[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

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

                                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

                                 ------                                

        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

                              ----------                              

                        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

                              ----------                              --
----


                        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.
                                ------                                --
----


 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.
                                ------                                --
----


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.
                                ------                                --
----


  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.
                                ------                                


  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.
                                ------                                


   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.
                                ------                                --
----


  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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