[Senate Hearing 110-1007]
[From the U.S. Government Publishing Office]
S. Hrg. 110-1007
REDUCING RISKS AND IMPROVING OVERSIGHT IN THE OTC CREDIT DERIVATIVES
MARKET
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HEARING
before the
SUBCOMMITTEE ON
SECURITIES AND INSURANCE AND INVESTMENT
OF THE
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TENTH CONGRESS
SECOND SESSION
ON
REDUCING RISKS AND IMPROVING OVERSIGHT IN THE OTC CREDIT DERIVATIVES
MARKET
__________
WEDNESDAY, JULY 9, 2008
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate /
senate05sh.html
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York WAYNE ALLARD, Colorado
EVAN BAYH, Indiana MICHAEL B. ENZI, Wyoming
THOMAS R. CARPER, Delaware CHUCK HAGEL, Nebraska
ROBERT MENENDEZ, New Jersey JIM BUNNING, Kentucky
DANIEL K. AKAKA, Hawaii MIKE CRAPO, Idaho
SHERROD BROWN, Ohio ELIZABETH DOLE, North Carolina
ROBERT P. CASEY, Pennsylvania MEL MARTINEZ, Florida
JON TESTER, Montana BOB CORKER, Tennessee
Shawn Maher, Staff Director
William D. Duhnke, Republican Staff Director and Counsel
Dean V. Shahinian, Counsel
David Stoopler, Professional Staff Member
Andrew Olmem, Republican Counsel
Dawn Ratliff, Chief Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
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Subcommittee on Securities and Insurance and Investment
JACK REED, Rhode Island, Chairman
WAYNE ALLARD, Colorado, Ranking Member
ROBERT MENENDEZ, New Jersey MICHAEL B. ENZI, Wyoming
TIM JOHNSON, South Dakota ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York CHUCK HAGEL, Nebraska
EVAN BAYH, Indiana JIM BUNNING, Kentucky
ROBERT P. CASEY, Pennsylvania MIKE CRAPO, Idaho
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
JON TESTER, Montana
Didem Nisanci, Staff Director
Tewana Wilkerson, Republican Staff Director
C O N T E N T S
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WEDNESDAY, JULY 9, 2008
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Allard............................................... 5
WITNESSES
Patrick M. Parkinson, Deputy Director, Division of Research and
Statistics, Board of Governors of the Federal Reserve System... 3
Prepared statement........................................... 34
Response to written questions of:
Senator Reed............................................. 136
James A. Overdahl, Chief Economist, Securities and Exchange
Commission..................................................... 6
Prepared statement........................................... 47
Kathryn E. Dick, Deputy Comptroller for Credit and Market Risk,
Office of the Comptroller of the Currency...................... 7
Prepared statement........................................... 54
Response to written questions of:
Senator Reed............................................. 141
Senator Crapo............................................ 146
Darrell Duffie, Dean Witter Distinguished Professor of Finance,
Graduate School of Business, Stanford University............... 23
Prepared statement........................................... 100
Response to written questions of:
Senator Reed............................................. 147
Senator Crapo............................................ 151
Robert Pickel, Chief Executive Officer, International Swaps and
Derivatives Association........................................ 25
Prepared statement........................................... 105
Response to written questions of:
Senator Reed............................................. 152
Senator Crapo............................................ 152
Craig S. Donohue, Chief Executive Officer, Chicago Mercantile
Exchange Group Inc............................................. 27
Prepared statement........................................... 110
Edward J. Rosen, Cleary Gottlieb Steen & Hamilton LLP, Outside
Counsel to The Clearing Corporation............................ 29
Prepared statement........................................... 121
Additional Material Supplied for the Record
Prepared statement of The Managed Fund Association............... 154
Letter from the Board of Governors of the Federal Reserve System
and Federal Reserve Bank of New York........................... 160
Letter from the Commodity Futures Trading Commission............. 164
Letter from the Securities and Exchange Commission............... 166
REDUCING RISKS AND IMPROVING OVERSIGHT IN THE OTC CREDIT DERIVATIVES
MARKET
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WEDNESDAY, JULY 9, 2008
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment, Committee on Banking, Housing, and
Urban Affairs,
Washington, DC.
The subcommittee met at 2:02 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. I will call the hearing to order. Senator
Allard is on his way. We have a vote or a series of votes that
is scheduled to begin at approximately 2:15. So I would make my
opening statement, and then I will recognize the panel. But
when Senator Allard arrives, we will interrupt or conclude that
statement and give him the opportunity to make his opening
statement. Although we do not have any additional colleagues
here yet, I would ask them to defer their opening statements so
we can get into the heart of the matter.
Let me welcome the witnesses, the first panel and the
second panel. I will introduce them individually in a moment.
But let me begin.
Since its inception, the credit derivatives market has
grown exponentially--in trading volume, in total value of
outstanding contracts, and also in the potential risks that
these instruments pose. According to the International Swaps
and Derivatives Association, the credit derivatives market has
exploded with the total notational value of contracts growing
from $919 billion in 2001 to over $62 trillion in 2007. Though
some argue that total losses could be less than this, perhaps
at around $2 trillion to replace all existing contracts in the
event of widespread default, this remains a staggeringly high
number.
The tremendous growth in this market occurs in an
environment of incidental regulation and an infrastructure that
has not kept pace with trading volumes and product complexity.
Today's hearing is an opportunity to explore a number of
issues, including the risks that these products pose to the
financial system and the proposed approaches to reducing such
risks through a central clearing entity or an exchange.
Counterparty risk in this market is now a major concern. It
played a significant role in problems surrounding Bear Stearns
and paved the way for the new ``too interconnected to fail''
standard. The lack of information and transparency with regard
to this market led to inadequate monitoring of risk in credit
default swaps. As some have suggested, this issue of
counterparty risk has become a ticking time bomb. These
products are traded from one counterparty to another to
another, making it virtually impossible to know who is holding
what and complicating regulators' ability to oversee
concentration of risks that buildup in the system.
Infrastructure problems have also long plagued the credit
derivatives market. This complex market has not been completely
automated to confirm trades and track overall risks. Though the
industry has made progress in automating risks, highly
structured and customized contracts are still difficult to
automate and confirm.
Since 2005, regulators, led by the New York Federal Reserve
Bank, have been coordinating efforts with the industry to
reduce risk in this market and have been gathering data about
the backlogs in confirmations. Though progress has been made,
it seems that whenever we have seen increased trading volumes
or fear that a major counterparty might go bankrupt, like with
Bear Stearns, suddenly all the progress fades away, and we have
spikes in the confirmation backlogs and in trade novations,
which strains the system and increases risk.
After 3 years of efforts, there has been some progress, but
are we becoming too complacent in our efforts to fully address
these risks and make the market more efficient and resilient?
Additionally, as the credit derivatives market plays an
increased role in setting the course of corporate debt, it
becomes critical that these prices reflect the actual risk of
default. For example, the interest that some companies pay for
their revolving credit is beginning to be based upon price
fluctuations in credit derivatives. However, there are no
regularly and publicly reported prices for credit derivatives,
leaving room for perception and rumor to factor into pricing
more than true economic fundamentals.
What information is used to set these prices and should
they be made public to avoid manipulation is another serious
question. The current proposals to handle these emerging risks
center on a proposed clearing entity with the main dealers as
members. But who will oversee this entity, and who determines
what trades will be cleared through this entity? If we have a
clearinghouse that lacks oversight, coupled with inadequate
risk management, does that really reduce the risk in the
marketplace?
Any new actions in this market must include improved
regulatory oversight. Have the regulators considered the
importance of price discovery in this market? And whether it
can be achieved through the clearing entity or whether it
requires an exchange is another important question.
With the recent sobering experience in the subprime
mortgage market, we must do more than hope that there isn't
another next big problem. Rather than just hoping, this hearing
is an attempt to explore these issues and bring them out on the
table in an effort to help move the industry and regulators
forward in resolving these difficult challenges.
And as I indicated, when Senator Allard arrives, he will be
recognized, but let me introduce the witnesses of our first
panel and then ask them to make their statements.
Mr. Patrick Parkinson is the Deputy Director, Division of
Research and Statistics, Board of Governors of the Federal
Reserve System.
Mr. James Overdahl is the Chief Economist and Director,
Office of Economic Analysis, United States Securities and
Exchange Commission.
And Ms. Kathryn E. Dick is the Deputy Comptroller for
Credit and Market Risk, Office of the Comptroller of the
Currency.
Your statements will be made part of the record. If you
would like to refine them, compress them, that is completely up
to you. And as I said, we are going to try to get through as
many statements as we can before the vote is called. But first
let me recognize Mr. Parkinson.
Could you bring the microphone forward and turn it on?
STATEMENT OF PATRICK M. PARKINSON, DEPUTY DIRECTOR, DIVISION OF
RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL
RESERVE SYSTEM
Mr. Parkinson. Thank you. Chairman Reed, other Members of
the Subcommittee, I am pleased to appear today to discuss the
over-the-counter derivatives market.
Estimates of the size of the global market for such
instruments indicate that it has been growing very rapidly. The
very rapid growth of the market reflects their perceived value
for managing credit risks. But use of credit derivatives
entails risks as well as benefits. Of particular importance is
counterparty credit risk.
Although the credit derivatives market often is described
as unregulated, by its nature it is subject to significant
regulatory oversight. All transactions in the market are
intermediated by dealers, and all major dealers are commercial
or investment banks that are subject to prudential regulation
by U.S. or foreign banking regulators or by the SEC. The
prudential supervisors devote considerable attention to the
dealers' management of the risks associated with activities in
the credit derivatives market and other OTC derivatives
markets, especially to their management of counterparty risk.
In addition, prudential supervisors, under the leadership
of the Federal Reserve Bank of New York, 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 adverse consequences, dealers
reported large backlogs of unconfirmed trades. By making
greater use of available platforms for electronic confirmation
of CDS trades, just a year later, by September 2006, they had
reduced confirmations outstanding more than 30 days by 85
percent.
Nonetheless, the financial turmoil during the summer of
2007 convinced prudential supervisors and other policymakers
that further improvements in the market infrastructure were
needed. In their reports on the financial market turmoil, both
the President's Working Group on Financial Markets and the
international Financial Stability Forum asked prudential
supervisors to take further actions to strengthen the OTC
derivatives market infrastructure.
The New York Fed convened a meeting of supervisors and
market participants on June 9th 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 includes developing well-designed central counterparty
services to reduce systemic risks. Several plans were already
under development to provide CCP services to the credit
derivatives market.
A central counterparty 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.
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, but at the same time require that
a CCP be supervised by an appropriate authority, such as a
Federal banking agency, the Commodity Futures Trading
Commission, or the SEC.
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.
An exchange is a mechanism for executing trades that allows
multiple parties to accept bids or offers from other
participants. Exchange trading requires a significant degree of
standardization of contracts. But where exchange trading of OTC
credit derivatives is feasible, it can produce several
benefits, including intermediation by a well-designed CCP,
elimination of confirmation backlogs, increased market
liquidity, and increased transparency with respect to bids and
offers, and the depth of markets at those bids and offers.
For these reasons, policymakers should encourage greater
standardization of contracts, which would facilitate more
trading on exchanges. 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.
I will be pleased to answer any questions you may have.
Thank you.
Chairman Reed. Thank you very much, Mr. Parkinson.
Now I would like to recognize Senator Allard for his
opening statement.
STATEMENT OF SENATOR WAYNE ALLARD
Senator Allard. Mr. Chairman, thank you very much. Sorry I
was late. I was in a very important meeting that I could not
get away from, and I appreciate your commitment to starting on
time. I had the same commitment. And I think that is the way we
need to run our committees. It is all too frequently that we
sit around and sit around and wait for somebody to show up for
a committee meeting to start.
I would like to thank you, Chairman Reed, for convening
this hearing of the Securities Subcommittee to examine the
over-the-counter derivatives market. The recent turmoil in the
credit markets and the demise of Bear Stearns have caused many
to scrutinize the role of credit derivatives and banks'
exposure to these potentially risky financial instruments. Even
though credit derivatives and the OTC market have existed since
the mid-1990s, they are still relatively new and trade on an
immature market that lacks substantial infrastructure and
transparency compared to other markets.
Since 2005, the Federal Reserve Bank of New York has taken
an active role in bringing together market participants and
supervisory agents in order to improve the OTC credit
derivative clearing and settlement process and to better ensure
risk management practices. This proactive approach was the
result of a backlog in the confirmation of credit derivatives
trades. A backlog totaling over 150,000 unconfirmed trades was
the result of relying on an inefficient manual confirmation
process that failed to keep up with growing volume and because
of the difficulties in confirming information for trades.
Through initiatives and innovation in the marketplace, the
number of credit derivatives confirmation outstanding more than
30 days has been reduced by 86 percent. That number will
hopefully continue to increase as we go forward.
I am pleased to see market participants and regulators have
agreed on an agenda that will continue to foster further
improvements in the OTC derivatives market's infrastructure.
This agenda will include developing a central counterparty for
credit swaps that will have a strong risk management
organization that can help reduce systemic risk.
The Clearing Corporation expects to start guaranteeing OTC
credit derivatives contracts in the third quarter of 2008,
increasing the credit default swaps products covered through
2008-2009. Not only will the introduction of a central
counterparty help reduce systemic risk, but it will also help
bring more transparency into the market.
While regulators and participants have taken some necessary
steps to improve the transparency and infrastructure of the OTC
credit derivatives market, further steps are still needed. Just
yesterday, at an FDIC conference on mortgage lending, Chairman
Bernanke said the infrastructure for managing these derivatives
still is not as efficient or reliable as other markets. As was
evident last summer when a surge in credit default swaps,
trading volume greatly increased backlogs of unconfirmed
trades.
I would like to take this time to welcome our distinguished
panelists for joining us today and thank them for their
testimony as we continue our look into the credit market.
Again, thank you, Chairman Reed, for convening today's
important hearing. I look forward to hearing from our
witnesses.
Chairman Reed. Thank you very much, Senator.
Mr. Overdahl, your statement, please.
STATEMENT OF JAMES A. OVERDAHL, CHIEF ECONOMIST, SECURITIES AND
EXCHANGE COMMISSION
Mr. Overdahl. Chairman Reed, Ranking Member Allard, I am
pleased to have the opportunity to testify today regarding the
Securities and Exchange Commission's efforts to encourage
enhancements to the operational infrastructure of the over-the-
counter credit derivatives market.
The SEC has a strong interest in this topic because of its
oversight of the largest internationally active U.S. securities
firms through its voluntary consolidated supervised entities,
or CSE, program. Each firm in this group--which includes
Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan
Stanley--plays a significant role in the over-the-counter
derivatives market. Strengthening the operational efficiency of
this market will serve to increase the effectiveness of
counterparty credit risk management systems used by these
market participants.
In their role as dealers, the CSEs make active markets in
credit derivatives and rely on these instruments to hedge their
dealing risk and to take proprietary positions. This buying and
selling of default protection generates market credit and
operational risk for the CSEs. At the same time, this activity
generates potential credit risk exposure for the CSEs' trading
counterparties. A significant part of the Commission's CSE
program is dedicated to monitoring and assessing CSEs' market
and credit risk exposures that arise from these trading and
dealing activities.
