[House Hearing, 111 Congress]
[From the U.S. Government Publishing Office]
HEARING TO REVIEW PROPOSED
LEGISLATION BY THE U.S. DEPARTMENT
OF THE TREASURY REGARDING THE
REGULATION OF OVER-THE-COUNTER
DERIVATIVES MARKETS
=======================================================================
HEARINGS
BEFORE THE
COMMITTEE ON AGRICULTURE
HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
SEPTEMBER 17, 22, 2009
__________
Serial No. 111-29
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
SCOTT MURPHY, New York
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
Thursday, September 17, 2009
Boswell, Hon. Leonard L., a Representative in Congress from Iowa,
submitted material............................................. 99
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
opening statement.............................................. 3
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 1
Prepared statement........................................... 2
Witnesses
Hixson, Jon, Director of Federal Government Relations, Cargill,
Incorporated, Washington, D.C.................................. 4
Prepared statement........................................... 6
English, Hon. Glenn, CEO, National Rural Electric Cooperatives
Association, Washington, D.C................................... 8
Prepared statement........................................... 10
Schryver, David, Executive Vice President, American Public Gas
Association, Washington, D.C................................... 11
Prepared statement........................................... 13
Hirst, Richard B., Senior Vice President and General Counsel,
Delta Air Lines, Minneapolis, MN; on behalf of Air Transport
Association.................................................... 19
Prepared statement........................................... 21
O'Connor, Gary N., Chief Product Officer, International
Derivatives Clearing Group, LLC, New York, NY.................. 50
Prepared statement........................................... 51
Damgard, John M., President, Futures Industry Association,
Washington, D.C................................................ 55
Prepared statement........................................... 56
Duffy, Hon. Terrence A., Executive Chairman, CME Group Inc.,
Chicago, IL.................................................... 60
Prepared statement........................................... 61
Pickel, Robert G., Executive Director and CEO, International
Swaps and Derivatives Association, New York, NY................ 71
Prepared statement........................................... 72
Supplemental material........................................ 121
Short, Johnathan H., Senior Vice President and General Counsel,
IntercontinentalExchange, Inc., Atlanta, GA.................... 77
Prepared statement........................................... 79
Supplemental material........................................ 122
Budofsky, Daniel N., Partner, Davis Polk & Wardwell LLP, New
York, NY; on behalf of Securities Industry and Financial
Markets Association............................................ 82
Prepared statement........................................... 84
Submitted Material
3M Company, submitted statement.................................. 150
Keating, Frank, President and CEO, American Council of Life
Insurers, submitted statement.................................. 102
Menezes, Mark W., David T. McIndoe, R. Michael Sweeney, Jr.,
Hunton & Williams LLP; on behalf of Working Group of Commercial
Energy Firms, submitted report................................. 103
National Association of Manufacturers, submitted statement....... 152
National Association of Real Estate Investment Trusts; The Real
Estate Roundtable; and International Council of Shopping
Centers, joint submitted statement............................. 153
Plank, Roger, President, Apache Corporation, submitted statement. 123
Rathert, Terry W., Founder, Executive Vice President, and Chief
Financial Officer, Newfield Exploration Company, submitted
statement...................................................... 145
Tuesday, September 22, 2009
Lucas, Hon. Frank D., a Representative in Congress from Oklahoma,
opening statement.............................................. 156
Peterson, Hon. Collin C., a Representative in Congress from
Minnesota, opening statement................................... 155
Witnesses
Gensler, Hon. Gary, Chairman, Commodity Futures Trading
Commission, Washington, D.C.................................... 157
Prepared statement........................................... 159
Schapiro, Hon. Mary L., Chairman, U.S. Securities and Exchange
Commission, Washington, D.C.................................... 163
Prepared statement........................................... 165
Submitted Material
Independent Petroleum Association of America, submitted statement 201
HEARING TO REVIEW PROPOSED
LEGISLATION BY THE U.S. DEPARTMENT
OF THE TREASURY REGARDING THE
REGULATION OF OVER-THE-COUNTER
DERIVATIVES MARKETS
----------
THURSDAY, SEPTEMBER 17, 2009
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 10:34 a.m., in Room
1300, Longworth House Office Building, Hon. Collin C. Peterson
[Chairman of the Committee] presiding.
Members present: Representatives Peterson, Holden, Boswell,
Scott, Marshall, Herseth Sandlin, Ellsworth, Walz, Kagen,
Schrader, Dahlkemper, Bright, Kratovil, Schauer, Kissell,
Boccieri, Murphy, Pomeroy, Minnick, Lucas, Goodlatte, Moran,
Neugebauer, Schmidt, Smith, Latta, Roe, Luetkemeyer, Thompson,
Cassidy, and Lummis.
Staff present: Adam Durand, Scott Kuschmider, Clark
Ogilvie, James Ryder, Debbie Smith, Tamara Hinton, Kevin Kramp,
Josh Mathis, Mary Nowak, Nicole Scott, Jamie Mitchell, and
Sangina Wright.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE
IN CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order. This
hearing of the Committee on Agriculture to review proposed
legislation by the U.S. Department of the Treasury regarding
the regulation of over-the-counter derivatives markets will
come to order.
I welcome everyone to today's hearing to review the
legislative language put forth by the U.S. Department of the
Treasury last month regarding the regulation of the over-the-
counter derivatives. We are beginning an important period in
our attempts to bring much-needed transparency and more
effective oversight to our financial markets, particularly for
unregulated swaps and derivatives.
Before the August district work period, House Financial
Services Committee Chairman Frank and I released a concept
paper outlining our shared principles on what over-the-counter
derivative legislation should entail. We put out the concept
paper before August so that Members could have plenty of time
to review it, critique it, develop ideas, suggestions,
thoughts, and comments in preparation of dealing with these
issues this fall.
With that said, I hope the Members of this Committee have
come armed with good questions today for our industry
stakeholders.
Earlier this year, the White House presented broad reform
proposals touching many sectors of the financial system.
Included in those proposals were provisions to regulate the
market for over-the-counter derivatives. Our Committee examined
these principles in July. And when Secretary Geithner appeared
before a joint hearing with the House Financial Services
Committee, we heard their general views at that time. Secretary
Geithner's testimony that day was informative, and I was
encouraged by his willingness to work with our two Committees
in a bipartisan manner as we move forward.
Following Secretary Geithner's appearance, Treasury has
filled in some of the blanks on their regulatory reform
principles with legislative language. And that is the subject
of today's hearing.
I am pleased to note that several of Treasury's proposals
are similar in concept to legislation that our Committee has
already passed this year, including mandatory clearing of all
standardized over-the-counter products and setting capital and
margin requirements for dealers.
Treasury's language expands on some of these principles,
and while I do have some outstanding concerns, such as the fair
treatment for end-users in any regulatory overhaul, I think
their ideas represent a decent beginning in the debate over
legislation that gives the American people the confidence that
our markets are being overseen and monitored by strong,
effective regulators.
This morning, we will hear from two panels of industry
stakeholders representing exchanges, traders, and end-users.
Next week, Commodity Futures Trading Commission Chairman Gary
Gensler will appear before the Committee for the first time,
and he will be joined by Securities and Exchange Commission
Chairman Mary Schapiro.
I look forward to hearing today's witnesses give their
thoughts on the central clearing model for OTC derivatives,
along with issues like OTC product standardization, dealer
regulation, and their thoughts on joint rulemaking between
agencies of jurisdiction.
Again, I thank today's witnesses for being here. 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 morning, and welcome to today's hearing to review legislative
language put forth by the U.S. Department of the Treasury last month
regarding the regulation of over-the-counter derivatives.
We are beginning an important period in our attempts to bring much-
needed transparency and more effective oversight of our financial
markets, particularly for unregulated swaps and derivatives.
Before the August District Work Period, House Financial Services
Committee Chairman Frank and I released a concept paper outlining our
shared principles on what over-the-counter derivative legislation
should entail.
We put out the concept paper before August so that Members could
have plenty of time to review it, critique it and develop ideas,
suggestions, thoughts and comments in preparation of dealing with these
issues this fall. With that said, I hope the Members of this Committee
have come armed with some good questions today for our industry
stakeholders.
Earlier this year, the White House presented broad reform proposals
touching many sectors of the financial system.
Included in those proposals were provisions to regulate the market
for over-the-counter derivatives. Our Committee examined these
principles in July, when Secretary Geithner appeared before a joint
hearing with the House Financial Services Committee.
Secretary Geithner's testimony that day was informative, and I was
encouraged by his willingness to work with our two Committees in a
bipartisan manner as we move forward. Following Secretary Geithner's
appearance, Treasury has filled in some of the blanks on their
regulatory reform principles with legislative language, and that is the
subject of today's hearing.
I am pleased to note that several of Treasury's proposals are
similar in concept to legislation that our Committee has already passed
this year, including mandated clearing of all standardized over-the-
counter products, and setting capital and margin requirements for
dealers. Treasury's language expands on some of these principles; and
while I do have some outstanding concerns, such as the fair treatment
for end-users in any regulatory overhaul, I think their ideas
represents a decent beginning in the debate over legislation that gives
the American people the confidence that our markets are being overseen
and monitored by strong, effective regulators.
This morning we will hear from a two panels of industry
stakeholders representing exchanges, traders, and end-users. Next week,
Commodity Futures Trading Commission Chairman Gary Gensler will appear
before this Committee for the first time, and he will be joined by
Securities and Exchange Commission Chairman Mary Schapiro. I look
forward to hearing today's witnesses give their thoughts on the central
clearing model for OTC derivatives, along with issues like OTC product
standardization, dealer regulation, and their thoughts on joint
rulemaking between the agencies of jurisdiction.
I thank today's witnesses for being here and I look forward to
their testimony. At this time, I would like to yield to my friend and
colleague from Oklahoma, the Ranking Member of the Committee, Mr.
Lucas, for his opening statement.
The Chairman. And, at this time, I would like to yield to
my friend and colleague from Oklahoma, the Ranking Member of
the Committee, Mr. Lucas, for an opening statement.
OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN
CONGRESS FROM OKLAHOMA
Mr. Lucas. Thank you, Mr. Chairman. And I want to thank you
for calling this series of important and timely hearings on the
Administration's proposal to regulate the over-the-counter
derivatives market.
I congratulate the Chairman on both the structure of the
hearings and on the diverse and highly impacted list of
witnesses. I hope they will be able to answer some of the many
questions I, and my colleagues on the Committee, will have
about the August 11 proposal.
At a time when all of America is being cost-conscious, the
Administration, once again, proves perhaps they don't quite get
that. Regardless of whether you think the economy is improving
or not, the Administration's proposal to regulate the over-the-
counter derivatives markets will do nothing but increase costs.
The Administration's proposals pile more regulations and
requirements on legitimate business activity--activity that is
aimed at controlling cost and managing risks. The increase in
regulation will increase the cost of doing business, and that
increase will be passed along to consumers.
With all of the focus on unlocking the credit markets, this
proposal, in my opinion, goes in the wrong direction. It takes
capital--capital that otherwise would be used for research and
development, payroll, and other employee benefits--and parks it
over at a clearinghouse where it will collect dust.
I am concerned that the increase in cost will reduce, if
not eliminate, the risk-management activity, which would only
translate into higher price and volatility for consumers. Those
businesses that decide that the new regulatory regime is too
costly will go without mitigating the risk or move its very
legitimate and necessary over-the-counter financial activities
out of the country. In either scenario, the government loses
any ability to oversee the activity, and we lose more jobs.
Why do we need the requirement to move transactions into
regulated exchanges? Where is the systematic risk that this
proposal is solving? Why do we need to go beyond increasing
transparency to government regulators? Instead of mandates and
prohibitions, we should encourage people to trade and clear in
healthy, liquid, American markets.
Mr. Chairman, over the next few days, I hope to learn the
answers to some of these questions. I look forward to hearing
our witnesses today, and I thank you very much for calling this
series of hearings.
The Chairman. I thank the gentleman.
And when this whole system collapses again, I hope people
will remember the statement, because I am afraid we are heading
in the same direction.
So, anyway, I want to recognize John Riley, who left our
Committee, went over to the CFTC. I don't think we have
publicly recognized him. Where is John? There he is.
[Applause.]
The Chairman. We miss him. He did a great job for many,
many years on the Committee, and he is doing good work now over
at the CFTC. And we look forward to working together with that
agency as we move forward.
We welcome the witnesses to the Committee. Our first panel
of witnesses: Mr. Jon Hixson, the Director of Federal
Government relations for Cargill; Hon. Glenn English, President
of the NRECA and a former distinguished Member of this
Committee and Subcommittee Chairman, who has worked on these
issues for a long time when he was here; Mr. Dave Schryver,
Executive Vice President of the American Public Gas
Association; and Mr. Ben Hirst, the Senior Vice President and
General Counsel for Delta Air Lines.
So welcome, all, to the Committee. Thank you for making
yourself available.
And, Mr. Hixson, you can begin.
Your full statements will be made part of the record, and
feel free to summarize. We are going to try to limit the
testimony to 5 minutes so we will have time for questions.
STATEMENT OF JON HIXSON, DIRECTOR OF FEDERAL
GOVERNMENT RELATIONS, CARGILL, INCORPORATED, WASHINGTON, D.C.
Mr. Hixson. Thank you, Mr. Chairman. My name is John
Hixson, Director of Federal Government Relations at Cargill. I
am testifying on behalf of Cargill, Incorporated, and I thank
the Committee for the opportunity to testify today.
Cargill previously testified before this Committee, in
February of this year, calling for better reporting and
transparency as well as enforceable position limits. We
continue to support those views and appreciate the opportunity
to discuss the Treasury Department's proposal today.
Cargill is an extensive end-user of derivatives on both
regulated exchanges as well as the over-the-counter markets.
Cargill's activity in offering risk-management products and
services to commercial customers and producers in the
agriculture and energy markets can be highlighted with the
following OTC examples:
We offer customized hedges to help bakeries manage the
price volatility of their flour so that their retail prices for
baked goods can be as stable as possible. We issue critical
hedges to help regional New England heating oil distributors
manage price spikes and volatility on their purchases so they
can offer families stable prices throughout the winter season.
And we offer customized hedges to help a restaurant chain
maintain stable prices on chicken so the company can offer
consistent prices and value to their retail customers when
selling chicken sandwiches.
Under the Treasury Department's proposal, it is highly
likely that Cargill would be forced to greatly reduce, if not
eliminate, offering our customers risk-management solutions
like those described above. Under the proposal, the risk-
management products that would remain in the market would
dramatically increase in borrowing and working capital required
for hedging. As a result, we expect prudent hedging of
commodity, interest rate, and foreign exchange risk by end-
users to decline significantly. With less hedging, end-users
will be faced with more price risk exposure and volatility.
We support the objectives of the Treasury Department's
proposal, which includes a recognition that traditional end-
user hedging in the OTC markets can and should occur. However,
we are concerned that several of the restrictions in the
legislation could have many negative unintended consequences.
Hedging is a valuable activity that is backed by an
offsetting position. Such hedging does not create systemic risk
and should be exempted from mandatory margining and clearing
requirements. The Treasury Department's proposal includes
language to define legitimate hedging and exempt it. We support
this view.
However, the definition and available exemptions need to be
clarified. The exemption from clearing should not be linked to
the eligibility requirements set by a clearing organization.
This would help avoid a conflict of interest. The exemption for
margining should recognize the inherently balanced nature of
hedges; for example, the offsetting position.
We recommend that hedges recognized under the exemption
meet a common sense definition. For example, that definition
could include a three-part test like improved documentation,
better transparency, and a measure to ensure the effectiveness
of the hedge. The exemption should not be tied to accounting
practices, which may not always account for bona fide hedging
activity such as hedge on a physical commodity. In addition,
the definition of the term major swap participant should be
structured to exempt entities seeking to maintain an effective
hedge.
The Treasury proposal calls for higher capital charges for
OTC products that are not cleared. In addition, the bill calls
for capital and margin requirements for non-bank dealers that
could be higher than for bank dealers. This requirement could
make non-bank dealers uncompetitive against bank dealers. Non-
bank dealers who are involved in hedging transactions have an
important role to play in serving customers in many commodity
markets. No non-bank dealer in the commodities markets required
a taxpayer bailout or caused systemic risk due to offering
commodity hedging products for their customers.
We recommend that the transparency and market oversight
proposals move forward, but that the regulatory agencies study
this segment of the market prior to developing appropriate
capital and regulatory guidelines.
Much has happened in the last 18 months across the
financial and commodities markets. The U.S. Treasury
Department's proposal calls for improved regulation,
accountability, and transparency that will be helpful in
preventing the build-up of systemic risk and allowing
regulators to appropriately monitor speculative activity.
However, actions that dramatically increase the cost of
managing risk may ultimately have the unintended consequence of
deterring prudent hedging. This could leave U.S. businesses
overexposed to volatile market conditions.
We appreciate the opportunity to testify before the
Committee and look forward to working with you as this
legislation continues to develop. Thank you.
[The prepared statement of Mr. Hixson follows:]
Prepared Statement of Jon Hixson, Director of Federal Government
Relations, Cargill, Incorporated, Washington, D.C.
My name is Jon Hixson, Director of Federal Government Relations at
Cargill. I am testifying on behalf of Cargill, Incorporated and want to
thank you for the opportunity to testify.
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, competitive,
and well-functioning futures markets and over-the-counter (OTC)
markets.
Cargill is an extensive end-user of derivatives products on both
regulated exchanges and in OTC markets, and is also active in offering
risk management products and services to commercial customers and
producers in the agriculture and energy markets.
Examples of OTC Products
Cargill's activity in offering risk management products and
services to commercial customers and producers in the agriculture and
energy markets can be highlighted with the following OTC examples:
--Customized hedges to help bakeries manage price volatility, so that
their retail prices for baked goods can be as stable as
possible for consumers and grocery stores.
--Hedges to help regional New England heating oil distributors avoid
price spikes and volatility, so that they can offer individual
households stable prices throughout the winter season.
--Customized hedges to help a restaurant chain receive stable prices
on chicken, so that the company can offer consistent prices and
value for their retail customers when selling chicken
sandwiches.
Under the Treasury Department's proposal, it is highly likely that
Cargill would be forced to greatly reduce, if not eliminate, offering
our customers the risk management solutions described above. Under the
proposal, the risk management products that would remain in the market
would dramatically increase the borrowing and working capital required
for hedging.
In addition, we would expect prudent hedging to decline
significantly in those situations where Cargill, like other end-users,
manages its own commodity, interest rate, and foreign exchange risks,
due to the imposition of mandatory margining and the drain on working
capital. With less hedging, end-users will be faced with more price
risk exposure and volatility.
We appreciate the Treasury Department's proposal and continue to
support its stated objectives. The proposal includes recognition that
traditional end-user hedging in the OTC markets can and should occur.
However, we are concerned that several of the restrictions in the
legislation could have many unintended negative consequences.
Exceptions to Central Clearing and Margining Need to Be Clearly Defined
Exceptions to clearing and margining requirements need to be
clearly defined for hedgers. Hedging is a valuable economic activity
which is backed by an offsetting position. Such hedging does not create
systemic risk and should be exempted from the mandatory margining and
clearing requirements. The Treasury Department's proposal includes
language to define legitimate hedging activity and to exempt it from
certain requirements. However, this definition and available exemptions
need to be clarified.
--The exemption from clearing should not be linked to the eligibility
requirements set by the clearing organization. This would help
avoid a conflict of interest.
--The exemption from margining should recognize the inherently
balanced nature of hedges, i.e., the offsetting position, and
should include an exemption for this category of end-users.
The exemption should not be tied to accounting
practices, which may not always account for bona fide
hedging activity.
Effective guidelines that improve documentation,
transparency and ensure hedge effectiveness can be
established as an appropriate alternative in defining this
exemption.
--The definition of the term Major Swap Participant should be
structured to exempt entities seeking to maintain an effective
hedge.
Capital Charges and Treatment of Non-Bank Dealers
The proposed legislation calls for higher capital charges for OTC
products that are not cleared by a registered derivatives clearing
organization than those applicable to swaps that are centrally cleared.
In addition, the bill calls for capital and margin requirements for
non-bank dealers that could be higher than for bank dealers. This
action could make non-bank dealers uncompetitive against bank dealers
and is without sound justification for this disparate treatment.
--Non-bank dealers who are involved in hedging transactions have an
important role to play in serving customers in many commodity
markets. Since no such non-bank dealer in the commodities
markets required a taxpayer bailout or caused systemic risk due
to offering commodity hedging products to their customers, we
recommend that the transparency and oversight proposals move
forward, but that regulatory agencies study this segment of the
market and develop capital and regulatory guidelines only to
the extent appropriate for this type of hedging transaction.
Cargill has previously testified this year before the House
Agriculture Committee, calling for better reporting and transparency,
as well as enforceable position limits. We continue to support those
views, and would like to call to the Committee's attention a few
regulatory steps taken in this area since we last testified.
--Commitments of Traders (COT) Report--On September 4, 2009, the
Commodity Futures Trading Commission (CFTC) issued its first
new COT that covers the major agriculture and energy contracts.
The COT reports currently break traders into two broad
categories: commercial and noncommercial. The new reports will
break the data into four categories of traders: Producer/
Merchant/Processor/User; Swap Dealers; Managed Money; and Other
Reportables.
--OTC Reporting and Transparency--The CFTC continues to collect data
on OTC transactions through its Special Call authority. The
CFTC will begin publishing this data, which highlights index
fund activity, on a quarterly basis with a goal of eventually
releasing this data on a monthly basis.
Conclusion
Much has happened in the last 18 months across the financial and
commodities markets. The U.S. Treasury Department's proposal calls for
improved regulation, accountability, and transparency that will be
helpful in preventing the build-up of systemic risk and allowing
regulators to appropriately monitor speculative activity.
However, it is critically important that Congress and regulators
take actions that focus on the areas of concern, while encouraging
prudent risk management.
Actions that dramatically increase the cost of managing risk may
ultimately have the unintended consequence of deterring prudent
hedging, and leaving U.S. businesses over-exposed to volatile market
conditions.
We appreciate the opportunity to testify before the Committee,
appreciate the work of the Chairman, the Ranking Member, and all
Members of this Committee, and look forward to working together as this
legislation continues to develop.
Thank you.
The Chairman. Thank you, Mr. Hixson.
Mr. English, welcome to the Committee.
STATEMENT OF HON. GLENN ENGLISH, CEO, NATIONAL RURAL ELECTRIC
COOPERATIVES ASSOCIATION,
WASHINGTON, D.C.
Mr. English. Thank you very much, Mr. Chairman. I
appreciate it. And, certainly, it is a pleasure to be back in
the Committee and have an opportunity to testify on this issue.
Thanks for inviting us.
I am Glenn English, Chief Executive Officer of the National
Rural Electric Cooperatives Association. And, as I think most
of you know, we are a not-for-profit, owned by our membership,
consumer-owned. And while we serve about 12 percent of the
population of the country, some 42 million people, those people
are scattered out over 70 percent of the land mass of the
United States. We maintain about 42 percent of the
infrastructure of this country.
And so, as we look at the particular issue that we have
before us, Mr. Chairman, I am sure some of the Members of the
Committee are probably wondering what in the world we are doing
here. This is a little different situation than they normally
find us being engaged and involved in.
But what it really comes down to is that hedging is
becoming a much more important factor for us in managing risk
for our memberships. And this world is becoming a good deal
riskier, as you deal with any kind of production of energy and
power, and as we move forward in dealing with the challenges of
climate change. And whether it is coming through the Clean Air
Act in the EPA or whether it is through legislation that passes
the Congress, either way, it is going to be more costly and
more risky. And hedging is going to play an even more important
role, as we move forward in the future, in trying to maintain
those risks, trying to keep those electric bills down and as
affordable as we can possibly keep them.
Now, we have, in the past, been engaged from time to time
through a couple of organizations that we have to manage risk
for electric cooperatives, most of it on the fuel side through
the Alliance of Cooperative Energy Services Power Marketing,
known as ACES Power Marketing. That is a group that we
established and electric cooperatives own, and many of our
generation and transmission organizations participate, and even
some of the distribution cooperatives participate through this
organization. And also through financing to help meet the
financial needs of electric cooperatives through the National
Rural Utilities Cooperative Finance Corporation; this is one
that we use in conjunction with the Rural Utilities Service. So
this helps us meet the infrastructure needs. Both of those
organizations use hedging to a great extent to try to minimize
the risks that they are facing.
Now, the Treasury Department's proposal, while the thrust
of the effort we don't really have an objection to, the problem
we come down to is the cost and what it is going to mean as far
as electric bills. The point that I am trying to make here, Mr.
Chairman, is we kind of find ourselves between a rock and a
hard spot on this particular issue.
You know, we have no problem as far as additional scrutiny
is concerned. We want to see transactions being open and clear.
We want to see efforts made to deal with any kind of
manipulation that might be ongoing. But, as we deal with this,
we find ourselves in kind of a difficult situation from the
standpoint that we are very small, and much of this is focused
and addressed toward big traders with a lot of money. And we
just don't have that many trades, and we are not of that size
or that magnitude.
Now, as far as trading on the exchanges themselves, of
course, we do have some trades that we do on exchanges. But,
quite frankly, when you come to the issue of margins and having
margin calls, that requires a huge amount of money. Now, most
of you are familiar with your electric cooperatives back home.
You don't have that kind of resources; you don't have that kind
of money. We have equity, but we certainly don't have the cash
on hand.
And so, as you move forward looking at issues like natural
gas and other fuels, dealing with issues like carbon, if you
get into the issue of carbon being traded on the exchanges,
that becomes a much more expensive proposition for us,
requiring a good deal of money. And that means we will have to
go out and borrow that money. And that means that we have to
show that cost. That cost will be reflected, then, as far as
electric bills for the membership, for your constituents.
And that is where our problem is with this particular
issue. So, as we move forward here, we are hopeful, Mr.
Chairman, that the Committee will search for a way for people
like us, who need increasingly to hedge--legitimate hedges, not
speculation, but legitimate hedges--that we can do that in such
a way that we can keep the costs down, that we are not subject
to the volatility of the marketplace as far as margin calls are
concerned, as it affects people like us.
And, if we can do that, that means that we can, obviously,
continue to protect your constituents and protect their
electric bills, and help minimize what we think are going to be
increases, in some cases substantial increases, in electric
bills.
So, Mr. Chairman, I want to thank you again for having us
here and giving us the opportunity to talk about this. I hope
that we will come back and focus a little bit on making sure
that folks that are not big traders, but, instead, have a need
for a market, whether it is through the derivatives, through
over-the-counter markets, or whether it comes back through the
exchanges, that we can have a way in which we can do that
affordably, and that whatever legislation moves forward from
this body is one that takes that into account and continues to
make that possible. Because that will make a big difference in
electric bills for the future, as far as members of electric
cooperatives and, I suggest, other utilities as well.
Thank you, Mr. Chairman.
[The prepared statement of Mr. English follows:]
Prepared Statement of Hon. Glenn English, CEO, National Rural Electric
Cooperatives Association, Washington, D.C.
Mr. Chairman, Ranking Member Lucas and Members of the Committee,
thank you for inviting me to discuss the perspective of electric
cooperatives regarding the U.S. Department of the Treasury's proposal
to regulate the over-the-counter (OTC) derivatives market. The National
Rural Electric Cooperative Association (NRECA) is the not-for-profit,
national service organization representing nearly 930 not-for-profit,
member-owned, rural electric cooperative systems, which serve 42
million customers in 47 states. NRECA estimates that cooperatives own
and maintain 2.5 million miles or 42 percent of the nation's electric
distribution lines covering \3/4\ of the nation's landmass.
Cooperatives serve approximately 18 million businesses, homes, farms,
schools and other establishments in 2,500 of the nation's 3,141
counties.
Cooperatives still average just seven customers per mile of
electrical distribution line, by far the lowest density in the
industry. These low population densities, the challenge of traversing
vast, remote stretches of often rugged topography, and the increasing
volatility in the electric marketplace pose a daily challenge to our
mission: to provide a stable, reliable supply of affordable power to
our members--including constituents of many Members of the Committee.
That challenge is critical when you consider that the average household
income in the service territories of most of our member co-ops lags the
national average income by over 14%.
Mr. Chairman, the issue of derivatives and how they should be
regulated is something with which I have a bit of personal history
going back twenty years in this very Committee. Accordingly, I am
grateful for your leadership, in pursuing the reforms necessary to
increase transparency and prevent manipulation in this marketplace.
From the viewpoint of the rural electric cooperatives, the U.S.
Department of the Treasury's proposal to regulate the $600 trillion
over-the-counter (OTC) derivatives market can be boiled down to a
single, simple concern that I know you have heard me articulate before:
affordability.
NRECA's electric cooperative members, primarily generation and
transmission members need predictability in the purchase price for
their inputs if they are to provide stable, affordable prices to their
customers. Rural electric cooperatives use derivatives to keep costs
down by reducing the risks associated with both volatile energy prices
and financial transaction costs. It is important to understand that
electric co-ops are engaged in activities that are pure hedging, or
risk management. We DO NOT use derivatives for other purposes. We are
in a difficult situation, but OTC derivatives are currently the best
tool we have to manage risk.
Most of our hedges are bilateral trades on the OTC market. Many of
these trades are made through a risk management provider called the
Alliance for Cooperative Energy Services Power Marketing or ACES Power
Marketing, which was founded a decade ago by many of the electric co-
ops that still own this business today. Through ACES, our folks make
sure that the counterparty taking the other side of a hedge is
financially strong and secure.
Half of the electric cooperatives' finance needs are met by private
cooperative lenders, including the National Rural Utilities Cooperative
Finance Corporation (CFC). Derivatives, specifically interest rate and
currency swaps, are an important asset/liability management tool for
cooperative lenders. As a cooperative lender, CFC is not a broker or
dealer, nor does it invest in derivatives for trading or speculative
purposes. It uses derivatives to manage currency and interest rate
risk, and thereby affords our electric cooperative borrowers more loan
options.
While hedges are necessary for electric co-ops, they pose risks. If
a counterparty does not pay up, there will be severe consequences for
our members, so we are extremely careful about who we trade with and
for how much. Our consumers expect stable, affordable electricity
prices, and electric suppliers need the OTC markets to manage the price
volatility risk for our consumer-owners.
Even though the financial stakes are serious for us, rural electric
co-ops are not big participants in the derivatives markets. I mentioned
earlier that this market is estimated at $600 trillion. Our members
have a fraction of that sum at stake and are simply looking for an
affordable way to hedge. Because many of our co-op members are so
small, legislative changes that would dramatically increase the cost of
hedging or prevent us from hedging all-together will impose a real
burden.
Electric cooperatives are owned by their consumers. Those very
consumers expect us, on their behalf, to protect them against
volatility in the energy markets that can jeopardize small businesses
and adversely impact the family budget. The families and small
businesses we serve do not have a professional energy manager. Electric
co-ops perform that role for them and should be able to do so in an
affordable way.
Our primary concern with the Treasury Department's proposal is that
it would require most of our transactions to be cleared since our
natural gas trades likely would be considered ``standardized''. And,
before going further, I want to remind you that we are NOT looking to
hedge in an unregulated market. NRECA DOES want derivatives markets to
be transparent and free of manipulation. The problem is that requiring
all derivatives contracts to clear is just not affordable for most co-
ops. That is because the initial and the ``working'' or ``variance''
margin we would have to provide would make hedging untenable for many
of our members--we would have to come up with hundreds-of-millions of
dollars in cash that we just do not have on hand.
In general, co-ops are capital constrained due to other capital
demands, such as building new generation and transmission
infrastructure to meet load growth, installing equipment to comply with
clean air standards, and maintaining fuel supply inventories, not to
mention the fact that as member-owned cooperatives, we cannot go to the
equity markets for additional resources. Maintaining 42% of the
nation's electrical distribution lines requires considerable and
continuous investment.
We have the same concern with Treasury's proposal to require higher
capital and margin requirements for non-standard products that are not
cleared; it comes back to the need for predictable affordability.
Clearing also presents a significant potential predictability
issue. In case of a catastrophic event, the marketplace could change
dramatically in a very short timeframe. If a catastrophic event
triggered market concern over fuel supplies, ratings could shift and
the prices for contracts could swing dramatically, triggering a sizable
margin call for a reason unrelated to the original trade. A co-op in
that position would not have the cash reserve to cover the margin call,
leaving only one, unattractive option--to borrow a large sum at
unaffordable rates.
Rural electric cooperatives do trade on exchange (and thus have
some trades cleared) when we can. Electric cooperatives customarily
have a couple thousand trades at any given time on NYMEX, but due to
the working margin requirements associated with clearing, most of our
trades are made on the OTC market. We don't like this situation, but we
feel pushed into hedging on the OTC market by the cost. We would like
to be able to trade everything on an exchange or go through a
clearinghouse, but many of our members just cannot afford it.
Another concern with the Treasury Department's proposal is that for
the electric power supply and natural gas business engaged in trading
actual electricity or natural gas, the exemption for any transaction
that is ``physically settled'' requires further clarification to exempt
transactions already regulated by the Federal Energy Regulatory
Commission (FERC), such as virtual bidding in day-ahead markets or the
purchase or sale of Financial Transmission Rights, market capacity, and
similar products in the organized markets. Importantly, many bilateral
physical electric and natural gas transactions are ``booked-out''
before delivery, for physical scheduling efficiencies. These ``booked
out'' transactions which are already regulated by FERC should not be
subject to additional regulation. Absent this clarification, the
proposal could accidently put such transactions within the domain of
derivatives regulation.
Mr. Chairman, at the end of the day, we are looking for a
legitimate, transparent, predictable, and affordable device with which
to hedge. I know there are many ideas under consideration, but
regardless of what specific solution is arrived at, I know that you and
your Committee are working hard to ensure these markets function
effectively. The rural electric co-ops just hope that at the end of the
day, there is a way for the little guy to effectively manage risk.
Thank you.
The Chairman. Thank you very much, Mr. English. Appreciate
it.
Mr. Schryver, welcome to the Committee.
STATEMENT OF DAVID SCHRYVER, EXECUTIVE VICE
PRESIDENT, AMERICAN PUBLIC GAS ASSOCIATION,
WASHINGTON, D.C.
Mr. Schryver. Chairman Peterson, Ranking Member Lucas, and
Members of the Committee, I appreciate this opportunity to
testify before you today, and I thank the Committee for calling
this important hearing.
My name is Dave Schryver, and I am the Executive Vice
President for the American Public Gas Association. APGA is the
national association for publicly owned, not-for-profit natural
gas retail distribution systems. There are approximately 1,000
public gas systems in 36 states, and over 720 of these are APGA
members.
APGA's number-one priority is the safe and reliable
delivery of affordable natural gas. If we are to fully utilize
natural gas at long-term affordable levels, 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 or other
market abuses.
Public gas systems depend upon both the physical commodity
markets, as well as the markets in OTC derivatives, to meet the
natural gas needs of their consumers. Together, these markets
play a critical role in these utilities' securing natural gas
supplies at stable prices for their communities.
APGA believes that the provisions relating to the
unregulated energy trading platforms contained in the CFTC
Reauthorization Act passed last Congress was, and is, a
critically important step in addressing our concerns. And we
commend this Committee for its work on the Reauthorization Act.
In addition, the CFTC, under the leadership of Chairman
Gensler, has taken many significant steps to address the
concerns raised by APGA through exercising their new authority
provided under the Reauthorization Act and using its existing
administrative authority.
However, APGA believes that significant regulatory gap
still exists with respect to the over-the-counter markets and
that Congress should provide the CFTC with additional statutory
authorities to enhance transparency, limit excessively large
speculative positions, and help prevent abuses in the markets
for natural gas.
The proposed legislation by the Department of the Treasury
offers Congress a constructive basis for addressing many of the
issues that remain open following enactment of the CFTC
Reauthorization Act. APGA strongly supports many of the
provisions suggested by the Treasury proposal, particularly
those relating to the reporting of large positions and OTC
transactions that serve a significant price discovery function.
APGA believes that these regulatory tools to enhance
transparency, and to limit excessively large speculative
positions, are a critically important step in effectively
addressing consumers' concerns.
APGA also supports the Treasury proposal's nuanced approach
to the mandated clearing of OTC contracts with certain
clarifications to the exemption. We are concerned that certain
recommendations to this Committee to require mandatory clearing
of all standardized transactions would have serious negative
consequences to public gas systems.
Public gas systems purchase firm supplies in the physical
delivery market at prevailing market prices and enter into OTC
derivative agreements customized to meet their specific needs,
reduce their consumers' exposure to future market price
fluctuations, and stabilize rates.
By using both markets, public gas systems are able to
purchase firm deliveries of natural gas from a diverse set of
suppliers, while hedging the risk of future market price
fluctuations. Proposals that would require all standardized OTC
transactions to be cleared would significantly impair the
ability of public gas systems to engage in these gas supply
strategies.
Under current practices in the OTC markets, many public gas
systems are not required to pledge collateral for transactions
below agreed-upon levels based upon their very high credit-
worthiness. In contrast, the mandated clearing of all OTC
transactions would require public gas systems to post initial
margin for all transactions and to meet potential margin calls
whenever required and on little notice. This would constitute a
significant financial and operational burden on these systems,
their communities, and their consumers.
It has been suggested that the clearing requirements would
be less burdensome if some end-users are given the option of
posting noncash collateral. Unfortunately, the alternative of
using noncash collateral would not provide any relief to public
gas systems. Noncash collateral would entail the deposit of
liquid assets, and public gas systems simply do not maintain
liquid assets in a quantity necessary to meet the requirements
associated with clearing.
APGA understands that provisions that require the clearing
of all OTC transactions are intended to address issues related
to systemic risk. However, the hedging of natural gas supply
purchases by public gas systems using noncleared bilateral OTC
derivatives do not present systemic risk to the market. In
addition, a proposed mandate to clear all standardized OTC
derivatives transactions would increase costs for public gas
systems and their municipalities, an increase which would be
borne 100 percent by their consumers.
It is critical that the nation's regulators have the tools
that they need to detect and deter market abuses. APGA believes
that the Treasury proposal provides this Committee with a very
good foundation for achieving those goals. And we look forward
to working with the Committee towards the passage of
legislation that strengthens consumer confidence in the
integrity of the markets' price discovery mechanism.
Thank you.
[The prepared statement of Mr. Schryver follows:]
Prepared Statement of David Schryver, Executive Vice President,
American Public Gas Association, Washington, D.C.
Chairman Peterson, Ranking Member Lucas and Members of the
Committee, I appreciate this opportunity to testify before you today
and I thank the Committee for calling this hearing to review proposed
legislation by the U.S. Department of the Treasury regarding the
regulation of over-the-counter derivatives markets. My name is Dave
Schryver and I am the Executive Vice President for the American Public
Gas Association (APGA).
I testify today on behalf of the APGA. 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 720 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. If we are to fully utilize clean domestically
produced natural gas at long-term affordable prices, 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, other abusive market conduct or
excessive speculation.
Over the past several years, and leading up to the passage of the
Reauthorization Act, APGA has sounded the alarm with respect to the
need for greater oversight and transparency of the over-the-counter
markets (``OTC'') in financial contracts in natural gas. APGA
previously testified before this Committee that APGA's members have
lost confidence that the prices for natural gas in the futures and the
economically linked OTC markets are an accurate reflection of supply
and demand conditions for natural gas. APGA further testified that
restoring trust in the validity of the pricing in these markets
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. APGA therefore strongly supported an
increase in the level of transparency with respect to trading activity
in these markets. For this reason, APGA strongly supported the recent
enactment of the CFTC Reauthorization Act of 2008.\1\
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\1\ Food, Conservation, and Energy Act of 2008, P.L. 110-246, 122
Stat. 2189, Title XIII.
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The Reauthorization Act
APGA believes that the increased regulatory, reporting and self-
regulatory provisions relating to the unregulated energy trading
platforms contained in the CFTC Reauthorization Act of 2008 was, and
is, a critically important step in addressing our concerns. We commend
this Committee for its work on the Reauthorization Act. The market
transparency language that was included in the Reauthorization Act 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.
APGA notes that the CFTC, under the leadership of Chairman Gensler,
has taken many significant steps to address the concerns raised by
APGA, exercising the new authority provided under the Reauthorization
Act and its existing administrative authority under the Act. For
example, the CFTC has exercised the authority given it in the
Reauthorization Act, finding that the LD1 natural gas contract traded
on the Intercontinental Exchange, Inc. is a significant price discovery
contract \2\ and is thereby subject to the enhanced regulatory
requirements of the Reauthorization Act. It also is providing enhanced
transparency through its Commitment of Traders Report and is using its
special call reporting authority aggressively in connection with OTC
contracts. In addition, the CFTC has formed and continues to seek
advice of an energy markets advisory committee. Many of these steps
were first recommended by APGA. APGA believes that all of these
enhancements have been important steps in addressing the problems faced
by the markets in natural gas.
---------------------------------------------------------------------------
\2\ See ``Order Finding That the ICE Henry Financial LD1 Fixed
Price Contract Traded on the Intercontinental Exchange, Inc., Performs
a Significant Price Discovery Function,'' 74 Fed. Reg. 37988 (July 30,
2009).
---------------------------------------------------------------------------
The Treasury Proposal on Regulating OTC Derivatives
However, we have also noted to the Committee in prior testimony
that we believed that it was likely that it would be necessary for
Congress to provide the CFTC with additional statutory authorities to
respond fully and effectively to the issues raised by trading in the
energy markets. We have expressed the view to Congress that additional
transparency measures with respect to transactions in the OTC markets
are needed to enable the cop on the beat to assemble a full picture of
a trader's position and thereby understand a large trader's potential
impact on the market.
APGA believes that the proposed legislation by the U.S. Department
of the Treasury, the ``Over-the-Counter Derivatives Markets Act of
2009,'' (``Treasury Proposal''), offers Congress a constructive basis
for addressing many of the issues that remain open following enactment
of the Reauthorization Act. Accordingly, APGA supports fully many of
the provisions suggested by the Treasury Proposal, particularly those
relating to reporting of large positions in OTC transactions and the
application of speculative position limits to such contracts. APGA
believes that these regulatory tools to enhance transparency, and to
limit excessively large speculative positions, are a critically
important step in effectively and fully addressing the issue we have
raised with respect to pricing anomalies in the natural gas market.
