[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]



               HEARING TO REVIEW DERIVATIVES LEGISLATION

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

                                HEARINGS

                               BEFORE THE

                        COMMITTEE ON AGRICULTURE
                        HOUSE OF REPRESENTATIVES

                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION

                               __________

                          FEBRUARY 3, 4, 2009

                               __________

                            Serial No. 111-1


          Printed for the use of the Committee on Agriculture
                         agriculture.house.gov






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                        COMMITTEE ON AGRICULTURE

                COLLIN C. PETERSON, Minnesota, Chairman

TIM HOLDEN, Pennsylvania,            FRANK D. LUCAS, Oklahoma, Ranking 
    Vice Chairman                    Minority Member
MIKE McINTYRE, North Carolina        BOB GOODLATTE, Virginia
LEONARD L. BOSWELL, Iowa             JERRY MORAN, Kansas
JOE BACA, California                 TIMOTHY V. JOHNSON, Illinois
DENNIS A. CARDOZA, California        SAM GRAVES, Missouri
DAVID SCOTT, Georgia                 MIKE ROGERS, Alabama
JIM MARSHALL, Georgia                STEVE KING, Iowa
STEPHANIE HERSETH SANDLIN, South     RANDY NEUGEBAUER, Texas
Dakota                               K. MICHAEL CONAWAY, Texas
HENRY CUELLAR, Texas                 JEFF FORTENBERRY, Nebraska
JIM COSTA, California                JEAN SCHMIDT, Ohio
BRAD ELLSWORTH, Indiana              ADRIAN SMITH, Nebraska
TIMOTHY J. WALZ, Minnesota           ROBERT E. LATTA, Ohio
STEVE KAGEN, Wisconsin               DAVID P. ROE, Tennessee
KURT SCHRADER, Oregon                BLAINE LUETKEMEYER, Missouri
DEBORAH L. HALVORSON, Illinois       GLENN THOMPSON, Pennsylvania
KATHLEEN A. DAHLKEMPER,              BILL CASSIDY, Louisiana
Pennsylvania                         CYNTHIA M. LUMMIS, Wyoming
ERIC J.J. MASSA, New York
BOBBY BRIGHT, Alabama
BETSY MARKEY, Colorado
FRANK KRATOVIL, Jr., Maryland
MARK H. SCHAUER, Michigan
LARRY KISSELL, North Carolina
JOHN A. BOCCIERI, Ohio
EARL POMEROY, North Dakota
TRAVIS W. CHILDERS, Mississippi
WALT MINNICK, Idaho

                                 ______

                           Professional Staff
                    Robert L. Larew, Chief of Staff
                     Andrew W. Baker, Chief Counsel
                 April Slayton, Communications Director
                 Nicole Scott, Minority Staff Director

                                  (ii)















                             C O N T E N T S

                              ----------                              
                                                                   Page

                       Tuesday, February 3, 2009

Graves, Hon. Sam, a Representative in Congress from Missouri, 
  prepared statement.............................................     6
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma, 
  opening statement..............................................     5
Peterson, Hon. Collin C., a Representative in Congress from 
  Minnesota, opening statement...................................     1
    Prepared statement...........................................     3

                               Witnesses

Buis, Tom, President, National Farmers Union, Washington, D.C....     6
    Prepared statement...........................................     7
Damgard, John M., President, Futures Industry Association, 
  Washington, D.C................................................     9
    Prepared statement...........................................    11
Greenberger, J.D., Michael, Professor, University of Maryland 
  School of Law, Baltimore, MD...................................    17
    Prepared statement...........................................    19
Gooch, Michael A., Chairman of the Board and CEO, GFI Group, 
  Inc., New York, NY.............................................    31
    Prepared statement...........................................    32
Cota, Sean, Co-Owner and President, Cota & Cota, Inc.; Treasurer, 
  Petroleum Marketers Association of America, Bellow Falls, VT; 
  on behalf of New England Fuel Institute........................    35
    Prepared statement...........................................    37
Duffy, Hon. Terrence A., Executive Chairman, CME Group Inc., 
  Chicago, IL....................................................    39
    Prepared statement...........................................    41
Roth, Daniel J., President and CEO, National Futures Association, 
  Chicago, IL....................................................    77
    Prepared statement...........................................    79
Slocum, Tyson, Director, Energy Program, Public Citizen, 
  Washington, D.C................................................    81
    Prepared statement...........................................    83

                           Submitted Material

American Public Gas Association, submitted statement.............   101
Suppan, Steve, Senior Policy Analyst, Institute for Agriculture 
  and Trade Policy, submitted statement..........................   107

                      Wednesday, February 4, 2009

Lucas, Hon. Frank D., a Representative in Congress from Oklahoma, 
  opening statement..............................................   112
Peterson, Hon. Collin C., a Representative in Congress from 
  Minnesota, opening statement...................................   111
    Prepared statement...........................................   112

                               Witnesses

Masters, Michael W., Founder and Managing Member/Portfolio 
  Manager, Masters Capital Management, LLC, St. Croix, U.S. VI...   113
    Prepared statement...........................................   114
    Supplemental material........................................   262
Short, Johnathan H., Senior Vice President and General Counsel, 
  IntercontinentalExchange, Inc., Atlanta, GA....................   132
    Prepared statement...........................................   134
Taylor, Gary W., CEO, Cargill Cotton Company, Cordova, TN; on 
  behalf of National Cotton Council; American Cotton Shippers 
  Association; and AMCOT.........................................   137
    Prepared statement...........................................   139
Pickel, Robert G., Executive Director and CEO, International 
  Swaps and Derivatives Association, New York, NY................   141
    Prepared statement...........................................   143
Morelle, Hon. Joseph D., Assemblyman and Chairman, Standing 
  Committee on Insurance, New York Assembly; Chairman, Financial 
  Services and Investment Products Committee, National Conference 
  of Insurance Legislators, Troy, NY.............................   147
    Prepared statement...........................................   150
Concannon, Christoper R., Executive Vice President, Transaction 
  Services, NASDAQ OMX, New York, NY.............................   179
    Prepared statement...........................................   180
Hale, William M., Senior Vice President, Grain and Oilseed Supply 
  Chain North America, Cargill, Incorporated, Wayzata, MN; 
  accompanied by David Dines, President, Risk Management, 
  Cargill, Incorporated..........................................   185
    Prepared statement...........................................   187
Cooper, Karl D., Chief Regulatory Officer, NYSE Liffe, LLC, New 
  York, NY; on behalf of NYSE Euronext...........................   192
    Prepared statement...........................................   194
Cicio, Paul N., President, Industrial Energy Consumers of 
  America, Washington, D.C.......................................   196
    Prepared statement...........................................   197
Brickell, Mark C., CEO, Blackbird Holdings, Inc., New York, NY...   200
    Prepared statement...........................................   202
Book, Thomas, Member of the Executive Boards, Eurex and Eurex 
  Clearing AG, Frankfurt am Main, Germany........................   215
    Prepared statement...........................................   217
Kaswell, Stuart J., Executive Vice President and General Counsel, 
  Managed Funds Association, Washington, D.C.....................   223
    Prepared statement...........................................   224
Rosen, J.D., Edward J., Partner, Cleary Gottlieb Steen & Hamilton 
  LLP, New York, NY; on behalf of Securities Industry and 
  Financial Markets Association..................................   232
    Prepared statement...........................................   233
Weisenborn, Brent M., CEO, Agora-X, LLC, Parkville, MO...........   241
    Prepared statement...........................................   243
Fewer, Donald P., Senior Managing Director, Standard Credit 
  Group, LLC, New York, NY.......................................   245
    Prepared statement...........................................   247

                           Submitted Material

Chilton, Hon. Bart, Commissioner, U.S. CommodityFutures Trading 
  Commission, submitted statement................................   261
Jacoby, A. James, President, Standard Credit Securities, Inc., 
  submitted statement............................................   270
McDermott, Steve, COO, ICAP, submitted letter....................   272
National Grain and Feed Association, submitted statement.........   264
Seltzer, Susan O., Former Assistant Vice President, Synthetic 
  Securities, U.S. Bank, submitted letter and statement..........   266

 
               HEARING TO REVIEW DERIVATIVES LEGISLATION

                              ----------                              


                       TUESDAY, FEBRUARY 3, 2009

                          House of Representatives,
                                  Committee on Agriculture,
                                                   Washington, D.C.
    The Committee met, pursuant to call, at 1:05 p.m., in Room 
1300, Longworth House Office Building, Hon. Collin C. Peterson 
[Chairman of the Committee] presiding.
    Members present: Representatives Peterson, Boswell, Scott, 
Marshall, Walz, Kagen, Schrader, Halvorson, Dahlkemper, Massa, 
Bright, Markey, Schauer, Kissell, Boccieri, Pomeroy, Minnick, 
Lucas, Graves, Neugebauer, Conaway, Fortenberry, Latta, Roe, 
and Thompson.
    Staff present: Adam Durand, John Konya, Scott Kuschmider, 
Clark Ogilvie, John Riley, April Slayton, Debbie Smith, Kristin 
Sosanie, Tamara Hinton, Kevin Kramp, Bill O'Conner, Nicole 
Scott, and Jamie Mitchell.

OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE 
                   IN CONGRESS FROM MINNESOTA

    The Chairman. The Committee will come to order.
    We have Members coming in. We don't have votes until 6:30, 
so I appreciate the Members making an effort to come back. I 
think we will have more Members joining us.
    Good afternoon to everybody, and welcome to today's hearing 
on derivatives legislation.
    For those on the Committee who were here in the 110th 
Congress, today's hearing will cover many of the issues and 
topics considered during the nine hearings held last year on 
this subject. The effort to strengthen oversight and improve 
transparency in derivatives markets, whether regulated or 
unregulated, whether they are physically based commodities or 
financial commodities has been a top priority of this 
Committee.
    For those of you who are new to the Committee, welcome to 
the fire. Members and staff have been working hard on this 
issue since the last Congress adjourned, and it is my intent to 
move expeditiously this month; because every day we delay is 
another day where markets operate without the oversight or 
transparency they desperately need.
    Last year, we began our journey with extensive public 
hearings on the issue of speculation, lack of convergence, lack 
of effective oversight, and increased transparency of 
derivative markets. The result of those hearings was a strong 
bipartisan bill that had more than \2/3\ majority when it 
passed the House last September.
    We will continue this effort in the 111th Congress, but 
this time with new provisions resulting from the hearings we 
held late last year on the role of credit derivatives in the 
economy after the collapse of large financial institutions that 
were heavily engaged in the over-the-counter derivatives 
transactions and market.
    The language that I circulated last week, and that this 
Committee will be discussing, contains provisions similar to 
last year's bipartisan bill. It will strengthen confidence and 
trader position limits on all futures markets as a way to 
prevent potential price distortions caused by extensive 
speculative trading. It would close the so-called London 
loophole by requiring foreign boards of trade to share trading 
data and adopt position limits on contracts that trade U.S. 
commodities linked to U.S.-regulated exchanges. It would direct 
the CFTC to get a clearer picture of the over-the-counter 
markets, and it calls for a new full-time CFTC staff to improve 
enforcement, prevent manipulation, and prosecute fraud.
    This proposal would bring a sense of order to the over-the-
counter market by requiring transparent central clearing for 
all OTC derivatives. The legislation contemplates multiple 
entities, whether regulated by the CFTC, the SEC, or the 
Federal Reserve, offering clearing services for the market. In 
that sense, it is modeled after the current law. However, the 
bill requires these clearing entities to follow the same set of 
core principles in their operations as a means of avoiding 
regulatory arbitrage.
    The failures of AIG, Lehman, Bear Stearns, and other 
institutions have shown us that it is time for some 
transparency in the market for credit derivatives. The way for 
us to identify and reduce the risk out there is to facilitate 
clearing it.
    The draft bill provides the CFTC with authority to exempt 
some derivatives from clearing in recognition of the fact that 
not every OTC trade is suitable for clearing. However, those 
seeking to remain in the derivatives business without clearing 
will have to report their actions and demonstrate their 
financial soundness.
    In the debate over credit derivatives, there has been much 
discussion about choosing the proper regulator, whether it is 
the CFTC, the SEC, or the Fed. I have made it clear that I 
believe the CFTC is the agency that has the knowledge and the 
expertise in these markets.
    I am flat-out opposed to the Fed having a role in clearing 
or overseeing these products. If I could have my way, the Fed 
would not be involved. However, that is probably not a 
political reality of today, and the draft legislation reflects 
that.
    The Federal Reserve is an independent banking system, not a 
police officer of derivatives transactions. I share the 
concerns of those who think the Fed controls too much already. 
They are an unelected body that sets monetary policy, oversees 
its state member banks, oversees holding companies, and now 
they are printing money for the bailout.
    I am not surprised that the large banks are clamoring for 
the Fed to regulate derivative activity, given their cozy 
relationship with Fed members. Plus, they probably think it is 
a good idea to have a regulator with resources to bail them out 
if things go wrong.
    I am also strongly opposed to allowing the SEC to have 
primary authority over these contracts. The SEC uses a rules-
based system that is behind the curve of today's modern, 
complex financial products and in my opinion is just not 
workable. They are not just trying to solve yesterday's 
problems or last week's problems; they are still trying to 
solve the last decade's problems. As a result, they have done a 
poor job.
    How much confidence can we have in an agency that 
repeatedly ignored calls even from within its own agency to 
examine the investment advisory business of Bernard Madoff, 
which turned out to be the biggest Ponzi scheme in history? 
They gave them a road map as to what was going on; and they 
missed it. They even missed the red flags in their oversight of 
Bear Stearns, as was detailed in a report by the SEC Inspector 
General.
    Other people are trying to use the problems of credit 
default swaps as an argument to create a super financial 
regulator. However, in my opinion, taking something that is 
working, like the CFTC oversight of the futures market, and 
moving it to another place where things are not working is, 
frankly, crazy. To name a financial czar or a single super-
regulator over the whole thing is an even worse idea and has 
the potential to create financial markets' version of the 
Department of Homeland Security, which a lot of us don't want 
to see happen. So I don't want to even imagine the problems 
that we would create if we would go down that avenue.
    So as this Committee moves forward on this matter, we will 
continue to work on a bipartisan basis on this bill. We will do 
our work out in the open, and we will listen to any and all who 
want to comment. That is what we did with the farm bill, with 
the reauthorization of the Commodity Exchange Act and with our 
examination of speculation. The result of that approach was 
passage of strong bipartisan legislation last Congress that had 
the support of the Ranking Member at the time, Mr. Goodlatte, 
and it received \2/3\ of the vote in the House.
    This is must-pass legislation, in my view, which is why we 
need to move quickly; and that is why I have circulated this 
language, and why we are holding these hearings today and over 
the next couple of weeks. So I welcome all of today's witnesses 
and the Members to the hearing. I look forward to their 
testimony.
    [The prepared statement of Mr. Peterson follows:]

  Prepared Statement of Hon. Collin C. Peterson, a Representative in 
                        Congress From Minnesota
    Good afternoon and welcome to today's hearing on derivatives 
legislation.
    For those on the Committee who were here in the 110th Congress, 
today's hearing will cover many of the issues and topics considered 
during the nine hearings held last year on this subject. The effort to 
strengthen oversight and improve transparency in derivative markets, 
whether regulated or unregulated; whether they are physically based 
commodities or financial commodities has been a top priority of this 
Committee. For those of you who are new to the Committee, welcome to 
the fire.
    Members and staff have been working hard on this issue since the 
last Congress adjourned and it is my intent to move expeditiously this 
month because every day we delay is another day where markets operate 
without the oversight or transparency they desperately need.
    Last year, we began our journey with extensive public hearings on 
the issue of speculation, lack of convergence, lack of effective 
oversight, and increased transparency of derivatives markets. The 
result of those hearings was a strong, bipartisan bill that had more 
than a \2/3\ majority when it passed the House last September. We will 
continue this effort in the 111th Congress, but this time with new 
provisions resulting from the hearings we held late last year on the 
role of credit derivatives in the economy after the collapse of large 
financial institutions that were heavily engaged in OTC derivative 
transactions.
    The language that I circulated last week and that this Committee 
will be discussing contains provisions similar to last year's 
bipartisan bill. It would strengthen confidence in trader position 
limits on all futures markets as a way to prevent potential price 
distortions caused by excessive speculative trading. It would close the 
so-called London Loophole by requiring foreign boards of trade to share 
trading data and adopt position limits on contracts that trade U.S. 
commodities linked to U.S.-regulated exchanges. It would direct the 
CFTC to get a clearer picture of the over-the-counter markets, and it 
calls for new full-time CFTC staff to improve enforcement, prevent 
manipulation, and prosecute fraud.
    This proposal would bring a sense of order to the over-the-counter 
market by requiring transparent, central clearing for all OTC 
derivatives. The legislation contemplates multiple entities, whether 
regulated by the CFTC, the SEC, or the Federal Reserve, offering 
clearing services for market.
    In that sense, it is modeled after current law. However, the bill 
requires these clearing entities to follow the same set of core 
principles in their operations, as a means to avoid regulatory 
arbitrage.
    The failures of AIG, Lehman, Bear Stearns, and other institutions 
have shown us that it is time for some transparency in the market for 
credit derivatives. The way for us to identify and reduce the risk out 
there is to facilitate clearing it. The draft bill provides the CFTC 
with authority to exempt some derivatives from clearing, in recognition 
of the fact that not every OTC trade is suitable for clearing. However, 
those seeking to remain in the derivatives business without clearing 
will have to report their actions and demonstrate their financial 
soundness.
    In the debate over credit derivatives, there has been much 
discussion about choosing the proper regulator; whether it is the CFTC, 
the SEC, or the Fed. I have made it clear that the CFTC is the agency 
that has the knowledge and expertise in these markets.
    I am flat opposed to the Fed having a role in clearing or 
overseeing these products. If I could have my way, the Fed would not be 
involved; however that is not the political reality of today, and the 
draft legislation reflects that. The Federal Reserve is an independent 
banking system, not a police officer of derivatives transactions. I 
share the concerns of those who think the Fed controls too much 
already. They are an unelected body that sets monetary policy, oversees 
its state member banks, oversees holding companies, and now they are 
printing money for the bailout. I am not surprised that the large banks 
are clamoring for the Fed to regulate derivative activity, given their 
cozy relationship with Fed members.
    Plus, they probably think it is a good idea to have a regulator 
with the resources to bail them out when things go south.
    I am also strongly opposed to allowing the SEC to have primary 
authority over these contracts. The SEC uses a rules-based system that 
is behind the curve of today's modern, complex financial products and 
is just not workable. They are not just trying to solve yesterday's 
problem or last week's problem; they are still trying to solve last 
decade's problem. As a result, they have done a poor job. How much 
confidence can we have in an agency that repeatedly ignored calls, even 
from within its own agency, to examine the investment advisory business 
of Bernard Madoff, which turned out to be the biggest Ponzi scheme in 
history, having cheated an untold number of investors, charities, and 
foundations out of billions; or that missed the red flags in its 
oversight of Bear Stearns, as was detailed by a report from the SEC 
Inspector General?
    Other people are trying to use the problems with credit default 
swaps as an argument for creating a super financial regulator. However, 
in my opinion, taking something that is working, like CFTC oversight of 
the futures markets, and moving it to another place where things are 
not working is just crazy. To name a financial czar or single super 
regulator over the whole thing is an even worse idea that has the 
potential to create a financial markets version of the Department of 
Homeland Security. I don't want to even imagine the kind of mess that 
would create.
    As this Committee moves forward on this matter, we will continue to 
work on a bipartisan basis on this bill, and we will do our work out in 
the open and listen to any and all who want to comment. That is what we 
did with the farm bill, with reauthorization of the Commodity Exchange 
Act, and with our examination of speculation.
    The result of that approach was passage of strong bipartisan 
legislation last Congress that had the support of the Ranking Member at 
the time, Mr. Goodlatte, and achieved \2/3\ votes in the House.
    This is must-pass legislation, in my view, which is why we need to 
move quickly. That is why I have circulated this language and why we 
will be holding hearings over the next 2 weeks.
    I welcome today's witnesses and I look forward to their testimony. 
At this time I would like to yield to Ranking Member Lucas for an 
opening statement.

    The Chairman. At this time, I would yield to Ranking Member 
Lucas for an opening statement.

 OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN 
                     CONGRESS FROM OKLAHOMA

    Mr. Lucas. Thank you, Chairman Peterson, for calling 
today's hearing. We appreciate the opportunity to examine your 
draft legislation that addresses concerns with the derivatives 
industry and its impact on the U.S. economy.
    During the past several months, the Committee has spent a 
great deal of time monitoring the issue of trading activity in 
the futures market, as well as exploring the role credit 
default swaps have played in our current financial crisis. The 
draft legislation we are considering would impact a wide array 
of financial instruments, and what the ultimate effect will be 
in the marketplace is unknown.
    My main concern is how the legislation will impact risk 
management for agricultural producers. How far will this 
legislation go beyond credit default swaps and derivatives in 
general? I support greater transparency and accountability in 
respect to the over-the-counter transactions. However, I also 
believe any legislation to regulate financial markets has to 
strike a delicate balance between protecting the economic 
workings of this country and creating opportunities for 
economic growth, business expansion, risk management for our 
agricultural producers. To that end, I believe this Committee 
must work to ensure that the Commodity Futures Trading 
Commission, the CFTC, plays a leading role in appropriately 
regulating the derivative and commodity markets once the 
Committee decides what level of additional regulations are 
needed.
    We should also work to ensure that the CFTC has the tools 
it needs, human resources, technical resources, economic 
resources to effectively carry out its statutory mandate. It 
must be noted that the CFTC has a proven track record in 
clearing futures contracts, and to date has not lost a single 
dollar of a single customer's money due to failure of a 
clearinghouse.
    Finally, I would like to thank the participants of our two 
panels today. We appreciate your time and your commitment to 
the public policy process, and we look forward to your 
testimony and answers to our questions.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman and his staff for 
working with us through this process. We have been working on a 
bipartisan basis, and we will continue to do that.
    The chair would request that other Members submit their 
opening statements for the record so that witnesses may begin 
their testimony and we ensure that we will have ample time for 
questions.
    [The prepared statement of Mr. Graves follows:]

  Prepared Statement of Hon. Sam Graves, a Representative in Congress 
                             From Missouri
    Thank you, Chairman Peterson and Ranking Member Lucas for holding 
this hearing to review the Chairman's draft bill on derivatives 
legislation.
    Investor Warren Buffet has described the multi-trillion dollar 
market in financial derivatives as the equivalent of a financial pearl 
harbor. The unregulated and often shadowy market in financial 
derivatives trading has contributed greatly to the uncertainty and 
volatility that is paralyzing financial markets and hindering our 
economic recovery.
    Sunshine is often the best policy. Last Congress I sponsored 
legislation to bring greater regulatory oversight and transparency to 
the over-the-counter trade in natural gas contracts. As many Members of 
this Committee know, natural gas is an important component of many 
agriculture products, including fertilizer.
    While my bill was focused on combating market manipulation, I 
believe its transparency components are applicable here, to financial 
derivatives.
    Like anything, the devil is in the details and I look forward to 
learning more about the Chairman's proposal and hearing the opinions of 
today's panel. Again I would like to thank the Committee for holding 
this hearing.
    Thank you.

    The Chairman. So, with that, without objection we would 
like to welcome our first panel of witnesses to the table.
    First, we have Mr. Tom Buis, the President of the National 
Farmers Union. Welcome. Mr. John Damgard, the President of the 
Futures Industry Association; Mr. Michael Greenberger, Law 
School Professor at the University of Maryland School of Law; 
Mr. Michael Gooch, the Chairman and Chief Executive Officer of 
GFI Group, Incorporated, of New York; Mr. Sean Cota, President 
of Cota & Cota, Incorporated, on behalf of the Petroleum 
Marketers Association of America and the New England Fuel 
Institute of Bellow Falls, Vermont; and Mr. Terrence Duffy, the 
Executive Chairman of the Chicago Mercantile Exchange Group, 
Incorporated, of Chicago, Illinois.
    So, gentlemen, welcome to the Committee, welcome to the 
panel. We look forward your testimony.
    Mr. Buis, you can begin, if you are ready.

   STATEMENT OF TOM BUIS, PRESIDENT, NATIONAL FARMERS UNION, 
                        WASHINGTON, D.C.

    Mr. Buis. Thank you, Chairman Peterson, Ranking Member 
Lucas, and Members of the Committee. It is indeed an honor to 
be able to testify on this important issue before the 
Committee.
    We got involved in this last winter and spring, when we 
started receiving numerous phone calls from farmers. As wheat 
prices hit record levels, corn prices were also in the record 
category. Farmers were calling and saying they couldn't market 
their grain the way they would normally market it, which is, by 
and large, being able to price their grain after harvest for 
delivery. When they were precluded, they were told that the 
reason was many of the local elevators and co-ops were running 
up against their credit limits because the prices of the 
commodities were going up to the limit day after day and having 
to meet those margin calls; and their only alternative was to 
quit offering futures contracts after harvest.
    So, we contacted the CFTC and urged them to take a look at 
it, not long after they held a hearing. There were a number of 
people there, but they started out the hearing, and basically 
they went through all of their data and concluded before the 
hearing was even over that nothing out of the ordinary was 
happening.
    Well, Mr. Chairman, something out of the ordinary was 
happening. Farmers, who were probably the original derivative, 
were being precluded from the marketplace at a time when they 
could have really capitalized on the higher market prices. So 
we were a little frustrated with the reaction.
    As the year went on, we began to find out more and more 
that really what was causing higher food prices, really what 
was causing higher input costs was the excessive speculation 
that was going on in the commodity markets. Whether you look at 
oil, whether you look at grains, you look at any of the inputs, 
fertilizer, they were all based on either energy and/or future 
feed use or future use for other processing. As a result, 
farmers and ranchers didn't get the high prices and had to wait 
for prices to come down at harvest in order to sell their wheat 
and other commodities.
    We also witnessed something that I don't think anyone can 
explain, and that is the cotton market virtually doubled 
overnight. Our impression is that we have a lot of cotton in 
storage. It is difficult to move. As a result, it was 
definitely a speculative market that lasted a very short time. 
I have yet to meet a cotton farmer that got those pries up in 
the 90 cents range for their cotton.
    So we were impacted tremendously. I think it caused higher 
food prices, which impacted consumers. It caused a divisive 
attitude among agriculture producers, because livestock 
producers were being told that corn prices and feed prices were 
going to go even higher. So they had to lock in their prices.
    I just got back from Central Valley of California, Mr. 
Chairman, and many of those producers that locked in feed 
prices because they believed all the speculative reports that 
prices were going to continue to rise, and they did the prudent 
thing in locking in their future feed uses, and now they are 
all in as bad a financial shape as I have ever seen in the 
dairy industry. It is the same for other livestock producers 
and livestock processors.
    Ethanol companies did the same thing. They were all sort of 
wrapped up in this speculative environment.
    So I really commend you for your efforts, both last year 
and this year, to move forward. It is badly needed. Your 
legislation is right on target establishing speculative limits 
for all commodities, the increased transparency, providing the 
resources for CFTC, and including even carbon credits to be 
traded on the marketplace and a regulated marketplace. Actually 
being able to give the regulators a chance to know how much 
money is in there, who it is by, whether it is commercial, 
whether it is speculative, or whether it is under an exemption 
or over-the-counter or foreign exchanges has to be done. I 
think it is the most important thing for the rural economy, 
which, as you know, has certainly flipped in the last few 
months.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Buis follows:]

  Prepared Statement of Tom Buis, President, National Farmers Union, 
                            Washington, D.C.
    Good afternoon, Mr. Chairman and Members of the Committee. I 
appreciate the opportunity to testify on behalf of the farm, ranch and 
rural members of National Farmers Union (NFU). NFU was founded in 1902 
in Point, Texas, to help the family farmer address profitability issues 
and monopolistic practices while America was courting the Industrial 
Revolution. Today, with family farm, ranch and rural family members, 
NFU continues its original mission to protect and enhance the economic 
well-being and quality of life for family farmers and ranchers and 
their rural communities.
    Last spring, NFU called upon the Commodity Futures Trading 
Commission (CFTC) to conduct a thorough and comprehensive investigation 
regarding the activity and volatility in the commodities markets. In 
particular, the role of speculative commodity futures trading, both on 
and off-exchange, in increasing that volatility, with much of that 
trading hidden from view of the CFTC in the derivatives and other off-
exchange markets.
    Farmers and ranchers are generally relieved to end the 2008 
agriculture market roller coaster, but they are extremely anxious as 
they approach the 2009 production year. During 2008 we witnessed 
periods of record or near record nominal prices for many commodities 
traded on U.S. exchanges. As the year ended, we have also witnessed a 
historic collapse in market prices for major grains and dairy products.
    NFU was frustrated by remarks from some CFTC officials who 
suggested that the market volatility was simply a response to market 
fundamentals. This assessment did not adequately explain the price 
shock in the cotton market or lack of convergence between cash and 
futures markets during the contract settlement period. This assessment 
also failed to explain why many farmers were precluded from utilizing 
traditional market risk management tools, such as forward cash 
contracts, because of excessive margin risk to those who typically 
would offer such products to their customers.
    As speculators created a market bubble and attitude that higher 
prices were set to stay, crop, livestock and dairy producers locked in 
higher inputs and feed costs. The false signals were not reserved for 
agricultural producers, but extended beyond production agriculture to 
the ethanol and biodiesel industries and input suppliers, all locking 
in higher feedstocks and supplies. The 2008 economic collapse and 
bursting of bubble have jeopardized the economic livelihoods of all 
these players, which will ripple throughout our rural communities. This 
impact will not be short-lived, as it could take up to a year or longer 
before the negative impact is resolved.
    In these times of despair, commodities and industries become pitted 
against each other creating a divisive environment in which to 
establish helpful policy. As you can imagine, it was very frustrating 
for farmers who were paying record amounts for inputs, but could not 
implement effective marketing plans or strategies to take advantage of 
the higher prices for their crops. While this activity was occurring in 
2008, the media, with help from food processors, held fast to the 
position that farmers and ranchers were getting rich from record high 
commodity prices and cited these prices as the sole cause of increasing 
retail food prices. Nothing could have been further from the truth. The 
reality of what happened has come to light as commodity prices have 
plummeted, yet retail food costs remain high.
    The effort being made by this Committee to ensure that we do not 
experience a repeat of 2008, is to be commended. It became obvious, in 
a number of areas, that modernized regulations were warranted to ensure 
the mistakes of the past are not repeated. The broad, bipartisan 
support for increased oversight and transparency with the House-passed 
Commodity Markets Transparency and Accountability Act of 2008 provided 
a good starting point. The Derivatives Markets Transparency and 
Accountability Act (DMTAA) of 2009 would be of even greater benefit to 
agricultural producers and the entire economy.
    In a letter to the CFTC last year, NFU cited the single biggest 
concern among producers as a lack of market transparency. This is still 
the case. Provisions within the DMTAA, seek to inject necessary 
transparency through the detailed reporting and disaggregation of 
market data and the over-the-counter (OTC) transparency and record-
keeping authorities as outlined in the legislation. Without these 
provisions, the public will continue to be in the dark regarding who is 
involved in commodity markets and to what capacity. These new 
authorities are needed to ensure regulators are able to keep pace with 
the use of new financial and market instruments that result in market 
manipulation, fraud or excessive speculative market volatility.
    NFU has called for an investigation to determine the role and 
impact that OTC trading and swaps have on markets. Without full access 
to data and other information concerning these types of trading 
activities, it is impossible to determine whether manipulation, fraud 
or excessive speculation is occurring. DMTAA requires all prospective 
OTC transactions to be settled and cleared through a CFTC regulated 
clearinghouse or other appropriate venue. The addition of principles 
for the designated clearing organizations, including (1) daily 
publication of pricing information; (2) fitness standards; and (3) 
disclosure of operational information, will protect the integrity of 
the new OTC requirements by assuring the clearinghouses remain 
transparent.
    The legislation also requires the CFTC to study and report on the 
effects of potential position limits within OTC trading. Again, this 
information will enhance the public's confidence that markets are not 
being manipulated, fraudulently exploited or overwhelmed by speculation 
and if so, corrective action can be launched.
    When the CFTC proposed increasing speculative position limits in 
2007, NFU filed public comments in opposition to such action. 
Speculators have an important role to play in the commodity markets in 
terms of providing market liquidity. However, when left unregulated and 
allowed to become excessive, the positive attributes that speculators 
bring to the markets undermines the legitimate price discovery and risk 
management functions these markets were designed to provide to 
commercial market participants. DMTAA establishes new standards and 
limits for all commodities.
    Moreover, we are pleased to see the establishment of a Position 
Limit Agricultural Advisory Group. By involving producers and 
traditional users of the market in making recommendations concerning 
position limits, the new limits will be legitimized and fair. With the 
rapid growth of market speculation, we are in unchartered waters today 
and we believe this third-party review function can significantly help 
in ensuring market integrity in the future.
    NFU believes the CFTC needs to take a broader look at the concept 
of manipulation and it implications for price discovery. Unfortunately, 
the CFTC's test to determine manipulation requires that an individual 
or group of traders acquire a market position that enables them to 
consciously distort prices in noncompliance with market fundamentals. 
What the CFTC is failing to recognize is that the deluge of money from 
Wall Street, hedge funds and other large traders in and of itself is 
driving prices in ways that may not reflect the fundamentals of the 
underlying markets.
    In 2006, NFU became an approved aggregator for trading carbon 
credits on the Chicago Climate Exchange (CCX). Currently, we are the 
largest aggregator of agricultural soil carbon offsets to CCX. The CCX 
is the world's first greenhouse gas emissions registry, reduction and 
trading system, trading more than 86 million tons of carbon offsets to 
date. As carbon trading continues to advance rapidly, NFU appreciates 
the provision within the legislation that will protect the integrity of 
carbon credit trading by requiring those contracts to be traded on a 
designated contract market. Furthermore, the cross pollination between 
the CFTC and the U.S. Department of Agriculture to develop procedures 
and protocols for market-based greenhouse gas programs will help ensure 
these markets will perform a legitimate function for participants and 
the public in general.
    This legislation will begin to answer many of the questions from 
2008. We are currently enduring the train wreck caused in large part by 
the dysfunction of the futures market--in 2008.
    NFU strongly endorses this bill and looks forward to its swift 
approval; I am hopeful Congress will continue its bipartisan efforts to 
establish greater oversight of the commodity and energy futures 
markets. I thank the Committee for the opportunity to be here today and 
look forward to any questions you may have.

    The Chairman. Thank you, Mr. Buis, for your statement.
    Mr. Damgard, welcome to the Committee.

   STATEMENT OF JOHN M. DAMGARD, PRESIDENT, FUTURES INDUSTRY 
                 ASSOCIATION, WASHINGTON, D.C.

    Mr. Damgard. Thank you very much, Mr. Chairman.
    Chairman Peterson, Ranking Member Lucas, and Members of the 
Committee, I am John Damgard, President of the Futures Industry 
Association; and, as the principal spokesman for the U.S. 
futures industry, FIA is pleased to be able to testify on the 
Derivatives Markets Transparency and Accountability Act of 
2009. But before addressing the far-reaching legislation, I 
want to step back and try to put it in some context.
    In recent months, our economy has faced unprecedented 
financial turbulence, leading to bankruptcies and bailouts. 
During that time, U.S. futures markets have performed 
flawlessly. Fair and reliable prices have been discovered 
transparently, hedgers have managed price risks in liquid 
markets, all trades have been cleared, customers have been 
paid. Not a blip. This record of excellence is the best 
evidence possible that the regulatory system established by 
this Committee works superbly well. It is also the best 
evidence that the Commodity Futures Trading Commission has done 
its job, and done it well. The Committee should take pride in 
both the regulatory structures you put in place and the agency 
that you created years ago. Other agencies should learn from 
the CFTC.
    But, in any event, a simple merger is not the answer; and, 
in that regard, I agree with both the Chairman and the Ranking 
Member.
    The legislation before you would build on existing 
regulatory structure to enhance the CFTC's current powers. We 
support additional special call and other transparency 
provisions to allow the CFTC to strengthen its market 
surveillance capabilities, we support additional resources for 
the CFTC, we support coordinated oversight of linked 
competitive markets, and we support looking at further ways to 
adapt CFTC regulation to the ever-increasing pace of market 
innovation. But, despite our support in those areas, FIA cannot 
support the bill as a whole.
    Our major objections rest in three areas: number one, the 
hedge exemption; number two, mandatory clearing of all OTC 
instruments; and number three, the ban on naked credit default 
swaps. The bill's narrow hedging definition erases decades of 
progress to expand the use of regulated futures markets by 
businesses that use futures in an economically appropriate way 
to manage their price risks. Those companies are not 
anticipating higher or lower prices. They are managing a risk 
of higher or lower prices that they already face. In fact, if 
the companies do not manage that risk, they would be 
speculating.
    But if this bill becomes law and constraining positions are 
imposed, then automakers could not hedge gasoline prices, 
agribusiness could not hedge currency prices, airlines could 
not hedge interest rates, and utilities could not hedge weather 
risk. This would be bad economic policy at a time when we need 
stability, not uncertainty. Mandating clearing of all OTC 
derivatives would lead to market uncertainty or worse.
    You might think that I would support clearing everything, 
because my regular members are the clearing members whose 
businesses would increase if everything were cleared. But we 
don't support mandatory clearing for all OTC derivatives. Some 
derivatives are too customized and their pricing too opaque to 
be cleared safely and efficiently. Making it illegal not to 
clear an OTC derivative would, therefore, be a recipe for 
economic instability and litigation.
    FIA believes clearing should be encouraged through capital 
treatment or other regulatory measures. FIA also believes that 
if the Committee insists on a clearing mandate, it should be 
coupled with a flexible CFTC power to exempt classes of 
instruments from that mandate.
    Unfortunately, the draft bill's exemptive powers are so 
limited we fear the CFTC would only be able to exempt a sliver 
of the current OTC market, leaving the rest facing intolerable 
legal uncertainty or the ability to do this business somewhere 
outside the United States.
    Last, we oppose the ban on naked credit default swaps. The 
ban would remove important liquidity from our credit markets at 
just the wrong time for many struggling businesses. FIA would 
prefer to see Congress encourage clearing of CDS instruments 
and provide more effective, systemic risk protections through 
oversight of the institutions that enter into these 
transactions.
    Mr. Chairman, FIA thanks you very much for the opportunity 
to testify this afternoon, and I look forward to answering any 
questions.
    [The prepared statement of Mr. Damgard follows:]

  Prepared Statement of John M. Damgard, President, Futures Industry 
                     Association, Washington, D.C.
    Chairman Peterson, Ranking Member Lucas and Members of the House 
Agriculture Committee, I am John Damgard, President of the Futures 
Industry Association. The FIA is pleased to be able to testify on the 
discussion draft of the Derivatives Markets Transparency and 
Accountability Act of 2009.
Introduction
    FIA understands well the interest of Chairman Peterson and others 
in crafting this draft bill. Financial derivatives are now an integral 
part of our national economy and have been used by many businesses to 
reduce the multi-faceted price risks they face. Some of these 
derivatives and related market structures have evolved since Congress 
considered major changes to the Commodity Exchange Act in 2000. Some 
have even become more prominent since Congress adopted important 
changes to the Act as part of the 2008 Farm Bill. Given this 
Committee's experience and history with derivatives regulation, FIA 
welcomes discussion with the Committee on whether we need to bolster 
existing regulatory systems at this time.
    The draft bill is far-reaching. It would make substantial revisions 
to the Commodity Exchange Act that would affect trading on exchange 
markets as well as over-the-counter transactions. While FIA is the 
trade association for the futures industry,\1\ and its traditional 
focus has been on exchange markets, we try to take a holistic view of 
futures and other derivatives markets in order to advise the Committee 
on what our members believe would be the best public policy for our 
country and our industry.
---------------------------------------------------------------------------
    \1\ FIA is a principal spokesman for the commodity futures and 
options industry. Our regular membership is comprised of 30 of the 
largest futures commission merchants in the United States. Among our 
associate members are representatives from virtually all other segments 
of the futures industry, both national and international. Reflecting 
the scope and diversity of its membership, FIA estimates that its 
members serve as brokers for more than ninety percent of all customer 
transactions executed on United States contract markets.
---------------------------------------------------------------------------
Draft Bill
    FIA has analyzed the draft bill through the prism of the 
congressional findings that form the foundation of the Commodity 
Exchange Act. Congress has found that the Act serves the public 
interest by promoting the use of liquid and fair trading markets to 
assume and manage price risks in all facets of our economy, while 
discovering prices that may be disseminated widely. CFTC regulation 
fosters those interests through four core objectives:

   preventing price manipulation,

   avoiding systemic risk and counterparty defaults through 
        clearing,

   protecting customers, and

   encouraging competition and innovation.

    FIA supports these Congressional findings and objectives. They are 
valid today as they were when first enacted. In FIA's view, some of the 
draft bill's provisions are consistent with these findings and 
objectives. We support those provisions which would strengthen CFTC 
market surveillance capabilities and deter price manipulation, by 
adapting the current regulatory systems to ever evolving market 
innovations. We also support the pro-competition decisions embodied or 
implicit in the bill's provisions.
    But many of the draft bill's provisions would disserve the very 
public interests and economic policies Congress designed the CEA to 
serve by draining market liquidity, making hedging more costly, curbing 
innovation and discouraging trading in the U.S. We can not support 
those sections of the bill. Attached to this testimony FIA has included 
a section-by-section review of the draft bill which describes our 
positions on its specific sections.
FIA's Principal Objections
    To summarize our objections, FIA fears the bill would:

    (1) increase the cost of hedging and price risk management for U.S. 
        businesses, a bad result at any time, but one that is 
        particularly harmful when those same businesses are struggling 
        to cope with a deepening recession;

    (2) increase price volatility by removing vital market liquidity 
        through artificial limits or outright prohibitions on 
        participation in regulated exchange trading and OTC 
        transactions;

    (3) disadvantage U.S. markets and firms by creating inadvertent 
        incentives to trade overseas both exchange-traded and OTC 
        derivatives; and

    (4) weaken CFTC regulation by saddling the agency with 
        responsibilities that would be resource-intensive to perform 
        with little corresponding public benefit.

    Our major concerns center on provisions in sections 6, 13 and 16 of 
the bill.
    Section 6 would require the CFTC, under a cumbersome and costly 
advisory committee system, to impose fixed speculative position limits 
on all commodities traded on regulated exchanges. Today those limits 
are set by the exchanges for all non-agricultural commodities. No 
evidence exists that this position limit system has caused any market 
surveillance difficulties or failed to stop any market manipulation.
    But the bill not only usurps the exchange's powers to set the 
limits, it would greatly expand the application of those limits by 
transforming into speculators many businesses that use futures in an 
economically appropriate manner to reduce price risks they face. Under 
the bill, any business becomes a speculator if its futures position is 
not a substitute for a transaction in the physical marketing channel or 
does not arise from a change in value in an asset or liability the 
business owns or service it provides.
    Under this restrictive test, for example, automobile manufacturers 
will not be able to hedge gasoline prices. Yet gasoline prices often 
play a major role in determining what cars consumers will buy and, 
hopefully, manufacturers will make. No one will be able to use weather 
derivatives to hedge climate changes of any kind (weather is not in the 
physical marketing channel). Agribusinesses will be unable to hedge 
their foreign currency risk and airlines will be unable to hedge their 
interest rate risk. The list of increased, unmanaged (speculative) 
price risk to our economy goes on and on.
    FIA understands that many Members of the Committee are concerned 
that speculation may have artificially influenced market prices in some 
commodities in the last year. We are still awaiting any objective fact-
finding that would support that conclusion. For now, FIA has seen no 
evidence to distrust the market surveillance capabilities of the CFTC, 
especially when armed with the new special call reporting authority as 
the bill provides.
    FIA does not believe that restricting the ability of businesses to 
hedge or manage price risks on regulated exchange markets is an 
appropriate response in any event. We do not believe it is sound 
economic policy to force businesses that want to use U.S. futures 
markets to manage their price risks to trade on overseas markets or 
enter into OTC derivative positions. FIA urges Chairman Peterson and 
the Committee to reconsider section 6.
    Section 13 of the bill mandates clearing of all OTC derivative 
transactions, unless exempted by the CFTC under strict criteria. As the 
Committee well knows, all derivatives transactions involve counterparty 
credit risk. Different methods exist to deal with that risk. One of 
those methods is the futures-style clearing system.
    FIA is a strong supporter of clearing systems. Clearing removes 
each party's risk that its counterparty may default. As I testified 
before the Committee in December, FIA's regular members--the clearing 
firms--provide the financial backbone for futures clearing. Our members 
guarantee the financial performance of every trade in the system.
    FIA believes the futures clearing system works exceptionally well 
to remove counterparty risk and to reduce systemic risk. Increasing the 
number of transactions submitted for clearing also should be good for 
my members' bottom lines. In that sense, the Committee might expect FIA 
to support mandatory clearing of all OTC derivatives.
    But we don't. While a clearing mandate may have some superficial 
appeal, FIA is concerned that section 13 could promote economic 
instability in the U.S. Most directly of concern to FIA clearing 
members, a mandate may force derivatives clearing organizations to 
clear OTC products that are not sufficiently standardized to be cleared 
safely. Not every derivative can be cleared. The DCOs will surely try 
to clear what they can clear, consistent with their risk management 
systems. But as the experience with CDS clearing shows, developing 
appropriate clearing systems takes time and an indiscriminate statutory 
mandate for immediate clearing of OTC products would add financial risk 
to clearing members as well as the financial system as a whole.
    In addition, mandatory clearing of credit and other derivatives 
could lead to uncertainty in credit and other markets at a time when we 
are struggling to stabilize or restart those vital economic functions. 
It is true section 13 authorizes the CFTC to exempt classes of OTC 
derivatives from the clearing mandate. As drafted, however, section 13 
would severely constrict the CFTC's ability to exempt OTC transactions.
    FIA trusts the CFTC's experience and expertise. If clearing is to 
be mandated at all for any transactions, we believe the CFTC could 
craft a workable and specific exemption if the statutory exemption 
criteria are sufficiently flexible. We believe that flexibility will 
lead to the best national economic policy. Otherwise we fear mandatory 
clearing of OTC derivatives could trigger a rush to overseas OTC 
markets that would be counter-productive to our national economic 
interests.
    FIA strongly supports one policy decision that is implicit in 
section 13. We know that some would mandate exchange trading of all 
derivatives in the U.S. FIA opposes that anti-competitive, anti-
innovation approach and is pleased the draft bill does not go down that 
road. Consistent with section 13, FIA believes in an open, competitive 
system whereby classes of derivatives are first executed on exchange or 
dealer trading platforms as well as bilaterally and then submitted for 
clearing. Exchange and dealer competition for executing derivatives 
trades will serve well the interests of all market participants. FIA 
supports that approach.
    Unlike section 13, the provisions of section 16 are anti-
competitive and anti-innovation. It appears to ban so-called naked 
credit default swaps in OTC dealer markets (where all CDS transactions 
now occur), while allowing them on exchange markets (where today none 
occurs). In addition to the unfair competition feature of section 16, 
it would remove important liquidity from our credit markets and could 
operate to make credit itself more expensive for those in struggling 
businesses that now thirst for credit.
    History teaches that removing liquidity provided by speculators 
leads to increased price volatility and costs for hedgers. Without 
speculators, hedgers may be forced to pay higher prices, rather than 
prices discovered by competitive market forces. The ban also would 
invite parties to the CDS market to conduct this business overseas, 
outside the jurisdictional reach of the U.S. financial regulatory 
system. That transactional exodus would complicate the job of Federal 
financial regulators, making it harder, if not impossible, to monitor 
systemic risk.
    FIA understands Chairman Peterson's concern that trading in credit 
derivative swaps could add substantial counterparty credit risks to our 
economy. But developing and implementing appropriate clearing systems 
for these instruments should address that concern. In fact, section 13 
of the bill is based on that premise. FIA believes the Committee should 
focus on improving the clearing provisions of section 13 of the bill, 
rather than banning liquidity providers from the CDS market or favoring 
exchanges over OTC dealers.
CFTC Regulation
    FIA understands that Congress soon may receive proposals on 
financial market regulatory restructuring. In that regard, one aspect 
of the recent financial market turmoil must be highlighted. Despite 
unprecedented financial turbulence that has led to bankruptcies and 
bailouts, the U.S. futures markets have performed flawlessly. Fair and 
reliable prices have been discovered transparently. Hedgers have 
managed price risks in liquid markets. All trades have been cleared. 
Customers have been paid. Not a blip.
    This record of excellence in an unprecedented crisis is the best 
evidence possible that the regulatory system this Committee has 
authored for decades works superbly well. It is also the best evidence 
that the Commodity Futures Trading Commission has done its job and done 
it well. This Committee should take pride in the record of the 
regulatory structures you put in place and the agency you created 
decades ago. Any efforts to rationalize Federal financial regulation 
should learn from the CFTC's example and make certain to preserve the 
best features of the futures regulatory system.
    One feature of the current regulatory system that must be preserved 
is the exclusive jurisdiction of the CFTC over all facets of futures 
trading and related activities. Congress long ago determined that other 
Federal or state regulation should not duplicate or conflict with the 
CFTC's regulation of the futures markets. We know this Committee has 
been vigilant in protecting this important public policy which has 
allowed CFTC-regulated futures markets to prosper for many years.
    The decision by this Committee to establish an experienced and 
specialized agency to oversee U.S. futures markets also has worked well 
for decades. Yet, there is always talk that simply merging the CFTC 
into the SEC will cure all regulatory ills. FIA knows this Committee 
appreciates that such a merger would not promote the public interests 
served by the Commodity Exchange Act and would not resolve the public 
policy issues that have arisen out of the latest credit market stress. 
We thank the Committee for its leadership in this area.
Conclusion
    FIA thanks Chairman Peterson and the Committee for this opportunity 
to share our views. We would be pleased to assist your deliberations in 
any way we can and to answer any questions you may have.
                               Attachment
Analysis of Derivatives Markets Transparency and Accountability Act of 
        2009
Section 3--Speculative Limits and Transparency of Off-Shore Trading
    Section 3 has three subsections. FIA opposes the first subsection 
and supports the other two subsections which parallel provisions in 
H.R. 6604 passed by the House last year.
    FIA supports coordinated market surveillance for linked products 
offered by competing U.S. and foreign exchanges. Last session, Rep. 
Moran offered legislation that would have addressed these issues in a 
comprehensive and reciprocal manner. FIA supports that approach. 
section 3(a), however, could spark retaliation by foreign regulators 
against U.S. firms and exchanges. The Moran approach is less likely to 
trigger that response and has broader application.
    FIA supports subsections 3(b) and 3(c) which afford a safe harbor 
and legal certainty to CFTC-registered firms that execute or clear 
trades for customers on foreign exchanges even if those exchanges 
themselves do not comply with each and every CFTC requirement. U.S. 
firms should not be liable for any non-compliance by foreign exchanges. 
Last session, H.R. 6604 contained these provisions in a form that 
achieved the stated objectives. In the draft bill, important language 
has been inadvertently dropped from subsection 3(b). FIA would support 
the provision if the language from H.R. 6604 is restored.
Section 4--Detailed Reporting and Disaggregation of Market Data
    Section 4 would add a new  4(g) of the Commodity Exchange Act. FIA 
has no objection to having the CFTC define index traders and swap 
dealers. FIA also does not oppose monthly public reporting by the CFTC 
of the aggregate open positions held by index traders as a group and by 
swap dealers as a group using the data reported under the CFTC's large 
trader reporting system. FIA believes the CFTC also should consider 
other ways to make their Commitment of Trader Reports more granular and 
meaningful to all market participants.
    FIA opposes requiring index traders and swap dealers to file 
``routine detailed'' reports with the CFTC. (7:18) No other large 
traders--speculators or commercials--are subject to such a requirement. 
It should be sufficient to treat index traders and swap dealers that 
qualify as large traders like all other large traders for reporting 
purposes. FIA would also recommend the deletion of the language ``in 
all markets to the extent such information is available.'' (8:11-12) 
The aggregate information included in the COT reports should be for 
futures and options positions only. Otherwise market participants that 
refer to the COT reports will receive a distorted view of the open 
interest and volume composition in futures and options markets.
Section 5--Transparency and Recordkeeping Authorities
    Section 5 has three subsections.
    Subsection 5(a) would require a CFTC-registered futures commission 
merchant, introducing broker, floor trader or floor broker to make 
reports and keep records as required by the CFTC for ``transactions and 
positions traded'' by those registered professionals or their customers 
in, generally, OTC derivatives transactions that are exempted from the 
CEA and CFTC rules. FIA does not object to giving the CFTC this 
authority but questions whether it is at least partially duplicative of 
the special call provisions provided in the second part of the section.
    Subsection 5(b) has two parts. First, Subsection 5(b) would require 
any large trader of futures contracts in a commodity to maintain books 
and records of transactions and positions in that commodity which are 
otherwise generally exempt and excluded from the CEA. FIA does not 
object to this provision. Second, Subsection 5(b) would codify the 
CFTC's power to issue special calls for books and records relating to 
otherwise excluded or exempt transactions under the CEA when the CFTC 
determines it would be appropriate for market integrity purposes. FIA 
supports giving the CFTC this standby authority to enhance its market 
surveillance capabilities as circumstances require. Subsection 5(b) 
also requires large traders to retain the required books and record for 
5 years. These required books and records shall include the ``complete 
details'' of all ``such transactions, positions, inventories, and 
commitments, including the names and addresses of all persons having an 
interest therein.'' (10:8-12) FIA questions whether these statutory 
requirements are necessary or whether it would be preferable to grant 
the CFTC general authority to adopt appropriate record-keeping rules 
for large traders that engage in otherwise exempt or excluded 
transactions.
    Subsection 5(c) contains conforming amendments to codify that the 
amendments in Subsections 5(a) and 5(b) create explicit exceptions to 
the statutory exclusions and exemptions in the CEA. FIA supports this 
legal certainty.
Section 6--Trading Limits to Prevent Excessive Speculation.
    FIA opposes section 6. FIA sees no reason to repeal the exchanges' 
current authority to set position limits for their markets. (Today the 
CFTC sets position limits only for agricultural commodities.) The CFTC 
retains the power to review and amend any position limit set by an 
exchange if those limits are set in a manner that invites price 
manipulation or other market integrity concerns. Any member of the 
public is free to submit to the CFTC at any time a recommendation for 
changes to an exchange set position limit or accountability level. A 
formal advisory committee process is costly and unwarranted.
    The major deficiency in section 6 is its restrictive hedging 
definition. If a business establishes a futures position ``which is 
economically appropriate to the reduction of risks in the conduct and 
management of the commercial enterprise,'' that business is not a 
speculator. Instead, the business is managing an economic risk it faces 
in its business. Section 6 would misclassify that business as a 
speculator unless it also meets the ``substitute transaction'' and 
``change of held assets/liabilities'' tests to become a physical 
hedger. These restrictions are bad economic policy and would impose 
unwarranted restrictions on businesses that want to use futures markets 
to hedge. Section 6 also would consider a swaps dealer to be a 
speculator if its futures positions are established to reduce the 
dealer's price risk on its net swaps position simply because some of 
its swaps counterparties are not physical hedgers. The swaps dealer is 
managing its price risk prudently and doing so in a transparent market 
through transactions without counterparty credit risk. That swaps 
dealer should be subject to all the market surveillance oversight faced 
by all large traders. But it should not be treated as a speculator 
because it is not speculating; it is trading futures to reduce its 
price risk in an economically appropriate manner.
    Section 6 conflicts with the policy of promoting price risk 
management through exchange-traded and cleared markets. FIA strongly 
recommends that the Committee drop the hedging definition in section 6 
and instead direct the CFTC to conduct a rulemaking to define, for 
position limit purposes, speculation, hedging and price risk management 
consistent with the public interests to be served by the CEA.
Section 7--CFTC Administration
    FIA supports section 7's authorization of at least 200 new full 
time employees for the CFTC.
Section 8--Review of Prior Actions
    FIA opposes requiring the CFTC to spend its resources reconsidering 
all of its currently effective regulatory actions as well as those of 
the exchanges to determine if they are consistent with the provisions 
of the bill. CFTC has not yet adopted regulations to implement the 
provisions enacted in the farm bill in 2008, which would enhance 
customer protection and market surveillance. Before reviewing past 
actions, FIA believes the CFTC should implement the farm bill's 
reforms. FIA appreciates that the CFTC is given no deadline for 
completing this ``prior action'' review. We are sure the CFTC will move 
expeditiously to implement this bill's regulatory provisions, if 
enacted, as well as the farm bill provisions from last year. The key is 
providing the CFTC with adequate resources to do the job and section 7 
is an important step in this direction.
Section 9--Review of Over-the-Counter Markets
    FIA does not oppose having the CFTC study eventually whether 
position limits should be imposed on exempt transactions in physically-
based agricultural or energy commodities when those transactions are 
fungible with regulated futures contracts and significant price 
discovery contracts. FIA also does not oppose including in that study 
whether it would be good policy for the CFTC to adopt umbrella limits 
for futures, swaps and any other fungible transactions in such 
commodities. FIA would urge the Committee, however, to remove the 
deadlines and timelines for such studies. The CFTC should be able first 
to adopt and implement its rules for Significant Price Discovery 
Contracts as required in the 2008 Farm Bill. Then, after it has had 
experience with such rules, the CFTC could tackle the required study. 
At this point, it seems to be premature to study what contracts are 
fungible with SPDC contracts, especially where the CFTC has not yet 
implemented its SPDC authority.
Section 10--Study Relating to International Regulation of Energy 
        Commodity Markets
    FIA does not oppose having the Comptroller General study the 
international regime for regulating the trading of energy commodity 
futures and derivatives. Some of the terms used in the study outline 
should be clarified. For example, it is not clear what is meant by 
``commercial and noncommercial trading'' (21:8-9). It is also not clear 
what constitutes ``excessive speculation'' (21:23-24) or ``price 
volatility'' (21:25). Last, the study contemplates a proper functioning 
market ``that protects consumers in the United States.'' (22:34) The 
phrase suggests that markets should have a downward price bias to serve 
the interests of consumers. FIA instead believes that markets should 
reflect accurately market fundamentals, including the forces of supply 
and demand. FIA recommends that the Committee adjust the study outline 
to ensure it will provide beneficial, not skewed, results for further 
deliberations.
Section 11--Over-The-Counter Authority
    FIA has no objection to having the CFTC analyze whether any exempt 
or excluded transaction is fungible with transactions traded on a 
registered entity, including an electronic facility that lists a 
Significant Price Discovery Contract. If such fungible contracts are 
found, and if the CFTC also finds that such contracts have the 
potential to harm the price discovery process on a registered entity, 
section 11 provides that the CFTC may use its existing emergency 
authority in section 8a(9) to impose position limits on such fungible 
contracts. This new authority would parallel the CFTC's new Significant 
Price Discovery Contract authority provided in the 2008 Farm Bill. As 
written, however, FIA can not support this provision. FIA is concerned 
about the breadth of the language ``have the potential to'' (22:24) 
harm market integrity on registered entities. The CFTC should be 
empowered to use these regulatory authorities only if it finds an 
actual emergency condition to exist which affects trading on registered 
entities. Otherwise the CFTC could use a mere possibility of an impact 
on a registered entity to restrain or prevent competition from arising 
among trading facilities or dealer markets with exchange markets. FIA 
also believes the Committee should make clear in section 11 that the 
CFTC should not apply its authority to restrict fair competition.
Section 12--Expedited Process
    FIA has no objection generally to allowing the CFTC to use 
expedited procedures to implement the authorities in this bill if the 
CFTC deems it to be necessary. FIA does not believe the authority in 
section 12 itself is necessary because the Administrative Procedure Act 
provides the CFTC and other agencies with appropriate powers to 
expedite the kinds of rule making actions the bill contemplates. FIA 
does object to this provision if it is misread to authorize the CFTC to 
expedite and disregard APA or even Constitutionally-required procedural 
protections whenever the CFTC believes it to be necessary. That 
sweeping and standardless grant of authority could allow the agency to 
disregard well-established administrative procedural protections that 
have been adopted for many years to ensure reasoned and impartial 
agency decisions.
Section 13--Certain Exemptions and Exclusions Available Only for 
        Certain Transactions Settled and Cleared Through Registered 
        Derivatives Clearing Organizations
    FIA supports encouraging market participants to clear appropriately 
standardized derivatives transactions. But FIA does not believe that 
mandatory clearing of all OTC derivatives is sound public policy. 
Clearing should only be available to those instruments that regulated 
clearing facilities decide they can safely clear. To date, no clearing 
facility believes it could or should clear all OTC derivatives. And 
even if a clearing facility believed it could clear a particular class 
or type of OTC derivative (and some do now), FIA would want that 
private entity's judgment confirmed by an expert Federal regulatory 
body, like the CFTC. FIA believes that clearing should be encouraged 
with incentives, not mandates, and only when the clearing entity and 
its government regulator agree that the particular class of OTC 
derivative could be submitted safely for clearing. Mandating clearing 
in a vacuum and without the necessary safety and soundness predicates, 
as section 13 appears to do, would be most unwise.
    Section 13 does grant to the CFTC the authority to declare spot and 
forward contracts immune from the mandatory clearing requirement. 
(31:12-17) The CFTC's authority is appropriately broad and flexible. 
But given the structure of section 13 and the traditional meanings of 
the terms spot and forward contracts, FIA is uncertain whether most or 
all OTC derivatives could fall into the spot or forward category.
    If not, the provisions in section 13 granting the CFTC the power to 
exempt classes of OTC transactions from the clearing mandate become 
particularly important. Unfortunately, the criteria in section 13 that 
would guide the CFTC's exemption decisions are much too rigid and 
constraining. As written, the CFTC would have to find a class of 
derivatives is ``highly customized;'' ``transacted infrequently;'' 
``serves no price discovery function;'' and ``being entered into by 
parties with demonstrated financial integrity.'' (29:23-30:9) It would 
be difficult, if not impossible, for the CFTC to craft an appropriate 
exemption under these mandatory criteria. The result would be that 
section 13 would operate as a ban on all non-cleared OTC derivatives 
transactions in the U.S. and an invitation to market participants to 
enter into OTC transactions outside the jurisdictional reach of the 
CEA. Removing that significant market liquidity and making transactions 
more opaque to U.S. regulators would be detrimental to the public 
interest. FIA strongly opposes section 13.
Section 14--Treatment of Emission Allowances and Off-Set Credits
    FIA supports defining emission allowances and off-set credits as 
``exempt commodities'' like all other energy-related commodities. 
Section 14, however, excludes these commodities from the ``exempt 
commodity'' definition and would treat them like agricultural 
commodities. FIA does not know of any public policy reason to constrain 
the development of market innovations, including multilateral 
electronic trading facilities or clearing, for trading in these 
instruments in these energy commodities. Achieving energy policy goals 
will require promoting and expanding innovation, not restricting it. 
The Committee should reconsider the policy implications of treating 
these energy commodities like agricultural commodities.
Section 15--Inspector General of the CFTC
    FIA has no objection to creating the Inspector General of the CFTC 
as a Presidential appointment, subject to Senate confirmation. At the 
same time, we do not believe the absence of an IG appointed by the 
President is a weakness in the current CFTC structure.
Section 16--Limitation on Eligibility to Purchase a Credit Default Swap
    FIA opposes the ban on naked credit default swaps. Section 16 will 
effectively terminate the U.S. CDS market and send it overseas. CDS 
transactions have fostered many economic benefits and it would be 
better to improve regulation and oversight of this market rather than 
jettisoning it to foreign shores.
    FIA does support the provision that defines a credit default swap 
and allows registered entities that list for trading or clear CDS 
instruments to operate without having to comply with regulatory 
conditions imposed by the SEC. (38:1-9)

    The Chairman. Thank you very much, Mr. Damgard.
    Mr. Greenberger, welcome to the Committee.

 STATEMENT OF MICHAEL GREENBERGER, J.D., PROFESSOR, UNIVERSITY 
            OF MARYLAND SCHOOL OF LAW, BALTIMORE, MD

    Mr. Greenberger. Thank you, Mr. Chairman.
    Mr. Chairman, Ranking Member Lucas, first of all, I want to 
congratulate this Committee. It has been at the forefront of 
elucidating these issues by the many hearings it has held; and 
if you want to understand the problems either with speculation 
in the energy or agriculture markets or credit default, the 
problems with credit default swaps and its cause of the present 
meltdown, you only have to read the work of this Committee.
    Second, Mr. Chairman, I want to congratulate you and then 
Ranking Member Goodlatte for the good work you did in the last 
Congress. I know that bipartisanship is the mark of good 
legislation, especially with the advent of President Obama's 
emphasis on that. I congratulate you for having gotten the 
Transparency Act through by an over \2/3\ vote, if I calculate 
correctly. I think you had 283 votes.
    But, also, I want to congratulate you on something you 
yourself did not mention and you deserve a lot of credit for, 
and so does Ranking Member Goodlatte. On June 26th, on 1 day's 
notice, when gasoline prices were going over $4 and crude oil 
was approaching a world record high of $147, you on 1 day's 
notice with Ranking Member Goodlatte crafted legislation that 
passed on June 26th by a 402-19 vote that ordered the CFTC to 
immerse itself in those markets and use all its powers to drain 
any speculation, if it were there, in causing these problems.
    Unfortunately, neither your June 26th bill, nor your 
September 18th bill was able to make its way through the 
Senate, but it was a model of aggressive leadership and 
bipartisanship, your doing that.
    If this Committee wants the CFTC to stay as the principal 
regulator in this, it must work aggressively and it must 
demonstrate to the American people--and when I say ``the 
American people,'' the industrial consumers of commodities are 
at this table, the farmers, the heating oil dealers, the gas 
station owners, the airlines are all very supportive of what 
you are doing and would ask for a little bit more in order to 
control these markets. And by that I talk about aggregated spec 
limits. I am not going to take time talking about it now, but 
that is something you should seriously consider.
    With regard to your legislation, Mr. Damgard has worried 
about what Gerald Corrigan of Goldman Sachs testified to you 
are the, ``bespoke,'' swaps transactions. Those are 
individually negotiated swaps transactions. Your bill has a 
broad exemption in there. Yes, the CFTC, after a public 
hearing, has to grant those exemptions, but this bill takes 
care of the nonstandardized but beneficial swaps transactions 
that need to be performed.
    I would also say, when the airline industry is mentioned as 
suffering from this, I expect you will hear from the airline 
industry that it suffered substantially from the deregulation 
that it experienced over the last summer. So, yes, you have 
called for mandatory clearing, but you have an exemption in 
there. I would point out Senator Harkin, whose bill is tougher 
on the Senate side, does not allow for exemptions. Your bill 
does.
    By the way, in 1993 the CFTC passed the so-called swaps 
exemption that allowed for tailored swaps to be marketed. Your 
exemption is broader than that, and I am of the opinion that 
the breadth you have articulated is needed. Naked credit 
default swaps have tripled--at least tripled the exposure to 
debt in these markets. It is one thing for there not to be 
enough money to pay, for example, for the subprime mortgages, 
but the naked credit default swaps allowed people to bet that 
those mortgages wouldn't be paid. As Eric Dinallo pointed out, 
New York's Insurance Superintendent who has responsibility for 
AIG and for MBIA, it tripled--the bets tripled the amount of 
money the American taxpayer must infuse into the financial 
system. I feel strongly that the ban on naked credit default 
swaps is important.
    I identify myself completely with prior testimony of the 
Chairman of the Chicago Mercantile Group. I agree that the 
futures market is a beautiful market if it is properly policed. 
The swaps market was taken out of the jurisdiction of the CFTC. 
The Enron and London loopholes took agriculture and energy out 
of the CFTC. If they are put back into the CFTC, yes, the 
futures market is a wonderful market if you have good 
institutions like CME policing it and you have a strong CFTC 
overseeing those markets. And that is what your draft bill 
accomplishes. I would urge some minor tweaking, but it is a 
very good bill, and you are to be congratulated.
    Thank you.
    [The prepared statement of Mr. Greenberger follows:]

Prepared Statement of Michael Greenberger, J.D., Professor, University 
                of Maryland School of Law, Baltimore, MD
    I want to thank this Committee for inviting me to testify on the 
important issue that is before it today.
    I also want to congratulate and thank Chairman Peterson, Ranking 
Member Lucas, the whole Committee, and the Committee staff for the 
Committee's continuing hard work, thoughtful analysis, and leadership 
that it has brought to bear on the widespread concerns that the 
deregulated over-the-counter derivatives market has caused the most 
serious financial distress in the Nation's economy since the Great 
Depression.
    Since the summer of 2008, this Committee has repeatedly taken the 
leadership on regulatory issues of greatest concern to the American 
people. When gas prices were reaching over $4.00 a gallon by the end of 
June 2008, this Committee drafted on a day's notice and supervised the 
June 26, 2008 passage by a vote of 402-19 emergency legislation that 
would have required the CFTC to implement emergency procedures in the 
crude oil futures markets to bring down the then sky rocketing price of 
gasoline, heating oil, and crude oil.\1\ The Committee then drafted and 
supervised the passage by a 283-133 September 18, 2008 vote of the 
Commodity Markets Transparency Act of 2008, which was designed to bring 
transparency and accountability to the OTC energy markets, thereby 
stifling excessive speculation and unnecessarily high prices for 
America's energy needs.\2\ Evidence adduced since the passage of this 
September 2008 legislation on the House floor has made it even clearer 
that excessive speculation in the unregulated energy and swaps markets 
has caused and continues to cause unnecessary and substantial 
volatility in the agriculture and energy markets.\3\ On January 14, 
2009, for example, it was reported that, ``[b]etween Christmas [2008] 
and a week ago oil prices soared 40 percent, only to reverse almost as 
sharply in recent days.'' \4\ `` `The oil markets are suffering acute 
whiplash,' said Daniel Yergin, an energy consultant and author of `The 
Prize,' a history of world oil markets. `Price volatility is adding to 
the sense of shock and confusion and uncertainty.' '' \5\
---------------------------------------------------------------------------
    \1\ David Cho, ``House Passes Bill Bolstering Oil Trade 
Regulator'', Wash. Post, June 27, 2008, at D8 available at http://
www.washingtonpost.com/wp-dyn/content/article/2008/06/26/
AR2008062604005.html. 
    \2\ Commodity Markets Transparency and Accountability Act, 110th 
Cong. (2008) available at http://thomas.loc.gov/cgi-bin/bdquery/
z?d110:HR06604:@@@R. 
    \3\ Michael Masters, Adam White, The Accidental Hunt Brothers (July 
31, 2008) available at http://accidentalhuntbrothers.com/ (stating 
``[t]he total open interest of the 25 largest and most important 
commodities, upon which the indices are based, was $183 billion in 
2004. From the beginning of 2004 to today, Index Speculators have 
poured $173 billion into these 25 commodities.''); Maher Chymaytelli, 
Opec Calls for Curbing Oil Speculation, Blames Funds, January 28, 2009, 
available at http://www.bloomberg.com/apps/
news?pid=newsarchive&sid=aw4VozXUOVwU (stating ``Oil surged 46 percent 
in the first half of 2008 to a record $147.27 only to plunge by the end 
of the year. So-called net-long positions in New York crude futures by 
hedge funds and other large speculators betting on higher prices peaked 
at 115,145 contracts in March, according to data from the CFTC. They 
switched direction in July to a net-short position, or wager against 
prices, which reached 52,984 contracts by mid-November, the CFTC data 
show. Oil futures traded 6 cents down at $41.52 a barrel on the New 
York Mercantile . . . down 72 percent from last year's record.''); The 
Price of Oil. (January 11, 2009). CBS: 60 Minutes.
    \4\ Clifford Kraus, Where Is Oil going Next, New York Times 
(January 14, 2009) B1 at 
http://www.nytimes.com/2009/01/15/business/worldbusiness/15oil.html. 
    \5\ Id.
---------------------------------------------------------------------------
    From October through December 2008, this Committee has held a 
highly productive, informative and widely publicized series of hearings 
on the role unregulated over-the-counter (``OTC'') financial 
derivatives have played in causing the present economic meltdown. Now, 
under the leadership of Chairman Peterson, a new and comprehensive 
discussion draft of the Derivatives Markets Transparency and 
Accountability Act of 2009, has been circulated for comment and is the 
subject of today's hearings. Again, that draft legislation is designed 
to apply time-tested tools of market regulation to the OTC agriculture, 
energy and financial derivatives markets.
    There can be little doubt that the overwhelming message of the 
testimony presented to this Committee in its hearings on OTC 
derivatives has largely established a consensus that the previously 
unregulated OTC markets have caused severe systemic economic shocks to 
the economy, because of a lack of transparency to the nation's 
financial regulators of these private bilateral agreements, and because 
of inadequate capital reserves set aside by OTC derivative 
counterparties to underpin the trillions of dollars of financial 
commitments they made (and are now owed) through the OTC transactions 
in question.
    In almost all the credit markets examined, the derivative 
transactions have increased exponentially the risk and resulting 
indebtedness within the underlying markets. For example, New York 
Insurance Superintendent, Eric Dinallo, who has been responsible for 
overseeing two major troubled financial institutions that come within 
his regulatory ambit (AIG and MBIA), has demonstrated that outstanding 
credit default swaps (``CDS'') ``could total three times as much as the 
actual debt outstanding'' in the markets for which the CDS provide 
guarantees.\6\ In other words, because of ``naked'' credit default 
swaps that provide payouts to counterparties who have no interest 
insurable risk emanating from debts within these markets (i.e., they 
are simply wagering, for example, in exchange for a relatively small 
insurance-like premium, that subprime mortgages will not be paid off), 
the actual billions of dollars of losses in these markets have been 
magnified three fold by rampant and uncontrolled ``betting'' on these 
markets.\7\
---------------------------------------------------------------------------
    \6\ The Role of Financial Derivatives in the Current Financial 
Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. at 3 
(October 14, 2008) (written testimony of Eric Dinallo, Superintendent, 
New York State Insurance Dept.) available at http://
www.ins.state.ny.us/speeches/pdf/sp0810141.pdf.
    \7\ The Role of Financial Derivatives in the Current Financial 
Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. 
(October 14, 2008) (stating ``by 2000 we engaged in the Commodities 
Futures Modernization Act, which specifically did a few things. It made 
credit default swaps not a security, so it couldn't be regulated as a 
security; as you said, put it out of reach of the CFTC; and it said 
this act shall supersede and preempt the application of any state or 
local law that prohibits or regulates gaming or the operation of bucket 
shops.'')
---------------------------------------------------------------------------
    By virtue of bailouts, guarantees, and loans (e.g., the FED 
exchanging Treasuries at its discount window for banks' troubled 
subprime assets) made by the United States Treasury and/or the Federal 
Reserve, the American taxpayer has been required to make good on 
unfulfilled or potentially unfulfilled commitments of our largest 
financial institutions in the OTC derivatives market of up to $6 
trillion.\8\ With the advent of the stimulus legislation and President 
Obama's soon to be announced overarching financial package, the 
American public's outlay will doubtless soon grow by further trillions 
of dollars through further possible guarantees, purchases of troubled 
assets (i.e., a ``bad bank''), mortgage and other loans, and further 
capital infusions into the financial system.
---------------------------------------------------------------------------
    \8\ David Leonhardt, The Big Fix, N.Y. Times (February 1, 2009), 
(stating that ``the debt that the Federal Government has already 
accumulated [. . .] is equal to about $6 trillion, or 40 percent of 
G.D.P. [. . .] The bailout, the stimulus and the rest of the deficits 
over the next 2 years will probably add about 15 percent of G.D.P. to 
the debt. That will take debt to almost 60 percent, which is above its 
long-term average but well below the levels of the 1950s. But the 
unfinanced parts of Medicare, the spending that the government has 
promised over and above the taxes it will collect in the coming decades 
requires another decimal place. They are equal to more than 200 percent 
of current G.D.P.'')
---------------------------------------------------------------------------
    Of course, the subject of today's hearing does not, and cannot, 
address the present multi-trillion dollar ``hole'' in our economy, 
which, in turn, has brought the world markets to their knees. This 
hearing and the legislation to which it is addressed is forward 
looking. The underlying thesis here is: if we are fortunate enough to 
dig ourselves out of the huge financial mire in which we find 
ourselves, a regulatory structure must be put in place that will 
prevent the risk creating and risk bearing folly that led to the 
present fiasco.
    I have appended hereto a paper I prepared that outlines the severe 
damage unregulated OTC derivatives have caused to the market and that 
proposes a generic regulatory program designed to apply traditional and 
time tested tools of regulatory oversight now governing our equity, 
debt and regulated futures markets to our OTC derivatives markets. 
Suffice it to say, that I am in agreement with many who have already 
come before this Committee and the Senate Agriculture Committee on 
these issues, including Terrence A. Duffy, Executive Chairman of the 
CME Group, Inc.; \9\ Eric Dinallo (the New York Insurance 
Superintendant); \10\ Professor Henry Hu, Professor of Law at the 
University of Texas Law School; \11\ Professor William K. Black of the 
University of Missouri-Kansas City; \12\ and Erik Sirri, Director of 
SEC's Division of Trading and Markets \13\ as to the regulation of 
financial OTC derivatives; and Adam K. White, CFA,\14\ and PMAA's 
witnesses as to agriculture and energy OTC derivatives. Former Chair of 
the Federal Reserve, Paul Volker, has elsewhere made recommendations 
and observations consistent with the above referenced testimony,\15\ as 
has the January 29, 2009 Special Report on Regulatory Reform of the 
Congressional Oversight Panel mandated by the Emergency Economic 
Stabilization Act of 2008 (``the bailout legislation'').\16\ Finally, 
former SEC Chair Arthur Levitt has recommended reversal of the 
deregulatory effects of 2000 Commodity Futures Modernization Act on the 
OTC markets,\17\ and even former Fed Chair Alan Greenspan has admitted 
that it was an error to deregulate the credit default swaps market.\18\
---------------------------------------------------------------------------
    \9\ The Role of Credit Derivatives in the U.S. Economy: Hearing 
Before the House Comm. on Agriculture, 110th Cong. (December 8, 2008).
    \10\ The Role of Credit Derivatives in the U.S. Economy: Hearing 
Before the House Comm. on Agriculture, 110th Cong. (November 20, 2008).
    \11\ The Role of Credit Derivatives in the U.S. Economy: Hearing 
Before the House Comm. on Agriculture, 110th Cong. (October 15, 2008).
    \12\ Role of Financial Derivatives in Current Financial Crisis: 
Hearing Before Senate Agricultural Comm., 110th Cong. (October 14, 
2008).
    \13\ The Role of Credit Derivatives in the U.S. Economy: Hearing 
Before the House Comm. on Agriculture, 110th Cong. (November 20, 2008).
    \14\ To Review Legislation Amending the Commodity Exchange Act: 
Hearing Before the House Comm. on Agriculture, 110th Cong. (July 10, 
2008).
    \15\ Paul A. Volcker, Address to the Economic Club of New York, at 
1-2 (April 8, 2008) available at econclubny.org/files/
Transcript_Volcker_April_2008.pdf).
    \16\ Congressional Oversight Panel, 111th Cong., Special Report on 
Regulatory Reform: Modernizing the American Financial Regulatory 
System: Recommendations for Improving Oversight, Protecting Consumers, 
and Ensuring Stability  (2009).
    \17\ Goodman, The Reckoning: Taking Hard New Look at a Greenspan 
Legacy, N.Y. Times (October 9, 2008) available at http://
www.nytimes.com/2008/10/09/business/economy/
09greenspan.html?pagewanted=1&_r=1; Michael Hirsh, The Great Clash of 
'09: A looming battle over re-regulation, Newsweek, (December 24, 2008) 
available at http://www.newsweek.com/id/176830.
    \18\ Congressional Oversight Panel, 111th Cong., Special Report on 
Regulatory Reform: Modernizing the American Financial Regulatory 
System: Recommendations for Improving Oversight, Protecting Consumers, 
and Ensuring Stability. (2009) at 7 (quoting former Federal Reserve 
Chairman Alan Greenspan ``Those of us who have looked to the self-
interest of lending institutions to protect shareholders' equity, 
myself included, are in a state of shocked disbelief.''
---------------------------------------------------------------------------
    I am pleased that the draft legislation that we discuss today 
adopts most of the points made in my appended paper and the 
recommendations of the witnesses I have cited above.
    In this regard, I support Discussion Draft's:

    1. Requirement of mandatory clearing of OTC derivatives both 
        through the CFTC or other appropriate Federal financial 
        regulators and by the CFTC exclusively in the energy and 
        agriculture markets.

    2. Reporting requirements and regulatory oversight obligations 
        placed on designated clearing organizations (``DCOs'').

    3. Tailored, precise, and limited exemptions that may be granted by 
        the CFTC to the mandatory clearing requirements for 
        individually negotiated or, in the words of Goldman Sachs' E. 
        Gerald Corrigan, ``bespoke'' derivatives, i.e., derivatives 
        that by the instrument's limited reach and their unsuitability 
        for trading cannot cause systemic risk to the nation's economy.

    4. Imposition of speculative limits for noncommercial trading on 
        designated contract markets (``DCMs''), designated transaction 
        execution facilities (``DTEFs'') and on other electronic 
        trading facilities, as well as foreign boards of trade, 
        especially insofar as those speculation limits are recommended 
        by Position Limit Advisory Groups composed in significant part 
        by commercial hedgers within the relevant markets, i.e., those 
        who have intimate knowledge of the degree of speculation needed 
        in each market to provide liquidity.

    5. Establishment of a clear and concise definition of a ``bona fide 
        hedging transaction'' limiting that exclusion from speculation 
        limits to those actually engaged as a primary business activity 
        in the ``physical marketing channel'' of the commodity.

    6. Imposition of three additional core principles to the criteria 
        for establishing of a designated clearing organization 
        (``DCO''): (1) disclosure of general information; (2) 
        publication of trading information; and (3) fitness standards.

    7. ``Transition rule'' requiring existing uncleared swaps or 
        uncleared swaps executed for the period after enactment to 
        establish the regulatory scheme to be required by the statute 
        to be reported to the CFTC.

    8. The banning of ``naked'' credit default swaps, i.e., those swaps 
        that are merely a wager on the viability of an institution or 
        financial instrument without requiring the corresponding 
        underlying risk from the failure of those institutions or 
        instruments.

    9. The creation of an independent CFTC Inspector General confirmed 
        by the Senate.

    10. The appointment of at least 200 new full time CFTC employees.

With regard to my comments in support of the draft legislation, I want 
to particularly call attention to two commendable aspects of the 
legislation.

    1. The ban on ``naked'' credit default swaps. Former SEC Chairman 
        Christopher Cox has since September 2008 repeatedly criticized 
        these instruments as ``naked'' shorts on public corporations 
        that evade the requirements for shorting stocks in the 
        regulated equity markets.\19\ He and the New York Insurance 
        Superintendent, Eric Dinallo, have warned that these 
        instruments encourage the ``moral hazard'' of providing 
        perverse incentives to take actions that cause companies 
        covered by the CDS to fail or, in the case of naked short of 
        subprime mortgage paper, borrowers to default on their mortgage 
        loans.\20\ As to incentives of undercut the mortgage backed 
        paper, i.e., mortgage backed securities or collateralized debt 
        obligations, that has led many holders of CDS guarantees to 
        oppose, for example, mortgage workouts so that mortgage 
        defaults trigger ``naked'' CDS payments. Chairman Peterson had 
        it exactly right when he recently said: `` `It is hard for me 
        to understand what useful purpose these things are serving, . . 
        . I'm not out to get Wall Street, but what's gone on there is 
        jeopardizing the world economy.' '' \21\ Those who support 
        ``naked'' CDS argue that it is needed for ``price discovery.'' 
        However, the reported ``short interest'' on public companies in 
        the regulated equities market already is an adequate ``price 
        discovery mechanism'' for the worth of those companies. For 
        price discovery on CDS guarantees of collateralized debt 
        obligations, those CDS that insure actual risk on CDO 
        investments should serve any needed price discovery function; 
        to the extent that ``real'' CDS are inadequate for that 
        purpose, the undisputed harm done to the economy by ``naked'' 
        CDS far outweighs any price discovery benefits from allowing 
        the continued trading of ``naked'' CDS. Had ``naked'' CDS been 
        banned in the passage of the CFMA in 2000, it is my firm belief 
        that there would have been no need for this hearing today in 
        that the outlawing of that product, in and of itself, would 
        have substantially mitigated the worldwide financial meltdown 
        we are now experiencing.
---------------------------------------------------------------------------
    \19\ O'Harrow and Denis, Downgrades and Downfall, Washington Post 
(December 31, 2008) A1 (stating `` `The regulatory blackhole for 
credit-default swaps is one of the most significant issues we are 
confronting on the current credit crisis,' Cox said, `it is requires 
immediate legislative action.' '').
    \20\ The Role of Financial Derivatives in the Current Financial 
Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. 3 
(October 14, 2008) (opening statement of Eric Dinallo, Superintendent, 
New York State Insurance Dept.) (stating ``We engaged in the ultimate 
moral hazard . . . no one owned the downside of their underwriting 
decisions, because the banks passed it to the Wall Street, that 
securitized it; then investors bought it in the form of CDOs; and then 
they took out CDSs. And nowhere in that chain did anyone say, you must 
own that risk.'').
    \21\ Matthew Leising, Bloomberg.com, ``Peterson Plans Bill to Force 
Credit Default Swaps Clearing'' (December 15, 2008).

    2. Mandatory Clearing. While the financial services industry has 
        supported the ``availability'' of clearing OTC derivatives as a 
        ``firewall'' against systemic risk, they have, for the most 
        part, opposed mandatory clearing. As has been explained in 
        testimony by the CME Group, for example, a clearing facility, 
        which is guaranteeing the performance of both counterparties to 
        an OTC derivative contract, can only assume that substantial 
        risk for performance for those contracts about which it has 
        complete understanding. The requirement to understand 
        contractual risk, inter alia, requires that the OTC cleared 
        contracts be standardized, i.e., so that the clearing facility 
        has substantial comprehension of the guarantor role it is 
        playing. Those who oppose mandatory clearing worry about the 
        inability to clear non-standardized OTC derivatives. As far 
        back as 1993, however, the CFTC has promulgated a ``swaps'' 
        exemption for individual negotiated swaps agreements that are 
        not executed on an electronic trading facility.\22\ Moreover, 
        the draft legislation provides an arguably broader 
        ``individualized'' exemption with the corresponding precise 
        standards that assure that the exemption will only be granted 
        when systemic risks will not be posed. In short, the draft 
        legislation is a reasonable compromise that accommodates 
        individually negotiated contracts that cannot be cleared. It 
        should also be born in mind that the Senator Harkin's 
        legislation flatly bans exceptions from his requirement that 
        all OTC contracts be exchange traded--not merely cleared.\23\ 
        In this regard, the New York Stock Exchange has just advocated 
        that ``U.S. policy makers should extend existing [exchange] 
        rules so that they apply to unregulated derivatives instead of 
        drafting new legislation that may take years to implement, . . 
        .'' \24\
---------------------------------------------------------------------------
    \22\ 17 C.R.F. Part 35 (1993).
    \23\ The Derivatives Trading Integrity Act, 111th Cong. (January 
15, 2009); Senate Agriculture Comm., Statement of Chairman Tom Harkin: 
Role of Financial Derivatives in the Current Financial Crisis (Oct. 14, 
2008); Posting of James Hamilton to Jim Hamilton's World of Securities 
Regulation, http://jimhamiltonblog.blogspot.com/2009/01/senate-bill-
would-regulate-otc.html (Jan. 17, 2009, 14:58) (stating ``[t]he broad 
goal of the [Senator Harkin's] legislation is to establish the standard 
that all futures contracts trade on regulated exchanges.'').
    \24\ Lisa Brennan, ``Exchange Rules Should Apply to Derivatives, 
NYSE Says'' (Bloomberg, February 2, 2009).

---------------------------------------------------------------------------
    My only questions and/or comments on the draft legislation are:

    1. Express Pre-approval Findings of Suitability of Designated 
        Clearing Organizations. The CFMA sets out 14 core principles 
        for the establishment of a DCO. As mentioned above, the 
        discussion draft adds three new core principles borrowed from 
        the core principles applicable to designated transaction 
        execution facilities DTEFs (i.e., non-retail exchange trading 
        for high net work institutions and individuals). However, as 
        made clear by the CFTC's Director of Clearing and Intermediary 
        Organizations, Ananda Radhakrishnan, under the Commodity 
        Exchange Act, ``DCOs do not need pre-approval from the CFTC to 
        clear derivatives, [but] any such initiative would be required 
        to comply with the relevant core principles set forth in the 
        [statute] and the CFTC would review it for compliance with 
        those principles. . . .'' \25\ In other words, the statute 
        allows facilities to self certify as DCOs and the CFTC would 
        only then examine compliance with core principles after the 
        fact. As is now well known, the CFTC ``announced'' on December 
        23, 2008 that ``the CFTC staff would not object to the [DCO] 
        certification.'' \26\ The CME submitted its plans to the CFTC 
        staff prior to the operation of its DCO. The ``CFTC staff 
        reviewed CME's plans to clear credit default swaps, including 
        CME's planning risk management procedures, . . .'' \27\ My 
        search of the CME docket number on the CFTC website shows no 
        accompanying order by the Commission or the CFTC staff 
        indicating or explaining such approval. I hasten to add that I 
        have little doubt about the qualifications (or indeed the great 
        benefit) of the CME, the world's largest derivatives exchanges, 
        engaging in this clearing. However, others are eligible to 
        apply for DCO status and in an age when the American public is 
        clamoring for transparency in governmental actions, especially 
        actions surrounding the present financial crisis, and given the 
        great importance of approving an institution to clear these 
        highly volatile and potentially toxic products, it would seem 
        that pre-approval of a clearing facility should be required and 
        that the Commission--not just the staff--should issue 
        affirmative and detailed findings about its confidence in the 
        applicant serving as a DCO. Indeed, prior to the passage of the 
        CFMA in December 2000, the CFTC and its staff issued 18 single 
        space pages of detailed findings endorsing the safety and 
        soundness of the first applicant to clear swaps.\28\ Since the 
        CFTC staff checks the safety and soundness of a DCO one way or 
        another, the Committee should add a provision to the 
        legislation requiring pre-approval of DCOs trading OTC 
        derivatives and that that pre-approval be accompanied by 
        findings demonstrating that the DCO applicant meets all 
        applicable statutory requirements. Given the importance of the 
        clearing facility in serving as a firewall against breakdown of 
        the economy, it seems a small burden to require a transparent 
        Commission document reflecting its careful attention this 
        important decision.
---------------------------------------------------------------------------
    \25\ The Role of Financial Derivatives in the Current Financial 
Crisis: Hearing before the Senate Agricultural Comm., 110th Cong. 3 
(October 14, 2008).
    \26\ Press Release, Commodity Futures Trading Commission, CFTC 
Announces That CME Has Certified a Proposal to Clear Credit Default 
Swaps (Dec. 23, 2008) available at http://www.cftc.gov/newsroom/
generalpressreleases/2008/pr5592-08.html.
    \27\ Id.
    \28\ Order Granting the London Clearing House's Petition for an 
Exemption Pursuant to Section 4(c) of the Commodity Exchange Act, 64 
Fed. Reg. 53346-64 (October 1, 1999).

    2. Fraud and Manipulation. As the CFMA is presently drafted, the 
        swaps exemption in section 2(g) of the Act excludes swaps from 
        the anti-fraud and anti-manipulation provisions within the 
        statute.\29\ (This exclusion distinguishes itself from 
        ``exempt'' commodities, e.g., energy futures, which are subject 
        to the Act's fraud and manipulation prohibitions.) Senator 
        Harkin's legislation, S. 272, by requiring the exchange trading 
        of swaps and the elimination of ``exemptions'' and 
        ``exclusions'' brings the swaps market within the umbrella of 
        the Act's central fraud and manipulation prohibitions. As 
        Patrick Parkinson (Deputy Director, Division of Research and 
        Statistics of the Federal Reserve System) made clear in his 
        November 20, 2008 testimony before this Committee, the 
        President's Working Group on Financial Markets is advising that 
        OTC clearing facilities qualifications be measured against the 
        ``Recommendations for Central Counterparties'' of the Committee 
        on Payment and Settlement Systems of which Mr. Parkinson was 
        the Co-Chair and on which the CFTC and SEC served.\30\ Those 
        recommendations are replete with concerns about combating fraud 
        in the clearing process. In the present climate of American 
        public's distrust of financial markets, OTC swaps, as is true 
        of ``exempt'' futures, should be subject to fraud and 
        manipulation prohibitions. Moreover, it would seem to be a 
        difficult argument to make that, whereas swaps should be 
        cleared, fraud and manipulation should not be barred or, 
        conversely, that logic would seem perversely to dictate that 
        fraud and manipulation be permitted.\31\
---------------------------------------------------------------------------
    \29\  Johnson & Hazen, Derivatives Reg., section 1.18[6][B] at p. 
332 (2004 ed.) ``[U]nlike excluded transaction, with exempt off-
exchange transactions [, exempted transactions and swaps transactions], 
the CFTC retains its enforcement authority in case of fraud or market 
manipulation.'' Interpretation of CEA  2(c), 2(d) and 2(g).
    \30\ Patrick M. Parkinson, Statement of Testimony before the 
Committee on Agriculture United States House of Representatives on 
November 20, 2008, he stated that ``We [the CFTC, SEC, and Federal 
Reserve] have been jointly examining the risk management and financial 
resources of the two organizations that will be supervised by U.S. 
authorities against the `Recommendations for Central Counterparties,' a 
set of international standards that were agreed to in 2004 by the 
Committee on Payment and Settlement Systems of the central banks of the 
Group of 10 countries and the Technical Committee of the International 
Organization of Securities Commissions,'' available at http://
agriculture.house.gov/testimony/110/h91120/Parkinson.pdf.
    \31\ [No citation in submitted testimony.]

    3. Important Inconsistency between sections 6 and 9 of the 
        Discussion Draft. As I read section 6(2)(A) of the Discussion 
        Draft, it requires that the CFTC 
        ``shall . . . establish limits on the amount of positions, as 
        appropriate, other than bona fide hedge[rs] that may be held by 
        any person with respect to . . . commodities traded . . . on an 
        electronic trading facility as a significant price discovery 
        contract.'' Section 6(B)(i) and (iii) mandate that these limits 
        ``shall be established'' within set time periods for ``exempt 
        commodities'' and ``excluded commodities.'' Exempt commodities 
        include over-the-counter energy futures contracts exempt from 
        regulation by  2(h) of the CEA. Excluded commodities cover 
        swaps are exempt under  2(g). Therefore, it would seem that 
        section 6 of the Discussion Draft mandates the imposition of 
        position limits on OTC ``exempt'' and ``excluded'' trading. 
        Moreover, section 6 seems, by the breadth of its language, to 
        authorize implicitly the CFTC to impose aggregated limits 
        across contract markets for specified commodities. On the other 
        hand, section 9, by its terms, appears to require the CFTC to 
        ``study'' each of these issues already addressed in section 6 
        and to report back to this Committee within 1 year of 
        enactment. Given the overwhelming evidence that has been 
        gathered about the impact of excessive speculation on the 
        energy futures and energy swaps markets,\32\ for example, 
        section 9 should be struck from that statute, because the time 
        for study has long since passed. Moreover, I would urge this 
        Committee to follow the bipartisan lead of Senators Reid, 
        Lieberman and Collins \33\ and require--not simply authorize--
        the CFTC to impose aggregated speculation limits upon U.S. 
        traders and those trading in the U.S. across the energy and 
        agriculture contract markets. It should be emphasized that on 
        July 26, 2008 [check date] the Reid bill garnered 50 of 93 
        Senate votes in the last Congress in an unsuccessful attempt to 
        sustain cloture in the last Congress.\34\ Again, given the 
        heightened evidence of excessive speculation in the crude oil 
        markets that post-date that July 26th vote, it could be 
        expected that the 60 votes needed to bring the Reid aggregate 
        spec limits bill to a vote on the merits will be reached in 
        this Congress. My understanding is that this Committee will 
        receive testimony from a broad coalition of industrial 
        consumers of energy, including the airlines, truckers, farmers, 
        heating oil dealers, and petroleum marketers, strongly backing 
        the inclusion of aggregated spec limits for energy and 
        agriculture in any bill reported out by this Committee.
---------------------------------------------------------------------------
    \32\ Supra at n. 3.
    \33\ See S. 3044, ``Consumer-First Energy Act'', 110th Congress, 
Sponsored by Sen. Henry Reid. See Also S. 3248, ``Commodity Speculation 
Reform Act'', 110th Congress, Sponsored Sen. Joseph Lieberman, Sen. 
Christopher Bond, Sen. Maria Cantwell and Sen. Susan Collins.
    \34\ Record Vote Number: 146, 110th Congress (June 10th, 2008). 
Cloture motion rejected--51 Yeas, 43 Nays, 6 Not voting. The four 
supporting republicans were, Collins (R-ME), Smith (R-OR), Snowe (R-ME) 
and Warner (R-VA).

    4. Standards for Approving a Designated Clearing Organization. As 
        stated above, I support the Discussion Draft's addition of 
        three core principles to the statute's 14 criteria governing 
        the approval of DCOs. I have also recommended above that the 
        Commission--and not just the CFTC staff--make detailed pre-
        approval findings that the applicant for DCO status meets the 
        criteria for clearing OTC derivatives. Again, the approval 
        process is critical because it is universally recognized that a 
        ``risk management failure by a [clearing facility] has the 
        potential to disrupt the markets it serves and . . . [cause] 
        disruptions to securities and derivatives markets and to 
        payment and settlement systems, . . .'' A mistaken decision by 
        the CFTC about the appropriateness of an applicant to serve as 
        a DCO will simply recreate the instability of the present 
        system where counterparties--even counterparties rated AAA at 
        the commencement of the derivatives transactions--were 
        ultimately downgraded and not able to fulfill their contractual 
        obligations. The DCO approval decision requires great 
        sophistication. Three years ago, many then AAA rated 
        institutions, such as Lehman, Bear Stearns, or AIG, would have 
        very likely been deemed strong DCO candidates. In short, 
        today's AAA rated institution may be tomorrow's 
        undercapitalized and overwhelmed entity whose failure will 
        undermine the OTC derivatives settlement process; and possibly 
        the Nation's economy as a whole. The Fed's and the SEC's 
        reliance, for example, on the intricately detailed CPSS's 
        ``Recommendation for Central Counterparties,'' raises the 
        question whether the CFMA's generalized DCO approval criteria--
        even as supplemented by the Discussion Draft's three additional 
        criteria--are detailed enough to ensure that only the most 
        prudent and stable entities to clear OTC derivatives. If the 
        CPSS's recommendations are more thorough in this regard (they 
        are certainly more detailed), adoption of the CPSS's standards 
        by other Committees of Congress for their regulators, may 
        become a pretext to seek the removal of the CFTC from clearing 
        approval authority. The CPSS recommendations should be studied 
---------------------------------------------------------------------------
        to ensure that that the DCO criteria are complete.

    It is for that reason that my preference would be to adopt exchange 
trading criteria to OTC derivatives as is required by S. 272. The New 
York Stock Exchange has also recently supported an exchange based 
approach.\35\ The statutory requirements for a designated transaction 
execution facility are more rigorous than those for a DCO even as those 
DCO criteria are upgraded by the discussion draft. DCOs are not 
expressly required to establish net capital requirements or financial 
integrity standards for counterparties; \36\ there is no regulation of 
DCO intermediaries as is true in the case of DTEFs; \37\ \38\ unlike 
DTEFs, the emergency authority of a DCO is expressly limited to 
withstanding ``disasters'' which in context of the statute is appears 
to be limited to natural disasters or Y2K types of information 
technology problems and not the threat of a systemic meltdown of the 
facility as a whole; \39\ and there is no requirement for self 
regulation of DCOs as is true of DTEFs.\40\ Finally, while it is true 
that DTEFs, unlike Designated Contract Markets (``DCM''), do not 
expressly have to establish dispute resolution mechanisms, this would 
be a worthy requirement to be applied to DCOs dealing with the highly 
volatile OTC derivatives markets.\41\
---------------------------------------------------------------------------
    \35\ Supra at n. 24.
    \36\ Compare 7 U.S.C.  7a(b)(3)(B)(iv) (2008) (stating the minimum 
net capital requirements for a party to trade on a registered DTEF) and 
7 U.S.C.  7a(c)(4) (2008) (mandating that DTEF boards of trade must 
``establish and enforce rules or terms and conditions providing for the 
financial integrity'' of both participants and transactions entered on 
or through the board of trade) to 7 U.S.C.  7a-1(c)(2)(C)(i) (2008) 
(merely requiring ``appropriate minimum financial requirements'' for 
admission and continued eligibility, but providing no explicit 
standards).
    \37\ Intermediaries, such as futures commission merchants, 
depository institutions, and Farm Credit System Institutions, must meet 
certain requirements in order to interact with a DTEF. 7 U.S.C.  
7a(e)(1) (2008). The intermediary must be in good standing with the SEC 
or the Federal bank regulatory agencies (whichever is appropriate. 7 
U.S.C.  7a(e)(2)(A) (2008). Additionally, if the intermediary holds 
customer funds for more than a day, it must be registered as futures 
commission merchant and must be a member of a registered futures 
association. 7 U.S.C.  7a(e)(2)(B) (2008). There is no statutory 
equivalent for DCOs concerning FCMs, depository institutions Farm 
Credit Institutions, or any other type of intermediary. See generally 7 
U.S.C.  7a-1 (2008).
    \38\ See 7 U.S.C.  7a(d)(7) (2008) (stating that ``the board of 
trade shall establish and enforce appropriate fitness standards for 
directors, members of any disciplinary committee, members, and any 
other persons with direct access to the facility, including any parties 
affiliated with any of the persons described in this [statute].''). 
There is no comparable requirement for DCOs. See generally 7 U.S.C.  
7a-1 (2008).
    \39\ 7 U.S.C.  7a-1(c)(2)(I)(ii) (2008) (requiring the maintenance 
of emergency procedures, a disaster recovery plan, and periodic testing 
of backup facilities, but not the establishment of a contingency plan 
to deal with economic emergencies).
    \40\ While both DTEFs and DCOs have various requirements that they 
are responsible for carrying out, it is only in the context DTEFs that 
the concept of ``self regulation'' is expressly addressed. See 7 U.S.C. 
 7a(b)(2)(E) (2008) (noting that the Commission will consider the 
entities history of this self regulation when determining if there is a 
threat of manipulation); see, e.g., 7 U.S.C.  7a(d)(2008) (explaining 
the core principles and explicit duties of a DTEF); 7 U.S.C.  7a-
1(c)(2) (2008) (listing in broad terms the responsibilities of a DCO).
    \41\ However, it is worth noting that:

      a board of trade may elect to operate as a registered derivatives 
transaction execution facility if the facility is--

        (1) designated as a contract market and meets the requirements 
of this section; or

        (2) registered as a derivatives transaction execution facility 
under subsection (c) of this section.

    7 U.S.C.  7a(a)(1)-(2) (2008).

    If the DTEF chose to operation under section (1), it follows that 
the board of trade would be obligated to follow all of the requirements 
for a DCM.

    In sum, the Committee should be congratulated for the scope of its 
hearings on these critically important questions and for the 
thoroughness of the Discussion Draft.
                               Appendix A
Memorandum on Regulatory Reform of Credit Default Swaps
January 24, 2009

Professor Michael Greenberger.