In terms of operational risk, credit derivatives pose
challenges for prudential supervisors. One challenge is that
the efforts of the CSE firms to reduce market and credit risk
exposures can often serve to increase the operational risk
borne by these firms. This is because the easiest way to reduce
risk often is to enter into new, offsetting trades rather than
to unwind ones. This paradox, in part, explains why the
Commission is interested in centralized clearing as one means
for improving the operational efficiency of credit derivatives
trading.
A paramount concern of supervisors and market participants
about proposed clearing systems for credit derivatives such as
the system recently proposed by The Clearing Corporation will
be the ability of a central counterparty, or CCP, to implement
sound risk management practices. This is because the CCP
concentrates risk. A CCP typically ``novates'' bilateral
contracts so that it assumes any counterparty risks. Novation
allows the CCP to enter into separate contractual arrangements
with both of the contract's counterparties--becoming buyer to
one and seller to the other.
A CCP can serve a valuable function in reducing systemic
risk by preventing the failure of a single market participant
from having a disproportionate effect on the overall market. A
CCP also may facilitate the offset and netting of obligations
arising from contracts that are cleared through the system.
While providing a number of potential benefits, a CCP for
credit derivatives should not be viewed as a silver bullet for
concerns about risk related to these instruments. Even with a
CCP, preventing a systemic risk buildup would require that
dealers and other market participants manage their remaining
bilateral exposures effectively, a process that will require
ongoing regulatory oversight.
SEC staff has been addressing the question of whether a CCP
must register as a securities clearing agency and the potential
availability of exemptive relief. We have also been approached
about the possibility of the Commission issuing an exemption
for broker-dealer registration for firms that would use the
CCP. We are currently considering how best to proceed.
It is not uncommon for derivative contracts that are
initially developed in the over-the-counter market to become
exchange-traded, as the market for the product matures.
Exchange trading of credit derivatives would add both pre-and
post-trade transparency to the market and can also reduce
liquidity risk by allowing market participants to efficiently
initiate and close out positions. In this regard, I note that
last year the Commission approved the proposal by the Chicago
Board Options Exchange to list and trade two credit default
products.
As you can see, developments in the derivatives space pose
significant operational and regulatory challenges, which will
have to be addressed as this market matures. Again, thank you
for this opportunity to discuss these important issues, and I
welcome your questions.
Chairman Reed. Thank you very much, Mr. Overdahl.
Ms. Dick, please.
STATEMENT OF KATHRYN E. DICK, DEPUTY COMPTROLLER FOR CREDIT AND
MARKET RISK, OFFICE OF THE COMPTROLLER OF THE CURRENCY
Ms. Dick. Chairman Reed, Ranking Member Allard, and Members
of the Subcommittee, I appreciate this opportunity to discuss
how the OCC supervises derivative activities in national banks
and to share our views on the risk mitigation efforts underway
in the credit derivatives market.
I have spent 24 years at the OCC working as a national bank
examiner and have had the opportunity to examine the
derivatives and trading activities at many of our largest
national banks that function as financial intermediaries in
over-the-counter derivative markets. I currently serve as the
Deputy Comptroller for Credit and Market Risk supporting OCC
senior management and identifying supervisory solutions for
financial risk management issues in the national banking
system.
For over 20 years, OTC derivatives have been an important
component of the risk management products and services that
national banks offer to their clients. As noted in our first
quarter 2008 derivatives report that is attached to my written
statement, the five largest national banks, all supervised by
the OCC, account for 97 percent of the total U.S. commercial
bank derivative holdings. These same five banks are responsible
for nearly all credit derivatives trading among U.S. commercial
banks.
We believe that these large national banks with their
access to resources for people, technology, and capital to
support trading businesses are best equipped to shoulder these
risks. This does not mean they will not make mistakes. These
are not risk-free businesses. But it does mean they have the
wherewithal to devote the necessary talent and resources to
establish risk management systems that meet the expectations
and standards set by the OCC.
At these large national banks, the OCC has established
resident teams of examiners who serve as the foundation of our
supervisory program with their continuous, onsite examination
of complex areas such as credit derivatives. The dynamic nature
of bank trading activities requires the OCC to frequently
evaluate our risk management expectations, clearly communicate
these expectations to our banks, and continually evaluate their
compliance with our standards.
From our perspective, there are two significant risks in
the credit derivatives market: the first is counterparty credit
risk; the second is operational risk. The OCC and other
regulatory agencies are actively working to address these risks
in the credit derivatives market. Given the global nature of
derivative markets, these risks and the issues they raise cut
across legal and national boundaries. As a result, our efforts
involve both U.S. and key foreign regulators and are aimed at
all of the major global financial market participants,
commercial and investment banks.
Through collaborative work, we have been successful in
focusing industry attention on significantly reducing aged
outstanding confirmations in the credit derivatives market,
while increasing automation to ensure a stronger financial
market going forward. We have also been successful in
developing a set of risk metrics that improves transparency
among firms and supervisors. And we have developed a useful
forum for identifying and responding to emergent issues in a
timely manner. But our work is not done.
At our June 9th meeting between supervisors and the
industry participants, agreement was reached on an expanded set
of future goals. The industry is developing a new commitment
letter that will address, among other things, new trade-
processing goals, a proposed central counterparty
clearinghouse, incorporating an auction-based settlement
mechanism into standard derivatives documentation, and
extending these infrastructure improvements to over-the-counter
equity, interest rate, foreign exchange, and commodity
derivatives.
The clearinghouse proposal, which would create a central
counterparty for the clearing of credit derivatives should
reduce counterparty risk and operational risk by providing a
mechanism for multilateral netting among major market
participants. A related issue is the question of whether an
exchange should be created for credit derivatives. From our
perspective, the evaluation of potentially competing
alternatives is appropriately being conducted by industry
participants who will need to use these mechanisms if risk
mitigation objectives are to be achieved. Our role will be to
ensure that large national banks who intend to participate in
one or more of these alternatives meet our risk management
standards and expectations.
While the proposed clearinghouse or exchange-based
solutions will certainly contribute to our objective of
reducing counterparty credit and operational risks in the
credit derivatives market, we must not lose sight of the fact
that the dynamic nature of this market will require ongoing
consideration of other initiatives that may also facilitate
risk reduction.
I appreciate the Subcommittee's interest in the OCC's
supervisory work with respect to credit derivatives, and I look
forward to answering any additional questions or comments you
may have.
Chairman Reed. Well, thank you all very much for your
excellent testimony.
We are in the midst of two votes, so I would propose to
recess briefly, and Senator Allard and I will go vote and
return and engage in a round of questioning. Thank you all very
much.
We stand in recess.
[Recess.]
Chairman Reed. Thank you for your patience in allowing us
to go over and vote, and I will begin with a 7-minute round of
questioning and then turn it over to Senator Allard.
A question for all the panelists. Some major investors have
claimed, as I indicated in my opening statement, that this is a
major ticking time bomb, that this poses a potentially system
risk to the market system, and I wonder if you could, starting
with Mr. Parkinson, just comment upon that. How serious is this
potential? And, obviously, what are the steps that you think
should be taken to preclude the risk?
Mr. Parkinson. I think it is a significant risk. We have
been devoting significant resources to trying to strengthen the
system. I think in terms of a day-to-day basis the primary
reason we are worried about the infrastructure and the backlogs
is the potential for them to magnify market and counterparty
credit risk by permitting errors in trading records to go
undetected. The really good thing about fully confirming your
trades with a counterparty is that then you have a good
understanding of what the terms are and, therefore, you have
good records of those trades.
In terms of systemic risk, I think the major concern is
that it might complicate the resolution of a default by a major
market participant if one were to occur. I think, for example,
we would be concerned that derivatives counterparties might
have difficulty promptly determining what their credit
exposures are to a counterparty if they have not confirmed all
their trades with that counterparty. And I think if a major
counterparty were to default, that would be a real challenge to
its counterparties and a challenge to the system.
Chairman Reed. Mr. Overdahl.
Mr. Overdahl. I would agree with that and just add that I
think the confirms issue can pose risk in a few different ways.
It can undermine the risk management capability, the
effectiveness of the risk management--counterparty credit risk
management of the major players. It can make that management
less effective. It can also pose credit risk issues in terms of
just knowing who your exposure is and monitoring that
counterparty credit risk, and also market risk if there is a
trade that is not agreed to and has to be replaced, that that
can pose significant market risk.
So, you know, there is certainly potential here for a lot
of risk, and I think efforts to strengthen that system can only
pay off in more effective risk management by the firms.
Chairman Reed. Ms. Dick, please.
Ms. Dick. I would maybe supplement the comments of my
colleagues with a couple of observations from what we have seen
in the national banking system. Again, credit derivatives are
probably about a fifth or 20 percent of the volume of
transactions, so from a volume standpoint, and even, quite
frankly, a counterparty credit risk standpoint, they are
somewhere around 20, 25 percent of total exposure. I think some
of the systemic issues arise because it is a young market. You
do not have standardization of documents. You have perhaps
participants in that market that are less well understood and
recognized in the market. So there is variabilities that we see
in other markets. At the same time, in the national banking
system, we have got large over-the-counter markets and interest
rates and foreign exchange that, again, started under similar
circumstances, and 20 years later are, in fact, very sound,
robust markets.
So as both Jim and Pat mentioned, I think one of the keys
here is looking for all alternatives to improve infrastructure
and the credit risk that is associated with these contracts so
we can diminish any unwarranted exposure.
Chairman Reed. Ms. Dick, let me follow up with a slightly
different question. We have just come through a very tumultuous
episode with mortgage-backed securities, and there were credit
default swaps written on these products. To what extent do
these credit default swaps exacerbate the underlying problem?
And were banking regulators--and I will turn to Mr. Overdahl
also--aware early on that this was a potential problem with the
credit default swaps?
Ms. Dick. Well, again, we were aware that credit default
swaps were used as part of the structured products. I will say
the losses we have seen in the national banking system are
largely associated with cash underlying securities. So, in
fact, it really is not, again, from a product standpoint, a
derivative.
Now, again, a benefit is that they do allow for hedging of
some exposures as well, so there is a plus, I guess, to the
credit derivative product in some of the structured product
markets.
Chairman Reed. Mr. Overdahl, you can respond to that
question with regard to securities but also with respect to
Bear Stearns. There was an issue there with credit default
swaps, and there were some commentators that suggested that
that was one of the principal reasons that there had to be
regulatory action, just uncertainty about how that would all
fall out. I think it tracks Mr. Parkinson's response about if a
major institution fails, no one quite knows where the ball will
stop rolling. Could you comment?
Mr. Overdahl. Let me take the first question first. The
role of the SEC in its consolidated supervised entities program
is looking at the risk controls, the risk structure, the risk
management of the entire structure, and so to that certainly
there is awareness of the exposures without necessarily second-
guessing the risk appetite for any particular firm, but making
sure--or asking the questions, making sure that those risks are
well understood and well controlled.
With respect to Bear Stearns and the role of credit default
swaps, I am not sure that in terms of confirmations that there
was really an issue there. In terms of the CSEs, they exceeded
industry standards in terms of their confirmation processing.
They were also among the CSEs the smallest with respect to
their over-the-counter positions outstanding, although still
being a CSE that is fairly substantial. I think the big risk--
one risk that we have become very aware of was just the scale
of novations that occurred as counterparties substituted away
the Bear Stearns name, and I will turn it over to Pat.
Chairman Reed. Let me--and I will, Mr. Parkinson. But a
follow-on question is that under the general concepts of an
exchange or a clearing mechanism, these novations would be
better managed. Is that fair? Or is that one of the objectives
of such a system?
Mr. Overdahl. I think it can be better managed. It can
certainly be better managed that way. Also, I think another
significant thing is just the rumors that can start as a result
of the novation process and that is something that could be
eliminated, largely. You cannot eliminate rumors, but you can
eliminate that source of them using a central counterparty or
an exchange.
Chairman Reed. Mr. Parkinson, your comment, and then I will
turn to Senator Allard, and then we will do a second 7-minute
round.
Mr. Parkinson. Just on the Bear Stearns situation, I think
there has been some confusion about this. I think the primary
cause of Bear's demise was a loss of confidence in its ability
to meet its obligations, which triggered a classic run on the
bank. And, in particular, investors who provided Bear with
large amounts of secured overnight financing, primarily through
repo agreements, refused to roll over that financing and
demanded repayment of a substantial amount of money.
Where derivatives may have played a role in that is that
attempts by counterparties to novate trades with Bear to other
dealers in some instances were refused, and that seems to have
contributed to the initial loss of confidence.
With respect to what we were worried about in the case of
Bear, I think the concerns about the potential impact of Bear's
bankruptcy on its derivatives counterparties were not the
primary factor in the decision by the Federal Reserve and other
policymakers to facilitate its acquisition by JPMorgan. The
primary fear was that its bankruptcy would spark a run on the
other dealers who are equally reliant on the same kind of
secured financing that Bear was. But we were also concerned
that counterparties would have serious difficulty promptly
determining their vulnerability to losses on derivatives from
Bear's default and that their efforts to replace the hedges
with Bear would have placed additional pressures on markets
that already were quite stressed. So the derivatives concerns
were a factor but not the predominant factor in both its
troubles and in our response to those troubles.
Chairman Reed. Thank you very much.
Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
It has been about a year now when we saw a large spike in
the credit default swaps, and I think there were attempts to
try in the past to reverse some of these backlogs that occur.
And my question--I have kind of a two-fold question. What
progress have market participants made to improve the
infrastructure in processing so it operates more efficiently
when we go through these sustained periods of high-volume and
high market volatility periods? And what has the President's
Working Group--with their recommendations that came out in
March, what do you see the results of that n the financial
market development concerning credit derivatives? And I address
that question to you, Mr. Parkinson.
Mr. Parkinson. OK. Well, I think they are sort of one and
the same because we had this existing initiative led by the New
York Fed involving all the supervisors at this table and many
others to improve the infrastructure. I think significant
progress had been made between the fall of 2005 and the summer
of 2007.
That said, as you noted, in the summer of 2007 there was a
five-fold increase in the backlogs. I think if they had not
made the improvements they had made over the previous year and
a half, it could have been far worse and, indeed, might have
impaired the liquidity of those markets at a critical time. But
we recognize that further improvements are necessary. Both the
President's Working Group on Financial Markets and the FSF have
asked that group of supervisors under the New York Fed's
leadership to ensure that specific improvements in the
infrastructure are made. And at the June 9th meeting, agreement
was reached on a set of goals for improving the infrastructure.
Market participants and regulators agreed that participants
should write a letter to the regulators by the end of July
setting out the specific steps they are going to take. So I
think at that time we will be able to be much more specific on
exactly what is being done to address this continuing concern.
Senator Allard. Now, there has been some resistance, I
understand, to the use of electronic trading platforms. How do
you think the use of electronic platforms--why do you think it
remains so limited? And why is there some resistance to using
that when we have so much technological innovation being used
at other exchanges?
Mr. Parkinson. Well, I think part of it is simply inertia.
They have been using over-the-counter markets, they have been
using voice brokers for many, many years, and it is hard to
wean them from that. I think also the use of the electronic
trading platforms does require some further standardization of
the contracts. But that said, I think a fair amount of what is
being traded is amenable to processing on electronic platforms,
so I think that some people do not see that in their economic
self-interest to make use of that technology.
But, in any event, as you indicate, the take-up has been
pretty slow. I think actually it has been a little bit better
in the credit derivatives markets than some of the other
derivatives markets, and for reasons that are not completely
transparent to me, more successful, more widely used in Europe
than the United States.