APGA also supports the Treasury Proposal's nuanced approach to mandated
clearing of OTC contracts. At the same time, we note that certain
recommendations to this Committee with respect to mandatory clearing of
all transactions would have serious, negative consequences to our
members. We will address each of these issues in turn.
The Treasury Proposal seeks to apply a regulatory framework to
trading in OTC swaps. Many public gas systems use both or either the
OTC derivatives markets and regulated futures markets to hedge their
exposures related to their purchases and sales of natural gas. As
publicly-owned distribution systems, the savings that public gas
systems realize from hedging their purchases and sales of natural gas
using exchange-traded or OTC derivatives directly lowers the rates paid
by their customers. Thus, the proper functioning of the markets is
important to public gas systems because well-functioning markets affect
the rates that their consumers will ultimately pay.
APGA believes that the goal of Treasury's Proposal to close
regulatory loopholes and bring needed regulatory oversight to the OTC
markets is sound. In light of the importance of these markets to public
gas systems, and ultimately to their customers, we endorse the goal of
Treasury's Proposal, generally, including the expectation that
regulatory agencies will cooperate in overseeing the OTC derivatives
markets.
Mandatory Clearing.
Section 713 of the Treasury Proposal requires the clearing of
standardized swap contracts by a derivatives clearing organization
except if no derivatives clearing organization will clear the
transaction, or one of the counterparties is not a dealer or a ``major
swaps participant and does not meet the eligibility qualifications of a
derivatives clearing organization. A major swap participant is defined
as an entity that maintains a substantial net swap position other than
to create and maintain a hedge under generally accepted accounting
principles, or as the CFTC and SEC further define by rule.''
APGA supports this exemption from the mandated clearing
requirement. As hedgers, with very high credit ratings, assured
collections from rate payers, and substantial assets in physical
infrastructure, public gas systems under current practice in the
bilateral swaps market often are not required to pledge liquid
collateral for transactions below agreed upon levels. Moreover,
adjustments to collateral levels are made on a pre-defined, periodic
basis. This is particularly suitable to the routine funding and fee
collection practices of public natural gas distribution systems. The
customers of public gas systems reap the benefits of these arrangements
through lower rates for the natural gas which they purchase. The
hedging of natural gas supply purchases by public gas systems using
non-cleared bilateral OTC derivatives do not present the types of
systemic risks posed by some dealers of credit-default swaps, which is
the impetus behind the proposed clearing mandate.
Accordingly, APGA strongly supports the inclusion of the exemption
for hedgers which are not major swap participants. The availability of
this exemption is critical to our member's ability to continue to bring
natural gas to their customers at the lowest possible cost in a
fiscally sound and operationally efficient manner.
However, we suggest that the definition of ``major swap
participant'' be revised. Currently, the definition is tied to a
finding that the net position of outstanding swaps is an effective
hedge under generally accepted accounting principles (GAAP). APGA
members use the OTC derivatives markets to hedge their physical
operations. We are concerned that an overly rigorous interpretation of
this definition may require tying particular swaps transactions to
particular physical requirements. We suggest that the definition of
``non-major swap participant'' address this concern by being revised to
include a category for ``an entity which is a commercial user,
processor or distributor of the physical commodity that enters into
swap contracts in connection with their purchase or sales of the
physical commodity.''
There have been some who have suggested that Congress should not
include this exemption in a final bill, and mandate that all
standardized OTC derivatives be required to be cleared regardless of
the nature of the end-user counterparty.
Public gas systems depend upon both the physical commodity markets
as well as the markets in OTC derivatives to meet the natural gas needs
of their consumers. Together, these markets play a critical role in
these utilities securing natural gas supplies at stable prices for
their communities. Specifically, natural gas distributors purchase firm
supplies in the physical delivery market at prevailing market prices,
and enter into OTC derivative agreements customized to meet their
specific needs, reduce their consumers' exposure to future market price
fluctuations and stabilize rates. By using both markets, these public
gas systems are able to purchase firm deliveries of natural gas from a
diverse set of suppliers while hedging the risk of future market price
fluctuations.
However, proposals that would require all standardized OTC
derivatives transactions to be cleared would significantly impair the
financial ability of public gas systems to engage in these gas supply
strategies. As noted above, under current practices in the OTC markets,
many APGA based upon their very-high credit worthiness are not required
to post collateral for an agreed upon number of transactions. In
contrast, the mandated clearing of all OTC transactions would require
public gas systems to post initial margin for all transactions and to
meet potential margin calls whenever required on little notice. This
would constitute a significant financial and operational burden on
these systems, their communities and their consumers.
It has been suggested that the clearing requirements would be less
burdensome if some end-users are given the option of posting non-cash
collateral. Unfortunately, the alternative of using non-cash collateral
would not provide any relief to public gas systems. Public gas systems
generally are prohibited by their constitutional documents from
pledging as collateral the components of their physical infrastructure,
such as pipelines. Accordingly, public gas systems would only be
permitted to pledge non-cash collateral in the form of liquid assets.
However, public gas systems simply do not maintain such liquid assets
in the quantity necessary to meet the requirements associated with
clearing. And maintaining this level of liquid assets would be at odds
with their routine funding operations.
Another result of mandatory clearing would be the de facto
elimination of the use of tax-exempt financing for the prepayment of
long-term natural gas contracts, also known as ``prepays.'' Prepays
were endorsed by Congress as part of the Energy Policy Act of 2005 and
have been a key tool that public gas systems, including ours, have used
to secure long-term, firm supplies for terms up to 30 years. One
critical component of the prepay is an OTC swap transaction that
enables the public gas system to ultimately pay a price discounted
below the prevailing spot market price. Importantly, the OTC
derivatives utilized in prepays are ``tear up'' agreements, that is,
they terminate at no cost in the event the prepay terminates. Because
of their size and long-range nature, requiring clearing of the prepay
swap would be cost prohibitive, thereby eliminating a tool public gas
systems have utilized to lock into long-term supplies of natural gas
and protect our consumers from price volatility.
Accordingly, APGA strongly rejects the suggestion that all OTC
derivatives be required to be cleared regardless of the nature of the
end-user counterparty. That suggestion, if enacted into law, would
constitute a significant financial and operational burden on publicly
owned natural gas distribution systems, their communities and their
consumers, and would not address any problem which has brought about
the current financial crises. From our perspective, the continued
availability of individually negotiated, non-cleared OTC transactions
will provide our Members the widest range of tools to continue to offer
natural gas at the best possible prices to their customers.
Speculative Position Limits
Section 723 of the Treasury Proposal would make the Commodity
Exchange Act's speculative position limit provisions applicable to any
swaps that perform or affect a significant price discovery functions
with respect to regulated markets. Such limits may be aggregated across
positions held in designated contract markets, contracts on a foreign
board of trade, or swaps serving a significant price discovery function
with respect to a regulated market.
As hedgers that use both the regulated futures markets and the OTC
energy markets, our members 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 dramatic 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
reportedly accumulated excessively large long positions and complex
spread strategies far into the future. The Report by the Senate
Permanent Committee on Investigations affirmed that ``Amaranth's
massive trading distorted natural gas prices and increased price
volatility.'' \3\ APGA believes that these price distortions directly
increased the cost of natural gas for many of our member's customer
rate payers.\4\-\5\
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\3\ 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.
\4\ 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.
\5\ 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.
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Applying Aggregate Position Limits Across all Positions.
The Treasury Proposal would apply speculative position limits
across all economically linked instruments, regardless of whether they
are exchange-traded or traded OTC. The determination of whether to
apply position limits consistently across all markets and participants
is perhaps the single most important issue for the energy market. As we
noted above, the various market segments for energy contracts are
economically linked, and actions in one market segment can affect
prices in the other segments. Recent events in the economically linked
markets for natural gas have shown the danger of traders being able to
move positions from one market to another in order to evade application
of a market's position accountability rule or position limit.\6\ A
unified limit administered by the Commission across all markets,
including the OTC markets (in addition to the limits adopted and
administered by each separate market) would effectively address this
issue and provide an effective and meaningful limitation on the total
size of positions that a trader could amass in the delivery month.
---------------------------------------------------------------------------
\6\ See generally, PSI Report.
---------------------------------------------------------------------------
APGA strongly supports the use of spot month speculative position
limits as a proven and effective tool for addressing markets with
constrained deliverable supplies, which is typical of the markets for
natural gas. The CFTC recently promulgated rules implementing the
Reauthorization Act's provisions with respect to the oversight of
SPDCs.\7\ APGA believes that the final rules are a very good foundation
for addressing the issue, but recommends that the CFTC consider taking
additional steps within its existing statutory authority to strengthen
the effectiveness of this important regulatory tool.
---------------------------------------------------------------------------
\7\ ``Significant Price Discovery Contracts on Exempt Commercial
Markets; Final Rule,'' 74 Fed. Reg. 12178 (March 23, 3009).
---------------------------------------------------------------------------
In this regard, APGA notes that the CFTC deferred action to make
spot month speculative position limits or back month position
accountability apply to both cleared and non-cleared transactions on a
market that operates as a SPDC. Despite recognition of the important
role that non-cleared transactions play in price formation, the
speculative position limits that the Commission's rules require apply
only to cleared transactions and do not require that non-cleared
transactions be included in calculating whether a trader has violated a
spot month speculative position limit. This clearly and inexplicably
weakens the prophylactic protection that spot month speculative
position limits are intended to provide. Accordingly, APGA suggests
that the Commission use its current statutory authority and include
linked, non-cleared SPDCs within the speculative position limit
requirement.
The Treasury Proposal would address this regulatory gap by
expressly providing that speculative positions limits shall apply to
swaps that serve a significant price discovery function with respect to
a regulated contract. APGA considers it vitally important that any
legislative proposal include unified speculative positions limits for
contracts that are traded and maintained OTC. Where such contracts are
economically linked to contracts traded on exchange traded or exempt
commercial markets, such OTC contracts may have an important influence
on pricing and on the performance of other market segments.
Recent events in the economically linked markets for natural gas
have shown the danger of traders being able to move positions from one
market to another in order to evade application of a market's position
accountability rule or position limit.\8\ A unified limit administered
by the Commission across all markets (including OTC transactions), in
addition to the limits adopted and administered by each separate market
would effectively address this issue and provide an effective and
meaningful limitation on the total size of positions that a trader
could amass in the delivery month.
---------------------------------------------------------------------------
\8\ See PSI Report.
---------------------------------------------------------------------------
Large Trader Reporting
Section 731 of the Treasury Proposal would add a new provision
requiring persons holding swaps positions in swaps that perform a
significant price discovery function in respect of a regulated market
which exceed a stated size to report to the CFTC such information as
the CFTC shall require. This mirrors the requirement which underpins
the current CFTC Large Trader Reporting System. The provision includes
a books and records requirement.
The current lack of transparency with respect to large OTC
transactions leaves regulators unable to answer questions regarding
speculators' possible impacts on the over-all market. Without being
able to see a large trader's entire position, 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.
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 the regulated market. 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/non-commercial) and their
concentration in the market, including the percentage of the total
positions held by each category of trader (commercial/non-commercial).
The CFTC also relies on the information from its large trader
reporting system in its surveillance of the regulated market. In
conducting surveillance of the regulated natural gas futures 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.
The CFTC Reauthorization Act, recently empowered the CFTC to
collect large trader information with respect to ``significant price
discovery contracts.'' However, there remain significant gaps in
transparency with respect to trading of OTC energy contracts, including
many forms of contracts traded on the Intercontinental Exchange, Inc.
Despite the links between prices for the regulated 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.
Our members, and the customers served by them, believe that
although the Reauthorization Act 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 continued
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 a regulated
futures exchange, on an exempt electronic market or through bilateral
OTC transactions, which can be conducted over the telephone, through
voice-brokers or via electronic platforms.
The Treasury Proposal addresses this regulatory gap by including
all economically linked contracts that affect price discovery in the
regulated market within a large trader reporting system. APGA strongly
backs this proposal. We note that this is necessary in order to achieve
meaningful transparency in the market. We believe that this would give
the cop on the beat the tools necessary to patrol for manipulation,
abuse, congestion, and price distortions. We urge that this provision
be included in any financial reform legislation.
* * * * *
In order to protect consumers the regulators 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 720 public gas system members applaud your continued oversight
of the futures and related markets for natural gas markets. We look
forward to working with the Committee to determine the further
enhancements that may be necessary to address the remaining regulatory
gaps, enhance enforcement and restore consumer confidence in the
integrity of the price discovery mechanism.
Natural gas is a lifeblood of our economy and millions of consumers
depend on natural gas every day to meet their daily needs. It is
critical that the price those consumers are paying for natural gas
comes about through the operation of fair and orderly markets and
through appropriate market mechanisms that establish a fair and
transparent marketplace. Without giving the government the tools to
detect and deter manipulation, market users and consumers of natural
gas who depend on the integrity of the natural gas market cannot have
the confidence in those markets that the public deserves. We believe
that the Treasury Proposal provides this Committee with a very good
foundation for achieving those goals.
The Chairman. Thank you very much.
Your testimony, Mr. Hirst?
STATEMENT OF RICHARD B. HIRST, SENIOR VICE PRESIDENT AND
GENERAL COUNSEL, DELTA AIR LINES, MINNEAPOLIS, MN; ON BEHALF OF
AIR TRANSPORT ASSOCIATION
Mr. Hirst. Thank you, Mr. Chairman. My name is Ben Hirst. I
am General Counsel at Delta Air Lines, but I appear today on
behalf of the Air Transport Association, which represents the
major passenger and cargo airlines in the United States, an
industry which has been devastated in the past 2 years by the
high price of fuel and volatility in the oil markets.
We appreciate your determination to address the causes of
these conditions, which have destroyed some airlines and deeply
damaged the rest. We strongly support strengthened regulation
of the oil futures market.
U.S. airlines are suffering through a very difficult
economic climate and have been forced to cut employees and air
service. Unfortunately, the impact of the recession on the
airlines has been exacerbated by a recent volatility in the
fuel markets. In 2008 alone, U.S. airlines spent $16 billion
more on fuel than they did the year prior, almost $60 billion
in total, despite the fact that they actually decreased their
fuel consumption by more than five percent.
Because fuel is our largest single expense, we are
particularly susceptible to the recent wild swings in fuel
prices. At Delta Air Lines, we consume approximately 4 billion
gallons of jet fuel annually, which makes us the second-largest
consumer of jet fuel in the world, after only the U.S.
Government. Jet fuel consumes 30 to 40 percent of our total
revenues. A $1 increase in the price per barrel of oil,
annualized, increases Delta's fuel cost by $100 million.
The speculative oil price bubble that began in mid-2007
cost Delta approximately $8 billion in fuel expense and hedge
losses compared with what we would have spent on jet fuel if
the price of oil had remained where it was in mid-2007 at $60 a
barrel. In addition, it forced Delta to reduce capacity by ten
percent and eliminate 10,000 jobs.
In the past 3 years, we have seen a significant increase in
the volatility of oil prices. This increase in volatility has
been associated with a massive increase in speculative
investment in the oil market. The total value of investment in
commodity index funds has increased tenfold since 2003, from an
estimated $15 billion in 2003 to around $200 billion in mid-
2008. Over the same period, global demand for physical barrels
of oil has remained static, virtually unchanged.
For airlines, the volatility in oil prices associated with
this increase in speculation creates three serious problems:
First, it increases the costs and risks of hedging. As a result
of last year's oil bubble, for example, Delta incurred about
$1.7 billion in hedge losses when the bubble burst and the
price of oil fell precipitously. Second, speculative activity
last year pushed fuel prices so high that capital within the
industry has been depleted. And, finally, with each spike in
oil prices, airlines ground aircraft, reduce air service,
eliminate jobs, and defer capital expenditures.
It is worth remembering that the ultimate purpose of
commodities futures markets is to provide hedging opportunities
for producers and end-users of commodities, not to provide a
financial playing field for speculators. Speculators play a
valuable role in providing the liquidity needed for hedging to
occur; however, to the extent excess speculation destabilizes
actual commodity prices and markets, Congress should provide
the CFTC with adequate authority and resources to ensure that
markets enjoy enough speculation to provide liquidity, but not
so much as to create wild volatility and harm to consumers.
Congress and the CFTC can look to the period before the
explosion of index fund investment in the earlier years of this
decade as a guide to appropriate speculative levels in relation
to levels of volatility.
About 10 years ago, when volatility was low, it has been
estimated that only about 25 percent of the open interest in
oil futures was held by speculators. Today, the percentage is
estimated at 70 to 80 percent. Unfortunately, the CFTC's
authority over the swaps in OTC markets, which have greatly
expanded in the last decade as speculation has increased, is
ambiguous, and it was weakened by loopholes in the Commodities
Futures Modernization Act.
The Treasury Department recently sent Congress proposed
legislation that would give the CFTC clear authority to
exercise oversight over the swaps and OTC derivatives markets.
It would expressly repeal the swaps in Enron loopholes and
strengthen oversight of foreign boards and trades. It would
increase transparency by requiring reporting of all derivatives
and futures trades to a central repository, and by making
available to the public aggregated data on all open positions
in trading volumes. It would clarify the CFTC's authority to
deter market manipulation and to police conflicts of interest.
And, most importantly from our perspective, it would give the
CFTC clear authority to set position limits for OTC and swaps
markets that perform a significant price discovery function.
The airline industry would support legislation which
requires the CFTC to set aggregate and individual position
limits in the oil futures markets. Now, the Administration
proposal does not go that far, but it does require the CFTC to
set position limits--I am sorry, it gives the CFTC authority to
set position limits across all markets, which is a very
important step, where it determines that those markets would
significantly affect price discovery. And, as a result, we
strongly support these provisions.
The current state of the oil futures market is completely
unworkable for the airline industry, and that is not debatable.
It is also harmful to our nation's economy as a whole. We urge
you to enact legislation to restore the proper balance between
commercial hedging and speculative investment, to increase the
transparency of trades and traders in these markets, and to
close the loopholes that have hindered adequate oversight of
these vital markets for years.
Thank you very much, and I look forward to answering your
questions.
[The prepared statement of Mr. Hirst follows:]
Prepared Statement of Richard B. Hirst, Senior Vice President and
General Counsel, Delta Air Lines, Minneapolis, MN; on Behalf of Air
Transport Association
Introduction
Good morning Chairman Peterson, Ranking Member Lucas, and Members
of the Committee. I am Ben Hirst, General Counsel of Delta Air Lines,
and I am appearing today on behalf of the Air Transport Association,
which represents the U.S. commercial airline industry, an industry that
has been devastated in the past 2 years by the high price of fuel and
volatility in oil markets. We, and our employees, are grateful for your
commitment to addressing the causes of these conditions, which have
destroyed some airlines and deeply damaged the rest.
Industry Conditions
As an industry, commercial aviation helps drive $1.14 trillion in
annual economic activity in the U.S., $346 billion per year in personal
earnings, and 10.2 million jobs. It also contributes $692 billion per
year to our nation's gross domestic product--roughly 5.2% of
GDP.Unfortunately, U.S. commercial aviation is suffering through a very
difficult economic climate. Recently, Merrill Lynch analyst Michael
Linenberg was quoted as saying, ``We are lowering our 2009.net income
forecast [for the airline industry] . . . from a profit of $1.0 billion
to a loss of $2.3 billion. While at the start of the year we were
projecting a modest net profit for the industry despite the worst
global economic downturn since World War II, our forecast has been
stymied by the impact of the H1N1 influenza, creeping energy prices,
and a revenue environment that is showing no signs of improvement.''
Demand for air travel and air cargo is down sharply in 2009--by
approximately 21 percent below the same period last year--and U.S.
airlines expect 14 million fewer passengers in the summer 2009 than we
had in 2008. This has forced our industry to do the only thing it can
to survive--cut capacity, ground planes, eliminate routes, and reduce
the number of cities served.
The number of full-time employees at passenger airlines is down 29
percent from our peak employment in May 2001--a total of 154,000 jobs
lost in our industry. And airlines continue to cut. In the fourth
quarter of this year, domestic seating capacity is expected to decline
to levels we last saw in the fourth quarter of 2001, in the immediate
aftermath of 9/11. In fact, by the fourth quarter of this year, U.S.
carriers will offer almost 1.8 billion fewer available seat miles \1\
every week than they did in the fourth quarter of 2007. And that figure
represents the cuts on domestic routes only. When you add the cuts that
have been made to international routes, the numbers are even
larger.Unfortunately, all of these problems are being exacerbated by
volatility in fuel markets. In 2008, U.S. airlines spent $16 billion
more on fuel than they did the year prior--almost $60 billion in
total--despite consuming more than five percent fewer gallons of fuel.
---------------------------------------------------------------------------
\1\ An available seat mile (ASM) is one passenger seat flown one
mile and is the standard unit of capacity in the passenger airline
sector.
---------------------------------------------------------------------------
We at Delta Air Lines employ over 70,000 people worldwide and offer
service to more than 170 million passengers each year to 382
destinations in 69 different countries. We consume approximately 4
billion gallons of jet fuel annually, making us the second largest
consumer of jet fuel in the world, next to the U.S. Government. Our
business is dramatically impacted by volatility in the oil markets.
Each $1 change in the cost of a barrel of oil has an annual impact of
$100 million to Delta's bottom line. In 2008, as oil prices and
volatility peaked, fuel expense (including the cost of hedging)
consumed 40 percent of our total revenues directly resulting in the
need to reduce our capacity by more than ten percent and eliminate
nearly 10,000 jobs.The financial health and security of the airline
industry depends, in significant part, on a commodities market
structure that is stable, rational and predictable. Today's energy
commodities markets, however, do not display these characteristics.
Excessive Speculation Drives Volatility
Since 2005 we have seen a significant increase in the volatility of
oil prices. The increase has been particularly dramatic in the last 2
years. From 1999 through 2004, the average annual variance between the
high price of a barrel of oil for the year and the low price was about
$16. From 2005 through 2008 the average annual per-barrel variance was
about $52. In 2007 the variance between the high and low prices was $48
and in 2008 it was $111. Daily volatility in 2004 was generally under
one dollar. In 2008, the price of a barrel of oil rose $10.75 in a
single day (June 6), and daily volatility of $3 or more became the
norm. The average monthly difference in prices in 2008 was over $19 per
barrel.
Moreover, these indices tend to have a very heavy bias toward long
investing, further increasing the upward pressure on energy markets.
This increase in speculative activity is closely correlated with the
increased volatility of oil prices, which has caused so much harm.\2\
Total world demand for oil from 2005 to 2008 (in million barrels per
day):
2005--84.00
2006--84.98
2007--85.90
2008--85.33
Source: Energy Information Administration.
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For an airline, an oil market characterized by high volatility
driven by speculation presents a number of serious problems. First, it
increases the costs and risks of hedging. Second, in recent years this
volatility has pushed prices to levels so high that they have depleted
the capital of the firms in our industry. Third, with each spike in oil
prices, airlines ground aircraft, reduce air service, and eliminate
jobs.
To be clear, we acknowledge that a certain level of speculative
investment in commodity markets injects much-needed liquidity in those
markets and positively impacts market functions. However, because
excessive speculation clearly destabilizes commodity markets and harms
consumers, Congress should provide the CFTC with the authority and
guidance it needs to ascertain the proper level of speculative
investment in the market while preventing volatility. The period before
the explosion of index fund investment in the early years of this
decade can serve as a valuable guide to appropriate levels of
speculative positions in relation to acceptable levels of volatility.
Oil Prices and Volatility Have Risen as Speculation Has Increased
[GRAPHIC] [TIFF OMITTED] T8.4
billion, compared with what we would have spent on jet fuel if the price
of oil had remained at $60 a barrel. This includes $1.7 billion
in hedge losses and premiums. At least we're still in business.
Other airlines without our financial reserves have not been so
fortunate. Since December 2007, eight airlines have ceased
operations.
Solutions
Delta Air Lines and the Air Transport Association strongly support
reforms to energy market regulation that promote price stability,
market integrity, and accurate price discovery. This is because the
fundamentals of supply and demand alone, while certainly influencing
the price of commodities, cannot explain the destructive volatility we
have seen in oil markets over the past 16 months. The dramatic and
devastating run-up in oil prices that we experienced last summer--and
the almost-as-devastating price crash last fall--was largely caused by
a massive influx of speculative investment into commodity markets
generally and energy markets in particular. Congress must provide the
CFTC with the authority needed to prevent a recurrence of these
devastating conditions by enacting bold commodity market reform
legislation. The draft legislation recently released by the Obama
Administration provides a strong blueprint for this reform and we urge
congress to consider it in the coming weeks.
Delta Air Lines and the Air Transport Association are pleased that
the Obama Administration has taken an active role in advocating
significant reforms to the laws governing the regulations and oversight
of derivatives markets. We applaud the President for coming forth with
a strong and detailed legislative proposal to deal with the many
shortcomings we see in the current oversight framework and generally
support the reforms that he is advocating.
Furthermore, Delta Air Lines uses derivatives markets to hedge in
both financial risk and commodity price risk, and we view both tools as
valuable. That said, my company continues to be more concerned with the
explosion of price volatility that we have seen in energy commodities
in recent years than it is about increased costs for managing financial
risks using financial derivatives. Excessive speculation in oil
markets, and the volatility it foments, has been our focus throughout
this debate and we continue to primarily advocate policies that reform
commodities markets--the portion of this provision that is the purview
of this Committee.
Now to discuss some of the specifics of the bill. The President's
proposal addresses most of the policy priorities the ATA has enumerated
throughout this debate. It effectively closes the loopholes in the law
that hamper the ability of the CFTC to effectively regulate the
market--the Swaps Loophole, the ``Enron'' Loophole, and the foreign
exchange loophole. It also has the potential to limit the massive
influx of speculative dollars that we have seen flow into the markets
in recent years by providing the CFTC the authority to impose
speculative position limits, requires more transparency and reporting,
implements conflict-of-interest rules in this area for the first time,
and increases CFTC funding or staff.
Regarding the imposition of aggregate position limits across all
markets, one of the ATA's highest policy priorities, the proposal gives
the CFTC clear authority to set position limits for any futures
transactions that ``perform or affect a significant price discovery
function.'' This change will allow the CFTC to address the excessive
speculative pressure--and the concomitant volatility--imposed on oil
markets by massive pension funds, sovereign wealth funds, and other
major market players that use index funds to trade immense amounts of
commodity contracts. While the ATA would prefer language to require the
CFTC to take such steps rather than the mere grant of authority
contained in the Obama Administration proposal, we are confident that
the current leadership of the CFTC would effectively use this authority
to increase oversight and inject stability into these markets.
By imposing consistent position limits on all non-commercial
traders across all markets, traders will continue to have the
opportunity to invest in energy commodities, but only up to the level
necessary to ensure adequate liquidity in the market. This would
prevent a recurrence of excessive speculative activity that created the
2008 commodity bubble while ensuring that the markets continue to enjoy
the liquidity they need to function efficiently.
The Obama proposal also contains major improvements in
transparency. It requires traders to report to the CFTC many types of
transactions not currently reported and requires CFTC to aggregate that
data and make it available to the public. The bill also would require
most transactions not cleared or exchange traded to be reported to the
CFTC. The collection and dissemination of this information would
greatly enhance the ability of both the CFTC and public watchdogs to
monitory market activity and maintain market integrity.
The Obama proposal supports the harmonization of regulations
regulating commodity and financial derivatives, and imposes conflict-
of-interest rules on swap dealers and major swap participants. Swaps
dealers would have to create ``firewalls'' between their market
research arms the branch of the company that engages in trading. They
also will have to disclose related conflicts, material risks, financial
incentives, and other interests to counterparties.
Finally, the proposal requires many transactions in standardized
swaps be traded on a board of trade or cleared through an ``alternative
swap execution facility.'' To ensure the integrity of these trades,
margin requirements sufficient to cover potential exposure will likely
be required. While Delta Air Lines and other ATA members are generally
more concerned with market volatility than the potential burdens market
reform impose, it is imperative that actual physical hedgers in
commodity markets be allowed continued access to these risk management
tools without significantly increased cost burdens. Commodity markets
were created for the benefit of physical hedgers and they must continue
to remain accessible to them. In a trade where at least one party is a
legitimate physical hedger in a commodity, the Agriculture Committee
should consider provisions that would enable these transactions to
occur to with little additional financial burden on the parties
involved.
Conclusion
Again, thank you for the opportunity to testify before the
Committee on these vital issues. Fuel has become airlines' single
largest expense. The extreme volatility we have seen in these markets
in recent months has made it impossible to undertake necessary
corporate planning and has been devastating to our industry and the
employees and communities that depend on us. The Obama Administration
has laid out a workable blueprint and we urge Congress to take the
significant steps needed to reform these markets. We in the airline
industry, on behalf of our employees and the communities we serve,
commend you for the leadership you are exercising on this critical
issue. I look forward to answering any questions you may have.
The Chairman. Thank you, Mr. Hirst.
And I thank all of the members of the panel.
Part of what I was trying to do here today, and Tuesday, is
to get to the bottom of this issue of how the proposal affects
folks that use this in the real world that need to use this for
their business. And they get tangled up in all these folks that
are involved in this for other reasons, either making a lot of
money putting these things together, or selling investments, or
whatever they are doing.
So part of what I was trying to do here with these panels
is to kind of flesh out the concerns. And then hopefully on
Tuesday we can get some more direct answers from Mr. Gensler
and Ms. Schapiro about what they actually intend to do.
I think some of the current concerns that people have are--
I don't get the sense that they are going to go as far as what
some people think, and I think there is some lack of clarity in
the proposals that have been put forward. But that is part of
what I am trying to do here, is see if we can get that nailed
down and figure out how to proceed.
I am somewhat concerned that the big players in this are
sending people over here to talk to Members to try to get
exemptions for themselves again. And there is some of that
going on, I am sure. And I want to sort all that out. But, I
guess where I am coming from is we are not really here to put
you guys in a tougher position, drive up your costs, screw up
what you are doing. You are not the problem. But, in the
process, I don't want to leave a loophole that is going to get
us back in this position again. And that is what I am trying to
sort through here.
You know, as far as I am concerned, we are not going back
to the system we had before. And, in the big picture what I am
trying to do is make sure that the risk that is out there is
going to be borne by the people that are doing the business and
not by the government. And, if you have a different way of
covering the risk, then we should be able to accommodate that.
But all we are trying to do is make sure that we are not
setting up some big risk here that they are going to come back
and try to get the taxpayers to take care of.
So, Mr. Hixson, there was a concern about this exemption, I
guess. For standardized swaps to become exempt, one of the swap
counterparties must not be a swap dealer or a swap participant
as defined, and then the additional condition is that the
counterparty does not meet the eligibility requirements of any
clearinghouse that clears a swap, even if the counterparty is
not a clearing member. And if they meet the clearing member
eligibility, then they would still be required to clear the
swap.
So this additional condition could reduce the number of
end-users who could qualify for the exemption. Mr. Hixson
mentioned this concern.
Did anyone else have this concern? Do any of you know,
generally, what is required to be a clearinghouse member and
whether your company or members of your association would meet
those requirements and, hence, would be required to clear all
the standardized swaps?
We know where Mr. Hixson is at. So, Mr. English?
Mr. English. Mr. Chairman, we do and are involved through
NYMEX, as far as natural gas is concerned. And we anticipate,
as we move forward, again, looking to the likelihood of dealing
with the issue of climate change, that we will be even more
heavily involved, as far as natural gas is concerned and the
need for hedging. So, yes, that is an area that does concern
us.
The Chairman. Mr. Schryver?
Mr. Schryver. We are concerned, as well. We are concerned
that we might be eligible as customers. If the intent is to
exempt end-users from hedging, then we think there might be a
better way to do it.
The Chairman. Have you got language or a proposal of how--I
met with some people yesterday that are getting us some
language or ideas about how to deal with it. Maybe you are
involved with those folks.
Mr. Schryver. We are not, but we would be happy to submit
some language.
The Chairman. Well, if you could get us that, that is what
we need. We need ideas about how we can split this baby so that
we get the right outcome here.
Mr. Schryver. We will do that.
The Chairman. Mr. Hirst?
Mr. Hirst. Mr. Chairman, most fuel hedging that airlines do
is done on the swaps market in nonstandardized ways under
conditions in which it is not necessary to post initial margin.
And we would be concerned about provisions that would make that
difficult and require us to operate on the exchanges where we
would have to post initial margin. The expense of that might
cause us to reduce hedging or not hedge at all.
But, having said that, the issue of overriding importance
to us is the actual price of oil and the effect that the
futures markets have on that price. And if we had to choose
between reducing volatility in the oil market and not hedging
at all, we would prefer to reduce volatility in prices.
The Chairman. Yes. Well, I am not sure I am totally up to
speed on understanding the nuances of all of this. But where we
are coming from, or where I am coming from anyway, is I am not
that hung up on putting these on the exchanges. I am more
focused on going to clearinghouses, which is a different level.
And I believe that we can devise a system whereby, if the
clearinghouse decides that it is not something that they can
clear--and that is where I would be coming from for the
standard--if they decide they can't clear it, then it is going
to go over into some other category. And then we would have to
try to figure out what kind of collateral or what kind of
backing is sufficient. And, it doesn't have to be, necessarily,
margins or Treasury bills or whatever. For myself, I think
there are other ways we can make sure we have adequate backing.
And that is where I am coming from, trying to find how we
do that. But you get these folks involved in this thing that
have a different agenda here. And, frankly, a lot of this fight
over all of this has to do with how much money you make in the
end. The more you standardize this stuff and the more you clear
it, the more the margin narrows and the less money some of
these big sell-side banks are going to make. So that is part of
what is going on here, and I understand that.
But, anyway, whatever you can do or whatever you can bring
to us, ideas of how to deal with this so that we make sure that
we are not creating some kind of risk out there that is not
covered but works within your business model, that is what we
are trying to find, the way to proceed on that, I would
appreciate it.
Mr. Lucas?
Mr. Lucas. Thank you, Mr. Chairman.
And I would note, before I ask my questions to the panel,
that your input today and the input to the Committee and the
Members over the coming days and weeks, perhaps months, is
critically important. There will be a bill. It is just how will
it be structured, how will it be crafted, what will the net
effect be? There will be a bill. So these issues, these nuances
are so critically important.
And, with that, I guess I would like to turn first to Mr.
English and perhaps Mr. Schryver. Let's discuss for just a
moment this issue about collateral in the way the Treasury's
proposal seems to work.
I mean, what do you gentlemen have, in particular in your
areas, for use as collateral? I don't think you sit on piles of
cash. I am not sure how you mortgage the lines or the pipes.
But let's touch on that for a moment. What would be your base
under the Treasury proposal for collateral to cover your
margins?
Mr. English. Well, from our standpoint, you are right, we
don't have a lot of money. As I mentioned, we have a lot of
equity; we don't have a lot of cash on hand. So, basically, the
more volatile this becomes, the greater the call, it means that
our members are going to have to go out and borrow large sums
of money. That is about the only way in which we can address
it.
And that is where our concern is, with regard to the cost.
That is going to be a very expensive proposition. And we have
no choice; since we are a not-for-profit, that will be passed
on to our members. That goes directly to the electric bills.
The Chairman. Mr. Schryver?
Mr. Schryver. We have pretty much a similar concern. Our
belief is, by requiring public gas systems to post collateral,
you are, in effect, punishing the victim. You know, our members
have been victims of market volatility.
And by requiring them to post collateral, they are either
going to have to get a line of credit, with is going to affect
their municipality's credit rating; raise rates on ratepayers;
or not hedge or reduce their hedging, which, in effect, would
hurt their consumers as well. So any efforts to require public
gas systems to post collateral would harm their consumers.
Mr. Lucas. And while we are on this point, gentlemen,
explain for just a moment in greater detail how the regulatory
regime that you are subject to from the Federal Energy
Regulatory Commission, how this would be impacted by the
proposal, as it now appears the White House has offered up. And
would it, in effect, lead to double regulation or uncertainty
in regulation, potentially? Could you expand on that for a
moment?
Mr. English. I don't think there is any question unless
that is a very bright line that is drawn with regard to the
exemption, any transaction that is physically settled, we would
be uneasy, even given the language that is contained, that has
been put forward to this point, we would feel uncomfortable
that we are going to be regulated by both entities. Even though
there is some language there that addresses that, we think that
needs to be clarified.
But, obviously, FERC already deals in this area, and we
really find ourselves in a very difficult position if we get
regulated by two Federal agencies. We have had that experience
in the past, and that was not good.
Mr. Lucas. Mr. Hirst, you stated quite clearly you believe
that the volatility, the price volatility that has been so
devastating, so crippling to the airline industry--and this
Committee has had various hearings on that in the past, your
fuel cost--would cause problems with the swap activity.
Would you say it was a greater issue in the swap activity
or over the regulated exchange activity? Could you expand on
that for just a moment?
Mr. Hirst. Well, it is really hard, sir, to sort this out
with precision because there isn't transparency today into the
level of activity in the swaps market. But we have seen a huge
increase in index fund investment in the market. And that, in
growing from $15 billion to $200 billion over the last 5 years,
has clearly had an impact on futures prices, which is
translated into pressure on the upside on oil prices.
And we support the aspects of this bill that would extend
CFTC jurisdiction into the swaps markets so that it can
determine exactly how much activity is going on there and what
ought to be done to it.
Mr. Lucas. My understanding is that one of the highest
policy priorities you all have advocated, of course, are the
aggregate position limits. Do you support the imposition of
those position limits on all contract months, not just the
nearbys, but all contract months? Could you expand on that for
a moment?
Mr. Hirst. Well, again, we strongly support extending the
authority of the CFTC to the over-the-counter and swaps
markets, clarifying that it has the authority to do what needs
to be done there.
We think that the CFTC should act with respect to all
months that do have a significant price discovery function. You
know, whether the outer months exert the same level of
influence on spot prices as the close-in months is a fact
question that probably ought to be left to them to determine.
Mr. Lucas. Thank you.
And thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Iowa, Subcommittee Chairman, Mr.
Boswell.
Mr. Boswell. Thank you, Mr. Chairman, and I appreciate you
doing this today.
I wonder, Mr. Hixson, Cargill has such a big play in so
many things because of your size, and we understand that, but
could you explain a little more, if Cargill produces--the cost
of the food products Cargill produces if costs imposed by the
Treasury proposal actually would discourage prudent hedging, as
you have suggested, leading to volatile market conditions,
could you kind of expand on that a little bit?
Mr. Hixson. Sure. I think we have analyzed this as a
company, and I think if--and I should state from the outset, we
are huge fans of exchange traded markets. We use them
extensively for our price discovery purchases. So whenever we
are buying from farmers, that is typically hedged directly at
an exchange. Sometimes there is an appearance of, kind of, a
one or the other, which we, I don't think, view it as that way.
We kind of view it more symbiotic, that they really can work
together and well between the OTC and the exchange traded
markets. So we do rely heavily on the exchange traded markets.
But, for example, if you go with the Treasury Department's
proposal, through our over-the-counter work, even though about
90 percent or more of our trades are exchange traded, it would
require us to take a billion dollars of capital and remove it
from either building new facilities, new crush plants in Iowa
and that sort of thing and putting it into margin accounts. And
that would, obviously, change, kind of, our cost structure and
our investment decisions on where we deploy capital.
But probably more important is to understand the benefits
as it moves down the supply chain, if you will. I think in my
examples we talk about, kind of, both a bakery customer or more
kind of an odd one for us, it might seem from an Iowa
standpoint, but the hedge we do for a heating oil customer.
Well, the initial margin on that heating oil would be about at
ten percent. So if that contract now has to be margined, and
you are a small jobber selling a million dollars of heating
oil, you now have to come up with $100,000. That is a major
change for a small player.
So it affects us, and I hope that casts a little bit of
light on how it treats us. But it is also important to look at
it through the supply chain on where the ultimate beneficiary
sometimes resides.
Mr. Boswell. Anybody else want to make a comment on the
panel?
Mr. English, I appreciate that you helped us out when we
worked on the, if you will, the energy bill. We thought we had
worked out a pretty good--keep us whole. I say ``us''; I am a
user. But then we go back out in our districts, and you need to
communicate some more that we actually worked this out
together. I just throw that in, a little extra here. And you
don't have to say a lot about it, but you are welcome to say
what you want. But, nevertheless, it seemed to be a lack of
appreciation that we did communicate and got a response from
you in writing that we did okay; of course, you would like
more. But at least we got to the table and got some resolve in
that question.
So I just want to throw that in. Maybe we could talk later.
But I would just like for you to make sure they understand the
effort that you made and that we made up here to make sure that
no harm was done.
Mr. English. I appreciate that very much and certainly
appreciate this Committee, appreciate the Chairman. And I think
we made great progress.
The point that I think a lot of our folks, your
constituents, my members, probably view the process as the end.
They consider the House legislation the end. And we have been
trying to explain to them, this is only the beginning; we still
have to go through the Senate and see what we can do with
regard to a conference, and we expect this legislation will do
far better.
So I appreciate that.
Mr. Boswell. We don't have to belabor it. But, anyway, I
just want to get the point across to give them a little
reminder, please.
Mr. English. I will be going to a regional meeting this
afternoon. So we will again underscore that.
Mr. Boswell. I yield back. Thank you.
The Chairman. I thank the gentleman.
The gentleman from Kansas, Mr. Moran.
Mr. Moran. Mr. Chairman, thank you.
I am sorry I heard only the testimony of two of the
panelists before I had to step out, but I am looking for the
kernel. What is it that we should--in your opinion, what
problem are we trying to fix, and what is the solution?
My guess is that the two panelists I didn't hear--kind of,
the typical testimony we will hear is that we have broad
agreement that we need to make some changes, we are concerned
about some specifics that are included in this legislation,
please don't do this.
What is it that you would like to see or what do you
believe is necessary for us to accomplish the goal of a fairer,
freer market?
Yes, sir, Congressman?
Mr. English. That is an issue that we were examining 15
years ago, so this is nothing that is new. I think the point
that I would make, and I think that we all can agree on, is
that there needs to be transparency in these markets. There is
absolutely no question about that. I think we need to also be
focused on manipulation, no question about that. And we do have
those people doing it.
It is a difficult challenge, as you look at both the
exchanges under regulation with the CFTC and the derivatives,
which don't bear the same kind of scrutiny. And as I understand
where the Chairman is trying to go, and what this is really
focused on, is how we maintain that level of protection and
enhance the protection to the government and to the American
people, while, at the same time, understanding the fact that we
want to continue the legitimate efforts of, in fact, allowing
people to hedge and meet their needs. And we have to have
speculation involved in that.