    While a litany of factors including lending and financial abuses 
led to the present economic meltdown, chief among them was the opaque 
nature of the estimated notional $596 trillion \1\ unregulated over-
the-counter derivatives market. That market includes what is estimated 
to be the $35-$65 trillion credit default swaps (``CDS'') market.\2\ 
The over-the-counter derivatives market was, prior to December 20, 
2000, conventionally understood to be subject to regulation under the 
Commodity Exchange Act (``CEA''). On that date, the Commodity Futures 
Modernization Act (``CFMA'') was passed. That legislation was, for the 
most part, rushed through Congress and enacted during a lame duck 
session as a rider to an 11,000 page omnibus appropriation bill.\3\ 
That statute removed swaps transactions from all meaningful Federal 
oversight.
---------------------------------------------------------------------------
    \1\ See, Bank for International Settlements, BIS Quarterly Review 
(September, 2008), available at http://www.bis.org/publ/qtrpdf/
r_qa0809.pdf#page=108.
    \2\ Id.
    \3\ See, e.g., Johnson & Hazen, Derivatives Regulation,  1.17 at 
41-49 (2009 Cum. Supp.)
---------------------------------------------------------------------------
    In warning Congress about badly needed reform efforts when it 
considered the bailout legislation in Senate hearings before the Senate 
Banking Committee in September, 2008, SEC Chairman Christopher Cox 
called the CDS market a ``regulatory blackhole'' in need of ``immediate 
legislative action.'' \4\ Former SEC Chairman Arthur Levitt and even 
former Fed Chair Alan Greenspan have acknowledged that the deregulation 
of the CDS market contributed greatly to the present economic 
downfall.\5\
---------------------------------------------------------------------------
    \4\ `` `The regulatory blackhole for credit-default swaps is one of 
the most significant issues we are confronting on the current credit 
crisis,' Cox said, `it is requires immediate legislative action.' '' 
O'Harrow and Denis, Downgrades and Downfall, Washington Post (December 
31, 2008) A1.
    \5\ Goodman, The Reckoning: Taking Hard New Look at a Greenspan 
Legacy (October 9, 2008) A1; http://mobile.newsweek.com/
detail.jsp?key=39919&rc=camp2008&p=0&all=1.
---------------------------------------------------------------------------
    In brief, the securitization of subprime mortgage loans evolved 
from simple mortgage backed securities (``MBS'') to highly complex 
collateralized debt obligations (``CDOs''), which were the pulling 
together and dissection into ``tranches'' of huge numbers of MBS, 
theoretically designed to diversify and offer gradations of risk to 
those who wished to invest in that market. However, investors became 
unmoored from the essential risk underlying loans to non-credit worthy 
individuals by the continuous reframing of the form of risk (e.g., from 
mortgages to MBS to CDOs); the false assurances given by credit rating 
agencies that gave misleadingly high evaluations of the CDOs; and, most 
importantly, by the ``insurance'' offered by CDO issuers in the form of 
CDS. The CDS ``swap'' was the exchange by one counterparty of a premium 
for the other counterparty's ``guarantee'' of the financial stability 
of the CDO. While CDS has all the hallmarks of insurance, issuers of 
CDS were urged not to refer to it as ``insurance'' out of a fear that 
CDS would be subject to insurance regulation by state insurance 
commissioners. By using the term ``swaps,'' CDS fell into the 
regulatory blackhole afforded by the CFMA.
    Because CDS was not insurance or any other regulated instrument, 
the issuers of CDS were not required to set aside adequate capital 
reserves to stand behind the guarantee of the financial stability of 
CDOs. The issuers of CDS were beguiled by the utopian view (supported 
by ill considered mathematical algorithms) that housing prices would 
always go up and that, even a borrower who could not afford a mortgage 
at initial closing, would soon be able to extract that appreciating 
value in the residence to refinance and pay mortgage obligations. Under 
this utopian view, the writing of CDS was deemed to be ``risk free'' 
with a goal of writing as many CDS as possible to develop cash flow 
from the ``premiums.''
    To make matters worse, CDS was deemed to be so risk free (and so 
much in demand) that financial institutions began to write ``naked'' 
CDS, i.e., offering the guarantee to investors who had no risk in any 
underlying mortgage backed instruments or CDOs. Naked CDS provided a 
method to ``short'' the mortgage lending market, i.e., to place the 
perfectly logical bet for little consideration (i.e., the premium) that 
those who could not afford mortgages would not pay them off. The 
literature surrounding this subject estimates that more ``naked'' CDS 
instruments are extant than CDS guaranteeing actual risk.
    Finally, the problem was further aggravated by the development of 
``synthetic'' CDOs. Again, these synthetics were mirror images of 
``real'' CDOs, thereby allowing an investor to play ``fantasy'' 
securitization. That is, the purchaser of a synthetic CDO does not 
``own'' any of the underlying mortgage or securitized instruments, but 
is simply placing a ``bet'' on the financial value of a the CDO that is 
being mimicked.
    Because both ``naked'' CDS and ``synthetic'' CDOs were nothing more 
than ``bets'' on the viability of the subprime market, it was important 
for this financial market to rely upon the fact that the CFMA expressly 
preempted state gaming laws.\6\
---------------------------------------------------------------------------
    \6\ Johnson & Hazen, Derivatives Regulation,  4.04[11] at 975 
(2004 ed.) referencing 7 U.S.C.  16(e)(2).
---------------------------------------------------------------------------
    It is now common knowledge that: (1) issuers of CDS did not (and 
will not) have adequate capital to pay off guarantees as housing prices 
plummet, thereby defying the supposed ``risk free'' nature of issuing 
huge guarantees for the small premiums that were paid; (2) because CDS 
are private bilateral arrangements for which there is no meaningful 
``reporting'' to Federal regulators, the triggering of the obligations 
there under often come as a ``surprise'' to both the financial 
community and government regulators; (3) as the housing market worsens, 
new CDS obligations are triggered, creating heightened uncertainty 
about the viability of financial institutions who have or may have 
issued these instruments, thereby leading to the tightening of credit; 
(4) the issuance of ``naked'' CDS increases exponentially the 
obligations of the CDS underwriters; and (5) the securitization 
structure (i.e., asset backed securities, CDOs and CDS) is present not 
only in the subprime mortgage market, but in the prime mortgage market, 
as well as in commercial real estate, credit card debt, and auto and 
student loans. As these latter parts of the economy falter, the 
toxicity of the underlying financial structure falls into a continuous 
destabilizing pattern. As a result, for example, the Fed is now 
spending $200 billion to buy instruments outside of the residential 
mortgage market.\7\
---------------------------------------------------------------------------
    \7\ GAO Report, supra note 17, at 31; Press Release, Federal 
Reserve, Nov. 25, 2008, available at http://www.federalreserve.gov/
newsevents/press/monetary/20081125a.htm.
---------------------------------------------------------------------------
    Finally, while CDS and synthetic CDOs constitute the lit fuse that 
leads to the exploding financial destabilization we are experiencing 
today, the remainder of the over-the-counter derivatives market has 
historically led to other destabilizing events in the economy, 
including the recent energy and food commodity bubble (energy and 
agriculture swaps), the failure of Long Term Capital Management in 1998 
(currency and equity swaps), and the Bankers Trust scandal and the 
Orange Country bankruptcy of 1994 (interest rate swaps).
    Because ``swaps'' are risk shifting instruments or, in their most 
useful sense, hedges against financial risk, they were almost certainly 
subject to the Commodity Exchange Act prior to the passage of the CFMA 
in 2000. The Commodity Future Trading Commission (``CFTC'') in 1993 
exempted swaps from that CEA's exchange trading requirement if their 
material economic terms were individually negotiated and if they were 
not traded on a computerized exchange.\8\ However, the 1993 exemption 
did not satisfy the financial services sector and, by 1998, the market 
grew to over $28 trillion in notional value without utter disregard for 
the exchange trading requirements within the CEA.
---------------------------------------------------------------------------
    \8\ 17 C.R.F. Part 35 (1993).
---------------------------------------------------------------------------
    As a result in May 1998, the CFTC, under the leadership of then 
Chair Brooksley Born, issued a ``concept release'' inviting public 
comment on how that multi-trillion dollar industry might most 
effectively be covered by the CEA on a ``prospective'' basis.\9\ While 
that effort was blocked by the Executive Branch and Congress (including 
the passage of the CFMA in 2000), the CFTC concept release spelled out 
a menu of regulatory tools that have historically been applied to 
financial instruments, e.g., equities, bonds, and traditional futures 
contracts that have the financial force to destabilize the economy 
systemically.
---------------------------------------------------------------------------
    \9\ 63 Fed. Reg. 26114 (May 12, 1998).
---------------------------------------------------------------------------
    The classic indicia of regulation of financial instruments that 
have potential systemic adverse impacts on the economy include:

    1. Transparency. These kinds of financial instruments are reported 
        to, and, even often, registered with, a Federal oversight 
        agency prior to execution. Transparency also requires that all 
        transactions and holding be accounted for on audited financial 
        statements. The present meltdown has been characterized by the 
        use of off balance sheet investment vehicles, e.g., structured 
        investment vehicles (``SIVs'') to house those instruments with 
        potential systemic risk hidden from public view.

    2. Record Keeping. Counterparties should be required to keep 
        records of these transactions for 5 years.

    3. Immediate Complete Documentation. Since August 2005, the Fed has 
        complained that financial instruments pertaining to credit 
        derivatives have been poorly documented with back offices being 
        very far behind the execution of credit derivatives by sales 
        personnel.

    4. Capital Adequacy. Federal regulators traditionally require that 
        parties to regulated transactions have adequate capital 
        reserves to ensure payment obligations.

    5. Disclosure. Federal regulators traditionally require full and 
        meaningful disclosure about the risks of entering into the 
        regulated transaction.

    6. Anti-fraud authority and anti-manipulation. The regulated 
        markets are governed by statutes that bar fraud and 
        manipulation. The CFMA provided only limited fraud protection 
        for counterparties by the SEC. The inadequacy of that 
        protection is evidenced by both SEC Chairman Cox and former SEC 
        Chairman Levitt calling regulation of these markets a 
        ``regulatory blackhole.'' \10\ Fraud protection without 
        transparency to the Federal regulator is meaningless. Moreover, 
        no manipulation protection was included within the CFMA with 
        regard to swaps. Effectively, the CFMA authorized this massive 
        multi-trillion dollar worldwide swaps market without any 
        provisions for protecting against fraud or manipulation. Fraud 
        and anti-manipulation protections included within the 
        securities and regulated futures laws should be restored to 
        these markets.
---------------------------------------------------------------------------
    \10\ See Speech by SEC Chairman Christopher Cox: Opening Remarks at 
SEC Roundtable on Modernizing the Securities and Exchange Commission's 
Disclosure System (Oct. 8, 2008).

    7. Registration of Intermediaries. ``Brokers'' of equity and 
        regulated futures transactions are subject to registration 
        requirements and prudential conduct. There is no such 
---------------------------------------------------------------------------
        protection within the swaps market.

    8. Private Enforcement. As is true in securities laws and laws 
        applying to the regulated futures markets, private parties in 
        the swaps markets should have access to Federal courts to 
        enforce anti-fraud and anti-manipulation requirements, thereby 
        not leaving enforcement entirely in the hands of overworked 
        (and sometimes unsympathetic) Federal enforcement agencies.

    9. Mandatory Self Regulation. As is true of the securities and 
        traditional futures industries, swaps dealers should be 
        required to establish a self regulatory framework, including 
        market surveillance.

    10. Clearing. Again, as is true of the regulated securities and 
        regulated futures infrastructure, a strong clearing 
        intermediary should clear all trades as further protection 
        against a lack of creditworthiness of counterparties.

The adoption of the traditional regulatory protections for swaps with 
systemic risk characteristics would essentially return these markets to 
where they were as a matter of law prior to the passage of the CFMA in 
2000. The general template would be that swaps would have to be traded 
on a regulated exchange (which provides each of the protections 
outlined above) unless the proponents of a risk shifting instrument 
bear the burden of demonstrating to a Federal regulator that the 
instrument cannot cause systemic risk and will not lead to fraudulent 
or manipulative practices if traded outside an exchange environment. It 
is for that reason, for example, that, in 1993, the CFTC exempted from 
exchange trading requirements privately negotiated contracts not traded 
in standardized format.

    The Senate Chair of the committee of jurisdiction over swaps, 
Senator Harkin,\11\ has argued that trading in these instruments should 
be moved back onto regulated exchanges and he even posed the 
possibility of an outright ban on ``naked'' CDS. In other words, he has 
called for reversing the CFMA in this regard and returning to the 
regulated exchange trading environment with direct Federal oversight 
and self regulatory protections that existed prior to the passage of 
the CFMA.
---------------------------------------------------------------------------
    \11\ Lynch, Harkin Seeks to Force All Derivatives on Exchanges, 
Wall Street Journal, November 20, 2008 at http://online.wsj.com/
article/SB122721812727545583.html. See also Hunton & Williams LLP, The 
Derivatives Trading Integrity Act--Beginning of the End for OTC 
Trading?, December 2008, available at http://www.hunton.com/files/
tbl_s10News%5CFileUpload44%5C15843%5Cderivatives_trading_integrity_act.p
df (``Senate Agriculture Committee Chairman Tom Harkin (D-Iowa) 
introduced the Derivatives Trading Integrity Act of 2008 (`the bill'), 
hoping to end `casino capitalism' in the market for over-the-counter 
(OTC) derivatives. The bill amends the Commodity Exchange Act (CEA) to 
require that all contracts with future delivery trade on regulated 
exchanges similar to how commodity futures currently trade . . . The 
bill reverses [the CFMA], forcing swap transactions to be conducted on 
designated or registered clearing houses or derivatives clearing 
organizations.'').
---------------------------------------------------------------------------
    Three final points should be made.
    Simple Clearing Is Not Enough. The financial services industry and 
the Bush Administration have argued that clearing facilities for CDS 
will provide adequate regulation. Clearing proposals have been advanced 
to the FED, the SEC, and the CFTC, where they are in various stages of 
approval. As I understand it, the clearing is wholly voluntary. Second, 
clearing without each of the other regulatory attributes outlined 
above, while helpful, does not provide a systemic risk firewall. Stocks 
and traditional futures trading have a complete regulatory 
infrastructure built around the clearing process. For example, we would 
never settle for clearing, and clearing alone, as a substitute for the 
regulatory and self regulatory structure that surrounds the equities 
market.
    Moreover, clearing without other prudential safeguards just places 
an apparently sound financial institution as the guarantor of the 
counterparties. Five years ago, AIG might have convincingly advanced 
itself as such an institution. Similarly, a AAA entity that appears 
sound today may become unstable if the entire derivatives market is not 
adequately policed. In sum, the limited step of clearing by itself does 
not adequately protect against systemic risk.
    State Insurance Regulation. As mentioned above, CDS has all of the 
attributes of insurance. As a result, the New York Insurance 
Superintendant and the Governor of New York in September 2008 required 
that its insurance registrants trading CDS to those wanting to 
indemnify their own real risks in the mortgage market be subject to 
state insurance law by January 1, 2009 with corresponding capital 
adequacy requirements.\12\ In this vein, it is interesting to note that 
AIG, a New York insurance regulatee, had $20 billion in reserve for 
each of its regulated insurance subsidiaries at the time it was rescued 
by the U.S. on September 17, 2008, because of CDS trading in an 
unregulated portion of the company. That fact seems to be unanswerable 
vindication of the efficacy of state insurance regulation, which is 
even now not preempted by the CFMA. In November 2008, New York 
temporarily suspended the CDS mandate it had issued in September on the 
theory that the prospects for Federal regulation had improved.\13\ On 
January 24, 2009, the National Conference of Insurance Legislators is 
holding a hearing in New York City to discuss whether CDS should be 
subject to state regulation. My view is that state efforts in this 
should be encouraged as a further safeguard against systemic risk, 
especially insofar as the CFMA itself did not preempt state insurance 
laws. The CFMA limited its preemptive effect to state gaming and bucket 
shop laws.
---------------------------------------------------------------------------
    \12\ New York State Insurance Dept., Recognizing Progress By 
Federal Government In Developing Oversight Framework For Credit Default 
Swaps, New York Will Stay Plan To Regulate Some Credit Default Swaps, 
press release, November 20, 2008 (``Dinallo announced that New York had 
determined that some credit default swaps were subject to regulation 
under state insurance law and that the New York State Insurance 
Department would begin to regulate them on January 1, 2009.'').
    \13\ New York State Insurance Dept., Recognizing Progress By 
Federal Government In Developing Oversight Framework For Credit Default 
Swaps, New York Will Stay Plan To Regulate Some Credit Default Swaps, 
press release, November 20, 2008 (Superintendent Dinallo stating ``I am 
pleased to see that our strong stand has encouraged the industry and 
the Federal Government to begin developing comprehensive solutions. 
Accordingly, we will delay indefinitely regulating part of the 
market.'').
---------------------------------------------------------------------------
    As some commentators have also made clear, the New York Insurance 
Superintendant's proposed extension to of New York insurance law 
relating to those seeking to indemnify actual risks from the actual 
holding of CDOs is too limited. ``Naked'' CDS, or the guarantees to 
counterparties who hold no CDO risk and who just want to bet against 
mortgage commitments being fulfilled, are the kind of insurance that 
led to the creation of state insurance laws.\14\ Under state insurance 
laws, you cannot insure against someone else's risk. Insurance of that 
kind creates so-called ``moral hazard,'' or the creation of perverse 
and nonproductive incentives to take actions that will lead to the 
triggering of the insurance guarantee. For example, the holder of a 
``naked'' CDS might want to interfere with mortgage ``work outs'' to 
avoid defaults on loans, thereby insuring that the ``guarantee'' 
against loan default within the naked CDS will be triggered. 
Accordingly, if states are to regulate here, they should bar ``naked'' 
CDS as the very kind of unlawful insurance that caused regulation in 
this area.
---------------------------------------------------------------------------
    \14\ Kimbal-Stanley, Arthur, Dissecting A Strange Financial 
Creature, The Providence Journal, April 7, 2008 (``Insurance contracts 
used to protect against the loss of property owned by the person buying 
the policy helped the buyer eliminate the consequences of calamity. 
Insurance contracts used to bet on whether or not calamity would befall 
someone else's property not only let the buyer place a bet, it gave the 
buyer incentive to make that calamity occur, to destroy the insured 
property he did not own, to sink the other guy's ship, in order to 
collect on an insurance contract. In 1746, Parliament passed the Marine 
Insurance Act, requiring anyone seeking to collect on an insurance 
contract to have an interest in the continued existence of the insured 
property. Thus was born the insured-interest doctrine . . . The 
doctrines have been part of insurance law in both England and the 
United States (which in 1746 were colonies under English common law) 
ever since.'').
---------------------------------------------------------------------------
    Finally, there is a strong ``regulatory reform'' movement to 
preempt some or all of state insurance law in favor of a Federal 
insurance regulator.\15\ If the states ``stand down'' on the CDS 
market, i.e., consciously decide not to regulate products that have all 
the elements of insurance, in favor of exclusive Federal regulation, 
that will be the first exhibit used by those advocating Federal 
regulation as to the purported inadequacy of state regulation. CDS 
represent class insurance products.\16\
---------------------------------------------------------------------------
    \15\ Insurance Journal, AIG Crisis Restarts Debate Over State vs. 
Federal Insurance Regulation, September 17 2008, available at http://
www.insurancejournal.com/news/national/2008/09/17/93798.htm?print=1.
    \16\ [No citation in submitted testimony.]
---------------------------------------------------------------------------
    Structural Regulation Alone. A further school of thought, most 
clearly evidenced by the President's Working Group on Financial Markets 
``regulatory reform'' proposal of March 2008, is that the present 
regulatory failures have been caused by structural inadequacies, e.g., 
too many regulators looking at huge institutions carrying out in a 
single structure a host of financial activities.\17\ The March 2008 
proposal was intended to mimic the U.K.'s then extant unified 
regulatory structure that was premised on ``principles'' rather than 
``rules.'' For example, the March 2008 proposal would merge the CFTC 
into the SEC, but have the SEC use the CFTC's ``principles'' based 
regulation. Moreover, the March 2008 proposal would hand over to the 
Fed considerable consolidated ``rescue'' powers. It may very well be 
that there needs to be a restructuring of the Federal regulatory 
system. However, the adverse lesson emanating from the creation of the 
Department of Homeland Security should be an object lesson in the 
dangers of governmental reorganization in a time of crisis. More 
importantly, it is not enough to improve Federal ``rescue'' 
capabilities. There are neither principles nor rules that govern the 
OTC derivatives market. It is a ``blackhole.'' Even the U.K. is 
``reforming'' its regulatory structure, recognizing that it was 
inadequate to the task in the present meltdown.
---------------------------------------------------------------------------
    \17\  http://www.ustreas.gov/press/releases/reports/
pwgpolicystatemktturmoil_03122008.pdf.

    The Chairman. Thank you very much, Mr. Greenberger.
    Mr. Gooch, welcome to the Committee.

 STATEMENT OF MICHAEL A. GOOCH, CHAIRMAN OF THE BOARD AND CEO, 
                  GFI GROUP INC., NEW YORK, NY

    Mr. Gooch. Thank you.
    I am Michael Gooch, Chairman and CEO of GFI Group Inc. 
Thank you, Chairman Peterson and Ranking Member Lucas, for 
inviting us here to testify today.
    I began my career in financial brokerage in London in 1978, 
emigrated to the U.S. in 1979, and eventually became a 
naturalized U.S. citizen. I founded GFI Group in 1987 with 
$300,000 of capital. The firm is now one of five major global 
inter-dealer brokers, or IDBs, with approximately 1,700 
employees on six continents and with $500 million in 
shareholder equity.
    GFI Group is a U.S. public company listed on NASDAQ under 
the symbol GFIG. GFI Group and other inter-dealer brokers 
operate neutral marketplaces in a broad spectrum of credit, 
financial, equity, and commodity markets, both in cash 
instruments and derivatives. We are transaction agents to the 
markets we serve and do not trade for our own accounts. GFI is 
also a leading provider of electronic trading platforms to many 
global exchanges and competing IDBs.
    GFI has been ranked as the number one broker of credit 
derivatives since the market began over 11 years ago, which 
provides us with far more experience with the product than any 
exchange. The leading IDBs offer sophisticated electronic 
trading technology that has been widely adopted in Europe and 
Asia. These European markets have functioned well in the wake 
of the credit crisis.
    The electronic ATS trading environment for inter-dealer 
OTC-CDS that is operating successfully in Europe and Asia could 
be replicated in the U.S. immediately. Most, if not all, of 
GFI's individual brokers of credit derivatives in the U.S. are 
licensed, registered representatives, regulated by FINRA.
    GFI supports this Committee's initiatives for greater 
transparency, central counterparty clearing, and effective 
regulatory oversight. However, the matter of central 
counterparty clearing is not a simple one. Any clearing 
mechanism is only as good as its members in the event that its 
initial clearing funds are exhausted. It is my opinion, and I 
believe it is shared by many in the financial community, that 
in the event major global investment banks had failed last 
September, then the clearinghouses of the various futures 
exchanges would have failed, too.
    Sixty percent of the inter-bank volume in credit 
derivatives is transacted outside of the United States. To 
successfully achieve OTC clearing, large inter-bank dealer and 
global cooperation will be required. Notwithstanding the 
complexities of central clearing a global OTC credit 
derivatives market, it is my view that the listed exchanges can 
play an important role in introducing simple vanilla futures 
contracts on the most liquid indexes and single names. Both 
cleared and uncleared OTC and listed futures can co-exist as 
they do in most other financial markets.
    I would like to specifically address two sections of the 
proposed legislation: section 14 and section 16.
    We support the extension of CFTC regulation to the market 
for carbon offset credits and emissions allowances under 
section 14 of the bill. As a major broker of European emissions 
credits, we are very familiar with the importance of an 
orderly, efficient, and well-regulated marketplace. Therefore, 
we do not see a reason why the proposed legislation requires 
all trades to be done on a designated contract market and not 
also allowed on a CFTC-regulated DTEF. We believe that the 
limitation of transactions to DCMs needlessly stifles 
competition, leading to greater costs that are ultimately 
passed along to the consumer.
    With regard to section 16, we are very concerned that the 
elimination of naked interest will kill the CDS market and 
significantly inhibit the liquidity of credit markets, 
including the market for corporate bonds and bank loans. Just 
as third-party liquidity providers and risk takers are willing 
to buy and sell futures and options in agricultural products, 
providing much-needed liquidity for businesses in agriculture 
to hedge and offset risk, so do such risk takers enhance 
liquidity in credit markets. There is plenty of capital on the 
sidelines today willing to take risk in credit without becoming 
direct lenders. This source of credit will not be available if 
the buying of credit derivatives is limited to those with a 
direct interest in the underlying instruments. That is because 
risk takers need to take risk on both sides of the market in 
order for there to be a liquid market.
    New issuance of corporate debt cannot happen without a 
liquid, functioning bond market; and since credit derivatives 
are often more liquid than the market for the underlying bonds, 
it is clear that a functioning credit derivatives market is 
paramount for the unfreezing of credit markets. Killing the CDS 
market will contribute to an extended period of tight lending 
markets, where credit will only be available to the most secure 
borrowers, which will extend and deepen the current recession 
we are experiencing.
    Thank you for this opportunity to address you today. I will 
be happy to answer any questions you may have.
    [The prepared statement of Mr. Gooch follows:]

Prepared Statement of Michael A. Gooch, Chairman of the Board and CEO, 
                     GFI Group, Inc., New York, NY
    I am Michael Gooch, Chairman and CEO of GFI Group, Inc. Thank you 
Chairman Peterson and Ranking Member Lucas for inviting us to testify 
today.
    About GFI Group: I began my career in financial brokerage in London 
in 1978, emigrated to the U.S. in 1979 and became a naturalized U.S. 
citizen. I founded GFI Group in 1987 with $300,000 of capital. The firm 
is now one of five major global ``inter-dealer brokers'' with 
approximately 1,700 employees on six continents and with 500 million 
dollars in shareholder equity. GFI Group is a U.S. public company 
listed on the NASDAQ under the symbol ``GFIG''.
    GFI Group and the other inter-dealer brokers operate neutral market 
places in a broad spectrum of credit, financial, equity and commodity 
markets both in cash instruments and derivatives. GFI group has a 
strong presence in many over-the-counter (or ``OTC'') and listed 
derivative markets and has a reputation as being the leader globally in 
Credit Derivatives. We function as an intermediary on behalf of our 
brokerage clients by matching their trading needs with counterparties 
having reciprocal interests. We are transaction agents to the markets 
we serve and do not trade for our own account.
    We offer our clients a hybrid brokerage approach, combining a range 
of telephonic and electronic trade execution services, depending on the 
needs of the individual markets. We complement our hybrid brokerage 
capabilities with decision-support service, such as value-added data 
and analytics products and post-transaction services including 
straight-through processing (or ``STP'') and transaction confirmations. 
We earn revenues for our brokerage services and charge fees for certain 
of our data and analytics products. We are also a leading provider of 
electronic trading software through our Trayport subsidiary, which 
licenses critical transaction technology in numerous product markets 
from energy to equities that is used by institutional market 
participants, such as futures exchanges and competing IDBs.
    GFI is a global leader in numerous OTC derivatives markets. We have 
ranked as the number one broker for credit derivative since the market 
began over 11 years ago. In that time, GFI Group has brokered billions 
of dollars of credit derivative transactions that provides us with far 
more experience with the product than any exchange. In 2008, GFI was 
ranked as both the Number One Credit Derivative Broker and the Number 
One Commodity Broker.
About Inter-Dealer Brokerage:
    I would like to take a moment to describe the market role played by 
inter-dealer brokers such as GFI. Inter-dealer Brokers (or ``IDBS'' as 
they are known) are an established part of the global, financial 
landscape. GFI and its competitors, aggregate liquidity and facilitate 
transactions in both OTC and exchange transactions between major 
financial and non-financial institutions around the world. IDBs cross 
transactions over-the-counter in listed futures in equities, energy and 
financial markets and post them to recognized exchanges within 
stringent regulator-mandated reporting time frames. The leading IDBs 
offer sophisticated electronic trading technology that has been widely 
adopted in Europe and Asia. These European markets have functioned well 
in the wake of the credit crisis.
    In the credit derivatives market, for example, millions of 
electronic messages are recorded and processed by IDBs in real time 
every business day. With the most sophisticated IDBs that handle the 
bulk of the inter-dealer business in Europe, Asia and the U.S., the 
technology is connected via API to the Depository Trust Clearing 
Corporation (DTCC) the main central warehouse for CDS trades with 
Straight through Processing (STP) to all the major credit derivatives 
dealers. The electronic ATS trading environment for inter-dealer OTC-
CDS that is operating successfully in Europe and Asia could be 
replicated in the U.S. immediately. At least four global regulated 
inter-dealer brokers have the ATS technology in place to achieve this 
now.
    Most, if not all, of GFI's individual brokers of credit derivatives 
in the U.S. are licensed, registered representatives regulated by the 
Financial Industry Regulatory Authority (FINRA). Such IDBs with FINRA 
registered representatives keep electronic copies of all communications 
supporting each credit derivatives transaction they cross and the bids 
and offers leading up to those trades. Trading data, in some cases, 
goes back as far as 1996.
About the Proposed Legislation:
    As a major aggregator of liquidity in OTC derivatives, GFI supports 
this Committee's initiatives for greater transparency, central 
counterparty clearing and effective regulatory oversight. We believe 
that enhancing transparency and eliminating counterparty risk will be a 
major improvement in the CDS market structure that will ensure its role 
as a credit transfer tool for investors.
    We commend the Committee for its efforts to achieve these goals. We 
also support its efforts to provide the CFTC with greater regulatory 
oversight. We have a deep appreciation for the work of the CFTC. Our 
experience is that they are dedicated, competent, and hard working and 
have done an excellent job.
    Nevertheless, the matter of central counterparty clearing is not a 
simple one. A central clearing mechanism requires a degree of 
standardization and price transparency not available for all 
instruments and all credits. Any clearing mechanism is only as good as 
its members in the event its initial clearing funds are exhausted. It 
is my opinion and I believe it is shared by many in the financial 
community that in the event certain major, global investment banks had 
failed last September, then the clearing houses of the various futures 
exchanges would have failed too. The large banks and prime brokers 
represent the bulk of the open interest on the various futures 
exchanges and the gapping of markets that would have occurred overnight 
in such an outcome would have led to a call on the capital of the very 
firms that may have failed. To have illiquid credits in such clearing 
mechanisms would only have exacerbated the problem. Since the large 
banks and prime brokers represent the bulk of the clearing capital at 
risk, it makes sense that a clearing solution provided by those banks 
with a high degree of transparency on pricing and mark to market makes 
the most sense.
    We believe that the credit derivatives market could certainly 
benefit from a central counterparty. It would be a mistake, however, to 
presuppose that the entire market for credit derivatives operates only 
in the U.S. and that a single vertical clearing and execution venue can 
be designated for the entire global market. Sixty (60%) percent of the 
inter-bank volume in credit derivatives is transacted outside of the 
United States. Central counterparty clearing in CDS is a complex issue 
that is under-estimated by those that propose or believe it can be 
achieved almost overnight. To successfully achieve OTC clearing, large 
inter-bank dealer and global co-operation will be required.
    Notwithstanding the complexities of centrally clearing a global OTC 
credit derivative market, it is my view that the listed exchanges can 
play an important role in introducing simple vanilla futures contracts 
on the most liquid indexes and single names. Both cleared and un-
cleared OTC and listed futures can co-exist as they do in most other 
financial markets.
Issues Raised by the Proposed Legislation
    I would like to specifically address two sections of the proposed 
legislation: section 14 and section 16.
    We support the extension of CFTC regulation to the market for 
carbon offset credits and emission allowances under section 14 of the 
bill. As a major broker of European emissions credits, we are very 
familiar with the importance of an orderly, efficient and well 
regulated marketplace. Therefore, we do not see a reason why the 
proposed legislation requires all trades to be done on a Designated 
Contract Market (or ``DCM'') and not also on a CFTC-regulated 
``Derivatives Transaction Execution Facility'' (or ``DTEF''). We 
believe that the limitation of transactions to DCMs needlessly stifles 
competition leading to greater costs that are ultimately passed along 
to the consumer.
    With regard to section 16, we are very concerned that limiting 
participation in the Credit Derivatives market to entities with a 
direct interest in the credit being protected, i.e., elimination of 
naked interest, will kill the CDS market and significantly inhibit the 
liquidity of the credit markets, including the market for debt 
instruments such as corporate fixed income and bank loans. Just as 
third party liquidity providers and risk takers are willing to buy and 
sell futures and options in agricultural products providing much needed 
liquidity for businesses in agriculture to hedge and offset risk, so do 
such risk takers enhance liquidity in credit markets. There is plenty 
of capital on the side lines today willing to take risk in credit 
without becoming direct lenders. This source of credit will not be 
available if the buying of credit derivatives is limited to those with 
a direct interest in the underlying instruments. That is because risk 
takers need to take risk on both sides of the market in order for there 
to be a liquid market.
    Without question, new issuance of corporate debt cannot happen 
without a liquid, functioning bond market and, since credit derivatives 
are often more liquid than the market for the underlying bonds, it is 
clear that a functioning credit derivatives market is paramount for the 
unfreezing of credit markets. Killing the CDS market will contribute to 
an extended period of tight lending markets where credit will only be 
available to the most secure borrowers. CDS has become so integral to 
the functioning of credit markets that killing it will extend and 
deepen the current recession we are experiencing.
    In conclusion, let me just say that the global market for credit 
derivatives is not murky or unregulated as some would have us believe. 
Rather, it is highly liquid and, potentially, quite transparent. It is 
today functioning well and will play an important role in the 
unfreezing of the credit markets and the recovery of the global 
economy. That critical role could be jeopardized if we do not sort out 
the half-truths and misperceptions surrounding credit derivatives and 
their market structure. It is only then that the discussion of 
improving the credit derivatives market through central clearing and 
electronic trading can be put in proper context.
    Thank you for this opportunity to address you today. I will be 
happy to answer any questions you may have.

    The Chairman. Thank you very much, Mr. Gooch, for your 
testimony.
    Mr. Cota, welcome to the Committee.

 STATEMENT OF SEAN COTA, CO-OWNER AND PRESIDENT, COTA & COTA, 
 INC.; TREASURER, PETROLEUM MARKETERS ASSOCIATION OF AMERICA, 
   BELLOW FALLS, VT; ON BEHALF OF NEW ENGLAND FUEL INSTITUTE

    Mr. Cota. Thank you, Honorable Chairman Peterson and 
Ranking Member Lucas, distinguished Members of the Committee. 
Thank you for the invitation to testify before you today. I 
appreciate the opportunity to provide some insight on your 
draft legislation.
    First, I would like to thank Chairman Peterson and the 
Committee for their tireless efforts in bringing greater 
transparency and accountability to commodity markets. Without 
your dedication, this issue would never have gained the 
attention it deserves and needs.
    I serve as an officer of the Petroleum Marketers 
Association of America. PMA is a national federation of 47 
states and regional associations, representing over 8,000 
independent fuel marketers. These marketers account for nearly 
half of the gasoline and nearly all of the distillate fuel 
consumed in the United States.
    I am also here representing the New England Fuel Institute, 
which represents over 1,000 heating oil dealers in the 
Northeast.
    Further, I am a third generation co-owner and operator of a 
home fuel delivery company in Vermont and New Hampshire. My 
business provides home heating fuel to 9,000 homes and 
businesses. I also market motor fuels and biofuels. Unlike 
larger energy companies, most retail fuel dealers are small, 
family-run businesses that personally deliver products to the 
doorstep of American homes and businesses.
    We respectfully urge the Committee to impose aggregate 
position limits at the control entity level on noncommercial 
traders across all trading environments, including the over-
the-counter markets that do not have any direct physical 
connection to the underlying commodity.
    We have been voicing our concerns to Congress regarding 
dark markets for more than 3 years. Large-scale institutional 
investors speculating in the energy markets continue to act as 
the driving force behind energy prices. The rise in crude oil 
prices, which reached $150 a barrel for December delivery in 
July of last year, only to fall to a low of $33, was not the 
result of supply and demand. It was the direct result of large 
and excessively leveraged speculators, index traders, and hedge 
funds.
    According to a CBS News 60 Minutes investigation last 
month, oil should not have skyrocketed to the levels seen last 
year. The piece highlighted how investment speculators, or 
``invesculators,'' looking to make a fast buck in a paper trade 
caused oil prices to rise faster and fall harder than ever 
could be explained by ordinary market forces alone. American 
consumers, small businesses, and the broader economy were 
forced into a roller coaster ride of greed and fear.
    The retail petroleum industry is one of the most 
competitive industries, dominated by small, independent 
businesses. As gas prices go up, markets become even more 
competitive; and, at times, retailers sell gasoline below cost. 
In addition, because they must pay for their inventory before 
they sell it, credit lines were stretched to the max, creating 
a credit crisis with marketers' banks. The resulting liquidity 
problems caused serious financial hardship for many petroleum 
marketers and gas station owners. Many were forced to close 
shop.
    This problem extends to the heating fuel industry. In the 
summer of 2008, Goldman Sachs, which trades commodities, 
predicted that crude oil would hit $200 per barrel, translating 
to $6 per gallon heating oil by winter. Heating oil dealers, 
who typically hedge fuel in warmer months, were experiencing 
the highest prices ever. Some consumers, scared by these 
statements made by Goldman Sachs and others, demanded fixed-
price agreements with their dealers in an attempt to shelter 
their family from higher prices. Many dealers offered these 
contracts. They committed to purchase fuel they needed to 
supply these contracts during the winter months; and when the 
invesculators exited the market this fall, heating fuel dealers 
and their customers who had locked in were committed to a fuel 
at a much higher cost than it is currently worth.
    Commodity markets were not designed as an investment class. 
They are set up for physical hedgers and to manage price risk 
by entering into futures contracts to hedge price for future 
delivery. Bona fide hedgers, like my company, rely on these 
markets to provide the consumer with quality product at a price 
that is reflective of market fundamentals. Traditional 
speculators are important and healthy in this role; 
invesculators are not.
    We support the bill and urge Congress to move it quickly 
through the legislative process. Do not allow this important 
bill to be stalled by the financial service regulatory reform 
debate that is ongoing or by Wall Street's opposition.
    We strongly support the following provisions in this bill: 
expanding transparency, record-keeping, and clearing 
requirements to the OTC trades; closing the foreign markets or 
the London loophole; closing the swaps trading loophole to 
distinguish between legitimate hedgers and pure speculation; 
and providing the CFTC with sufficient staff and resources to 
do its job.
    We also urge you to make further adjustments to the bill by 
immediately mandating aggregate speculation limits in energy 
futures trades across all markets at the control level or the 
ownership level for contracts traded within the United States 
or by U.S. traders. Additionally, we urge you to mandate the 
aggregate position limits, regardless of any study that takes 
place required under section 9 of the bill.
    We are encouraged by your desire to take a strong stand 
against excessive speculation and abusive trading practices 
that have artificially inflated energy and severely damaged our 
economy. Let's return these markets so that they are driven by 
supply and demand and not purely by the speculative whims and 
greed of Wall Street.
    Thank you for this opportunity to testify.
    [The prepared statement of Mr. Cota follows:]

 Prepared Statement of Sean Cota, Co-Owner and President, Cota & Cota, 
  Inc.; Treasurer, Petroleum Marketers Association of America, Bellow 
           Falls, VT; on Behalf of New England Fuel Institute
    Honorable Chairman Peterson, Ranking Member Lucas and distinguished 
Members of the Committee, thank you for the invitation to testify 
before you today. I appreciate the opportunity to provide some insight 
on draft legislation entitled the ``Derivatives Markets Transparency 
and Accountability Act.'' I am also pleased to speak to the affect that 
opaque, inadequately regulated commodities markets and abusive trading 
practices have had on our nation's independent fuel marketers and home 
heating fuel providers.
    First, I would like to thank Chairman Peterson and the Committee 
for their tireless efforts to bring greater transparency and 
accountability to commodity markets. Without your dedication, this 
issue would never have gained the attention it deserved.
    I serve as Treasurer on the Petroleum Marketers Association of 
America's (PMAA) Executive Committee. PMAA is a national federation of 
47 state and several regional trade associations representing over 
8,000 independent fuel marketers. These marketers account for 
approximately half of the gasoline and nearly all of the distillate 
fuel consumed by motor vehicles and home heating equipment in the 
United States.
    I am also here representing the New England Fuel Institute (NEFI), 
a 60 year old trade association representing well over 1,000 heating 
fuel dealers and related service companies within the Northeastern 
United States.
    In addition, I speak before you today as co-Owner and President of 
Cota & Cota, Inc. of Bellows Falls, Vermont, a third generation family-
owned and operated home heating fuel provider in southeastern Vermont 
and western New Hampshire. My business provides quality home heating 
fuel, including propane, heating oil and kerosene, to approximately 
9,000 homes and businesses. I also market motor fuel, off-road diesel 
fuel, jet fuel and biofuels. Unlike larger energy companies, most 
retail fuel dealers are small, family-run businesses. Also unlike 
larger energy companies, we personally deliver product directly to the 
doorstep of American homes and businesses.
    Before I begin, I would like to highlight the fact that PMAA and 
NEFI are hereby respectfully urging the Committee to impose aggregate 
position limits at the control entity level on noncommercial traders 
and across all trading environments, including over-the-counter markets 
that do not have any physical connection to the underlying commodity.
    Our organizations have been voicing concern to Congress regarding 
the activities in ``dark'' commodity markets for more than 3 years now. 
It has become abundantly clear that large-scale, institutional 
investors speculating in the energy markets, were and continue to act 
as the driving force behind energy prices. The rise in crude oil 
prices, which reached $147 in July of last year only to fall 
dramatically to as low as $33 in December was not a result of supply 
and demand fundamentals--it was the direct result of excessively-
leveraged speculators, index investors and hedge funds.
    After 3 years of advocating for greater transparency and 
accountability in these markets, we have seen very little progress to 
this end. I would like to thank the Members of this Committee for 
passing the ``Close the Enron Loophole Act'' which was enacted as part 
of last year's farm bill. It was an important first step. However, as 
addressed by this Committee last year in H.R. 6604, this is a serious 
problem that needs a more aggressive legislative response, especially 
in light of the 2008 unprecedented run-up in commodity prices. The 
solution requires an unwavering commitment to vigorous oversight and 
enforcement by the new President and the Commodity Futures Trading 
Commission, which we believe to have been lacking in recent years.
    According to a January 11, 2009 60 Minutes investigation titled, 
``Did Speculation Fuel Oil Price Swings?'' several experts agreed that 
oil should not have skyrocketed to previously mentioned record levels 
last year, only to see prices dramatically collapse few months later. 
The piece highlighted how investors were looking not to actually buy 
oil futures, but to make a fast buck in a ``paper trade.'' This 
practice caused oil prices to rise faster and fall harder than could 
ever be explained by ordinary market forces alone. American consumers, 
small businesses and the broader economy were forced onto a roller 
coaster ride of greed, fear and uncertainty. However, the greatest 
victim of the 2008 energy crisis was consumer confidence in these 
markets' ability to determine a fair and predictable price for energy.
    In 2007 and most of 2008, gasoline and heating oil retailers saw 
profit margins from fuel sales fall to their lowest point in decades as 
oil prices surged. The retail motor fuels industry is one of the most 
competitive industries in the marketplace, which is dominated by small, 
independent businesses. Retail station owners offer the lowest price 
for motor fuels to remain competitive, so that they generate enough 
customer traffic inside the store where station owners can make a 
modest profit by offering drink and snack items. As gas prices go up, 
the market becomes even more competitive and at times retailers are 
selling gas at a loss. In addition, because petroleum marketers and 
station owners must pay for the inventory they sell, their lines of 
credit were approaching their limit due to the high costs of gasoline, 
heating oil and diesel. This created a credit crisis with marketers' 
banks, which created liquidity problems and caused serious financial 
hardship for many petroleum marketers and station owners--some even 
were forced to close up shop.
    In the summer of 2008, Goldman Sachs, a firm that trades in the 
crude oil market, predicted that crude oil would hit $200 per barrel 
(translating to $6 per gallon heating oil) by winter. Heating oil 
dealers, who typically purchase fuel in the summer months when seasonal 
product costs are typically at their lowest, were experiencing higher 
prices than ever before. Some customers, scared by statements made by 
Goldman Sachs and others, began demanding a fixed-price agreement with 
their dealer in an attempt to shelter their family budgets from higher 
prices.
    Many dealers offered such contracts to meet this demand, driving 
many of them to purchase the fuel needed to supply these contracts up 
front during the summer months; for fear that prices would only head 
higher. When institutional investors exited the market in the fall, 
heating fuel dealers and their customers who had ``locked in'' to a 
price contract were put in a very bad spot, committed to fuel at a much 
higher cost than its current worth. Many of these consumers are elderly 
Americans and struggling families trying to make ends meet in a 
slumping economy riddled with high unemployment rates and evaporating 
savings and retirement accounts.
    Ignoring or unaware of the potential consequences of their actions, 
investment-only speculators were concerned only about turning a profit. 
They were completely disconnected from the commercial marketplace and 
the struggling consumers that fuel retailers like me serve personally 
every day. Commodity markets were not designed as an investment class--
they were set up for physical hedgers to manage price risk by entering 
into a futures contract in order to lock in a price for future 
delivery. These ``Investulators,'' funds who believe commodities are an 
asset class, are really unwitting speculators, and are so large and 
lack any commodity market fundamental knowledge; they have dramatically 
distorted the markets we rely on. The abuse of this original intent 
must end now.
    We rely on these markets to provide the consumer with a quality 
product at a price reflective of market fundamentals. Traditional 
speculators serve an important and healthy role by providing needed 
liquidity in the commodities market for this to be accomplished. 
However, institutional investors have wreaked havoc on the price 
discovery mechanism that commodity futures markets provide to bona fide 
physical hedgers, including heating fuel dealers. Congress should act 
quickly to restore the transparency and oversight needed for secure and 
stable commodities markets and help restore the confidence in these 
markets that physical hedgers and consumer once had.
    Therefore, PMAA and NEFI urge Congress to pass the ``Derivatives 
Markets Transparency and Accountability Act'' and enable the critical 
changes to the Commodity Exchange Act (CEA) needed for fully regulated 
futures markets. We further urge Congress to expedite commodity markets 
reform legislation through the legislative process and not allow the 
bill to be stalled by the financial services regulatory overhaul 
debate.
    PMAA and NEFI strongly support most provisions in the ``Derivatives 
Markets Transparency and Accountability Act,'' including:

   Distinguishing between legitimate hedgers in the business of 
        actually delivering the fuel to consumers, and those who are in 
        the market for purely speculative purposes;

   Closing the ``London Loophole'' by requiring foreign 
        exchanges with energy contracts for delivery in the U.S. and/or 
        that allow U.S. access to their platforms to be subject to 
        comparable U.S. rules and regulations;

   Closing the ``Swaps Loophole'' which allows so-called 
        ``index speculators'' (that now amount to \1/3\ of the market) 
        an exemption on position limits which enable them to control 
        unlimited amounts of energy commodities; and

   Increasing staff at the CFTC with an additional 200 
        employees and other resources.

    While we applaud the Committee for its diligent work on this 
legislation, we urge you to make the necessary adjustments to the 
``Derivatives Markets Transparency and Accountability Act of 2009'' by 
mandating aggregate speculative position limits on energy futures 
across all contract markets at the control or ownership level for 
contracts traded within the U.S. or by U.S. traders. This important 
measure will help return the market to the physical market participants 
it was intended to serve. Aggregate position limits will also prevent a 
trader from going into one commodity exchange and trading the maximum 
amount of crude oil allowed and then going into another exchange to 
trade another large amount of futures positions, thereby circumventing 
anti-manipulation measures in order to take a massive and controlling 
position in one commodity. Additionally, PMAA and NEFI urge you to 
either strike Section 9--Review of Over-the-Counter Markets, which 
requires the CFTC to study and report on the effects of potential 
position limits in OTC trading and aggregate limits across the OTC 
market, designated contract markets, and derivative transaction 
execution facilities. Or to include section 9 but still mandate 
aggregate OTC position limits immediately before any study takes place.
    We and our customers need our public officials in the new Congress, 
including those on this Committee, in the new Administration and the 
CFTC, to take a stand against excessive speculation and abusive trading 
practices that artificially inflate energy prices. We strongly support 
the free exchange of commodity futures on open, well regulated and 
transparent exchanges that are subject to the rule of laws and 
accountability. Reliable futures markets are crucial to the entire 
petroleum industry and the American economy. Let's make sure that these 
markets are competitively driven by supply and demand and not the 
speculative whims and greed of Wall Street.
    Thank you again for allowing me the opportunity to testify before 
you today.

    The Chairman. Thank you, Mr. Cota.
    Welcome. I appreciate your testimony. Mr. Duffy, welcome to 
the Committee.

 STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME 
                    GROUP INC., CHICAGO, IL

    Mr. Duffy. Thank you; and let me echo my fellow panelists 
and thank you, Chairman Peterson and Ranking Member Lucas, for 
the opportunity to present our views.
    The CME Group Exchanges are neutral marketplaces. Our 
Congressionally mandated role is to operate markets that foster 
price discovery and hedging in a transparent, efficient, self-
regulated environment overseen by the CFTC. We provide 
producers and processors with necessary information to make 
important economic decisions and serve their global risk 
management needs. We offer a comprehensive selection of 
benchmark products in all major asset classes.
    We are also joining market users to operate a green 
exchange. This exchange will provide trading and clearing 
services to serve cap and trade programs respecting emissions 
and allowances.
    Additionally, we are joint venturers with Citadel to 
provide trading and clearing platforms for credit default 
swaps. Our risk analytics and financial safeguards have been 
thoroughly examined by the CFTC, the Federal Reserve, and the 
SEC. So we appreciate the proposed clarification that will 
enhance our ability to provide clearing services for credit 
default swap contracts. We also appreciate that it will not 
infringe on the SEC's regulatory responsibilities and will 
permit competition in this very important market.
    The draft bill is offered as an amendment to the Commodity 
Exchange Act to bring greater transparency and accountability 
to commodity markets. We support the bill's purpose to enhance 
the enforcement capabilities and structure of the CFTC, but it 
is essential that care be taken to avoid constraints on U.S. 
markets that would further weaken the already fragile U.S. 
economy, damage the competitiveness of U.S. markets, hurt U.S. 
consumers, produce less transparency, and deprive the 
Commission of vital information.
    We understand that there may be some markets in which 
excessive speculation, as defined in the Commodity Exchange 
Act, may cause price distortion.
    All agricultural and natural resource futures and options 
contracts are subject to either Commission or exchange spot 
month speculative position limits. The CFTC and the exchanges 
enforce those limits. We do not agree that hard position limits 
play a constructive role, either with commodities that are not 
physically delivered or with commodities whose trading does not 
affect any physically delivered market. We do not agree that 
the CFTC should be the front-line regulator setting hard 
limits.
    We also disagree with the creation of advisory committees 
for setting hard limits in agriculture and energy products. The 
proposed committees are dominated by long and short hedgers who 
are not constrained by any standards, and who do not operate 
subject to a defined process. We are concerned that these 
committees may excessively influence the setting of limits. 
Also, they may adversely affect the ability of our markets to 
efficiently perform their price discovery function.
    In addition, we believe the bill's direction to the 
Commission is overly restrictive in defining a direct hedging 
transaction; and it is restrictive with respect to dealers, 
funds, and others who have assumed risks in the over-the-
counter market which are consistent with their legitimate 
businesses.
    We are strong proponents of the benefits of central 
counterparty clearing. It is an effective means to collect and 
provide timely information to regulators. It also greatly 
reduces systemic risk imposed on financial systems by 
unregulated bilateral OTC transactions.
    We would benefit from section 13 of the draft bill, but we 
are not confident that it is workable. If the OTC dealers do 
not embrace clearing, they can easily transact in another 
jurisdiction. In that way, they could avoid the obligations 
imposed by the draft bill. This could cause significant damage 
to a valuable domestic industry.
    We urge the Committee to shape its bill in recognition of 
the reality of markets that operate in a global economy. 
Trading systems are electronic, banking is international, and 
every important trader has easy access to markets that are not 
regulated by the CFTC and not constrained by this bill. We are 
concerned with prohibitions or costly impediments to legitimate 
business activities in the United States. We believe they will 
divert business to jurisdictions that adopt other regulatory 
measures to protect against future meltdowns.
    We are eager to work with the Committee and the industry to 
help shape incentives that will encourage clearing and other 
provisions that support the goal of this bill. My written 
testimony highlights several technical issues in the draft. 
More importantly, it offers our pledge to work with the 
Committee and help assure that U.S. futures markets remain 
positive contributors to our economy.
    Thank you, sir.
    [The prepared statement of Mr. Duffy follows:]

 Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME 
                        Group Inc., Chicago, IL
    I am Terrence Duffy, Executive Chairman of Chicago Mercantile 
Exchange Group Inc. (``CME Group'' or ``CME''). Thank you Chairman 
Peterson and Ranking Member Lucas for this opportunity to present our 
views.
CME Group Exchanges
    CME Group was formed by the 2007 merger of Chicago Mercantile 
Exchange Holdings Inc. and CBOT Holdings Inc. CME Group is now the 
parent of CME Inc., The Board of Trade of the City of Chicago Inc., 
NYMEX and COMEX (the ``CME Group Exchanges''). The CME Group Exchanges 
are neutral market places. They serve the global risk management needs 
of our customers and producers and processors who rely on price 
discovery provided by our competitive markets to make important 
economic decisions. We do not profit from higher or lower commodity 
prices. Our Congressionally mandated role is to operate fair markets 
that foster price discovery and the hedging of economic risks in a 
transparent, efficient, self-regulated environment, overseen by the 
CFTC.
    The CME Group Exchanges offer a comprehensive selection of 
benchmark products in all major asset classes, including futures and 
options based on interest rates, equity indexes, foreign exchange, 
agricultural commodities, energy, and alternative investment products 
such as weather and real estate. We are in the process of joining with 
market users to operate a green exchange to provide trading and 
clearing services that will serve cap and trade programs respecting 
emissions and allowances.
    We are joint venturers with Citadel to provide trading and clearing 
platforms for credit default swaps. Our risk analytics and financial 
safeguards have been thoroughly vetted by the CFTC, the Federal Reserve 
and the SEC. Our efforts to open our doors have been complicated by 
jurisdictional issues, but we are very close to a launch of the 
service.
    We also offer order routing, execution and clearing services to 
other exchanges as well as clearing services for certain contracts 
traded off-exchange. CME Group is traded on NASDAQ under the symbol 
``CME.''
Executive Summary
    The draft bill that was recently circulated is purposed as an 
amendment ``to the Commodity Exchange Act to bring greater transparency 
and accountability to commodity markets.'' We support that statement of 
the bill's purpose. We unequivocally support enhancing the enforcement 
capabilities and machinery of the CFTC, but it is essential that care 
be taken to avoid constraints on U.S. markets that will further weaken 
the already fragile U.S. economy; damage the competitiveness of U.S. 
markets; hurt U.S. consumers and produce less transparency and deprive 
the Commission of vital information.
    We understand that there may be some markets in which ``excessive 
speculation,'' as defined in the CEA, may cause price distortion; we 
set hard limits in those markets or enforce CFTC limits. We do not 
agree that hard position limits play a constructive role with respect 
to commodities that are not physically delivered and commodities whose 
trading does not affect any physical delivery market. We do not agree 
that the CFTC should be the front-line regulator setting hard limits. 
We disagree with the creation of ``advisory'' committees for setting 
hard limits in agriculture and energy products. The proposed committees 
are dominated by long and short hedgers, who are not constrained by any 
standards and who do not operate subject to a defined process. We are 
concerned that these committees will inordinately influence the setting 
of limits and will adversely affect the ability of our markets to 
efficiently perform their price discovery function. We believe that the 
bill's direction to the Commission to define a bona fide hedging 
transaction is overly restrictive both with respect to direct hedgers 
and its constraints on the ability of dealers, funds and others who 
have assumed risks in the over the counter market, which are consistent 
with their legitimate businesses.
    We are strong proponents of the benefits of central counterparty 
clearing as an effective means to collect and provide timely 
information to prudential and supervisory regulators and to greatly 
reduce systemic risk imposed on the financial system by unregulated 
bilateral OTC transactions. We would be a major beneficiary of section 
13 of the draft bill, but we are not confident that it is practicable. 
If the OTC dealers do not embrace clearing, they can easily transact in 
another jurisdiction, avoid the obligations imposed by the draft bill 
and cause significant damage to a valuable domestic industry. We urge 
the Committee to shape its bill in recognition of the reality of 
markets that operate in a global economy. Trading systems are 
electronic, banking is international, and every important trader has 
easy access to markets that are not regulated by the CFTC and not 
constrained by this bill. Prohibitions or costly impediments to 
legitimate business activities in the U.S. will simply divert business 
to jurisdictions that adopt rational measures to deal with the causes 
and protection against future financial meltdowns. We are eager to work 
with the Committee and the industry to shape incentives that will 
encourage clearing in appropriate cases and bring us quickly to the end 
position envisioned by the bill.
    Finally, we appreciate the proposed clarification that will enhance 
our ability to provide clearing services for credit default swap 
contracts in a manner that does not infringe on the SEC's regulatory 
responsibilities and that will permit competition in this important 
market across regulatory regimes. We are concerned, however, that the 
bill will foreclose trading of CDSs in the U.S.
Drafting and Technical Issues
    We welcome a dialogue with the Committee's staff to resolve our 
technical and philosophical concerns with the draft. For convenience, 
we describe our most serious concerns below.
Sec. 3. Speculative Limits and Transparency of Offshore Trading.
    Subpart (a) directs the Commission to preclude direct access from 
the U.S.: ``to the electronic trading and order matching system of the 
foreign board of trade with respect to an agreement, contract, or 
transaction that settles against any price (including the daily or 
final settlement price) of one or more contracts listed for trading on 
a registered entity,'' unless the foreign board of trade satisfies a 
broad set of conditions respecting position limits, information 
sharing, and the definition of bona fide hedging.
    The draft bill is calibrated appropriately to focus only on a 
narrow range of contracts that might be traded on a foreign board of 
trade, although we wonder why it is restricted to financially settled 
contracts and does not include substantially identical physically 
settled contracts. We are, nonetheless, concerned that this effort may 
provoke retaliatory behavior from foreign governments or regulatory 
agencies that could severely impair our business.
Sec. 4. Detailed Reporting and Disaggregation of Market Data.
    Section 4 amends the CEA to require that the Commission issue a 
``rule defining and classifying index traders and swap dealers (as 
those terms are defined by the Commission) for purposes of data 
reporting requirements and setting routine detailed reporting 
requirements for any positions of such entities . . . .'' The draft 
requires the Commission to impose ``routine detailed reporting 
requirements'' on such traders. It is unclear that a higher level of 
routine reporting for such traders is necessary or appropriate; the 
Commission is empowered to issue special calls for information without 
demonstrating any cause. Section 4 also requires swap dealers and index 
traders to report all positions on foreign boards of trade, without 
regard to whether those positions implicate any U.S. regulatory 
interests. It is not clear that this was intended; it is not necessary 
and imposes an unnecessary burden on the CFTC.
    Section 4 also includes a reporting provision that we do not 
understand. The Commission is required to publish: ``data on 
speculative positions relative to bona fide physical hedgers in those 
markets to the extent such information is available.'' The Commission 
does not have information on hedgers who do not exceed speculative 
limits: in consequence this number is likely to be highly misleading.
Sec. 5. Transparency and Recordkeeping Authorities.
    Subpart (a) extends the reporting requirements for CFTC registrants 
beyond trading on any board of trade in the United States or elsewhere 
to include OTC ``trading of transactions and positions traded pursuant 
to subsection (d), (g), (h)(1), or (h)(3) of section 2, or any 
exemption issued by the Commission by rule, regulation or order.'' We 
agree that these transactions should not escape CFTC scrutiny but 
question whether subsection (a) is necessary in light of the special 
call provisions in subpart (b).
Sec. 6. Trading Limits To Prevent Excessive Speculation.
    Section 6 requires the Commission to: ``establish limits on the 
amount of positions, as appropriate, other than bona fide hedge 
positions, that may be held by any person . . .'' The mandatory limits 
apply to all commodities traded on regulated markets, without regard to 
whether excess speculation has ever been an issue in the commodity or 
whether it is a foreseeable danger. The standard that the Commission 
must apply is:

                  ``(B) to the maximum extent practicable, in its 
                discretion--

                          (i) to diminish, eliminate, or prevent 
                        excessive speculation as described under this 
                        section;
                          (ii) to deter and prevent market 
                        manipulation, squeezes, and corners;
                          (iii) to ensure sufficient market liquidity 
                        for bona fide hedgers; and
                          (iv) to ensure that the price discovery 
                        function of the underlying market is not 
                        disrupted; and

                  (C) to the maximum extent practicable, in its 
                discretion, take into account the total number of 
                positions in fungible agreements, contracts, or 
                transactions that a person can hold in other markets.''

    We are concerned that the bill imposes conflicting standards and 
offers no guidance to the Commission on how those conflicts are to be 
resolved other than that each is to be fulfilled to the maximum extent 
practicable. Position limits are a device to promote liquidation and 
orderly delivery in physical contracts. If position limits are not 
being used for those purposes they artificially impose restrictions on 
access to markets and are more likely to prevent prices from reaching a 
true equilibrium than to serve a positive purpose.
    Moreover, position limits are not appropriate for all commodity 
contracts. Where the final price of the futures contract is determined 
by reference to an externally calculated index that is not impacted by 
the futures market, for example rainfall during a fixed period, 
position limits cannot be justified. Most financial futures traded on 
CME Group are not settled by delivery of an underlying commodity and 
therefore are not readily susceptible to market manipulation. In such a 
case, accountability levels are more appropriate than position limits.
    Mandating position limits in non-spot month physical delivery 
contracts is unnecessary because those contracts do not have a close, 
direct impact on the price discovery function for the cash market of 
the underlying commodity. Accountability levels are sufficient to deter 
and prevent market manipulation in non-spot months.
    CME Group has numerous surveillance tools, which are used routinely 
to ensure fair and orderly trading on our markets. Monitoring the 
positions of large traders in our market is a critical component of our 
market surveillance program. Large trader data is reviewed daily to 
monitor reportable positions in the market. On a daily basis, we 
collect the identities of all participants who maintain open positions 
that exceed set reporting levels as of the close of business the prior 
day. Generally, we identify in excess of 85% of all open positions 
through this process. This data, among other things, are used to 
identify position concentrations requiring further review and focus by 
Exchange staff. Any questionable market activity results in an inquiry 
or formal investigation.
    Section 6 also requires that the Commission establish advisory 
committees with respect to agriculture based futures and energy based 
futures to advise the Commission on speculative position limits. These 
advisory committees are, by law, dominated by enterprises that have a 
direct interest in the markets on which they are advising. In addition 
to this inherent conflict, the bill offers no standard to direct the 
deliberations of these advisory committees. Instead, it puts 19 or 20 
people, with diverging financial interests, in a room and tells them to 
make a decision. We strongly oppose this process, which empowers market 
participants whose objectives differ materially from the CEA's purpose 
in establishing position limits.
    Regulated futures markets and the CFTC have the means and the will 
to limit speculation that might distort prices or distort the movement 
of commodities in interstate commerce. Former CFTC Acting Chairman 
Lukken's testimony before the Subcommittee on Oversight and 
Investigations of the Committee on Energy and Commerce United States 
House of Representatives (December 12, 2007) offers a clear description 
of these powers and how they are used:

        All agricultural and natural resource futures and options 
        contracts are subject to either Commission or exchange spot 
        month speculative position limits--and many financial futures 
        and options are as well. With respect to such exchange spot 
        month speculative position limits, the Commission's guidance 
        specifies that DCMs should adopt a spot month limit of no more 
        than \1/4\ of the estimated spot month deliverable supply, 
        calculated separately for each contract month. For cash settled 
        contracts, the spot month limit should be no greater than 
        necessary to minimize the potential for manipulation or 
        distortion of the contract's or underlying commodity's price. 
        For the primary agricultural contracts (corn, wheat, oats, 
        soybeans, soybean meal, and soybean oil), speculative limits 
        are established in the Commodity Exchange Act and changes must 
        be approved via a petition and public rulemaking process.

        http://www.cftc.gov/stellent/groups/public/@newsroom/documents/
        speechandtestimony/opalukken-32.pdf.

    Subsection (2) directs the Commission to define a bona fide hedge, 
which permits traders to exceed the hard speculative limits. Proposed 
subpart (A) pertains to hedgers acting for their own accounts. Subpart 
(B) governs swap dealers and others who are hedging risks assumed in 
the OTC market. We believe that subpart (A) has unintended and highly 
detrimental consequences respecting the ability of regulated futures 
exchanges to provide hedging opportunities for important business 
enterprises. The bill provides that a futures position does not qualify 
as a bona fide hedge unless it: ``(A)(i) represents a substitute for 
transactions made or to be made or positions taken or to be taken at a 
later time in a physical marketing channel . . . .'' This 
interpretation is compelled by the linking of clauses (i), (ii) and 
(iii) by the conjunctive ``and,'' which requires that all three 
conditions be satisfied.\1\ As a result, the provisions in (ii) and 
(iii), which currently operate as independent grounds for a hedge 
exemption, are nullified. This works perfectly for a grain elevator or 
farmer who shorts his inventory or expected crop. Futures markets, 
however, are also used for more sophisticated hedging.
---------------------------------------------------------------------------
    \1\ ``(2) For the purposes of contracts of sale for future delivery 
and options on such contracts or commodities, the Commission shall 
define what constitutes a bona fide hedging transaction or position as 
a transaction or position that--

      ``(A)(i) represents a substitute for transactions made or to be 
made or positions taken or to
  be taken at a later time in a physical marketing channel;
      ``(ii) is economically appropriate to the reduction of risks in 
the conduct and management
  of a commercial enterprise; and
      ``(iii) arises from the potential change in the value of--

        ``(I) assets that a person owns, produces, manufactures, 
processes, or merchandises or ant-
    icipates owning, producing, manufacturing, processing, or 
merchandising;
        ``(II) liabilities that a person owns or anticipates incurring; 
or
        ``(III) services that a person provides, purchases, or 
anticipates providing or purchasing;''
---------------------------------------------------------------------------
    Obviously, this limitation precludes electric utilities from 
hedging capacity risks associated with weather events by use of degree 
day unit futures contracts. That hedge involves no substitute for a 
transaction in a physical marketing channel. Insurance companies may 
not hedge hurricane or other weather risks. Enterprises that consume a 
commodity that is not used in a ``physical marketing channel'' such as 
airlines that use fuel, generating facilities that use gas and produce 
electricity, freight companies whose loads depend on geographic pricing 
differentials and hundreds of other important examples that readily 
present themselves, will not be entitled to a hedge exemption from 
mandatory speculative limits. Even if ``or'' were substituted, a 
significant number of clearly legitimate hedging transactions are 
precluded.
    Subpart (B) offers swap dealers a very narrow window within which 
to qualify for a hedge exemption. The position being hedged must 
reduce: ``risks attendant to a position resulting from a transaction 
that--. . . was executed opposite a counterparty for which the 
transaction would qualify as a bona fide hedging transaction . . . .'' 
On a practical basis, swap dealers use the futures market to reduce 
their overall risk; we do not believe that particular futures positions 
can be linked to identified OTC transactions. Thus, the utility of 
futures markets as a risk transfer venue will be seriously impaired. We 
are happy to work with the staff to devise language that will eliminate 
the use of OTC intermediaries as a mask for trading that would 
otherwise violate position limits.
    We believe that the bill's direction to the Commission to define a 
bona fide hedging transaction set out in section 6(2) is overly 
restrictive with respect to its constraints on the ability of dealers, 
funds and others who have assumed risks in the over-the-counter market, 
which are consistent with their legitimate businesses, to transfer the 
net risk of their OTC positions to the futures markets. CME Group is 
concerned that this limitation on hedge exemptions for swap dealers 
will limit the ability of commercial enterprises to execute strategies 
in the OTC market to meet their hedging needs. For example, commercial 
participants often need customized OTC deals that can reflect their 
basis risk for particular shipments or deliveries. In addition, not all 
commercial participants have the skill set necessary to participate 
directly in active futures markets trading. Swap dealers assume that 
risk and lay it off in the futures market.
    This restriction contravenes the otherwise clear intent of the 
draft bill to limit systemic risk by driving OTC generated risk into a 
central counterparty clearing context. The consequences of this 
constraint are magnified by the simultaneous imposition of hard 
position limits on financial futures that are settled by reference to 
prices that are not susceptible to manipulation, such as Eurodollars or 
currencies.
Sec. 8. Review of Prior Actions.
    Section 8 of the proposed bill imposes a burden on the Commission 
that is not justified and that will divert it from the important 
responsibilities assigned to it in section 7. It requires the 
Commission to:

        ``review, as appropriate, all regulations, rules, exemptions, 
        exclusions, guidance, no action letters, orders, other actions 
        taken by or on behalf of the Commission, and any action taken 
        pursuant to the Commodity Exchange Act by an exchange, self-
        regulatory organization, or any other registered entity, that 
        are currently in effect, to ensure that such prior actions are 
        in compliance with the provisions of this Act.''

    No guidance is offered as to what is appropriate, and we are 
unaware of any action that the Commission has taken, including those 
with which we have disagreed, that could be found to be ``not in 
compliance with the `provisions of this Act.' '' The review of the 
rules of the rules of registered entities and the NFA will be a massive 
undertaking, given the size and complexity of the rule books, 
interpretations and notices that govern the business of the registered 
entities and the NFA and the lack of direction. We are not aware of any 
significant dissatisfaction with the Commission's actions or the 
actions of the registered entities and the SRO's that would compel so 
wide-reaching a review.
Sec. 11. Over-The-Counter Authority.
    Section 11 authorizes the Commission to impose position limits on 
transactions exempted or excluded from the CEA by ``subsections (d), 
(g), (h)(1), and (h)(3) of section 2,'' if it first finds that such 
contracts are: ``fungible (as defined by the Commission) with 
agreements, contracts, or transactions traded on or subject to the 
rules of any board of trade or electronic trading facility with respect 
to a significant price discovery contract . . . .'' We are surprised by 
the use of the term ``fungible,'' which is generally limited to 
contracts that may be offset. We assume that this power should apply 
when the contracts are close economic substitutes. Second, the 
reference to the defined term ``board of trade'' rather than the phrase 
``designated contract markets and derivatives transaction execution 
facilities'' or ``registered entity'' (as is ordinarily used in the 
bill) is bound to be afforded some significance, which escapes us. 
While we are generally in agreement with the purposes of this section, 
we expect that representative of the participants in the OTC market are 
best positioned to discuss the impact of this provision and any other 
technical drafting issues.
Sec. 12. Expedited Process.
    Section 12 grants the Commission authority to act in an expedited 
manner ``to carry out this Act if, in its discretion, it deems it 
necessary to do so.'' The Commission currently has comprehensive 
authority to respond to an emergency. This provision eliminates the 
salutary requirement that there be an emergency before the Commission 
is empowered to act precipitously and we do not agree that it is either 
necessary or appropriate to grant such powers.
Sec. 13. Certain Exclusions and Exemptions Available Only for Certain 
        Transactions Settled and Cleared Through Registered Derivatives 
        Clearing Organizations.
    Section 13 is intended to force certain transactions that were 
exempted from the exchange trading requirement and most other 
Commission regulations by 2(d)(1)(C), 2(d)(2)(D), 2(g)(4), 2(h)(1)(C), 
or 2(h)(3)(C) of the Act either onto a regulated trading platform or to 
be cleared by a CFTC Designated Clearing Organization or a comparable 
clearing house. While this section appears to favor our organization 
and advances our goals, we are concerned that it will fail to produce 
the desired result and negatively impact the U.S. derivatives industry. 
We discussed this point in the introductory portion of this testimony.
Sec. 14. Treatment of Emission Allowances and Offset Credits.
    Section 14 authorizes the trading of: ``any allowance authorized 
under law to emit a greenhouse gas, and any credit authorized under law 
toward the reduction in greenhouse gas emissions or an increase in 
carbon sequestration.'' The CEA was already sufficiently broadly worded 
to permit such contracts to be traded on futures exchanges subject to 
the Commission's exclusive jurisdiction. We are concerned that the 
specific description may, in the future, be read as a limitation on the 
authority to create futures contracts relating to the greening of 
America and we believe that the Committee needs to generalize the 
language to avoid that implication.
Sec. 16. Limitation on Eligibility To Purchase A Credit Default Swap.
    Section 16, which makes it: ``unlawful for any person to enter into 
a credit default swap unless the person would experience financial loss 
if an event that is the subject of the credit default swap occurs'' is 
worded in a manner that prohibits the use of credit default swaps for 
any purpose. The language requires both the buyer and seller of credit 
protection to suffer a loss if the event were to occur and there was no 
credit default swap in place. Obviously, only the buyer of credit 
protection qualifies.
    However, even if the language were corrected, we are opposed to 
this provision as an unwarranted restriction on functioning of free 
markets. This provision punishes the instrument and legitimate users of 
the instrument for the excesses of the management of AIG. The 
instrument was innocent as were the vast bulk of the users of the 
instrument and the markets in which the instruments were transacted. We 
do not purport to be the appropriate spokesperson for the industry, but 
we can assure you that all of our plans to clear CDSs will come to 
naught if this provision is adopted.
    Credit default contracts serve an important economic purpose in an 
unfortunately imperfect manner. At the ideal level, credit default 
contracts permit investors to hedge specific risk that a particular 
enterprise will fail or that the rate of failure of a defined group of 
firms will exceed expectations. However, because credit default 
contracts are not insurance, investors who are not subject to any 
specific risk can assume default risk to enhance yield or buy 
protection against a default to speculate on the fate of a company or 
the economy generally. Credit default contracts are also an excellent 
device to short corporate bonds, which otherwise could not be shorted.
    If such contracts are executed in a transparent environment, if the 
regulators responsible for controlling systemic risk can easily keep 
track of the obligations of the banks, brokers and other participants 
in the market and if a well regulated clearing house acts as the 
central counterparty for such contracts, we believe that they can serve 
an important role in our economy without imposing undue systemic risks.
Conclusion:
    Futures markets perform two essential functions--they create a 
venue for price discovery and they permit low cost hedging of risk. 
Futures markets depend on short and long term speculators to make 
markets and provide liquidity for hedgers. Futures markets could not 
operate effectively without speculators and speculators will not use 
futures markets if artificial barriers or tolls impede their access. 
CFTC-regulated futures markets have demonstrated their importance to 
the economy, the nation's competitive strength and America's 
international financial leadership. We have the means and the power to 
protect our markets against speculative excesses and are committed to 
doing so.

