and
procedures.
V-22. The Policy Group recommends that the industry should
consider the formation of a ``default management
group'', composed of senior business
representatives of major market participants (from
the buy-side as well as the sell-side) to work with
the regulatory authorities on an ongoing basis to
consider and anticipate issues likely to arise in
the event of a default of a major market
counterparty.
V-23. Recognizing the benefits of a counterparty clearing
arrangement (CCP) as discussed above, the Policy
Group strongly recommends that the industry develop
a CCP for the credit derivatives market to become
operational as soon as possible and that its
operations adhere to the BIS Recommendations.
The Chairman. Thank you very much, Dr. Corrigan, I
appreciate your testimony.
And last, Mr. Murtagh.
STATEMENT OF BRYAN M. MURTAGH, J.D., MANAGING
DIRECTOR, FIXED INCOME TRANSACTION RISK
MANAGEMENT, UBS SECURITIES LLC, STAMFORD, CT
Mr. Murtagh. Thank you. Chairman Peterson, and Members of
the Committee my name is Bryan Murtagh. I am Managing Director
in UBS Investment Bank Fixed Income Division. I am responsible
for Fixed Income's transaction risk management function in the
Americas.
I am pleased to appear before you today on behalf of the
UBS Investment Bank to discuss the role of credit derivatives
on financial markets and the regulatory framework that governs
them. As the Committee is aware from its earlier hearings,
there is a broad consensus among market participants and
regulators that credit default swaps are a valuable risk
management tool that they provide substantial benefits to U.S.
and global economy.
With respect to the Committee's interest in the regulatory
framework for these products I would note that based
principally on the institutional nature of market participants,
the current regulatory framework applicable is based primarily
on oversight and supervision of market participants. As a
result conduct in the credit default swap market is regulated
through the supervision of derivative dealers by primary
regulators. This is the case in the U.S. and overseas.
Consistent with the regulatory and supervisory
responsibilities over OTC derivative dealers the relevant U.S.
and international regulatory authorities launched a series of
initiatives in 2005 to improve OTC derivative operations and
risk management policies. It should be emphasized that the need
to address the operational risk associated with directly
expanding OTC derivatives market when identified by the dealer
community and the counterparty risk management policy groups
2005 report on OTC derivative markets well before the onset of
the current crisis in the credit markets. These efforts have
been extremely unsuccessful in reducing operational risk in the
credit derivative markets. Nevertheless, the current distress
in our financial markets underscores the importance of
continuing these efforts and, indeed, these efforts are
continued.
On October 31st, dealers and major buy-side institutions
committed to a series of new initiatives, significantly these
commitments were accompanied by detailed memorandum summarizing
the progress to date and outlining the plans for future
enhancements of the OTC derivatives markets. A central
component of these new commitments is the implementation of
central counterparty for credit default swaps, which the
President's Working Group described as its top near term
priority for the OTC derivatives markets.
UBS and other major dealers have been actively involved in
the development of an essential counterparty for the past 2
years. UBS is supportive of President's Working Group
commitment to implementation of one or more central
counterparties in this regard.
We applaud the adoption of the multi-agency Memorandum of
Understanding that was designed to insure that jurisdictional
issues do not interfere with the prompt implementation of
central counterparties.
As a final point it should be emphasized that considerable
time and effort has been dedicated by the industry to develop a
central counterparty. While UBS is supportive of the
establishment of one or more central counterparties, we believe
it is imperative that Congress and the relevant regulatory
agencies permit the industries initiatives to proceed.
In conclusion, we believe that the improvements made to
date coupled with our plans for further enhancements, and the
positive dialogue between dealers and the regulatory agencies,
demonstrate the industry's commitment to strengthen the credit
derivatives market and support the policy objectives set forth
by the President's Working Group.
UBS looks forward to working with the Congress, the
President's Working Group and other market participants to
enhance the credit derivatives market by developing robust
operational practices and infrastructure to support credit
default swap trading.
Mr. Chairman, thank you for the opportunity to share our
views with the Committee. I will be happy to answer any
questions that you or Members of the Committee may have.
[The prepared statement of Mr. Murtagh follows:]
Prepared Statement of Bryan M. Murtagh, J.D., Managing Director, Fixed
Income Transaction Risk Management, UBS Securities LLC, Stamford, CT
Chairman Peterson, Ranking Member Goodlatte and Members of the
Committee, thank you for inviting UBS to participate in this hearing to
review the role of credit derivatives in the U.S. economy and the
regulatory framework that governs them.
My name is Bryan Murtagh. I am a Managing Director in UBS
Investment Bank's Fixed Income Division and am responsible for Fixed
Income's transactional risk management function in the Americas. In
this capacity, I address legal, regulatory, operational and other
issues associated with new businesses, new products and structured
transactions, including various forms of credit derivatives.
UBS is a global financial services firm with operations in over 50
countries, including a sizeable presence in the United States, where we
employ approximately 30,000 individuals in our Asset Management,
Investment Bank and Wealth Management businesses. The views expressed
here relate to the Investment Bank.
I understand that the Committee has held several hearings with
respect to the nature of the credit derivatives market and its
regulation. As the Committee is particularly interested in credit
default swaps, I will focus my comments on those instruments.
Overview of Credit Derivative Market and Credit Default Swaps
Broadly speaking, credit derivatives are financial instruments that
transfer the credit risk associated with a particular financial asset
or a reference entity from one party to another party without
transferring the underlying financial asset. These instruments are
generally traded by financial institutions and certain financially
sophisticated corporations and institutional investors (such as hedge
funds). As a general rule, retail investors do not participate in the
credit derivative market.
Credit default swaps (CDS) are a particular type of credit
derivative. Specifically, CDS are privately negotiated contracts
between two institutional counterparties in which one of the parties
(generally called the ``seller of protection'') takes on exposure to
the credit risk of a third party (generally called the ``reference
entity'') in return for periodic payments from the other transacting
party (generally called the ``buyer of protection''). If certain types
of credit-related defaults (generally called ``credit events''), occur
in respect to the reference entity, then the buyer of protection may be
entitled to transfer qualifying debt obligations of the reference
entity to the seller of protection at an agreed-upon price. This so-
called ``physical settlement'' of the CDS transaction results in the
seller of protection assuming the risk associated with collecting any
amounts owed in respect to the delivered obligation.
Alternatively, the buyer and seller of protection may agree that,
upon the occurrence of a credit event, the seller of protection will
make a cash payment to the buyer of protection which is calculated
based on the trading price of qualifying obligations of the reference
entity. This so-called ``cash settlement'' alternative may be agreed to
at the outset of the CDS transaction or may be agreed to upon the
occurrence of the credit event.
In recent years, CDS market participants have increasingly relied
on the cash settlement alternative to settle large numbers of CDS
transactions following the occurrence of a credit event. These cash
settlements have been accomplished through so-called auction protocols,
in which market participants voluntarily agree to cash settle their CDS
transactions based on an auction process. While market participants are
not obligated to utilize the cash settlement auction protocol, an
overwhelming number of CDS transactions have been settled through these
voluntary protocols. This practice has significantly eased the
operational pressures associated with the simultaneous settlement of
large numbers of CDS transactions which follows the occurrence of a
credit event.
Most credit default swaps relate to reference entities that are
sovereigns or corporations. Over the last few years a number of indices
referencing various segments of the credit market (e.g., U.S.
investment grade reference entities, U.S. non-investment grade
reference entities, European investment grade reference entities) have
been developed and have become the subject of significant trading in
the credit default swap market. In addition, there are several kinds of
specialized credit default swaps referencing mortgage-backed securities
and other asset-backed securities (generally referred to as ``CDS on
ABS'' transactions), but the number of transactions of these types is
only a small part of the credit default swap market. Accordingly, my
comments focus on CDS relating to corporate reference entities and to
the related indices since they represent the overwhelming majority of
transactions in the credit default swap market.
It should be noted that CDS transactions expose each of the
counterparties (but particularly the buyer of protection) to
counterparty credit risk (i.e., the risk that its counterparty will
fail to perform its obligations under the relevant swap transaction).
As a result, the vast majority of CDS transactions are documented under
ISDA master agreements which have been negotiated between the buyer and
seller of protection. These master agreements are typically
collateralized on a mark-to-market basis and, in some cases, may be
subject to additional transaction-specific initial margin requirements
depending on the creditworthiness of the parties. The existence of such
collateral arrangements mitigates but does not eliminate the
counterparty credit risk associated with CDS transactions. Although the
terms of each CDS transaction will be individually negotiated by the
parties, they will typically rely on certain standardized definitions
and market conventions for CDS transactions that have been published by
ISDA.
Role of Credit Derivative Transactions in the Economy
Credit derivatives (including CDS transactions) are important risk
management tools in the financial markets and may be used by market
participants for hedging or investment purposes. In either application,
the key role that credit derivatives play is to effectively and
efficiently transfer the desired risk elements from the buyer of
protection to the seller of protection.
It should be emphasized that while certain elements of a typical
credit default swap transaction are standardized, one of the most
important features of the CDS market is the ability of counterparties
to customize the economic terms of their transactions. The ability to
customize CDS transactions to match specific hedging requirements or
desired exposure characteristics distinguishes credit default swaps
from futures contracts and other exchange traded financial products,
which generally do not permit product customization.
CDS are frequently used by bond investors and bank lenders to hedge
themselves against the default risk of an issuer/borrower. For example,
a bank that desires to hedge a portion of its illiquid credit exposure
to a customer may be able to transfer a portion of that credit exposure
by entering into a CDS transaction with a derivatives dealer, which may
in turn retain such credit exposure or hedge it with other market
participants that are seeking to gain credit exposure to the customer.
Although credit default swaps are most frequently employed to hedge
default risks relating to bond or loan positions, CDS can also be used
to hedge against the default risk associated with other types of claims
or obligations. For example, a manufacturer can use credit default
swaps to hedge against the potential losses on accounts payable that it
might suffer if a key customer goes bankrupt and fails to pay its
account payable balances.
Credit default swaps can also be used by market participants to
express an educated view on the creditworthiness of a particular
reference entity, based on such market participant's research, analysis
and mathematical modeling. A market participant may sell credit
protection if it believes the reference entity's creditworthiness is
likely to improve or may buy protection if it believes the reference
entity's creditworthiness is likely to deteriorate. Changes in
reference entities' perceived creditworthiness will be reflected in its
credit spreads which will result in gains or losses in the CDS
transaction. It should be noted that such gains and losses are not
dependent upon the actual occurrence of a credit event and may be
realized by terminating the CDS transaction prior to its scheduled
expiration date or entering into a new offsetting transaction.
U.S. Regulatory Framework
The U.S. regulatory framework for over-the-counter (OTC)
derivatives has been the subject of considerable discussion since the
mid-1990s. Based principally on the institutional nature of the OTC
derivative markets' participants, the current U.S. regulatory framework
applicable to credit default swaps is based primarily on oversight and
supervision of market participants--particularly OTC derivative
dealers. As a result, conduct in the credit default swap market is
regulated indirectly through the supervision of derivative dealers by
their primary regulators. In addition, credit default swaps, like all
securities-related swap transactions, are subject to the anti-fraud and
anti-manipulation provisions of U.S. securities laws. The significance
of the applicability of the U.S. securities laws to credit default
swaps should not be under-estimated. In our experience, derivative
dealers are very sensitive to the need to manage their trading
activities in a manner that ensures compliance with these laws.