Senator Allard. Yes, I have noticed. I think we made a trip
to some of the exchanges in Europe, and they seemed to be much
more willing over there to accept electronic platform than over
here.
This question I want to address to all three of you on the
panel, and that is, do you believe that as regulators you have
the tools and the access to information that you need to
oversee the OTC credit derivatives market? And if not, what do
you need?
Ms. Dick. I will begin that answer.
Senator Allard. I think that is fair.
Ms. Dick. Very good. I believe at the OCC we do feel that
we have the tools and information needed to oversee the over-
the-counter derivative activities in the national banking
system. I had mentioned, I think, in my oral statement that we
have got over-the-counter derivative markets, the largest
there, which is interest rate contracts and foreign exchange,
that have been in existence now for 20 years. We have learned
over a period of time the type of information we need with
respect to risk management.
I will say via participation in this effort that has been
initiated in 2005 on the credit derivatives market in
particular, as well as some of the work that has been done on
an interagency basis between regulators, both domestically and
internationally, since the credit market turmoil began last
summer, that we actually find ourselves sharing information on
emerging issues in some of these over-the-counter markets
earlier with colleagues and other agencies than before for
instance, if we are seeing trends in the national banking
system, we can share that information with our counterparts who
might be seeing participants in another part of the market and
looking for any systemic issues and identifying them earlier
than perhaps we might have in the past where we have tended to
do our work more in isolation.
Senator Allard. Yes, and your comment sort of spurred
another question. We have different accounting standards in the
United States as well as internationally. Theirs is more
conceptual. Ours is more detailed and more specific,
regulatory. Does that make a difference for you to bring
accountability into the system when you are dealing with
international trades?
Ms. Dick. I do not believe from a risk management
standpoint that affects the information that we are looking at
in our firms. But I know when we look at, for instance,
information that is disclosed by these firms, we have our call
reports in the U.S. for the commercial banks, which has a fair
amount of information on over-the-counter derivatives, and then
clearly in published financial statements there is more
information about some of the risk aspects.
It is very different when you start to look at foreign
firms to try and gauge what that risk exposure is because the
disclosures are different and, again, the accounting standards
are different.
Senator Allard. Mr. Overdahl, maybe you would like to
comment on those two questions.
Mr. Overdahl. Sure. In terms of the oversight of the
market, our window into the market is through our authority
with respect to the CSEs, and with respect to that authority, I
think we have the tools we need to do the job that we do with
the CSEs in the oversight of risk management controls that they
have, which would include the credit default swaps market, but
it is only their piece, their management of the counterparty
credit risk, the pricing issues, these type of things that
directly affect those that are within our jurisdiction.
In terms of the accounting, I cannot really see that as an
issue. The risk numbers that we see are not really subject to
that type of differences in accounting treatment.
Senator Allard. Next.
Mr. Parkinson. I agree we have all the authority that we
need. I think in particular one thing to be realized about the
existing oversight regime, which is this cooperative effort by
the prudential supervisors and all the major dealers, is that
because it is a global market, that kind of cooperation is
essential to accomplish anything. And if one contemplated a new
regime or a different regime, you would have to figure out how
to replicate that degree of international cooperation, which
would be difficult. On accounting, I do not really have
anything to add to that.
Senator Allard. Thank you. I see my time has expired, Mr.
Chairman.
Chairman Reed. I have a few more questions, and I will take
them, and then I will turn to Senator Allard.
One of the aspects of the credit derivatives issue has been
the fact that some institutions are finding themselves on both
sides of a transaction, in some respects, a bank loaning to a
company, and then sells credit protection to that company, and
it gets complicated. I wonder if you might respond to this, Ms.
Dick, about this whole notion of the concentration of risk and
the ability to understand the risk, your viewpoint, and if you
gentlemen would like to add anything else, that is fine.
Ms. Dick. Very good. With respect to credit derivatives, as
you mentioned, they can be used as a tool both to assume credit
risk as well as shedding credit risk, which is what our large
national banks do. Most of the activity they report in their
call reports of activity that they are involved in is actually
financial intermediation activity, where they are taking
requests from clients that want to either assume or shed credit
risk, designing a credit derivative transaction, and then
managing that risk internally.
Clearly, as you mentioned, there is the potential for
either concentrations of risk or parties finding themselves--
and I think frequently it is actually not the regulated
institutions, but perhaps some of the unregulated that are in a
position where they might have lending exposures as well as
large credit derivative exposures.
We do require, again, you know, robust risk management
systems in our firms. One of the things that they will look at
when they look at credit exposure as one of these large banks
is both cash exposure in the form of either securities owned or
loans, as well as any derivative exposure. And, again, one
benefit of the derivative product is the fact that it allows
you to alter your credit risk profile. So if as a bank you are
very concentrated in an industry and your lending portfolio,
you can actually diversify that by assuming some credit risk in
another industry. It is a risk that certainly has to be
managed, but I see risk management tools in the system that I
think are very capable of doing that.
Chairman Reed. So these tools in the system in a very
simplified way, if the lines are all crossed, loans, credit
defaults, co-ops, other instruments at one institution, that
sets a red light off, I guess, or some sort of warning that you
have to look closely?
Ms. Dick. Again, firms will have internal capacity for how
much risk they are willing to take to any given name.
Now, I would not want to leave you with the impression that
people are pushing magic buttons and can gather all this
information. As a supervisor, we wish, of course, that were the
case. But because the business is concentrated primarily, in
the national banking system in five large institutions, we have
the ability to go in and where we see deficiencies in that
aggregation capability, work with bank management to get those
deficiencies resolved.
Chairman Reed. Now, your perspective, Mr. Overdahl, from
SEC.
Mr. Overdahl. I think that our perspective is very much
similar to the banking supervisors in that we are looking at
the risk management capabilities of these firms, and to the
extent that these type of concentration issues exist, we are
looking at the systems to make sure that they can identify and
pick up that type of risk, and looking at how they manage that
counterparty credit risk but more looking at the process,
making sure that the process is in place that these risks are
identified and understood. So it is very similar.
Chairman Reed. Mr. Parkinson, your comments.
Mr. Parkinson. Just that I think both at the level of the
banks and the level of the regulators, we need to be looking at
aggregate exposures to a particular corporate obligor and
aggregating those across the cash holdings of the instrument
and any derivative holdings they have, and not looking at the
cost of derivative in isolation or failing to aggregate them.
That can sometimes be a challenge to do. I do not know that
it has been in the case of CDS, but I know in the case of
subprime exposures, our banks did not always distinguish
themselves in managing their exposures on an aggregate firm-
wide basis. But that said, certainly that is the goal, that is
the expectation.
Chairman Reed. Let me begin with Mr. Parkinson and ask
another question. It seems to me there are two general
institutional responses to this issue of CDS. One is an
exchange approach, and the other is a clearing approach, a
clearing entity. The advantages of one versus the other and is
there any sort of institutional or regulatory preference or
bias?
Mr. Parkinson. An exchange would employ a central
counterparty, so the question really is what further benefits
and what further disadvantages exchange trading per se would
have over a CCP for the OTC markets.
I think exchange trading does require a significant degree
of standardization of contracts, although many of these
contracts already are standardized to an important degree. But
where it is feasible, it can provide additional benefits,
possibly including elimination of the confirmation backlogs. I
think as Jim said in his testimony, in active markets trades
are basically locked in at execution, and the whole
confirmation process is obviated. They also can increase market
liquidity and they can increase transparency with respect to
bids and offers and market depth. The major disadvantage of
exchange trading would be, again, the need to standardize the
contracts, and that would be a concern where customization
allows the OTC contracts to meet the individual risk management
needs of counterparties that could not be met by the
standardized contracts. But I think standardized contracts
trading on an exchange and the more customized contracts
trading in the over-the-counter markets might give us the best
of both worlds.
Chairman Reed. Mr. Overdahl, any comments? And then Ms.
Dick.
Mr. Overdahl. I agree with Pat's comments, and I would just
note that there are other markets outside of the financial
world where we have seen over-the-counter clearing, and perhaps
in the energy area is the best example where you had a very
successful product developed for clearing at the energy
exchanges. And it is interesting. When there were credit
disruptions in that market, where people were concerned about
credit risk, some of the same type of things you are seeing
today in financial markets, the people voted with their feet,
and they moved to those systems because they could see the
benefits of the central counterparty, and they could also see
the benefits of the transparency that an exchange offered.
Now, how that is going to play out is really ultimately the
choice of markets participants of just how they value those
features of these competing marketplaces.
Chairman Reed. Ms. Dick.
Ms. Dick. I would echo the comments of my colleagues, and
highlight that in looking at the proposed clearinghouse
arrangement that is being discussed by the industry right now,
we see clear benefits with respect to, again, the two risks we
think are most important--the counterparty credit and the
operational. If you have a central counterparty, as was
mentioned by one of my colleagues, many of these trades that
are now being layered one on top of another to actually manage
your market or credit risk would no longer be necessary. That
also reduces volume of trades, which, again, would address some
of the operational issues.
A drawback, however, and one we just need to recognize, is
that it would concentrate risk in the clearinghouse, so it has
got to be structured properly. We need to make sure there is
the right capital support behind that clearing arrangement so
that if there is a problem with one of the large participants,
that, again, that does not actually exacerbate the credit
issue.
Near as I can tell with respect to the exchanges, Mr.
Parkinson mentioned probably the biggest benefit, which I think
also can be a drawback, is the standardization of contract
terms. I think what we see right now is that with respect to
index and some other transactions, they are actually quite
standardized. But many of the credit derivative transaction
that we see in the national banking system are still standard,
single-name transactions that are done to assist some client in
managing their own credit risk profile. It may be difficult to
standardize those contracts in a form that would be necessary
for an exchange, and in that regard, if that is the case, the
client is looking for customized trades. If the trades do not
occur on the exchange, you are not going to get the benefits,
again, of the operational and credit counterparty reduction.
Chairman Reed. Let me follow up with Mr. Parkinson and Mr.
Overdahl. As I understand, the proposed clearing arrangement
would take the form of a state bank, which would be supervised
at the Federal level by the Federal Reserve. But it is the SEC
that to date has had much more extensive experience in clearing
operations. Can you comment on that, Mr. Overdahl?
Mr. Overdahl. Well, certainly the SEC has had experience
over many years in central clearing in the securities markets,
and it is interesting that many of the operational difficulties
that we are talking about here today were evident in the
securities market at one time, and there was a great effort,
part of the national market system in the mid-1970s, that
addressed many of those issues at that time.
In terms of this particular proposal, I am not sure that
there is really much--in terms of the structure, there is much
more I can add about--I mean, certainly we see the benefits,
potential benefits of centralized clearing and, again, as Kathy
said, it really depends on the financial safeguards that are in
place and the quality of the guarantees that they can--the
credibility of those guarantees in order for it to be a
successful venture.
Chairman Reed. I just want to ensure that I understand. The
proposed arrangement now of the major institutions that are
setting up the clearing house would require Federal Reserve
supervision. Is that correct, Mr. Parkinson? Would you be the
primary supervisor, or the SEC? Let me clarify that.
Mr. Parkinson. I think that is their choice. Under existing
law, which is the Commodity Futures Modernization Act of 2000,
a CCP for OTC derivatives needs to be regulated. But they have
their choice of regulators. It can either be one of the banking
agencies; it can be the CFTC or it can be the SEC. I think you
are referring to The Clearing Corporation, which has made a
decision to organize as a bank chartered by the State of New
York and a member of the Federal Reserve System, which would
bring them under our supervision. And in addition, as Mr.
Overdahl mentioned in his testimony, if CDS are considered
securities, which they might be, then securities have to be
cleared through an SEC-registered clearing agency unless the
SEC grants an exemption that would allow it to be cleared by an
entity that is not an SEC-registered clearing agency. So I
infer from that that The Clearing Corporation would need an
exemption from the SEC from their clearing agency requirements
to proceed with their plan to organize as a member bank
regulated by the Fed.
Chairman Reed. And if all of those exemptions are granted,
it would be regulated by the Federal Reserve in its capacity as
the clearing agent. Is that correct?
Mr. Parkinson. Yes, it would be regulated both by the New
York State Banking Department as the chartering authority and
by the Federal Reserve, by virtue of its choosing to be a
member of the Federal Reserve System.
Chairman Reed. But it would just seem to me the expertise,
the operational expertise is more in the realm of the SEC than
the Federal Reserve. There would be no sort of institutional
cost for you to chin up the regulation?
Mr. Parkinson. We do not currently regulate any central
counterparties. We do have a role in regulating securities
settlement systems in the case of the Depository Trust Company,
which is organized as a State-chartered member bank, much in
the way that The Clearing Corporation is planning. We also
regulate the CLS Bank which settles foreign exchange
transactions, which is organized as an Edge Corporation.
I might also mention--I think the SEC mentioned in their
testimony, as we did, the CPSS IOSCO standards. We played a
leading role in developing those standards for CCPS. So we do
not have the specific experience that the SEC does, but we have
a lot of other relevant experience.
Chairman Reed. Very good. Thank you.
We have been joined by Senator Schumer. Do you have
additional questions?
Senator Allard. I do, if I might just briefly, and then----
Chairman Reed. Since he has not had an opportunity----
Senator Allard. Go ahead.
Chairman Reed. OK.
Senator Schumer. Thank you. I thank both of my colleagues
and only apologize for coming in and leaving, but they are
debating the Medicare bill on the floor, and I am very much
involved in that. So I apologize to both my colleagues.
First, to Mr. Parkinson, do you believe that the effort
underway by various swap dealers to create a clearinghouse and
central counterparty will be able to significantly reduce the
risks posed by OTC derivative markets?
Mr. Parkinson. I think that a CCP has the potential to
reduce systemic risks and risks to the counterparty
participants. But that will be the case only if it robustly
manages the risks that are concentrated in the CCP by virtue of
its activities. In terms of making judgments as to whether a
particular proposal for a CCP reduces systemic risk, we would
apply these international standards, the so-called CPSS IOSCO
standards, and we would apply those to any plan for providing
CCP services to those markets. But we believe that if they do
meet those standards--and that would be challenging given some
of the unique features of OTC derivatives--then that would be
reducing systemic risk.
Senator Schumer. OK. Thank you.
And now to all the witnesses, the question is: Will the
consolidation of information about the markets and the
clearinghouse offer you and other regulators a better view of
the safety and soundness and systemic risks posed by these
markets? And I also want to address the debate over encouraging
credit default swaps and other derivatives to become exchange
traded. While I recognize the value that exchange trading can
offer in terms of price discovery and settlements, I am also
concerned that forcing immature products onto an exchange will
reduce innovation and competitiveness. This is the age-old push
and pull of regulation.
So, Mr. Parkinson, aren't the OTC derivatives markets where
the parties are free to negotiate and customize their contracts
some of the most innovative and fastest-growing financial
markets? If that is the case, while it may make sense to
encourage some of the most mature contracts to an exchange, we
should be careful to preserve our financial markets' ability to
innovate and continue to compete. Isn't that correct? And since
these markets are so international, what steps are the Fed,
SEC, and OCC taking to coordinate their oversight of the OCC
derivative markets with international regulators? Are there any
indications at the moment that some international markets may
fail to implement regulations that are similar to the U.S.'
potentially putting us at a comparative disadvantage?
It is a series of related questions. First, Mr. Parkinson,
then Mr. Overdahl and Ms. Dick.