    The Chairman. Thank you, Mr. Duffy.
    I thank all of the panel members for their excellent 
testimony. We again appreciate you being with us.
    I don't want to pick on you, Mr. Duffy, but, because you 
were last, on December 8th of last year you stated in response 
to a direct question from me your support for mandatory 
clearing of all CDSs. Today, however, your testimony seems to 
back away from this position in your statement that if the OTC 
dealers do not embrace clearing, they could easily transact in 
another jurisdiction. You didn't cite this concern previously; 
is this a new concern?
    Mr. Duffy. Mr. Chairman, with all due respect, on 
supporting mandatory clearing, you are right, sir, I did 
support it. But, at the same time, I did say that there are 
some products that are traded today that are not suitable for 
clearing because of the nature of the risk that they may 
present to the clearing operation.
    So, yes, we do support the mandatory clearing. I did say 
that at your Committee hearing. But we are also realistic that 
there are some products that would not benefit from being 
cleared under our umbrella, or the risk might be to a point 
where it is just not worth it for us to clear them.
    The Chairman. Well, I think the Committee understands that, 
too. That is why we proposed some exemptions. But, what I am 
trying to get at, bottom line here, is to get the risk of these 
transactions at least put out there someplace by some 
independent party so the risk doesn't end up being on the 
taxpayers again. That is where I am coming from. So we are 
probably not in that much disagreement.
    Mr. Duffy. No, we are not.
    The Chairman. A number of you mentioned these provisions on 
the ban on naked credit default swaps. Some of you don't like 
this idea. So, for those who don't like the idea, and I guess 
the ones that do, you can comment on this. There are other 
alternatives that we looked at.
    Here is where I am coming from on this: When we had this 
situation with the SEC banning the naked short selling of 
stock, I had some people tell me that by not having a similar 
ban in the CDS market we actually put some people in a bad 
situation where they couldn't basically protect themselves.
    So one of the ideas is that we would have the provision 
only apply when the SEC bans short selling of stock; there 
would also be a ban on short selling or naked short selling of 
CDSs. If that were the provision, would that change your 
position on what we have proposed, if we changed it? Mr. 
Damgard?
    Mr. Damgard. Yes, I would continue to argue that this ban 
really would dry up liquidity at a time when we don't need it. 
I am sure that the SEC has looked long and hard at their 
decision. I mean, they reversed themselves because the options 
industry came in and said, the only way we can operate is if we 
can sell short; and, as a consequence, the SEC reversed that. 
But I do think better coordination between the CFTC and the SEC 
is certainly a laudable goal.
    The Chairman. But does it create a situation, though, where 
people could move against a company if the SEC does have a 
short selling ban?
    Mr. Damgard. I would yield to Mr. Gooch on that. I think he 
is really the expert on the commodities defaults.
    The Chairman. I don't know enough about this. I know enough 
to be dangerous.
    Mr. Gooch. Mr. Chairman, first of all, you have to look at 
equities and credit in sort of the opposite role. So if you 
were banning the short selling of the equities, you would ban 
the buying of the credit derivatives. You buy the credit 
derivative because you are basically buying protection against 
a default. That would be going the same direction in the market 
as selling the equities. Because if a company defaults, its 
equities are going to be worthless as well.
    So, the concern is that when the banning of short selling 
in the financials took place, it was sort of an emergency 
situation because we were in a death spiral, which was 
contributed to by the mark-to-market rules on the banks. I 
would say that 98 percent of the time I would want to know what 
the assets my bank has are worth. But in certain very unusual 
circumstances it might be necessary to have some kind of 
circuit breaker in place that would allow some breathing room 
so that you don't have this death spiral that occurred back in 
September, when there was the buying of the credit derivatives 
and the selling of the equities. Because that would be where 
you would potentially hedge a short credit derivative position 
and, at the same time, the run on the capital of the banks, as 
their equities were declining with the necessity then to find 
liquidity. This means selling more assets in fire sales, and 
down the spiral goes.
    I would certainly think that 98 percent of the time you 
don't need to worry about this. But in situations where we are 
in a very difficult financial environment, maybe there should 
be some kind of circuit breaker that would address all the 
markets. But, at the same time, once again, you need global 
cooperation, because you can always trade these things outside 
of the U.S.
    Mr. Greenberger. Mr. Chairman?
    The Chairman. Mr. Greenberger.
    Mr. Greenberger. If I could address the question, I would 
urge you to keep the provision in the statute.
    Mr. Gooch talks about CDS buying protection. We are talking 
about naked CDS. With naked CDS, there is no need to protect. 
It is a bet that, in the case of subprime mortgages, that the 
homeowner will not pay his mortgage or her mortgage. These get 
paid off if the collateralized debt obligations fail. The 
collateralized debt obligations are a security interest in 
homeowners paying their mortgages. These are people who don't 
have the security interest in that.
    John Paulson, in 2007, took out these naked credit default 
swaps; and because there were so many forfeitures of your 
constituents, he was able to take home $4 billion that year. 
Now, he was lucky, because he got to the window when the people 
who were issuing the guarantees still had money. AIG ran out of 
money. And, by the way, you and I and your constituents are now 
sending money in the front door of AIG and Citigroup and 
others, so it will go out the back door to pay people who took 
a naked bet that homeowners would not pay their mortgages.
    Because you are having bets out there that have no 
reflection of the real economic debt, as Eric Dinallo told you, 
it is magnifying the problems by threefold, somebody says 
eight-fold. In other words, more people are betting the 
mortgages won't be paid than there are mortgages.
    With regard to your correlation between the SEC short and 
this, I believe that Chairman Cox, a former Member of the House 
of Representatives and President Bush's Chair of the SEC, wants 
to ban naked credit default swaps because it is a way to get 
around the regulated equity markets. In other words, if you 
think GM is going to fail, you buy a naked credit default swap 
on GM, even if you don't own a bond in GM. And then what do 
some of those people do? It is reported they go out and take 
every action they can take to encourage the failure of GM.
    In the case of insuring subprime loans, Barney Frank has 
made the point that when banks have gone in and tried to 
renegotiate to leave people in their houses, that hurts the 
people who have guarantees for the failure. So they are 
bringing lawsuits to prevent that renegotiation.
    These naked credit default swaps create the grossest form 
of moral hazard. From 1789, when this Republic was founded, to 
the mid-1990s we didn't have credit default swaps or naked 
credit default swaps.
    I ask you, are your constituents, when you go home, saying, 
please, please, please allow us to have naked credit default 
swaps? No. It is the bankers who got us into this problem who 
want these naked credit default swaps. They should be banned; 
and I believe if this Committee doesn't do it, it will be done 
by the SEC. And it will be the first step in the pillar to say 
the CFTC is not doing the job, let's get rid of it and put it 
in the SEC.
    The Chairman. Thank you very much. My time has expired.
    Mr. Lucas.
    Mr. Lucas. Thank you, Mr. Chairman.
    Would anyone else on the panel like to comment on what Mr. 
Greenberger just offered up? Please, Mr. Duffy.
    Mr. Duffy. I will just make a quick comment, only because I 
can't help it.
    You have to look at what happened here. When you talk about 
naked credit default swaps and credit default swaps in general, 
what we have proposed is to have a clearing mechanism for 
credit default swaps, which we think eliminates a lot of the 
risk associated with these products.
    What is critically important for credit default swaps or 
any other product is liquidity. If you don't have liquidity, 
bona fide hedgers are not going to be able to move in and out 
of their positions at all. Because the bid offer will be so 
wide you won't be able to transact any business, whether it is 
in grains, crude oil, or credit default swaps. So these people 
are essential to both sides of the marketplace.
    So, when we talk about mandatory clearing of these things, 
it is a little bit different than a bilateral transaction by 
AIG, who was completely under-collateralized and didn't have 
the risk management capabilities to facilitate this market, of 
which they were only two percent of the entire CDS market. So 
there are a lot of differences in here that need to be cleared 
up.
    Thank you, Mr. Lucas.
    Mr. Damgard. It is a slippery slope. I mean, Mr. 
Greenberger confuses manipulation with speculation. Clearly, a 
stockholder of General Motors is entitled to sell his stock. 
But should only a stockholder of General Motors be able to sell 
that stock, or should somebody be able to speculate outside of 
whether or not he is a current stockholder or not?
    I mean, it seems to me Mr. Duffy is absolutely correct. At 
a time when credit is so tight, anything that limits the 
liquidity of the credit market is a bad idea. I am simply 
willing to debate Mr. Greenberger anytime, but I don't know 
that this is the right place.
    Mr. Greenberger. Well, Mr. Damgard should not only debate 
Mr. Greenberger, but he should debate Mr. Volcker, and Mr. 
Greenspan, who has said, ``I made a terrible mistake when I 
allowed these credit default swaps to be deregulated.'' He 
should debate Mr. Cox, who was Chair of the SEC. He should 
debate Mr. Geithner, who has now talked about putting these 
things----
    Mr. Damgard. This is wasting time.
    Mr. Greenberger. Mr. Damgard, the American public is flat 
on its back. They don't have a fancy suit and a fancy tie and 
represent all these bankers. Please let me finish my statement. 
You interrupted and said that the Committee didn't want to hear 
what I had to say.
    Mr. Damgard. I didn't say that.
    Mr. Lucas. Gentlemen, I control the time as the questioner. 
You may proceed. But there will be a fair and equitable 
distribution of time for everyone to respond.
    Mr. Greenberger. Thank you, Mr. Lucas.
    I just want to say the American taxpayer has now guaranteed 
$6 trillion of the banking system. A large part of that amount 
is unregulated credit default swaps.
    Mr. Volcker says that Mr. Greenspan, who was a great 
advocate of them, has said, ``I made a terrible mistake.'' Mr. 
Cox, a Republican, who was a Member of your House of 
Representatives, has called it a regulatory black hole and in 
September urged immediate action.
    There is an exemption provision in your draft discussion. 
If any of these naked credit default swaps are so important to 
liquidity--and, by the way, the liquidity here is being given 
by the American taxpayer. These credit default swaps are 
operational today because we, as taxpayers, are giving AIG, 
Citigroup, Bank of America, and Merrill Lynch money to pay off 
these bets. They have no economic purpose. They have dragged 
the country into a mire.
    Two percent of the market--there are estimates out there 
that for every one credit default swap insuring real risk, 
there are eight that are bets that mortgage homeowners will not 
pay their mortgages.
    Mr. Lucas. Thank you, Mr. Greenberger.
    Mr. Greenberger. I think that is a terrible thing. It 
creates high moral hazard, and the Chairman is absolutely right 
in putting that provision in his draft discussion bill.
    Mr. Lucas. Mr. Gooch, do you have any thoughts?
    Mr. Gooch. Yes. I think that there is a danger in doing 
something drastic with a marketplace that exists now that is 
very liquid, and has actually functioned very well throughout 
the credit crisis.
    I would just like to point out that the taxpayer, in any 
case, in the United States of America, 50 percent of the 
country doesn't even pay taxes under Obama's tax plans; and so 
they are not picking up the tab. During the boom, when things 
were going very well and profits were being made, the 
government was taking a 35 percent corporate tax, the 
government was taking 38 percent, 35 percent taxes on incomes, 
and 15 percent capital gains. So, during the boom times, the 
government was taking more than 50 percent of the upside.
    And when you go through a cycle, which this one happens to 
be extremely severe, the government needs to then become 
involved in stepping in and paying their fair share in 
stabilizing the marketplace. But to step in now and kill the 
credit derivative market at this point in time where we are 
very delicately trying to get banks to lend, and they won't 
lend until they get these bad assets off their balance sheets. 
All this money that is sitting on the sidelines is willing to 
sell credit derivatives, which reduces cost of borrowing; and 
they won't be willing to sell them if they can't buy them 
naked. You will kill the credit derivative market and, in my 
opinion, extend the recession, possibly even creating a deeper 
recession for a very, very long period of time.
    Mr. Lucas. Thank you, Mr. Gooch.
    If the Chairman will indulge me, Mr. Cota?
    Mr. Cota. Let me be very brief.
    These are very complex financial instruments; and, to the 
extent that they are complex, don't just give up and let it 
pass. It is the scale of these that are staggering. The 
estimate for the credit default swaps is somewhere between $40 
and $60 trillion of value. If you add in the other derivatives 
that may apply under this regulation, it could be as high as 
$500 trillion, according to some news reports. Those are so 
many times the size of the U.S. GDP or even world GDP that it 
is so significant that it needs to be dealt with. And that is 
where my expertise ends.
    Mr. Lucas. Thank you, Mr. Cota. I yield back.
    Mr. Boswell [presiding.] Thank you, and I appreciate the 
discussion.
    Mr. Marshall.
    Mr. Marshall. Thank you, Mr. Chairman.
    Mr. Gooch, in your testimony you said that if the major 
investment houses had failed, in your opinion, the 
clearinghouses, the various futures exchanges, would have 
failed as well. That would mean CME, Mr. Duffy. I think that 
was what Mr. Gooch had in mind.
    You also have this statement, since the large banks and 
prime brokers represent the bulk of the clearing capital at 
risk, it makes sense that a clearing solution provided by those 
banks with a high degree of transparency on pricing and mark-
to-market makes the most sense.
    Could you elaborate a little bit about that?
    Mr. Gooch. My point with the state of the environment about 
the credit clearing, so it would be the clearing house in the 
various futures exchanges, that these large banks and 
investment banks and SCMs, their capital is ultimately at risk 
if there is a demand on the capital of the clearing facility.
    I think the CME has $7 billion of clearing capital, and 
then after that it is the margin money that is on deposit, and 
then after that it is the capital of the various banks. So it 
is a horrible Armageddon concept, but had there been a major 
banking failure, which is what Secretary Paulson was concerned 
about, that weekend towards the end of September, a couple of 
weeks after Lehman had failed, that if certain investment banks 
had gone into bankruptcy similar to Lehman, and then there had 
been a domino theory through the banking system, the futures 
markets would have gapped wildly.
    The margin money on deposit would not have been sufficient 
to make good on all of the positions in the futures market, and 
then you would have been going for the very capital of the 
failing banks. So the clearing facility would collapse with the 
banking system, and you would simply end up bailing out the 
clearing system.
    Mr. Marshall. You have heard many commentators, Professor 
Greenberger being one, saying that we are exposed to a huge 
systemic risk as a result of these naked CDSs. The Chairman has 
suggested one possible solution, which is simply to ban the 
naked CDSs. The response is very much like the argument that we 
had last summer concerning the underlying bill to which we have 
added the CDS provisions, and that is that traditional 
speculation is necessary for liquidity in these markets. It can 
provide all kinds of benefits. One suggestion that has been 
made is that if the naked CDSs are all on-exchange, they are 
all cleared, the systemic risk posed by naked CDSs would be 
diminished substantially. Do you agree with that?
    Mr. Gooch. I don't necessarily agree that----
    Mr. Marshall. You don't agree that there are substantial 
systemic risks presented by making the----
    Mr. Gooch. I think having the instruments in a central 
environment where you can see everything optically is helpful 
for regulators so they can see where the risk lies. But, 
certainly, margining for credit default is very complex. I 
mean, I give the example of Lehman. Their senior debt was 
trading at 85 cents on the Friday before they went into 
bankruptcy, and on Monday morning it was trading at 11 cents. I 
don't see how you could effectively margin for that level of 
price move over the weekend.
    Mr. Marshall. What some are searching for here is a 
compromise position where folks like you could say, by adopting 
the compromise, the exposure--and not necessarily the market 
manipulation part of this, which is a separate question. Mr. 
Damgard is right about that--but the exposure that we have 
caused by this notional value, which is huge, has diminished 
substantially.
    Are you suggesting that it really doesn't matter whether or 
not you have an elaborate clearing mechanism set up, you are 
still exposed; there is no way to lessen the exposure 
systemically?
    Mr. Gooch. I still think there is potential risk, but my 
point is that you do need the major banks whose capital is 
ultimately at risk in that clearing mechanism to be cooperating 
with the clearing process. That is my point.
    Mr. Marshall. Do they need to be the members?
    Mr. Gooch. They are the members, but, that you definitely 
require their cooperation. But you also require global 
cooperation, because these instruments are also traded 
throughout Europe. So you can't have a clearing mechanism that 
considers that all of the transactions are only in the U.S.
    Additionally, of course, there are highly illiquid 
instruments that just dump themselves for clearing, and that 
the financial system benefits from the willingness of investors 
to put capital at risk that provides liquid markets. I am a 
free marketeer myself, so I believe that it is important to 
have free liquid markets. If you create price controls, you 
create shortages.
    This price control, which is what it would amount to be, 
would be creating a shortage of credit. You know, blaming the 
CDS is like shooting the messenger, because the CDS were the 
instruments that were certainly used in the financial markets, 
but there was no ultimate failure in the CDS market. The CDS 
markets performed perfectly.
    What is failing is the mortgages and the lending that was 
done to persons that shouldn't have been borrowing. And to that 
extent we have a sort of global responsibility for having just 
enjoyed living beyond our means and having a massive global 
credit bubble, and that credit bubble also drove oil prices to 
$140.
    I mean, until it burst, investors overseas that would be 
concerning themselves with the future needs of the growing 
economy in countries like China, buying up oil reserves, was 
what partly was driving the price of oil.
    So it is not the credit derivatives that are at fault, it 
is the entire free, cheap credit in the system that was the 
problem.
    Mr. Marshall. Thank you, Mr. Gooch. My time has expired.
    Thank you, Mr. Chairman.
    Mr. Boswell. The chair recognizes the gentleman from Texas, 
Mr. Neugebauer.
    Mr. Neugebauer. Thank you, Mr. Chairman.
    I want to go to kind of an example here, because I heard 
several of the panelists saying that these are challenging 
credit times, and so we don't want to do things that could 
inhibit the credit markets.
    Mr. Cota, I was actually thinking about your company as I 
was going through that scenario in that there are a lot of 
companies around the country who may have very, very large 
contracts with one or two customers that make up a huge risk to 
that company. So, they go to their banker, and they ask their 
banker to factor their receivables, or to loan them operating 
money, based on the amount due them by some of these very large 
companies.
    Now the banker, if he is trying to work with you, may try 
to hedge his risk to your customer, because he knows that, ``so 
goes your largest customers, so goes you.''
    So, when we start limiting the ability for lending 
institutions, or the people they provide capital to in this 
very choppy water, we are, in fact, inhibiting the ability for 
the financial systems and the financial institutions to help 
us.
    Now, government's role here is transparency and integrity, 
but I have heard people say that we need to control these 
markets. Well, I certainly think you don't want the United 
States Congress controlling these markets. Is there something, 
is there a flaw in my thinking on this, Mr. Duffy, or Mr. Cota, 
do you want to respond to that as well?
    Mr. Cota. Yes. With regard to risk of customers and those 
sorts of issues, that risk did present itself. In July, prices 
had stayed where they were at. Just my possible margining of 
positions would have created a huge cash-flow issue that most 
banks would not have loaned into. Generally what banks will do 
is they will loan on the basis of inventory and assets, the 
principal asset being the receivables. They took a look at the 
amounts required at that point for our industry; it would have 
been multiples of company values. So the bank also looks at 
what the underlying company value is, because the receivables 
go to a zero value if you don't stay in business, so that is a 
risk.
    On the positive side of how it affects banking, it is the 
largest banks that have dried up the liquidity in our markets. 
My market region, actually the small business banks and the 
small banks in our region are deposit-based lending, so they 
have tons of money. They are actually encouraging me to go out 
and do additional work right now to deploy capital that they 
need to put to work. It is only the large financial 
institutions that didn't have prudent reserves in order to be 
able to do that.
    So the impacts and risks are there. I think that if you are 
prudent, and you don't necessarily give authority to Congress, 
but to the CFTC, we can get more of those credit requirements 
that would lend itself to prudent business relationships.
    Mr. Neugebauer. Thank you.
    Mr. Duffy.
    Mr. Duffy. I agree with Mr. Cota, what he said.
    Again, from our standpoint, liquidity, as we talked about 
it earlier, is critically important to our participants. What 
we had seen throughout some of the increase in prices is really 
the credit prices affecting our clients where they weren't able 
to get credit to finance the hedges they had on the books of 
the exchanges, and in return they had to liquidate those 
positions.
    So that is one of the things we have seen. But it is not so 
much a fundamental flaw of the price or the product; it is the 
fundamental flaw in the credit. We could not get the credit.
    Mr. Neugebauer. Don't, in fact, these CDSs in many ways 
provide some other tools for people to manage those risks?
    Mr. Duffy. Yes, they do. Credit default swaps are a very 
valuable tool in this economy that we live in. Just maybe to 
touch on it real quick, one of the things that we think about 
with clearing these products, we eliminate the systemic risk 
associated.
    One of the things that Mr. Gooch didn't mention is that we 
would not clear these like traditional futures contracts. We 
are talking about having 5 days' margin up. We are talking 
about a minimum $300 million per account. We are not talking 
about having $25,000 like you would margin an S&P futures 
contract.
    So there are huge fundamental differences in clearing 
credit default swaps that are S&Ps, crude oils or grains. So we 
think that by netting it down, we have already figured we could 
net the credit default swap market down by a factor of 5:7 by 
compressing it in our clearing house. It is already at $27 
trillion and shrinking off of $63 trillion.
    So this is a market that we think, with our expertise, we 
could certainly manage risk much better and help free up more 
credit and go through the system.
    Mr. Neugebauer. Mr. Damgard, do you want to respond to 
that?
    Mr. Damgard. Yes, I would agree with that as well. Even Mr. 
Buis' part about corn, I mean, the reason you couldn't sell 
your corn is--and I sold some over $7--because the elevators 
don't own the corn. The elevator is storing the corn for the 
farmer. The farmer wants his money, and the elevator goes to 
the bank or the CoBank, and they say, ``We can't loan you any 
more money because you don't have the assets to put up.''
    So to the extent that all of this really relates to credit, 
it seems to me whether it is the cotton market or whether it is 
the corn market, the last thing we want to do is tighten up on 
the credit market right here. I agree with everything Mr. Gooch 
had to say.
    The Chairman [presiding.] I thank the gentleman.
    The gentleman from Wisconsin, Mr. Kagen.
    Mr. Kagen. Thank you, Mr. Chairman. Thank you very much for 
holding this hearing.
    Mr. Buis, you have been sitting on the sidelines here for 
about the last 45 minutes. How are things really working for 
farmers and farm families across the country?
    Mr. Buis. Well, thank you, Congressman. I was enthralled by 
the debate that was going on here, and certainly trying to 
follow along on those credit default swaps.
    Things on the farm are not good, and this deregulatory 
approach, or the lack of oversight by CFTC, has led to it. 
Farmers thought they were going to get good prices. They were 
precluded from the market, and Mr. Damgard is right, they ran 
up against their credit limits.
    But what they don't tell you is that those markets were 
going up, not because of market fundamentals, but because of 
the tremendous amount of Wall Street money that came into those 
markets. And everyone saw this as a great opportunity to make 
money. As a result, you gave false hopes to the grain farmers 
that they were going to get these prices. They were precluded. 
You gave false hopes or big scares to the livestock industry 
because they thought the prices were going to continue to go 
higher and higher, so they locked in feed costs. You gave false 
hope to the ethanol industry, the biodiesel industry, all the 
processors that, to hedge themselves, they paid higher prices 
because the big fear was that it was going to continue. And 
when the bubble burst, and when commodity prices collapsed, it 
has virtually impacted every aspect of agriculture.
    Mr. Kagen. So now your input costs are higher than the 
price that the farmer----
    Mr. Buis. Absolutely.
    Mr. Kagen.--is going to receive, so they are in a losing 
position.
    Mr. Buis. In a very losing position, and they are locked 
into these higher costs, whether it is livestock producers or 
grain producers. Buy fertilizer based on record inputs, and 
fertilizer prices followed oil, and we all know that was a 
false bubble as well.
    Mr. Kagen. When do you expect the consumers to feel the 
impact of that?
    Mr. Buis. Well, the irony is consumers aren't feeling the 
impact. You know, wheat prices were $23 a bushel on the 
Minneapolis Exchange last winter. They are now down around $6, 
and the price of a loaf of bread has gone up over $1 this year. 
So that would be another subject for another hearing, Mr. 
Chairman, Members of the Committee.
    Mr. Kagen. Mr. Greenberger, Mr. Gooch has suggested that 
the credit derivatives market is transparent. Do you agree with 
that?
    Mr. Greenberger. I don't, I don't, and I want to make a 
point about the worry about credit.
    We know today there is no credit in the markets. Why is 
there no credit in the markets? Because everybody is worried 
that somebody else holds these private, bilateral contracts 
that have nothing to do with helping people get mortgages. They 
are simply bets that people won't pay the mortgages, but they 
are trillions of dollars of debts.
    If Lehman Brothers fails, if Bear Stearns fails, if Fannie 
and Freddie fail, if Citigroup has spent $300 billion of their 
troubled assets thing, everybody is saying to themselves, we 
can't loan to anybody because anybody may fail.
    Mr. Kagen. And isn't it true that the notional value of 
those potential assets are far greater than the real estate 
holdings, the real market value?
    Mr. Greenberger. Absolutely, because people are betting. It 
is just like when you say in the Super Bowl, how much money is 
at risk----
    Mr. Kagen. Please, let me follow up on a statement by Mr. 
Gooch, that the banks are illiquid primarily because of the 
unknown market value of the paper, bad paper, toxic assets that 
they are holding, because those things haven't been marked-to-
market, those things are unsellable at a market price that they 
can come out with any profit on; isn't that true?
    Mr. Greenberger. That is exactly right. If you have the 
legislation that this Committee has proposed would give those 
credit default swaps that are traded--and, by the way, if you 
have risk, in other words you have loaned money, and you want 
to make a risk against it, you can go on Mr. Kelly's exchange 
and buy a credit default swap.
    If you don't have risk, that is the question, should you be 
able to bet that people won't pay their mortgages or that GM 
will fail?
    Mr. Peterson, in his draft bill, is saying betting is for 
Las Vegas, not for the exchanges. By the way, Las Vegas, if 
they regulated the stuff, would have never gotten into the 
trouble that AIG had. Or, for that matter, if the Mafia had 
done this, they would have balanced their book.
    Mr. Kagen. Well, I am going to assume they are not in the 
room, but they might be watching.
    Mr. Greenberger. Okay.
    Mr. Kagen. But coming back to the point that was made by 
Mr. Gooch, and that was that the mortgages have failed and not 
the CDSs, it is just the opposite, because the notional value 
that is a result of the CDS activity is far, far greater, 
perhaps to the tune of $50 trillion greater, than the 
underlying assets of the mortgages in the paper.
    I see my time has expired, and I apologize for going over 
if I have. But, Mr. Gooch, if you would like to make a comment, 
do you stand by your statement that it was the mortgages that 
have failed that have helped to create this illiquid condition 
throughout the global marketplace and not the derivatives 
markets?
    Mr. Gooch. Yes, I do. The CDS is a specific type of credit 
derivative that I am concerned about the elimination of the 
naked risk. If you went to that extent, then I guess you could 
disallow disinterested parties from buying and selling stock 
options or shorting stocks. And you could just do the same 
thing in the foreign exchange markets and the bond markets, and 
have the same thing in the agricultural markets and have no 
liquid markets.
    My concern with the elimination of the naked-risk trading, 
the elimination of it in the CDS market, is once you do that, 
you take the risk-taker and capital provider out of the 
equation, right now I take the contrary view to Mr. Greenberger 
that the credit derivatives are not the reason the banks aren't 
lending. The banks aren't lending because they are concerned 
about their capital requirements. You have mark-to-market, 
which I said in normal markets makes sense, and they are 
reluctant to put money out on the street because they can't get 
it back in a moment's notice; and they don't want to go to you 
guys for very expensive preferred equity, so they are sitting 
there not lending. Finally enough, the only lenders in the 
market are the providers of credit default swap protection that 
are still very willing to provide that protection, and that is 
making it possible for some of the most secure credits to be 
provided with capital. It is also allowing for these very banks 
to protect some of their risk they have with certain lending 
relationships they have now, which, otherwise, they might 
curtail to an even greater extent.
    So, as you know, I only have 18 percent of my business in 
credit derivatives. If it disappeared tomorrow, we would find 
something else to intermediate, probably carbon credits. So I 
am not speaking from my own personal best interest, I am 
actually talking about the U.S. economy and the global economy.
    My concern, as an independent, neutral marketplace for 
credit derivatives, is that if you take it away, you are going 
to really significantly damage the very fragile credit market 
we have now.
    Mr. Kagen. Thank you for your comments, and I would finally 
say that once we restore confidence to the marketplace by 
providing transparency, we might be able to unfreeze some of 
that credit. Thank you.
    The Chairman. Thank you.
    The gentleman from Texas, Mr. Conaway.
    Mr. Conaway. Thank you, Mr. Chairman.
    At the risk of beating a dead horse, section 16 does give 
me some pause if for no other reason than a ban on any other 
kind of otherwise legal activity is always troublesome. I would 
like some comments as to if, in fact, we do institute this ban, 
what instruments take these CDSs' places in the market? We have 
some very bright people out there who will find something else 
that you and I aren't thinking of right now, perhaps, to do 
that.
    Most of the comments seem to be as a result of the scale 
and the size of this thing. My view--and I would like your 
comments--if we had the normal reserve and capital requirements 
that insurance companies have to abide by when they sell an 
insurance product--and the CDS is an insurance product--and you 
had those capital requirements in place, and then you had on 
top of that the margin requirements on exchanges that further 
add a protection, that would drop the scale of these things 
back. You would still allow them to do it, still allow the 
activity to go on.
    I had a conversation yesterday with a friend from Fort 
Worth, Texas, who is one of those dreaded hedge funds guys. He 
and two of his buddies scraped together some capital about 10 
years ago, and they have been able to parlay that into a lot of 
money for themselves and their clients, and nothing wrong with 
that. They are long in the stock market, in this instance 
mining stocks. They use credit default swaps as a hedge, in 
their mind, a legitimate hedge, to offset the perceived risk in 
that, and it worked on their behalf.
    So, comments on capital requirements or reserve 
requirements for folks who write the original contract, CDS, 
and then as well as the impact the margin requirements would 
have on stabilizing these things so that if there is a loss, 
someone other than the American taxpayer pays that loss off.
    Mr. Duffy.
    Mr. Duffy. Thank you, sir.
    Maybe the answer to your first question is what new 
products would they come up with to trade if there was a ban on 
credit default swaps or others. I don't think they would. I 
think they would just trade them someplace else, such as in 
London. So they would continue to trade the product of credit 
default swaps.
    Second, I think capital requirements are essential and 
reserves are essential for this product. We still believe this 
is a very viable product for participants to use to manage risk 
in credit default swaps.
    But, again, when Mr. Greenberger says that Chairman 
Volcker, Mr. Greenspan, Mr. Geithner, and others have said that 
these things should be banned, that is not true. What they have 
said is they need to be regulated, not banned.
    And, that is going to what you are saying, Congressman. We 
need to come up with ways to make sure there is transparency 
and people can use risk management for these products so we 
don't have systemic risk so it is coming back for the taxpayer 
to be bailed out.
    So we completely concur with that, we agree with that. No 
one likes going back to the government to be bailed out. We 
believe that a cleared model for credit default swaps makes 
complete sense, recognizing that there are certain ones that 
are just not potentially clearable, and we may have to trade 
off-exchange.
    Mr. Conaway. Mr. Damgard.
    Mr. Damgard. I would agree. I would say there are a lot of 
legitimate businesses out there that used the futures market 
and used credit default swaps for their own protection, as you 
just evidenced. The credit default swaps are not going away. 
There are very, very fine markets outside of the United States, 
both in the listed derivatives business and the unlisted 
derivatives.
    It seems to me anything we do to encourage people to use 
markets outside of the United States diminishes the CFTC's and 
the SEC's ability to see what is going on. This would be a 
perfect example of taking business that is creating jobs in the 
United States, it is providing liquidity, and moving it 
offshore.
    Mr. Conaway. Mr. Greenberger, 30 seconds max.
    Mr. Greenberger. I would just say I agree with you 
completely about capital requirements. Your state insurance 
commissioners are doubtless right now thinking that the CDS is 
insurance of a risk or unlawful insurance of no risk.
    If there were capital requirements, that would be very 
helpful. If there were collateral requirements, that would be 
very helpful.
    Mr. Marshall is looking for a compromise here. If you 
require people who entered into these transactions to have the 
capital to pay them off and collateralize their things, yes, 
that would be an adequate substitute to an absolute ban.
    Mr. Conaway. Thank you, Mr. Greenberger.
    Sections 4 and 5 talk about detail reporting, transparency 
and that kind of thing. I am a CPA by background, and one of 
the ways to whack somebody is to regulate them to death, and I 
am not experienced enough in this kind of reporting to 
understand that--are we overreaching, Mr. Duffy, Mr Gooch or 
Mr. Damgard? Talk to us about sections 4 and 5 real quickly. Is 
that too far, is that okay, is it a subject you can comply 
with?
    Mr. Gooch. I am not entirely sure what sections 4 and 5 say 
because I was focusing on 14 and 16.
    Mr. Conaway. Okay.
    Mr. Gooch. But I would just like to add that I do support, 
and my firm is in favor of, what the Committee is trying to 
achieve in trying to find transparency and regulation in the 
marketplace. My concern is simply not banning something in some 
kind of knee-jerk reaction that could actually do more damage 
than good.
    Mr. Conaway. Mr. Duffy, 4 and 5, you guys, can you confer 
with that?
    Mr. Duffy. You know, I had to just confer with counsel, but 
right now, sections 4 and 5, it just is a lot of daily 
reporting activities. We don't have issue with what you are 
doing on these two sections, sir.
    Mr. Conaway. We would like, if there is anybody else out 
there that has any comments about how they would actually 
comply with that, and if that is such a stifling burden, we may 
adjust it.
    Thank you, Mr. Chairman, I yield back.
    The Chairman. I thank the gentleman.
    Mr. Schrader, the gentleman from Oregon.
    Mr. Schrader. Thank you, Mr. Chairman. I appreciate that. I 
guess I am concerned about some of the credibility of what we 
have heard today.
    I mean, I am a new Member. I won't pretend to understand 
some of the arcane notions of derivatives and futures trading, 
but I do know that for most of this country's history, we 
didn't have any credit default swaps, and we seemed to get 
along okay.
    I also find it interesting that most of the people affected 
by naked default swaps are in favor of this legislation, namely 
the agricultural community and the petroleum marketers. That 
speaks volumes in itself to whether this is, as such, a bad 
piece of legislation, and it is so incomplete in its scope. I 
am curious why the people that are most affected seem to be 
totally in favor of most of this piece of legislation.
    To me, I guess I need to hear from Mr. Damgard, Mr. Gooch 
and Mr. Duffy. Do they or do they not believe that speculation, 
rampant speculation, speculation holocaust is indeed part of 
this problem that we are enduring right now in this economy.
    When I hear people, Mr. Duffy, say CDS is a very important 
tool in the economy we live in, well, I would suggest that the 
economy we are living in is not too good right now. I do not 
subscribe to that philosophy of the CDSs, or certainly naked 
CDSs. My folks back home would ban them. They would get rid of 
hedge funds, they would get rid of CDSs altogether. I 
understand that there is somewhat of a lack of understanding in 
some of the way the market works right now. But I certainly 
think that this modest proposal is certainly acceptable, and I 
guess we need to hear from you gentleman if you don't think 
that speculation, rampant speculation, has anything to do with 
the problems on our farms and our petroleum marketers, gas 
stations back home.
    Mr. Damgard. Well, I would say speculation has been 
demonized to the point where people think speculation is the 
same thing as manipulation. We speculate all the time by buying 
stocks, selling stocks. The people that are using futures 
markets historically, Mr. Congressman, have been institutional 
users that know precisely what the risks are, and they use 
those markets for price protection.
    We have seen those markets expand every year for the last 
20 years with one exception, and it is really a credit to this 
Committee and the education that has gone on that has gotten 
more and more people involved in these markets that are used 
primarily by people that are managing risk.
    Now, without speculators, they wouldn't be able to do that, 
and the spreads would widen.
    So speculation is----
    Mr. Schrader. I am talking about rampant speculation versus 
investment; it is a big difference.
    Mr. Damgard. I think you have to trust the CFTC. There are 
spec limits on speculative traders that are not there for the 
hedgers. The CFTC has a pretty admirable history in making sure 
that these markets have worked as well as they have. Random 
speculation, or outrageous speculation, is something that, in 
my judgment, is left to the decision of the people in the 
Surveillance Department of the CFTC, and to legislate hard and 
fast rules, particularly as these markets expand, is pretty 
dangerous.
    We want speculators in these markets. We want hedge funds 
in the markets. We want pension funds in the markets. Clearly, 
an awful lot of the money that was made in the rise in the 
price of oil was pension funds and endowment funds that had 
deserted the equity markets. The people that manage those 
endowments recognized that there was more opportunity in the 
commodity area.
    There have been a lot of adjustments in our market since 
the advent of electronic trading. It used to be that certain 
markets, particularly when it was floor-based, were kind of a 
club. With electronic trading, everybody that has access and 
money to an account with a clearing member has the opportunity 
to invest in whatever they want to invest in.
    Mr. Schrader. I appreciate the testimony.
    I would like to hear from Mr. Gooch and Mr. Duffy. I 
understand rampant speculation is okay with you.
    Mr. Gooch. No, certainly not; that is subjective. I would 
not be in favor of rampant speculation. I mean, there are 
situations where the Hunt brothers cornered the silver market 
way back in the past. Clearly there has to be some regulation 
in that respect. I don't think you can just have--when you use 
the words ``rampant'' and ``holocaust,'' obviously, that would 
be bad. But to then take all speculation----
    Mr. Schrader. I think it is pretty bad right now.
    Mr. Gooch. Well, you say that, but at the same time the 
United States, even in this significant downturn, still has the 
highest standard of living in the world.
    Mr. Schrader. Well, we are going the other way as hard as 
we can.
    Mr. Gooch. The entire world was over-leveraged and went 
through a credit bubble that may have significant causes other 
than the various instruments that we used to transact the risk.
    Yes, I completely support the concept of centralized 
clearing, but I agree with Mr. Duffy, not all products could be 
put into centralized clearing. Regulation, transparency and 
limits, limits on positions relative to capital and things like 
that, those things all make sense.
    Certainly, AIG should not have been selling credit default 
swaps and pocketing the premiums and treating it as if it was 
income. They should have been far more conservative. But there 
is always, throughout history, the case of either individuals 
or corporations or governments that overspeculate, and they 
should be held to some kind of limits.
    The Chairman. I thank the gentleman.
    The gentleman from Ohio, Mr. Latta, has he left?
    Mr. Duffy. Mr. Chairman, may I make a comment, sir?
    The Chairman. Yes.
    Mr. Duffy. I didn't have a chance to answer the 
Congressman. I think it is important for the record that I do 
so, right, because he talked about not having credit default 
swaps around or anywhere else as of 10 or 11 years ago, and 
that is absolutely true. But you also have to remember that 
product innovation in financial services is as critical as it 
is to research and development of any other business. So in 
order for economies to grow, we need to have new products that 
people can manage their risk properly with that to help us 
continue to grow and bring us into new centuries. So, that is 
really important for product innovation to move forward.
    And as far as rampant speculation, when you look at 
regulated exchanges with limits proposed on their trading, 
spending a big part of a portion of their own budgets--we are 
public companies--to make certain that we don't have rampant 
speculation that could turn into manipulation, it is critically 
important to the success of any publicly traded company such as 
CME Group.
    So, no, we don't condone excessive speculation or rampant 
speculation, as you put it, sir, but we do believe that there 
is a buyer for every seller, a seller for every buyer. The more 
liquidity there is, the better price the person that is trying 
to hedge their risk will get for the product.
    Thank you, Mr. Chairman.
    The Chairman. Thank you.
    The gentleman from Nebraska, Mr. Fortenberry.
    Mr. Fortenberry. Thank you, Mr. Chairman, for holding this 
very important hearing and for delving very deeply into this 
complex issue, and I thank the panel as well for the lively and 
informative exchange. It has been very productive.
    When gasoline went over $4 in Nebraska last year, I stopped 
in to see Bill Sapp. He does something similar to you, Mr. 
Cota. Any of you who have gone down Interstate 80 right outside 
of Omaha might see a big coffee pot sitting 100 feet in the 
air. That is Bill's business. I said, Bill, what is going on, 
and he said, speculation.
    I want to follow up with your comments, Mr. Cota, talking 
last year when we hit $140 or so on oil futures, and now we are 
back down to $40. Your suggestion that this is being driven by 
greed and fear, being untethered from any supply or demand 
conditions, simply being accelerated because of artificial 
factors, outside, again, of the underlying fundamentals, led to 
such disruption not only in terms of gasoline prices, but all 
of the other commodities. And you, sir, had mentioned 
consequences for the other agricultural markets.
    If we presume that is true, and last year we held numerous 
hearings on this with the CFTC to figure out what systemically 
was potentially failing, where has regulation gone wrong. Their 
conclusion was we can't find a smoking gun, but we need more 
time and more help to potentially find a smoking gun.
    Let us unpack the reasons for, again, that rapid spike in 
speculation that everyone agrees has been terribly disruptive 
and not normal. Mr. Gooch, you alluded to it, to a portion of 
the reason, maybe the significant portion, in terms of credit 
and credit bubbles and investing in commodities as an 
inflationary hedge or for other reasons, because people were 
just getting on this accelerating train.
    If we can get to that underlying question, and then we know 
a lot more as to how to potentially prevent this type of 
systemic failure, disruption into the future, which has been, 
again, underlying a big portion in this economic malaise that 
we are in.
    Mr. Cota. Congressman, first with regard to your comments 
on the CFTC in that they didn't have enough information in 
order to determine whether or not there was speculation having 
an impact, that is because they don't have jurisdiction over 
large chunks of the market through various--closing the Enron 
bill does take part of that, but those administrative rules are 
not in place yet, and it still exempts the lending loophole in 
all of those. So until you start counting the whole pie, it 
doesn't make any sense.
    The case of Amaranth, which was a hedge fund that went bad, 
they only got caught because they did some of their trades upon 
a regulated exchange, a subsidiary of the Chicago Merc, the New 
York Mercantile Exchange, where they were cornering--it was 
perceived that their positions were too large for the February 
contract.
    In retrospect, after an investigation, it turned out that 
they had 80 percent of the U.S. total natural gas production 
for the February contract, just for their position. So until 
you see what these aggregate position limits are of these large 
entities, and you keep track of it, that is the only time you 
can bring it to the light of day. I like to have exchanges do 
most of this, because you put all of the players together in 
the same room, and they know what is going on. When they see 
somebody is going to put them at risk, they are going to be 
much more diligent and make sure that person doesn't.
    As to what started the whole process, we started when the 
subprime market went bad, so people needed to put their money 
as they sold out of that. The banks that lost money on that 
initially lost because they had loaned money to people to buy 
these subprimes, and then they decided it went as high as 
possible, so I had better short it.
    So they shorted it. People they loaned money to went bad. 
People needed to move money out quickly. Any pyramid collapses 
faster than it went up, and then they went into their remaining 
items. The remaining investments were equities at that point, 
so in 2007 you saw a bump in equities. As that started to come 
apart, it moved into currencies and commodities. It was the 
only thing that was cash. As people became afraid of everything 
else, a stock may go to zero, Lehman may go to zero, a 
commodity will never go to zero. It may go to 2 cents on the 
dollar, but it won't go to zero.
    So the investing world was so afraid of any sort of 
investment. The banks didn't trust one another so that they 
went into the few things that they thought were left. That, to 
me, underscores the issue that you need to have sensible 
regulation.
    The world looks to the United States to have the most 
coherent regulation of financial markets in an open and free 
market--so that you can trust your money is going to be worth 
something. The other markets around the world don't have that. 
I am a kind of a contrarian to some of the conversations here--
if you do have a well-regulated market in the United States, 
the money will flood back in because they can trust this 
market. They may not be able to trust the others. That is my 
analysis of what occurred.
    Mr. Fortenberry. Thank you.
    The Chairman. I thank the gentleman.
    The gentleman from North Carolina, Mr. Kissell.
    Mr. Kissell. Thank you, Mr. Chairman.
    Thank you, panel.
    I am going to approach this a little bit differently than 
Mr. Damgard and Mr. Gooch. Mr. Gooch, you said you had thought 
the system functioned very well, and maybe I am interpreting it 
wrong, but it seemed to me it functioned well because there was 
no major train wreck like we saw in the financial end; the 
banks weren't collapsing and so forth. But from the perspective 
of the individuals, the families in my district and across this 
nation, there were millions of train wrecks.
    I am interested in your idea that the system functioned 
well when the speculation that took place caused so much 
hardship for our families, and created such an economic crisis 
of energy and food and other hardships on our families. So how 
could the system maybe be tweaked so that it continues to 
function well in some regards, but it offers protections to our 
families where those small train wrecks are taking place?
    Mr. Damgard. Well, I was speaking specifically of the 
futures markets. The futures markets did work extremely well, 
and they worked very well under the rules that this Committee 
has established for the CFTC, and that doesn't mean that there 
wasn't speculation and that there weren't bubbles in some of 
these markets.
    Having been here for years and years, I have been here at 
hearings where our producers were angry when the price was high 
or the price is low, depending on what their producers, and 
users are just the opposite. We did have enormous volatility in 
the oil market. The CFTC study, as I recall, determined that 
most of the speculators were basically decreasing their 
positions in the first half of last year, number one; and, 
number two, they also indicated that most speculators had 
spread positions, which means that they were both long and 
short, and that suggests that there was an equal amount of 
pressure on buying and selling.
    So it may be that the oil speculators are being blamed for 
more than they should be blamed for. I don't know the answer to 
why that market went up, but I remember at the time that the 
criticism was that these funds had all moved out of equities, 
and they were so-called passive investors. Well, at $145 they 
got out of the market, so they weren't all that passive. Now we 
have $40 oil, and we have people that have pension funds that 
are complaining that somehow the decrease in the value of their 
pension fund is the direct result of speculators selling the 
oil price.
    So, I have gotten used to people complaining about high 
prices and low prices, and how that relates to the average 
family. I go back to the point that Mr. Gooch made, that the 
mortgage market and the drying up of credit are the root cause 
of what we are going through right now.
    I represent the futures market, which is the listed 
derivatives market, and Mr. Duffy and I don't always agree on 
everything, but I do want to say that people are using that 
market. They just had another record year.
    Mr. Kissell. Mr. Damgard, I don't mean to interrupt you, 
but I do apologize. I understand the home mortgage situation, 
but we were having these problems with these little train 
wrecks long before the home mortgage became a crisis.
    See, I am just curious about the system. How can the system 
work well when our families are the ones hurting? I can feel 
tens of thousands of people here and say something went wrong 
when prices went up that much, and nobody can explain it. That 
is why I am curious. How should we tweak the system?
    Mr. Greenberger, you might have a different point of view 
on this.
    Mr. Greenberger. I don't have a different point of view, 
because Mr. Damgard keeps saying I represent the registered 
futures market, but he doesn't want the unregistered futures 
market to be registered.
    Yes, the regulated markets function fine. They have spec 
limits.
    What Mr. Peterson in his draft discussion bill is doing is 
saying we are going to take these markets and regulate them. 
They will have to trade on the Chicago Mercantile Exchange.
    In fact, Mr. Gooch, if he is upset that somehow his 
software is going to be taken off the thing, he can come to the 
CFTC and have an exchange.
    Please remember, when they tell you there are spec limits 
not on the unregulated markets, that is what Chairman Peterson 
is trying to do.
    With regard to credit default swaps, those are private, 
bilateral transactions; nobody can accurately tell you. The 
estimates are anywhere from $23 trillion to $63 trillion. What 
Chairman Peterson is trying to do is bring that into a 
centralized facility so that everybody in the Federal 
Government knows where these potential time bombs are.
    Mr. Gooch says if we had had clearing in September, the 
clearinghouses would have failed, but we didn't have clearing 
in September. If we had had clearing in September, AIG would 
have had to put up collateral, and they wouldn't have just had 
to make these raw bets without having the capital adequacy. If 
they had to go on Mr. Duffy's exchange, they would have had to 
have collateral. A prior recommendation was made here: capital 
adequacy.
    Mr. Dinallo, a New York insurance superintendent, will be 
here tomorrow and say these are insurance companies, they have 
capital reserves. As Mr. Gooch said, they were just making 
bets, taking in the money, never realizing a day would come 
when those bets would have to be paid off.
    Finally, I would say if these credit default swaps are so 
wonderful, I would advise people to invest in the so-called bad 
banks that are being established. They are taking those 
wonderful instruments outside of all the financial institutions 
because nobody will lend them money when they are on the books, 
and the taxpayer is going to create a bad bank.
    If we called torture ``enhanced interrogations,'' one would 
think we would come up with a better name than ``bad bank,'' 
but we can't, because bad banks hold bad instruments that were 
unregulated. There is a hole in the economy of trillions of 
dollars, and that is the solution.
    The Chairman. I thank the gentleman.
    The gentleman from Pennsylvania, Mr. Thompson.
    Mr. Thompson. Thank you, Mr. Chairman.
    A number of witnesses here today and over the next couple 
of days will testify that in spite of the draft bill's purposes 
of promoting transparency and accountability, its provisions 
will have the unintended effects of disrupting market 
liquidity, and sending trading activity either offshore or on 
to otherwise unregulated trading venues.
    I am just interested in seeing what your response is to 
those concerns.
    Mr. Greenberger. Mr. Thompson, if I can address that 
question, a lot has been said here today, if we regulate in the 
United States, they will go to London, they will go to 
somewhere else. I have been working with the United Nations and 
other organizational organizations. I can guarantee you, London 
will regulate this stuff faster than we will regulate it.
    Every major central banker around the world is upset that 
these instruments were deregulated, and, quite frankly, as a 
loyal patriot, I don't like to hear this, but the blame is 
being put on the United States for having created this crisis. 
I know Chairman Peterson went to Europe, maybe he can opine 
about this, but I have been in front of several international 
organizations with the central bankers from all over the world, 
and they are furious with us that we deregulated these markets.
    All Chairman Peterson is saying is put these instruments 
back on a transparent market like the Chicago Mercantile 
Exchange, who has come forth as a central clearing party here, 
so we know what is going on; require capital adequacy; and if 
for some reason those general rules are no good, he has 
provided an exemption from them to be overseen by the CFTC.
    Mr. Gooch. I just want to clarify a couple of things. Mr. 
Greenberger mentioned that the assets in the bad banks, so to 
speak, are credit default swaps, and they are not. Credit 
default swaps are not the assets that would be taken off the 
balance sheets of banks. I think they are CDOs, collateralized 
debt obligations, and CMOs and CLOs and that type of thing that 
have gone bad. It is not CDS.
    So, part of why I am here today talking about not killing 
the credit default swap market is because of this 
misinformation. It isn't the other credit default swaps.
    The other gentleman asked me what did I mean by, the 
markets functioned fine. When Lehman finally did go out of 
business, their credit default swap book settled perfectly with 
all counterparties. There wasn't this systemic risk that people 
seemed to fear that was as the result of credit default swaps. 
So credit default swaps end up getting a bad name.
    I am totally in favor of having essential clearing 
mechanisms, one or more, as long as you have the situation from 
the major dealers that are actually involved with marketing 
these instruments. I am totally in favor of that and regulation 
and oversight. I think it is very important for the 
marketplace.
    But we need to be very careful here today not to get caught 
up in that hyperbole of blaming credit default swaps when they 
are not to blame, and risking cutting off a source of credit in 
the marketplace at a very fragile time in the recovery, hopeful 
recovery, of the United States and the global economy.
    To answer your question, Mr. Thompson, in terms of trading 
overseas, I will just mention, when I started in this business 
in 1978, the United States Government didn't allow U.S. banks 
to spot trade foreign exchange internationally, nor to make 
your dollar deposits with foreign banks. As a result, there was 
a massive foreign exchange market and euro/dollar deposit 
market that traded outside of the United States.
    At that point in time, when I worked for a brokerage 
company in the U.K., we had 300 or 400 employees involved in 
these marketplaces, and their New York office had less than 20 
employees. It was 1979 when they deregulated that and put the 
American banks on a level playing field that the business 
exploded in the U.S., which is how come I got to be brought out 
to the United States, because at 20 years old, I was considered 
an experienced foreign exchange trader.
    But that will give you an example of how the United States 
was behind in those global markets. Absolutely, certainly, if 
you squeeze a balloon here, it is going to pop out somewhere 
else.
    Right now, the Russian ruble trades massively in London on 
what is known as a nondeliverable forward. Russia, the 
Government of Russia, has no control over that marketplace. 
They trade the Russian ruble in London on a nondeliverable 
forward. That is the case with a number of currencies around 
the world. If the United States wants to put themselves in that 
position by potentially introducing regulation that stifles 
their competition in the marketplace, the markets will move 
overseas.
    Just one last quick comment. I don't know much about the 
agricultural markets, but I do understand that there is some 
CFTC regulation that requires the elevator owners that buy the 
grain to hedge that in the futures market. It is because of the 
margin requirement on those hedges that they couldn't buy grain 
from the producers, which is why those producers weren't able 
to actually lock in the high prices when the high prices were 
there.
    So all I would say is it was probably a very good piece of 
regulation when it was introduced, but it didn't work in a very 
volatile market. So you just have to be careful with regulation 
that you have flexibility, but I do certainly support 
transparency in these markets.
    Mr. Cota. Congressman Thompson, you also asked the question 
about how much liquidity is liquidity. Talking about very dull 
commodities like energy, the heating oil market is about 8 
billion gallons per year in the United States, 7 or 8 billion 
gallons. That amount in regulated U.S. exchanges is traded 
multiple times per day. There is no lack of liquidity in those 
markets.
    Now, it is a little bit more complex than that, because 
those trades also trade other types of commodities, but there 
continue to be huge amounts of commodities in these markets. 
The only time that they seem to be illiquid is when you have 
extreme volatility within these markets, and the last remaining 
portion of the floor-traded aspects, which are purely floor 
traded, are options trade. Options trading, because of the 
volatility, did dry up, and to me that meant that there was too 
much volatility in the markets because too much money was 
coming in and coming out. So I kind of argue the other side of 
that.
    Mr. Thompson. Thank you, Mr. Chairman.
    Mr. Damgard. I certainly share your concern about the 
business moving offshore. The largest agricultural futures 
market in the world is Dalian, China, and that is because they 
sent a lot of people over here, and they studied the Merc, and 
they studied the Board of Trade, and they went back to their 
respective countries and they built fantastic markets.
    Singapore has a great market. Hong Kong has a great market. 
They both trade energy futures, and they would love to see the 
market move out of New York to their markets. So, we have to be 
very cautious to make sure that whatever the Committee does, we 
don't encourage people to use markets outside of the United 
States.
    There will always be a place for people to speculate, and 
if they want to speculate in energy and they can't do it here, 
they will do it elsewhere, notwithstanding Mr. Greenberger, who 
said we have to regulate credit default swaps--truthfully they 
have never been regulated. This is all part of the innovation, 
and what the Committee is doing is extremely proper and 
extremely appropriate. Nobody is for excess speculation, but I 
do think that the CFTC knows more about it than anybody else.
    Mr. Greenberger. Also, I would just say, you will have to 
decide, possibly, when the Obama Administration--if they do 
recommend bad banks--I don't know where Mr. Gooch gets his 
intelligence that CDS won't be part of the bad banks. I am 
quite confident people like AIG, who owe trillions or hundreds 
of billions, I should say, are going to want to get rid of 
those instruments, and they will be in the bad banks.
    The Chairman. I thank the gentleman.
    The gentleman from Iowa, Mr. Boswell.
    Mr. Boswell. Thank you, Mr. Chairman.
    The comments that Mr. Gooch just made perked some interest 
about what is happening to the country elevators.
    Mr. Buis, do you have any comment? It seems like I remember 
something not too long ago as they tried to do their forward 
hedging and so on, that they couldn't do it because they didn't 
have any capital for any call or whatever.
    Mr. Buis. Yes, you are absolutely right, Mr. Boswell. What 
Mr. Gooch was suggesting, if I heard him right, would be the 
worst move ever. Requiring country elevators to hedge is what 
keeps them from going bankrupt and farmers and elevators from 
losing their money. We have been through that period.
    Mr. Boswell. I think I remember that back in the 1980s, 
when I was Chairman of the Board of an elevator.
    Mr. Buis. Absolutely. You know, I hear all of us talk 
about, well, we can't regulate in the United States because 
China is not going to, or London is not going to. That is not a 
good reason.
    I mean, people's livelihoods are at risk. Rural America 
lost lots of money off of this effort. I think, as Mr. Cota 
said, it is because no one knows what the positions were, how 
extensive the money was, and who held those positions. So how 
can anyone convince me that you didn't have excessive 
speculation if you are not even accounting for all the activity 
in the marketplaces because of the exemptions, the swaps, the 
foreign market exchanges, et cetera?
    Mr. Boswell. Thank you.
    I have a question for Mr. Gooch, but I will yield to Mr. 
Marshall for the rest of my time. Mr. Marshall.
    Mr. Marshall. Thank you, Mr. Boswell. I appreciate that 
very much.
    I would like to return to this notion of trying to diminish 
the systemic risk associated with naked credit default swaps by 
using clearing as the mechanism.
    Mr. Gooch, you have made it very clear you don't think 
clearing is going to work very successfully unless the major 
investment banks are committed to it, involved in it. You are 
very familiar with the derivatives market. You have been 
brokering in the derivatives market for longer than I have been 
in Congress. Why is it that the major institutions would not be 
interested in clearing? Do they broker through you? I assume 
they broker among themselves, and probably don't use your 
services that much. But why wouldn't they be interested in 
clearing?
    Mr. Gooch. No, I believe they are interested in clearing. 
In fact, the major dealers launched their initiative with the 
Chicago Clearing Corp. that we were part of, back almost 2 
years ago, then to begin the process towards creating a central 
clearing mechanism. But there was the situation that occurred 
in the summer and through September in the credit markets that 
then potentially put that behind the 8-ball, because their 
trading positions became more important in the immediate point 
in time. Then they have continued and most recently signed a 
potential joint venture agreement with ICE Clear to create a 
clearing entity for that purpose.
    Mr. Marshall. The Chairman led a CODEL to Europe. We had 
about a week to do nothing but focus on credit default swaps. 
We heard an awful lot of people comment about the different 
proposed clearing mechanisms that might be adopted. One of the 
comments was that having the major investment houses operate 
the clearing facility was probably not a good idea, that that 
would increase risk, because it is, as they said in Germany, 
kind of letting the goat tend the garden. Having an independent 
entity like CME, for example, might be an important part of the 
checks and balances process.
    Mr. Gooch. The important thing to remember, though, is at 
the end of the day it would be those banks and investment 
banks' balance sheets that ultimately were the security to that 
clearing entity. So, in one respect, if you insist that the 
clearing be done in one certain place, where you don't 
necessarily have the full cooperation of the dealer community 
because they want to know what is going into that clearing 
mechanism, and they want to know which counterparties have 
access to it and, therefore, what is going to be the risk to 
their balance sheet.
    We wouldn't have the capital to be a clearing member in 
that kind of environment, but I certainly, if I had a large 
investment bank with a large balance sheet, I wouldn't be 
interested in putting----
    Mr. Marshall. You wouldn't want to take an unnecessary 
risk.
    Mr. Gooch. Right. I wouldn't want to put all of my balance 
sheet at risk.
    Mr. Marshall. Professor Greenberger, briefly, you noted 
that perhaps the problem with the default issues associated 
with naked credit default swaps is minimized if they are 
cleared. There has been testimony that a number of credit 
default swaps won't be cleared. They just, practically 
speaking, can't. Assuming that they are permitted and assuming 
that naked credit default swaps, uncleared, are permitted and 
the CFTC is in charge of granting exemptions permitting that to 
occur, would it be possible for the CFTC to set some capital 
requirements--things along those lines that lessen the risks 
sufficiently to permit that kind of behavior to move forward?
    Mr. Greenberger. Absolutely, Congressman Marshall. That is 
doubtlessly what is going to happen. Not only will the CFTC do 
it but people who come with the exemptions are going to want to 
say, voluntarily, ``By the way, I set aside enough capital to 
deal with this to get the permission to do it.'' So you have 
the best of all worlds.
    If capital had been required before CDS obligations had 
been made, whether they were to protect real interests because 
you own the bond or own the mortgage-backed security, you are 
taking a bet. AIG would have had a fraction of the CDS, because 
it didn't want to set aside the capital. That would shrink the 
market. And that, I think you are absolutely on target.
    Mr. Marshall. Thank you, Mr. Chairman.
    Mr. Boswell [presiding.] Thank you.
    Mr. Pomeroy.
    Mr. Pomeroy. Thank you, Mr. Chairman. I appreciate the 
hearing and found the panel to be really excellent in all of 
the perspectives advocated.
    I used to be a state insurance commissioner. Honest to God, 
I have trouble getting my mind around the kind of unreserved 
risk that we passed throughout the economy on these CDSs. In 
the end, and over the years, we would have people at this table 
lauding the innovation occurring in the financial services 
marketplace, how it enhanced liquidity of our markets, how it 
allowed our economy to grow.
    Well, we now know the truth. It grew like a great big 
souffle. It was air, over-leveraged air; and it collapsed. 
Worse yet, here we are well into the collapse, at the highest 
unemployment registered in decades, and we don't even know if 
we are down to the bottom of that darn souffle yet.
    So what has happened by all this innovation, in my opinion, 
has not been something that has served some terrific end. The 
notion that we are going to allow credit for risk ceded without 
any looking at whether or not there is a creditworthy partner 
providing the backstop, to me is just mind-boggling.
    Mr. Greenberger. Mr. Pomeroy, tomorrow, Mr. Dinallo will be 
here, the New York Insurance Superintendent, who was 
responsible for AIG, by the way; and he will opine along the 
lines you have said. Actually, in September, the Governor of 
New York and Mr. Dinallo said that credit default swaps that 
had an insurable interest should be regulated after January 1st 
as insurance. He has temporarily ceded that to see what 
Committees like this were going to do.
    A week ago Saturday, I testified in front of the National 
Council of Insurance Legislators. There were people from North 
Dakota, Connecticut, New York, all over the country; and they 
are meeting again in March. Their view is, until they are told 
that insurance law is preempted, they are going to start 
treating this like insurance. The swap here for credit default 
is a premium, a small premium in exchange for a guarantee that 
something bad won't happen.
    Mr. Pomeroy. Right. It allowed investors to basically book 
a value on a collateralized bond obligation because it was 
backstopped by a credit default swap. The credit default swap 
provider did not have to post a capital requirement, nor was 
the credit default swap provider even prohibited from 
subsequently transferring that to unknown other parties.
    Mr. Greenberger. And, to boot, people were issuing 
insurance, this insurance, when people had no risk. It was like 
my taking out insurance on somebody else's life. That is 
illegal under state insurance law.
    In fact, in England, in the turn of the 19th century, 
people were insuring cargoes on ships when they were fighting 
the French. So people would insure cargoes and tell the French 
Navy the English ship is going out there, to collect; and that 
is why we have insurance law today.
    Mr. Dinallo's point is that he feels he has the power to go 
after the insurance on real risks. That is, you own a mortgage-
backed security and you are insuring against it. But he won't 
over what he deems to be 80 percent of the market when the 
insurance is just a bet that somebody is going to die.
    Mr. Pomeroy. You know, I believe that it would be probably 
far beyond this Committee--somebody, maybe the Fed, is going to 
be charged with evaluating systemic risk throughout our 
economy. We shouldn't have to pass a law, in my opinion, to the 
Executive Branch with the regulatory and other authorities 
relative to overseeing the economy of the United States of 
America that you have to keep an eye on this. I am absolutely 
aghast as to how this possibly could have happened in the first 
place.
    Mr. Gooch--and I certainly don't say this to pick on you. I 
think you have been an incredibly articulate representative of 
your viewpoint. But I am hearing from you a kind of unbowed 
support for a lot of the free market laissez-faire treatment 
that got us into this mess. Are there points of response that 
you find acceptable? Is there some common ground across this 
panel where we can at least begin to forge a legislative 
response?
    Mr. Gooch. Yes, sir. I am certainly in favor of free 
markets, but to some extent maybe I have been painted into a 
corner as somehow not being supportive of this proposed 
regulation. My strong position here today, and in my opening 
statement, was in this concept of disallowing naked credit 
derivatives, because of my knowledge about the market and my 
concern that you will kill the CDS market. That might be one of 
Mr. Greenberger's goals, but that it would be a big mistake for 
the American economy.
    Right now, as we know, it is very difficult for anyone to 
borrow money. The banks aren't lending. But some corporations 
can still issue debt. But one of the things that is going on in 
the marketplace right now is those debt issuances are very 
often now tied to CDS prices. Without the willing sellers of 
CDS that are your speculators, if you like, but I call them 
risk takers, who are willing to sell that credit risk, you take 
away a huge portion of willing lenders. They are synthetic 
lenders. When they sell a credit default swap, they are not 
lending the money, but they are a synthetic lender. They are 
effectively underwriting the risk.
    Mr. Pomeroy. We are over our time. They are basically the 
market maker on assessing the value of the underlying 
instrument.
    Whatever happened to underwriting? How come we can't just 
evaluate what the likelihood is this thing is actually going to 
get paid back and establish it on the underlying instrument, 
not a side bet being waged by third parties?
    Mr. Gooch. The insurance companies did historically for a 
long time sell debt insurance, but it is not a dynamic 
marketplace. You can get the debt insurance on an entire issue 
from an insurance company, but you don't have the ability, 
therefore, to tap additional pools of capital that are willing 
to effectively be synthetic lenders if you restrict it to just 
insurance companies.
    What I would say has occurred, in that respect, is that 
this is innovation in the marketplace. Throughout history we 
have had innovation. We had stock market crashes in the 1920s. 
We had the introduction of futures in the early 1970s. The 
over-the-counter markets are five times as big as the future 
markets. This is all innovation that has helped contribute to 
the prosperity of the free world. That is why I am a free 
marketeer.
    Now I do recognize that there is always the time in any 
free market where you will have certain speculative bubbles. I 
mean, I do agree with this Committee in looking to bring 
regulation and transparency to that market. We are totally, 100 
percent, in support of transparency and also in order--not 
order limits but limits on the degree of risk-taking that 
entities are allowed to take subject to their balance sheets.
    Mr. Pomeroy. My time has expired. Mr. Chairman, I thank you 
for your leeway.
    Mr. Boswell. You are welcome.
    Mr. Boccieri, pronounce your name for the rest of us.
    Mr. Boccieri. Boccieri. Like bowl of cherries.
    Mr. Boswell. Boccieri. Okay. Thank you.
    Mr. Boccieri. Life is like that these days, I guess.
    Mr. Chairman, thank you for your leadership in having this 
Committee panel assembled here.
    Having a bit of an economics degree in college, it is 
amazing to me that it seems as if we are throwing the laws of 
supply and demand out the door. We are creating these 
artificial bubbles with these CDSs that drive price 
fluctuations up and down that have absolutely nothing to do, in 
my humble opinion, with supply and demand.
    When you have, for instance, oil prices spiking at $4 a 
gallon, even though there was more supply in the market a year 
ago than there was previous to that, there seems to be a push 
away from this notion that supply and demand should be running 
the market, rather than CDSs. I am a little bit concerned, and 
confused, about the argument that we are making here today for 
supporting this unregulated, unchecked, artificial price spike, 
if you will, of commodities and futures that are very important 
to American families. Having a stable market, a reliable market 
that underscores that when a consumer, a family goes to a gas 
station that they can have a reliable price there that they 
know was equitable and fairly traded, and that was marked by 
supply and demand and not by speculation, or manipulation like 
Mr. Damgard had suggested.
    I guess my question to the panel is this, that some of the 
panel have suggested that we take a broader look at 
manipulation, and that our concern about the test for 
manipulation is limited to conscious efforts versus those that 
are unconscious. Manipulation is a crime, and there are 
penalties associated with it. If the market participants are 
impacting markets unconsciously, but with the same impact as 
those who have attempted manipulation, shouldn't they be 
punished the same as those conscious manipulators?
    Mr. Damgard. The answer to that is certainly yes, to the 
full extent of the law. And my only point was don't confuse 
speculation with manipulation. I think speculation doesn't have 
to be as demonized as it has been. Speculators have been pretty 
important to the market.
    I believe the CFTC has done an excellent job in determining 
when there is manipulation in the market. Frankly, that is why 
you created the agency; and that is one of its foremost goals. 
In my judgment, there is no evidence, credible evidence to 
suggest that any manipulation was taking place. They looked at 
it long and hard, and they looked at the speculators, and there 
were more shorts than there were longs in the first half of 
last year when we saw the bubble.
    Mr. Boccieri. Mr. Damgard, I want to ask a question. I 
remember reading an article last year where it was suggested 
that big oil companies were betting on the price of fuel going 
up. To me, with a simple mind and simple notion, that sounds 
like insider trading, with respect to the fact that they knew 
that prices were going to go up because everybody was 
speculating and betting on the price of it going up, even 
though there was more supply of oil in the market than there 
was a year ago. Would you hold those unconscious participants, 
those speculators to the same criminal standard as 
manipulators?
    Mr. Damgard. Yes, but if an oil company was in the market 
and the price was at a certain point, they could either buy it 
or sell it. They couldn't go out and sell oil for more than 
what the world standard was worth. I am not sure what your 
point is.
    Mr. Boccieri. But if they are betting billions and billions 
of dollars that the price is going to go up, and to me part of 
this artificial control of the market, rather than letting 
supply and demand control the market, seems to me that that is 
a bit of--they unconsciously or consciously know that the price 
is going to go up at some point.
    Mr. Damgard. I am not familiar with the dynamics of the 
market at that time, but for every buyer there was a seller in 
our futures markets. Somebody obviously thought the market was 
going to go down, or they wouldn't be selling.
    If, in fact, there was large trader activity, that comes to 
the attention of the Surveillance Department of the CFTC, and 
they investigate that and they examine it. Their track record 
has, quite honestly, been very, very good. That doesn't explain 
how the price got to $145, but the price got to $145 because 
there were a lot more buyers than sellers. Much of the evidence 
suggests that these were pension funds and endowment funds that 
had moved out of the equity markets because they saw a better 
opportunity to benefit their pensioners.
    Mr. Boccieri. It is everybody else's fault, it seems like. 
Everybody's pointing the finger. Mr. Gooch has suggested that 
it was the family who had a mortgage and they lost their job. 
It is their fault because they had a mortgage. That is like the 
teenage son who borrows the family car and says, ``Dad, I would 
have never got in a wreck if you wouldn't have lent it to me.'' 
It doesn't make any sense to me.
    Mr. Gooch. I would say in any bubble there is always going 
to be some level of fraud at the peak of the bubble. I am not 
blaming the person who tried to buy a home and couldn't afford 
it. I would blame the unscrupulous mortgage broker who 
encouraged someone to take a mortgage they couldn't afford, on 
a house that wasn't worth the mortgage, simply because they 
were going to get a $3,000 commission. In this circumstance 
where you have had 7 years of extremely cheap credit and the 
global, spectacular growth throughout the world's economies, 
that is what has driven all of these commodity prices up to 
record levels.
    I don't know enough about those energy companies. I 
wouldn't jump to the conclusion that they were involved in 
insider trading because they imagined the price of oil would go 
up. I mean, frankly, who knew? Right? Sitting here today we all 
can see that everybody right up to the highest levels of 
government isn't able to predict the future that clearly.
    Mr. Greenberger. I would say the reason they are unable to 
predict the future that clearly is that a large portion, 
because of the Enron loophole, the London loophole, the swaps 
loophole was completely outside of the government's ability to 
see what was going on. The effect of Mr. Peterson's draft 
discussion bill is to bring transparency to those markets so 
everybody else knows what is going on.
    There were accusations here about the Hunt brothers in 1980 
cornering the silver market. Mr. Masters will testify tomorrow, 
he and Mr. White did a report called The Accidental Hunt 
Brothers, which showed through the swaps, the deregulated 
swaps, the passive long investments went from $14 billion in 
2004 to $313 billion long in the summer of 2008; and then $70 
billion was taken out of that market immediately, which 
explains the drop. These markets were unregulated.
    What Mr. Peterson is trying to do is bring them--we have 
heard a lot of great things about the CFTC here. That is great. 
Let's give the CFTC the power to see what is going on.
    Mr. Boccieri. Let me try to suggest whether it is farmers, 
or oil companies, or car manufacturers, betting on the price of 
their product going up to me just seems like a total disconnect 
with respect to regulating the laws of the supply and demand.
    Mr. Greenberger. President Roosevelt would have agreed with 
you, Congressman. Because, in 1934, he proposed the Commodity 
Exchange Act, which included speculation limits in it. That 
wasn't to bar speculation. It was to bar excessive speculation. 
The Act does bar excessive speculation.
    What we did in 2000 with the Commodity Futures 
Modernization Act was take oil futures, agriculture futures, 
and swaps outside of the speculation limits to ban not 
speculation, which we need, but excessive speculation.
    Mr. Cota. And the key component----
    The Chairman [presiding.] I thank the gentleman.
    The gentleman from Minnesota, Mr. Walz.
    Mr. Walz. Thank you, Mr. Chairman, and to our Ranking 
Member for holding this, as my colleagues have said, incredibly 
informative discussion.
    I do want to thank each and every one of you. You are being 
very candid, very open; and that is very helpful to us.
    Because, the bottom line is that we all want our markets to 
function correctly. We want to make sure that they are 
regulated to the point where people have trust in them, but 
that we are still encouraging innovation and people to move 
forward on some of these instruments.
    So all of us are trying to understand this. I think in that 
spirit, because this is very complicated--and I do thank 
Chairman Peterson personally. He has for several years talked 
to me and tried to educate me on these.
    What I would like to do, maybe Mr. Buis or Mr. Gooch, if 
you would help me, if each one of you would tell me--Mr. Buis, 
you can pick that soybean farmer out in Albert Lea, Minnesota, 
that is a Farmers Union member. Tell me how the future market 
works for them and how it affects their paycheck.
    Then, Mr. Gooch, tell me what your brokers do and what the 
futures market does and how they collect their paycheck, and 
what role each of them has in securing the economic well-being 
of this country.
    If you could do that, that would really help. Because I 
want to talk to my constituents about why this affects them. It 
is all too easy to demonize or take a populist position and 
point fingers. I want to get it right.
    So, Tom, if you want to start.
    Mr. Buis. All right. Thank you, Congressman.
    That farmer, that soybean farmer in Albert Lea, what this 
really means to them is their ability to price their product 
when they can get a decent return out of the marketplace. That 
doesn't occur after harvest, because you generally have a lot 
of product coming onto the market. So they look for 
opportunities at other times during the year, after harvest, on 
when they are going to deliver that product and get the best 
price.
    When they are precluded from the marketplace, like this 
time, in many cases--my friend, Mr. Damgard, got $7\1/4\ for 
his corn, but not everyone did--then they have to accept a 
price after harvest. If you look at all the spring crops this 
year, in Minnesota and elsewhere, they all collapsed before 
harvest; and so those producers were put at even a greater 
risk.
    I would remind the Committee this is--the original 
derivative is farmers selling their products after harvest into 
the future, and that sound financial instrument was taken out 
of their hands this year.
    Mr. Walz. Mr. Gooch, if you could explain to me what does a 
broker at your firm do, and how do they look to the futures 
market in terms of how it affects the paycheck they are taking 
home?
    Mr. Gooch. Certainly. We operate a number of electronic 
marketplaces for both OTC and listed derivatives. And in the 
very cash end of the marketplace, in such things as government 
bonds and the most liquid instruments like foreign exchange and 
the most liquid equities, they lend themselves very well to 
pure electronic trading.
    But when you move across the curve to further out, what we 
could be talking about, a 5 year Russian default swap or 
something like that, there is a need to have some interface 
amongst our brokers that work with the customers--and the 
customers tend to be large banks, large investment banks, some 
hedge funds--in helping them find the best execution, and 
finding the best counterparty to offset that transaction with.
    Our brokers work in an environment which looks like a 
trading floor that you have probably seen at any investment 
house on TV, et cetera, et cetera. They communicate with their 
customers via e-mail, instant message, Bloomberg messaging, 
telephone, and also via our electronic trading platform; and 
they generate conditions for crossing trades. Those 
commissions, that is the fee we charge to our customers for 
generating the transaction; and then our brokers are typically 
paid a percentage of that fee that is generated. That is how 
they get paid their commission, once every 6 months or so, on 
the business that they produced on the trading desk.
    Mr. Walz. So for both of you--yes, go ahead, Mr. Damgard.
    Mr. Damgard. I would just like to correct the record. I got 
a little over $7 for a little bit of my corn.
    Mr. Walz. Okay. Thank you.
    Mr. Damgard. We didn't use the futures market. We went to a 
cooperative country elevator, and we sold that corn. When that 
country elevator ran out of credit from CoBank, he could no 
longer accept forward delivery.
    Our alternative at that point--and I live fairly near the 
Illinois River--was to deliver directly to a delivery point, at 
which point my contract allows me to do that. But not a lot of 
farmers use the futures market in the sense that they actively 
trade. It is the elevator that utilizes the futures market in a 
way that he can offer the soybean farmer in Minnesota or 
Illinois a cash price.
    Mr. Walz. My final question, and I know I am right at the 
end of my time, is for some of the rest of you to explain this 
to me. I am still having trouble understanding why full 
transparency would be a bad thing. It is a very important 
point, and I believe they need it to work. I just don't 
understand why we don't want a clearing mechanism for these. Is 
it just unsustainable? Was that the argument that we heard, 
that in September they would have collapsed right along with 
everyone else?
    Mr. Gooch. I think everybody seems to be in favor of a 
clearing mechanism. I certainly have spoken in favor of a 
clearing mechanism. I haven't heard anybody here say that they 
are not in favor of a clearing mechanism and full transparency.
    Mr. Duffy. And, just to add on to that, you are seeing the 
major Wall Street firms agree that a clearing solution is 
definitely needed for the future of credit default swaps.
    So I don't think anyone is opposing it. I think what some 
are saying in this room, and some are saying on Wall Street, 
that there is a certain type of products that may not lend 
itself for trading or clearing because of the illiquid nature 
that they represent. But the majority of the contracts, I think 
everybody's in agreement they do need to be cleared to avoid 
the systemic risk in the system.
    Mr. Damgard. Estimates are that 75 percent of these 
contracts are standardized to the point where they could be 
cleared. But if they are too customized, or if the owners of 
the clearinghouse feel that the risk profile is such that they 
don't want to clear them--I mean, I represent the clearing 
members, and they are very interested in this business. They 
are interested in it in Mr. Duffy's exchange, which is an 
extremely well-run clearinghouse, but there are others as well, 
both in the United States and outside the United States, that 
are anxiously racing each other to see who can be there first 
in case they can be the one that does most of the----
    Mr. Walz. Thank you. Thank you for the time, Mr. Chairman.
    The Chairman. I would just say if these things are too 
risky that nobody wants to clear them, they probably shouldn't 
be done in the first place. Okay?
    The gentleman from Alabama, Mr. Bright.
    Mr. Bright. I have no questions.
    The Chairman. All right.
    Well, we have gone longer than we expected. Thank you very 
much.
    Mr. Conaway. Mr. Chairman, I had one quick one. It has to 
do with these noncleared contracts. Could we get some sort of a 
sense of what the risks to the overall system are for having 
these two-party, very discrete, very unique contracts between 
two parties, do those then represent risks beyond just the two 
parties who entered into the contract? Can you help us 
understand what risks are there that aren't----
    Mr. Greenberger. Congressman, I would say that that is why 
this exemption is so valuable, because they don't. When they 
are standardized and they are traded like this, that is when 
the risk is created. I think Mr. Marshall is on to something. 
If the exemption that Mr. Peterson has for the things that 
can't be cleared but are safe is put into effect, part of the 
safety should be the CFTC should make sure that both parties 
have adequate capital to deliver if they lose the transaction.
    Mr. Conaway. Okay. Mr. Damgard or Mr. Duffy, you guys 
agree?
    Mr. Damgard. I mean, I would say there are a lot of 
bilateral transactions out there that are relatively small. If 
you are going to buy a car and you put down a down payment, and 
it is going to be delivered 60 days from now, that shouldn't be 
something the CFTC worries about. That is the trust of the 
dealer and the purchaser. So, that there is some individual 
responsibility in any bilateral transaction to make sure that 
the other person----
    Mr. Conaway. Yes, but we are not talking about cars. We are 
talking about something broad enough or big enough that would 
really threaten our markets that we should have cleared even 
though it was unique.
    Mr. Duffy. I believe, sir, that the risk can be--it is 
going to be minimized because of the fact that a high 
percentage of these credit default swaps will be able to be 
cleared on an exchange. Even the ones that are really toxic in 
nature--and I agree with Chairman Peterson, what he said, that 
maybe if they are too toxic they should be untradeable. We are 
coming up with pricing mechanisms to value those so we can go 
ahead and clear these products. So, it will be a small amount 
of outstanding credit default swaps. And, yes, there may be a 
couple that do go away.
    Mr. Conaway. Okay. But, over time, you think the bulk of 
those unique ones would go away?
    Mr. Duffy. I think the bulk of them can be cleared almost 
to 100 percent.
    Mr. Conaway. All right. Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman.
    Panel, thank you very much for being with us. It was very 
helpful, we apologize for keeping you so long, but the panel is 
excused.
    We have one more panel with two members. We will try to 
move through this as expeditiously as we can.
    Welcome the final panel for the day: Mr. Daniel Roth, 
President and CEO of the National Futures Association in 
Chicago; and Mr. Tyson Slocum, who is the Director of Public 
Citizen's Energy Program in Washington, DC.
    We welcome you to the Committee.
    Your statements will be made part of the record, and we 
encourage you to summarize your statements.
    Mr. Roth, you are recognized for 5 minutes.

   STATEMENT OF DANIEL J. ROTH, PRESIDENT AND CEO, NATIONAL 
                FUTURES ASSOCIATION, CHICAGO, IL

    Mr. Roth. Thank you, Mr. Chairman.
    My name is Dan Roth, and I am the President of National 
Futures Association. I would like to thank you very much for 
the opportunity to be here today to discuss our views.
    Certainly the draft bill that you have been discussing this 
afternoon couldn't be more timely. I think we all know that the 
current financial crisis has highlighted the importance of 
these issues. So I applaud you for your efforts to deal with 
these very complex issues.
    We have some suggestions in our written testimony regarding 
some improvements that we think could be made to the bill, and 
we would be happy to discuss those. But one thing I want to 
talk about today, at risk of getting us off on a little bit of 
a tangent, and I certainly don't mean to do that. But, as 
important as the issues are that are covered by the bill, I 
hope we don't lose sight of an important customer protection 
issue that needs to be addressed and is somewhat overdue.
    As we sit here today, we have to recognize that we have 
completely unregulated futures markets aimed expressly at 
unsophisticated retail customers. That is not a good situation 
to be in.
    Through a series of bad cases, starting with the Zelener 
decision, we have had a series of decisions which essentially 
gutted the CFTC's ability, gutted the CFTC's jurisdiction with 
respect to bucket shops. Those contracts, those cases basically 
hold that certain contracts that may walk like a futures 
contract, talk like a futures contract, smell like a futures 
contract will be deemed by the courts not to be a futures 
contract if the scammer drafts the contract in a certain way, 
and therefore deprives the CFTC of jurisdiction.
    Congress addressed this issue last May with respect to 
forex contracts--and God bless you for doing that--but, as we 
said at the time, the problem isn't limited to forex contracts 
and the solution can't be limited to that way, either.
    We testified previously that if we only dealt with the 
forex aspect of this problem, then we would simply see a 
migration of problematic contracts from forex to other 
commodities; and that is exactly what we have seen. I don't 
have exact numbers, because, of course, these entities are 
unregistered, but just in our routine Internet surveillance and 
through customer complaints we are aware of dozens, dozens of 
these markets that are aimed exclusively at retail customers 
that are offering futures look-alike products for gold, silver, 
and energy.
    For all these markets, there is no capital requirement. 
There is no registration requirement. There is no one doing 
audits and examinations. There is no sales practice rules. 
There is no arbitration. There is no nothing. These are 
completely unregulated markets, and they are taking advantage 
of retail customers.
    We had a caller a couple weeks ago, a gentleman lost over 
$600,000 with one of these outfits. It was essentially all of 
his life savings.
    I think it is safe, given the volume of the activity that 
we see, that there are thousands of customers who have lost 
millions of dollars through these types of unregistered, 
unregulated markets. It is not right, and the time has come to 
fix that problem.
    We have a solution. It is a solution we have discussed 
before. It is a solution that we have worked on with the 
exchanges. Basically, what we have proposed in the past, and 
have proposed now, would be a statutory presumption that any 
market that offers a leveraged contract offered to retail 
customers, and that retail customer has no commercial use for 
this product and no ability or capacity to take delivery, that 
under those circumstances there would be a presumption that 
those were in fact futures contracts, and therefore had to be 
traded on-exchange.
    This is simply nothing more than the codification of the Co 
Petro case, which the Zelener case overturned. That presumption 
would ensure that customers get the regulatory protections they 
deserve and need if trading in a regulated environment, and it 
is a change which is long overdue.
    So, Mr. Chairman, I know there are other very important, 
very complex issues on the table. We have our opinions about 
some portions of the draft bill. We have included that. But I 
hope we don't lose sight of this important customer protection 
issue while you are dealing with this legislation.
    Thank you, Mr. Chairman.
    [The prepared statement of Mr. Roth follows:]

   Prepared Statement of Daniel J. Roth, President and CEO, National 
                    Futures Association, Chicago, IL
    My name is Daniel Roth, and I am President and Chief Executive 
Officer of National Futures Association. Thank you, Chairman Peterson 
and Members of the Committee, for this opportunity to present our views 
on legislation to bring greater transparency and accountability to 
commodity markets.
    NFA is the industry-wide self-regulatory organization for the U.S. 
futures industry. NFA is a not for profit organization, we do not 
operate any markets, we are not a trade association. Regulation and 
customer protection is all that we do.
    NFA certainly understands the importance of responding to the 
current financial crisis, dealing with systemic risk and creating 
greater transparency in OTC markets. NFA would like to point out that 
as a result of bad case law, more and more retail customers are being 
victimized in off-exchange futures markets. This is a customer 
protection issue that needs to be addressed now.
Customer Protection
    For years, unsophisticated, retail customers that invested in 
futures had all of the regulatory protections of the Commodity Exchange 
Act. Their trades were executed on transparent exchanges, their brokers 
had to meet the fitness standards set forth in the Act and their 
brokers were regulated by the CFTC and NFA. Today, for too many 
customers, none of those protections apply. A number of bad court 
decisions have created loopholes a mile wide and retail customers are 
on their own in unregulated, non-transparent OTC futures-type markets.
    Congress acted to close those loopholes last May with respect to 
forex trading but customers trading other commodities, such as gold and 
silver, are still stuck in an unregulated mine field. It's time to 
restore regulatory protections to all retail customers.
    Let me remind you how we got here. In the Zelener case, the CFTC 
attempted to close down a boiler room selling off-exchange forex trades 
to retail customers. The District Court found that retail customers 
had, in fact, been defrauded but that the CFTC had no jurisdiction 
because the contracts at issue were not futures, and the Seventh 
Circuit affirmed that decision. The ``rolling spot'' contracts in 
Zelener were marketed to retail customers for purposes of speculation; 
they were sold on margin; they were routinely rolled over and over and 
held for long periods of time; and they were regularly offset so that 
delivery rarely, if ever, occurred. In Zelener, though, the Seventh 
Circuit based its decision that these were not futures contracts 
exclusively on the terms of the written contract itself. Because the 
written contract in Zelener did not include a guaranteed right of 
offset, the Seventh Circuit ruled that the contracts at issue were not 
futures.
    For a short period of time, Zelener was just a single case 
addressing this issue. Since 2004, however, various Courts have 
continued to follow the Seventh Circuit's approach in Zelener, which 
caused the CFTC to lose enforcement cases relating to forex fraud. Last 
year Congress plugged this loophole for forex contracts but not for 
other commodities.
    Unfortunately, the rationale of the Zelener decision is not limited 
to foreign currency products. In testimony before this Subcommittee in 
2007, I predicted that if Congress only addressed the forex aspect of 
the Zelener decision, the fraudsters would merely move their activities 
to other commodities. That's just what has happened. We cannot give you 
exact numbers, of course, because these firms are not registered. 
Nobody knows how widespread the fraud is, but we are aware of dozens of 
firms that offer Zelener contracts in metals or energy. Some of these 
firms are being run by individuals that we have kicked out of the 
futures industry for fraud. Several weeks ago, we received a call from 
a man who had lost over $600,000, substantially all of his savings, 
investing with one of these firms. We have seen a sharp increase in 
customer complaints in the last 3 months. It is safe to say that these 
unregulated bucket shops have plundered millions of dollars from retail 
customers.
    NFA and the exchanges have previously proposed a fix to Zelener 
that goes beyond forex and does not have unintended consequences. Our 
approach codifies the approach the Ninth Circuit took in CFTC v. Co 
Petro--which was the accepted and workable state of the law until 
Zelener--without changing the jurisdictional exemption in section 2(c) 
of the Act. In particular, our approach would create a statutory 
presumption that leveraged or margined transactions offered to retail 
customers are futures contracts if the retail customer does not have a 
commercial use for the commodity or the ability to make or take 
delivery. This presumption is flexible and could be overcome by showing 
that the transactions were not primarily marketed to retail customers 
or were not marketed to those customers as a way to speculate on price 
movements in the underlying commodity.
    This statutory presumption would effectively prohibit off-exchange 
contracts--other than forex--with retail customers when those contracts 
are used for price speculation. This is the cleanest solution and the 
one NFA prefers. If Congress is hesitant to ban these transactions, 
however, they should at least be regulated in the same manner as retail 
OTC forex futures contracts. (See section 2(c)(2)(B) of the Act.)
Commission Resources
    NFA strongly supports the bill's effort to provide the Commission 
with much-needed resources. CFTC staffing levels are at historic lows. 
As trading volume rose over the years, staffing levels moved in the 
other direction. Something here is not right. It is always a struggle 
for a regulator to keep up with an ever changing market place, but that 
becomes harder and harder to do when you have fewer people on hand to 
do more work. NFA applauds proposals for emergency appropriations to 
the CFTC to hire additional people and upgrade its technology.
Position Limits
    NFA is concerned with the proposal to impose position limits on 
futures contracts for excluded commodities. In 2000, Congress amended 
the Commodity Exchange Act to define certain commodities as ``excluded 
commodities.'' These are primarily financial commodities, indices, and 
contingencies. By their very nature, excluded commodities are not 
susceptible to manipulation, either because there is such a large 
supply that it cannot be cornered or because, as with the 
contingencies, the contracts are based on events that are beyond 
anyone's control. Therefore, position limits in excluded commodities 
serve no purpose except to reduce the liquidity that helps banks and 
other institutions manage their risks. Furthermore, this reduced 
liquidity would come at a time when risk management is more critical 
than ever.
Credit Default Swaps
    Section 16 of the draft bill is an even greater threat to 
liquidity. That section appears to restrict the use of credit default 
swaps to hedgers. NFA supports efforts to bring greater transparency to 
these transactions and to reduce their systemic risk. This proposed 
remedy, however, is likely to kill the patient. You cannot have an 
effective market if you do not have liquidity and you cannot have 
liquidity if you do not have speculators. Eliminating speculators from 
the credit default swap market will make it much more difficult for 
firms to manage their risks, which cannot be good for those firms or 
for the economy.
Mandatory Clearing of OTC Derivatives
    Clearing organizations in the U.S. futures markets have performed 
superbly for over 100 years. The current financial crisis has posed the 
ultimate test to the clearing system--a test that was passed with the 
highest possible grades. Even under the greatest market stress we have 
seen for generations, no futures customers lost money due to an FCM 
insolvency and positions were transferred from distressed firms to 
healthy ones smoothly and efficiently. There has been no Federal 
bailout necessary for the futures industry. Clearing in the futures 
markets works and the spread of clearing to OTC markets can be a very 
positive development.
    All OTC derivatives, however, are not like futures. It is the 
standardized nature of futures contracts and the ability to mark them 
to a liquid and transparent market that make clearing work so well. 
Many OTC instruments are quite standardized and susceptible to 
clearing. Others, though, are highly individualized and privately 
negotiated and difficult to mark to a market. The bill attempts to 
recognize these problems by providing the CFTC with exemptive 
authority. That authority, however, is circumscribed. I suspect it is 
impossible to draft legislation that can take into account all of the 
factors that might make it appropriate to exempt an OTC transaction 
from mandatory clearing. We would suggest that the bill give the CFTC 
greater flexibility to exercise its exemptive authority.
    In conclusion, NFA's overriding concern with the bill is in what it 
does not contain. Retail customers trading in OTC metals and energies 
should not be left at the mercy of scammers. We encourage the Committee 
to revise the draft to prohibit--or at least regulate--Zelener-type 
contracts in commodities other than currencies.
    As always, NFA looks forward to working with the Committee, and I 
would be happy to answer any questions.

    The Chairman. Thank you very much. That is very much on 
point, and we will definitely take that into consideration. We 
have been so focused on this other stuff we kind of lose sight 
sometimes. So I appreciate your being with us.
    Mr. Slocum?
    Go ahead.
    Mr. Roth. No, I am just happy to be a nag about it, because 
it is an issue that is important to us.
    The Chairman. Very much. Thank you.
    The Chairman. Mr. Slocum?

  STATEMENT OF TYSON SLOCUM, DIRECTOR, ENERGY PROGRAM, PUBLIC 
                   CITIZEN, WASHINGTON, D.C.

    Mr. Slocum. I am Tyson Slocum. I direct the Energy Program 
at Public Citizen.
    Public Citizen is one of America's largest consumer 
advocacy groups. We primarily get our funding from the 100,000 
Americans across the country that pay dues to support our 
organization's work.
    My particular area of focus is on energy policy, and we 
have heard from our members and from Americans all over the 
country about the incredibly harmful impacts the volatility in 
energy prices have had on working people across the country. 
There is no question that this volatility is the direct result 
of rampant speculation, speculation made possible due to 
unregulated or under-regulated energy futures markets. I think 
that it is not a coincidence that the speculative bubble burst 
in crude oil at the same time that the Wall Street credit 
crisis occurred. These speculators were speculating on highly 
leveraged bets; and once the credit seized up, their ability to 
continue speculating also evaporated. So the huge drop in 
prices from $147 a barrel in just 5 months to $40 a barrel was 
a direct result of the ability of the speculators to continue 
evaporating.
    So the draft legislation that has been put together by 
Chairman Peterson does an excellent job as a first step to 
addressing the need to increase transparency and regulation 
over these futures markets. By bringing foreign exchanges under 
CFTC jurisdiction, by requiring mandatory clearing for OTC 
markets--although there is this big exemption that I am 
concerned about--requiring more detailed data from index 
traders and swaps dealers, requiring a review of all past CFTC 
decisions, which I believe undermined the transparency of the 
market, all of these are excellent things.
    The need to re-regulate these markets is all the more 
important because of the enormous consolidation that we have 
seen among the speculators. In response to the Wall Street 
crash, there has been a number of mergers between entities that 
had significant energy trading portfolios. There were no 
hearings when any of these mergers were approved; and so you 
had a lot of these very powerful entities become even larger 
and more powerful, with little or no public scrutiny over the 
impacts on the future of energy trading markets. So improving 
transparency, as the draft Derivatives Markets Transparency and 
Accountability Act, is an excellent start.
    There is an area that the legislation doesn't address that 
I would like to touch on for the rest of my opening statement. 
And that is dealing with what Public Citizen identifies as a 
serious matter of concern regarding the intersection of 
speculators like Wall Street investment banks and their 
ownership or control over physical energy infrastructure assets 
such as storage facilities, pipelines, oil refineries, and 
other physical energy infrastructure assets.
    There has been an explosion just over the last couple of 
years of Wall Street investment banks taking over pipeline 
systems and other energy infrastructure with, I believe, the 
sole purpose to provide them with added ability to enhance 
their speculative activities in the futures market. It is the 
only reason that I could figure why a company like Goldman 
Sachs would acquire 40,000 miles of petroleum product pipeline 
in North America through its 2006 acquisition of Kinder Morgan. 
Owning pipelines is a relatively low return business. With 
pipeline operations, their profits are heavily regulated. But 
owning and controlling pipeline systems gives an investment 
bank that has a large speculative division an insider's peek 
into the movement of information, of product that enhances 
their ability to make large speculative trades.
    The fact that Morgan Stanley, when I was reviewing their 
most recent annual report, boasted that they were going to be 
spending half a billion dollars in 2009 leasing petroleum 
storage facilities in the United States and, as Morgan Stanley 
said--I am quoting from their annual report--in connection with 
its commodities business, Morgan Stanley enters into operating 
leases for both crude oil and refined product storage for 
vessel charters. These operating leases are integral parts of 
the company's commodities risk management business.
    Just a month ago, Bloomberg reported that investment banks 
and other financial firms had 80 million barrels of oil stored 
offshore in oil tankers that were not being shipped to deliver 
into markets, to deliver oil and other needed products to 
consumers, but simply to use them to enhance their speculative 
hedging tactics.
    So, that it would be great if the Committee could examine a 
study by the CFTC or another appropriate entity to determine 
whether or not the intersection of ownership and control over 
physical energy assets with energy market speculative 
activities requires additional levels of scrutiny.
    Thank you very much for your time, and I look forward to 
your questions.
    [The prepared statement of Mr. Slocum follows:]

 Prepared Statement of Tyson Slocum, Director, Energy Program, Public 
                       Citizen, Washington, D.C.
Protecting Families From Another Energy Price Shock: Restoring 
        Transparency and Regulation to Futures Markets To Keep the 
        Speculators Honest
    Thank you, Mr. Chairman and Members of Committee on Agriculture for 
the opportunity to testify on the issue of energy futures regulation. 
My name is Tyson Slocum and I am Director of Public Citizen's Energy 
Program. Public Citizen is a 38 year old public interest organization 
with over 100,000 members nationwide. We represent the needs of 
households by promoting affordable, reliable and clean energy.
    The extraordinary volatility in energy prices, particularly crude 
oil--which soared from $27/barrel in September 2003 to a high of $147/
barrel in July 2008 before plummeting to its current price of $40/
barrel--wreaked havoc with the economy while making speculators rich. 
The spectacular 75% decline in oil prices in just 5 months cannot be 
explained purely by supply and demand; rather, a speculative bubble 
burst, triggered by the Wall Street financial crisis. Strapped of their 
credit that had been fueling their highly leveraged trading operations, 
the credit crisis ended the speculators' ability to continue driving up 
prices far beyond the supply demand fundamentals. This speculation was 
made possible by legislative and regulatory actions that deregulated 
these energy futures markets. Although energy prices are no longer at 
record highs, it must be assumed that it is a matter of when, not if, a 
return to high prices will occur. Absent reregulation of the energy 
futures markets, aggressive government efforts to restore liquidity and 
unfreeze the credit markets will give new life to the Wall Street 
financial speculators, ushering a return to an energy commodity 
speculative bubble.
    Restoring transparency to futures markets is all the more urgent 
given the wave of consolidation that has occurred among the financial 
firms that were leading the speculative frenzy. Several major energy 
trading firms merged their operations in response the credit crisis:

   In 2007, ABN Amro was purchased by the Dutch National 
        Government, the Royal Bank of Scotland and Spain's Banco 
        Santander.

   In April 2008, J.P.Morgan Chase acquired Bear Stearns and 
        its trading operations.

   In September 2008, Bank of America acquired Merrill Lynch.

   In October 2008, Wells Fargo and Wachovia agreed to merge.

   Electricite de France arranged to purchase all of Lehman 
        Bros. energy trading operations in October 2008.

   Wells Fargo agreed to buy Wachovia in October 2008.

   In January 2009, UBS sold its energy trading operations to 
        Barclays.

    Congress can take two broad actions to provide relief: providing 
incentives to households to give them better access to alternatives to 
our dependence on oil, and restoring transparency to the futures 
markets where energy prices are set. The former option is of course an 
effective long-term investment, as providing incentives to help 
families afford the purchase of super fuel efficient hybrid or 
alternative fuel vehicles, solar panel installation, energy efficient 
improvements to the home and greater access to mass transit would all 
empower households to avoid the brunt of high energy prices.
    The second option-restoring transparency to the futures markets 
where energy prices are actually set--is equally important. Stronger 
regulations over energy trading markets would reduce the level of 
speculation and limit the ability of commodity traders to engage in 
anti-competitive behavior that is contributing the record high prices 
Americans face. And as Congress considers market-based climate change 
legislation that would create a pollution futures trading market, the 
priority of establishing strong regulatory oversight over all energy- 
and pollution-related futures trading is the only way to effectively 
combat climate change, in order to ensure price transparency.
    Of course, supply and demand played a role in the recent rise and 
decline in oil prices. Gasoline demand in America is down, with 
Americans driving 112 billion less miles from November 2007 to November 
2008,\1\ and global demand--even in emerging economies like China, 
India and oil exporting nations in the Middle East--has slackened in 
response to the global economic downturn, thereby offsetting the fact 
that mature, productive and easily-accessible oil fields are in 
decline. Claims of Saudi spare capacity are questioned due to the 
Kingdom's refusal to allow independent verification of the country's 
oil reserve claims. Simply put, oil is a finite resource with which the 
world--until recently--has embarked on unprecedented increased demand.
---------------------------------------------------------------------------
    \1\ www.fhwa.dot.gov/ohim/tvtw/tvtpage.htm.
---------------------------------------------------------------------------
    But there is no question that speculators and unregulated energy 
traders have pushed prices beyond the supply-demand fundamentals and 
into an era of a speculative bubble in oil markets. While some 
speculation plays a legitimate function for hedging and providing 
liquidity to the market, the exponential rise in market participants 
who have no physical delivery commitments has skyrocketed, from 37 
percent of the open interest on the NYMEX West Texas Intermediate (WTI) 
contract in January 2000 to 71 percent in April 2008.\2\
---------------------------------------------------------------------------
    \2\ http://energycommerce.house.gov/Investigations/
EnergySpeculationBinder_062308/15.pdf.
---------------------------------------------------------------------------
    Rather than demonize speculation generally, the goal is to address 
problems associated with recent Congressional and regulatory actions 
that deregulated energy trading markets that has opened the door to 
these harmful levels of speculation. Removing regulations has opened 
the door too wide for speculators and powerful financial interests to 
engage in anti-competitive or harmful speculative behavior that results 
in prices being higher than they would otherwise be. When oil was at 
$145/barrel, many estimated that at least $30 of that price was pure 
speculation, unrelated to supply and demand.
    While the Commodity Futures Trading Commission (CFTC) and Congress 
have taken recent small steps in the right direction, more must be done 
to protect consumers. While the CFTC has been disparaged by consumer 
advocates as being too deferential to energy traders, it has responded 
to recent criticism by ordering the United Kingdom to set limits on 
speculative trading of WTI contracts, proposing stronger disclosure for 
index traders and swap dealers, spearheading an interagency task force 
to more closely monitor energy markets and strengthening disclosure 
requirements in its amended Dubai Mercantile Exchange No Action letter. 
But these actions are hardly enough to rein in the harmful levels of 
speculation and anti-competitive behavior that are causing energy 
prices to rise. A new CFTC Chairman presents important opportunities 
for the agency to take a more assertive role in policing these markets.
    Recent Congressional action, too, has been beneficial to consumers, 
but the legislation has not gone nearly far enough. Title XIII of H.R. 
6124 (the ``farm bill'') that became law in June 2008, closed some 
elements of the so-called ``Enron Loophole,'' which provided broad 
exemptions from oversight for electronic exchanges like ICE. But the 
farm bill only provides limited protections from market manipulation, 
as it allows the CFTC, ``at its discretion,'' to decide on a contract-
by-contract basis that an individual energy contract should be 
regulated only if the CFTC can prove that the contract will ``serve a 
significant price discovery function'' in order to stop anti-
competitive behavior.
    In December 2007, H.R. 6 was signed into law. Sections 811 through 
815 of that act empower the Federal Trade Commission to develop rules 
to crack down on petroleum market manipulation.\3\ If these rules are 
promulgated effectively, this could prove to be an important first step 
in addressing certain anti-competitive practices in the industry.
---------------------------------------------------------------------------
    \3\ http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=110_cong_public_laws&docid=f:publ140.110.pdf.
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    Public Citizen recommends four broad reforms to rein in speculators 
and help ensure that energy traders do not engage in anti-competitive 
behavior: 


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



   Require foreign-based exchanges that trade U.S. energy 
        products to be subjected to full U.S. regulatory oversight.

   Impose legally-binding firewalls to limit energy traders 
        from speculating on information gleaned from the company's 
        energy infrastructure affiliates or other such insider 
        information, while at the same time allowing legitimate hedging 
        operations. Congress must authorize the FTC and DOJ to place 
        greater emphasis on evaluating anti-competitive practices that 
        arise out of the nexus between control over hard assets like 
        energy infrastructure and a firm's energy trading operations.

    Legislation introduced by U.S. Representative Collin C. Peterson, 
``The Derivatives Markets Transparency and Accountability Act of 
2009,'' \4\ does a great job addressing most of Public Citizen's 
recommendations. There are two areas, however, upon which the 
legislation could be improved. First, the bill should immediately 
subject OTC markets to the same regulatory oversight to which regulated 
exchanges like NYMEX must adhere. Second, the legislation should impose 
aggregate speculation limits over all markets to limit the ability of 
traders to engage in harmful speculation.
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    \4\ http://agriculture.house.gov/inside/Legislation/111/
PETEMN_001_xml.pdf.
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Energy Trading Abuses Require Stronger Oversight
Background
    Two regulatory lapses are enabling anti-competitive practices in 
energy trading markets where prices of energy are set. First, oil 
companies, investment banks and hedge funds are exploiting recently 
deregulated energy trading markets to manipulate energy prices. Second, 
energy traders are speculating on information gleaned from their own 
company's energy infrastructure affiliates, a type of legal ``insider 
trading.'' These regulatory loopholes were born of inappropriate 
contacts between public officials and powerful energy companies and 
have resulted in more volatile and higher prices for consumers.
    Contrary to some public opinion, oil prices are not set by the 
Organization of Petroleum Exporting Countries (OPEC); rather, they are 
determined by the actions of energy traders in markets. Historically, 
most crude oil has been purchased through either fixed-term contracts 
or on the ``spot'' market. There have been long-standing futures 
markets for crude oil, led by the New York Mercantile Exchange and 
London's International Petroleum Exchange (which was acquired in 2001 
by an Atlanta-based unregulated electronic exchange, ICE). NYMEX is a 
floor exchange regulated by the U.S. Commodity Futures Trading 
Commission (CFTC). The futures market has historically served to hedge 
risks against price volatility and for price discovery. Only a tiny 
fraction of futures trades result in the physical delivery of crude 
oil.
    The CFTC enforces the Commodity Exchange Act, which gives the 
Commission authority to investigate and prosecute market 
manipulation.\5\ But after a series of deregulation moves by the CFTC 
and Congress, the futures markets have been increasingly driven by the 
unregulated over-the-counter (OTC) market over the last few years. 
These OTC and electronic markets (like ICE) have been serving more as 
pure speculative markets, rather than traditional volatility hedging or 
price discovery. And, importantly, this new speculative activity is 
occurring outside the regulatory jurisdiction of the CFTC.
---------------------------------------------------------------------------
    \5\ 7 U.S.C.  9, 13b and 13(a)(2).
---------------------------------------------------------------------------
    Energy trading markets were deregulated in two steps. First, in 
response to a petition by nine energy and financial companies, led by 
Enron,\6\ on November 16, 1992, then-CFTC Chairwoman Wendy Gramm 
supported a rule change--later known as Rule 35--exempting certain 
energy trading contracts from the requirement that they be traded on a 
regulated exchange like NYMEX, thereby allowing companies like Enron 
and Goldman Sachs to begin trading energy futures between themselves 
outside regulated exchanges. Importantly, the new rule also exempted 
energy contracts from the anti-fraud provisions of the Commodity 
Exchange Act.\7\ At the same time, Gramm initiated a proposed order 
granting a similar exemption to large commercial participants in 
various energy contracts that was later approved in April 2003.\8\
---------------------------------------------------------------------------
    \6\ The other eight companies were: BP, Coastal Corp. (now El Paso 
Corp.) Conoco and Phillips (now ConocoPhillips), Goldman Sachs' J. Aron 
& Co., Koch Industries, Mobil (now ExxonMobil) and Phibro Energy (now a 
subsidiary of CitiGroup).
    \7\ 17 CFR Ch. 1, available at www.access.gpo.gov/nara/cfr/
waisidx_06/17cfr35_06.html.
    \8\ ``Exemption for Certain Contracts Involving Energy Products,'' 
58 Fed. Reg. 6250 (1993).
---------------------------------------------------------------------------
    Enron had close ties to Wendy Gramm's husband, then-Texas Senator 
Phil Gramm. Of the nine companies writing letters of support for the 
rule change, Enron made by far the largest contributions to Phil 
Gramm's campaign fund at that time, giving $34,100.\9\
---------------------------------------------------------------------------
    \9\ Charles Lewis, ``The Buying of the President 1996,'' pg. 153. 
The Center for Public Integrity.
---------------------------------------------------------------------------
    Wendy Gramm's decision was controversial. Then-Chairman of a House 
Agriculture Subcommittee with jurisdiction over the CFTC, Rep. Glen 
English, protested that Wendy Gramm's action prevented the CFTC from 
intervening in basic energy futures contracts disputes, even in cases 
of fraud, noting that that ``in my 18 years in Congress [Gramm's motion 
to deregulate] is the most irresponsible decision I have come across.'' 
Sheila Bair, the CFTC Commissioner casting the lone dissenting vote, 
argued that deregulation of energy futures contracts ``sets a dangerous 
precedent.'' \10\ A U.S. General Accounting Office report issued a year 
later urged Congress to increase regulatory oversight over derivative 
contracts,\11\ and a Congressional inquiry found that CFTC staff 
analysts and economists believed Gramm's hasty move prevented adequate 
policy review.\12\
---------------------------------------------------------------------------
    \10\ ``Derivatives Trading Forward-Contract Fraud Exemption May be 
Reversed,'' Inside FERC's Gas Market Report, May 7, 1993.
    \11\ ``Financial Derivatives: Actions Needed to Protect the 
Financial System,'' GGD-94-133, May 18, 1994, available at http://
archive.gao.gov/t2pbat3/151647.pdf.
    \12\ Brent Walth and Jim Barnett, ``A Web of Influence,'' Portland 
Oregonian, December 8, 1996.
---------------------------------------------------------------------------
    Five weeks after pushing through the ``Enron loophole,'' Wendy 
Gramm was asked by Kenneth Lay to serve on Enron's Board of Directors. 
When asked to comment about Gramm's nearly immediate retention by 
Enron, Lay called it ``convoluted'' to question the propriety of naming 
her to the Board.\13\
---------------------------------------------------------------------------
    \13\  Jerry Knight, ``Energy Firm Finds Ally, Director, in CFTC Ex-
Chief,'' Washington Post, April 17, 1993.
---------------------------------------------------------------------------
    Congress followed Wendy Gramm's lead in deregulating energy trading 
contracts and moved to deregulate energy trading exchanges by exempting 
electronic exchanges, like those quickly set up by Enron, from 
regulatory oversight (as opposed to a traditional trading floor like 
NYMEX that remained regulated). Congress took this action during last-
minute legislative maneuvering on behalf of Enron by former Texas GOP 
Senator Phil Gramm in the lame-duck Congress 2 days after the Supreme 
Court ruled in Bush v. Gore, buried in 712 pages of unrelated 
legislation.\14\ As Public Citizen pointed out back in 2001,\15\ this 
law deregulated OTC derivatives energy trading by ``exempting'' them 
from the Commodity Exchange Act, removing anti-fraud and anti-
manipulation regulation over these derivatives markets and exempting 
``electronic'' exchanges from CFTC regulatory oversight.
---------------------------------------------------------------------------
    \14\ H.R. 5660, an amendment to H.R. 4577, which became Appendix E 
of P.L. 106-554 available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=106_cong_public_laws&docid=f:publ554.106.pdf.
    \15\ Blind Faith: How Deregulation and Enron's Influence Over 
Government Looted Billions from Americans, available at 
www.citizen.org/documents/Blind_Faith.pdf.
---------------------------------------------------------------------------
    This deregulation law was passed against the explicit 
recommendations of a multi-agency review of derivatives markets. The 
November 1999 release of a report by the President's Working Group on 
Financial Markets--a multi-agency policy group with permanent standing 
composed at the time of Lawrence Summers, Secretary of the Treasury; 
Alan Greenspan, Chairman of the Federal Reserve; Arthur Levitt, 
Chairman of the Securities and Exchange Commission; and William Rainer, 
Chairman of the CFTC--concluded that energy trading must not be 
deregulated. The Group reasoned that ``due to the characteristics of 
markets for nonfinancial commodities with finite supplies . . . the 
Working Group is unanimously recommending that the [regulatory] 
exclusion not be extended to agreements involving such commodities.'' 
\16\ In its 1999 lobbying disclosure form, Enron indicated that the 
``President's Working Group'' was among its lobbying targets.\17\
---------------------------------------------------------------------------
    \16\ ``Over-the-Counter Derivatives Markets and the Commodity 
Exchange Act,'' Report of The President's Working Group on Financial 
Markets, pg. 16. www.ustreas.gov/press/releases/docs/otcact.pdf.
    \17\ Senate Office of Public Records Lobbying Disclosure Database, 
available at http://sopr.senate.gov/cgi-win/opr_gifviewer.exe?/1999/01/
000/309/00030933130, page 7.
---------------------------------------------------------------------------
    As a result of the Commodity Futures Modernization Act, trading in 
lightly-regulated exchanges like NYMEX is declining as more capital 
flees to the unregulated OTC markets and electronic exchanges such as 
those run by the IntercontinentalExchange (ICE). Trading on the ICE has 
skyrocketed, with the 138 million contracts traded in 2007 representing 
a 230 percent increase from 2005.\18\ This explosion in unregulated and 
under regulated trading volume means that more trading is done behind 
closed doors out of reach of Federal regulators, increasing the chances 
of oil companies and financial firms to engage in anti-competitive 
practices. The founding members of ICE include Goldman Sachs, BP, Shell 
and TotalfinaElf. In November 2005, ICE became a publicly traded 
corporation.
---------------------------------------------------------------------------
    \18\ Available at www.theice.com/exchange_volumes_2005.jhtml.
---------------------------------------------------------------------------
The Players
    Goldman Sachs' trading unit, J. Aron, is one of the largest and 
most powerful energy traders in the United States, and commodities 
trading represents a significant source of revenue for the company. 
Goldman Sachs' most recent 10-k filed with the U.S. Securities and 
Exchange Commission show that Fixed Income, Currency and Commodities 
(which includes energy trading) generated 17 percent of Goldman's $22 
billion in revenue for 2008.\19\ That share, however, masks the role 
that energy trading plays in Goldman's revenue as the company lumps 
under-performing activities such as securitized mortgage debt, thereby 
dragging down revenues for the entire segment. Indeed, Goldman touted 
the performance of its commodity trading activities in 2008, noting 
that it ``produced particularly strong results and net revenues were 
higher compared with 2007.''
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    \19\ http://idea.sec.gov/Archives/edgar/data/886982/
000095012309001278/y74032e10vk.htm.
---------------------------------------------------------------------------
    In 2005, Goldman Sachs and Morgan Stanley--the two companies are 
widely regarded as the largest energy traders in America--each 
reportedly earned about $1.5 billion in net revenue from energy 
trading. One of Goldman's star energy traders, John Bertuzzi, made as 
much as $20 million in 2005.\20\
---------------------------------------------------------------------------
    \20\ http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee--prints&docid=f:28640.pdf, 
pages 24 and 26.
---------------------------------------------------------------------------
    In the summer of 2006, Goldman Sachs, which at the time operated 
the largest commodity index, GSCI, announced it was radically changing 
the index's weighting of gasoline futures, selling about $6 billion 
worth. As a direct result of this weighting change, Goldman Sachs 
unilaterally caused gasoline futures prices to fall nearly 10 
percent.\21\
---------------------------------------------------------------------------
    \21\ Heather Timmons, ``Change in Goldman Index Played Role in 
Gasoline Price Drop,'' The New York Times, September 30, 2006.
---------------------------------------------------------------------------
    Morgan Stanley held $18.7 billion in assets in commodity forwards, 
options and swaps at November 30, 2008. As the company noted in its 
annual report: ``Fiscal 2008 results reflected . . . record revenues 
from commodities . . . Commodity revenues increased 62%, primarily due 
to higher revenues from oil liquids and electricity and natural gas 
products.''
    A deregulation action by the Federal Reserve in 2003--at the 
request of Citigroup and UBS--allows commercial banks to engage in 
energy commodity trading.\22\ Since then commercial banks have become 
big players in the speculation market. The total value of commodity 
derivative contracts held by the Citigroup's Phibro trading division 
increased 384 percent from 2004 through 2008, rising from $44.4 billion 
to $214.5 billion.\23\ Bank of America held $58.6 billion worth of 
commodity derivatives contracts as of September 2008.\24\ Merrill 
Lynch, which BoA acquired in September 2008, experienced ``strong net 
revenues for the [third] quarter [2008] generated from our . . . 
commodities businesses.'' \25\
---------------------------------------------------------------------------
    \22\ Regulation Y; Docket No. R-1146, www.federalreserve.gov/
boarddocs/press/bcreg/2003/20030630/attachment.pdf.
    \23\ http://idea.sec.gov/Archives/edgar/data/831001/
000104746908011506/a2188770z10-q.htm.
    \24\ http://idea.sec.gov/Archives/edgar/data/70858/
000119312508228086/d10q.htm.
    \25\ http://idea.sec.gov/Archives/edgar/data/65100/
000095012308014369/y72170e10vq.htm.
---------------------------------------------------------------------------
    Just a year after Enron's collapse, the Commodity Futures Trading 
Commission finalized rules allowing hedge funds to engage in energy 
trading without registering with the CFTC, opening the door to firms 
like Citadel and D.E. Shaw.\26\
---------------------------------------------------------------------------
    \26\ 17 CFR Part 4, RIN 3038-AB97, ``Additional Registration and 
Other Regulatory Relief for Commodity Pool Operators and Commodity 
Trading Advisors,'' final rule issued August 1, 2003.
---------------------------------------------------------------------------
The Consequences of Deregulation
    A recent bipartisan U.S. Senate investigation summed up the 
negative impacts on oil prices with this shift towards unregulated 
energy trading speculation:

        Over the last few years, large financial institutions, hedge 
        funds, pension funds, and other investment funds have been 
        pouring billions of dollars into the energy commodity markets--
        perhaps as much as $60 billion in the regulated U.S. oil 
        futures market alone . . . The large purchases of crude oil 
        futures contracts by speculators have, in effect, created an 
        additional demand for oil, driving up the price of oil to be 
        delivered in the future in the same manner that additional 
        demand for the immediate delivery of a physical barrel of oil 
        drives up the price on the spot market . . . Several analysts 
        have estimated that speculative purchases of oil futures have 
        added as much as $20-$25 per barrel to the current price of 
        crude oil . . . large speculative buying or selling of futures 
        contracts can distort the market signals regarding supply and 
        demand in the physical market or lead to excessive price 
        volatility, either of which can cause a cascade of consequences 
        detrimental to the overall economy . . . At the same time that 
        there has been a huge influx of speculative dollars in energy 
        commodities, the CFTC's ability to monitor the nature, extent, 
        and effect of this speculation has been diminishing. Most 
        significantly, there has been an explosion of trading of U.S. 
        energy commodities on exchanges that are not regulated by the 
        CFTC . . . in contrast to trades conducted on the NYMEX, 
        traders on unregulated OTC electronic exchanges are not 
        required to keep records or file Large Trader Reports with the 
        CFTC, and these trades are exempt from routine CFTC oversights. 
        In contrast to trades conducted on regulated futures exchanges, 
        there is no limit on the number of contracts a speculator may 
        hold on an unregulated OTC electronic exchange, no monitoring 
        of trading by the exchange itself, and no reporting of the 
        amount of outstanding contracts (``open interest'') at the end 
        of each day.\27\
---------------------------------------------------------------------------
    \27\ The Role Of Market Speculation In Rising Oil And Gas Prices: A 
Need To Put The Cop Back On The Beat, Staff Report prepared by the 
Permanent Subcommittee on Investigations of the Committee on Homeland 
Security and Governmental Affairs of the U.S. Senate, June 27, 2006, 
available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf.

    Thanks to the Commodity Futures Modernization Act, participants in 
these newly-deregulated energy trading markets are not required to file 
so-called Large Trader Reports, the records of all trades that NYMEX 
traders are required to report to the CFTC, along with daily price and 
volume information. These Large Trader Reports, together with the price 
and volume data, are the primary tools of the CFTC's regulatory regime: 
``The Commission's Large Trader information system is one of the 
cornerstones of our surveillance program and enables detection of 
concentrated and coordinated positions that might be used by one or 
more traders to attempt manipulation.'' \28\ So the deregulation of OTC 
markets, by allowing traders to escape such basic information 
reporting, leave Federal regulators with no tools to routinely 
determine whether market manipulation is occurring in energy trading 
markets.
---------------------------------------------------------------------------
    \28\ Letter from Reuben Jeffrey III, Chairman, CFTC, to Michigan 
Governor Jennifer Granholm, August 22, 2005.
---------------------------------------------------------------------------
    One result of the lack of transparency is the fact that even some 
traders don't know what's going on. A recent article described how:

        Oil markets were rocked by a massive, almost instant surge in 
        after-hours electronic trading one day last month, when prices 
        for closely watched futures contracts jumped 8% . . . this 
        spike stands out because it was unclear at the time what drove 
        it. Two weeks later, it is still unclear. What is clear is that 
        a rapid shift in the bulk of crude trading from the raucous 
        trading floor of the New York Mercantile Exchange to anonymous 
        computer screens is making it harder to nail down the cause of 
        price moves . . . The initial jump ``triggered more orders 
        already set into the system, and with prices rising, people 
        thought somebody must know something,'' Tom Bentz, an analyst 
        and broker at BNP Paribas Futures in New York who was watching 
        the screen at the time, said the day after the spike. ``The 
        more prices rose, the more it seemed somebody knew something.'' 
        \29\
---------------------------------------------------------------------------
    \29\ Matt Chambers, ``Rise in Electronic Trading Adds Uncertainty 
to Oil,'' The Wall Street Journal, April 10, 2007.

    Oil companies, investment banks and hedge funds are exploiting the 
lack of government oversight to price-gouge consumers and make billions 
of dollars in profits. These energy traders boast how they're price-
gouging Americans, as a recent Dow Jones article makes clear: energy 
``traders who profited enormously on the supply crunch following 
Hurricane Katrina cashed out of the market ahead of the long weekend. 
`There are traders who made so much money this week, they won't have to 
punch another ticket for the rest of this year,' said Addison 
Armstrong, manager of exchange-traded markets for TFS Energy Futures.'' 
\30\
---------------------------------------------------------------------------
    \30\ Leah McGrath Goodman, ``Oil Futures, Gasoline In NY End 
Sharply Lower,'' September 2, 2005.
---------------------------------------------------------------------------
    The ability of Federal regulators to investigate market 
manipulation allegations even on the lightly-regulated exchanges like 
NYMEX is difficult, let alone the unregulated OTC market. For example, 
as of August 2006, the Department of Justice is still investigating 
allegations of gasoline futures manipulation that occurred on a single 
day in 2002.\31\ If it takes the DOJ 4 years to investigate a single 
day's worth of market manipulation, clearly energy traders intent on 
price-gouging the public don't have much to fear.
---------------------------------------------------------------------------
    \31\ John R. Wilke, Ann Davis and Chip Cummins, ``BP Woes Deepen 
with New Probe,'' The Wall Street Journal, August 29, 2006.
---------------------------------------------------------------------------
    That said, there have been some settlements for manipulation by 
large oil companies. In January 2006, the CFTC issued a civil penalty 
against Shell Oil for ``non-competitive transactions'' in U.S. crude 
oil futures markets.\32\ In March 2005, a Shell subsidiary agreed to 
pay $4 million to settle allegations it provided false information 
during a Federal investigation into market manipulation.\33\ In August 
2004, a Shell Oil subsidiary agreed to pay $7.8 million to settle 
allegations of energy market manipulation.\34\ In July 2004, Shell 
agreed to pay $30 million to settle allegations it manipulated natural 
gas prices.\35\ In October 2007, BP agreed to pay $303 million to 
settle allegations the company manipulated the propane market.\36\ In 
September 2003, BP agreed to pay NYMEX $2.5 million to settle 
allegations the company engaged in improper crude oil trading, and in 
July 2003, BP agreed to pay $3 million to settle allegations it 
manipulated energy markets.\37\
---------------------------------------------------------------------------
    \32\ ``U.S. Commodity Futures Trading Commission Assesses Penalties 
of $300,000 Against Shell-Related Companies and Trader in Settling 
Charges of Prearranging Crude Oil Trades'' available at www.cftc.gov/
newsroom/enforcementpressreleases/2006/pr5150-06.html.
    \33\ ``Commission Accepts Settlement Resolving Investigation Of 
Coral Energy Resources,'' available at www.ferc.gov/news/news-releases/
2005/2005-1/03-03-05.asp.
    \34\ ``Order Approving Contested Settlement,'' available at 
www.ferc.gov/whats-new/comm-meet/072804/E-60.pdf.
    \35\ ``Coral Energy Pays $30 Million to Settle U.S. Commodity 
Futures Trading Commission Charges of Attempted Manipulation and False 
Reporting,'' available at www.cftc.gov/opa/enf04/opa4964-04.htm.
    \36\ www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5405-
07.html.
    \37\ ``Order Approving Stipulation and Consent Agreement,'' 104 
FERC  61,089, available at http://elibrary.ferc.gov/idmws/common/
opennat.asp?fileID=10414789.
---------------------------------------------------------------------------
    In August 2007, Oil giant BP admitted in a filing to the Securities 
and Exchange Commission that ``The U.S. Commodity Futures Trading 
Commission and the U.S. Department of Justice are currently 
investigating various aspects of BP's commodity trading activities, 
including crude oil trading and storage activities, in the U.S. since 
1999, and have made various formal and informal requests for 
information.'' \38\
---------------------------------------------------------------------------
    \38\ www.sec.gov/Archives/edgar/data/313807/000115697307001223/
u53342-6k.htm.
---------------------------------------------------------------------------
    In August 2007, Marathon Oil agreed to pay $1 million to settle 
allegations the company manipulated the price of West Texas 
Intermediate crude oil.\39\
---------------------------------------------------------------------------
    \39\ www.cftc.gov/newsroom/enforcementpressreleases/2007/pr5366-
07.html.
---------------------------------------------------------------------------
    There is near-unanimous agreement among industry analysts that 
speculation is driving up oil and natural gas prices. Representative of 
these analyses is a May 2006 Citigroup report on the monthly average 
value of speculative positions in American commodity markets, which 
found that the value of speculative positions in oil and natural gas 
stood at $60 billion, forcing Citigroup to conclude that ``we believe 
the hike in speculative positions has been a key driver for the latest 
surge in commodity prices.'' \40\
---------------------------------------------------------------------------
    \40\ The Role Of Market Speculation In Rising Oil And Gas Prices: A 
Need To Put The Cop Back On The Beat, Staff Report prepared by the 
Permanent Subcommittee on Investigations of the Committee on Homeland 
Security and Governmental Affairs of the U.S. Senate, June 27, 2006, 
available at http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf.
---------------------------------------------------------------------------
    Natural gas markets are also victimized by these unregulated 
trading markets. Public Citizen has testified before Congress on this 
issue,\41\ and a March 2006 report by four State Attorneys General 
concludes that ``natural gas commodity markets have exhibited erratic 
behavior and a massive increase in trading that contributes to both 
volatility and the upward trend in prices.'' \42\
---------------------------------------------------------------------------
    \41\  ``The Need for Stronger Regulation of U.S. Natural Gas 
Markets,'' available at www.citizen.org/documents/
Natural%20Gas%20Testimony.pdf. 
    \42\  The Role of Supply, Demand and Financial Commodity Markets in 
the Natural Gas Price Spiral, available at www.ago.mo.gov/pdf/
NaturalGasReport.pdf.
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    The Industrial Energy Consumers of America wrote a January 2005 
letter to the Securities and Exchange Commission ``alarmed at the 
significant increase in unregulated hedge funds trading on the NYMEX 
and OTC natural-gas markets.'' \43\ In November 2004 the group wrote 
Congress, asking them to ``increase energy market oversight by the 
Commodity Futures Trading Commission.'' \44\
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    \43\ www.ieca-us.com/downloads/natgas/SECletter013105.doc.
    \44\ www.ieca-us.com/downloads/natgas/
111704LettertoCongr%23AAC2.doc.
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    While most industry analysts agree that the rise in speculation is 
fueling higher prices, there is one notable outlier: the Federal 
Government. In a widely dismissed report, the CFTC recently concluded 
that there was ``no evidence of a link between price changes and MMT 
[managed money trader] positions'' in the natural gas markets and ``a 
significantly negative relationship between MMT positions and prices 
changes . . . in the crude oil market.'' \45\
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    \45\ Michael S. Haigh, Jana Hranaiova and James A. Overdahl, 
``Price Dynamics, Price Discovery and Large Futures Trader Interactions 
in the Energy Complex,'' available at www.cftc.gov/files/opa/press05/
opacftc-managed-money-trader-study.pdf.
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    The CFTC study (and similar one performed by NYMEX) is flawed for 
numerous reasons, including the fact that the role of hedge funds and 
other speculators on long-term trading was not included in the 
analysis. The New York Times reported that ``many traders have scoffed 
at the studies, saying that they focused only on certain months, 
missing price run-ups.'' \46\
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    \46\ Alexei Barrionuevo and Simon Romero, ``Energy Trading, Without 
a Certain `E','' January 15, 2006.
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Latest Trading Trick: Energy Infrastructure Affiliate Abuses
    Energy traders like Goldman Sachs are investing and acquiring 
energy infrastructure assets because controlling pipelines and storage 
facilities affords their energy trading affiliates an ``insider's 
peek'' into the physical movements of energy products unavailable to 
other energy traders. Armed with this non-public data, a company like 
Goldman Sachs most certainly will open lines of communication between 
the affiliates operating pipelines and the affiliates making large bets 
on energy futures markets. Without strong firewalls prohibiting such 
communications, consumers would be susceptible to price-gouging by 
energy trading affiliates.
    For example, In January 2007, Highbridge Capital Management, a 
hedge fund controlled by J.P.Morgan Chase, bought a stake in an energy 
unit of Louis Dreyfus Group to expand its oil and natural gas trading. 
Glenn Dubin, co-founder of Highbridge, said that owning physical energy 
assets like pipelines and storage facilities was crucial to investing 
in the business: ``That gives you a very important information 
advantage. You're not just screen-trading financial products.'' \47\
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    \47\ Saijel Kishan and Jenny Strasburg, ``Highbridge Capital Buys 
Stake in Louis Dreyfus Unit,'' Bloomberg, January 8, 2007, 
www.bloomberg.com/apps/news?pid=20601014&sid=aBnQy1botdFo. 
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    Indeed, such an ``information advantage'' played a key role in 
allowing BP's energy traders to manipulate the entire U.S. propane 
market. In October 2007, the company paid $303 million to settle 
allegations that the company's energy trading affiliate used the 
company's huge control over transportation and storage to allow the 
energy trading affiliate to exploit information about energy moving 
through BP's infrastructure to manipulate the market.
    BP's energy trading division, North America Gas & Power (NAGP), was 
actively communicating with the company's Natural Gas Liquids Business 
Unit (NGLBU), which handled the physical production, pipeline 
transportation and retail sales of propane. A PowerPoint exhibit to the 
civil complaint against BP details how the two divisions coordinated 
their manipulation strategy, which includes ``assurance that [the] 
trading team has access to all information and optionality within [all 
of
BP] . . . that can be used to increase chance of success [of market 
manipula
tion] . . . Implement weekly meetings with Marketing & Logistics to 
review trading positions and share opportunities.'' \48\
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    \48\ www.cftc.gov/files/enf/06orders/opa-bp-lessons-learned.pdf.
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    And in August 2007, BP acknowledged that the Federal Government was 
investigating similar gaming techniques in the crude oil markets.
    BP is not alone. A Morgan Stanley energy trader, Olav Refvik, ``a 
key part of one of the most profitable energy-trading operations in the 
world . . . helped the bank dominate the heating oil market by locking 
up New Jersey storage tank farms adjacent to New York Harbor.'' \49\ As 
of November 2008, Morgan Stanley committed $452 million to lease 
petroleum storage facilities for 2009. As the company notes: ``In 
connection with its commodities business, the Company enters into 
operating leases for both crude oil and refined products storage and 
for vessel charters. These operating leases are integral parts of the 
Company's commodities risk management business.'' \50\ In 2003, Morgan 
Stanley teamed up with Apache Corp. to buy 26 oil and gas fields from 
Shell for $500 million, of which Morgan Stanley put up $300 million in 
exchange for a portion of the production over the next 4 years, which 
it used to supplement its energy trading desk.\51\ Again, control over 
physical infrastructure assets plays a key role in helping energy 
traders game the market.
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    \49\ http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee_prints&docid=f:28640.pdf, 
page 26.
    \50\ http://idea.sec.gov/Archives/edgar/data/895421/
000119312509013429/d10k.htm.
    \51\ Paul Merolli, ``Two Morgan Stanley M&A deals show bullish 
stance on gas,'' Natural Gas Week, Volume 19; Issue 28, July 14, 2003.
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    The Wall Street Journal suggested that the bankruptcy of a single 
firm, SemGroup, served as the initial trigger of crude oil's price 
collapse this summer. The company operated 1,200 miles of oil pipelines 
and held 15 million barrels of crude storage capacity, but was 
misleading regulators and its own investors on the extent of its 
hedging practices. Data suggests that SemGroup was taking out positions 
far in excess of its physical delivery commitments, becoming a pure 
speculator. When its bets turned sour, the company was forced to 
declare bankruptcy.\52\
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    \52\ Brian Baskin, ``SemGroup Loses Bets on Oil; Hedging Tactics 
Coincide With Ebb In Price of Crude,'' July 24, 2008, Page C14.
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    This shows that the energy traders were actively engaging the 
physical infrastructure affiliates in an effort to glean information 
helpful for market manipulation strategies. And it is important to note 
that BP's market manipulation strategy was extremely aggressive and 
blatant, and regulators were tipped off to it by an internal 
whistleblower. A more subtle manipulation effort could easily evade 
detection by Federal regulators, making it all the more important to 
establish firewalls between energy assets affiliates and energy trading 
affiliates to prevent any undue communication between the units.
    Financial firms like hedge funds and investment banks that normally 
wouldn't bother purchasing low-profit investments like oil and gasoline 
storage have been snapping up ownership and/or leasing rights to these 
facilities mainly for the wealth of information that controlling energy 
infrastructure assets provides to help one's energy traders manipulate 
trading markets. The Wall Street Journal reported that financial 
speculators were snapping up leasing rights in Cushing, Ok.\53\
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    \53\ Ann Davis, ``Where Has All The Oil Gone?'' October 6, 2007, 
Page A1.
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    In August 2006, Goldman Sachs, AIG and Carlyle/Riverstone announced 
the $22 billion acquisition of Kinder Morgan, Inc., which controls 
43,000 miles of crude oil, refined products and natural gas pipelines, 
in addition to 150 storage terminals.
    Prior to this huge purchase, Goldman Sachs had already assembled a 
long list of oil and gas investments. In 2005, Goldman Sachs and 
private equity firm Kelso & Co. bought a 112,000 barrels/day oil 
refinery in Kansas operated by CVR Energy, and entered into an oil 
supply agreement with J. Aron, Goldman`s energy trading subsidiary. 
Goldman's Scott L. Lebovitz & Kenneth A. Pontarelli and Kelso's George 
E. Matelich & Stanley de J. Osborne all serve on CVR Energy's Board of 
Directors.
    In May 2004, Goldman spent $413 million to acquire royalty rights 
to more than 1,600 natural gas wells in Pennsylvania, West Virginia, 
Texas, Oklahoma and offshore Louisiana from Dominion Resources. Goldman 
Sachs owns a six percent stake in the 375 mile Iroquois natural gas 
pipeline, which runs from Northern New York through Connecticut to Long 
Island. In December 2005, Goldman and Carlyle/Riverstone together are 
investing $500 million in Cobalt International Energy, a new oil 
exploration firm run by former Unocal executives.
Conclusion
    This era of high energy prices isn't a simple case of supply and 
demand, as the evidence suggests that weak or non-existent regulatory 
oversight of energy trading markets provides opportunity for energy 
companies and financial institutions to price-gouge Americans. Forcing 
consumers suffering from inelastic demand to continue to pay high 
prices--in part fueled by uncompetitive actions--not only hurts 
consumers economically, but environmentally as well, as the oil 
companies and energy traders enjoying record profits are not investing 
those earnings into sustainable energy or alternatives to our addiction 
to oil. Reforms to strengthen regulatory oversight over America's 
energy trading markets are needed to restore true competition to 
America's oil and gas markets.
Solutions
   Re-regulate energy trading markets by subjecting OTC 
        exchanges--including foreign-based exchanges trading U.S. 
        energy products--to full compliance under the Commodity 
        Exchange Act and mandate that all OTC energy trades adhere to 
        the CFTC's Large Trader reporting requirements. In addition, 
        regulations must be strengthened over existing lightly-
        regulated exchanges like NYMEX.

