[House Hearing, 110 Congress]
[From the U.S. Government Publishing Office]



 
  HEARING TO REVIEW THE ROLE OF CREDIT DERIVATIVES IN THE U.S. ECONOMY

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



                                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

                              ----------                              
                                                                   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

                              ----------                              


                      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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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).
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    \5\ Indeed, it now appears that AIG may be the beneficiary of up to 
an additional $37.8 billion in Federal aid.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \6\ Over-the-Counter Derivatives Markets and the Commodity Exchange 
Act, Report of the President's Working Group on Financial Markets, 
November 1999.
---------------------------------------------------------------------------
    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
---------------------------------------------------------------------------
    * Copyright  2008 by Henry T.C. Hu. All rights reserved.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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)
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
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    \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\
---------------------------------------------------------------------------
    \4\ As of December 4, 2008.

    Working closely with its members, LCH.Clearnet has successfully 
---------------------------------------------------------------------------
        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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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).
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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\
---------------------------------------------------------------------------
    \1\ For a detailed description of the CDS see Appendix A.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
                                 ______
                                 
                 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.
                                 ______
                                 
  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.
[GRAPHIC] [TIFF OMITTED] 

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