And so it is a careful balancing act. I hate to say, before
I left, I never did find that right balance, and I know the
Committee is still searching for it. But that is about the best
I can do for you.
Mr. Moran. Mr. Schryver?
Mr. Schryver. We also support transparency. We think it is
important to help ensure that----
Mr. Moran. Let me try to narrow that. When you say ``we
support transparency,'' what does that mean we should do
legislatively?
Mr. Schryver. I think enhanced large trader reporting. I
don't think you need clearing, at least as it pertains to
public gas systems, to enhance transparency. We think position
limits make sense for natural gas. You have a finite supply,
few deliverable points, so position limits for natural gas make
sense.
But, again, our concern is that clearing is really intended
to address systemic risk. And our APGA members, public gas
systems, just don't present a systemic risk to the market. And,
in effect, you will be punishing the victims.
Mr. Moran. The typical painting-with-too-broad-of-a-brush
approach.
Mr. Schryver. Yes.
Mr. Moran. Mr. Hixson?
Mr. Hixson. I think we share a similar concern on the
transparency front. And maybe to give a tangible example of
that, it has been mentioned the bid has spread the market
efficiency on the exchange traded side. And we certainly see
that, as heavy users over on that side. But, a lot of that can
occur with more transparency. And, actually, we, as end-users,
will benefit because we will see these situations where you
have pockets of similarly traded contracts and see what the
spreads are. It is better than likely that a exchange can
develop a contract that will provide that efficiency.
So, there are a lot of gains to be achieved from the
transparency alone that probably aren't truly recognized.
Mr. Moran. Mr. Hixson, you talk about mandatory margining
and capital charges. If that is included in the legislation and
becomes law, how do you see that playing out in the
marketplace?
Mr. Hixson. I think you will see a couple of different
changes. You know, already it kind of depends upon where you
are in the marketplace, if you will. In the heating and oil
example I used, you might see more fuel surcharges. I think
there are multiple ways of handling risk. It can either be done
through an efficient means of some sort of a hedge. The other
way to handle it is to try to force that onto your ultimate
consumers. And some industries do that and do that pretty well.
So I think you will see, kind of, a drive for more surcharges
and of that sort of nature.
The real challenge is if you are perhaps an international
manufacturer, where you are building a bulldozer in Illinois
and you are competing with a firm that is building them and has
a home in Japan. Well, if they can hedge all the risks in their
supply chain and you can't, you have to go to that end customer
and say, ``Well, I would like to sell you bulldozers, but I am
going to need a rider on there for any steel volatility I may
have and a surcharge for steel. And, oh, by the way, if your
local currency goes down, I am going to need a rider for that,
as well.''
So, when you are looking at those two bids, it is going to
be very challenging for the U.S. manufacturer to compete with
that inherent level of uncertainty in the bid that they can
provide compared to the international competitor.
Mr. Moran. Thank you very much.
Thanks, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman.
I really appreciate the Chairman's very practical approach
to this. None of us is as facile as any of you are with regard
to these issues. You know, we dabble in them; you live with
them. And so we have to take a lot of guidance from you.
And the Chairman has asked that you give us language. In
addition to giving us the language, if you could explain why
that language works and it is not going to create a loophole,
that would be helpful.
And those who think that exceptions along the lines that
you all are suggesting should not be granted--no doubt they are
listening in to this hearing--they probably ought to look at
the language that is submitted and start suggesting to us what
sort of loopholes would be created if we adopted that kind of
language. None of us wants to excessively burden you.
I find myself wondering--it seems to me quite likely that
there are a very small number of swaps dealers that provide the
hedging that you all need, and that in some instances the hedge
is pretty substantial. I mean, it is a big deal for your
businesses. And say you are looking to cover the cost of jet
fuel in February anticipating X, and you want to be pretty sure
that you can pay X and get the jet fuel you are going to need,
and something happens in the market and all of a sudden X is
4X. You are relying upon the solvency of the entity that you
are dealing with, and if that entity goes under, if the entity
turns out to not have the wherewithal in order to meet the
obligation, then you are kind of in trouble.
And it would be natural, under those circumstances, for you
to want the entity to be putting up capital as the market
starts moving, you would want the entity to be margining in
some way, just to protect yourself.
Now, from our perspective, while we care about each of our
individual businesses, I don't think--your failure doesn't pose
a systemic risk, really. So we could say, ``Well, that is your
business. You are big boys. Why should we insist that you
insist on some sort of margining, some sort of capital exchange
to assure that the deal is going to be doable as the price
catastrophically moves higher and higher and higher?''
What we are really worried about is, what happens with
these big banks? Historically here, in part, I guess, because
they figure we will bail them out--and that is the unfortunate
part of having to step in and do things like TARP--and we will
bail them out without insisting that the shareholders take the
hit or the bondholders take the hit, as they should--they
should be the first entities to step up--they take excessive
risks. And so, they are guaranteeing your swaps and other
swaps, et cetera, and they are not putting up enough to assure
that they are actually going to be able to meet these
obligations. Things aren't sufficiently transparent. And the
upshot is that all these entities that are dealing with them,
they are afraid to deal with them and we have another credit
freeze and it happens 2 or 3 years from now.
So, I also think you need to be telling us how we get
around that. Do we say, ``Well, it is only one side that is
going to have to put up some collateral, it is the big banks
that are going to have to put up some collateral,'' as price
moves in a certain direction, to discourage their risk-taking?
I don't know, and it would be great to have some guidance along
those lines.
Mr. Hirst. If I could, Mr. Marshall, in the current world,
when airlines hedge in the swaps market and if price moves
against us, we have to post collateral. So there is some
balance in that world from our perspective.
The biggest issue for us----
Mr. Marshall. Could I interrupt?
Mr. Hirst. Yes, sir.
Mr. Marshall. So you are already posting collateral, both
sides to the transaction?
Mr. Hirst. Yes.
Mr. Marshall. You know, I have a sense that there are
people out there right now talking about how they are going to
develop the entity that is going to be providing the $100,000
that your dealer needs in doing a hedge and collateral--in
doing those loans. The cost will be cost to carry it, it would
seem to me if the market is working appropriately.
So it doesn't sound to me like there is that much change if
you are actually putting up collateral anyway.
Mr. Hirst. The big issue for us is the impact of the
futures markets on spot prices. And the most important aspect
of the Treasury proposal, from our perspective, is the
authority it gives to the CFTC to bring that back into balance.
Mr. Marshall. As the Chairman has noted, we have had
hearings on this. We are with you; we have to figure that one
out. We would like to see something reasonable done in that
regard, and we have proposed legislation here.
But back to this concern that these margining requirements
are going to somehow really kill the market and unreasonably
so.
Mr. Schryver. Right now, public gas systems, they will
engage in an OTC transaction, bilateral transaction, and they
will have a built-in agreement within that transaction where
neither party will have to post collateral.
Having standardized clearing would eliminate that ability
for them to do that and they, in turn, would have to post
collateral; and as I said, that would eventually raise their
rates or it would reduce their ability to hedge.
Mr. Marshall. My time is up, Mr. Chairman. If we have a
second round----
The Chairman. Yes. We will get through the Members and then
we will see.
The gentleman from Texas, Mr. Neugebauer.
Mr. Neugebauer. Thank you, Mr. Chairman. Thank you for
calling this hearing.
Mr. Hixson, you talked about in your testimony that there
could be some unintended consequences of this legislation. One
of the things I am always concerned about legislation is,
sometimes we are trying to address one thing and we maybe make
a dab at that, but then we end up with some unintended
consequences. And particularly right now in our financial
markets we don't need any unintended consequences, because we
have them under about as much stress as they probably need to
be at this point in time.
This exemption piece we have heard testimony about, you
mentioned the baker on flour. We have heard from a lot of
small, intermediate-size businesses that they are using OTC
derivatives to manage risks, and that it is more important for
their working capital to be working rather than sitting in a
margin account somewhere.
Would Cargill be considered to meet the eligibility
requirements of a clearinghouse? And then would you be required
to clear your standardized OTC contracts?
Mr. Hixson. Some of the definitions we are not quite sure
on, but--I mean, let me explain a little bit more in a generic
sense that might add a little clarity to what we view as the
conflict of interest.
And the example I have been using is, say you are the
doorman at a night club, and you are paid a dollar a person if
they come in the door. Well, no matter how full the room gets
paid, you kind of have a dollar incentive to let a few more
people in the door.
So to the extent that you have an entity that is built upon
collecting that dollar by determining that more people are
eligible, we would suspect that the threshold for eligibility
would be pretty modest. So, yes, we would think under that
scenario we would likely be forced into that category.
Mr. Neugebauer. You know, one of the things that goes on in
the OTC market, and the analogy I would use is, there is a lot
of credit lending, as opposed to using margin for, and that
basically in many cases that you may loan that banker--baker a
position. He is buying a position from you, and you are loaning
him the ability based on his financial statement to do that.
Is that a correct assumption?
Mr. Hixson. That is a correct assumption, and maybe I
should just set shed a little light on kind of how that
transaction works, and that might address a few of Congressman
Marshall's concerns as well.
So in the baker example, what Cargill would likely do is
work with the customer and figure out what specific volume they
want to cover, what specific time frame they want to cover; and
then what is their risk tolerance, as well as kind of how
financial well capitalized they are.
You know, you can pay more or less, depending on how much
volatility you want to take out of the system. If you want to
narrow it down very tight, it costs a little more; if you have
a little wiggle room, it costs a little less. So you design the
specific product for their risk thresholds.
Then we, as the dealer in this case, turn around and do go
and park off as much of that risk into the exchange, which we
think is an absolutely critical piece of this. You know, there
is value in mutualization of that risk, and we want to make
sure that is clearly understood that the baker has the inherent
risk on their books already because they have to buy the flour.
So they are inherently going to be long in flour, if you will.
The hedge just allows them to help offset that risk. But then
throughout the supply chain as it moves back, we then seek to
hedge as much of that risk as we can.
Certainly we keep working capital for any portion of it
that we can't hedge, but by and large we seek to lay off as
much of that risk in the regulated exchange, which we think is
absolutely the proper thing to do. So what the baker in this
case is doing is focusing on baking and kind of outsourcing the
service of designing the hedge to a trading company. And
Cargill certainly has a background in hedging and trading.
Mr. Neugebauer. Mr. Hirst, I want to go back. In your
testimony you indicated that Delta does use the swap market, I
believe, to do your hedging; is that correct?
Mr. Hirst. That is correct, sir.
Mr. Neugebauer. But you are concerned about the volatility
of the exchanges and with the speculation. Your indication is
that there is too much speculation in that market, and you
believe that is impacting the price of the commodity; is that
correct?
Mr. Hirst. Well, we think that all the futures markets,
both over-the-counter swaps and exchange-based markets, have a
price discovery function in the oil market; that is, they
influence the spot price of oil. And so if we have a single
issue that is of overriding importance to us, it is the
necessity of imposing position limits on speculative activity
in these markets.
Mr. Neugebauer. Just a final question then. You said there
is too much speculation. We have heard people say that
testimony before.
What is the appropriate amount of speculation in the
market?
Mr. Hirst. Sir, in our view, the appropriate amount of
speculation is that amount which provides sufficient liquidity
for hedging to occur, but not so much that it creates
volatility in the market. And where that level is probably
can't be determined with scientific precision.
But when we look at the history of oil prices in relation
to the level of speculation, if you look back about 10 years,
what you would see is that the level of speculation in relation
to hedging by producers and end-users was about 25 percent or
thereabouts. And it is currently about three times that. It is
something on the order of 70 to 75 percent of the activity in
the futures market, so people have estimated.
And so we believe that is out of balance.
The Chairman. I thank the gentleman.
The gentleman from Georgia, the Subcommittee Chairman, Mr.
Scott.
Mr. Scott. Thank you, Mr. Chairman.
I would like to get each of your responses to this
scenario. Presumably we are working on increased regulation and
improving transparency in the over-the-counter markets in order
to protect end-users of commodities and, ultimately, consumers
from excessive speculation, however you may define that, which
may lead to unwarranted spikes in the prices of commodities.
There is a real risk, however, that too much regulation--
that is to say, too strict clearing requirements or capital
requirements that are too high--could actually prevent end-
users and legitimate hedgers from mitigating their risks. In
fact, it seems the loosely defined end-user commodity, as
diverse as it is, is not really of one mind on this issue, with
some fearing the loss of their ability to hedge more than they
fear the effects of speculators.
So it would appear that the Treasury has recognized the
risk to legitimate hedgers in its proposal, that its proposal
may pose and, as such, they have tried to build in some
exemptions to its clearing requirements. However, these
exemptions are tied to what seems to be a long and complicated
set of conditions placed on the contract participants.
Now, many of you all have touched on this before, but I
would like each of you to elaborate on, one, whether or not you
think these conditions are overly stringent; two, whether or
not you think you would qualify for these exemptions as they
stand now; and three, if not, would exposure to these new
clearing and capital requirements prevent you from doing the
hedge your business needs to do either for financial or
technical reasons?
Mr. Hirst. I would be happy to start, sir.
As I mentioned earlier, airlines generally, when they
hedge, hedge in the swaps markets with nonstandardized
instruments that don't require posting initial margin, although
if the price moves against you, then you do have to post
margin. But you enter into an agreement with the swaps dealer
that, in effect, extends you credit for that initial margin
requirement.
To the extent that the rules change and airlines are
required to post initial margin in order to hedge, it would
deter hedging. To the extent that we are able to continue
hedging in other fora without having to post initial margin, we
would welcome that.
Mr. Schryver. From APGA's perspective, I don't know if I
would use the word--an overly stringent definition, but we
think the definition--if the intent is to exempt end-users that
don't pose a systemic risk, we think the definition can be
clarified.
In terms of if we do qualify for the definition under the
current language that is unclear to us, we are not sure if we
would be exempted or not, which is one of our concerns. And
that is why we support clarifying the definition.
And third, if we did fail to qualify for the exemption and
would be required to post collateral, it would certainly impact
our members' ability to hedge.
Mr. English. We believe that most of our contracts, as it
applies to natural gas in particular, would be considered
standardized. And as a result of that, that would put us in a
position that the margin requirements would be such that it
would be unaffordable for our members. And that is where our
difficulty comes in. We have to keep it affordable and we have,
in order to take care of risk, we have to hedge. So if this
crowds us into a position that it becomes unaffordable for us
to hedge, then obviously, the risks become enormous.
Mr. Hixson. I think we tend to agree. We would say the
contingencies are a little too stringent. I think they can
clarify.
What we view as their intent was to try to remove hedgers
from this obligation, and we think yes, we probably would be
captured under this. There is an incentive to capture as many
people as you can, and we think the ultimate end result of this
would indeed be to have less hedging.
Mr. Scott. Thank you. Your comments have been very helpful.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Virginia, Mr. Goodlatte.
Mr. Goodlatte. Thank you, Mr. Chairman. I want to thank
you, as others have, for holding this hearing, in fact, a
series of hearings which are very important as we work on this
issue. I would like to ask anyone on the panel about the
authorities that are proposed to be granted in this proposal.
Everyone, well, I should say, almost everyone supports greater
transparency, but transparency alone is not enough. Additional
authorities need to be granted to the regulators so that the
information that comes along with greater transparency is
meaningful. What regulatory authorities that are in this
proposal do you agree with? What ones do you disagree with? And
are there others that are not in this proposal that you would
consider? Anyone want to jump in there?
Mr. Hirst. I would be glad to start. Really I am just
repeating what I said earlier sir. But the most important issue
from the airlines standpoint is position limits in the oil
futures market. And this proposal clarifies the CFTC's
authority to impose position limits in all markets that have a
price discovery function of significance, not just the
exchanges.
There is ambiguity largely because of the loopholes in the
Commodity Futures Modernization Act; and we think the thrust of
this bill, if it becomes a bill, would be very helpful in that
regard.
Mr. Goodlatte. Anyone else? Mr. Schryver?
Mr. Schryver. We also support position limits. We think
they need to be enforceable, as Mr. Hixson said. We also think
they need to be aggregate, so you don't have a case where an
entity moves from one area to another to escape position
limits.
Mr. English. Reporting and position limits.
Mr. Hixson. I think we are directionally okay on the
transparency. But you have hit on probably--what we would
probably view as the most complex part of the bill is truly
understanding what the authorities are relative to the CFTC,
SEC, and how they are split. I will have to just get back to
you with a more detailed answer.
Mr. Goodlatte. Okay. Thank you.
You know, this Committee has witnessed firsthand how poorly
the CFTC and the SEC work together. The Commodity Futures
Modernization Act passed by this Committee nearly 10 years ago
charged them with a few joint rule-makings. We are still
waiting for the two agencies to produce what the law mandated a
nearly a decade ago.
This proposal is replete with joint rule-making between the
CFTC and the SEC, and I want to know if this causes any concern
to anyone. Is anyone concerned that the Secretary of the
Treasury will make the decision if the two independent
regulators can't?
The gentleman from New York is concerned. Anybody on the
panel?
Mr. English. I have a little history with that, and I think
your concerns are very valid. I think you have to take that
particular provision with an understanding of the history and
the likelihood of not much improvement for the future. So it
sounds good, it is a nice phrase, but the history kind of
indicates it is not likely to take place.
Mr. Goodlatte. Is there anyone else?
Let me also ask you--and again I will address this to the
whole panel--what percentage of your current swap contracts
would be considered standardized, and how much more do you
think it will cost to trade those same contracts on-exchange
and have the contracts cleared by a designated clearinghouse?
Where will you get the money to cover the increased costs, and
how will the trading and clearing mandate affect your risk
mitigation strategy?
Mr. Hirst. On behalf of Delta Air Lines, and I can't really
speak with precision for other airlines, virtually all our
hedging activity takes place in swaps market. We do not have to
post initial margin. If we had to transfer that activity into
the regulated exchanges, post initial margin, a sort of back-
of-the-envelope estimate that we made a couple of weeks ago was
that it would cost us about $300 million annually in liquidity.
Mr. Schryver. From APGA's perspective, most of the
contracts we engage in we believe would be considered
standardized. It would have a significant cost upon our members
at roughly $5,000 a contract; it would certainly reduce their
ability to hedge.
Mr. English. Most would be considered standardized. There
is no question that it would cost us hundreds of millions of
dollars, and we would just have to borrow the money.
Mr. Goodlatte. And Mr. Hixson.
Mr. Hixson. Well, that is an interesting question. Like I
said, even though we trade the vast majority, some 85 to 90
percent, kind of, on the exchange already, the move to roll in
these other products would cost us an additional billion
dollars a year.
Mr. Goodlatte. That is pretty--collectively, you are
talking about a couple of billion dollars or more. That is
pretty stunning.
Mr. Hixson, currently, when you enter into a swap, do you
know who your counterparty is?
Mr. Hixson. Yes, we do. That is kind of the nature of the
swap. It is a very bilateral transaction between two known
counterparties.
Mr. Goodlatte. How much due diligence do you conduct before
you enter a swap with most of your other parties?
Mr. Hixson. An enormous amount. It is a critically
important component of what we do.
First of all, we typically try to have a relationship with
them and understand what their business model is. We generally
offer most of our hedging activities in markets where we have
some physical presence, so it is in the food and agricultural
and maybe energy industry. So we do that.
We also do margining with about 80 percent of our
customers, so it is not like there is no margin that goes on,
it is just set on a different parameter. And then we also have
an independent credit department within the company as well. So
we do margining, a lot of research on understanding their
physical needs and their risk tolerances, and then also have
credit analysis on top of that
Mr. Goodlatte. Mr. Chairman, I know my time has expired. I
wonder if I could ask one follow up to Mr. Hixson about that.
If you are forced to clear, does the increased cost of
clearing pay for the benefit of not needing to know who your
counterparty is, or is that just a cost that outweighs the
benefit?
Mr. Hixson. Well, it probably outweighs the benefit because
we use the markets for different purposes to some degree. Like
I said, we trade extensively, and we are huge fans and just
supporters of the regulated exchanges. For price discovery and
for the bulk of our trading and hedging activities, they serve
that purpose really well.
But the expense you would be adding on the over-the-counter
side for many counterparties and customers that don't have that
in-house trading and hedging expertise that would by far
outweigh the benefit over there.
Mr. Goodlatte. Thank you.
Thank you, Mr. Chairman.
Mr. Boswell [presiding.] Let's see. I am trying to fill in
up here and see who we have up next. I believe it is Mr.
Schrader from Oregon.
Mr. Schrader. Thank you, Mr. Chairman.
I guess a question for the panel as a whole is, a few years
ago, the CFMA was passed; and I am curious how that changed
your investment, your accounting and your hedging practices,
and whether or not it affected the margins you are required to
have.
Mr. Hixson, I'll start with you.
Mr. Hixson. Cargill has been in the risk management
business offering customized risk contracts and the OTC product
since 1994. So for the types of bilateral transactions we do,
where we oftentimes have a relationship of selling the
product--corn or beans or flour, for example--it didn't really
change much in the dynamics of the products that we tend to
offer.
Mr. English. We created a group that I mentioned earlier
known as ACES Power Marketing. It is owned by our members. It
is there specifically for that purpose, to handle risk
management, and to also do the kind of examination, as far as
counterparties are concerned, that minimizes any exposure we
might have.
Mr. Schryver. The CFMA did provide greater certainty to
swaps, and as a result, more of our members are using them to
hedge.
Mr. Hirst. Mr. Schrader, our main concern with the CMFA is
the effect it had on the CFTC's jurisdiction over the
nonexchange-traded futures markets and the impact that that has
had, we think, on increasing speculative activity and causing
volatility in the spot market for oil.
Mr. Schrader. I tend to agree with Mr. Hirst. I would think
that is a critical element that needs to be readdressed, and
hopefully we get to, to some degree, in legislation here.
Most of you have testified about the margin requirements
being perhaps the most onerous of the potential changes you see
coming down the road here, and some exemption for end-users.
Could you define that a little bit more and assume you are
trying to get to the middlemen that have no stake in the game,
if you will, at any point in the process? Could you talk a
little bit more about how you would exempt end-users?
Mr. Hixson. In our testimony, I think we kind of
characterize what we think the intent of the legislation is, to
go after the hedger, the classical definition of somebody, like
I said, the baker who has the underlying flour coming into
their business and they need to run their plant. So that is
kind of how we structured our test for what would be the proper
terms of the exemption, would be whether or not, kind of like
the folks at the table, you are a classical hedger. You have an
underlying commodity; you are just trying to lay the OTC hedge
on top of that to take out the volatility and to address the
risk.
Mr. English. I would agree.
Mr. Schryver. Yes, we would also support an exemption for
hedgers.
Mr. Hirst. I thought Mr. Hixson's articulation was clear.
We agree with it.
Mr. Schrader. So you could come up with the language, I
assume, to make that possible. I think the Committee would be
interested in that.
I yield back my time, Mr. Chairman.
Mr. Boswell. Thank you.
Mr. Roe.
Mr. Roe. Thank you, Mr. Chairman. I have just a couple of
quick questions.
Everybody always hates to pick up the phone the day your
broker is on the line to let you know your margin call is in.
And I guess, Mr. English, I am going to you because I live in a
rural area of Tennessee. I wonder about the costs of this,
added costs, we have, potentially, the carbon tax that is going
to add cost to our consumers in these rural areas and then
across America.
How much are you talking about for the individual customer
or business out there? I mean, I know you are paying interest
on the money you have to borrow and you have to find a line of
credit and all that.
The same thing I guess would go for Mr. Schryver, too.
Mr. English. I think you have to view this--what we are
discussing here today is the world as it exists today. We would
expect that you are going to see a significant change either
through the Clean Air Act and the dealing of the issue of
carbon through that mechanism or through any legislation.
And as we move forward in trying to deal with that--for
instance, a lot of our members are going to be looking to
natural gas in the short term. That is good news for Mr.
Schryver. He is very happy with that.
But the point that I would make is, that brings a good deal
more volatility in this whole issue, so there is a greater need
to hedge. There is a greater risk that we are going to be
facing. And depending upon how this legislation addresses this
particular problem, obviously, it could very well be hundreds
of millions of dollars very easily, just with regard to
addressing this question. That's not counting additional costs
we might have as we have to make a conversion, which is going
to be very costly indeed.
Mr. Roe. If you are covering 12 percent of the population--
--
Mr. English. That is correct.
Mr. Roe. It would be more than hundreds of millions if you
are hedging.
Mr. English. That is--again, it is difficult to estimate
how risky, how much additional risk would be involved. But just
looking at natural gas alone and the shift we would anticipate,
obviously it is going to be far greater than what we are
looking at today, without question.
Mr. Schryver. Actually--and in terms of climate change
legislation, we are actually a little concerned. I don't know
how much Public Gas is going to benefit because we are
concerned about more natural gas being used for electricity
generation.
As Mr. English said, it will become the fuel of choice; it
is going to increase demand and drive up the prices. And our
members are the direct users of natural gas. So that actually
is one of our concerns, largest concerns, about climate change
is the price of natural gas being driven up.
In terms of the cost of margining, I will use one example.
One of our members, that also generates electricity, will hold
thousands of contracts at one time as part of a 3 year hedging
program. They anticipate that it would increase their costs by
about $25 million. They also did a prepay, which is a tool
Congress endorsed as part of the Energy Policy Act of 2005. It
allows the use of tax-exempt financing for natural gas
contracts to allow public gas systems to provide natural gas
for their consumers over the long-term at a lower rate.
And those prepaids are very large, over long periods of
time, sometimes as long as 30 years. One prepay involved 15,000
contracts. And to clear that prepay at $5,000 a contract, you
are talking $75 million, which, in effect, eliminates the
ability of public gas systems and public power systems to do
prepays.
Mr. Roe. Well, we know that natural gas companies are going
to pay, consumers are. I mean, that is who pays the bill. When
you talk about paying it, that is who is going to pay it.
And I guess what we want to do in the futures market--quite
frankly, it seemed to work pretty well during this financial
crisis, banking crisis and so forth that we had. It seemed to
work fairly well because there is a buyer on each side of the
trade. And I mean, it worked well.
I guess putting those requirements so high on what you are
talking about adds another cost to the consumer, along with
other costs that are heading along. And I know the co-ops in
our area work as hard as any business I have ever seen to keep
the costs down for consumers since they are nonprofits.
Thank you. I yield back my time, Mr. Chairman.
Mr. Boswell. Thank you.
Mr. Kissell.
Mr. Kissell. Mr. Chairman, the couple of questions I had
prepared basically have been asked. I am going to yield my time
to Mr. Marshall from Georgia.
Mr. Boswell. Okay. Mr. Marshall.
Mr. Marshall. Thank you, Mr. Kissell.
You all can really help us out a lot, as you give us advice
concerning how to modify the proposal so as not to unduly
burden you, if you can really pin down what the cost of the
burden would be.
And I am certain there are folks out there, right now,
working up a business model where they are going to lend margin
money. And so it is a matter--obviously, I am asking you to
assume that that market will be there; and so let's say it is a
billion dollars' worth of margin money that is needed.
What is going to be involved in the cost to carry for
borrowing that money? What is the real cost of putting up
margin? And then the typical swaps deal contemplates that as
the price moves, money is going to get put up.
So that is the other thing. If we require clearing and if,
in essence, the clearing organization is going to require the
exact same money to be put up as the price moves, that doesn't
really change anything at the moment. But what it would maybe
tend to do from our perspective is give us greater comfort that
there is less systemic risk on the other end since all this
stuff seems to be packaged in just a few AIG-type entities.
And if you could help us think through that, I think it
would be enormously useful to us because we just don't have the
kind of expertise that you all have.
Now, it may be we can avoid the systemic risk that is our
real focus here. I mean, as I said before, we all think, the
Chairman is absolutely determined not to put any burden on you,
or on your customers, or on American consumers that we don't
view as really necessary to avoid systemic risk. So if you can
come up with some other way that we can minimize the systemic
risk that these big banks pose, that would really be helpful to
us. And obviously to others who are listening in on the hearing
with views on both sides, that would be enormously helpful as
well.
With that, Mr. Chairman, Mr. Kissell, maybe I should yield
back to you if you have some additional thoughts along those
lines.
Mr. Kissell. Thank you, Mr. Marshall.
Mr. Chairman, I yield back.
Mr. Boswell. Okay. I believe that you are next in line.
Please.
Mr. Cassidy. I moved up here without a sign. I am Mr.
Cassidy.
You know, you guys think about this all the time, and I am
trying to understand it now from your perspective. But in my
mind, I think of those folks who would like to do an OTC, such
as you collateralizing your capital to somehow interface with
the folks that would do a monetized exchange.
I think of that kind of Greek myth of Janus, the god that
looks both one way and the other. This legislation obviously is
trying to create something to interdigitate the two systems,
OTC and an exchange. How would you do it?
If you were running the exchange, Mr. Hirst, I guess Delta
puts the value of their jets as collateral, I can imagine. How
would you interdigitate this OTC market with the standardized
exchange?
Mr. Hirst. Well, sir, again, our major concern is in the
price of the commodity itself. And hedging is a luxury for us
in relation to actually buying oil, which is a necessity.
The volatility that the market has experienced over the
last several years has not only increased our fuel costs, but
it has vastly increased our cost of hedging. And so my answer
to that question really is to--is really the Administration's
answer here. I think it is to give the authority to the CFTC to
think through how that relationship should be managed.
Mr. Cassidy. Mr. English, how would do you that? You have
written legislation before, so----
Mr. English. I think we are dealing with--and it was
mentioned earlier--between the CFTC and the SEC. I haven't
examined recently what the budget is of the CFTC. But
historically speaking, CFTC has been viewed more as a stepchild
from the standpoint of appropriations and resources. It came
into being at a time in which regulation was not in vogue,
didn't have the support, I don't think, of the Congress,
political community in general.
I think, without question, in many of these areas, it is
not just a question of what is in the law, it is a question of
whether or not the regulatory agency is going to have the
resources to be able to carry out the law in a fashion which is
intended.
Mr. Cassidy. So, you are suggesting that you wouldn't
necessarily interdigitate the two. You would rather just
strengthen the ability of the CFTC to monitor and create
transparency and allow the market to continue somewhat as is?
Mr. English. I think that is an area that I would certainly
examine carefully. And as I said, I haven't reviewed where we
are, from a resource standpoint, of what the strength is. And I
am thinking about this from years ago, but I doubt that it has
changed all that much, to be honest about it.
But I think that as we move forward on this, we have to
keep in mind, keep in view that people such as ourselves, we
are looking for a way in which we can deal with the risk.
Mr. Cassidy. Let me move on just because I am going to run
out of time.
Mr. English. Right. If the cost gets too high then we are
out of it, so it would defeat the purpose.
Mr. Schryver. I believe Mr. Hixson discussed a dealer
taking on that function, and that is something that we would
support.
Mr. Cassidy. So will you repeat that, sir?
Mr. Hixson. I want to make sure I have clarity on your
question too. If I understand it correctly, it is kind of
what--how would you correlate the relationship, if you will, in
the regulatory status of the over-the-counter side and the
regulated exchange side?
Mr. Cassidy. As I understand, the end-user would be exempt
unless somehow--but on the other hand when you transfer into
the standardized exchange, the exemption becomes threatened, if
you will.
Mr. Hixson. Correct. So that is why in our testimony and
kind of our recommendation, what we--the modifications we made
really steered it towards looking more at the what the
transaction is.
If it goes back to that classical sense of, it is a hedge
and there is an effective hedge on an underlying risk, then
that is the nature of the transaction that should grant the
exemption. That is a more appropriate standard in terms of what
you are trying to prevent in the over-leverage and the types of
things that would capture those under that metric, but would
kind of allow the conventional hedging that we are talking
about to continue.
So that is kind of how I think we----
Mr. Cassidy. So would the utilities still be able to put up
their capital assets as collateral for the purchase of a large
amount of natural gas?
Mr. Hixson. To the extent that is appropriate.
I mean, I guess the main kind of OTC contracts are
generally secured in one of three ways. They either use a
credit agreement, they use collateral or they use some kind of
margining. And it is important to recognize that within the
over-the-counter markets, the classical hedging side of the
uses that were described here went through a very tumultuous
year and performed well.
So the challenging side of the market was where it gets
kind of split, leveraged, sold, far removed from the underlying
product; and it is a little bit of a strain in our minds to
call that necessarily a pure hedge anymore. So that is why we
choose that area to draw the line.
Mr. Schryver. Of those three options you laid out--
collateral, margining--a public gas system, its constitutional
documents would really prevent it from putting up its system as
collateral. And I can't think of any of the city councils that
regulate our members that would allow them to do that. So it is
really not an option for us.
Mr. Cassidy. Okay. Thank you.
The Chairman [presiding.] The gentleman from Ohio, Mr.
Boccieri.
Mr. Boccieri. Thank you, Mr. Chairman.
Just a quick question, specifically to the testimony of Mr.
English from the Rural Electric Cooperatives. How will OTC
reforms affect or not affect states that have a very solid
regulatory authority like Ohio with the Public Utilities
Commission? And how, somehow, is that managed with respect to
the risk associated, taking on derivatives?
Mr. English. As far as the state regulatory body, I am not
sure that that would have any impact. I am not sure on Ohio. I
am not that familiar with it, but I don't believe it would have
any impact as far as dealing with the risk issue in any
particular specific way. It wouldn't vary from state to state
whether regulated or not.
As you are probably aware, some states' electric
cooperatives are regulated, other states' are not. But I don't
believe in this case it would make any difference.
Mr. Boccieri. So no risk decisions are made based upon
states that have regulatory authority with respect to
derivatives that they take on?
Mr. English. In this particular case, with regard to
whether it is either dealing with interest rates or currency
swaps done through our national association, or whether it is
done through ACES, which your G&T in Ohio does participate in,
if I recall correctly and is a member of, it would be done
through that national association and not specifically through
the local, I don't believe.
Mr. Boccieri. Specifically, I was referencing the section
in your testimony that says, ``OTC markets manage the price
volatility risk for our consumers who expect affordable
electricity prices and electric suppliers.'' I was just curious
how you were drawing the connection between the OTC markets and
electricity prices in states that have regulatory authorities.
Mr. English. Well, what I was referring to and what the
concern is, if we get into a situation between the regulatory
body on the Federal level and FERC, we do have issues of
concern with regard to getting regulated by two Federal bodies
as opposed to state bodies. So that was a reference to FERC and
the fact that they do, in fact, have jurisdiction over any
physically settled transactions that--and under the Treasury
proposal, as I understand it, there is an exemption, but it is
not clear to our satisfaction that that would take care of the
problem.
Mr. Boccieri. Okay.
I just want to be clear that I understand this. So you are
suggesting that there would be an attempt to usurp state
authority to help regulate and control prices?
Mr. English. Well, there very well could be, under these
circumstances, depending on how this transaction played out.
But jurisdictional questions obviously are always of paramount
interest, and the thing that concerns us is if there is
confusion with regard to jurisdictions or if we are, in fact,
regulated by competing bodies.
Mr. Boccieri. Okay.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentlelady from
Ohio, Mrs. Schmidt. Did you ask questions already? No
questions.
Mrs. Schmidt. No, not at this time.
The Chairman. Mr. Thompson.
Mr. Thompson. Thank you, Mr. Chairman.
I thank the panel for coming in and sharing your
experiences. I want to back up a little bit for kind of a
35,000 foot look at this. We hear a lot about the driving force
behind this; the keyword has been ``volatility,'' and I was
really interested in getting your impressions of the situation
from your--and your observations.
In terms of trends by commodities, are there specific
commodities that you see the risk of volatility?
You know, sometimes we see a one-size-fits-all-type
approach to addressing problems, and it has a lot of unintended
consequences. We have also heard that word here in the hearing.
And so I was curious to see if, in your observations, your
experience, are there specific commodities that really are
within this risk of volatility to be impacted that way?
Mr. Hirst. Mr. Thompson, I don't claim to be a commodities
expert from the airline business. But we have been focused on
the price of oil over the last 2 years because we have seen so
much volatility in the price that we have had to pay. And as I
have tried to study it, it has become clear that oil is a
commodity that is highly susceptible to the levels of
speculative activity in the futures market.
Now, when I observe what is happening in other commodities,
I can't say that the same factors that are affecting the price
of oil work exactly the same way in, say, the gas market or in
other markets. So I tend to agree with your observation that
one-size-fits-all approaches probably won't work, and that
there are different problems in different areas. There are
different issues and different kinds of systemic risks
presented by financial derivatives, financial markets versus
derivative activity in commodity markets, for example.
Mr. Thompson. And I bring that up, because in listening to
you reading your testimony and listening to your remarks, I
have heard you talk about--when we talked about commodities, we
have been talking about energy, energy, energy. And even Mr.
Hixson, part of the testimony was energy--not all, but part of
it. And so I wondered if there were any observations of other
areas of commodities.
Mr. Hixson. Maybe I could share one example, that it just
highlights the challenge of tightly correlating volatility with
speculation or whatever the activity is. And the example I
would use is one of the more volatile commodity markets last
year was the hard red spring wheat market in the Minneapolis
Grain Exchange, not a large commodity market and has virtually
no index money it. Wheat went to $25 a bushel last year and was
by far one of the more volatile than probably Chicago or the
other commodity markets that also traded other categories of
wheat.
So it is not always easy to correlate strictly volatility,
per se, with distribution of participants in the market.
Mr. Thompson. Thank you.
We have talked about petroleum, and of course we have a
couple of witnesses that deal directly with natural gas. And
obviously, that is not a world market, meaning that we can
significantly influence its price here at home through supply
and demand.
Mr. Schryver, in your view, what role has domestic supply
played in the volatility of the natural gas prices?
Mr. Schryver. In going back to what you said earlier in
terms of volatility, natural gas has been one of the more
volatile commodities out there. I think last year the price hit
$13, and now it is down below $4. We are not complaining about
that, but unfortunately, some of our members did buy $13 gas,
and they should have because their hedging strategies would
entail them buying gas at certain times, and just hoping the
price will come down is not a viable hedging strategy.
And we are not opposed to all volatility. We understand
commodities will have some volatility. It is just unwarranted
volatility that has our members concerned.
In terms of natural gas, as you mentioned, it is
domestically produced. And as Mr. English stated, as Congress
anticipates climate change legislation, that demand for natural
gas is going to be driven up even more. And that is one of our
concerns. We would certainly--we have pushed for and we would
be very supportive of Congress opening up more areas for
production and allowing more production of natural gas. The
more supply you have, to some extent you are going to reduce
the volatility of the commodity.
Mr. Thompson. Well, I have 15 counties with Marcellus Shale
I would love to offer for that.
Congressman, it is good to see you again. Just real quick--
final--obviously, Pennsylvania relies really heavy on coal and
oil and natural gas for energy demands. And I just wanted to
get your impact on what effect this legislation, if it would go
through, as it is at this point, would have on overall
electricity costs.
Mr. English. Well, for our members, and again, looking to
the future and taking into account climate change, we could
think it could have a huge impact. We think it could, in fact,
increase electric bills and increase them considerably.
And we fully understand and appreciate where the Committee
is going, appreciate the objective of the Committee, but this
is a balancing act that we are looking at here. On one hand is
the cost of the risk, on the other hand the cost of the
regulation. And somewhere in here we have to find a way in
which we can hedge and deal with the risk and still make it
affordable for people like us.
Mr. Thompson. Thank you.
The Chairman. I thank the gentleman.
The gentleman from Michigan, Mr. Schauer.
Mr. Schauer. Thank you, Mr. Chairman.
Mr. Hirst, I want to direct a question to you. Thanks for
being with us. Thanks for all of you. Your airline has a major
presence in my State of Michigan. I appreciate that. And I am
studying your testimony very carefully.
Your airline, it indicates, eliminated nearly 10,000 jobs
in 2008 as a result, at least in part, of oil price volatility.
It is difficult to estimate how many jobs were lost overall in
our country's economy due to that price volatility and the
market. Consumers certainly experienced that at the gas pump,
certainly in the price of groceries and a number of other
areas.
You talked about how a certain level of speculative
investment in commodity markets has the benefit of injecting
liquidity into the market. But then you state that Congress
should provide the Commodity Futures Trading Commission with
the authority and guidance it needs to ascertain the proper
level of speculative investment in the market.
Give me the best guidance you can. What is that proper
level? I am very concerned about the impact on speculation
driving up prices, costing us jobs, and hurting our economy. So
can you expand upon your written testimony and give us some
more guidance on that proper level?
Mr. Hirst. Well, I will do the best I can, sir.
Ten years ago, if you looked at various measures of the
volatility of oil prices, spot prices, you would conclude that
the level of volatility was not high. From 1998 roughly through
2003-2004, the years' high price versus the years' low price
varied about $15 or $16, typically.
Since that time, as speculation in the market has gone from
about 25 percent of the market, the oil futures market, to 70
or 75 percent, volatility has increased. So, on an annual
average over the last 3 years it has been over $50. And so I
would say, at least as a starting point, one ought to go back
to a period of time, not so long in the past, before index
funds became a huge factor of the market, and look at what the
level of speculative activity was then and use that as a
benchmark. And our estimate is that that was in the 25 percent
range.
There was adequate liquidity. People who wanted to hedge
could hedge. And airlines that needed to buy fuel could buy
fuel without experiencing the kind of devastating impacts we
experienced in 2008 that led directly to the loss, as you said,
of 10,000 jobs.
Mr. Schauer. How do you do that from a regulatory
standpoint? Do you set a cap?
Mr. Hirst. Yes, sir. There are two ways, and both--we think
both techniques should be adopted. It is possible to put an
aggregate limit on the level of speculative activity that is
financial activity as opposed to activity by commercial users
and producers at a level. And when I was speaking earlier of 25
percent, I meant that as an aggregate limit.
In addition, individual limits can be placed on
participants in the markets to ensure that no individual
participant has too much influence.
And both approaches have been given a lot of thought by the
CFTC and others.
Mr. Schauer. Thank you.
The Chairman. I thank the gentleman.
The gentleman from New York, Mr. Murphy.
Mr. Murphy. I want to go in a little different direction.
As we have seen so many of the banks pull back and some
consolidation in the financial sector, has that impacted
liquidity for you as you have been trying to hedge? Have you
guys been having trouble getting the bilateral contracts or
getting as aggressive a pricing?
Mr. Hirst. We have had no problem hedging.
Mr. Schryver. We have not heard any concerns from our
members.