   Impose legally-binding firewalls to limit energy traders 
        from speculating on information gleaned from the company's 
        energy infrastructure affiliates or other such insider 
        information, while at the same time allowing legitimate hedging 
        operations. Congress must authorize the FTC and DOJ to place 
        greater emphasis on evaluating anti-competitive practices that 
        arise out of the nexus between control over hard assets like 
        energy infrastructure and a firm's energy trading operations. 
        Incorporating energy trading operations into anti-trust 
        analysis must become standard practice for Federal regulatory 
        and enforcement agencies to force more divestiture of assets in 
        order to protect consumers from abuses.

   Raise margin requirements so market participants will have 
        to put up more of their own capital in order to trade energy 
        contracts, and impose aggregate position limits on 
        noncommercial trading to reduce speculation. Currently, margin 
        requirements are too low, which encourages speculators to more 
        easily enter the market by borrowing, or leveraging, against 
        their positions. And aggregated limits over all markets--not 
        just select ones--would preclude an energy trader from dipping 
        their hands in multiple futures market cookie jars with the 
        intent to speculate.

    The Chairman. Thank you, Mr. Slocum.
    Thank both of you for being with us today.
    I hadn't really thought about, Mr. Slocum, what you had 
brought up there. I don't really agree with the terminology 
``speculation'' for what Goldman Sachs is doing. Because they 
have created an investment that they are selling to people. 
That is going into the market, and they are using the regulated 
market to hedge their risks and so forth.
    So, the fact that they are selling an index that has 10 
percent corn, 40 percent oil, and eight percent copper or 
whatever, that is going into the market based on those 
percentages, and there is not a whole lot of thought going into 
it. It is just an investment vehicle they are selling to 
people.
    I am not sure there is anybody sitting around there 
scheming what is going to happen. They are just getting their 
commissions by selling these investments to pension funds and 
some of these other people. They are putting out this 
information, they are still running seminars trying to convince 
people that they ought to take their money out of other areas 
and put them into commodities because they can make more money 
because oil prices are going up or whatever.
    So I don't know if I can connect the dots there. But I do 
have, personally, a concern about this money that has been 
coming into this market from these areas that don't have 
anything to do with the underlying commodity situation.
    In fact, the first draft I put out last year banned pension 
funds from being involved in this commodity market at all, 
which I still personally believe we should do. I am just 
waiting for the day for the pension funds to come to the United 
States Congress and tell us that we have to bail them out 
because of this failed strategy that cost them all this money 
in their pension funds, and now they can't pay the benefits. 
That is probably going to come at some point here, too.
    But we will take that under consideration, and I guess I 
would like to learn more about what you think the connection is 
there.
    Mr. Roth, you have some proposed ideas on how to get a 
handle on this retail stuff that is going on?
    Mr. Roth. Exactly, Mr. Chairman. We have language that we 
would be happy to share with the staff and with Members of the 
Committee. It is language that we have circulated before, but 
we think it has broad support.
    The Chairman. You might find a more receptive audience now. 
Times have changed.
    The gentleman from Texas, Mr. Conaway.
    Mr. Conaway. Thank you, Mr. Chairman.
    I don't have a lot to say, other than I share Mr. Roth's 
concern about bucket shops and preying on the uninformed and 
folks that shouldn't be in these markets.
    Mr. Slocum, I am a little bit concerned about some of the 
allegations that you kind of throw around. I am assuming you 
have empirical evidence behind everything you accused folks of 
doing in your opening statement.
    Mr. Slocum. The accusation of what, that there was a----
    Mr. Conaway. The rampant speculation for one thing. You 
have empirical evidence on that?
    Mr. Slocum. Absolutely. I wasn't accusing anyone of 
manipulating markets.
    Mr. Conaway. Which is, sir?
    Mr. Slocum. Which is data from the CFTC, which is numerous 
other----
    Mr. Conaway. And the fact the Chairman of the CFTC has been 
in here numerous times saying the data that we have, we can't 
find market manipulation from rampant speculation.
    Mr. Slocum. And there have been numerous criticisms of----
    Mr. Conaway. I understand. Nobody likes it. Nobody likes 
the high prices. Nobody likes the run-up. But we have to be 
careful that we use evidence to try to determine public policy. 
Just because we don't like something doesn't mean that it is 
automatically some kind----
    Mr. Slocum. I am not discussing likes and dislikes. I am 
talking about an unprecedented rise and then collapse of crude 
oil prices; where any analyst examining it could see a wide 
disconnect between supply-demand fundamentals. When you have 
prices rise that quickly, demand does not collapse overnight. 
There were no new massive oil fields that appeared. This 
collapse in oil prices was directly the result of the inability 
of financial players who were betting on these markets----
    Mr. Conaway. You have evidence to that?
    Mr. Slocum. Well, it is my knowledge of the way that the 
futures markets work.
    Mr. Conaway. Yes. Your interest in restricting the physical 
assets that go along with certain commodities, how do you--the 
guy that grows corn, you would restrict him from being able to 
work in these markets as well?
    Mr. Slocum. My experience and expertise is on energy 
markets.
    Mr. Conaway. Okay. I am an oil and gas producer, and I 
drill for oil and gas. I find some reserves. I get a petroleum 
engineer who gives me an estimate of that value. I go to my 
bank and want to borrow against that reserve. The bank says, 
well, you can do that, but you have to hedge the price that you 
used in your valuation contest. I own the barrels. I am long 
the barrels. I can somehow manipulate the system by doing that?
    Mr. Slocum. No. There is a difference between what I 
consider legitimate hedging and what I consider speculation. So 
a legitimate hedger, sir, would be someone like a Valero 
Energy, which is based in Texas.
    Mr. Conaway. Why would Goldman Sachs not be a legitimate 
hedger? If they own Kinder Morgan and they own the assets, the 
long assets, why would they not be a----
    Mr. Slocum. Well, they have no physical delivery 
commitments. They acquire ownership over transportation----
    Mr. Conaway. Right.
    Mr. Slocum.--of oil, so they are not responsible for 
physically delivering. There is no one in a Goldman Sachs 
uniform delivering home heating oil to my family in New 
England. There are other entities that are doing that.
    The Chairman raised the point about Goldman's index fund, 
which is a passive player. But Goldman also has an extensive 
futures operation outside of its index fund, where they are a 
major player in the futures markets.
    Mr. Conaway. Okay. Reclaiming my time, Mr. Slocum, you said 
there were 80 million barrels on the high seas?
    Mr. Slocum. Eighty million barrels----
    Mr. Conaway. That is how much of a production?
    Mr. Slocum. I am sorry? That is enough for a day's worth 
of----
    Mr. Conaway. Okay. Just to make sure I understand, what is 
the holding cost on 80 million barrels? In other words, you 
have to finance it. What is your interest hold on 80 million 
barrels?
    Mr. Slocum. Well, according to the article, the daily rate 
for a supertanker to hold a million or 2 million barrels of oil 
a day was in the range of like $40,000 to $70,000 a day.
    Mr. Conaway. So multiply that times 80.
    Mr. Slocum. Right. It is a big number.
    Mr. Conaway. It is a big number, a huge number. So is there 
some nefarious reason I would do that and incur those costs?
    Mr. Slocum. Because you can make more money holding it and 
by controlling these physical assets.
    Mr. Conaway. But isn't that what buying and selling is all 
about?
    Mr. Slocum. Sure. But the concern I have is when this 
occurs in an unregulated format by players who do not have 
physical delivery commitments.
    Mr. Conaway. If I have 80 million barrels in tankers, I 
have the asset. I am long the barrels.
    Mr. Slocum. Right. But your primary purpose of holding that 
and hoarding that is not to physically deliver it but to take 
it off the market.
    Mr. Conaway. So I am now hoarding?
    Mr. Slocum. That is right. That is the definition of 
hoarding, sir, and the concern I have----
    Mr. Conaway. To buy inventory in anticipation that it would 
go up later and I could sell it later, that I am a hoarder at 
this point now?
    Mr. Slocum. If you are a financial firm whose primary focus 
is----
    Mr. Conaway. Is making money.
    Mr. Slocum.--entering into the futures market and you are 
acquiring or leasing storage facilities for the sole purpose of 
supplementing your trading desk, that is hoarding. And I am not 
asking----
    Mr. Conaway. Okay. If I am a financial company, I am buying 
stocks with the anticipation that those go up, and they go up 
because there is a shortage of folks who want to sell, I am now 
a hoarder?
    Mr. Slocum. Well, the difference in commodities markets is, 
if I have information about the movement or storage levels of a 
commodity----
    Mr. Conaway. Right. And who has----
    Mr. Slocum.--that gives me a massive insider's peek, an 
information advantage as to how other traders are going to 
react. By having control over pipelines or storage facilities, 
you have access to proprietary data that is not widely 
available to other speculators in the marketplace. So, as 
Morgan Stanley notes in its own annual report, that getting 
control over those storage facilities plays a very integral 
role in their trading operations. And their trading operations 
are purely speculative. They do not have physical delivery 
commitments.
    Mr. Conaway. As the Chairman already said, they are using 
those operations to create instruments that they sell to their 
customers. They themselves are trying to make money. You and I 
are unlikely to agree on much of this, Mr. Slocum, but I 
appreciate you coming today and will yield back to the 
Chairman.
    Mr. Roth. If I could just add one historical perspective.
    The Chairman. Sure.
    Mr. Roth. I mean, there are laws on the books right now 
against manipulation of markets; and there have been cases 
brought by the CFTC in which an integral part of the 
manipulation effort was a control over the delivery points, or 
the control of the delivery ability of the underlying 
commodity. So it is an interesting question that you pose, but 
there are anti-manipulation laws in effect that have been 
applied to the circumstances similar to those that you 
describe.
    Mr. Slocum. Right. The case that caused Public Citizen to 
look at this on our radar screen was last year when British 
Petroleum, a major oil company, agreed to a $300 million 
settlement when it attempted to manipulate the entire U.S. 
market for propane, and they did it when their energy traders 
were communicating with their propane pipeline and storage 
affiliates. But the only reason that regulators knew about it 
was because an internal employee at BP blew the whistle.
    The ability of regulators to examine that kind of activity 
is limited, which is why I suggested to the Committee that in 
legislation we should consider examining whether or not this is 
a problem.
    The Chairman. Thank you very much.
    The gentleman from Georgia, Mr. Marshall.
    Mr. Marshall. Thank you, Mr. Chairman.
    Mr. Roth, It has been 4, 5 years now we have been working 
on a Zelener fix; and it sure would be nice to get one that is 
more effective than what we have done in the past. I think we 
will; and I appreciate you being persistent, a nag as you 
described it, on that subject.
    What do you think about the legislation that we have 
otherwise, our efforts with regard to credit default swaps, 
transparency, regulating or banning or severely limiting naked 
swaps, that sort of thing?
    Mr. Roth. We make a couple of points in my written 
testimony.
    Mr. Marshall. If you want to just refer to your written 
testimony, that is fine.
    Mr. Roth. That is fine. I would be happy to summarize a 
couple of points quickly.
    It was interesting to watch the previous panel. With 
respect to naked credit default swaps, it seemed to me that Mr. 
Greenberger's point was he was not worried about hedgers in 
those markets, he just wanted to deal with the speculators. The 
point is, as was made by many people, that you can't deal with 
the speculators without affecting the hedgers, and that I am 
not aware of any derivative market anyplace that can survive 
without liquidity. I don't know of any market that can have 
liquidity without speculators. So, your idea of looking for 
some form of compromise on that point is the right path to be 
traveling.
    Mr. Marshall. Okay. Mr. Slocum, just an observation, 
something I am sure that you are already aware of, but the CEA 
permits people to trade on insider information. And so to the 
extent that you are wondering whether or not we should permit 
parties to have physical assets that are associated with the 
futures that they are trading and the derivatives that they are 
trading in. You are wondering whether or not we should revisit 
altogether, at least if you are worried about insider trading, 
revisit altogether the CEA's permission to use insider trading, 
the whole idea there being that we want to get the best 
possible angle on what the right price is and that that helps 
the entire market. It helps all the farmers. It helps the 
elevators. It helps everybody.
    I think you are absolutely right, that to the extent that 
there is an entity that has control of a substantial or a 
critical part of the physical infrastructure associated with a 
particular market, and at the same time is in the derivatives 
or futures market, there can be a temptation to use physical 
control, somehow, for manipulation--not just information but to 
actually manipulate the market.
    As Mr. Roth has pointed out, we have laws that address 
that. You are worried that a lot of the fraud that could 
potentially occur as a result of this kind of control is not 
really discoverable. So you might want to suggest ways in which 
we could enhance our ability to discover problems along those 
lines.
    I will just make one further observation. We heard lots of 
testimony last year that one of the reasons why there wasn't 
convergence, and one of the reasons why the futures markets 
weren't working effectively is because we didn't have enough 
storage for delivery. Some of us said how we deliver products 
should not be driven by the way these contracts are drafted, 
and it is kind of stupid for all of us, for the world to 
reorganize itself just to meet this contractual need that could 
be changed. Others said, no there is a real reason why these 
contracts are so narrowly drawn, that delivery has to be in a 
particular place.
    So it is not farfetched for me to think that Morgan Stanley 
and others legitimately are concerned about delivery and the 
ability to deliver, and the ability to store those sorts of 
things and want to do that to enhance their ability to 
participate in these markets, given what happened over the last 
few years. I suspect that is the argument they would make.
    So if you could just help us out, not necessarily right 
now--but with some specific suggestions for how we enhance our 
ability to determine who is manipulating, that would be 
enormously helpful to us.
    Mr. Slocum. Right. Well, just to very quickly respond, the 
Federal Energy Regulatory Commission, which has jurisdiction 
over natural gas storage facilities, has explicit Code of 
Conduct rules prohibiting an entity that has controller 
ownership over natural gas storage from communicating with any 
affiliates that are engaged in the futures market for natural 
gas. For natural gas, there are very explicit barriers that do 
not exist for crude oil and other petroleum products.
    So Public Citizen is only seeking that crude oil and other 
petroleum products are treated the same as natural gas; and 
since this is a hearing about futures markets and abuses that 
have occurred in the futures market, it is entirely 
appropriate. Again, it must be crafted in a way that does not 
inhibit what I see as legitimate hedging.
    The example I was trying to give earlier was of Valero in 
San Antonio, a major independent refiner. They do not produce 
any oil themselves, but they refine oil into useful products 
that we all need. They absolutely must go into the futures 
market to hedge for their basic business operations.
    I do not want to inhibit their ability to do that. I do 
want to inhibit what I see as a purely financial speculator, 
like a Goldman Sachs, like a Morgan Stanley, who is getting 
into the physical ownership and control of energy assets purely 
to supplement their futures operation. That I do not think is 
economically useful for the United States.
    Mr. Marshall. We very much appreciate what both of you and 
your organizations do to help the citizens of the United 
States.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman.
    The gentleman from Iowa, Mr. Boswell.
    Mr. Boswell. Thank you, Mr. Chairman.
    I had to step out. I apologize. If this has been asked, 
just stop me.
    But, to Mr. Roth, I guess we will get better acquainted as 
I take on the new responsibility with commodities and risk 
management that the Chairman has seen so fit to give me, but we 
will talk more as time goes on.
    But I am concerned. There is a lot of blame for hastening 
the downward spiral for the naked credit default swaps. Would 
you just comment some more on that? That is done through, some 
say, bad actors; to short a company and then drive the company 
down by sending market signs through the CDS market, decreases 
the company's ability to borrow or raise capital, while other 
companies require higher margin capital requirements.
    How would you propose Congress weighs a systemic risk to 
the market without lending legitimate risk mitigation strategy?
    Mr. Roth. Well, as the previous panel indicated, the 
natural evolution of these products toward a centralized 
clearing is a beneficial sort of development for everyone and 
adds greater transparency to the process.
    So I think you are right. Anytime there is some sort of a 
crisis, anytime there is sort of a problem, there is always a 
desire to point the finger and usually at somebody else.
    So with respect to credit default swaps, I am not aware of 
any financial derivative product which has thrived that didn't 
serve a valid and useful economic purpose. So I am assuming 
that there is a valid and useful economic purpose to these 
instruments.
    I think that the more transparency Congress can bring to 
these instruments the better. The fact that they are moving 
towards centralized clearing is helpful; and, at the same time, 
as Mr. Duffy and others provided, or pointed out, it is hard to 
put a round peg in a square hole. Certain instruments simply 
cannot be cleared because of their highly individualized 
nature.
    I know the draft bill has exemptive authority in there for 
the CFTC. I would just try to draft that legislation, that 
section of the bill in such a way to give the Commission 
maximum flexibility. Because to try to delineate in a statute 
all the different factors that would be appropriate to consider 
is very tough drafting, and I would emphasize the need to give 
the Commission as much flexibility as possible.
    Mr. Boswell. Thank you. I yield back.
    The Chairman. I thank the gentleman.
    The gentleman from Wisconsin, Mr. Kagen.
    Mr. Kagen. Thank you, Mr. Chairman.
    Mr. Roth, I have read your very brief report, and in it on 
page 5 you indicated, ``NFA supports efforts to bring greater 
transparency to these transactions''--referring to CDS credit 
default swaps--``and to reduce their systemic risk.''
    So what specific recommendations would you give towards 
changing the language of the draft to reduce that system at 
risk?
    Mr. Roth. Congressman, I have Zelener language for you, and 
I will give you that.
    I don't have language sitting in my pocket. What I am 
concerned about is, with respect to the mandatory clearing of 
OTC derivatives, the concern would be that, number one, that 
the Commission not have enough flexibility to grant exemptions. 
But, and you really need to talk to someone more directly 
involved in this market than I am, but it is hard for me to 
understand if two individuals are doing a highly privatized, 
highly individualized, privately negotiated instrument, and it 
is the first time they have done this instrument; before they 
consummate their transaction do they have to call the CFTC and 
get an exemption so everything is in unless it is out. Every 
time you do a new deal with a new counterparty you have to go 
to the CFTC and get an exemption? That strikes me as being an 
awkward sort of structure.
    Those are the types of things I would be looking for. I 
don't have language for you today, but I would be happy to give 
it some thought. Again, not directly within NFA's realm, but I 
would be happy to give some further thought to it. But those 
are my general concerns.
    Mr. Kagen. Mr. Slocum, would you care to comment on 
systemic risk?
    Mr. Slocum. I don't think I have a comment----
    Mr. Roth. Are you against it?
    Mr. Slocum. Yes.
    Mr. Kagen. Thank you, gentlemen.
    The Chairman. The gentleman from Oregon, Mr. Schrader.
    Mr. Schrader. Thank you, Mr. Chairman.
    I would just be interested in the panel's thoughts on the 
bill's inclusion of carbon offsets and emission allowances that 
are being proposed for the CFTC to have jurisdiction over. 
There is going to be some interesting legislative discussions 
about who should, indeed, have jurisdiction as this process 
moves forward.
    So we heard great things about the CFTC as a regulator it 
has done a wonderful job. This particular market, as long as it 
is allowed to regulate certain instruments, has done a great 
job. Is this the appropriate place, the CFTC, to regulate that 
market?
    Mr. Roth. Well, there is already a market that the CFTC is 
regulating. My question, when I read that section of the bill, 
is whether the language is necessary. I mean, do we think the 
CFTC lacks jurisdiction to oversee a futures contract market 
that trades those types of products? I don't think so.
    So, to me--and I am sorry, Congressman. I didn't study it 
in depth. But when I read the bill, my question was whether the 
language was surplusage, whether it was really necessary.
    Mr. Slocum. Well, I actually think it is necessary. Because 
what I see is a jurisdictional fight between Members of the 
Energy and Commerce Committee and Members here of the 
Agriculture Committee, where I know that, in drafts of climate 
bills put together by Energy and Commerce Committee Members, 
they are putting jurisdiction of carbon markets under the 
Federal Energy Regulatory Commission where they have regulatory 
jurisdiction.
    I actually agree with the approach taken here. The CFTC is 
actually the most relevant and most prepared agency to regulate 
an economy-wide cap and trade program with emissions credits 
and all of that. So I do think that you need to include it 
here, because this is going to become a very big issue this 
year, and it is crucial that the CFTC have jurisdiction over 
this new market.
    Mr. Schrader. I yield back the rest of my time, sir.
    The Chairman. I thank the gentleman.
    That is why we included it. I don't have any problem with 
the FERC regulating the cash market, whatever cash market there 
might be in these credits, but we have enough problems; the 
FERC has never regulated any futures situation. Why would we 
get them into that?
    There are people over in that other Committee that think 
that they should reinvent the wheel or something.
    Mr. Roth. Congressman, anything you have to do to defend 
the CFTC's exclusive jurisdiction is something that we would 
strongly support.
    The Chairman. Right. So it is a preemptive strike.
    Anyway, thank you very much for being with us today. You 
added to the hearing. We appreciate you being patient and 
waiting to get on the panel and thank all the members.
    Mr. Conaway, do you have anything to say?
    Mr. Conaway. No, but I appreciate both witnesses coming and 
hanging in there all afternoon until the very end. We 
appreciate that.
    One of the good things about being last is that you don't 
have to stay very long. So, anyway, we thank both of you for 
coming today. We appreciate it.
    The Chairman. All right. I thank the panel. I thank the 
Committee Members. The Committee stands adjourned subject to 
the call of the chair.
    [Whereupon, at 4:10 p.m., the Committee was adjourned.]
    [Material submitted for inclusion in the record follows:]
         Submitted Statement by American Public Gas Association
    Chairman Peterson, Ranking Member Lucas and Members of the 
Committee, the American Public Gas Association (APGA) appreciates this 
opportunity to submit testimony to you today. We also commend the 
Committee for calling this hearing on the important subject of 
derivative trading. APGA would also like to commend Chairman Peterson 
and the House Agriculture Committee for its ongoing focus on market 
transparency and oversight.
    APGA is the national association for publicly-owned natural gas 
distribution systems. There are approximately 1,000 public gas systems 
in 36 states and over 700 of these systems are APGA members. Publicly-
owned gas systems are not-for-profit, retail distribution entities 
owned by, and accountable to, the citizens they serve. They include 
municipal gas distribution systems, public utility districts, county 
districts, and other public agencies that have natural gas distribution 
facilities.
    APGA's number one priority is the safe and reliable delivery of 
affordable natural gas. To bring natural gas prices back to a long-term 
affordable level, we ultimately need to increase the supply of natural 
gas. However, equally critical is to restore public confidence in the 
pricing of natural gas. This requires a level of transparency in 
natural gas markets which assures consumers that market prices are a 
result of fundamental supply and demand forces and not the result of 
manipulation, excessive speculation or other abusive market conduct.
    We, along with other consumer groups, have watched with alarm over 
the last several years certain pricing anomalies in the markets for 
natural gas. More recently, we have noted much greater volatility in 
the price of energy and other physical commodities. APGA has strongly 
supported an increase in the level of transparency with respect to 
trading activity in these markets from that which currently exists. We 
believe that additional steps are needed in order to restore our 
current lack of confidence in the natural gas marketplace and to 
provide sufficient transparency to enable the CFTC, and market users, 
to form a reasoned response to the critically important questions that 
have been raised before this Committee during the course of these 
hearings.
    APGA believes that the increased regulatory, reporting and self-
regulatory provisions relating to the unregulated energy trading 
platforms contained in legislation that reauthorizes the Commodity 
Futures Trading Commission (``CFTC'') is a critically important first 
step in addressing our concerns. Those provisions are contained in 
Title XIII of the farm bill which has become law. We commend this 
Committee for its work on this important legislation. The market 
transparency language that was included in the farm bill will help shed 
light on whether market prices in significant price discovery energy 
contracts are responding to legitimate forces of supply and demand or 
to other, non-bona fide market forces.
    However, APGA believes that more can, and should, be done to 
further increase transparency of trading in the energy markets. Many of 
these steps would likely also be useful in better understanding the 
current pricing trends in the markets for other physical commodities as 
well.
    Although the additional authorities which have been provided to the 
CFTC under Title XIII of the 2008 Farm Bill will provide the CFTC with 
significant additional tools to respond to the issues raised by this 
hearing (at least with respect to the energy markets), we nevertheless 
believe that it may be necessary for Congress to provide the CFTC with 
additional statutory authorities. We are doubtful that the initial 
steps taken by the reauthorization legislation are, or will be, 
sufficient to fully respond to the concerns that we have raised 
regarding the need for increased transparency. In this regard, we 
believe that additional transparency measures with respect to 
transactions in the Over-the-Counter markets are needed to enable CFTC 
to assemble a more complete picture of a trader's position and thereby 
understand a large trader's potential impact on the market.
    We further believe, that in light of the critical importance of 
this issue to consumers, that this Committee should maintain active and 
vigilant oversight of the CFTC's market surveillance and enforcement 
efforts, that Congress should be prepared to take additional 
legislative action to further improve transparency with respect to 
trading in energy contracts and, should the case be made, to make 
additional amendments to the Commodity Exchange Act, 7 U.S.C.  1 et 
seq. (``Act''), that allows for reasonable speculative position limits 
in order to ensure the integrity of the energy markets.
Speculators' Effect on the Natural Gas Market
    As hedgers that use both the regulated futures markets and the OTC 
energy markets, we value the role of speculators in the markets. We 
also value the different needs served by the regulated futures markets 
and the more tailored OTC markets. As hedgers, we depend upon liquid 
and deep markets in which to lay off our risk. Speculators are the 
grease that provides liquidity and depth to the markets.
    However, speculative trading strategies may not always have a 
benign effect on the markets. For example, the 2006 blow-up of Amaranth 
Advisors LLC and the impact it had upon prices exemplifies the impact 
that speculative trading interests can have on natural gas supply 
contracts for local distribution companies (``LDCs''). Amaranth 
Advisors LLC was a hedge fund based in Greenwich, Connecticut, with 
over $9.2 billion under management. Although Amaranth classified itself 
as a diversified multi-strategy fund, the majority of its market 
exposure and risk was held by a single Amaranth trader in the OTC 
derivatives market for natural gas.
    Amaranth reportedly accumulated excessively large long positions 
and complex spread strategies far into the future. Amaranth's 
speculative trading wagered that the relative relationship in the price 
of natural gas between summer and winter months would change as a 
result of shortages which might develop in the future and a limited 
amount of storage capacity. Because natural gas cannot be readily 
transported about the globe to offset local shortages, the way for 
example oil can be, the market for natural gas is particularly 
susceptible to localized supply and demand imbalances. Amaranth's 
strategy was reportedly based upon a presumption that hurricanes during 
the summer of 2006 would make natural gas more expensive in 2007, 
similar to the impact that Hurricanes Katrina and Rita had had on 
prices the previous year. As reported in the press, Amaranth held open 
positions to buy or sell tens of billions of dollars of natural gas.
    As the hurricane season proceeded with very little activity, the 
price of natural gas declined, and Amaranth lost approximately $6 
billion, most of it during a single week in September 2006. The 
unwinding of these excessively large positions and that of another 
previously failed $430 million hedge fund--MotherRock--further 
contributed to the extreme volatility in the price of natural gas. The 
Report by the Senate Permanent Subcommittee on Investigations affirmed 
that ``Amaranth's massive trading distorted natural gas prices and 
increased price volatility.'' \1\
---------------------------------------------------------------------------
    \1\ See ``Excessive Speculation in the Natural Gas Market,'' Report 
of the U.S. Senate Permanent Subcommittee on Investigations (June 25, 
2007) (``PSI Report'') at p. 119.
---------------------------------------------------------------------------
    Many natural gas distributors locked-in prices prior to the period 
Amaranth collapsed at prices that were elevated due to the accumulation 
of Amaranth's positions. They did so because of their hedging 
procedures which require that they hedge part of their winter natural 
gas in the spring and summer. Accordingly, even though natural gas 
prices were high at that time, it would have been irresponsible (and 
contrary to their hedging policies) to not hedge a portion of their 
winter gas in the hope that prices would eventually drop. Thus, the 
elevated prices which were a result of the excess speculation in the 
market by Amaranth and others had a significant impact on the price 
these APGA members, and ultimately their customers, paid for natural 
gas. The lack of transparency with respect to this trading activity, 
much of which took place in the OTC markets, and the extreme price 
swings surrounding the collapse of Amaranth have caused bona fide 
hedgers to become reluctant to participate in the markets for fear of 
locking-in prices that may be artificial.
    Recently, additional concerns have been raised with respect to the 
size of positions related to, and the role of, passively managed long-
only index funds. In this instance, the concern is not whether the 
positions are being taken in order to intentionally drive the price 
higher, but rather whether the unintended effect of the cumulative size 
of these positions has been to push market prices higher than the 
fundamental supply and demand situation would justify.
    The additional concern has been raised that recent increased 
amounts of speculative investment in the futures markets generally have 
resulted in excessively large speculative positions being taken that 
due merely to their size, and not based on any intent of the traders, 
are putting upward pressure on prices. The argument made is that these 
additional inflows of speculative capital are creating greater demand 
then the market can absorb, thereby increasing buy-side pressure which 
results in advancing prices.
    Some have responded to these concerns by reasoning that new futures 
contracts are capable of being created without the limitation of having 
to have the commodity physically available for delivery. This explains 
why, although the open-interest of futures markets can exceed the size 
of the deliverable supply of the physical commodity underlying the 
contract, the price of the contract could nevertheless reflect the 
forces of supply and demand.
    As we noted above, as hedgers we rely on speculative traders to 
provide liquidity and depth to the markets. Thus, we do not wish to see 
steps taken that would discourage speculators from participating in 
these markets using bona fide trading strategies. But more importantly, 
APGA's members rely upon the prices generated by the futures to 
accurately reflect the true value of natural gas. Accordingly, APGA 
would support additional regulatory controls, such as stronger 
speculative position limits, if a reasoned judgment can be made based 
on currently available, or additional forthcoming market data and 
facts, that such controls are necessary to address the unintended 
consequences arising from certain speculative trading strategies or to 
reign in excessively large speculative positions. To the extent that 
speculative investment may be increasing the price of natural gas or 
causing pricing aberrations, we strongly encourage Congress to take 
quick action to expand market transparency in order to be able to 
responsibly address this issue and protect consumers from additional 
cost burdens. Consumers should not be forced to pay a ``speculative 
premium.''
The Markets in Natural Gas Contracts
    The market for natural gas financial contracts is composed of a 
number of segments. Contracts for the future delivery of natural gas 
are traded on NYMEX, a designated contract market regulated by the 
CFTC. Contracts for natural gas are also traded in the OTC markets. OTC 
contracts may be traded on multi-lateral electronic trading facilities 
which are exempt from regulation as exchanges, such as the 
IntercontinentalExchange (``ICE''). ICE also operates an electronic 
trading platform for trading non-cleared (bilateral) OTC contracts. 
They may also be traded in direct, bilateral transactions between 
counterparties, through voice brokers or on electronic platforms. OTC 
contracts may be settled financially or through physical delivery. 
Financially-settled OTC contracts often are settled based upon NYMEX 
settlement prices and physically delivered OTC contracts may draw upon 
the same deliverable supplies as NYMEX contracts, thus linking the 
various financial natural gas market segments economically.
    Increasingly, the price of natural gas in many supply contracts 
between suppliers and local distribution companies, including APGA 
members, is determined based upon monthly price indexes closely tied to 
the monthly settlement of the NYMEX futures contract. Accordingly, the 
futures market serves as the centralized price discovery mechanism used 
in pricing these natural gas supply contracts.
    Generally, futures markets are recognized as providing an efficient 
and transparent means for discovering commodity prices.\2\ However, any 
failure of the futures price to reflect fundamental supply and demand 
conditions results in prices for natural gas that are distorted and do 
not reflect its true value.\3\ This has a direct affect on consumers 
all over the U.S., who as a result of such price distortions, will not 
pay a price for the natural gas that reflects bona fide demand and 
supply conditions. If the futures price is manipulated or distorted, 
then the price consumers pay for the fuel needed to heat their homes 
and cook their meals will be similarly manipulated or distorted.
---------------------------------------------------------------------------
    \2\ See the Congressional findings in section 3 of the Commodity 
Exchange Act, 7 U.S.C.  1 et seq. (``Act''). Section 3 of the Act 
provides that, ``The transactions that are subject to this Act are 
entered into regularly in interstate and international commerce and are 
affected with a national public interest by providing a means for . . . 
discovering prices, or disseminating pricing information through 
trading in liquid, fair and financially secure trading facilities.'' A 
further question with respect to whether other speculative strategies, 
or excessively large speculative positions is also distorting market 
prices by pushing prices higher than they otherwise would be.
    \3\ The effect of Amarath's trading resulted in such price 
distortions. See generally PSI Report. The PSI Report on page 3 
concluded that ``Traders use the natural gas contract on NYMEX, called 
a futures contract, in the same way they use the natural gas contract 
on ICE, called a swap. . . . The data show that prices on one exchange 
affect the prices on the other.''
---------------------------------------------------------------------------
    Today, the CFTC provides generally effective oversight of futures 
exchanges and the CFTC and the exchanges provide a significant level of 
transparency. And under the provisions of the Title XIII of the farm 
bill, the CFTC has been given additional regulatory authority with 
respect to significant price discovery contracts traded on exempt 
commercial markets, such as ICE. This is indeed a major step toward 
greater market transparency. However, even with this additional level 
of transparency, a large part of the market remains opaque to 
regulatory scrutiny. The OTC markets lack such price transparency. This 
lack of transparency in a very large and rapidly growing segment of the 
natural gas market leaves open the potential for a participant to 
engage in manipulative or other abusive trading strategies with little 
risk of early detection; and for problems of potential market 
congestion to go undetected by the CFTC until after the damage has been 
done to the market.
    Equally significant, even where the trading is not intended to be 
abusive, the lack of transparency for the over-all energy markets 
leaves regulators unable to answer questions regarding speculators' 
possible impacts on the market. For example, do we know who the largest 
traders are in the over-all market, looking at regulated futures 
contracts, significant price discovery contracts and bilateral OTC 
transactions? Without being able to see a large trader's entire 
position, it is possible that the effect of a large OTC trader on the 
regulated markets is masked, particularly when that trader is 
counterparty to a number of swaps dealers that in turn take positions 
in the futures market to hedge these OTC exposures as their own.
Regulatory Oversight
    NYMEX, as a designated contract market, is subject to oversight by 
the CFTC. The primary tool used by the CFTC to detect and deter 
possible manipulative activity in the regulated futures markets is its 
large trader reporting system. Using that regulatory framework, the 
CFTC collects information regarding the positions of large traders who 
buy, sell or clear natural gas contracts on NYMEX. The CFTC in turn 
makes available to the public aggregate information concerning the size 
of the market, the number of reportable positions, the composition of 
traders (commercial/noncommercial) and their concentration in the 
market, including the percentage of the total positions held by each 
category of trader (commercial/noncommercial).
    The CFTC also relies on the information from its large trader 
reporting system in its surveillance of the NYMEX market. In conducting 
surveillance of the NYMEX natural gas market, the CFTC considers 
whether the size of positions held by the largest contract purchasers 
are greater than deliverable supplies not already owned by the trader, 
the likelihood of long traders demanding delivery, the extent to which 
contract sellers are able to make delivery, whether the futures price 
is reflective of the cash market value of the commodity and whether the 
relationship between the expiring future and the next delivery month is 
reflective of the underlying supply and demand conditions in the cash 
market.\4\
---------------------------------------------------------------------------
    \4\ See letter to the Honorable Jeff Bingaman from the Honorable 
Reuben Jeffery III, dated February 22, 2007.
---------------------------------------------------------------------------
    Title XIII of the 2008 Farm Bill, empowered the CFTC to collect 
large trader information with respect to ``significant price discovery 
contracts'' traded on the ICE trading platform. However, there remain 
significant gaps in transparency with respect to trading of OTC energy 
contracts, including many forms of contracts traded on ICE. Despite the 
links between prices for the NYMEX futures contract and the OTC markets 
in natural gas contracts, this lack of transparency in a very large and 
rapidly growing segment of the natural gas market leaves open the 
potential for participants to engage in manipulative or other abusive 
trading strategies with little risk of early detection and for problems 
of potential market congestion to go undetected by the CFTC until after 
the damage has been done to the market, ultimately costing the 
consumers or producers of natural gas. More profoundly, it leaves the 
regulator unable to assemble a true picture of the over-all size of a 
speculator's position in a particular commodity.
Greater Transparency Needed
    Our members, and the customers served by them, believe that 
although Title XIII of the 2008 Farm Bill goes a long way to addressing 
the issue, there is not yet an adequate level of market transparency 
under the current system. This lack of transparency has led to a 
growing lack of confidence in the natural gas marketplace. Although the 
CFTC operates a large trader reporting system to enable it to conduct 
surveillance of the futures markets, it cannot effectively monitor 
trading if it receives information concerning positions taken in only 
one, or two, segments of the total market. Without comprehensive large 
trader position reporting, the government will remain handicapped in 
its ability to detect and deter market misconduct or to understand the 
ramifications for the market arising from unintended consequences 
associated with excessive large positions or with certain speculative 
strategies. If a large trader acting alone, or in concert with others, 
amasses a position in excess of deliverable supplies and demands 
delivery on its position and/or is in a position to control a high 
percentage of the deliverable supplies, the potential for market 
congestion and price manipulation exists. Similarly, we simply do not 
have the information to analyze the over-all effect on the markets from 
the current practices of speculative traders.
    Over the last several years, APGA has pushed for a level of market 
transparency in financial contracts in natural gas that would 
routinely, and prospectively, permit the CFTC to assemble a complete 
picture of the overall size and potential impact of a trader's position 
irrespective of whether the positions are entered into on NYMEX, on an 
OTC multi-lateral electronic trading facility which is exempt from 
regulation or through bilateral OTC transactions, which can be 
conducted over the telephone, through voice-brokers or via electronic 
platforms. APGA is optimistic that the enhanced authorities provided to 
the CFTC in the provisions of the CFTC reauthorization bill will help 
address the concerns that we have raised, but recognizes that more 
needs to be done to address this issue comprehensively.
Additional Potential Enhancements in Transparency
    In supporting the CFTC reauthorization bill, we previously noted 
that only a comprehensive large trader reporting system would enable 
the CFTC, while a scheme is unfolding, to determine whether a trader, 
such as Amaranth, is using the OTC natural gas markets to corner 
deliverable supplies and manipulate the price in the futures market.\5\ 
A comprehensive large trader reporting system would also enable the 
CFTC to better detect and deter other types of market abuses, including 
for example, a company making misleading statements to the public or 
providing false price reporting information designed to advantage its 
natural gas trading positions, or a company engaging in wash trading by 
taking large offsetting positions with the intent to send misleading 
signals of supply or demand to the market. Such activities are more 
likely to be detected or deterred when the government is receiving 
information with respect to a large trader's overall positions, and not 
just those taken in the regulated futures market. It would also enable 
the CFTC to better understand the overall size of speculative positions 
in the market as well as the impact of certain speculative investor 
practices or strategies on the future's markets ability to accurately 
reflect fundamental supply and demand conditions.
---------------------------------------------------------------------------
    \5\ See e.g. U.S. Commodity Futures Trading Commission v. BP 
Products North America, Inc., Civil Action No. 06C 3503 (N.D. Ill.) 
filed June 28, 2006.
---------------------------------------------------------------------------
    Accordingly, APGA supports proposals to further increase and 
enhance transparency in the energy markets, generally, and in the 
markets for natural gas, specifically. APGA supports greater 
transparency with respect to positions in natural gas financial 
contracts acquired through bilateral transactions. Because bilateral 
trading can in fact be conducted on an all-electronic venue, and can 
impact prices on the exchanges even if conducted in a non-electronic 
environment, it is APGA's position that transparency in the bilateral 
markets is critical to ensure an appropriate level of consumer 
protection.
Electronic Bilateral trading
    One example of the conduct of bilateral trading on an all-
electronic trading platform was ``Enron On-line.'' Enron, using its 
popular electronic trading platform, offered to buy or sell contracts 
as the universal counterparty to all other traders using this 
electronic trading system. This one-to-many model constitutes a 
dealer's market and is a form of bilateral trading. This stands in 
contrast to a many-to-many model which is recognized as a multi-lateral 
trading venue. This understanding is reflected in section 1a(33) of the 
Commodity Exchange Act, which defines ``Trading Facility'' as a ``group 
of persons that . . . provides a physical or electronic facility or 
system in which multiple participants have the ability to execute or 
trade agreements, contracts or transactions by accepting bids and 
offers made by other participants that are open to multiple 
participants in the facility or system.'' On the Enron On-line trading 
platform, only one participant--Enron--had the ability to accept bids 
and offers of the multiple participants--its customers--on the trading 
platform.
    Section 1a(3) continues by providing that, ``the term 'trading 
facility' does not include (i) a person or group of persons solely 
because the person or group of persons constitutes, maintains, or 
provides an electronic facility or system that enables participants to 
negotiate the terms of and enter into bilateral transactions as a 
result of communications exchanged by the parties and not from 
interaction of multiple bids and multiple offers within a 
predetermined, nondiscretionary automated trade matching and execution 
algorithm . . . .'' This means that it is also possible to design an 
electronic platform for bilateral trading whereby multiple parties 
display their bids and offers which are open to acceptance by multiple 
parties, so long as the consummation of the transaction is not made 
automatically by a matching engine.
    Both of these examples of bilateral electronic trading platforms 
might very well qualify for exemption under the current language of 
sections 2(g) and 2(h)(1) of the Commodity Exchange Act. To the extent 
that these examples of electronic bilateral trading platforms were 
considered by traders to be a superior means of conducting bilateral 
trading over voice brokerage or the telephonic call-around markets, or 
will not fall within the significant price discovery contract 
requirements, their use as a substitute for a more-regulated exempt 
commercial market under section 2(h)(3) of the Act should not be 
readily discounted.
Non-Electronic Bilateral Trading
    Moreover, even if bilateral transactions are not effected on an 
electronic trading platform, it is nonetheless possible for such direct 
or voice-brokered trading to affect prices in the natural gas markets. 
For example, a large hedge fund may trade bilaterally with a number of 
counterparty/dealers using standard ISDA documentation. By using 
multiple counterparties over an extended period of time, it would be 
possible for the hedge fund to establish very large positions with each 
of the dealer/counterparties. Each dealer in turn would enter into 
transactions on NYMEX to offset the risk arising from the bilateral 
transactions into which it has entered with the hedge fund. In this 
way, the hedge fund's total position would come to be reflected in the 
futures market. Thus, a prolonged wave of buying by a hedge fund, even 
through bilateral direct or voice-brokered OTC transactions, can be 
translated into upward price pressure on the futures exchange.
    As NYMEX settlement approaches, the hedge fund's bilateral 
purchases with multiple dealer/counterparties would maintain or 
increase upward pressure on prices. By spreading its trading through 
multiple counterparties, the hedge fund's purchases would attract 
little attention and escape detection by either NYMEX or the CFTC. In 
the absence of routine large-trader reporting of bilateral 
transactions, the CFTC will only see the various dealers' exchange 
positions and have no way of tying them back to purchases by a single 
hedge fund.
    Given that the various segments of the financial markets that price 
natural gas are linked economically, it is critical to achieving market 
transparency that traders holding large positions entered into through 
bilateral transactions be included in any large-trader reporting 
requirement. As explained above, by trading through multiple dealers, a 
large hedge fund would be able to exert pressure on exchange prices 
similar to the pressure that it could exert by holding those positions 
directly. Only a comprehensive large-trader reporting system that 
includes positions entered into in the OTC bilateral markets would 
enable the CFTC to see the entire picture and trace such positions back 
to a single source.
    If large trader reporting requirements apply only to positions 
acquired on multi-lateral electronic trading platforms, traders in 
order to avoid those reporting requirements may very well move more 
transactions to electronic bilateral markets or increase their direct 
bilateral trading. This would certainly run counter to efforts by 
Congress to increase transparency. APGA remains convinced that all 
segments of the natural gas marketplace should be treated equally in 
terms of reporting requirements. To do otherwise leaves open the 
possibility that dark markets on which potential market abuses could go 
undetected would persist and that our current lack of sufficient 
information to fully understand the impact of large speculative traders 
and certain trading strategies on the markets will continue, thereby 
continuing to place consumers at risk.
Derivatives Markets Transparency and Accountability Act of 2009
    As stated previously, APGA supports proposals to further increase 
and enhance transparency in the energy markets, generally, and in the 
markets for natural gas, specifically. APGA commends Chairman Peterson 
for drafting the Derivatives Markets Transparency and Accountability 
Act of 2009. This legislation would significantly enhance market 
transparency and would provide the CFTC with additional needed 
resources to help ensure that the ``cop on the beat'' has the tools 
needed to do its job.
    Specifically, this legislation would provide greater transparency 
with respect to the activities of the Index Funds by requiring them to 
be separately accounted for in the CFTC's Commitment of Traders 
Reports. APGA strongly supports provisions in the legislation that 
would provide greater transparency to the CFTC with respect to 
bilateral swap contracts.
    Another provision in the bill that APGA strongly supports is the 
requirement that the CFTC appoint at least 100 new full time employees. 
The CFTC plays a critical role in protecting consumers, and the market 
as a whole, from fraud, manipulation and market abuses that create 
distortion. It is essential that the CFTC have the necessary resources, 
both in terms of employees but also in terms of information technology, 
to monitor markets and protect consumers from attempts to manipulate 
the market. This is critical given the additional oversight 
responsibilities the CFTC will have through the market transparency 
language included in the 2008 Farm Bill and the additional transparency 
requirements that APGA is proposing to the Committee.
    Over the last several years, trading volumes have doubled while 
CFTC staffing levels have decreased. In fact, while we are experiencing 
record trading volumes, employee levels at the CFTC are at their lowest 
since the agency was created. Further, more complex and comprehensive 
monitoring practices from the CFTC will require the latest technology. 
It is critical that CFTC have the necessary tools to catch abuses 
before they occur. APGA is concerned that if funding for the CFTC is 
inadequate, so may be the level of protection.
Conclusion
    Experience tells us that there is never a shortage of individuals 
or interests who believe they can, and will attempt to, affect the 
market or manipulate price movements to favor their market position. 
The fact that the CFTC has assessed over $300 million in penalties, and 
has assessed over $2 billion overall in government settlements relating 
to abuse of these markets affirms this. These efforts to punish those 
that manipulate or abuse markets or to address those that might 
innocently distort markets are important. But it must be borne in mind 
that catching and punishing those that manipulate markets after a 
manipulation has occurred is not an indication that the system is 
working. To the contrary, by the time these cases are discovered using 
the tools currently available to government regulators, our members, 
and their customers, have already suffered the consequences of those 
abuses in terms of higher natural gas prices.
    Greater transparency with respect to traders' large positions, 
whether entered into on a regulated exchange or in the OTC markets in 
natural gas will provide the CFTC with the tools to answer that 
question and to detect and deter potential manipulative or market 
distorting activity before our members and their customers suffer harm.
    The Committee's ongoing focus on energy markets has raised issues 
that are vital to APGA's members and their customers. We do not yet 
have the tools in place to say with confidence the extent to which the 
pricing mechanisms in the natural gas market today are reflecting 
market fundamentals or the possible market effects of various 
speculative trading strategies. However, we know that the confidence 
that our members once had in the pricing integrity of the markets has 
been badly shaken.
    In order to protect consumers the CFTC must be able to (1) detect a 
problem before harm has been done to the public through market 
manipulation or price distortions; (2) protect the public interest; and 
(3) ensure the price integrity of the markets. Accordingly, APGA and 
its over 700 public gas system members applaud your continued oversight 
of the CFTC's surveillance of the natural gas markets. We look forward 
to working with the Committee towards the passage of legislation that 
would provide further enhancements to help restore consumer confidence 
in the integrity of the price discovery mechanism.
                                 ______
                                 
 Statment Submitted by Steve Suppan, Senior Policy Analyst, Institute 
                    for Agriculture and Trade Policy
    The Institute for Agriculture and Trade Policy (IATP) is a 
501(c)(3) organization headquartered in Minneapolis, MN with an office 
in Geneva, Switzerland. IATP, founded over 20 years ago, works locally 
and globally to ensure fair and sustainable food, farm and trade 
systems. IATP is grateful for the opportunity to comment on a bill that 
is crucial for ensuring that commodities exchange activities contribute 
to the orderly functioning of markets that enable food and energy 
security.
    In November, IATP published ``Commodity Market Speculation: Risk to 
Food Security and Agriculture'' (http://www.iatp.org/iatp/
publications.cfm?accountID=451&refID=104414). The study found that 
commodity index fund speculation in U.S. commodity exchanges distorted 
prices and induced extreme price volatility that made the futures and 
options market unusable for commercial traders. For example, one market 
consultant estimated that index fund trading accounted for about 30 
percent of the nearly $8 a bushel price of corn on the Chicago Board of 
Trade at the height of the commodities bubble in late June. Until the 
bubble burst, many country elevators, unable to assess their risk in 
such volatile markets, had stopped forward contracting, endangering the 
cash flows and operations of many U.S. farms. The spike in developing 
country food import bills and increasing food insecurity, both in the 
United States and around the world, is partly due to the financial 
damage of deregulated speculation.
    While researching this study, I monitored the Committee hearings 
that contributed to H.R. 6604, ``Commodity Exchange Transparency and 
Accountability Act of 2008.'' IATP congratulates the Committee for the 
intense and expedited schedule of hearings and legislative drafting 
that resulted in the passage of H.R. 6604 and revisions to it in the 
draft ``Derivatives Markets Transparency and Accountability Act of 
2009'' (hereafter ``the Act''). Due to the complexity of the 
legislation, our comments will only concern a small portion of the 
Act's provisions.
Section 3. Speculative limits and transparency of off-shore trading and 
        Section 6. Trading limits to prevent excessive speculation
    U.S. commodity exchanges have a dominant international influence 
over both cash and futures prices for many commodities. Because of the 
affects of that influence on food security and agriculture around the 
world, it is crucial that U.S. regulation and oversight of commodity 
exchanges be exemplary for the regulation of other markets. However, 
incidents of off-shore noncommercial traders benefiting from U.S. 
commodity exchanges while claiming to be beyond the jurisdiction of the 
Commodity Exchange Act (CEA) have resulted in the need for the prudent 
measures of section 3.
    The Committee and its staff are to be congratulated for the work 
undertaken since the passage of H.R. 6604 on September 18 to improve 
the bill. Particularly noteworthy are the visits of Chairman Peterson 
and Committee staff to regulatory authorities in London and Brussels 
both to explain H.R. 6604 and to learn how it might be improved.
    Section 3 would do by statute what the Commodities Futures Trading 
Commission's (hereafter ``the Commission'') memoranda of understanding 
with other regulatory authorities have failed to do: to ensure that 
foreign traders of futures, options and other derivatives cannot trade 
on U.S. exchanges unless they submit completely to the authorities of 
the CEA. Section 6 is so drafted as to avoid the possibility of a trade 
dispute ruling against the United States for ``discrimination'' against 
foreign firms in the peculiar trade and investment policy sense of that 
term. However, the World Trade Organization negotiations seek to 
further liberalize and deregulate financial services, particularly 
through the Working Party on Domestic Regulation of the General 
Agreement on Trade in Services (GATS).\1\ The members of the Financial 
Leaders Group that has lobbied effectively for GATS and U.S. 
deregulation (and particular regulatory exemptions for their firms) are 
major recipients of taxpayer bailouts through the Troubled Asset Relief 
Program.
---------------------------------------------------------------------------
    \1\ Ellen Gould. ``Financial Instability and the GATS 
Negotiations.'' Canadian Centre for Policy Alternatives. July 2008. 
http://www.tradeobservatory.org/library.cfm?refID=103596. 
---------------------------------------------------------------------------
    The Committee should invite testimony from the Office of the U.S. 
Trade Representative (USTR) concerning U.S. GATS commitments, to ensure 
that those commitments and/or USTR positions advocated at the GATS 
negotiations not conflict with sections 3 and 6 or leave them 
vulnerable to WTO challenge. Furnished with that testimony and 
documents relevant to it, legislative drafting may be tightened to 
avoid the possibility of a WTO challenge.
    As the Committee is well-aware, the number of contracts held by 
noncommercial speculators far outweighs those of bona fide physical 
hedgers. The overwhelming dominance of purely financial speculation has 
induced price volatility that can be neither explained nor justified in 
terms of physical supply and demand, bona fide hedging by commercial 
traders and/or the amount of purely financial speculation required to 
clear trades. For example, in May, The Brock Report stated, ``no 
[commercial] speculator today can have a combined contract position in 
corn that exceeds 11 million bushels. Yet, the two biggest index funds 
[Standard and Poors/Goldman Sachs and Dow Jones/American Insurance 
Group] control a combined 1.5 billion bushels!'' \2\
---------------------------------------------------------------------------
    \2\ ``A Big Move Lies Ahead.'' The Brock Report. May 23, 2008.
---------------------------------------------------------------------------
    Section 3 of the Act seeks to close the regulatory exemption 
granted to Wall Street banks that enabled this massive imbalance 
between bona fide hedging on physical commodities and contracts held 
purely for financial speculation. However, closing that loophole will 
not suffice to begin to repair the damage wrought by the speculative 
position exemption. In 2004, the Security Exchange Commission granted 
for just a half dozen investment banks an exemption to prudential 
reserve requirements to cover losses, thus freeing up billions of 
dollars of speculative capital and handing the chosen banks a huge 
competitive advantage.\3\ These two regulatory exemptions enabled the 
asset price bubbles that began to burst in July, with dire consequences 
for the entire financial system and the global economy. The Act should 
authorize the Commission to work with the SEC to close all exemptions 
to prudential capital reserve requirements.
---------------------------------------------------------------------------
    \3\ Stephen LaBaton. ``Agency's `04 Rule Let Banks Pile Up New 
Debt, and Risk.'' The New York Times. October 3, 2008.
---------------------------------------------------------------------------
    Despite the commodities price collapse, Goldman Sachs, whose then 
CEO Henry Paulson lead the successful campaign to exempt his firm and 
other paragons of risk management from prudential capital reserve 
requirements, is estimated to have made $3 billion in net revenue in 
2008 from its commodities division alone. The average bonus for a 
commodities trading managing director is estimated to be $3-$4 million 
in 2008, down 25 percent from 2007.\4\ Hence, there is little trader 
disincentive to exceed whatever speculative position limits that are 
agreed as a result of the deliberations of the Position Limit 
Agricultural and Energy Advisory Groups (stipulated by section 6. 4a). 
The Act provides for no advisory group for base and precious metals, 
which suggests that those components of the index funds may continue 
without speculative limits. The Act can readily be amended to provide 
for a Position Limit Metals Advisory Group. Given the financial service 
industry incentives structure, there is much to be done in the Act to 
provide strong disincentives for firms and individual traders to exceed 
the agreed speculative position limits.
---------------------------------------------------------------------------
    \4\ Ann Davis. ``Top Traders Still Expect the Cash.'' The Wall 
Street Journal. November 19, 2008.
---------------------------------------------------------------------------
    One of the responsibilities of the advisory groups is to submit to 
the Commission a recommendation about whether the exchanges themselves 
or the Commission should administer the position limit requirements 
``with enforcement by both the registered entity and the Commission'' 
(lines 10-12, p. 15). While IATP agrees that the exchanges may have a 
role to play in administering the position limits requirement, we fail 
to understand why enforcement is not exclusively the Commission's 
prerogative. We urge the Committee to modify this provision to remove 
any suggestion of exchange enforcement authority.
Section 4. Detailed Reporting and Disaggregation of Market Data and 
        Section 5. Transparency and Record Keeping Authorities
    The provisions in these sections will help regulators monitor the 
size, number and value of contracts during the reporting period ``to 
the extent such information is available'' (Sec. 4(g)(2)). It is this 
qualifying last clause that worries IATP, since the Commission's 
ability to carry out its statutory obligations depends on complete and 
timely reporting of index fund data that disaggregates the 
agricultural, energy, base metal and precious metal contract components 
of these funds. The duration of agricultural futures contracts are 
typically 90 days, while energy and metals futures are for 6 months to 
a year. Both sections should stipulate that disaggregation not only 
concern contract positions held by traders with a bona fide commercial 
interest in the commodity hedged versus contracts held by financial 
speculators. Disaggregated and detailed reporting requirements should 
also stipulate reporting data from all component commodities contracts 
of the index funds, taking into account the differences in typical 
contract duration. Furthermore, the Act should authorize the Commission 
to stipulate that the reporting period for the disaggregated and 
detailed data be consistent with the duration of the index funds' 
component contracts, rather than with the reporting period of the index 
fund itself. The Act should further stipulate that the privilege to 
trade may be revoked or otherwise qualified if that trader's reporting 
does not provide sufficient information for the Commission to determine 
whether the trader is complying with the CEA as amended.
    Section 5 anticipates that traders will exceed the speculative 
position limits set by the Commission and provides for the terms of a 
special call by the Commission for trading data to determine whether 
the violation of the position limit has lead to price manipulation or 
excessive speculation, as defined in the CEA. Although IATP finds these 
provisions necessary for prudential regulation, we believe that the Act 
should stipulate how the Commission should seek to obtain the documents 
requested in the special call, when the trading facilities are located 
outside the United States. The Act wisely provides a ``Notice and 
Comment'' provision concerning the implementation of the reporting 
requirements for deals that exceed the speculative position limits. We 
anticipate that this ``Notice and Comment'' period will be used and 
guide the Commission's implementation of section 5 reporting 
requirements.
Section 7. CFTC Administration
    IATP believes that the increase in Commission staff, above that 
called for in H.R. 6604, is well warranted. The Committee should 
consider adding to this section a provision for a public ombudsman who 
could take under consideration evidence of misuse or abuse of the Act's 
authorities by Commission employees and evidence of damage to market 
integrity that may result from non-implementation or non-enforcement of 
the Act's provisions.
Section 9. Review of Over-the-Counter Markets
    Because of the prevalence of over-the-counter trades in commodities 
markets, and the damage to market integrity caused by lack of 
regulation of OTC trades, the need for speculative position limits on 
those trades seems all but self-evident. However, the Committee is wise 
to mandate the Commission's study of the OTC market given the 
heterogeneity, as well as the sheer volume of OTC contracts. We would 
suggest, however, that the study not be limited to transactions 
involving agricultural and energy commodities, but should also include 
base and precious metals.
Section 10. Study Relating to International Regulation of Energy 
        Commodity Markets
    IATP is very disappointed that section 10 has dropped the study of 
agricultural commodity markets called for in H.R. 6604. The Commission 
will be better able to carry out its responsibilities if it understands 
how agricultural commodities are regulated or not on exchanges outside 
of the United States. While U.S. exchanges are dominant in determining 
futures and cash prices for many agricultural commodities, there are 
other influential exchanges for certain commodities. The Commission 
should study these exchanges to find out whether there are best 
practices from which U.S. exchanges could benefit. IATP urges the 
Committee to restore the provision for a study of the international 
regulation of agricultural commodity markets to section 10.
Section 13. Certain Exclusions and Exemptions Available Only for 
        Certain Transactions Settled and Cleared Through Registered 
        Derivatives Clearing Organizations
    We confess to not understanding these amendments to the CEA and to 
skepticism about the need for the exclusions, exemptions and waivers, 
in light of the exclusions, exemptions, and waivers whose abuse has 
helped bankrupt both financial institutions and individual investors. 
IATP suggests that the Committee add a ``Notice and Comment'' provision 
to this section, so that the public has an opportunity to argue for or 
against individual provisions of this section.
Section 14. Treatment of Emission Allowances and Off-Set Credits
    This addition to H.R. 6604 may be premature, as the efficacy of 
emissions trading for actual reduction of global greenhouse gas 
emissions is under debate in the negotiations for a new United Nations 
Framework Convention on Climate Change. IATP believes that the 
Committee should await the results of the Framework Convention 
negotiations in December in Copenhagen before deciding whether to add 
this amendment to the CEA. If the Committee decides to retain this 
section, it should consider whether the current amendment should be 
limited to carbon sequestration or whether it should cover other green 
house gas emissions.
    Again, I thank the Committee for the opportunity to submit 
testimony. I congratulate the Committee on moving forward on this 
important work. I'm available to answer any questions concerning this 
testimony.


               HEARING TO REVIEW DERIVATIVES LEGISLATION

                              ----------                              


                      WEDNESDAY, FEBRUARY 4, 2009

                          House of Representatives,
                                  Committee on Agriculture,
                                                   Washington, D.C.

    The Committee met, pursuant to call, at 10:37 a.m., in Room 
1300, Longworth House Office Building, Hon. Collin C. Peterson 
[Chairman of the Committee] presiding.
    Members present: Representatives Peterson, Holden, Boswell, 
Baca, Cardoza, Scott, Marshall, Herseth Sandlin, Cuellar, 
Costa, Ellsworth, Schrader, Dahlkemper, Massa, Bright, Markey, 
Kratovil, Boccieri, Pomeroy, Minnick, Lucas, Goodlatte, Moran, 
Johnson, Graves, Neugebauer, Conaway, Schmidt, Smith, Latta, 
Luetkemeyer, Thompson, and Cassidy.
    Staff present: Adam Durand, Tyler Jameson, John Konya, 
Scott Kuschmider, Robert L. Larew, Clark Ogilvie, John Riley, 
April Slayton, Debbie Smith, Kristin Sosanie, Tamara Hinton, 
Kevin Kramp, Bill O'Conner, Nicole Scott, and Jamie Mitchell.

OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE 
                   IN CONGRESS FROM MINNESOTA

    The Chairman. The Committee will come to order. We have 
Members wandering in, but we will get started.
    We have three panels today, 15 total witnesses. So good 
morning and welcome to our second day of hearings on derivative 
legislation. We have a lot to get to, so I will try to be brief 
here.
    Yesterday, we had a very spirited discussions between 
Members and witnesses about the issues being considered in the 
draft legislation. I think that is a good thing and what I 
intended. We need to have this debate, we need to have it now, 
and we need to have it out in the open.
    It is important that we understand the concerns of those 
who think we are going too far, and from those who think we are 
not going far enough. Despite the fact that some of our 
witnesses yesterday took issue with some sections of the draft 
bill, I believe the consensus is that we need to take real 
steps to improve transparency and oversight of derivative 
markets whether they are on exchanges or over-the-counter.
    Today, we will continue the debate with three panels of 
witness representing financial exchanges, commodity groups, 
industry groups and investment companies. Since we do have so 
many witnesses testifying here today, I will ask you all to be 
brief. Your full written statements will be made part of the 
record. I welcome you to the Committee and appreciate you 
taking your time to be with us.
    [The prepared statement of Mr. Peterson follows:]

  Prepared Statement of Hon. Collin C. Peterson, a Representative in 
                        Congress from Minnesota
    Good morning, and welcome to our second day of hearings on 
derivatives legislation. We have three panels and fifteen total 
witnesses today and a lot to get to, so I will be very brief.
    Yesterday, we had a very spirited discussion between Members and 
witnesses about the issues being considered in the draft legislation. I 
think that's a good thing. We need to have this debate, we need to have 
it now, and we need to have it out in the open. It is important that we 
understand the concerns of those who think we are going too far, and 
from those who think we are not going far enough.
    Despite the fact that some of our witnesses yesterday took issue 
with some sections of the draft bill, I believe the consensus is that 
we need to take real steps to improve transparency and oversight of 
derivatives markets, whether they are on exchanges or over-the-counter.
    Today we will continue the debate with three panels of witnesses 
representing financial exchanges, commodity groups, industry groups, 
and investment companies. Since we do have so many witnesses testifying 
here today, I will ask you all to be brief, and your full written 
statements will be made part of the record.
    And now, I will to yield to Ranking Member Lucas for any opening 
remarks he may have today.

    The Chairman. I will now yield to Ranking Member Lucas for 
any opening remarks that he may have.

 OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN 
                     CONGRESS FROM OKLAHOMA

    Mr. Lucas. Thank you, Chairman Peterson.
    These hearings will serve as a useful resource for this 
Committee as we consider the draft legislation you have 
proposed. It is important that we gather as much information as 
possible from those who will be impacted by our actions.
    No one can argue with the concepts of transparency and 
accountability. We must make sure that we create responsible 
legislation that calls for an appropriate level of regulation 
that respects the nature of the financial marketplace and 
considers the limits of government intervention.
    I appreciate the time and effort that the participants of 
our three panels have put into today's hearings, and I look 
forward to your testimony and your answers to the questions 
posed by our Committee Members.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman.
    The chair would request that other Members submit their 
opening statements for the record so witnesses may begin their 
testimony to ensure that we have ample time for questions.
    We would like to welcome our first panel of witnesses to 
the table: Mr. Michael Masters, the Managing Member and 
Portfolio Manager of Masters Capital Management; Mr. Jonathan 
Short, Senior Vice President and General Counsel of 
IntercontinentalExchange, Incorporated of Atlanta; Mr. Gary 
Taylor, CEO of Cargill Cotton, on behalf of the National Cotton 
Council, American Cotton Shippers and AMCOT in Cordova, 
Tennessee; Mr. Robert Pickel, Executive Director and CEO of the 
International Swaps and Derivatives Association of New York; 
and the Honorable Joseph Morelle, Chair of New York's State 
Assembly Standing Committee on Insurance, on behalf of the 
National Conference of Insurance Legislators from Troy, New 
York.
    The Chairman. Mr. Masters, we will have you up first.
    To all of the witnesses, we appreciate your time; and, Mr. 
Masters, you can begin.

          STATEMENT OF MICHAEL W. MASTERS, FOUNDER AND
           MANAGING MEMBER/PORTFOLIO MANAGER, MASTERS
          CAPITAL MANAGEMENT, LLC, ST. CROIX, U.S. VI

    Mr. Masters. Chairman Peterson and Members of the 
Committee, thank you for the opportunity to appear before you 
to discuss this critical piece of legislation. As we witnessed 
in the last 18 months, what happens on Wall Street can have a 
huge impact on the average American.
    There are three critical elements that must be part of any 
effective regulatory framework.
    First, transparency. Effective regulation requires complete 
market transparency. In recent years, the big Wall Street banks 
have preferred to operate in dark markets where regulators are 
unable to see what is occurring. This limited transparency has 
enabled them to take on massive amounts of off-balance-sheet 
leverage, creating what amounts to a shadow financial system. 
Regulators cannot regulate if they cannot see the whole 
picture.
    Given the speed with which financial markets move, this 
transparency must be available on a real-time basis. The best 
way to bring transparency to over-the-counter (OTC) 
transactions is to make it mandatory for all OTC transactions 
to clear through an exchange. For that reason, I am very glad 
to see the sections of this bill that call for exchange 
clearing. This is a critical prerequisite for effective, 
regulatory oversight.
    The second thing that regulators must do is eliminate 
systemic risk. A lack of transparency was one of the primary 
factors in the recent financial meltdown. The other primary 
factor was the liquidity crisis brought on by excessive 
leverage at the major financial institutions. One of the most 
dangerous things about OTC derivatives is that they offer 
virtually unlimited leverage, since typically no margin is 
required. This is one of the reasons that Warren Buffett 
famously called them financial weapons of mass destruction.
    By mandating that OTC transactions clear through an 
exchange, your bill provides for the exchange to become the 
counterparty to all transactions. Since the exchange requires 
the posting of substantial margin, the risk to the financial 
system as a whole is nearly eliminated. When sufficient margin 
is posted on a daily basis, then potential losses are greatly 
contained and will prevent a domino effect from occurring.
    I do not know the specifics of the clearinghouse that ICE 
and the major swaps dealers are working to establish, but I 
would encourage policymakers to look very closely at the amount 
of margin the swaps dealers were required to post on their 
trades. If there is a substantial difference between what ICE 
requires and what CME Group requires, then swaps dealers, in a 
quest for maximum leverage will flock to the clearing exchange 
that has the lowest margin requirements.
    This is exactly opposite of what regulators and 
policymakers would want to see. The stronger the margin 
requirements, the greater will be the mitigation of systemic 
risk. The weaker the margin requirements, the greater chance we 
face of another systemic meltdown.
    The third thing that regulators must do is eliminate 
excessive speculation. Speculative position limits are 
necessary to eliminate excessive speculation and protect us 
from price bubbles. In commodities, if they had been in place 
across all commodity derivatives markets, then we would not 
have seen last year's spike and crash in commodities prices.
    The fairest and best way to regulate the commodities 
derivatives market is to subject all participants to the same 
regulations and speculative position limits, no matter where 
they trade. Every speculator should be regulated equally.
    The over-the-counter markets are dramatically larger than 
the futures exchanges. If speculative position limits are not 
imposed on all OTC commodity derivatives, it would be like 
locking one's doors to prevent a robbery, while leaving the 
windows wide open.
    This bill needs to include aggregate speculative position 
limits. If it does not, there is nothing protecting your 
constituents from another, more damaging bubble in food and 
prices. Once OTC commodity derivatives are cleared through an 
exchange, regulators will be able to easily see every trader's 
position; and the application of speculative limits will be 
just as simple for over-the-counter as it is for futures 
exchanges today.
    In summary, we have now witnessed how damaging unbridled 
financial innovation can be. The implosion on Wall Street has 
destroyed trillions of dollars in retirement savings and has 
required trillions of dollars in taxpayer money. Fifteen years 
ago, before the proliferation of OTC derivatives and before 
regulators become enamored with deregulation, the financial 
markets stood on a much firmer foundation. It is hard to look 
back and say that we are better off today than we were then. I 
think it is clear to everyone in America that this grand 
experiment, rather than delivering on its great promise, has in 
fact turned out to be a great disaster.
    Thank you.
    [The prepared statement of Mr. Masters follows:]

 Prepared Statement of Michael W. Masters, Founder and Managing Member/
 Portfolio Manager, Masters Capital Management, LLC, St. Croix, U.S. VI
    Chairman Peterson and Members of the Committee, thank you for the 
opportunity to appear before you today to discuss this critical piece 
of legislation. As we have witnessed in the last 18 months, what 
happens on Wall Street can have a huge impact on Main Street. The 
implosion of Wall Street has destroyed trillions of dollars in 
retirement savings, has required trillions of dollars in taxpayer money 
to rescue the system, has cost our economy millions of jobs, and the 
devastating aftershocks are still being felt. Worst of all, this crisis 
was completely avoidable. It can be characterized as nothing less than 
a complete regulatory failure.
    The Federal Reserve permitted an alternative, off-balance sheet 
financial system to form, which allowed money center banks to take on 
extreme amounts of risky leverage, far beyond the limits of what your 
typical bank could incur. The Securities and Exchange Commission 
allowed investment banks to take on the same massive amount of leverage 
and missed many instances of fraud and abuse, most notably the $50 
billion Madoff Ponzi scheme. The Commodities Futures Trading Commission 
allowed an excessive speculation bubble to occur in commodities that 
cost Americans more than $110 billion in artificially inflated food and 
energy prices, which in turn amplified and deepened the housing and 
banking crises.\1\
---------------------------------------------------------------------------
    \1\ See our newly released report entitled ``The 2008 Commodities 
Bubble: Assessing the Damage to the United States and Its Citizens.'' 
Available at www.accidentalhuntbrothers.com.
---------------------------------------------------------------------------
    Congress appeared oblivious to the impending storm, relying on 
regulators who, in turn, relied on Wall Street to alert them to any 
problems. According to the Center for Responsive Politics ``the 
financial sector is far and away the biggest source of campaign 
contributions to Federal candidates and parties, with insurance 
companies, securities and investment firms, real estate interests and 
commercial banks providing the bulk of that money.'' \2\ Clearly, Wall 
Street was pleased with the return on their investment, as regulation 
after regulation was softened or removed.
---------------------------------------------------------------------------
    \2\ ``Finance/Insurance/Real Estate: Background,'' OpenSecrets.org, 
Center for Responsive Politics, July 2, 2007. http://
www.opensecrets.org/industries/background.php?cycle=2008&ind=F.
---------------------------------------------------------------------------
    So I thank you today, Mr. Chairman and Members of this Committee 
for your courageous stand and your desire to re-regulate Wall Street 
and put the genie back in the bottle once and for all. I share your 
desire to focus on solutions and ways that we can work together to 
ensure that this never happens again.
    I have included with my written testimony a copy of a report that I 
am releasing, along with my co-author Adam White, which provides 
additional evidence and analysis relating to the commodities bubble we 
experienced in 2008, and the devastating impact it has had on our 
economy (electronic copies can be downloaded at 
www.accidentalhuntbrothers.com). I would be happy to take questions on 
the report, but I want to honor your request to speak specifically on 
this piece of legislation that you are proposing.
    I believe that the Derivatives Markets Transparency and 
Accountability Act of 2009 goes a long way toward rectifying the 
inherent problems in our current regulatory framework and I commend you 
for that. While Wall Street will complain that the bill is 
overreaching, I believe that, on the contrary, there are opportunities 
to make this bill even stronger in order to achieve the results that 
this Committee desires.
    I am not an attorney and I am not an expert on the Commodity 
Exchange Act, but I can share with you what I see as the critical 
elements that must be part of any effective regulatory framework, and 
we can discuss how the aspects of this bill mesh with those critical 
elements.
Transparency
    Effective regulation requires complete market transparency. 
Regulators, policymakers, and ultimately the general public must be 
able to see what is happening in any particular market in order to make 
informed decisions and in order to carry out their entrusted duties.
    In recent years, the big Wall Street banks have preferred to 
operate in dark markets where regulators are unable to fully see what 
is occurring. This limited transparency has enabled them to take on 
massive amounts of off-balance-sheet leverage, creating what amounts to 
a ``shadow financial system.''
    Operating in dark markets has also allowed the big Wall Street 
banks to make markets with wide bid-ask spreads, resulting in outsized 
financial gains for these banks. When a customer does not know what a 
fair price is for a transaction, then a swaps dealer can take advantage 
of informational asymmetry to reap extraordinary profits.
    Regulators cannot regulate if they cannot see the whole picture. If 
they are not aware of what is taking place in dark markets, then they 
cannot do their jobs effectively. Regulators must have complete 
transparency. Given the speed with which the financial markets move, 
this transparency, at a minimum, must be available on a daily basis and 
should ideally be sought on a real-time basis.
    The American public, which has suffered greatly because of Wall 
Street's failures, deserves transparency as well. Individuals should be 
able to see the positions of all the major players in all markets on a 
delayed basis, similar to the 13-F filing requirements of money 
managers in the stock market.
    The best way to bring over-the-counter (OTC) transactions out of 
the darkness and into the light is to make it mandatory for all OTC 
transactions to clear through an exchange. Nothing creates transparency 
better than exchange clearing. All other potential solutions, like 
self-reporting, are suboptimal for providing necessary real-time 
information to regulators.
    For these reasons, I am very glad to see the sections of this bill 
that call for exchange clearing of all OTC transactions. This is a 
critical prerequisite for effective regulatory oversight. For that 
reason, it should be a truly rare exception when any segment of the OTC 
markets is exempted from exchange clearing requirements.
    I am further encouraged by sections 3, 4 and 5, which bring 
transparency to foreign boards of trade and make public reporting of 
index traders' and swaps dealers' positions a requirement.
    Lack of transparency was a primary cause of the recent financial 
system meltdown. Unsure of who owned what, counterparties assumed the 
worst and were very reluctant to trade with anyone. The aforementioned 
provisions in this bill will help ensure the necessary transparency to 
avoid a crisis of confidence like we just experienced.
    Wall Street would much prefer that the OTC markets remain dark and 
unregulated. They will push to keep as much of their OTC business as 
possible from being brought out into the light of exchange clearing. 
They will argue that we should not make major changes to regulation now 
that the financial system is so perilously weak.
    From my perspective this sounds like an intensive care patient that 
refuses to accept treatment. The system is already on life support. 
Transparency is the cure that will enable the financial system to 
recover.
    Congress must prioritize the health of the financial system and the 
economy as a whole above the profits of Wall Street. The profits of 
Wall Street are a pittance when compared with the cost to America from 
this financial crisis. We must clear all OTC markets through an 
exchange to ensure that this current crisis does not recur.
Systemic Risk Elimination
    The other primary factor in the meltdown of the financial system 
was the liquidity crisis, brought on by excessive leverage at the major 
financial institutions.
    By mandating that OTC transactions clear through an exchange, the 
Derivatives Markets Transparency and Accountability Act of 2009 
provides for the exchange to become the counterparty to all 
transactions. Since the exchange requires the posting of substantial 
margin, the risk to the financial system as a whole is nearly 
eliminated. When margin is posted on a daily basis, then potential 
losses are greatly contained and counterparty risk becomes virtually 
nil.
    To protect its interests, Wall Street will try to water down these 
measures. The substantial margin requirements will limit leverage, and 
limits on leverage, in turn, mean limits on profits, not only for 
banks, but for traders themselves. Because traders are directly 
compensated with a fraction of the short-term profits that their 
trading generates, they have a great deal of incentive to use as much 
leverage as they can to maximize the size of their trading profits. 
These incentives also exist for managers and executives, who share in 
the resulting trading profits.
    One of the most dangerous things about OTC derivatives is that they 
offer virtually unlimited leverage, since typically no margin is 
required. This is one of the reasons that Warren Buffet famously called 
them ``financial weapons of mass destruction.''
    This extreme over-leveraging is essentially what brought down AIG, 
which at one time was the largest and most respected insurance company 
in the world. While by law they could not write a standard life 
insurance contract without allocating proper reserves, they were able, 
in off-balance-sheet transactions, to write hundreds of billions of 
dollars worth of credit default swaps and other derivatives without 
setting aside any significant amount of reserves to cover potential 
losses.
    If AIG were clearing its credit default swaps through an exchange 
requiring substantial margin, it would never have required well over 
$100 billion dollars in taxpayer money to avoid collapsing.
    I do not know the specifics of the clearinghouse that the 
IntercontinentalExchange (ICE) and the major swaps dealers are working 
to establish but I would encourage policymakers to look very closely at 
the amount of margin that swaps dealers will be required to post on 
their trades. If there is a substantial difference between what ICE 
requires and what CME Group requires then swaps dealers, in a quest for 
maximum leverage, will flock to the clearing exchange that has lower 
margin requirements.
    This is exactly opposite of what regulators and policymakers would 
want to see. The stronger the margin requirements, the greater will be 
the mitigation of systemic risk. The weaker the margin requirements, 
the greater chance we face of having to bail out more financial 
institutions in the future.
    I strongly urge Congress to resist all pressure from Wall Street to 
soften any of the provisions of this bill. We must eliminate the 
``domino effect'' in order to protect the system as a whole, and 
exchange clearing combined with substantial margin requirements is the 
best way to do that.
Excessive Speculation Elimination
    Speculative position limits are necessary in the commodities 
derivatives markets to eliminate excessive speculation. When there are 
no limits on speculators, then commodities markets become like capital 
markets, and commodity price bubbles can result. If adequate and 
effective speculative position limits had been in place across 
commodity derivatives markets, then it is likely we would not have seen 
the meteoric rise of food and energy prices during the first half of 
2008, nor the ensuing crash in prices when the bubble burst.
    The fairest and best way to regulate the commodities derivatives 
markets is to subject all participants to the same regulations and 
speculative position limits regardless of whether they trade on a 
regulated futures exchange, a foreign board of trade, or in the over-
the-counter markets. Every speculator should be regulated equally. If 
you do not, then you create incentives that will directly favor one 
trading venue over another.
    The over-the-counter (OTC) markets are dramatically larger than the 
futures exchanges. If speculative position limits are not imposed on 
all OTC commodity derivatives then there is a gaping hole that 
speculators can exploit. It would be like locking one's doors to 
prevent a robbery, while leaving one's windows wide open.
    The best solution is to place a speculative position limit that 
applies in aggregate across all trading venues. Once OTC commodity 
derivatives are cleared through an exchange, regulators will be able to 
see every trader's positions and the application of speculative limits 
will be just as simple for OTC as it is for futures exchanges today.
    This type of aggregate speculative position limit is also better 
than placing individual limits on each venue. For example, placing a 
1,000 contract limit on ICE, a 1,000 contract limit on NYMEX and a 1 
million barrel (1,000 contract equivalent) limit in the OTC markets 
will incentivize a trader to spread their trading around to three or 
more venues, whereas with an aggregate speculative position limit, they 
can trade in whichever venue fits their needs the best, up to a clear 
maximum.
    I applaud the provisions of your bill that call for the creation of 
a panel of physical commodity producers and consumers to advise the 
CFTC on the level of position limits. I believe it affirms three 
fundamental truths about the commodities derivatives markets: (1) these 
markets exist for no other purpose than to allow physical commodity 
producers and consumers to hedge their price risk; (2) the price 
discovery function is strengthened and made efficient by the trading of 
the physical hedgers and it is weakened by excessive speculation; and 
(3) speculators should only be allowed to participate to the extent 
that they provide enough liquidity to keep the markets functioning 
properly. Physical commodity producers and consumers can be trusted 
more than the exchanges or even the CFTC to set position limits at the 
lowest levels possible while still ensuring sufficient liquidity.
    I understand the legal problem with making this panel's decisions 
binding upon the CFTC. Still, I hope it is clear that this panel's 
recommendations should be taken very seriously, and if the CFTC chooses 
to not implement the recommendations they should be required to give an 
account for that decision. I further believe that the exchanges and 
speculators should not be part of the panel because they will always 
favor eliminating or greatly increasing the limits.
    CME and ICE may perhaps oppose speculative position limits in 
general out of a fear that it will hurt their trading volumes and 
ultimately their profits, but I believe this view is shortsighted. If 
CME, ICE and OTC markets are all regulated the same, with the same 
speculative position limits, then trading business will migrate away 
from the OTC markets and back to the exchanges, because OTC markets 
will no longer offer an advantage over the exchanges.
    I am glad that this bill gives the CFTC the legal authority to 
impose speculative position limits in the OTC markets, but I openly 
question whether or not the CFTC will exercise that authority. Like the 
rest of our current financial market regulators, they have been steeped 
in deregulation ideology. While I hope that our new Administration will 
bring new leadership and direction to the CFTC, I fear that there will 
be resistance to change.
    When Congress passed the Commodity Futures Modernization Act of 
2000, they brought about the deregulation that has fostered excessive 
speculation in commodities derivatives trading. Now Congress must make 
it clear that they consider excessive speculation in the commodities 
derivatives markets to be a serious problem in all trading venues. 
Congress must make it clear to the CFTC that they have an affirmative 
obligation to regulate, and that a critical part of that is the 
imposition and enforcement of aggregate position limits to prevent 
excessive speculation.
Summary
    We have now witnessed how damaging unbridled financial innovation 
can be. Wherever there is growing innovation there must also be growing 
regulation. Substantial regulation is needed now just to catch up with 
the developments on Wall Street over the last fifteen years.
    This bill is ambitious in its scope and its desire to re-regulate 
the financial markets, and for that I am encouraged. These drastic 
times call for bold steps, and I am pleased to support your bill. My 
sincere wish is that it be strengthened and not weakened by adding a 
provision for aggregate speculative position limits that covers all 
speculators in all markets equally.
    Fifteen years ago, before the proliferation of over-the-counter 
derivatives and before regulators became enamored with deregulation, 
the financial markets stood on a much firmer foundation. Today, with 
all of the financial innovation and the deregulation of the Clinton and 
Bush years, it is hard to look back and say that the financial markets 
are better off than they were 15 years ago. I think it is clear to 
everyone in America that this grand experiment, rather than delivering 
on its great promise has, in fact, turned out to be a great disaster.
                               Attachment

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    The Chairman. Thank you very much, Mr. Masters. We 
appreciate your being with us.
    Next, we will have Mr. Short from ICE, welcome to the 
Committee.

          STATEMENT OF JOHNATHAN H. SHORT, SENIOR VICE
PRESIDENT AND GENERAL COUNSEL, IntercontinentalExchange, INC., 
                          ATLANTA, GA

    Mr. Short. Thank you.
    Chairman Peterson, Ranking Member Lucas, I am Johnathan 
Short, Senior Vice President and General Counsel with 
IntercontinentalExchange or ICE. We are grateful for the 
opportunity to provide comments on the discussion draft of the 
Derivatives Markets Transparency and Accountability Act, and I 
fully support the goals of the Act to bring transparency and 
accountability to commodity markets.
    As the owner of regulated exchanges and clearinghouses in 
the United States, the United Kingdom and Canada, ICE has 
committed to facilitating global regulatory cooperation to 
ensure that regulatory best practices are adopted around the 
world. As the global nature of this financial crisis aptly 
illustrates, systemic market problems cannot be solved 
unilaterally, and solutions will require close cooperation 
between governments of major developed nations and a 
willingness on the part of those governments to implement the 
best financial market practices, regardless of their source of 
origin. Combined with commitment to open markets, such an 
approach will be the best way to achieve the goals of the 
DMTAA.
    Against this backdrop, we would offer brief thoughts on 
three sections of the Act: section 3, foreign boards of trade; 
section 6, trading limits to prevent excessive speculation; and 
section 16, limitation on the ability to purchase credit 
default swaps. Please note that our views on specific 
provisions of the Act should not be misconstrued as opposition 
to the Act as a whole, or opposition to the important steps 
that this Committee has taken to restore confidence in our 
financial markets.
    Beginning with section 3 on foreign boards of trade, ICE is 
generally supportive of this provision as it codifies existing 
obligations that ICE Futures Europe has been complying with 
since late last year, including implementation of position 
limits and accountability for DCM link contracts. And, for the 
first time in a European exchange regulation, the generation of 
large trader reporting to assist the CFTC in its markets 
surveillance efforts.
    However, section 3 of the Act contains one provision that 
would inappropriately discriminate against foreign exchanges 
and the competition that they bring to bear. Unlike the 
requirements applicable to domestic exchanges, section 3 
requires that foreign exchanges adopt position limits taking 
into consideration the relative sizes of respective markets. 
This provision would hamper competition between exchanges and 
would effectively prevent foreign exchanges from attaining 
sufficient market liquidity to offer the type of trading 
markets necessary to compete with domestic exchanges as all 
competitors would, by definition, start with little or no 
market share. Domestic exchanges could ultimately be impacted 
as well by this provision if foreign governments adopt similar 
provisions in their laws.
    Considering the significant benefits that competition has 
brought to the marketplace and the need for international 
regulatory cooperation, we would respectfully request that this 
provision of the Act be modified, and would note that if the 
goal of the provision is to prevent multiplication of positions 
across numerous exchanges, the same goal could be achieved 
through requiring market participants to liquidate positions 
should they exceed an aggregate limit observed by the CFTC.
    Turning to section 6 of the Act, ICE's subsidiary, ICE 
Futures U.S., formerly the New York Board of Trade, is a 
designated contract market regulated by the CFTC. Among the 
products it lists for trading are three international soft 
commodity contracts: coffee, wool, sugar and cocoa; and it is 
the preeminent market for price discovery in these commodities. 
None of these commodities are grown in the United States or are 
subject to any domestic price support programs, unlike domestic 
commodities'; and all of these commodities are also traded on 
established exchanges in London, Brazil and the Far East.
    Section 6 fails to distinguish between the international 
agricultural commodities and domestically grown agricultural 
commodities that have traditionally been the focus of the 
Committee's oversight. Section 6 would require the CFTC, rather 
than ICE Futures U.S., to set position limits with respect to 
these international markets, and would replace ICE Futures' 
strong market expertise in these areas to the detriment of both 
the exchange and the broader markets, potentially shifting 
trading in these commodities to foreign markets that are not 
subject to CFTC jurisdiction.
    Finally, turning to section 16 of the Act that prohibits 
trading and credit default swaps without ownership and the 
underlying obligation. As with all trading markets, hedgers 
must be able to transact with another party willing to buy 
their risk for a price. Section 16 would likely end the CDS 
market in the United States due to the inability of hedgers to 
find counterparties legally able to buy their risk, and could 
prove problematic for the trading of CDS indices in which 
parties would apparently have to own all of the underlying 
bonds to trade an index. This would be counterproductive, as 
transparent and stable CDS markets are important for the 
recovery of broader financial markets.
    Many of the problems that have been identified in the CDS 
market relate to the lack of transparency in markets and 
outsize risks undertaken by financial entities, and we believe 
that these issues can be addressed through central counterparty 
clearing. ICE is proud to be working towards establishing ICE 
U.S. Trust to clear these products.
    In conclusion, ICE strongly supports the goals of the Act 
and will continue to work cooperatively with this Committee to 
find solutions that promote the best marketplace possible.
    [The prepared statement of Mr. Short follows:]

  Prepared Statement of Johnathan H. Short, Senior Vice President and 
      General Counsel, IntercontinentalExchange, Inc., Atlanta, GA
Introduction
    Chairman Peterson, Ranking Member Lucas, I am Johnathan Short, 
Senior Vice President and General Counsel of IntercontinentalExchange, 
Inc., or ``ICE.'' We are grateful for the opportunity to provide 
comments on the ``discussion draft'' of the Derivatives Markets 
Transparency and Accountability Act (DMTAA).
    ICE fully supports the goal of the DMTAA to ``bring transparency 
and accountability to commodity markets.'' Over the past decade, we 
have worked with regulators both in the United States and abroad to 
achieve this end and appreciate the opportunity to work on additional 
improvements.
    As background, ICE operates three regulated futures exchanges: ICE 
Futures Europe, formerly known as the ``International Petroleum 
Exchange,'' is regulated by the U.K. Financial Services Authority 
(FSA). ICE Futures U.S., previously known as ``The Board of Trade of 
the City of New York (NYBOT)'' and the New York Clearing Corporation 
are both regulated by the CFTC. ICE Futures Canada, which was 
previously called the Winnipeg Commodity Exchange, is regulated the 
Manitoba Securities Commission. In addition, ICE operates an over-the-
counter (OTC) energy platform as exempt commercial market, as defined 
by the Commodity Exchange Act. On these exchanges, ICE offers futures 
and options contracts on energy products (including the benchmark Brent 
and WTI contracts), agricultural commodities, currencies and equity 
indexes.
    ICE has worked to provide transparency to a varied array of 
markets. For example, ICE brought transparency to OTC energy markets 
nearly a decade ago, with a digital platform that transformed the 
marketplace from an opaque, telephone-based network of brokerages to a 
global market with real-time prices on electronic trading screens. In 
its 2007 State of the Markets Report, Federal Energy Regulatory 
Commission (FERC) observed that ICE ``provides the clearest view we 
have into bilateral spot markets.'' \1\
---------------------------------------------------------------------------
    \1\ Federal Energy Regulatory Commission, 2007 State of the Markets 
Report, pg. 9 (Issued, March 20, 2008).
---------------------------------------------------------------------------
    In 2002, in response to the credit and counterparty risk crisis 
that were then gripping the energy markets, we introduced clearing into 
the OTC energy markets. Cleared contracts now account for more than 90 
percent of ICE's OTC business. Believing that centralized clearing is 
an essential next step in stabilizing the credit derivatives market, 
since last summer ICE has been working with the Federal Reserve System, 
the New York Banking Department and a number of industry participants 
to develop a clearing solution for credit default swaps (CDS).
    Last May, as part of the farm bill reauthorization, Congress 
provided the CFTC with greater oversight of electronic OTC markets, or 
Exempt Commercial Markets. The new law provides legal and regulatory 
parity between fully regulated futures exchanges and OTC contracts that 
serve a significant price discovery function,\2\ while also recognizing 
and preserving the role of OTC markets in providing innovation and 
customization. ICE supported this legislation, and we remain grateful 
for this Committee's leadership during that debate.
---------------------------------------------------------------------------
    \2\ This provision of the farm bill is commonly referred to as the 
``Closing the Enron Loophole Act.''
---------------------------------------------------------------------------
    Because ICE operates markets in both domestic and foreign 
jurisdictions, ICE is keenly aware of the global nature of most 
commodity and financial derivative markets. Furthermore, ICE is 
committed to facilitating global regulatory cooperation and the 
implementation of best practices in financial markets around the world. 
As the global nature of this financial crisis illustrates, systemic 
market problems cannot be solved independently, and solutions will 
require both close coordination and cooperation between governments of 
major developed nations and a willingness to implement best practices 
regardless of their source of origin. Combined with a commitment to 
open markets, such an approach will be the best way forward toward 
solving the problems that have impacted economies around the world.
    We offer our comments on several provisions in the bill in the 
spirit of finding solutions that will achieve the stated purpose of 
improving transparency and accountability in commodity markets.
Section 3--Foreign Boards of Trade
    Earlier last month, the G30's Working Group on Financial Reform, 
led by Chairman Paul Volcker, published its Framework for Financial 
Stability. Core recommendation two states, ``The quality and 
effectiveness of prudential regulation and supervision must be 
improved. This will require better-resourced prudential regulators and 
central banks operating within structures that afford much higher 
levels of national and international policy coordination.'' 
Recommendation 6b, on regulatory structure, states, ``In all cases, 
countries should explicitly reaffirm the insulation of national 
regulatory authorities from political and market pressures and reassess 
the need for improving the quality and adequacy of resources available 
to such authorities.''
    By supporting coordination and information sharing among 
international regulators, the foreign board of trade provision in the 
DMTAA, advances the G30's recommendations. We are concerned; however, 
that one aspect of that provision could limit competition between 
domestic and foreign exchanges and ultimately threaten cooperation 
between domestic and foreign regulators, and indeed domestic and 
foreign governments, in implementing uniform standards to improve 
markets.
    Since 2006, ICE has worked with the United Kingdom's Financial 
Services Authority to provide the CFTC with visibility into markets 
traded on its foreign board of trade to allow the CFTC to properly 
surveil domestic regulated markets. On June 17, 2008, the CFTC revised 
the conditions under which ICE Futures Europe operates in the United 
States by amending the ``no-action relief letter'' that permits that 
exchange to have direct access to U.S. customers for its WTI Crude Oil 
Futures Contract. The amended letter conditioned ICE Futures Europe's 
direct screen based access on the adoption of U.S. equivalent position 
limits and accountability levels, together with reporting obligations, 
related to contracts that are linked to the price of a U.S. designated 
contract market price. Since October, ICE Futures Europe has been 
complying with the revised No Action letter.
    Section 3 of the DMTAA essentially codifies the conditions set 
forth in the CFTC's revised No Action letter for ICE Futures Europe, 
with one important exception. Unlike the requirements applicable to 
domestic exchanges, section 3 requires foreign exchanges to adopt 
position limits for the affected contract taking ``into consideration 
the relative sizes of the respective markets''. This provision 
discriminates against foreign exchanges, and would effectively prevent 
them from attaining sufficient market liquidity to compete with 
domestic exchanges as all competitors would by definition start out 
with little or no market share. In addition, domestic exchanges could 
be impacted through the adoption of similar provisions of law in 
foreign countries which have a larger relative share of the underlying 
commodity market.
    In recent years, the only effective competition in the futures 
industry has come from foreign exchanges and exempt commercial markets. 
That competition has led U.S. exchanges to transition markets to 
transparent electronic trading, with full audit trails and improved 
risk management through straight through processing. It has also 
resulted in more efficient markets bringing about many benefits for 
market participants such as lower trading costs and tighter bid/ask 
spreads. With one exchange in control of more than 97 percent of U.S. 
futures market, competition is more important than ever. Requiring 
foreign markets to set position limits according to respective market 
size would effectively bar foreign exchanges from competing in the 
U.S., would likely be viewed was extraterritorial regulation by foreign 
market regulators, and would be inconsistent with the higher level of 
international policy coordination contemplated by the G30 policy 
recommendations. ICE respectfully requests that this particular 
provision of section 3 be reconsidered for the broader policy goals 
that are sought to be achieved by the G30 policy recommendations and in 
recognition of the fact that no single piece of legislation adopted 
here or elsewhere will achieve its ends unless appropriate standards 
are adopted on an international basis.
Section 6--Trading Limits To Prevent Excessive Speculation
    ICE's U.S. subsidiary, ICE Futures U.S. (formerly the New York 
Board of Trade) is a designated contract market regulated by the CFTC. 
Among the products it lists for trading are three international soft 
commodities--coffee, world sugar and cocoa--and it is the pre-eminent 
market for price discovery of these commodities. None of these 
commodities is grown in the United States or is subject to domestic 
price support programs. Moreover, none of them was the subject of 
hearings last year conducted by Congressional Committees or reviews by 
the CFTC into the rise and fall of certain commodity prices. Because 
they are liquid contracts traded on a designated contract market, our 
futures and options contracts in these commodities have been subject to 
position accountability levels and spot month position limits that have 
been established and administered by the Exchange for more than a 
decade without incident. Under the terms of the standardized futures 
contracts, ICE Futures U.S. also regulates physical delivery of those 
three international commodities from ports or warehouses located in 
more than two dozen foreign countries around the world.
    Section 6 of the proposed legislation fails to distinguish between 
ICE's international agricultural contracts and the domestically-grown 
agricultural commodities that we believe were the bill's intended 
subjects. Specifically, the legislation would require the CFTC to set 
position limits on the number of futures and option contracts that a 
person could hold in any one futures month of a commodity, in all 
combined futures months of a commodity, and in the spot month. In 
contrast, ICE Futures U.S. sets limits for its coffee, sugar and cocoa 
contracts based on its extensive experience with these markets.
    In addition, the proposed legislation would amend the Commodity 
Exchange Act core principles applicable to designated contract markets 
like ICE Futures U.S. by eliminating the availability of ``position 
accountability'' levels for speculators in international agricultural 
commodities. As noted previously, ICE Futures U.S. has set and 
administered position accountability levels in its internationally-
based products for over a decade. For example, through its market 
oversight, ICE Futures U.S. has been able to respond to market 
conditions and the needs of its users in a flexible manner, while 
maintaining transparent and liquid markets relied upon throughout the 
world. This provision, if implemented, would replace ICE Futures U.S.'s 
strong market surveillance role with an inflexible regime that would be 
established, and possibly administered, by the CFTC. This could very 
well drive business to London, Brazil and the Far East where these 
products already trade on established futures markets. We do not 
believe this was the drafters' intent.
Section 6--Limitations on index traders
    Section 6 defines bona fide hedging in a way that would prohibit 
index traders from taking a position in excess of position limits. This 
would be a significant change in market structure and will have an 
immediate and deleterious impact. A recent market study performed by 
Informa examined the impact of index funds on market volatility. The 
study employed both Granger causality and vector auto-regression tests 
and determined that there was no link between index funds and market 
volatility. Greatly reducing the participation of index funds in the 
market would be disadvantageous to the market at-large and would most 
likely only benefit the very largest participants in a given market. In 
a soft commodities market (e.g., coffee, sugar or cocoa), the removal 
of this additional liquidity could potentially enable a single large 
entity or a small group of entities to wield considerable influence on 
the market dynamics.
    Section 9 requires the CFTC to study the impact of commodity 
``fungibility'' and whether there should be ``aggregate'' position 
limits for similar agriculture or energy contracts traded on DCMs, 
DTEFs, 2(g) and 2(h) markets. Sec. 10 requires a GAO study of 
international regulation of energy commodity markets. Both reports are 
due in a year. ICE supports these studies without reservation, and we 
believe this legislation would be improved if it were informed by 
equally thorough reports on the issues we have discussed today.
Section 16--Limitation on Ability To Purchase Credit Default Swaps
    Section 16 of the bill would prohibit trading in credit default 
swaps without ownership of the underlying reference obligation. This 
provision is problematic on several levels.
    First, CDS perform an important market function in allowing parties 
to hedge credit risk. Section 16 is titled ``Limitation on Eligibility 
to Purchase a Credit Default Swap.'' However, the language in 
subsection (a) prohibits parties from ``entering into a credit default 
swap'' unless they own the underlying bonds. As with all trading 
markets, another party must be willing to assume the hedger's risk; 
therefore, section 16 would likely end the CDS market in the United 
States due to the inability of hedgers to find counterparties legally 
able to ``buy their risk''. This would be counterproductive, as a 
transparent and stable CDS market is important for the recovery of 
financial markets. Furthermore, not all credit risk has a tailored 
credit default swap. Section 16 would prohibit parties from hedging 
default exposure by purchasing credit default indices, unless the party 
owned every underlying bond in the index.
    Second, ICE believes that the goals of transparency and mitigation 
of counterparty credit risk and systemic risk can be achieved through 
central clearing of CDS and through resulting public and regulatory 
transparency. Section 16 would run counter to this goal as it would 
impair the liquidity needed to efficiently manage risk within a 
clearinghouse in the event of a default or similar event. ICE 
respectfully requests that the Committee consider eliminating this 
provision of the draft bill.
    During the financial crisis, as cash markets evaporated, and 
markets for commercial paper, corporate bonds and other debt 
instruments dried up, the CDS market has remained liquid, offering 
lenders and investors a way to hedge risk and--just as important--a 
market-based, early-warning price discovery function. Broader 
availability of credit protection can encourage sovereign and corporate 
lending. As lenders and investors consider ways to improve credit risk 
evaluations, CDS spreads have proven to be more reliable indicators of 
an institution's financial health than credit agency ratings.
    Finally, on the note of global cooperation, last week in Davos, 
E.U. Financial Services Commissioner Charlie McCreevy said he would not 
support a ban on trading credit default swaps unless the party held a 
position in the underlying bonds. Prohibiting this trade in the United 
States will almost certainly lead to a wholesale migration of the CDS 
marketplace overseas, outside the reach of U.S. regulators and this 
Committee. We do not believe that is the intent of this legislation.
Conclusion
    ICE is a strong proponent of open and competitive derivatives 
markets, and of appropriate regulatory oversight of those markets. As 
an operator of global futures and OTC markets, and as a publicly-held 
company, we understand the essential role of trust and confidence in 
our markets. To that end, we are pleased to work with Congress to 
address the challenges presented by derivatives markets, and we will 
continue to work cooperatively for solutions that promote the best 
marketplace possible.
    Mr. Chairman, thank you for the opportunity to share our views with 
you. I am happy to answer any questions you may have.

    The Chairman. Thank you, Mr. Short. I thank you for being 
with the Committee.
    Mr. Taylor, welcome to the Committee.