Mr. Parkinson. All right. I do not think we should force
things onto exchanges, but if market participants choose to
move activities to exchanges, we should not stand in the way. I
think it will never be the case that all the products that are
traded today in the OTC markets will be traded on exchanges.
That would require more standardization in some cases than
market participants would find in their interest.
With respect to the question you raised about international
coordination, I think there is where we have this existing
initiative under the leadership of the Federal Reserve Bank of
New York where they have the prudential supervisors of all the
global derivatives dealers and the market participants coming
together and working together to improve and strengthen the
markets so there is a substantial degree of regulatory
coordination internationally. When it comes to the specific
issue of central counterparties, you have international
standards for central counterparties, the CPSS IOSCO standards.
Again, that provides a substantial degree of comfort that there
will be a level playing field in that area as well.
Senator Schumer. Mr. Overdahl.
Mr. Overdahl. I agree with those comments in terms of the
ability of market participants to choose the best venue for
where they would trade. One thing the SEC has spent quite a bit
of time thinking about over the last few years is the best way
to streamline the process that products can brought to market.
So when an exchange identifies an opportunity, that can be done
in a quick way in which the risks that have been identified,
the product can be there to help manage them. And also, with
the international standards, again, the SEC has participated in
many of the same forums that Pat just mentioned, with the CPSS
IOSCO. The SEC was involved in that standard setting. So we
have been involved internationally. We have been involved in
discussing these issues with our counterparts overseas.
Senator Schumer. Ms. Dick.
Ms. Dick. I would just maybe step back to the first
question you asked, which I think was about information we
might receive as supervisors. In the effort we have had
underway right now that Mr. Parkinson mentioned, led by the New
York Fed, I will say we have achieved a great deal of
information from the industry both about the firms we
individually supervise but also their competitors, which has
been extremely helpful. So we have information about how long
it takes for a trade to be confirmed, the volume of
transactions our firms are involved in, the ability to
electronically process those trades. And because the global
nature of the business is such that there are only 15 to 20
large global firms involved, it is very useful as a primary
supervisor to be able to go to one of your institutions and
identify when they are an outlier in that population and push
stronger and harder and really more effectively for some kind
of change if there are risk management issues.
So I think based on what we know about a clearinghouse,
there is a strong probability we could get additional
information that would be useful, and I think the structure, at
least as we understand it, that is being discussed right now
would also assist in reducing counterparty credit risk and
operational risk.
From the OCC's perspective, I do not think we see strong
compelling reasons for an exchange, but we would not be opposed
to that either. The risks we are worried about are really
addressed with the clearinghouse.
Senator Schumer. Thank you, Mr. Chairman. Thank you,
Ranking Member Allard.
Chairman Reed. Thank you very much.
Senator Allard.
Senator Allard. Thank you, Mr. Chairman.
You know, my understanding of derivatives is that they have
to have some flexibility to meet the various situations that
come up, and we have Ph.D.s that work on derivatives who in
many cases probably know more than a regulator.
Would you talk a little bit about how far we could
standardize derivatives through rules and regulations, or how
far your clearinghouse can go on something like this?
Mr. Parkinson. I do not think that we should be
standardizing derivatives through rules and regulations, and I
do not think a clearinghouse can standardize. It offers its
services for a range of contracts. The range of contracts will
not be unlimited, so it will require a certain amount of
standardization of contracts for those to be eligible for
clearing. But market participants are not compelled to
participate in these arrangements, so the fact that the
clearinghouse only clears a limited range of contracts does not
stop them from trading contracts that do not fit the
clearinghouse's parameters. Indeed, in that regard, we have had
a CCP for interest rate swaps in London operating since 1999
that is used by all the big dealers. It only clears so-called
plain vanilla interest rate swaps. That has not stopped the
dealers from customizing interest rate swaps where they see
their customers having an interest in their doing that. It is
just that those do not get cleared through the clearinghouse.
So I do not really think mandating the terms of derivatives
transactions is on the table.
Senator Allard. Mr. Overdahl.
Mr. Overdahl. Yes, I would agree that I think that it is
really not the role of a regulator to decide how that
standardization should occur. That is something that really is
a choice of market participants, and they have to evaluate the
advantage of standardization that comes along with liquidity,
perhaps, and perhaps the use of a central counterparty for
clearing, that advantage versus the advantage of getting a
highly customized deal that will meet their specific business
needs. And that is really a business decision of market
participants and one that I think we would be extremely
reluctant to get in the middle of.
Senator Allard. Ms. Dick.
Ms. Dick. Yes, with regard to standardization of contracts,
I think as my colleagues have mentioned, what we have seen in
the over-the-counter derivative markets are perhaps larger and
longer-lived in the banking industry, the interest rate and
foreign exchange, is that they are really not mutually
exclusive. Many of these contracts start out in these markets
in true customized contract form, and then as we have even seen
in the credit derivative market, the documentation becomes more
standardized, certain names become the reference names people
are looking for, and those can be more standardized. And as I
think both my colleagues mentioned, it is really the market
participants that drive which--you know, that these contracts
become more standardized.
So we see the central counterparty, again, being an
alternative to help reduce counterparty risk, operational
issues. We see the standardization of contracts as one that we
will likely see follow the path we have seen in other over-the-
counter markets. But I believe there will be a large number of
these trades that will continue to be over the counter because
that is really the nature of the risk that some client, again,
is trying to manage.
Senator Allard. At the risk of starting an argument among
the panelists here, I want to ask the next question. The Fed
had decided to infuse cash with the secondary--or the risk--the
loans that were high-risk loans. And, of course, though, this
has had an impact on industrial--or investment banks, and I
assume that they put together some of these derivatives perhaps
and do the swaps and whatnot. And then Chairman Bernanke has
just decided to extend that.
Mr. Overdahl and Ms. Dick, do you think that is helpful? Or
should we let these things just live and die on their own
merits? And then maybe Mr. Parkinson would like to respond.
Mr. Overdahl. I am afraid I am just really not in a
position to make that judgment.
Senator Allard. Do they feed into the derivatives and the
swaps on the investment banks, some of the things they put
together? Do they feed into investments in swaps?
Mr. Overdahl. Well, certainly, they are major participants
and dealers in the markets.
Senator Allard. Yes.
Mr. Overdahl. So I am not sure--could you help me out here
with----
Senator Allard. Well, I am just fishing a little bit.
[Laughter.]
I admit that. But I am just wondering if there is a
downside to this or a positive side as far as you are looking
at OTC----
Chairman Reed. Extending the----
Senator Allard. Yes, yes.
Mr. Overdahl. Well, you know, our role as securities
regulators is not to oversee the entire over-the-counter
market. It is a very limited role in our jurisdiction. So
certainly, you know, our focus is on the consolidated--the CSE
groups of investment banks and making sure that their policies
and procedures for risk management are in place. I am not sure
beyond that there is really much of a role.
Senator Allard. But the Fed is starting to assume a role,
and so does that mean you look at them a little differently as
far as their security?
Mr. Overdahl. Well, I am not sure it is looked at any
differently. Certainly we have worked closely with our Fed
counterparts through the MOU that was just signed the other
day, information sharing, making sure that the look that we are
seeing with our people who are on the ground in these banks, in
the investment banks, are sharing information with our
counterparts at the Federal Reserve, and that we are seeing the
look that they are seeing from a bigger picture, from the
primary dealers and others that may help us do our job better.
Senator Allard. Ms. Dick, do you want to comment?
Ms. Dick. Senator Allard, I think you have correctly noted
some of the issues that have arisen in this period of market
turmoil over the last 9 months, one of them, a key issue being
that of liquidity--liquidity in markets, liquidity in
institutions. And, Chairman Reed, you had mentioned this in
your opening comments as well. Some of the actions we see now
in financial markets that are driven by either other
participants or perhaps facilitated by the fact that they have
a number of tools with which to take exposures in the credit
derivatives market would be in the individual names of firms.
The liquidity issues, some of the issues associated with
market stability, are all issues that I think we are regulators
recognize are a distinct priority for each of us and ensuring
that our firms can both manage their own risks safely and
soundly but also key market participants can contribute to a
stable financial market in each of these instruments, and
perhaps more broadly with respect to the financial system.
There are a number of issues, many of which we have been
discussing through this forum. We have talked about at the
hearing today with respect to the regulators both domestically
and internationally that I think will have to be resolved
through perhaps additional guidance or standard by the
regulators, but also some risk management practices in the
firms that will have to be enhanced with respect to areas such
as liquidity risk management, aggregation of risk exposures for
individual names, as Mr. Parkinson mentioned, reference names,
and derivative counterparties. So I think there are a number of
these types of ancillary issues that certainly have some
implications for the credit derivative market, but also are
going to have to be addressed by the supervisors.
Senator Allard. Mr. Parkinson, do you want to comment or do
you want to pass?
Mr. Parkinson. In general terms, I think there is a
connection between the Bear Stearns episode and the actions we
took to stabilize the financial system in that instance and the
subject matter of this hearing, and that is that we recognize
that in providing liquidity and facilitating the acquisition of
Bear Stearns, that entails a certain amount of moral hazard and
that people may come to expect it will take such actions and
that those actions will protect their interests and that that
might lead them to be less rigorous about protecting their own
interests.
So I think one of the things we are trying to do to
mitigate that moral hazard risk is strengthen the
infrastructure of financial markets so that some of the
concerns that really required us to intervene would no longer
be concerns because the infrastructure had been made stronger
so that the system can better withstand the failure of a large
firm. And one of those infrastructure initiatives--by no means
the only one, but one of the main ones that we have been
emphasizing is this initiative to strengthen the infrastructure
for the OTC derivatives markets, and, in particular, the credit
derivatives markets. So there is a connection there as you
perceived.
Senator Allard. Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Allard.
Thank you very much for your very thoughtful testimony and
for your dedicated service. Thank you very much.
I will now call up the second panel.
Senator Allard. Mr. Chairman, while we are waiting for this
panel, I wonder if I might insert some records that were
requested be put in the record by Senator Crapo, who is a
Member of this Subcommittee.
Chairman Reed. Without objection, the statement will be
made part of the record, and all statements of Members of the
Committee will be made part of the record.
We are ready now to introduce the second panel, and we
thank all of you gentlemen for joining us this afternoon.
Our first witness is Dr. Darrell Duffie. Dr. Duffie is the
Dean Witter Distinguished Professor of Finance at Stanford
University, the Graduate School of Business. He is the author
of a number of books and articles on topics in finance and
related fields and is currently working on a paper on the
global derivatives market.
Mr. Robert Pickel is the Executive Director and CEO of the
International Swaps and Derivatives Association, ISDA. He also
serves as a member of the board of directors of the Institute
for Financial Markets, a member of the Bretton Woods Committee,
and a member of the board of the Capital Markets Journal.
Mr. Craig Donohue is Chief Executive Officer of the Chicago
Mercantile Exchange Group. Before joining CME as an attorney in
1989, Mr. Donohue was associated with the Chicago law firm of
McBride Baker & Coles. During his time at CME, he has been
involved in the merger between CME and the Chicago Board of
Trade.
Our fourth witness is Mr. Edward J. Rosen of Cleary
Gottlieb Steen & Hamilton, who is outside counsel to The
Clearing Corporation. He is co-author of the two-volume book
titled ``U.S. Regulation of the International Securities and
Derivatives Markets.''
Gentlemen, thank you for joining us, and all your
statements will be made part of the record, so if you would
like to summarize or abbreviate, that is fine.
We will start with Dr. Duffie. Dr. Duffie.
You might want to push that button.
STATEMENT OF DARRELL DUFFIE, DEAN WITTER DISTINGUISHED
PROFESSOR OF FINANCE, GRADUATE SCHOOL OF BUSINESS, STANFORD
UNIVERSITY
Mr. Duffie. Thank you. Thank you, Mr. Chairman and
distinguished Members of the Committee.
The financial industry got ahead of itself by allowing
extreme growth of its credit derivatives markets before it had
safe and effective ways to manage the associated risks. I have
been concerned about inadequate methods for the pricing and
risk management of the types of credit derivatives that played
a role in the recent credit crisis, and I have also been
concerned about a lack of robust operational infrastructure. I
am going to focus now on the operational issues such as trade
documentation and clearing.
Credit derivatives are traded almost entirely in the over-
the-counter market, where a dealer normally acts as a seller to
buyers of default protection, and as a buyer to sellers of
default protection. In order to balance their positions,
dealers often take positions with other dealers. In addition,
hedge funds often expose one dealer to another when they
reassign their positions in an existing contract. As a result,
dealers find themselves significantly exposed to the event of
default by some other dealers, normally a very remote but
potentially dangerous possibility.
Had Bear Stearns collapsed before the 2005 initiative of
the Fed led to reduced documentation backlogs, and had quick
action by the Fed and JPMorgan not occurred, the unwinding of
Bear Stearns' derivatives portfolio could have been extremely
dangerous. In the absence of clear and up-to-date records of
derivatives positions, dealers would have been uncertain of
their own and other dealers' exposures and could have responded
by a dramatic withdrawal of financing to each other, which
could have indeed caused other dealers to fail, with
potentially disastrous economic consequences.
In addition to a lack of good records, the market has
suffered from an unnecessary buildup of exposure of dealers to
each other. For a simple illustrative example, suppose that
Goldman Sachs, for example, has exposure to Merrill Lynch
through a $1 billion credit derivatives position, while at same
time Merrill Lynch has a similar $1 billion exposure to
JPMorgan, and JPMorgan in turn has the same exposure to
Goldman. If all three dealers in this circle of exposures were
to reassign their contractual positions to a central clearing
counterparty, then each dealer's positions would net to zero.
None of them would be exposed through these positions, nor
would the central clearing counterparty.
Through a new electronic confirmation platform known as
DerivServ, I believe that the trade documentation problem has
now been largely addressed, although even more progress should
be made in that direction. The Clearing Corporation is likely
to come online in the credit derivatives market later this year
and will reduce dealers' exposures to each other significantly
for standardized credit derivatives, which constitute the bulk
of dealer exposures. The Clearing Corporation offers roughly
the benefits of exchange-based clearing, although we have yet
to see the details.
The market is achieving a more robust infrastructure
through these and other procedural improvements, such as new
protocols for auction-based cash settlement of contracts and
for novation.
These infrastructure improvements have come to the over-
the-counter derivatives market rather late. Many of their
benefits have been available all along through exchange
trading.
Separate from the issue of operational risks, exchanges and
over-the-counter markets offer different merits as venues for
finding counterparties and for negotiating prices. Exchanges
are more transparent and more easily regulated. They are
natural for trading highly standardized contracts. The OTC
market suffers from a lack of price transparency. On the other
hand, the OTC market is more flexible and, thus, better suited
to financial innovation and to customization for clients,
especially those seeking to transfer large amounts of a
specific type of risk.
I would be concerned about the unintended consequences of a
regulatory allocation of certain types of financial trading
between the OTC and exchange markets. Aside from the chance of
getting it wrong or of dampening incentives for future
innovation, there is also the question of international
competition. The United States has the world's premier
derivatives exchange, but is competing with the United Kingdom
for leadership in the OTC derivatives market. Over several
decades, the U.S. over-the-counter derivatives market has
nevertheless served as an engine for innovation and economic
growth in the financial services sector in a manner analogous
to the role of Silicon Valley in the manufacturing sector.
Thank you.
Chairman Reed. Thank you, Dr. Duffie.