Mr. English. We have heard concerns from our members about
this, yes.
Mr. Murphy. So they are seeing spreads widen?
The other piece that I hear a lot is, people say one of the
problems with some of the bilateral stuff is that you may be
able to get aggressive pricing getting in, but in a bilateral
you don't have the ability necessarily to get as aggressive a
price in getting out.
Do you guys see that if you ever tried to? Or maybe you
guys don't actually try to, if you are using these hedges, you
may never try to get out of some of these transactions, but I
am curious if you have seen spread problems when you try to get
out.
Mr. English. Just about everything we are doing is hedging.
We are strictly focused on hedging.
Mr. Hirst. Sir, in 2008, when oil spiked at $147 a barrel
and then in September dropped very rapidly, a number of
airlines, including Delta, were unable to unwind hedges and
experienced very significant hedge losses as a result. And that
kind of volatility, while it hasn't impacted the availability
of hedging, has significantly increased the risk and the prices
that we have had to pay.
Mr. Murphy. Mr. Hixson, did you want to get in on either of
those?
Mr. Hixson. No, sir.
Mr. Murphy. Okay. So some of the people that we see
testimony from--and this is more on the financial side, but I
am curious about how it would impact you guys. If we went to a
clearing system and got away from some of the bilateral stuff
or more of a fungible clearing system, that that might help
with that you describe, Mr. Hirst, and make some of this stuff
more easily transactible with other counterparties.
Is that something that you guys worry about at all? Or is
that an issue that just doesn't seem to apply?
Mr. Hixson. I don't think that seems to apply in our case.
I think we have said it before. We kind of welcome the moves on
transparency, but the tradeoff that you would get on the cost
structure and the challenges on working capital would be
farther off-site.
Mr. Murphy. I follow that for sure.
That is all. I yield my time back.
The Chairman. I thank the gentleman.
Anybody else?
Mr. Marshall, do you have a follow-up?
Mr. Marshall. Mr. Kissell was kind enough to yield me some
time. Thank you, sir.
The Chairman. Well, I think that will wrap it up for this
panel. Thank you very much. I think we have gotten some good
information that we need to focus on and figure out how we sort
this out.
So I thank the panel for your testimony. Send us your
ideas, and we will take a look at them and see what we can do.
Thank you.
They were talking about having votes, but I guess we will
call the next panel and, hopefully, see how far we can get
here. And we have to switch around the nameplates, I guess, and
so forth.
But while we are doing that, and to save time, I will
announce the panel, panel two, which is Mr. Gary O'Connor, the
Chief Product Officer of the International Derivatives Clearing
Group of New York; John Damgard, the President of the Futures
Industry Association in Washington; Mr. Terry Duffy, Executive
Director, of the CME Group of Chicago; Mr. Robert Pickel,
Executive Director, Chief Executive Officer, International
Swaps and Derivatives Association, New York; Mr. Johnathan
Short, Senior Vice President, Intercontinental Exchange of
Atlanta; and Mr. Daniel Budofsky, Davis Polk & Wardwell on
behalf of the Securities Industry and Financial Markets
Association.
I think we have about 10 minutes, so we are going to have
two of you give your testimony and then we are going to have to
take a break to have votes and we will be back.
Does anybody know how many votes we have? Nine to ten.
Well, we will get a couple of you guys' testimony in, and then
it sounds like there will be time for you to go have lunch,
because we have nine or ten votes, so it will probably be an
hour before we get back. So let's make use of the time.
Mr. O'Connor, welcome to the Committee. We look forward to
your testimony.
STATEMENT OF GARRY N. O'CONNOR, CHIEF PRODUCT
OFFICER, INTERNATIONAL DERIVATIVES CLEARING GROUP, LLC, NEW
YORK, NY
Mr. O'Connor. Chairman Peterson, Ranking Member Lucas, my
name is Garry O'Connor, and I am the Chief Product Officer of
the International Derivatives Clearing Group, or IDCG. IDCG
currently offers a cleared solution to the OTC interest rate
derivatives market through a CFTC-regulated clearinghouse. I
appreciate the opportunity to appear before you to discuss the
legislation proposed by the Treasury.
IDCG applauds the considered approach of all regulatory
bodies who contributed to the proposed legislation. We believe
that the goals of reducing systemic risk, promoting
transparency and efficiency, and preventing market abuses are
achieved by the proposed legislation without substantive
change, but we think that they can made more effective in these
three areas.
First, we believe that the test that an OTC derivative is
standardized for the purpose of clearing should be different
from the test that an OTC derivative is standardized for
exchange trading; second, how the definition of major market
participant is used; and finally, the importance of governance
independence of clearinghouses and exchanges.
First, the issue of what is standardized: The term
standardized itself has led to some confusion as it suggests
the customized aspects of the contract need to be stripped
away.
This is not the case. This has been particularly troubling
to corporate America that sees tremendous value in these
customized products. But if there exists a strong valuation
backbone and sufficient liquidity to cure a default, then there
is no good reason why these products cannot benefit from
clearing.
There are some products, however, that while suitable for
clearing, do not lend themselves to exchange trading.
Essentially, you need a certain velocity of transactions in
order to get the price transparency and market efficiency that
an exchange can deliver.
We would suggest mandating exchange trading for an OTC
derivative only if it is listed for trading by a regulated
exchange. As with the presumption of standardized for clearing,
this definition does not force the exchanges to do something
they do not have the capability to do. It already is subject to
regulatory overview and adapts dynamically to changes in the
marketplace.
Now, to major market participants, we would urge caution in
allowing exceptions for those who do not qualify for this
designation. Many of the problems of the current crisis were
caused by activities of institutions that slipped through
regulatory cracks, the obvious example being AIG. We worry that
by introducing exceptions into the legislation that these same
cracks may be opened up.
Corporate America again has been very vocal to ensure their
beneficial use of OTC derivatives is not impacted by regulatory
reform. However, there is no reason, there is no technical
reason why this legislation should curtail their use of these
products.
While it is the task of legislators and regulators to limit
the impact of failure of a systemically significant institution
in the future, it should also be the obligation of our industry
leaders to ensure that their institutions, customers and
employees are also protected.
To simply assume that the government of the day will
continue to support their counterparts in the financial system
is not good enough. Central clearing is the tool that allows
them to mitigate this exposure and to contribute to a stronger
financial system.
Finally, the issue of independence, given the important
role that clearinghouses and exchanges have to play in
facilitating the change in structure of the OTC derivatives
market and their role in determining what is standardized, I
would encourage their substantial governance independence from
any participant or group of participants. This will be
essential to the development of open and competitive platforms
and, without it, confidence will be eroded and the value
provided by these tools will be lost.
Thank you, Mr. Chairman on behalf of IDCG and myself for
the opportunity to appear here today. I would be happy to
answer any questions you may have.
[The prepared statement of Mr. O'Connor follows:]
Prepared Statement of Gary N. O'Connor, Chief Product Officer,
International Derivatives Clearing Group, LLC, New York, NY
Chairman Peterson, Ranking Member Lucas, my name is Garry O'Connor,
and I am the Chief Product Officer of the International Derivatives
Clearing Group (IDCG). The objective of IDCG is to bring a centrally
cleared solution to the largest segment of the over-the-counter (OTC)
derivatives market, specifically interest rate derivatives. This is
something that we do today through the operation of a U.S. Commodity
Futures Trading Commission (CFTC) regulated clearinghouse. IDCG is
independently operated with majority ownership held by the NASDAQ OMX
Group and minority stakes held by Bank of New York, founders, and
management. I have spent close to 2 decades in the OTC derivatives
markets trading interest rate derivatives for large U.S. Investment
Banks. IDCG appreciates the opportunity to appear before you and we
look forward to discussing the proposed the Over-the-Counter
Derivatives Markets Act of 2009 (the Proposed Legislation) put forward
by the U.S. Department of the Treasury on August 11, 2009.
Today we will show our support for the form of the Proposed
Legislation, highlight the urgency with which it should be introduced,
and point out three areas where we feel that it can be made more
effective.
First and most importantly we want to point out the urgent need for
regulatory reform. It is perhaps becoming a worn out point, but we now
stand 1 year on from the collapse of Lehman Brothers and we cannot look
back with pride upon the changes we have made. There is no doubt that
these are complex issues that require due consideration but at the same
time we hold grave concerns that the further away from the trauma of
the financial crisis that we move the less urgency will be felt to
address the underlying faults in our system of regulation. We must not
fall into this trap. The OTC derivatives markets currently represent a
greater risk to our underlying economy than they did before the
financial crisis began. They are failing to effectively fulfill their
role as a venue for the efficient pricing and transfer of risk, are
further exposed by the attrition amongst major banks who act as the
major liquidity providers, resulting in tremendous levels of
concentration, and finally are dominated by the world's largest banks,
which are rapidly returning to the same levels of risk that drove them
to the brink of collapse less than twelve months ago.
The OTC derivatives markets are failing to provide a venue for the
efficient pricing and transfer of risk. Reduced competition within the
banking sector, the traditional providers of liquidity to these
markets, has allowed the major banks to increase their price for
liquidity. A number of much respected individuals within significant
market participants have made this observation;
b Larry Fink, Chief Executive of BlackRock, has highlighted the
``luxurious'' profits being enjoyed by Wall Street banks,
reflecting their ability to take advantage of diminished
competition.
b Mohamed El-Erian, Chief Executive of PIMCO, pointed out ``bid-offer
spreads have remained unusually wide, notwithstanding the
normalisation of financial markets''.
b Ken Griffin, Chief Executive of Citadel, commented in his testimony
to the Senate Banking Committee on the egregious spreads being
charged by traditional liquidity providers on OTC derivative
transactions, in part because of the lack of price depth.
While the commercial interests of the major banks are clear the
market structure in which this situation has been allowed to develop
needs to be addressed. End users are desperate for a more diverse base
of liquidity providers to bring transaction costs back to pre-crisis
levels and to provide a buffer to the extreme volatility that has been
present in financial markets since the summer of 2007. Only by allowing
new and existing participants access to these markets in an open and
competitive manner can this be addressed. All to all central clearing
and exchange trading are the tools to achieve this.
In a market with a high concentration of participants, the risk of
the failure of a single entity becoming a systemic event is increased.
The Comptroller of the Currency indentified just such a situation in
the OCC's Quarterly Report on Bank Trading and Derivatives Activities
(2009 Q1). It was shown that derivatives activity in the U.S. banking
system is dominated by five large commercial banks which represent 96%
of the total industry notional outstanding and 83% of the industry net
current credit exposure. 90% of this derivatives activity was reported
as being OTC in nature. IDCG's own shadow clearing service, which has
currently processed close to USD 600 billion in notional, has confirmed
the presence of this kind of imbalance in the USD interest rate swap
market. Further evidence of this concerning situation can be seen in
the Bank of International Settlements (BIS) Semiannual OTC derivatives
statistics (2008 Q4). The Herfindahl Index, which measures market
concentration, is at its highest level in published history for USD OTC
interest rate derivatives. Perhaps more concerning is how the U.S.
market has fallen behind other major markets, notably Europe, in this
regard and now demonstrates a higher concentration than much smaller
markets such as Sweden and Japan where one would expect a natural bias
towards a smaller number of participants. Only by allowing new and
existing participants access to these markets in an open and
competitive manner can this be addressed. All to all central clearing
and exchange trading are the tools to achieve this.
We can see through Regulatory Filings that Banks are increasingly
and heavily reliant on their trading desks for revenue as their
traditional banking revenues still struggle to recover from the
financial crisis. Specifically, as Stevenson Jacobs has recently
reported for the Associated Press, the same five largest banks which
dominate the OTC derivatives markets average potential loss from a
single days trading exceeded $1 billion in the second quarter. This
represents a 75% increase over the past 2 years. When you consider
large banks are taking more risk in markets that are more intertwined
and less liquid than they were 2 years ago it is easy to see why we say
the OTC derivatives markets currently represent a greater risk to our
underlying economy than they did before the financial crisis began.
Again the only solution is to allow new and existing participants
access to these markets in an open and competitive manner. All to all
central clearing and exchange trading are the tools to achieve this.
Urgency aside, IDCG applauds the considered approach of all the
regulatory bodies who contributed to the Proposed Legislation. The
stated goals of; guarding against activities in OTC derivatives markets
that would pose an excessive risk to the financial system, promoting
the transparency and efficiency of OTC derivatives markets, preventing
market abuses and the inappropriate marketing of OTC derivative to
unsophisticated parties, are an appropriate response to the financial
crisis that we have all faced over the past few years. We believe that
these goals are achieved by the Proposed Legislation without
substantive change but think that they can be made more effective in
three areas:
1. The test that OTC Derivates is ``standardized'' for the purpose
of clearing should be different to the test that an OTC
derivatives is ``standardized'' for the purpose of trading on a
regulated exchange or alternative swap execution facility,
2. The definition of Major Market Participants, and
3. The importance of the independence of clearinghouses.
What is ``standardized''?
The presumption in the Proposed Legislation that an OTC derivative
that is accepted for clearing by a regulated central clearing house is
``standardized'' is a very simple solution to a difficult problem. The
risk in a more traditional definition was a raft of unintended
consequences and a definition which failed to adapt to changes in the
marketplace. The term ``standardized'' itself however, can lead to
confusion, as it suggests that the customized aspects of the contract
need to be stripped away, which is not the case. This has been
particularly troubling to corporate America who sees tremendous value
in these customized products. In a traditional futures clearinghouse
this may have been the case due to technology constraints, but as
clearinghouses adapt OTC risk management systems and approaches they
will be more than capable of offering cleared solutions for the vast
majority of these products. If there exists a strong valuation backbone
and sufficient market liquidity to cure defaults then there is no good
reason why these products cannot be cleared.
Some products however are not suitable for exchange trading, even
if they can be cleared. There is little reason to force an infrequently
traded customized product onto an exchange. Doing so will only result
in wide prices and potentially erroneous price information, effectively
the opposite of the price transparency and efficient execution that an
exchange is designed to deliver. If the price of this customized
product can be easily implied from a pool of deeply liquid instruments,
which are suitable for exchange trading, then the benefits of price
transparency and market efficiency are more easily reached through
central clearing without the potential misinformation generated by
forcing them to an exchange.
We noted with interest the change in language from the original
Administration white paper, which suggested the encouragement of
exchange trading, to the final proposal which mandates it for all
``standardized'' contracts. There is no doubt this decision was not
taken lightly, and motivated by significant benefits that exchange
trading can bring and the difficulty in effectively defining what is
suitable in legislation. We would discourage the mandating of exchange
trading for products simply because they are suitable for clearing; we
see this as restricting the amount of clearing that is done. Instead we
would recommend a presumption of the same style that has been used to
define ``standardized'' clearing products. If an OTC derivative is
accepted for trading by a regulated exchange, then it should be
considered ``standardized'' for that purpose. In the same way as the
original definition, this prevents forcing the exchanges and
clearinghouses into something they do not have the capability for and
remains flexible enough to adapt to changes in the marketplace.
Who are Major Market Participants?
We would urge caution in allowing exceptions for those who do not
qualify for designation as Major Market Participants. Many of the
problems of the current crisis were caused by the activities of
institutions that slipped through the regulatory cracks, the obvious
example being AIG. We worry that by introducing exceptions into the
legislation these same cracks may be opened up. There is no way to
identify who the next systemically devastating organization may be
other than by throwing a wide and thorough regulatory net. Corporate
America has been very vocal to ensure their beneficial use of OTC
derivatives is not impacted by regulatory reform. However, as detailed
earlier in this testimony there is no reason why central clearing
should curtail their use of these products. Nor do we see why Corporate
America should be immune from being part of the solution to the crisis
we find ourselves in.
One of the most frustrating aspects of the current financial crisis
is that all the American people are paying the price for it, not just
those who instigated the problem. While it is the task of Legislators
and Regulators to limit the impact of failure of a systemically
significant institution in the future, it should also be the obligation
of our captains of commerce to ensure that their institutions are not
exposed unduly to the same failure. To simply assume that the
government of the day will continue to support their counterparts in
the financial system is not good enough. Central clearing is the tool
that allows them to mitigate this exposure and contribute to a stronger
financial system.
We would encourage the adoption of CFTC Chairman Gensler's
suggested enhancements to the Proposed Legislation which he outlined in
a letter to the Chairman and Ranking Member of the U.S. Senate
Agriculture Committee on August 17, 2009. In particular the categories
dealing with removing the suggested exclusion of foreign exchange swaps
and the removing of exceptions to the mandatory clearing and trading
requirements. This last section especially demonstrates the CFTC's in
depth understanding of the mechanics of the industry and how they
impact the objectives of policy. As an aside, the major market
participants that IDCG speaks to all identify a Futures Commission
Merchant (FCM) cleared solution under the auspices of the CFTC as the
most robust clearing model available and one that is easiest, cheapest,
and fastest for them to adopt. This is something that the CFTC and its
officers should take great pride in.
Why is independence important?
The final point we would make is regarding the independence
governance of clearinghouses and exchanges. Given the important role
that clearinghouses have to play in facilitating the migration of the
OTC derivatives market into a centrally cleared and exchange traded
environment and their role in determining what is ``standardized'' I
would encourage their substantial independence from any single
participant or group of like participants. This will be essential to
the development, perceived or otherwise, of open and competitive
platforms. Clearinghouses must navigate a fine line when establishing
an appropriate price for risk. Charge too much and become
uncompetitive, charge too little and fail at their mandate. When a
market participant with a significant governance position has a clear
interest for that balance to be tipped in their favor, regardless of
how appropriate the price for risk is, confidence will be eroded and
the value provided by central clearing will be lost.
In conclusion, we have highlighted the urgent need for change in
our regulatory system to correct the imbalances in the current
marketplace and prevent a repeat of the financial crisis that we find
ourselves in today. IDCG supports the form of the Proposed Legislation
that is before you and offers three suggestions where the effectiveness
of this proposal may be enhanced; standardization, exceptions, and
independence. Thank you, Mr. Chairman, on behalf of IDCG and myself for
the opportunity to appear here today. IDCG looks forward to continue
working with all branches and agencies of government to help develop
the strongest and most competitive market place possible. I would be
happy to answer any questions you may have.
The Chairman. Thank you very much.
Mr. Damgard.
STATEMENT OF JOHN M. DAMGARD, PRESIDENT, FUTURES INDUSTRY
ASSOCIATION, WASHINGTON, D.C.
Mr. Damgard. Thank you very much, Mr. Chairman, for
inviting me to testify.
Mr. Chairman and Ranking Member Lucas, Members of the
Committee, I am John Damgard, President of the Futures Industry
Association, and I am pleased to be here today to discuss the
Treasury's proposals.
As our name implies, FIA's primary focus is futures
trading. In last year's credit crisis, futures markets
performed superbly; and I might add, this Committee can take a
lot of credit for that. All positions were cleared; all
customers were paid; no one had any cause for concern. FIA,
therefore, believes it would be a mistake to use last year's
crisis to increase regulation on futures markets. What has
proven not to be broken under tremendous stress simply doesn't
need fixing.
At the same time, last year's crisis did reveal gaps in the
swaps regulation, and FIA strongly supports Treasury's efforts
to close those gaps. While it is hard in 5 minutes to capture
our views on over 100 pages of amendments to the Commodity
Exchange Act, I would like to single out four areas for our
comments.
First, jurisdiction: FIA believes that the Treasury has
proposed a workable jurisdictional division in the general
outline of swaps regulation. The SEC should focus on security-
based swaps, including those involving a single company or a
small basket of companies. All other swaps should be regulated
by the CFTC, including swaps on agricultural and energy
products, interest rates and broad-based security products.
Second, clearing: FIA is a strong proponent of the futures
clearing system, as you might expect. Our member firms provide
the capital that underwrites most of the credit risk in most
futures transactions. Yet we do not recommend mandatory
clearing for all so-called standardized swaps.
Any legal definition of standardization will be inherently
fuzzy. Mandates based on fuzzy definitions lead to legal
uncertainty, and that uncertainty would lead many to shift
their swap transactions to other countries.
That migration could harm price discovery and the futures
business in the United States. Worse yet, some businesses might
simply not hedge their price risk. That could harm our economy
in ways no one really wants to contemplate.
Third, position limits: FIA supports the Treasury bill's
provision giving the CFTC standby position limited authority
for certain OTC swaps. We believe this authority, if used
wisely, could actually diffuse much of the misguided
controversy surrounding speculation.
Swap dealers and index funds: In FIA's view, speculation
doesn't cause artificial prices, manipulation does. The CFTC
has ample anti-manipulation tools in its arsenal already.
And fourth, foreign boards of trade: My members compete
every day in a global marketplace. Effective global regulation
requires consultation and negotiation.
Treasury's bill takes a different stance. It imposes U.S.
regulation on foreign exchanges. FIA believes that approach
will boomerang. It will harm U.S. firms and exchanges without
increasing market surveillance or transparency in any way.
FIA would prefer to see mandated negotiation by the CFTC
and its foreign counterparts with linked contracts that are
traded in different countries. Representative Moran's proposal
along these lines deserves considerable merit.
FIA looks forward to working with the Committee to perfect
the Treasury's legislative proposals in these and other areas
of concerns. I am happy to answer questions and once again
thank you for inviting me to be here.
[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
Committee, I am John Damgard, President of the Futures Industry
Association. Thank you for inviting FIA to testify on the legislation
recently issued by the Treasury Department and entitled ``Improvements
to Regulation of Over-the-Counter Derivatives Markets.''
FIA is the trade association for the futures industry.\1\ Our
traditional focus has been on exchange markets because our regular
members comprise the major clearing firms that underwrite counterparty
credit risk for the futures clearing system. In other words, our member
firms provide the capital that is the lifeblood of the futures clearing
system.
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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 eighty percent of all customer
transactions executed on United States contract markets.
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Some of our regular members are affiliated with swap dealers and
SEC-regulated broker-dealers. Some of our regular members are not.
Given the diversity of the membership we serve, FIA offers a broad
perspective on the statutory changes embodied in the Treasury bill. In
this testimony we will summarize our major reactions to the
legislation, reserving the right to supplement the record after we have
heard the views of the relevant regulators at next week's hearing.
Overview
The regulated U.S. futures markets performed admirably during last
year's financial and credit crisis. This record is a credit to this
Committee, the Commodity Futures Trading Commission, the futures self-
regulatory organizations and our member firms. This record of success
also supports retaining much of the existing regulatory mechanisms for
futures. Treasury's legislation, however, uses the existence of gaps in
regulation of off-exchange swap transactions as a reason to revamp many
aspects of on-exchange futures regulation. FIA believes that trying to
fix what isn't broke could actually weaken regulation in the U.S. We
would urge this Committee to prune back the Treasury's bill in many of
those areas. The one exception would be the proposal to enhance the
public process for CFTC review of certain rules of self-regulatory
bodies, which FIA supports.
Treasury's bill also focuses on areas of perceived regulatory gaps
or weakness for swaps. FIA supports closing genuine regulatory gaps. As
we read the bill, all derivatives will be subject to meaningful Federal
regulation, whether traded on regulated exchanges and cleared through a
clearing system, or not. In general outline, futures, options and
standardized swaps will be regulated alike, while non-standardized
swaps will be subject, for the first time, to a major regulatory scheme
that will include transparency, registration and sales practices. FIA
fully supports these different regulatory models in concept as well as
the jurisdictional lines of responsibility the bill would assign.
As this Committee knows, futures regulation focuses primarily on
promoting price discovery, preventing price manipulation, protecting
customers and preserving financial integrity. Each of these goals would
be undermined if, in attempting to fix regulatory gaps, Congress
created inadvertent incentives for legitimate trading activity in any,
or many, commodities, whether on exchange or OTC, to move overseas.
Commodity and financial markets today are global, and much of the price
discovery that today occurs in the U.S. could easily shift to foreign
markets. To avoid that result, this Committee and Congress as a whole
must establish a sensible balance in regulatory policy. We will
identify for the Committee the major areas where we are concerned the
Treasury's bill fails to meet that standard and threatens commodity and
financial price discovery in the U.S.
One area the Treasury bill does not address is harmonization of
securities and futures regulation. The CFTC and the SEC have held
meaningful hearings to begin the process of reviewing the many
complicated issues harmonization would entail. As this Committee stated
35 years ago, futures and securities regulation are ``often erroneously
viewed as twins.'' The Commissions' hearings confirmed that in many
fundamental areas that statement is as true today as it was in 1974.
Still each Commission can learn some regulatory lessons from the other
in order to strengthen regulation, enhance competition and provide
cost-efficiencies in both futures and securities markets. We are
looking forward to working with the SEC and the CFTC as they move
forward on the harmonization mission they have been assigned by
President Obama.
Jurisdiction and Regulatory Duplication
Jurisdictional divisions are never perfect. Over time, however,
even less than perfect jurisdictional divisions will work effectively
if premised on generally sound principles. The Treasury bill's
jurisdictional boundaries for swaps are grounded in current law as
embodied in the 1982 Shad-Johnson Accord, as amended in 2000, and
should be workable. Trading in securities-based swaps where company-
specific disclosures and insider trading might be implicated should be
of regulatory concern to the SEC. All other swaps should be regulated
by the CFTC. It has the experience and expertise in regulating trading
in macro-economic derivatives markets from agricultural products and
energy sources to governmental debt and broad-based security indices.
Jurisdictional divisions of any kind may become problematic if
combined with regulatory duplication and the threat of inconsistent
regulatory standards. The Treasury's bill addresses this concern by
requiring that the regulatory standards for entities subject to
regulation for their swap transactions--whether security-based or not--
should be adopted jointly by the SEC and CFTC. We agree. FIA also would
recommend strongly that the uniformity of regulatory standards should
not stop at the agency level, but should apply to the self-regulatory
organizations that operate subject to each Commission's oversight.
Otherwise the SROs could undermine the very uniformity of regulatory
standards the Treasury sought to achieve for swap transactions.
Under current law, FIA members and many others, have worked with
the Commissions to try to adopt a market neutral standard for portfolio
margining that would provide risk-based efficiencies with customer
protection. Over the years, the difficulties in achieving a joint SEC-
CFTC portfolio margining system have been, at least in some respects,
exacerbated by differences caused by established historical practice
and entrenched legal standards. The Treasury's proposal tries to avoid
that kind of difficulty by calling for joint regulatory action in
implementing the new swap regulations. As the history of portfolio
margining shows, it is easier to build that kind of common ground in a
new regulatory system than an old one. FIA commends the Treasury for
this important aspect of its proposal.
Legal Uncertainty and the Standardization Mandate
No regulatory system will be considered to be effective if there is
no business activity to regulate. That may be the true definition of
regulatory overkill.
Treasury's bill threatens to run afoul of this basic principle
through its mandate that standardized swaps must be traded on regulated
platforms (exchanges or alternative swap execution facilities) and
submitted to regulated clearing organizations.
Aided by modest statutory guidance, the bill assigns to the SEC and
CFTC the task to come up with definitive swap standardization rules
that would govern all swap market participants. The bill also allows
the SEC and CFTC, in sum, to prosecute any one who violates the spirit
of this mandate, if not its letter.
There is no easily applicable standardization definition. No matter
what words are used, the concept of standardization will be either
fuzzy or elastic, depending on your perspective. The bill's exchange
trading and clearing mandate will therefore subject swap market
participants to substantial legal risk from a government prosecutor or
a reneging counterparty claiming that an OTC swap was standardized and
should have been traded on an exchange and submitted to a clearing
system. This kind of legal risk is good for lawyers, not for market
participants or regulators. Market participants will be able to avoid
this legal uncertainty only by trading on U.S. exchanges or outside the
jurisdictional reach of the U.S.
Treasury's bill tries to address that problem in part by granting
some market participants that are not swap dealers or major swap
traders an exemption from the exchange-trading mandate. That carve-out
is sound and should be retained. But CFTC Chairman Gensler proposes
repealing the carve-out. His proposal should not be adopted.
Some might say, Chairman Gensler is right, we don't want most, if
not all, swap transactions to be done in the U.S. unless they are on an
exchange. Some might also see this as a windfall for the U.S. exchange
business. FIA is concerned, however, that forcing market participants
to chose from either on exchange trading in the U.S. or OTC swaps
overseas will lead to most legitimate OTC swaps activity migrating
overseas and that related hedging of risk through exchange trading will
follow that migration. The result would mean less liquidity and more
price volatility in the U.S. for both exchange and OTC markets, where
price discovery and hedging also would suffer.
The standardization mandate should be replaced by incentives to
trade on exchanges and through a clearing system. But the bill should
recognize that non-standardized swaps serve a legitimate role by
reducing the basis risk hedgers face in their businesses every day.
Under the Treasury's bill those non-standardized swaps would still, for
the first time, be subject to substantial CFTC or SEC regulation in
terms of registration, transparency and sales practices. That
meaningful form of regulation should more than adequately protect the
public interest.
Market Surveillance and Position Limits
Section 723 of the Treasury Bill expands the reach of the
Commission's position limit power to include ``swaps that perform or
effect a significant price discovery function with respect to regulated
markets.'' \2\ FIA supports granting the Commission this authority and
notes that as written it would apply whether a swap was standardized or
not. This gives the CFTC adequate flexibility to apply its powers to
preserve the integrity of the price discovery process as appropriate.
---------------------------------------------------------------------------
\2\ FIA assumes the term ``regulated markets'' means designated
contract markets or alternative swaps execution facilities as provided
for in the bill.
---------------------------------------------------------------------------
Just as importantly, Section 723 affords the CFTC broad exemption
powers to exempt conditionally or unconditionally any person or class
of persons, or any swap or class of swap, from the position limits it
might impose. Granting the CFTC this flexible authority is an important
improvement over the provisions of H.R. 977 which restricted the CFTC's
powers to exempt persons or transactions from position limits. The only
curious aspect of this provision in the Treasury bill is that it
extends to swaps and apparently not to futures or options traded on
designated contract markets. FIA can think of no reason for this
disparity and urges the Committee to make certain that the exemption
power in the bill treats futures, options and swaps alike.
The CFTC's expanded position limit authority to cover some swaps
should reduce the controversy over the current exemptions from position
limits for swap dealers, a controversy FIA believes is not based on a
full understanding of the facts in any event.
First, swap dealers currently are not exempt for their speculative
futures positions. Dealers are only currently exempt for futures
positions they establish, like other hedgers, to reduce their price
risks. Sometimes that price risk results from the net swaps positions
dealers have established with OTC counterparties in various
commodities. In other instances, some dealers incur price risks from
existing or anticipated holdings of physical commodities or through
complex hedge transactions for energy sources or materials that may be
correlated with commodity prices, but are not traditionally understood
to be commodities. In any event, dealers that have received those hedge
exemptions still operate under specific position limits that are
included as conditions for their exemptions.
Second, by equating in some instances, OTC swaps and on exchange
futures for position limit purposes, the Treasury bill would reduce the
need for the dealer exemption at all. For example, dealers that are net
long a crude oil swap and then offset that long risk with a short
futures position will not need to worry about position limits if the
swap and futures are considered to be part of the same position limit
basket; the dealer should not have any price exposure following the
offset and no net long or short position. Thus, the legislation may
remove the need for the dealer hedge exemption and certainly should
remove any controversy about it.
As we have testified before, FIA continues to believe that
speculation is essential to allow futures markets to serve their price
discovery and hedging function. FIA also does not understand position
limits to have ever been a cure for higher prices or lower prices.
Instead, position limits have always played an important role to
prevent congestion or squeezes in physically-delivered contracts during
the delivery period. FIA would expect the Commission to use its new
stand-by position limit authority consistent with this unassailable
role for position limits. Moreover, as under current law, unless the
Commission finds that the absence of position limits would lead to
``sudden or unreasonable fluctuations or unwarranted changes in the
price of [a commodity],'' FIA believes the Commission should refrain
from imposing position limits under its new authority in Section 723 of
the Treasury bill.
Foreign Boards of Trade
Section 725 has two problematic provisions for foreign boards of
trade.
First, if a foreign exchange provides U.S. persons direct access to
its trading system, regardless of the nature of the contracts the
exchange offers, the CFTC may require the foreign board of trade to
register with the CFTC and comply with regulatory criteria the CFTC
could impose at its discretion. For example, let's say an exchange in
Brazil wants to allow U.S. persons direct computer access to trade
futures on Brazilian government debt, the exchange would have to
register first with the CFTC and comply with its registration criteria.
While this provision is permissive in nature, and the CFTC hopefully
would never use it, even the threat of a new FBOT registration could
have ramifications for foreign exchanges and U.S. firms. Rather than
running the risk of triggering the CFTC registration requirement, a
foreign exchange could simply and rationally say ``no intermediary in
the U.S. or market participant in the U.S. may have direct access to
our exchange.'' Foreign competitors and even affiliates of U.S. firms
and market participants could access the exchange's markets directly,
but not their counterparts in the U.S. That result would seriously
hamper business interests in the U.S. and could even lead to exporting
price discovery in certain commodities to overseas exchanges. It is
unclear why such a Draconian requirement is thought to be necessary. It
is also unclear what the ramifications would be, other than
substantially higher costs, if foreign governments retaliated and
required U.S. exchanges to register in every country where those
exchanges provide now or in the future direct access to its citizens.
Second, Section 725 prohibits a board of trade located outside the
U.S. from providing direct access to persons in the U.S. for contracts
that settle against the price of futures contracts listed for trading
in the U.S. unless the foreign exchange adopts U.S. mandated position
limits as well as other substantial and invasive U.S. regulatory
requirements. The Treasury bill does not have any provision for when a
U.S. exchange seeks to compete with a foreign exchange by listing on
the U.S. exchange contracts that settle against the foreign exchange's
futures prices. Yet competition among exchanges is a two way street.
There are instances, like the NYMEX Brent Oil contracts, where the
primary contract is a foreign exchange traded contract (with no
position limits) and the U.S. exchange is trying to challenge that
exchange dominance. If foreign authorities adopted the Treasury's ``our
way or the highway'' regulatory approach where the foreign markets are
dominant, it could work to harm U.S. exchanges and their competitive
interests.
The Treasury bill's failure to address this reciprocity ignores
market realities and could spark trade war style retaliation or worse.
The legislation proposed by Representative Moran in this area last
year, H.R. 6921, offered a more balanced approach. Under the Moran
approach, when a U.S. or foreign exchange link the pricing of a new
contract to a contract traded on an exchange located in another
country, the two country's regulators would need to consult with each
other to negotiate common methods for addressing market surveillance
and other regulatory needs of the linked markets. FIA believes the
Moran proposal would be less likely to lead to regulatory gaps and more
likely to lead to cooperative, effective solutions adopted by the CFTC
and its foreign regulatory counterparts.
No one wants to see trading on foreign exchanges become regulatory
escape havens. Everyone understands that the best regulatory solution
for a global trading market would be uniform international regulatory
standards fostered by international communication and mutual
recognition. Treasury's bill takes just the opposite approach. This
Committee should review Representative Moran's proposal and use it as a
substitute for the Treasury's unfortunate attempt to mandate U.S.
regulatory standards for the world.
Conclusion
Treasury's bill has many facets and would amend the Commodity
Exchange Act in many different ways. In this testimony, we have touched
on our major areas of current interest and concern. We look forward to
answering any questions the Committee may have and to working with the
Committee as it fashions legislation to close regulatory gaps and
enhance regulatory safeguards where warranted.
The Chairman. Thank you.
I think we have time to squeeze you in, Mr. Duffy. We
haven't gotten to the 5 minute vote yet, so we appreciate you
being with us.
STATEMENT OF HON. TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME
GROUP INC., CHICAGO, IL
Mr. Duffy. Thank you, sir. I am Terry Duffy, the Executive
Chairman of the CME Group, and I want to thank you, Chairman
Peterson, and Ranking Member Lucas for inviting us to testify
today.
You asked us to discuss the Treasury's proposal, Title VII,
Improvements to Regulation of Over-the-Counter Derivatives
Markets. Of course, we were pleased that the proposed
legislation preserves and extends to the OTC world the terms of
the Shad-Johnson Accord. We also agree with the
Administration's stated goals which are, one, to reduce
systemic risk through central clearing and exchange trading of
derivatives, to increase data transparency in price discovery
and to prevent fraud and market manipulation.
While these goals are commendable, certain well-intended
provisions of Title VII could have severe, adverse, unintended
consequences for U.S. futures exchanges and clearinghouses. In
the limited time available, I can briefly discuss only two of
the many important issues raised by Title VII.
First, constraints on current business models: Under the
proposed legislation, the CFTC would gain new prescriptive
authority over margins, position limits, new rules and
contracts. This conflicts with the Treasury's recommendation
last year for the SEC to move towards the CFTC's principle-
based regime. It also overlooks repeated testimony at the joint
harmonization hearings by market participants and industry
experts that a principles-based regime presents the appropriate
framework for regulating futures exchanges.
We have said it before, but it bears repeating. Derivatives
transactions conducted on a CFTC-regulated futures exchange and
cleared by a CFTC-regulated clearinghouse did not--I repeat,
did not--contribute to the current financial crisis.
CFMA, or Commodity Futures Modernization Act, has allowed
U.S. futures exchanges to innovate, grow and compete
effectively on a global playing field. U.S. futures exchanges
are more efficient, more economical and safer and sounder under
CFMA than at any time in their history.
Second, open access clearing for OTC versus mandated
interoperability: Title VII prescribes that all swaps with the
same terms and conditions are fungible and may be offset with
each other. We understood that the purpose of this language was
to ensure that clearinghouses for OTC derivatives would provide
open access to all trading platforms and to privately
negotiated OTC transactions. However, certain segments of the
industry are lobbying to reinterpret the clause to force all
clearing into a single clearinghouse or to force
interoperability among clearinghouses.
The ostensible goals of mandating interoperability are to
reduce costs, encourage innovation and foster competition.
Interestingly, the same demand for interoperability among
futures clearinghouses was eventually rejected by the industry,
the CFTC and the Congress just a few years ago. That is because
a fair examination of the proposal revealed that forced
interoperability created risk that was not cost effective.
We do not want one clearinghouse having to assume another
clearinghouse's credit risk. This would stop innovation and put
the entire system at risk.
In contrast, all the benefits attributed to
interoperability can be achieved privately at no cost and
without creating individual or systemic risks for any
participant in the system. CME Group proposed the following
four principles to guide regulatory reform regulation
respecting the CFTC, SEC and OTC derivatives.
Recommendation one: The CFTC and SEC should jointly adopt
regulations in accordance with Title VII of the
Administration's proposal, but a single agency should function
as the primary regulator to administer those rules and
regulations. Where an exchange clearinghouse or financial
services enterprise is engaged in both commodities and
securities businesses, its primary regulator should be based on
a predominance test.
Recommendation two: The CFTC and SEC should avoid
jurisdictional conflict respecting novel contracts and products
that include both commodity and security futures by
institutionalizing last year's Memorandum of Understanding for
novel derivative products.
Recommendation three: The principles-based regulatory
regime adopted by CFMA should provide the model for the joint
regulations adopted by the CFTC and the SEC.
And finally, Recommendation four: The existing customer
segregation regime for customers of a CFTC derivatives clearing
organization should be preserved for all customers of that
clearinghouse. The SEC's SIPA, Securities Investors Protection
Act, regime should continue to apply to securities account
holders. Legislation should be adopted to rationalize the
treatment of the separate classes of customers in the event of
a bankruptcy of a combined broker-dealer FCM.
My written testimony explains these recommendations in
greater detail. And I thank you, Mr. Chairman and Ranking
Member Lucas, for your attention today.
[The prepared statement of Mr. Duffy follows:]
Prepared Statement of Hon. Terrence A. Duffy, Executive Chairman, CME
Group Inc., Chicago, IL
I am Terrence A. Duffy, executive Chairman of CME Group Inc. Thank
you Chairman Peterson and Ranking Member Lucas for inviting us to
testify today. You asked us to discuss the Treasury's proposed TITLE
VII--IMPROVEMENTS TO REGULATION OF OVER-THE-COUNTER DERIVATIVES
MARKETS, which I am sure we all recognize is far broader than its title
implies. We will also discuss the ongoing efforts of the Securities
Exchange Commission (``SEC'') and Commodity Futures Trading Commission
(``CFTC'' or ``Commission'') to harmonize their regulatory regimes, as
was suggested by the Treasury White Paper.
CME Group is the world's largest and most diverse derivatives
marketplace. We are the parent of four separate regulated exchanges,
including Chicago Mercantile Exchange Inc. (``CME''), the Board of
Trade of the City of Chicago, Inc. (``CBOT''), the New York Mercantile
Exchange, Inc. (``NYMEX'') and the Commodity Exchange, Inc.
(``COMEX''). The CME Group Exchanges offer the widest range of
benchmark products available across all major asset classes, including
futures and options on futures based on interest rates, equity indexes,
foreign exchange, energy, metals, agricultural commodities, and
alternative investment products.
CME Clearing, a division of CME, is one of the largest central
counterparty clearing services in the world, which provides clearing
and settlement services for exchange-traded contracts, as well as for
over-the-counter derivatives contracts through CME
ClearPort'. Using the CME ClearPort' service,
eligible participants can execute an OTC swap transaction, which is
transformed into a futures or options contract that is subject to the
full range of Commission and exchange-based regulation and reporting.
The CME ClearPort' service mitigates counterparty credit
risks, provides transparency to OTC transactions and enables the use of
the exchange's market surveillance monitoring tools.
The CME Group Exchanges serve the hedging, risk management and
trading needs of our global customer base by facilitating transactions
through the CME Globex' electronic trading platform, our
open outcry trading facilities in New York and Chicago, as well as
through privately negotiated CME ClearPort transactions.
I. Introduction
A. Title VII: The Department of the Treasury released the
Administration's legislative language as ``TITLE VII--IMPROVEMENTS TO
REGULATION OF OVER-THE-COUNTER DERIVATIVES MARKETS'' (the ``proposed
legislation'' or ``Title VII''). The heading is not fully descriptive
of the proposed legislation. Of particular interest to this Committee,
Title VII: (i) proposes a major restructuring of the classes of
regulated and exempt futures exchanges; (ii) grants the CFTC authority
over new contracts and rules; (iii) eliminates exemptions and
exclusions for certain OTC contracts; (iv) weakens the principles-based
regulatory regime created by Commodity Futures Modernization Act
(``CFMA''); grants the CFTC authority over foreign boards of trade; and
(v) more comprehensively and proscriptively, regulates the operation of
clearing houses by means of an expanded list of core principles.