   STATEMENT OF GARY W. TAYLOR, CEO, CARGILL COTTON COMPANY, 
               CORDOVA, TN; ON BEHALF OF NATIONAL
            COTTON COUNCIL; AMERICAN COTTON SHIPPERS
                     ASSOCIATION; AND AMCOT

    Mr. Taylor. Thank you.
    Thank you, Chairman Peterson, Ranking Member Lucas, and 
Members of the Committee. I am Gary Taylor, CEO of Cargill 
Cotton in Memphis, Tennessee; and I appear today here 
representing the members of the National Cotton Council, the 
American Cotton Shippers and AMCOT, which is a trade 
association of marketing cooperatives.
    In the past year, the cotton industry has undergone severe 
financial strain due to the unpredictable risk caused by a 
dysfunctional futures market. The March 2008, debacle and the 
ICE No. 2 Cotton Contract forced a number of first handlers 
into bankruptcy, while others have announced orderly closures.
    Traditional merchandising relationships have ceased, 
because price risks are too great for hedging purposes. Growers 
continue to be concerned about the financial viability of 
marketing entities with whom they have previously contracted.
    To ensure the survival of our marketing structure, the 
cotton futures market must be returned to its historical 
function of price discovery and risk management relative to 
real market conditions.
    As the cotton industry informed this Committee in 2008, 
investment funds and over-the-counter operatives flooded our 
futures markets with record amounts of cash. In our opinion, 
their presence distorted both the futures and physical markets. 
We believe the legislation before the Committee, the 
Derivatives Markets Transparency and Accountability Act of 
2009, addresses these concerns raised by our industry and the 
agriculture sector and restores confidence of the commercial 
trade and lending institutions. It will facilitate market 
fundamentals, not speculative activity, resulting in accurate 
price discovery.
    The cotton industry acknowledges the importance of market 
liquidity and the essential function speculative interests 
perform in our commodity markets. In our view, by requiring 
full transparency and accountability of speculative trades, the 
proposed legislation would not discourage speculative 
participation in the commodity contracts. Market liquidity is 
essential, but it must be tempered and monitored, and it should 
not dictate the direction of the market.
    In the current regulatory structure, Congress's CFTC has 
imposed speculative position limits in our futures contracts to 
reduce the potential for market disruption or manipulation. 
Such limits are no longer effective for three reasons: first, 
hedge exemptions granted to investment funds allowed them to 
exceed the limit; second, large traders using swaps exemptions 
operate outside the regulatory framework altogether; and third, 
nontraditional trader's speculative limits are only imposed as 
these contracts go into convergence.
    The other significant area of concern is the exempt status 
afforded swaps transactions that are executed off-exchange with 
each party mutually agreeing to satisfy each other's credit 
standards, and to remit margins to one another as the 
underlying market fluctuates. Such transactions pose problems 
when one of the parties has a hedge exemption that exempts his 
or her on-exchange futures trading from position size limits.
    These arrangements, along with billions of dollars invested 
in index funds, has brought so much cash into our markets that 
the traditional speculators could not take a short position to 
match the institutional longs. This left it up to the 
commercials to offset these positions. But, lacking the 
necessary capital to meet the huge margin requirements, they 
could not do so. The result is a market with no economic 
purpose for the commercial traders. Simply put, the investment 
funds have negated the real purpose of our futures markets.
    In order to restore the integrity of the markets, and to 
ensure they fulfill the basic roles of price discovery risk 
management and hedging, the cotton industry has developed a 
number of recommendations that are incorporated into the 
legislation before the Committee.
    First, establish trading limits to prevent excessive 
speculation; second, subject all contract and over-the-counter 
market participants to speculative position limits; third, 
subject speculative entities to the same weekly reporting 
requirements as the trade; and finally, limit hedge exemptions 
and limit eligibility for hedge margin levels to those actually 
involved in the physical handling of our commodities.
    The cotton industry also believes that the lack of 
transparency and disparate reporting requirements by market 
participants is appropriately addressed by legislation 
requiring the CFTC to disaggregate index funds, and publish the 
number of positions and total value of the index funds and 
other passive, long-only, short-only investors and data on 
speculative positions relative to their bona fide physical 
hedges. And also to establish reporting requirements for index 
traders and swap traders in designated market contracts, 
derivative transaction execution facilities and all other 
trading areas.
    In addition to these necessary changes, the cotton industry 
feels strongly that the CFTC should require the 
IntercontinentalExchange and its clearinghouse members to 
adhere to the practice of margining futures to futures 
settlements and options to options settlements.
    Also, the cotton industry has an important caveat for both 
the Committee and the CFTC. We submit that no action should be 
taken to discourage over-the-counter transactions with 
legitimate commercial purposes, transactions that are 
transparent and have proven to be beneficial risk management 
tools. It is essential that we encourage commercial innovation 
for those producing, merchandising or using physical 
commodities traded in the futures market.
    In closing, I would like to stress restoring confidence in 
the futures markets is of the utmost importance, and we thank 
you for considering our views.
    [The prepared statement of Mr. Taylor follows:]

   Prepared Statement of Gary W. Taylor, CEO, Cargill Cotton Company,
  Cordova, TN; on Behalf of National Cotton Council; American Cotton 
                    Shippers Association; and AMCOT
    Chairman Peterson, Ranking Member Lucas, and Members of the 
Committee, I am Gary Taylor, CEO of Cargill Cotton Company in Cordova, 
Tennessee. Cargill Cotton is a division of Cargill, Incorporated, an 
international provider of food, agricultural and risk management 
products and services. We service growers, ginners, buyers and textile 
mills worldwide through our network of buying, selling and shipping 
offices and our cotton gins and warehouses. I appear today representing 
the members of the National Cotton Council, the American Cotton 
Shippers Association, and AMCOT, a trade association of marketing 
cooperatives.
    We appreciate your scheduling this week's hearing and the 
outstanding leadership you have provided this past year on this subject 
critical to farmers, marketers, processors and consumers of 
agricultural and energy products. The involvement of the Committee this 
past year exemplifies its interest and its willingness to effectively 
oversee the commodity futures markets and to address issues vitally 
important to the functioning of the U.S. economy.
Impact of Futures Markets on Cotton Industry
    The sound and effective regulation of a transparent futures market 
would provide significant benefits to the cotton industry, which is 
concentrated in 17 cotton-producing states, stretching from Virginia to 
California with the downstream manufacturers of cotton apparel and home 
furnishings located in virtually every state. The industry and its 
suppliers, together with the cotton product manufacturers, account for 
more than 230,000 jobs in the U.S. The annual economic activity 
generated by cotton and its products in the U.S. is estimated to be in 
excess of $100 billion.
    In the past year, the cotton industry has undergone severe 
financial strain due to the uncertainty and unpredictable risk caused 
by a dysfunctional futures market. Coming to light is the damage of the 
March 2008 debacle in the ICE No. 2 Upland Cotton Contract as a number 
of first handlers have been forced into bankruptcy, several have 
announced orderly closures, and most have seen their assets dwindle to 
a critical level. Traditional merchandising relationships between 
growers and buyers have ceased because price risks are too great for 
short hedging purposes. Growers continue to be concerned about the 
financial viability of marketing entities with whom they have 
previously contracted crop sales. The inability of merchandisers to 
hedge their risks translates into a weaker basis and lower prices 
offered to the cotton producer. Each penny reduction in the price of 
cotton means that U.S. cotton farmers lose $85 million in revenue. 
Therefore, to insure the survival of our marketing structure, the 
cotton futures market must be returned to its historical function of 
price discovery and risk management relative to real market conditions.
The Lesson Learned
    As the cotton industry and the agricultural complex informed this 
Committee in 2008, investment funds and over-the-counter (OTC) 
operatives flooded the futures markets with record amounts of cash, 
throwing the trading fundamentals out of balance, resulting in a 
widened basis, and thereby making these markets illiquid for those for 
whom Congress created these markets. The presence of large speculative 
funds and index funds in the energy and agricultural futures contracts 
distorted the futures and the physical or cash markets of these 
commodities. The abundance of unregulated cash allowed these funds to 
overwhelm these markets negating their primary purposes.
    Long before others in the Congress or the regulatory agencies 
recognized the problem or began to take action, the House Agriculture 
Committee had hearings underway and appropriate legislation before the 
Congress. Now, the leaders of the developed and developing world are 
calling for the U.S. to effectively regulate the commodity markets. We 
commend the Committee for that bipartisan foresight and believe that 
the legislation before the Committee, The Derivatives Markets 
Transparency and Accountability Act of 2009, would address the concerns 
raised by the cotton industry and the agricultural sector and restore 
the confidence of the commercial trade and the lending institutions. 
Above all, it will facilitate market fundamentals, not speculative 
activity, resulting in accurate price discovery in the futures markets.
The Importance of Market Liquidity
    The cotton industry acknowledges the importance of market liquidity 
and the essential function the speculative interests perform in the 
commodity markets. We welcome that participation and do not wish to 
discourage it. In our view, the legislation before the Committee by 
requiring full transparency and accountability of speculative trades 
would not discourage speculative participation in the commodity 
contracts. Market liquidity is essential, but it must be tempered and 
monitored--it should not dictate the direction of the market.
Speculative Position Limits and the Swaps Exemption
    In the current regulatory structure of the futures markets, 
Congress, through the CFTC, has imposed speculative positions limits in 
the futures contracts to reduce the potential for market disruption or 
manipulation. But such limits are no longer effective for three 
reasons:

    1. The CFTC has granted Hedge Exemptions to the investment funds 
        allowing them to exceed the limits;

    2. Large traders were permitted by Congress, through the Swaps 
        Exemption, to operate outside the regulatory framework 
        altogether; and

    3. Non-traditional traders speculative limits are only imposed as 
        contracts go into convergence.

    The other significant area of concern is the exempt status afforded 
Swaps transactions that are executed off-exchange with each party 
mutually agreeing to satisfy each other's credit standards and to remit 
margins to one another as the underlying market fluctuates. Such 
transactions, however, pose problems when one of the parties to the 
Swap has a ``Hedge Exemption'' that exempts his or her on-exchange 
futures trading from position-size limits.\1\
---------------------------------------------------------------------------
    \1\ In such situations, the Swaps dealer would take an equal and 
opposite position in the futures market to the Swaps trade. For 
example, should a pension fund desire to purchase $20 million in long 
exposure in a commodity, it can purchase this exposure from a Swaps 
dealer. The dealer, now short the price of that commodity via the Swap, 
enters the futures market to hedge his position by buying futures in 
that commodity. Given that he is a ``hedger,'' the CFTC allows him to 
trade futures in excess of the normal speculative position-size limits. 
This has created a situation where such large investors can trade in 
any contract in any size they desire without regard to position limits. 
They are not limited by the CFTC. Only a Swaps dealer can limit such 
trades, and it is unlikely that a Swaps dealer would turn a deaf ear to 
a financial entity awash in cash.
---------------------------------------------------------------------------
    These arrangements, along with the billions of dollars invested in 
index funds, brought so much cash into the market that the traditional 
speculators could not take a short position to match the institutional 
longs. This left it up to the commercials to offset these positions. 
But lacking the necessary capital to meet the huge margin requirements, 
they could not do so.
    That has been the situation this past year as the funds continued 
to purchase futures. Unwilling to assume such margin risks in such a 
volatile futures market, the commercial traders were forced to remain 
passive not only in the futures, but in the physical markets as well. 
The result: markets with no economic purpose for the commercials. 
Therefore, no business was done. Producers, lacking a price, could not 
properly plan and processors had to buy hand to mouth. Simply put, the 
investment funds have negated the real purpose of the futures markets, 
causing severe disruptions in the marketing process.
Cotton Industry Recommendations
    In order to restore the integrity of the futures and derivatives 
markets and to ensure that such markets function properly by providing 
price discovery and hedging thereby allowing producers and 
manufacturers to lock in prices and merchants and cooperatives to offer 
forward prices to producers and manufacturers, the U.S. cotton industry 
has developed a number of recommendations that are incorporated in The 
Derivatives Markets Transparency and Accountability Act of 2009. 
Congress should:

   Establish trading limits to prevent excessive speculation,

   Subject all contract and over-the-counter market 
        participants to speculative position limits,

   Subject speculative entities to the same weekly reporting 
        requirements as the trade, and

   Limit hedge exemptions and limit eligibility for hedge 
        margin levels to those actually involved in the physical 
        handling of the agricultural commodity.

    The cotton industry also believes that the lack of transparency and 
disparate reporting requirements by market participants is 
appropriately addressed by the legislation by requiring the CFTC to:

   Disaggregate index funds and publish the number of positions 
        and total value of the index funds and other passive, long-only 
        and short-only investors, and data on speculative positions 
        relative to their bona fide physical hedges, and

   Establish reporting requirements for index traders and swap 
        dealers in designated contract markets (exchanges), derivative 
        transaction execution facilities and all other trading areas.

    In addition to these necessary changes, the cotton industry feels 
strongly that the CFTC should require the IntercontinentalExchange and 
its clearing house members to adhere to the practice of margining 
futures to futures settlements and options to options settlements.
    Also, the cotton industry has an important caveat for both the 
Committee and the CFTC. We submit that no action should be taken to 
discourage over-the-counter transactions with legitimate commercial 
purposes--transactions that are transparent and have proven to be 
beneficial risk management tools utilized by producers, merchants, and 
manufacturers. It is essential that we encourage commercial innovation 
for those producing, merchandising, manufacturing, or using the 
physical commodity traded in the futures markets.
    In closing, I would like to stress that restoring confidence in the 
futures market is of the utmost importance to our industry. Thank you 
for considering our views and recommendations during the development 
and consideration of this vitally important legislation.

    The Chairman. Thank you, Mr. Taylor, for your presentation.
    Mr. Pickel, welcome to the Committee.

  STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CEO, 
              INTERNATIONAL SWAPS AND DERIVATIVES
                   ASSOCIATION, NEW YORK, NY

    Mr. Pickel. Thank you, Chairman Peterson, Ranking Member 
Lucas, and Members of the Committee. Thank you again for asking 
us to testify before this Committee, this time regarding the 
Derivatives Markets Transparency and Accountability Act of 
2009.
    It is worth noting at the outset that OTC derivatives have 
continued to perform their important risk management function 
during the current market turmoil. It is our hope that 
policymakers will keep in mind the relative health of OTC 
derivatives throughout the market downturn as you consider 
measures which might profoundly change the way these markets 
function.
    As I noted before this Committee in December, the roots of 
the current global financial crisis lie in imprudent decisions, 
particularly with respect to residential housing. OTC 
derivatives were not the cause of the current financial crisis. 
OTC derivatives have remained available, despite the recent 
market turmoil. This has enabled companies to hedge risk that 
would have had a significant adverse financial impact on them, 
but for a well-functioning OTC derivatives market.
    Parties to OTC derivatives have received the benefit of 
their bargain, and the legal certainty provided by the 
Commodity Futures Modernization Act is a big reason for this. 
OTC derivatives serve a very valuable purpose. They allow 
companies to manage risks like interest rate risk, foreign 
exchange risk, commodity price risk and credit risk. The 
financial system and the economy as a whole are stronger and 
more resilient because of OTC derivatives. OTC derivatives are 
a way for businesses to obtain protection against market events 
that they cannot control.
    Despite many claims to the contrary, it is also worth 
remembering that the overwhelming majority of OTC market 
participants use collateral to protect themselves against loss.
    The Agriculture Committee has a great deal of experience 
with the OTC derivatives market. Going back to the earliest 
days of OTC derivatives, this Committee helped create the 
framework for legal certainty which underpins the health and 
success of the U.S. OTC derivatives business. This legacy of 
leadership has helped create a thriving, vibrant risk 
management industry, which even today, amidst the global 
financial meltdown, continues to employ thousands of Americans 
and provide tax revenue to states and the Federal Government.
    However, portions of this bill would severely harm these 
markets and prevent them from functioning properly in the 
United States, while also impairing the ability of American 
companies to hedge their risk. More importantly, the 
consequences of certain of the provision of this bill would 
harm many mainstream American corporations. Many American 
corporations use OTC derivatives to hedge their cost of 
borrowing or the operating risks of their business.
    Many of those who do business overseas need to hedge their 
foreign currency exposure. Some American corporations may also 
hedge their commodity or credit exposure. The current wording 
of the bill would have a disastrous effect to the large 
majority of these corporations by taking away risk management 
tools that American corporations use in the day-to-day 
management of their business.
    Regarding some specific provisions of the legislation, let 
me make the following comments:
    Section 6 would effectively eliminate the hedge exemptions 
for entities which use the futures market to gain exposure to 
certain asset classes, or which facilitate risk management by 
other entities which cannot or choose not to use the futures 
markets. The effect of this provision would be to severely 
limit the use of the hedge exemption and thus access to the 
futures markets. This would likely result in more costly 
hedging, increased volatility, reduced liquidity and a 
deterioration in the price discovery function of futures 
markets.
    Section 11 of the bill authorizes the CFTC to impose 
position limits on OTC transactions if the agency determines 
that transactions have a potential to disrupt a contract traded 
on a futures markets or the underlying cash market. There is a 
lack of credible evidence or academic studies to support the 
proposition that derivatives markets cause imbalance in cash 
markets.
    In addition, this provision allows the CFTC to order 
otherwise regulated institutions such as banks and broker 
dealers to terminate their privately negotiated contracts. This 
provision effectively gives the CFTC the authority to cancel 
OTC derivative contracts.
    We have also concerns about the mandatory clearing 
provisions of section 13. Clearing can provide benefits and in 
appropriate cases should be encouraged. However, it is not 
clear what justification there is for a requirement that all 
OTC contracts should be cleared. To the contrary, since the 
advent of the OTC derivatives market, bilateral credit 
arrangements have been used to settle contracts smoothly and 
efficiently. There is simply no evidence suggesting anything 
other than the bilateral credit arrangements contained in 
standard ISDA documentation work extremely well.
    Finally, section 16 makes it unlawful to enter into a 
credit default swap unless the person entering into the 
transaction would experience a financial loss upon the 
occurrence of a credit event. This provision would effectively 
eliminate the credit default swap business in the United 
States.
    This provision would mean that a dealer could not hedge its 
risks. Therefore, the only participants in the CDS market would 
be counterparties which each had perfectly matched risk which 
they had sought to hedge. The number of such persons is likely 
to be extremely small.
    In conclusion, OTC derivatives markets play an important 
role in the U.S. and world economy. Despite exaggerated reports 
to the contrary, they did not cause the market meltdown and, in 
fact, have helped mitigate the effect of the downturn for many 
institutions. OTC derivatives remain an essential element in 
returning our financial system to full health, and harming 
these markets is not in keeping with that goal.
    This Committee is to be commended for addressing these 
questions and seeking answers to help set right our economy. 
But to the extent oversight of OTC derivatives markets need 
review and reform, it should be part of a larger dialogue on 
reform of the financial system in general.
    I look forward to your questions, and I thank you for 
inviting us today.
    [The prepared statement of Mr. Pickel follows:]

  Prepared Statement of Robert G. Pickel, Executive Director and CEO, 
     International Swaps and Derivatives Association, New York, NY
    Mr. Chairman and Members of the Committee:

    Thank you very much for allowing ISDA to testify at this hearing 
regarding the ``Derivatives Markets Transparency and Accountability Act 
of 2009''. We are grateful to the Committee for seeking a broad range 
of views as it considers legislation addressing the bilaterally 
negotiated or OTC derivatives industry. It is worth noting at the 
outset that these markets have continued to perform their important 
risk management function during the current market turmoil. It is our 
hope that policymakers will keep in mind the relative health of OTC 
derivatives throughout the market downturn as you consider measures 
which might profoundly change the way these markets function.
About ISDA
    ISDA, which represents participants in the privately negotiated 
derivatives industry, is the largest global financial trade 
association, by number of member firms. ISDA was chartered in 1985, and 
today has over 800 member institutions from 56 countries on six 
continents. These members include most of the world's major 
institutions that deal in privately negotiated derivatives, as well as 
many of the businesses, governmental entities and other end users that 
rely on over-the-counter derivatives to manage efficiently the 
financial market risks inherent in their core economic activities.
    Since its inception, ISDA has pioneered efforts to identify and 
reduce the sources of risk in the derivatives and risk management 
business. Among its most notable accomplishments are: developing the 
ISDA Master Agreement; publishing a wide range of related documentation 
materials and instruments covering a variety of transaction types; 
producing legal opinions on the enforceability of netting and 
collateral arrangements; securing recognition of the risk-reducing 
effects of netting in determining capital requirements; promoting sound 
risk management practices; and advancing the understanding and 
treatment of derivatives and risk management from public policy and 
regulatory capital perspectives. ISDA continues to provide clarity and 
certainty to the risk management industry through our collaborative 
initiatives with market users and policymakers worldwide.
OTC Derivatives and the Current Market Turmoil
    As I noted before this Committee in December, the roots of the 
current global financial crisis lie in imprudent lending decisions, 
particularly with respect to residential housing but also extending to 
other areas including consumer receivables, auto finance and commercial 
development. These imprudent decisions were reinforced by credit 
ratings of securities composed of these loans which proved to be 
grossly overconfident, and by faulty risk management practices of some 
of the institutions investing in those securities. These securities 
should not be confused with derivatives.
    One thing that should by now be clear is that OTC derivatives were 
not the cause of the current financial crisis. In fact, had the 
Commodity Futures Modernization Act of 2000 (CFMA) not been passed we 
would find ourselves in exactly the same financial crisis we are in 
today. Indeed the crisis might be worse, as the CFMA created legal 
certainty for OTC derivatives and thus allows market participants to 
hedge risk through privately negotiated risk management contracts. It 
is worth noting that the OTC derivatives market has continued to 
function despite the recent market turmoil. This has enabled companies 
to hedge risks that, without a well functioning OTC derivatives market, 
would have had a significant adverse financial impact on them. The 
derivatives markets have remained open and liquid and fulfilled their 
hedging purposes while other asset prices have collapsed.
    OTC derivatives serve a very valuable purpose: they allow companies 
to manage risks, like interest rate risk, foreign exchange risk, 
commodity price risk and credit risk. The financial system and the 
economy as a whole are stronger and more resilient because of OTC 
derivatives, and those that disparage their use, or confuse them with 
asset backed securities and collateralized debt obligations (or CDOs, 
an acronym that leads to some confusion with the straightforward credit 
derivative instrument CDS) which have proved illiquid and difficult to 
value in the current crisis, threaten to damage a sector of the 
financial services industry that remains healthy.
    Some point to the large outstanding notional value of OTC 
derivatives as somehow representing a source of concern. It is 
important to understand first that notional values represent an 
underlying quantity upon which payment obligations are calculated. For 
example two parties may agree to an interest rate swap with a notional 
value of $10 million. Under that contact one party will pay to the 
other a fixed rate of interest on that $10 million, while the other 
will pay a floating rate of interest on that same amount. At no point 
do the parties exchange $10 million, and at no point is $10 million 
dollars at risk. Nevertheless, when referring to notional amounts of 
OTC derivatives, that is precisely what people are doing: notional 
amount refer to hypothetical amounts of money, not money that is 
actually at risk.
    However there is an even more fundamental point to be made about 
notional amounts: to the extent they represent actual money at risk, 
they are representing risk that is being hedged. Notional figures 
indicate how much protection parties have purchased against some 
underlying, uncontrollable risk. In general policymakers have concluded 
that encouraging risk management is sound public policy, and so it 
would seem to still be the case today. OTC derivatives are a way for 
businesses to obtain protection against market events that they cannot 
control.
    It is also worth remembering that the overwhelming majority of OTC 
market participants are collateralized to protect themselves against 
loss. Standard industry practice requires counterparties to secure one 
another against the possibility that the other party will fail to make 
its required payments. The ability to access this collateral in the 
event of default is protected under Federal law, and this has proved to 
be an important way to minimize the fallout of insolvency in the 
current market.
The Draft Bill
    The Agriculture Committee has a great deal of experience with the 
OTC derivatives market. Going back to the earliest days of OTC 
derivatives this Committee helped create the framework for legal 
certainty which underpins the health and success of the U.S. OTC 
derivatives business. The Futures Trading Practices Act of 1992 gave 
the CFTC exemptive power and directed the agency to use this authority 
to exempt swap agreements. When the Commission acted in ways which 
called into question the viability of that exemption this Committee 
adopted an amendment in the 1999 Agricultural and related agencies 
appropriations act which reinforced the enforceability of OTC 
derivatives and prevented the CFTC from challenging their exemption 
under the law. In 2000, of course, this Committee led the way in 
adopting the Commodity Futures Modernization Act which most clearly 
established the legal framework for the U.S. OTC markets. And as 
recently as last year this Committee reaffirmed that framework when it 
passed the CFTC Reauthorization Act of 2008.
    This legacy of leadership has helped create a thriving, vibrant 
risk management industry which even today, amidst the wreckage of the 
global financial meltdown, continues to employ thousands of Americans 
and provide tax revenue to the states and Federal Government. However 
portions of this bill would severely harm these markets and prevent 
them from functioning properly in the United States while also 
impairing the ability of American companies to hedge their risks.
    More importantly the consequences of certain of the provisions of 
this bill would harm many mainstream American corporations. Many 
American corporations use OTC Derivatives to hedge their cost of 
borrowing or the operating risks of their business. Many of those who 
do business overseas need to hedge their foreign currency exchange rate 
exposure. Some American corporations may also hedge their commodity or 
credit exposure. The current wording of the bill would have a 
disastrous effect for the large majority of these corporations by 
taking away basic risk management tools that American corporations use 
in the day to day management of their of business.
     Below are a few selected provisions of the legislation which bear 
particular mention:
Section 6: Trading Limits
    This section requires the CFTC to establish position limits for all 
commodity futures contracts traded on an exchange or exempt commercial 
market which offers significant price discovery contracts. These 
position limits would be required to be established for all 
commodities, including financial commodities. As an initial matter we 
question whether it is necessary to establish position limits for 
financial commodities given that the markets are broad, liquid and have 
an effectively limitless supply.
    The section would effectively eliminate the hedge exemption for 
entities which use the futures market to gain exposure to certain asset 
classes, or which facilitate risk management by other entities which 
cannot or choose not to use the futures markets. The effect of this 
provision would be to severely limit the use of the hedge exemption and 
thus access to the futures markets. This would likely result in more 
costly hedging, increased volatility, reduced liquidity and a 
deterioration in the price discovery function of futures markets. It is 
also of note that this provision is based on the unproved, and if 
several credible studies are to be believed disproved, theory that 
speculation creates higher prices.
Section 11: Over-the-Counter Authority
    This provision authorizes the CFTC to impose position limits on OTC 
transactions if the agency determines that the transactions have the 
potential to disrupt a contract traded on a futures market, or the 
underlying cash market. As stated above, there is a lack of credible 
evidence or academic studies to support the proposition that 
derivatives markets cause imbalances in cash markets. Supply and demand 
inexorably determine prices. In addition, this provision allows the 
CFTC to order otherwise regulated institutions such as banks and 
broker/dealers to terminate their privately negotiated contracts. This 
seems to represent an unwarranted intrusion into the jurisdiction of 
other Federal regulators. Lastly, as OTC derivatives contracts are 
privately negotiated agreements between two counterparties this 
provision effectively gives the CFTC the authority to cancel private 
contracts. This fundamentally undermines legal certainty, would make it 
difficult for parties to calculate how much capital to hold against 
such contracts and would likely cause a significant decrease in OTC 
activity.
Section 13: Clearing
    This section requires that all currently exempted and excluded OTC 
transactions must be cleared through a CFTC regulated clearing entity, 
or an otherwise regulated clearinghouse which meets the requirements of 
a CFTC regulated derivatives clearing organization. The provision gives 
the CFTC the authority to provide exemptions from this requirement 
provided that the transaction is highly customized, infrequently 
traded, does not serve a significant price discovery function and is 
entered into by financially sound counterparties.
    Clearing can provide benefits and in appropriate cases should be 
encouraged. However it is not clear what justification there is for a 
requirement that all OTC derivatives should be cleared. To the 
contrary, since the advent of the OTC market bilateral credit 
arrangements have been used to settle contracts smoothly and 
efficiently. These arrangements have been supported by Federal law and 
policy, which promotes netting and close-out of bilateral agreements in 
the event of the bankruptcy of a counterparty. These arrangements have 
been tested both in the market and in the courts and have been 
successfully used to settle thousands of OTC trades. During the current 
market turmoil we have witnessed the failure or default of a major OTC 
dealer (Lehman Bros.), two of the largest issuers of debt in the world 
(Fannie and Freddie), and a sovereign country (Ecuador). Indeed, on an 
almost weekly basis there are failures which call into action the 
carefully crafted settlement provisions of ISDA documentation. In every 
case the contracts have settled according to their terms and according 
to market expectations, with net settlements changing hands being much 
smaller than media pundits had anticipated (in Lehman's case, 
approximately $5bn changed hands in respect of CDS contracts). There is 
simply no evidence suggesting anything other than that the bilateral 
credit arrangements contained in standard ISDA documentation work 
extremely well. While clearing should be encouraged, and market 
participants continue to work with Federal and international regulators 
to create a viable clearing solution for OTC derivatives, mandating 
clearing of all OTC derivatives is unwarranted.
Section 16: Credit Default Swaps
    This provision makes it unlawful to enter into a CDS unless the 
person entering into the transaction would experience a financial loss 
upon the occurrence of a credit event. This provision would effectively 
eliminate the CDS business in the United States.
    As written the provision would make it impossible for sellers of 
protection to hedge their own risks. Most dealer firms, which by and 
large are federally regulated banks, run a hedged portfolio which seeks 
to minimize their losses in the case of a loss on a particular 
contract. Thus for CDS, a dealer firm will seek to ensure that if it 
has to pay out protection under a CDS contract it will within its own 
portfolio have a hedged position to minimize its loss. This provision 
would mean that a dealer could not hedge its risks. Therefore the only 
participants in the CDS market would be counterparties which each had 
perfectly matched risks which they sought to hedge. The number of such 
persons is likely to be extremely small.
    This provision would also have the effect of turning all CDS into 
insurance contracts as it requires parties to a CDS to show a loss. As 
such under most state insurance statutes a party to a CDS would be 
required to be regulated by state insurance law, thus bringing 
federally regulated institutions under the authority of local state 
authorities.
    As noted above this provision would effectively end the CDS 
business in the U.S. As noted in this testimony and elsewhere the 
credit derivatives market has continued to function throughout the 
downturn, providing a way for market participants to hedge credit risk 
and express a view on market conditions. Limiting access to credit 
derivatives would create disincentives to lending at a time when 
Federal authorities are seeking to promote lending in order to restart 
the economy. It is difficult to see what public purpose would be served 
by destroying these currently healthy and important markets.
Conclusion
    OTC derivatives markets play an important role in the U.S. and 
world economy. Despite hyperbolic reports to the contrary they did not 
cause the market meltdown, and in fact have helped mitigate the effect 
of the downturn for many institutions. To the extent some participants 
in the markets have suffered losses related to derivatives, or failed 
to adequately secure themselves or their counterparties against the 
possibility of losses, this reinforces the need for sound risk 
management practices and a careful review of the actions of regulators 
charged with overseeing these institutions. OTC derivatives remain an 
essential element in returning our financial system to full health, and 
harming these markets is not in keeping with that goal.
    This Committee is to be commended for addressing these questions 
and seeking answers to help right our economy. But to the extent 
oversight of OTC derivatives markets needs review and reform it should 
be part of a larger dialogue on reform of the financial system in 
general. Acting hastily is likely to have unintended consequences and 
prove counterproductive.

    The Chairman. Thank you, Mr. Pickel.
    And, last, Mr. Morelle, welcome.

            STATEMENT OF THE HON. JOSEPH D. MORELLE,
ASSEMBLYMAN AND CHAIRMAN, STANDING COMMITTEE ON INSURANCE, NEW 
  YORK ASSEMBLY; CHAIRMAN, FINANCIAL SERVICES AND INVESTMENT 
                      PRODUCTS COMMITTEE,
     NATIONAL CONFERENCE OF INSURANCE LEGISLATORS, TROY, NY

    Mr. Morelle. Good morning, Chairman Peterson, Ranking 
Member Lucas, my good friend who hails from Monroe County, 
Congressman Massa, and Members of the Committee. Thank you for 
allowing me to testify on a matter key to the stability and 
well-being of our Nation's financial system.
     I am New York State Assemblyman Joseph Morelle, testifying 
on behalf of the National Conference of Insurance Legislators, 
or NCOIL. I chair the New York State Assembly Committee on 
Insurance, and serve as Chairman of NCOIL's Financial Services 
Committee.
    NCOIL is a multi-state organization comprised of 
legislators whose main area of public policy concerns 
insurance.
    I am pleased to be here today on behalf of NCOIL to discuss 
the provision of the draft legislation that relates to credit 
default swaps, and the question of whether and how to regulate 
this vast and yet somewhat obscure marketplace.
    On a point of interest, this is the third hearing in which 
I have participated regarding CDSs. I chaired the first two, 
one in my capacity as Chairman of the Assembly's Insurance 
Committee and the other as Chairman of NCOIL's Financial 
Services Committee.
    I congratulate the Committee for its commitment to gain and 
provide a greater understanding of the importance of credit 
default swaps. Frankly, this discussion is not only appropriate 
but overdue. It is a discussion with broad implications that go 
to the fundamental notions of how to effectively regulate and 
strengthen the free market system.
    In recognition of this, NCOIL has, like the Committee, 
turned its attention to the critical questions surrounding 
CDSs: namely, what manner of financial instrument are they; 
and, once defined, how shall they be subject to the safeguards 
that are a fact of life for the buyers and sellers of other 
similar financial instruments?
    On behalf of NCOIL, I would like to spend the time that I 
have been allotted to address these questions and make the 
following points:
    CDSs are, in fact, a species of insurance, and naked swaps 
are more akin to gaming than insurance since they lack 
insurable interest. The states are best suited to regulate this 
type of financial guaranty.
    Relative to the question of whether CDSs are a species of 
insurance, I point to New York insurance law, section 1101. 
Insurance contract means any agreement or other transaction 
whereby one party is obligated to confer benefit or pecuniary 
value upon another party dependent upon the happening of a 
fortuitous event in which the insured or beneficiary has or is 
expected to have at the time of such happening a material 
interest which will be adversely affected by the happening of 
such event.
    Or, as defined in a letter dated February 23rd, 2006, by 
the GAO, insurance is a contract whereby one undertakes to 
indemnify another or pay a specified amount upon determinable 
contingencies.
    What is a credit default swap? Simply put, it is a 
financial guaranty against a negative credit event. A negative 
credit event triggering a CDS payment clearly meets the 
definition of a fortuitous event, one occurring by chance.
    In recognition of these facts, the NCOIL Financial Services 
Committee approved a 2009 committee charge to explore the role 
of CDSs. And, as I mentioned, NCOIL held a public hearing on 
January 24th regarding proper marketplace regulation and the 
role of states in that regulation. NCOIL was represented by 
legislators from Connecticut, Kentucky, Mexico, North Dakota, 
and New York.
    While NCOIL took no formal action at the hearing, members 
generally agreed on a few broad principles: Credit default 
swaps are a form of insurance; naked swaps lack insurable 
interest and more closely resemble directional bets than 
insurance; state legislators and regulators should be 
responsible for regulating this market; and the CFMA played an 
unexpected and negative role in the proper and necessary 
regulation of swaps.
    The Financial Services Committee will chart a formal policy 
course for the organization later this month.
    The third point, in reference to state primacy in insurance 
regulation, is rooted in decades of established law. From the 
McCarran-Ferguson Act of 1945 established state preeminence in 
the area of insurance legislation and regulation. If we 
conclude that CDSs are a species of insurance, than regulatory 
authority must accrue to the states.
    It is our position that state regulators, with their 
extensive experience at regulating insurance products, are 
uniquely qualified to regulate covered CDSs as insurance. They 
are best able to ensure that the standards set for the 
insurance industry, such as insurable interest, reserving 
requirements, and insolvency tests are met by CDS providers.
    Respectfully, it is our position that Congress erred by 
preempting the states from regulating CDSs when it passed the 
CFMA.
    I would note parenthetically that state regulation of 
insurance is not to blame for the difficulties at AIG. State 
subsidiaries of AIG remain solvent and robust. The problem with 
CDS is deregulation by CFMA. That Act permitted so-called naked 
swaps, contracts that are speculative in nature and are merely 
directional bets on market outcomes, to proliferate to the 
point where it is estimated they now constitute 80 percent of 
the market.
    Let me state clearly that, as a matter of philosophy, that 
we believe that the Committee is on the right track in banning 
naked swaps. We believe naked CDSs pose a threat to global 
financial stability.
    Section 16 of the draft bill makes it a violation of the 
Commodity Exchange Act to enter into a naked CDS. The language 
establishes that a party could not enter into such contract 
unless it had direct exposure to financial loss should the 
referenced credit event occurred. Furthermore, it defines the 
term of a contract which ensures a party to the contract 
against the risk that an entity may experience a loss of value 
as a result of an event specified in the contract, such as a 
default or downgrade.
    We agree that they are insurance, and with the direction 
and spirit of the legislation now before you, even as we again, 
respectfully, aver that the implementation of a CDS regulator 
mechanism should be at the state level.
    Speaking for myself, however, I would respectfully suggest 
a broadening of the definition of covered swaps to include 
those that provide a legitimate hedge against negative credit 
events. In the domain of naked swaps, there is a critical need 
to delineate between those that are purely speculative and 
those in which some direct or indirect exposure ties the buyer 
to the insured asset. For example, an owner or investor of Ford 
dealerships may want to hedge their exposure to a negative 
credit event by purchasing a CDS on Ford.
    The point of demarcation is not so much one of clothed 
versus naked, but rather hedge versus speculative.
    Although CDSs used for hedging activity may not contain as 
direct an exposure as owning an underlying bond, they may 
contain an indirect exposure or insurable interest. Such 
activity can be identified through GAAP accounting, which 
requires derivative transactions be disclosed as either hedging 
or speculative.
    Thus, any prohibition on speculative CDS contracts, in my 
view, must make this distinction between the clear differences 
that exist in the inherent interest and nature of contracts 
that are purely speculative, and those in which there is a 
demonstrable exposure, direct or indirect, related to the 
contract buyer.
    In closing, NCOIL urges that the Committee and Congress 
consider the question of whether the goals of this draft bill 
would be best realized and enacted by the states; whether the 
CFMA was overbroad in its intent and application; and whether 
the powers removed from state government in relation to the Act 
might be restored as an avenue to establish what President 
Obama in his inaugural address called the watchful eye of 
oversight necessary to ensure that freedom in the financial 
markets does not degenerate into simple and destructive 
anarchy.
    It has been my pleasure, privilege and distinct honor to 
appear before you today on behalf of NCOIL. I look forward to 
working with you and the Committee as it moves forward in its 
review of CDS regulation. Thank you.
    [The prepared statement of Mr. Morelle follows:]

Prepared Statement of Hon. Joseph D. Morelle, Assemblyman and Chairman, 
     Standing Committee on Insurance, New York Assembly; Chairman,
     Financial Services and Investment Products Committee, National
             Conference of Insurance Legislators, Troy, NY
Introduction
    Good afternoon Chairman Peterson, Ranking Member Lucas, and Members 
of the Committee. Thank you for inviting me to testify before the 
Committee on a matter key to the stability and well-being not only of 
our nation's financial system, but, as we have learned, the U.S. 
economy as a whole.
    I am New York State Assemblyman Joseph D. Morelle, testifying this 
morning on behalf of the National Conference of Insurance Legislators 
(NCOIL). I chair the New York State Assembly's Standing Committee on 
Insurance and serve as Chairman of NCOIL's Financial Services & 
Investment Products Committee.
    NCOIL is a multi-state organization comprising legislators whose 
main area of public policy concern is insurance. NCOIL legislators 
chair or serve on committees responsible for insurance legislation in 
their respective state houses.
    I am pleased to be here today on behalf of NCOIL to discuss draft 
legislation titled the ``Derivatives Markets Transparency and 
Accountability Act of 2009,'' and the greater question of whether and 
how to regulate this vast and yet somewhat obscure marketplace. On a 
point of interest, this is the third hearing in which I have 
participated regarding credit default swaps; I chaired the first two, 
one in my capacity as Chairman of the Assembly's Insurance Committee 
and the other as Chairman of NCOIL's Financial Services and Investment 
Products Committee.
Credit Default Swaps as Insurance
    I greatly appreciate the opportunity to offer testimony in this 
instance, and heartily congratulate the Committee for its commitment to 
gain and provide a greater understanding of the importance of credit 
default swaps. Frankly, this discussion is not only appropriate but, 
perhaps, sadly overdue.
    It is a discussion with implications beyond even the very broad 
horizons of its specific subject matter, for it relates to our 
fundamental notions of the free market system, a system that has 
produced wealth more prodigiously than any other but which, absent 
oversight, can result in the rapid destruction of institutional and 
personal assets and reverse the hard-won achievements of a generation 
of Americans.
    In recognition of this, and particularly in the wake of the near 
collapse of American International Group, Inc. last September, NCOIL 
has turned its attention more closely than ever to the critical 
questions surrounding credit default swaps: namely, what manner of 
financial instrument are they and, once defined, how shall they be 
subject to the safeguards that are a fact of life for the buyers and 
sellers of other similar financial instruments?
    Why NCOIL? Primarily because of a rising conviction on the part of 
many observers that credit default swaps constitute a species of 
insurance, and should be regulated as such. Certainly, I have come to 
strongly believe that they do indeed meet the standing definition of 
insurance, and therefore, are best left to the regulatory purview of 
the states, whether acting collectively or individually.
    On behalf of NCOIL, I would like to spend the few minutes that I 
have been allotted to make the following points: (1) credit default 
swaps are a species of insurance; (2) naked swaps are more akin to 
gaming than insurance since they lack ``insurable interest''; and (3) 
that the states are best suited to regulate this type of financial 
guaranty.
    Under New York State Insurance Law,  1101: ``Insurance contract'' 
means any agreement or other transaction whereby one party, the 
``insurer,'' is obligated to confer benefit of pecuniary value upon 
another party, the ``insured'' or ``beneficiary,'' dependent upon the 
happening of a fortuitous event in which the insured or beneficiary 
has, or is expected to have at the time of such happening, a material 
interest which will be adversely affected by the happening of such 
event.
    What is a credit default swap? Simply put, a credit default swap is 
a financial guaranty against a negative credit event. A negative credit 
event triggering a credit default swap payment certainly meets the 
definition of a ``fortuitous'' event, one occurring by chance, under 
New York statute.
The NCOIL Process
    In recognition of these facts, the NCOIL Financial Services and 
Investment Products Committee last November approved a 2009 Committee 
charge to ``explore the role of credit default swaps and other 
financial instruments, develop a position, and communicate to 
legislative colleagues regarding their public policy implications.''
    And as I alluded to earlier in these remarks, the NCOIL Steering--
Officers, Chairs, and Past Presidents--and Financial Services 
Committees convened a public hearing in New York City on January 24th 
to receive testimony from interested parties regarding proper 
marketplace regulation and the role of state lawmakers and NCOIL in 
that regulation. NCOIL was represented by legislators from Connecticut, 
Kentucky, New Mexico, North Dakota, and New York.
    New York State Insurance Superintendent Eric Dinallo, and 
representatives of the International Swaps and Derivatives Association 
(ISDA), Assured Guaranty and the Association of Financial Guaranty 
Insurers (AFGI), AARP, the National Association of Mutual Insurance 
Companies (NAMIC), and the American Academy of Actuaries, among others, 
testified at the hearing. For your reference, electronic testimony is 
available on the NCOIL web site at www.ncoil.org.
    While NCOIL took no formal action at the hearing--the Financial 
Services Committee will chart a policy course for the organization 
during the NCOIL Spring Meeting, which will be held here later this 
month--members generally agreed on a few broad principles, including 
that:

   credit default swaps have many of the characteristics of 
        insurance transactions.

   so-called ``covered'' swaps closely resemble financial 
        guaranty insurance.

   ``naked'' swaps are very troubling because they lack 
        insurable interest and more closely resemble directional bets 
        than insurance.

   state legislators and regulators should be responsible for 
        regulating the credit default swap market.

   by preventing states from enforcing long-standing regulatory 
        statutes, the Commodity Futures Modernization Act played an 
        unexpected and negative role in the proper and necessary 
        regulation of swaps.
States as Insurance Regulators
    This final point, in reference to state primacy in insurance 
regulation, is rooted in decades of established law. As the 
distinguished Members of the Committee know, the McCarran-Ferguson Act 
of 1945 established the state preeminence in the area of insurance 
regulation. If we conclude that credit default swaps are a species of 
insurance, and I would strongly argue that they are, then authority in 
relation to CDS must accrue to state legislatures and state insurance 
regulators.
    It is NCOIL's position that state regulators, with their extensive 
experience at regulating insurance products, are extremely qualified to 
regulate covered CDS as insurance products. They are best able to 
ensure that the standards set for the insurance industry at large--such 
as identification of insurable interests, institutional solvency and 
the other elements essential to indemnification--are met by CDS 
providers as well.
    Thus, respectfully, it is also NCOIL's position that Congress erred 
when it preempted the states from regulating CDS under our gaming and 
bucket shop laws when it passed the Commodities Futures Modernization 
Act of 2000 (CFMA). The CFMA permitted so-called ``naked swaps''--those 
CDS contracts that are speculative in nature and are merely directional 
bets on market outcomes--to proliferate to the point where they now 
constitute 80 percent of the CDS market, which has a notional value of 
around $54 trillion, with no regulatory framework.
    Let me state clearly that as a matter of philosophy, the members of 
NCOIL believe that this Committee is on the right track in banning 
``naked'' swaps. We believe that naked CDS pose a dangerous threat to 
global financial stability.
Defining Naked Swaps
    Section 16 of the draft bill makes it a violation of the Commodity 
Exchange Act to enter into a ``naked'' credit default swap. The 
language establishes that a party could not enter into such a contract 
unless it has a direct exposure to financial loss should the referenced 
credit event occur. Furthermore, it defines the term ``credit default 
swap'' as a contract which insures a party to the contract against the 
risk that an entity may experience a loss of value as a result of an 
event specified in the contract, such as a default or credit downgrade.
    Again, NCOIL agrees that credit default swaps are insurance, and 
with the direction and spirit of the legislation now before you, even 
as we again, respectfully, aver that the actual implementation of CDS 
regulatory mechanism should be at the state rather than Federal level.
    Speaking for myself, however, I would respectfully suggest a 
broadening of the definition of clothed or covered swaps to include 
those that provide a legitimate hedge against negative credit events. 
In the domain of naked swaps, there is a critical need to delineate 
between those that are purely speculative and those in which some 
``stream of commerce'' ties the buyer to the insured asset. In other 
words, if a CDS were used for hedging rather than speculative purposes, 
we should consider that the economic utility of such transactions as 
more than mere speculative activity. For example, an owner or investor 
of Ford dealerships may want to hedge their exposure to a negative 
credit event by purchasing a credit default swap on Ford.
    The point of demarcation, then, is not so much one of ``clothed'' 
versus ``naked'' swaps, but rather ``speculative'' versus ``hedged.''
    Although CDS used for hedging activity may not contain as direct an 
exposure as owning an underlying bond covered by a CDS, an insurable 
interest exists which can be identified through GAAP accounting--which 
requires that CDS be listed as used for hedging or speculative 
purposes.
    Thus, any prohibition of speculative CDS contracts, in my view, 
must make this distinction between the clear differences that exist in 
the inherent intent and nature of contracts that are purely speculative 
and those in which there is an arguable ``stream of commerce'' related 
to the contract buyer and, therefore, whether legitimate and beneficial 
economic stimulus is derived by permitting such contracts to occur.
Conclusion
    In closing, NCOIL urges that the Committee and Congress consider 
the question of whether the goals of the transparency and 
accountability draft would be best realized and enacted by the states; 
whether the CFMA of 2000 was overbroad in its intent and application; 
and whether the powers removed from state government in relation to 
that Act might be restored as an avenue to establish what President 
Obama in his inaugural address called the ``watchful eye'' of 
oversight, necessary to ensure that freedom in the financial markets 
does not degenerate into simple and destructive anarchy.
    It has been my pleasure, privilege and distinct honor to appear 
before you today on behalf of NCOIL and all those whose interests are 
impacted by this Committee's deliberations. We look forward to working 
with the Committee as it proceeds in its review of credit default swap 
regulation.
    I certainly stand ready at this time to answer any questions you 
may have. Thank you.

    The Chairman. Thank you, Mr. Morelle. We appreciate your 
being with us.
    I visited with Mr. Dinallo last week. He was here at the 
Committee, and because of the direction we were moving he 
decided to stand down, I guess, for the time being on the 
question of what they are going to do.
    New York has a good knowledge of this and being a lot of it 
is based there, I think your folks are pretty knowledgeable. 
What about the other states? I am not sure some of these other 
states even know what this stuff is.
    So I guess you haven't gotten that far, but how would you 
guys regulate this? If the states did this, you would put 
capital requirements on the people that are involved in this? 
Or would you do it on individual transactions or contracts? How 
exactly would it work?
    Mr. Morelle. Well, thank you for the question, Mr. 
Chairman.
    First of all, I am appearing on behalf of National 
Conference of Insurance Legislators. I think we agree that a 
group of states together in either compact or with model 
legislation would come up with a national standard that could 
be used. And, obviously, as you point out, New York has a 
special position relative to this kind of regulation. In many 
ways, this mirrors the work that we do with bond insurers, 
where we require reserving, as we would do with any underwriter 
of risk, as well as insuring those insurable interests.
    The speculative activity simply put, in our view, is 
gaming, and that is what I believe the Superintendent has said 
at various times. We are working together, but we would work 
with the various states, and we would have reserving 
requirements, as we do for what we call monoline insurers, 
those insurers who write bond insurance.
    The Chairman. I guess you guys haven't gotten to the bottom 
line on this, and you are going to have a meeting and come with 
more specific recommendations. I get the sense then that where 
you guys are coming from is you think these naked swaps, CDSs, 
are gambling and basically you would ban them?
    Mr. Morelle. Yes. With the only caveat to that as I 
mentioned in the testimony. We require, under New York State 
law, life insurers to file with us a derivative use plan. And 
under state law they are allowed only to use derivatives or 
credit default swaps as a hedge, as opposed to speculative 
activity. And from my perspective, speaking for myself, to 
narrowly construe naked swaps as only those that have a direct 
exposure or insurable interest is probably too narrow, and 
instead to look at a broader definition which would include 
indirect exposures as well.
    I mentioned the example of a Ford dealership and Ford 
credit default swap as a way to hedge legitimate exposure. I 
think we would take the view, however, that anything in which 
there was not some connection in commerce to exposure would be 
gaming.
    The Chairman. So like the airlines using whatever it is, 
heating oil, as something that is close to jet fuel because jet 
fuel really doesn't have a market, or that kind of thing, is 
what you are talking about?
    Mr. Morelle. That would be correct.
    The Chairman. What do you say to the folks that are saying 
the world is going to come to an end and that these CDSs have 
been a big help in all of this, and what we are doing here is 
going to make matters worse because these things have been 
wonderful and provided liquidity? What do you say to that?
    Mr. Morelle. Again, respectfully, sir, I would argue a 
couple of things.
    First of all, they are referred to often as bilateral 
contracts, but I would argue that they are trilateral contracts 
in that you and I and the 300 million Americans have stepped up 
to the plate to provide the backstop on many of these 
contracts. So I don't necessarily agree with that.
    I would also argue that risk needs to be dealt with in a 
reasonable way. I also think sacrificing legitimate risk 
management at the altar of liquidity has led us down a 
dangerous path. I certainly don't dispute the fact that credit 
default swaps play an important role in our financial 
institutions, but they are insurance, they are a financial 
guaranty and ought to be treated as such. And those who have no 
insurable interest, frankly, I would continue to argue, are 
purely speculative, and add nothing of value to the real 
economy.
    The Chairman. But you guys wouldn't actually set up a 
system where every contract was kind of looked at individually 
and the margins set on them and so forth. You would have a more 
broad type of regulation and requirements, right?
    Mr. Morelle. Well, presumably, we would have the 
underwriters of those bonds. The sellers of protection would be 
treated in a manner similar to the way that we treat monoline 
insurers, those who write bond insurance and are required to 
reserve on the contracts that they write.
    The Chairman. How would we be assured that there wouldn't 
be risk here that was more than there was capital to cover? I 
am very skeptical about what the SEC is doing in the way that 
they regulate. They try to do things at the front end, and it 
is hard to get whatever authority you need out of them. They 
run you through a whole bunch of bureaucracy, but then they 
don't have anybody to check things, as you have seen with 
Madoff and so forth.
    So if we move in that direction, how could we be sure that 
the states would ferret out this risk and we wouldn't be 
entering into a bunch of risky contracts that are going to end 
up at the doorstep of the taxpayers again?
    Mr. Morelle. I would point out that, as it relates to state 
regulation of insurance companies, that we have reserving 
requirements and insolvency tests. The question about 
collateral calls, which is often talked about, a posting of 
collateral; typically, the collateral posted is not nearly the 
amount of collateral necessary to be able to pay claims. So 
reserving does do it. It requires an analysis of losses, 
projected losses based on histories, and we have not had those 
insurers who have defaulted in regulated states. We have not 
had defaults. In fact, they remain robust and strong.
    I point out AIG, for instance, the subsidiary companies are 
robust; and we do that through reserving and making certain 
that when people take on risk or underwrite risk they have 
adequate resources to be able to cover the claims.
    The Chairman. I have taken more time than I should, but if 
the Committee will bear with me. I know you guys are good at 
doing that, but one of the things that everybody brings up is 
this. These things are hard to price and figure out what the 
risk is and so forth. You guys believe you have the expertise 
to be able to do that?
    Mr. Morelle. I believe we do, and the superintendents of 
the various states together with NAIC, which is their 
organization, in conjunction with NCOIL would certainly be able 
to put standards in place that would meet that requirement.
    The Chairman. My guess would be that what you will require 
will probably shut down this market more than what we are 
talking about. Because you are going to be requiring some 
significant reserves to cover this risk, I would guess.
    If the Committee will indulge me, is there a way to have an 
arrangement where you would be involved in setting the 
regulation for systemic risk, or whatever you want to call it, 
and that we would have some kind of a system within the CFTC 
that would have some kind of margining requirement on the 
instruments so there would be some combination of the two? Is 
that a possibility?
    Mr. Morelle. I think it is, Mr. Chairman, and we would 
certainly love to work with you and the Committee and Congress 
on that. We do think there is an appropriate and important role 
to play for the states. And I would again suggest that one of 
the hallmarks of insurance regulation is that when people make 
commitments on future events that there is the ability to meet 
those commitments. That clearly has not happened in many cases 
that we have talked about, AIG being the most prominent. But, 
as well, in many of the other investment banks and some of the 
banks that are under distress right now.
    I certainly think there is a role to play and a combination 
of the responsibilities and the strengths of the various levels 
of government to provide that security. But, I am not persuaded 
in the conversations that I have had and the testimony we have 
taken that prudent risk management should be sacrificed in the 
effort to have more and more liquidity. That is part of the 
problem that we have gotten ourselves into.
    The Chairman. I agree with you.
    I thank the Committee for the indulgence, for giving me a 
little extra time.
    The gentleman from Oklahoma, Mr. Lucas.
    Mr. Lucas. Thank you, Mr. Chairman.
    Mr. Pickel, would you care to comment on Mr. Taylor's 
testimony that this bill will not discourage speculators from 
participating in commodity markets?
    Mr. Pickel. We focus on the trading limits and the hedge 
exemption provisions. Keep in mind that we represent the 
bilateral, privately negotiated derivatives business. In that 
role, parties, whether we are talking about interest rates or 
other types of commodities, would typically be entering into 
bilateral contracts that are tailored to the particular needs 
of the counterparties.
    The dealer in that situation hedges its risk in various 
ways. If it can find an offsetting position with another 
bilateral trade it will do that, but often it looks to manage 
that risk via the futures markets. That is the root of the 
hedging exemption that is provided for, is to recognize that 
ability for the dealer to hedge its position that it takes on 
the bilateral trade it may wish to access the futures market 
and, therefore, that is the appropriate role for that 
exemption.
    Mr. Lucas. Mr. Taylor, along those lines, in Mr. Pickel's 
testimony he notes that supply and demand ultimately determine 
prices and that speculation does not increase prices. Would you 
care to offer some observations on that point?
    Mr. Taylor. Well, probably the best testimony I can offer 
on that is that there is an ongoing CFTC investigation of what 
happened in our market on March 3rd and 4th of 2008. And for 
those who don't know, we had a 1 day event on March 3rd where 
the market traded from the mid-70 cents to well over a dollar 
synthetically with no fundamental reason for that happening. So 
we will know soon, hopefully, when the CFTC does respond or 
issue their report, what did cause that. But, that to me, at 
least on the face of the evidence of what happened that 1 day, 
would suggest that perhaps there were some other forces and 
factors that were entering our market that caused the 
distortion to occur.
    Mr. Lucas. Would anyone else on the panel care to touch on 
any of these points?
    Mr. Short and then Mr. Masters after that.
    Mr. Short. Thank you.
    I would just like to comment. The market that Mr. Taylor 
was referring to is ICE Futures U.S.'s cotton market. Based 
upon the exchange's examination of facts, we have not found 
that that price spike was due to speculative interest.
    I don't want to comment on the CFTC's ultimate finding. He 
is correct. There is an ongoing review that is being 
undertaken. But, based upon the exchange's view, it was a 
convergence of a number of issues, including commercials having 
to cover their short positions that led to the price spike. 
Certainly ICE as an exchange is very concerned about Mr. 
Taylor's views, because without his commercial interest you 
really don't have a market. So we are working with the 
commercial sector to make sure that there is proper convergence 
and proper margining of positions on the exchange.
    Mr. Lucas. Mr. Masters.
    Mr. Masters. I would just like to put out the idea that 
more and more people now, especially the American public in 
general, have come to the conclusion that there was no doubt 
that there was a significant amount of speculation in crude oil 
markets, and indeed, most of the commodity markets over the 
last 9 months.
    You will notice in my testimony we put out a report on that 
in which we calculate that the excessive speculative activity 
over the last 6 months cost the average American $850 per 
capita, per household, in excess of $110 billion over that 
period of time. And it is interesting to me that dealers from 
Wall Street and other folks can come up and say, well, money 
moves markets in everything but commodities. Of course money 
moves markets in commodities. We had money coming in. We had 
$70 billion come in, and we had $70 billion come out.
    Let me just read you a couple of statements that have come 
out subsequent to our initial testimony about excessive 
commodity speculation. One of them is from Paul Tudor Jones, 
who is probably considered one of the greatest commodity 
traders of all times. He said, ``There is a huge mania, and it 
is going to end badly. We have seen it play out over hundreds 
of times over the centuries, and this is no different. It is 
just the nature of a rip-roaring bull market.''
    I will give you another example, Dr. Bob Aliber from the 
University of Chicago. He is a distinguished professor. He 
said, ``You have got speculation and a lot of commodities, and 
that seems to be driving up the price. Movements are dominated 
by momentum players who predict price changes from Wednesday to 
Friday on the basis of the price change from Monday to 
Wednesday.''
    Since our testimony, organizations such as the World Bank, 
the United Nations, MIT, the Austrian Ministry of Finance, the 
Japan Ministry of Trade and other organizations and academics 
around the world have come out and said there is no doubt that 
excessive speculation was a primary cause for the movements we 
saw in commodities markets over the last year.
    So, to your question, I would say that the speculation 
absolutely had a role, and could continue to have a role in 
prices in the commodity futures markets.
    Mr. Lucas. Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman.
    The gentleman from Pennsylvania, Mr. Holden.
    Mr. Holden. Thank you, Mr. Chairman.
    For those of you who oppose the draft provision on naked 
credit default swaps, could you accept mandatory clearing of 
naked credit default swaps as an alternative to the outright 
ban? And for those of you who support the draft provisions, 
would a clearing mandate alleviate your concerns about the 
instruments?
    Mr. Pickel. Yes. I would say that, from our perspective, 
and we commented in our testimony regarding the mandatory 
clearing requirement, again, we look at and put in place the 
infrastructure that is used for OTC derivative trades, 
including credit default swap trades over the past 20 plus 
years, and that infrastructure works extremely well.
    There is a master agreement which parties enter into. It 
provides the benefits of netting, which the Congress has 
recognized repeatedly as a beneficial risk management tool. It 
also is very common and certainly recommended that people 
consider the usage of collateral to collateralize those 
positions.
    So when we look at suggestions of mandatory clearing, we 
look and point to the infrastructure that exists and does work. 
We don't see a need to, even in the credit default swaps space, 
to require clearing.
    Now a number of firms have voluntarily committed to 
regulators via the New York Fed, and there have also been 
discussions with the European Commission about committing to 
put as much of their credit default swap trades as possible 
through one of the several clearinghouses that are under 
consideration. I think that is a positive step.
    There is the ability to utilize clearing as another means, 
an additional tool in the infrastructure that we put in place 
to help manage risk most effectively. Forcing everything to go 
from here over to there ties people's hands in terms of their 
ability to manage risk effectively.
    Mr. Holden. Anyone else on the panel want to comment?
    Mr. Short. I would add to Mr. Pickel's comment that 
clearing goes a long way to address many of the issues with 
CDS; whether that clearing would be done under ICE's 
clearinghouse, or any of the other competing clearing models 
such as CME, or some of the other industry participants. I 
think the counterparty credit risk and remediation, and the 
transparency the clearing would bring would benefit the market 
significantly.
    I will note that we don't believe that all CDS can 
necessarily be cleared. There are certain CDS that, due to the 
lack of standardization in the product and lack of liquidity, 
it really wouldn't make sense to clear. This Committee actually 
hit upon a very good framework to address that type of issue 
when it passed the farm bill.
    In the case of exempt commercial markets, when different 
contracts served a significant price discovery function, a 
similar template could be applied here where one CDS had 
attained a certain level of liquidity, or there was some 
systemic risk issue. You might require clearing of CDS at this 
point and not make it mandatory for all CDS. But, certainly, 
those CDS that are liquid, and capable of being cleared, we are 
in favor of having them cleared.
    Mr. Holden. Anyone else on the panel care to comment?
    Mr. Morelle. I would just like to note that the argument 
that naked CDSs, as I would define them, that don't provide any 
hedge at all but are purely speculative, aren't a tool for risk 
management since there is no risk on the part of the buyer of 
the protection. While the clearing makes a great deal of sense 
potentially for the hedged or clothed or covered swaps, I would 
want to know more about the construct of them and how they 
work, the proposed ones. I would still argue that the naked 
swaps, to the extent that I defined them, should not be 
permitted because there is no risk management involved because 
there is no risk.
    Mr. Holden. I yield back, Mr. Chairman.
    The Chairman. The gentleman from Texas, Mr. Neugebauer.
    Mr. Neugebauer. Mr. Taylor, I know that I heard from a 
number of my producers when we had the anomalies in the cotton 
market, and everybody was scrambling as they wanted to 
certainly find a way to sell at the prices the commodity 
contracts moved to. Since then, things have seemed to have 
stabilized some. Can you kind of give me a quick snapshot? 
Currently, are the markets behaving in a more normal way and 
are producers able to cover or put in place the risk management 
that they need to do?
    Mr. Taylor. Yes, things have normalized to some degree, but 
there has been so much stress and a number of competitors of 
ours have vanished, as I mentioned in my testimony. There is 
not the richness or the number of offers that are out there for 
cotton. There are offers. It is traded. It is just not as 
robust.
    And I would say that producers are probably not receiving a 
traditional basis for the cotton that they are selling. We 
probably took out 30 to 35 percent of our merchandizing 
capacity in that 1 week. And that competition is good for 
everyone, and we have less of it.
    Mr. Neugebauer. Now you advocate for aggregate position 
limits for noncommercial traders. One of the things this body 
is struggling with is making sure that we don't push so many 
people out that we can't actually handle the appropriate amount 
of liquidity in the marketplace, so that our producers can use 
this as an effective price discovery and risk management tool.
    When I think about a bale of cotton in the 19th 
Congressional District, I think about all of the people who 
really have some commercial interest in that. All the way from 
the seed company to the fertilizer and the equipment company, 
the gins and merchants, and other people relying on the 
behavior of the cotton commodity price for their livelihood.
    So kind of two things begin to come to my mind there. When 
we start picking, who can and cannot participate in hedging a 
risk that they perceive, or putting together a business model 
where they can manage those risks? And, also, if we push too 
many people out of the marketplace, then if you have this many 
people trying to use a commodity as somewhat of a business 
hedge, that we don't have enough people to be on the other 
side.
    What is the right prescription of who you allow to play and 
who you don't allow to play?
    Mr. Taylor. Well, this is America, and I think everybody 
ought to be able to play. But everybody needs to play by the 
same rules, and positions need to be reported, people need to 
have the same opportunity.
    We do not want to not allow people to play. We just want 
people to report, people to have a consistent behavior and 
consistent requirements in limits and all operate with the same 
rules. I think that what we are proposing here is transparency, 
full disclosure, aggregating positions, so that we all know 
when an event is taking place and we are prepared for it, and 
the market can digest it. We are all fine with that. So we 
certainly don't want to discourage participation. We need 
speculators in all of our markets and don't want to do anything 
to eliminate that.
    Mr. Neugebauer. Are there places where cotton is traded 
over-the-counter or where there isn't. For example, 
transparency, anybody using anything off of an exchange for 
cotton. I am asking this question, because I don't know the 
answer.
    Mr. Taylor. We have a number of products for cotton 
producers and cotton textile mills tailored to their specific 
price risk needs. So there are a number of those things. I 
don't think it is particularly significant, but it is very 
helpful for them to manage their costs. You know, options 
markets, there are only five cotton options per year, and an 
element of the cost of those options is the time value. So we 
have products that tailor that time-value cost to that specific 
need.
    I don't think that disclosing positions, aggregating 
positions, in our market would have any negative impact on 
prohibiting people from participating.
    Mr. Neugebauer. So I want to be clear and understand you. 
So you would be, for these products that you offer in a 
specialized way, you would be for clearing those in a way where 
there would be open transparency of what the prices and the 
terms of those are?
    Mr. Taylor. To an earlier point here, some of those are so 
specialized and unique that it would be difficult to clear 
those because the terms are unique to that transaction, 
probably aren't significant. There probably isn't a ready 
market to clear those. So we would in those cases like to deal 
directly with our producers or with our textile mill customers, 
and not clear those. That would add significant costs and 
wouldn't really add any value at all to that transaction.
    Mr. Neugebauer. But would you disclose it?
    Mr. Taylor. We are for disclosure, but not necessarily 
clearing.
    Mr. Neugebauer. Because it just isn't a uniform 
transaction?
    Mr. Taylor. That is correct.
    Mr. Neugebauer. Thank you very much.
    The Chairman. I thank the gentleman.
    The gentleman from Georgia, Mr. Scott.
    Mr. Scott. Thank you, Mr. Chairman.
    I do have a couple of concerns about the legislation. I 
serve on the Foreign Affairs Committee and I am a member of the 
NATO Parliamentary Assembly, and as such I get the opportunity 
to travel abroad three to four times a year to meet regularly 
with our colleagues from other countries, especially Europe, 
the Middle East and Asia. And as such, I have become especially 
conscious of how our actions are viewed outside of these walls, 
outside of the country.
    Recently at the World Economic Forum in Dubai, a cloud hung 
over the discussions about solving the current economic crisis 
permeating almost every country in the world, and the fears 
that nations would resort to economic protectionism, as is 
typical in tough economic times as these, that seemed to 
dominate these discussions.
    It is understandable that countries would seek to preserve 
jobs for citizens and assure their own quality of life. We see 
this manifest in Buy-American provisions, increased domestic 
subsidies, our increased tariffs. However, this protectionism 
comes at a price. They more often than not invite some form of 
retaliation from our partners around the world. We need look 
only to the jurisdiction of this Agriculture Committee for 
examples. Indeed, we have been battling protectionist policies 
for years in the agriculture sector to try to open up markets 
for U.S. goods, and have had some difficulty in doing so.
    I say this because I fear that we may be inviting some of 
this same retaliation with certain provisions of this bill, 
particularly with elements of the foreign boards of trade 
language.
    So I wanted to try to open up a discussion on that by first 
of all asking you, Mr. Short, yesterday the CME Group expressed 
concerns with section 3 of the draft which deals with foreign 
boards of trade. They fear that these provisions will offend 
our foreign partners and in fact provoke retaliation.
    Now, in your testimony, assuming the draft was corrected in 
the manner which you support in your testimony, do you think 
such fears are justified? Second, if so, why haven't we heard 
directly from our foreign partners about this?
    Mr. Short. I don't really have a view on the issue of 
whether you have heard from foreign partners on this. I think 
the draft legislation is relatively new and that may be yet to 
come.
    I do think there is a fundamental problem with the relative 
size of market provision in section 3 because it applies a 
different standard to a foreign exchange accessing these 
markets than it would to a domestic exchange, and ultimately 
that is going in the wrong direction.
    As far as codifying the other elements of section 3 and the 
no-action regime that ICE Futures Europe presently operates 
under, at a high level you would probably find a receptive 
audience internationally to having information sharing and 
transparency in contracts that are linked to domestic markets.
    I am not terribly troubled by section 3, absent the 
relative size of markets provision, because as I mentioned in 
my testimony, I ultimately think that governments in the United 
States and in all major developed nations are going to have to 
work on standards that address those issues because we really 
live in global world and a global marketplace.
    Mr. Scott. You have discussed your concern about the form 
of discrimination and the size the markets. But let me just 
mention this to you. Others might counter that position limits 
set for a larger market like NYMEX, for example, might not 
necessarily be appropriate for a smaller market even on the 
same contract.
    How do you respond to is that?
    Mr. Short. I would respond to that that is not the correct 
view to take, because ultimately where someone will trade is 
dependent upon market liquidity, being able to provide tight 
markets. If you imposed a very small position limit because a 
new competitor was launching a contract and didn't have 
significant market share, you would just never develop the 
liquidity to make it worth the trading party's while to trade 
in your market. So, the key here is transparency and not have a 
doubling up, if you will, of position limits or accountability, 
but not kind of putting a hard limit on positions based upon 
the relative size of markets.
    Mr. Scott. Mr. Chairman, could I have 30 seconds to ask a 
follow-up question?
    I wanted to ask a follow-up question to Mr. Taylor who 
brought up a point about ICE and clearing. Your testimony asked 
that the CFTC should make ICE and its clearing members adhere 
to the practice of margining futures to future settlements and 
options to options settlement. What has ICE done differently 
and how has it impacted cotton trading, for example? And if it 
is a different practice, do other exchanges behave similarly or 
not?
    Mr. Taylor. There have been some changes since last March, 
but what occurred at that time was when we had that rapid rise, 
that 1 day increase in the market, we were required to margin 
our positions to what we call synthetic or option closes, and 
that created a tremendous amount of financial pressure. In 
fact, it caused, I believe, some commercial interests to have 
to close their positions because they didn't have the financial 
wherewithal to make the margin call.
    What we have proposed is that we have daily trading limits, 
we stop trading when we hit those limits, and we margin to 
those. We have currently 3 cents, 4 cents, and 5 cents limits 
depending on the number of days the market has moved, and that 
is the way we, as the cotton committee, wish to operate. That 
is very similar to the way the grains operate.
    Now, in ICE's defense, our committee actually was on board 
with the margining that took place on that day, so we have to 
look in the mirror when we place the blame there. But we are 
working with ICE to modify the rules, to stop the trading and 
to margin to those daily trading limits, and not a 20 cents to 
30 cents move, which is what we had on that day.
    Mr. Short. If I could add one point, the whole issue arises 
because there is a limit in the amount that a price can move in 
the cotton contract, and the situation that was faced by the 
exchange was we hit the limit and the OTC market and options 
markets were indicating that the real price was going well 
above that limit. From the standpoint of properly margining 
positions in the clearinghouse, we have to protect all market 
participants. We used the synthetic price indicated by the 
options price rather than where the futures price cut off. From 
our perspective we were trying to do what was right from the 
standpoint of risk management.
    Mr. Scott. Thank you. Thank you for your courtesy, Mr. 
Chairman.
    The Chairman. Thank you, Mr. Scott.
    The gentleman from Louisiana, Mr. Cassidy.
    Mr. Cassidy. No questions.
    The Chairman. No questions. I think we have to get a 
Republican. Who is next here? Unless you want to switch 
parties, Mr. Massa.
    Mr. Massa. No, no.
    The Chairman. The gentleman from Pennsylvania, Mr. 
Thompson.
    Mr. Thompson. No questions.
    The Chairman. The gentleman from Texas, Mr. Conaway.
    Mr. Conaway. Well, Mr. Chairman, the risk of replowing old 
ground that has already been plowed by a newcomer just walking 
in here is greater than the chance I might come up with 
something that hasn't already been asked, so I yield back.
    The Chairman. All right. I am going to recognize now, out 
of order, the gentleman from Iowa, who is the Chairman of the 
Subcommittee that has jurisdiction, and then we will get back 
to the regular order.
    Mr. Boswell. Thank you, Mr. Chairman, and thank all of you 
for your presentations today and comments. I am quite sure you 
are aware of what happened yesterday, so any comments you might 
make about that would be appreciated.
    For starters to Mr. Masters and Mr. Taylor, a number of 
witnesses today, and yesterday, testified in spite of the draft 
bill's purposes of promoting transparency and accountability, 
its provisions will have the unintended effects of disrupting 
market liquidity and sending trading activity either offshore 
or on to otherwise unregulated trading venues.
    Please respond to that and share your concerns or your 
comments. I will start with you, Mr. Masters.
    Mr. Masters. Thank you. I think that is an empty threat. I 
think that the idea that folks are going to go offshore for all 
of their trading has been an idea that has been promoted by the 
futures industry and other folks as a scare tactic to prevent 
regulation, necessary regulation, in our markets. In fact, if 
they really want to trade over there, I am not sure we 
shouldn't buy them a one-way ticket, because the bottom line is 
that without significant government intervention, AIG, and $110 
billion, it is very likely that our markets would have had a 
systemic meltdown. Fiduciaries today are not going to go to a 
place where they are worried about counterparty.
    There are some people worried about counterparties in the 
U.S., there are some people worried about the U.S. as a 
counterparty, but I can tell you there are a lot of people 
worried about counterparties in other places, including Dubai 
and whatnot.
    That is just not where folks want to go. They do not want 
to trade with less transparency and with less regulation. 
Trustees of large institutional investors want to trade with 
more regulation and more transparency, and the U.S. should take 
the lead on that. And I am quite sure that the FSA and other 
regulatory jurisdictions will follow along. Whatever path we 
choose, it is very likely they are going to follow us. So, that 
is just something not even in the realm of possibility right 
now.
    Mr. Boswell. Thank you very much.
    Mr. Taylor?
    Mr. Taylor. Yes. Thank you for the question, and I guess I 
probably need to answer that within the context of cotton, 
which I know better than the other commodities. But we do have 
an exchange in China that is being used principally by the 
Chinese. There are a few companies that do use it. But I would 
echo the comments made at the end of the table that this 
probably is an empty threat.
    Participants want to go where they can trust the market, 
where there is reporting, there is no ``funny business'' or a 
minimum of ``funny business'' going on. We enjoy today a 
preferred position. Our market is trusted. The regulated 
people, participants are very comfortable using the ICE 
exchange. So, we need to be mindful of that risk.
    I do think as China develops, and China is the largest 
producer of cotton, the largest consumer of cotton, the largest 
exporter of textiles, there is that opportunity. But with their 
attitude with foreigners in general, and foreign investment, 
currencies, et cetera, it will be difficult for them to 
continue.
    Mr. Boswell. Mr. Pickel?
    Mr. Pickel. Yes. Regarding the threat of business moving 
overseas, when you outlaw a particular type of contract, 
parties will have no choice but to go elsewhere to trade that. 
Certainly under the laws of the U.K., for instance, where the 
bulk, the majority of credit default swap trading occurs, it is 
very clear that the full range of transactions is available to 
parties in London to trade those. There are other venues, Hong 
Kong and London, where they would continue to actively trade 
those transactions. I think when you make things illegal, it is 
very clear business would move elsewhere.
    Regulation imposes costs. Costs would be looked at on the 
margin. On the margin, yes, some people are going to look to do 
certain transactions elsewhere. Whether the entire business 
dies or not would remain to be seen. But when you make things 
unlawful, as section 16 does, that business will move 
elsewhere.
    I think also as it relates to AIG, which is certainly the 
situation where credit default swaps are involved, there was a 
question of the risks they were taking on, the fact they didn't 
use collateral, and the fact that they did not make a proper 
assessment of risk. Those are all very serious concerns, but 
they didn't relate to the product itself.
    Mr. Boswell. I appreciate that.
    Mr. Taylor, I have been concerned for our cotton growers 
for a long time. We will talk about that someday. I have never 
planted or held a cotton seed in my life, but I still feel very 
concerned about it, and we will talk.
    Mr. Masters, I want to address this back to the Chairman. 
You and I kind of participate in PAYGO and things of that 
nature and we think it is important, which it is. But, with the 
stimulus and the new Administration and all these problems--
first off, we are a world community, and you are pointing that 
out.
    I think that we are into an area, Mr. Chairman, where we 
have to have transparency and honesty and oversight like we 
have never had before, and that this panel and those folks that 
you brought yesterday and today, you got to help us. We have to 
make this work, because if any of you fail, we all fail. We 
can't do that to this country.
    A lot of you, like me and many others up here, are putting 
it on the line for this country. And, damn it, we can't let 
this happen, not for any particular reason, but just because of 
what we do. So it is time that we have to bite the bullet, and 
that is what our President challenged us to do when he talked 
to us in his inaugural address.
    It is you, and you, and you, and you, and me, and if we are 
not willing to do that, shame on us. You can tell your children 
that I had my chance and I screwed it up. I think we have one 
chance. Maybe I am making too strong a statement here, but we 
have one chance, and we better not muck it up.
    So if you have some real strong feelings about how you can 
contribute, and I think you do, I have a lot of confidence in 
you, we have to come to the forefront and do this right.
    This Chairman is trying to put a bill forth that will help 
us, and if it needs some tweaking, let's talk about it. That is 
what we are doing. But we can't continue business as we have 
been doing it. You know it, I know it, and the whole world 
knows it.
    So that is where this guy is coming from. I am educable. I 
am a good listener. I think we have our feet to the fire. We 
are standing on the precipice, we could fall off the edge. And 
I don't want it to happen on my watch, any more than you do, 
and I know you don't.
    So, please, this is asked: Let's do it together, and if we 
have to suffer a little, let's suffer. Let's do it now, instead 
of passing it on to those coming behind us. There has been too 
much of that going on. It has got to stop, and we are the ones 
that have to do it. Ain't nobody else gonna do it. It is up to 
us.
    I would like for all of you, this country has to lead. That 
is what we are all about. So let's do it.
    Thank you, Mr. Chairman. I yield back.
    The Chairman. I thank the gentleman.
    The Committee went to Europe the first week in December, 
and I came away with the impression that this threat of going 
to foreign markets does not hold water either. One of the 
things that came up again and again over there is the 
bankruptcy laws. And they say until they change the bankruptcy 
laws in Europe, that we have a big advantage built in; plus the 
fact that, as Mr. Masters said, people want to be here. The 
Chinese are buying Treasury bills for zero percent interest 
because they think it is safer to do that than to buy 
securities someplace that has a return that they are not sure 
about.
    The gentleman from Georgia, Mr. Marshall.
    I am sorry, I apologize to the former Chairman and Ranking 
Member. My good friend Mr. Goodlatte from Virginia is 
recognized.
    Mr. Goodlatte. Mr. Chairman, thank you. If I can pass for a 
round, I would appreciate that.
    The Chairman. The gentleman from Georgia, Mr. Marshall, is 
recognized for 5 minutes.
    Mr. Marshall. Thank you, Mr. Chairman.
    Gentleman, I am going to have to ask that some of you 
answer for purposes of the record; in other words, do a little 
bit more work after this hearing responding to questions, 
because I just have too many questions for you to respond to 
verbally now. I apologize for the extra work. I would like for 
you to respond not only for the record, but if you could send 
your responses to my office as well, I appreciate it.
    Mr. Morelle, God bless you and I appreciate your interests, 
but I just can't imagine the regulatory arbitrage problems that 
we would have if we broadened this to 50 jurisdictions within 
the United States. We already have regulatory arbitrage 
problems, and it is just hard for me to fathom. Particularly 
when our principal concern is how this affects our money supply 
globally, and how this affects the large institutions that are 
too big to fail, at least we are identifying them as too big to 
fail. We are here largely because of that right now. And to 
suggest that individual states will be having a large say in 
decisions that could affect global money supplies, national 
money supplies, just seems far-fetched to me. You might want to 
comment on that if you could in writing.
    You also define ``naked'' too broadly. It seems to me that 
if one institution needs hedging and they go to A and A says 
sure, I will hedge with you, then A has this risk. A then might 
go to B and say--A, by the way, in deciding whether or not it 
can actually cover the risk, is taking into account the fact 
that it could conceivably to go to B, C and D. But it goes to 
others and tries to lay off that risk.
    So A, I would assume in a reasonable definition of what is 
``naked,'' that person wouldn't be naked. And then going to the 
next person or the next entity, yes, that entity to start out 
with has no interest, but once that entity has gone ahead and 
covered some of the risk or offset the risk somehow, then B has 
got an interest. Then you see where I am going. So it is the 
characters that are totally on the sideline that just want to 
place bets among themselves that you really have in mind as 
being naked.
    Mr. Masters, you are arguing for position limits on and 
off-exchange and I have a lot of sympathy for that, but I 
suspect that maybe a lot of what you want to accomplish can be 
accomplished by simply having CDSs cleared. I should say that 
those that aren't cleared would be only permitted if some 
regulatory body, I would think the CFTC, says grace over them, 
probably in advance. There would have to be some sort of 
general scheme, the kinds that will be permitted, the kinds 
that won't.
    Then the clearinghouses are making public not the details 
of the private transactions, but generally making public 
information to enhance public transparency. And if the CFTC 
were required to do the exact same thing with regard to these 
things that aren't being cleared but are transparent to 
regulators, it seems to me, it is going to be an absolute 
minimum. I think that might accomplish a lot of your 
objectives.
    What worries me that everybody is going to have these 
position limits, on-exchange off-exchanges, that means that 
market makers, traditional market makers that are important to 
the liquidity of the market, they could be caught up in this 
and somehow limited in offering their liquidity. And they 
haven't been part of the problem. You don't think they are part 
of the problem, I don't think they are part of the problem.
    Then there are traditional speculators, who are not, as was 
described by Mr. Gooch yesterday as ``invesculators,'' who are 
not invesculators. They aren't just using these markets as a 
means to invest in commodities or something like that, they 
have helped us with price discovery and liquidity as well, 
historically. So if you could give some thought as to whether 
or not some lesser approach than simply across-the-board 
position limits would work, that would be great.
    Mr. Pickel, I am saving the best for last. I have the 
impression that the industry, you are the industry spokesperson 
and I credit you with being very effective in your job, but you 
are just stonewalling here. It is fine to say that there is no 
credible scholarship out there that demonstrates that CDS is a 
substantial part of the problem. A lot of obvious logical 
arguments for why they would be exist. But, at this point it 
would be very helpful if the industry produced credible 
scholarship showing that they aren't part of the problem as 
opposed to simply saying there isn't anything proving it.
    I think the burden has shifted at this point, and that is 
certainly the attitude in Congress and the attitude publicly. 
So I would encourage you to step forward with some real 
credible information that this is not a problem. And I would 
ask that the industry start considering compromises instead of 
just blowing through all of this, and saying that any 
compromise just doesn't make any sense that it would lessen 
liquidity substantially and cause people to run off overseas, 
et cetera.
    One of the compromises that has been suggested is this 
clearing compromise. Obviously all things can't be cleared, so 
some process that would take that into account, maybe CFTC 
approval to noncleared under these circumstances, or 
specifically looking at noncleared. And certainly there has to 
be at a minimum record-keeping, reporting to the regulator, 
with some sort of public reporting. I mean, you all need to 
start thinking about this and proposing something that works 
for your industry and will meet some of the real concerns that 
we have and solutions we are working on. And simply to 
stonewall repeatedly, I don't think cuts it here.
    So if you want a quick--my time is up. I guess you ought to 
have time to at least respond to that, and then if you could 
respond in writing in general, that would be great.
    Mr. Boswell [presiding.] We will be going back to the next 
round shortly, so we will just come right back to it.
    Mr. Goodlatte, are you ready?
    Mr. Goodlatte. Thank you, Mr. Chairman.
    Mr. Masters, just to clarify your testimony, the CFTC, by 
allowing an excessive speculation bubble, amplified and 
deepened the housing and banking crisis. Is that your 
conclusion?
    Mr. Masters. That is. I think that the excessive 
speculation tax, if you will, the giant move upwards in energy 
and food prices that American consumers had to endure the first 
6 months of this year, certainly it aggravated an economy that 
was already weakening, and that there is no question that it 
had adverse effects. You see in my testimony there are some 
folks in there that have made statements to that effect, 
economists, folks from the American Bankers Association, folks 
from the big city, the National Urban League said the same 
thing.
    Mr. Goodlatte. Let me ask, from your testimony it appears 
that you are a strong advocate of mandatory clearing through an 
exchange. Do you agree with the testimony that we received 
yesterday that that will only strengthen the large market 
players and those that can afford these margin requirements?
    Mr. Masters. No, I don't think so. I think that the reason 
we are for exchange clearing is really two reasons. Number one, 
it is equal. It actually is more democratic. It is not just 
going to strengthen the large players. Obviously, the level of 
margin that is required is the key issue there. But in terms of 
preventing systemic risk, had AIG, for example, been trading 
their CDS, cleared it on an exchange, then they would have had 
to reserve significant amounts of dollars on the exchange, 
which would have really avoided the U.S. Government having to 
bail them out.
    In other words, the real reason for exchange clearing is to 
avoid a systemic meltdown in the future. And the other reason 
is because in regulation, it really allows regulators, to 
understand on a real-time basis exactly the positions of these 
different participants. Right now one of the big issues in the 
over-the-counter market is we really don't have any idea. 
Nobody knows. And getting them on an exchange and having them 
clear allows regulators transparency, and it prevents the kind 
of systemic meltdown that we had this fall.
    Mr. Goodlatte. Well, tell me about the risks if we do that. 
I understand that and we have heard a lot of testimony with 
that, but what is the risk? Are going to encourage business to 
move overseas if we impose the same position limits on 
regulated exchanges, foreign boards of trade and over-the-
counter markets?
    Mr. Masters. Well, just so you know, I already commented on 
that on a previous question, I think it is an empty threat. I 
think there is very little risk that business migrates 
overseas, and I testified to that.
    But in terms of the position limits, the best way to do 
position limits, and the reason we are for aggregate position 
limits, is because they treat speculators equally. Everybody is 
equal under that scenario.
    You don't want to have a position limit on an exchange and 
then have no position limits in the over-the-counter market, 
because that encourages everybody to go off the exchange and 
trade over-the-counter. You don't want to have that kind of 
perverse incentive. What we would like to do, especially today 
given the meltdown we have had in the financial system, is 
allow folks to trade, encourage them to trade on an exchange 
where there is not counterparty risk.
    So the whole idea of aggregate position limits, the reason 
for doing that is to treat everybody equally, whether you trade 
oil futures over-the-counter, whether you trade it with a 
dealer, whether you trade it in Dubai, whether you trade it on 
ICE, whether you trade it anywhere else. This is only if you 
are a speculator.
    Mr. Goodlatte. Let me interrupt you, since my time is 
running down here, and ask you if you want to respond to Mr. 
Short's testimony regarding the study that he cited, the study 
that found no link between index funds and market volatility?
    Mr. Masters. I think common sense says that is not the 
case. We have plenty of studies that we can show that say that 
index funds were in fact an issue, and excessive speculation 
was a driver in creating the commodity markets bubble. There 
are studies from MIT, from the World Bank, from the United 
Nations. I saw one a couple days ago from the Austrian Ministry 
of Finance. There is one from the Japanese Ministry of Trade. 
There have been a lot of studies that have come to the opposite 
conclusion. So I could submit those if you would like to see 
them.
    Mr. Goodlatte. Mr. Chairman, if I could have leave to allow 
Mr. Short to respond to that, I would like to hear him.
    Mr. Short. I would like to respond to Mr. Masters' 
statement and note that futures markets are inherently 
speculative markets. They are about predicting the future. So 
even Mr. Taylor, who is typically called a commercial or a 
hedger, is speculating about what the future price of something 
will be.
    But what I really worry about here is whether we are making 
a distinction between speculators who are following a 
fundamental market trend and perhaps accelerating our discovery 
of what the future may hold, or are those speculators 
distorting the market? I think if it is the former and not the 
latter, candidly it is a good thing. Because, these future 
markets are the only early warning systems we have when there 
are fundamental problems in the marketplace, and the only 
signals that can be sent to consumers, producers, everybody, to 
modify their behavior appropriately. And I am really concerned 
that if you regulate speculators out of the market, you might 
not like the price signal that is being sent about the future, 
but I have yet to find a more predictive way to predict the 
future than a market.
    Mr. Goodlatte. Thank you, Mr. Chairman.
    Mr. Boswell. Ms. Herseth Sandlin, the newest, happiest 
mother in the universe.
    Ms. Herseth Sandlin. Thank you, Mr. Chairman, that is true.
    Thank you all for your testimony. Mr. Pickle, I would like 
to start with you, a couple of questions. Much of the 
justification presented for past arguments that over-the-
counter derivatives aren't appropriately regulated as futures 
stem from the fact that the transactions are customized and the 
creditworthiness of the counterparties is a material term.
    With much of the market apparently now interested in 
centralized clearing, it is obvious that there is substantial 
standardization, and that the creditworthiness of the involved 
parties or the counterparties isn't an issue. So given the fact 
that the conditions seem to have changed, can we continue to 
justify the case that OTC derivatives aren't appropriately 
regulated as futures?
    Mr. Pickel. Well, let's look at the full range of the 
market. We focused a lot on CDS, and we will talk about that in 
a second. But if we look at interest rates, currency 
transactions, many commodity transactions, those are still very 
much custom tailored to the particular needs of the 
counterparties, the interest rate dates of the loans, or the 
delivery dates of the commodities. So in that area, yes, that 
continues to be the case. Custom tailored, the creditworthiness 
of the parties is very important. Collateral is used to address 
that credit exposure.
    In the credit default swap markets, it is fair to say that 
in our documentation and in market practices, yes, on the 
spectrum of standardization we have moved further down that 
spectrum to more standardized products. And, that is why at 
this point clearing for those products becomes very compelling. 
The major dealers have been working on developing a clearing 
initiative here, which is now housed within ICE. They have been 
working on that for at least 2 and maybe 3 or more years. It 
has taken on a greater urgency in the last few months with the 
credit crisis, but they have understood the need, the 
attractiveness of a clearing option for those contracts in part 
because they are more standardized.
    Ms. Herseth Sandlin. But you still continue to have 
concerns and perhaps oppose clearing provisions in the draft 
bill?
    Mr. Pickel. In terms of mandating clearing and saying that 
you have no choice but to clear the transactions. There is a 
very good example in the interest rate swap world where there 
has been a clearinghouse for close to 10 years over in London, 
dealers who are using that clearinghouse, are members of that 
clearinghouse, and have told me they use that very dynamically. 
It is another tool in their tool kit to manage risk. The OTC is 
the documentation structure with collateral and netting for 
many of the transactions, but they will put a number of those 
trades into the clearinghouse, and that just allows them to be 
much more dynamic in their hedging.
    Ms. Herseth Sandlin. Your own testimony acknowledges the 
authority that the CFTC would have in exempting certain 
contracts.
    Mr. Pickel. Well, we look at the existing structure under 
the CFMA in terms of the exempt commodities, the excluded 
commodities, and that structure is how we look at the treatment 
of different types of financial instruments.
    Ms. Herseth Sandlin. Okay. But I would like to just 
understand a little bit better. Since the draft legislation 
includes the authority to grant exemptions, do you question the 
CFTC's ability in particular to grant these exemptions? Is that 
where your concern lies?
    Mr. Pickel. Well, I guess our focus is more on the 
presumption that everything has to be cleared unless the 
standards for exemptions apply to that particular transaction. 
So, it is the presumption that everybody has to be cleared 
unless otherwise proven.
    Ms. Herseth Sandlin. But you acknowledge that there is the 
authority to provide the exemptions?
    Mr. Pickel. In the legislation, I acknowledge that that is 
the path that the legislation takes.
    Ms. Herseth Sandlin. You just are concerned--I want to get 
to the heart of this. I understand your concern that it assumes 
everything has to be cleared. But is it a concern you have with 
the CFTC's ability, or are you dissatisfied with the statutory 
provisions that set out when the CFTC could grant exemptions?
    Mr. Pickel. It is more focused than that. I have no 
question about the CFTC's authority or ability to analyze 
particular trades. I think it is the narrowness of the 
standards that apply to the ability to exempt, not the question 
of the CFTC's ability.
    Ms. Herseth Sandlin. My time is running out, so just one 
more question for Mr. Short. Your written statement is silent 
on the provisions of the draft relating to clearing. And 
perhaps this has been asked before. What is ICE's views on the 
clearing provisions in the bill?
    Mr. Short. On the issue of mandatory clearing of all 
products? I think our issue there is what I alluded to earlier 
in response to a question, which is that there are certainly 
products, derivative products, that should be cleared that are 
standardized, but there are also derivative products that 
probably aren't amendable to clearing. I think the proper 
framework would be to encourage clearing of standardized 
products that could present some level of systemic risk or have 
an important price transparency function in the broader 
marketplace, but to leave the nonstandardized, custom-tailored 
OTC instruments, like Mr. Taylor referred to, to the OTC 
marketplace.
    Ms. Herseth Sandlin. Mr. Chairman, a quick follow-up, if I 
might. So what about the types of customized derivatives? Would 
you support some sort of evaluation by an entity about whether 
they might present a systemic risk?
    Mr. Short. I think transparency to regulators is key here. 
I think we have moved beyond the days where people can argue 
that transparency to appropriate regulatory bodies isn't good. 
I am not sure I would go as far as to suggest that something 
needs to be preapproved to be traded. For example, that could 
lead to a lot of gridlock and maybe hamper product innovation. 
But certainly transparency would be appropriate to give the 
regulator the view about whether something needed to be 
cleared, or whether additional steps needed to be taken.
    Ms. Herseth Sandlin. And you would be comfortable with the 
CFTC making those decisions?
    Mr. Short. I am comfortable with the CFTC making those 
decisions. I am also very comfortable with the Fed making those 
decisions. As you know, our clearing solution is a bank that is 
governed by the Fed. But I have no quarrel whatsoever with the 
CFTC as a regulator.
    Ms. Herseth Sandlin. Thank you, Mr. Chairman.
    Mr. Boswell. Mr. Conaway, I am going to let Mr. Marshall 
get back in. I let him have that little extra follow-up, and if 
you will indulge us, let's do that because I have turned around 
and made up for it with others.
    Mr. Marshall, I apologize. Let's wrap yours up.
    Mr. Marshall. Am I limited to the subject matter?
    Mr. Pickel, I guess the time has passed, and it really 
isn't necessary for you to respond to my observation. It is 
just troubling to me, that the industry, and that would mean 
you, aren't willing to give us a little bit more help here as 
opposed to just saying no, no, no. Make some suggestions. You 
sort of know where we are headed and what we are trying to 
accomplish. Or make some suggestions that will head us in that 
direction and still work for the industry.
    Mr. Masters, on your call for equality in treatment, we all 
love that. We are all in favor of equality. I thought the 
concern from most, and I thought it was your concern when you 
were talking about this last summer, is there was too much 
passive investment money in the market and it skewed things. It 
pulled things north, and then once things started collapsing, 
it pulled things south, and so consequently there was too much 
volatility.
    So I will just get you to think about this. Suppose there 
are just ten players in the market and five of them are 
tradition speculators, market makers, whoever you want, the 
gamblers we have all approved of, coming into the market, 
providing liquidity and consequently lower spreads, better 
target prices. Price discovery works better with that. Let's 
say there are a total of ten, and five of them are passive--
``invesculators'' is the term that was used yesterday-- and 
things are working okay with just the five and five.
    Then more passive folks show up. And let's say they are all 
at their limits. And let's say 50 more passive people show up, 
because this is now exciting. People have gone out and sold the 
deal and they are passing through the position limits to the 
entities or the individuals, so there are tons of them out 
there. There are not that many traditional speculators, but 
there are tons of the rest of these folks.
    So what happens is 50 more show up. Now you have five 
traditional speculators hitting their position limits and 45 
passive folks hitting their position limits. They are all being 
treated equally, but the market is being skewed like heck from 
the perspective of the individuals who want to use that market 
to hedge their crops, et cetera. So I don't think that works.
    I think you need to think about something other than pure 
equality as the tool for meeting the objective that you have 
had. I would just ask you to think about that and maybe respond 
in writing, because it too complicated really to get into here, 
if that is okay with you.
    Thank you, Mr. Chairman.
    Mr. Boswell. Mr. Conaway.
    Mr. Conaway. Thank you, Mr. Chairman. And your passionate, 
heartfelt call to a higher self earlier, I appreciate that. I 
have seven grandkids, and I don't believe they can afford the 
things that we have been doing as of late, going back several 
years, not just currently.
    Mr. Taylor, the cotton contract: There has been some 
comments that there are some flaws in that contract that would 
or would not be addressed in this legislation that helped 
contribute to the widening basis last year. Can you respond to 
that?
    Mr. Taylor. I can. I think the major issue with the March 
event had to do with the margining. Really the contract is 
fine. We have great convergence, we have a lot of deliverable 
space, and actually after the event it came back pretty quickly 
to where it needed to come. But it is particularly, I think, 
the issue that is setting a limit. Allowing the daily trading 
limit or not allowing the synthetic trading and then margining 
to that synthetic trading was the problem that really caused 
that.
    Mr. Conaway. Does this bill address that? Should this bill 
address that?
    Mr. Taylor. No, I think that needs to be addressed directly 
with ICE and the exchange. I don't think the bill needs to 
address that.
    Mr. Conaway. Mr. Short, on what is referred to as the Balls 
Clause in the U.K. with their FSA, does section 3, do you think 
that is going to trigger that retaliation? Is it too strong?
    Mr. Short. It is certainly possible. I think just in terms 
of the issue of working with foreign regulators and the whole 
debate about whether business could go overseas, we are 
certainly not suggesting that there should be a race to the 
bottom. I think this is a global financial crisis. It is a 
global problem.
    What I am suggesting is that we affirmatively work with 
foreign regulators to adopt appropriate standards, and in all 
candor the United States will have to maybe begrudgingly accept 
that there are some legitimate different points of view out 
there on how markets should efficiently operate. I just worry 
that without the proper amount of coordination with foreign 
regulators, this is the type of thing that could be viewed as, 
well, this is the United States doing what it always does. It 
is our way or the highway, and the rest of the world can do 
whatever it wants.
    I think really to solve problems in a global marketplace, 
you need to cooperate, and get to the right standards, and then 
adopt appropriate laws.
    Mr. Conaway. I guess anybody on the panel in the time 
remaining, rather than mandating clearing, which is obviously 
something we could do, are there ways that we can promote 
clearing that would be quicker and more efficient perhaps, 
allowing the market to figure that out, as opposed to some 
uninitiated Members of Congress trying to figure that out?
    Mr. Pickel. I think the industry is in dialogue with 
regulators, both here in the U.S. and in Europe. This is 
related to credit default swap clearing. The New York Fed, as 
you probably know, over the last 3\1/2\ years has brought the 
industry together, the major firms, to talk to them about 
operational aspects of credit default swaps. And they have 
actually extended that beyond to interest rates and equity. And 
in those discussions, certainly on the credit default swap 
front, but potentially in other areas, there will be greater 
encouragement of clearing, although not a mandatory requirement 
for clearing. So I think that group is exploring that. Then 
over in Europe, similarly, there is an effort to introduce 
clearing there.
    One of the issues there that relates to this whole question 
of pushing here and what that affects over there, the Europeans 
perceive that the initiatives through the New York Fed 
regarding clearing were moving in a direction of all the 
clearing happening in the United States. Actually, if you talk 
to CME or ICE or others who are proposing clearing, they want 
to be able to be a global clearing. So it was U.S.-based or 
U.S.-initiated, but it was a U.S. solution. But the Europeans 
are very much focused on the fact that they want to have a 
European clearinghouse for European transactions, and we see 
some of that protectionism, if you will, almost playing out in 
those debates. So that is an area of concern for the industry.
    Mr. Conaway. Anyone else, Mr. Masters, on promoting 
clearing rather than mandating it?
    Mr. Masters. I think you have to mandate clearing and you 
have to be pretty strong with that. And the reason you have to 
is because people aren't going to clear unless you mandate it. 
There are lots of folks out there, hedge funds in particular, 
that will not clear if you don't mandate it. If you mandate it, 
they will; but if you don't, they won't. Why should they?
    Mr. Conaway. Well, there was a lot of money lost over the 
last 6 or 12 months, money made as well, and a lot of hedge 
funds lost a lot of money in the arena. So they don't get paid 
to lose money, I don't think, but maybe they do.
    Thank you, Mr. Chairman. I yield back.
    Mr. Boswell. Thank you. Last but not least, but maybe the 
best, Mr. Massa from New York.
    Mr. Massa. Thank you, Mr. Chairman. Let me just observe for 
the record, sir, there are no forces in the universe that could 
entice me to change party affiliation for the opportunity of 
asking a question earlier.
    I am the most junior Member of Congress, sometimes referred 
to as Nancy Pelosi's bookend. However, I am struck by the 
erudite and intellectual nature of the conversation today. It 
befalls upon me to mention to you that I have hundreds of 
constituents in my district, where it is 14 degrees outside 
back home, and because of the failures cumulatively of this 
entire industry, will not be able to fill up their propane tank 
and may end up having to either go cold, move into assisted 
living, or otherwise have their lives destructed or destroyed 
by what we are talking about today. This is not some ethereal 
pie-in-the-sky conversation. It has incredible impact.
    So to Mr. Masters, I would like to comment to you that when 
you talk about the speculative nature of the markets, I would 
say that much of what we have seen in the past 8 months is not 
speculative. It is either unethical, immoral, destructive or in 
fact criminal. And if it is not criminal, it should be; and I 
take these matters as very, very seriously.
    Certainly Mr. Short, if you could respond to my quick 
question in writing, you made the statement there is nothing 
more accurate than the forces of the market in predicting the 
future.
    Considering the nature of what we have seen in the past 18 
months, if you would be willing to send me a letter with some 
of those predictions, I would welcome that, if for no other 
reason than to participate in the success of those predictions. 
Because frankly, from where I sit back home, the market has 
gotten it abjectly wrong across the border in virtually every 
sector. Not only as it was subject to false inflationary, but 
also the crash that followed, that is again infecting my 
constituents with a sense of doom, and has led to the United 
States losing incredible market share. I would welcome a letter 
on that topic from you, sir, if you could.
    Last, or next to last but not least, Mr. Pickel, you stated 
should we make an action or act illegal? We should perhaps do 
that because we would see those markets move overseas, implying 
that the act of finding illegal activity is justified because 
somebody else is just going to do it.
    Mr. Marshall. Mr. Chairman, the gentleman's microphone 
isn't on.
    Mr. Massa. This will be a technical test.
    The Chairman. Why don't you move to the next microphone?
    Mr. Massa. We have great agility in our ability to shift.
    The point being, sir, you said just because we think it is 
illegal, we should tolerate it, because it might move overseas. 
If you could give me an example, singularly or in numerous 
quantities, of things that this country, based on our value 
systems, think that are illegal that we have made illegal, that 
you think we should bring back here because it is being 
processed or conducted elsewhere in the world, I would love to 
consider those options.
    I happen to believe that is a specious argument, and that 
it is the requirement of this argument to ferret out 
potentially illegal activity and protect the citizens of this 
nation. So if you would be willing to engage in a conversation 
in writing with me on that, I would very much welcome that.
    Last, not many people understand out of New York how badly 
New York has been hit by our current financial situation. I am 
honored to know that Chairman Morelle has been at the forefront 
of the forensic investigation as to many of the things that 
have happened. We heard here today a lot of what did not 
contribute to the failure of AIG.
    Mr. Morelle, in 1 minute or less, and then perhaps followed 
up under a special hearing, could you tell me what you think 
the factors are that did in fact cause the AIG crisis?
    Mr. Morelle. Well, thank you Congressman. I just would 
point out, as I mentioned in my testimony, that if you look at 
AIG from the perspective of the state-regulated companies, AIG 
has many state-regulated insurance subsidiaries. In New York 
alone, the property and casualty companies that come under AIG 
have roughly a $20 billion surplus that is robust, 
policyholders have been protected, and the experience has been 
similar in other states.
    And to Congressman Marshall's point earlier about 
regulatory arbitrage, I will respond in writing and I 
appreciate the question because it is an important one. But I 
do note that the experience was similar across other states in 
the countries that have subsidiaries of AIG.
    You contrast that with the financial services arm of AIG, 
unregulated, and by virtue of the Commodity Futures 
Modernization Act unregulated by the states and by the Federal 
Government. Their great exposure to credit default swaps in 
particular and their inability to manage risk, as Mr. Pickel 
indicates, the lack of ability to be able to quantify risk, and 
obviously other mark-to-market rules, et cetera, exacerbated 
their problem. To me that serves as a great contrast between 
those that take seriously the notion of financial guaranty and 
underwriting standards, et cetera, and the unregulated 
marketplace.
    I would just say in closing, it is also noteworthy that 
under state regulations, we would not allow in New York, for 
instance, or any other state, the surpluses at the regulated 
subsidiaries to flow upward to provide support for AIG's 
financial services company, because it would have jeopardized 
the financial commitments that they had made to policyholders, 
and we hold that very dear at the state level.
    Mr. Massa. Well, Mr. Chairman, thank you very much for your 
testimony today, and I commend and recommend to the other 
Members of this Committee liaison with you, as you have delved 
so deeply into this in the State of New York.
    Mr. Chairman, let me just conclude by saying I associate 
myself with great enthusiasm and vigor with Mr. Boswell's 
remarks. I find nothing inappropriate with emotion and vigor in 
defending the interests of the people we represent, and I yield 
back the balance of my time.
    The Chairman. I thank the gentleman.
    The gentleman from California, Mr. Costa, do you have any 
questions? We are just about at the end of this panel.
    Mr. Costa. Thank you, Mr. Chairman.
    I don't know if it was covered while I was out of the room, 
but it dawned on me while listening to Mr. Master's testimony 
earlier, that you spent a great deal of your time discussing 
excessive risk and trying to put some parameters on excessive 
risk as you expounded on in your testimony. And I am trying to 
get a better handle on how you define ``excessive risks.''
    Obviously there has been a lot of support in testimony 
today for the proposed legislation that the Chairman has 
introduced, and there has been also critiques argued by Mr. 
Pickel and others as to the potential impacts if such 
legislation is implemented.
    But could you respond?
    Mr. Masters. Sure. In the bill, in terms of defining what 
position limits should be, there is a sort of principle that 
was really developed by Franklin Roosevelt in the first 
Commodity Exchange Act, and that was there is something called 
``excessive speculation.'' There is not just manipulation, 
there is excessive speculation. And that only applies to 
commodities futures markets, it doesn't apply to other markets.
    The reason it applies to commodities futures markets is 
because these markets used to be dominated by physical hedgers, 
and they are there for them to price risk. That is why we have 
commodity futures markets. We have a different regulator. We 
have a different way of looking at the markets, because these 
are commodities. They are not interest rates. Nobody goes home 
and eats a bowl of interest rates.
    Mr. Costa. We understand that.
    Mr. Masters. So the idea is, this is a different kind of 
situation, so limits apply at each commodity. And the way the 
bill is structured, there would be an advisory panel made up of 
physical hedgers that would suggest position limits. By the 
way, exchanges would not be included, because exchanges have a 
built in conflict of interest to have the highest limits 
possible because they want volume on the exchange.
    So what we need is sufficient speculation to provide the 
needs of Mr. Taylor and his constituency, and other kinds of 
constituencies, in the futures markets to provide liquidity 
that physical hedgers need. We need some speculation, but not 
too much speculation, not excessive speculation.
    And the idea would be that since these markets are for 
physical hedgers, that a panel of physical hedgers would be 
best justified in setting the limits. After all, they are not 
going to cut off their nose to spite their face. They also want 
enough liquidity. But they don't want the markets driven by 
excessive speculation where their markets lose all reality of 
supply and demand forces in their market. They just want them 
big enough.
    Mr. Costa. You believe that the transparency of this 
commission would suffice in determining what would be viewed as 
an acceptable risk versus an excessive risk, because, unlike 
the commodities exchange that we are talking about, whether it 
be pork bellies or whether it be other future markets in 
agricultural commodities, in these instruments that we are 
talking about here, as you said, you can't eat a bowl of 
derivatives, I guess.
    And so, where has this worked in a way that there is 
previous practices that we could draw from experience on?
    Mr. Masters. The nice thing about position limits is we 
have 7 years of experience with them. Before the CFTC excluded 
some broker dealers, it basically exempted them from position 
limits. Before the Commodity Futures Modernization Act, which 
allowed swaps and other over-the-counter derivatives to be 
created that would allow broker dealers to trade off-exchange 
in significant fashion with other speculators. That is the 
loophole we have talked about in the past, before we had those 
issues, we had a very solid, working commodity futures market 
that served the needs of producers for years and years.
    In fact, in 1998, producers, physical hedgers, and 
consumers of commodities were the dominant force of the market. 
They were 70 percent of the market. Speculators were about 30 
percent.
    Mr. Costa. My time is almost expired. I don't know, do any 
of the others of you care to comment?
    Mr. Short. I would just like to add one comment. I do think 
Mr. Masters is right that the original focus of position limits 
in the Commodity Exchange Act in its original form was to 
protect farmers who were growing their crops and needed to 
hedge.
    But it is an interesting question depending on which side 
of the table you happen to be on, as far as being a net 
producer or a net consumer of something. I would just ask 
people to contemplate global oil. We produce very little global 
oil in this country. We are a massive consumer of it. If you 
really want to have the producers setting the price, aren't you 
giving the fox the keys to guard the henhouse?
    Speculators keep those prices in line. And it is a more 
complex question than just saying that we need to hand it back 
over to the physical side of the market.
    Mr. Costa. Well, my time is expired, but you touched on 
kind of a sensitive nerve there. I mean, a number of people 
argue that, in part, the whole reason we had the tremendous 
increase last summer of oil prices was because of a great deal 
of speculation that took place. How did that protect the 
consumer in America?
    Mr. Short. If I can answer that question with your 
indulgence, these are futures markets, and they are trying to 
predict. And no one can accurately predict the future.
    Mr. Costa. I understand that. But you had people making 
profits on the upswing and on the downswing, related to the 
whole oil futures market.
    Mr. Short. That is right. And markets don't always operate 
with perfect----
    Mr. Costa. And our consumers paid the price.
    Mr. Short. Markets don't always operate with perfect 
efficiency. But you could go back to some of the statements by 
people who were saying that the real price of oil should be $70 
or $80 a barrel. It now happens to be $40 a barrel. So are we 
suggesting that we should raise the price of oil?
    I mean, markets won't get things right all the time, but 
they will get them more right than they will wrong. And, it is 
just a very slippery slope, in my mind, if you are trying to 
micro-manage a market. Because, ultimately, I think what those 
markets did--speculators got us to a market equilibrium faster 
than we otherwise would have. I don't like the price of oil 
being high, but it got there ultimately because of physical 
market conditions.
    Mr. Costa. My time has expired. Thank you very much, Mr. 
Chairman.
    The Chairman. Well, I thank the gentleman.
    And, I may have been where Mr. Short was, but I have to 
tell you we had all this money come into the market and the 
price went up, not in only oil but wheat or whatever. When the 
financial crisis hit and all the money left, the prices went 
down significantly.
    I believe oil is too cheap at $40. It is causing this 
country a lot of problems. So it has not only been a problem on 
the top side, it is a problem on the bottom side. We are going 
to kill off the renewable fuels industry and other things that 
we are trying to get going in this country, because of all this 
volatility. So that is a big concern on the part of this 
Committee.
    And Mr. Costa said you can't eat derivatives. Mr. Frank has 
said that he wants to change the jurisdiction so that we only 
have jurisdiction over things you can eat, and their Committee 
has jurisdiction over things you can't eat. I would suggest 
that what is going on here is we are forcing the taxpayers to 
eat a lot of new debt and a lot of stuff that we are talking 
about.
    So I would make the argument that because of that, we do 
have jurisdiction over this. Because we are forcing the 
American people to eat a lot of stuff here that they don't 
particularly like, but they are eating it, whether you like it 
or not.
    Mr. Marshall has one last thing. And we are going to have a 
vote here in just a minute, and then we are going to dismiss 
this panel. We are going to go vote, give you guys a little bit 
of break, and we will take the second panel as soon as the vote 
is over.
    So, Mr. Marshall, you are recognized.
    Mr. Marshall. Thank you, Mr. Chairman.
    And, Mr. Pickel, one more thought. You described CDSs as 
not being at fault for the mess we are in at the moment. But a 
number of people suggest that the availability of CDSs, the 
lack of transparency, the lack of required margining, and 
things like that are the problem. While the instrument itself 
is a good thing, the interwoven nature of exposure that has 
occurred with the major institutions where nobody can really 
tell what is going to happen next has caused investors to sit 
by the sideline, and has caused our money supply essentially to 
collapse dramatically. And CDSs are a large part of what has 
caused this interwoven ``almost unfathomable to the individual 
institution, let alone outsiders who are trying to figure out 
what is going on'' nature of our banking system right now.
    And so, if that is the case, maybe in your response on the 
record to the Committee, a written response--if you would send 
a copy to me, I would appreciate it--you could describe a 
future where we have solved that problem so that people do 
understand the exposures of these large institutions and, 
consequently, can comfortably invest or not invest instead of 
just sitting on the sideline, frightened, because you just 
cannot tell what the heck is happening. And, largely, it is 
derivatives and swaps that cause that dilemma for so many 
investors and for the institutions themselves. If you would.
    Mr. Pickel. We certainly will respond in writing to that 
question.
    Obviously, ``transparency'' is in the name of the Act; it 
is a very important issue to focus on. And there are several 
different aspects of transparency. One is the parties who 
engage in the transaction, whether they have the information 
available to decide whether the price is correct or not. I 
think in the CDS space, there is a great deal of transparency 
there.
    Transparency of the regulators is critical. A lot of the 
institutions who are engaging in this business are regulated. 
To the extent that there needs to be more information to the 
regulators or more involvement of the regulators in 
understanding that, by all means we should explore how that can 
be more effective.
    Also, there is transparency just generally to the public. 
And there are some steps that the industry has undertaken 
recently to provide more information about the amount 
outstanding on any particular reference entity or index. And 
that is information that is provided through this warehouse 
that the Depository Trust and Clearing Corporation has 
established.
    So there are steps in that direction. And I think that 
those are the types of things, in response to your earlier 
comment, that we ought to be working on as an industry and 
working together with this Committee to identify those 
additional means of transparency.
    Mr. Marshall. Thank you.
    Thank you, Mr. Chairman.
    The Chairman. I thank the gentleman.
    I would just observe how far the debate has come. Because, 
when we started all of this, the argument was that this 
transparency was not necessary and was not good. So we have 
made some progress. We apparently now have everybody to the 
point where they at least agree on that part of things, which 
is better than where we were 8 months ago.
    The gentlelady from Ohio, do you have a question?
    Mrs. Schmidt. Not at this time.
    The Chairman. Okay. Welcome.
    With that, we appreciate the panel's testimony and 
involvement. It has been very helpful. We appreciate your 
patience. And we will dismiss this panel.
    I think we are going to vote here shortly. It is only one 
vote, and I would encourage Members to vote and come back. And, 
staff, if you could have the other panel ready to go when we 
get back, we will proceed with the second panel.
    I thank you again.
    [Recess.]
    The Chairman. The Committee will come back to order.
    I would like to welcome our second panel of witnesses: Mr. 
Chris Concannon, Executive Vice President of NASDAQ OMX, New 
York; Mr. Bill Hale, Senior Vice President of the Grain and 
Oilseed Supply Chain, of Cargill; Mr. Karl Cooper, Chief 
Regulatory Officer of New York Stock Exchange Liffe, on behalf 
of NYSE Euronext; Mr. Paul Cicio, President of the Industrial 
Energy Consumers of America.
    And is Mr. Brickell here? He is just out? Okay. He is from 
Blackbird Holdings of New York and will be back.
    So welcome, all of you, to the panel. Thank you for your 
patience. We are working through this as best we can. And your 
full statements will be made a part of the record. Feel free to 
summarize.
    And, Mr. Concannon, you are up first. And welcome to the 
Committee.