Consistent with their regulatory and supervisory responsibilities
over OTC derivative dealers, various U.S. regulatory agencies, together
with regulatory and supervisory authorities from other countries,\1\
initiated a series of initiatives in 2005 to improve market
participants' management of their OTC derivative operations and risk
management practices. It should be emphasized that the need to address
the operational risks associated with rapidly expanding OTC derivative
markets and credit default swaps was identified by the dealer community
in the 2005 Report of the Counterparty Risk Management Policy Group
II--well before the onset of the current crisis in the credit markets.
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\1\ These regulatory and supervisory agencies included the Federal
Reserve Bank of New York, the Office of the Comptroller of the
Currency, the New York Banking Department, and the Securities and
Exchange Commission, as well as the U.K.'s Financial Services
Authority, Germany's Federal Financial Supervisory Authority and
Switzerland's Federal Banking Commission.
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As a result of these initiatives, UBS and other major credit
derivative dealers have made a series of commitments to a growing group
of global regulators which are designed to: (i) reduce the systemic and
operational risks in the credit default swap market; (ii) strengthen
the credit default swap market infrastructure; (iii) improve the
transparency and integrity of the credit default swap market; and (iv)
generally enhance risk management practices in the credit default swap
market. These efforts have been extremely successful and have been
expanded to include major buy-side market participants. To date, the
specific improvements include: (i) a reduction in trade confirmations
remaining unsigned or unacknowledged for more than 30 days by 92% (even
though trade volumes have increased by 300% over the same period); (ii)
the adoption of a protocol requiring that market participants request
original counterparty consent before assigning trades to a third-party;
(iii) the adoption of an online matching and confirmation platform for
credit default swaps by the Depository Trust & Clearing Corporation and
the commitment of the dealers to use it or another electronic
confirmation platform for the great majority of trading activity; and
(iv) the creation of an electronic ``trade information warehouse''
(also by the Depository Trust & Clearing Corporation), which serves as
a central repository containing the details of credit default swap
transactions and facilitates the processing of various events in the
lifecycle of a CDS transaction.
Most recently, dealers and major buy-side institutions committed to
new initiatives which were set out in a letter to the global regulators
on October 31, 2008. Significantly, these commitments were accompanied
by a detailed memorandum summarizing the progress that has been made
since 2005 and the plans for future enhancements to the operational
infrastructure supporting different segments of the OTC derivative
market (e.g., credit, equity, interest rate, commodities). These
commitments include: (i) global use of central counterparty processing
and clearing to significantly reduce counterparty credit risk and
outstanding net notional positions; (ii) continued elimination of
economically redundant trades through trade compression; (iii)
electronic processing of eligible trades to enhance the issuance and
execution of confirmations on the trade date; (iv) elimination of
material backlogs in confirmation processing; and (v) central
settlement for eligible transactions to reduce manual processing and
reconciliation of payments.
President's Working Group Policy Objectives and Memorandum of
Understanding
On November 14, 2008, the President's Working Group on Financial
Markets (the ``PWG'') announced a series of policy initiatives designed
to further strengthen the oversight and infrastructure of the OTC
derivative markets, which included: (i) a statement of policy
objectives for OTC derivatives (the ``Policy Objectives''); (ii) a
summary of the progress that has been made by dealers in addressing
operational risks associated with OTC derivatives; and (iii) a
Memorandum of Understanding regarding the development of central
counterparties for credit default swaps.
Broadly speaking, the Policy Objectives include: (i) establishment
of central counterparties and central trade repositories for CDS and
possibly other OTC derivative transactions; (ii) public reporting of
certain transactional information regarding standard CDS transactions;
(iii) maintenance of additional information regarding standard and
nonstandard CDS transactions; and (iv) establishment of consistent
standards and best practices for centralized counterparties, dealers
and other market participants. UBS supports the Policy Objectives and
would note that they are consistent with the ongoing efforts of the
U.S. and international regulators and major credit derivative dealers
to improve the operational practices and infrastructure supporting the
credit default market.
At the same time, UBS believes that it is critical that the
regulators and other stakeholders continue to work in close
collaboration with the dealers and other market participants to
implement these Policy Objectives. Without such consultation, there is
a danger of harm being done to the credit default swap market. For
example, price reporting should be implemented in a manner that does
not reduce market liquidity or result in the publication of misleading
information. Similarly, a broad-brush requirement that all eligible
contracts be cleared through a central clearinghouse could in some
instances hamper derivative dealers' ability to manage counterparty
risk.
While UBS strongly supports the ongoing development of stronger
market infrastructure, including the ongoing initiatives to bring
further ``electronification'' to the credit default swap market, it is
important for these initiatives to be allowed to develop in a
thoughtful and iterative manner, particularly with respect to such
projects as the development of centralized counterparties, central
contract repositories and exchanges and similar trading platforms for
standardized credit default swap contracts. In addition, it is critical
that the market infrastructure preserve the ability of market
participants to customize transactions to meet their hedging or
investment needs.
Centralized Counterparty
In its recent announcement, the PWG noted that successful
implementation of central counterparty services in the credit default
swap market is the PWG's top near-term priority in this market. In
general, a central counterparty is an entity that will stand between
counterparties to a financial contract, acting as the buyer to the
seller and as the seller to the buyer.
This type of central counterparty is already in use in the interest
rate swap market, where it is estimated that nearly 50% of U.S. dollar
interest rate swaps are cleared with central counterparties. A number
of central counterparty clearing initiatives are being developed in the
U.S. and in Europe. UBS is supportive of those efforts and believes
they will significantly reduce counterparty credit risk in the credit
default swap market by allowing market participants to eliminate
offsetting transactions.
We understand that the PWG has indicated that any central
counterparty will need to satisfy the standards established by the
CPSS-IOSCO Recommendations for Central Counterparties. We are
supportive of these standards and believe that their adoption will
ensure that the central clearing services are efficient and reliable.
Conclusion
Credit default swaps are an important risk management tool for
financial institutions and generally provide key benefits to the
financial markets. As the PWG noted in their November 14th
announcement, credit default swaps and other over-the-counter
derivatives ``are integral to the smooth functioning of today's complex
financial markets and . . . can enhance the ability of market
participants to manage risk.'' We believe that the significant
improvements made to the systemic and operational infrastructure for
credit default swaps over the last 3 years, the positive dialogue
between the major credit default swap dealers and the relevant
regulatory agencies, and the ongoing market infrastructure projects
(including the development of central counterparty platforms),
demonstrate the financial services industry's commitment to
strengthening the credit default swap market and support for the Policy
Objectives set out in the PWG's announcement. UBS looks forward to
working with the PWG, other market participants, and Congress in
enhancing the credit default swap market by developing robust
operational practices and infrastructure to support CDS trading.
Mr. Chairman, thank you for the opportunity to share our views with
the Committee. I would be happy to answer any questions you or Members
of the Committee may have.
The Chairman. I thank you very much, Mr. Murtagh. And we
thank all members of the panel for their fine testimony and we
will proceed to questions.
I am going to ask you the same questions I asked the other
panel, that there have been proposals to mandate the clearing
of credit default swaps. To each of you, do you believe that
such a mandate is necessary?
Mr. Damgard. As you know, I represent many of the firms in
the exchange traded space, so my view probably is not nearly as
important as my member firms down the way, but I do understand
that some of these lend themselves to clearing rather easily,
and there are others individually negotiated and are unable to
be cleared. And to the extent that participants in the market
face the choice of clearing or not clearing their contract,
clearly recent experience has indicated that there is a whole
lot more safety in removing the counterparty risk. So I think
Congress is well advised to look for ways to encourage clearing
on those kind of CDSs that lend themselves to clearing.
Mr. Pickel. Mr. Chairman, I think in the process that Mr.
Murtagh referred to that lead to the October 31 letter to the
regulators. There was a very clear commitment from the major
dealers in that they would look to clear as many transactions
as possible. I think that that process of the private-public
dialogue there is probably the best way to achieve a high
degree of clearing, together with the fact with the first
panel, we have four major organizations who are very actively
looking to develop clearing solutions in this space.
I do think there is the President's Working Group objective
to play out, there will continue to be privately negotiated,
custom-tailored transaction that don't lend themselves to
clearing solutions. We shouldn't restrict the abilities of
parties to develop solutions that address their particular
needs by requiring across the board clearing.
The Chairman. Mr. Thompson.
Mr. Thompson. I agree with that. I think that we have
clearly committed to the regulators to clear the lion's share
of contracts that can be cleared. But, an important feature of
this market since its inception has been innovation and the
ability to provide hand-tailored risk management solutions for
clients. I would not want to see anything in terms of a mandate
which would impede our ability to serve our clients in that
regard.
The Chairman. Dr. Corrigan.
Dr. Corrigan. Mr. Chairman, I think it is rather widely
known that I have been advocating such a result for quite a
number of years, so my answer is enthusiastically yes. With one
quick caveat. As I said before, we will probably have two or
three or four different approaches for this on kind of a
competitive basis, but over time, I rather suspect and frankly
will not hurt my feelings if we gravitate toward a single,
global CCP subject to the kinds of regulation that you and
other Members of this Committee have also been advocating for
some period of time.
Now I don't like monopolies, I want to emphasize that under
the approach that is suggested, you would still have a great
deal of front end competition between exchanges and other
entities. But, to me, given my orientation about systemic risk
and things like that, having the process at the end of the day
in one place where the regulators and everybody else can see it
and control it has a great deal of appeal, even though I
recognize that, it has a monopolistic characteristic to it.
The Chairman. Mr. Murtagh, do you have a comment?
Mr. Murtagh. With respect to the mandatory requirements I
think I would say that as long as the standards are clear in
terms of which types of credit default swaps the mandatory
clearance would apply to would be fine, but I think as others
have suggested, there are likely to be certain types of the
bespoke transactions that would probably be best done off the
clearing exchange.
The Chairman. Assuming such a mandate was imposed, how much
time would the industry, and you, need to meet that mandate? In
this regard, we had some discussion with the last panel, maybe
you were here. With the standardized stuff is probably fairly
quick. But say that we decided to mandate everything, including
these so-called tailor-made deals, maybe that part of things
will go away, but how long would it take to--should we give it
some kind of time frame? I think there was a bill introduced in
the Senate that would do it immediately, which seems to be a
little drastic.
Mr. Damgard. I would take the exchanges at their word, if
they said they were operationally ready right away for the
standardized products, particularly the indexes, I believe
that. And I think they were just waiting for regulatory
approval. In the others I think it is such an interesting
space, and there is so much innovation taking place, it is not
clear that any of them would ever be able to clear all the new
products that are coming down the line.
The Chairman. I think we have had about as much innovation
as we can take. Mr. Pickel.
Mr. Pickel. I think that, first of all, as it is, we would
continue to focus on the privately negotiated transactions
across the board whether it is credit default swaps or interest
rates or equity, so in terms of our involvement and the timing,
it is really not our position to say. We would work with all
the exchanges we have to date to make sure that they can move
forward if they were required.
The Chairman. You must have a view, though.
Mr. Pickel. On timing of that?
The Chairman. Yes.
Mr. Pickel. I really do not have a view of how long it
would take for them to put this in place. It is important for
us to continue to focus again on the infrastructure in the OTC
business while working with the exchanges, all of whom are
members of our organization.
The Chairman. Mr. Thompson.