The proposed legislation preserves the allocation of jurisdiction
between the CFTC and SEC set forth in the Shad-Johnson Accord, and
extends that allocation to credit default swaps (``CDS'') and other OTC
contracts. This is accomplished by dividing the OTC world into swaps,
which include swaps on broad-based security indexes and exempt
securities, which are regulated by the CFTC, and security-based swaps,
which include swaps on securities and narrow-based indexes and are
regulated by the SEC.
The Administration's stated goals are to reduce systemic risk
through central clearing and exchange trading of derivatives; to
increase data transparency and price discovery; and to prevent fraud
and market manipulation. We support these overarching goals. We are
concerned, however, that certain well-intentioned provisions of Title
VII could have severe, adverse, unintended consequences on U.S. futures
exchanges and clearing houses, including the following:
Constraints on Current Business Models. Under the proposed
legislation, the Commission gains new, direct authority over
margins, position limits, new rules and contracts. Enhanced
authority over approval of new contracts unnecessarily
decreases exchanges' ability to be competitive in the global
marketplace. Additionally, taking control of margin setting
away from clearing houses and exchanges and placing it in the
hands of legislators prevents those in the best position to
make decisions about risk management from doing so and will
potentially drive business to more favorable regimes. Similar
concerns arise out of the Commission's new authority respecting
position limits. Further constraining existing business models
is the proposed legislation's move away from the CFMA's
principles-based regulation towards prescriptive regulation.
Shifting Business Overseas. The efforts to drive OTC
transactions onto electronic trading platforms and into
regulated clearing houses may dampen OTC business in the U.S.
in a manner that will deny U.S. exchanges and clearing houses
the opportunity to serve that market. If the proposed
legislation's constraints--including the scope of mandated
trading and clearing and increased capital requirements--are
unacceptable to the major OTC dealers and hedge funds, they may
choose to shift their OTC business operations overseas,
substantially reducing the size of the U.S. OTC market and
jeopardizing U.S. futures markets that are complemented by OTC
markets.
Engender Retaliatory Action from Overseas Regulators. The
provisions to close the ``London Loophole'' require foreign
boards of trade (``FBOTs'') to register with the CFTC if there
is direct access from the U.S. to the electronic trading system
of such FBOTs. The definition of ``direct access'' is broad
enough to permit the CFTC to capture every FBOT that can be
accessed from the U.S. The proposed legislation does not
include a carve-out from the registration requirements for
exchanges registered and regulated in high quality regulatory
venues. While the CFTC has discretion to exempt FBOTs from
registration if certain conditions are met, this extension of
U.S. jurisdiction could incite retaliatory actions requiring
U.S. futures exchanges to register and be regulated in numerous
jurisdictions.
B. Additional Harmonization Issues: Integral to the
Administration's efforts to reform regulation of the financial sector
is its mandate to the CFTC and SEC to submit to it by September 30 a
document detailing the differences in agencies' regulatory regimes and
including an explanation as to why these differences could not be
``harmonized,'' should that be the agencies' determination. As part of
this ``harmonization'' effort, the CFTC and SEC held joint hearings on
September 2 and 3 (the ``harmonization hearings'') to discuss the
myriad of issues presented by the harmonization process. During the
harmonization hearings, CFTC Chairman Gensler stated that three issues
should be addressed during the process of harmonization: (1)
eliminating gaps in the current regulatory system to reduce risk,
protect market integrity and promote market transparency by adopting
comprehensive regulatory reform for OTC derivatives; (2) limiting
overlapping regulation by the SEC and CFTC to only where it is
beneficial, and eliminating opportunities for arbitrage or regulatory
uncertainty; and (3) eliminating cases in which the SEC and CFTC
regulate similar products, practices or markets in a different manner
when those differences could stifle competition, increase costs or
limit investor protection. SEC Chairman Schapiro was less specific as
to the goal of the harmonization process, stating that the agencies
needed harmonized regulation for similar financial products, unless it
could be explained why differences between the two agencies'
regulations were necessary.
During the course of the harmonization hearings, Chairman Gensler
also listed 12 areas that he believes the two agencies should examine
in their efforts to meet the harmonization goal, and then mentioned two
more at the end of the meetings. These areas include: the process for
approving new products; the process for approving new exchange and
clearinghouse rules; the methods for setting margin in customer
accounts (portfolio margining); market structure (fungibility and
competition among exchanges); differences in manipulation standards;
insider trading rules; customer suitability standards; the application
of fiduciary standards to intermediaries; international mutual
recognition; a review of the CFTC's principles-based approach to
regulation versus the SEC's rules-based approach; differences in the
two agencies' approaches to regulating investment funds; and
differences in the various definitions of sophisticated investors
embedded in SEC and CFTC regulations.
In addition to the harmonization hearings, the SEC and CFTC are
meeting at the Commissioner and staff levels to further the
harmonization process. We believe that a number of issues have surfaced
to date in the harmonization process that pose potential risks to the
U.S. futures industry.
As we testified during the harmonization hearings, in our view,
``harmonization'' should be defined by its goal, and that goal should
be to assure that the regulatory regimes for derivatives, securities
and security options avoid costly duplication, work together to produce
a net welfare gain through efficiently operating markets and clearing
houses and eliminate regulatory gaps. One concern we have, which was
shared by almost every one of the thirty witnesses who testified at the
harmonization hearings, is that the real goal of ``harmonization'' will
be lost and we will be driven toward a merger of the existing
regulatory structures into a single set of one-size-fits-all rules
administered by separate agencies or a super agency, a result that
would undermine the integrity of both the securities and the futures
markets and add nothing in the way of reducing systemic risk.
We are also concerned that the harmonization process will invite
each agency to attempt to expand its jurisdiction without warrant,
although the public message is that the agencies will work together in
a manner that serves the best interest of public customers, financial
service industry intermediaries and other professionals and the market
as a whole.
II. Fundamental Distinctions Between Securities and Futures Markets
Among other critical distinctions, futures markets and securities
markets serve different purposes and different classes of customers.
Futures markets provide price discovery and an efficient means to
hedge or shift economic risk for sophisticated market participants.
Information is disclosed to the market through the trading of market
participants and not through a disclosure regime.
In contrast, securities markets support capital formation by
providing a secondary market for trading plain vanilla securities.
Because the most relevant information is company specific, regulation
focuses on creating a level playing field where insiders are precluded
from taking unfair advantage of uninformed investors.
Treatment of customer funds is another critical difference between
futures and securities markets. The CFTC's customer segregation rules
and the consequent portability of customer positions in the event of an
intermediary's bankruptcy are essential for the class of customers and
type of contracts traded on futures exchanges. SIPA would not provide
protection for derivatives participants because of payment limits and
because it does not focus on portability or customer positions in the
event of an intermediary's failure.
The competitive environments in which futures and securities
markets operate are distinct. Derivative markets face global
competition. Inappropriate levels of regulation in the U.S. invites
major market participants to migrate business to their off shore
offices and off shore markets. On the contrary, competition among
securities markets is local. Securities markets are inherently
domestic. The only issue posed by overregulation of securities markets
is whether the regulator creates a distorted playing field among its
regulated entities; there is no threat that our securities markets will
shift to jurisdictions with more rational regulatory regimes.
These important distinctions between securities and futures markets
are directly pertinent to the question of whether law or regulation
ought to be directed at bringing the two regulatory regimes closer
together, and are discussed in more detail in the testimony of CME
Group's CEO Craig Donohue, submitted in conjunction with the
harmonization hearings.
III. Title VII--Impact on Designated Contract Markets and Clearing
Organizations
Although Title VII proposes changes that impact all aspects of and
participants in the derivatives market, our testimony focuses on the
provisions of Title VII that most directly impact designated contract
markets (``DCMs'') and derivatives clearing organizations (``DCOs'').
Title VII grants extraordinary levels of discretionary authority to the
CFTC and mandates that the CFTC and SEC jointly develop the regulatory
regime applicable to trading and clearing OTC derivatives. This
wholesale transfer of law making authority to the agencies makes it
impossible to assess the consequences to the industry if Title VII were
enacted.
A. Clearing of Swaps (Section 713; Section 3B)
Title VII divides OTC swaps into two categories--swaps and
security-based swaps. It allocates jurisdiction of swaps to the CFTC
and security-based swaps to the SEC. Although appealing on paper, we
agree with the Futures Industry Association (``FIA'') that the proposed
legislation will require some revisions to avoid being unworkable.
Specifically, Title VII calls for dual registration with both the SEC
and CFTC by clearing houses, trading platforms, swap dealers, major
swap participants, alternative swap execution facilities (``ASEF'') and
mixed swaps and permits each agency to fully and simultaneously
regulate. Imposing duplicative and costly regulatory regimes on market
participants without purpose, such as this, completely contradicts the
purpose and intent of harmonization and is contrary to every reasonable
principle of efficient regulation. Moreover, if this dual-regulatory
structure remains in the final piece of legislation, we believe that it
will perpetuate the continuing jurisdictional conflicts between the SEC
and CFTC.
As we have previously testified, we are proponents of eliminating
jurisdictional wrangling over the undistributed middle between the
Securities Acts and the Commodity Exchange Act (``CEA''). Rather than
imposing unduly and unnecessary burdens on the markets, however, we
believe that the correct approach to resolving this issue is to grant
primacy to the regulator that has primary regulatory authority over
other aspects of the regulated entity's operations. The CFTC has
effectively used its exemptive power to achieve such a result. Had the
SEC granted a similar accommodation in respect of CME's efforts to
create an effective clearing solution for credit default swaps it would
have facilitated the process of bringing our offering to market. The
arguments usually advanced against this option--that there will be a
race to the lowest regulatory standard--should not be a concern where
both regulators are agencies of the same government and are enforcing
identical, effective regulatory regimes, as the CFTC and SEC would be
under Title VII.
We believe that only minor revisions are necessary to correct the
unworkable situation presented by the dual-regulatory regime embedded
in Title VII. Indeed, the language of Title VII suggests that Treasury
identified an effective means to accomplish the goals of harmonization,
while permitting clearing houses to operate without costly, duplicative
two-headed regulation. Specifically, Title VII requires the SEC and the
CFTC to ``jointly adopt uniform rules governing persons that are
registered as derivatives clearing organizations for swaps under this
subsection and persons that are registered as clearing agencies for
security-based swaps under the Securities Exchange Act of 1934 (15
U.S.C. 78a, et seq.).'' \1\ Title VII also creates a uniform set of
core principles under which both forms of clearing house must operate.
With this framework, regulatory arbitrage and regulatory gaps are
completely eliminated, and both CFTC-regulated and SEC-regulated
clearing houses are permitted to clear both swaps (province of the
CFTC) and security-based swaps (province of the SEC). Thus, legislators
need only add a provision to Title VII that permits the regulator with
the most existing contacts with the regulated entity to have primary
regulatory jurisdiction over the regulated entity. Such a change will,
among other things, reduce legal uncertainty, minimize regulatory
inefficiencies and speed bringing new products to the markets.
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\1\ Notably absent from Title VII, however, is any explanation as
to how regulatory principles that should/would be applicable to
security-based swaps will work with respect to swaps that are not
security-based, making it difficult to understand how a harmonization
of rules for these two regimes will succeed. (Section 713(h), Subtitle
A.)
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Finally, whether a drafting error or intentional, the CFTC is made
the junior partner in this two-headed regulatory scheme. Specifically,
Title VII authorizes the CFTC to defer to the SEC and exempt an SEC-
registered clearing agency from registration with the CFTC. However, no
comparable exemption authority is given to the SEC in Title VII. This
uneven construct undoubtedly will steer clearing houses to ``choose''
the SEC as their regulator and seek an exemption from the CFTC, to
avoid being dually regulated. Our preferred solution is to allocate
responsibility to the primary regulator of the enterprise, as discussed
above.
B. Position Limits (Section 723)
The CEA currently grants the CFTC sufficient authority to set
limits for DCMs. Section 4a(a) of the CEA directs the Commission to fix
position limits for a commodity traded on a DCM if it first finds that
such action is ``necessary to diminish, eliminate, or prevent''
``sudden or unreasonable fluctuations or unwarranted changes in the
price of such commodity.'' However, the Commission's direct use of the
authority conferred in Section 4a(a) is neither required nor justified
if the relevant designated contract market has acted effectively to
avoid ``excessive speculation.'' Indeed, as the Commission has
previously noted, the exchanges have the expertise and are in the best
position to set position limits for their contracts. In fact, this
determination led the Commission to delegate to the exchanges authority
to set position limits in non-enumerated commodities, in the first
instances, almost 30 years ago.
Since that time, the regulatory structure for speculative position
limits has been administered under a two-pronged framework with
enforcement of speculative position limits being shared by both the
Commission and the DCMs. Under the first prong, the Commission
establishes and enforces speculative position limits for futures
contracts on a limited group of agricultural commodities. Under the
second prong, for all other commodities, individual DCMs, in
fulfillment of their obligations under the CEA's core principles,
establish and enforce their own speculative position limits or position
accountability provisions (including exemption and aggregation rules),
subject to Commission oversight.
Title VII permits DCMs and ASEF to continue to set position limits
or position accountability levels, where appropriate. The core
principles differentiate between the lead month and back months.
(Section 719.) However, no guidance is provided as to how such limits
or accountability levels should be calculated. (Section 723(a)(1).) We
believe that each DCM and ASEF should be required to set its own
position limits based on and in proportion to its liquidity, volume,
open interest and other factors respecting trading for which it is
directly responsible.
The proposed legislation also grants the CFTC authority to impose
aggregate limits on contracts listed by boards of trade and on swaps
that perform a significant price discovery function with respect to
regulated markets; however, it does not provide clear guidance as to
how aggregate limits will be calculated. (Section 723(a)(2).)
We support the provisions of Title VII that expand the CFTC's
authority to impose and enforce position limits on positions taken in
excluded commodities and other OTC transactions. We also agree with the
elimination of the protected ECM category.
We urge, however, that the CFTC's power to set position limits be
subject to explicit guidance comparable to the existing regime in that
it should only act if the relevant regulated market has failed to act
and only act for the purpose of avoiding ``sudden or unreasonable
fluctuations or unwarranted changes in the price of such commodity.''
It is critical that position limits do not become a political issue
that are imposed in the hope of controlling the underlying prices in
the cash market. First, it will not work. Second, it will have a
devastating impact on the U.S. futures industry and participants that
rely on these markets to manage risk.
The United States has been the center of global futures trading
because of its first mover advantage and its rational regulatory regime
which has provided efficient and fair markets while encouraging
innovation. If speculative traders and accumulators like swap dealers
and index funds are restricted from trading global commodities such as
oil and metals on U.S. exchanges and on the U.S. OTC market, their
alternative is clear. They will turn to their foreign affiliates and
the market will move offshore. For example, although Natural Gas
delivered at Henry Hub is a natural U.S. product and it is not likely
that that specific contract will move offshore, natural gas is a global
product and it is certain that a new global benchmark contract will
emerge on a foreign exchange if trading on U.S. markets is constricted
by inappropriate limits. The likely chain of effects is predictable and
unacceptable; liquidity of U.S. markets will be impaired, causing
damage to the domestic natural gas industry and its customers.
Even if Congress or the Commission could find a legitimate basis to
restrict or impede U.S. firms from participating in offshore markets,
the only consequence will be to disadvantage U.S. firms and U.S.
markets. World prices would be set without U.S. participation. Thus,
precisely calibrated and properly administered position limits on
energy contracts, along with a carefully managed exemption process, are
critically important to the preservation of properly functioning
markets.
C. Treatment of Foreign Boards of Trade (Section 725)
Title VII imposes a number of registration and compliance
requirements on an FBOT that grants U.S. users ``direct access'' \2\ to
its systems for trading. Section 725(b)(1) provides, ``The Commission
may adopt rules and regulations requiring registration with the
Commission for a foreign board of trade that provides the members of
the foreign board of trade or other participants located in the United
States direct access to the electronic trading and order matching
system of the foreign board of trade, including rules and regulations
prescribing procedures and requirements applicable to the registration
of such foreign boards of trade.'' The proposed legislation, however,
fails to define any criteria for determining whether or not to require
registration. If the CFTC does require such registration, FBOTs must
meet all requirements of the CEA.
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\2\ ``Direct access'' is defined as an explicit grant of authority
by an FBOT to an identified member or other participant located in the
United States to enter trades directly into the trade matching system
of the FBOT. (Section 725(b)(1), Subtitle A.)
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Even if registration is not required, Section 725(b)(2) makes it
unlawful for an FBOT to provide a member or other participant located
in the U.S. with direct access to its trading and order-matching system
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 FBOT complies with, among other things, information reporting
requirements and positions limits requirements, which mirror those
imposed on U.S. contract markets. There is substantial risk that if
enacted as currently drafted, foreign countries in which U.S. DCMs and
DCOs that have customers and physical facilities, may enact similar
requirements that could subject U.S. DCMs and DCOs to registration and
regulation in such countries.
D. Principles-Based Regulation, Self-Certification Process (Sections
721, 724 and 725)
Despite Treasury's recommendation last year that the SEC move
towards the CFTC's principles-based regime, and the repeated testimony
at the harmonization hearings by market participants and industry
experts that this regime presents the appropriate framework for
regulating futures exchanges, Title VII of the Treasury's proposal
would grant the CFTC administrative authority to eradicate the
advantages of the CFMA's principles-based regime. Specifically, whereas
the CEA currently prohibits the CFTC from providing that its ``Guidance
On, and Acceptable Practices In, Compliance with Core Principles''
(Appendix B to Part 38 of CFTC's Regulations) is the exclusive means to
comply with core principles (CEA 5c(a)(2)), Title VII expressly
grants the CFTC the authority to state that an interpretation may
provide the only means for compliance with core principles.\3\ By
eliminating this option, Title VII substantially inhibits the ability
of U.S. futures exchanges to develop innovative and potentially more
effective ways of complying with the core principles.
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\3\ Section 5c(a)(2) is amended by striking ``shall not'' and
inserting ``may.'' All of the new core principles included in Title VII
are modified by language similar to the following: ``Except where the
Commission determines otherwise by rule or regulation, a derivatives
clearing organization shall have reasonable discretion in establishing
the manner in which it complies with the core principles.''
---------------------------------------------------------------------------
The CFMA has facilitated tremendous innovation and allowed U.S.
exchanges to compete effectively on a global playing field. Principles-
based regulation of futures exchanges and clearing houses permitted
U.S. exchanges to regain their competitive position in the global
market. U.S. futures exchanges are able to keep pace with rapidly
changing technology and market needs by introducing new products, new
processes and new methods by certifying compliance with the CEA and
thereby avoiding stifling regulatory review. U.S. futures exchanges
operate more efficiently, more economically and with fewer complaints
under this system than at any time in their history.
Unfortunately, instead of pursuing this successful regime, the
reaction against excesses in other segments of the financial services
industry appears to have generated pressure to force a retreat from the
principles-based regulatory regime adopted by CFMA. The myriad of
problems resulting in the financial services meltdown did not originate
in futures markets and the exchanges performed impeccably throughout
the crisis and should not be penalized by a return to a prescriptive
regulatory regime. Moreover, this is exactly the regime that impaired
the competitiveness of the U.S. futures industry pre-CFMA.
The benefits of CFMA's principles-based regulatory regime are
easily overlooked in the turmoil following the collapse of the housing
market and major investment banks. We have said it before, but it bears
repeating: derivative transactions conducted on CFTC-regulated futures
exchanges and cleared by CFTC-regulated clearing houses did not
contribute to the current financial crisis. Moreover, it was not
unintentional gaps in the regulatory jurisdiction of the SEC and the
CFTC that caused the meltdown. To the extent that regulatory gaps
contributed to the problem, those gaps existed because Congress
exempted broad classes of instruments and financial enterprises from
regulation by either agency.
Another aspect of Title VII that adversely impacts innovation and
puts regulators in the position of making business judgments for market
participants is the proposed amendments to Section 5c(c)(1) of the CEA,
which will require a time consuming justification process for every
significant new contract and new rule. This proposed amendment steers
the CFTC closer to the product and rule approval process currently
employed by the SEC, the very process about which those regulated by
the SEC complained at the harmonization hearings. Indeed, William J.
Brodsky of the Chicago Board of Options Exchange testified that the
SEC's approval process ``inhibits innovation in the securities
markets'' and urged the adoption of the CFTC's current certification
process.
E. Margin (Section 722, Subtitle A)
Title VII includes explicit standards respecting the setting of
collateral requirements, which are in accord with CME's processes and
procedures. However, Section 722 of Title VII would amend Section 8a(7)
of the CEA and grant the CFTC authority to alter or amend a DCM's rules
respecting margin requirements. Previously, the setting of margin
(except for equity index margin) was excepted from the Commission's
authority to alter or amend exchange rules, but the Commission did have
power to act in an emergency. We are deeply concerned that this grant
of authority will politicize the process and move away from a regime
where true experts in risk management are supplanted by an oversight
agency with no experience and no incentive to set collateral
requirements at appropriate levels.
It has been clearly demonstrated that the setting of collateral
levels for derivatives, both at the customer and at the clearing house
level, is purely a matter of safety and soundness. The operators of
clearing houses that mutualize risk among their member firms have the
clearest incentives and are most capable of doing the job correctly.
The record of futures clearing houses in this country is unambiguous.
In this regard, it is worth noting that, over a history of continuous
operation dating back more than 100 years, no CME customer has ever
lost funds as a result of the failure of a clearing member firm. There
is no benefit to transferring this responsibility to government
employees, only potential harm to DCMs as this is an invitation to
politicize the margin-setting process.
F. Netting Swaps vs. Interoperability (Section 713(j)(1)(B))
Title VII prescribes that ``all swaps with the same terms and
conditions are fungible and may be offset with each other.'' We
understood that the purpose of this language was to insure that
clearing houses for OTC derivatives would provide open access to all
trading platforms and to privately negotiated OTC transactions and that
identical swap contracts, regardless of the execution venue, would be
deemed fungible and could be offset against one another if the
positions resided at the same clearing house. We have since learned
that certain segments of the industry are lobbying to reinterpret the
clause to force all clearing into a single clearing house or to force
interoperability among clearing houses.
Mandated interoperability among swaps clearing houses is being
promoted as a means to foster market entry by new clearing houses and
encourage competition among existing clearing houses. Mandated
interoperability forces all clearing houses to permit a customer with a
position at clearing house A, for example, short a notional $1 billion
in the XXX equity index, to direct that the position be transferred to
clearing house B. Of course, in order to assure that the books of both
clearing houses remain balanced, clearing house B must be substituted
as the short on clearing house A's books. Clearing house A also becomes
the long on clearing house B's books. Each of the clearing houses must
post collateral with the other and each must make twice daily pays and
collects. Each is exposed to the failure of the other. This system
becomes increasingly complex as additional clearing houses are added to
the chain, and ultimately, unworkable.
The ostensible goals of mandated interoperability are to reduce
costs, encourage innovation and foster competition. The same demand for
interoperability among futures clearing houses was rejected by the
industry, the CFTC and Congress because a fair examination of the
proposal revealed that forced interoperability was complex, risky and
not cost effective. Specifically, it was demonstrated that:
the linkages would subject each of the linked clearing
houses to the failure of any of them and that fire breaks that
ordinarily contain or limit such failures would be eliminated,
thereby effectively creating significant specific and systemic
risks;
time and cost to market implementation were significant;
the theoretical savings that might be generated by
competition were outweighed by the costs of operating the
system;
innovation would be inhibited in that each linked clearing
house would be required to limit its pace of innovation to the
ability of the weakest;
changes in contract specifications would require the consent
of each market and clearing house; and
genuine competition among clearing houses and exchanges
would be eliminated.
At the most basic, technical level, in order to make
interoperability feasible, each participating clearing house must agree
on an identical set of operating procedures to coordinate collateral,
variation margin and settlement flows. Each clearing house should
insist that each other participating clearing house has financial
resources at least equal to its own and that each conduct regular
detailed financial and operational audits of each other member of the
interoperability circle. Finally, no clearing house can permit changes
in contract specifications that will distort future cross clearing
house flows.
An important consideration is that the actual benefits of moving
open positions among clearing houses can be achieved privately, at no
cost and without creating systemic or particular risks to any
participant in the system. The customer holding a swap position at
clearing house A can close out that position and reestablish it at
clearing house B in several ways. First, the customer can enter into an
equal, but opposite swap position, on any swap platform or privately,
and submit it for clearing to clearing house A. The customer's swap
position is netted to zero the moment the new trade is accepted. The
customer can reestablish that position at clearing house B by means of
a second swap that is submitted to clearing house B. Second, because
the swap market is not subject to the CFTC's wash trading rules, the
customer can enter into a matched pair of swaps to move the position
without market risk. Finally, if sufficient customer demand ever
develops for the service, clearing houses can enter into agreements
that permit the transfer of matched trades amongst themselves. In that
case, any two traders with offsetting positions who wish to transfer
could do so by means of an appropriate notification and fee. All of
this can be accomplished without government intervention, without cost
and without creating systemic risk.
The immediate impact of mandated interoperability is to force
regulated exchanges and their associated clearing houses to truncate
the services that they offer to their customers by giving up control
over the clearing function that provides the financial, banking and
delivery services that guarantee performance of futures contracts.
Exchange control of these services--either in-house or through a
dedicated third party--is at the heart of current efforts to improve
the value of exchange services by offering straight-through, integrated
processing to clearing member firms and their clients.
It is only through differentiation that product innovation is
accomplished. Differentiation with respect to product and the delivery
of that product has been a fundamental tenet of CME's business strategy
and, intuitively, a prerequisite for product advancement. CME opposes
any suggestions to impede its ability to explore new opportunities in
non-generic, unique products--accessible through unique value added
trading platforms--cleared and settled on an essentially ``straight-
through,'' integrated basis.
G. The CEA's Jurisdictional Preservation Clause
The CEA's exclusive jurisdiction provision mandates that CFTC
regulation is the sole legal standard applicable to virtually all
futures trading. This exclusivity provision was purposely included in
the CEA decades ago to prevent duplication and inconsistency in
regulating the industry; indeed, the phrase ``except as hereinabove
provided'' was inserted in the original CFTC Act so that it would
supersede all others in regard to futures and commodity options
regulation. Despite the success of this jurisdictional delineation to
date, Title VII proposes to disrupt it. Specifically, Section 712(b)
states that the CFTC's exclusive jurisdiction does not supersede any
other authority's jurisdiction under the proposed legislation and would
be referenced in existing CEA Section 2(a)(1)(A) as an exception to the
CFTC's exclusive jurisdiction clause. Moreover, Section 728 appears to
give CFTC ``primary'' enforcement authority over Subtitle A matters but
permits other regulators to take action if CFTC does not, the effect of
which would be to subject market participants to potentially
conflicting standards and multiple regulators. We strongly believe that
the CEA's exclusivity provision should be retained as we move forward
in the regulatory reform process.
IV. Additional Items Raised by Chairman Gensler for Potential
Harmonization
As previously noted, Chairman Gensler raised a number of issues
that he thought should be the focus of the harmonization process.
Although CME has thoughts on each of those issues, we address only a
few below. We are available at your convenience to discuss any of these
further as well as those issues not addressed in this testimony.
A. Manipulation
Under the CEA, price manipulation constitutes acting with specific
intent to create an artificial price. In the securities market, SEC
Rule 10b-5, which applies to alleged manipulation, requires a showing
of neither specific intent nor artificial price effects. Adoption of
the specific intent standard of Rule 10b-5 would contradict the CFTC's
jurisprudence and impose a significant threat to the proper functioning
of the U.S. futures markets in crude oil and gasoline. Indeed, when the
CFTC was asked years ago to consider abandoning the specific intent
standard as the required mens rea for finding manipulation, the CFTC
responded that it was ``unable to discern any justification for a
weakening of the manipulative intent standard which does not wreak
havoc with the market place.'' In re Indiana Farm Bureau Coop. Ass'n,
CFTC No. 75-14, 1982 WL 30249, at *5 (Dec. 17, 1982). Likewise,
elimination of the requirement to show artificial price effects in the
futures realm would seriously threaten the proper functioning of the
U.S. futures markets.
B. Insider Trading
Adopting the SEC's insider trading prohibitions in the commodities
markets could impair price discovery and efficient markets. Insider
trading prohibitions in the securities markets are based upon the
premise that corporate executives and other fiduciaries should not use
their privileged access to information to trade when such material
information is not available to the broader marketplace. In the
commodities derivatives markets, however, market participants typically
trade based upon their own informed self-interest, often hedging price
risks that are, by definition, based upon information that is not
available to the broader marketplace and which contributes to the
futures price formation process. The price discovery function is
optimized when all market information known to hedgers or to
speculators is reflected in the market price of a given contract.
Moreover, hedging depends upon knowledge of cash market positions,
physical market conditions, and other manner of information to
determine the appropriate position to take or hedge to place on a
futures market. If such information were required to be publicly
disclosed in advance of trading on futures markets, hedging would be
impossible.
CFTC Rule 1.59(d) does, however, prohibit exchange governing board
members, committee members, members, employees and consultants from
disclosing or trading in any commodity interest on the basis of
material, nonpublic information obtained through their official
exchange duties. Furthermore, this rule also prohibits any person from
trading in any commodity interest, whether for such person's own
account or on behalf of another person, on the basis of material,
nonpublic information that such person knows was obtained in violation
of the CFTC rule from an exchange governing board member, committee
member, member, employee or consultant.
C. Customer Suitability
As the National Futures Association (``NFA'') testified during the
harmonization hearings, in 1985 it adopted a Know-Your-Customer rule
(NFA Compliance Rule 2-30) that provides protections comparable to the
Financial Industry Regulatory Authority's (``FINRA'') suitability rule
but that are tailored to the unique requirements of the futures
industry. NFA explained the necessary distinction between its rules and
FINRA's: Since all futures contracts are highly volatile and risky
instruments, a suitability determination should be made on a customer-
by-customer basis, rather than trade-by-trade. We agree with NFA that
it makes no sense to say that a customer is suitable for a
recommendation to invest in heating oil futures but not in Treasury
note futures. In general, NFA's rule requires its members to obtain
basic information about each prospective customer and determine whether
futures trading is appropriate for each customer. The rule imposes an
affirmative obligation to inform customers in appropriate circumstances
that futures trading is simply too risky for that customer.
IV. Guiding Principles of Harmonization
CME Group proposes the following five principles to guide
regulatory reform legislation respecting the CFTC, SEC and OTC
derivatives:
Recommendation One: The CFTC and SEC should jointly adopt
regulations in accordance with Title VII of the Administration's
proposal, but a single agency should function as the primary regulator
to administer those rules and regulations. Where an exchange, clearing
house, or financial services enterprise is engaged in both commodities
and securities businesses, its primary regulator should be based on a
predominance test. Where no segment of the firm's business clearly
predominates, the firm should be free to pick its regulator. For
example, the CME derivatives clearing organization should be primarily
regulated by the CFTC even if it also clears security-based swaps. As
many of the participants in the recent joint SEC/CFTC hearings noted, a
primary regulator should take front-line responsibility for the
oversight of the regulated enterprise, including oversight of its SRO
responsibilities, where applicable. This primacy should extend to
audits and enforcement.
Recommendation Two: The CFTC and SEC should avoid jurisdictional
conflict respecting novel contracts and products that include both
commodity and security features by institutionalizing last year's
Memorandum of Understanding (``MOU'') for Novel Derivatives Products.
Such an approach would ensure the recognition of mutual regulatory
interests while operating under principles designed to promote, among
other things, innovation and competition as well as market neutrality.
Recommendation Three: The principles-based regulatory regime
adopted by CFMA should provide the model for the joint regulations
adopted by the CFTC and SEC. No retreat from principles-based
regulation should be accepted without clear justification.
Recommendation Four: The existing customer segregation regime for
customers of a CFTC derivatives clearing organization should be
preserved for all customers of that clearing house. The SEC's SIPA
regime should continue to apply to securities account holders.
Legislation should be adopted to rationalize the treatment of the
separate classes of customers in the event of a bankruptcy of a
combined broker-dealer/futures commission merchant.
Recommendation Five: Interoperability among clearing houses should
not be mandated by legislation or regulation. As has been previously
demonstrated, forced interoperability is complex, risky and not cost
effective. The actual benefits of moving open positions among clearing
houses can be achieved privately, at no public cost and without
creating systemic or particular risks to any participant in the system.
The Chairman. I thank the gentleman.
And we are going to be gone for a while. I think it will be
at least 1 hour--we have a motion to recommit--so we will see
the rest of you folks when we get back. Thank you.
[Recess.]
The Chairman. The Committee will come back to order. And we
apologize for that, but that is part of the deal.
Mr. Pickel, welcome to the Committee. We appreciate your
being here.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CEO,
INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, INC., NEW YORK, NY
Mr. Pickel. Thank you, Mr. Chairman, Ranking Member Lucas,
we appreciate the opportunity to testify here.
ISDA, as you know, is an international trade association
representing major dealers, end-users, government entities,
investors in the privately negotiated derivatives business. We
share the goals of the Administration and of this Committee for
protecting the integrity of our financial system and promoting
the stability of that system; and we support many of the
principles contained in the Administration's proposal.
Specifically, we support appropriate oversight and
regulation of all financial institutions that may pose a
systemic risk to the financial system. We support stronger
counterparty risk management, including clearing requirements,
improved transparency through clearing and reporting
requirements, and a resilient operational infrastructure that
bolsters the system supporting the derivatives markets.
An example of our commitment is the industry's efforts to
improve the clearing process by establishing counterparty
clearing facilities. In the credit default swaps base alone,
more than $2 trillion worth of contracts have been cleared, and
early in this month, ISDA and 15 large derivatives dealers
publicly committed to the Federal Reserve Bank of New York and
regulators from other countries that the firms would submit 95
percent of new, eligible CDS trades for clearing by October
2009. Additional commitments have been made to clear interest
rate swaps.
Today, however, we draw the Committee's attention to
several provisions of the bill that are inconsistent with these
goals.
The scope of U.S. companies that would be subject to these
regulations would be overly broad and would include firms that
are in no way systemically significant. The definition includes
all dealers, regardless of their size or trading volume. A firm
that acts as a dealer in ten swaps a year is treated the same
as a dealer that does 10,000 swaps.
Major swap participants would include nonfinancial end-
users of derivatives and financial firms that are not
systematically significant.
The proposal's reliance on GAAP accounting for
qualification for an exemption is misplaced.
Many end-users enter into economic hedges that do not meet
the strict FAS 133 definition of an effective hedge.
The determination of when an OTC contract is standardized
needs more scrutiny also. Standardization is an important goal,
but equally important is the availability of customized
derivatives products to end-users.
The privately negotiated derivatives business has grown
because standardized contracts are only of limited use in
hedging. Initiatives that would seek to standardize the terms
of all OTC swaps are counterproductive. So long as the risk
that businesses face are not fully standardized, the tools that
allow them to manage those risks will not be fully
standardized.
Product uniformity is not beneficial to American companies
when they have risks unique to their business and need
customized risk management tools to mitigate those risks. The
industry is committed to standardizing the processes
surrounding the product, such as clearing the settlement and
confirmation. That will go a long way to reducing risk.
A third point is that mandatory clearing and mandatory
exchange trading are not feasible in many circumstances. Not
all standardized contracts can be cleared because the ability
of a central counterparty clearing facility to clear a contract
depends on such factors as liquidity, trading volume and daily
pricing. Standardized illiquid contracts are hard to price
daily, making it difficult for the clearinghouse to calculate
collateral requirements consistent with prudent risk
management.
Clearing of OTC derivatives contracts should not be
mandatory. Nevertheless, commitments had been made regarding
clearing, and the industry is delivering on those commitments.
Mandatory exchange trading should not be required in any
circumstance because it would restrict the ability to custom
tailor risk management solutions to meet the needs of end-
users. End-users should not be subject to mandatory clearing or
exchange trading because they are not systematically
significant, and regulations intended to improve stability and
decrease systemic risk should not apply to them.
Finally, the capital requirements in the proposal for
cleared swaps are redundant. The proposal's imposition of a
capital requirement on cleared swaps does not reflect the
capitalization requirements of the clearinghouse, or its
imposition of collateral requirements on its counterparties.
In closing, ISDA joins with thousands of American companies
who rely on customized over-the-counter derivatives to manage
the risks that they face in the normal course of their
business. ISDA also will continue to work with this Committee,
with Congress and the Administration, to ensure financial
stability and reduce risk.
Thank you for your time, and I look forward to your
questions.
[The prepared statement of Mr. Pickel follows:]
Prepared Statement of Robert G. Pickel, Executive Director and CEO,
International Swaps and Derivatives Association, New York, NY
Chairman Peterson and Members of the Committee:
Thank you very much for allowing ISDA to testify at this hearing to
review proposed legislation by the U.S. Department of the Treasury
regarding the regulation of over-the-counter derivatives markets.
About ISDA
ISDA, as you may know, represents participants in the privately
negotiated derivatives industry. Today it ranks as the largest global
financial trade association by number of member firms. ISDA was
chartered in 1985, and today has over 850 member institutions from 56
countries on six continents. These members include most of the world's
major institutions that deal in privately negotiated derivatives, as
well as many of the businesses, governmental entities and other end-
users that rely on over-the-counter derivatives to manage efficiently
the financial market risks inherent in their core economic activities.
A Broad Consensus for Key Reform Concepts
Let me state very clearly at the outset of my remarks: Today, there
is a broad consensus for a comprehensive regulatory reform plan to
modernize and protect the integrity of our financial system. ISDA and
the privately negotiated derivatives business support many of the key
public policy concepts contained in the Administration's proposal. This
includes:
Appropriate regulation for all financial institutions that
may pose a systemic risk to the financial system;
Stronger counterparty risk management, including
clearinghouses;
Improved transparency; and
A strong, resilient operational infrastructure.
What's more, we are not waiting for legislation or additional
regulation to demonstrate our support and commitment to these
principles. We are actively doing so today. One example can be seen in
the use of central counterparty clearing facilities. To date, more than
$2 trillion of credit default swaps contracts have been cleared. And
earlier this month, ISDA and 15 large derivatives dealers publicly
committed in a letter to the Federal Reserve Bank of New York that the
firms would submit 95% of new eligible credit default swap trades for
clearing within 60 days, by October 2009. A copy of the letter is
attached.
Mr. Chairman and Committee Members, let me assure you that ISDA and
our members intend to maintain the scope and the scale of the progress
that we have made thus far. Since its inception nearly 25 years ago,
ISDA has pioneered efforts to identify and reduce the sources of risk
in the derivatives and risk management business. Our focus is on
continuing--and enhancing--our efforts in this area as we move forward.
The depth and breadth of our activities in derivatives documentation,
netting, collateral, risk management, capital, operations and
technology underscore our intense global commitment to further reducing
risk.
There are, however, certain aspects of the bill that work against
its broad public policy goals. These include:
The scope of firms that would be subject to the legislation;
The parameters for determining when an OTC derivatives
contract is standardized and when it can be cleared;
Mandatory clearing and exchange trading of standardized OTC
derivatives;
Capital requirements for cleared swaps.
These provisions would reduce or restrict the availability of
customized risk management tools without contributing in any
significant positive way to the Treasury's goals of reducing risk and
ensuring financial stability. As a result, they would make it more
difficult for American companies to effectively manage their business
and financial risks. Resources that could have been allocated more
productively to generate growth in revenues and profitability would
instead be devoted to less efficient and effective risk management
activities.
The Need for Privately Negotiated Derivatives
As Secretary Geithner has previously testified before this
Committee, ``One of the most significant developments in our financial
system during recent decades has been the substantial growth and
innovation in the markets for derivatives, especially OTC
derivatives.'' In his remarks, Secretary Geithner also noted that
derivatives today play a critical role in our financial markets, and
they bring substantial benefits to our economy by enabling companies to
manage risks.
Today, privately negotiated derivatives are widely used by American
companies. According to research we have conducted, nearly all of the
Fortune Global 500 companies based in the U.S. use derivatives to
manage their risks. A broader survey of non-financial firms in 47
countries was conducted earlier this decade by professors at Lancaster
University and the University of North Carolina at Chapel Hill. Of the
2,076 U.S. companies in the survey, about 65 percent used OTC
derivatives.
The reason why derivatives are so widely used is clear: American
companies want and need these customized risk management tools to
manage the risks that arise in the normal course of doing business. For
companies that do business overseas, those risks include fluctuations
in the relative value of foreign currencies. For companies that issue
debt to fund their growth, the risks may include changes in interest
rates and consequently in interest payments. For companies that rely
heavily on commodities--such as airlines--those risks include changes
in the current and future prices of fuel.
Key Issues in the Treasury's Proposal
While there is consensus regarding many of the key concepts in the
Treasury's proposal, certain of its provisions raise serious questions
for dealers in and users of derivatives. These provisions, as outlined
below, would reduce or restrict the availability of customized risk
management tools for American companies. At the same time, these
provisions offer no significant offsetting benefit; in other words they
would not meaningfully contribute to the Treasury's goals of reducing
risk and ensuring financial stability.
(1) The scope of firms that would be subject to the legislation.
The legislation defines two types of firms that would be subject to
its provisions: ``swaps dealers'' and ``major swap participants.'' Both
definitions are overly broad and would include firms that are in no way
systemically significant. In so doing, the legislation would penalize
such firms and may well prevent them from either dealing in or using
derivatives.
Let me explain: in the proposal, a swap dealer is defined as
including any person engaged in the business of buying and selling
swaps for such person's own account, through a broker or otherwise.
This definition includes all dealers, regardless of their size or
trading volume. It treats a firm that acts as a dealer in ten swaps a
year the same as a dealer that does 10,000.
Similarly, the term major swap participant is essentially defined
as any person who is not a swap dealer and who maintains a substantial
net position in outstanding swaps, other than to create and maintain an
effective hedge under generally accepted accounting principles. This
definition is so broad that it would include financial entities that
are not systemically significant.
It would also include non-financial end-users of derivatives. These
corporate end-users would as a result be subject to the nation's
banking and financial regulatory framework, which would impose
significant costs, divert key resources and decrease the
competitiveness of such firms.
(2) The parameters for determining when an OTC derivatives contract is
standardized.
A key component of Treasury's proposal for OTC swaps is its
requirement that standardized swaps be cleared. The proposal does not
define the term standardized. Instead, it would require that, within 6
months of the proposal's enactment, the SEC and CFTC jointly define
``as broadly as possible'' what constitutes a standardized swap.