STATEMENT OF CHRISTOPER R. CONCANNON, EXECUTIVE VICE PRESIDENT, 
         TRANSACTION SERVICES, NASDAQ OMX, NEW YORK, NY

    Mr. Concannon. Thank you, Chairman Peterson, Ranking Member 
Lucas, and other Members of the Committee, for the invitation 
to speak today on this important legislation.
    You may be wondering why NASDAQ OMX, the operator of the 
largest equities exchange in the world, is testifying on OTC 
derivatives. Well, we currently own and operate 17 markets and 
eight clearinghouses in trade equities, fixed income, 
derivatives, and energy products around the globe.
    While I must admit that we have some self-interest in the 
reform of OTC derivatives, our interest is the product of 
almost 4 decades of experience in delivering efficient and 
transparent markets to investors. Over the past several years, 
trillions of dollars of investment instruments have been 
crafted through an unregulated web of interconnected 
counterparty relationships. Because these instruments are not 
valued in a transparent, efficient market with the opportunity 
for centralized clearing, unrecognized risk continues to be 
piled upon unrecognized risk.
    We at NASDAQ are confident of the beneficial effects of 
centralized clearing, transparency, and regulation for the OTC 
markets. It is possible to transform an OTC market to one that 
is centrally cleared and visible to all. We have done it. When 
NASDAQ was founded 37 years ago, our primary mission was to 
bring order, discipline, and fairness to the over-the-counter 
equities market.
    What we know from our experience is simple yet 
revolutionary for this market. These OTC instruments need to be 
centrally cleared to better distribute or mutualize the risk. 
Central clearing fundamentally means more parties are backing a 
transaction versus one or just a few.
    NASDAQ OMX recently became the majority owner of the 
International Derivatives Clearing Group, IDCG, a CFTC-
registered clearing organization. IDCG has developed an 
integrated derivatives trading and clearing platform that will 
allow members to convert their OTC interest rate swaps into a 
cleared future product with the full benefits of centralized 
clearing.
    Building on decades of experience, NASDAQ OMX is bringing 
the values of organized markets, including central clearing, 
standardized margin, transparency, and real valuations, to what 
is a $458 trillion interest rate swap market. While there has 
been much discussion around the CDS market, you should be aware 
that the interest rate swap market is six times larger.
    IDCG is live today, operating a highly efficient market to 
clear and settle U.S. dollar-denominated interest rate swaps. I 
must commend the CFTC for its thorough review and professional 
timeliness in approving IDCG's operation December of last year.
    Thus, NASDAQ OMX is highly supportive of provisions in 
section 13 of your legislation that would protect our financial 
system and investors by requiring most OTC derivatives to be 
settled and cleared. In addition, we support the need to set 
some limited exemptions for derivatives that may contain 
complex contractual aspects rendering them inappropriate for 
clearing.
    Let me highlight one benefit of central clearing of 
interest rate swaps within the banking system. Current 
regulatory capital treatment for derivatives applies a higher 
capital charge for bilateral uncleared holdings. Simply, under 
accounting rules and international treaties such as BASEL I and 
BASEL II, bilateral trading of OTC derivatives introduces 
systemic risk while creating an extremely inefficient use of 
capital. We believe the entire financial system would benefit 
from a large capital infusion as a result of simply mandating 
centralized clearing.
    Capital efficiency is also greatly enhanced by the process 
of netting. With central clearing, financial institutions can 
net out their positions across the entire market and further 
reduce their required capital reserves, while at the same time 
reducing the complexity and risk of the bilateral world.
    We also support the efforts by the Federal Reserve, the 
FDIC, and the Office of Comptroller to evaluate the need for 
enhanced regulatory capital charges for non-cleared OTC 
transactions. We think that customers that use these 
derivatives should also demand that their transactions be 
subjected to clearing. According to a recent Bloomberg story, 
several State Attorneys General are investigating the opaque 
fees several local governments paid to obtain interest rate and 
other derivatives to hedge swings in borrowing costs for 
schools, states, and cities.
    We know that the larger issues of financial regulatory 
reform are beginning to receive consideration. We believe that 
it is important to apply modern regulatory concepts like 
principle-based regulation, practiced successfully by the CFTC 
and regulators around the world.
    Finally, we must be mindful that these OTC instruments 
ignore international borders. So we agree with President Obama 
that these issues cannot be handled with domestic action alone. 
For many reasons, working through multilateral structures like 
the G20 will ensure that global markets work together in what 
is a global problem. In this way, we will ensure that 
regulatory arbitrage is minimized and market participants are 
not driven to engage in jurisdiction shopping.
    Again, thank you for the invitation. I am happy to take 
questions.
    [The prepared statement of Mr. Concannon follows:]

     Prepared Statement of Christoper R. Concannon, Executive Vice 
       President, Transaction Services, NASDAQ OMX, New York, NY
    Thank you Chairman Peterson and Ranking Member Lucas for the 
invitation to speak to you this morning regarding your legislation, the 
Derivatives Markets Transparency and Accountability Act of 2009.
    Some of you may be wondering why NASDAQ OMX, the operator of the 
world's largest cash equities exchange, is testifying regarding OTC 
derivatives. Well, NASDAQ OMX owns and operates 17 markets and eight 
clearing houses around the globe. Our markets trade equities, 
derivatives and fixed income products. Not only do we pride ourselves 
in operating our markets efficiently, but we are exceptionally proud of 
the efficiencies that we have delivered to these markets. In regards to 
OTC derivatives, I will admit that we have self interest in the reform 
of these markets. But this self interest is the product of almost 4 
decades of experience in delivering efficiency and transparency to the 
financial markets.
    When we examine your legislation we see a policy initiative that 
will bring fundamental change to a market that is defined by 
counterparty risk, unknown systemic risk and opaque markets. While we 
continue to deal with the worst financial crisis since World War II, we 
can't simply wait for it to end before we study and implement needed 
reforms. Reforms can and should be implemented now.
    As your legislation recognizes, over the past several years and 
throughout the economy, trillions of dollars in investment instruments 
have been crafted through an unregulated web of interconnected, 
counterparty relationships. Even after all the billions in Federal 
subsidies, the books of banks and businesses are littered with these 
complex instruments whose value is opaque and potentially mispriced. 
These particular credit instruments continue to be traded in what's 
known as the over-the-counter or OTC market. Because these instruments 
are not valued in a transparent, efficient market with the opportunity 
for centralized clearing, unrecognized risk continues to be piled upon 
unrecognized risk.
    The negative aspects of the over-the-counter market have been 
documented well by the hearings of this Committee. There is no need to 
further expand on those findings. It is now time to implement change 
both by government action and by the markets themselves.
    The markets and clearing houses that sit before you today are here 
to explain how our markets worked throughout this horrible crisis. Very 
few people can sit before Congress today and explain how their systems 
discovered prices everyday; how their clearing houses absorbed the 
impact of major defaults such as Lehman; or how they were able to 
settle each and every trade. We represent the markets that worked while 
the OTC markets represent the opaque market that tied these 
unsuspecting victims into a complex web of financial disaster. The 
point is--centralized clearing worked as designed and it worked in many 
asset classes around the globe.
    We at NASDAQ are confident of the beneficial effects of centralized 
clearing, transparency and regulation for the OTC markets. NASDAQ made 
its name by being a pioneer in the over-the-counter cash equities 
market. Until NASDAQ came on the scene, the cash equities market also 
once operated similar to the current OTC derivatives market.
    NASDAQ was born out of a need to share information about stock 
trading in a central fashion, accessible to all, with a system designed 
to protect investors and facilitate discovery of the right price for 
each stock. We continue to operate on a simple principle that is the 
foundation of all markets: An informed and willing buyer and an 
informed and willing seller agreeing to trade is the best valid price 
discovery mechanism.
    It is possible to transform an over-the-counter market to one that 
is centrally cleared and visible to all. We have done it; when NASDAQ 
was founded 37 years ago our primary mission was to bring order, 
discipline and fairness to the over-the-counter equities market. What 
we know from our experience is simple, yet revolutionary for this 
market: These OTC instruments need to be centrally cleared to better 
distribute or mutualize the risk. Central clearing fundamentally means 
more parties are backing a transaction versus one or just a few. 
Centralized clearing gathers strength from more parties while 
delivering capital efficiency through the benefits of netting multiple 
risk exposures.
    Building on the decades of experience, NASDAQ OMX is bringing the 
values of organized markets including central clearing, standardized 
margin, transparency, and real valuations to what the Bank for 
International Settlements estimates is a $458 trillion over-the-counter 
interest rate swap market. While there has been much discussion about 
the credit default swap market, you should be aware that the interest 
rate swap market is six times larger than the credit default swap 
market.
    As you may know, NASDAQ OMX recently became the majority owner of 
the International Derivatives Clearing Group (IDCG). IDCG, an 
independently operated subsidiary of The NASDAQ OMX Group, has 
developed an integrated derivatives trading and clearing platform. IDCG 
is transforming the interest rate swap marketplace, allowing members to 
convert their OTC swaps into a cleared future product with the full 
benefits of central clearing. This CFTC approved platform will provide 
an efficient and transparent venue to trade, clear and settle interest 
rate swap (IRS) futures.
    One of the most compelling attributes of our IDCG endeavor is that 
it allows for all forms of execution. We have the ability to allow 
customers the flexibility to operate their business as they have, but 
with an independent and standardized view of the risk. This 
independence is the absolute core of a centrally cleared market place. 
By concentrating its focus on risk, IDCG can be open to multiple forms 
of execution. This flexibility allows for more of the market to 
participate in an open and consistent manner while all of the risk is 
marked-to-market by the same benchmark.
    I must commend the Commodity Futures Trading Commission (CFTC) for 
its thorough review coupled with professional timeliness in approving 
the application for IDCG to operate. With CFTC approval of IDCG's 
Derivatives Clearing Organization (DCO) license on December 22, 2008, 
IDCG is ``live'' today; operating a highly efficient market to clear 
and settle U.S. dollar denominated interest rate swap futures. We, 
along with IDCG, look forward to the day when vast parts of the over-
the-counter market are no longer stored in the back-rooms of brokerage 
houses but are held in well-capitalized clearing houses transparent to 
all--including the regulators and public policymakers.
    Thus, NASDAQ OMX is highly supportive of provisions in section 13 
of your legislation that would protect our financial system and 
investors by requiring most OTC derivatives be settled and cleared. We 
believe this section is good public policy and hope to see it enacted 
into law. In addition, we support the ability of the CFTC to set some 
limited exemptions for derivatives that may contain complex contractual 
aspects rendering them inappropriate for clearing.
    Let me offer one benefit of clearing in the interest rate swap 
space that will have an immediate and direct positive impact on the 
banking system. Current regulatory capital treatment for derivatives 
held by banks and other financial institutions applies a higher capital 
charge for bilateral, uncleared, holdings. If existing banks cleared 
their interest rate swap transactions through a central clearing house, 
significant capital would be released for the banks to apply to new 
lending or against other assets. Simply, under the current accounting 
rules, insolvency laws and international treaties (such as BASEL I & 
II), the current method of bilateral trading is not only less 
efficient--it is a more expensive use of capital.
    We believe the entire financial system would benefit from a capital 
infusion as a result of mandating centralized clearing. To put it as 
succinctly as I can, centralized clearing reduces the market, 
counterparty, and operational risk of a portfolio. In addition, it can 
also reduce capital requirements that today, unfortunately, are often 
being supplied with non-performing taxpayer money.
    Capital efficiency is greatly enhanced in conjunction with another 
benefit of central clearing: the process of netting. With central 
clearing, financial institutions can ``net'' out their positions across 
the entire market and further reduce their required capital reserves 
while at the same time reducing the complexities and risk of the 
bilateral world.
    We also support efforts by the Federal Reserve, the FDIC and the 
Office of the Comptroller to evaluate the need for enhanced regulatory 
capital charges for non-cleared OTC transactions. We, at NASDAQ, 
believe it is critical that all forms of risk are appropriately priced, 
and that regulatory capital rules provide meaningful incentives to 
drive OTC derivatives on to central clearing houses.
    We think that customers that use these derivatives should also 
demand that their transactions be subjected to clearing. According to a 
recent Bloomberg story, several State Attorneys General are 
investigating the opaque fees several local governments paid to obtain 
interest rate and other derivatives to hedge swings in borrowing costs 
for schools, states and cities--fees which were more difficult to 
challenge when neither information about execution pricing nor pricing 
of risk were publicly available. Certainly, if state and local 
governments adopted the mandate to only transact cleared products, the 
trend for clearing would be enhanced. The Bloomberg article is an 
addendum to my written testimony.
    We know that the larger issues of financial regulatory reform are 
beginning to receive consideration by you and your colleagues here in 
Congress. While we don't have detailed views on regulatory reform, we 
believe the key concept to keep in mind is to apply modern regulatory 
concepts like the principles-based approach to regulation practiced 
successfully by the CFTC and regulators around the world. We hope that 
the process of updating U.S. regulation will retain the CFTC's 
principle-based approach and expand that approach throughout our 
regulatory framework where appropriate.
    Mr. Chairman, NASDAQ OMX supports your interest in prohibiting 
over-the-counter trading of carbon offset credit futures. NASDAQ owns a 
carbon trading facility in Europe called NordPool. NordPool was the 
pioneer in carbon products--the first exchange worldwide to list carbon 
allowances (EUA) and carbon credits (CER). And, although NordPool is 
the number two marketplace for carbon in Europe, 70% of all trading now 
takes place in the OTC space, away from effective regulation and 
supervision. Therefore, it is impossible to know the exact volumes that 
are traded. Our experience in Europe suggest that the opaque use of OTC 
derivatives in the European Cap and Trade experiment contributed to the 
chaos and failure of that marketplace. We want NordPool to be part of 
the U.S. market solution for greenhouse gas emission reductions and 
look forward to working with you and the Committee towards ensuring 
that your legislation allows that expertise to be part of the equation.
    Finally, Mr. Chairman, we must be mindful that these OTC 
instruments ignore international borders and jurisdictions. So we agree 
with President Obama that these issues can not be handled only with 
domestic action. For many reasons, working through multilateral 
structures like the G20 will ensure that the global markets work 
together on what is a global problem. In this way we will ensure that 
regulatory arbitrage is minimized and market participants are not 
driven to engage in ``jurisdiction shopping.'' We understand that 
President Obama hopes to make these issues, and a coordinated global 
response, a key aspect of the G20 meeting in April and NASDAQ OMX 
supports the President's leadership on this matter.
    Again, thank you for inviting NASDAQ OMX to testify and for your 
efforts to bring transparency and order to these important 
marketplaces. We look forward to working with you and the full 
Committee membership as you seek to tackle these important public 
policy challenges.
                           Additional Exhibit
California Probes Muni Derivatives as Deficit Mounts (Update1)
By William Selway and Martin Z. Braun


[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


    The investigations center on the investments that schools, states 
and cities buy with the proceeds of some of the $400 billion of 
municipal bonds they sell annually and on the interest-rate swaps 
designed to guard against swings in borrowing costs, authorities have 
said. Financial advisers are hired to solicit bids for the investments 
and to determine if their government clients pay fair rates in swaps, 
which are unregulated instruments not traded on exchanges.
    States ``almost have no choice but to join in because it involves 
their towns and cities and maybe even the states themselves,'' said 
Christopher ``Kit'' Taylor, the former executive director of the 
Municipal Securities Rulemaking Board, the municipal bond industry 
regulator. ``They're sitting there saying this is a situation where we 
may have been taken.''
Continuing Probes
    Christine Gasparac, a spokeswoman for California Attorney General 
Jerry Brown, confirmed California's participation. She declined to 
comment further. The probe comes as the most populous U.S. state and 
the biggest issuer of municipal debt struggles to close a record $42 
billion deficit through next year and faces credit rating cuts on $67 
billion of debt.
    Connecticut has had a continuing probe. ``Our investigation is 
active and ongoing,'' Connecticut Attorney General Richard Blumenthal 
said in a statement.
    Florida Attorney General Bill McCollum has sent out 38 subpoenas 
asking firms for information on sales of derivatives, including 
guaranteed investment contracts, where governments place money raised 
from bond sales until it is needed for projects, said Sandi Copes, a 
spokeswoman for McCollum.
    Among the documents Florida requested were bids and communications 
between the firms and financial advisers related to the purchase or 
sale of municipal derivatives, according to the subpoena.
    Copes declined to comment further, citing the pending 
investigation.
    U.S. prosecutors and the Securities and Exchange Commission have 
searched for more than 2 years for evidence of collusion between banks 
and brokers to overcharge cities, states and local government agencies.
Winning Leniency
    In February 2007, Charlotte, North Carolina-based Bank of America 
Corp. was granted leniency by the Justice Department for its 
cooperation in a national investigation of bid-rigging and price fixing 
involving municipal derivatives.
    In exchange for voluntarily providing information and offering 
continuing cooperation, the Justice Department agreed not to bring 
criminal antitrust charges against the bank.
    Derivatives are contracts whose value is derived from assets 
including stocks, bonds, currencies and commodities, or from events 
such as changes in interest rates or the weather.
    ``This is a trillion-dollar market, and this goes back to the 
1980s,'' said Michael D. Hausfeld, an antitrust lawyer representing 
municipalities, including Fairfax County, Virginia, in a class-action 
case against 30 banks.
Rigged Bids
    Investigators are looking into whether bidding for guaranteed 
investment contracts was rigged. U.S. Internal Revenue Service rules 
require that the agreements be awarded by competitive bidding from at 
least three banks.
    Eight California municipalities, including Los Angeles, Fresno and 
San Diego County, filed civil class-action, or group lawsuits. The 
suits, most of which were consolidated with others in U.S. District 
Court in New York City, allege that banks colluded by deliberately 
losing bids in exchange for winning one in the future, providing so-
called courtesy bids, secretly compensating losing bidders and allowing 
banks to see other bids.
    Brokers participated in the collusion by facilitating communication 
among banks and sharing in illegal profits, the civil class-action 
suits allege.
    Three advisers to local governments, CDR Financial Products Inc., 
Sound Capital Management Inc. and Investment Management Advisory Group 
Inc., were searched by the FBI in November 2006. More than a dozen 
banks and insurers were subpoenaed and former bankers at New York-based 
JPMorgan Chase & Co., Bear Stearns & Cos. and UBS AG of Zurich were 
advised over the past year that they may face criminal charges.
New Mexico
    Now, Federal prosecutors are investigating whether New Mexico 
Governor Bill Richardson's Administration steered about $1.5 million in 
bond advisory work to CDR, which donated $100,000 to Richardson's 
political committees.
    CDR also advised Jefferson County, Alabama, on more than $5 billion 
of municipal bond and derivative deals. A combination of soaring rates 
on the bonds and interest-rate swaps is threatening the county with a 
bankruptcy that would exceed Orange County, California's default in 
1994. Jefferson County paid JPMorgan and a group of banks $120.2 
million in fees for derivatives that were supposed to protect it from 
the risk of rising interest rates.
    Those fees were about $100 million more than they should have been 
based on prevailing rates, according to James White, an adviser the 
county hired in 2007, after the SEC said it was investigating the 
deals.
    CDR spokesman Allan Ripp has said the company stands by the pricing 
of the swaps and said White's estimates were incorrect because they 
didn't take into account the county's credit profile, collateral 
provisions between the county and the banks and the precise time of the 
derivative trades.
    To contact the reporters on this story: Martin Z. Braun in New York 
at [Redacted].

Last Updated: January 23, 2009 09:34 EST 

    The Chairman. Thank you, Mr. Concannon.
    Mr. Hale, welcome to the Committee.

STATEMENT OF WILLIAM M. HALE, SENIOR VICE PRESIDENT, GRAIN AND 
  OILSEED SUPPLY CHAIN NORTH AMERICA, CARGILL, INCORPORATED, 
   WAYZATA, MN; ACCOMPANIED BY DAVID DINES, PRESIDENT, RISK 
               MANAGEMENT, CARGILL, INCORPORATED

    Mr. Hale. Chairman Peterson, Ranking Member Lucas, 
Committee Members, thank you. My name is Bill Hale. I have been 
in the grain merchandising business with Cargill for 35 years. 
I am joined this morning by David Dines, who has managed our 
OTC business for the past 15 years. As a merchandiser and 
processor of commodities, the company relies heavily upon 
efficient and well-functioning futures markets.
    First, I would like to thank the Chairman for holding this 
hearing and for his willingness to listen and address some of 
our concerns. We appreciate the changes made in the draft to 
better accommodate highly customized risk management products.
    Cargill encourages policymakers to develop regulatory 
systems that foster efficient, well-functioning, exchange-
traded and OTC markets for agriculture and energy products. 
This can best be achieved by establishing better reporting and 
transparency for market participants, establishing and ensuring 
enforceable position limits.
    The existing draft of the Derivatives Markets Transparency 
and Accountability Act takes several positive steps, especially 
in the area of reporting, which will enhance the ability of the 
regulator to properly monitor market activities.
    However, the draft bill has two areas of concern. Section 
6, position limits which are not constructed in the same manner 
for exchange-traded and OTC markets. This can be addressed by 
modifying how position limits are structured. This is not a 
question of whether they should apply.
    To put this in perspective, think in terms of highway speed 
limits. They apply to individual drivers. You do not send a 
car-maker a ticket when someone speeds. The same structure 
currently applies in the Chicago futures markets, and the same 
structure should apply in the OTC market.
    The other area of concern is section 13, mandatory 
clearing, which will stifle activity in the OTC market and 
reduce hedging opportunities in the agricultural and energy 
markets. This can be addressed by increased reporting 
requirements for OTC providers.
    While Cargill supports better reporting, transparency, and 
enforceable position limits, we urge caution and restraint for 
policymakers. We believe there is real danger in treating all 
over-the-counter products across all asset classes the same.
    In addition, the changes needed to improve some commodity-
specific exchange-traded markets, particularly wheat and 
cotton, are often contract issues that have to be resolved 
between the exchanges and the market participants. Legislative 
measures are poor instruments to resolve these specific issues.
    Products provided by the OTC markets help hedgers, such as 
food, feed, industrial companies, meet risk management needs 
with tailored alternatives. Too often it is thought that the 
OTC market is solely used by speculators. However, it is 
critical to note that the majority of our OTC activity is for 
commercial and producer hedgers seeking tailored management 
solutions.
    Most critically during this unprecedented volatility, 
systemic risk was avoided because of the availability of both 
OTC and exchange-based hedging tools. Given the stress on the 
markets, some weaknesses were exposed, and the bill seeks to 
address those areas. But much of the basic functionality of the 
agriculture and energy markets performed well.
    It is important to remember that the dramatic volatility 
and price rise in 2008 was influenced by many variables. With 
strong fundamentals, commodity markets attracted many 
participants, both hedgers and speculators.
    Regarding section 6, Cargill supports enforceable position 
limits for noncommercial participants. However, as it was 
designed in the draft bill, position limits are not applied in 
the same manner for the OTC market as they are in exchange-
traded markets. They should be structured in a similar manner 
for both markets. The draft bill seeks to apply the same 
position limit to the OTC provider as it does to the 
noncommercial participant. This is too restrictive to the OTC 
provider, since its role is to serve as an intermediary to more 
than one customer. This restriction will limit the size of the 
OTC market beyond the intended noncommercial position limits. 
The Committee will be able to achieve its objective of ensuring 
position limits in OTC transactions by applying position limits 
to the noncommercial participants.
    For section 13, we do not believe that mandatory clearing 
is needed. The stated benefits of central clearing are better 
transparency, reporting, and mitigation of counterparty risk. 
This can be accomplished efficiently by having standardized 
reporting requirements to the CFTC. The CFTC would have the 
ability to investigate and curtail any OTC customer whose 
position they believe is to large for the underlying commodity 
market.
    Centralized clearing has a role and should be encouraged 
for financially weaker market participants. However, 
financially strong food companies, industrials, commercials, 
and producers should have the flexibility to negotiate credit 
terms. Removing this flexibility from both simple and tailored 
OTC products will greatly reduce hedging activity through the 
working capital requirements of margin. Changes to the current 
system would be occurring at a time when liquidity and credit 
are already constrained, and at a time when hedging should be 
encouraged.
    Agriculture and energy OTC providers for many years have 
effectively used collateralized margining agreements and other 
credit support mechanism to manage credit and market exposures. 
This system works very well.
    It was simple OTC swaps on the grains that helped enable 
Cargill and other grain buyers to reopen deferred grain 
purchases from the farmer during 2008. Had the bill been in 
place in its current form, Cargill and other grain buyers would 
have been unable to use simple swaps to mitigate the margin 
requirements imposed on futures hedges. As a consequence, 
farmers would have been further burdened by the lack of pricing 
and liquidity for their crops.
    While the bill currently has provisions that allow for 
exceptions to centralized clearing for highly customized 
transactions, it is a little unclear to us what will and will 
not qualify for this exception. It is critical that no changes 
be made that would inhibit customized hedges, as this would 
also significantly reduce prudent hedging among market 
participants.
    If you think of the futures contract as one type of 
product, Cargill has over 130 different types of OTC products. 
The hedging customer can choose to further tailor the 
protection time frame, price level, and transaction size. Given 
this, no two 0TC transactions are identical, which is why 
centralized clearing is problematic. Clearing organizations do 
not have the systems and processes necessary to value and clear 
a wide range of products with a high degree of customization.
    In conclusion, Cargill appreciates the work of the House 
Agriculture Committee, ensuring that both exchange-traded and 
OTC markets perform well. These markets provide critical 
functions. This past year was clearly a volatile and difficult 
time for the commodity markets. Steps can and should be taken 
to improve market transparency and reporting, as well as 
ensuring that position limits are effectively enforced.
    We have serious concerns about sections 6 and 13 in the 
draft legislation, but we are confident that we can work 
constructively with Members of the Committee to develop policy 
alternatives that will help ensure the integrity of the 
markets.
    Thank you.
    [The prepared statement of Mr. Hale follows:]

Prepared Statement of William M. Hale, Senior Vice President, Grain and 
 Oilseed Supply Chain North America, Cargill, Incorporated, Wayzata, MN
    My name is Bill Hale, Senior Vice President, Grain and Oilseed 
Supply Chain North America. I am testifying on behalf of Cargill, 
Incorporated and have been in the grain merchandising business for 35 
years. I am also joined this morning by David Dines, President of 
Cargill Risk Management.
    Cargill is an international provider of food, agricultural, and 
risk management products and services. As a merchandiser and processor 
of commodities, the company relies heavily upon efficient and well-
functioning futures markets. Cargill is also active in the energy 
markets, offering risk management products and services to commercial 
customers.
    Cargill encourages policymakers to develop regulatory systems that 
foster efficient, well-functioning exchange-traded and over-the-counter 
markets for agricultural and energy products.
    This can be best achieved by:

   Establishing better reporting and transparency for market 
        participants.

   Establishing and ensuring enforceable position limits.

    This past year was a period of remarkable volatility driven by many 
factors and, by large measure, the agriculture and energy commodity 
markets responded appropriately.
    The existing draft of the Derivatives Markets Transparency and 
Accountability Act of 2009 takes several positive steps, especially in 
the area of reporting which will enhance the ability of the regulator 
to properly monitor market activities. However, the draft bill has two 
areas of concern:

   Section 6: Position limits, which are not constructed in the 
        same manner for exchange-traded and OTC markets.

     This can be addressed by modifying how the position 
            limits are structured. This is not a question of whether 
            they should apply.

   Section 13: Mandatory clearing, which will stifle activity 
        in the OTC market and reduce hedging opportunities in the 
        agricultural and energy markets.

     This can be addressed by increased reporting 
            requirements for OTC providers and segmenting credit 
            default swaps from traditional agriculture and energy 
            contracts.

    While Cargill supports better reporting, transparency and 
enforceable position limits, we urge caution and restraint for 
policymakers. The agricultural and energy over-the-counter markets are 
not the source of systemic risk and abuse that the credit default swap 
market has been. We believe there is real danger in treating all over-
the-counter products across all asset classes the same.
    In addition, the changes needed to improve some commodity-specific 
exchange-traded markets, particularly wheat and cotton, are very often 
contract issues that have to be resolved between the exchanges and the 
market participants. A well-informed regulator can be helpful in making 
sure balanced decisions are made that ensure contract functionality and 
market integrity, but broad legislative measures are poor instruments 
to resolve these specific issues.
Role of Commodity Futures Markets and Over-the-Counter Markets
    The objective of a commodity futures market is to provide a price 
discovery mechanism and allow for effective risk transfer. For a 
commodity futures market to meet this objective, there must be both 
convergence with the futures price relative to the underlying cash 
value of the commodity at the time of delivery and a balanced range of 
market participants to provide adequate liquidity and efficiency.
    In addition to buyers and sellers with a physical interest in the 
underlying commodity, speculators also play a vital role in enhancing 
liquidity and futures contract performance. In effect, they help bridge 
the gap between buyers and sellers and ensure that contracts are 
quickly filled with the least possible transaction costs.
    Beginning with farmers and other commodity producers, and extending 
all the way through the supply chain to end-users, it is critical to 
have well-performing futures markets. Futures products allow farmers to 
know what their product is worth and to better manage their risks by 
setting a price for the commodity that is close to their actual 
delivery time. For consumers or processors, the same is true in 
allowing them to hedge their risks and gain greater certainty over 
their costs.
    Products provided by the over-the-counter (OTC) markets help 
hedgers meet risk management needs with tailored alternatives that 
cannot realistically be provided by traditional commodity futures and 
options markets. Too often is it thought that the OTC market is solely 
used by speculators, however it is critical to note that a majority of 
our OTC activity is for commercial and producer hedgers seeking risk 
management solutions tailored for their business needs.
Unprecedented Commodity Market Volatility During 2008
    During 2008, we experienced an unprecedented increase in commodity 
prices, only to be immediately followed by a decline of the same 
historical magnitude. This in itself has been tough for market 
participants to bear, but we now know that this has been followed by 
one of the worst economic crises in 80 years.
    In the world of risk management, we often talk of stress events and 
this was one of epic proportions. No risk manager could have ever 
contemplated what the markets have just gone through. I mention this 
because if there was ever a test for the agricultural and energy 
futures and over-the-counter markets it was these past twelve months.
    Fortunately, in many ways, these markets performed well as 
demonstrated by limited credit issues and limited contract defaults.
    Most critically, during this unprecedented volatility, systemic 
risk was avoided because of the availability of both OTC and exchange-
based hedging tools. Given the stress on the markets, some weaknesses 
were exposed and the bill seeks to address those areas, but much of the 
basic functionality of the agriculture and energy markets performed 
well.
Fundamental Factors Influencing Market Behavior and Speculation
    It is important to remember that the dramatic volatility and price 
rise in 2008 was influenced by many variables. Ending stocks for many 
of the key commodities were tight. In wheat, for example global 
supplies had been reduced by 2 years of major drought in Australia, a 
major wheat exporter.
                Global stocks of grain and key oilseeds

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


        Source: USDA. Foreign Agricultural Service.

    The ethanol mandate increased demand for corn. In response, 
producers planted more corn acres during the 2007 crop year and fewer 
soybeans, resulting in a very tight carryout balance for soybeans prior 
to the 2008 harvest.
    Also on the demand side, projections for continued growth in China, 
India and much of the developing-world showed growing needs for many of 
the basic agricultural and energy commodities. These factors were 
widely known within the farming, trading, processing, and investing 
communities.
                          USDA Ag Outlook 2008
                        Projected Demand Growth
                               1996 = 100

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


        Source: USDA.

    With strong fundamentals, commodity markets attracted many 
participants, both hedgers and speculators, who believed commodity 
prices would rise. These fundamentals did not only attract capital to 
futures markets, but also attracted resources toward physical commodity 
production. Land costs increased for good quality farmland and 
producers stepped up investments in production technology through 
equipment, seeds and fertilizer.
    It is also important to note that even exchange-traded markets with 
no index fund participation also experienced extreme volatility this 
year. The volatility and price movements of the Hard Red Spring Wheat 
contract traded at the Minneapolis Grain Exchange were especially 
dramatic. Prices rallied 500% from May 2007 through February 2008, 
reaching a high of $25 per bushel.
Derivatives Markets Transparency and Accountability Act of 2008
    Cargill supports many of the components of the draft bill before 
the Committee today and appreciates the work of the Chairman. The bill 
would improve reporting and transparency. However, we are concerned 
with two specific areas under consideration by the Committee:

   Section 6, regarding how position limits may be applied to 
        OTC product providers.

   Section 13, regarding mandatory clearing of OTC transactions 
        through a derivative clearing organization.

    Both provisions have negative unintended consequences.
Section 6: Application of Position Limits
    Cargill supports enforceable position limits for noncommercial 
participants. However, as designed in the draft bill, position limits 
are not applied in the same manner for the OTC market as they are in 
the exchange-traded markets. They should be structured in a similar 
manner for both markets.

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]



    In exchanged traded markets, the clearing broker serves as an 
intermediary or aggregator of positions, just like the dealer does in 
the OTC market. Position limits are applied to noncommercial 
participants in exchange-traded markets and not to the clearing broker. 
Limits in the OTC market should be categorically applied in the same 
manner, only to the noncommercial participant and not the OTC provider.
    The draft bill seeks to apply the same position limit to the OTC 
provider as it does to the noncommercial participant. This is too 
restrictive to the OTC provider since its role is to serve as an 
intermediary to more than one customer. This restriction would limit 
the size of the OTC market beyond the intended noncommercial position 
limits.
    The Committee will be able to achieve its objective of ensuring 
position limits in OTC transactions by applying position limits to only 
the noncommercial participants. Addressing this issue in this manner 
will ensure enforceable position limits and continue the functionality 
of this segment of the market.
Section 13: Clearing of Over-the-Counter Transactions
   Substantial benefits can be achieved through better 
        reporting by OTC providers.

   Segment the OTC market to focus on areas with the greatest 
        challenges.

   Tailored risk management OTC contracts for hedgers cannot be 
        cleared.

   Standardized swaps convey substantial benefits to a wide 
        range of market participants and these benefits will be lost if 
        clearing is mandatory.

    A stated benefit of central clearing is better transparency and 
data reporting. However, this is a restrictive and expensive means for 
collecting data about OTC market positions and participants. Cargill 
believes that this can accomplished efficiently by having standardized 
reporting requirements to the CFTC by the OTC provider community. Other 
sections of the draft bill directly address the issue of better data 
and reporting, and will achieve the needs of the Commodity Futures 
Trading Commission and Congress.
    One solution would be to have the CFTC restrict OTC activity to 
approved OTC providers. These approved OTC providers would have a 
reporting requirement to the CFTC in a standardized format and on a 
regular basis of all OTC transactions by customer that exceed a certain 
size threshold. The CFTC would have the ability to investigate and 
curtail any OTC customer whose position they believe is too large for 
the underlying commodity markets. The CFTC has this existing authority 
for investigating customer positions at the clearing broker on listed 
futures and it works well.
    Another stated benefit of centralized clearing is the mitigation of 
counterparty credit risk, since it requires both initial margin and the 
daily settlement or margining of 100% of the mark-to-market differences 
between the two parties. While centralized clearing has a role and 
should be encouraged for financially weaker market participants, 
financially strong food companies, industrials, commercials and 
producers should have flexibility to negotiate their own credit terms.
    As they stand today, the agriculture and energy OTC markets allow 
for efficient and prudent extension of credit by the OTC provider to 
financially strong hedging customers. Removing this flexibility for 
both simple and tailored OTC products will greatly reduce hedging 
activity due to the working capital requirements of margining. Changes 
to the current system would be occurring at a time when liquidity and 
credit are already critically constrained, and at a time when hedging 
should be encouraged, given the volatility in today's commodity 
markets.
    Agricultural and energy OTC product providers for many years have 
effectively used margining agreements and other credit support 
mechanisms to manage credit exposures. OTC product providers, including 
Cargill, have developed processes and built systems that enable us to 
value our customers' OTC positions and send position statements daily 
with updated and transparent product valuations. Based upon these 
valuations and statements, the parties pay or receive margin collateral 
daily once a credit threshold is reached. This system works very well. 
Again, if there was ever a test for this it was during the past year.
    Changing this flexibility in setting credit terms will have the 
perverse effect of reducing the hedging activity across financially 
stronger customers since they are the ones currently receiving 
margining credit from the OTC provider community. Financially weaker 
customers are either not receiving the margining credit from the OTC 
provider or they are already using futures because it is their only 
option. It must be recognized that centralized clearing penalizes 
participants with strong financial positions.
Mandatory Clearing Can Impact Producer Pricing Opportunities
    Within the agriculture and energy markets, simple OTC swaps convey 
many benefits through the flexibility in setting credit terms. In the 
physical grain business, cash flow mismatches exist for grain buyers 
since they are required to meet the daily margining requirements of 
futures hedges and are not able to collect an offsetting margin payment 
from the farmer since physical grain purchase contracts are typically 
not margined with the farmer. Last Spring, many U.S. grain buyers, 
including Cargill, curtailed their deferred purchases of grain from 
farmers because of the historic run-up in commodity prices and the 
significant amounts of working capital that were needed for operational 
inventories and to fund the margin requirements of the underlying 
futures hedges for deferred contracted grain. This was an extremely 
difficult time for farmers and for grain buyers.
    Critically, it was simple OTC swaps on the grains that helped 
enable Cargill and other grain buyers to reopen deferred purchases of 
grain from the farmer during 2008. Using simple OTC swaps, grain buyers 
were able to move their hedging for contracted bushels from futures to 
OTC swaps with OTC providers that put in place margin credit thresholds 
on the mark-to-market exposure. The bill in its current form only 
grants an exception to centralized clearing for highly customized 
swaps, but not for simple swaps. Had the bill been in place in its 
current form, Cargill and other grain buyers would not have been able 
to use simple swaps to help mitigate the margin requirements imposed on 
futures hedges. As a consequence, farmers would have been further 
burdened by a lack of pricing and liquidity for their crops.
Mandatory Clearing Is Extremely Difficult for Customized Products
    While the bill currently has provisions that allow for exceptions 
to centralized clearing for highly customized transactions, it is 
unclear what will and will not qualify for this exception. It is 
critical that changes are not made that would in any way inhibit 
customized hedges, as this would also significantly reduce prudent 
hedging among market participants.
    A key attribute of the OTC markets in agricultural and energy is 
the broad menu of product choices, as well as specific tailoring of the 
hedging instrument to precisely meet the hedger's needs. The advantages 
of product choices and tailoring are that they deliver both a more 
efficient hedge and a more cost-effective hedge because the hedger is 
not paying for something that they do not need. It also allows for 
diversification of products, which is so critical in today's 
marketplace. OTC product choices include protection size, protection 
periods, protection levels, and types of protection.
    If you think of a futures contract as one type of product, Cargill 
has over 130 different types of OTC products that we are offering our 
hedging customers. From these 130 different product types, the hedging 
customer can choose to further tailor the protection timeframe, price 
level and transaction size. Given this, no two OTC transactions are 
identical, which is why centralized clearing is problematic. Clearing 
organizations do not have the systems and processes necessary to value 
and clear a wide range of products with a high degree of customization. 
If this were the case, tailored risk management services would have 
become available on exchanges years ago.
    OTC providers such as Cargill create new products by having strong 
customer relationships, listening to and understanding our customers' 
commodity risks, and developing products to address these risks. This 
requires a significant investment of time, human and technological 
resources, and financial capital. Centralized clearing will put 
intellectual property in the public domain immediately which will 
eliminate any economic incentive that OTC providers have for new 
product development. Now more than ever, customers need new and better 
products to help them hedge.
Summary
    Cargill appreciates the work of the House Agriculture Committee in 
ensuring that both the exchange-traded and OTC market perform well. 
These markets provide critical functions in allowing open price 
discovery and enhance risk management opportunities. Well performing 
markets benefit all participants across the supply chain.
    This past year was clearly a volatile and difficult time for the 
commodity markets. Steps can and should be taken to improve market 
transparency and reporting, as well as ensuring that position limits 
are effectively enforced.
    We have serious concerns about sections 6 and 13 in the draft 
legislation, but we are confident that we can constructively work 
together with Members of this Committee to develop policy alternatives 
that will help ensure the integrity of the markets, while minimizing 
the unintended consequences.
    Thank you for the opportunity to testify before the Committee today 
and we look forward to working together as the legislation continues to 
develop.

    The Chairman. Thank you very much, Mr. Hale, for your 
testimony.
    Mr. Cooper, welcome to the Committee.

         STATEMENT OF KARL D. COOPER, CHIEF REGULATORY
   OFFICER, NYSE LIFFE, LLC, NEW YORK, NY; ON BEHALF OF NYSE 
                            EURONEXT

    Mr. Cooper. Chairman Peterson, Ranking Member Lucas, and 
Members of the Committee, I am Karl Cooper. I am the Chief 
Regulatory Officer of NYSE Liffe. NYSE Liffe is the new futures 
exchange launched by NYSE Euronext just this past September. 
All in all now, NYSE Euronext operates seven cash equity 
exchanges and seven derivatives exchanges in five different 
countries around the world.
    It is a pleasure to appear before you today to share NYSE 
Euronext's views and thoughts on the ``Derivatives Markets 
Transparency and Accountability Act.'' We strongly support the 
two major purposes of the proposed legislation: to support the 
integrity of U.S. contract markets and to promote the 
transparency of the over-the-counter derivatives market.
    We do have to share with you, though, our reservations that 
many provisions of the bill may not be the most effective means 
to achieve your ends. That is because the bill tends to run 
counter to the international cooperative approach that the CFTC 
has championed over the past many years, and has led to some 
great successes. Namely, it has allowed U.S. market 
participants to have access to foreign markets, and it has also 
allowed U.S. exchanges to compete globally.
    I would like to focus my remarks, though, on three specific 
provisions of the bill: first, section 3, which deals with the 
direct regulation of foreign exchanges; section 13 of the bill, 
which mandates centralized clearing; and finally, section 16.
    With regard to foreign exchanges, we are concerned that, 
without evidence that the CFTC has been unable to obtain 
through cooperative means critical trade information, that the 
mere mandate of that by the Congress could have regulatory 
retaliatory consequences by foreign regulators. That would not 
serve Congress's purpose. It would not serve U.S.-based 
exchanges that are trying to compete, such as ourselves, 
globally. And it would hinder our ability to bring new 
exchange-traded and centrally cleared solutions that are 
desperately needed now in light of the current market turmoil.
    With regard to section 13, we have a similar concern around 
the international impact, potentially, of the legislation. But 
let me first say that, obviously, we support the centralized 
clearing of OTC derivatives. We have established and launched 
the first CDS clearing solution this past December 22nd in our 
London exchange, Liffe, with our partner, LCH.Clearnet. But the 
legislation, as drafted, would not allow foreign MCOs that are 
regulated by an acceptable foreign regulator to play that 
clearing function, at least for commodities outside of excluded 
commodities.
    Second, we would suggest that the exemptive provision in 
section 13 should be broader to give the CFTC the ability to 
work through the complex issues of bringing the OTC derivative 
products into a centralized clearing format, with the 
flexibility around the types of products that should go into 
the clearinghouse.
    With regard to section 16, which limits allowable CDS to 
only those transactions where the participant has the 
underlying risk, we think that this restrictions goes too far. 
Of course the CDS marketplace needs additional enhanced 
regulation. There must be controls for systemic risk. There 
must be monitoring for fraud, abusive and manipulative 
activity. But simply banning all but the limited types of 
transactions that the bill currently would allow would 
eliminate market making, would eliminate index trading, and 
would basically eliminate speculation.
    The Commodity Exchange Act has always allowed for 
speculation, but it has not allowed excessive speculation. So, 
that is where the balance could best be struck. And, again, 
without coordinating our efforts with our international 
regulatory colleagues, we would have the effect of pushing the 
business offshore, which would not serve U.S. citizens and the 
U.S. economy in the long run.
    Thank you very much for inviting me to appear before you 
today. And I would be happy to answer any questions you might 
have.
    [The prepared statement of Mr. Cooper follows:]

 Prepared Statement of Karl D. Cooper, Chief Regulatory Officer, NYSE 
          Liffe, LLC, New York, NY; on Behalf of NYSE Euronext
    Chairman Peterson, Ranking Member Lucas, Members of the Committee. 
My name is Karl Cooper, and I am the Chief Regulatory Officer of NYSE 
Liffe, LLC (``NYSE Liffe''), a subsidiary of NYSE Euronext. NYSE Liffe 
is a relatively new exchange, having been designated by the Commodity 
Futures Trading Commission (``Commission'') as a contract market in 
August 2008. I am pleased to appear this morning on behalf of NYSE 
Euronext and its affiliated exchanges as the Committee considers the 
Derivatives Markets Transparency and Accountability Act of 2009.
    NYSE Euronext operates the world's largest and most liquid exchange 
group. NYSE Euronext brings together seven cash equities exchanges in 
five countries and seven derivatives exchanges. In the United States, 
we operate the New York Stock Exchange, NYSE Arca, NYSE Alternext 
(formerly the American Stock Exchange), and NYSE Liffe. In Europe, we 
operate five European-based exchanges that comprise Euronext--the 
Paris, Amsterdam, Brussels and Lisbon stock exchanges, as well as the 
Liffe derivatives markets in London, Paris, Amsterdam, Brussels and 
Lisbon. We also provide technology to more than a dozen cash and 
derivatives exchanges throughout the world. NYSE Euronext's geographic 
and product diversity has helped to inform our analysis of the bill you 
are considering today.
    NYSE Euronext supports the essential purposes of the Committee 
draft legislation: (i) enhancing the integrity of U.S. contract 
markets; and (ii) bringing transparency and risk reduction to the over 
the counter (``OTC'') derivatives markets. Nonetheless, we are 
concerned that the breadth of the bill may have unintended 
consequences. Our comments today focus on those provisions of the bill 
that we believe could inhibit the ability of U.S. exchanges to compete 
globally and deny U.S. market participants access to critical risk 
management products.
    The Commission, with the encouragement and active support of 
Congress and market participants, has long played an active role in 
developing standards of regulatory best practices and strengthening 
customer and market protection through international cooperation 
including, in particular, information sharing among regulatory 
authorities. The Commission has been an active participant in the 
meeting of the International Organization of Securities Commissions 
(``IOSCO'') and, more recently, has joined with the Committee of 
European Securities Regulators (``CESR'') to consider ways to 
facilitate the conduct and supervision of international business. In 
addition, the Commission is party to a number of bilateral and 
multilateral memoranda of understanding, each of which is designed to 
assure timely access to critical market information.
    Similarly, the regulatory relief that the Commission has provided 
to foreign exchanges that seek to do business with U.S. market 
participants is predicated on a Commission finding that the exchange is 
subject to a comprehensive regulatory program that is comparable, 
though not identical, to the Commission's own regulatory program. As 
important, such relief is subject to extensive terms and conditions. In 
particular: (i) satisfactory information sharing arrangements must be 
in place among the Commission, the foreign exchange, and the foreign 
exchange's regulatory authority; and (ii) the foreign exchange and each 
member of the exchange that conducts business under the relief must 
consent to the Commission's jurisdiction. In all cases, the Commission 
retains authority to modify, suspend, terminate or otherwise restrict 
the terms of any relief that it may provide.
    By any measure, we believe the Commission's approach to 
international regulation has been a success, assuring the protection of 
customers and the integrity of the exchange-traded markets, while 
facilitating the development of global derivatives markets. A critical 
key to this success has been the Commission's willingness to cooperate 
with those regulatory authorities in foreign jurisdictions that share a 
common regulatory philosophy. A different regulatory approach, one that 
imposed our regulatory structure on any foreign exchange or 
intermediary that sought to do business with U.S. market participants, 
might well have led to regulatory retaliation, causing the global 
competitiveness of U.S. exchanges to suffer.
    As the Committee continues its consideration of the Derivatives 
Markets Transparency and Accountability Act of 2009, we ask the 
Committee to ensure that this legislation will in no way weaken the 
spirit of international cooperation that has played such an important 
role in the growth of the regulated derivatives markets, and which the 
Commission has so successfully fostered.
    Section 3. Transparency of Off-Shore Trading. It is the fear of 
regulatory retaliation that underlies our concern with the provisions 
of section 3 of the Committee draft legislation. We appreciate the 
Committee's desire that the Commission have access to critical trade 
information relating to contracts listed for trading on foreign 
exchanges that settle to a contract listed for trading on a U.S. 
contract market. We also recognize that this section is narrowly 
written to target a specific perceived problem. Nonetheless, as 
written, section 3 appears to subject the foreign exchange to the 
direct supervision of the Commission.
    As discussed above, the Commission has full authority through its 
information sharing arrangements with a foreign exchange authorized to 
permit direct access and its home country regulator to obtain the type 
of information described. Further, the Commission can rescind this 
authorization at any time, if the requested information is not 
provided. In the absence of evidence that the Commission has been 
unable to obtain required trade information through cooperative means, 
we believe section 3 sets an unnecessarily confrontational tone and 
risks setting off a chain reaction of retaliatory measures.
    Section 13. Clearing of OTC Derivatives. For many of the same 
reasons, we are troubled by the provisions of section 13, which would 
require that, except for OTC derivatives instruments on ``excluded 
commodities,'' all OTC derivatives must be cleared through a 
derivatives clearing organization registered with the Commission. To be 
clear, NYSE Euronext strongly supports legislative action that would 
encourage and facilitate the clearing of OTC derivatives instruments.
    In this regard, we note that, on December 22, our London 
derivatives exchange, Liffe, acting in cooperation with LCH.Clearnet 
Ltd., launched the first clearing solution for the processing and 
clearing of credit default swaps (``CDSs'') based on certain credit 
default indexes. Shortly thereafter, we received necessary exemptions 
from the Securities and Exchange Commission to offer CDS clearing to 
qualified U.S. customers. (Both Liffe and LCH.Clearnet are supervised 
by the U.K. Financial Services Authority.)
    Nonetheless, we believe section 13 goes too far in seeking to force 
a clearing solution for OTC derivatives instruments limited to DCOs. We 
are especially concerned that this section apparently would no longer 
permit a multilateral clearing organization supervised by a foreign 
financial regulator that the Commission determines ``satisfies 
appropriate standards'' to clear OTC derivatives instruments, as is 
currently provided under section 409 of the FDIC Improvements Act of 
1991.
    Liffe expects to receive authorization shortly from the Financial 
Services Authority to act as a self-clearing recognized investment 
exchange. Among other services, Liffe anticipates acting as a central 
clearing counterparty for OTC derivatives instruments. Under the 
provisions of section 13, however, Liffe could not offer these services 
to U.S. persons (except with respect to excluded commodities), unless 
it first applied for registration with the Commission as a DCO. Such 
registration would subject Liffe to duplicative and, in some instances, 
potentially conflicting regulatory requirements.
    The OTC derivatives market is a global market, which demands a 
global response. An American solution to clearing OTC derivatives 
instruments is no less palatable than a European solution. Yet, this 
legislation would lend support to those in Europe who are urging such 
action.
    Separately, we believe the standards pursuant to which the 
Commission would be able to grant an exemption from clearing are too 
narrow. Fully implementing a clearing solution for OTC derivatives will 
be very difficult. The Commission should have broader authority to 
grant exemptions where appropriate.
    Section 16. Credit Default Swaps. With all of the negative 
publicity that credit default swaps have received over the past several 
months, we appreciate the Committee's concern and its desire to 
restrict in some way the volume of trading in these instruments. But 
the fact remains that credit default swaps are a vitally important tool 
in managing risk. In difficult economic times, the diversification of 
risk, if used properly, will continue to add value to the marketplace.
    We believe section 16 goes too far in seeking to reduce any 
perceived financial risk in the trading of CDS. Its provisions would 
effectively close the market in the U.S., driving the business 
overseas. This is because it is impossible to conceive of a situation 
in which both parties to a CDS would experience a financial loss if an 
event to a credit default swap occurs. By definition, one party must 
benefit from such a trade. The market for CDS, no less so than the 
market for exchange-traded futures, needs speculators if it is to 
maintain sufficient depth. Without the liquidity that speculators bring 
to the market, price spreads would widen, severely reducing, if not 
eliminating, its value.
    Moreover, we are concerned that the provisions of section 16 would 
prohibit swaps on credit default indexes. We believe it is unlikely 
that institutional participants that use these indexes to hedge their 
securities portfolios hold all of the securities that comprise the 
index. Nonetheless, these swaps are more liquid and are easier to trade 
than CDSs on a single name security. Although not perfect, they provide 
a sufficient hedge at a lower cost than a series of CDSs on single 
names.
    Conclusion. Thank you, again, for the opportunity to appear before 
the Committee today. I would be happy to respond to any questions you 
may have.

    The Chairman. Thank you very much, Mr. Cooper.
    Mr. Cicio, welcome to the Committee.

   STATEMENT OF PAUL N. CICIO, PRESIDENT, INDUSTRIAL ENERGY 
             CONSUMERS OF AMERICA, WASHINGTON, D.C.

    Mr. Cicio. Good afternoon, Mr. Chairman, Ranking Member 
Lucas, and Members of the Committee. My name is Paul Cicio. I 
am the President of the Industrial Energy Consumers of America, 
thank you for the opportunity to testify here.
    IECA member companies are exclusively from the 
manufacturing sector and unique, in that our competitiveness is 
dependent upon the cost of energy.
    Mr. Chairman, we are very grateful for the attention this 
Committee is giving to this incredibly important issue. And 
this legislation is an excellent start to addressing excessive 
speculation in commodity markets. Specifically, excessive 
speculation in the first half of 2008 cost consumers $40.4 
billion, and that is just for natural gas.
    IECA supports most of the draft as it is currently written, 
so, with your permission, I will just address those areas where 
we have some recommendations or concerns.
    Point number one: section 6 creates an energy and 
agriculture position limit advisory group. It is essential that 
the advisory group be numerically weighted in favor of physical 
producers and consumers who are bona fide hedgers, and that its 
governance favor the consumer to ensure the best interests of 
those who are paying the bill, the consumer.
    Point number two: We strongly encourage the legislation to 
require aggregate position limits. Your draft bill proposes 
Federal speculation limits on the regulated markets and 
eliminates the swap loophole by limiting hedging exemptions to 
bona fide hedgers who would have physical risk. However, Mr. 
Chairman, the draft bill only calls for studying speculative 
position limits on the over-the-counter market.
    In order to prevent speculators from moving between markets 
to evade speculation limits, speculative position limits need 
to be aggregated to cover designated contract markets, the 
exempt commercial markets, foreign boards of trade, and over-
the-counter markets.
    Over-the-counter trading is not insulated from the cash 
markets. It impacts cash prices in two ways: first, through 
arbitrage between the OTC swap market and the cash market; and, 
second, through arbitrage between the swaps market and the 
futures market. Futures prices, in turn, are used as the 
reference price for most cash transactions. Swap dealers can 
also shift their risk to other trading platforms, such as the 
IntercontinentalExchange, and foreign boards of trade, such as 
ICE Futures.
    Mr. Chairman, unless there is an umbrella which covers all 
of these venues, particularly with respect to commodities for 
U.S. delivery such as natural gas, speculators will circumvent 
the regulated venues in favor of unregulated venues. For that 
reason, we urge to you require the CFTC to provide aggregate 
position limits across all exchanges in order to control 
excessive speculation in energy commodities.
    Point number three: section 13 requires clearing of all 
over-the-counter transactions. We do not support requiring bona 
fide commercial hedgers, such as ourselves, to clear. The 
problem of excessive market speculation is not caused by 
commercial hedgers, and our volumes are too small to manipulate 
the market. For example, in natural gas, our volumes are well 
under five percent of the market. Requiring us to clear our 
transactions will significantly increase transaction costs to 
the extent that it could become a disincentive for industrial 
consumers to manage risk. Clearing transactions would require 
us to post significant sums of margin capital, which is very 
difficult to do even under good economic times.
    Point number four: Consumers need assurances that this 
legislation deals appropriately with index funds and other 
passive, long-only, short-only investment instruments that have 
a significant negative impact on the market, and will do so 
again unless these instruments are limited in volume or banned. 
The draft legislation only requires reporting, which is not 
sufficient.
    Number five, and our final comment: Regarding treatment of 
carbon allowances and offsets, we have deep concerns about 
including this provision. U.S. manufacturing companies who have 
been studying cap and trade and our colleagues in Europe 
believe that carbon trading could very well be the next 
subprime crisis. Our written testimony includes an article from 
The Guardian, a U.K. newspaper, dated January 30, 2009, 
entitled ``Carbon Trading: The Next Sub-prime.''
    Trading and offsets are very susceptible to fraud and 
manipulation. Cap and trade is only one of several policy 
approaches to regulating carbon, and the alternatives would not 
require carbon trading and creation of other high-risk 
derivative trading markets. Including carbon emissions as a 
tradeable commodity is premature to Federal policy decision 
making, and Congress should not limit the debate to trading.
    Thank you.
    [The prepared statement of Mr. Cicio follows:]

   Prepared Statement of Paul N. Cicio, President, Industrial Energy 
                 Consumers of America, Washington, D.C.
    Mr. Chairman, Ranking Member Lucas, and Members of the Committee, 
my name is Paul N. Cicio. I am President of the Industrial Energy 
Consumers of America (IECA). Thank you for the opportunity to testify 
before you on the draft legislation entitled ``Derivatives Markets 
Transparency and Accountability Act of 2009''.
    IECA is a 501(c)(6) national nonprofit non-partisan cross-industry 
trade association whose membership is exclusively from the 
manufacturing sector. IECA promotes the interests of manufacturing 
companies for which the availability, use and cost of energy, power or 
feedstock play a significant role in their ability to compete in 
domestic and world markets. IECA membership represents a diverse set of 
industries including: fertilizer, steel, plastics, cement, paper, food 
processing, aluminum, chemicals, brick, rubber, insulation, glass, 
industrial gases, pharmaceutical, construction products, foundry 
resins, automotive products, and brewing.
    For those on Wall Street who still do not acknowledge that 
excessive speculation is a problem, let me briefly describe what 
happened to natural gas prices in the time period of January to August 
of 2008.
    During the first half of 2008, excessive speculation drove the 
NYMEX price of natural gas from $7.17/mm Btu in January to a high of 
$13.60/mm Btu in July before prices began to recede. During that same 
time period, the Energy Information Administration reports that 
domestic production increased by 8.6 percent; demand was essentially 
unchanged from the previous year and that national inventories were in 
the normal 5 year average range for that time of the year. These facts 
prove that the price spike was not driven by supply versus demand 
fundamentals. Unfortunately for homeowners, farmers and manufacturers, 
the net increase in the price of natural gas cost consumers over $40.4 
billion from January to August 2008 when compared to the same time 
period in 2007.
    It is also important to highlight to the Committee that natural gas 
was specifically targeted by traders for manipulation more than any 
other commodity during that same time period by a significant margin. 
This information comes from the Commodity Futures Trading Commission 
(CFTC) September, 2008 report entitled ``Staff Report on Commodity Swap 
Dealers & Index Traders with Commission Recommendations.'' The report 
highlights that more noncommercial traders exceeded the speculative 
limit or exchange accountability levels for trading natural gas than 
any other commodity and by a very high margin.
    The below paragraph is from the report.

        Exceeding Position Limits or Accountability Levels: 

        On June 30, 2008, of the 550 clients identified in the more 
        than 30 markets analyzed, the survey data shows 18 
        noncommercial traders in 13 markets who appeared to have an 
        aggregate position (all on-exchange futures positions plus all 
        OTC equivalent futures combined) that would have been above a 
        speculative limit or an exchange accountability level if all 
        the positions were on-exchange. These 18 noncommercial traders 
        were responsible for 35 instances that would have exceeded 
        either a speculative limit or an exchange accountability level 
        through their aggregate on-exchange and OTC trading that day. 
        Of these instances: eight were above the NYMEX accountability 
        levels in the natural gas market; six were above the NYMEX 
        accountability levels in the crude oil market; six were above 
        the speculative limit on the CBOT wheat market; three were 
        above the speculative limit on the CBOT soybean market; and 12 
        were in the remaining nine markets. 

    Mr. Chairman, we are very grateful for the attention this Committee 
is giving this incredibly important issue and this legislation is an 
excellent start to addressing excessive speculation in commodity 
markets.
    IECA strongly supports: section 3 that establishes speculative 
limits and transparency of offshore trading; section 4 that requires 
increased transparency through detailed reporting and disaggregation of 
market data that includes index funds and other passive, long-only and 
short-only investors in all regulated markets and data on speculative 
positions; section 5 that increases transparency and record-keeping to 
the CFTC and includes over-the-counter (OTC) contracts; section 6 that 
establishes trading limits to prevent excessive speculation and creates 
a Energy and Agriculture Position Limit Advisory Group that would 
provide recommendations on setting position limits; section 7 that 
provides for at least 200 additional full-time CFTC employees; section 
8 that ensures that prior CFTC actions are consistent with this Act.
    IECA areas of concern and recommended improvements are as follows:
More Transparency in CFTC Processes
    We encourage the legislation to reflect a change in culture at CFTC 
to one that has more transparency and public input into their decision 
making processes. We prefer the Federal Energy Regulatory Commission 
(FERC) model. The FERC frequently have rule making processes that allow 
for public comment and organize sessions that are similar to your 
Congressional hearings in which entities are solicited for comment. At 
FERC, there are ample opportunities for written public input as well.
Section 13: Clearing of Over-the-Counter Transactions
    We do not support requiring commercial hedgers such as ourselves to 
be required to clear their transactions. The problem of market 
speculation is not caused by commercial hedgers and they are a 
relatively small portion of the market. The problem is non-hedgers or 
speculators. For this reason, only speculator bilateral OTC 
transactions should be cleared. We believe that requiring commercial 
hedgers to clear their transactions will potentially decrease our 
competitiveness through increased complexity and cost creating a 
disincentive for industrial users to manage risk.
    We also urge the Chairman to add provisions to section 13 that will 
increase transparency to the CFTC decision making process and with a 
public comment period.
Section 6: Trading Limits to Prevent Excessive Speculation--
        Establishment of Advisory Groups
    We strongly support the establishment of a Position Limit Advisory 
Group for both agricultural and energy commodities. However, we 
recommend an additional step in the process by requiring that a public 
comment period be added to further increase transparency of the 
process. We further recommend that the governance of this advisory 
group favor the consumer perspective to ensure the best interest of 
those paying the bills.
Section 14: Treatment of Emission Allowances and Offset Credits
    We have concerns including this provision. Including carbon 
emissions as a tradable commodity in this legislation is premature to 
Federal policy making. The Congress has not decided how it will 
regulate greenhouse gas emissions and we are concerned that this 
legislation would preempt that decision.
    U.S. manufacturing companies that have been studying cap and trade 
and our colleagues in Europe believe that carbon trading will be the 
next Sub-Prime Crisis. Attached is a copy of a recent article from The 
Guardian, a UK newspaper dated January 30, 2009 entitled ``Carbon 
Trading: The Next Sub-Prime.'' We encourage the Committee to read it. 
(Attachment A)
    Carbon cap and trade is only one of several policy approaches to 
regulating carbon and alternatives would not require trading carbon. 
Other alternatives include a carbon tax, sector approaches (example: 
CAFE); energy efficiency or GHG intensity mandates for the 
manufacturing sector or setting energy efficiency standards on every 
major energy consuming device thereby reducing energy consumption 
(example: appliance standards) and building codes for homes and 
commercial buildings.
    In general, manufacturers have raised serious concerns regarding 
cap and trade because it is not transparent; offsets are easily subject 
to manipulation; it cannot be effectively border adjusted which means 
importers who are not burdened with equivalent higher costs will take 
business away from domestic producers and will result in lost jobs; it 
raises energy costs that manufacturers cannot pass-on because of 
international competition.
    The Industrial Energy Consumers of America welcomes the opportunity 
to work with the Committee on Agriculture as it moves forward with this 
legislation.

Paul N. Cicio,

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


President,
February 4, 2009.
                              Attachment A
Carbon Trading: The Next Sub-Prime
January 30, 2009

The Guardian, Friday 30 January 2009
By Terry Macalister

    Climate and Capitalism has long argued that carbon trading is a 
scam to boost profits without reducing emissions. Here's confirmation 
from an unexpected source: the CEO of a major European energy company.

    The row over the working of the European Union's emissions trading 
scheme intensified last night when EDF Energy warned that speculators 
risked turning carbon into a new category of sub-prime investment.
    Vincent de Rivaz, the chief executive of the UK arm of the French-
owned gas and electricity group, said politicians and regulators needed 
to revisit the way the ETS was working and whether it was bringing the 
results they wanted. ``We like certainty about a carbon price,'' he 
said. ``[But] the carbon price has to become simple and not become a 
new type of sub-prime tool which will be diverted from what is its 
initial purpose: to encourage real investment in real low-carbon 
technology.''
    Green campaigners have long been critical of the way the emissions 
trading scheme was set up, but it is unusual for a leading industry 
figure to cast doubt on it, as power companies lobbied hard for a 
market mechanism to deal with global warming.
    ``We are at the tipping point where we . . . should wonder if we 
have in place the right balance between government policy, regulator 
responsibility and the market mechanism which will deliver the carbon 
price,'' said de Rivaz.
    De Rivaz's comments came as Tony Hayward, chief executive of BP, 
emphasised that a predictable global carbon price was important because 
it would make ``vast numbers of alternative energy sources 
competitive''. He told the World Economic Forum in Davos that certainty 
over carbon emissions would help ``solve the world's energy problems''.
    Their comments came days after the Guardian revealed that 
steelmakers and hedge funds were cashing in ETS carbon credits obtained 
for free, causing the price of carbon to plunge. The price of carbon 
has slumped from =30 a tonne to below =12, leading to a tail-off in 
clean-technology offset projects in the developing world.
    The EU's emissions trading scheme was set up as a market solution 
to cut greenhouse gas pollution from industry. Polluters were issued 
with permits that can be traded between companies and countries as a 
way of encouraging an overall reduction in carbon output. However, 
companies are now cashing them in. Up to =1bn-worth of permits are said 
to have been sold off in recent months as companies see an opportunity 
to bring in funds at a time when their carbon output is expected to 
fall due to lower production.
    De Rivaz said an over-reliance on markets without tougher 
safeguards was responsible for the financial turmoil that has sent 
banks into administration or forced sale. He believed there had been a 
``lost sense of values'' and he was anxious that this should not extend 
into the energy sector, but was not prepared yet to call for a carbon 
tax to replace the ETS.
    Point Carbon, an information provider and consultancy, claims the 
sell-offs are only one of a number of factors influencing carbon prices 
and argues it is ``rational'' for them to be selling off credits.
    ``Recession in Europe is bringing a slowdown in manufacturing, 
meaning less production and less emissions,'' said Henrik Hasselknippe, 
global head of carbon at Point Carbon. ``Companies are doing exactly 
the rational thing in these circumstances, which is to sell if they are 
long on credits. If they are emitting less then they do not need the 
credits so much and the price of carbon will fall.''
    However, Bryony Worthington, an expert on climate change and 
founder of sandbag.org.uk, said: ``What should have been a way to kick-
start investment in much needed low-carbon, efficient technologies is 
now a cash redistribution exercise.''
    A study commissioned by the WWF environmental organisation from 
Point Carbon, published in March last year, estimated that ``windfall 
profits'' of between =23bn and =71bn (20.9bn-
64.4bn) would be made under the ETS between 2008 and 2012, 
on the basis that the price of carbon would be between =21 and =32. Up 
to =15bn could be made by British companies that were given credits 
they did not need.

    The Chairman. Thank you, Mr. Cicio.
    Mr. Brickell, welcome to the Committee.

 STATEMENT OF MARK C. BRICKELL, CEO, BLACKBIRD HOLDINGS, INC., 
                          NEW YORK, NY

    Mr. Brickell. Thank you, Mr. Chairman. Thank you, Members 
of the Committee, for inviting Blackbird Holdings to testify at 
this hearing about the ``Derivatives Markets Transparency and 
Accountability Act of 2009.''
    We are grateful that the Committee and the Congress want to 
address the causes of the financial crisis. Americans are 
concerned. Banks have been shaken. The stock market has 
tumbled. Pension investments and home values have shriveled. 
The wolf is at the door. What can Congress do to help? The 
first step would be to identify the true causes of the 
financial crisis.
    Our global financial crunch is a housing finance crisis. 
Trillions of dollars of mortgage loans have been made that are 
not being repaid on time. Those loans are worth less than face 
value, and so are the mortgage-backed securities that contain 
them. Stockholders, bond holders, taxpayers will absorb as much 
as $1 trillion of losses from loans that should not have been 
made.
    But this bill doesn't target foolish mortgage loans. It 
targets derivatives. If our country has a wolf problem, it 
probably won't help to go into the field to shoot birds.
    Mr. Chairman, these privately negotiated derivatives, these 
swap contracts, have helped the financial system and the 
economy. Every company faces risks when it opens its doors to 
do business, and swaps help those companies shed the risks they 
don't want and assume the risks that they do.
    Each company's portfolio of risks is unique. Each firm's 
appetite and ability to manage risk is unique. And swaps meet 
those individual needs because they can be custom-tailored. 
Banks structure them to meet a client's market risks, right 
down to the dollar and to the day, if necessary.
    And we don't just structure them to meet market risks. 
Swappers custom-tailor the credit risk of the contracts, too. 
Each counterparty in a swap contract is on the hook to the 
other. So each one has a good reason to assess the other's 
credit quality, and do it with care. If one doesn't like what 
he sees, he asks the other to shrink the deal, or shorten the 
maturity, or post collateral, or raise more capital.
    We use innovative technology to promote transparency, 
integrity, and control of credit risk, the goals of your bill. 
And our company has built an electronic trading platform for 
swaps. Not only does it allow users to find counterparties for 
their swaps online, our patented credit filter prevents one 
firm from trading with another when credit lines are full.
    Credit risk is managed more precisely than it is with a 
central clearinghouse to the individual specifications of each 
user of the system. Companies need custom-tailoring, and that 
is why swaps were invented. It is also why there are nearly 
$700 trillion, a notional amount, that are managing risks today 
for companies and governments around the globe.
    And Congress knows this. You all have passed the laws that 
make the framework in which standardized futures contracts are 
traded on futures exchanges, regulated by the CFTC, and cleared 
through CFTC-regulated clearinghouses. While swaps that have 
many of the same risks as bank loans are defined in Federal law 
as banking products, banking supervisors have access to the 
details of every swap on a bank's books.
    How good is this framework? Not only has it been good for 
the economy, it has also been good for the futures exchanges. 
The custom-tailored risks that banks collect from their clients 
they often manage with futures contracts. So futures trading 
has grown along with swap activity.
    No country has built a more diverse, robust risk management 
industry. Now, it is not perfect. No financial transaction or 
system of risk management can prevent all investment losses. 
Good judgment remains the essential element in sound financial 
management. But it is good. Swaps make it easier and less 
expensive to create the risk management profile that a company 
prefers.
    I am concerned about the proposed legislation because it 
will do damage to all of this. It is not just that derivatives 
are the wrong target. This legislation is like shooting doves 
with an 8-gauge: If you connect, there won't be anything left. 
And American firms, in the middle of a credit crunch, would 
face new obstacles as they try to manage credit risk. Important 
tools for managing not just credit risk but interest rate risk, 
as well, would be more costly and less available. So American 
firms would have to watch from the sidelines as their 
competitors in other countries manage their risks with greater 
precision, and more freely than American companies would be 
able to do.
    So if this bill passes, we will not have much of a swaps 
activity left in the United States, and we would not be better 
off. Suppose that Congress passed a law that outlawed swaps 
completely? Would the financial crisis be gone? No. Those 
trillions of dollars of troubled mortgage loans would still be 
there. They would just be harder to manage.
    Privately negotiated derivatives with bilateral 
infrastructure, sound documentation, netting provisions to 
support them, have been called no less than the creation of 
global law by contractual consensus. It is a system that has 
benefited thousands of companies, financial institutions, and 
sovereigns. It is a system that has an important part to play 
as we work to solve the problems of economic weakness and 
financial market uncertainty. Great care should be taken to 
optimize and not to weaken this innovative and important 
business.
    Thank you.
    [The prepared statement of Mr. Brickell follows:]

Prepared Statement of Mark C. Brickell, CEO, Blackbird Holdings, Inc., 
                              New York, NY
    Mr. Chairman and Members of the Committee:

    Thank you very much for inviting Blackbird Holdings, Inc. to 
testify at this hearing about the ``Derivatives Markets Transparency 
and Accountability Act of 2009''. We are grateful to the Committee for 
asking for our views as it seeks a wide perspective on the benefit and 
drawbacks of legislation affecting privately negotiated derivatives. 
For more than 2 decades, swaps and related derivatives contracts have 
made an important contribution to improvements in risk management at 
banks, in the financial sector, and in the economy. The benefits of 
these transactions are sufficiently important that any measures adopted 
by the Committee or the Congress should not reduce the availability or 
increase the cost of these valuable tools.
About Blackbird
    Blackbird Holdings, Inc. is a privately held corporation 
headquartered in Charlotte, North Carolina. It was founded by swap 
traders from J.P.Morgan & Co. who developed an electronic trading 
platform for the negotiation of interest rate and currency swaps. Our 
innovative technology has been patented three times by the U.S. 
Government. The benefits of electronic trading have already been 
achieved in the execution of most types of financial transactions, 
including foreign currency, equities, U.S. Treasury bonds and corporate 
bonds, and futures contracts. When swap contracts are executed 
electronically in greater numbers, swaps will have greater 
transparency, and accurate electronic records will be created at the 
moment the trade is executed so that error-free straight through 
processing, including accurate record-keeping, will be a hallmark of 
the business. Blackbird is still a small company, but we are global, 
and we help swap counterparties find each other and execute swaps 
either across our electronic platform, or through our people in 
Singapore, Tokyo, London, and New York.
    I have served as Chief Executive Officer of Blackbird since 2001. 
Before that, I served for 25 years at JP Morgan & Co., Inc., where I 
was a Managing Director and worked in the derivatives business for 15 
years. During that time, I served for 4 years as Chairman of the 
International Swaps and Derivatives Association, and for 2 years as 
Vice Chairman, during more than a decade that I served on its board of 
directors. ISDA represents participants in the privately negotiated 
derivatives business, and is now the largest global financial trade 
association, by number of member firms. ISDA was chartered in 1985, and 
today has over 850 member institutions from 56 countries on six 
continents. These members include most of the world's major 
institutions that deal in privately negotiated derivatives, as well as 
many of the businesses, governmental entities and other end users that 
rely on swaps and related contracts to manage efficiently the financial 
market risks inherent in their core economic activities. As a result, I 
was involved in discussions about all Federal swaps legislation between 
1988 and 2000.
Why Swaps?
    The moment that companies open their doors to do business, they 
become exposed to financial and other risks that they must manage. 
Changes in foreign currency rates can affect the volume of their 
exports; interest rate volatility the level of investment returns, and 
commodity price fluctuations the cost of raw materials--or sales 
revenue. Managing these risks was an essential part of decision-making 
in business and finance before swaps were developed, and would remain 
so if swaps did not exist.
    Custom-tailored swap transactions were developed to make it easier 
to manage these risks. They allow a party to shed a risk that he does 
not want to take, in return for assuming another risk to which he would 
rather be exposed, or for making a cash payment. By tearing apart and 
isolating the strands of risk that are entwined in traditional business 
and financial transactions, they make it possible to manage risks with 
greater precision, and allow businesses to focus on the things they do 
best. A company that sells hamburgers around the globe can use swaps to 
shift its exposures to interest rates and foreign currencies to other 
parties, and concentrate on managing its operations, raw materials 
costs, and real estate holdings, if it believes that these are the 
source of its comparative advantage. Similarly, the counterparties to 
its swap trades believe that they are better able to manage the 
interest rate and currency risks being shed by the other enterprise.
Benefits of Swap Activity
    As thousands of swap counterparties make individual decisions about 
which risks to take and which to transfer to others, several useful 
things happen. First, the risk profiles of the firms improve every time 
they make a correct decision. This strengthens them, and makes it 
possible for them to serve their customers better and grow more 
rapidly. A bank that has a strong relationship with a borrower might 
find that the size of its loans to that customer was becoming so great 
that its loan portfolio was becoming poorly diversified. By entering 
into credit default swaps, the banker can transfer enough of the loan 
risk to make room for more loans to its customer, strengthening its 
business relationship and helping credit to flow. That's good for 
business, jobs, and the economy.
    Second, as thousands of swap transactions have been executed in the 
past 3 decades, bankers and finance professionals have gained access to 
new information about financial risks. This allowed better measurement 
and management of risks, first in swap portfolios and, as time passed, 
in the other financial portfolios. I watched that process take place in 
the 1980s as the risk management techniques developed on the swap desks 
of ISDA member banks, including my own, were adopted by the managers of 
the same risks that had long been embedded in other financial 
portfolios at their institutions, including the portfolios of loans and 
deposits. This process was so constructive that swap professionals were 
asked in 1993 by the Group of Thirty, to write down their best 
principles and practices for managing financial risks. The report that 
we produced was disseminated through the global banking system and 
other parts of the financial world, and was also used by banking 
supervisors and financial system regulators to improve their 
supervisory practices. As Paul Volcker, the Chairman of the Group of 
Thirty wrote in the introduction to our report, ``. . . there can be no 
doubt that each organization's conscious and disciplined attention to 
understanding, measuring, and controlling risk along the lines 
suggested should help ensure that the risks to individual institutions 
and to markets as a whole are limited and manageable.''
    As swap transactions are executed, the prices of these deals reveal 
the beliefs of thousands of individuals about the future course of 
interest rates, or the creditworthiness of borrowers, which are 
collected and distilled in the price of the deals. This information can 
be used even by parties who do not enter into the transactions. Central 
bankers now use swaps prices to understand interest rate expectations 
and help them make decisions about monetary policies. Rating agencies 
have begun to track the information about the credit quality of 
borrowers that is contained in the price of credit default swaps to 
identify changes in market opinion, and alert their analysts to changes 
in the condition of companies that they rate, so that they can drill 
down on potential problems and strengthen the quality of their ratings. 
If credit default swaps had existed a decade earlier, to sound a tocsin 
of warning, current problems in the financial system might not be so 
grave.
    Of course, no type of financial transaction or system of risk 
management can prevent all investment losses. The good judgment of 
financial professionals remains the essential element in sound 
financial management. Swaps simply make it easier and less expensive to 
create the risk management profile that a company prefers.
    You might expect a business that does so much good for so many 
people to grow quickly, and the swaps business has. While I have been a 
participant in the swaps business, I have seen it grow by roughly 25% 
per annum for more than 20 years. As a result, there are now according 
to the BIS almost $684 trillion of swaps outstanding, mainly on 
interest rates and currencies As of January 27, there were some $28 
trillion of credit default swaps outstanding. It is worth noting that, 
even when other financial activities become illiquid, the swap business 
tends to be resilient. Credit default swaps dealers, for example, 
indicate that there has been liquidity in swaps even when traditional 
cash markets have become illiquid at times in the past year.
Public Policy for Swaps in the United States
    These are important benefits. They exist in part because Congress 
has legislated carefully and wisely with respect to swaps on at least 
five earlier occasions since 1988. We all want to preserve benefits 
like these, and I am grateful to you for identifying in legislation now 
before the Committee several policy ideas that have been floated in 
recent months, and for your careful consideration of those ideas at 
this hearing. With careful action, this Committee can continue to play 
an essential role in building a sound framework for swap activity.
    The policy consensus about swaps that is embodied in the statutory 
and regulatory framework reflects the fact that swap activity arose not 
in the exchange traded, centrally cleared business of standardized 
futures contracts regulated by the Commodity Futures Trading 
Commission, but in the banking sector. Swap contracts are custom-
tailored transactions that are often designed to match the exact cash 
flows that a corporation wants to hedge; this makes them harder to 
construct, to value, and to transfer, than the futures contracts 
regulated by the CFTC, in much the same way that a bank loan is 
different from a corporate bond. This is why the first policy adopted 
by the CFTC with respect to swaps, in its May 1989 Swaps Policy 
Statement, after more than 18 months of study, was that swaps are not 
appropriately regulated as futures. That original CFTC Policy reflects 
a policy consensus that has lasted 2 decades, reaffirmed and 
strengthened by the 1991 CFTC Statutory Interpretation, the 1992 
Futures Trading Practices Act, and the Commodity Futures Modernization 
Act enacted in 2000 and signed into law by President Clinton, as well 
as other legislation. That is why swaps are defined in Federal law as 
banking products.
    A robust, innovative American financial services business has been 
built on the foundation of this policy consensus. I am concerned that 
provisions in the legislation before the Committee would undermine that 
foundation and weaken a business that helps the American economy, and 
the world.
Management of Credit Risk in Swaps Transactions
    One area of the legislation that would have that effect is the 
section requiring clearing of privately negotiated derivatives. Like 
every commercial and financial contract, swaps contain credit risk. One 
party must be confident that his counterparty will perform according to 
the terms of the contract.
    Financial institutions are able to manage this credit risk in 
different ways. In the banking system, where swaps originated, credit 
risk is managed by experts who analyze the quality of each 
counterparty, including its financial strength, the quality and 
character of management, even the legal and political risk of the 
country where it is based. In doing this, bankers and their 
counterparties often rely on private information available to them in 
their special role as creditors. The techniques used to manage the 
credit risk of swaps are usually the same ones used to manage the risk 
of other privately negotiated credit contracts such as bank loans or 
bank deposits, and they can include the posting of collateral so that 
if a counterparty defaults on a trade, the non-defaulting party will be 
able to enter into a new, replacement transaction at no additional 
cost. Of course, if a counterparty is not satisfied with the amount or 
quality of the information he receives, or the credit enhancement 
techniques available, he is not required to enter into any swap deal.
    Financial institutions have developed a number of ways to manage 
credit risk in privately negotiated derivatives, appropriate to their 
capital levels and those of their clients.
    First, there are different ways to document transactions. The 
simplest method is to use an exchange of confirmations, one for each 
transaction. This approach makes no attempt to reduce risks by netting, 
it simply relies on well drafted confirmations and good credit judgment 
in the choice of counterparties.
    Risks are reduced by netting under bilateral master agreements, 
either for single products--interest rate swaps against interest rate 
swaps--or reduced further by including other derivatives under the 
master. Netting across products--foreign exchange options against 
credit default swaps, for example--reduces potential exposures even 
more than single product netting. The ISDA Master Agreement is used 
around the globe to achieve this purpose.
    As you can see, we are starting to build a sort of continuum of 
approaches, in which increasing the numbers of transactions netted 
against each other results in greater netting benefits. Multilateral 
netting of credit risks is another step along the continuum, in which a 
multilateral clearinghouse substitutes its own credit for that or 
others, and has a bilateral relationship with each of them. In each 
bilateral relationship, the credit exposure at any moment in time is 
the net value of the transactions.
    At first, this might sound different from the banking model, 
because futures exchanges operate multilateral clearinghouses. But the 
difference is mainly one of scale. Every bank serves as a central 
counterparty for its inter-bank trading partners and its clients. So, 
in this sense, every swap dealer bank using netting provisions under 
the ISDA Master Agreement is a clearinghouse.
    Each swap dealer assesses the likelihood that his counterparty will 
default, and his own ability to withstand such a default. In doing so, 
he is mindful of his own capital base, and the capital strength of his 
counterparty. Where capital is not high relative to risk, it is more 
likely that one or both swap counterparties will demand collateral from 
the other.
    Now we have a more complete picture of credit risk mitigation 
schemes for derivatives. Each scheme has characteristics appropriate to 
its participants. On one end of the continuum are banks and insurance 
companies, with traditionally strong capital cushions. At the other end 
are margin-reliant entities including futures exchange clearinghouses.
A Clearinghouse for Swaps?
    It should be clear at this point that creating a new clearinghouse 
for swaps, or for one type of swaps like credit default swaps, or 
forcing swaps into some other clearinghouse, would not exactly make 
order out of chaos. A good deal of order already exists. It is the 
order that markets bring to human affairs, giving participants the 
opportunity to choose, and to change their choices. Today swap 
participants can choose among several different methods to handle 
credit risk. We can keep the contracts on our own books, netting them 
against other contracts, taking collateral to support the risk as 
appropriate, or we can submit them to a third party clearinghouse. A 
system like this allows us to make the right judgments for ourselves 
and our counterparties, as capital positions change and the mix of 
clients changes. Every bank changes its mix of business along the 
continuum, every day.
    For this reason, section 13 of the bill is troubling. This section 
requires that all currently exempted and excluded OTC transactions must 
be cleared through a CFTC regulated clearing entity, or an otherwise 
regulated clearinghouse which meets the requirements of a CFTC 
regulated derivatives clearing organization. While the provision 
authorizes the CFTC to provide exemptions from the clearing 
requirement, it can only grant the relief under limited circumstances, 
provided that the transaction is highly customized, infrequently 
traded, does not serve a significant price discovery function and is 
entered into by financially sound counterparties.
    Driving swap activity into a central clearinghouse would be 
undesirable for several reasons. First, it would create a central choke 
point for activity that is, today, distributed across multiple 
locations. If a single swap dealer has processing problems or other 
difficulties, they affect only the dealer's clients. If a central 
clearinghouse were to have problems, they would affect the entire 
system's derivatives flows.
    Second, the same is true of the credit risk of such a central 
entity. Pulling the credit risk of swaps out of the institutions where 
they reside today, and forcing them into a central counterparty, risks 
creating a new, ``too-big-to-fail'' enterprise that represents a new 
risk to taxpayers.
    Third, a centralized, collateral-reliant scheme would tend to 
reduce market discipline. Because parties to bilateral netting 
agreements retain some individual credit exposure, they must assess 
their counterparties' credit standing, giving them an incentive to 
control their positions carefully. The resulting widespread awareness 
of credit risk makes the financial system safer. In contrast, 
clearinghouse arrangements tend to socialize credit risk. Our financial 
system today shows the ill effects of a reduction in market discipline, 
and Federal policies should increase it, not reduce it.
    Fourth, one reason for this is that credit discipline encourages 
financial institutions to strengthen their capital bases.
    Finally, building a central clearinghouse may be an expensive 
proposition, requiring new capital of its own. In contrast, increased 
use of bilateral cross product netting under ISDA Master Agreements can 
be accomplished at low cost. The marginal cost of adding another 
transaction to an ISDA bilateral master agreement is zero. No other 
technique offers such substantial risk reduction at such a low cost.
    Since, as I indicated above, every swap dealer bank serves as a 
clearinghouse for its swap trading partners and clients, the provision 
would have the effect of limiting the ability of banks to engage in 
this segment of the banking business without the approval of the CFTC. 
I do not know of any reason to unwind the policy consensus for swaps to 
adopt such a policy. The netting and close out arrangements that are in 
use among swap counterparties are the result, in part, of careful work 
by Congress to establish the enforceability of netting agreements under 
bankruptcy law. These arrangements have been used in the marketplace 
and tested in the courts and have managed the credit risk of hundreds 
of thousands of swap transactions. In the last 12 months alone, the 
failure or default of a major swap dealer, Lehman Brothers, two of the 
world's largest debt issuers, Fannie Mae and Freddie Mac, and a 
sovereign country Ecuador, in addition to the more routine failures of 
other counterparties have been successfully resolved using these 
arrangements. In every case the well drafted netting and close out 
provisions of the ISDA Master Agreements have done what they were 
supposed to do. Simply put, these arrangements work well, and there is 
no evidence to support a statutory requirement for clearing of all swap 
agreements through CFTC-approved central counterparties.
Conclusion
    The privately negotiated derivatives business--and the bilateral 
infrastructure, documentation, and netting that support it--have been 
called ``no less than the creation of global law by contractual 
consensus.'' It is a system that works. It is a system that has well 
served the economy and the financial markets in the U.S. and around the 
world. It is a system that has benefitted thousands of companies, 
financial institutions and sovereigns. And it is a system that has an 
important part to play as we work toward a solution to today's economic 
weakness and financial markets uncertainty. Great care should be taken 
to optimize--and not weaken--this innovative and important system.