Mr. Thompson. As a perspective of the user of the services
as opposed to the designer of the service which would proceed
extremely quickly. The limiting constraint would be for the
exchanges to digest the large volume of outstanding
transactions and new transactions as they arose. From our
perspective, the sooner the better. The limiting factor will be
the ability of exchanges to go through the processes they have
to go through in order to get the products to the
clearinghouse.
The Chairman. Dr. Corrigan.
Dr. Corrigan. Index trades, in a matter of weeks, single
name trades, 2 to 3 months. Again, one caveat and that is the
regulators that have to opine on the financial infrastructure
stress testing and so on to satisfy themselves that the
clearinghouse can function, even under extreme, extreme
conditions should not be artificially expedited to meet an
otherwise artificial time schedule.
Mr. Murtagh. And I would agree with that. I think some of
the people in the prior panel pointed out they would not
necessarily want to be committed to clearing all the
transactions that might come about. For exactly the reasons
that I think were described, we have to come up with
appropriate risk models for them so we can set appropriate
marginal requirements.
The Chairman. Thank you, my time has expired. The gentleman
from Texas, Mr. Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman. Without a mandate,
will enough business migrate to the clearing facilities to
mitigate concern about counterparty risk that have contributed
some say to the credit freeze? I will go down the line.
Mr. Damgard. My view is there is a lot of incentive right
now for people to seek the clearinghouse to eliminate the
counterparty risk, so my answer would be that I think it is
appropriate for Congress to look for ways to encourage and
mandate is one of the ways to do that. But, my sense is that
most participants in the market, as has been stated by others,
are looking for ways now to seek clearing.
Mr. Pickel. I think, again, with the commitment of the
major dealers already to put as many trades as possible into
the clearinghouse, I think we will see that. Whether there is
sufficient volume over the long term to support four different
clearing entities, I am not sure about that. I would tend to
agree with Dr. Corrigan, but we will see how that will develop.
I think that will happen. Again, existing framework under the
ISDA contract will remain in place for the many transactions
that would not be put into the clearinghouse. First, we will
need to make sure that they continue to manage that effectively
as they move a large number of trades into a clearinghouse.
Mr. Neugebauer. Mr. Thompson.
Mr. Thompson. I think you have very real economic
incentives to move about which can be cleared on to the
clearinghouses. I think when you couple that with the fact that
the major dealers have all made very firm commitments to the
regulators to clear what can be cleared, I think that that that
critical mass will build up relatively quickly.
Dr. Corrigan. It keeps the pressure on.
Mr. Murtagh. I understand the desire for the pressure, but
I also believe that the industry had started moving in this
direction actually before many of the problems had started. I
think the benefits clearly outweighed the costs associated with
the industry, it had already made the decision to go in that
direction some time ago. I think what has happened in the
market has forced us through that forward even more quickly.
Mr. Neugebauer. If we didn't mandate the clearing, made it
voluntary, in a sense what percentage, we talked about indexed,
individual and somebody used the word ``toxic.'' I don't have a
good feel of what percentage of what swap transactions would
probably not be brought to the clearinghouse. Can I get an
opinion from the group on that?
Mr. Damgard. I would yield to my colleague on that.
Mr. Pickel. I think the nature of the credit default swaps
that are widely traded are fairly standardized products, so
there would be a fairly strong incentive to put a lot of those
transactions into the clearinghouse. Perhaps instructive is the
experience with LCH SwapClear, which clears interest rate
swaps, where firms do actually manage their OTC business
together with the cleared business in a very dynamic way. I
think we would expect to see that. And perhaps most likely more
so in the credit default swaps space given the more highly
standardized nature of the contracts.
Mr. Thompson. I can assure you I never use the word
``toxic.'' I think that the percentage would be certainly be
north of 90 percent in terms of the outstanding notional volume
of contracts. The market is very highly concentrated in terms
of the standardized index and single name product. I think you
would have an overwhelming percentage of outstanding contracts
that could be eligible for clearing.
Mr. Neugebauer. Dr. Corrigan.
Dr. Corrigan. I agree with Mr. Thompson. Again, one caveat
here as well, the risk characteristics CDS depend in no small
way on what the reference entity itself is. So in other words,
if the reference entity is alone or a bond of a well-known
visible corporation, the risk profile and characteristics
associated with the instrument are one thing. But if, on the
other hand, the reference entity unfortunately is something
like a CDO, that is a very different ball game. So again, I
think when we think about the profile of the marketplace, we
have to keep in mind that the profile of the so-called
reference entity matters a lot as well.
Now what I would hope as things evolve in a way, my
colleagues have suggested that we keep that in mind, so as to
make sure that the CCP itself is in a position to capture as
much of that stuff as possible, even in the case of the more
complex reference entities themselves.
Mr. Murtagh. Maybe just be a little more specific on that
point, because I agree with Dr. Corrigan. It is just that where
many of the spectacular losses were incurred were in connection
with CDOs backing residential mortgage-backed securities. And
so I think it is very important in terms of capturing the risk
associated with the current market would eventually bring those
types of transactions to the clearing corporation, but one
would need to do so with great care to make sure that the risk
had been appropriately modeled and understood by everyone
involved.
Dr. Corrigan. Exactly.
Mr. Damgard. I would like to add that a number of my member
firms have expressed concern about the different risk profiles
of a credit default swap versus what Mr. Duffy referred to as
his core business. To the extent that separate pools of capital
could be used in order to protect those members just using
futures products would probably be advantageous to the market
user.
Mr. Neugebauer. Thank you, Mr. Chairman.
Mr. Holden [presiding.] The chair thanks the gentleman.
Assuming there is no clearing mandate, should there be a
mandatory reporting requirement for parties in CDS who decide
not to clear those agreements? And should there be a mandatory
reporting requirement for parties in any over-the-county
transaction.
Mr. Damgard. I would yield once again to Dr. Corrigan on
that, I would say the more pressure the better. Whether or not
an absolute mandate would be disadvantageous to business done
in the United States or not is not something that I feel I have
a very good feel for.
Mr. Pickel. I think with respect to the vast majority of
participants in this market, the major dealers and banks, if
they are not already required by their regulators to provide
that type of disclosure, then yes, to their regulator they
should provide a great deal of disclosure. I do think a lot of
that occurs, but by all means that should be reviewed and
strengthened if necessary after review.
Mr. Thompson. Yes, we are broadly supportive of PWG's
objective of public reporting of prices, trading volumes, and
aggregate open interest to increase market transparency. Also
to be crystal clear we think that to the extent regulators want
information about the CDS market, they should get it in
whatever form they would like, as frequently as they would like
and whatever level of detail they like in order to allow them
to fulfill their oversight responsibilities.
Dr. Corrigan. Again, I probably agree with what has been
said. As I indicated in my statement, I certainly do agree that
prudential supervisors should indeed feel free to ask for the
kind of information you suggested. And as I also said, I would
go one step further and say that on a case-by-case basis, if
they don't like what they see, they should encourage, if not
require, risk reduction on the part of individual market
participants.
The other point I would make, Mr. Congressman, I think this
was mentioned earlier, just within the past few weeks, the
Depository Trust Clearing Corporation Warehouse for CDS
transactions has begun to publish, I think, on a weekly basis,
if I have it correctly, the names of the 500 largest reference
entities and the volume of transactions against those reference
entities. And this is really a significant enhancement in
transparency for the marketplace across the board. Again, I
just kind of wish it would have happened a little earlier, but
I am not going to fight it, I think it is a terrific
improvement.
Mr. Thompson. I would also point out that that DTCC
information is available to the public at large, they post it
on their website. It is not something which goes only to
regulators or for which you need to pay a fee to obtain the
service. It is like publishing in The Wall Street Journal.
Mr. Murtagh. We are in support of those efforts, and would
only suggest that we try and come up with something that is
consistent internationally so the global market can get similar
information across the globe.
Mr. Holden. Where do you see the CDS market heading in the
future months?
Mr. Damgard. To the clearinghouse.
Mr. Thompson. You stole my line.
Mr. Pickel. I would say in addition to the clearinghouse
with the focus on credit, people will want to look at ways in
which they can manage the credit risk that they have. As I
mentioned in my remarks, the credit default swaps market has
remained available for those who wish to hedge their risk in
some way even in light of the turmoil. So I think we will see
that in the very short term short term.
Mr. Thompson. I continue to believe that the credit
derivatives market will be a very active market. It is by far
the most highly functioning of the credit markets out there
today. It is increasingly being used as a benchmark for the
creditworthiness of issuers, and as people see that most of it
is migrating to a clearinghouse, thus allaying the fears of
systemic risk and counterparty credit risk, I think you will
continue to see the market grow and prosper.
Dr. Corrigan. Ironically, if we get all the things done
that we are talking about doing, it might accelerate the growth
of the market, even though intuition might suggest the
opposite. I think the market will continue to grow and grow
rapidly. One caveat I would have is that I rather suspect that
market participants are going to think a lot longer and a lot
harder about providing so-called protection against some of
these very, very complex financial instruments such as CDOs and
CDO squared. And to the extent that occurs, I must say it is
not going to hurt my feelings.
Mr. Murtagh. I agree that the structured market is not
likely to see very much volume over the next few months or
years. I think what we will probably see is the economy
continue to have some difficulties, we will have some more
credit events occur over the course of the year, and the
industry will have to work towards settling those transactions,
hopefully, in as efficient a manner as we have to date.
Mr. Holden. Do you foresee an increase in the rate of
defaults for CDS reference entities?
Mr. Damgard. I have no view on that.
Mr. Pickel. I don't have a personal view, but I think most
observers would expect to see some additional level of defaults
of firms in light of the economy.
Mr. Holden. Anyone else care to add anything?
Mr. Thompson. I think the answer was no, I fear the answer
is yes.
Dr. Corrigan. I am neutral.
Mr. Murtagh. I have to confess, I didn't hear the question.
Mr. Holden. Do you foresee an increase in the rate of
defaults for CDS reference entities?
Mr. Murtagh. Yes.
Mr. Holden. Thank you, Mr. Chairman.
The Chairman [presiding.] The gentleman from Texas, Mr.
Conaway.
Mr. Conaway. Thank you, Mr. Chairman. Continuing on that
line of--maybe I will start at this end of the panel, you say
the skyrocketing spreads on CDS is affecting these proposed
central clearinghouses.
Mr. Murtagh. I am sorry, I didn't hear your question.
Mr. Conaway. The increasing spreads on the CDS instruments,
you see that as having impact on the migration to central
clearinghouses?
Mr. Murtagh. No, I don't.
Mr. Conaway. Dr. Corrigan.
Dr. Corrigan. If anything, it would accelerate it, the
gravitation towards the CCP.
Mr. Thompson. I agree with that, the fact that a protection
seller is taking increased credit risk to the protection buyer
as a consequence of a much higher spread increases his
counterparty credit risk concerns in a way that might not be as
palpable in the case of a trade with a low spread.
Mr. Pickel. I think the process would accelerate towards
utilizing clearing.
Mr. Damgard. And I would agree with that.
Mr. Conaway. That is because it would lower the
counterparty risks?
Mr. Pickel. Yes.
Mr. Conaway. In spite of my Chairman's distaste for future
innovation, are there other new instruments out there that are
on the horizon that would create the same market instability
that we ought to be watching, and looking at including in this
sweep of regulatory revision.
Dr. Corrigan. I will take a stab at that, at least for
starters. One thing, despite all we have been through over the
past 16 months what we do not want to do is artificially
suppress innovation. So consistent with that, I think it is
inevitable and appropriate there will be continued innovation.