Mr. Pickel, please.
STATEMENT OF ROBERT PICKEL, CHIEF EXECUTIVE OFFICER,
INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION
Mr. Pickel. Chairman Reed and Ranking Member Allard, thank
you very much for inviting ISDA to testify before the
Subcommittee. ISDA represents participants in the privately
negotiated derivatives industry and today has over 830 member
institutions from 56 countries around the world. It is our
pleasure to share with you our insights on ``Reducing Risks and
Improving Oversight in the OTC Credit Derivatives Market.''
The vast majority of credit derivatives take the form of
the credit default swap, which is a contractual agreement to
transfer the default risk of one or more reference entities
from one party to the other. They are the fastest-growing part
of the OTC derivatives business and the source of a great deal
of innovation.
Credit derivatives arose in response to two needs in the
financial industry. The first was the need to hedge credit
risk. Prior to the existence of credit derivatives, lenders had
a limited number of ways to protect themselves if the financial
condition of a borrower were to deteriorate. One was to take
collateral and the other was by selling the loan, which
normally requires the consent of the borrower. A second need
was diversification of credit risk. Financial economists have
long noted the benefits of applying a portfolio approach to
investments by means of diversification, but practical
considerations made diversification difficult to achieve in the
credit markets before credit derivatives. By allowing banks to
take a short credit position, credit derivatives enable banks
to hedge their exposure to credit losses without disrupting
their relationship with their customers. And a protection
seller can increase its exposure to certain entities,
diversifying risk in a cost-efficient way.
Two features of the market have enhanced the ability of
credit derivatives to fulfill the two needs of hedging and
diversification. The first feature is standard legal
transaction documentation published by ISDA. Along with other
ISDA documentation, these definitions factiliate transactions
and enhance legal certainty, which is a necessary condition for
derivatives activity. The second is index trading, that is,
buying and selling protection on a diversified index of
entities instead of a single firm. By providing additional
opportunities for investors to take positions in credit risk,
index trading has vastly increased the liquidity of credit
derivatives generally. The result is that banks and other firms
seeking to hedge credit risk can do so more efficiently and at
a lower cost. This greater efficiency in turn means that credit
risk can be more widely and deeply dispersed in the economy so
that the costs of default are felt less acutely in any one
sector.
ISDA has made continuous efforts to improve the legal
documentation for credit derivatives. We have published a
series of documents to cover new products and to adapt the
documentation framework to the increasing use of automation in
the marketplace. The success of the market and the entrance of
new market participants such as investment managers and managed
funds has led to the increasing use of novations, a process in
which one party to the contract assigns or novates its
obligations to a third party. After concerns were raised as to
whether proper notifications to the remaining party in the
trade were being widely shared, in 2005 we published a Novation
Protocol, which has proved extremely successful in reducing the
number of outstanding confirmations due to novations.
Standard credit derivative documentation currently provides
for physical settlement of transactions following the
occurrence of a credit event. Through nine credit events over
the last 3 years, ISDA and its members have established an
alternative mechanism that utilizes an auction process that
facilitates cash settlement while preserving the option of
physical settlement.
ISDA and a group of the major credit derivative dealers
have commenced the process of incorporating this mechanism into
our definitions. It is anticipated that this process will be
completed by year end.
The rapid growth in the credit derivatives market has
increased the need to automate post-trade activities. Financial
products Markup Language--FpML--is the technical standard
developed by ISDA for electronic messaging covering the OTC
derivatives lifecycle and is widely used in the industry.
Currently a high percentage of trades--greater than 90
percent--are confirmed electronically, and the industry
continues to strengthen the infrastructure. One example of this
is the Trade Information Warehouse, a central repository
managed by the Depository Trust & Clearing Corporation that
keeps the legally binding version of all trades and to which
all market participants submit their trades.
Starting in May, ISDA has facilitated discussions among a
working group to explore methods that could be used to reduce
the current gross notional credit default swap market size. The
process, known as ``Portfolio Compression,'' offers tangible
benefits to CDS market participants through potential capital
savings and a reduction in operational risk by decreasing the
number of trades.
The market for OTC derivatives has grown rapidly, thanks
both to the usefulness of these products as a risk management
tool and to the strong legal and operational infrastructure
that currently exists for OTC derivatives. While continued
innovations will challenge existing frameworks, and while
market participants and regulators alike will need to continue
to be vigilant, there is no question that the infrastructure
for OTC credit derivatives is strong and improving.
Thank you very much for allowing ISDA to testify today. I
look forward to answering any questions you may have.
Chairman Reed. Thank you very much, Mr. Pickel.
Mr. Donohue, please.
STATEMENT OF CRAIG S. DONOHUE, CHIEF EXECUTIVE OFFICER, CHICAGO
MERCANTILE EXCHANGE GROUP INC.
Mr. Donohue. Chairman Reed, thank you for inviting CME
Group to be here today and to testify before your Subcommittee.
You have already heard a great deal about the value and
importance of these products and markets, as well as the
exponential growth that has occurred in these markets in recent
years, and so I will not belabor those factors. But I believe
you have also heard today that the trading confirmation, risk
management, and settlement systems in these markets have not
kept pace with that growth or with the sophistication of market
participants and the full range of trading strategies that they
now use in these markets.
There are solutions that can increase transparency and
reduce risk within the credit default swaps market. For more
standardized credit products, the transparent price discovery
and multilateral trading and clearing mechanisms of an exchange
model allow for monitoring risks on a current basis, reducing
systemic risks, and enhancing certainty and fairness for all
market participants.
At the same time, an exchange model would offer regulators
the information and transparency they need to assess risks and
to prevent market abuses. An exchange model would reduce the
informational asymmetries in today's credit default swaps
market and protect the broader financial markets.
Let me provide a few specific examples of the problems
inherent in this market and the solutions that an exchange-
based model could offer.
First, CDS markets are opaque. Best price information is
not readily available as it would be on a centralized
marketplace. Efficient and accurate mark-to-market practices
are hindered by the lack of transparency in the CDS markets.
Disagreements are common, leading to subjective and
inconsistent marks and potentially incomplete disclosure to
investors of unrealized losses on open positions.
Earlier this week, as an example, Toronto Dominion Bank
announced a nearly $94 million loss, believed to be related to
credit derivative indices and index tranches that had been
incorrectly priced by a senior trader. Traders often generation
their own marks in the credit derivatives market due to
perceived unreliability of some end-of-day pricing services. In
an exchange-based model with transparent and reliable end-of-
day marks and market data dissemination to all credit
derivatives market participants, portfolio-based valuation
errors of this type 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 simply 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 crisis, which caused
major disruptions in the market. As Bear Stearns faltered,
credit spreads for most dealers widened, volatility increased,
and liquidity declined, and ultimately 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 been more
accurate and timely in terms of their understanding of the
firm's positions, exposures, and collateral requirements. The
clearinghouse and regulators would be 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 are
far larger than necessary, adding to the risk of a cascading
series of failures across the markets. Adjusting exposures
through novated trades is overly complex and time-consuming,
and such trades often remain unconfirmed for weeks. The
benefits that an exchange model would bring to this market are
substantial. Centralized electronic trading would offer
scalable, efficient mechanisms to market participants and bring
price transparency to the entire market, improving accounting
practices and public reporting. Such systems would permit
nearly instantaneous trade confirmation. An experienced
clearinghouse could substantially reduce systemic risks. The
CME clearinghouse currently holds more than $60 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, and we monitor large account positions
and perform daily stress testing.
We are not here today to ask Congress to mandate one
solution. Much has already been said about The Clearing
Corporation proposal, although public information is limited.
We believe that there are alternative structures that could
better suit the needs of all market participants. We recommend
that financial market regulators be encouraged to foster an
open and competitive environment in which different solutions
can compete.
The best path will be one that permits multiple offerings
to bring to market new innovations that will help the credit
default swaps market mature and evolve, and we look forward to
working with the appropriate regulatory community to achieve
that end.
Thank you, sir.
Chairman Reed. Thank you very much, Mr. Donohue.
We are scheduled to have a vote at any moment, so, Mr.
Rosen, please begin, but forgive me if I have to interrupt and
recess for a moment.
Mr. Rosen. I will do that, Mr. Chairman. Thank you.
Chairman Reed. If you could bring the microphone forward
and push the button.
STATEMENT OF EDWARD J. ROSEN, CLEARY GOTTLIEB STEEN & HAMILTON
LLP, OUTSIDE COUNSEL TO THE CLEARING CORPORATION
Mr. Rosen. Thank you, Mr. Chairman. TCC welcomes this
opportunity to share its plans to develop a clearinghouse for
credit default swaps, or CDS, as they are commonly known.
The Clearing Corporation was originally established as the
Board of Trade Clearing Corporation more than 80 years ago, in
1925, and currently clears for a number of derivatives markets.
This is an area in which The Clearing Corporation has
demonstrated competence.
Over the past 18 months, TCC and its owners have undertaken
an intensive effort to structure and develop a CDS
clearinghouse, and it has worked in close consultation with a
number of Federal regulators and industry in that process. I
would point out that CCTC, the entity that TCC intends to
create for this purpose, will not be involved in the
negotiation or the execution phase of transactions, but will
accept transactions that are eligible for clearing once they
have been executed, and it intends to do that through the DTCC
DerivServ platform that has been the vehicle for driving down
the backlog in confirmations over the past couple of years very
successfully.
Participation in the new clearing corporation, CCTC, will
be open to all qualified participants, but there will be
stringent and standard criteria for membership, including
significant minimum net capital requirements, creditworthiness
requirements, operational and risk management requirements, and
a very significant presence in the credit default swap market.
As has been noted before, it is contemplated that the
clearing organization will be a New York State bank and a
Federal Reserve System member bank and, as such, will be
regulated by the New York Fed as well as the New York State
Banking Department. The clearing organization is working
diligently with those groups in order to accomplish the
chartering of CCTC within a prompt timeframe.
Although the qualitative and quantitative details are not
nailed down at this early stage, I think the Committee can be
very comfortable that the clearing operations will be
structured in a manner at CCTC that conforms to all U.S.
regulatory requirements, as well as international standards,
both for banks and clearinghouses. An overview of that
structure is outlined in our written testimony, and we would be
pleased to elaborate on it at your request.
I would like to give a very concrete set of examples as to
how the OTC market will interface with the clearinghouse and
what the implications will be. I am going to start by presuming
that Senator Schumer runs a large New York bank and he has lent
$100 million to the AAA Buggy Whip Company. Now, he hails from
New York, but he ultimately comes to realize what a buggy whip
is, and he decides that he may want to diversify or hedge his
exposure to that company. So he calls you and says, ``Mr.
Chairman, I am willing to pay you X dollars every quarter if
you are willing to agree that in the event that this buggy whip
company fails, you will buy AAA Buggy Whip loans with a face
value of $100 million from me for $100 million, regardless of
what their value is.'' Senator Schumer, being a persuasive
fellow, and you, being attracted to the revenue stream, agree.
Now, time passes and you have second thoughts about the
credit exposure that you have to the AAA Buggy Whip Company, so
you call up Senator Schumer and you say, ``Are you amenable to
unwinding this transaction?'' And Senator Schumer says, ``Well,
no, I like my position now but, in any event, would want a very
steep price for unwinding it.'' So you call Senator Crapo, who
runs a different bank, and you make the same proposition to
Senator Crapo that he will stand ready upon payment by you on a
quarterly basis of X or Y dollars to buy those loans from you
for $100 million, regardless of their value if the Company
fails. He agrees because he is a supporter of liquid markets,
and you are a persuasive fellow.
Now, you look at your position and you say, ``I am hedged.
I have no market risk.'' And you are right. However, you do
have $200 million in notional exposure to CDS, and I hesitate
to say this, but in their absence I feel somewhat more
comfortable, you also have the credit risk that Senator
Schumer's bank is not going to perform its obligations to pay
you periodically, and you are subject to the risk that Senator
Crapo's bank will not be around to pay you in the event that
the AAA Buggy Whip Company goes under.
If you are in Wall Street in this position, you would be
welcomed to the club because this is the position that most
major banks find themselves in, although, obviously, the
scenario is significantly larger in size and in consequences.
Now, if the three of you were all participants in CCTC and
you submit your trades to the clearinghouse, here is what
happens. The clearinghouse steps into the middle of your
transactions, so the credit default protection that you
provided to Senator Schumer you are now providing to the
clearing corporation and it is providing that in turn to
Senator Schumer. The credit protection that you purchased from
Senator Crapo you are now purchasing from the clearing
corporation and it is purchasing it in turn from Senator Crapo.
You are both purchasing and selling the same credit protection
to the clearing corporation, and in the process of novating
that transaction, your two transactions are utterly
extinguished. You have no more exposure, you have no notional
exposure, and you have no credit risk. You do not have credit
risk to the clearing organization. You do not have credit risk
to either of your colleagues' banks.
The benefits of this are self-evident. Of course, Senator
Crapo and Senator Schumer both have credit risk to the clearing
corporation, and the clearing corporation to them, and the
infrastructure that is being developed for CCTC will be
rigorously developed with state-of-the-art risk management
infrastructure in order to address those credit risks both to
protect CCTC against the default of a member, but also to
ensure that the default of a single member does not cascade
throughout the participants at the clearing corporation.
I see I am over my time.
Chairman Reed. Thank you very much.
Let me begin with a question I addressed initially to the
previous panel, which is that some commentators and some
individuals who are significant investors have suggested that
this is the next big shoe that will fall, this whole related
issue of credit default swaps, and I wonder, just your comments
and having heard the previous panel also, beginning with Dr.
Duffie.
Mr. Duffie. There is still some systemic risk associated
with failures of dealers, but the risk has been mitigated by
reduction of trade documentation backlog. And once the clearing
corporation or clearing more generally along the lines
described by Mr. Donohue has been set up--pardon me, Mr. Rosen
has been set up, that will further reduce the systemic risk to
the point that I think we will be much better off than we were
2 years ago.
Chairman Reed. Mr. Pickel, your comments?
Mr. Pickel. Yes, I think the continued efforts on the
operational side to reduce backlogs, to put this mechanism in
place for settling trades will be a significant focus for us.
We are also focusing on what we have always focused on, which
is the robustness of our documentation infrastructure, key
provisions such as netting and collateral. Keep in mind that
these credit derivatives are done under an ISDA master
agreement, and the relationships extend between two parties
beyond just credit derivatives to the whole range of
transactions that might exist. And so it is a risk management
proposition for participants, the two parties to the contract,
to maintain that overall portfolio of trades, not just the
credit derivatives but also the entire derivatives portfolio
between them.
Chairman Reed. Thank you.
Mr. Donohue.
Mr. Donohue. Sir, I think that is a difficult question to
answer because of the lack of information about gross and net
exposures that exist in the market. But we know from 150 years
of successful operation of the central counterparty clearing
system at the CME Group that the market wants confidence. They
want confidence in the ability to have their counterparties
perform, and a central counterparty clearing system provides
and enhances that confidence to market users.
So we do not know the answer to that question, but more
transparency and the application of true central counterparty
clearing services will help answer that question and help
reduce risks in the market.
Chairman Reed. Thank you.
Mr. Rosen, your comments?
Mr. Rosen. I agree, Mr. Chairman. I think that there is not
a panacea. I think there are a number of steps that need to be
taken, and I think we need to continue to take them. And I
think a central counterparty system will be a major element in
that effort, but not a panacea.