    The Chairman. Thank you.
    Is it not true that, by utilizing these derivatives and 
swaps or whatever, that these firms were allowed or were able 
to leverage themselves a lot further than they would have been 
had they not been available?
    I mean, it just looks pretty obvious to me that, without 
them ostensibly laying off these risks with these credit 
default swaps and so forth, that they wouldn't have been able 
to leverage themselves as far as they did. I mean, it did have 
some effect on this.
    The underlying problem are the CDOs and all that, I 
understand that, the mortgages that shouldn't have been made in 
the first place. But my concern is that this exacerbated the 
problem.
    Mr. Brickell. Mr. Chairman, I am very glad that you asked 
that question. I heard statements made from the prior panel, 
and I have certainly seen comments in the newspaper that 
suggest there are people who believe that swaps allow unlimited 
leverage or unlimited speculation.
    The Chairman. No, I am not saying unlimited, but I am 
saying it allowed them to leverage themselves further than they 
would have been able to otherwise.
    Mr. Brickell. Absolutely not true, and this is why: When 
you enter into a swap contract, your counterparty is judging 
whether or not you are able to perform your end of the bargain.
    The Chairman. Like those geniuses at AIG?
    Mr. Brickell. You mean the people who judged that AIG would 
perform?
    The Chairman. Well, the guy who set up the AIG situation 
told the CEO that this was free money, that there was no way 
they could ever lose a penny on this. And you are telling me 
this is good?
    Mr. Brickell. Well, I said it is good, it is not perfect, 
but I believe that it is good.
    The Chairman. This is good, something that almost took down 
the biggest insurance company in the world?
    Mr. Brickell. Well, if you want to shift the focus to that 
particular company, let's state at the outset----
    The Chairman. The reality is that this is very complicated 
stuff, and I don't claim to understand this totally. The sad 
news is that I may understand this about as well as anybody in 
this Congress, and that is scary. Okay?
    But what a lot of these guys know is about AIG. And so 
whether it is fact or fiction, or right or wrong, it is 
something you are going to have to deal with.
    Mr. Brickell. I would be glad to answer the question. Let's 
state at the outset that, as helpful as swap professionals try 
to be, we haven't found a way to guarantee that every investor 
makes a profit. So I appreciate the question about AIG because 
it allows me to address some fundamental misperceptions about 
how and why they ran into difficulty.
    AIG is a regulated financial institution, regulated at the 
Federal level. It had plenty of capital. And it took too much 
exposure to the wrong mortgages. They own a mortgage insurance 
business. They bought plenty of mortgage-backed bonds. And, on 
top of that, they guaranteed mortgages that were owned by 
others, often writing credit default swaps to do that.
    They knew what positions they were taking. Their regulator 
knew what positions they were taking. Their regulator, 
according to the articles I have seen in The Wall Street 
Journal, had people who lived in their offices up in Wilton, 
Connecticut, in the offices of AIG-FP.
    The Chairman. Well, but those are the same people that were 
given the road map to the Madoff situation two or three times 
and missed it. We don't have a lot of confidence, in this 
Committee, in those regulators, okay?
    Mr. Brickell. I believe there is good reason to ask 
questions about the effectiveness of that oversight. AIG made 
bad decisions. Their Federal regulator didn't keep them from 
doing that. So, like you, I don't take too much comfort from 
the idea that a Federal regulator would help limit the activity 
of the counterparty.
    Now, there is one important problem that AIG faced, and it 
is something that we warned about. I mentioned in my written 
testimony the Group of Thirty report on derivatives that I and 
others wrote 15 years ago, published in 1993, under Paul 
Volcker's stewardship. He was the Chairman of the Group of 
Thirty. He oversaw the preparation of that report.
    And we said then that, if you run a company that is 
entering into swap contracts and you offer collateral to your 
counterparties and the collateral has ratings triggers, so 
that, for example, if you are a AAA corporation and you are not 
posting collateral while you are AAA, but make the arrangement 
to provide collateral to your counterparties when your AAA 
rating is lost, you have to manage the liquidity demands that 
that construct is going to put on your corporation.
    The Chairman. But they didn't.
    Mr. Brickell. We wrote that down 15 years ago in the Group 
of Thirty report. It was read by participants in the business 
and it was read by the regulators. So I would like to think 
that we tried very hard in the swaps business to be part of the 
solution to this kind of problem, and anticipated it by a 
decade and a half.
    Now, we have written good advice about how to manage risk. 
That doesn't mean that everybody will follow it all the time. 
And, in this case, it seems to have been ignored.
    The Chairman. Well, my time has expired. But, I mean, we 
may be ham-handed or not understand what we are doing here, but 
I think that the problem we are having is because we have one 
regulator out there that is trying to operate under 
circumstances that were in place 40 years ago when the market 
was a lot less complex.
    One of the things we have done in this Committee is we have 
moved to a principles-based regulation scheme, which is what we 
need to do with all the regulators. We need to have the 
regulations follow the marketplace, and have a system whereby 
this risk is brought into view. That is what we are trying to 
do here.
    I have no confidence if you are going to give this to the 
SEC or the Fed and a bunch of bureaucrats are going to figure 
this out. This is way too complicated. They are not going to 
know what is going on. And you guys will be so far ahead of 
them that it wouldn't make any difference.
    So what we are trying to do is to force the risk out into 
the open as we go through, and not rely on the people that are 
doing it to do that, but have somebody independent making that 
decision. That is kind of what we are trying to do here. Now, 
how we get there, that is the question.
    But something is going to happen here. And we are hoping on 
this Committee to help make it the most reasonable, and 
effective. If we are not successful, I guarantee what is going 
to come out is going to be a hell of a lot worse. So, I hope 
you will work with us, and we look forward to that.
    I had a couple other questions, but I burned up all my 
time. So I recognize the Ranking Member, the gentleman from 
Oklahoma, Mr. Lucas.
    Mr. Lucas. Thank you, Mr. Chairman.
    Mr. Concannon, you made an interesting point that NASDAQ's 
history is such that it was founded to bring order to the OTC 
equities market. Do you see similarities between that market 
prior to NASDAQ and the OTC derivatives market today?
    Mr. Concannon. Absolutely. Today the OTC derivatives market 
is a phone-based market. The only difference of NASDAQ when it 
was formed and the equities market at the time was that it had 
centralized clearing. It allowed us to form a market around 
this centralized clearing and bring pricing transparency to an 
otherwise inefficient market.
    OTC derivatives today, given the bilateral nature of the 
product, the product is actually priced based on your 
creditworthiness. That doesn't exist in things that are 
centrally cleared. We standardize creditworthiness through a 
clearinghouse and a system of margin, standardized margin, and 
collateral collection. So, just like any equity owner can buy a 
share of Microsoft and they are not judged on their status and 
their financial well-being, they don't pay a different price. 
And that can be delivered in the over-the-counter derivatives 
market.
    I think it is important, though, that we take steps. 
Clearing first is an important concept here because of the 
nature of the market today. It is a highly complex market. And 
it can continue to be a phone-based market, but we can 
eliminate a lot of the counterparty risk by just introducing 
mandated clearing.
    Mr. Lucas. Thank you.
    Mr. Brickell, you are critical, and it was in your written 
testimony, of pulling the credit risk swaps out of institutions 
where they reside today and forcing them into a central 
counterparty, because of the risk of creating a new, too-big-
to-fail enterprise and the risk that would represent to 
taxpayers.
    I kind of agree with the Chairman, there are a lot of 
things today that we have discussed that ignore the political 
reality of the world. But that being what it is, I guess my 
question to you is, is there a way to mutualize the risk 
without mandating clearing?
    Mr. Brickell. Well, it probably comes through in my 
testimony that I tend to admire a system that, rather than 
mutualizing the risk, requires each participant to make good 
judgment about the quality of his counterparty.
    I think you get more strength, and discipline, in the 
financial system if you don't mandate the mutualization, 
because it forces each participant to think hard about whether 
his counterparty is a creditworthy enterprise. I think that 
market discipline is something that is good for the system.
    Mr. Lucas. In the countryside, an old farmer will point out 
to you that, if you have a rogue bull, that he will go around 
and cripple all the other young bulls. It almost seems as 
though, by certain actions taken by certain entities and 
certain groups, it has been that sort of an effect on the 
economy and compelled us and the Administration, both past and 
present, to, in effect, use the Treasury to mutualize those 
risks. So, fascinating testimony, sir.
    Mr. Chairman, I yield back.
    The Chairman. I thank the gentleman.
    The gentleman from Pennsylvania, Mr. Holden.
    Mr. Holden. Thank you, Mr. Chairman.
    Mr. Concannon, can you describe for the Committee the 
measures that your derivatives clearing operation has in place 
to ensure it can survive the financial stress of any of its 
members?
    Mr. Concannon. Absolutely. Because it is approved by the 
CFTC, the CFTC requires certain risk measures that are built in 
to the system. A deposit is required by every member. An 
initial clearing fund is built and required. And then variation 
margin, daily variation margin, which is set by the CFTC based 
on the product construct, is also required. We will collect 
margin every day. We will calculate the margin twice a day.
    That is very different than how the OTC derivatives market 
is conducted today, where clearly good judgment, as Mr. 
Brickell uses, failed us. In certain instances, OTC derivative 
traders will not collect margin. If you are a large hedge fund 
that does a lot of business with an individual bank, there are 
times where they may not, and they certainly have the 
discretion to not, collect margin for you on a given day or a 
given week. And so, it is that good judgment that actually 
failed us in 2008.
    Mr. Holden. Thank you.
    Mr. Hale, you mentioned that, had the draft bill been in 
place last year, Cargill would not have been able to offer the 
simple swaps that allowed it to restart its market for making 
deferred purchases from crop producers.
    Why would a clearing requirement prevent you from entering 
into swaps, especially those of simple nature such as those 
that you mention in your testimony?
    Mr. Hale. It would have to do with the capital requirements 
to be extending margin upon those transactions if they were 
cleared on a daily basis. In many cases, customers and even 
Cargill at times was nearing its point of its borrowing limit. 
So, if we had been forced to put up capital on a daily basis 
for margin, it may have had us leave the market earlier than we 
did actually.
    Mr. Holden. Thank you.
    I yield back, Mr. Chairman.
    The Chairman. I thank the gentleman.
    The gentleman from Kansas, the Ranking Member of the 
Subcommittee, Mr. Moran.
    Mr. Moran. Mr. Chairman, thank you very much.
    Mr. Hale, as I understand the testimony from yesterday and 
today, there is a common theme from witnesses. And it seems, 
whether it is the exchanges or the brokers or commercial market 
participants, there seems to be exception taken with section 6 
and section 13. All seem to believe that the definition of bona 
fide hedging is too narrow and that mandatory clearing is a 
good idea but impractical.
    One thing you mentioned in your testimony is that you do 
not want position limits to apply to the swap dealer but, 
rather, to the person who trades on both the designated market 
and over-the-counter market. The difference here is that we 
have two separate markets where speculative position limits 
would apply.
    My question is, which market should the trader reduce his 
position in, the DCM or the OTC market; or should the trader 
decide that?
    Mr. Hale. I am not sure I understood your question exactly, 
sir.
    Mr. Moran. Well, it is hard to always understand the 
testimony, but it seemed to me that you don't want position 
limits to apply to the swap dealer but, rather, the person who 
trades on the OTC or the designated market. And my question is, 
who decides where the trader reduces his or her position; if it 
exceeds the position?
    Mr. Hale. Well, we said we have been in favor of aggregated 
position limits across OTC and exchange. So, assuming they 
still had room in either exchange or their OTC limit, I would 
think that the individual who is asking to make the swap would 
make that decision.
    As a provider, we are creating swaps across multiple 
counterparties. And if, in fact, we are put on a limit, if the 
providers put on a limit such as a market participant, then 
basically the market is going to shrink, because the provider 
is not going to be there to be able to make the market for 
them.
    Mr. Moran. Thank you.
    To anybody on the panel, many of our panelists believe that 
the bill as written that mandates clearing, with a narrow 
exception for the CFTC to grant a case-by-case exemption, is 
not practical. Looking for alternatives, if you clear your OTC 
trade, your trade will remain a regulated swap, exempt or 
excluded commodities as stated in the Chairman's draft.
    If you choose not to clear your over-the-counter trade, 
because it is not structured for clearing, or maybe you don't 
want to clear it for proprietary reasons, what if we 
established a set of core principles, similar to those which 
the exchanges are now subject to? Those core principles would 
give direction about how counterparties to an OTC trade must 
post margin or make adjustments to capital accounts.
    Would this be a method by which we would avoid mandatory 
clearing, and, yet, still protect traders in the market as a 
whole from the type of market default that we are concerned 
with?
    Mr. Concannon. I will try to answer that.
    Well, obviously, we stated that we support the provision 
mandating clearing. I think it is critical that the CFTC, who 
does have the expertise to create exemptions, does in fact 
create exemptions. We don't believe all things OTC can be 
centrally cleared. Obviously, there are numerous complexities 
and unique products that will never be able to be cleared 
centrally.
    I think there are a number of ways, similar to the one you 
referenced, that will entice end-users to use a cleared 
product. But when they need the unique nature of the OTC 
product, they will pay the cost of using the OTC product.
    So, whether it is the capital charges that currently exist 
and increasing capital charges for carrying an OTC position, 
whether it is tax treatment and tax benefits to the extent you 
move to a cleared versus an OTC treatment. There are numerous 
ways outside of mandating that can strongly encourage central 
clearing.
    Mr. Cooper. I think we also agree largely with those 
thoughts. An incentive scheme that would give market 
participants the economic incentive to clear is probably a very 
workable alternative.
    Mr. Hale. If you would allow, Mr. Dines would like to 
comment on that question.
    Mr. Dines. I think it is a very interesting option to come 
up with some core fundamentals. I would just like to make one 
point, if I could.
    As an OTC provider today, we are already doing many of the 
things that centralized clearing does. We send our customers a 
daily position report that has updated pricing with updated 
valuations. We are also collecting margin, passing margin back 
and forth every day with our customers. And we are doing that 
for the bulk of our customers. So some of the same things that 
we are talking about achieving in centralized clearing are 
already happening in the OTC area.
    And, as far as getting to the greater transparency, greater 
reporting side of things, as an OTC provider, we are already 
doing that through our special calls now that we are doing with 
the CFTC. And we think that that should be standardized and put 
on a more regular basis, and that would get to a lot of what 
you are trying to achieve.
    Thank you.
    Mr. Hale. Thank you, Mr. Chairman.
    The Chairman. I would just say you all have made valid 
points. The problem is--I am not talking about you--but, within 
the Congress, nobody trusts you guys, okay? That is part of 
what we are dealing with here. You know, you probably could do 
all of this, but people right now are having a hard time 
believing that is going to happen. And that is part of what we 
are dealing with here.
    The Chairman of the Subcommittee, Mr. Boswell from Iowa.
    Mr. Boswell. Well, thank you, Mr. Chairman. I appreciate 
the discussion that is going on here.
    Maybe one point here to Mr. Concannon. As the market sorts 
out the various proposals for clearing derivatives traded in 
the OTC derivatives markets, we see the potential for 
regulation of the clearing that is being conducted by the Fed 
and the SEC, as well as the CFTC.
    In your view, does this arrangement make sense? What is the 
most sensible regulatory approach to clearing in this area, if 
you will?
    Mr. Concannon. Well, today we are regulated by both the 
CFTC and the SEC. We haven't added the Fed to that list yet. I 
think it is critical that we have one regulator and that that 
regulator, regardless of its name, uses a principle-based 
regulatory approach.
    As we travel the world, we have exchanges around the globe 
where we interact directly with regulators around the globe, 
and we find the great majority are using principle-based 
regulation, as the CFTC does today. It allows exchanges the 
flexibility to bring new products into the market, similar to 
the OTC products, into a market, and centrally cleared, where 
investors are better suited and better protected.
    So I would say, without naming the name of the single 
regulator, we do support a single regulator of all these 
instruments.
    Mr. Boswell. Anybody else want to comment?
    Mr. Cooper. We, NYSE Euronext, would also strongly support 
a principle-based regulatory approach to help us deliver the 
solutions that Congress is looking for, centralized clearing, 
exchange-traded solutions.
    Thank you.
    Mr. Boswell. Can I assume that you agree with most of us 
that it ought to be here with the CFTC?
    Mr. Cooper. For the centralized clearing of OTC 
derivatives, yes.
    Mr. Boswell. Interesting. I yield back.
    The Chairman. I thank the gentleman. The gentleman from 
Georgia, Mr. Marshall.
    Mr. Marshall. Thank you, Mr. Chairman.
    Mr. Brickell, the Chairman noted in response to your 
testimony that we are not quite as comfortable as you appear to 
be with private-market discipline as the answer to the current 
crisis, because folks like you 30 years ago, as you pointed 
out, made various recommendations to the market concerning how 
it should discipline itself and it just didn't happen.
    I can easily imagine the sort of pressures that are on 
traders and institutions as far as profits and bonuses, et 
cetera, are concerned, agree to swaps, hedges, those sorts of 
things that can make their books look a little bit better when 
in fact they are not. It would be enormously challenging to 
regulators to come in and take a look at those books. And you 
are right, the regulator does have access, where the big banks 
are concerned, to the details of every swap. The problem is, 
the regulator doesn't really have access to the circumstances 
of the counterparty or the others that the counterparty is 
relying on. And the web that is created is one that is quite 
challenging.
    Maybe in a better world where you could rely on all 
individuals to act appropriately with regard to gauging risk, 
dissemination of the risk over a wide number of people as 
opposed to concentrating it in single institutions is probably 
a very good idea. But what has happened here is there have been 
various market failures, and the upshot is that we end up 
plugging in a whole bunch of money and more money. And worse 
than that, actually, is a total collapse of the economy which 
has just hurt all kinds of people.
    We are headed in the direction of greater regulation, and 
we just appreciate the help from folks like you in trying to 
guide us to regulation that doesn't do too much damage in the 
course of doing more than you would want us to do.
    I would be delighted to talk a little bit further with you 
about this. But, it would be useful to the Committee to hear 
from two folks here that are not really all that interested in 
paying fees to a clearinghouse to comply with what the 
Committee would like to do in order to lessen systemic risks. 
And a couple of folks here are representing clearinghouses, 
saying we really ought to have clearing, and also suggesting we 
ought to come up with some sort of incentives to encourage the 
folks that don't really want to incur these fees associated 
with clearing, to clear.
    I am kind of curious to know what kind of fees and 
margining, et cetera, do you anticipate that would really 
dampen the market. I guess that would be Mr. Hale and Mr. 
Cicio. And then a quick response from those who are favoring 
clearing that no, they are not being realistic here, the market 
will go on, it is not going to die, it is not going to 
substantially contract, those sorts of things.
    What are the fees and problems you anticipate with being 
required to clear? And let's assume that there is a willingness 
to clear. Obviously, there are going to be some transactions 
people won't be willing to clear, and then some are going to 
just be too customized to fool with them. It is just too much.
    Mr. Hale. I don't know exactly how the fees would be 
structured as yet, but if they are similar to the regular 
futures contracts, you are going to have an initial margin fee 
to put up, there will be transactional costs and there is daily 
margining as the market changes. So there is going to be 
working capital costs to the participant in that case as well 
as transactional costs, which don't exist today to that full 
extent in the OTC market. There are margins.
    Mr. Marshall. Is that the principal thing that you are 
trying to avoid, is those enhanced costs?
    Mr. Hale. I think it is really that, and what it does to 
our customers who are going to have to provide that margin 
today, where we may have credit agreements with them, where 
they don't have to do that.
    Mr. Marshall. That is where Mr. Brickell would say, let 
private market discipline handle the margining requirements day 
to day and they will make wise decisions. It sounds like Alan 
Greenspan again, and it just doesn't seem to have worked real 
well recently.
    Mr. Hale. Right. It has worked fairly well in the 
agricultural markets. I mean, we haven't really had any 
significant meltdowns in that regard. Now, it doesn't mean it 
can't happen. I am not naive enough to try and tell you that. 
But I think that the system we have today is working quite 
well. There is an extreme amount of due diligence that goes on 
in assessing credit risks with our customers. So that is going 
on on a daily basis.
    Frankly, whether you have a transaction that goes through a 
clearinghouse or individually, it is not necessarily going to 
guarantee performance. There have been defaults on the 
clearinghouse, and so it is not a guarantee that there is going 
to be performance in the end.
    Mr. Marshall. Mr. Cooper? Mr. Concannon? Should they be 
concerned about margining requirements and fees?
    Mr. Cooper. Well, apparently they are. Yes, there would be 
these additional initial margin payments that don't exist in 
the over-the-counter marketplace. How significant that would 
be, I don't know. I suspect that we are just hearing about, 
sort of as a hypothetical matter, an initial margin payment. 
Any one of the market participants, market position, the 
initial margin payment that is due on Monday may be offset by 
variation credits they are getting for mark-to-market on their 
position in the clearinghouse on Friday. So it is not clear 
exactly what the impact would necessarily be, would be as great 
as they fear.
    Mr. Marshall. Mr. Chairman, earlier you noted or you 
suggested in response to Mr. Brickell's testimony that the 
effect of all of this really has been to permit these folks to 
margin out more. And, truly, even for cautious institutions, 
the effect has been that people get comfortable and take on way 
too many risks. We saw that with AIG making all kinds of 
mistakes, but some of the other institutions as well.
    So whether you call it leveraging or not, I guess you would 
say yes, there is a cost associated with this, Mr. Cooper, Mr. 
Concannon, those who are offering clearing. But, maybe it is a 
cost society needs to require that folks bear and come up with 
some way to encourage people to bear it, and maybe we come up 
with some way to try and minimize it.
    Competition might be good. Do you expect there is going to 
be just one clearinghouse ultimately?
    Mr. Cooper. We certainly have long been advocating 
competition in the over-the-counter clearing solution space, 
and that would be beneficial to the country and to the global 
marketplace, to offer alternatives and let the marketplace 
decide who are the strongest competitors and who offers the 
best solutions.
    Mr. Marshall. My time has expired some time ago, 2 minutes 
ago, and I appreciate the Chairman's indulgence. Obviously we 
could go a lot longer. We don't have other Members at the 
moment, so we are not going to have additional questions
    The Chairman. We have another panel. So I would like to 
wrap up. I thank the gentleman.
    I thank this panel for being with us and for your good 
testimony and answers. We will be in further discussion with 
you, I am sure, as we move through this process. You are 
dismissed.
    We have one more panel to get through today. While we are 
making the transition, I am going to introduce the panel.
    We have Mr. Thomas Book, who is a Member of the Executive 
Boards, of Eurex Deutschland and Eurex Clearing AG of 
Frankfurt, Germany.
    Mr. Stuart Kaswell, General Counsel of Managed Funds 
Association of Washington, DC.
    Mr. Edward Rosen, Partner, Cleary Gottlieb Steen & Hamilton 
LLP, on behalf of the Securities Industry and Financial Markets 
Association.
    Mr. Brent Weisenborn, CEO of Agora-X, LLC, of Parkville, 
Missouri.
    And Mr. Donald Fewer, the Senior Managing Director, 
Standard Credit Group, LLC, of New York, New York.
    So welcome to the Committee. Your complete statements will 
be made part of the record. We would encourage you to summarize 
your statements.
    Mr. Book, you will begin. Welcome to the Committee.

STATEMENT OF THOMAS BOOK, MEMBER OF THE EXECUTIVE BOARDS, EUREX 
        AND EUREX CLEARING AG, FRANKFURT AM MAIN, GERMAN

    Mr. Book. Chairman Peterson, Ranking Member Lucas, Members 
of the Committee, I appreciate the opportunity to testify 
before you today. I thank the Committee for calling this 
hearing on this important piece of legislation.
    I am Thomas Book, a Member of the of the Executive Boards 
of Eurex and Eurex Clearing. I have overall responsibility for 
management of the clearing business. Eurex Clearing is one of 
the leading clearinghouses in the world and is by far the 
largest European clearinghouse. It is licensed and supervised 
by the German Federal Financial Supervisor Authority. It is 
also recognized by the U.K.'s Financial Services Authority.
    Eurex and Eurex Clearing understands the importance of 
public confidence in the derivative markets. We support the 
Committee's efforts to increase transparency and to ensure 
appropriate regulation of the over-the-counter markets.
    Eurex Clearing strongly endorses the provision of section 
13 of the draft bill that permits any number of clearinghouses 
to act as CCP for OTC transactions in excluded commodities. 
Eligible CCPs could be supervised by the CFTC, the SEC, the 
Federal Reserve, or by a foreign regulator that meets 
appropriate standards. Such a non-U.S. clearinghouse is termed 
a multilateral clearing organization.
    This approach recognizes the high degree of competence of 
each of the U.S. financial regulators, and of many foreign 
regulators, to establish and enforce an appropriate level of 
supervision and oversight of the activities of the CCPs.
    However, for overseas transactions in exempt commodities, 
such as contracts on energy or precious or base metals are, the 
bill would permit only a CFTC-recognized derivatives clearing 
organization to act as a CCP. Eurex Clearing strongly 
encourages the Committee to amend the bill and permit non-U.S. 
multilateral clearing organizations to clear OTC contracts on 
exempt commodities if the CFTC has found that the applicable 
foreign regulator meets appropriate standards.
    Turning now to section 3 of the bill, foreign boards of 
trade such as Eurex, that are eligible to permit their U.S. 
members to directly access their markets, would be required to 
meet certain enhanced conditions with respect to contracts that 
settle to the prices of U.S. markets.
    It should be noted that the information collection systems 
of other countries may differ. For example, non-U.S. markets 
may collect information on large positions only during the spot 
month or only during the period preceding contract expiration. 
Accordingly, we recommend that the bill be modified to include 
room for such differences by explicitly permitting the CFTC to 
accept comparable alternative methods of market surveillance on 
the part of the foreign board of trade or the foreign 
regulatory authority.
    One of the boldest provisions of the proposed bill is the 
section 13 requirement that all derivative transactions, unless 
exempted by the CFTC, be submitted for central counterparty 
clearing. Eurex Clearing strongly supports clearing of OTC 
transactions as a means of safeguarding market integrity and 
the stability of the financial system.
    We firmly believe that the enhanced transparency of a 
neutral clearinghouse would have alerted market participants to 
the risk of their positions at an earlier time, resulting in 
much smaller losses. However, not all OTC transactions will be 
suitable for CCP-style clearing. Such noncleared transactions, 
nevertheless, serve bona fide economic purposes. To address 
this reality, the bill provides a mechanism whereby the CFTC 
can exempt certain kinds of nonstandardized transactions from 
the clearing requirement.
    Eurex Clearing believes that it is important that this 
exemptive authority be implemented in a practical way that 
preserves the vitality of the OTC markets. We believe that the 
CFTC should use its exemptive authority liberally.
    I would also note that we are concerned by the proposal in 
the draft bill to prohibit naked purchase of credit default 
swaps. We believe that this provision would seriously impair 
the functioning of the CDS market to the detriment of its many 
legitimate and valuable uses.
    Finally, I would like to share with you the same thoughts 
we have expressed to the European Commission. We have strongly 
supported the Internal Market Commissioner Charlie McCreevy's 
call for action to improve market infrastructure for OTC 
clearing, and, in particular, for credit default swap clearing. 
We believe that improvements in Europe are of common interest 
to all market participants because they will also contribute to 
market stability on a global scale.
    This Committee's deliberations provide an important 
opportunity to improve market infrastructure and the efficiency 
of the global financial system. For this reason we applaud 
Chairman Peterson for driving much-needed change to the OTC 
market structures. I appreciate the opportunity to discuss 
these critically important issues with the Committee and I am 
happy to answer your questions.
    [The proposed statement of Mr. Book follows:]

  Prepared Statement of Thomas Book, Member of the Executive Boards, 
        Eurex and Eurex Clearing AG, Frankfurt am Main, Germany
    Chairman Peterson, Ranking Member Lucas, Members of the Committee, 
on behalf of Eurex Deutschland (``Eurex'') and Eurex Clearing AG 
(``Eurex Clearing'') I would like to express our appreciation for this 
opportunity to testify before you today and to thank the Committee for 
calling this hearing on this important piece of legislation, the 
``Derivatives Markets Transparency and Accountability Act of 2009.'' My 
name is Thomas Book. I am a Member of the Executive Board of Eurex as 
well as Eurex Clearing and have overall responsibility for management 
of Eurex Clearing. Eurex and Eurex Clearing are part of the Deutsche 
Borse Group.
    Eurex and Eurex Clearing understand the importance of public 
confidence in the derivatives markets and support the Committee's 
efforts to increase transparency and ensure appropriate regulation of 
these markets. As Reto Francioni, the Deutsche Borse Group CEO, 
emphasized last week at the Group's annual New Year's reception:

        At Deutsche Borse . . . we have always seen it as an 
        advantage--in terms of transparency and fairness--that we are 
        subject to regulation and supervi
        sion . . . . Through the crisis, we have seen--and still see--
        that particularly where market organization was neither 
        effectively and efficiently regulated . . . those cases were 
        characterized by unfairness and opaqueness and resulted in 
        extraordinary damages.
Eurex and Eurex Clearing are key international exchange and clearing 
        services providers
    As I testified previously before this Committee,\1\ Eurex is one of 
the largest derivatives exchanges in the world today. Eurex is in fact 
the largest exchange for Euro-denominated futures and options 
contracts. While it is headquartered in Frankfurt, Germany, Eurex has 
405 members located in 22 countries around the world, including 74 in 
the United States.
---------------------------------------------------------------------------
    \1\ Hearing To Review the Role of Credit Derivatives in the U.S. 
Economy: Hearing before the House Committee on Agriculture, 110th Cong, 
2d sess. (December 8, 2008) (statement of Thomas Book, Member of the 
Executive Board, Eurex and Eurex Clearing).
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    Eurex Clearing is one of the leading clearinghouses in the world 
and by far the largest European clearinghouse. Eurex Clearing acts as 
the central counterparty (``CCP'') for all Eurex transactions and 
guarantees fulfillment of all transactions in futures and options 
traded on Eurex, all transactions on other Deutsche Borse Group 
exchanges and trading platforms, transactions on several independent 
exchanges, and transactions executed over-the-counter (``OTC''). Eurex 
Clearing is directly connected with a number of national and 
international central securities depositories, thereby simplifying the 
settlement processes of physical securities for its clearing members. 
As Europe's largest and one of the world's leading clearing houses, 
Eurex Clearing clears more than two billion transactions each year. 
Eurex Clearing has over 125 clearing members. It currently does not 
operate in the United States and has no U.S. clearing members,\2\ 
although through its clearing members it does indirectly clear trades 
on behalf of Eurex's U.S. members.
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    \2\ However, a number of its members are European affiliates or 
parents of U.S. entities. In addition, Eurex Clearing has an agreement 
with The Clearing Corporation relating to the operation of a clearing 
link between Germany and the United States.
---------------------------------------------------------------------------
    Eurex Clearing is highly experienced in offering fully automated 
and straight-through post trade services for derivatives, equities, 
repo, energy and fixed income transactions. Besides clearing 
transactions executed on exchange, Eurex Clearing also accepts, 
novates, nets and guarantees a broad range of derivatives transactions 
from the over-the-counter markets on the same basis that it clears 
exchange-traded contracts. Eurex Clearing's OTC clearing business is 
growing and accounted for about 40% of the total cleared derivatives 
volume last year. As we discussed in our Testimony to this Committee 
last December, like a number of other major derivatives clearinghouses, 
Eurex Clearing is developing clearing services for the Credit Default 
Swaps market.
High Degree of Regulation Applies
    Eurex Clearing is required to be licensed as a CCP by the German 
Federal Financial Supervisory Authority (``BaFin''). In addition, on 
January 16, 2007, Eurex Clearing was recognized by the United Kingdom's 
Financial Services Authority (``FSA'') as a Recognized Overseas 
Clearing House (``ROCH''), on the basis that the regulatory framework 
and oversight of Eurex Clearing in its home jurisdiction is based on 
common principles and practices to those of the FSA.
    As noted in our prior testimony to this Committee, the German 
Banking Act (``Banking Act'') provides the legal foundation for the 
supervision of banking business, financial services and the services of 
a CCP in Germany. The activity of credit and financial services 
institutions is restricted by the Banking Act's qualitative and 
quantitative general provisions. These broad, general obligations are 
similar to the Core Principles of the Commodity Exchange Act which 
apply to U.S. Derivatives Clearing Organizations (``DCOs''). A 
fundamental principle of the Banking Act is that supervised entities 
must maintain complete books and records of their activities and keep 
them open to supervisory authorities. BaFin approaches its supervisory 
role using a risk-based philosophy, adjusting the intensity of 
supervision depending on the nature of the institution and the type and 
scale of the financial services provided.
    The Banking Act requires that a CCP have in place suitable 
arrangements for managing, monitoring and controlling risks and 
appropriate arrangements by means of which its financial situation can 
be accurately gauged at all times. In addition, a CCP must have a 
proper business organization, an appropriate internal control system 
and adequate security precautions for the deployment of electronic data 
processing. Furthermore, the institution must ensure that the records 
of executed business transactions permit full and unbroken supervision 
by BaFin for its area of responsibility.
    BaFin has the authority to take various sovereign measures in 
carrying out its supervisory responsibilities. Among other things, 
BaFin may issue orders to a CCP and its Executive Board to stop or 
prevent breaches of regulatory provisions or to prevent or overcome 
undesirable developments that could endanger the safety of the assets 
entrusted to the institution or that could impair the proper conduct of 
the CCP's banking or financial services business. BaFin may also impose 
sanctions to enforce compliance. BaFin has the authority to remove 
members of the Executive Board of an institution or, ultimately, to 
withdraw the institution's authorization to do business.
    In addition, the German Federal Bank (``Deutsche Bundesbank'') 
coordinates and cooperates, with BaFin, the primary regulator, in the 
supervision of Eurex Clearing. Deutsche Bundesbank plays an important 
role in virtually all areas of financial services and banking 
supervision, including the supervision of Eurex Clearing. Under the 
Banking Act, Deutsche Bundesbank exercises continuing supervision over 
such institutions, including evaluating auditors' reports, annual 
financial statements and other documents and auditing banking 
operations. Deutsche Bundesbank also assesses the adequacy of capital 
and risk management procedures and examines market risk models and 
systems. Deutsche Bundesbank adheres to the guidelines issued by BaFin. 
As appropriate, Deutsche Bundesbank also plays an important role in 
crisis management.
    Both supervisory authorities use a risk-based approach to 
oversight, under which the supervisory authority must review the 
supervised institutions' risk management at least once a year to 
evaluate current and potential risks. In so doing, the supervisory 
authority takes into account the scale and importance of the risks for 
the supervised institution and the importance of the institution for 
the financial system. Institutions classified as of systemic 
importance, including Eurex Clearing, are subject to intensified 
supervision by both supervisory authorities.
The Derivatives Markets Transparency and Accountability Act of 2009
    As many have observed, the derivatives markets, both exchange-
traded and OTC, are global in nature. Accordingly, Eurex and Eurex 
Clearing have a critical interest in, and potentially will be affected 
by, this Committee's deliberations. Eurex and Eurex Clearing view the 
proposed Derivatives Markets Transparency and Accountability Act of 
2009 (the ``DMTAA'') as an important piece of legislation which will 
increase oversight and transparency of the OTC and exchange-traded 
derivatives markets. We commend the Committee for taking the initiative 
to address some of the thorniest issues that confront the financial 
markets in this period of economic crisis and support the Committee's 
efforts to ensure that these markets are appropriately regulated. With 
that as background, I am pleased to provide specific comments on the 
draft DMTAA.
The DMTAA Appropriately Recognizes Global Markets
    Section 3 of DMTAA has three sub-sections. The first would 
establish conditions that the Commodity Futures Trading Commission 
(``Commission'') must apply in granting Foreign Boards of Trade 
(``FBOT'') permission to provide direct market access to their trade 
matching system from the U.S. for contracts that settle against any 
price of a U.S. registered entity. These conditions include providing 
transparency with respect to certain daily trading information relating 
to such contracts, providing similar position accountability or 
speculative position limits as the U.S. registered entity imposes and 
providing information to the Commission with respect to large trader 
information. Although Eurex has been granted permission to provide 
direct market access to its U.S. members,\3\ it does not currently list 
any contracts which would be subject to the additional section 3 
requirements. Nevertheless, if in the future Eurex determines to list 
such a contract and make it available by direct market access from the 
U.S., it would be subject to these conditions.
---------------------------------------------------------------------------
    \3\ See Letter of the Commodity Futures Trading Commission Division 
of Trading and Markets, dated August 10, 1999, at: http://www.cftc.gov/
tm/letters/99letters/tmeurex_no-action.htm.
---------------------------------------------------------------------------
    First, it should be noted that section 3 of the DMTAA builds upon 
the foundation of the current procedures for reviewing and considering 
requests by FBOTs to provide direct market access from the U.S.\4\ 
Eurex strongly supports the current procedures. The current process is 
premised upon the underlying concept of ``mutual recognition'' of 
international regulatory frameworks. It is based upon two broad 
principles: (1) the conduct by the Commission of a thorough pre-
admission due diligence review to ensure that the FBOT is a bona fide 
market subject to a comparable regulatory scheme, and (2) recognition 
that the home country regulator is responsible in the first instance 
for regulation and oversight of the operation of the foreign market.
---------------------------------------------------------------------------
    \4\ The Commission on November 2, 2006, adopted a formal policy 
statement with respect to the procedure to be used in reviewing and 
granting permission to FBOTs to provide direct market access to their 
trade matching engines from the U.S. ``Boards of Trade Located Outside 
of the United States and No-action Relief from the Requirement to 
Become a Designated Contract Market or Derivatives Transaction 
Execution Facility,'' 71 Fed. Reg. 64443 (November 2, 2006) 
(``Commission Policy Statement'').
---------------------------------------------------------------------------
    This U.S. approach has been widely accepted internationally and 
with the application by foreign regulatory authorities of broadly 
similar procedures to permit direct market access by U.S. exchanges in 
their jurisdictions, provides an important base-line of international 
regulatory requirements which has been critical to the ability of both 
U.S. and foreign derivatives exchanges to operate global electronic 
trading systems. This has been accompanied by an increased level of 
consultation and cooperation between and among national regulators.
    The pre-admission due diligence review conducted by the Commission 
is extensive and thorough. In permitting FBOTs to establish direct 
market access from the U.S., the Commission imposes conditions that the 
FBOT must fulfill.\5\ The DMTAA builds upon this foundation, requiring 
that additional transparency, reporting and other requirements apply 
for direct market access by the foreign market with respect to 
contracts that settle to prices of a U.S. registered entity.
---------------------------------------------------------------------------
    \5\ These conditions include, among others, appointment by the FBOT 
of a U.S. agent for receipt of Commission communications, assent by the 
FBOT's members operating under a No Action letter to the jurisdiction 
of the Commission and appointment of a U.S. agent to receive legal 
process, a number of requirements relating to maintenance and 
accessibility of original books and records and required reporting by 
the FBOT to the Commission of specified information both on a periodic 
and special request basis. FBOTs must also keep the Commission informed 
of any material changes to their operations and the home country 
regulations under which they operate and must stand ready to 
demonstrate compliance with the conditions of the No-action relief. 
Finally, the FBOT must notify the Commission ten days prior to listing 
new contracts for trading from its U.S. terminals and must request 
supplemental relief with respect to contracts subject to section 
2(a)(1)(B) of the Commodity Exchange Act. See e.g. http://www.cftc.gov/
tm/letters/tmeurex_no-action.htm at 14.
---------------------------------------------------------------------------
    The DMTAA provides that where markets are linked through the use of 
one another's settlement prices, enhanced conditions for access will be 
applied. However, not all jurisdictions apply speculative position 
limits or position accountability rules in the same manner as U.S. 
markets. Markets may rely on other regulatory powers or authorities to 
fulfill their market surveillance obligations, especially for 
commodities that do not have limited deliverable supplies. Accordingly, 
we recommend that the DMTAA be modified to explicitly permit the 
Commission to accept comparable or alternative methods of market 
surveillance on the part of the FBOT or the foreign regulatory 
authority. In this regard, it should be noted that foreign markets or 
jurisdictions may collect information on large positions, but may do so 
only during the spot month or only during the period preceding contract 
expiration, or may not routinely aggregate such information across 
trading members' accounts. Such a framework should be understood 
nevertheless as being able to meet the conditions of section 3 of the 
DMTAA.
    The second subsection of section 3 of the DMTAA provides that a 
Commission registrant shall not be found to have violated the Commodity 
Exchange Act (``Act'') if the registrant believes the futures contract 
is traded on an authorized FBOT and the Commission has not found the 
FBOT to be in violation of the exchange-trading requirement of the Act. 
The third subsection provides that a contract executed on a FBOT will 
be enforceable even if the FBOT fails to comply with any provision of 
the Act. Eurex supports both of these provisions which will provide 
greater legal certainty with respect to trading on non-U.S. markets. 
This greater level of legal certainty is appropriate in the face of the 
increasing globalization of trading. Although Eurex endeavors to be in 
compliance at all times with all provisions of the Act that apply to 
it, the third subsection will provide all U.S. participants in a 
foreign market with greater certainty with respect to the 
enforceability and finality of the contracts which they trade.
The DMTAA will encourage clearing of OTC derivatives, including CDS
    Section 13 of the DMTAA seeks to bring greater transparency and 
accountability to the derivatives markets by requiring that OTC 
contracts, agreements and transactions in excluded commodities (mainly 
interest rates, equity indexes and other types of financial 
instruments) be cleared by: (1) a DCO registered by the CFTC; (2) by an 
SEC registered clearing agency; (3) by a banking institution subject to 
the supervision of the Federal Reserve System; or (4) by a clearing 
organization that is supervised by a foreign financial regulator that a 
U.S. financial regulator has determined satisfies appropriate 
standards. This last category of approved clearing organization is a 
multi-lateral clearing organization (``MCO'') recognized under section 
409(b)(3) of the Federal Deposit Insurance Corporation Improvement Act 
of 1991 (``FDICIA''). Section 13 of the DMTAA further provides that OTC 
contracts, agreements or transactions in exempt commodities (mainly 
energy, precious metals and possibly emissions or carbon rights) would 
be required to be cleared through a CFTC-registered DCO.
    Eurex Clearing strongly supports clearing of OTC transactions as a 
means of safeguarding market integrity and the stability of the 
financial systems. Eurex Clearing believes that clearing OTC 
derivatives provides undeniable benefits not only to the individual 
clearing participant but to the entire financial market as well by 
enhancing transparency, avoiding undue concentrations of risk 
positions, and providing a system to contain and reduce systemic 
failures. We firmly believe that the enhanced transparency of central 
counterparty clearing by a neutral clearinghouse would have alerted 
market participants to the risk of their positions at an earlier time, 
resulting in much smaller trading losses, and potentially avoiding some 
of the extraordinary mitigation efforts that have ensued.
    To be sure, a derivatives clearinghouse is not a panacea, but, with 
regard to our current financial turmoil, clearing might in many 
instances have prevented entities from building unsustainable 
positions. The twin disciplines of marking positions to market and 
collecting collateral, or margin, are market mechanisms that are the 
very heart of the value of CCP clearing. These market mechanisms are 
very efficient at discouraging the build-up of unaffordable risk. Also, 
direct access to clearing services is, by its nature, limited to 
creditworthy institutions--the clearing members--who are willing and 
able to mutualize their counterparty risk. Because of this structure, 
exchange-traded derivatives or those that were traded OTC but 
subsequently submitted for CCP clearing, have not been an issue during 
the current market crises. Derivatives clearinghouses on both sides of 
the Atlantic have functioned well and, by doing so, have assured that 
CCP-cleared derivatives markets continue to provide their crucial risk 
shifting and price discovery functions.
    CCP clearing has previously not been available for credit default 
swaps (``CDS''). Eurex Clearing is confident that CCP clearing of CDS 
will help ameliorate systemic risk for the financial markets by 
mitigating counterparty risk and by enhancing transparency regarding 
exposures, the sufficiency of risk coverage, operational weaknesses, 
and technical capacity shortfalls. Given the huge, widely held exposure 
in CDS contracts, robust clearinghouses are needed to act as the 
central counterparty to these trades.
    As we detailed in our prior Testimony to this Committee, Eurex 
Clearing has been working with ISDA, Deriv/SERV, international banks 
and dealers, major buy-side firms and European public authorities to 
launch clearing services for Euro-denominated CDS by the end of this 
calendar quarter.
The DMTAA appropriately encourages competition among providers of OTC 
        clearing services
    We note that one of the boldest provisions of the proposed bill is 
the requirement that all derivatives transactions, unless exempted by 
the Commission, be cleared. We further note that OTC contracts in 
excluded commodities could be cleared by a registered DCO, by a 
clearing house supervised by the SEC or the Fed, or by an MCO 
supervised by a foreign regulator that has been recognized by a U.S. 
regulator as meeting appropriate standards (``Foreign Regulated MCO'').
    Eurex supports DMTAA's provision of permitting a number of clearing 
houses to offer clearing services for OTC contracts, agreements or 
transactions in excluded commodities. The alternative of mandating that 
only a single clearinghouse be licensed by an identified regulator to 
clear all OTC transactions world-wide would be contrary to the public 
interest. That type of mandated industry-wide monopoly or utility 
generally has reduced incentives to maximize efficiencies and 
innovation.
    Accordingly, Eurex Clearing supports the approach adopted by DMTAA 
of permitting market participants to decide which clearinghouse to use 
from a number of possible clearing houses. Moreover, the DMTAA's 
provision which would permit such clearinghouses to be supervised by 
one of several possible U.S. regulators or by a foreign regulator that 
has been found by a U.S. financial regulator to meet appropriate 
standards recognizes the high degree of competence of each of the U.S. 
financial regulators, and of many foreign regulators, to establish and 
enforce an appropriate level of supervision and oversight of the 
activities of the CCPs. In this regard, the DMTAA addresses possible 
issues of overlap and duplication among the several regulators by 
requiring consultation by the Commission with the other regulators and 
by sharing of information. Eurex commends this legislation for 
addressing these potential problems.
The DMTAA Should Permit Foreign Regulated MCOs to Clear Exempt 
        Commodity Transactions
    Section 13 of the DMTAA would require that all CCPs for 
transactions with respect to OTC contracts, agreements or transactions 
on exempt commodities be registered with the Commission as a DCO. 
Although DMTAA may be premised on the assumption that the Commission 
should exercise oversight of CCP clearing of OTC transactions in which 
the underlying is a commodity and not a financial instrument, section 
13(b) of the DMTAA unnecessarily restricts a Foreign Regulated MCO from 
acting as a CCP for such transactions. As currently drafted, the DCO 
requirement in the DMTAA seems to erect an unnecessary barrier to well-
regulated foreign competition which may undermine the Act's general 
promotion of competition to assure efficiency and encourage innovation.
    Eurex Clearing currently does not operate in the United States but 
would like to consider offering clearing and other services here in the 
future with respect to OTC contracts, agreements and transactions on 
excluded commodities, and may also consider offering such services with 
respect to exempt commodities.
    At the moment, Eurex Clearing is not registered with the CFTC. In 
this regard, Eurex Clearing notes that it is in discussions with staff 
of the Commission regarding applying for Commission recognition as a 
Foreign Regulated MCO. We further note that several non-U.S. 
clearinghouses previously have been so recognized. Of the currently 
recognized Foreign Regulated MCOs, all may act as CCPs for OTC 
contracts on exempt commodities.\6\ Eurex Clearing strongly encourages 
the Committee to amend the DMTAA to include transaction clearing of OTC 
contracts on exempt commodities by a Foreign Regulated MCO so long as 
the Commission has approved the foreign regulator of the MCO as meeting 
appropriate standards.
---------------------------------------------------------------------------
    \6\ They are, ICE Clear Europe, MCO Order issued on August 31, 
2008; NetThruPut, Order Issued February 27, 2006; and Nos Clearing Asa, 
Order issued January 11, 2002. At least two, NetThruPut and Nos 
Clearing act as CCPs for exempt commercial markets on exempt 
commodities.
---------------------------------------------------------------------------
    This change would reflect the fact that the Commission, in 
administering the provisions of section 409 of FDICIA, has significant 
experience in reviewing the standards of foreign regulatory authorities 
to ensure that they are appropriate. In this regard, the Foreign 
Regulated MCO process is a form of mutual recognition which facilitates 
the operation in the U.S. of foreign clearing organizations which the 
CFTC has found are subject to comparable regulation in jurisdictions 
with comparably rigorous regulation. Furthermore, the CFTC requires 
that adequate information-sharing agreements with the foreign regulator 
are in place.
    In reviewing applications by a Foreign Regulated MCO for an Order 
under section 409 FDICIA, the Commission determines whether the foreign 
CCP is subject to oversight by its home country regulator comparable to 
that which the Commission requires of U.S. DCOs in meeting the Core 
Principles. Accordingly, the Commission reviews both applications for 
DCO registration as well as requests for an Order recognizing a Foreign 
Regulated MCO in relation to the standards established by the Core 
Principles for Derivatives Clearing Organizations.
    For this reason, Eurex Clearing also supports the DMTAA provision 
that would require a Foreign Regulated MCO to comply with requirements 
similar to the requirements of section 5b and 5c of the Act and the 
DMTAA's addition of three new Core Principles relating to daily 
publication of pricing information, fitness standards and disclosure of 
operational information. Eurex Clearing already meets all existing and 
proposed Core Principles and believes that these are an appropriate 
requirement for any foreign CCP wishing to operate in the U.S. as a 
Foreign Regulated MCO.
DMTAA Provides a Useful Mechanism for Exempting Transactions from the 
        Clearing Requirement
    Eurex Clearing firmly believes that central clearing services are 
the most suitable option effectively to mitigate counterparty risk and 
to improve market transparency. These are key elements in any effort 
toward a sustainable reduction in risk on a global scale and we support 
all voluntary efforts to increase the availability and use of CCP 
clearing for OTC transactions. In this vein, we applaud the Committee's 
recognition of the important role that derivatives clearinghouses 
provide in stabilizing the world's financial markets.
    As the DMTAA recognizes, not all OTC transactions will be suitable 
for CCP style clearing. Such transactions may nevertheless serve bona 
fide economic purposes. To address this reality, the DMTAA provides a 
mechanism whereby the Commission can exempt certain types of non-
standardized transactions from the clearing requirement. The 
Commission's determination would be based upon several factors, 
including the degree of customization of the transaction, the frequency 
of such transactions, whether the contract serves a price discovery 
function and whether the parties have provided for the financial 
integrity of the agreement. Eurex Clearing believes that these factors 
are the correct criteria to consider in making a determination that a 
transaction or class of transactions should be exempt from the clearing 
requirement.
Conclusion
    Eurex Clearing supports the Committee in its efforts to encourage 
greater use of CCPs. We are ourselves working to secure the commitment 
by financial institutions to participate in the development of and to 
use the services of our CDS clearing offering.
    Eurex Clearing understands the importance of public confidence in 
these markets and is committed to the utmost level of cooperation with 
the regulatory authorities in Europe and the U.S. We appreciate the 
opportunity to work with the U.S. regulatory authorities with respect 
to our plans to offer clearing services for CDS transactions.
    Eurex Clearing also believes that the existing treatment of 
derivatives clearinghouses which envisions the possibility of more than 
one CCP offering its services to the OTC markets supervised by any one 
of the qualified financial regulators offers an appropriate, workable 
and sound legal and regulatory framework.
    Eurex Clearing also notes that within the framework of the DMTAA, 
the possibility exists for CCPs that are regulated in their home 
countries comparably to the requirements of the Core Principles that 
apply to Derivatives Clearing Organizations to be able to offer their 
services in the United States as a multi-lateral clearing organization. 
We urge the Committee to permit Eurex Clearing (once its status has 
been recognized by the Commission) and the other MCOs that have already 
received recognition as such from the CFTC to clear OTC contracts, 
agreements and transactions not just on excluded commodities but also 
on exempt commodities. Eurex Clearing supports the application of the 
additional proposed Core Principles to Derivatives Clearing 
Organizations and to Foreign Regulated Multi-lateral Clearing 
Organizations.
    In this spirit, I would like to share with you the same thoughts we 
have expressed to the European Commission. We have strongly supported 
the Internal Markets Commissioner Charlie McCreevey's call for action 
to improve market infrastructure for OTC clearing and in particular for 
credit default swap clearing. We believe that improvements in Europe 
are of common interest to all market participants because they will 
also contribute to market stability on a global scale. Furthermore, we 
believe that there should be an alignment of regulatory policy 
regarding OTC clearing, first across the Atlantic and then globally. We 
recognize that that will take time to achieve and that the European 
regulators believe that decisive action may be appropriate now.
    Finally, I note that this is the second time that I have testified 
before this Committee on behalf of Eurex and Eurex Clearing and we are 
deeply honored to have been invited back to present our views to this 
Committee. We very much appreciate the opportunity to discuss these 
critically important issues with the Committee. I am happy to answer 
your questions.

    Mr. Holden [presiding.] Thank you, Mr. Book.
    Mr. Kaswell.

         STATEMENT OF STUART J. KASWELL, EXECUTIVE VICE
          PRESIDENT AND GENERAL COUNSEL, MANAGED FUNDS
                 ASSOCIATION, WASHINGTON, D.C.

    Mr. Kaswell. Thank you, Mr. Chairman.
    Mr. Chairman, Ranking Member Lucas, and Members of the 
Committee, I am Stuart Kaswell, Executive Vice President and 
General Counsel, Managed Funds Association. MFA appreciates the 
opportunity to testify before you today.
    MFA represents the majority of the world's largest hedge 
funds and is the primary advocate for sound business practices 
and industry growth for professionals in hedge funds, funds of 
funds, and managed funds, as well as the industry service 
providers. MFA appreciates the opportunity to share its views 
with the Committee regarding the proposed Derivatives Markets 
Transparency and Accountability Act of 2009.
    As participants in our nation's markets, MFA's members 
share your concerns regarding the challenges in those markets 
and the difficulties facing our economy. We commend this 
Committee for considering measures which, in seeking to 
strengthen the regulatory framework, can help restore stability 
and confidence in our markets and the economy they serve.
    The DMTAA has a number of provisions that MFA generally 
supports. These provisions would strengthen and codify the 
information that the CFTC receives to ensure that its decisions 
are well informed. For example, we support section 4, which 
would improve reporting of positions of index funds and require 
the CFTC to issue a rule defining and classifying index traders 
and swap dealers for data reporting.
    We also view sections 9 and 10 of the legislation as useful 
provisions which should provide the Committee and regulators 
with greater information about the OTC derivatives markets and 
international energy commodity markets.
    Our members also support the provisions included in section 
3, which would codify the CFTC's authority to set conditions on 
the access of foreign boards of trade to the United States.
    While we support these provisions and the Committee's 
commitment to promoting greater transparency and a more sound 
regulatory structure, we are concerned about certain other 
aspects of the legislation.
    Section 6 would direct the CFTC to set position limits for 
all commodities. We believe this provision is unnecessary. The 
exchanges currently perform this important function and are in 
a better position to establish and enforce position limits. 
Moreover, we believe that position limits are more appropriate 
for the spot month of physical delivered commodities than for 
the back months of such contracts.
    We also view the language in section 11 as problematic, as 
it; first, effectively mandates that the CFTC set position 
limits on OTC derivatives; and second, is premature given the 
lack of understanding about this market. As the Committee 
knows, section 9 of the bill seeks more detailed information 
about this market, which we believe is an important predicate 
before Congress takes further action.
    Finally, we believe that section 16, which seeks to 
eliminate the so-called naked credit default swap transactions, 
would significantly damage the liquidity and price discovery 
process in the CDS market. Such an outcome would not only 
undermine the efficiency of this market, but would also have a 
negative impact on the real economy as it would increase the 
cost of capital, and potentially cause the cost of projects and 
business development to rise substantially.
    With respect to section 13, MFA strongly supports moving to 
a clearing system and a central counterparty for OTC products. 
In fact, we believe that the credit review and margin 
requirements attendant to central clearing would address many 
of the concerns that may have been the motivation for the 
section 16 language.
    While we strongly support central clearing, which has 
proven to help reduce risks in other commodity and financial 
markets, we believe that Congress should not mandate this 
requirement in the OTC market until such platform is fairly 
mature. Moreover, we believe that over time many OTC products 
should be standardized and centrally cleared. It would be 
inadvisable to require all OTC transactions to be centrally 
settled and cleared since customized products are an important 
risk management tool.
    Mr. Chairman, Ranking Member, although we have outlined 
certain concerns, MFA and our members are grateful for the 
opportunity to testify and we appreciate the bipartisan 
approach you have taken in fashioning this legislation. We 
appreciate your willingness to consider the views of all 
interested parties.
    We welcome the opportunity to work with you. I do have one 
request. I would like to add to the record a letter that MFA 
sent to the Federal Reserve Bank of New York, the SEC and the 
CFTC to supplement my written statement.
    [The prepared statement of Mr. Kaswell follows:]

 Prepared Statement of Stuart J. Kaswell, Executive Vice President and 
      General Counsel, Managed Funds Association, Washington, D.C.
    Managed Funds Association (``MFA'') is pleased to provide this 
statement in connection with the House Committee on Agriculture's 
hearing on the ``Derivatives Markets Transparency and Accountability 
Act of 2009'' (the ``Derivatives Act'') to be held February 2, 2009. 
MFA represents the majority of the world's largest hedge funds and is 
the primary advocate for sound business practices and industry growth 
for professionals in hedge funds, funds of funds and managed futures, 
as well as industry service providers. MFA's members manage a 
substantial portion of the approximately $1.5 trillion invested in 
absolute return strategies around the world.
    MFA appreciates the opportunity to express its view on the 
Derivatives Act and the important issues that it raises. MFA members 
are active participants in the commodities and over-the-counter 
(``OTC'') derivatives markets and have a strong interest in promoting 
the integrity of these markets. MFA consistently supports coordination 
between policy makers and market participants in developing solutions 
to improve the operational infrastructure and efficiency of the OTC 
credit derivatives markets. We are supportive of the Committee's goals 
to: (1) enhance transparency and reduce systemic risk; (2) promote a 
greater understanding of the OTC markets and their interaction with 
exchange-traded and cleared markets; (3) ensure equivalent regulatory 
oversight in the international regulatory regime for energy commodities 
and derivatives and provide for greater information sharing and 
cooperation among international regulators; and (4) provide additional 
resources to the Commodity Futures Trading Commission (``CFTC'').
    Nevertheless, we have significant concerns with several provisions 
of the Derivatives Act, including, in chronological order, Section 6 
``Trading Limits to Prevent Excessive Speculation'', Section 11 ``Over-
the-Counter Authority'', Section 12 ``Expedited Process'', Section 13 
``Clearing of Over-the-Counter Transactions'', and Section 16 
``Limitation on Eligibility to Purchase a Credit Default Swap''. We 
believe these provisions would have the effect of reducing market 
participants' hedging and risk management tools, and negatively impact 
our economy by raising the cost of capital and reducing market 
transparency and efficiency in capital markets. We would like to work 
with the Committee in addressing these issues. We respectfully offer 
our suggestions in that regard.
Trading Limits To Prevent Excessive Speculation
    As a general matter, greater market liquidity translates into more 
effective price discovery and risk mitigation, especially in 
physically-settled contracts. We are concerned that Section 6 ``Trading 
Limits to Prevent Excessive Speculation'' will impose upon the CFTC a 
new obligation that historically has been left to the exchanges in 
deference to their greater expertise respecting the various factors 
that affect liquidity in these markets. We are concerned that section 6 
implements an overly rigid structure for establishing speculative 
position limits. We urge that the markets are best served by placing 
the CFTC in an oversight role.
    Currently, the exchanges, as part of their self-regulatory 
obligations, are involved daily in monitoring the activities of market 
participants. They frequently engage in soliciting the views of 
speculators and hedgers in their markets. Also, they are more closely 
engaged in watching deliverable supply. Because position limits may 
have an impact on price, we believe speculative position limits are 
best determined by a regulatory authority, rather than market 
participants through position limit advisory groups. For these reasons, 
we believe that the exchanges, subject to their regulatory obligations 
under the Commodity Exchange Act (``CEA''), should propose the size of 
the speculative position limits following the processes they now employ 
with their energy and other markets.
    Section 6 would require the CFTC to convene a Position Limit 
Agricultural Advisory Group and a Position Limit Energy Group, 
consisting of industry representatives, exchanges and electronic 
trading facilities, to provide the CFTC with position limit 
recommendations. While, as stated, we believe the exchanges, subject to 
the CFTC's oversight, should determine and administer speculative 
position limits, we are concerned that the make-up of these advisory 
groups is not well-balanced and therefore does not provide a mechanism 
for obtaining the views of all parties active in these markets. For 
example, noncommercial participants add vital liquidity to these 
markets through investment capital and are necessary to the success of 
a market. Thus, we believe that each advisory Committee should have the 
same number of noncommercial participants as there are short and long 
hedgers.
    We support the setting of speculative limits in spot months for 
physically-delivered energy and agriculture commodities for two 
reasons. First, physically-delivered futures contracts are more 
vulnerable to market manipulation in the spot month, because the 
deliverable supply of the commodity is limited and, thus, more 
susceptible to price fluctuations caused by abnormally large positions 
or disorderly trading practices. Second, the commodity is likely 
delivered by the contract owner during the spot month and has a closer 
nexus to the end-price received by consumers.
    On the other hand, we believe that requiring speculative position 
limits for all months and for aggregate positions in the energy 
markets, in particular, has the capacity to distort prices. Commercial 
hedgers often enter into long-dated energy futures (for example, a 
contract with an expiration date 7 years into the future) to hedge 
specific projects. Speculators typically take the other side of these 
contracts. The markets for contracts in these distant (or back) months 
are less liquid as there are fewer buyers and sellers for long-dated 
contracts.
    We are concerned that by setting position limits for all months, 
including the less liquid, back months, the speculative position limit 
will reduce liquidity in these distant months and distort the market 
price for these contracts. We note that the CFTC already has at its 
disposal several tools, including position reporting and accountability 
levels, which serve effectively in ensuring market integrity without 
the inflexibility of speculative position limits.
    Cash-settled commodities do not raise the same market manipulation 
concerns as do physically-delivered commodities in that the ability to 
impact the futures price by controlling deliverable supply is absent. 
Cash-settled commodities (particularly financial futures) tend to have 
deep and liquid markets, are primarily used for hedging and risk 
mitigation by commercials, do not contribute to price discovery which 
is usually set in the cash markets and therefore have little or no 
impact on consumers. The CEA, as amended by the CFTC Reauthorization 
Act of 2008, provides that any contract that has a significant price 
discovery function on an exempt commercial market, is subject to 
greater CFTC regulation and oversight.
    We are concerned that imposing speculative position limits on cash-
settled commodities will have the effect of depressing liquidity and 
thereby increase the cost of using these back months. It would appear 
that Congress has already addressed this issue in section 4a of the CEA 
which grants to the CFTC broad authority to impose limits on trading 
and to curb excessive speculation. In MFA's view it would be advisable 
for all interested parties to work together to address concerns about 
excessive speculation, rather than having Congress mandate a process 
that could result in negative consequences. As market participants, we 
have a strong interest in promoting fair and orderly markets. To this 
end, we believe the CFTC should be afforded regulatory flexibility, 
which the current framework provides, in addressing excessive 
speculation and policing the markets.
Over-the-Counter Authority and Central Clearing
    MFA supports the requirement in Section 9 ``Review of Over-the-
Counter Markets'' that the CFTC study and analyze the effects of OTC 
trading and aggregate limits across the OTC markets, designated 
contract markets and derivative transaction execution facilities. We 
applaud this effort in conjunction with the additional authority 
Congress seeks to provide to the CFTC through Section 4 ``Detailed 
Reporting and Disaggregation of Market Data'' and Section 5 
``Transparency and Recordkeeping Authorities''. We believe these 
provisions will provide the CFTC with better information to understand 
the OTC markets and how best to regulate these markets. However, we 
believe that the CFTC should be authorized to determine position limits 
under Section 11 ``Over-the-Counter Authority'' only after the study 
has defined the existence of risks that are appropriately controlled by 
the imposition of such limits. In other words, the results of such 
study should be the predicate for taking further legislative or 
regulatory action.
    We are concerned that section 11 creates a test that can only 
result in the CFTC concluding that all fungible OTC agreements must be 
subject to position limits. Section 11 requires the CFTC to determine 
whether fungible OTC agreements have the potential to disrupt market 
liquidity and price discovery functions, cause severe market 
disturbance, or prevent prices from reflecting supply and demand. It 
would be extremely difficult for the CFTC to find that OTC agreements 
have absolutely no potential for disruption under any circumstances, 
whether currently known or unknown. Thus, section 11 may be interpreted 
to automatically provide the CFTC with the authority to impose and 
enforce position limits for anyone trading in fungible significant 
price discovery agreements. We recognize that the bill would leave to 
the CFTC the discretion to use its authority as to the size of the 
position limits it imposes. Nonetheless, we think the grant of 
authority is too broad.
    With regard to Section 13 ``Clearing of Over-the-Counter 
Transactions'', we strongly support the concept of central clearing and 
believe that it offers many potential market benefits. We greatly 
appreciate the urgent attention of Federal regulators and Congress in 
addressing this important matter. The private sector, working in 
conjunction with the Federal Reserve Bank of New York (``NY Fed''), has 
made strong progress in standardizing credit default swap (``CDS'') 
contracts and establishing a central clearing house for these 
contracts. There is also a private sector initiative to develop 
exchange trading for CDS contracts. As investors in the OTC derivatives 
markets, we would like to see greater contract standardization and a 
move toward central clearing for other OTC derivatives instruments, 
including interest rate, foreign exchange, equity and commodity 
derivatives.
    MFA shares Congress' desire to expedite the establishment of 
central clearing platforms covering a broad range of OTC derivative 
instruments. We believe a central clearing platform, if properly 
established, could provide a number of market benefits, including: (1) 
the mitigation of systemic risk; (2) the mitigation of counterparty 
risk and protection of customer collateral; (3) market transparency and 
operational efficiency; (4) greater liquidity; and (5) clear processes 
for the determination of a credit event (for CDS). In fact, MFA and its 
members have been actively involved in the establishment of CDS central 
clearing platforms.
    Congress, regulators, and the private sector should promote central 
clearing of OTC derivative products. However, while we urge Congress 
and regulators to stay engaged in the process and development of 
establishing central clearing platforms for OTC derivatives products, 
we do not believe that Congress should mandate clearing for all OTC 
derivatives by a certain date. As a step in this direction, Congress 
should simplify regulatory procedures and remove obstacles to prompt 
approval of central clearing for OTC products. For example, in view of 
the support shown by many spokespeople for different sectors of the 
agricultural industry, we believe Congress should allow agricultural 
swaps to be centrally cleared without the need to first obtain an 
exemption from the CFTC.
    Our concern with section 13 mandating central clearing of all OTC 
derivatives transactions is twofold. First, as central clearing 
platforms for financial derivatives are still in development, there 
remain many undetermined and unresolved operational factors that could 
limit the value of central clearing. Among the operational factors are: 
most importantly, protection of customer collateral; central 
counterparty governance and dispute resolution; the most appropriate 
formats for clearing; and the optimum fee structure.
    To the point on protection of customer collateral, we are 
especially concerned that early discussions on central clearing 
operations will not protect customer assets through segregated 
accounts. As noted in our December 23, 2008 letter to the NY Fed, the 
Securities and Exchange Commission (``SEC'') and the CFTC (attached 
hereto), the current collateral management mechanism used by banks do 
not adequately protect a participant's pledged collateral, and as such, 
contributes to systemic risk. For example, because pledged collateral 
at Lehman Brothers was not segregated, once the company was placed in 
bankruptcy, pledgors became general creditors of the company. With 
respect to central counterparty governance, we believe a central 
counterparty should be an established independent body led by a board 
reflecting balanced representation of all market participants. 
Similarly, a central counterparty should have an independent, fair and 
efficient dispute resolution process.
    Second, central clearing is not readily attainable for the majority 
of OTC derivatives because these products are not standardized. We 
appreciate the Committee's attempt to address the issue of non-
standardized, highly unique (individually-negotiated or bespoke) 
contracts by providing the CFTC with the authority to exempt a 
transaction from the section 13 clearing requirement. We note that as 
part of a regulatory framework that maximizes the ability of market 
participants to mitigate risk and encourage product innovation, it is 
important to provide market participants with the ability to engage in 
non-standardized, highly unique contracts. However, in view of the 
number of OTC derivative contracts that would have to rely on an 
exemption and the delays that occur when an agency must staff a new 
mandate, we are concerned that the implementation of section 13 would 
be highly disruptive to the marketplace.
    In contrast to other OTC derivatives, the CDS market has quickly 
become more standardized for various reasons. When the CDS markets 
began to develop in 1997, only a few of the major derivatives dealers 
traded these products. Since these dealers were similarly positioned in 
the market and traded these contracts as both buyers and sellers, they 
were able to negotiate and develop standardized templates for CDS 
contracts. These template contracts, with some modifications, have 
remained relatively unchanged and are currently used by all market 
participants that trade CDS. This standardization is a major reason why 
CDS contracts are highly liquid and attractive products.
    Conversely, derivatives dealers are generally the sellers of other 
OTC derivatives and will negotiate and structure different terms with 
each counterparty. As a result, other OTC derivatives are not as 
fungible or liquid as CDS. The fungibility and liquidity of CDS 
contracts have caused them to reach a certain level of standardization 
and efficiency, which have made them ripe for centralized clearing. The 
same can be said for certain interest rate, energy and agricultural 
commodity derivatives.
    By way of comparison, the majority of OTC derivatives markets, 
including those trading interest rate, foreign exchange, and equity 
derivatives, are nowhere near the level of standardization of the CDS 
markets. The CDS markets account for roughly 8% to 9% of the notional 
volume of the OTC derivatives market. As stated above, these other OTC 
derivative instruments are not interchangeable between buyers and 
sellers, and are generally sold by banks or dealers to market 
participants other than banks or dealers.
    MFA fully supports collaborative industry-wide efforts and 
partnerships with regulators, like the NY Fed, SEC and CFTC to develop 
solutions to promote sound practices and to strengthen the operational 
infrastructure and efficiency in OTC derivatives trading. MFA is an 
active participant in the Operations Management Group (the ``OMG''), an 
industry group working towards improving the operational infrastructure 
and efficiency of the OTC derivatives markets. The goals of the OMG 
are:

   Full global use of central counterparty processing and 
        clearing to significantly reduce counterparty credit risk and 
        outstanding net notional positions;

   Continued elimination of economically redundant trades 
        through trade compression;

   Electronic processing of eligible trades to enhance T+0 
        confirmation issuance and execution;

   Elimination of material confirmation backlogs;

   Risk mitigation for paper trades;

   Streamlined trade lifecycle management to process events 
        (e.g., Credit Events, Succession Events) between upstream 
        trading and confirmation platforms and downstream settlement 
        and clearing systems; and

   Central settlement for eligible transactions to reduce 
        manual payment processing and reconciliation.

    In recent years, the OMG and other industry-led initiatives have 
made notable progress in the OTC derivatives space. Some of the more 
recent market improvements and systemic risk mitigants have included: 
(1) the reduction by 80% of backlogs of outstanding CDS confirmations 
since 2005; (2) the establishment of electronic processes to approve 
and confirm CDS novations; (3) the establishment of a trade information 
repository to document and record confirmed CDS trades; (4) the 
establishment of a successful auction-based mechanism actively employed 
in 14 credit events including Fannie Mae, Freddie Mac and Lehman 
Brothers, allowing for cash settlement; and (5) the reduction of 74% of 
backlogs of outstanding equity derivative confirmations since 2006 and 
53% of backlogs in interest rate derivative confirmations since 2006.
    MFA supports the principles behind section 13, but, as discussed, 
has concerns with how these principles will be implemented. Although 
central clearing is not appropriate for all OTC derivative contracts, 
we firmly believe that greater standardization of OTC derivative 
contracts and central clearing of these more standardized products 
would bring significant market benefits. Indeed, we believe that 
central clearing offers substantially greater opportunity to address 
concerns about systemic risk, than other alternatives, such as section 
16 of the legislation. To this end, MFA is committed to continuing its 
collaboration with the major derivatives dealers and service providers 
to prioritize future standardization efforts across OTC derivatives and 
other financial products. MFA also understands Congress's desire to 
have greater oversight of these markets and believes there is an 
important role for the NY Fed, CFTC and SEC to play in monitoring and 
guiding industry-led OTC derivatives solutions. We believe it would be 
more appropriate at this stage to require the applicable regulatory 
authorities to work with market participants towards the principles 
espoused in section 13 and to provide the Committee with frequent 
progress reports.
Expedited Process
    Section 12 ``Expedited Process'' provides the CFTC with the 
authority to use emergency and expedited procedures. While we do not 
object to this authority, we strongly urge Congress and the CFTC to use 
the notice and comment process whenever possible. We believe the notice 
and comment process is more likely to protect the public interest, 
minimize market disruptions and unintended consequences, and result in 
better regulation.
Limitation on Eligibility To Purchase a Credit Default Swap
    Credit derivatives are an important risk transfer and management 
tool. Market participants use credit derivatives for hedging and 
investment purposes. We believe both are legitimate uses of the 
instrument and are equally important components of a liquid and well-
functioning market.
    Section 16 would make it a violation of the CEA for a market 
participant to enter into a CDS unless it has a direct exposure to 
financial loss should the referenced credit event occur. We appreciate 
that it is the goal of the provision to add stability to the CDS market 
by reducing excess speculation. Nonetheless, this provision would 
severely cripple the CDS market by making investment capital illegal 
and removing liquidity providers. Without investment capital in the 
market, market participants wishing to hedge their position through a 
CDS would find few, if any, market participants to take the other side 
of the contract. As a result, the CDS market could cease functioning 
for lack of matching buyers and sellers. Market participants that risk 
their own capital provide depth and liquidity to any market, and the 
market for CDS is no exception. Because the provision would eliminate 
such market participants, the CDS market would have much less price 
transparency and continuity.
    This outcome is particularly troubling given the benefits the CDS 
markets provide to the capital markets and to the overall economy. CDS 
contracts have improved our capital markets by enhancing risk 
transparency, price discovery and risk transferal, with the effect of 
reducing the cost of borrowing. Market participants use the CDS market 
as a metric for evaluating real-time, market-based estimates of a 
company's credit risk and financial health; and it is in this way that 
the CDS markets provide risk transparency and price discovery. Market 
participants find that CDS market indicators are a superior alternative 
to relying on credit rating agency scores.
    CDS contracts also provide banks, dealers and other market 
participants with a tool to mitigate or manage risk by dispersing 
credit risk and reducing systemic risk associated with credit 
concentrations in major institutions. Take the following scenario, 
which section 16 would prohibit, for example:
    Bank A owns a $1 billion loan to Company X. Bank B owns a $1 
billion loan to Company Y. Both banks would be better off from a risk 
management perspective, assuming that Companies X and Y have comparable 
credit worthiness, if they each had a $500 million Company X loan and a 
$500 million Company Y loan. The loans, however, are not transferable. 
Through CDS contracts, Bank A is able to buy Company X protection and 
sell Company Y protection, and Bank B is able to do the opposite. In 
this way, market participants use CDS contracts to manage risk. 
Financial markets benefit overall from the reduction in systemic risk.
    Accordingly, these products reduce an issuer's cost of borrowing 
from banks, dealers and other market participants by enabling these 
entities to relay existing risk and/or purchase risk insurance against 
a particular issuer. Simply put, CDS markets facilitate greater lending 
and support corporate and public finance projects. By reducing the 
depth and liquidity of the CDS market, the cost of capital would rise. 
As a consequence, new investment in manufacturing facilities and other 
private sector projects and public works efforts would be more 
expensive.
    If market participants could not hedge their market risk through 
CDS contracts, the risk premium on debt would increase significantly. 
We do not believe this is advisable, especially in light of the 
troubled state of the U.S. economy and the Congress' current stimulus 
package deliberations. To our knowledge, Congress has never before 
imposed a trading restriction such as is proposed in section 16 on any 
type of commodity or financial instrument, and for good reason. 
Congress has previously recognized in section 3 of the CEA that we have 
a national public interest in providing a means for managing and 
assuming price risks, discovering prices or disseminating price 
information. Shutting out investors from the CDS market would be 
contrary to the public policy interests enumerated in the Act. As noted 
below, we believe that there are more effective alternatives for 
addressing concerns about the CDS markets.
All Commodities Are Not Equal
    Finally, we are concerned with the expansion of the bill to all 
commodities. Physically-delivered, cash-settled and OTC commodities 
each trade in distinct markets and have different characteristics. We 
believe the rationale behind certain requirements, such as spot month 
speculative limits and aggregate position limits, are not applicable to 
financial futures or their OTC derivatives. Legislation that attempts 
to regulate all commodity and financial markets in an identical manner 
will fail to take into consideration the different needs of these 
markets and important functions they serve. Specifically, we refer to 
sections 6, 11 and 13, which we believe attempts to uniformly regulate 
these distinct markets. Moreover, such legislation will risk affecting 
liquidity and the opportunity for innovation that have made these 
markets so widely used and integral to the economy.
Conclusion
    As Congress, including this Committee, considers ways to restore 
stability and confidence to our markets and to address the recent 
economic downturn, we believe it is important to recognize the 
important role the OTC derivatives markets have played. These products 
allow market participants to contribute vital market liquidity, 
mitigate risk, support lending and project finance, and facilitate 
economic growth.
    In considering ways to promote enhanced risk management and greater 
transparency in the marketplace, we urge you to resist any efforts 
which, while well-intended, could prove harmful to these important 
markets and our broader economy. These markets have played a pivotal 
role with respect to the development of our financial markets and the 
growth of our nation's economy. This success is attributable to the 
innovation and sophistication of our financial markets and the 
participants of these markets. It is also a testament to the competency 
of the underlying regulatory framework.
    MFA would like to thank the Committee for allowing us the 
opportunity to share our views on these important issues. MFA, and our 
members, are committed to working constructively with this Committee, 
the Congress, and the Administration over the coming weeks and months 
as this legislation and the broader dialogue regarding financial 
regulatory reform progresses.
    Thank you.
                               Attachment
December 23, 2008

Timothy F. Geithner,

President,

Federal Reserve Bank of New York;

Hon. Christopher Cox,

Chairman,

U.S. Securities and Exchange Commission;

Hon. Walter Lukken,

Acting Chairman,

U.S. Commodity Futures Trading Commission.


    Dear President Geithner, Chairman Cox and Chairman Lukken:

    Recently, Managed Funds Association (``MFA'') \1\ and its members 
met with the Federal Reserve Bank of New York (the ``NYFRB'') to 
discuss and provide comments regarding the state of the credit default 
swap (``CDS'') market, including our feedback on current proposals to 
establish a central clearing counterparty for the CDS market. As part 
of our ongoing commitment to proactively work with regulators on topics 
that pose significant market or systemic risk concerns, we wish to 
direct your attention to the protection and safeguarding of customers' 
initial margin that they deposit with dealer financial institutions in 
connection with the trading of all over-the-counter (``OTC'') 
derivatives.
---------------------------------------------------------------------------
    \1\ MFA is the voice of the global alternative investment industry. 
Its members are professionals in hedge funds, funds of funds and 
managed futures funds, as well as industry service providers. 
Established in 1991, MFA is the primary source of information for 
policy makers and the media and the leading advocate for sound business 
practices and industry growth. MFA members include the vast majority of 
the largest hedge fund groups in the world who manage a substantial 
portion of the approximately $1.5 trillion invested in absolute return 
strategies. MFA is headquartered in Washington, D.C., with an office in 
New York. For more information, please visit: www.managedfunds.org.
---------------------------------------------------------------------------
Effects of Current Collateral Management Practices
    By way of background, the default of Lehman Brothers, a major OTC 
derivatives counterparty, and the resulting market concerns about the 
viability of other major dealers, has caused significant volatility in 
the capital markets. These concerns demonstrate that current mechanisms 
for collateral management, outside of the context of broker-dealer 
accounts covered by Exchange Act Rule 15c3-3, do not adequately protect 
the pledgors of collateral and can contribute to systemic risk in 
several important respects:

   The purpose of initial margin is to provide dealers with a 
        cushion against the potential counterparty risk they assume 
        when entering into an OTC derivatives contract with a customer. 
        However, since such margin is not typically segregated from the 
        dealers' other unsecured assets, what is supposed to be a 
        credit mitigant for the dealer instead subjects the customer to 
        actual credit risk on the posted amounts.

   If a dealer becomes insolvent, initial margin posted by 
        customers that is not so segregated is treated in bankruptcy as 
        a general unsecured claim of the customer. As a result, 
        customers who are counterparties to that dealer stand to incur 
        significant losses, regardless of the current value of their 
        derivatives contracts.

   Investment managers have fiduciary duties to their 
        investors. When a dealer experiences difficulties, the risk to 
        initial margin may cause managers to seek to hedge counterparty 
        exposure to such dealer (either through the CDS market or by 
        trying to close-out or assign derivatives trades away from such 
        dealer). These hedging actions can have a further destabilizing 
        impact on such dealer and the market generally, thereby 
        increasing systemic risk.

   In addition, given that dealers are able to freely use 
        posted collateral, they have come to rely on initial margin, a 
        fluctuating source of cash, to fund their business activities. 
        As trades are closed-out or assigned, dealers are required to 
        return initial margin to their customers. The return of margin 
        constricts dealers' liquidity and, as recent events 
        demonstrate, the inability of the dealers to access cash has 
        potentially severe market consequences.

    We highlight that the aforementioned counterparty risks related to 
customer initial margin have been greatly exacerbated over the last few 
months as dealers as a whole have significantly increased their demands 
for initial margin. These risks are in turn further compounded by the 
general weakening of the financial sector as a whole.
Enhanced Customer Segregated Accounts
    As you are aware, the segregation of initial margin is a key 
component of the central clearingparty initiatives for the CDS market, 
and we understand that the NYFRB, SEC and CFfC have stipulated this 
condition to be a prerequisite for regulatory approval. We agree that 
segregation of initial margin is crucial to the success of these 
clearing initiatives, but also believe that the protection of customer 
initial margin should be implemented more broadly for all OTC 
derivatives, irrespective of the launch of any CDS central counterparty 
because it is critical in order to promote broader market stability and 
to mitigate counterparty risk. Protection of customer initial margin 
with respect to all bilaterally negotiated OTC derivatives could be 
incorporated into the existing transaction structure through dealer use 
of a segregated account, in the name of, and held for the benefit of, 
the customer (e.g., at a U.S. depository institution or a regulated 
U.S. broker-dealer), whereby the dealer would not be permitted to 
rehypothecate the initial margin held in such an account. This would 
promote broader market stability and mitigate counterparty risk.
    Given that dealers will be required to provide initial margin 
segregation as part of the clearing initiatives, they should be capable 
of offering this to customers on a broader basis. However, to date the 
dealer community, as a whole, has been resistant to such efforts by 
MFA's members and other investment managers.
          * * * * *
    We recognize the efforts of regulators to collaborate on mitigating 
risk and promoting market stability. We appreciate the constructive 
working relationship fostered by each of you as well as the opportunity 
to share the views of our members on this important topic. We welcome 
the opportunity to discuss this issue further with each of your staffs. 
If we can provide further information on this topic, or be of further 
assistance, please do not hesitate to contact us at [Redacted].
            Yours Sincerely,

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]

            
Richard H. Baker,
President and Chief Executive Officer.
cc:
Hon. Ben Bernanke,
Chairman,
Board of Governors, Federal Reserve System;

Patrick M. Parkinson,
Deputy Director,
Division of Research and Statistics, Board of the Federal Reserve 
System;

Ananda Radhakrishnan,
Director,
Division of Clearing and Intermediary Oversight, Commodity Futures 
Trading Commission;

Theodore Lubke,
Senior Vice President,
Bank Supervision Group, Federal Reserve Bank of New York;

Erik R. Sirri,
Director,
Division of Trading and Markets, U.S. Securities and Exchange 
Commission.


    Mr. Holden. Without objection.
    Mr. Rosen.

      STATEMENT OF EDWARD J. ROSEN, J.D., PARTNER, CLEARY
        GOTTLIEB STEEN & HAMILTON LLP, NEW YORK, NY; ON
          BEHALF OF SECURITIES INDUSTRY AND FINANCIAL
                      MARKETS ASSOCIATION

    Mr. Rosen. Thank you, Mr. Chairman. I should clarify I am 
here today representing SIFMA, the Securities Industry and 
Financial Markets Association.
    SIFMA commends the Committee for its attention to the 
integrity of the U.S. markets and the leadership role that this 
Committee in particular has played over the years in addressing 
these issues. There is undoubtedly a need for regulatory----
    The Chairman. Could you pull the microphone a little 
closer?
    Mr. Rosen.--including reform that will relate to OTC 
derivatives. Measures are needed to improve regulatory 
transparency particularly to ensure appropriate capital 
oversight of professional intermediaries and OTC derivatives 
whose activities, as we have seen, can have systemic 
consequences.
    We look forward to working with this Committee and Congress 
on broad regulatory reform to address these issues. However, we 
are deeply concerned that the draft bill could have profound, 
albeit unintended, adverse consequences not merely for American 
markets, but for many mainstream American companies. This would 
contribute to the forces that are driving the current credit 
crisis.
    SIFMA's testimony describes the extraordinary extent to 
which mainstream American companies depend on CDS and other OTC 
derivatives to manage their risks and obtain access to 
financing. Direct and indirect limitations on access to these 
products will increase the risks to which these companies are 
subject, and in turn increase the risks of loss to which they 
are subject, the volatility of their earnings, their cost of 
funds, and thereby reduce their share prices and impair their 
competitiveness. A number of provisions in the draft bill raise 
these concerns.
    The proposed prohibition on purchasing so-called naked CDS 
protection would essentially eliminate the corporate CDS 
market. We can think of no traded product that is subject to a 
restriction of this kind, yet every financial product can be 
equally used for hedging or to express a positive or negative 
market view. It is precisely the interaction of these market 
views that is the essence of price discovery and efficient 
markets. As a result of this, CDS would become extremely 
expensive and illiquid in the sense of financial guarantee 
insurance or a product whose limitations the credit default 
swap market was specifically developed to address.
    American companies, including companies in the agricultural 
sector, would have reduced access to financing, and available 
financing costs would increase. Bank revenues from lending 
activity would also be reduced, placing further pressure on the 
financial strength of the banking sector, which currently 
depends heavily on public funds.
    Mandating the clearing of all OTC derivatives with a narrow 
exception for contracts that are both highly illiquid and 
highly customized is understandable but impractical, and we 
think unnecessary. Not all OTC derivatives can be cleared. As 
this Committee has heard, clearinghouses must be able to obtain 
reliable current pricing and historical data in order to 
calculate the appropriate collateral requirements and to model 
the clearinghouse risk. Also, not all companies have the 
operational infrastructure to participate.
    But rather than mandating clearing, we believe it would be 
far more effective for a prudential supervisor to have 
authority over all systemically significant market 
participants, including the authority to require clearing where 
it is appropriate and/or impose capital charges for the 
incremental risks represented by uncleared positions. We think 
this would be an important element in any comprehensive 
regulatory reform.
    With regard to carbon offsets, we believe it is clear that 
off-exchange markets compliment exchange markets. They serve as 
incubators for developing products, and they enable derivatives 
to be tailored to companies' risk management needs. Prohibiting 
them in the case of environmental derivatives will, in our 
view, only impede the development of a market that is a 
national priority.
    Provisions of the bill would impose indirect and 
potentially direct position limits on OTC derivatives. In our 
view, off-exchange physical positions have a far greater 
ability to influence commodity pricing and disrupt markets than 
purely notional financially settled contracts. In the absence 
of a perceived need to impose limits on the size of OTC 
physical positions, we don't see the justification for limits 
on notional exposures.
    The restrictive definition of bona fide hedging in the 
proposed bill would effectively impose a de facto position 
limit on OTC derivatives that are hedged on futures exchanges. 
However, the proposed position limit exception for swap dealers 
does not reflect the way in which companies manage their risk, 
or the manner in which swap dealers intermediate client risk. 
The result could be to curtail corporate access to OTC 
derivatives even for highly desirable risk management purposes.
    The draft bill also does not recognize that many index and 
other strategies are not speculative in nature, and would 
curtail the use of important strategies that are effectively 
market-neutral and stabilizing, and preclude fiduciaries from 
protecting retirees and others investing for retirement from 
protecting their retirement income from erosion due to high 
rates of inflation.
    Commercial interests are inherently directionally biased 
market participants and have the greatest capacity to influence 
prices and markets. All or virtually all the CFTC energy 
manipulation cases brought over the last 5 years have involved 
commercial energy traders. By decreasing the prevalence of 
directionally neutral participants and increasing the relative 
dominance of commercial interests, SIFMA is concerned that the 
draft bill would make the U.S. futures markets far more 
susceptible than they are today to manipulation. At a minimum, 
it will increase spreads and the cost of hedging for commercial 
interests.
    [The prepared statement of Mr. Rosen follows:]

 Prepared Statement of Edward J. Rosen, J.D., Partner, Cleary Gottlieb 
 Steen & Hamilton LLP, New York, NY; on Behalf of Securities Industry 
                   and Financial Markets Association
Introduction
    Chairman Peterson, Ranking Member Lucas, and Members of the 
Committee:

    My name is Edward Rosen \1\ and I am appearing today on behalf of 
the Securities Industry and Financial Markets Association (SIFMA).\2\ 
We thank you for the invitation to testify today on the Committee's 
draft legislation, entitled ``Derivatives Markets Transparency and 
Accountability Act of 2009''.\3\ My testimony today reflects the views 
of SIFMA member firms active in both the listed and over-the-counter 
(OTC) derivatives markets in the United States and abroad.
---------------------------------------------------------------------------
    \1\ Mr. Rosen is a partner in the law firm Cleary Gottlieb Steen & 
Hamilton LLP, testifying on behalf of and representing the views of 
SIFMA and not those of Cleary Gottlieb Steen & Hamilton LLP.
    \2\ SIFMA brings together the shared interests of more than 650 
securities firms, banks and asset managers locally and globally through 
offices in New York, Washington, D.C. and London. Its associated firm, 
the Asia Securities Industry and Financial Markets Association, is 
based in Hong Kong. SIFMA's mission is to champion policies and 
practices that benefit investors and issuers, expand and perfect global 
capital markets and foster the development of new products and 
services. Fundamental to achieving this mission is earning, inspiring 
and upholding the public's trust in the industry and the markets. (More 
information about SIFMA is available at http://www.sifma.org).
    \3\ Draft dated January 28, 2009 (1:08 p.m.).
---------------------------------------------------------------------------
Overview
    Preservation of the integrity of U.S. markets must be a paramount 
concern for the public sector and the private sector alike. SIFMA thus 
appreciates the Committee's current attention to this objective and 
commends the Committee for the ongoing leadership role that it has 
played over many years in sponsoring measures necessary to ensure the 
integrity of U.S. derivatives markets.
    SIFMA wholeheartedly endorses a number of the central themes that 
underpin the draft bill. Specifically, we agree that:

   Regulatory Transparency. Effective regulatory oversight of 
        commodity markets requires appropriate regulatory transparency 
        that ensures timely CFTC access to relevant position 
        information;

   OTC Clearing. The clearance of OTC derivatives can and, we 
        think, will play an important role in mitigating operational 
        and counterparty risks for large segments of the OTC 
        derivatives markets and, where appropriate, should be given a 
        high priority by supervisors and the private sector;

   Speculative Limits. Limits on the size of speculative 
        positions can play an important role in preserving orderly 
        markets; and

   Global, Linked Markets. Listed derivatives, OTC derivatives 
        and physical commodity markets are global and inextricably 
        linked.

    We commend the draft bill's focus on these themes.
    Nonetheless, SIFMA and its members are deeply concerned by a number 
of provisions in the draft bill. We believe these provisions do not 
represent the most effective solutions to current market issues. 
Instead, we believe these provisions would have profound adverse 
consequences not merely for OTC and listed derivatives markets, but 
also for mainstream American companies. Specifically, key provisions in 
the draft bill would:

   Prohibit the purchase of uncovered CDS protection;

   Require the clearing of all OTC derivatives, subject to 
        limited exceptions;

   Authorize the imposition of position limits for OTC 
        derivatives;

   Prohibit off-exchange trading in futures on carbon credits 
        and emission allowances; and

   Eliminate position limit exemptions for risk management 
        strategies.

    We believe these provisions would:

   Deepen the current crisis by fundamentally undermining both 
        the efficacy and availability of listed and OTC derivatives as 
        risk management tools for large and small American businesses, 
        thereby increasing costs, risks and earnings volatility for 
        such companies throughout the economy; the draft bill's CDS-
        related provisions in particular would significantly and 
        adversely impact access to, and the cost of, financing for 
        American companies, which could lead to continued job losses;

   Increase (and not decrease) the susceptibility of commodity 
        markets to manipulation and disorderly trading and enhance the 
        ability of commercial traders with a vested interest in 
        commodity prices to influence such prices;

   Impede successful development of cap and trade programs by 
        prohibiting non-exchange derivatives on carbon offsets and 
        emission allowances;

   Preclude pensioners, retirees and those saving for 
        retirement from protecting the real dollar value of their 
        retirement income against erosion from the effects of commodity 
        price inflation through the use of commodity derivatives; and

   Drive the development outside the United States of markets 
        in energy and other core commodities and financial products 
        that are key to the U.S. economy, with the result that, while 
        these markets would have the ability to inform or drive U.S. 
        prices for the affected commodities and products, the U.S. 
        Congress would have no ability to influence these markets.

    We believe the potential consequences of these provisions run 
directly counter to the Committee's own well-intentioned objectives. 
They also run counter to the efforts of Congress and the supervisory 
community to address the credit crisis and, if enacted, would almost 
certainly exacerbate the crisis.
    SIFMA understands that there is a need for regulatory reform and 
that such reform will need to address issues such as regulatory 
transparency and prudential oversight with respect to OTC derivatives. 
However, SIFMA strongly believes that any statutory changes in the 
regulation of OTC derivatives, particularly changes that would have 
such far-reaching consequences as those proposed in the draft bill, 
should only be undertaken in the context of broader regulatory reform 
and should focus on decreasing risk and improving transparency and 
efficiency in the OTC derivatives markets, while maintaining the 
significant benefits these markets currently provide for mainstream 
American companies and institutional investors.
    It is estimated that more than 90% of the 500 largest companies in 
the world use OTC derivatives.\4\ An even greater percentage (94%) of 
the American companies in this group use OTC derivatives. More than 
half of medium-sized American companies are estimated by Greenwich 
Associates to use OTC derivatives.\5\ These companies rely on access to 
OTC derivatives for important risk management purposes (some of which 
may, but many of which will not, fall within the draft bill's proposed 
definition of bona fide hedging).
---------------------------------------------------------------------------
    \4\ International Swaps and Derivatives Association, Inc., 2003 
Derivatives Usage Survey, http://www.isda.org/statistics/.
    \5\ Greenwich Associates, http://www.greenwich.com.
---------------------------------------------------------------------------
    Mainstream American companies in every sector of the U.S. economy, 
including within the agricultural sector, depend on access to 
efficiently priced financing in order to make capital investments, 
purchase inventory and equipment, hire employees and otherwise fund 
their businesses. The availability of a robust corporate CDS market is 
essential if lenders are to meet the demand for these borrowings and to 
be in a position to do so on an efficiently-priced basis.
    CDS and other OTC derivatives thus not only play an important 
market function, they also play a critical role in enabling ordinary 
companies, outside the financial sector, to manage the risks of their 
businesses and to obtain the financing necessary to expand, and in many 
cases to sustain, their businesses. And, as the statistics cited above 
indicate, significantly more than half of the U.S. economy would be 
directly and adversely affected by the inability of professional 
intermediaries to make these products available and to utilize them 
themselves.
    Against this background and, particularly in the context of the 
current crisis, it is all the more important that Congress adopt 
legislative initiatives that preserve the benefits of these products, 
and access to these products, while carefully targeting those measures 
that are appropriate to protect the public interest.
    Our comments with respect to specific provisions of the draft bill 
are summarized in the following section.
Section-by-Section Comments
Prohibition of ``Naked'' CDS (Section 16)
    Section 16 of the draft bill would prohibit the purchase of CDS 
protection by any person who does not have direct exposure to financial 
loss should the referenced credit events occur. Very simply, the 
proposed prohibition would effectively eliminate the corporate CDS 
market.
    Although CDS are a relatively recent financial innovation, they 
have quickly become the most important tool available to banks and 
institutional investors, such as pension funds, for managing the credit 
risks arising from commercial loans and corporate bond investments. 
CDS, which are typically fully collateralized, are the only liquid 
financial instruments that enable a company exposed to a third party's 
default risk to manage that credit risk in an efficiently priced 
market. As such, CDS enable lenders to hedge the credit risks inherent 
in corporate financing that are essential to economic growth, and, in 
turn, reduce the cost of funds for borrowers. CDS also free up 
additional credit capacity, which enables banks to expand credit 
facilities available to their corporate clients.
    In addition, CDS provide important benefits for other market 
participants as well. For example, asset managers and other 
institutional investors use CDS as a liquid instrument through which to 
obtain credit exposure to particular companies and to adjust their 
credit exposures quickly and at a lower cost than alternative 
investment instruments. In addition, many market participants use CDS 
pricing to provide a more accurate valuation of credit risk than would 
otherwise be possible by looking solely to less liquid cash markets.
    No traded product is subject to a restriction similar to the one 
proposed to be imposed on CDS by the draft bill. This is not surprising 
given that the proposal would strictly limit CDS to hedging 
transactions and would significantly restrict the involvement of 
professional intermediaries and investors in these products.
    As a policy matter, the purchase of uncovered CDS protection is no 
different than buying or selling futures, options, stocks or bonds 
because the relevant product is perceived to be undervalued or 
overvalued by the market. These investment activities are critical to 
liquidity, reduced execution costs and efficient price discovery in 
these markets and all involve legitimate and, indeed, desirable 
investment activities.
    Absent the participation of intermediaries and non-hedgers, CDS 
would cease to trade in a market, and they would become extremely 
illiquid and costly--both to enter into and to terminate.\6\ As a 
direct result, lenders and investors would be left with far more 
limited and more expensive alternatives for managing the credit risks 
arising from their lending and investment activities. In turn, American 
companies, including those in the agricultural sector, would have 
significantly reduced access to financing, and the financing that would 
be available would be more costly. Bank revenues from lending activity 
would also be reduced, placing further pressure on the financial 
strength of the banking sector.
---------------------------------------------------------------------------
    \6\ The proposed requirement could also subject CDS to regulation 
as a form of financial guarantee insurance, thereby subjecting 
providers of protection to the additional burdens and inefficiencies of 
regulation by insurance supervisors in each of the 50 states.
---------------------------------------------------------------------------
    The impact of these effects on the credit crisis, and efforts to 
reverse the credit crisis, are plain.
    The OTC derivatives markets in general, and the corporate CDS 
market in particular, have performed extremely well and have remained 
liquid throughout the current market turmoil, providing important 
benefits not only for financial market participants but also for large 
numbers of mainstream American companies. The corporate CDS market in 
particular has provided a critical price discovery function for the 
credit markets, which have otherwise become extraordinarily illiquid 
during the crisis and, as a result, provide extremely little credit 
market price discovery apart from corporate CDS. Measures that would 
interfere with this function would be highly undesirable and would 
further exacerbate the credit crisis.
    The segment of the CDS market in which extremely significant losses 
have been incurred involved the writing of CDS protection on mortgage-
related asset-backed securities; in many ways, a very different product 
than corporate CDS. The market for CDS on asset-backed securities is 
also a relatively small segment of the overall CDS market; generally 
less than 2% of the aggregate CDS market.\7\ Losses in this segment 
led, in part, to the rescue of the AIG insurance conglomerate and the 
failure or near failure of many monoline financial guarantee insurers 
subject to oversight by state insurance supervisors. The losses 
incurred through these products did not result, however, from flaws in 
the products; in fact, the products transferred the risk of the 
referenced asset-backed securities as intended by the parties. These 
losses were directly related to the unexpectedly large losses in the 
subprime mortgage sector and the leveraging of these exposures through 
highly structured securities, such as mortgage-related collateralized 
debt obligations (CDOs--not to be confused with CDS). A number of 
capital market participants incurred significant losses in the subprime 
mortgage-related CDS and CDO market.
---------------------------------------------------------------------------
    \6\ DTCC Deriv/SERV Trade Information Warehouse Reports (data as of 
the week ending January 23, 2009), http://www.dtcc.com/products/
derivserv/data/index.php.
---------------------------------------------------------------------------
    Although some CDS market participants have incurred large losses in 
connection with corporate CDS, for example, in the case of CDS 
referencing financial institutions such as Lehman Brothers, the 
corporate CDS market nonetheless functioned well as a result of 
effective bilateral mark-to-market collateral arrangements. The private 
sector's initiative to establish a clearinghouse for CDS will further 
reinforce the salutary and stabilizing effects of appropriate bilateral 
collateral arrangements.
    The measures proposed in the draft bill would do little to address 
the regulatory issues actually presented by the failures and near 
failures resulting from these events; and we see nothing in the events 
of the recent past that would justify a response in the form of the 
effective elimination of corporate CDS.
Mandatory Clearing of OTC Derivatives (Section 13)
    Section 13 of the draft bill would require the clearing of all OTC 
derivatives, subject to a very limited exemptive process in the case of 
products that are infrequently transacted, highly customized, do not 
serve a price discovery function and are entered into by parties able 
to demonstrate their financial integrity.
    The clearing of OTC derivatives transactions has the potential to 
provide many important benefits, including the mitigation of 
operational and counterparty risks and facilitation of regulatory 
oversight, and should be encouraged where appropriate. However, section 
13 of the draft bill would mandate that all OTC derivative contracts 
must be cleared, including not only CDS but also other OTC derivatives 
such as interest rate and currency swaps, the markets for which are 
also significant and have performed well throughout the current credit 
crisis, with an extremely narrow exception for certain infrequently 
traded and highly customized contracts. Such a clearing requirement is 
unworkable as a practical matter and would adversely affect mainstream 
American companies and reinforce conditions contributing to the current 
credit crisis.
    As a threshold matter, not all OTC derivatives contracts are 
suitable for clearing or can be cleared without presenting unacceptable 
risk management challenges for a clearinghouse, and not all market 
participants can participate in a clearing system. In order to mitigate 
its counterparty risk, a clearinghouse must determine the aggregate 
risk to which it is exposed as a result of its clearing activities and 
must collect mark-to-market margin, in cash or liquid securities such 
as U.S. Treasury securities, every day from each of its members with 
respect to such members' positions in the clearinghouse. In order to do 
this, the clearinghouse must be able to model the risks associated with 
the products it clears and must be able to determine the amount of the 
market-to-market margin it is to pay or collect each day, a process 
that requires access to price data. The administrative and financing 
demands of participating in a clearinghouse on members are significant, 
and as a practical matter, mainstream American companies that are end 
users would not participate because they do not have the personnel, 
operational infrastructure and expertise, nor the cash and securities 
on hand, to do so. As evidence of this, although exchange-traded 
interest rate and currency futures are widely available, mainstream 
American companies are negligible users of such products.
    Reliable risk modeling requires statistically robust historical 
price data sets for each cleared product. Reliable mark-to-market 
margining, in turn, requires (1) products that are both completely 
standardized and sufficiently liquid (one or the other of these 
characteristics is not sufficient) and (2) ready access to reliable 
price sources. Even where these conditions are present, existing 
clearinghouses must have developed an approved risk modeling approach 
in order for market participants to clear their positions without 
subjecting themselves or the clearinghouse to inappropriate market and 
counterparty risks.
    Against this background, it is clear that a regulatory model that 
requires market participants to obtain a prior exemption based on 
highly subjective criteria before they transact would be utterly 
unworkable, would inject unnecessary legal uncertainty (potentially 
subjecting transactions to after-the-fact legal challenges), would 
interfere with the execution of risk management transactions and would 
impede new product development. Further, as noted above, limitations on 
the availability of CDS would directly and adversely affect American 
companies.
    While measures to promote standardization can afford risk-reducing 
benefits, there are many circumstances in which customized solutions 
will be more appropriate. For example, standardization of products 
effectively precludes the application of hedge accounting by American 
companies, as standardization vitiates the ability to structure 
customized hedges that comply with the requirements of Financial 
Accounting Standard 133. Without hedge accounting, American companies 
who do choose to use derivatives would experience significant 
volatility in their reported earnings, for reasons altogether unrelated 
to their core businesses. The potential for such volatility in reported 
earnings would result in less hedging and more risks being borne by 
companies who are ill-equipped to manage them.
    Moreover, the proposed provision is unnecessary and exemplifies the 
pitfalls of addressing the regulation of OTC derivatives outside of an 
appropriate comprehensive regulatory framework. As a practical matter, 
the major OTC derivatives intermediaries (at least in financial 
derivatives) are subject to supervision by Federal regulators, 
including the Office of the Comptroller of the Currency and the Board 
of Governors of the Federal Reserve System, as national banks, Federal 
Reserve System member banks or members of bank (or financial) holding 
company groups. These supervisors have plenary authority to identify 
those circumstances in which clearing is appropriate and to require 
such clearing and/or impose capital charges that address any 
incremental risks that are associated with transactions not so cleared. 
Indeed, the industry has been working with the Federal Reserve since 
2005 on various voluntary initiatives to reduce risk and improve the 
infrastructure of the CDS market, including the development of a CDS 
clearinghouse. We believe a model under which these issues are 
addressed by a direct prudential supervisor of all systemically 
significant participants in the OTC derivatives markets is a far more 
effective approach than, and one that would avoid the significant 
pitfalls of, a more rigid statutory mandate such as the one included in 
the draft bill.
Imposition of Position Limits on OTC Derivatives (Section 11)
    Section 11 of the draft bill would authorize the CFTC to impose 
position limits on ``speculative'' OTC transactions that are fungible 
with exchange-traded futures. The potential limitation on the scope of 
permitted OTC derivatives exposures as contemplated by section 11 of 
the draft bill would have potentially profound ramifications. The 
potentially adverse implications of such limits for mainstream American 
companies are significantly exacerbated by the draft bill's proposed 
categorization of risk management transactions as ``speculative.'' (See 
the immediately following discussion of section 6 of the draft bill.)
    The CFTC and the futures exchanges have been able to ensure orderly 
futures markets through, among other measures, limitations on 
speculative futures positions without having to limit, for example, 
off-exchange positions in fungible (i.e., deliverable) physical 
commodities. It is plain that large physical positions on either side 
of the market have a far greater potential to disrupt futures markets 
than do purely notional, financially-settled OTC derivatives. In the 
absence of such limitations on physical positions, or any perceived 
need for such limitations, we question the need to impose such limits 
on purely notional, financially-settled OTC derivatives positions. As 
noted above, any such proposal for direct and restrictive regulation of 
OTC derivatives would, in any event, be more appropriately considered 
in the context of broader regulatory reform.
Elimination of Risk Management Exemption (Section 6)
    Section 6 of the draft bill would limit the availability of 
position limit exemptions for risk management positions other than 
those held by commercial entities directly engaged in a physical 
merchandising chain under a highly restrictive definition of bona fide 
hedging.
    The policy rationale for position limit exemptions has historically 
been based on the inference that a trader who is directionally neutral 
with respect to the price of a commodity underlying its futures 
position lacks the motivation to engage in abusive price manipulation. 
Thus, hedging, arbitrage and spread trading were early examples of 
cases in which such exemptions were available. As portfolio theory 
evolved, and financial futures and OTC derivatives became prevalent, a 
variety of risk management strategies became the basis for similar 
exemptions.
    The draft bill would reject this policy rationale and would 
arbitrarily subject broad ranges of financial hedging and risk 
management activity to the limitations applicable to truly speculative 
positions. SIFMA believes that these limitations would have a profound 
adverse impact on futures and OTC derivatives markets, on retirees and 
investors, and on companies seeking to manage the commercial and 
financial risks to which they are subject.
    These adverse effects are all the more troubling in light of the 
absence of any rigorous analysis of empirical data indicating that the 
involvement of noncommercial entities in the futures markets has caused 
the recent volatility in energy and other commodity prices. Indeed, the 
only rigorous analysis to date of relevant empirical data by the CFTC 
has reached precisely the opposite conclusion.
Swap dealers and mainstream American companies.
    Section 6 of the draft bill would severely restrict the ability of 
swap dealers to provide customized OTC derivatives hedges to commercial 
end users and corporations. In most cases, swap dealers use a portfolio 
approach under which they manage price risk using combinations of 
physical transactions, OTC financially-settled transactions and 
exchange-traded futures. Thus, when entering into an OTC swap 
transaction with a counterparty, the dealer does not necessarily hedge 
that specific transaction with a specific offsetting transaction in the 
U.S. futures markets or the OTC derivatives markets. Rather than hedge 
the price risk created by a specific OTC transaction, the dealer might 
use the U.S. futures markets or the OTC derivatives markets to hedge 
the net exposure created by multiple transactions conducted 
contemporaneously or even at another point in time.
    Known as ``warehousing risk'', a dealer may also enter into 
numerous or long-dated OTC transactions with a client that is seeking 
to hedge its price risk. At the time of entering into the transactions, 
it may not be prudent or possible for the dealer to enter into 
offsetting transactions in the futures markets or with other OTC 
dealers. Thus, in warehousing risk, the dealer assumes the price risk 
from its client and manages it in its trading book using the portfolio 
approach described above.
    By requiring that dealers, in order to qualify for the hedge 
exemption from speculative position limits, be able to demonstrate that 
any given position in the futures or OTC derivatives markets (hedged by 
futures) serves as a hedge against a specific OTC transaction with a 
counterparty that is itself hedging price risk, the draft bill would 
prohibit useful and risk-reducing hedging, which clearly runs counter 
to the public policy goals of the draft bill, and would significantly 
limit dealers' ability to effectively intermediate the risks of their 
end user and corporate clients which, in turn, would likely 
significantly reduce liquidity in the futures and OTC derivatives 
markets, increase hedging costs and leave the markets far more 
susceptible than they are today to undue influence by commercial 
interests that have a stake in directional price movements. It would 
also increase hedging costs for mainstream American companies, leaving 
them more susceptible to price risk and less competitive.
Index strategies.
    The draft bill's proposed speculative position limit provisions 
would limit futures trading that is not, in fact, speculative and that 
does not have a market impact analogous to speculative trading, and, in 
turn, could potentially interfere with commodity price formation to the 
detriment of the markets.
    As an example, pension plans and other investment vehicles hold 
portfolios whose ``real dollar'' value is eroded by inflation. 
Investment of a targeted allocation of the portfolio in a broad-based 
commodity index can effectively ``hedge'' that risk financially. Such a 
strategy, like ``bona fide'' physical hedging, is undertaken for risk 
management and risk reduction purposes, is passive in nature (i.e., 
positions are bought in accordance with the index algorithm and asset 
allocations and are generally held, not actively traded) and is not 
speculative in purpose or effect. The strategy does not base trading 
decisions on expectations as to whether prices will go up or down--the 
strategy is generally indifferent as to whether prices go up or down. 
The strategy generally leads to trading in the opposite direction of 
speculators, offsetting their impact: when commodity index levels rise, 
portfolio allocations to index strategies are reduced (resulting in 
selling), when commodity index prices fall, allocations to index 
strategies are increased (resulting in buying). Over the long term, the 
strategy acts as a stabilizing influence for commodity prices.
    These trends were found by the CFTC in its recent study to be 
consistent with its analysis of relevant trading data. On the other 
hand, we are unaware of a rigorous analysis of empirical trading data 
that supports the correlations that have been alleged between index 
trading and increasing commodity prices. In addition, investing on a 
formulaic basis in a broad-based commodity index would be the least 
effective means of ``manipulating'' the market for an individual 
commodity.
Increased susceptibility to manipulation.
    By restricting the hedge exemption to commercial entities, the 
draft bill would, in effect, significantly increase the relative market 
share of these entities and simultaneously reduce liquidity, by 
reducing the sizes of positions of traders employing risk management 
strategies that are truly market neutral. Any proposed legislation on 
this topic must take into account three basic facts. First, although a 
commercial user's futures position may be offset by a physical 
position, commercial entities are almost never price neutral. Second, 
the category of market participant that is best positioned to influence 
market prices are commercial users controlling large physical 
positions. Third, significantly increasing the relevant market share of 
commercial entities increases the ability of such traders to influence 
prices.
    As a result, SIFMA believes that the draft bill would make the U.S. 
futures markets far more susceptible than they currently are to price 
manipulation by commercial traders with directional biases. Indeed, 
nearly all of the CFTC energy manipulation cases that have been brought 
over the last 5 years have been brought against traders at firms that 
would be considered commercial entities under the draft bill.
Carbon Offset Credits and Emission Allowances (Section 14)
    Section 14 would establish an exchange monopoly for the trading of 
futures on carbon offset credit and emission allowances and criminalize 
off-exchange trading in such products.
    The most successful, liquid and efficient markets are those in 
which trading is permitted both on-exchange and off-exchange. Indeed, 
exchange markets are generally enhanced by the success of related off-
exchange markets. Off-exchange trading is also essential for a number 
of reasons. Off-exchange markets serve as the incubators through which 
trading terms are able to coalesce around agreed market conventions 
that promote liquidity and efficiency. This process facilitates the 
evolution of standardized and liquid products that can be effectively 
exchange traded. Off-exchange trading also enables derivatives to be 
tailored to the risk management needs and circumstances of individual 
companies. Off-exchange trading also facilitates the cost-effective 
execution of large wholesale transactions for which an exchange 
environment can be inefficient. Finally, the proposed prohibition would 
eliminate the fundamental salutary market benefits of inter-market 
competition--a cornerstone of efficient markets and American 
capitalism.
    As a result, we believe the proposed prohibition would impair 
market efficiency and impede innovation and the successful development 
of these products. As a direct consequence of these effects, the 
proposed provisions would, in our view, undermine rather than promote 
the important national policy objective of encouraging the development 
of successful and efficient trading markets in these important 
products.
OTC Reporting Requirements (Section 5)
    Section 5 of the draft bill would require the CFTC to impose 
detailed reporting requirements with respect to OTC derivatives. We 
note that the CFTC currently has the authority to ascertain information 
regarding the OTC derivatives positions of large traders holding 
reportable positions in related futures contracts.
    SIFMA urges the Committee to avoid the creation of an ongoing 
detailed reporting regime applicable to OTC derivatives generally, as 
such a regime has the potential to result in large amounts of, but 
disproportionately little useful, information, imposing significant 
costs and burdens on the resources of the private sector and the CFTC 
alike. SIFMA would not, however, be opposed to a carefully tailored 
reporting regime (similar to that currently employed by the CFTC) under 
which the CFTC may require firms to provide upon request targeted 
information regarding large positions in OTC derivatives that are 
fungible with exchange-traded futures contracts (or significant price 
discovery contracts) that are under review by the CFTC as part of its 
market surveillance function or in connection with any investigation.
Reporting Entity Classification (Section 4)
    Section 4 of the draft bill addresses the classification and 
disaggregation of large position data and would require disaggregation 
and reporting of positions of swap dealers and index traders. SIFMA 
supports the classification of position data into categories that 
promote the market surveillance function of the CFTC. The distinction 
between market participants who have directionally biased positions and 
those that are directionally neutral is a key one in this context. On 
the other hand, since swap dealers and index traders may fall into 
either of these categories, it is not clear that the proposed 
disaggregation would promote the CFTC's surveillance function.
Foreign Boards of Trade (Section 3)
    Section 3 of the draft bill would require the CFTC to impose 
specific rule mandates on foreign boards of trade. Recognizing that our 
markets are global and inextricably linked, international coordination 
and harmonization are important objectives. However, these objectives 
can be better accomplished without the prescriptive imposition of U.S. 
rules on foreign markets. In addition to potentially curtailing U.S. 
access to foreign markets, any such approach would likely be regarded 
as imperious and may well invite retaliatory measures that could 
compromise the ability of U.S. exchanges to compete for international 
business--currently an important growth segment of U.S. exchange 
markets.
Conclusion
    OTC derivatives markets play a key role in the functioning of the 
American economy by helping companies, lenders and investors to manage 
risk and arrange financing. With the limited exception noted above 
involving the writing of CDS protection on mortgage-related asset-
backed securities by AIG and monoline financial guarantee insurers, the 
OTC markets have performed well and remained liquid throughout the 
current market turmoil, providing important benefits for a large number 
and wide range of companies.
    It must be recognized that the consequences of many of the proposed 
provisions in the draft bill would not fall solely or even most heavily 
on the professional intermediaries participating in these markets. 
Instead, the consequences of these provisions would, if enacted, harm 
very large numbers of mainstream American companies whose financial 
strength is critical to the welfare and recovery of our national 
economy.
    As noted above, many American companies use OTC derivatives to 
hedge their cost of borrowing or the operating risks of their 
businesses. Many of those who do business overseas use OTC derivatives 
to hedge their foreign exchange exposures. Many companies also hedge 
their commodity and other price exposures. For many companies, the 
availability of efficiently priced access to financing and other 
products depends on access by their counterparties to OTC derivatives 
such as CDS and interest rate and currency swaps. By limiting or 
eliminating access to basic risk management tools that American 
companies routinely use in the day-to-day management of their 
businesses, the draft bill could have a potentially profound negative 
impact on these companies and our nation's economic recovery.
    Recognizing the importance of OTC derivatives, we continue to 
support efforts to address the risks and further improve the 
transparency and efficiency of the OTC derivatives markets. Similarly, 
recognizing the importance of efficient and orderly exchange markets we 
continue to support tailored measures to improve the efficiency and 
integrity of listed futures markets. We look forward to working with 
this Committee, Congress and regulators on initiatives designed to 
improve oversight of OTC derivatives, while maintaining the significant 
benefits the OTC derivatives markets currently provide, and to promote 
orderly and efficient exchange markets.