Certainly, I would expect for example internationally, if you
just take the CDS base, there will be a lot more reference
entities.
Mr. Conaway. What is the CES again?
Dr. Corrigan. Credit default swaps.
Mr. Conaway. CES or CDS?
Dr. Corrigan. DS, sorry. We don't want to put the genie of
innovation back in the bottle. I would strongly emphasize that,
going forward, we can and should do a little better job, if not
a lot better job, in making sure that we are vigilant in
recognizing that innovation in the financial sector has
something in common, if I may say this, with prescription
drugs. There can be side effects, just as we have to be
vigilant about side effects for prescription drugs, we have to
be much more vigilant about side effects in the financial space
as well.
Mr. Thompson. Yes, when I think about risk and innovation,
I frankly worry more about how products are used and the nature
of the products themselves. And one thing we have seen in a lot
of the blowups of the past 18 months or so are very common
themes that don't have a lot to do with product innovation, but
present tremendous risks, such as the concept of funding very
long dated assets which may become illiquid with very short-
term money that can evaporate overnight.
I worry less about the products themselves than I worry
about how people use them, and the amount of leverage on the
part of users as well as lack of adequate capital on the part
of users.
Mr. Damgard. I would add existing exchanges and new
exchanges are certainly involved with the environment. And I
expect to see a lot of innovation in climate and carbon type
contracts, probably ultimately destined to be traded on an
exchange.
Mr. Pickel. Also the vast majority of these credit default
swaps are single name and index trades which have a very well
identified and appreciated usage in the marketplace. There was
some reference earlier to the usage in the credit structure
area where there may be a greater point of concern. I think
also that a lot of focus on credit default swaps has been a
function of just the sheer rate of growth as we have seen over
the past 8 years in this particular product area, but that is a
testament to the success of the utility of the product. If we
were to look at other areas, whether it be emission
derivatives, property derivatives, we are not seeing that rate
of growth just yet. So you wouldn't have that indicia of
growth.
Mr. Conaway. What kind of early warning system should we
put in place? In other words, derivatives are coming around in
1997-ish time frame through the writing of the Commodity Act
really wasn't at a scope that threatened the world. It grew in
the last 8 years to a staggering number. Is there some soft of
an early warning system that you would look at for innovative
products, new technique, new products that are out there, risks
that are growing bigger that would help us at least see
something that we might not have otherwise seen?
Mr. Pickel. I think you have to see whether Dr. Corrigan
organizes another counterparty risk management policy group
report. I know he has published three of those going back to
1999, and has focused on different aspects of market of the
market. So there is that ongoing private-public dialogue that
we are seeing, particularly focused with the New York Fed. It
goes on here in Washington regularly as well. So, there is the
ability to identify areas where regulators, and legislators,
should have greater focus.
Mr. Conaway. Is that dollar denominated; if the scope of
the market gets to a point where you simply say, Congress take
a look at this?
Mr. Pickel. I think it is it is really a function of
feedback that regulators can provide in that regular dialogue
that they have in the oversight that they have of these
regulated institutions. I think having the regulators, as well
as the industry, up here regularly and hearing from them is an
important part of the dialogue.
Mr. Damgard. And I would add CFTC has done an excellent job
over the years of being organized by issue with advisory groups
and they are constantly looking at that.
The Chairman. I thank the gentleman. The gentleman from
North Carolina, the Chairman of the Subcommittee, Mr.
Etheridge.
Mr. Etheridge. Mr. Chairman, thank you. And along that
line, let me follow that with a little different direction on
my question, because it is kind of hard to follow it if you
don't know what is out there. I grew up on a farm, if you don't
know you have deer, you are not going to go deer hunting, you
may be rabbit hunting.
I hear this from a lot of folks, they wonder why in the
world we haven't had a clearinghouse for credit default swaps
already. So my question to you is you are the folks involved in
it, why do you think that a clearing solution for CDSs were not
implemented in the past? Was it because we didn't get in
trouble?
Mr. Damgard. My answer is basically hearsay, but I think
the problem was that nobody knew how to value them. If you
can't value it, you can't margin it, so it didn't fall into the
kind of formula that worked very well in a traditional
clearinghouse. That is something that the Fed and the industry
have been working on for the last couple of years to determine
what would work that isn't exactly like SPAN'
margining.
Mr. Pickel. The infrastructure that is utilized to engage
in risk management of these activities is the infrastructure we
have put in place with our members over the years, which is the
master agreement and netting of positions and collateral that
is used to provide credit protection against the net position.
Keep in mind that is comprehensive across different product
types. So you have interest rates in there, as well as credit,
equity, energy. And I think that the focus of the industry with
the rate of growth in credit default swaps lead eventually--
this really does go back over years where the industry
participants first started looking at the possibility of
clearing--with the growth of the market they felt it was
important to explore a clearing solution.
Mr. Thompson. I agree with Bob in the sense that the
industry has been very aware of, and focused on, counterparty
credit risk for a long time, that predated the development of
the credit derivatives market.
Mr. Etheridge. Can you give us a date?
Mr. Thompson. It has been a long time since I started doing
this in the late 1980s, everybody has recognized that these
instruments, because they are market sensitive and present
default risk, give you a counterparty credit risk. The way
people have typically attacked that in the absence of a
multilateral solution, such as a clearinghouse is by bilateral
netting and collateral arrangements, whereby we agree that all
exposures net down upon a default and that parties daily margin
that net exposure, and that has worked relatively well. We have
been working on a clearinghouse for a couple of years now, it
has been challenging because, first, there are a significant
number of issues that need to be dealt with in order to
establish a clearinghouse. Second, it has been a very
challenging market in which to do it where necessary resources
for development of the clearinghouse have been diverted because
of things like Lehman bankruptcy, which need to be dealt with
on an immediate basis.
Mr. Etheridge. Which led to the necessity of getting the
clearinghouse in place real quick.
Mr. Thompson. Well, the necessity for the clearinghouse has
been there for a long time and we recognized it, but like many
good ideas in a complicated market, it takes time and effort
and resources to achieve it. And we are committed to do that as
an industry and we are actively working on it. But that is an
explanation as to why it doesn't exist now.
Dr. Corrigan. Let me quickly add a couple of things. First
of all, unfortunately, as we all know, there are circumstances
in which things have to get bad before they get better. I think
there may be some element of that here as well. But I don't
think any of my colleagues would disagree with me when I say
that the wisdom of the CCP has indeed been around a long time.
But if we go back again to use CRMPG I, I have been the
Chairman of three efforts in this area, one in 1999 after a
long term capital, one in 2005 and one that we just published
this past summer. At times it has been frustrating, it has been
a struggle. What you have to do here, which I can't begin to
overstate how difficult it is, you have to get everybody to
agree to everything. And that is not easy to do. Especially
when ``the everybody'' are all life and death competitors with
one another.
So I do think, Mr. Congressman, it is fair to say that all
things considered, a lot of progress has been made. We are
almost there, we will get there. But all things considered, I
would probably would have been happier if we would have gotten
there a little earlier.
Mr. Murtagh. I want to make sure the Congressman is aware,
I am not sure if your question related to OTC derivatives or
about credit default swaps. With respect to the interest rate
market, there is, in fact, the clearing function, swaps clear
what is out there and it has been for some time. As Dr.
Corrigan suggested, that one got going a lot more quickly
because there was much more consensus more quickly around the
terms. When the credit derivatives market first started, there
was a lot of effort spent in refining the product. There were a
number of years and iterations before it reached some level of
regularity. It is only with the index that we ended up having
that level of volume.
Mr. Etheridge. Thank you.
The Chairman. I thank the gentleman, the gentleman from
Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. Dr. Corrigan, your
description of agonizing process that you go through in order
to reach some sort of an agreement that contemplates some
progress where security is concerned is understandable and
disconcerting at the same time. It almost sounds as if you need
a big brother at the table to encourage you along, even though
there are some dissenters here, it sounds good, we are going to
go ahead and do it for the sake of the broader society that is
affected by these financial markets.
While the big brother at the table are the regulators,
there is nobody else in the room obviously, and it would be
nice if we could avoid regulatory arbitrage with everybody
running to one that is least likely to be the big brother who
does encourage people to move along and to run to the one that
is most likely to sort of leave the parties to the process they
have been using all along.
Gentlemen what kind of changes should we be making
legislatively to the regulatory scheme that governs this whole
process, this whole area, this over-the-counter market? You
know, the Financial Stability Forum was created right after
long-term capital and supposedly had the best and brightest
around the world anticipating what the next problem was going
to be, missed this one altogether. And in April, frankly,
issued recommendations as it started to see the dominoes
falling, and then missed September altogether. There needs to
be a lot of self-reflection here it seems to me. The industry
has done society a huge disservice by not being able to move
forward as rapidly as it should.
So what kind of changes do we need to make with
authorities, with regulation, et cetera? Dr. Corrigan, I might
as well start with you.
Dr. Corrigan. I could spend the afternoon on that one. Let
me try to reduce it to the basics as best I can. First of all,
I think the issues that this Committee is focused on, even
today, in terms of keeping the momentum to get the CCP and the
related regulatory oversight in place, are along the lines of
the Committee's work, and some of my suggestions are clearly a
step that has to be taken. So that is easy; not easy to do, but
easy to agree on.
On the broader question of what can we do in the regulatory
sphere, or for that matter in the private sphere to better
anticipate. Earlier the suggestion was made in terms of early
warning systems. That is really tough to do. I have been at
this for 42 years, and our collective capacity to anticipate
the timing and triggers of the next financial dislocation
shock, crisis, whatever you want to call it, unfortunately is
quite limited, because we are dealing with a very specific form
of human nature.
So I think that as we reflect on the events of the past 16
months, the first thing we have to do is agree on a couple of
broad principals that are going to have to shape the regulatory
structure and focus on the future. The first of those
principals is to recognize that there is a difference between
prudential supervision, which is aimed at financial stability
as a public policy goal on the one hand, and market practice,
which is equally important, but it is aimed at things like
insider trading, front running, market manipulation. The first
thing we have to figure out is how do we square the circle at a
philosophical level between those two public policy goals,
because we cannot, in my judgment, go on with a system like we
have in the United States where there are 15 or so Federal
agencies in the same sand box, and 50 state regulators in that
same sand box. We have to simplify that and our chances to find
our way to better insights or early warning, or whatever, would
be much greater to the extent we can simply.
But the principle of simplification has, in my judgment,
another meaning and that is because the world of contemporary
finance is so complex, we can't put that genie back in the
bottle. I think we also have to learn to get ourselves and our
thought processes out of the trenches and up on the mountain a
bit so we can see what is in front of us, as well as what is in
back of us. So there is a big cultural change that we as a
nation face in terms of trying to do a much better job in this
sphere that obviously we have done in the recent past. And I
apologize for being so long-winded, but as you can see this
strikes a bit of a passionate chord with me.
Mr. Marshall. It is a huge question for the country and my
time has expired. I don't know, Mr. Chairman, you may want to
have answers from some of the others on what sort of regulatory
changes they would like to see; your call, sir.
The Chairman. Yes, each of you respond briefly if you think
we need to make changes.