Chairman Reed. The impression that I got from the first
panel was that they see the role of both an exchange-based
approach and a clearinghouse approach, and the question I would
have now is--I guess I will rephrase that. In an ideal world,
market participants would move to those arrangements that were
most favorable to them, most profitable to them. Are there any
obstacles at the moment to that sort of smooth migration,
marketplace, regulatory obstacles or other obstacles? And let
me begin again with Dr. Duffie.
Mr. Duffie. Well, the over-the-counter market has taken the
first move or advantage on standardization of their major
products, such as the CDX contract, and they, in fact, have
intellectual property rights over the use of that particular
index, which is very popular.
The exchanges might have more difficulty convincing trade
to migrate to the exchange on a contract like that without the
ability to offer precisely that contract now that liquidity has
been established in the OTC market.
But, generally, I think the premise of that question, that
market participants will migrate to whatever trading venue is
most suitable for them, is about right. Regulators have an
important role to play in ensuring the systemic soundness of
clearing corporations, whether exchange or OTC.
Chairman Reed. But, again, and not just for Dr. Duffie but
for the rest of the panel, is there anything that you point to
now that are obstacles to that market migration or things that
should be done in a positive way to provide for the smooth
transition to either exchange or clearing?
Mr. Duffie. I myself am not aware of any major obstacles.
Chairman Reed. Mr. Pickel, your comments?
Mr. Pickel. I think it is important to keep in mind that
the development of this particular product area is quite
different from some of the other derivatives markets we have
seen develop over the last 25 years. In many of those areas,
interest rates, currencies, there were well-established
exchange-traded markets that existed either before the OTC or
really developed simultaneously with the OTC. In fact, since
the CFMA we have seen, you know, both exchange and OTC business
grow significantly, and there is a reason for that. They are
related. They provide a means of--the exchange provides a means
of offsetting risk in the OTC trades.
Credit derivatives developed initially as an OTC market,
and that is how it is--the liquidity is there. There is an
ability to trade. I think we are seeing, you know, a further
standardization of transactions, which might lead more
naturally to exchange-traded products. There have been some
efforts to establish exchange-traded products. We have tried to
work with the exchanges. The CME has a product where they
utilize our definitions. The recovery rates are fixed recovery
rates, unlike the OTC products, which is a variable recovery
rate. We have also worked with the exchanges over in Europe,
Eurex and Euronex Life, to discuss with them some of the
products that they are looking to roll out in the credit
derivative space.
So I think there is--you know, there is self-percolating
here, and we will have to see where it goes and what the market
reaction will be.
Chairman Reed. Mr. Donohue.
Mr. Donohue. Mr. Chairman, if I could clarify just briefly
before answering your specific question, I do think it is
important to think differently. It is not, in our view, a
difference between an exchange solution and a CCP or a central
counterparty solution but, rather, whether we choose to bring a
bundled trade execution as well as clearing solution to market,
or, alternatively, just offer central counterparty clearing
services while continuing to allow market users to transact
bilaterally as well as on an exchange type of platform.
With that explanation, I do think it will be important for
us to encourage the various regulators that are interested in
these issues--and that certainly does include the Federal
Reserve, the CFTC, and the SEC--to work together to help foster
a competitive environment where different organizations with
capability in these matters can offer innovative new solutions.
Whether they be trading execution solutions or central
counterparty clearing solutions, there are a variety of very
complex legal issues that could prevent those solutions from
coming to market quickly if the regulators do not work together
to help solve those problems.
Chairman Reed. Mr. Rosen, the same question.
Mr. Rosen. Yes, the securities law issues that the first
panel mentioned are issues that are important and would need to
be resolved in order for the CCP clearing solution to go
forward.
Chairman Reed. Well, I want to thank you gentlemen, and I
have just been informed that we have 9 minutes left on the
vote, and I think more importantly and significantly that
Senator Kennedy is on the floor to vote. So I am going to rush
over there, if you will forgive me. If there are additional
questions from my colleagues or from the staff, they will be
submitted to you in writing, and if you could respond no later
than July 16th--we will try to get the questions to you by July
16th, and please respond within the shortest possible time.
Thank you very much for your excellent testimony. The
hearing is adjourned.
[Whereupon, at 4:19 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM PATRICK M.
PARKINSON
Q.1. The explosion in credit derivatives basically occurred
during a time when corporate defaults were near record
historical lows. But a few months ago, Moody's Investors
Service projected that the junk-bond-default rate is likely to
climb to a range of 7% to 7.5% in the next 12 months--
substantially up from the current rate of less than 2%. If
these projections are correct, what might the implications be
for credit derivatives markets and those markets' corollary
impact on overall financial markets?
A.1. According to the statistics published by the Bank for
International Settlements (BIS) for December 2007, credit
default swaps on below-investment-grade reference entities were
16 percent of total single-name credit default swaps. If the
prediction for an increase in the junk-bond default rate is
borne out, the number of settlements on credit default swaps
will increase. Settling multiple defaults may pose a challenge
to the market infrastructure. Part of the supervisory agenda
for improving the infrastructure of OTC derivatives markets
includes improving the process for settling credit default
swaps following a default, including incorporating a cash
settlement mechanism into standard documentation for credit
default swaps. The industry has committed to achieve this by
year-end 2008.
A second implication of an increase in the junk-bond
default rate is the potential for counterparty credit risk
exposures on credit default swaps to increase. Counterparty
credit risk is of particular importance in credit derivatives
markets. Dealers manage their counterparty credit risks in a
variety of ways, but it remains a challenging task which is
made more challenging by the weaknesses in the market
infrastructure that, as I discussed in my testimony,
supervisors and market participants are working to address.
Q.2. According to news accounts, during the leveraged-buyout
boom in 2006 and early 2007, a number of credit default swaps
grew substantially in value before details of certain buyout
deals were publicly announced, raising concerns over issues of
possible insider-trading. Please comment on this issue and what
regulatory actions might be needed to reduce such insider
trading?
A.2. Section 10(b) of the Securities Exchange Act of 1934 and
Rule 10b-5 issued thereunder by the Securities and Exchange
Commission (SEC) have been interpreted to prohibit the purchase
or sale of a security on the basis of material non-public
information about the security or its issuer in breach of a
duty of trust or confidence. Congress enacted the Commodity
Futures Modernization Act of 2000 (CFMA) to, among other
things, provide legal certainty for certain swap agreements
under U.S. laws. Title III of the CFMA makes clear that certain
SEC rules and regulations (and related judicial precedents)
that prohibit fraud, manipulation or insider trading apply to
``securities-based swap agreements'' to the same extent as they
apply to securities. As such, participants effecting
transactions in credit default swaps that qualify as security-
based swap agreements would be subject to the insider trading
restrictions under Rule 10b-5 promulgated and enforced by the
SEC.
Q.3. We understand that your agencies are conducting closeout
drills to see how the market would handle the unwinding of
trades after the default of a major counterparty, given what
might have happened with Bear Stearns if it were to have gone
bankrupt.
What have you seen from these exercises?
Do you feel that firms would be able to
efficiently handle unwinding such trades?
A.3. The Federal Reserve recently met with a small number of
large, complex financial institutions to understand the
processes they have in place with respect to closing out a
major counterparty. We will be conducting additional meetings
at other institutions in September along with other supervisory
agencies to understand the full range of practices. All of the
firms interviewed to date recognize that they need to have
procedures in place to aggregate data and potentially close out
a major counterparty. However, the level of preparedness
differs from firm to firm. Some firms are still evaluating
their approach while others have detailed policies and
procedures in place and have stress tested potential close-outs
of selected counterparties. We are encouraging firms to take
the following steps: (1) develop the operational capacity to
aggregate all counterparty exposures and payment obligations
for a complex counterparty within a matter of hours; (2)
formulate written policies and procedures for managing the
relationship with a counterparty under stress; and (3) conduct
periodic scenario analyses around the potential closeout of a
major counterparty. The private-sector Counterparty Risk
Management Policy Group III recently made similar
recommendations to major market participants.
Q.4. In your testimony and answers to questions, you indicated
that you think you have the access to information that you need
for overseeing the OTC credit derivatives market. One of the
major concerns with Bear Stearns was that there was no clear
sense of the counterparties that held trades, and what the
impact would be on the market. Do you have access to
counterparty positions for the institutions that you supervise?
In other words, do you know how exposed your institutions are
to particular counterparties? Is this information available in
reports provided directly to you, or is this discovered as
needed when reviewing risk management systems at these firms?
A.4. Yes, we do have access to counterparty positions for the
institutions we supervise. The information is available in
reports provided directly and routinely to us. As needed, we
obtain ad hoc updates on banks' exposures, as well as
information on the causes of changes in counterparty exposures.
While this information allows us to assess the direct
counterparty exposures to the banking organization in question,
the assessment of indirect exposures that might-result from any
market impact of the close-out of a major market participant's
positions is much more difficult to assess.
Q.5. The issue of standardization is often raised as an
impediment to a clearing system or an exchange paired with
clearing. How much standardization is required for clearing as
compared to an exchange?
A.5. A central counterparty (CCP) clearing service must make
clear to its participants what types of contracts are eligible
for clearing. At a minimum, to the extent that a CCP wants to
make use of existing electronic trade confirmation services,
the contracts must be sufficiently standardized to be eligible
for confirmation using those services. But a CCP may choose to
place further limits on eligibility, based in part on its
assessment of the reliability of available methods for
assigning valuations to contracts and quantifying potential
changes in those market values. For example, LCH.Clearnet's
SwapClear service, which clears nearly 50 percent of global
inter-dealer interest rate swaps, clears only ``plain vanilla''
interest rate swaps in major currencies and with maturities
less than or equal to certain maximums (e.g., 30 years for U.S.
dollar-denominated swaps). It has chosen not to clear interest
rate options. An exchange is likely to require considerably
more standardization of terms for the contracts it lists. For
example, exchanges typically standardize interest reset dates,
maturities, and notional principal amounts.
Q.6. Is there any one standard for reporting information about
this market? It appears that the OCC requires data on bank call
reports, the Bank for International Settlements gathers data,
and the International Swaps and Derivatives Association (ISDA)
also gathers information. Is there any movement towards an
industry standard for measuring total volume, concentration
risks, etc., so that regulators can better oversee market-wide
risks?
A.6. I believe that the best source of data on the OTC
derivatives markets are the statistics published semiannually
by the Bank for International Settlements (BIS). (Unlike the
OCC data, the BIS data cover all major dealers, not just U.S.
commercial banks. Unlike the OCC or the ISDA data, the BIS data
are based on reporting procedures that avoid double-counting of
transactions between dealers.) The BIS data include notional
amounts and gross market values by contract type (foreign
exchange, interest rate, equity, commodity, and credit), by
instrument type (forwards, swaps, and options), and, for
foreign exchange and interest rate contracts, by currency.
Measures of market concentration for various instrument types
also are reported, which show that the OTC derivatives markets
generally are unconcentrated. (See http://
www.bis.orgipubilotchyo8O5.htrn)
Q.7. What form of oversight should be established over
exchanges in terms of credit derivatives? What are the
strengths of that regulator overseeing this exchange?
A.7. In principle, exchanges for credit derivatives can be
overseen effectively by either the SEC or the CFTC. Both
agencies have extensive experience overseeing exchange-traded
derivatives. The particular regulations that would need to
apply would depend in part on the nature of market
participants. To date, participants in the CDS markets have
predominantly been sophisticated parties, including banks,
securities firms, hedge funds, and traditional asset managers.
If this continues to be the case, the need for regulation to
protect investors would be limited. Any regulatory regime would
need to address the potential for market manipulation and for
trading on the basis of non-public information.
Q.8. What are the limitations in the proposed clearing entity
because membership will not be open to all market participants?
Does this limit the risk-sharing strengths of the clearing
entity if hedge funds and other market participants are
unlikely to join as members?
A.8. A critical element of any CCP's procedures for managing
its exposures to defaults by its participants is the
establishment of participation requirements that require
participants to have sufficient financial resources and robust
operational capacity to meet obligations arising from
participation in the CCP. Consequently, a CCP cannot be
expected to be open to all market participants. Nonetheless,
participation requirements should not limit access on grounds
other than risk, so as to ensure that the benefits of CCP
clearing are extended as widely as possible and to avoid
creating competitive imbalances among market participants. A
CCP's exclusion of hedge funds from participation would be
justifiable only if the CCP can demonstrate that participation
of hedge funds would expose the CCP to unacceptable risks that
cannot otherwise be mitigated through, for example, higher
initial margin requirement.
Q.9. Is pricing transparency in this market a public policy
goal? If not, why not?
A.9. Pricing transparency in the credit derivatives market is a
goal. But the degree of pricing transparency that can or should
be expected for nonstandardized contracts, which account for
much of trading in OTC markets, is not the same as the degree
of pricing transparency expected for standardized contracts,
such as would be traded on exchanges. Currently various vendors
collect and make available to subscribers quotes from dealers
and other market participants on prices of a variety CDS
contracts. But these are often indicative prices rather than
firm bids or offers that market participants could execute
against. Greater price transparency should be promoted by
encouraging greater standardization of contracts, which would
facilitate the trading of CDS on exchanges, where greater price
transparency is feasible. Indeed, proponents of exchange
trading correctly identify greater price transparency as an
important potential benefit of such trading.
Q.10. What is your assessment for why exchange-traded credit
derivatives have not yet picked up?
A.10. It is not entirely clear. Exchange-traded derivatives
necessarily are more standardized than contracts traded in the
OTC markets, and, in order to navigate the requirements of both
the commodities laws and the securities laws, some exchanges
have been forced to structure contracts in ways that may limit
their appeal to market participants. No doubt some market
participants see considerable benefit in tailoring contract
terms to specific needs, which leads them to prefer OTC
products. But many of the contracts traded in the OTC markets
are fairly standardized. Some have charged that those exchange
members that are OTC derivatives dealers have not encouraged
their customers to use exchange-traded products because
executing trades in the OTC markets is more profitable to the
firms. But some exchange members are not OTC derivatives
dealers, and, if there were significant demand for exchange-
traded contracts, one would think that those exchange members
would be able to meet the demand.
Q.11. What have you learned from the CDO and MBS problems that
we can apply to the credit derivatives markets? Have you
spotted the lessons learned and begun to apply them?
A.11. The problems in the MBS markets and in the markets for
CDOs collateralized by MBS had their roots in a breakdown of
underwriting standards for subprime mortgages and certain other
mortgages in recent years. The breakdown in underwriting
standards was made possible by a breakdown in market discipline
on those involved in the securitization process, which, in
turn, was made possible by flaws in credit rating agencies'
assessments of those products and by excessive reliance on
credit ratings by institutional investors and the asset
managers that they employ. To some extent, the weakening of
underwriting standards in the corporate credit markets over the
same period reflected the securitization of such credit through
CDOs (including synthetic CDOs created through use of credit
derivatives). But the deterioration was not nearly as severe as
in the subprime mortgage markets. Furthermore, participants in
the CDS markets do not appear to rely heavily on credit
ratings. Credit spreads typically widen well before ratings
downgrades occur. Thus, it is not straightforward to draw
lessons for the CDS markets from the problems in the MBS and
CDO of MBS markets.
Q.12. If Bear had in fact declared bankruptcy, do you have a
firm handle on how much would have had to be paid out and to
whom? To what extent was the Fed intervention with Bear Stearns
motivated by a lack of visibility into the credit derivatives
market?