Additionally, the proposal provides that acceptance of a product by a
clearinghouse for clearing would create a presumption that the relevant
product is standardized.
Both of the proposal's methods for determining if an OTC
derivatives contract is standardized are flawed and need to be revised.
With regard to the former method, the need for consistency amongst
policymakers regarding what is standardized and what is not argues for
broader participation by Federal regulators in this process. Regarding
the latter method, because of commercial considerations, the
willingness of a clearinghouse to accept a transaction for clearing
should not create a presumption of standardization.
In addition, it's important to keep in mind that while
standardization is an important goal in the OTC derivatives world, it's
also important to retain customization of derivative products. American
businesses pervasively use customized contracts to manage operational
risks, and it is critical that Congress preserve these companies'
ability to do so. Customized products exist only because end-users find
them useful, and indeed necessary, in their day-to-day operations. In
fact, the privately negotiated derivatives business has grown because
standardized contracts are only of limited use in hedging. Initiatives
that would seek to standardize the terms of all OTC swaps are
counterproductive. Product uniformity is not beneficial to American
companies when they have risks unique to their businesses and need
customized risk management tools to mitigate these risks, and when
accounting rules require customized products that are closely tailored
to an end-user's specific risks.
(3) Mandatory clearing and exchange trading.
The Treasury proposal would require that standardized OTC
derivatives contracts be cleared and traded on an exchange of
alternative swap execution facility.
Not all standardized contracts can be cleared. Contracts that are
infrequently traded, for example, are difficult if not impossible to
clear even if they contain standardized economic terms. That's because
the ability of a central counterparty clearing facility to clear a
contract depends on such factors as liquidity, trading volume and daily
pricing. Standardized, illiquid contracts are hard to price daily,
which makes it difficult for the clearinghouse to calculate collateral
requirements consistent with prudent risk management. As a result,
clearing of OTC derivatives contracts should not be mandatory.
To the extent that policymakers do adopt mandatory clearing
requirements, ISDA and our members believe that a clearly defined
framework for so doing is essential. This framework should be
constructed by Federal regulators, who should proceed by notice and
comment and endeavor to ensure that the requirement would promote
consistent international standards, choice of clearinghouses, economic
efficiency, fungible treatment of cleared contracts, and clearinghouse
interoperability. The framework for a mandatory clearing requirement
should only include standardized inter-dealer transactions in which at
least one of the dealers is systemically significant.
ISDA and our members believe that mandatory exchange trading should
not be required in any circumstance. Mandating that OTC derivatives
contracts trade on an exchange would undercut their very purpose: the
ability to custom tailor risk management solutions to meet the need of
end-users.
In addition, exchanges provide three general purposes, all of which
the OTC derivatives industry is meeting in other ways. First and most
important is central clearing, which the industry is now well along on
and is committed to continued progress. Second is position and risk
transparency, which we are achieving through centralized trade
repositories as well as central clearing facilities. And the third is
price transparency, which is also being achieved through a combination
of increased cleared trading volume and electronic platforms.
Finally, ISDA and our members believe that end-users should not be
subject to a clearing or exchange trading requirement, even if they are
major swap participants or meet the eligibility requirements of a
derivatives clearing organization. End-users are not systemically
significant and regulations intended to improve stability and decrease
systemic risk should not apply to them.
(4) Capital requirements for cleared swaps.
The Treasury proposal would impose a capital requirement on cleared
swap transactions. ISDA and our members oppose this requirement for
several reasons. First, the capitalization of the derivatives
clearinghouse is designed to provide adequate protection to swap
counterparties. That is the fundamental purpose of the clearing
facility. In addition, the clearinghouse imposes its own layer of
additional protection in the form of collateral requirements on its
counterparties. So in effect there are already two layers of capital:
that which with the clearinghouse is capitalized, and that which the
clearinghouse imposes on its members when it trades with them.
Conclusion
Let me conclude by saying that ISDA and our members appreciate the
opportunity to testify and answer your questions today. We recognize
that policymakers today have real and legitimate concerns regarding
their twin goals of ensuring financial stability and reducing risk.
We in the OTC derivatives industry share these goals. We have moved
very quickly in recent months in a broad range of areas to allay
policymakers' concerns. We know that we have more work ahead--and we
are committed to taking on these challenges.
At the same time, we believe--and we are joined by thousands of
American companies who also believe--that the customized nature of OTC
risk management tools provides a substantial benefit . . . a benefit to
our firms, our economy and our country. We must not lose sight of the
important role that OTC derivatives play as we work together on
financial regulatory reform.
Thank you.
Attachment
8 September 2009
Hon. William C. Dudley,
President,
Federal Reserve Bank of New York,
New York, NY
Dear Mr. Dudley:
We are writing to inform you of our commitment to increase the
usage of central counterparties for clearing, which we believe will
significantly reduce the systemic risk profile of the OTC derivatives
market. We have set the following initial performance targets as a
demonstration of that commitment. We will increase these target levels,
which are the first set for central clearing, as we improve our
clearing capabilities.
For Interest Rate Derivatives:
Each G15 member (individually) commits to submitting 90% of
new eligible trades (calculated on a notional basis) for
clearing beginning December 2009.
The G15 members (collectively) commit to clearing 70% of new
eligible trades (calculated on a weighted average notional
basis) beginning December 2009.
The G15 members (collectively) commit to clearing 60% of
historical eligible trades (calculated on a weighted average
notional basis) beginning December 2009.
For Credit Default Swaps:
Each G15 member (individually) commits to submitting 95% of
new eligible trades (calculated on a notional basis) for
clearing beginning October 2009.
The G15 members (collectively) commit to clearing 80% of all
eligible trades (calculated on a weighted average notional
basis) beginning October 2009.
Furthermore, we will issue performance metrics that address both
new transactions and the outstanding trade population on a monthly
basis. The first report will be issued on the 10th business day of
October 2009 and will be in respect of September 2009, and for each
month thereafter, the relevant report will be issued as part of the
monthly metrics we currently report.
We will continue to work with the regulators to explore means by
which we can look to improve submission levels and clearing yields. We
will review the performance metrics and targets contained in this
letter with the global regulators on a regular basis to ensure that the
metrics and targets demonstrate the industry commitment to increased
clearing of OTC transactions.
G15 members commit to actively engaging with CCPs and regulators
globally to broaden the set of derivative products eligible for
clearing, taking into account risk, liquidity, default management and
other processes.
The G15 members also commit to work with eligible CCPs and
regulators globally to expand the set of counterparties eligible to
clear at each eligible CCP taking into account appropriate counterparty
risk management considerations, including the development of buy-side
clearing.
Of course, successful expansion of the sets of eligible products
and counterparties is necessarily dependent on several factors,
including ensuring proper risk management, CCP capabilities and
business choices, regulatory treatment and decisions of non-G15 firms.
We commit to work actively with our supervisors and other regulators to
remove any of these impediments to our efforts.
Yours sincerely from the Senior Managements of:
Bank of America-Merrill Lynch;
Barclays Capital;
BNP Paribas;
Citigroup;
Commerzbank AG;
Credit Suisse;
Deutsche Bank AG;
Goldman, Sachs & Co.;
HSBC Group;
International Swaps and Derivatives Association, Inc.;
JP Morgan Chase;
Morgan Stanley;
The Royal Bank of Scotland Group;
Societe Generale;
UBS AG;
Wachovia Bank, N.A.
Identical letters sent to:
Board of Governors of the Federal Reserve System;
Connecticut State Banking Department;
Federal Deposit Insurance Corporation;
Federal Reserve Bank of Richmond;
French Secretariat General de la Commission Bancaire;
German Federal Financial Supervisory Authority;
Japan Financial Services Agency;
New York State Banking Department;
Office of the Comptroller of the Currency;
Securities and Exchange Commission;
Swiss Financial Market Supervisory Authority;
United Kingdom Financial Services Authority.
Copies to:
Commodity Futures Trading Commission;
European Commission;
European Central Bank.
The Chairman. Thank you, Mr. Pickel.
Mr. Short, welcome to the Committee.
STATEMENT OF JOHNATHAN H. SHORT, VICE PRESIDENT AND GENERAL
COUNSEL, IntercontinentalExchange, INC.,
ATLANTA, GA
Mr. Short. Chairman Peterson Ranking Member Lucas, I am
Johnathan Short, Senior Vice President and General Counsel of
IntercontinentalExchange, or ICE. We very much appreciate the
opportunity to appear before you today to testify on the
Department of the Treasury's Over-the-Counter Derivatives
Markets Act of 2009.
ICE has an established track record of working with market
participants and regulators alike to introduce transparency and
risk intermediation into OTC markets. Along with the
introduction of electronic trading to OTC energy markets, ICE
pioneered the concept of cleared OTC energy swap contracts in
2002.
ICE recognizes that appropriate regulation of OTC
derivatives is of utmost importance to the long-term health and
viability of our financial system and to our broader economy.
In this regard, the current Treasury proposal contains many
provisions that will benefit both the derivatives markets and
the broader economy as a whole.
We cannot summarize all of our comments on the OTCDMA in
this oral testimony, but we will highlight several points in
the proposed legislation which warrant further scrutiny and
consideration by Congress in order to strike the proper balance
between needed market reform, while maintaining the usefulness
of OTC derivatives to the broader economy.
These three points in ICE's recommendations for improvement
are:
One, while mandating clearing and electronic trading for
most standardized swap transactions may be appropriate to
achieve certain goals of the OTCDMA, Congress should consider
appropriate exclusions for transactions involving commercial
entities and transactions in illiquid contracts that may be
difficult to clear.
Two, clearinghouses should not be forced to make clearing
of swaps fungible or be forced to provide margin offsets for
positions held in other clearinghouses, as such a mandate could
increase rather than decrease the potential for systemic risk.
And, three, careful consideration should be given to the
provisions requiring registration of foreign boards of trades
and, in particular, the provisions giving the CFTC authority to
set position limits on contracts traded on a foreign board of
trade that do not have a linkage to a domestically traded
contract. Such provisions will invite retaliation from foreign
regulators and inhibit necessary global regulatory cooperation.
To elaborate on these three points, the OTCDMA recognizes
the benefits of exchange trading and clearing by requiring all
standardized swaps to be exchange traded and cleared. The
OTCDMA instructs the CFTC and SEC to define the term
standardized as broadly as possible and includes a presumption
of standardization for any contract that a clearinghouse is
willing to accept.
Clearing and electronic execution and trade processing are
core to ICE's business model, and ICE would clearly stand to
benefit from legislation that required all derivatives
transactions conducted in the U.S. to be cleared and traded on
exchanges or electronic trading facilities. However, such a
provision may result in significant unintended consequences by
attempting to force transactions that are not readily amenable
to clearing into clearinghouses, or by forcing commercial
market participants who would rather outsource their risk
management to an OTC swaps dealer to incur the costs of
expensive trading and clearing standardized contracts that may
not perfectly fit their risk management needs.
Instead of forcing all derivative transactions to be
exchange traded and cleared, Congress should require this for
the segments of the market where risk is greatest like the
inner dealer or major swaps participant derivatives market.
Mandating that inner dealer or major swaps participant
trades be cleared would eliminate much of the bilateral
counterparty risk that was central to the financial crisis last
year, and achieved many of the risk reduction and transparency
goals that the Treasury is seeking.
To address any potential for a gap in oversight, this step
could be supplemented with enhanced prudential regulation of
swaps dealers and major market participants to allow regulators
to ensure that such entities were not engaging in trading
conduct with commercial entities that exposed them to excessive
counterparty risk.
On the issue of fungible clearing for swaps, the OTCDMA
includes a provision that requires clearinghouses to prescribe
that all swaps with the same conditions and terms are fungible
and may be offset with one another. This provision could be
interpreted to force clearinghouses to treat standardized swaps
as fungible with positions held in other clearinghouses, and to
offer margin risk offsets against positions in other
clearinghouses. Such a requirement would be very difficult to
implement across multiple clearinghouses, making it more
difficult for the clearinghouse to do what the proposed
legislation intends for them to do, which is to properly manage
risk positions held in the clearinghouse and mitigate systemic
risk.
A forced linkage of clearinghouses could perversely
reintroduce the interconnectedness problem that we have all
just experienced in the OTC markets among major financial
institutions and allow problems in one clearinghouse to infect
other clearinghouses.
Finally, on foreign boards of trade, careful consideration
should be given to the provisions of the proposed legislation
requiring registration of foreign boards of trade, and the
provisions giving the CFTC the authority to set position limits
on any contract traded on a foreign board of trade that is
offered to U.S. market participants. The provisions requiring
registration are likely to result in similar requirements being
imposed by foreign regulators on domestic markets.
In addition, the provisions related to position limits are
problematic as well. While placing position limits on U.S.
market participants trading in a linked contract, one linked to
a U.S. contract market are appropriate; providing that the CFTC
could set position limits on other foreign contracts is not
appropriate, would be repugnant to foreign regulators, and
would likely inhibit the regulatory cooperation amongst
regulators at a time when it is most needed.
Mr. Chairman, thank you for the opportunity to share our
views with you, and I would be happy to answer any questions
that you may have.
[The prepared statement of Mr. Short follows:]
Prepared Statement of Johnathan H. Short, Senior Vice President and
General Counsel, IntercontinentalExchange, Inc., Atlanta, GA
Chairman Peterson, Ranking Member Lucas, I am Johnathan Short,
Senior Vice President and General Counsel of IntercontinentalExchange,
Inc., or ``ICE.'' I very much appreciate the opportunity to appear
before you today to testify on the Department of the Treasury's Over
the Counter Derivatives Markets Act of 2009 (``OTCDMA'').\1\
---------------------------------------------------------------------------
\1\ Title VII, Improvements to Over-the-Counter Derivatives Markets
(August 11, 2009).
---------------------------------------------------------------------------
Background
ICE launched its electronic OTC energy marketplace in 2000. The ICE
OTC platform was designed to bridge the void that existed between the
voice brokered OTC markets which were bilateral and opaque, and the
open-outcry futures exchanges, which were inaccessible or lacked the
products needed to hedge in the power markets. Since then, ICE has
acquired and operates three regulated futures exchanges through three
separate subsidiaries, each with its own governance and regulatory
infrastructure. The International Petroleum Exchange (renamed ICE
Futures Europe), was a 20 year old exchange specializing in energy
futures when acquired by ICE in 2001. Located in London, it is a
Recognized Investment Exchange, or RIE, operating under the supervision
of the UK Financial Services Authority (FSA). In early 2007, ICE
acquired the 137 year old ``The Board of Trade of the City of New
York'' (renamed ICE Futures U.S.), a CFTC-regulated Designated Contract
Market (DCM) headquartered in New York and specializing in
agricultural, foreign exchange, and equity index futures. In late 2007,
ICE acquired the Winnipeg Commodity Exchange (renamed ICE Futures
Canada), a 120 year old exchange specializing in agricultural futures,
regulated by the Manitoba Securities Commission, and headquartered in
Winnipeg, Manitoba. ICE also owns and operates five derivatives
clearinghouses, each serving a distinct part of its trading business.
These clearinghouses include:
ICE Clear U.S., a Derivatives Clearing Organization located
in New York and serving the markets of ICE Futures U.S.;
ICE Clear Europe, a Recognized Clearing House located in
London that serves ICE Futures Europe, ICE's OTC energy
markets, and the European portion of ICE's credit default swaps
clearing initiative;
ICE Clear Canada, a recognized clearing house located in
Winnipeg, Manitoba that serves the markets of ICE Futures
Canada;
ICE Trust, a U.S.-based CDS clearing house which began
clearing CDS transactions in March 2009, and which to date,
along with ICE Clear Europe, has cleared over $2 trillion in
notional value of credit default swaps; and
The Clearing Corporation, established in 1925 as the
nation's first independent futures clearing house. It provides
the risk management framework, operational processes and
clearing infrastructure for ICE Trust. The Clearing Corporation
also provides clearing services to the Chicago Climate Futures
Exchange.
ICE has an established track record of working with market
participants to introduce transparency and risk intermediation into OTC
markets. We have also worked closely with regulators to improve
supervision and access to information from the OTC markets. Along with
the introduction of electronic trading to energy markets, ICE pioneered
the concept of cleared OTC energy swap contracts. These changes to a
traditionally opaque, bilateral market structure were made in response
to a crisis in the energy markets in 2002, and have dramatically
transformed the way energy derivatives are traded and risks are managed
by market participants.
Need for OTC Regulation
Appropriate regulation of OTC derivatives is of utmost importance
to the long term health and viability of our financial system and to
our broader economy. The current financial crisis has exposed a
significant gap in market transparency and regulation that has allowed
systemic risk to grow and for its effects to be felt beyond Wall Street
to Main Street. However, in considering the need for OTC derivatives
regulation, it is equally important to understand the true size and
nature of OTC derivatives markets and their importance to the broader
U.S. economy. Derivatives are commonly thought to be complex financial
instruments that are only traded between large investment banks and
hedge funds. However, derivatives are central to the U.S. and global
economy: 94% of the world's 500 largest companies use derivatives to
manage a broad variety of risks.\2\ Use of derivatives is not
constrained to the financial sector, but cuts across the entire
spectrum of business and government, including manufacturing, airline,
health care and technology companies, as well as a variety of state and
local governmental entities. It also bears emphasizing that
derivatives--both futures and OTC instruments--could play a central
role in any ``cap and trade'' program to combat climate change.
---------------------------------------------------------------------------
\2\ Study by the International Swaps and Derivatives Association
(April 23, 2009). http://www.isda.org/press/press042309der.pdf.
---------------------------------------------------------------------------
ICE believes that increased transparency and proper risk and
capital management, coupled with legal and regulatory certainty, are
central to OTC market financial reform and to restoring confidence to
these vital markets. In this regard, the current Treasury proposal
embodied in the OTCDMA contains many provisions that will benefit the
derivatives markets and the broader economy as a whole. However,
several key points in the legislation warrant further scrutiny and
consideration by Congress in order to strike the proper balance between
needed market reform and maintaining the usefulness of OTC derivatives
to the broader economy.
Mandating Clearing and Electronic Trading
The OTCDMA recognizes the benefits of exchange trading and clearing
by requiring all standardized swaps to be exchange traded and cleared.
The OTCDMA instructs the CFTC and the SEC to define the term
``standardized'' as ``broadly as possible after taking into account''
factors as (i) which terms of the trade, including price, are
disseminated to third parties; (ii) the volume of transactions; (iii)
the extent to which the swap is similar to other swaps that are
centrally cleared; (iv) whether the swap is similar to other swaps in
ways that are of economic significance; and (v) other factors that the
Commodity Futures Trading Commission (``CFTC'') and the Securities and
Exchange Commission think relevant.\3\ This broad definition is
designed to capture most derivative transactions.
---------------------------------------------------------------------------
\3\ OTCDMA, Section 713(a).
---------------------------------------------------------------------------
Clearing and electronic execution and trade processing are core to
ICE's business model. As a result, ICE would clearly stand to benefit
commercially from legislation that required all derivatives
transactions conducted in the U.S. to be cleared and traded on
exchanges or electronic trading facilities. However, the mandated
electronic trading and clearing provisions of the OTCDMA may result in
significant unintended consequences by attempting to force transactions
that are not readily amenable to clearing into clearinghouses, or by
forcing commercial market participants--including those who would
rather, for a price, outsource their risk management to an OTC swaps
dealer--to incur the cost and expense of trading in standardized
contracts that may not perfectly fit their risk management needs. In
addition, many commercial market participants will be forced to post
significant cash collateral to margin cleared positions when they
historically have been able to use illiquid assets to back OTC
bilateral swap positions that they have entered into with swaps
dealers.
The critical factors for efficient clearing include not only the
standardization of products, but also the availability of adequate
pricing and market liquidity. Pricing is essential for the
clearinghouse to mark open positions to market on a daily basis and to
properly margin positions, which protects both the clearinghouse and
market in the event of a clearing participant default. The depth of
market liquidity and number of clearing participants or intermediaries
impacts margin and guaranty fund calculations, as well as the ability
to efficiently mutualize risk across enough clearing participants to
make clearing economically viable. Where market depth is poor, margin
and risk mutualization cost is very high and can make it uneconomic
from a market perspective for a product to be cleared given the
necessary conservatism on the part of a clearinghouse.
Thus, while ICE certainly supports clearing and exchange trading
of as many standardized contracts as possible, there will always be
products which are not sufficiently standardized or which do not
possess sufficient market liquidity for clearing to be practical,
economic or necessary. Pursuant to the OTCDMA's broad definition of
``standardized swap'', many thinly traded instruments will be submitted
for clearing and traded on exchange. This could increase risk to
clearinghouses and to the financial system in general.
Finally, forcing all derivatives transactions and all market
participants to trade through exchanges and to clear through
clearinghouses will greatly increase cost to commercial companies and
ultimately to consumers. Currently, many commercial entities address
their risk management needs through trading with swaps dealers. The
swaps dealers offset the risk they undertake through internal offsets,
trading with other swaps dealers, or through trading on exchanges.
Under these arrangements the commercial entities have the flexibility
to post illiquid collateral (such as a pledge of hard assets or a
pledge of future production) that could not be accepted by a
clearinghouse. Forcing these transactions into clearinghouses will
cause these companies to post their most liquid assets, impairing their
ability to operate efficiently. This will put U.S. firms at a severe
disadvantage to foreign competitors.
Instead of forcing all derivative transactions to be exchange
traded and cleared, Congress should focus on the segments of the
markets where risk is greatest, like the inter-dealer and major swaps
participant derivatives market. Mandating that inter-dealer and major
swaps participant trades be cleared would eliminate the bilateral
counterparty risk that was central to the liquidity crisis that
occurred last year, and achieve many of the risk reduction and
transparency objectives that Treasury is seeking without impacting
clearinghouse risk management and the competitiveness of U.S.
commercial businesses. This step could be supplemented with enhanced
prudential regulation of swaps dealers or major swaps participants that
would allow regulators to ensure that such entities do not engage in
trading conduct with other parties that poses any systemic risk.
Fungible Clearing for Swaps
The OTCDMA includes a provision that requires clearinghouses to
``prescribe that all swaps with the same terms and conditions are
fungible and may be offset with each other.'' \4\ This provision would
force clearinghouses to treat standardized swaps as fungible with
positions held other clearinghouses and offer risk offsets against
positions held in other clearinghouses. This could make proper risk
management by clearinghouses extremely difficult, and inadvertently
increase systemic risk--the very thing that clearinghouses are intended
to eliminate under the OTCDMA.
---------------------------------------------------------------------------
\4\ OTCDMA, Sections 713(a), 753(a).
---------------------------------------------------------------------------
Clearinghouses have been some of the few institutions that have
operated well in the financial markets during this time of crisis.
Clearinghouses perform a vital risk management function in margining
derivative positions and performing real time risk management for their
customers. Forcing clearinghouses to take contracts from other
clearinghouses or to provide margin offsets with other clearinghouses
could present significant systemic risk issues, making it more
difficult to track positions and counterparty risk exposure, and
creating significant problems in the event of a default of a major
market participant. To understand this risk, consider what would have
happened in the real world Lehman Brothers default scenario if Lehman's
positions had been spread across ten different clearinghouses, none of
whom may have had the full risk picture and all of whom might have been
dependent on the risk management practices of the weakest link in the
``offset'' chain. In this regard, interconnected clearinghouses might
not have been very different from interconnected banks, with problems
in one competing clearinghouse impacting other clearinghouses.
Many important problems would need to be overcome to make fungible
clearing and margin offsets workable. For example, what if rules at
each clearinghouse are not exactly the same with respect to a default,
which clearinghouses' rules would have precedent? What if one clearing
house chose to adopt more stringent margin requirements than the
minimum legally required--would it have to provide a margin offset for
positions held at a second clearinghouse that only chose to adopt the
minimum margin standards that are legally required?
It is important to note that fungible clearing is currently
allowed, but not forced upon futures clearinghouses, pursuant to Core
Principle E of the Commodity Exchange Act. Thus, clearinghouses have
the ability to create netting and offsetting arrangements with other
clearinghouses on a voluntary basis, with appropriate risk management
considerations in mind. Congress should eliminate the fungibility
requirement from the OTCDMA before passage.
Foreign Boards of Trade
The OTCDMA gives the CFTC greater authority over foreign boards of
trade. Foreign Boards of Trade will need to register with the CFTC in
order to provide electronic access to U.S. participants. In order to
register with the CFTC, the foreign board of trade must adopt position
limits for contracts that are linked to a contract traded on a U.S.
DCM.\5\ The OTCDMA goes further than linked contracts, however, and
gives the CFTC the authority to set position limits on any contract
traded on a foreign board of trade that is offered to U.S. market
participants.\6\
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\5\ OTCDMA, Section 725. ICE's London-based subsidiary, ICE Futures
Europe, complies a similar requirement through its ``no-action''
letter.
\6\ OTCDMA, Section 723.
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While placing position limits on U.S. market participants trading
in contracts linked to a contract traded on a U.S. exchange is
appropriate, allowing the CFTC to place position limits on foreign
exchange contracts that have no nexus or ``linkage'' to U.S. traded
contracts presents serious issues. For example, if a foreign exchange
offered access to U.S. market participants to a contract that was not
linked to a U.S. traded contract, under the OTCDMA the CFTC rather than
the foreign exchange regulator would set position limits. The provision
would allow the CFTC to set aggregate position limits on traditionally
sovereign contracts such as German bonds or Asian currencies. This
would be unacceptable to the foreign government regulating a market,
would invite retaliation by foreign regulators against U.S. exchanges,
and would impede regulatory cooperation among governments in what is
today a global financial market. Congress should eliminate this
provision from the OTCDMA since it does not pertain to the stated goals
of the proposal.
Conclusion
ICE has always been and continues to be a strong proponent of open
and competitive markets, and of appropriate regulatory oversight of
those markets. As an operator of global futures and OTC markets, and as
a publicly-held company, ICE understands the importance of ensuring the
utmost confidence in its markets. Subject to the foregoing
considerations which should be addressed by Congress in any final
legislation, the OTCDMA offers many improvements to the existing
regulatory framework in enhancing market transparency and eliminating
elements of systemic risk from the financial system.
Mr. Chairman, thank you for the opportunity to share our views with
you. I would be happy to answer any questions you may have.
The Chairman. Thank you very much Mr. Short.
Mr. Budofsky.
STATEMENT OF DANIEL N. BUDOFSKY, PARTNER, DAVIS POLK & WARDWELL
LLP, NEW YORK, NY; ON BEHALF OF
SECURITIES INDUSTRY AND FINANCIAL MARKETS
ASSOCIATION
Mr. Budofsky. Thank you, Mr. Chairman. As you noted, I am
Dan Budofsky. I am a Partner at the law firm of Davis Polk &
Wardwell, and I am here today to testify on behalf of the
Securities Industry and Financial Markets Association.
Thousands of Americans companies use over-the-counter
derivatives to manage the financial risks inherent in their
businesses. Many SIFMA members have built successful businesses
by offering derivatives products to these companies. It is
therefore in their interest, as well as in the interest of
their customers, to support legislative and regulatory measures
to improve the integrity, soundness and efficiency of the OTC
derivatives markets.
There is much in the Act that SIFMA supports. SIFMA
supports comprehensive regulatory oversight of systematically
significant derivatives dealers. SIFMA also supports regulatory
transparency as a means to facilitate oversight of derivatives
markets and the activities of individual market participants.
The Act would accomplish these goals by requiring that swaps
either be cleared through a derivatives clearing organization,
or be reported to a swap repository, the CFTC or the SEC. And
standardized swaps would be required to be cleared.
The Act goes much further than this, however, and I will
briefly touch upon several aspects of the Act that concern
SIFMA and its members.
First, SIFMA does not believe that legislation should
mandate exchange trading rather than over-the-counter trading
for derivatives. The Act seems to reflect the view that
transparency and risk reduction are best achieved through
exchange trading. SIFMA believes, instead, that these goals are
achieved through regulatory access to market information and
clearing, regardless of the trading environment. For example,
the U.S. bond market is overwhelmingly over-the-counter, yet it
is transparent and well regulated.
SIFMA is also concerned about the Act imposing burdensome
regulatory requirements on end-users. For example, the Act
could effectively force certain end-users to submit derivatives
transactions to clearinghouses. Although there is an exception
to the mandatory clearing requirement for standardized swaps,
if one of the parties is neither a dealer nor a major swap
participant, this is only available if that party also fails to
meet the eligibility requirements of the clearinghouse, which
could be unlikely for many large end-users.
Moreover, the definition of major swap participant is so
broadly and vaguely drafted that it could easily pick up many
end-users. Either way, an end-user might be compelled to submit
particular transactions through a clearinghouse, thereby
incurring significant costs including the not insignificant
opportunity cost of posting margin in the form of cash or cash
equivalents.
Another area of concern is margin. Under the Act,
regulators may, but would not be required to impose a margin
requirement on noncleared transactions, and would be required
to if the end-user falls within the definition of major swap
participant or the transaction does not qualify for hedge
accounting under FAS 133. This means that an extension of
credit created through a swap transaction must be
collateralized under the Act even though most other extensions
of credit between the parties could be made on an unsecured
basis.
SIFMA is also troubled by the Act's requirements of
additional capital for cleared transactions. Clearing reduces
risk by creating a well-capitalized central counterparty and by
requiring margin. Policymakers should be concerned about
imposing unnecessary costs that could discourage prudent risk
management.
I would also like to point out that the Act is written to
preclude any use of exemptive authority by the agencies. This
is unduly restrictive and would mean that legitimate practices
arising in the future that were never intended to be covered by
the Act might be affected, leading to unintended consequences.
A better approach might be to permit the agencies to grant
appropriate exemptions, but regularly report to Congress to
ensure that they are granted in accordance with the intent of
lawmakers.
Finally, SIFMA is concerned that the 180 day transition
period would not give the market sufficient time to comply with
the Act's complex and far-reaching provisions. SIFMA believes
that the effective date should be no less than 1 year after
enactment.
In conclusion, Mr. Chairman, I would like to reiterate the
support of SIFMA and its members for legislation to address
weaknesses in the current regulatory framework for derivatives.
The events of the past year have made it clear that
improvements are needed.
However, derivatives have become an integral part of our
economy, and they play an important role in the risk management
efforts of commercial companies across the country. As such, it
is important that legislation intended to improve derivatives
regulation and reduce systemic risk does not unnecessarily
impair the usefulness of derivatives, and thereby, increase the
risk exposure of many of the companies that have come to depend
on them.
Thank you.
[The prepared statement of Mr. Budofsky follows:]
Prepared Statement of Daniel N. Budofsky, Partner, Davis Polk &
Wardwell LLP, New York, NY; on Behalf of Securities Industry and
Financial Markets Association
Chairman Peterson, Ranking Member Lucas, and Members of the
Committee:
My name is Dan Budofsky. I am a partner of the law firm Davis Polk
& Wardwell LLP. I am appearing today on behalf of the Securities
Industry and Financial Markets Association (``SIFMA'') \1\ and its
members. Thank you for your invitation to testify today.
---------------------------------------------------------------------------
\1\ The Securities Industry and Financial Markets Association
brings together the shared interests of more than 650 securities firms,
banks and asset managers locally and globally through offices in New
York, Washington, DC, 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.)
---------------------------------------------------------------------------
The membership of SIFMA is diverse and includes financial firms of
different sizes as well as firms that are active in different parts of
the financial services business. Although my testimony today is being
presented on behalf of financial services firms, it also is focused on
the interests and concerns of those firms' customers, the thousands of
American corporations that benefit directly from the broad availability
of derivatives transactions to manage various risks that arise in
connection with their day-to-day business activities. These companies
also benefit indirectly from the availability of over-the-counter
derivatives (OTC derivatives) such as credit default swaps, which make
credit more readily available to them and at lower cost because it
permits those who extend credit to those companies to hedge their risks
as well. SIFMA's members have built successful derivatives businesses
by offering products that meet important needs of their customers, and
it is in their interest to support legislative and regulatory measures
that will improve the integrity, soundness and efficiency of the OTC
derivatives markets on which their businesses are based. Such measures
serve the interests of all market participants--the dealers and their
customers--and the American public, as well.
Indeed, fifteen major OTC derivatives dealers, in a recent letter
to the Federal Reserve Bank of New York, committed to clear 90% of all
new eligible interest rate derivatives and 95% of all new credit
default swaps through centralized counterparties by December and
October 2009, respectively. This, along with working with lawmakers and
regulators, will help achieve the laudable goals of increasing
regulatory transparency and reducing systemic risk in the OTC
derivatives market.
At the same time, SIFMA's members are concerned about legislative
proposals that would unnecessarily diminish the usefulness of available
derivatives or limit the availability of useful derivatives by imposing
significant new costs or limitations in connection with their use.
There is much in the Over-the-Counter Derivatives Markets Act of
2009 (the ``Act'') that SIFMA and its members support. In particular,
SIFMA supports legislative proposals to ensure that systemically
significant derivatives dealers are subject to comprehensive regulatory
oversight. The lack of meaningful regulation of AIG's derivatives
affiliate allowed poor business practices to go unchecked and ended in
a situation in which the Federal Government had to invest tens of
billions of dollars in that enterprise. Legislation that implements
comprehensive regulatory oversight of systemically significant firms
would address this regulatory gap.
SIFMA also supports measures that will improve regulatory
transparency and thereby facilitate oversight of derivatives markets
and the activities of individual market participants. The Act would
accomplish this by requiring that swaps either be cleared through a
derivatives clearing organization (a ``DCO'') (in fact, if they are
standardized they would be required to be cleared through a DCO) or be
reported on a post-trade basis to a swap repository or the CFTC.
Similar requirements, including reporting to the SEC, would be imposed
under the Act with respect to security-based swaps. SIFMA believes that
by combining regulatory transparency with oversight of systemically
important firms, the Act addresses the regulatory shortcomings that
allowed the AIG situation to threaten the global financial system.
The Act goes much further than this and, in so doing, could
adversely affect the availability and usefulness of derivatives
transactions. I will briefly describe several of the issues in the Act
that SIFMA has identified as particularly problematic.
The Act mandates that all swaps that are standardized be traded on
an exchange or an alternative swap execution facility. SIFMA believes
that the legislation incorrectly views transparency and risk reduction
as being achievable solely through exchange trading, but these goals
can be achieved through other means. SIFMA does not believe there is
any reason for the government to mandate that business be transacted in
this particular manner. In the equity markets we have both exchange
trading and over-the-counter trading. The policy goals of transparency
and systemic risk reduction are achieved by timely post-trade price
reporting and clearance of transactions effected by broker-dealers
through registered clearing agencies. It has long been recognized that
while an exchange is a facility for transacting business that provides
buyers and sellers with a place to meet, it is by no means the only way
for transactions to occur. Highly liquid, frequently traded products
may benefit from exchange trading, whereas it may be more appropriate
for products that trade less frequently to trade over-the-counter. For
example, the U.S. bond market is an overwhelmingly over-the-counter
market, yet it is transparent and well-regulated. Bond transactions are
reported to trade reporting facilities that make the execution prices
available to regulators for surveillance purposes. Bonds clear through
clearing agencies such as DTCC that provide a central counterparty, and
this performs an essential risk mitigation function.
SIFMA also is concerned about the application of the Act's many
regulatory provisions to the customers of derivatives dealers, the
corporations that use derivatives. For example, the Act would
effectively require corporate end-users to become members of registered
clearing agencies. Let me explain why. The Act includes an exception to
the mandatory clearing requirement for standardized swaps in the case
of transactions in which one of the parties is not a dealer or major
swap participant (i.e., is a corporate end-user), but only if that
party also does not meet the eligibility requirements of the
clearinghouse. The definition of major swap participant is so broad and
vague that it could easily include many corporate end-users, and the
eligibility requirements of clearinghouses will not necessarily
constitute a significant hurdle, particularly insofar as they are
profit-making entities eager to expand their businesses. If corporate
end-users were required to clear their standardized swaps they would
incur the very significant cost of posting margin in the form of cash
or cash equivalents, which is the form of collateral required by
clearing agencies. Because these funds would no longer be available for
productive investment in the corporate end-user's business, a clearing
requirement would create a significant disincentive to use swaps to
manage risk. Today, in the OTC derivatives world, corporate end-users
may be required by their dealer counterparty to post margin, but that
margin may be in the form of assets other than cash or cash
equivalents.
Although CFTC Chairman Gary Gensler recently suggested in a letter
to Members of Congress that end-users could post margin in the form of
assets other than cash, SIFMA does not believe that is a realistic or
viable alternative, as it would expose the clearinghouse, which as the
central counterparty must be highly liquid, to unacceptable levels of
risk.
Another example of the Act's potential impact on end-users arises
in connection with margin requirements. Although regulators are not
required to impose a margin requirement on end-user transactions that
are not cleared, the Act says they may do so, and would be required to
if the end-user falls within the definition of major swap participant
or the transaction does not qualify for hedge accounting treatment
under FAS 133. This means that an extension of credit created through a
swap transaction must be collateralized, even though most other
extensions of credit between the parties could be made on an unsecured
basis.
In short, SIFMA does not believe that corporate end-users, as
opposed to professional market participants such as swap dealers,
should be subject to burdensome new regulatory requirements in
connection with their swap transactions. If they are, the result will
likely be that they are exposed to more risk, not less.
SIFMA members also are concerned about the imposition of
incremental capital requirements with respect to their cleared swaps.
The clearing process makes these transactions less risky. Market
participants benefit by gaining a well-capitalized clearinghouse as a
counterparty and by the clearinghouse's requirement that all of its
transactions be secured by margin. The addition of a further safeguard
by imposing the requirement of additional capital for cleared
transactions seems unnecessary, in particular because the cost of each
of these layers of protection is directly borne by the dealers, and
ultimately by their customers. Policymakers should be concerned about
imposing a level of cost that discourages prudent risk management.
Giving the CFTC, the SEC, and prudential regulators the general
authority to establish capital requirements would seem to be
sufficient.
SIFMA also has a practical concern about the short implementation
time provided in the Act. Its provisions are to become effective 180
days after the date of enactment. SIFMA does not believe this would
give derivatives dealers and other swap participants sufficient time to
comply with the Act's complex and far-reaching provisions. SIFMA
believes that the effective date should be no less than 1 year after
the date of enactment.
In conclusion, Mr. Chairman, I would like to reiterate the support
of SIFMA and its members for legislation to address weaknesses in the
current regulatory framework for derivatives transactions. The events
of the past year have made it clear that improvements are needed.
However, derivatives have become an integral part of our economy and
they play an important role in the risk management efforts of
commercial companies across the country. As such, it is important that
legislation intended to improve derivatives regulation and reduce
systemic risk does not unnecessarily impair the usefulness of
derivatives and thereby increase the risk exposure of the many
companies that have come to depend on them.
The Chairman. Thank you.
I thank the panel for your patience in sticking with us
here.
Mr. O'Connor, I was reading your testimony. I want to try
to understand better what you are saying. From what I can
gather, you are saying that what we heard from the end-users on
the first panel was maybe more dramatic than you think it
really is. Am I right about that?
You seem to think that clearing is not as big a problem as
some people are make making it out to be. Am I reading that
right?
Mr. O'Connor. I think there are two issues that people have
with clearing, and the panel this morning dealt predominantly
with the cost of clearing.
There is a cost to central clearing, but there is also
great benefit to it. So, it is difficult to sit in this room
and say, I would like to see more transparency in my markets, I
would like to be protected from systemic risk, and I would like
to see more done about abuses in the market that cause undue
volatility, but I don't want to pay anything for it.
So there are benefits.
The Chairman. Sounds like the health care debate.
Mr. O'Connor. I will leave that alone.
So that is one concern. But that comes down to an
assessment of the cost in benefits.
And the other concern you have heard, perhaps from this
panel, is about concerns around standardization and the loss of
the ability to use customized derivatives. That is what I spoke
more to in my written testimony and--this morning that that is
perhaps a historic perspective, and that as technology and
talent is brought to bear on the problem by the industry, that
what was once standardized is now a much broader aspect of the
market.
The Chairman. And so in other words you are saying it is
not--whatever the standardization, and I am not exactly sure I
know what it is--but it is not as hard to do or complicated as
some people make out?
Is that what you are saying?
Mr. O'Connor. It can be done.
The Chairman. Can be done?
Mr. O'Connor. Yes.
The Chairman. And the way that the Treasury has put out
this proposal in terms of standardization and so forth, you
seem to think it might be workable or close to workable?
Mr. O'Connor. I think it is a difficult thing to define in
legislation, and you need to be careful that unintended
consequences don't happen.
But, the presumption that if a regulated clearinghouse is
able to offer a product for essential clearing, then it is
standardized, I think is a good one. It doesn't force the
industry to do something they don't feel they have the
capability to do. It already falls within regulatory oversight,
and it adapts dynamically to the marketplace. As new products
comes on line and as new capability is developed, it tends to
roll with the punches.
The Chairman. And the clearinghouses, I guess they have a
business model and they do things a certain way. From what I
can tell, some of these end-users, they put up collateral, but
they do it a different way than they do it in clearinghouses,
and that seems to be the bigger part of the problem than
anything.
And that can't be dealt with?
Mr. O'Connor. I think it can be dealt with. There is a
layer between the clearinghouse and the end-user.
The Chairman. That is what I was wondering. Couldn't you do
that?
Mr. O'Connor. Yes, there is a clearing agent within sort of
most CFTC-regulated clearinghouses; that is the futures
commission merchant. They are able to offer secured financing
to their customers to support margin requirements. A good
majority of those futures commission merchants are banks, so
there is certainly capability there for the industry to respond
to the needs for financing secured--to support those positions.
The Chairman. So this idea that they are going to have to
put up cash for the margins and that is inflexible is not
necessarily true. There is some flexibility there; you could do
it a different way.
Mr. O'Connor. There is flexibility there, yes.
The Chairman. It maybe isn't done that much now, but it
could be done.
Mr. O'Connor. I think the people who participate in those
markets, as they currently stand, probably are in a better
position to provide cash. But secured financing does happen
today, and there is no reason why that offering couldn't be
expanded.
The Chairman. If they are making a deal in the swap market
using this, and it works, and the people that are doing the
deal think that they are covered, I don't see why it couldn't
be done, or on a more organized clearinghouse order. That has
been my question.