Mr. Damgard. Well, we are always concerned about the
competitive nature of the exchanges outside the United States
and the race to the bottom is a problem. I think that in terms
of recognizing that this is a global situation, I don't know
whether it is going to require treaties, but truthfully, the
CFTC has done an excellent job of relating to other regulators
around the United States. And one of our concerns is yes, a lot
has gone wrong, but not very much of it can be--the CFTC can't
be held responsible for much of that, nor can this Committee.
This Committee can take a lot of pride in the kind of
upgrades that you have made, since 1974, to the Commodity
Exchange Act. Our concern is more along the lines of not
throwing the baby out with the bath water. Everybody recognizes
that the next Congress and the next Administration is going to
take a good, long comprehensive look with very, very good
debate on what makes more sense going forward. And from our
standpoint, we want to make sure that all the good things that
have been done by this Committee on behalf of the regulated
futures market don't get caught in some tsunami that results in
a lot of over-regulation and disadvantages U.S. markets.
Mr. Pickel. You pointed out clarification as to
authorities. I think that came up in the first panel, as well,
where there were some questions in terms of SEC involvement.
Providing those clarifications and that is based, perhaps, in
terms of who regulates which of the entities that are engaged
in this business and who is therefore accountable to Congress
among the regulators, is very important.
I think also the PWG objectives that a number of us have
referred to provides a framework, and a lot of those are laid
out as challenges to regulators under existing authorities and
the requirements for market participants. Congress would want
to look at those very closely and decide whether the
Congressional action would be necessary to put a little umph
behind them.
Mr. Thompson. Mr. Congressman, I agree.
First of all, it is critically important for the country.
It is also an extraordinarily complex undertaking. When I think
about it, I can't think of any way to do it on a product-by-
product basis because, really, at the end of the day, we are
not talking about products. We are talking about risk. And the
only thing that I think has a chance of keeping us out of the
current situation we are in is a holistic assessment of risk
across all products by a prudential supervisor of every
systemically important market participant. I think trying to
regulate this pocket of risk or that pocket of risk just means
that people who are inclined to blow themselves up will access
another source for taking that risk, and unfortunately do so.
So I see no easy way out of this. I think that is the only
thing in my mind that has a chance of success.
Mr. Murtagh. I would agree with that and would suggest that
you need to put most of the responsibility on the primary
supervisor for the particular users of product. They are the
ones who are going to see, holistically, exactly how different
risks are being managed; and, ultimately, greater reporting and
transparency will help make sure that people can see what is
going on within a particular institution. That question is
probably more focused on financial institutions than it is,
perhaps, with certain other parties, but that is where I think
most of the systemic risk comes from.
The Chairman. I thank the gentleman.
The gentleman from Ohio, Mr. Space.
Mr. Space. Thank you, Mr. Chairman.
Gentlemen, I wanted to ask a question that was asked to the
first panel earlier today. We have been hearing that the
European Union is desperately seeking to attempt a European
solution to the need for clearing credit default swaps; and, to
that end, the European Commission may be considering requiring
all CDS agreements to which Europeans are the only parties to
be cleared only through a European-approved clearinghouse. For
CDS agreements between Europe, European, and non-European
parties, the CDS would have to be cleared only through a
European-approved clearinghouse if the agreement is denominated
in Euros; and if the referenced entity in a CDS is a European
company, that agreement, too, would be required to be cleared
through a European clearinghouse.
What are your thoughts about these possible requirements?
Would they expedite or delay the establishment of a CDS
clearinghouse here? And what would be, if adopted, their
consequences? How important is it to have continuity of
regulation on both sides of the Atlantic with regards to these
clearinghouses?
Mr. Pickel. The European dialogue is one that ISDA is very
closely involved in on behalf of its members. It is the case--
we have been of the view that there is room for competition in
the clearing space even if ultimately there is one, or there is
one in Europe versus one in the United States. But I think that
it is important to allow competition to determine that, to make
sure that there is that test, that ability to ensure that the
one who prevails is the one that is most competitive. So I
think it is most important to encourage that.
My impression is the regulators are engaged in a dialogue
to try to make sure that there is coordination. But we know
that there is a desire in Europe to establish one particular
approach. But we will continue to engage in the dialogue to try
to encourage the competition in the trans-Atlantic dialogue.
Dr. Corrigan. Let me respond to that as best I can.
First of all, I think there really are some substantial
practical problems here. Because if you define a CDS that must
be cleared in Europe as being denominated in the Euro, well,
what do you do about a CDO written in New York by J.P.Morgan
that is denominated in a Euro? Or what do you do about a
subsidiary of UBS that is in Chicago and has a CDS against the
European reference entity? So there is going to be a lot of
very, very difficult practical problems here.
I think we should also recognize that, at least at the
margin, I think the drive to have a separate CDS CCP in Europe,
represents some frustration among our friends in Europe to the
effect that a lot of the problems that we have seen in the last
16 months kind of had its roots here in the United States. They
see this maybe as a way to insulate themselves a little bit
from these kinds of events. And I, frankly, don't much agree
with that myself at all.
But, having said all that, I go back to the language in my
statement. Speaking for myself, if I was king for a day, what I
would like to see happen would be a single credit default swap
CCP on a global basis. And while that is not where we are
likely to start out, I would be willing to make a small wager
that that may be where we would end up.
Mr. Damgard. Yes. Only Dr. Corrigan can do that in 1 day.
Dr. Corrigan. Not in 1 day.
Mr. Space. So the concerns about looking for
competitiveness raised by Mr. Pickel would not be something
that would enter into your sphere as to how this should be set
up. And I guess that is not so much a question as it is a
statement. But I am concerned about, if competition and
competitiveness is a criteria in determining where these CDSs
are going to be cleared, doesn't that invite under-regulation
or lack of regulation, and inherently create a system that may
be more suspect to catastrophic failure?
Dr. Corrigan. I don't know. I am going to leave that one to
others except to say that this is clearly a space where we want
the best of the best to emerge as the winner. Very simple.
Mr. Pickel. Yes. I would say that competition would be on
the basis of things like price of clearing, as opposed to
whether the collateral requirements are different. I think that
the standards are the ones that either are at the international
level or at the CFTC guidelines, and you would have to have a
clearinghouse comply with those. Then, to the extent that they
want to compete on price, that that will only encourage more
people to clear through that platform.
Mr. Thompson. I agree with that. And I understand the need
to--or the desire to avoid regulatory arbitrage and the race to
the bottom. But to replace that with something which is
essentially random, where if Goldman Sachs in New York and
J.P.Morgan in New York do a trade denominated in dollars on a
European-referenced entity, that means it has to be cleared in
Europe, there doesn't seem to me to be a principle underlying
that.
Dr. Corrigan. It is not going to work.
Mr. Damgard. If there were some way to create a linkage
between clearinghouses and--because I think it is unreasonable
to think that the U.S. firms will all yield to a single
clearinghouse in Europe, any more than the European firms would
all yield to--even though it may be Dr. Corrigan's dream, it is
my judgment that that is unlikely. There may very well be a
role for Congress in determining what kind of standardization
would be necessary in order for these clearinghouses to develop
some sort of a link.
Mr. Murtagh. I think whatever benefits are likely to be had
from having multiple clearing counterparties, you really want
interoperability amongst them, such that if there is a problem
that they can basically transfer their function to someone who
is not having an issue.
The Chairman. I thank the gentleman.
The gentleman from California, Mr. Costa.
Mr. Costa. Thank you, Mr. Chairman.
Starting with Mr. Damgard, I would like to ask and go
through the lineup there whether or not you believe that there
is a conflict of interest in a clearinghouse run by the same
dealer banks that have the largest position in a current credit
default swap market.
Mr. Damgard. Well, most clearinghouses actually are
connected in a vertical silo to an exchange. So, for instance,
the governance of the Chicago Mercantile Exchange decides what
is going to happen at the clearinghouse at the Merc even though
there is a risk committee made up of member firms that can make
recommendations which can either be followed or not followed.
Mr. Costa. Do you think there is a conflict of interest?
Mr. Damgard. I don't think the conflict of interest exists
at the firm level. I think from time to time there may be a
conflict of interest at the exchange level, and we would
encourage exchanges to put as many public members as possible
on their Boards in order to avoid that risk.
Mr. Pickel. As far ISDA, we don't have a particular
position on that issue.
Mr. Costa. You don't have to have a position. Do you
believe there is conflict of interest?
Mr. Pickel. I think that you need to have robust governance
in place, which I think Mr. Short and others on the first panel
referred to. And I think that Dr. Corrigan referred to earlier
about the tension among the firms who are competitors. I think
you see that play out in the development of the clearing
platform.
Mr. Costa. I want to get to that competition issue. Mr.
Thompson, how do you see that?
Mr. Thompson. I don't believe there is a conflict of
interest. As we have gone through the process with ICE on ICE
Trust U.S., it has become abundantly clear to me that they are
making all of the important fundamental decisions. They will
seek dealer input on particular risk management issues, but I
don't view ourselves as having any conflict.
Mr. Costa. Dr. Corrigan?
Dr. Corrigan. I think it is inevitable that there is at
least a potential for conflict in some of these relationships.
But, having said that, I would likely hasten to add that that
potential for conflict I think is clearly manageable.
Mr. Murtagh. I would agree with that and just say that
these companies are typically providing services to financial
institutions who are very much interested in making sure those
services are performed properly.
Mr. Costa. Well then, for the three representatives
representing J.P.Morgan and UBS and Goldman, how much ownership
interest would you have in an ICE Trust as being proposed?
Mr. Thompson. I don't believe we have any current ownership
interest in them.
Dr. Corrigan. Again, I do not know the answer to that
question.
Mr. Costa. Mr. Thompson.
Mr. Thompson. I am informed we have some preferred shares
but do not have a seat on the Board and do not own any of the
equity.
Mr. Murtagh. I am unaware of what our ownership interest
is, but we can find out for you and get back to you.
Mr. Costa. Please.
Mr. Damgard. Mr. Costa, each clearing member is required to
own a substantial number of shares in the Chicago Mercantile
Exchange in order to become a clearing member; and naturally,
for competitive reasons, they belong to every clearinghouse.
They don't want one of their competitors to be able to bring
customers to a clearinghouse other than their own.
It is a two-edged sword. There is some capital
inefficiencies in belonging to a lot of different
clearinghouses, but there is also the advantage of competition,
keeping prices in reasonable shape.
Mr. Costa. Well, I want to get back up to about 50,000 feet
here, because we talked a lot about risk and risk management
and how we assess risk. And clearly, as my colleagues have
stated earlier, I think our constituents are very frustrated
and want to know why there weren't any canaries in the coal
mine, so to speak, in indicating that risk wasn't being
properly managed. Dr. Corrigan, in your experience, what are
the hallmarks of prudent risks, since we haven't done it so
well here lately?
Dr. Corrigan. Well, the way I think about it, Mr.
Congressman, is you go back and you look at financial train
wrecks over a fairly long period of time.
Mr. Costa. We have a history of them.
Dr. Corrigan. Pardon me?
Mr. Costa. We have a history of them.
Dr. Corrigan. Yes, we have. And so do others, by the way. I
do think there is something to the proposition that there are
three or four common denominators that tend to be associated
with most of them.
The first is the phenomenon that Mr. Thompson mentioned
earlier, and that is broad-based, wide-spread maturity
mismatches in the credit space, and that has been there almost
every time.
The second is a systematic tendency for a period of time to
under-price credit risk, and that has been there almost every
time. In this case, it is really the dimensions of that problem
that are astonishing.