A.12. We did not have information on market participants' net
positions in CDS for which Bear Stearns was the reference
credit. However, concerns about potential losses from writing
credit protection on Bear Stearns were not an important
consideration in the decision to intervene. We were concerned
about potential losses to firms that had acted as counterparty
to Bear Stearns in credit derivatives and other derivatives.
But we had access to Bear Stearns's estimates of its
counterparties' exposures to Bear's default. In any event, our
greatest concern was about the potential for Bear's bankruptcy
to result in a loss of secured financing by other large firms
that are critically dependent on such financing.
Q.13. If the Federal Reserve Bank of New York were to oversee
the new clearinghouse for OTC credit derivatives, what would
this oversight entail? Please explain how it would ensure that
the concentration of risks in this entity were offset by robust
risk management processes and systems. Also, how would the New
York Federal Reserve track information to review systemic risk?
A.13. As specified in its Policy Statement on Payments System
Risk, the Federal Reserve expects central counterparties, at a
minimum, to meet the Recommendations for Central Counterparties
that were developed by the Committee on Payment and Settlement
Systems of the G-10 Central Banks and the Technical Committee
of the International Organization of Securities Commissions
(CPSS-IOSCO Recommendations). The CPSS-IOSCO Recommendations
recognize that a CCP concentrates risk and responsibility for
risk management and lay out comprehensive risk management
standards that are intended to ensure that CCPs address the
concentration of risk with suitably robust risk management
processes and systems.
The Clearing Corporation plans to form a state-chartered
bank to become a CDS central counterparty and to apply for that
bank to be a member of the Federal Reserve Bank of New York.
The Federal Reserve Board will not approve the membership
application unless the Clearing Corporation is designed to meet
the CPSS-IOSCO Recommendations. If the application is approved,
the bank's CDS clearing activity would be subject to Federal
Reserve supervisory authority. The Federal Reserve would use
the same supervisory tools we use for supervising other
depository institutions, which includes both ongoing monitoring
and targeted, in depth, reviews. The reviews would focus on
areas identified as important in the CPSS-IOSCO
Recommendations. Examples of such areas to be reviewed are:
governance of the organization, risk management controls,
liquidity arrangements, and business continuity.
With respect to systemic risk, we would very carefully
assess whether the Clearing Corporation meets the CPSS-IOSCO
recommendation relating to the CCP's financial resources. That
recommendation requires a CCP to maintain sufficient financial
resources to withstand, at a minimum, a default by a
participant to which it has the largest exposure in extreme but
plausible market conditions.
------ --
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM KATHRYN E.
DICK
Q.1. The explosion in credit derivatives basically occurred
during a time when corporate defaults were near record
historical lows. But a few months ago, Moody's Investors
Service projected that the junk-bond-default rate is likely to
climb to a range of 7% to 7.5% in the next 12 months--
substantially up from the current rate of less than 2%. If
these projections are correct, what might the implications be
for credit derivatives markets and those markets' corollary
impact on overall financial markets?
A.1. While default rates are increasing, not only for junk
bonds but also investment grade bonds, we do not believe this
is the primary area of supervisory concern in the credit
derivatives market. This is because defaults will only trigger
a large cash settlement if protection sellers have not posted
collateral to secure their exposures. In practice, many
protection sellers post both initial margin and variation
margin. Initial margin helps to protect the protection buyer
from changes in the market value of the transaction that may
occur subsequent to the protection seller's failure to meet a
margin call. Variation margin is the daily collateral provided
to the protection buyer to secure the current market value of
the transaction. In normal market circumstances, as a reference
entity's credit quality declines, and its credit spreads
increase, the protection buyer will require the protection
seller to post daily variation margin to secure its obligation.
Based on recent events in the credit default swap market,
we can see that the real credit risk in the credit derivatives
market arises from counterparty risk exposures. In
circumstances where highly rated entities sell credit
protection and do not provide collateral to the protection
buyers, a downgrade of the protection seller may result in the
requirement to post large sums of collateral that cannot be
raised in the short period of time required to meet margin
calls. This can begin a negative spiral as protection sellers
try to sell assets to raise cash and put downward pressure on
already strained markets.
Q.2. According to news accounts, during the leveraged-buyout
boom in 2006 and early 2007, a number of credit default swaps
grew substantially in value before details of certain buyout
deals were publicly announced, raising concerns over issues of
possible insider-trading. Please comment on this issue and what
regulatory actions might be needed to reduce such insider
trading.
A.2. Bank trading desks are typically market makers in
derivatives products and run a market-neutral position. This
means they generally will have limited incentives to take
positions based upon anticipated credit spread changes,
particularly for individual reference entities. Banks' credit
managers will also use credit derivatives as part of their
credit portfolio management functions to address risks
associated with loan portfolios. It is our experience that the
trading and credit groups within national banks that actively
engage in credit derivatives transactions are kept on the
``public'' side of the functional information wall to minimize
risk of accessibility to material non-public information.
Our reviews of controls around the disclosure of material
non-public information have found no evidence that national
banks have taken advantage of trading on insider information.
Financial institutions have both information controls and
policies related to the use and distribution of material non-
public information. Bank compliance departments and internal
audit staff ensure compliance with insider trading rules and
sharing of information. Controls include limited sharing of
material non-public information between the private side and
public side of the institution. In addition, compliance
departments provide training, monitor inter-departmental
communication, maintain restricted lists, and maintain records
related to the institution's compliance with policies and
procedures.
The OCC will continue to monitor the controls and will
consider this area for expansion of scope in future
examinations. If we determine there are weaknesses in controls
around the distribution of material non-public information, we
will ensure that deficiencies are corrected and issue guidance
on the topic, as appropriate.
Q.3. We understand that your agencies are conducting closeout
drills to see how the market would handle the unwinding of
trades after the default of a major counterparty, given what
might have happened with Bear Stearns if it were to have gone
bankrupt.
What have you seen from these exercises?
Do you feel that firms would be able to
efficiently handle unwinding such trades?
A.3. This is an important initiative that supervisors, under
the auspices of the Senior Supervisors' Group, are working on
with the industry. The close-out of a major counterparty goes
beyond just consideration of the credit derivatives markets and
must include assessments of interest rate, foreign exchange,
equity, and commodity derivatives positions, as well as other
credit exposures. We have seen the impact of a failure of a
major counterparty in today's fragile financial markets, and we
believe that appropriate processes to close-out a large
counterparty are critical to reducing systemic risks.
The work underway by the Senior Supervisors' Group is
coming to a close and the challenges we have identified across
the population of firms studied include: aggregation of
exposures, accuracy of pricing, and discrepancies in legal
documentation. We will continue working with our domestic and
international supervisory colleagues to address these issues
and will ensure that OCC supervised entities take remedial
action, where necessary, to correct any system or control
deficiencies that hinder their ability to efficiently handle
the close-out of a major counterparty.
This question highlights the need for the industry to
continue using other means to reduce the volume of outstanding
credit derivatives, including compression exercises where
institutions coordinate with each other to cancel open
contracts that offset each other. There are also several
industry efforts to develop electronic trading and settlement
platforms for derivatives in the U.S. and Europe. These
platforms would be available to all industry participants and
would provide the ability for participants to confirm
transactions immediately. The electronic platforms would also
allow for immediate payment and settlement between
counterparties, thereby reducing operational and credit risks.
Q.4. In your testimony and answers to questions you indicated
that you think you have the access to information that you need
for overseeing the OTC credit derivatives market. One of the
major concerns with Bear Stearns was that there was no clear
sense of the counterparties that held trades, and what the
impact would be on the market. Do you have access to
counterparty positions for the institutions that you supervise?
In other words, do you know how exposed your institutions are
to particular counterparties? Is this information available in
reports provided directly to you, or is this discovered as
needed when reviewing risk management systems at these firms?
A.4. As noted in my testimony, the credit derivatives business
is concentrated in a small number of large financial
institutions. Through our Large Bank Supervision resident team
process, our examiners in the largest national banks have
access to counterparty exposure positions at the national banks
they supervise. This information is readily available to the
on-site examination teams and is typically prepared monthly but
is also available on an ad-hoc basis if needed. We also
routinely review aggregate exposure numbers for large margined
and un-margined counterparties as part of our quarterly
derivatives analysis.
That said, we cannot overemphasize the challenges our large
national banks face when seeking to aggregate and analyze
counterparty exposures in a highly volatile market environment.
As such, we remain focused on working with our national banks
and fellow supervisors in identifying actions that can be taken
to improve risk identification and management. One example is
the risk identification benefit derived from the novation
protocol process implemented by the industry in 2005 as a
result of the OTC derivatives infrastructure project. Prior to
that protocol, counterparties had assigned trades to other
dealers without first obtaining the consent of the remaining
counterparty. In that environment, many dealers did not
necessarily know who their counterparties were on a large
number of outstanding trades.
Q.5. The issue of standardization is often raised as an
impediment to a clearing system or an exchange paired with
clearing. How much standardization is required for clearing as
compared to an exchange?
A.5. In our opinion, some degree of standardization of
contracts is required for both a clearinghouse and an exchange,
but the level of standardization cannot be easily quantified.
Since a clearinghouse can exist without an exchange, but an
exchange must offer a clearinghouse, the primary benefit of an
exchange over a clearinghouse is the additional price
transparency. The trade-off is that exchange participants can
lose the ability to customize contracts, which is often
important in the management of complex financial risks. The
current credit market crisis underscores the importance of
reducing operational and credit risks and restoring confidence
between credit market participants. We support the development
of a robust solution that best meets these objectives in the
quickest period of time.
Q.6. Is there any one standard for reporting information about
this market? It appears that the OCC requires data on bank call
reports, the Bank for International Settlements gathers data,
and the International Swaps and Derivatives Association (ISDA)
also gathers information. Is there any movement towards an
industry standard for measuring total volume, concentration
risks, etc., so that regulators can better oversee market-wide
risks?
A.6. No, there is no one standard for the reporting of
information in the credit derivatives market. The call report
data collected by the OCC is for insured U.S. commercial banks
and trust companies only. Therefore, our data does not include
derivatives totals for investment banks and foreign banks, some
of whom are major dealers in the OTC derivatives market. The
OCC Quarterly Derivatives Report attempts to provide
transparency around the volume of derivatives activities for
U.S. insured commercial banks. The Bank for International
Settlements (BIS) makes certain adjustments to their data that
the OCC does not. While the absolute numbers between the OCC
and BIS reports are different, these reports show similar
trends.
As we note in our quarterly derivatives analysis, there are
a number of metrics that can be useful for assessing risk in
derivatives markets. No single metric is perfect as a risk
indicator, and a complement of data is typically needed to
generate a meaningful assessment of market-wide risks. Because
we have on-site examination teams in our largest national
banks, we have access to a significant amount of proprietary
data to assist in our assessment of risks. Additionally, we use
the sources noted above, as well as other information sources
such as published financial reports. While we are not aware of
any movement towards an industry standard for measuring
derivatives risks, we do see continual improvement with regard
to transparency and will continue to support such developments.
Q.7. What form of oversight should be established over
exchanges in terms of credit derivatives? What are the
strengths of that regulator overseeing this exchange?
A.7. As indicated in my testimony, the OCC's principal
objectives are to see a reduction in operational and
counterparty risks in the OTC derivatives market. In addition
to industry efforts to reduce manual activity and compress OTC
trade volumes, exchanges as well as clearinghouses have both
been discussed as potential solutions. The OCC does not have a
position on the specific format or vehicle that may be
implemented to mitigate these risks. The role of financial
institution regulators in the oversight of an exchange would
depend on the structure and features that are ultimately chosen
by market participants. The OCC reviews the activities of
national banks that elect to participate in clearinghouse or
exchange arrangements on a case-by-case basis.
Q.8. What are the limitations in the proposed clearing entity
because membership will not be open to all market participants?
Does this limit the risk-sharing strengths of the clearing
entity if hedge funds and other market participants are
unlikely to join as members?
A.8. There are still a number of solutions under consideration
and we continue to believe that the best solution will the
one(s) that is most comprehensive in terms of participation,
while maintaining a strong financial base and the appropriate
risk management framework. It is our understanding that the
sponsors of the current clearinghouse proposal are
reconsidering their earlier decision to limit clearinghouse
membership only to dealers. In addition, there are other
solutions being proposed that would allow for open membership
and the trading of credit derivatives on an exchange. This
could allow other financial entities, such as hedge funds, to
conduct derivative trading activity in a more efficient manner.
We recognize the need to identify and implement a structure
that will effectively reduce operational and counterparty risks
in a timely manner and are engaged in frequent discussions with
the management teams at our national banks that will be
involved in such ventures.
Q.9. Is pricing transparency in this market a public policy
goal? If not, why not?
A.9. Pricing transparency in any market is desirable, but its
benefits must also be weighed against the needs of market
participants, including their preference for customized
derivatives solutions to address specific risk management
needs. We recognize that pricing transparency certainly is one
benefit of both a clearinghouse as well as an exchange.
Q.10. What is your assessment for why exchange-traded credit
derivatives have not yet picked up?
A.10. To date, there has been limited success with the use of
exchange-traded credit derivatives. We believe that the primary
reason for this is that users of credit derivatives desire the
ability to customize contracts to meet specific risk mitigation
needs. However, as the market develops, more standardized terms
evolve and in some cases, such as credit derivatives index
trades, there is already the ability for a high degree of
standardization.
Q.11. What have you learned from the CDO and MBS problems that
we can apply to the credit derivatives markets? Have you
spotted the lessons learned and begun to apply them?
A.11. The major losses firms have taken during this turmoil
have come from bonds and structured products with subprime
mortgages as the underlying asset class. The problems
experienced in the CDO and MBS markets stem from liberal
underwriting practices which, in an environment of falling home
prices, have led to significant levels of anticipated losses on
bonds that contained residential real estate credit exposures.
Other problems included investor over-reliance upon credit
ratings, excessively complex bond structures, and poor risk
governance, such as the inability for some major dealers to
aggregate sub-prime exposures across the firm.
While the major issues in the credit derivatives market
relate to operational infrastructure (processing,
confirmations, settlement upon credit events, etc.), one lesson
from the credit market turmoil is that investors must fully
understand their investment risks. Many structured credit
products (e.g., CDOs of RMBS and CDO\2\) are extremely complex,
with risk profiles beyond the capacity of even very
sophisticated investors to properly assess and value. Because
of these concerns, there is no longer any market demand for
these products.
These lessons underscore our continued emphasis on risk
governance, in particular having independent risk management
and control functions in banks to assess the risks taken and to
obtain timely position valuations.
There are several initiatives underway, led by the
President's Working Group, the Joint Forum, the Financial
Stability Forum, and the Senior Supervisors' Group, to address
the lessons learned from this current market turmoil and ensure
proper risk management is in place across financial
institutions. Although there are some recommendations for
supervisors in these documents, most are directed to banks.
Therefore, it is banks that will have to implement them. We
will require banks to benchmark themselves against those
recommendations and then evaluate their progress in addressing
any ``gaps'' they have identified. The OCC also plans to
supplement its guidance on derivatives to address the issues
identified in these documents.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM KATHRYN E.
DICK
Q.1. Should market participants have the broadest possible
range of standardized and customized options for managing their
financial risk and is there a danger that a one-sizefits-all
attitude will harm liquidity and innovation?
