[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.
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\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.
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\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\
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\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).
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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.
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\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\
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\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\
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\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\
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\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.
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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\
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\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.
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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.'').
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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.
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\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;''
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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.
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\1\ www.fhwa.dot.gov/ohim/tvtw/tvtpage.htm.
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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\
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\2\ http://energycommerce.house.gov/Investigations/
EnergySpeculationBinder_062308/15.pdf.
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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.
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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.
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\5\ 7 U.S.C. 9, 13b and 13(a)(2).
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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\
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\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\
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\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\
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\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.
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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\
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\13\ Jerry Knight, ``Energy Firm Finds Ally, Director, in CFTC Ex-
Chief,'' Washington Post, April 17, 1993.
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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.
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\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\
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\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.
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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.
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\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.
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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\
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\20\ http://frwebgate.access.gpo.gov/cgi-bin/
getdoc.cgi?dbname=109_cong_senate_committee--prints&docid=f:28640.pdf,
pages 24 and 26.
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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\
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\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\
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\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\
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\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\
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\30\ Leah McGrath Goodman, ``Oil Futures, Gasoline In NY End
Sharply Lower,'' September 2, 2005.
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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.
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\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\
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\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\
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\38\ www.sec.gov/Archives/edgar/data/313807/000115697307001223/
u53342-6k.htm.
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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.
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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\
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\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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\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\
---------------------------------------------------------------------------
\48\ www.cftc.gov/files/enf/06orders/opa-bp-lessons-learned.pdf.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
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\
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\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.
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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.
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\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.''
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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\
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\4\ See letter to the Honorable Jeff Bingaman from the Honorable
Reuben Jeffery III, dated February 22, 2007.
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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.
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\1\ Ellen Gould. ``Financial Instability and the GATS
Negotiations.'' Canadian Centre for Policy Alternatives. July 2008.
http://www.tradeobservatory.org/library.cfm?refID=103596.
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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\
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\2\ ``A Big Move Lies Ahead.'' The Brock Report. May 23, 2008.
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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\
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\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.
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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.
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\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.
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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.
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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.
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\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'').
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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.
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\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.
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\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.
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\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.
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\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.).
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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).
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\4\ International Swaps and Derivatives Association, Inc., 2003
Derivatives Usage Survey, http://www.isda.org/statistics/.
\5\ Greenwich Associates, http://www.greenwich.com.
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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.
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\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.
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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.
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\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
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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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