So you say it probably could be done?
Mr. O'Connor. Yes. There are a few more restrictions on it,
so you can't finance it outright. You can't just lend them the
money to support the transaction, but it is sort of a stronger
system.
The Chairman. And in your testimony you said that five of
the banks are now doing 96 percent of this customized business;
am I right about that?
Mr. O'Connor. I think that the statistic is from the
Comptroller of the Currency. In his latest statistical release
it suggests that of the U.S. banking system, 96 percent of the
current notional outstanding is held by the largest five banks.
The Chairman. We have actually concentrated the risk now
into fewer banks, and we have actually--it sounds to me like we
have gotten ourselves in a worse situation than we were in
before.
Mr. O'Connor. I think that is true. I think that the OTC
derivative markets pose a larger risk to our financial system
now than they did before the crisis began. I think you have
greater concentration in the markets; you have less liquidity
in the market, some of which we have heard about this morning;
and that is a bad situation.
The Chairman. Mr. Pickel.
Mr. Pickel. If I may elaborate on that, the OTC's
statistics include the banks, so it includes JPMorgan and Citi,
Wells, Wachovia and Bank of America and that is four of the
five; I forget what the fifth one is. But that is the U.S.
banks, so it doesn't include Deutschebank, it doesn't include
the foreign banks. It actually doesn't include Morgan Stanley
or Goldman Sachs either, so there is a slightly larger--
probably 10-12, especially in the interest rate swaps, where
these banks are more than willing to step in and take over
business from any of their competitors.
The Chairman. So if you take out the interest rates, is it
all right if I go? The interest rate swaps, that stuff is more
vanilla than these other customized things, or more exotic
things. If you set that aside and these other CDSs and so
forth, I am more concerned about what is the percentage, what
number of banks are engaging in that process. The same 10 or 12
entities?
Mr. Pickel. Yes, all of these institutions would be very
active dealers in CDS, and CDS volumes are--we just published
information this week--$31 trillion notional amount not the
amount at risk, but the outstanding amount of trades, there has
been a great effort to reduce those outstandings over the past
year, year and a half.
But that is the same universe of institutions that would be
offering those trades.
Mr. O'Connor. If I can just add something, I think Goldman
Sachs, now that they are a bank holding company, they are in
those numbers.
But it is true that there are other international banks
that aren't captured by the OCC, but you see the same in the
BIS statistics, which is--aggregation of all the central
banking data on market concentration shows that concentration
is higher than it has been. And of particular concern is,
concentration in the U.S. market is much higher than it has
been, and it has fallen behind other competitive marketplaces.
So while it might overstate it slightly to talk just about U.S.
banks, the U.S. market itself does demonstrate this.
The Chairman. Thank you.
The gentleman from Oklahoma.
Mr. Lucas. Thank you Mr. Chairman, and to continue for a
moment along this line, does anyone else on the panel have any
comments about this subject?
Fair enough. Then let's visit for a moment about the
Treasury proposal granting aggregate position limited authority
to regulators to impose limits across all markets. Provide me
with your insights, gentlemen. How many of you support that?
How many have opinions about that, how it would work or not
work?
It is a nice open-ended question, I promise.
Mr. Pickel. I will jump in here.
Yesterday, the CFTC had their Energy and Environmental
Market Advisory Committee meeting, and there was discussion of
position limits there and obviously they are focused on that.
As I pointed out, the OTC contract again is a bilateral
contract tailored to the particular needs of the counterparty.
To the extent it is mirroring an exchange traded contract,
there may be some ability--effectively it is a look-alike
contract, and you could aggregate those positions. But the
reality is that the bilateral nature of it makes it very
difficult, and the custom tailored nature of it makes it very
difficult to compare it with the exchange trading contracts.
And there are also issues in terms of how you would
aggregate those with the exchange traded world. And, there have
been suggestions that it would be aggregated with overseas
contracts also.
Mr. Lucas. Anyone else?
Mr. Short. Speaking on behalf of ICE, we would support
position limits across various venues and markets. We do have a
view that the Commission should be the body that administers
that in order to have a fair and competitive landscape amongst
trading venues.
One particular piece of the proposed legislation that I
think is problematic, I candidly think was an oversight. They
actually had a provision that says that the CFTC could impose a
position limit on a contract traded on a foreign board of trade
that isn't a look-alike that is linked to a domestic market,
and I think that is problematic.
Mr. Damgard. And I would agree with that. I think--we are
going to need a lot of cooperation between foreign regulators,
it seems to me. Both Europe and London have been on record as
saying that they have a lot of different ways to detect
manipulation, and they are pleased to know that the U.S.
regulator is going to depend on position limits, but in each
case they said that they are not. And it worries me that if we
have position limits imposed on U.S. exchanges, but without the
reach to do it outside the United States, we damage the
opportunity for U.S. exchanges to continue to get the kind of
business that they are getting today.
Mr. Duffy. Mr. Lucas, also on that point, position limits;
the CME Group has supported aggregated position limits as long
as there is a formula based on how you come to those position
limits. We believe that it has to have, and we have it spelled
out in our white paper, that it has to be based off of certain
criteria of open interest, which are open positions on the
exchange at the time.
So the work that we put into development of all these
products historically, just can't--you can come up with an
arbitrary number that everybody gets the same number, and then
that would literally disenfranchise a group like CME Group that
has worked very hard to put these positions on its books and
serve its clients.
So we would be at a huge disadvantage if the aggregation
amongst position limits wasn't done at least on a formula base
which made sense from a business perspective.
Mr. Short. I would just add that that is the issue that we
think makes that proposal anti-competitive on its face, because
if you were to apply an open interest test to the positions
that could be held on an exchange, a new entrant to the market
could never compete. It could never generate sufficient
liquidity to compete with the incumbent.
Mr. Duffy. That is totally not true. There have been many
examples, sir, historically of competing exchanges listing
other exchanges' product and becoming quite successful.
One of them is the IntercontinentalExchange listing the WTI
contract of the New York Mercantile Exchange and gaining a 30
percent market share quite rapidly.
So there are many examples how new companies can come into
this space and become quite successful. But we don't believe it
should be at the expense of noncompetitive business. Thank you.
Mr. Lucas. You have both made your points very well and
clear.
Mr. Damgard, in your testimony, you mentioned about how the
standardization mandate should be replaced by incentives on
trade, on exchanges, and through clearing systems. Could you
expand just a moment on this concept of incentives to cause
behavior?
Mr. Damgard. Well, I mean, for the most part, we believe
that the exchange traded world works extremely well. And we
know that it works well because it takes on an awful lot of
risk that is done in the OTC market.
Defining standardization is pretty tricky. What really
constitutes standardization in a product is not something that
we are totally comfortable can be done in a statute. We think
the CFTC should have the authority to look at what is
standardized and what is not standardized.
But to the extent that an OTC product is accepted by a
clearinghouse, that, we believe, is Treasury's position, that
therefore it should be considered standardized, and that is
good enough for us. We are not sure that it is necessary to
mandate that it be cleared, because, in some instances,
clearinghouses and clearing members ought to be able to
determine what they want to clear.
I mean, these are voluntary organizations. And if, all of a
sudden, the clearinghouses are forced to clear products that
they can't value and they can't margin, it seems to me the
clearing members have almost an obligation to their own
stockholders to withdraw from the clearinghouse, which would be
catastrophic in the long run.
Mr. Lucas. Thank you.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Iowa, Mr. Boswell.
Mr. Boswell. Well, thank you, Mr. Chairman. I want to just
take a moment and thank you and Mr. Lucas for the personal
effort and attention you are giving to this business that has
got a lot of concern.
Earlier today, you made a comment, if I might remind us,
not wanting to go back to the system that got us into the
trouble that we are in. Last week, about a week ago Monday,
talking to a constituent, a small-business owner, very
successful small business but it is a small business, and
talking about health care, and he said, ``Well, are you aware
that Wall Street is securitizing life insurance and doing a
bundling, if you will, bundles of life insurance?'' So we
talked about it. I didn't think he probably knew what he was
talking about, but he seemed like he does about everything
else, so we did a little checking up on it. And almost the same
day, The New York Times came out with an article called, Wall
Street Pursues Profit in Bundles of Life Insurance.
And the idea is that you can buy up somebody's life
insurance, a half-a-million-dollar policy or whatever policy
for half or whatever they can agree on, and take the gamble
that they are going to die, and then they can cash it in. But
that is not good enough. That is good, just bundle them up and
get a bunch of them.
And I would like, I guess, to have you comment on that,
what your thoughts of it are. I am going to ask to put into the
record this article.
But, the professor from Duke said, ``It is bittersweet. The
sweet part is there are investors interested in exotic products
created by underwriters who make large fees and rating agencies
who then get paid to confer ratings. The bitter part is it is a
return to the good old days.''
Now, I look at this panel--I was hoping Mr. Secretary would
be here, but we will address this to him, too, I guess. But do
you have an opinion on that? I would like to start with you,
Mr. Budofsky, and just anybody else who wants to comment, and
just tell us what you think about all that.
Mr. Budofsky. I don't think that--well, I am not aware of
SIFMA having a particular position on that particular
instrument. So I would be happy to consult with them on that
particular instrument.
However, I would say that this is an example of why SIFMA
supports general improved regulatory oversight over the types
of entities that would be selling these products. And, to the
extent that there are issues with that type of instrument, then
regulatory oversight would be a way of having the regulators
express a view.
Mr. Boswell. Anybody else? Please.
Mr. Pickel. Yes, I saw that article. I read it with
interest.
I would point out that that is a--well, it is in the nature
of a collateralized debt obligation, which is a security, not
an over-the-counter derivative product, but a security that is
bundled with taking those cash flows from those insurance
policies and paying them out to the securities holders. So the
securities laws would apply to the offering and distribution of
those instruments.
As it relates to OTC derivatives, and it wasn't really
discussed in that article, but there is an area, an emerging
area of OTC derivatives that is potentially very useful for
pension funds and insurance companies, and that is what are
often called ``mortality derivatives,'' ``life derivatives,''
where there would be--again, there is the same concern.
A pension fund has a certain horizon, in terms of the
expectations about how long somebody will live, and they may
live longer than that, so there is a risk there that they need
to manage. An insurance company is expecting somebody to live a
certain length of time, and they might die sooner, and they
would have to pay out sooner than they expected. And there are
these instruments, and they are very effective, and they are
very tailored to particular needs that allow pension funds,
insurance companies to manage that risk in a very effective
way.
Mr. Boswell. Good point.
I would just say this, Mr. Chairman, the article goes on to
say that oftentimes these life insurance policies lapse before
a person dies, for a variety of reasons: their children grow
up, no longer need the financial protection, or the premiums
become too expensive. And sometimes when this happens, the
insured doesn't want to keep it going, so the insurer doesn't
have to make a payout. But if it is purchased and packaged into
a security, investors will keep paying the premium that might
have been abandoned.
As a result, more policies will stay in force, ensuring
more payouts over time and less money for insurance companies.
And what does that do? Well, I guess, currently, when they set
their premiums--and they have all these actuarial studies,
which you know more about than I do--but they base them on
assumptions that were wrong if this takes place.
So I think this needs a little more look. So I would ask if
we could enter this into the record, and I would like to do so.
The Chairman. Without objection, so ordered.
[The document referred to is located on p. 99.]
Mr. Boswell. Thank you. I yield back.
The Chairman. Thank you.
The gentleman from Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman. Thank you for
holding the hearing, and thank you for a pretty practical
approach to trying to get to the bottom of all this stuff.
All of you heard the first panel testify, I think to a
person, that they weren't real thrilled by the notion of being
forced to clear. And, Mr. Duffy and Mr. O'Connor, both of you
were interested in clearing operations. And you heard them say
that they just wouldn't be able to fund it, they wouldn't be
able to finance it, they wouldn't be able to get--if they were
able to borrow the money for margins, it would be at a very
onerous cost.
And then you also heard the representative from Delta
saying that, at least in the swaps area, as price moves, there
are capital requirements, margining requirements. I guess I
would like to hear your thoughts about how onerous this would
be.
And then I would like to hear a little bit about tailored
swaps. It seems to me there are probably plenty of swaps where
the parties agree that they don't put up--it is individually
tailored, so why would they be required to put up money as the
price moves?
You know, if I am dealing with Goldman Sachs, at least 5
years ago, I probably wouldn't insist that they put something
up. I would just assume that this is sort of like, they have
the money. And that led us into the AIG mess. And that is the
systemic risk we are trying to avoid here.
So, what about the clearing being too onerous? I know you
testified, Mr. O'Connor, that there is value to this. But they
are grownups; they can decide whether or not they need to have
some third party stand good for their swap. If they choose to
do a swap, free market, why shouldn't we just let them do a
swap and just sort of try and deal with the systemic risk part
of it?
Mr. Duffy. I don't disagree with that. They are grownups,
and they can do what they want as a third party. But, there are
some misconceptions as it relates to clearing and the costs
associated with clearing and collateral.
First of all, the collateral that you put up for margin is
not too dissimilar than the collateral you are going to put up
for an OTC transaction. So if you put up zero for an OTC
transaction, I am assuming the risk around that trade of one
person not paying off at the time of maturity could be an issue
or a failure in the system.
In the regulated clearing model, you put up that margin
money, and if the position goes obviously in your favor, you
can take that excess funds and do with them as you see fit, as
long as the position stays margined. So there are ways to
utilize the capital in the clearinghouse during the point
before maturity of the transaction.
So, that is the first and second misconception of what kind
of collateral can be accepted for trade, OTC versus an
exchange. And, second, if you don't put up any collateral for
an OTC transaction, I am assuming that--what do you do at the
end of maturity? How do you know that your counterparty is
going to be good?
Mr. Marshall. Well, the counterparty is AIG, so everybody
knew it would be good.
Mr. Duffy. Right. That worked out well.
Mr. Marshall. But that is exactly what we are trying to
figure out how to avoid that.
Mr. Duffy. Well, basically, you need to have some kind of
capital or margin up there to margin these positions. You just
can't have zero up there and then, at the point of maturity,
have a default. And then if you do that multiplied by the
amount of times, you can see where you are at.
Mr. Marshall. Right. And forcing everything through
clearing accomplishes that objective.
Mr. Duffy. No, not everything through clearing.
Mr. Marshall. Well, obviously, you can't do--you wouldn't
be able to force--but if you could put everything through
clearing, you would accomplish the objective of making sure
that people, as price moves, that they are required to follow
that with appropriate experience.
Mr. Duffy. That is the risk-management system that the CME
deploys, sir, yes.
Mr. Marshall. Right. So we recognize that there will at
least be custom swaps. It would be very helpful if you could
help us understand what the real costs would be and whether or
not there would be funding available for these businesses that
don't have a lot of excess capital. I mean, you heard that
testimony repeatedly. They want to hedge; they don't have
excess capital to be tying up in a margin.
Mr. Duffy. So they are not hedging at all, I am assuming
then.
Mr. Marshall. No, they do hedge. They just don't have to
put a margin up if they are swapping, is what I thought the
testimony was earlier.
The Chairman. Would the gentleman yield----
Mr. Marshall. Yes, sir.
The Chairman.--on that point, if anybody knows?
So these guys that claim they don't have the money and they
are doing these hedges, I don't know if they are putting up
their equity or whatever they are doing. But the people that
are doing the deal are going to, they are not going to do this
for free. So what do they do? Do they charge a larger
percentage fee then? Is that how they get their money out of
this if they are not--how does that work?
Mr. Pickel. Well, typically, it is a credit relationship,
so they would do a credit analysis and determine what type of
exposure they are willing to have. There would probably be some
pricing element that would reflect the fact that if they are a
high-quality counterparty, the pricing would be tighter than a
lower-quality counterparty. But I think----
The Chairman. But the counterparty is actually putting up
the money. The person that is hedging is not putting up any
money. So they are going to charge for that, too, then, I
suppose.
Mr. Duffy. They are using the company's balance sheet, and
the company is charging more for the transaction.
Mr. Pickel. But I guess one thing, partly in response to
you, Mr. Marshall, is that in situations where you have an
active trading relationship, this two-way--this is in the
bilateral world--the two-way movement of collateral back and
forth is extremely common. So between dealers, between dealers
and hedge funds, dealers and asset managers who are trading on
a pretty regular basis, or even a company like Delta, which
sounds like they are a pretty active user of the market, you
would typically have collateral in the relationship.
For the occasional user that is maybe accessing the
interest rate swap market when it occasionally issues a bond,
often the dealer is willing to do that on an uncollateralized
basis, where neither party would post collateral.
Mr. Marshall. I think the reason we are interested here is,
we want to get a better handle on whether or not we actually
are going to screw people up, somehow impair significantly
their ability to hedge risk or burden them too much. And you
can help us do that by helping us understand this.
And if, in fact, in the swaps world, effectively the same
level of security is presented, as a result of margining going
back and forth or collateral going back and forth in order to
secure performance in the event of price changes, as things
move forward, that is happening anyway, then what does clearing
add? And here is what I suspect: is that it happens depending
upon who the parties are.
I am Delta. It is 5 years ago or 10 years ago when Delta is
blue chip, and I am dealing with AIG or I am dealing with
Goldman Sachs, blue chip also. I am able to hedge at very
little or no expense and with very little or no collateral
moving back and forth as price changes. But I am able to say to
my board or whoever, ``Yes, we have hedged that.''
Am I right? It is really dependent upon what the parties
wanted to agree to as between themselves?
Mr. Pickel. That is right. It is left to a bilateral
negotiation.
Mr. Marshall. So where the systemic stuff is concerned, our
concern is that we are concentrating this risk in these large
banks, 5, 10, 12, something like that. You know, the sense that
I get as I talk with the Chairman and others, and as we talk to
our European regulators, all of us have the sense that there
has to be something besides the inclination of the parties at
that level to put up appropriate collateral, that we have to
have something that assures that that occurs.
Now, if we were able to force everything to be cleared,
then the clearing agency would wind up making sure that
appropriate flows of collateral go back and forth, so that
there is not any AIG-type event. Everybody concedes, though,
that we can't do that, because there are just going to have to
be custom swaps that won't fit in a clearing setting, and we
don't want to force the clearing agencies to have to clear when
they don't want to. So there is going to be a bunch of stuff
out there.
So how do we, as regulators--how are we assured, as
regulators, unless we have something like the President's
proposal, that, in fact, appropriate collateral is moving back
and forth so that the systemic risk stuff doesn't come up?
Mr. Pickel. I think one of the key definitions is the
definition of major swap participant, which when we have been
discussing with the Treasury earlier in the summer that was
kind of intended to be the AIG provision, the one that would
capture the next AIG. And I think, therefore, it is a very
important definition.
It is a bit unclear as to what it is intended to mean in
the Treasury proposal, because it talks about a substantial net
position. Well, AIG's situation was, yes, they had a large net
position, but really they were just taking on one-way risk, and
that was really the problem. And they didn't fully understand
or analyze that risk, which augmented the problem.
I think that is a pretty important definition. But it is
important to get it right so you don't sweep in institutions
that really are just actively trading and may not be
particularly long or short position at any particular point in
time.
Mr. Duffy. Congressman, if I may add when this crisis all
happened, I think that--and I am just talking as a citizen now
and as a taxpayer--that these transactions were going to be
required to have more collateral associated with them so we
would not have the risk with it. We wouldn't be using leveraged
balance sheets for these transactions, as we have over the
past, in the future. So I am assuming that is it.
So if people want to continue to trade customized swap
transactions, which I think they should be able to do, I am
assuming the government is going to have different capital
requirements for people that want to participate in that type
of venue versus what they were doing before.
And if you want to trade or clear your product on an
exchange and let the exchange be the neutral facilitator or the
buyer for every seller, the seller for every buyer, you could
put up the margin and take the excess margin and do with it as
you please to manage your business.
So I assume that is what the path was going down when this
all happened.
The Chairman. Could I--we have Members who want to catch
planes. So, the gentleman from Georgia, Mr. Scott
Mr. Scott. Thank you very much, Mr. Chairman. And I
appreciate the panelists coming and your holding the hearing.
You know, we have basically three proposals here--you have
Treasury's proposal; we have our own, H.R. 977; and then,
again, in my Financial Services Committee, we have another
bill--all working to increase regulation, transparency, and
oversight of the over-the-counter market. I want to try to
narrow mine into an issue within the Treasury Department's
proposal.
It seems that Treasury intended to give clearinghouses the
ability to allow end-users to move swaps transactions from one
clearinghouse to another. But, as it is done currently, the CEA
gives clearinghouses the ability to treat transactions as
fungible. So it seems no change to current law would be
necessary. However, the language in Treasury's proposal could
be read to force--to force--clearinghouses to treat
transactions as fungible, which could have a negative systemic
risk implication.
Mr. Short, let me ask you--because I believe that you
mentioned this as a part of your concerns over Treasury's
proposal, if I am correct--would you mind elaborating on this
point?
Mr. Short. Sure. I think the language in the Treasury
proposal talks about fungible clearing and margin offsets for
swaps. And I have heard some background information that that
may not have been the true intent of that provision, that it
may have actually just meant that if you were trading through
one electronic avenue into a clearinghouse you could trade out
on another.
But that language, as written, could provide for or be
interpreted to require one clearinghouse to provide margin
offsets in another clearinghouse. And what you run into there
is, kind of, the linkage problem. I have to be confident that
Terry's clearinghouse is run properly--not that I think his
clearinghouse is a problem. But when you multiply that out over
a number of clearinghouses, some of which may be domestic, some
of which may be foreign, you can quickly see how this could,
instead of isolating risk and allowing a clearinghouse to
really do what it is supposed to do, it could actually increase
systemic risk. And that is why I think that provision should be
dropped or clarified.
Mr. Scott. And so how would you say it would be clarified
or dropped? Is there specific language? Is there something that
you would suggest in that?
Mr. Damgard. I actually think the language says that a
clearinghouse has to accept trades from multiple execution
facilities, which would create the fungibility at the
clearinghouse.
Mr. Scott. Do you agree with that, Mr. Short?
Mr. Duffy, I would also like for you to comment on this.
You are with the Chicago Mercantile Exchange.
Mr. Duffy. Yes, sir.
Mr. Scott. So are you----
Mr. Duffy. I agree with Mr. Short on this topic right now.
And we actually have submitted language to the Committee,
supplemental language, and to the Treasury on this issue
because we agree with you, sir, it can be--I guess it is up to
the person who reads it as to how they are going to determine
it, and that is not good legislative language. So we think we
want to have clarity.
We do not want to put the CME Group's clearinghouse at risk
by accepting the credit risk of another clearinghouse, whether
it be ICE or somebody else, as the same way they don't want to
accept the credit risk of the CME.
So what the language says is, the fungibility should be
amongst trading platforms, not among clearinghouses. But, as I
said in my oral testimony, it could be interpreted that--and
other people are trying to force it to a single clearinghouse,
which is what Mr. Short is saying.
So we would love to see the language changed. And we have
submitted it, and we would be happy to send it to your office,
sir.
Mr. Scott. I agree with you. I think, Mr. Chairman, that
that makes a lot of sense. I think you would agree to that.
Was there something else you wanted to say there?
Mr. Damgard. No, I understood the language, and I agree
that it is confusing. But, what the Treasury was trying to do
was say, any clearinghouse, not just one or not just two, but
any clearinghouse would have to accept trades from all of the
execution facilities if, in fact, it was the same product. And
I am not sure if that is accurate or not.
Mr. Duffy. No disagreement, as long as it is from the
trading facility, not from the clearing entity. And that is the
big distinction that we need to have clarity here, sir, because
it is very fuzzy, as Mr. Damgard said earlier in his testimony.
Mr. Scott. Very good.
Let me ask a follow-up, if I may, Mr. Chairman, one little
thing here.
The Chairman. We are running short of time, so be very
brief.
Mr. Scott. I will be very brief.
Mr. Short, I believe you also expressed concern about the
Administration's proposal covering foreign boards of trade and
how position limits would apply to certain contracts,
particularly those that are not tied to United States-based
contracts.
Given your experience with foreign boards of trade at ICE,
could you elaborate the concerns laid out in your testimony
very briefly?
Mr. Short. Yes. Very briefly, we operate ICE Futures
Europe, which is a London-based exchange. It was the former
International Petroleum Exchange. It is basically the European
equivalent of the NYMEX.
While we understand the need for position limits on linked
contracts, which we have several in that there is a price
linkage to contracts traded on the NYMEX. I think the language
in the Treasury proposal doesn't limit the CFTC's authority to
set position limits across venues to link contracts.
So you could have, for example, our Brent Crude Futures
contract subject to a CFTC position limit, and I think the FSA
would have an issue with that, as the CFTC would have an issue
with a foreign regulator attempting to set a position limit on
a domestic contract.
Mr. Scott. All right. Thank you, Mr. Chairman. I appreciate
that.
The Chairman. I thank the gentleman.
We have to move it along. So we thank this panel for their
patience and for their testimony and the answers to our
questions.
Now, before I adjourn, does the Ranking Member have any
comments?
Mr. Lucas. No, Mr. Chairman.
The Chairman. Okay.
Under the rules of the Committee, the record of today's
hearing will remain open for 10 calendar days to receive
additional material, supplementary written responses from the
witnesses and to any question posed by a Member.
And this hearing of the Committee of Agriculture is
adjourned.
[Whereupon, at 3:12 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Material by Hon. Leonard L. Boswell
Wall Street Pursues Profit in Bundles of Life Insurance
The Wall Street Journal
September 6, 2009
By: Jenny Anderson
After the mortgage business imploded last year, Wall Street
investment banks began searching for another big idea to make money.
They think they may have found one.
The bankers plan to buy ``life settlements,'' life insurance
policies that ill and elderly people sell for cash--$400,000 for a $1
million policy, say, depending on the life expectancy of the insured
person. Then they plan to ``securitize'' these policies, in Wall Street
jargon, by packaging hundreds or thousands together into bonds. They
will then resell those bonds to investors, like big pension funds, who
will receive the payouts when people with the insurance die.
The earlier the policyholder dies, the bigger the return--though if
people live longer than expected, investors could get poor returns or
even lose money.
Either way, Wall Street would profit by pocketing sizable fees for
creating the bonds, reselling them and subsequently trading them. But
some who have studied life settlements warn that insurers might have to
raise premiums in the short term if they end up having to pay out more
death claims than they had anticipated.
The idea is still in the planning stages. But already ``our phones
have been ringing off the hook with inquiries,'' says Kathleen
Tillwitz, a senior vice president at DBRS, which gives risk ratings to
investments and is reviewing nine proposals for life-insurance
securitizations from private investors and financial firms, including
Credit Suisse.
``We're hoping to get a herd stampeding after the first offering,''
said one investment banker not authorized to speak to the news media.
In the aftermath of the financial meltdown, exotic investments
dreamed up by Wall Street got much of the blame. It was not just
subprime mortgage securities but an array of products--credit-default
swaps, structured investment vehicles, collateralized debt
obligations--that proved far riskier than anticipated.
The debacle gave financial wizardry a bad name generally, but not
on Wall Street. Even as Washington debates increased financial
regulation, bankers are scurrying to concoct new products.
In addition to securitizing life settlements, for example, some
banks are repackaging their money-losing securities into higher-rated
ones, called re-remics (re-securitization of real estate mortgage
investment conduits). Morgan Stanley says at least $30 billion in
residential re-remics have been done this year.
Financial innovation can be good, of course, by lowering the cost
of borrowing for everyone, giving consumers more investment choices
and, more broadly, by helping the economy to grow. And the proponents
of securitizing life settlements say it would benefit people who want
to cash out their policies while they are alive.
But some are dismayed by Wall Street's quick return to its old
ways, chasing profits with complicated new products.
``It's bittersweet,'' said James D. Cox, a professor of corporate
and securities law at Duke University. ``The sweet part is there are
investors interested in exotic products created by underwriters who
make large fees and rating agencies who then get paid to confer
ratings. The bitter part is it's a return to the good old days.''
Indeed, what is good for Wall Street could be bad for the insurance
industry, and perhaps for customers, too. That is because policyholders
often let their life insurance lapse before they die, for a variety of
reasons--their children grow up and no longer need the financial
protection, or the premiums become too expensive. When that happens,
the insurer does not have to make a payout.
But if a policy is purchased and packaged into a security,
investors will keep paying the premiums that might have been abandoned;
as a result, more policies will stay in force, ensuring more payouts
over time and less money for the insurance companies.
``When they set their premiums they were basing them on assumptions
that were wrong,'' said Neil A. Doherty, a professor at Wharton who has
studied life settlements.
Indeed, Mr. Doherty says that in reaction to widespread
securitization, insurers most likely would have to raise the premiums
on new life policies.
Critics of life settlements believe ``this defeats the idea of what
life insurance is supposed to be,'' said Steven Weisbart, senior vice
president and chief economist for the Insurance Information Institute,
a trade group. ``It's not an investment product, a gambling product.''
After Mortgages
Undeterred, Wall Street is racing ahead for a simple reason: With
$26 trillion of life insurance policies in force in the United States,
the market could be huge.
Not all policyholders would be interested in selling their
policies, of course. And investors are not interested in healthy
people's policies because they would have to pay those premiums for too
long, reducing profits on the investment.
But even if a small fraction of policy holders do sell them, some
in the industry predict the market could reach $500 billion. That would
help Wall Street offset the loss of revenue from the collapse of the
United States residential mortgage securities market, to $169 billion
so far this year from a peak of $941 billion in 2005, according to
Dealogic, a firm that tracks financial data.
Some financial firms are moving to outpace their rivals. Credit
Suisse, for example, is in effect building a financial assembly line to
buy large numbers of life insurance policies, package and resell them--
just as Wall Street firms did with subprime securities.
The bank bought a company that originates life settlements, and it
has set up a group dedicated to structuring deals and one to sell the
products.
Goldman Sachs has developed a tradable index of life settlements,
enabling investors to bet on whether people will live longer than
expected or die sooner than planned. The index is similar to tradable
stock market indices that allow investors to bet on the overall
direction of the market without buying stocks.
Spokesmen for Credit Suisse and Goldman Sachs declined to comment.
If Wall Street succeeds in securitizing life insurance policies, it
would take a controversial business--the buying and selling of
policies--that has been around on a smaller scale for a couple of
decades and potentially increase it drastically.
Defenders of life settlements argue that creating a market to allow
the ill or elderly to sell their policies for cash is a public service.
Insurance companies, they note, offer only a ``cash surrender value,''
typically at a small fraction of the death benefit, when a policyholder
wants to cash out, even after paying large premiums for many years.
Enter life settlement companies. Depending on various factors, they
will pay 20 to 200 percent more than the surrender value an insurer
would pay.
But the industry has been plagued by fraud complaints. State
insurance regulators, hamstrung by a patchwork of laws and regulations,
have criticized life settlement brokers for coercing the ill and
elderly to take out policies with the sole purpose of selling them back
to the brokers, called ``stranger-owned life insurance.''
In 2006, while he was New York Attorney General, Eliot Spitzer sued
Coventry, one of the largest life settlement companies, accusing it of
engaging in bid-rigging with rivals to keep down prices offered to
people who wanted to sell their policies. The case is continuing.
``Predators in the life settlement market have the motive, means
and, if left unchecked by legislators and regulators and by their own
community, the opportunity to take advantage of seniors,'' Stephan
Leimberg, co-author of a book on life settlements, testified at a
Senate Special Committee on Aging last April.
Tricky Predictions
In addition to fraud, there is another potential risk for
investors: that some people could live far longer than expected.
It is not just a hypothetical risk. That is what happened in the
1980s, when new treatments prolonged the life of AIDS patients.
Investors who bought their policies on the expectation that the most
victims would die within 2 years ended up losing money.
It happened again last fall when companies that calculate life
expectancy determined that people were living longer.
The challenge for Wall Street is to make securitized life insurance
policies more predictable--and, ideally, safer--investments. And for
any securitized bond to interest big investors, a seal of approval is
needed from a credit rating agency that measures the level of risk.
In many ways, banks are seeking to replicate the model of subprime
mortgage securities, which became popular after ratings agencies
bestowed on them the comfort of a top-tier, triple-A rating. An
individual mortgage to a home buyer with poor credit might have been
considered risky, because of the possibility of default; but packaging
lots of mortgages together limited risk, the theory went, because it
was unlikely many would default at the same time.
While that idea was, in retrospect, badly flawed, Wall Street is
convinced that it can solve the risk riddle with securitized life
settlement policies.
That is why bankers from Credit Suisse and Goldman Sachs have been
visiting DBRS, a little known rating agency in lower Manhattan.
In early 2008, the firm published criteria for ways to securitize a
life settlements portfolio so that the risks were minimized.
Interest poured in. Hedge funds that have acquired life
settlements, for example, are keen to buy and sell policies more
easily, so they can cash out both on investments that are losing money
and on ones that are profitable. Wall Street banks, beaten down by the
financial crisis, are looking to get their securitization machines
humming again.
Ms. Tillwitz, an executive overseeing the project for DBRS, said
the firm spent 9 months getting comfortable with the myriad risks
associated with rating a pool of life settlements.
Could a way be found to protect against possible fraud by agents
buying insurance policies and reselling them--to avoid problems like
those in the subprime mortgage market, where some brokers made
fraudulent loans that ended up in packages of securities sold to
investors? How could investors be assured that the policies were
legitimately acquired, so that the payouts would not be disputed when
the original policyholder died?
And how could they make sure that policies being bought were
legally sellable, given that some states prohibit the sale of policies
until they have been in force 2 to 5 years?
Spreading the Risk
To help understand how to manage these risks, Ms. Tillwitz and her
colleague Jan Buckler--a mathematics whiz with a Ph.D. in nuclear
engineering--traveled the world visiting firms that handle life
settlements. ``We do not want to rate a deal that blows up,'' Ms.
Tillwitz said.
The solution? A bond made up of life settlements would ideally have
policies from people with a range of diseases--leukemia, lung cancer,
heart disease, breast cancer, diabetes, Alzheimer's. That is because if
too many people with leukemia are in the securitization portfolio, and
a cure is developed, the value of the bond would plummet.
As an added precaution, DBRS would run background checks on all
issuers. Also, a range of quality of life insurers would have to be
included.
To test how different mixes of policies would perform, Mr. Buckler
has run computer simulations to show what would happen to returns if
people lived significantly longer than expected.
But even with a math whiz calculating every possibility, some risks
may not be apparent until after the fact. How can a computer accurately
predict what would happen if health reform passed, for example, and
better care for a large number of Americans meant that people generally
started living longer? Or if a magic-bullet cure for all types of
cancer was developed?
If the computer models were wrong, investors could lose a lot of
money.
As unlikely as those assumptions may seem, that is effectively what
happened with many securitized subprime loans that were given triple-A
ratings.
Investment banks that sold these securities sought to lower the
risks by, among other things, packaging mortgages from different
regions and with differing credit levels of the borrowers. They thought
that if house prices dropped in one region--say Florida, causing
widespread defaults in that part of the portfolio--it was highly
unlikely that they would fall at the same time in, say, California.
Indeed, economists noted that historically, housing prices had
fallen regionally but never nationwide. When they did fall nationwide,
investors lost hundreds of billions of dollars.
Both Standard & Poor's and Moody's, which gave out many triple-A
ratings and were burned by that experience, are approaching life
settlements with greater caution.
Standard & Poor's, which rated a similar deal called Dignity
Partners in the 1990s, declined to comment on its plans. Moody's said
it has been approached by financial firms interested in securitizing
life settlements, but has not yet seen a portfolio of policies that
meets its standards.
Investor Appetite
Despite the mortgage debacle, investors like Andrew Terrell are
intrigued.
Mr. Terrell was the co-head of Bear Stearns's longevity and
mortality desk--which traded unrated portfolios of life settlements--
and later worked at Goldman Sachs's Institutional Life Companies, a
venture that was introducing a trading platform for life settlements.
He thinks securitized life policies have big potential, explaining that
investors who want to spread their risks are constantly looking for new
investments that do not move in tandem with their other investments.
``It's an interesting asset class because it's less correlated to
the rest of the market than other asset classes,'' Mr. Terrell said.
Some academics who have studied life settlement securitization
agree it is a good idea. One difference, they concur, is that death is
not correlated to the rise and fall of stocks.
``These assets do not have risks that are difficult to estimate and
they are not, for the most part, exposed to broader economic risks,''
said Joshua Coval, a professor of finance at the Harvard Business
School. ``By pooling and tranching, you are not amplifying systemic
risks in the underlying assets.''
The insurance industry is girding for a fight. ``Just as all
mortgage providers have been tarred by subprime mortgages, so too is
the concern that all life insurance companies would be tarred with the
brush of subprime life insurance settlements,'' said Michael
Lovendusky, vice president and associate general counsel of the
American Council of Life Insurers, a trade group that represents life
insurance companies.
And the industry may find allies in government. Among those
expressing concern about life settlements at the Senate Committee
hearing in April were insurance regulators from Florida and Illinois,
who argued that regulation was inadequate.
``The securitization of life settlements adds another element of
possible risk to an industry that is already in need of enhanced
regulations, more transparency and consumer safeguards,'' said Senator
Herb Kohl, the Democrat from Wisconsin who is Chairman of the Special
Committee on Aging.
DBRS agrees on the need to be careful. ``We want this market to
flourish in a safe way,'' Ms. Tillwitz said.
______
Prepared Statement of Frank Keating, President and CEO, American
Council of Life Insurers
September 17, 2009
Hon. Collin C. Peterson, Hon. Frank D. Lucas,
Chairman, Ranking Minority Member,
Committee on Agriculture, Committee on Agriculture,
Washington, D.C.; Washington, D.C.
RE: Regulation of the Derivatives Markets
Dear Chairman Peterson and Ranking Member Lucas:
The American Council of Life Insurers (ACLI) respectfully provides
its views on the important dialog in Congress about the appropriate
regulation of the derivatives markets. Life insurers are significant
end-users of derivative instruments and utilize them to prudently
manage the risks of their assets and liabilities, as permitted under
state insurance codes and regulations. The composition of life
insurers' assets reflects the long-term commitments and stability
necessary for life insurers to provide products, such as life insurance
and annuities.
Life insurers' financial products protect millions of individuals,
families and businesses through guaranteed lifetime income, life
insurance, long-term care and disability income insurance. The long-
term nature of these products requires insurers to match long-term
obligations with assets of a longer duration than most other financial
institutions. Derivatives allow life insurers to prudently manage the
credit and market risk of their significant portfolios, and
concomitantly to fulfill their obligations to contract owners. The
regulatory status of derivatives, therefore, is critically important to
the life insurance industry.
Some basic background reflecting 2008 data \1\ may provide useful
scope and context:
---------------------------------------------------------------------------
\1\ These calculations are based on data from the NAIC and the U.S.
Federal Reserve Board, Flow of Funds Accounts of the U.S. See American
Council of Life Insurers, Life Insurers Fact Book (2009).
Life insurance industry assets were invested in: corporate
bonds (42%); stocks (24%); government bonds (14%); commercial
---------------------------------------------------------------------------
mortgages (7%); other assets (13%);
Life insurers provide the single largest U.S. source of
corporate bond financing;
Approximately 56 percent of life insurers' $4.6 Trillion
total assets in 2008 were held in bonds, with 42 percent
composed of corporate bonds; and
Over 41 percent of corporate bonds purchased by life
insurers have maturities in excess of 20 years (at the time of
purchase).
Through their investments, life insurers are indispensable to
American businesses and governments in cost-effectively raising
capital. Moreover, these investments support life insurers' obligations
to provide retirement and financial security for millions of Americans.
The derivatives markets are instrumental to both of these functions.
Accordingly, in legislative approaches to derivatives regulation,
ACLI supports:
Federal regulation of the derivatives markets and
marketplace professionals;
State insurance department (or any ultimate functional
regulator) jurisdiction over life insurers' use of derivatives;
and
Federal preemption of any conflicts in state regulation of
the derivatives markets and marketplace professionals.
As a primary source of long-term capital for American businesses
and governments, life insurers must be able to responsibly manage
portfolio risks within a rational regulatory environment. Life insurers
can continue to successfully serve the nation's retirement and
financial security with life insurance, annuities and other products
through the implementation of a reasonable and responsible legislative
approach to derivatives regulation.
We greatly appreciate your attention to our views. Please let me
know if you have any questions.
Sincerely,
______
Submitted Report by Mark W. Menezes, David T. McIndoe, R. Michael
Sweeney, Jr., Hunton & Williams LLP; on Behalf of Working Group of
Commercial Energy Firms
September 28, 2009
Hon. Collin C. Peterson,
Chairman,
Committee on Agriculture,
Washington, D.C.
Re: Comments on Hearing to Review Proposed Legislation by the U.S.
Department of the Treasury Regarding the Regulation of Over-the-Counter
Derivatives Markets
Dear Chairman Peterson:
In response to the request for comments made by the House Committee
on Agriculture (``Committee'') at its September 17, 2009 hearing to
review proposed legislation released by the U.S. Department of the
Treasury reforming the regulation of over-the-counter (``OTC'')
derivatives markets, Hunton & Williams LLP hereby submits the enclosed
position paper on behalf of the Working Group of Commercial Energy
Firms (the ``Working Group'').
The Working Group is a diverse group of commercial firms in the
domestic energy industry whose primary business activity entails the
physical delivery of one or more energy commodities to customers,
including industrial, commercial and/or residential consumers. The
Working Group considers and responds to requests for public comment
regarding legislative and regulatory developments affecting the trading
and hedging of energy commodities, including derivatives and other
contracts that reference energy commodities.
The Working Group sincerely appreciates the opportunity provided by
the Committee to present in writing as part of the public record the
significant business and policy concerns raised by the Treasury
Department's proposed OTC derivatives reform legislation. Should
Committee Members or staff have any questions, or if the Working Group
can be of further assistance in any regard, please contact the
undersigned at [Redacted].
Sincerely,
David T. McIndoe,
R. Michael Sweeney, Jr.,
Counsel for the Working Group of Commercial Energy Firms.
Attachment
September 23, 2009
Hon. Collin C. Peterson, Hon. Frank D. Lucas,
Chairman, Ranking Minority Member,
Committee on Agriculture, Committee on Agriculture,
Washington, D.C.; Washington, D.C.
RE: Submission for the Record of the Committee's Hearing on September
17, 2009.