A.1. While we believe that market participants should have the
broadest possible range of standardized and customized options
available for managing their financial risk, this flexibility
must be balanced against the need for risk and price
transparency. This is extremely beneficial in ensuring
financial risk is managed appropriately. One of the greatest
benefits of the credit derivatives market has been that it
allows market participants to develop customized contracts for
managing credit risk. We do not believe, however, that the
development of a central clearinghouse will harm liquidity or
innovation in the credit derivatives market and we do believe
this type of infrastructure change is necessary to reduce
unnecessary risks in the credit derivatives market.
Q.2. Is there a danger that centralizing credit risk in one
institution could actually increase systemic risk?
A.2. This is why it is critical that appropriate risk
management and controls are put in place for a central
clearinghouse. The central clearing party must have strong risk
controls, financial resiliency, and resources to withstand the
failure of one or more large clearing members. A clearinghouse
will not eliminate the potential of a large counterparty
failure; if structured properly, it should reduce the systemic
impact if such a failure occurs and thereby reduce the
potential volatility to the credit derivatives market
specifically and financial markets more broadly. In addition, a
clearinghouse will improve operational efficiency by reducing
the volume of outstanding confirmations via the ability to
conduct multilateral netting of exposures, reduction in payment
flows between counterparties, and improving the timeliness of
settlements.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM DARRELL
DUFFIE
Q.1. The explosion in credit derivatives basically occurred
during a time when corporate defaults were near record
historical lows. But a few months ago, Moody's Investors
Service projected that the junk-bond-default rate is likely to
climb to a range of 7% to 7.5% in the next 12 months--
substantially up from the current rate of less than 2%. If
these projections are correct, what might the implications be
for credit derivatives markets and those markets' corollary
impact on overall financial markets?
A.1. The market infrastructure, including documentation and
settlement mechanisms, should be able to accommodate this
increase in default activity, and if current improvements
continue as expected, substantially higher levels of default
activity within another year or so. Default by a systemically
important financial institution, however, would be very
disruptive. Separate from the issue of infrastructure,
substantially more defaults would obviously not be good for the
general stability of financial markets and the performance of
the economy. Speculative-grade default rates exceeded 10
percent in the 1989-91 recession and the 2001-2002 recession,
so the forecasted corporate-debt default rate is not an
especially alarming one in an historical context.
Q.2. Can you clarify how involved pension funds are in OTC
credit derivatives? How equipped are pension funds to make
determinations about the risks involved in credit default
swaps, and are they provided with adequate disclosures about
the potential risks?
A.2. According to the best available data, from the British
Bankers Association, pension funds are somewhat active in the
credit derivatives market, but probably account for less than a
few percent of global volumes. For reputational and legal
reasons, dealers have some responsibility to verify that
pension funds and any less financially sophisticated
counterparties are aware of the risks that they take in
derivatives positions such as these. Obviously, investors such
as these, who are not normally specialized financial investors,
would find it prudent to become aware of the risks on their
own. In many cases, they have relevant internal controls. Any
large entity responsible for trading on behalf of individual
investors should have controls ensuring that trading activity
conducted on its behalf is done by properly educated and
informed representatives. Pension funds use credit derivatives
both to offer risk protection to others, and also to protect
themselves from default risk, by buying protection from
counterparties. Even when exposing themselves to the risk of
default of the borrowers named in the credit derivatives
contract, pension funds and other protection sellers are taking
much the same risk as if they had purchased direct debt
obligations, such as bonds, of the named borrowers. Bonds
subject to default, for example corporate bonds, are indeed
normal investments for pension funds. From this point of view,
the main distinction between direct bond investments and credit
derivative protection selling is that credit derivatives do not
require up-front cash. This means that the availability of
pension fund capital is less of a brake on the risk appetite of
the pension fund. In addition to creating exposures to the
default of the borrowers stipulated in the credit derivatives
contract, there is also exposure to the performance of the
credit derivatives counterparty, for example a dealer.
Normally, this risk is remote, but it should be considered, and
it is present whether the pension fund is buying or selling
protection.
Q.3. We understand that during the leveraged-buyout boom in
2006 and early 2007, a number of credit default swaps grew
substantially in value before details of certain buyout deals
were publicly announced, raising concerns over issues of
possible insider-trading. Would you please comment on this
issue and what regulatory actions might be needed to reduce
such insider trading?
A.3. Yes, these concerns have been raised, and there are other
potential situations of moral hazard arising from private
information. For example bank lenders may have more information
about a borrower's credit quality than the rest of the market,
and participate in credit derivatives trading on that borrower.
Members of creditor committees of defaulting firms are
sometimes charged with representing other creditors, but may
potentially not have disclosed that they have offset some or
all of their economic exposure through credit derivatives.
Although I am not a legal expert, it is my understanding that
those with inside information or related conflicts of interest
are restricted in their credit derivatives trading by existing
laws and regulations, for example, those enforced by the
Securities and Exchange Commission, and liable under those laws
and regulations in much the same manner as when buying or
selling (or short selling) the underlying debt obligations.
Disclosure is important in these circumstances, and it is my
understanding that legal disclosure requirements are not as
clearly defined or as demanding for credit derivatives as for
outright asset positions. It would be best, however, for you to
obtain more expert legal opinions, for example from the
Securities and Exchange Commission. It is highly beneficial to
have the relevant laws and regulations in harmony with those of
other jurisdictions, because the credit derivatives market is
global.
Q.4. What have we learned from the CDO and MBS problems that we
can apply to the credit derivatives markets? Have we spotted
the lessons learned and begun to apply them?
A.4. In many cases, credit derivatives were the vehicles by
which CDO and MBS losses were transferred from one investor to
another. To the extent that one wants to make it more difficult
to transfer CDO and MBS losses, or default losses stemming from
other asset classes in the future, one could attempt to slow
down or reverse the growth and efficiency of the credit
derivatives market. In my view, that would be a mistake. Risk
transfer through credit derivatives allows those who want to
buy protection, or to obtain diversification, to do so more
efficiently. Moreover, credit derivatives prices are important
sources of information on the financial health of borrowers,
and on the valuation of portfolios of debt. (I will say more
about that in response to one of your other questions.) With
regard to the abuses and other failures that occurred in the
MBS and CDO markets, it is natural to think of credit
derivatives as devices that enabled investors to transfer to
each other the losses as they occur, rather than the cause of
the losses in the first instance. (As a matter of terminology,
some would consider a CDO to be a form of ``credit
derivative,'' although I am using the term ``credit
derivative'' in this context in the narrower sense of a default
swap contract, of the sort that was discussed in my testimony.)
Q.5. What kind of data and pricing information should be
available to regulators to help them oversee this market,
especially with more trades going to The Clearing Corporation?
Will more data be available by having a central clearing
entity? Would even more data be available by having an
exchange?
A.5. Some credit derivative pricing data are already available
for selected high-volume CDS contracts from some financial news
sources, such as Bloomberg, from some brokers, and from
specialized information vendors, such as Markit Partners.
Unfortunately, these data are not especially comprehensive, and
are often only suggestive of actual transaction prices. In my
view, it is worthwhile to consider a move toward the
availability of transaction-level data in the CDS market in a
manner analogous to that already available in the over-the-
counter bond market, through the system known as TRACE. Prices
for the vast majority of OTC corporate bond trades are now
available to essentially anyone through TRACE. This allows
investors to more easily ``comparison shop'' when trading, and
in principle allows regulators simpler access to price
information for their own purposes, for example when attempting
to detect potential insider trading. Dealers could in some
cases be adversely affected by TRACE-like transparency in their
profit margins on credit derivatives trades. Some investors who
are attempting to create or offset exposures would be adversely
affected by having some of the information regarding the size
and prices of their trades (although not their identities)
revealed to the market, causing prices to move against them
before having completed the change in their overall position.
A central clearing corporation for the over-the-counter
market would, according to the proposed design, play much the
same legal role in a credit derivatives trade as any non-
clearing counterparty. I am not aware of any currently proposed
mechanism by which cleared trades would result in any more
public disclosure than uncleared trades. A clearing corporation
would presumably be a repository of a significant amount of
trade information, along the lines of an exchange clearing
corporation. Whether and how this information would be
accessible to regulators is unclear to me. The Deriv/SERV
information warehouse (which already includes the majority of
inter-dealer credit derivative trade execution data) exists
independently of the existence of a clearing corporation, and
would presumably have much the same information, if not more
information. An exchange would indeed provide much more data on
prices and volumes for a given CDS contract than does the
current OTC market, at least for any derivative that achieves
liquid market conditions. This would be the case even with the
advent of TRACE-like transparency for the OTC market, although
the superiority of exchange-level transparency over OTC
transparency would in that be dramatically reduced with TRACE-
like OTC transparency. As a final note, transparency is
generally desirable for a financial market, but there are some
good reasons to allow investors (and the dealers that represent
them) to retain a significant degree of privacy. For example,
privacy creates better incentives for investing in fundamental
financial research (for example, regarding the financial health
of borrowers), and through that, more incentives for prices to
reflect correct information.
Q.6. In your testimony you note that a clearing entity provides
more or less the same benefits as an exchange. Can you
elaborate on what these benefits are?
A.6. In my testimony, I was restricting attention on this point
to the benefits associated with the clearing function for
dealers. (A clearing corporation is not a trading venue like an
exchange, so one would not compare the benefits with respect to
trade execution, price discovery, and so on.) For each dealer-
to-dealer trade, an exchange clearinghouse and an OTC central
clearing counterparty effectively become the buyer to the
dealer that is selling, and the seller to the dealer that is
buying. In both cases, OTC clearing and exchange clearing,
dealers are therefore protected from exposure to each other's
default so long as the clearing entity remains solvent. For
this reason, as I indicated in my testimony, it is important to
ensure that an OTC central clearing counterparty is well
designed. It should be well capitalized and adhere to other
high standards for clearing entities, such as those of CPSS-
IOSCO. I presume that regulators will ensure this, and will
monitor such a clearing corporation carefully on an ongoing
basis. If this were not the case, my answer would obviously be
different. Exchange-based clearing has been extremely safe and
effective over many decades, and OTC-based clearing can be so
as well. Obviously, failure of a clearing entity (whether
exchange-based or OTC-based), or even the onset of fear of such
a failure, could be calamitous.
Q.7. Your testimony notes that exchanges provide price
transparency. Do you think that price transparency is an
important feature for this market to have, given the increasing
counterparty risks?
A.7. Yes, price transparency is highly beneficial, not only for
reasons of counterparty risk, but also for other reasons that I
have mentioned in response to your earlier question.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM DARRELL
DUFFIE
Q.1. Should market participants have the broadest possible
range of standardized and customized options for managing their
financial risk and is there a danger that a one-size-fits-all
attitude will harm liquidity and innovation?
A.1. A one-size-fits-all approach would indeed harm innovation.
Standardization allows simpler methods for mitigating some of
the market infrastructure problems that we have experienced,
through easier trade documentation, clearing, and settlement.
The appropriate degree of standardization, however, involves a
tradeoff with the benefits of innovation and customization to
customer needs. Generally, I believe that the markets should be
left to determine how much standardization is appropriate. The
safety and soundness of financial markets can be regulated more
effectively, in my view, by other methods than mandating
standardization of financial contracts.
Q.2. Is there a danger that centralizing credit risk in one
institution could actually increase systemic risk?
A.2. The centralization of risk in one institution, such as an
exchange or a central clearing corporation, could increase
systemic risk if that central institution is not carefully
designed and well capitalized. One approach to centralizing
credit risk, exchange-based clearing, has proven to be
extremely safe over many decades, including through a number of
serious financial crises. A central clearing counterparty for
the over-the-counter derivatives market could be essentially as
safe as exchange-based clearing if it is similarly well
designed and backed by significant capital or guarantees. So
long as the institution into which risk is centralized performs
as designed, it will reduce systemic risk, because it reduces
the average level of exposure of counterparties to each other.
The performance of a risk-centralizing institution is
absolutely critical, however, for if it experienced a failure,
the systemic effects could be grave. Because systemic risk is a
cost borne by the public for which no single financial
institution bears responsibility, there is a natural and
important role for regulation in monitoring the careful design
and ongoing safety of risk-centralizing institutions.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM ROBERT
PICKEL
Q.1. Do most firms in the OTC credit derivatives market use
your master agreement? If so, doesn't that indicate a fair
amount of standardization? How much standardization is required
for clearing as compared to an exchange?
A.1. The ISDA Master agreement is the standard form used
between counterparties in the OTC derivatives industry. The
ISDA Master (and the attendant schedules, annexes and related
confirmations) provides standardized definitions while leaving
the material economic terms of the contract to negotiation
between the parties. It is important to remember that a Master
Agreement outlines the relationship between two parties with
respect to a broad range of bi-laterally negotiated contracts
(such as a credit default swap or an interest rate swap). A
confirmation, on the other hand, documents an individual
contract such as a credit default swap or an interest rate
swap. Like the Master, a confirmation will have many
standardized definitions but will leave the material economic
terms to be individually negotiated by the counterparties.
Clearing would likely require a degree of standardization
not required for purely bi-lateral contracts, which are
dependent upon the creditworthiness of a counterparty. This is
because in order to be cleared the contracts must presumably be
fungible with other contracts in the clearinghouse.
Q.2. Can you clarify how involved pension funds are in OTC
credit derivatives? How equipped are pension funds to make
determinations about the risks involved in credit default
swaps, and are they provided with adequate disclosures about
the potential risks?
A.2. Pension funds, like other institutional investors, make
use of credit derivatives to protect their portfolios against
the risk of default of a major issuer of debt. Although it is
difficult to generalize about the sophistication of pension
funds it is worth noting that they are regulated entities and
in at least some cases, such as CalPERS, among the largest and
most sophisticated investors in the world.
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RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO FROM ROBERT
PICKEL
Q.1. Should market participants have the broadest possible
range of standardized and customized options for managing their
financial risk and is there a danger that a one-size-fits-all
attitude will harm liquidity and innovation?
A.1. ISDA believes that choice in the range of financial
products is a fundamental principle for fostering innovation
and liquidity in the financial markets. A flexible market
structure allows innovative products to be created to address
the ever-evolving needs of market participants. Successful
products then become more standardized over time, primarily
through ISDA's efforts in the areas of documentation and market
practice. The singular achievement of privately negotiated
derivatives is that, by encouraging that process to take place,
the needs of market participants are most effectively served,
enhancing market stability and reducing risk to the system.
Imposing one approach to managing risk will stifle innovation
and restrict the ability of liquidity to coalesce around those
products that most directly address market participants' needs.
Q.2. Is there a danger that centralizing credit risk in one
institution could actually increase systemic risk?
A.2. Concentration of risk of any sort is always a cause for
concern, and this is particularly true of counterparty credit
risk. One way to address concerns about concentration of risk
is to encourage risk to be dispersed through the system through
contractual arrangements and risk mitigation techniques, such
as the close-out netting and collateral provisions developed by
ISDA over the years. Where risk is proposed to be concentrated
in one institution, a high degree of care must be taken to
minimize the possibility that concentration of risk in fact
increases risk to the system. The tool kit for managing that
risk may be clearly identified (capital requirements for
clearing members, margin requirements for trades, back-up
facilities), but it is the implementation of those tools and
the creation of the necessary systems to reinforce their
purpose that are critical steps to ensuring that centralizing
credit risk does not have the adverse effect of increasing
systemic risk.
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