Mr. Costa. But, as a manager, you have risk assessment
wearing one hat and, as a risk manager, you are wearing another
hat. I mean, you are trying to assess the risk and manage the
risk.
Dr. Corrigan. Right. Right.
Mr. Costa. And it seems to me that folks in the last 18
months, based upon the meltdown that we have, have not done a
very good job in coordinating, managing the risk versus
assessing the risk. I mean, how else did we get into this mess
in the first place?
Dr. Corrigan. Well, as I said, if you go back, you can
pretty well come up with clear diagnostics of how we got into
this mess. But there is no single point. It is a collection of
things that built up over a period of time.
Now, when you look at the crisis itself, I would suggest--
and I suspect others would agree with this--that some of the
worst failures were not so much the complexities of risk
management but it was basic risk monitoring. There were
failures on the part of institutions and markets to simply be
able to monitor the extent to which they were at risk.
Mr. Costa. Maybe that is why we are having the hearing.
Dr. Corrigan. I think it is. In a very real way, I think it
is.
Mr. Costa. I mean, through transparency and through a
regulatory scheme, we hope they could in effect do a better job
at monitoring that risk.
Dr. Corrigan. One of the things that these gentlemen have
heard me stress is that, going forward, major financial
institutions should have the capacity in a matter of hours to
be able to monitor their counterparty exposures to any
organization, anyplace in the world, across all products,
across all services; and they should be in a position where
they can share that information with their primary supervisor.
And that is representative of the scale of some of the changes
that I think we have to make.
And I don't mean to monopolize this conversation, but I
assume the others would probably agree with what I just said.
Mr. Costa. Since you are considered the sage, and I have
gone way beyond my time, just one quick question, because it
ripples through all of our constituencies. What scares you the
most at this point in time?
Dr. Corrigan. I am sorry?
Mr. Costa. What scares you the most at this point in time?
Dr. Corrigan. What, I don't know.
Mr. Costa. Well, that is what scares all of us. But I am
talking about as it relates to the potential downsides of--I
mean, I don't think we have hit bottom yet.
Dr. Corrigan. Let me try to do the best I can.
What concerns me most of all right now is the pressure on
the macroeconomic situation. Because as all of you know, for a
variety of reasons, many of which are tied up with the
financial crisis, our economy and the economies throughout much
of the world are taking quite a beating. And that is why I
think that one of the things that the Congress and the new
President, when he takes office, has to this put right on the
top of the list in a fresh stimulus package. So that is
probably the thing that worries me most right now. I am mindful
of the fact that there are still pressures on the financial
side, but the number one issue for me is the economy.
Mr. Costa. Thank you.
The Chairman. I thank the gentleman.
The gentleman from North Dakota, Mr. Pomeroy.
Mr. Pomeroy. I thank the Chairman.
Dr. Corrigan, I will continue on with you, if you don't
mind.
You were involved in the aftermath postmortem of long-term
capital, assessing what happened, what the consequences were.
It looks to me like the core of long-term capital's problems
were extraordinary dimensions of leverage that weren't easily
understood or maybe were impossible to understand until it all
fell apart. It seems to me that we took the long-term capital
model and, rather than take steps to make sure nothing like
that could happen again, it became the modus operandi of doing
a lot of business. Credit default swaps going from $108 billion
of notional activity, notional value in 1998 to $57 trillion in
2008.
Now, you indicate that timing and triggering of events
can't be anticipated. But then you go through several recurring
themes that have brought about financial collapse--and I agree
with that analysis--the systematic tendency to under-price
credit risk and the failure to monitor the credit risk taken.
Now, with those two things, in my opinion, you don't go
from $108 billion to $57 trillion in a decade without having
probably each of those factors just screamingly apparent in
what is taking place. What frustrates me is no one was
calling--I mean, the regulators weren't responding, the leaders
of Wall Street didn't seem to be expressing concern, and now we
have this collapse.
You indicate that we don't want to put the genie of
innovation back in the box, and sometimes there are side
effects. Well, it looks to me like the side effects here is to
have credit default swaps and their unregulated activity and
their astonishing growth. And the questions now, surrounding
whether or not there is value behind them, have a terrible
impact on our economy and economies through the world. Those
are more than side effects.
What is the liability position of Goldman Sachs relative to
its presently held positions on credit default swaps?
Dr. Corrigan. I can't give you the exact number. But I know
it is fairly close to flat. In other words, we try very hard to
avoid open exposures on either side of the market, and that is
not always possible to achieve that. But certainly we monitor
those exposures very, very carefully.
Mr. Pomeroy. Mr. Murtagh, what is the UBS position?
Mr. Murtagh. I don't have the figure at my fingertips. I'm
sorry.
Mr. Pomeroy. Does the company know?
Mr. Murtagh. Yes, we do. It is reported in our third
quarter results. I know that.
Mr. Pomeroy. What was the third quarter numbers?
Mr. Murtagh. I just don't have the number with me. That is
all.
Mr. Pomeroy. Was it substantial?
Mr. Murtagh. I don't believe so, no.
Mr. Pomeroy. Mr. Thompson.
Mr. Thompson. Similar to Mr. Murtagh, I don't have the
number on hand. I believe it is significant, but it is
manageable. Much of it is collateralized. And, when you think
about the things that probably keeps our Chairman up at night,
I think he is worried much more about the things like our
exposure to credit cards, to retail borrowers, to the home
mortgage market and to the leverage loan market.
You know, we recognize that there is risk inherent in the
credit default swap product. We manage it as intelligently as
we can. It is one of a panoply of risks out there. And when you
go through your litany of the various companies that have
failed, I think it is important to note that many of them have
had--credit derivatives have not been a major element of their
failure. Other things, which Dr. Corrigan------
Mr. Pomeroy. Other than AIG.
Mr. Thompson. AIG is the notable example.
Mr. Pomeroy. Notable example to the tune of tens of
billions of dollars of taxpayer money.
Mr. Thompson. And when I think about what happened to AIG--
and it is part of the reason for my answer before about the
only thing that has a prayer of working is a prudential
regulator who has a holistic view of all of the risk activities
of the firm--the problem with AIG was all of its credit
derivatives activities were conducted in a non-insurance
subsidiary which was not subject to meaningful regulatory
oversight.
Mr. Pomeroy. Right. Credit default swaps weren't regulated.
Mr. Thompson. It is not that the product wasn't regulated.
It is that the entity AIG Financial Products was in a
regulatory gap and thus had no meaningful regulatory oversight.
Mr. Pomeroy. I think your distinction there is a little
ridiculous in terms of you don't worry about the products. You
worry about the participants. It is kind of like me not
worrying about the insurance policy I have. It is a fine
policy. It is just that the company backing it up has no
assets. I mean------
Mr. Thompson. No. I think that you need to distinguish
between the product and the entity. J.P.Morgan Chase Bank,
which is subject to prudential regulation by the Fed, has all
our CDS activities scrutinized very, very closely by the Fed.
They are in constant contact with us about information, and
they have a good picture of our overall risk profile with
respect to our CDS activity.
Mr. Pomeroy. So was the Fed monitoring--you are fairly new
under the Fed, right?
Mr. Thompson. No. We have been under the Fed forever.
Mr. Pomeroy. Okay. Would they assess then your net position
for credit default swap activity you were engaging in?
Mr. Thompson. They look at our credit default swap
activities in a variety of ways. One is--I think what you are
getting at is our net position. In other words, how much are we
exposed if GM were to default, for example. And they scrutinize
that very closely. They also scrutinize very closely the
counterparty credit risk which arises as a consequence of our
credit default swap activities.
Mr. Pomeroy. Not to interrupt but just to cut to the chase,
the Fed was monitoring your ultimate exposure on credit default
swap activity?
Mr. Thompson. Yes.
Mr. Pomeroy. Okay. Insurance commissioners weren't clearly
in the component of the AIG holding company.
Mr. Thompson. Insurance commissioners had no jurisdiction.
Mr. Pomeroy. And the SEC wasn't, relative to their
entities, under their regulation that were engaging in this
unregulated activity.
Mr. Thompson. That is my understanding.
Mr. Pomeroy. I don't understand how the SEC could basically
be signing off on reported financial statements of regulated
entities without having the same kind of comprehensive notion
that you are just saying the Fed did relative to your position
on credit default swaps. Do you have a thought about that?
Mr. Thompson. I think that is a reasonable question to ask,
but a question not to ask of me.
The Chairman. The gentleman's time has expired.
We have found out, a month ago, that your total notational
value, according to your filing with the OCC, is $8 trillion at
J.P.Morgan. And they only justify they have as much shorts as
longs. But from what I know about this, that is not the
problem. The problem is that there might be something in there
that looks fine now that might not be, and that is what has
jumped out and got a lot of people. So, anyway, we have to move
on.
In the November 28 issue of the Financial Times, there was
a story in there about how the banks--you guys are setting your
interest rates. And there is a provision in there that ties the
movement of the interest rates to what happens in the credit
default swap market, in terms of, if somebody starts moving
against somebody and drives up their illiquidity or drives down
the price of their stock, then you reprice their interest based
on the movement in that credit default swap. And according to
this article, people were going in and shorting the company and
then making a move against it where one person would sell a
swap to another and then they would sell it to another and that
person would sell it back to the first person so they didn't
have any exposure, and they bankrupted the company and made a
bunch of money on this move. And, I was questioning the SEC
doing this, stopping the short selling. But it clearly looks
likely to be a ridiculous situation if you are stopping it on
stock and not stopping it on the CDS situation.
But getting back to--are you guys doing this? Are you tying
the interest rates to the movement in the CDS market?
Mr. Thompson. The question is directed to me?
The Chairman. You were named, J.P.Morgan, UBS. I think all
of you guys were named as doing this, writing this into your
loan.
Mr. Thompson. It is my understanding that, in certain parts
of the loan market, pricing is sometimes a function of your
borrower's CDS spreads, on the theory that that is a much more
reliable indicator of the actual credit risk that you are
assuming, as opposed to other tests which have been used in the
past, such as your long-term credit rating by one of the major
credit rating agencies. I don't think inherently in and of
itself there is anything improper about that.
The second part that you mentioned, where you have a daisy
chain of people selling protection on a prearranged basis in
order to drive those CDS spreads up, presumably so that you
would change the loan pricing, is I believe called market
manipulation. It is illegal under current law, and anybody who
does it should be prosecuted.
The Chairman. But if the CDS market moves, you can change
the interest rates on it?
Mr. Thompson. I don't know how common a practice that is in
the loan market. I am a derivatives guy. But I do hear of that
from time to time. And if you would like us to report back on
how common a practice this is, we would be delighted to get you
that information.
The Chairman. I would like that.
Along that line for you and Dr. Corrigan and Mr. Murtagh,
what percentage of your existing credit default business do you
expect you will take to clearing? Do you have any idea if we
get do this set up.
Dr. Corrigan. I would estimate--and, again, let me--I
apologize once more--draw a bit of a distinction here, Mr.
Chairman, because this is a very good question.
In volume terms, the answer to your question is going to be
well up into the 90s. In value terms, it might be somewhat less
than that. And the reason why it might be somewhat less than
that is the point that all of these gentlemen have made before,
and that is there is the incidence of a relatively small number
of high-value, highly complex so-called bespoken trades that
just don't fit into a nice neat little box that lends
themselves to either exchanges or to CCPs.