    The Chairman [presiding.] Thank you very much, Mr. Rosen.
    Mr. Weisenborn. Welcome to the Committee.

STATEMENT OF BRENT M. WEISENBORN, CEO, AGORA-X, LLC, PARKVILLE, 
                               MO

    Mr. Weisenborn. Thank you.
    Mr. Chairman, Ranking Member Lucas and Members of the 
Committee, thank you for the opportunity to share my views on 
the important questions of OTC commodity market regulation that 
you are now considering. Before addressing the substance of my 
testimony, let me place my views in context by saying a few 
words about Agora-X and my background.
    Agora-X is a development stage company located in 
Parkville, Missouri. It is dedicated to bringing efficiency, 
liquidity and transparency to the over-the-counter commodity 
markets by means of advanced, regulatory compliant electronic 
platforms for OTC transaction. Agora-X was founded by FCStone, 
a commodities firm headquartered in Kansas City. Agora-X is now 
also partially owned by NASDAQ OMX. I have been a member of 
both the Chicago Board of Trade and the Kansas City Board of 
Trade. I also have self-regulatory experience of the NASDR, now 
renamed FINRA.
    OTC markets play an important role in market innovation. 
They provide an alternative venue for contract formation, price 
discovery and risk mitigation. For institutional participants, 
these markets can provide substantial public benefit if they 
are required to be transparent, reportable, clearable, and to 
function within the bounds of an electronic platform.
    Well-organized OTC markets can dramatically improve 
efficiency of commodity markets. By doing so, OTC markets can 
reduce the cost that consumers ultimately pay for commodities. 
When the markets are transparent, liquid and open, transaction 
costs fall and spreads contract. In transparent markets, there 
is much less room for manipulation.
    With broad, transparent OTC markets, the likelihood of 
devastating speculative bubbles is significantly reduced. Thus, 
well-regulated OTC markets can contribute to the integrity of 
U.S. financial markets as a whole. Of course, we must not 
ignore the lessons taught by the current crisis, but we should 
be careful to identify the true nature of these problems. In my 
view, the major problems have been in the misuse of certain 
commodity contracts and have not been in the means by which 
they are traded.
    This brings me to the major point I wish to make. I urge 
the Committee to preserve the existing OTC commodity markets, 
but to modify the existing law to improve them. The present 
financial crisis has demonstrated the need to reform to the OTC 
commodity markets. Clearly these markets can be improved by 
means of mandatory reporting, clearing, and by moving these 
markets to transparent electronic facilities.
    In addition, an important issue for this Committee is the 
treatment of OTC contracts on agricultural commodities. 
Contracts on agricultural commodities deserve the same 
treatment as contracts on non-ag commodities. Existing law and 
regulation discriminate against these commodities by making it 
difficult or impossible to create OTC agricultural contracts 
electronically, or to clear them. These restrictions, which do 
not advance any regulatory goal, make no sense today. An 
example may help to illustrate my point.
    Last summer, grain prices in the United States reached a 
very high level, but many producers who wanted to lock in those 
prices with cash-forward contracts were unable to do so. The 
country elevators who ordinarily offer such contracts could not 
do so because they could not finance the margin required for 
offsetting future positions. I think clearable, structured OTC 
contracts could have emerged to bridge that gap if it were not 
for the restrictive regulations.
    We currently face a time when agricultural markets 
desperately need liquidity. Allowing cleared, structured OTC 
contracts can help facilitate and accelerate liquidity. With 
the safeguards this Committee will add to protect the OTC 
markets, it is time for eligible agricultural commodity 
producers, processors, and users to have full access to the OTC 
markets.
    I think four things are essential to the OTC commodity 
markets' reform agenda.
    First, all physical commodities, including agricultural 
commodities, should be treated equally.
    Second, OTC commodity markets should be transparent and 
reportable to the CFTC.
    Third, OTC markets should be clearable and less narrow. 
CFTC-crafted exemptions should apply.
    Fourth, all OTC contracts should be established on or 
reported to an electronic facility.
    Accordingly, I generally support the language of the draft 
bill, but propose that it be improved to allow a quality of 
treatment of agricultural commodities, establish electronic 
documentation and audit trail, trading and clearing 
requirements, and to give CFTC authority to craft exemptions. 
Finally, the bill should appropriately define and authorize 
electronic trading facilities.
    Thank you for giving me the opportunity to share my views 
on the draft bill.
    [The prepared statement of Mr. Weisenborn follows:]

     Prepared Statement of Brent M. Weisenborn, CEO, Agora-X, LLC, 
                             Parkville, MO
    Mr. Chairman and Members of the Committee,

    My name is Brent Weisenborn of Parkville, Missouri. I am CEO of 
Agora-X, LLC. Thank you for the opportunity to share my views on the 
important questions of regulation of the OTC commodities markets that 
you are now considering in the proposed bill (draft bill) to amend the 
Commodity Exchange Act (CEA).
(1) Background.
    Agora-X, LLC is a development stage company that is dedicated to 
bringing efficiency, liquidity and transparency to over-the-counter 
(OTC) commodity markets by means of state of the art, regulatory 
compliant, electronic platforms for OTC contract negotiation as well as 
trading and transaction execution. Its initial focus is on cash-settled 
OTC contracts related to physical commodities, such as energy and 
agricultural commodities.
    Agora-X, LLC was founded in 2007 by FCStone Group, Inc, which is a 
commodities firm with deep roots in agricultural commodities markets. 
FCStone originated as a regional cooperative in the Midwest offering 
traditional hedging services to cooperative grain elevators, and has 
grown to offer commodity trading and price risk management services 
throughout the nation and beyond. In addition to FCStone, Agora-X is 
now also partly owned by The NASDAQ OMX Group, Inc.
    I am tremendously excited about the opportunity that exists to 
improve the functioning of the commodities markets by means of 
innovations such as the electronic platforms offered by my company and 
by adjustments to existing regulatory systems that you are now 
considering.
    I feel qualified to comment on these points, not only because of my 
role with Agora-X, but also because of years of experience in both the 
securities and commodities markets.
    I have been a member of both the Chicago Board of Trade (CBOT) and 
the Kansas City Board of Trade (KCBT). I traded futures and was an 
option market maker as a proprietary trader. I served on the Board of 
Directors of the KCBT from 1996 to 1998.
    I was a founder and served from 1987 until 2001 as President of 
Security Investment Company of Kansas City, an institutional only 
Broker-Dealer and NASDAQ Market Maker. Security Investment Company 
specialized in proprietary trading and wholesale market making.
    I was elected to the NASDR (renamed FINRA), District No. 4 District 
Committee in 1998 and was elected Chairman in 1999. I served as 
Chairman until January of 2001 and as co-Chairman of the District 4 & 8 
(Chicago) Regional Committee. The NASDR (FINRA) District No. 4 covers 
seven states: Missouri, Kansas, Iowa, Nebraska, North Dakota, South 
Dakota and Minnesota. At that time I was responsible for the regulatory 
oversight of approximately 55,000 stockbrokers in 2,500 offices. I also 
served on the NASDR National Advisory Council for the year 2000. In 
June of 2000, I was elected to the NASDR National Small Firm Advisory 
Board.
    As a result of my experience I have observed at close hand the 
evolution of the electronic markets for securities, and I see strong 
parallels with electronic markets for commodities that are just now 
emerging.
(2) Need for Regulatory Change.
    OTC markets play an important role of market innovation. They 
provide an alternative venue of contract formation, price discovery and 
risk mitigation outside the rigid and restrictive regulatory framework 
for ``designated contract markets'' that applies to commodity 
exchanges. OTC markets can provide substantial public benefit without 
creating systemic risk of the kind that precipitated last September's 
financial crisis if they are required to be transparent, reportable, 
clearable, and to function within the bounds of electronic 
communication networks (ECNs) or exempt commercial markets (ECMs).
    Well organized OTC markets also dramatically improve efficiency of 
commodity markets and by doing so OTC markets reduce the costs that 
consumers ultimately pay for commodities. When the markets are 
transparent, liquid and open, the spreads that swaps dealers can charge 
shrink and as a result, transaction costs fall. Efficient markets also 
inevitably attract liquidity and become broader. If these markets 
become clearable, they will also bring increased liquidity to clearing 
houses and registered commodity exchanges.
    In addition, in open markets there is much less room for 
manipulation and the possibility of committing fraud. Because of the 
transparency and breadth of these markets, the likelihood of 
devastating speculative bubbles is also significantly reduced. These 
markets will help bring interests of traders and sound market 
fundamentals into balance. Thus, well regulated and well managed OTC 
markets will contribute to the integrity of U.S. financial markets as a 
whole.
    Of course, we must not ignore the problems that have emerged from 
the current crisis, but we should be careful in identifying the sources 
of these problems. In my view, the major problems have been in the 
misuse of securities and commodities contracts, and have not been in 
the means by which they are traded.
    This brings me to the major point I wish to make. I urge the 
Committee to preserve the OTC commodity markets, but to modify the 
existing law to derive improvements in them.
    The present financial crisis demonstrated that there are 
inefficiencies in the regulation and functioning of the OTC commodities 
markets and that these markets can be improved by means of electronic 
audit trail and reporting, by clearing and by moving these markets to a 
transparent ECN or ECM facilities, where possible.
    In addition, an important issue for this Committee is the treatment 
of OTC contracts on agricultural commodities. We believe that 
agricultural derivatives, such as commodity swaps and options, deserve 
the same treatment as the non-agricultural commodities under the draft 
bill. Existing law and regulation discriminate against these 
commodities by making it difficult or impossible to create OTC 
agricultural contracts electronically or to clear them. Harmonization 
of regulation for OTC contracts on agricultural commodities with other 
contracts will provide the same public benefits to agricultural 
commodities as are available to all other commodities. In addition it 
will eliminate existing regulatory anomalies such as prohibitions of 
clearing and electronic trading that arose in the evolution of the OTC 
markets and were discarded over time for other commodities, but 
retained without critical analysis for agricultural commodities.
    An example may help illustrate the point. Last summer grain prices 
in the United States reached very high levels, but many producers who 
wanted to lock in those prices with cash forward contracts were unable 
to do so because the country elevators who ordinarily offer such 
contracts did not do so because of inability to finance the margin 
required for offsetting futures positions. I think clearable, 
structured OTC contracts could have emerged to bridge that gap if it 
were not for restrictive regulations.
    We currently face a time when agriculture desperately needs 
liquidity. The agricultural OTC market is a significant existing market 
that is developing entirely outside of registered commodity exchanges. 
Allowing cleared, structured agricultural OTC contracts on ECNs can 
help facilitate and accelerate liquidity, while adding transparency and 
efficiency.
    With the safeguards that this Committee will add to protect the OTC 
markets it is time for agricultural commodity producers, processors and 
users to have full access to such regulated markets.
(3) Conclusions and Recommendations.
    During the last few decades the securities markets have been truly 
revolutionized by innovative electronic trading methods. Now, the 
commodities markets are following the same path of innovation. Based on 
my experience I think four things are essential to the OTC commodity 
markets reform agenda:

    (A) The OTC commodity markets should be retained, but improved;

    (B) Unless exempted by the CFTC, all OTC commodity contracts, 
        agreements and transactions must be reportable to the CFTC;

    (C) Unless exempted by the CFTC, all OTC commodity contracts, 
        agreements and transactions must be clearable; and

    (D) Unless exempted by the CFTC, all OTC commodity contracts, 
        agreements and transactions must be negotiated on an electronic 
        communication network (ECN) via the request for quote process 
        (RFQ) or traded or executed algorithmically on an exempt 
        commercial market (ECM) or posted by means of give-ups to such 
        electronic trade reporting facilities.

    Accordingly, I generally support the language of the draft bill, 
but propose amending the draft bill as follows:

    1. Clearing of all OTC commodity contracts, agreements and 
        transactions. Repeal existing laws and regulations which 
        prohibit electronic trading and clearing of OTC contracts on 
        agricultural commodities and provide that agricultural 
        commodities should be given equal regulatory treatment with 
        non-agricultural commodities by amending section 2(g) of the 
        CEA. The draft bill implies some of this, but it should be 
        further clarified to assure that agricultural commodities fully 
        benefit from the reforms enacted.

    2. Electronic Documentation. Require that all OTC commodity 
        contracts, agreements and transactions be electronically 
        documented, whether or not cleared, to assure transparency and 
        to facilitate the reporting of these transactions.

    3. Negotiation, Trading and Execution on ECNs or ECMs. Require that 
        unless certain limited CFTC-defined exemptions and exclusions 
        apply, all OTC commodity contracts, agreements and transactions 
        be negotiated, traded and executed on an ECN or ECM or posted 
        by means of the give-ups to such electronic facilities.

    4. Definition of ECN. The definition of ``Trading Facility'' in the 
        CEA should be amended to explicitly not include the ECNs. A new 
        definition of the ECN should be drafted and added to the CEA.

    Thank you for giving me the opportunity to share my views on the 
draft bill. I look forward to offering any assistance with drafting 
this proposed legislation as you may request.

Brent M. Weisenborn,
CEO, Agora-X, LLC.
[Redacted]

cc:
Richard A. Malm, Esq.,
Dickinson, Mackaman, Tyler & Hagen, P.C.,
[Redacted];

Peter Y. Malyshev, Esq.,
McDermott, Will & Emery, LLP.,
[Redacted].

    The Chairman. Thank you very much, Mr. Weisenborn, for your 
testimony.
    Mr. Fewer, welcome to the Committee.

    STATEMENT OF DONALD P. FEWER, SENIOR MANAGING DIRECTOR, 
            STANDARD CREDIT GROUP, LLC, NEW YORK, NY

    Mr. Fewer. Thank you, Mr. Chairman.
    Chairman Peterson, Ranking Member Lucas and Members of the 
Committee, my name is Donald Fewer, Senior Managing Director of 
the Standard Credit Group, LLC in New York. As the first inter-
dealer broker in the over-the-counter CDS market, I consummated 
the first trades between dealers at the market's inception in 
1996, and have participated in the market's growth and 
development since then, including single named CDS, credit 
index and index tranches. I have submitted my full statement 
for the record and will comment on four areas in the proposed 
legislation.
    The first is regarding central counterparty clearing. My 
first point is an affirmation of the sentiments expressed by 
virtually all of the panelists that central clearing facilities 
of organized exchanges will work to eliminate counterparty 
credit issues in over-the-counter bilateral derivative 
contracts, and will undergird and strengthen the over-the-
counter derivatives market infrastructure.
    Providing access to all market participants, sell-side and 
buy-side, to an open platform centered in CCP, will stimulate 
credit market liquidity by reconnecting more channels of 
capital to the credit intermediation and distribution function. 
The use of exchange CCP facilities will have a significant 
impact on credit markets by enabling participants to free up 
posted collateral and recycled trading capital back into market 
liquidity.
    Legislation that expands the role of organized exchanges 
beyond CCP to include exchange execution of OTC credit 
derivative products will be disruptive, and lacks the clear 
recognition of the already well-established and economically 
viable over-the-counter market principles.
    My second point is exchange execution of over-the-counter 
credit derivative products. Given the size and established 
structure of the OTC derivatives market, migration toward 
exchange execution has been, and will be, minimal apart from 
mandatory legislative action. It has been argued that the lack 
of standard product specifications of OTC derivatives is a 
market flaw and should be remedied by mandated exchange listing 
and execution.
    This argument lacks support. CDS contracts utilize standard 
payments and maturity dates. Credit derivative participants 
have adopted a higher degree of standardization because credit 
risk is different from the other types of underlying risks. 
Unlike interest rate swaps in which the various risks of a 
customized transaction can be isolated and offset in underlying 
money and currency markets, credit default swaps involve lumpy 
credit risks that do not lend themselves to decomposition. 
Standardization, the most significant attribute of exchange-
traded products, is therefore a substitute for decomposition.
    Recent improvements in CDS market standards have resulted 
in up-front payments, and the establishment of annual payments 
that resemble fixed coupons similar to bonds. These changes 
will simplify trading and reduce large gaps between cash flows 
that can amplify losses. Most importantly, enhancing these 
standards will build a higher degree of integration between CDS 
and the underlying over-the-counter cash debt markets that 
simply cannot be replicated on an exchange. This aggregation 
and dispersion of credit risk between the over-the-counter cash 
and derivative markets is critical to the development of 
overall debt market liquidity, going forward.
    Other mechanisms implemented by the OTC market include 
post-default recovery rate auction and trade settlement 
protocols, innovation and portfolio compression methodologies. 
All of these functions performed exceptionally well during the 
market turbulence of last year. A regulation that would force 
exchange execution of CDS products would be harmful and 
disruptive to the credit risk transfer market.
    The third point I would like to address is underlying bond 
ownership requirements as proposed by the legislation. The 
draft legislation fails to recognize the underlying risk 
transfer facility of the plain vanilla credit default swap by 
requiring bond ownership. Limiting CDS trading to underlying 
asset ownership will cripple credit markets by stripping from 
the instrument the risk management and credit risk transfer 
efficiencies inherent in its design. The basic use of a credit 
default swap enables a credit intermediary, such as a 
commercial bank, to trade and transfer credit risk 
concentrations while being protected from a default at the 
senior unsecured level of the reference entity's capital 
structure.
    For example, financial institutions servicing large 
corporate clients must offer commercial lending, corporate bond 
underwriting, working capital facilities and interest rate risk 
management. In addition, the financial institution provides a 
market-making facility in all of the secondary markets for 
which it underwrites a client's credit. All of these financial 
services expose the financial institution to client 
counterparty risk.
    The credit risk transfer market optimizes the use of 
capital by enabling financial intermediaries to efficiently 
hedge and manage on- and off-balance-sheet credit risk. Credit 
derivatives therefore play a vital role to credit 
intermediation and market liquidity. Requiring bond ownership 
will counteract and work directly against the credit 
stimulation initiatives in the economic stimulus legislation 
currently under consideration.
    My fourth and final point is the unintended consequences of 
inappropriate regulatory action. As I detailed in my full 
statement, the value of cash bond trading has declined 
dramatically since the implementation of FINRA's Trade 
Reporting and Compliance Engine known as TRACE. TRACE led 
directly to the deterioration of the over-the-counter inter-
dealer, investment-grade, and high-yield bond trading volume.
    While TRACE was anticipated to facilitate transparency, its 
implementation revealed the failure to fully understand over-
the-counter corporate bond market structure, and created an 
inadvertent level of disclosure that frankly devastated the 
economic basis for dealer market-making. The lack of a liquid 
secondary market for corporate debt throughout the term 
structure of credit spreads dramatically increased the risk in 
underwriting new debt. The underwriters and dealers facility to 
trade out of and manage bond risk was so restricted that the 
unintended consequence was to damage the secondary bond market.
    It is not coincidental that the U.S. high-yield bond market 
reported zero new-deal issuance for the month of November in 
2008. Almost half of the U.S. companies fell below investment-
grade credit ratings, making the $750 billion high-yield bond 
market a critical source of financing.
    Mr. Chairman, Mr. Ranking Member and Members, I appreciate 
the opportunity to provide the testimony today and would urge 
you to continue to reach out to the inter-dealer market for its 
input.
    [The prepared statement of Mr. Fewer follows:]

   Prepared Statement of Donald P. Fewer, Senior Managing Director, 
                Standard Credit Group, LLC, New York, NY
    Mr. Chairman Peterson, Ranking Member Lucas and Members of the 
Committee:

    Good morning. My name is Donald P. Fewer, Senior Managing Director 
of Standard Credit Group, LLC. a registered broker/dealer and leading 
provider of execution and analytical services to the global over-the-
counter inter-dealer market for credit cash and derivative products. I 
was fortunate enough to have consummated the first trades between 
dealers at the markets inception in 1996 and have participated in the 
market's precipitous growth and development as well as its challenges. 
I would like to thank this Committee for the opportunity to share my 
thoughts on the draft legislation on Derivatives Markets Transparency 
and Accountability Act 2009, as it applies to the over-the-counter 
market generally and the credit derivatives market specifically.
    The Committee's draft legislation comes at a pivotal time. The 
consequences of the crisis paralyzing global credit markets will have 
significant and long term effects on credit creation, intermediation 
and risk transfer. I believe that legislation that attempts to address 
derivative market accountability and transparency should reflect a 
clear understanding of credit market dynamics, particularly credit risk 
transfer. With this in mind, I would like to address five areas of the 
draft legislation that does not meet this pre-requisite:

   Central Counterparty Clearing and the Role of Organized 
        Exchanges.

   Exchange Execution of OTC Credit Derivative Products.

   Transparency and Price Discovery.

   Underlying Bond Ownership Requirements of CDS.

   Unintended Consequences of Inappropriate Regulatory Action.
Central Counterparty Clearing, Credit Risk Transfer Derivatives and the 
        Role of Organized Exchanges
    There has been significant criticism of the over-the-counter 
derivative products market, particularly credit derivatives, as the 
root cause of our global crisis. While much disparagement is based upon 
misinformation and misunderstanding, effective regulation directed at 
supporting the proper functioning of the credit risk transfer market is 
critical. Use of central clearing facilities of organized exchanges 
will not only work to eliminate counterparty credit issues in OTC 
bilateral derivative contracts, it will undergird and strengthen the 
OTC derivatives market infrastructure. The role of organized exchanges, 
in providing CCP services, can be the mechanism by which new capital 
and liquidity providers participate in the credit risk transfer market. 
The use of CCPs by all market participants, including ``end-users'' 
(i.e., hedge funds, asset managers, private equity groups, insurance 
companies, etc.) should be encouraged by providing open and fair access 
to key infrastructure components including but not limited to exchange 
clearing facilities, private broker trading venues and contract 
repositories. OTC trading venues will provide voice and electronic pre-
trade transparency, trade execution and post-trade automation. This 
view of providing access to all market participants, sell side and buy 
side, to an open platform centered in CCP, will stimulate credit market 
liquidity by re-connecting more channels of capital to the credit 
intermediation and distribution function. The use of exchange CCP 
facilities will have a significant effect by enabling participants to 
free up posted collateral and recycle trading capital back into market 
liquidity.
    However, the proposed legislation, which expands the role of 
organized exchanges beyond CCP to include exchange execution of OTC 
credit derivative products, will be disruptive and lacks a clear 
recognition of the already well established and economically viable OTC 
market principles.
Exchange Execution of OTC Credit Derivative Products: Disruptive and 
        Unnecessary
    Given the size and establishment of the OTC derivatives market, 
migration toward exchange execution has been and will be minimal apart 
from mandatory legislative action. With regard to CDS, the failure to 
migrate to exchange execution is because the credit derivatives market 
is characterized with a higher degree of standardization than other 
forms of OTC derivatives. It has been argued that the lack of standard 
product specifications of OTC derivatives is a market flaw and should 
be remedied by mandated exchange listing and execution. This argument 
is inaccurate. CDS contracts utilize standard payments and maturity 
dates. Credit derivatives participants have adopted a higher degree of 
standardization because credit risk is different from other types of 
underlying risks. Unlike interest rate swaps, in which the various 
risks of a customized transaction can be isolated and offset in 
underlying money and currency markets, credit default swaps involve 
``lumpy'' credit risks that do not lend themselves to decomposition. 
Standardization, the most significant attribute of exchange traded 
products, is therefore a substitute for decomposition. Recent work on 
reinforcing CDS market standards will result in upfront payments and 
the establishment of annual payments that will resemble fixed coupons. 
These changes will simplify trading and reduce large gaps between cash 
flows that can amplify losses. Most importantly, enhancing these 
standards will build a higher degree of integration between CDS and 
underlying OTC ``cash'' debt markets that cannot be replicated on an 
exchange. This aggregation and dispersion of credit risk between OTC 
cash and derivative markets will be critical to the development of 
overall debt market liquidity going forward. Other mechanisms 
implemented by the OTC market include post-default recovery rate 
auction and trade settlement protocols, novation and portfolio 
compression methodologies. All of these functions performed 
exceptionally well during the market turbulence of last year. A 
regulation that would force exchange execution of CDS products would be 
harmful and disruptive to the credit risk transfer market.
    It has also been argued that the ``opaqueness'' of the OTC 
derivatives market is a detriment to market transparency and price 
discovery and exchange listing and execution is required to increase 
the integrity and fairness of the market place. With respect, this 
position does not reflect current market realities.
Transparency, Execution and Post-Trade Automation: The Work of OTC 
        Markets
    The over-the-counter market has a well established system of price 
discovery and pre-trade market transparency that includes markets such 
as U.S. Treasuries, U.S. Repo, EM sovereign debt, etc. OTC markets have 
been enhanced by higher utilization of electronic platform execution. 
Private broker platforms will interface directly to CCPs and provide 
automated post-trade services. This was clearly demonstrated in the 
wake of Enron's collapse and the utilization of CCP facilities by the 
leading over-the-counter energy derivatives brokers to facilitate 
trading and liquidity. It is clear to all market participants that 
financial dislocation and illiquidity will persist across many asset 
classes and geographies for some time. As alluded to earlier, the 
unique nature of the OTC market's price discovery process is absolutely 
essential to the development of orderly trade flow and liquidity in 
fixed income credit markets. We are entering a period with an abundance 
of mispriced securities where professional market information and 
execution is required. OTC price discovery throughout the term 
structure of credit spreads will require a more focused and integrated 
execution capability between OTC CDS and cash, utilizing key component 
inputs from equity markets and the various constituents of the capital 
structure (i.e., senior and subordinated corporate bonds, loans, etc.). 
This type of exhaustive price discovery service can only be realized in 
the over-the-counter market via execution platforms that integrate 
derivatives and cash markets across asset classes (i.e., debt, 
equities, emerging markets, etc.). This will be critical to the repair 
of credit market liquidity globally.
    The implementation of a central trade repository, (i.e., DTCC), 
that is publicly disseminating detailed information of the size, 
reference entity and product break-down of the credit derivatives 
market on a weekly basis will serve to strengthen public confidence in 
disclosure and transparency of the CDS market.
Underlying Bond Ownership Requirements: The Virtual Elimination of the 
        Inherent Value of CDS
    The draft legislation fails to recognize the underlying risk 
transfer facility of the ``plain vanilla'' credit default swap by 
requiring bond ownership for credit default swap purchases. Limiting 
CDS trading to underlying asset ownership will cripple credit markets 
by stripping from the instrument the risk management and credit risk 
transfer efficiencies inherent in its design. The basic use of a credit 
default swap enables a credit intermediary (i.e., commercial bank) to 
trade and transfer credit risk concentrations while being protected 
from an event of default at the senior unsecured level of the reference 
entities capital structure. For example, a financial institution 
servicing a large corporate client is required to offer commercial 
lending, corporate bond underwriting, working capital facilities, 
interest rate management services, etc. In addition, the financial 
institution provides a market-making facility in all of the secondary 
markets for which it underwrites a client's credit (i.e., senior, 
junior and convertible bonds, loans, etc.) All of these above services 
expose the financial institution to counterparty risk to the corporate 
customer. The credit risk transfer market optimizes the use of capital 
by enabling financial intermediaries to efficiently hedge and manage on 
and off balance sheet (i.e., unexpected credit line draw-downs, 
``pipeline'' risk, etc.) credit risk. Credit derivatives therefore play 
a critical and vital role to credit intermediation and market 
liquidity. The implementation of the use of CDS in requiring bond 
ownership will counteract and work directly against the credit 
stimulation initiatives currently under consideration by Congress in 
the Economic Stimulus Bill H.R. 1.
Unintended Consequences of Inappropriate Regulatory Action
TRACE--an example of disruptive regulatory action
    Goldman Sachs recently reported that the value of cash bond trading 
has fallen each year over year for the past 5 years. The value of cash 
bond trading stood at $12,151bn in 2003 and declined to $8,097bn in 
2008. The CDS market achieved CAGR exceeding 100% since 2004 and stood 
at $62tn year end 2007. The inter-dealer market experienced firsthand 
the decline in secondary market bond turnover and that decline can be 
correlated directly to the implementation of FINRA's Trade Reporting 
and Compliance Engine (TRACE) reporting system. TRACE led directly, as 
an unintended consequence, to the deterioration of OTC inter-dealer 
investment grade and high yield bond trading volume. While TRACE was 
anticipated to facilitate the demand for ``transparency'' its 
implementation revealed the lack of depth in understanding the OTC 
corporate bond market structure and created an inadvertent level of 
disclosure that devastated the economic basis for dealer ``market-
making''. The lack of a liquid secondary market for corporate debt 
throughout the term structure of credit spreads dramatically reduces 
the risk tolerance to underwrite new debt. The underwriters and 
dealers' facility to trade out of and manage bond risk was so 
restricted that the unintended consequence was to damage the secondary 
bond market. This is most notable in the U.S. High Yield bond market. 
It is not coincidental that the U.S. High Yield bond market reported 
zero new deal issuance for the month of November 2008. Almost half of 
U.S. companies have below-investment grade credit ratings, making the 
$750 billion junk-bond market a critical, if not sole source of 
financing for an increasing number of corporations large and small all 
across America.
Loss of Money and Capital Markets to Off-Shore Financial Centers
    The United States is at significant risk to lose the flow of money 
and capital market trading activities to off-shore financial centers 
more conducive to over-the-counter market development. While American 
financial institutions have been the originators of financial 
innovation that enabled the free flow of capital across international 
markets, the United States is declining as a recognized financial 
capital globally. Legislation that creates a regulatory environment 
that prohibits capital market formation will push market innovation and 
development to foreign markets, which would be welcoming.
    Mr. Chairman, Mr. Ranking Member and Members of the Committee, I 
appreciate the opportunity to provide this testimony today and would 
urge that you continue to reach out to the dealer market for its input. 
I am pleased to respond to any questions you may have. Thank you.

    The Chairman. Thank you, Mr. Fewer.
    Mr. Weisenborn, in the recommendations section of your 
testimony, you said that all the OTC contracts should be 
reportable, electronically documented unless exempted. What do 
you think about the statutory standards in the draft for 
exemptions, and would you change any of them?
    Mr. Weisenborn. Well, I would leave most of it to the CFTC 
to determine exemptions. They have years of experience in this 
area, and I would yield to their expertise. Generally, we agree 
with the language as it is currently constructed.
    The Chairman. Okay. Mr. Kaswell maintains that the majority 
of the OTC derivative contracts are nowhere near the level of 
the standardization of CDS markets.
    To Mr. Book and Mr. Weisenborn, do you agree with that 
statement? Is most of the volume in the OTC world too 
nonstandard for clearing?
    Mr. Book. If I may comment on that, Mr. Chairman, the 
limits for central clearing when the products have not 
sufficiently cleared need to come to a daily settlement price, 
and also the clearinghouses are not in a position to dispose of 
their positions in case of a default. Especially for structured 
products with little liquidity, it will be difficult for a 
clearinghouse to provide central clearing services. As 
mentioned in the testimony, for those products there should 
then be the review with CFTC if they provide sufficient 
economic benefit for hedging.
    Mr. Weisenborn. We feel that clearing is next to godliness, 
so in all circumstances we would encourage that all products 
would be cleared. In the cases where they are simply not 
standard enough to clear, we would urge the Committee to 
consider requiring those transactions to be reported 
electronically so that there is an electronic audit trail and a 
window of transparency for the regulator to see those 
transactions.
    The Chairman. That seems to make sense. Is that feasible? 
Is the electronic platform there to require that?
    Mr. Weisenborn. Yes, sir. This is the same evolution that 
occurred 10 years ago in the equity markets with our OTC market 
at the time. When I was on the Board of the NASDR we owned 
NASDAQ, and we had to bring in some rules to encourage or to 
mandate electronic audit trail and trade reporting. This 
software, Agora, is simply that. It is a piece of software that 
allows for electronic trading, audit trail, and electronic 
delivery. We have agreements with both NYMEX and CME. We use 
those as our DCO to clear our transactions. So this is probably 
the third generation of this software. It is quite feasible, 
sir.
    The Chairman. There are other people that have this 
software too, I assume?
    Mr. Weisenborn. Yes, sir. This is the first application 
that we are aware of in this asset class.
    The Chairman. Nobody else is electronically trading in this 
area?
    Mr. Weisenborn. To this point in the OTC commodity space, 
because of the prohibitions, we are a development-stage 
company. We have not begun trading. Our software is complete, 
and that is why we are here to urge a level playing field for 
agricultural commodities, so that they can be cleared and 
traded electronically. But from what we know, this would be the 
first application of ECN technology, such as BATS and some of 
the other things that have developed in Kansas City in this 
asset class.
    The Chairman. Mr. Kaswell, you are highly critical of 
setting the position limits, speculative position limits for 
all contracts. If we have limits and they have worked in the 
agricultural markets, why wouldn't it be appropriate to have 
them for all other markets of physical commodities?
    Mr. Kaswell. Thank you for the question, Mr. Chairman. We 
appreciate the importance of having an effective regulatory 
system, and appreciate the opportunity to make what we hope are 
useful suggestions in that regard.
    We think that with regard to the exchange rate of products, 
that the exchanges are closer to that market and therefore 
would be in a better position to make those assessments. We 
think they have done a good job. That is why we feel that the 
proposal in this statute is not optimal.
    The Chairman. So because you are going to do the right 
things?
    Mr. Kaswell. I am sorry, sir. I am having trouble hearing 
you.
    The Chairman. I said because you are in a position to do 
the right thing better than we are?
    Mr. Kaswell. I don't think I would quite put it that way. I 
think that an effective system of oversight is critical to the 
way the whole system operates. We feel that when it comes to 
making position limits on exchanges in the individual cases, 
that they are closer to it, and that you monitoring that system 
will be more effective in terms of getting the outcome you are 
looking for.
    The Chairman. Somebody on a previous panel talked about 
having the people that actually utilize the system be the same 
ones that decide what the position limits are in their various 
areas. Do you agree with that?
    Mr. Kaswell. Well, if there were no mechanism for 
oversight, I wouldn't take that point. But, as long as there is 
a strong system of oversight, then I think that there are 
economic incentives for the exchanges to monitor and make sure 
they are doing the right thing.
    I also think that your efforts with regard to clearing are 
important, and we support that general goal. I think as more 
products get moved into the clearing environment, that it will 
address risk overall in the whole system. So I applaud you for 
looking at this across the board.
    The Chairman. So the oversight you are talking about would 
be oversight from the CFTC. Is that what are saying?
    Mr. Kaswell. On the exchanges and boards of trade, yes, 
sir.
    The Chairman. You are not relying on us?
    Mr. Kaswell. Indirectly, yes.
    The Chairman. You might be in trouble there.
    All right, thank you very much.
    Mr. Lucas. No questions.
    The Chairman. Mr. Lucas passes.
    Mr. Boswell.
    Mr. Boswell. Well, thank you very much. I am sure you heard 
some of the discussion we had earlier today.
    Welcome to Mr. Book.
    I would like to address a couple of things to you in a 
language I understand a little better. As you develop clearing 
services for the CDS market, what are the special safeguards 
you are considering to address your members' large exposures 
for CDS products given a credit event?
    Mr. Book. First of all, if we look at the function of 
central clearing, it is worthwhile to point out the principal 
difference to all the other market participants is that the 
clearinghouse always has a balanced portfolio and position. 
There are several lines of defense that the clearinghouse will 
put into place to collateralize all the risk that the market 
participants hold.
    First of all, it is the margining, and part of the 
margining is a daily mark-to-market, daily articulation of the 
profits and losses of those holding positions. This is a major 
difference for many of the current standards in the OTC 
markets, so that there is always the situation that the market 
participants are in a position to cover their losses.
    The clearinghouse will also calculate margins, especially 
for the CDS market where it is pretty important to cover credit 
events. We have developed a risk concept that is especially 
designed to address the situation of credit events. As you 
know, these contracts contain a binary risk component in the 
event default occurs.
    In addition to that, there is a mutual guaranty fund which 
is funded by the clearing participants. We will set this up in 
a way that it is segregated from the credit default swaps 
business. In the end the clearing participants will hold a 
mutual guaranty fund to cover the risks that are coming out of 
that position. All of that is really designed to make sure that 
the positions that are held by the clearing participants are 
adequately collateralized so that the clearinghouse is always 
in a position to liquidate the position should there be a 
default situation.
    Mr. Boswell. Thank you. To continue, are there any U.S. 
reporting requirements that may be inconsistent with European 
laws? More broadly, what do you see as the major challenges to 
greater cooperation between U.S. and European regulators?
    Mr. Book. First of all let me respond to that, Congressman. 
The earlier suggestion was made here that the approach of 
having a European clearer might be protectionist. I think we 
would clearly say that we do not agree with that. Like the U.S. 
clearinghouses, we would operate globally as a European 
clearinghouse, and we believe that having a single mandated 
sort of worldwide monopoly clearinghouse would be clearly not 
an appropriate model for this market. But it is much more 
appropriate as the approach taken here in this bill to embrace 
competition.
    To the extent that the European market can be better served 
by a local European clearinghouse operating in that time zone 
like we are, European market participants will have that 
opportunity, and the European clearinghouse has the benefit of 
focusing on the European defined contracts which might differ 
from the U.S. contracts; and therefore can address the market 
peculiarities of the European market.
    With regards to the specific reporting schemes, our lawyer 
would probably prefer to come back on whether there are 
particular points to be raised in that regard.
    Mr. Boswell. Okay. Thank you very much.
    I guess I have a little bit of time left. CME Chairman 
Terry Duffy testified against the clearing provisions, stating 
he didn't think they would prove to be practical because over-
the-counter dealers may not embrace clearing. As another 
exchange that also has a clearinghouse, what do you think of 
his views?
    Mr. Book. Probably I will make a general comment in 
commending Mr. Duffy. I think in the last testimony also that 
was held here, I clearly made the point that mandatory clearing 
is required as an approach to change bilateral market 
structures in this market. And as we have seen over the past 
years, the economic incentive to migrate the current bilateral 
structures, and also the very much forward market, is not 
sufficient to come to a central clearing structure that is the 
standard like in all futures options markets.
    The approach to mandate clearing for suitable contracts is 
the right approach because it is a huge challenge and task to 
migrate this very significant asset class to central clearing 
market structures. And, of course, one of the changes is to get 
the right transition of the current positions that are pending 
to a central clearinghouse. One of the approaches that we have 
suggested, and want to take, is that we can download the 
existing business in the DTCC Warehouse to facilitate that 
transition, and that also refers to the common denominator in 
my testimony. I think the CFTC should take a practical approach 
in their exemptions for those contracts that cannot be, sort 
of, on day one cleared.
    Mr. Boswell. Thank you very much. My time is up. I think I 
can say for all of us, we want to have this world community to 
work, but we are going to have to grow together.
    The Chairman. Thank you, Mr. Chairman.
    The gentleman from Georgia, Mr. Marshall.
    Mr. Marshall. Thank you, Mr. Chairman.
    I guess we are trying to address here two related but 
different problems. One, the recent economic crisis that seems 
to have been compounded by systemic risk caused by an 
interwoven relationship that is very difficult to understand, 
as a result of the fact that this is a very opaque market. 
There are a lot of people that are involved in the market, and 
there would be lots of different ways of addressing that. 
Certainly clearing could be one.
    You have heard, I guess over the couple days, the different 
discussions we have had about clearing and compromises with 
regard to clearing. We started this legislation last summer 
though, because we were quite concerned about the volatility of 
commodity markets. And we passed legislation in the late summer 
or early fall that was designed to address that problem.
    I guess I would like to hear Mr. Kaswell and Mr. Rosen's 
thoughts, but I am going to have to make it a hypothetical 
question to you. I would like you to assume that we have 
concluded that passive investment money, it has been described 
as index fund money, et cetera, is a culprit in the sharp rise 
in commodity prices. Not necessarily all, some of it is demand-
driven. But let's assume that we have concluded that a 
substantial amount of the upswing, and now a substantial amount 
of the downswing, is explained by the presence of this money in 
these markets that hasn't been there before. It is a fairly 
recent phenomena. And what we would like to do is figure out a 
way to have the markets go back to functioning appropriately as 
they had, or at least functioning as well as they did, not 
perfectly, of course, but as well as they did prior to the 
presence of this money.
    A number of different suggestions have been made. One is 
aggregate position limits across all markets, so OTC, on-
exchange. Other suggestions have been position limits that 
apply only to the exchange-traded commodities and not to the 
OTC market. Others have suggested that the CFTC needs to be 
given some tools that would be a combination of maybe position 
limits and possible exemptions, and directed to minimize the 
inappropriate impact as we find it to be, of this kind of 
passive money or index money, or whatever you want to call it, 
in the futures markets, rather than directing the CFTC to set 
equal position limits, et cetera.
    I would like to hear you guys, your thoughts, if we are 
trying to accomplish this, how we would best go about 
accomplishing this without otherwise messing up the market?
    Mr. Rosen. Thank you for the question, Congressman 
Marshall.
    The first question I would ask about your observations: The 
markets are dynamic and they do evolve, and you are right that 
some of the price behavior that was observed was observed 
during a period in which new sources of investment money were 
coming into the markets. And one of the things that I think it 
is important to do is look at the short-term trend and the 
long-term trend, and decide whether in the long term the 
presence of those may be stabilizing and not destabilizing.
    I would also say that I think it is important.
    Mr. Marshall. I just want you to assume that we have 
concluded that they are destabilizing. It is because they have 
a different interest. It is a longer-term view of things. They 
have been instructed to take a position that is just part, say 
an endowments fund, and it is part of our portfolio management 
strategy. We are going to take a position in commodities, and 
the way we choose to do that is we go through Goldman Sachs' 
Commodity Index Fund, stay longer, we do it some other way, but 
basically we effectively get on the futures market as a way to 
hedge our long-term position. We have done that, and we are not 
really acting like the traditional speculator, each day trying 
to figure out where things are going.
    Mr. Rosen. Right. In that event, you are left to requiring 
that the CFTC have transparent insights into the positions that 
affect those markets. And clearly the linkages that exist 
between the various markets are critical to that, including the 
over-the-counter positions, but also physical positions. I 
think if you had a position in that approach which didn't take 
into account physical provisions, which many people would 
observe have a more direct influence or ability to influence 
prices and market liquidity and available supply, is going to 
be an inadequate tool.
    Having said that, I don't think you would have any choice 
if you were trying to give the CFTC the tools that it needed to 
deal with situations where the conclusion was reached that 
markets are disorderly as a result of this excessive 
speculation. You would have to give the CFTC the ability, and 
it may already have this under the statute, to go in and say 
these we are putting position limits on, or reducing them, or 
reducing the amount that you can take advantage of during this 
period while the markets are exhibiting this pricing behavior, 
I think it is a situation----
    Mr. Marshall. Would that be across-the-board or would that 
be with respect to specific markets?
    Mr. Rosen. I would say it would be with respect to the 
markets that are disrupted.
    Mr. Marshall. So it is just the markets. It is not the 
individuals who are in those markets?
    Mr. Rosen. Well, I think that you would have to go to the 
large positions in those markets and you would have to 
determine what levels, for example, it was necessary to 
establish for the relevant strategies in order to accomplish 
the level of market exposure that you think is consistent with 
getting the market to the right price. If you could figure that 
out, I think it is a very, very difficult undertaking.
    Mr. Marshall. Sure. Mr. Kaswell?
    Mr. Kaswell. Thank you. One point I feel duty bound to make 
is that the index funds that you are describing are not hedge 
funds. Hedge funds tend to be on both sides of the market and 
they don't tend to drive markets wildly up in one direction or 
down in another, by definition.
    Mr. Marshall. You are part of our price discovery team, 
providing liquidity.
    Mr. Kaswell. Yes, sir. We provide liquidity. And we take 
positions----
    Mr. Marshall. You in fact have white hats on. You are the 
good guys.
    Mr. Kaswell. Absolutely.
    Mr. Marshall. Having said that----
    Mr. Kaswell. Okay. I think that we appreciate that the bill 
has different provisions to collect more information about the 
markets, which we think is a good idea before making some of 
these judgments. Your question asks about additional position 
limits and the need for that.
    I guess I would say that I would agree with what Ed Rosen 
is saying, that it would depend on what authorities the CFTC 
already has, and look to them to try to make good judgments 
about the amount of position limits that would be necessary.
    Mr. Marshall. Do you agree, Mr. Rosen----
    The Chairman. Gentlemen, I have to go to a peanut meeting. 
I want to turn this over to Mr. Boswell to finish off the 
hearing if Mr. Moran has a question. Then you can keep going if 
you want.
    We are trying to figure out whether we are going to have 
another hearing next week. As is typical, the SEC and the Fed 
don't want to come and talk to us. We will have to figure out 
what we are going to do. But I do, for those of you, we are 
going to sort through this stuff and start looking at these 
sections that were criticized, and see if there is some way we 
can bring some sort of consensus amongst ourselves.
    But unless something happens here, I would be planning to 
try to move this to markup next week at some point before we 
get out of here. So I am going to be around the next couple of 
days and we will start trying to bring this together.
    Mr. Boswell, if you will take the chair. I thank the 
witnesses. I will have to head out. If you didn't mind 
answering a couple more questions.
    Mr. Boswell [presiding.] Mr. Marshall.
    Mr. Marshall. Just one last question. Mr. Kaswell, do you 
agree? Mr. Rosen observed and I acknowledged that you qualified 
that by saying, as new money moves in, it can have anomalous 
effects and maybe over time those anomalous effects could die 
down? Same impression?
    Mr. Kaswell. I am not sure that I focused necessarily on 
the new money per se. I think it is a matter of what motivated 
that new money to come into the market. Was it done as part of 
a change in the marketplace, some other new event or change in 
technology? Those kinds of things you would want to look at. So 
I think you have to look at----
    Mr. Marshall. A different investment objective?
    Mr. Kaswell. All of those things, yes, sir.
    Mr. Marshall. And that is the contention by many, is that 
there was simply an investment objective that was being served 
by this new money coming in.
    Mr. Kaswell. Well, there have been many studies with 
respect to oil, and there are different views on that. In our 
view, a lot of that was based on fundamentals. The index 
players added momentum to it, but if you are going to establish 
these kinds of limits, which is the premise of your question, 
it has to be a sophisticated analysis to make sure that you are 
filtering out the behavior that you didn't like and letting 
through the----
    Mr. Marshall. Get rid of the bad money and keep the good 
money.
    Mr. Kaswell. It is not easy.
    Mr. Marshall. Thank you, Mr. Chairman.
    Mr. Boswell. You are welcome.
    Mr. Moran.
    Mr. Moran. Mr. Chairman, thank you very much.
    Let me take this opportunity to congratulate you on 
becoming the Subcommittee Chairman on General Farm Commodities 
and Risk Management, a Subcommittee that I chaired at one point 
in time. And now I am your humble Ranking Member, and I look 
forward to working with you.
    Mr. Boswell. Remember to be with me now--some of the things 
that I read in the paper you might be doing.
    Mr. Moran. I look forward to working with you, Mr. 
Chairman, to the nth degree.
    Mr. Boswell. And I wish you well.
    Mr. Moran. Thank you so much.
    I have a couple of questions. I explored this with the 
previous panel and what I think I see in this draft, and what I 
hear from a number of witnesses, is that we are headed down the 
path of a forced clearing with a narrow exemption. And I just 
wanted to explore one more time what does anyone think the 
alternative should be to that. Is there an easy way to 
summarize that?
    Mr. Rosen. I think the question is how is it administered 
and what is the right way to get to maximizing clearing where 
it is appropriate. I think one of the fundamental problems is 
the equation is reversed. I think to say the default is that 
you must clear or you must come in and describe to somebody 
that this transaction isn't sufficiently customized and 
transactions are sufficiently infrequent, is an inherently 
flawed process.
    If you think about the way these products evolved, you 
would never have the certainty without knowing, well, what are 
other firms doing with that product? What is highly customized? 
And you would have people going to the regulator and trying to 
get comfort, to get individual transactions executed. I think 
that is the kind of inefficient friction that we would want to 
avoid.
    On the other hand, it is very clear to the regulators who 
obtain information about the transactions that are being 
executed when there are huge numbers of standardized 
transactions that are being executed. So, it is a far better 
standard to say you have to clear them once that determination 
has been made. But, as I said, I don't think the CFTC has the 
information to even begin to make that decision. They are not 
the supervisor of the major global banks who do this. That is 
not their job.
    We think that a far more effective approach would be to 
take advantage of the prudential supervision of the largest 
participants in the market, and that entity can determine when 
it is appropriate to require that the entities that it 
supervises are appropriately clearing their transactions. With 
respect to those that are not cleared, they should decide what 
ought to be the implications. What are the capital requirements 
that should be imposed for incremental risks that are created 
by having a large book of customized OTC transactions that are 
not subject to the disciplines and multilateral netting 
benefits of being in a clearing system?
    Mr. Kaswell. If I may, one thought that we put in our 
testimony, this is a little chicken-and-egg problem. The 
members of MFA are concerned that, while we are all very eager 
to see this happen quickly, that we are being asked to sign up 
for a system that is coming along. We are very optimistic that 
it will happen, but we don't want to sign up for something that 
we haven't seen, or be forced in the bill to do that. So how do 
you cut through that?
    Well, if there were many reporting requirements, oversight 
hearings, that sort of thing to keep the pressure on, that you 
would find the market would move there. Because there is an 
appetite for it in the private sector because of the very 
benefits that everybody agrees comes from clearing, and that 
you would find that many of the products would be in that 
cleared environment where it is appropriate. Some could get 
this sooner than later; and others you might not want to do it 
at all. As we all understand there is still a need for 
customized products. But, oversight and vigilance might work or 
get you where you are trying to go.
    Mr. Moran. Thank you.
    I have one more question, Mr. Boswell.
    This again may be to you, Mr. Rosen, because I notice that 
you took up the issue of foreign boards of trade. I introduced 
legislation last year to try to address this issue as well, and 
I worry that what we may be doing in the bill that is before us 
is allowing another loophole to occur.
    I guess my question is, with this current approach in this 
draft bill, would it just cause foreign boards of trade to 
close their trading desks in the U.S., but then continue to 
contract overseas where U.S. traders will continue to have 
access to the market where the CFTC doesn't have oversight?
    Mr. Rosen. I wouldn't want to make the knee-jerk reaction 
that as soon as the government does something that is 
potentially unpleasant that people will close off their access 
to or from the United States.
    I do think that if it was perceived that the standards that 
would be applied in the United States did not reflect the 
judgments of the international community, and that the manner 
in which the objective of sort of controlling speculation were 
being imposed prescriptively by the United States, there could 
be a couple of reactions. One reaction is in the regulatory 
community. I think it could invite retaliation and just another 
view that the United States is yet again being imperious when 
it is not necessary to do that.
    But to the extent that the market perceives that those 
constraints that are created by the imposition of those 
requirements on a foreign board of trade are going to impair 
the market, you could expect that. This is not just the foreign 
board of trade provision, Congressman Moran. I think it is 
related to a lot of the other provisions that impose 
constraints.
    If they are perceived as not conducive to the efficient 
operation of the market, there are no major traders certainly 
in the financial space that I am aware of who are not able to 
organize their affairs so that they can trade on foreign 
exchanges without a nexus to the United States.
    And I do have a concern that if we rush to judgment and try 
to solve short-term problems with long-term solutions that 
undermine the efficiency of the market, or are perceived by the 
market to undermine the market efficiency, those folks will be 
trading those products abroad. There is no reason why West 
Texas Intermediate crude is the price discovery contract for 
crude oil, other than the fact that we have been successful in 
developing highly efficient and low-cost markets. Most of the 
world transacts in forms of crude oil other than WTI. It is a 
small percentage, as you know.
    So I do have a concern that, if that were to transpire, 
there are many commodities that could be traded on foreign 
markets; and we would lose control over the regulation of those 
markets entirely. And if those markets are outside the United 
States, those markets will not even necessarily trade in U.S. 
dollars. It is not necessary for crude oil on the world stage 
to trade in U.S. dollars.
    I am not sure how it would advantage us to encourage the 
development of foreign markets driving the prices of stable 
commodities that our economy depends upon, and move those in a 
direction of trading in currencies other than the U.S. dollar. 
I think we do need to be concerned about those effects.
    Mr. Moran. Thank you for sharing your expertise.
    Thank you, Mr. Chairman.
    Mr. Boswell. You are very welcome.
    Anyone else? Mr. Marshall?
    I think that concludes our panel today. We cannot thank you 
enough for your time, your presence. I also think it is fair 
and reasonable to say we are going to need to continue the 
dialogue. As I think you may have heard earlier today, we have 
to do this right. We are counting on your input.
    So, again, thank you very much, and we will call this 
meeting adjourned.
    [Whereupon, at 3:18 p.m., the Committee was adjourned.]
    [Material submitted for inclusion in the record follows:]
      
Submitted Statement of Hon. Bart Chilton, Commissioner, U.S. Commodity 
                       Futures Trading Commission
    I commend Chairman Peterson for his continued leadership and 
support his efforts to restore the public's confidence in U.S. futures 
markets by ensuring appropriate oversight. The proposal incorporates 
needed changes to our current regulatory structure that will greatly 
improve our ability to protect consumers and businesses alike.
    In a speech last week, I quoted the American folklorist Zora Neale 
Hurston, who said; ``There are years that ask questions, and there are 
years that answer.'' This year must be a year of answers. During my 
remarks, I went on to lay out what I see as necessary steps to healing 
our fractures in our regulatory system. I'm pleased that the Chairman's 
proposal also addresses several of these critical components.

    (1) Require OTC reporting and record-keeping. This will enable the 
        CFTC to examine trading information, particularly information 
        about sizable, look-alike or price discovery transactions that 
        could impact regulated markets--markets that have a bearing on 
        what consumers pay for products like gasoline or food, or even 
        interest rates on loans.

    (2) Oversee mandatory clearing of OTC Credit Default Swap (CDS) 
        transactions, and encourage clearing for other OTC products as 
        appropriate. The stability and safety of our financial system 
        is significantly improved by enhancing clearing systems for 
        CDSs--in a manner that does not lead to cross-border 
        arbitrage--as well as for other OTC derivatives. Such clearing 
        would not only provide counterparty risk, but a data audit 
        trail for regulators.

    (3) Regulate OTC transactions if the Commission determines that 
        certain trades are problematic. The CFTC should be given the 
        authority to determine and set position limits (aggregated with 
        exchange positions, and eliminate bona fide hedge exemptions) 
        to protect consumers. Congress should also extend CFTC anti-
        fraud, anti-manipulation and emergency authorities as 
        appropriate to OTC transactions to allow greater openness, 
        transparency and oversight of our financial markets. These 
        provisions are included in the Chairman's proposal. I am 
        hopeful that the Committee will also consider two other items, 
        one within its jurisdiction--the other an appropriations 
        matter.

    (4) Public Directors on Investment Industry Boards. Corporate 
        boards would benefit greatly from the inclusion of public 
        directors who bring a diversity of backgrounds and experiences 
        to the boardroom. Such a provision would allow farmers, 
        consumer representatives or other individuals to serve and 
        provide different, yet important perspectives. All too often, 
        these boards look more like an extension of the companies 
        themselves than a group of individuals that are there to spot 
        problems and deliver constructive criticism. Unfortunately, 
        what we witnessed in the securities world is that this had to 
        be mandated rather than simply encouraged. For that reason, I 
        would urge Congress to consider a requirement that a third of 
        board members be considered public directors.

    (5) Congress should appropriate immediate full funding ($157 
        million for Fiscal Year 2009) in additional resources, which 
        would allow the CFTC to hire an additional 150 employees, and 
        fund related technology infrastructure so that the agency can 
        properly effectuate our duties under the Commodity Exchange 
        Act, as amended by the farm bill. Many in Congress have joined 
        together to call for increased resources for the Securities and 
        Exchange Commission (SEC). By comparison, the CFTC oversees 
        exchanges with significantly greater market capitalization than 
        the SEC. For example the CME Group alone has a market 
        capitalization of roughly $11 billion, while NYSE/Euronext 
        (largest U.S. securities exchange regulated by the SEC) has a 
        market capitalization of $5.5 billion. The SEC has 3,450 
        employees, while the CFTC struggles with roughly 450--fully 
        3,000 less staff. It is not a popular thing to call for more 
        money for Federal employees, but cops on the beat are needed to 
        detect and deter crimes. The CFTC needs these additional 
        resources and we need them now.

    There are many other provisions in the Chairman's proposal that I 
support, such as closing the London Loophole and ensuring exclusive 
jurisdiction over environmental futures market regulation. Simply put, 
the success of a cap-and-trade system requires an experienced 
regulator. The Chairman's proposal, if enacted, will bring much needed 
transparency and accountability to both over-the-counter and certain 
overseas markets; provide the CFTC the authorities necessary to prevent 
market disruptions from excessive speculation; and give regulators a 
window into currently ``dark markets'' by requiring reporting and 
record-keeping.
                                 ______
                                 
  Supplemental Material Submitted by Michael W. Masters, Founder and 
   Managing Member/Portfolio Manager, Masters Capital Management, LLC
    Dear Congressman Marshall:

    Thank you for your insightful questions and your leadership on the 
issue of excessive speculation. I wanted to respond promptly to your 
request for written answers to the two questions you posed during the 
hearing.
    Your first question pertained to a scenario wherein the commodities 
derivatives markets are balanced, with an equal number of speculators 
seeking trading profits on the one hand, and physical producers and 
consumers hedging their real business on the other. What happens, then, 
if a large number of ``invesculators'' enter the markets? What problems 
would that pose and what solutions would we need?
    I believe the scenario you describe is precisely what has happened 
to our commodity markets in the last 5 years, culminating with the 
extreme price movements of the last 18 months. ``Invesculators,'' as 
you referred to them, are extremely damaging to the commodities 
derivatives markets, due to their belief that commodities are an 
``asset class.'' Commodities are raw materials that are consumed by 
individuals and corporations. They are not an ``asset'' (like a stock 
or a bond) that can be bought and held for the long term. As much as 
institutional investors want to believe that commodities can be 
considered assets, they simply cannot.
    Physical hedgers--those who produce and consume actual 
commodities--never suffer from ``irrational exuberance.'' When prices 
rise, producers are motivated to produce more (that's their business), 
and consumers are motivated to consume less. In contrast, the 
``Invesculator'' responds to an increase in price by thinking, ``oh, 
that would be a good investment,'' and jumps on the bandwagon by 
submitting their own buy orders. This is the dynamic that causes price 
bubbles to form. Every capital asset category has had its bubbles 
through history: the Japan bubble, the emerging markets bubble, the 
Internet bubble, the housing bubble, the credit bubble, etc. 
Eventually, wherever investors go, price bubbles appear.
    When physical hedgers dominate the commodities derivatives markets 
then traditional speculators, because they are outnumbered, will 
emulate the behavior of the physical hedgers. But when speculators rule 
these markets then they can drive prices to irrational heights that 
have nothing to do with supply and demand. In the scenario that you 
described, wherein five speculators and five physical hedgers are 
transacting in the derivatives market, and then 45 ``invesculators'' 
show up, the result is a bubble, just as if you put your house on the 
market, had an open house, and 45 people showed up with their 
checkbooks. You're going to get a much higher price than if no one, or 
even a couple of people, showed up.
    While bubbles in asset markets can be intoxicating, bubbles in 
commodities are devastating. Every human being around the globe suffers 
when we experience bubbles in food and energy prices.
    So what can Congress do about it? Fortunately, the solution is 
simple, and Congress has already done it since 1936: put a limit on the 
size of positions that speculators can hold in order to prevent them 
from dominating the market. This worked superbly from 1936 until about 
1998. It is simple and proven, and carries no unintended consequences.
    Unfortunately in 1998 the CFTC began to let speculative position 
limits slide. For them the term ``excessive speculation'' came to mean 
basically the same as ``manipulation.'' At which point the CFTC decided 
position limits were only necessary to prevent manipulation. Then, in 
2000 the Commodities Futures Modernization Act (CFMA) allowed the 
formation of the Intercontinental Exchange (ICE), and exempted over-
the-counter (OTC) swaps dealers from all regulation. The result was 
that there were no longer any real speculative position limits in 
energy. Also, the OTC markets effectively rendered position limits in 
agricultural commodities meaningless. What ensued was rampant 
speculation, which led to the bubble that finally burst in the second 
half of 2008.
    It's easy to see why it is not only essential to reinstate a system 
of speculative position limits on the exchanges, but it is also 
critical for those limits to apply to ICE and other exchanges, as well 
as the OTC markets. When there is a clearly defined limit placed on the 
money flowing into a market, then prices cannot expand fast enough to 
cause a bubble.
    Your question seemed to also pose a more nuanced scenario: assuming 
a market in which the speculative position limit is, for example, 1,000 
contracts, and further assuming that 50,000 contracts are held by 
speculators and 100,000 contracts are held by physical producers and 
consumers, what if 300 new speculators show up and they all stay below 
the 1,000 contract limit, they can still buy 300,000 contracts 
combined, what should be done then? The answer is that speculative 
position limits need to be adjusted as market conditions dictate.
    This scenario provides an excellent illustration of why we 
recommend the formation of a physical hedgers' panel that would serve 
to adjust speculative position limits every 3-12 months. If the ratio 
of speculators to physical hedgers becomes too high (like 350,000 : 
100,000--which, for reference, was the approximate ratio in 2008), then 
the panel should lower the speculative position limit from 1,000 
contracts down to, say, 500 contracts. Similarly, if the ratio of 
speculators to physical hedgers is too low and the markets need more 
liquidity, then the panel would have the ability to raise the limit to 
allow speculators to take larger positions. Think of speculative 
position limits like a valve that controls the level of speculative 
money in the markets, as well as the speed with which money flows into 
the markets.
    We believe that the optimal ratio of speculators to physical 
hedgers is one to two (34% speculative). The commodities futures 
markets operated efficiently with no liquidity issues for decades while 
open interest stayed generally in the range of one speculator for every 
four physical hedgers. So if the physical hedgers' panel would target a 
ratio of one speculator for every two physical hedgers that would give 
the commodities derivatives markets abundant liquidity.
    Your second question pertained to the possible challenges of 
implementing across-the-board speculative position limits. The simplest 
and most effective way to implement speculative position limits is to 
enforce an ``aggregate'' speculative position limit that a speculator 
will face regardless of the transaction venue (e.g., a CFTC-regulated 
futures exchange like NYMEX, a non-CFTC-regulated futures exchange like 
ICE, or in the OTC market). Let's say that the physical hedger panel 
determines that the speculative limit for oil should be 5 million 
barrels or 5,000 contracts. Speculators would be told that they can buy 
up to 5 million barrels anywhere they want as long as they do not 
exceed this limit.
    Consider the problems that can arise if a system of speculative 
position limits is not established on an aggregate basis and instead 
individual trading venues are assigned their own unique limits. No 
matter what system is used for assigning those limits it will run into 
problems. As an example, if the aforementioned 5,000 contract 
speculative position limit for crude oil is apportioned as follows:

    NYMEX: 1,000

    ICE: 1,000

    OTC: 1,000 contract equivalent (1 million barrels)

    IPE: 1,000 (International Petroleum Exchange)

    DME: 1,000 (Dubai Mercantile Exchange)

    Then, under this scenario, speculators will be forced to spread 
their trading around in order to access their entire 5,000 contract 
speculative position limit. Since the amount of liquidity varies from 
one exchange/venue to the next, it would not make sense to encourage an 
equal amount of trading on each venue. For example, ICE has half the 
volume of NYMEX, so should they have the same limit as NYMEX or half 
the limit of NYMEX?
    Different problems arise however if unequal speculative position 
limits are imposed. If the limits were set to match current liquidity 
like this:

    NYMEX: 1,000

    ICE: 500

    OTC: 2,500

    IPE: 800

    DME: 200

    Then the growth of ICE and other exchanges would be stunted due to 
their low relative limits. This system has the further effect of 
forcing speculators to trade OTC in order to reach their 5,000 contract 
maximum. This is not something that I believe Congress wants to do.
    If limits are placed on some venues but not others, then trading 
will flow to the places that offer unlimited speculation (currently the 
OTC markets). This would fail to safeguard against future speculative 
bubbles, which is what the speculative limits are designed to do.
    The best system for implementing aggregate speculative position 
limits would entail the following:

    (1) All OTC commodity derivative transactions must clear through an 
        exchange.

    (2) Each speculator would have a trader identification number which 
        would be associated with every trade, just like a customer 
        account number.

    (3) Foreign boards of trade would have to supply information to the 
        CFTC on U.S. traders (looking at the parent entity level).

    Those who oppose exchange clearing will complain about ``chicken 
fat'' swaps and the like, but in reality, 99% of all commodity swaps 
are composed of futures contracts and basis trades, which would all 
clear. Congress should resist attempts by Wall Street to avoid exchange 
clearing by claiming that their derivatives are too exotic and that 
therefore large segments of the market need to be exempted from the 
clearing requirement. Almost all OTC commodity derivatives should 
clear.
    As part of the clearing process OTC derivatives are transformed 
into futures contract equivalents. Therefore the process of applying 
speculative position limits to OTC derivatives that have exchange 
cleared is as simple as applying limits to futures contracts. Under 
this system of speculative position limits and exchange clearing, the 
aggregate activity for an individual trader can be calculated simply by 
tracking the trader identification number and adding up how much each 
trader has bought through each venue in each commodity.
    A trader who exceeds their limit could face a stiff financial 
penalty (100% of which can go to the CFTC to fund their operations) and 
that trader's positions could be liquidated on a last-in, first-out 
basis.
    In order for this regulation to capture transactions on foreign 
boards of trade, they must be required to submit the necessary 
information to the CFTC on a real-time basis in exchange for the CFTC 
allowing them to place direct terminals in the United States. The CFTC 
has many ``hooks'' that would allow them to ensure that aggregate 
speculative position limits apply to foreign boards of trade as well.
    In summary, the idea is to give speculators one limit and let them 
``spend'' it wherever they see fit.
    I hope I have clarified why aggregate speculative position limits 
and exchange clearing are the surest protection against a future 
commodity bubble. Please let me know if I can be of any further 
assistance.
            Best regards,

Michael W. Masters,
Portfolio Manager,
Masters Capital Management, LLC.
                                 ______
                                 
       Submitted Statement of National Grain and Feed Association
    The National Grain and Feed Association (NGFA) appreciates the 
opportunity to submit the following statement for the record of the 
Committee's hearing on draft legislation titled the ``Derivatives 
Markets Transparency and Accountability Act of 2009.''
    The NGFA is the national association representing about 950 
companies in the grain, feed and processing industry and related 
commercial businesses. The NGFA's member companies operate more than 
6,000 grain handling and processing facilities nationwide. These 
companies are the traditional users of U.S. agricultural futures 
markets like the Chicago Board of Trade, the Kansas City Board of 
Trade, and the Minneapolis Grain Exchange. The NGFA's members rely 
heavily on products traded on regulated exchanges for price discovery 
and to manage their price and inventory risks. Properly functioning 
contracts and transparent markets are of the utmost importance. For 
these reasons, the NGFA's input on the draft bill goes more directly to 
futures market-related provisions than to proposed changes in the 
regulation of derivative products.
Contract Performance and Impact of Investment Capital
    The NGFA and its member firms have been extremely concerned during 
the last 3 years about performance of the CBOT wheat contract. We 
believe strongly that participation of investment capital in the CBOT 
wheat contract--a fairly recent phenomenon that has reached significant 
levels--has contributed to a disconnect between cash prices and futures 
prices on-exchange. This disconnect has made it difficult and costly 
for grain hedgers to rely on the soft wheat contract for hedging 
purposes and efficient pricing and has contributed to soft wheat basis 
behaving in ways that would not be expected historically. Together with 
serious concerns about financing margin calls on their hedges, which 
came to a head last spring and summer, and today's worries about the 
availability of sufficient credit, grain elevators have not been able 
to offer the same broad range of cash grain marketing opportunities 
that producers have come to expect.
    The NGFA believes that the draft legislation being discussed in the 
Committee on Agriculture contains several provisions that will help 
bring added clarity and transparency to agricultural futures markets. 
While not a guarantee of enhanced performance, these provisions will 
allow all market participants a better view of the marketplace and 
enhanced decision-making based on who is in the market and whether 
activity is based primarily on investment activity or true supply/
demand fundamentals.
    In particular, the NGFA supports the detailed reporting and data 
disaggregation language found in section 4 of the draft legislation. We 
believe identification of index traders and swaps dealers who are 
active in agricultural futures markets in reporting by the Commodity 
Futures Trading Commission (CFTC) will assist grain hedgers in making 
appropriate risk management decisions. The NGFA would suggest that 
additional legislative guidance be given to the CFTC to identify any 
additional market participants whose trading behavior may be similar 
for purposes of potentially including those participants under the same 
reporting requirements.
Position Limit Agricultural Advisory Group
    Section 6 of the draft legislation would establish a Position Limit 
Agricultural Advisory Group. The NGFA would suggest that, at least for 
the grains and oilseeds contracts, the current method of determining 
speculative position limits is working well. Typically, if changes in 
position limits are contemplated, a regulated exchange would propose 
the new limits for a specific agricultural futures contract, often 
following consultation with affected market participants; the CFTC 
would analyze and review these levels and evaluate input from the 
public and relevant futures market participants during a public comment 
period; and the Commission then would either approve or disapprove the 
proposed change in position limits. From the NGFA's perspective, this 
process has worked well, and we believe our industry has participated 
in a meaningful and effective way. For grains and oilseeds, we believe 
the current process is preferable to a broadly drawn advisory group 
that may not have sufficient expertise with each individual contract 
(e.g., most grain industry representatives on an advisory group would 
have little expertise in advising on position limits for cotton).
Concerns About ``Bona Fide'' Hedging Definition
    The NGFA's primary area of concern in the draft legislation is 
provisions in section 6 that would specifically define in law how the 
CFTC must define a ``bona fide'' hedge. We fully support the draft 
bill's intent: to distinguish between traditional hedgers who use 
futures contracts for price discovery and to hedge their price and 
inventory risks in cash markets, and newer, non-traditional 
participants who view futures markets as an investment category. For 
some time, the NGFA has made the case that investment capital's 
participation in agricultural futures markets has artificially inflated 
futures prices, skewed basis relationships and, especially in the case 
of the CBOT wheat contract, eroded the utility of futures markets for 
traditional participants.
    However, we strongly believe that legislating a concept as complex 
as defining a ``bona fide'' hedge--and, by extension, which entities 
should qualify for hedge exemptions--is fraught with risk. Even with 
the best of intentions, codifying this concept invokes the ``law of 
unintended consequences.'' We fear that a strict construction could 
unintentionally lay a snare for legitimate hedgers--and at the least, 
could have a constrictive effect on development of hedging strategies 
that benefit agricultural producers. We strongly urge the Committee to 
signal its intention to the CFTC on parameters of a ``bona fide'' 
hedge, but we also strongly urge that the Commission ultimately be 
allowed to develop and administer the definition. We would be very 
happy to work with the Committee to help structure such an approach.
Exchange Clearing of Over-the-Counter Transactions
    While the NGFA does not have a formal Association position on 
requiring reporting or exchange-clearing of OTC transactions, we would 
offer a couple of observations and a caution as the legislation 
proceeds. We are aware that some agricultural grain buyers and 
processors have structured a range of OTC products that back up and 
complement their cash contract offerings to producers and other 
customers. We are not aware that these useful OTC agricultural 
products, which provide tailored marketing opportunities to producers 
and others, have experienced the same problems as credit default swaps 
and other financial derivatives.
    Futures contracts are traded and cleared very efficiently on 
regulated exchanges because contract terms are standardized. Due to the 
very nature of OTC products--which typically are customized, 
individually-negotiated agreements--attempting to force them through an 
exchange's clearing corporation could present difficulties and likely 
would inhibit development of new marketing tools for agricultural 
products. We would caution against such a result. Perhaps an approach 
involving reporting of OTC participants and/or transactions would be a 
reasonable alternative approach.
    We appreciate the opportunity to submit these thoughts and 
recommendations. The NGFA stands ready to answer any questions or 
provide assistance to the Committee as the legislation proceeds.
 Submitted Letter and Statement of Susan O. Seltzer, Former Assistant 
            Vice President, Synthetic Securities, U.S. Bank

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                              Attachment 1
February 2, 2009

Hon. Collin C. Peterson,
Chairman,
Committee on Agriculture,
Washington, D.C.

RE: Derivatives Markets Transparency and Accountability Act of 2009

    Dear Congressman Peterson:

    Please consider adding to the Draft Language of ``Derivatives 
Markets Transparency and Accountability Act'' the stipulation that it 
would be mandatory for all counterparties to credit default swaps to 
unwind these contracts, going back to January 2007. The parties to 
these contracts would exchange profits and losses, alleviating the U.S. 
taxpayer from taking on the credit default swap counterparties 
obligations. Shifting this burden to the U.S. taxpayer has not solved 
the problem and it very well may be a continuing outflow of taxpayer 
dollars that could be more efficiently invested to generate a higher 
return, say in jobs, education or infrastructure.
    This perspective comes from thirteen years in the over-the-counter 
derivative markets at a major U.S. commercial bank when the swaps 
markets were first developing in the early eighties. My experience 
included advising corporations on the use of swaps, foreign currency 
forwards and options for hedging transactional and translational 
foreign currency exposures in the inter-bank market. For the commercial 
bank's executive credit committee, I prepared the analysis of the 
counterparty credit risk in these derivative transactions, including 
interest rate swaps, which was always monitored on an ongoing basis. I 
was also involved in ensuring there were appropriate Board approved 
position limits on all derivative contracts used in the over-the-
counter market.
    In addition, there is a central issue in 2009 Derivative 
Transparency that must be resolved prior to finalizing this bill. 
Please request that Treasury Secretary Geithner's office determine the 
ROI of using taxpayer dollars for contractual payments under credit 
default swap contracts. Consider having your bill reverse TARP funds 
and AIG loans used to date for this purpose. Insert language in the 
bill, which requires the unwinding of existing credit default swaps. 
Shift the burden of contractual payments required under credit default 
swaps from the U.S. taxpayer to the original parties to these 
contracts, effectively by unwinding these contracts. Unwinding swap 
contracts is unprecedented, but these times are unprecedented and AIG's 
right to enter into these contracts in the over-the-counter market, may 
have been fraudulent.
    Yes, all credit default swaps should be traded on a regulated 
exchange. However, change the language of this bill to ensure there are 
not any exceptions and there are not any credit defaults swaps 
contracts in the over-the-counter market.
    Finally, have the bill focus solely on credit default swaps use in 
the over-the-counter markets. Do not require interest rate swaps and 
foreign currency forwards to operate on a regulated exchange. To add to 
this bill the regulation of interest rate swaps and foreign currency 
contracts in the over-the-counter markets will add a layer of 
complexity and cost to commercial banks that can be deferred, until the 
financial crisis is resolved.
    As you are aware, the defenders of credit default swaps will argue, 
``They help us have a gauge on corporate credit risk and sovereign 
risk. These active markets give us spreads that reflect market 
sentiment on a given credit risk. Market sentiment is not a valid 
indicator of true creditworthiness.''
    According to the swap industry, which is promoting the ongoing use 
of these derivatives, they are critical to our financial markets. 
``Throughout the crisis, credit default swaps have remained available 
and liquid,'' said Eraj Shirvani, Chairman of the International Swaps 
and Derivatives Association (ISDA) and head of credit sales and trading 
at Credit Suisse.
    ``They have been the only means of hedging credit exposures or 
expressing a view at a critical time for the industry. Impairing their 
use would be counterproductive to efforts to return the credit markets 
to a healthy, functioning state.''
    There is a viable and valuable use for interest rate swaps and 
foreign exchange swaps and forwards in hedging interest rate and 
foreign currency exposures. Credit default swaps cannot effectively 
hedge credit risk. Credit risk, as you are aware, can only be managed 
by looking at the financials of the entity, at the time of credit 
extension and on an ongoing basis as market conditions change. Market 
sentiment developed through trades establishing ``an entity's credit 
worth'' have proven to be destructive to our financial system and their 
advocates have not demonstrated what value the continuing use of them 
will bring to our financial system. There is far greater downside, than 
upside, in continuing their use.
    One should respond to advocates of the continue use of credit 
default swaps with these two points:

   Common sense dictates a bank would not give unlimited credit 
        or a jumbo mortgage to a borrower with an income of $50,000 and 
        no assets. Common sense also dictates AIG should not have been 
        allowed to enter into an unlimited amount of credit default 
        swaps with counterparties. The AIG Board of Directors, in 
        allowing AIG's Financial Product division to be created, did 
        not set any parameters for AIG managing counterparty credit 
        risk.

   Merrill had a $15.31 billion net loss in the 4th quarter, 
        first reported 2 weeks ago. ``Behind some of the losses in the 
        quarter are two related trades that Merrill hasn't disclosed 
        publicly in detail.'' It has been reported the loss resulted 
        from a long position in corporate bonds, ``hedged by 
        derivatives, credit default swaps.'' When asked about this 4th 
        quarter multi-billion loss, Mr. Thain responded, ``that was a 
        legacy position.''

    U.S. taxpayers need an answer as to why, when taxpayer funds were 
used by Bank of America to take over Merrill; these legacy positions 
were not unraveled, saving us another $15 billion that could have been 
put into our schools in Minnesota. How many more credit default swap 
``legacy'' positions is the U.S. taxpayer going to be asking to fund?
    Thank you, Congressman Peterson, for taking the lead on unraveling 
the quagmire created by credit default swaps to swiftly restore our 
banking system to a functioning level. Again, I would recommend 
Washington listen to a more diverse opinion on credit default swaps. 
Reforms in this derivative have the appearance of being led by an 
Executive Branch that comprises many former bankers and economists with 
a vested interest in continuing to maintain credit default swap 
profits, while placing the burden of the losses on the taxpayers.
    As an unemployed Minnesotan, I would be pleased to come to 
Washington to work to research other viable alternatives to ensure 
taxpayer dollars are invested in a prudent fashion, as we work to 
unwind the aftermath of irresponsible, if not fraudulent, credit 
default swap financial contracts.
            Sincerely,

Susan O. Seltzer,
Former Assistant Vice President, Synthetic Securities,
U.S. Bank.
                              Attachment 2
MinnPost.com
http://www.minnpost.com/community--voices/2009/02/04/6377/
join_rep_peterson_in_solving_the_credit-default-swaps_mess
Join Rep. Peterson in solving the credit-default-swaps mess
By Susan Seltzer,
Wednesday, Feb. 4, 2009

    Minnesotans have an opportunity to take an active role in 
partnering with Rep. Collin Peterson, D-Minn., to ``effectively'' ban 
the further use of credit default swaps. Nouriel Roubini, professor of 
economics and international business at New York University's Stern 
School of Business, has cited credit default swaps as a pivotal factor 
in the collapse of our financial system.
    House Speaker Nancy Pelosi has appointed Peterson as her leader to 
get the derivative mess under control. Last November, he traveled to 
Europe to meet with international banks to get perspective on how to 
unwind the credit-default-swap derivative mess, which today still 
weighs heavily on the ability to restore our financial system. 
Peterson, who chairs the House Agricultural Committee, has an 
accounting background and a strong understanding of exchange-traded 
derivatives, through his committee's work with the Commodity Futures 
Trading Commission (CFTC).
    Draft language for a bill, ''Derivatives Markets Transparency and 
Accountability Act of 2009,'' was posted on the Agriculture Committee's 
website last week and is being debated in Congress today. One part of 
this bill serves to place all credit default swaps, interest-rate swaps 
and foreign-currency forwards currently being traded in the inter-bank 
or over-the-counter market on a regulated exchange. Certain 
``customized'' credit default swaps may be exempt. The bill proposes 
that credit default swaps only be used to hedge an underlying bond or 
position.
Lobbyists are already pushing back
    Peterson's proposed bill is already getting strong pushback from 
lobbyists, including the International Swap Dealer's Association (ISDA) 
and major banks. The Treasury secretary's nominated chief of staff, Tom 
Patterson, was a lobbyist for Goldman Sachs until last year. Revenue 
from financial services firms was over 25 percent of our GDP last year, 
a significant portion from credit default swaps. There is a strong 
incentive to maintain this revenue stream, but is this a revenue stream 
we want?
    Taxpayers do not yet have advocates that serve to protect our new 
ownership interest in AIG and other financial institutions. It may make 
sense to ask Peterson to consider adding to his bill the stipulation 
that it would be mandatory for all counterparties to credit default 
swaps to unwind these contracts, going back to January 2007. The 
parties to these contracts would exchange profits and losses, 
alleviating the U.S. taxpayer from taking on the credit default swap 
counterparties' obligations. Shifting this burden to the U.S. taxpayer 
has not solved the problem, and it very well may be a continuing 
outflow of taxpayer dollars that could be more efficiently invested to 
generate a higher return, say in jobs, education or infrastructure.
    This perspective comes from 13 years in the over-the-counter 
derivative markets at a major U.S. commercial bank when the swaps 
markets were first developing in the early 1980s. My experience 
included advising corporate CFOs on the use of swaps, foreign-currency 
forwards and over-the-counter options for hedging transactional and 
translational foreign currency exposures. For the commercial bank's 
executive credit committee, I prepared the analysis of the counterparty 
credit risk in these derivative transactions.
Seen in '90s as a win-win
    It was not until the late 1990s that a J.P.Morgan trader worked to 
solve the ongoing issue of managing ``credit risk'' and created the 
derivative, a credit default swap. The rest is history. There were some 
vocal skeptics, including Brooksley Born, former chair of the CFTC. 
Senate Banking Committee testimony in 2005 concluded that the use of 
credit default swaps was a win-win for all parties and there was no 
reason not to allow their ongoing use in the over-the-counter markets.
    Counterparty credit risk was not managed with credit default swaps, 
since inception. Players in these over-the-counter markets--like hedge 
funds, AIG and investment banks--have typically had a different credit-
risk orientation from commercial banks. Derivatives, used in the 
correct context, are powerful tools to hedge interest-rate risk and 
foreign-currency exposures. Derivatives have been a source of stability 
and revenue for major banks in both the over-the-counter market and 
regulated exchanges, and should continue to be. They are used by banks 
to manage mismatches in loan positions, to hedge risk of floating rate 
debt, for example. Small Minnesota importers use them, through 
commercial banks, when they buy products in foreign currency, to hedge 
their foreign-currency exposure. Hedging with derivatives is a more 
conservative position than not hedging.
Mostly used for speculation
    In contrast, credit default swaps were used for speculation in the 
majority of cases. Unlike interest-rate swaps and foreign-exchange 
forwards, they do not provide any underlying value to the U.S. banking 
system.
    (For some recent background on the credit default swap market, here 
is a link to a blog, Naked Capitalism (http://www.nakedcapitalism.com/
2007/08/are-credit-default-swaps-next.html), from August 2007, which 
details concerns on the credit default swap house of cards. In 
addition, a May 2008 Bloomberg story provides good history of how the 
Federal Reserve appointed J.P.Morgan to oversee the black hole of the 
CDS market with their takeover of Bear Stearns.)
    So what is the next step regarding Peterson's draft bill on 
transparency and regulation in the derivative markets?
    First, ask Treasury Secretary Timothy Geithner's office to 
determine the efficiency of using taxpayer dollars for contractual 
payments in credit default swap contracts. Consider having Peterson's 
bill reverse TARP funds and AIG loans used to date for this purpose. 
Insert language in the bill that requires the unwinding of existing 
credit default swaps. Shift the burden of contractual payments required 
under credit default swaps from the U.S. taxpayer to the original 
parties to these contracts, effectively by unwinding these contracts.
    Second, implement Peterson's recommendations that all credit 
default swaps must hedge an underlying position. Yes, all credit 
default swaps should be traded on a regulated exchange; however, change 
the language of this bill to ensure there are not any exceptions.
    Third, and finally, have the bill focus solely on credit default 
swaps' use in the over-the-counter markets. Do not require interest-
rate swaps and foreign-currency forwards to operate on a regulated 
exchange. To add to this bill the transfer of interest-rate swaps and 
foreign-currency contracts in the over-the-counter markets to a 
regulated exchange would add a layer of complexity and cost to 
commercial banks that can be deferred until the financial crisis is 
resolved. Do require disclosure and reporting requirements, as 
stipulated in the proposed bill, on interest-rate swaps and foreign-
currency-forward contracts.
    Congratulations to Rep. Collin Peterson for taking the lead in 
unraveling the quagmire created by credit default swaps.
    Susan Seltzer is a former Assistant Vice President, Synthetic 
Securities of U.S. Bank.
                                 ______
                                 
  Submitted Statement of A. James Jacoby, President, Standard Credit 
                            Securities, Inc.
    Chairman Peterson, Ranking Member Lucas, and Members of the 
Committee:

    Good morning. My name James Jacoby. I am President of Standard 
Credit Securities, Inc., a registered broker/dealer and leading 
provider of execution and analytical services to the global over-the-
counter inter-dealer market for credit cash and derivative products. I 
have been an active participant in both the OTC and on exchange 
securities markets since 1959 and have witnessed both the successes and 
challenges in the CDS market. I would like to thank this Committee for 
the opportunity to share my thoughts on the draft legislation on 
Derivatives Markets Transparency and Accountability Act 2009, as it 
applies to the over-the-counter market generally and the credit 
derivatives market specifically.
    The Committee's draft legislation comes at a significant time. In 
my view, any legislation that attempts to address derivative market 
accountability and transparency should reflect an historical 
perspective on the law of unintended consequences as it may arise from 
such legislation. With this in mind, I would like to briefly comment on 
two areas of the draft legislation that bear special attention:

   Underlying Bond Ownership Requirements of CDS.

   Unintended Consequences of Inappropriate Regulatory Action.
Bond Ownership as Prerequisite for CDS Transactions
    Section 16(a)(h) proposes to make it ``unlawful for any person to 
enter into a credit default swap unless the person would experience 
financial loss if an event that is the subject of the credit default 
swap occurs.'' Such a prohibition would effectively eliminate the 
credit default swap business in the United States. This provision would 
strip liquidity from the market and it would cease to function as an 
effective risk transfer arena. To limit the participants to those who 
``would experience financial loss'' narrows the market to very few 
participants and eliminates the many sources of liquidity. Essentially, 
a bond owner who seeks a CDS as a hedge against the potential default, 
will lack the ability to enter into such a transaction. No one will 
have the same risk of default that that is being hedged and, at the 
same time, be willing to enter into a swap. It seems that the only 
person from whom a swap could be purchased would also have to have 
exposure to the same default. Would not that person be seeking the same 
protection? If, for instance, only farmers could trade in the grain 
markets because of their potential loss, the market would be very thin, 
spreads very wide and volatility extreme. Speculation, under such 
circumstances, is not a bad characteristic and provides much needed 
liquidity in the market place. The same must be said for the CDS 
market.
Unintended Consequences of Legislation
    Comparisons have been offered between the effect the proposed 
legislation would have on the credit intermediation and risk transfer 
functions of the market and the effect the Trade Reporting and 
Compliance Engine (TRACE) regulation had on the secondary high yield 
bond market. These comparisons, I believe, are very instructive. When 
Congress mandated more transparency in the securities market it is 
unlikely that the impairment of the secondary high yield bond market 
was intended. However, that unintended consequence occurred and 
effectively ended the secondary high yield bond market as a viable 
market in which dealers, institutions and investors could participate. 
The deterioration of the secondary high yield bond market came about 
not a result of a ``slowdown'' in underwriting or other business cycle 
ripple effect, but as a result of new regulations that created the 
trade reporting mechanism.
     How did this happen? The process for increased transparency in the 
secondary high yield bond market was the subject of great debate over a 
period of years. I was Chairman of the NASD's Bond Transparency 
Reporting Committee and this committee urged the NASD to rethink the 
extent to which such regulation would impact market viability. We 
offered detailed explanations as to why the transparency being mandated 
would lead to the impairment of that market. Our advice 
notwithstanding, the NASD adhered to the mandate for increased 
transparency and produced transparency in intimate detail. Further, the 
NASD then insisted that the detail of each trade, regardless of size, 
be published in such a short period of time after a trade was executed 
that the financial incentive for dealers and underwriters to 
participate was eliminated and the market dried up. Underwriters and 
dealers were no longer able to price in their capital risk, profit 
objectives and costs into these transactions and thus they dramatically 
reduced their participation in the secondary high yield bond market. 
The secondary high yield bond market has yet to recover.
    Most of the offerings which were the subject of the secondary high 
yield bond market related to non-investment grade bonds. By all 
accounts this market was at least 50% of the total corporate bond 
market prior to TRACE. Investment grade offerings can be, and are, 
hedged in the government market because of their correlation. In the 
secondary high yield market, dealers cannot effectively hedge using 
government securities because the correlation between the two is too 
low. Since TRACE effectively eliminated the market making function 
traditionally performed by dealers, they were loath to undertake 
original issues of such non-investment grade offerings, because there 
would be limited distribution into the secondary market after the first 
trade was done and the street had access to the intimate details of the 
trade. Once the price was published on the first trade no one would 
lift an offer at a higher rate. Subsequently, the market has 
deteriorated.
    Interestingly enough, the growth in the credit default market 
correlates to the deterioration of the secondary high yield bond 
market. Once the full effect of TRACE became apparent, in order for the 
dealers to try to maintain a dealer market, dealers looked to the CDS 
market as a hedge against their ability taking potions in the secondary 
cash high yield market. London has a very active and competitive CDS 
market and they would welcome regulation that would further inhibit the 
viability of the U.S. CDS market. Such regulation would facilitate the 
movement of this transportable market to any number of overseas 
markets, such as London, Hong Kong, Tokyo, Dubai, and others.
    I offer these observations for an historical perspective on the law 
of intended consequences. I urge the Committee to examine in detail the 
effect that the proposed legislation will have on the CDS market and to 
reflect on the number of U.S. companies raising capital outside the 
United States in order to avoid the consequences of TRACE. Likewise, an 
increasing number of non U.S. companies have elected to delist from the 
U.S. equity markets because of the impact of Sarbanes-Oxley. London has 
taken the global leadership position as a venue for issuance of new 
equity and debt underwritings. By all accounts London will continue to 
occupy this global leadership position as more and more foreign 
corporation delist from the U.S. equity markets. In closing, I urge the 
Committee to carefully consider the potential impact of the proposed 
regulation on the continued viability of the United States as a leader 
in the global capital markets.
             Submitted Letter of Steve McDermott, COO, ICAP

[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]


                              Attachment 1
 submitted statement of christopher ferreri, managing director, hybrid 
                             trading, icap
Proposed Derivatives Markets Transparency and Accountability Act of 
        2009
ICAP Comments as at 10 February 2009
    ICAP would like to comment on a few specific aspects of the draft 
legislation entitled the Derivatives Markets Transparency and 
Accountability Act of 2009, which was recently distributed by the House 
Agriculture Committee and the subject of 2 days of hearings by the 
Committee on February 3rd and 4th.
About ICAP--Leading Broker in the OTC Markets
    ICAP is a publicly held company traded on the London Stock Exchange 
(symbol ``IAP''), has 4300 employees and maintains a strong presence in 
the three major financial markets--New York, London and Tokyo, together 
with a local presence in 30 other financial centers around the world. 
ICAP covers a broad range of ``over the counter'' (OTC) products and 
services in commodities, foreign exchange, interest rates, credit and 
equity markets as well as data commentary and indices. While ICAP does 
broker credit default swaps (CDS), it is a relatively small part of our 
overall OTC and exchange related business that intermediates $1.5 
trillion in transactions between its clients each day.
    ICAP is an Inter Dealer Broker whose sole objective is to bring 
together willing buyers and sellers to complete transactions and is the 
leading global broker in wholesale financial market. It sits at the 
crossroads of wholesale financial markets, facilitating the flow of 
liquidity in both the OTC and exchange transactions between commercial 
and investment banks and dealers representing companies, governments or 
other major financial customers around the world. ICAP also owns and 
operates a number of OTC trading platforms and post trade services and 
has a strong interest in the continuing health, efficiency and safe 
operation of the global wholesale financial markets.
Specific Comments on the Draft Legislation
    ICAP wants to address two major aspects of the bill. We agree with 
the thrust of section 13 of the bill to require central clearing for 
credit default swaps in lieu of mandating that these instruments be 
traded exclusively through an exchange. It is vitally important to 
understand the differences between central clearing and mandated 
exchange trading. The Committee has heard testimony on the benefits and 
limitations of exchange-traded products and over the counter trading. 
It is our viewpoint that the two can, and do, successfully coexist. In 
fact, there are numerous examples in the OTC markets where centrally 
cleared trading is the standard by which other markets can be judged. 
The most liquid, actively traded securities globally, U.S. Treasury 
Bills, Notes and Bonds, trade just this way. There is substantive 
evidence of OTC markets that operate together with exchange-traded, 
complimentary products. References to transaction frequency and 
customized products in section 13 are vague and subjective and we would 
welcome the opportunity to help craft appropriate guidelines.
    It the cases where a standardized futures contract can be designed 
to help hedge against the default of a borrower, those standardized 
contracts may attract sufficient liquidity to generate active open 
interest. In the event a more customized contract is necessary, the 
proposed exemptions should apply. There are examples in the markets 
where exchange-traded contracts and the underlying security co-exist 
and increase the overall liquidity of both products. In these markets, 
ICAP currently captures all transactions electronically and employs 
technology to automate trade reporting, affirmation and confirmation. 
It is important to note that market participants retain the ability to 
trade via multiple execution venues, encouraging competition and 
reducing costs, still, with access the same clearing pool. It would be 
very destructive to market efficiency and open competition to mandate a 
single place to trade assets, or to create a monopoly in trade 
execution and clearing.
    ICAP respectfully submits reservations with the broad scope of 
section 16 and the limited space dedicated to this issue. To limit the 
access to this marketplace only to those who have a direct ownership of 
the underlying obligor by its very nature will eliminate the sellers in 
the marketplace as they are writing the protection to those holding the 
underlying. This limitation will essentially eliminate credit default 
swaps. The credit default swap market serves as the only market-based 
method of price discovery and liquidity for establishing a market value 
of a company's credit. This is the only place that market participants 
can place a value on a company's ability to service or repay a loan. 
Much has been written about the possible negative impact of a credit 
default swap; however the alternative is more opaque and subjective. We 
have seen the ratings agencies fail in their ability to properly 
predict and forecast the deterioration of the credit rating of a 
company and the procedures with which those agencies operate has been 
in question. The credit default market actually increases the 
transparency of the credit worthiness of an obligor and generates a 
market value for that credit ranking.
    ICAP agrees with the Committee in the concept of clearing to 
increase transparency in financial reporting. The benefits of increased 
market transparency, automated post trade processes and availability of 
real-time market data will create the lion's share of the benefits to 
the credit default swap market and that limiting access to an exchange 
will essentially limit the benefits of the improvements. Fairness, 
transparency and suitable regulatory restraints will foster an 
environment that will help market participants better manage their 
risks and exposures.
The Context and Utility of OTC Markets
    As an integral part of the OTC markets and the leading global Inter 
Dealer Broker, we felt it was important to comment at this early stage 
in the process to highlight the importance of the derivatives markets 
and the central role they play in risk management and economic growth. 
ICAP has significant expertise in the OTC markets and has deployed 
electronic trading systems for a number of products, including credit 
default swaps. Approximately 60% of our CDS trading in Europe is 
electronically traded with all live, executable prices posted on these 
systems. In the U.S., the sovereign CDS market trades in a hybrid 
voice/electronic model with all live executable prices posted for all 
market participants to see. The structure of the markets and the ways 
in which the Inter Dealer Broker operates help increase and simplify 
price discovery, trade execution, trade reporting and post trade 
processing. Our ability to respond quickly to the changing needs of a 
marketplace has been a trademark of our company. The OTC environment is 
already full of examples where execution is on ``exchange-like'' 
systems and which are already centrally cleared, with the attendant 
advantages of transparency and auditability. Not all parts of the OTC 
space can survive without IDB intermediation, nor can market 
participants take on the risk of buying and selling in extreme market 
conditions without having an anonymous means of ``sounding out'' the 
market. Even then, ICAP has been a long-time advocate of clearing and 
the utilization of a Central Counter Party model, more rapid trade 
confirmation and reconciliation, the elimination of reset risk, and 
portfolio compression (of which more consideration is given below). 
ICAP's businesses submit very large volumes of OTC transactions to DTCC 
(FICC, MBSCC and other related systems) and LCH.Clearnet on behalf of 
its customers on a daily basis.
    It's critical that we avoid further constraining the flow of 
capital at a time when we should be encouraging its efficiency--
particularly given the turmoil in the economy. Certain key assets, such 
as public debt, only trade in the OTC environment and such markets of 
course play a critical role in facilitating capital raising and 
providing financing that enable companies to operate, expand and 
provide employment for millions of Americans.
    The OTC markets have developed in parallel to those markets traded 
on traditional stock, futures or commodities exchanges and the 
relationship between the traditional exchanges and the OTC market is 
more symbiotic than competitive. ICAP owns and operates a number of OTC 
trading platforms and integrated post trade services and understands 
this relationship. OTC and exchange markets each have separate, 
distinctive and logical reasons to exist--none of which are called into 
question by the recent market turmoil. Exchanges such as NYSE, NASDAQ, 
the London Stock Exchange and the CME Group--provide a trading platform 
for assets that are by their nature simple, in as much as they are all 
based on a single key measure (such as the anticipated financial 
performance of a company in the case of shares of stock or the value of 
a commodity at a time in the future in the case of exchange listed 
derivatives).
    In contrast, the wholesale OTC markets offer a deep and liquid 
trading environment for professional market participants such as major 
banks, insurance companies and other financial institutions, to execute 
transactions, the key terms of which are individually negotiated, 
rather than standardized.
    The OTC market has continually evolved over the last 25 years 
alongside the exchanges and serves a vital role in creating transparent 
credit and capital markets. Standard exchange-traded contracts very 
rarely provide a perfect hedge for actual economic risk and in fact can 
result in hundreds of variances to the original protection risk and 
increasing the frequency of trades. By contrast, users of the OTC 
markets can use non standardized financial products like credit default 
swaps or interest rate swaps to hedge their risk more precisely and 
transfer part of that risk to other professional OTC market 
participants.
    Consider the following example of standard contracts used to manage 
risk. A contractor is bidding on the plumbing system in the Freedom 
Tower, a project that will last for nearly a decade. The contractor is 
required to quote a complete price for the project, and has to take 
into consideration what materials and labor will costs several years 
out. After a thorough review of the plans, and using his expertise, he 
determines that he will need the equivalent of 100,000 pounds of copper 
for the job. Clearly, if the price of copper should increase, he may 
not be able to meet his obligation. The simple financial hedge is to 
buy copper futures and include the cost of the futures in his estimate. 
So the contractor enters an order to hedge the cost of 100,000 pounds 
of copper to a specific date in the future and he's good to go--not 
quite. You see, the hedge was simply a financial hedge to lock in a 
specific prices of underlying metal at a specific point in time; but 
you can't use just the metal for plumbing. You need fittings, elbows, 
tees, drains, valves and all of the other specialized components of a 
plumbing system. The contractor doesn't have a complete hedge against 
an increase in manufacturing costs of these goods, a specific date when 
the goods will absolutely be needed, protection against a fall in the 
value of the U.S. dollar that would impact the costs of imported 
fittings, a hedge against an increase in shipping or trucking costs and 
so on. A prudent contractor might seek to have interest rate and 
potentially currency exchange rate protection over the life of the 
contract; this level of financial expertise would not typically be 
found in a plumbing company. Without the efficient operation of the 
wholesale segment of the market the cost of providing interest and/or 
currency rate insulation for the contractor would be substantially more 
difficult and expensive.
An Opportunity to Improve Regulation
    While OTC markets have played a major role in global economic 
development and have been the hub of developments that benefit savers, 
investors, businesses and governments, we think their operation and 
effectiveness can be improved and ICAP favors changes to the regulatory 
framework supporting these wholesale financial markets. The challenge, 
of course, is for the regulation to be effective and limit any 
unintended consequences on the governmental entities, corporate and 
retail borrowers and investors that now rely on these markets. 
Specifically, the regulatory response to current events needs to focus 
on expanding and enhancing the transparency of the already existing OTC 
market infrastructure and making it more robust in those areas where it 
is too fragile. Regulations should mandate--as the New York Federal 
Reserve and others have been proposing--wider adoption of central 
counterparty (CCP) give up and or central clearing for OTC derivative 
markets. A Central Counter Party together with central clearing that is 
independent of the trading platforms and does not limit available 
sources of liquidity for those markets should be mandated for all 
markets.
    The solution to current problems in financial markets also does not 
lie in attempting to mandate the transfer of OTC trading onto existing 
exchanges. OTC markets have traded, and need to continue to trade, 
separately from exchange markets for many reasons. OTC markets are both 
larger in scale and broader in scope than exchange markets and provide 
a vital risk management tool. An exchange solution also needlessly 
grants the exchange a monopoly on trade execution to a single vertical 
of trading, clearing and settlement, which limits competition and is 
usually accompanied by restricted access to clearing--which will lead 
to increased costs, increased risk and less flexibility for market 
participants. The OTC market has already invested significantly in 
developing its infrastructure for price discovery, trade execution and 
post trade automated processing which contributes hugely to reducing 
risk. but it needs to be further developed and better leveraged for the 
benefit of all.
    ICAP has been an industry leader in developing solutions to reduce 
systemic and operational risk in the OTC markets, including the 
portfolio reconciliation and compression areas. TriOptima, a private 
company in which ICAP holds a minority interest, operates a global 
reconciliation and compression platform that has been in use for nearly 
a decade. Only through the prism of experience in servicing our markets 
can a clear vision of future improvements be seen. We have a history of 
innovation in an industry of innovation and would welcome the 
opportunity to broaden the knowledge of those charged with building a 
more robust regulatory environment.
Summary and Additional Reference Material
    ICAP would like to thank the Committee again for this opportunity 
to comment on the proposed legislation to regulate certain aspects of 
the over the counter market. In addition to this statement, we would 
ask that a White Paper entitled, The Future of the OTC Markets, by Mark 
Yallop, Group Chief Operating Officer, ICAP, dated November 10, 2008 
also be included in the hearing record. The paper goes into detail as 
to ICAP's positions on strengthening the OTC markets, but the key 
points that we believe can improve the way the OTC markets operate 
include a wider adoption of electronic trading; quicker settlement 
cycles; faster and automated trade confirmations; and greater use of 
netting and portfolio reconciliation and compression.
    Thank you and we look forward to working with the Committee as this 
legislation moves through the House and hope you will use ICAP as a 
resource given our experience and the scope of our operations.
                              Attachment 2

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