So, overall, I would guess the percentage is probably
around 90, with high 90s for the volume of trades, somewhat
lower number for a small number of high-value trades.
Mr. Murtagh. Mr. Chairman, I don't have a precise number. I
will say it will depend very much on the eligibility
requirements and some of the issues that were alluded to
earlier in terms of the impact of any European initiatives. It
is really very dependent on how this is all taken forward. We
do expect to move a substantial majority of our trading
positions, again by volume, onto a clearing platform as, and
when, it is available. I think it has been suggested earlier
there will be some time lag as we bring these onto the
platform. There are many years of exposure that needs to be
brought along.
Mr. Thompson. My answer would be consistent with these
gentlemen.
The Chairman. What about in the future? What do you expect
of your products, going forward, would be able to be cleared?
You know, I mean, one of the things that I worry about,
especially with this idea that you guys have cooked up with
ICE, that you are trying to get around something. You know,
maybe I am wrong; but I am suspicious.
And so I am just kind of wondering, going into the future,
is that percentage going to stay the same? Are you still going
to be having the same percentage of these ostensibly complex or
structured products as you have in the past? Is that going to
change, or has the marketplace changed so the appetite for this
is not there anymore?
Do you understand what I am talking about?
Mr. Thompson. I do. I don't anticipate it to change
materially from the answers we have given. I think there is a
temporary lull in the market with respect to highly structured
one-off transactions. But I suspect that that will change over
time as well and return to something approximately of what it
was in 2006 where, in terms of the notional amount of
outstanding transactions, the overwhelming percentage are
highly standardized and susceptible to clearing. And there will
be some residue that are not.
The Chairman. If there is more than one clearinghouse
created, how will you make your decision about where to clear
these things? By price or--because you are setting up this--if
you get this thing set up with ICE because you guys are part of
that, you will do everything there or what?
Mr. Thompson. I think we would decide which clearinghouse
to use on the totality of relevant factors: price, service,
capabilities they offer, the claim, the liability we might have
under the guaranty fund. I haven't thought of an exhaustive
list, but we would try to presumably take everything into
account and make the best decision for the firm overall.
Mr. Murtagh. Clearly, there is going to need to be an
identity of who your counterparty is, that they also clear on
the exchange. And then to the point we made earlier in terms of
the eligibility of the contract. But other than getting those
basic points nailed down, I think ultimately after that it will
be a variety of other factors in terms of ease and whoever
provides the best service ultimately.
Dr. Corrigan. I would hope that most of us would base our
decisions to a very, very important extent on the robustness as
we judge it of the financial infrastructure associated with the
clearinghouse. It is the whole set of arrangements, margins,
maintenance margins, guaranteed funds, quality of stress tests.
For me at least, having comfort on that infrastructure would be
more important than a nickel a trade or something like that.
The Chairman. Thank you.
The gentleman from Pennsylvania, Mr. Holden.
Mr. Holden. Thank you, Mr. Chairman.
I have two questions for Mr. Pickel. Mr. Pickel, please
tell us about your experience in conducting CDS auctions; and
does ISDA run all of the auctions itself?
Mr. Pickel. The auctions are not run by ISDA. We have
contracted with two organizations, one called Markit, which is
a data provider for the CDS business, the other called
Creditex, which is an electronic platform, another service
provider, which was acquired over the summer by ICE. So it is a
subsidiary now of ICE. So they are the ones who, on the day of
the auction, will actually collect the information from the
marketplace and calculate the final price based on a very wide
indication of interest from market participants, both dealers
and customers of the dealers who engage in the auction itself.
Mr. Holden. And how much data have you been able to collect
regarding recovery rate for CDS reference entities that have
defaulted?
Mr. Pickel. Well, we don't have the data regarding the
recovery rates. That is published in, recently, DTCC in both
the Lehman situation, I believe, and the Washington Mutual
situation, published information about the amount of payments
that were settled on the--that were made on the settlement date
for the particular name. And that was information that is
available from DTCC.
Mr. Holden. Thank you, Mr. Chairman.
The Chairman. Thank you.
Apparently, this DTCC had been told that this data could be
downloaded to either the CME or the Eurex. Is that true, that
it could be downloaded?
Mr. Pickel. Well, this information--the information that is
made publicly available on the website regarding outstanding
volumes for the vast majority of names traded in the market is
publicly available information, and I think could be
downloaded.
Separately I think for purposes of clearing the------
The Chairman. That wasn't what I was getting at. The
suggestion had been made that we should take all this stuff and
just do a hypothetical--just have it downloaded to CME or to
Eurex. Nobody would have to declare anything. Just put it on
there and see what we would get. What do you think about that
idea?
Mr. Pickel. I don't know exactly how that would work. But,
again, the information is out there. I suspect that people at
the CME and Eurex are probably looking at how they can crunch
that information, use that information to------
The Chairman. Well, it would be for us or for some
policymakers to see what the potential exposure is. By putting
all of this--and I am talking about everything. Just dumping
the whole data into their computers and trying to figure out
the risk and just see where we are at.
Because that is the question that everybody has, is what is
out there that we don't know and how big is it? Is it part of
what is freezing up the credit market? I don't know if this is
a good idea or not. But it came up someplace that this would
be, on an artificial basis, you would put it on there and see
what it generates. But I don't know how you would price it.
Mr. Pickel. I am not sure that the information that is on
the website would be------
The Chairman. I am not talking--everything that you have on
the DTCC, which should be all of these trades, even the ones
that are not cleared. So I am not putting everything on it. Not
just the stuff that is public.
Mr. Murtagh. I think the suggestion may be to take the data
and just drop it into the risk models and run the models and
see what sort of marginal requirements currency it would
actually produce.
Mr. Thompson. We would be supportive of that.
Dr. Corrigan. I think that, to some extent, this has
already been done. I am not familiar with the details, but I
know I have read reports that suggest, for example, that ex-
post, after the fact, precisely that kind of thing was done in
great detail with regard to trying to simulate the Lehman
failure, for example, and to see how that would actually have
played out had it occurred real-time, and if I--I may be wrong
about that. I know I am right. I am not just not sure I have
the facts right. But, hell, that never stops me. I know that
people have done those ex-post simulations. I just can't give
you the chapter and verse.
The Chairman. Theoretically, this could be done.
Dr. Corrigan. I will find out and let your staff know, Mr.
Chairman.
The Chairman. That was something that came up in some
discussion we were having. I just thought I would ask you guys
about it.
Anybody have anything else? I guess we have dragged this on
long enough.
Well, thank you all very much for being with us today. You
have been very generous with your time and answers. We
appreciate it. We are trying to learn as much as we can about
all of this stuff, and I am sure we will be having more
discussions in the future. So thank you all for being with us.
And, with that, the Committee stands adjourned until the
call of the chair.
[Whereupon, at 4:43 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement of Hon. Bart Stupak, a Representative in Congress
From Michigan
I want to commend Chairman Peterson and the Committee on
Agriculture for this recent series of hearings to assess whether
loopholes in the Commodity Exchange Act have permitted the credit
default swaps market to, in the words of Warren Buffet, become a
``financial weapon of mass destruction'' against our economy.
Credit default swaps are supposed to insure against the decline in
the value of debt instruments such as mortgages. However, unlike
traditional debt insurance, there is no regulator who requires that the
underwriter have the money to pay up on the insurance policies they
write.
It is estimated that the credit default swaps market has
skyrocketed to at least $57 trillion, which is nearly ten times the
size of the underlying debt obligations that these swaps ostensibly
insure. That means 90% of the credit default swaps are simply bets by
entities that have no underlying insured interest--such as a mortgage
that they hold and want insurance against the borrower's inability to
repay the loan.
Credit default swaps are naked insurance contracts, and are no
different than a gambling ticket--whereby a party puts a small amount
down for a large potential payoff tied to a specific event.
Gambling like this creates perverse incentives and Congress should
examine whether these instruments should be outlawed in the future.
For example, major investment banks, such as Goldman Sachs,
reportedly took huge bets on the decline of the mortgage securities
they were simultaneously marketing to their clients.
University of Texas Professor Henry Hu has questioned whether
bankruptcy creditors who also hold credit default swaps would be
incentivized to force a company out of business rather an allow them to
successfully reorganize--to the detriment of other creditors and
employees. Financial contracts that create the incentive to bring about
loss beg to be regulated by insurance regulators.
The 2000 amendments to the Commodity Exchange Act provided ``legal
certainty'' that swaps would not be subject to regulation. This enabled
a massive dark market in commodity swaps to flourish. The unregulated
commodity swaps market now dwarfs the size of trading on regulated
commodity futures exchanges. In addition, the CFTC has allowed swaps
dealers to be exempted from rules which prevent excessive speculation
when they take positions in futures markets. These loopholes when
combined with a massive inflow of capital contributed to an oil price
bubble which, at its peak, reached $147/barrel in July. Then over the
past 5 months, as investment banks and insurers were forced to
liquidate, bets on commodities were unwound. Coupled with plunging
economic activity, oil prices have fallen over $100 per barrel to $42
per barrel today--a 71% drop in a matter of 5 months. Changes in supply
and demand by themselves do not explain this volatility in oil or other
energy commodity prices.
This volatility has inflicted severe damage to the economy.
Airlines that sought to hedge rising jet fuel prices last summer when
investment banks predicted $200/barrel oil, now face hundreds of
millions in losses because they are obligated to buy fuel far above
today's market price. Ethanol producers who sought to protect
themselves against skyrocketing corn prices watched a bushel of corn
drop by half in a matter of months, and now face collateral calls that
have forced some into bankruptcy. How can automakers gear up to meet
demand for fuel efficient cars that are competitive at $4.00 per gallon
when prices dramatically plummet to $1.75 per gallon in a matter of
months?
Reasonable regulation is needed to ensure commodity prices reflect
the underlying supply and demand, and that credit default swaps are
either regulated or eliminated. We respectfully ask that the following
questions be addressed in the course of your hearings:
The Federal Reserve has proposed centralized clearing of
trading in credit default swaps. Is centralized clearing
sufficient to ensure these instruments cannot create a systemic
risk to financial system?
Should credit defaults swaps be regulated as an insurance
product so that those selling the product have enough money to
pay claims? If so, should credit default swaps be subject to
state insurance regulations, or should there be a Federal
regulator?
Should the same regulator which oversees trading and
clearing of swaps transactions also serve as the insurance
regulator? Or should there be separate regulators?
Should credit default swaps be deemed an unlawful if there
is no underlying insurable risk held by the owner of the swap?
Given the availability of traditional bond insurance, why
shouldn't credit default swaps be deemed contrary to the well
being of society and outlawed altogether?
To what extent are the incentives to reorganize companies in
bankruptcy undermined by creditors who can profit more through
credit default swaps holdings than through a successful
restructuring which might permit continued operations and
repayment of creditors? Should financial contracts that create
the incentive to bring about loss beg to be regulated by
insurance regulators?
Should the Administration work to reach agreement with the
G20 countries on a common basis for regulation, or is a
supranational regulator needed to monitor and protect against
systemic risk?
Should swaps exemptions in the CEA be eliminated? Should
preemption of state bucketing and gaming laws be removed from
the CEA? Should the concept of exempt and excluded commodities
be eliminated from the CEA? Should foreign boards of trade
operating in the U.S. be subject to U.S. regulation?
We look forward to working with you as you consider reforms to the
Commodity Exchange Act. Please contact me at [Redacted] if you have any
questions.
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Submitted Statement of Citigroup Inc.
Citigroup Inc. welcomes this opportunity to submit written
testimony regarding the role of credit derivatives in the U.S. economy.
The Credit Derivatives Market
CDS are the most common type of credit derivative traded in the
market today. Although CDS are a relatively recent financial
innovation, they have become the most important tool available to
market participants for managing and trading credit risk. Unlike cash
instruments, such as bonds and loans whose values are also influenced
by factors other than credit risk, such as interest rate movements, CDS
allow market participants to purchase and trade ``pure'' credit risk.
In addition, CDS enable market participants to hedge credit
exposures to individual companies, industry or geographic sectors, or
several companies at the same time. The versatility of CDS has led to
the development of a liquid CDS market, providing market participants
with access to an efficiently priced measure of the financial condition
of reference entities.
As a result, CDS have quickly become important and widely used
instruments in the financial markets. The ability of companies to issue
securities or obtain loans at attractive pricing levels is
significantly enhanced by the CDS market due to the ability of
investors and lenders to hedge their resulting credit exposures through
the purchase of CDS protection. Further, CDS enable banks to hedge the
credit risks inherent in corporate financings that are essential to
economic growth, and, in turn, reduce the cost of funds for borrowers.
CDS also free up additional credit capacity, which enables banks to
expand credit facilities available to their corporate clients. In
addition, many market participants use CDS pricing to provide a more
accurate valuation of credit risk than would otherwise be possible by
looking solely to less liquid cash markets. We have seen the CDS market
for corporate issuers continue to perform this important function very
effectively during the current crisis at a time when related credit
markets had become illiquid.
The Performance of CDS in the Current Market
The corporate CDS market, as a whole, has performed well and
provided much needed liquidity throughout the current market turmoil.
The bond markets, by comparison, have become increasingly illiquid as
investors have either hoarded cash or lost the ability to access
financing. The strength and resiliency of the corporate CDS market has
been demonstrated over the last few months as multiple entities
referenced under large numbers of CDS contracts failed, including
Lehman Brothers, Fannie Mae, Freddie Mac, Washington Mutual, and
several significant Icelandic financial institutions. Despite these
defaults, the CDS market has continued to perform well and has remained
liquid. CDS trades that referenced the defaulting companies were
settled in an orderly manner and in accordance with CDS participants'
expectations. Although the significant size of the notional amounts of
the CDS contracts referencing these entities was often reported in the
media and cited as a danger to the stability of the markets, the
settlement of obligations due under such CDS contracts went smoothly,
in part, due to standard market conventions pursuant to which sellers
of credit protection collateralize their commitments to buyers of
credit protection as the credit of reference entities deteriorates. The
effective operation of these markets was also benefited by the use of a
voluntary auction settlement process that facilitates an orderly
settlement of trades based on a single market-determined settlement
price.
The segment of the CDS market that experienced large losses and the
greatest difficulties involved CDS related to asset backed securities
linked to the subprime real estate market. Although the asset backed
CDS market is a relatively small segment of the overall CDS market,
large leveraged exposures in this segment magnified losses in the
subprime real estate market. The root causes of the problems
experienced with this segment of the CDS market arose from a number of
sources, including primarily: the failure of sellers of credit
protection, most notably monoline insurance companies, to collateralize
their commitments as is customary in the corporate CDS market; an
historic collapse in housing prices accompanied by soaring rates of
mortgage delinquency and default; and a market-wide failure to
appreciate the scope of the risk represented by exposure to the
subprime real estate sector.
It also should be acknowledged that the fast-paced growth in the
CDS market has presented significant operational challenges for major
market participants. Numerous initiatives by the private sector in
coordination with the official sector have contributed successfully to
addressing these issues. One of the most important of these that is
near completion is the creation of a central counterparty to clear CDS
transactions.
Creation of Central Counterparty for CDS and Other Infrastructure
Issues
Citigroup supports the creation of a clearinghouse to act as the
central counterparty to CDS transactions. Citigroup has been an active
participant in developing a central clearinghouse solution since the
initiative to establish a clearinghouse for CDS was first launched in
early 2007. Having a central counterparty will significantly reduce the
scope of credit risks, capital inefficiencies and operational
challenges that are currently associated with CDS trading, and will
enable regulators to better monitor trends in CDS, including the
positions of market participants, and provide access to aggregate end-
of-day pricing for market participants.
Citigroup believes that clearinghouse and settlement services
should be open to numerous trading venues in order to encourage
competition in execution services, provide all market participants with
more choice and lower execution fees, and spur innovation in a
regulated environment. This year has seen the beginning of this process
as several electronic trading venues were launched. Each provides
auditable trading capabilities to enhance transparency and each offers
effective straight-through-processing solutions to increase operational
efficiency. The central clearinghouse will also help provide additional
market data beyond the significant amount of data currently published
weekly by the Depository Trust & Clearing Corporation on the most
commonly traded corporate reference entities.
In addition to the development of a central counterparty for CDS,
Citigroup continues to support the numerous initiatives among both
industry representatives and regulatory agencies from across the globe
that are currently underway to build a more efficient operational
infrastructure for the over-the-counter CDS market. Such initiatives,
which began in 2005, include improvements to the back-office processes
for credit derivatives and other products, increased use of electronic
processing and faster confirmation of trades, greater use of central
repositories, faster trade confirmation, efforts to eliminate redundant
trades that cause capital inefficiencies and increase operational risk,
and the hardwiring of an auction settlement process into standard CDS
transactions.
The Regulation of CDS
As a bank holding company, Citigroup is subject to comprehensive
regulation by Federal banking regulators with respect to all of its
activities, including its CDS activities, as well as to the SEC's anti-
fraud and anti-manipulation authorities. Nonetheless, to the extent
there are gaps in oversight of the CDS market, Citigroup is receptive
to carefully tailored Federal regulation that addressees such gaps,
while preserving the ability of the CDS market to continue to evolve
and provide the considerable benefits that this market currently
provides to all segments of the U.S. economy. In particular, Citigroup
believes that any additional regulation of CDS should adhere to the
following principles:
Consolidated Oversight. Citigroup strongly believes that oversight
of both over-the-counter and centrally-cleared CDS should be
consolidated in a single Federal regulator that has the resources and
authorities necessary to address systemic risk. Consolidation of
regulatory oversight of the CDS market can help prevent gaps in
oversight, duplication, inconsistency, and ambiguity as to the
jurisdiction of one regulator over another. Unfortunately, both the
industry and the regulatory community are dealing with these issues
today as a result of the fragmented nature of our current regulatory
structure. Accordingly, in the near-term, we believe it is imperative
that regulators coordinate with one another in overseeing the CDS
market. In this regard, Citigroup believes the execution of the
Memorandum of Understanding between the Federal Reserve Board, the
CFTC, and the SEC is a helpful interim measure. In addition, we believe
it is imperative that any action taken in the U.S. is coordinated with
actions taken in other jurisdictions, particularly the EU, as they seek
to address the CDS market.
Enhanced Information to Regulators. Citigroup supports measures
that would provide regulators enhanced access to information regarding
the CDS market. In this regard, we believe the formation of a central
clearinghouse will provide an important tool and centralized source for
regulators to obtain enhanced information on pricing, on significant
position concentrations of central clearinghouse participants, and on
trends within the CDS market more broadly. In addition, Citigroup also
supports measures to allow regulators to obtain information from
systemically significant market participants regarding their CDS
activity. Such reporting requirements must be coordinated among
regulators both within the U.S. and internationally to prevent
duplicative or inconsistent information requests; information sharing
arrangements among regulators can mitigate occurrences of such
requests, while significantly benefiting the ability of regulators to
obtain information regarding CDS market participants.
Maintain Benefits of CDS. Citigroup believes it is necessary that
any regulation preserve the considerable benefits that the CDS market
currently provides to all segments of the U.S. economy. In particular,
we believe that a central clearinghouse should supplement, rather than
replace, over-the-counter bilateral CDS trading venues. Regulation
mandating submission of all CDS transactions to a central clearinghouse
would have a detrimental impact on the CDS market by preventing market
participants from entering into tailored contracts designed to achieve
specific risk management or investment objectives or developing new
products that lack the degree of standardization and product maturity
necessary to facilitate clearing. Mandated submission would stifle
innovation in the CDS market, limiting the ability of both the industry
and regulators to continue to improve the CDS market, and significantly
reducing the benefits of the CDS market described earlier. Similar
concerns would be presented by any mandate that CDS be limited to
exchange trading. This view is in line with those expressed by the
President's Working Group in November, which recognized that market
participants must have the flexibility to enter into customized
bilateral contracts as circumstances and risk management objectives
warrant.
Conclusion
Despite the fact that CDS are a relatively recent financial
innovation, they have rapidly become an important tool for mitigating
and transferring credit risk, and, as such, have provided significant
benefits to banks, borrowers, investors and the U.S. economy as a
whole. Recognizing the importance of CDS, Citigroup will continue to
support efforts to address the risks and further improve the
efficiencies and operational infrastructure of the CDS market, and we
look forward to working with Congress and regulators on initiatives to
improve oversight of CDS, while maintaining the significant benefits
the CDS market currently provides.
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Supplemental Material Submitted By Bryan M. Murtagh, J.D., Managing
Director, Fixed Income Transaction Risk Management, UBS Securities LLC
December 16, 2008
Hon. Collin C. Peterson,
Chairman,
Committee on Agriculture,
Washington, D.C.
Dear Chairman Peterson:
Thank you for the opportunity to testify as part of your
Committee's review of the role of credit derivatives in the economy and
the regulatory framework that governs them.
During the course of last week's hearing, I was asked two questions
by Members of your Committee Mr. Costa of California and Mr. Pomeroy of
North Dakota for which I did not have an answer readily available.
Below are my responses to both of these questions:
Congressman Costa. ``How much ownership interest would you have
in an ICE Trust being proposed?''
UBS will receive 6.31% of the Class B units (i.e., its current
percentage interest in The Clearing Corporation). Based on the profit
participation of the Class B units, UBS would receive 3.1575% of the
ICS Trust's net profits. The Class B units have limited voting rights
relating to certain dilutive actions or affiliated transactions. In
addition, the Class B units participate in the selection of the ICS
Trust's Risk Committee, which performs an advisory role to ICE Trust'
management.
Congressman Pomeroy. ``What is the liability position of UBS
relative to its presently held positions on credit default
swaps?''
On November 4, 2008, UBS published its third quarter results. On
page 63 of this report (attached), we include a table outlining
information relating to credit derivative contracts, which includes
credit default swaps. As described in that table, the aggregate
notional amount of UBS' credit derivative contracts as of September 30,
2008 was 4,574 billion SFr ($4,084 billion). The net replacement value
of these credit derivative contracts as of that date was 5.0 billion
SFr ($4.4 billion), which reflected positive replacement value (i.e.,
amounts owed to UBS) of 149 billion SFr ($133 billion) and negative
replacement value (i.e., amounts owed by UBS) of 144 billion SFr ($129
billion). The table includes similar information for as of June 30,
2008 and December 31, 2007.
Mr. Chairman, we thank you again for the opportunity to testify
before your Committee.
Should you or other Members of the Committee require any additional
information as you continue your review of credit derivatives, please
do not hesitate to contact me.
Sincerely,
cc:
Hon. Bob Goodlatte,
Ranking Minority Member;
Hon. Jim Costa;
Hon. Earl Pomeroy.
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