Dear Chairman Peterson and Ranking Member Lucas:
Thank you for the opportunity to represent ISDA before the
Committee at last week's hearing on the U.S. Treasury proposals for the
regulation of the OTC derivatives markets. Today, there is a broad
consensus for comprehensive regulatory reform to modernize and protect
the integrity of our financial system and we support many of the
concepts for improved regulation of the derivatives markets. The
Committee's hearing highlighted several aspects of the Treasury's
proposal that need further consideration. One of these issues is the
imposition of margin requirements.
Thank you for the opportunity to represent ISDA before the
Committee at last week's hearing on the U.S. Treasury proposals for the
regulation of the OTC derivatives markets. Today, there is a broad
consensus for comprehensive regulatory reform to modernize and protect
the integrity of our financial system and we support many of the
concepts for improved regulation of the derivatives markets. The
Committee's hearing highlighted several aspects of the Treasury's
proposal that need further consideration. One of these issues is the
imposition of margin requirements.
During the hearing, the issue of requiring end-users to post margin
as a result of mandatory clearing or as a result of the proposed
requirement that regulators impose margin requirements on all non-
cleared derivatives was raised. The suggestion that an end-user could
enter into a margin financing arrangement whereby another firm,
possibly a member of a clearinghouse, would lend the end-user the money
to meet the clearinghouse's margin requirements was offered as a
possible response to the difficulties some end-users will have in
meeting margin requirements. Margin financing was presented as a means
to facilitate end-user access to clearinghouses so that more trades can
be cleared.
(1) Margin financing does not eliminate or reduce the credit risk
associated with the OTC derivative transaction, rather it
simply shifts the risk from the OTC derivative to a debt
instrument. Either the clearing member or the lender would be
exposed to the risk that the end-user will not be able to repay
the money borrowed to satisfy the margin calls.
(2) Margin financing would subject the end-user to additional
clearing fees and fees associated with the borrowing. In some
cases, borrowing end-users would be subject to a commitment fee
whereby the end-user would pay even before drawing on the line-
of-credit.
(3) Margin financing may entail a floating rate of interest on a
line-of-credit, subjecting end-users to more interest rate
risk. In most cases, it is the need to mitigate or eliminate
interest rate risk that leads the end-user to use OTC
derivatives in the first place.
(4) Margin financing would result in end-users taking on more debt,
increasing their leverage.
(5) Margin financing loans would work like revolving credit
facilities wherein the end-user would draw down amounts as its
needs more margin and repay previously drawn amounts when its
positions move back in the money. The loan to the end-user
would be subject to greater risk in bankruptcy than an OTC
derivative contract with the end-user. The bankruptcy code's
protections for OTC derivative contracts do not apply to credit
facilities, leaving the lender more exposed to an end-user
default.
Once again, we appreciate the opportunity to testify before the
Committee on this important topic and to add to the hearing record
these additional points.
Please do not hesitate to call on us if we can be of further
assistance.
Yours Sincerely,
Executive Director and Chief Executive Officer,
ISDA.
Cc: Members of the House Committee on Agriculture.
______
Supplemental Material Submitted by Johnathan H. Short, Senior Vice
President and General Counsel, IntercontinentalExchange, Inc.
The IntercontinentalExchange, Inc. (ICE) respectfully submits the
following to supplement the testimony of Johnathan Short before the
Committee at the September 17, 2009 hearing on the Over the Counter
Derivatives Market Act (OTCDMA).
Position Limits
On September 16, the Chicago Mercantile Group (CME) released its
white paper, ``Excessive Speculation and Position Limits in Energy
Derivatives Markets.'' The paper made two recommendations for setting
position limits: (1) Exchanges should set position limits; and (2)
position limits should be set as a relative percentage of an exchange's
open interest. ICE disagrees with these recommendations.
The OTCDMA properly gives the Commission the power to set position
limits and accountability levels. ICE agrees with this provision of the
OTCDMA as the Commodity Futures Trading Commission (CFTC) has the
experience, systems, and budget to administer this regime. Only the
CFTC would be in a position to have broad and regular access to all
position data regardless of trading venue, and is therefore uniquely
able to determine appropriate limits and monitor compliance with
limits. It should also be noted that the CFTC has a similar regime in
place for enumerated agricultural contracts that has proven to be
effective.\1\ Furthermore, one of the most contentious issues
surrounding position limits has been the circumstances under which
hedge exemptions should be granted to market participants. Here again,
the CFTC would be in a better position to administer such exemptions
than individual exchanges given competitive considerations and the
CFTC's superior access to information.
---------------------------------------------------------------------------
\1\&Section 15(b) of the Commodity Exchange Act, 7 U.S.C. &19.
---------------------------------------------------------------------------
All position limits and accountability levels should be aggregate
(market-wide) in nature. The limits set by the CFTC should not be
exchange-specific, but rather marketwide to govern the sum total of all
positions that a market participant may hold for all economically
equivalent contracts, including those traded on a Designated Contract
Market (DCMs), an Exempt Commercial Market offering significant price
discovery contracts, Foreign Boards of Trade offering linked contracts,
and other OTC market venues. The CFTC has already successfully
implemented the most challenging aspect of such a system: collection
and aggregation of daily position data from the first three of these
sources.
Imposition of position limits and accountability levels by the
Commission should promote competition by being market and venue
agnostic. Setting position limits in the manner suggested by the CME,
as a percentage of an exchange's open interest, would be contrary to
the CFTC's statutory mandate to ``promote competition among exchanges
and seek to regulate the futures markets by the least anti-competitive
means available.'' Imposing smaller limits for smaller exchanges by
applying a ``percentage of open interest'' test for each individual
exchange would restrict competition by making it difficult for
competing exchanges to offer tight enough markets and build sufficient
liquidity in a contract to compete with an incumbent exchange. End
market users and consumers would ultimately suffer from the lack of
competition, bearing increased hedging costs and a lack of new product
innovation.
It is important to note the significant benefits of preserving
competition in the exchange sector. Competition in the futures industry
has spurred significant product and technological innovation, including
transparent electronic trading, straight through processing, the
introduction of clearing for OTC swap products, and significantly
tighter trading markets into which commercial entities can hedge their
risk. As Benn Steil, Director of International Economics at the Council
of Foreign Relations recently noted, ``the U.S. activities of one
[competitor] alone, Eurex (formerly DTB) have had a tremendous effect
in accelerating the move to more efficient electronic trading, in
motivating exchanges to demutualize, . . . in reducing trading fees,
and in stimulating new product development.''&\2\
---------------------------------------------------------------------------
\2\&Testimony of Benn Steil before the Commodity Futures Trading
Commission (June 27, 2006).
---------------------------------------------------------------------------
Today, futures markets are more robust and less susceptible to
manipulation than they were a decade ago, greatly reducing
transactional costs to market participants and the cost of risk
management to commercial entities. Regulation to promote fair and level
competition for the benefit of end-users, rather than regulation that
would entrench dominant incumbents, should be the goal of financial
market reform legislation.
ICE would be pleased to answer any questions of the Committee or
staff on this important subject.
______
Submitted Statement of Roger Plank, President, Apache Corporation
Chairman Peterson, Mr. Lucas and Members of the Committee, thank
you for this opportunity to provide testimony regarding reform of the
Over-the-counter (OTC) derivatives markets. I am Roger Plank, President
of Apache Corporation, an independent oil and gas exploration and
production company with operations in the United States and five other
nations and estimated proved reserves of 2.4 billion barrels of oil
equivalent. Apache, established in 1954, is listed on the New York
Stock Exchange with market capitalization of approximately $30 billion.
For the past fifteen years, Apache Corporation has been an
outspoken proponent of greater transparency and a return to integrity
in the natural gas markets, often finding ourselves at odds with
significant portions of the oil and gas industry. I have attached as
Appendix D the testimony of Apache Founder Raymond Plank, given to the
U.S. House Committee on Energy and Commerce on February 13, 2002, in
the wake of the Enron scandal. In his testimony, Mr. Plank made several
statements that reverberate today.
``. . . (many) have worked hard to introduce competition into
the nation's energy markets. But deregulation has been hijacked
by traders, hedge funds and others who profit from volatility
and scorn the hard-working men and women who produce these
important resources.''
``. . . Enron is gone, but the damage has been done to a vital
element of the nation's economic security. In some ways, this
is a homeland security issue: There is a ticking time bomb set
to wreak havoc when the economy comes back and energy demand
increases.''
I hope you agree that those statements were remarkably prescient
when they were made more than 7 years ago. Yes, Enron and others are
gone, but problems in the energy commodity markets persist. Even with a
serious recession, fundamentals of gas supply and demand cannot explain
the wild ride of natural gas futures from $12.62 per thousand cubic
feet (Mcf) in July 2008 to less than $3 per Mcf in recent weeks.
So, as you can see Apache does not object to the regulation of OTC
derivatives in philosophy or concept. In fact, we applaud the efforts
of the Administration and of Congress to rein in the unwarranted and
harmful speculation rampant in the markets. However, we believe the
Treasury Department proposal is overbroad where it negatively impacts
the legitimate financial transactions to manage the price risk inherent
in producing or consuming natural gas, crude oil and other commodities.
Apache, like most independent oil and gas producers and indeed most
producers of tradable commodities, is not a ``speculator.'' Our job is
providing natural gas and crude oil essential to economic growth.
Independent oil and gas producers and other commodities producers did
not contribute to the financial problems caused by the unchecked
speculation that occurred in the derivatives markets--that was the
realm of financial traders and middle-men speculators. Yet restricting
producers' financial flexibility could diminish our ability to help the
nation achieve important objectives, including expanded use of natural
gas to achieve our shared goal of reducing emissions of carbon dioxide
and increasing our nation's energy independence.
This legislation, as proposed, will reduce access to customized
transactions, will increase transaction costs and will impair, in
Apache's case, our ability to invest capital in finding additional
natural gas and crude oil by requiring producers to tie up their
capital unnecessarily in financial reserves or margins. We have worked
exclusively with the draft bill circulated by the U.S. Treasury
Department to simplify matters and preserve producers' ability to
manage risk as they seek to expand the nation's resources.
While we believe that an effort was made to exclude legitimate
hedgers and legitimate hedges from the dragnet, we don't believe the
exclusions as defined in the Treasury bill quite accomplish that goal.
We took a different and hopefully simpler approach to the problem
by attempting to exempt specific transactions rather than to define
broad categories of entities which would or would not be regulated. Our
suggestion is to exempt transactions that involve at least one party
that owns, produces, distributes, consumes, manufactures, processes, or
merchandizes a product from what amount to punitive margin requirements
and from the requirement that the transaction must clear through an
authorized exchange.
We believe that this approach allows true industry participants to
manage the risks inherent in commodity markets, while still allowing
for appropriate oversight and regulation of the paper market that
always follows physical transactions. By targeting these paper
transactions, it is our belief that excessive speculation will be
discouraged and price volatility dampened to the point that producers
and consumers of all commodities will at long last be able to see real
price signals from the market. This will improve our ability to make
sound investment decisions and deliver the energy necessary for
economic growth.
Thank you for your time, and for seizing the initiative to rein in
the excessive speculation and volatility that have plagued energy and
other markets far too long.
The following are Apache's recommendations for specific changes to
the Treasury Department's proposed legislation:
Proposed Change No. 1--Add definitions of ``Bona Fide Hedges'' and
``Bona Fide Hedgers'' and excepting Bona Fide Hedgers from the
definitions of ``swap dealer'' and ``major swap participant.''
Justification--The Treasury legislation contains definitions for
``swap dealer'' and ``major swap participant'' and excepts from these
defined terms, persons who enter into hedges that are effective under
generally accepted accounting principles (GAAP). This exception however
is limited as some legitimate hedges may not be effective under GAAP.
Apache proposes to expand the exception by adding an exception for
persons who enter into ``bona fide hedges''. Generally, Apache would
define a ``bona fide hedge,'' similarly to the definition used in H.R.
3300 as a hedge that arises from a potential change in the value of a
commodity that is owned, produced, distributed, consumed, manufactured,
processed or merchandized by the person entering into the hedge.
Expanding the exception is important because the status of a person
entering into a swap affects whether a swap must be cleared and traded
on an exchange and whether margin must be required. A person entering
into a bona fide hedge or a hedge that is effective under GAAP, should
be excepted from being a ``swap dealer'' and ``major swap participant''
so that the swaps entered into by such person will not have to be
cleared or traded on an exchange as Apache proposes in Proposed Change
No. 2 below and such person will be excepted from the requirement that
margin be posted as Apache proposes in Proposed Change No. 3 below.
Specific Amendatory Language--See the proposed definitions of
``Bona Fide Hedge'' and Bona Fide Hedger) in Appendix A. Also in
Appendix B and C, see changes to the definitions of ``swap dealer'' and
``major swap participant'' found on page 8, lines 3 through 15 of the
Treasury legislation.
Proposed Change No. 2--Except bona fide hedges and those hedges that
are effective under GAAP from the mandatory clearing and
mandatory trading requirements.
Justification--The Treasury legislation requires that all
``standardized'' swaps--a term the Treasury legislation says must be
defined ``as broadly as possible''--must be cleared and traded on
exchanges.
There is an exception from this requirement when (i) no clearing
organization will accept the swap for clearing or (ii) when one party
to the swap is not a swap dealer or major swap participant and such
party does not meet the ``eligibility requirements'' of any clearing
organization that clears swaps.
The Treasury's proposed exception is unclear. If all swaps must be
cleared and traded on exchanges, producers' ability to enter into
customized swaps will be limited and will result in less flexibility in
their ability to meet risk management objectives in finding, developing
and producing natural gas and crude oil. In addition, requiring that
all swaps be cleared and traded on an exchange will increase producers'
transaction costs, including clearing and exchange-related fees and
costs associated with the posting margins.
Specifically, Apache proposes to change the Treasury legislation to
expressly exclude from the definition of ``standardized'' swaps, both
bona fide hedges and hedges that are effective under GAAP and expressly
exclude bona fide hedges and those hedges that are effective under GAAP
from the clearing and trading requirements.
Specific Amendatory Language--To accomplish this objective, see
Appendix B and C for Apache's propose
Proposed Change No. 3--Except bona fide hedges and those hedges that
are effective under GAAP from the mandatory capital and margin
requirements.
Justification--It is not enough to except bona fide hedges and
those hedges that are effective under GAPP from the clearing and
trading requirements because the Treasury legislation requires the
imposition of capital requirements and margin on all swaps not cleared
by a clearing organization.
Apache is a producer of oil and natural gas; its oil and gas assets
have substantial value and require substantial capital to discover and
produce. When Apache enters into a swap, it is not doing so as a naked
speculator. The Treasury's proposed legislation would require Apache to
reserve capital in all cases and post margin unless Apache entered into
a swap with a bank and the bank's regulator did not require margin. If
Apache is required to tie up its capital, Apache will have less capital
available to invest in finding and producing oil and natural gas. There
are no exceptions to the requirement that capital requirements be
imposed. Our physical ownership of the commodity is our asset, our
capital and our collateral. Physical ownership of the commodity should
not be subject to this double hit when a producer enters into a
legitimate hedge transaction.
The Treasury's proposal provides for one limited exception to the
margin requirement which may apply when a bank is a swap counterparty
and the other party is (i) not a swap dealer or major swap participant,
(ii) is entering into an effective hedge under GAAP, and (iii)
``predominantly engaged in activities that are not financial.'' This
one margin exception is not adequate. It does not apply when Apache's
counterparty is not a bank and even when Apache's counterparty is a
bank, the bank's regulator may still require the bank to require margin
from Apache.
The mandatory nature of the capital and margin requirements is
problematic to producers. Apache proposes that persons that enter into
bona fide hedges and those hedges that are effective under GAAP be
excepted from the imposition of capital and mandatory margin
requirements whether the counterparty is a bank or non-bank. Apache
proposes to make it clear that regulators may not impose capital
requirements and margin requirements on persons that enter into bona
fide hedges and those hedges that are effective under GAAP.
Specifically, Apache proposes to add an exception to the requirement
that capital requirements be imposed and expand the existing exception
to include bona fide hedges and to apply this exception to non-bank
counterparties.
Specific Amendatory Language--See Appendix B and C for Apache's
proposed changes to page 39, beginning on line 13; page 39 at the end
of line 17; page 39 at the end of line 21; page 40, line 3; page 40,
line 8; and page 40, beginning on line 16.
APPENDIX A
Proposed Definition of ``Bona Fide Hedge'' and ``Bona Fide Hedger''
``(51) Bona fide hedge.--The term bona fide hedge means a swap
that--
(i) arises from the potential change in the value of physical
assets that a person owns, produces, distributes, consumes,
manufactures, processes, or merchandises as its primary
business or anticipates owning, producing, distributing,
consuming, manufacturing, processing, or merchandising as its
primary business; and
(ii) is economically appropriate to the reduction of risks in the
conduct and management of a commercial enterprise.''
``(52) Bona fide hedger.--The term bona fide hedger means a person
that--
(i) owns, produces, distributes, consumes, manufactures,
processes, or merchandises physical assets as its primary
business; and
(ii) enters into bona fide hedges or other effective hedges under
generally accepted accounting principles.''
APPENDIX B
Apache Corporation Proposed Changes to the ``Over-the-Counter
Derivatives Markets Act of 2009'' as Submitted by the Treasury
Department August 11, 2009
The Treasury Department's ``Over-the-Counter Derivatives Markets
Act of 2009'' is amended--
(1) by adding on page 7 between line 2 and line 3 the following:
``provided the term `narrow-based security index' shall
not include the Henry Hub, West Texas Intermediate or
any other price point or index for commodities.''
(2) by adding on page 8 line 7 the words ``bona fide hedger or''
between ``a'' and ``person'' and deleting on page 8 line 9 the
following:
``but not as a part of a regular business'' and
replacing with the following:
``provided such person is not buying and selling,
quoting prices, and making a market in swaps.''
(3) by adding on page 8 in paragraph (40) line 11 before ``The
term'' the following:
``(A) In general.--''
(4) by deleting on page 8 in paragraph (40) line 13 the
following:
``other than to create and maintain an effective hedge
under generally accepted accounting principles,''.
(5) by adding on page 8 into paragraph (40) at the end of
paragraph (40) the following:
``(B) Exception.--The term `major swap
participant' does not include a person that is
a bona fide hedger.''
(6) by adding on page 12 after paragraph (50) the following:
``(51) Bona fide hedge.--The term bona fide hedge
means a swap that--
(i) arises from the potential change in the
value of physical assets that a person owns,
produces, distributes, consumes, manufactures,
processes, or merchandises, as its primary
business or anticipates owning, producing,
distributing, consuming, manufacturing,
processing, or merchandising, as its primary
business; and
(ii) is economically appropriate to the
reduction of risks in the conduct and
management of a commercial enterprise.''
``(52) Bona fide hedger.--The term bona fide hedger
means a person that--
(i) owns, produces, distributes, consumes,
manufactures, processes, or merchandises
physical assets as its primary business; and
(ii) enters into bona fide hedges or other
effective hedges under generally accepted
accounting principles.''
(7) by adding on page 17 between line 1 and line 2 the following:
``; provided however, the term `standardized' shall not
include bona fide hedges or other effective hedges
under generally accepted accounting principles.''
(8) by deleting on page 18 line 10 the following:
``or''.
(9) by deleting the ``.'' at the end of line 14 on page 18, and
adding between line 14 and 15 the following:
``; or (C) the swap is a bona fide hedge or other
effective hedge under generally accepted accounting
principles.''
(10) by adding to page 39 between lines 13 and 14, at the end of
lines 17 and 21 the following:
``provided however, capital requirements shall not be
imposed for swaps that are bona fide hedges or other
effective hedges under generally accepted accounting
principles.''
(11) by deleting on page 40 line 3 the following:
``may, but are not required to,'' and replacing with
the following:
``shall not''
(12) by adding to page 40 line 8 after ``part of'' the following:
``a bona fide hedge or''
(13) by adding on page 40 line 16 the following:
``; provided however, margin shall not be required with
respect to swaps in which one of the counterparties
is--
``(i) neither a swap dealer, major swap
participant, security-based swap dealer nor a
major security-based swap participant;
``(ii) using the swap as part of a bona fide
hedge or an effective hedge under generally
accepted accounting principles; and
``(iii) predominantly engaged in activities
that are not financial in nature, as defined in
section 4(k) of the Bank Holding Company Act of
1956 (12 U.S.C. 1843(k)).''
APPENDIX C
Redline Changes
Mr. Chairman and Members:
Thank you for the opportunity to speak to the Committee today.
My name is Raymond Plank, and I am founder and chief executive
officer of Apache Corporation. Over 5 decades in the oil and gas
business, Apache has grown from one of the smallest to one of the
larger independent producers.
Natural gas is the single most important domestic energy source--an
abundant resource that warms millions of homes, fuels much of America's
industrial base and plays a large and growing role in the nation's
electricity industry. However, while many believe natural gas is the
fuel of the future, I believe that future is in jeopardy because of the
flawed structure of the natural gas market in this country.
The fact is, the nation's energy markets skated by and escaped a
disaster in the wake of Enron's collapse. Why? Certainly not because
this market--in its current dysfunctional state--serves the nation's
needs. No, we avoided a supply crunch because the recession and one of
the warmest winters in recent history combined to keep demand in check.
If the economy had been more robust, or if weather conditions had been
different, the story could have been far different.
This is an issue that should be important to the other members of
this panel because they have developed business plans, raised billions
of dollars from investors and erected power plants based on the
availability of reliable supplies of natural gas. The current market,
roiled by excessive price volatility, has undermined the ability of
Apache and other North American producers to meet their requirements.
Mr. Chairman, I know you have worked hard to introduce competition
into the nation's energy markets. But deregulation has been hijacked by
traders, hedge funds and others who profit from volatility and who
scorn the hard-working men and women who produce this important
resource. If you don't fix the natural gas market, then all your
efforts to bring competition to the electricity market will be for
naught because natural gas is the fuel of choice for new generating
capacity.
The uncertainty in the gas market caused by excessive price
volatility endangers the infrastructure required to explore for and
produce natural gas. Every time the price goes down and Apache and
other companies cut back, skilled workers--from roustabouts to
engineers to scientists--leave the industry. Drilling rigs are taken
out of service and cannibalized for spare parts and marginal wells are
shut in, never to return to production.
Right now, the industry is not drilling enough wells to maintain
production at current levels.
Yes, Mr. Chairman, Enron is gone, but the damage has been done to a
vital element of the nation's economic security. In some ways, this is
a homeland security issue: There is a ticking time bomb set to wreak
havoc when the economy comes back and energy demand increases.
I'd like to give you some background on how we came to our
position.
For the last 10 years, our ability to find and produce the natural
gas this country needs has been crippled by increasing price
volatility. North America is a mature producing province, which means
that while there is still a great deal of natural gas to be found,
producing it requires better technology, better science, more time and
more money. Most of these projects take from 12 months to 2 years to
complete. It is harder and harder to commit capital to these kinds of
projects when we can't forecast what the price of our product is going
to be tomorrow, much less a year from now.
Natural gas prices, like all commodity prices, run in cycles.
That's been true as long as I can remember. Recently, however, as hedge
funds and traders have come to dominate the market, the cycles have
become shorter in duration and more pronounced. In press reports and
presentations to analysts, these traders acknowledge that they derive
their profits from price volatility.
The casino mentality that has taken over the energy markets has a
real impact on consumers as well as producers.
Let me give you a real example that we all remember.
In December 1999, we were paid less than $2 for a thousand cubic
feet of gas. In January 2001, the price climbed to nearly $10, only to
fall back below $2 by October. To put that in perspective, think about
the impact on the stock market--and the American economy--if the Dow
Jones Industrial Average took a trip from 10,000 to 47,000 and back to
10,000 in a year and a half. What would your constituents be telling
you if the price of gasoline jumped from $1.20 per gallon to $6 and
then back down to $1.20?
Last winter's price spike dealt a damaging blow to the industrial
economy, which in total accounts for 40 percent of U.S. natural gas
consumption. Natural gas-intensive industries like steel, plastics and
petrochemicals significantly curtailed or shut in production in
response to extremely high gas costs. Some of this demand has been
permanently displaced. In addition, natural gas volatility played a key
role in California's energy problems. The consequences for the economy
due to overheated gas prices are painfully clear.
But when the price falls back to $2 per thousand cubic feet, the
capacity of the industry to supply natural gas is diminished--
permanently. One consequence is a brain drain in the industry. The
average age of U.S. geologists and petroleum engineers is 48 years old.
As young engineers and scientists seek opportunities elsewhere, the
nation will lose its technological edge in this industry.
When prices fall, companies like Apache reduce their drilling
expenditures and seek more profitable avenues for investment, usually
overseas. This year, Apache's North American exploration and
development budget has been cut by 70 percent. Other oil and gas
companies are taking similar measures.
As a consequence, I can assure you that the next price spike is
just around the corner. It may not come until this fall or next winter,
but it is inevitable and it could be severe.
As much as we know about getting natural gas out of the ground,
there are many things about this market that have been hidden from view
by powerful insiders who profit from its opacity. We can't find the
answers because we don't have subpoena power. It's up to you to break
through some of these Chinese walls and get to the bottom of this
structurally flawed market.
Now, I'd like to discuss some of the most glaring problems with
this market and our suggestions for fixing it.
Every month, the price we get for our natural gas production is
based on indices published in one or more trade publications. The
reporters who compile these price indices are generally hard-working,
honest journalists, but their sources--the pipelines, utilities and
marketers--are under no obligation to provide complete or even accurate
information. Similarly, the American Gas Association's weekly storage
report became a major market event because it was a proxy for supply
and demand data but it was based on voluntary, self-serving data.
In a market as important as the natural gas market, the
government should collect and disseminate real-time information
on natural gas supply and demand from market participants, with
penalties imposed on companies that fail to file accurate
reports.
Even some energy marketers acknowledge that the current rules give
unfair advantages to integrated energy companies with their regulated
pipelines, unregulated marketing affiliates and electric generating
units. While allegedly separate, these people go to work in the same
office buildings, share coffee--and benefit from the same corporate
incentive systems.
The current rules governing the conduct of regulated and
unregulated affiliates are weak and subject to abuse. To
prevent the trading of insider information, these functions
should be legally and geographically separated and their
dealings limited to real transactions with real money changing
hands. If companies abuse these rules, they should be required
to divest their unregulated affiliates.
Online trading platforms, which operate outside the longstanding
framework that regulates commodities exchanges, provide their owners
with vast information about the trading positions of other market
players which can be used to manipulate the market.
These online platforms are exchanges; they should be subject to
similar regulation to ensure fair treatment of all parties. In
the equities market, there is a basic rule that agents cannot
put their trades ahead of their clients' transactions; similar
rules should guide the conduct of the energy markets.
The bright light of Wall Street cast on energy marketers in the
aftermath of the Enron collapse revealed them to be over-leveraged.
They rely on mark-to-market accounting of energy contracts that allows
them to book the revenues and profits of long-term contracts up front,
long before the revenues are collected and the profits realized. Though
they appear profitable on the surface, a closer examination reveals
that the profits may prove to be illusory. The current system
incentivizes traders to book deal after deal, seeking profits from
every move in the market and distorting legitimate supply and demand
signals.
End mark-to-market accounting and require traders to book their
revenues and profits when they are realized. Impose capital
requirements to assure customers that the traders will be there
to deliver the gas and electricity.
Some would have you believe that the fact that a company as large
as Enron could fail without causing any disruption in the energy
markets is a signal that these markets are deep and liquid. I disagree.
I think it demonstrates that Enron and others like it add no value.
I also believe that failure to reform this market will cause
lasting damage to the nation's energy infrastructure and economic
health.
Mr. Chairman, you have before you the record of the fall of Enron--
the self-dealing, the subterfuge and the apparent fraud. I think it's
fair to ask whether the same behavior permeated Enron's biggest
business--its natural gas and electricity trading operations. Once your
Committee answers that question, I hope you will conduct a thorough
examination of the structure of the energy market and make the changes
necessary to ensure that there are not other Enrons out there waiting
to happen.
The task before you is clear: To introduce effective oversight and
transparency in this market, eliminate the casino mentality that places
price volatility above physical supplies and restore an environment
that will encourage producers to make the investments to meet the
nation's vital energy needs.
Thank you very much for the opportunity to be here today.
ATTACHMENT
3M thanks the Committee for studying the critical details related
to reforms to the U.S. financial system and for considering our
perspective in this important debate. In examining the concepts
outlined in the recent U.S. Treasury proposal on financial system
reforms, 3M respectfully urges the Committee to carefully consider the
distinct differences among various derivative products and how they are
used, and strongly encourages the Committee to preserve commercial
users' access to OTC derivative products to manage various aspects of
corporate risk.
Background on 3M
In 1902, five northern Minnesota entrepreneurs created the
Minnesota Mining & Manufacturing Company, now known today as 3M. 3M is
one of the largest and most diversified technology companies in the
world. 3M is home to such well-known brands as Scotch, Scotch-Brite,
Post-it, Nexcare, Filtrete, Command, and Thinsulate. 3M designs,
manufactures and sell products based on 45 technology platforms and
serves its customers through six large businesses: Consumer and Office;
Display and Graphics; Electro and Communications; Health Care;
Industrial and Transportation; and Safety, Security and Protection
Services. 3M achieved $25.3 billion of worldwide sales in 2008.
Headquartered in St. Paul, Minnesota, 3M has operations in 29 U.S.
states, including over 60% of 3M's worldwide manufacturing operations,
employing 34,000 people. 3M's U.S. sales totaled approximately $9.2
billion in 2008. While its U.S. presence is strong, being able to
compete successfully in the global marketplace is critical to 3M. 3M
operates in more than 60 countries and sells products into more than
200 countries. In 2008, 64% of 3M's sales were outside the U.S., a
percentage that is projected to rise to more than 70% by 2010.
Ahead of their peers, 3M's founders insisted on a robust investment
in R&D. Looking back, it is this early and consistent commitment to R&D
that has been the main component of 3M's success. Our diverse
technology platforms allow 3M scientists to share and combine
technologies from one business to another, creating unique, innovative
solutions for our customers. 3M conducts over 60% of its worldwide R&D
activities within the U.S.
Our commitment to R&D resulted in a $1.4 billion investment of 3M's
capital in 2008 and a total of $6.7 billion during the past 5 years
while producing high quality jobs for 3,700 researchers in the U.S. The
success of these efforts is evidenced not only by 3M's revenue but also
by the 561 U.S. patents awarded in 2008 alone, and over 40,000 global
patents and patent applications in force.
Our success is also attributable to the people of 3M. Generations
of imaginative and industrious employees in all of its business sectors
throughout the world have built 3M into a successful global company.
Our interest in speaking with you today is to preserve our ability to
continue to invest and grow, creating substantive jobs and providing
high quality products to a growing base of customers.
Treasury Proposal.
On August 11, 2009, the Administration submitted legislative
language focusing on the regulatory reform of OTC derivatives. The
Administration proposed the establishment of a comprehensive regulatory
framework for OTC derivatives that is designed to:
1. Guard against activities in those markets posing excessive risk
to the financial system.
2. Promote the transparency and efficiency of those markets.
3. Prevent market manipulation, fraud, insider trading, and other
market abuses.
4. Block OTC derivatives from being marketed inappropriately to
unsophisticated parties.
OTC Derivatives: Helping U.S. Companies Manage Risk in a Competitive
Marketplace.
While 3M unequivocally supports these objectives, we have strong
concerns about the potential impact of legislation on OTC derivatives
and our ability to continue to use them to protect our operations from
the risk of undue currency, commodity, and interest rate volatility.
Derivative products are essential risk management tools used by
American companies in managing foreign exchange, commodity, interest
rate and credit risks. The ability of commercial users to continue to
use OTC derivatives consistent with the requirements of hedge
accounting rules is critical for mitigating risk and limiting damage to
American businesses' financial results in volatile market conditions.
We urge policy makers to preserve commercial users' access to
existing derivative products as you design new regulations. We share
the following comments with you in the spirit of working together to
address the concerns about the stability of the financial system:
1. Guarding Against Activities Within OTC Markets From Posing
Excessive Risk To The Financial System:
We agree that the recent economic crisis has exposed
some areas in our financial regulatory system that should
be addressed. However, the vast majority of OTC derivatives
have not exposed the financial system to excessive risk,
and therefore regulation should be tailored. The OTC
foreign exchange, commodity, and interest rate markets have
operated uninterrupted throughout the economy's financial
difficulties, permitting corporate end-users to prudently
manage business risks through a difficult economic
environment. In the Administration's proposal, the term
``Major Swap Participant'' should not include end-users
that are using OTC derivatives for legitimate hedging
activity only. We urge policy makers to focus on the areas
of highest concern, such as credit default swaps.
We would like to work with policy makers to address
oversight where warranted, but recommend that it be
targeted and not applied to all derivatives and market
participants.
2. Promoting Transparency and Efficiency within the OTC Markets:
We understand the need for reporting and record
keeping. Publicly held companies are currently required by
the SEC and FASB to make significant disclosures about
their use of derivative instruments and hedging activities,
including disclosures in their 10Ks and 10Qs.
We would like to work with policy makers on ways to
efficiently collect information into a trade repository to
further enhance transparency. Guidelines which improve
documentation, transparency and ensure compliance with
hedge accounting rules should be considered as appropriate
criteria for exempting end-users from margin requirements.
We oppose a mandate to move all OTC derivatives into a
clearing or exchange environment. The ability to customize
the derivative to meet a company's specific risk management
needs is crucial. Provisions that would require clearing of
OTC derivatives would lead to standardization, thus
impeding a company's ability to comply with the
requirements of Financial Accounting Standard 133 (FAS
133). The inability to precisely hedge specific risks,
whether currency, interest rates or commodities within the
context of FAS 133, would expose corporate financial
statements to unwanted volatility and uncertainty. Results
could include lower capital expenditures and job growth as
companies undertake fewer growth investments due to the
need to maintain reserves for adverse impacts from unhedged
financial risks.
While we are mindful of the reduction in credit risk
inherent in a clearing or exchange environment, robust
margin requirements would create substantial incremental
liquidity and administrative burdens for commercial users,
resulting in higher financing and operational costs.
Capital currently deployed in growth opportunities would be
diverted into clearinghouse accounts. This could result in
slower job creation, lower capital expenditures and R&D,
and/or higher costs to consumers. Any exemption from
clearing should not be linked to any eligibility
requirements set by the clearing agencies.
Hedging in the OTC market is customized to fit the underlying
business risks being hedged. The clearinghouse concept
relies upon high volumes of standardized products, a
characteristic that does not exist in the customized
hedging environment of the OTC market.
By imposing initial and variation margin requirements,
clearinghouses will add significant capital requirements
for end-users, adding significant costs, discouraging
hedging, and diverting scarce capital that could otherwise
be used in further growing American businesses.
3. Preventing Market Manipulation, Fraud, Insider Trading, And
Other Market Abuses.
We support the appropriate regulatory agencies having
the authority to police fraud, market manipulation and
other market abuses. The CFTC is utilizing its existing
statutory and regulatory authority to add significant
transparency in the OTC market, receive a more complete
picture of market information, and enforce position limits
in related exchange-traded markets. The comment period
remains open on the CFTC proposal and this work should be
allowed to continue.
4. Blocking OTC Derivatives From Being Marketed Inappropriately To
Unsophisticated Parties.
We support modifications to current law that would
improve efforts to protect unsophisticated parties from
entering into inappropriate derivatives transactions.
We thank the Committee for the opportunity to share our perspective
as an employer interested in preserving and enhancing the global
competitiveness of American businesses and workers. 3M looks forward to
working with you as the Committee crafts legislation to reform the U.S.
financial system.
______
Submitted Statement by National Association of Manufacturers
Mr. Chairmen and Committee Members:
The National Association of Manufacturers (NAM)--the nation's
largest industrial trade association--represents large, mid-size and
small manufacturers in every industrial sector and in all 50 states.
The NAM's mission is to enhance the competitiveness of manufacturers by
shaping a legislative and regulatory environment conducive to U.S.
economic growth and to increase understanding among policymakers, the
media and the general public about the vital role of manufacturing to
America's economic future and living standards.
The NAM appreciates and supports the Administration's efforts to
improve transparency, accountability and stability in the derivatives
market. At the same time, NAM members have some concerns about the
regulatory framework for over-the-counter (OTC) derivatives proposed by
the Treasury Department.
Manufacturers of all sizes use customized OTC derivatives to manage
the risks of operating their businesses, including fluctuating currency
exchange, interest rates and commodity prices. For example,
Currency Exchange Rates: Companies that import or export may
not want to bear the risk that the price of the dollar will
fluctuate against the currencies they are using to buy or sell
goods. In these cases, businesses can enter into a customized
currency derivative that allows them to lock in the exchange
rate.
Interest Rates: Companies frequently borrow money at
variable rates tied to an interest rate index. Businesses can
manage the risk that the interest rate on their loan might
increase by entering into a customized interest rate derivative
and locking in a fixed rate for the entire maturity of the
loan.
Commodity Prices: Some manufacturers use large amounts of
commodities in the production process, e.g., natural gas, corn,
aluminum. In order to manage their operating risk and preserve
their margins, these companies can lock in the price of these
commodities by entering into a customized commodity price swap
linked to the price of the commodity causing the exposure.
The ability of end-users of all sizes to continue to use customized
OTC derivatives is critical for mitigating risk and limiting damage to
the health of American businesses, particularly during these
unprecedented economic conditions. Consequently, NAM members are
concerned about proposals that would require OTC derivatives used by
business end-users to be centrally cleared or executed on exchanges as
well as proposals that would impose capital requirements or prevent
end-users from using underlying assets as collateral. The proposals
would significantly increase costs for companies seeking to hedge risks
through OTC products and limit, or eliminate altogether, needed
customized products used for risk management.
A key benefit of OTC derivatives to end-users is the ability to
customize derivatives to the specific risk management needs of the
business. Provisions that require exchange trading of OTC derivatives
would lead to the standardization of these tools, impeding the ability
of companies to accurately hedge risks and comply with the requirements
of Financial Accounting Standard 133 (FAS 133). Without the ability to
hedge specific risks, companies would be forced to shoulder greater
risks in an environment already marked by high volatility.
NAM members are also concerned about the onerous liquid collateral
needs associated with OTC derivatives being exchange-traded or
centrally cleared. Exchanges and clearinghouses insulate commercial
participants from credit exposure by requiring the value of the
derivative contract (mark-to-market) to be posted in cash or Treasury
securities and for market moves twice a day. In general, a clearing
requirement for customized OTC derivatives would result in an
extraordinary drain on working capital for American companies by
requiring significant amounts of liquid collateral to be posted. These
margin requirements would create an additional administrative and
liquidity burden for commercial users, resulting in additional
financing and administrative costs.
On a broader note, the NAM agrees with the Administration that the
current financial crisis has exposed some areas in our financial
regulatory system that should be addressed. Not all OTC derivatives,
however, pose a risk to the financial system. NAM members welcome the
opportunity to work with policy makers to identify where increased,
targeted oversight is warranted.
Similarly, the NAM understands the need for adequate reporting and
record keeping. While corporations already provide reports to the
Securities and Exchange Commission (SEC) and other government agencies,
they would like to work with policy makers on ways to set up a trade
repository to enhance further transparency by pulling together
information already required under existing reporting requirements.
In addition, NAM members believe that any reform plan should
clearly delineate regulatory authorities and functions among the
Securities and Exchange Commission (SEC), the Commodity Futures Trading
Commission (CFTC) and other agencies in order to provide certainty to
the market and to ensure similar products are governed by similar
standards.
In sum, any reform effort should ensure companies' continued access
to OTC derivatives, providing them with greater financial certainty and
allowing them to allocate resources to core business activities. Thank
you in advance for considering our concerns. As this proposal moves
through the legislative process, the NAM looks forward to working with
you on legislation that encourages transparency and stability in the
derivatives markets without sacrificing the ability of corporations to
use these critical risk management tools.
APPENDIX
How a Small Manufacturer Uses an OTC Customized Derivative
Manufacturers of all sizes use OTC derivatives to manage risk in
their day to day operations. According to the International Swaps and
Derivatives Association, more than 90 percent of Fortune 500 companies
use customized derivatives, as do half of mid-sized companies and
thousands of small U.S. companies. Here is an example of how a small
manufacturer uses OTC customized derivatives to manage currency
exchange fluctuations:
Example: Company A, a U.S. exporter, sells heavy construction
equipment to a buyer in Korea. The exporter will be paid upon
delivery in South Korean Won.
In order to protect against the risk that the Won might decline
in value, the exporter enters into an OTC derivative to hedge
that risk. The OTC contract would sell Won, tailored to the
exact value that the exporter is being paid, on the specific
day that the exporter is scheduled to receive payment.
Under this example, the exporter knows the U.S. dollar value
they will receive for the export, and the currency risk is
effectively hedged. If the Won were to decline or increase in
value after the time of the sale, but before payment is
received, the exporter will be made whole through the
settlement of the OTC derivative. In summary, the loss in the
value of the goods sold would be offset by an increase in the
value of the derivative.
______
Submitted Joint Statement by National Association of Real Estate
Investment Trusts; The Real Estate Roundtable; and International
Council of Shopping Centers
The National Association of Real Estate Investment Trusts (NAREIT),
The Real Estate Roundtable (RER) and the International Council of
Shopping Centers (ICSC) (the ``Associations'') thank the Chairman, the
Ranking Member and the Committee for the opportunity to submit these
comments for the record of the hearing held by the Committee on
Agriculture on September 17, 2009, regarding the proposed legislation
by the Department of the Treasury to regulate over-the-counter (OTC)
derivative markets.
The Associations support efforts by the Administration and the
Congress to enact financial regulations that enhance transparency and
accountability while restoring stability to capital markets. The
Associations believe it is possible to enact this reform and minimize
systemic risk while still maintaining access to reasonably priced and
customized OTC derivative products for business end-users that seek to
control cost and manage the risk inherent to their day-to-day business
operations.
Commercial real estate companies rely upon low-cost, customized
over-the-counter derivative products--such as interest rate swaps,
forward starting swaps, and foreign exchange forward contracts--to
mitigate risk and to manage the costs of their development and
operational activities. By utilizing these products to minimize
volatility and reduce risk, these companies can better manage their
balance sheets and better serve their customers and shareholders.
We support efforts to contain any systemic risk posed by derivative
arrangements between two major market participants through reasonable
capital requirements and through mandatory central clearing or exchange
trading of standardized derivatives.
However, proposals that would require OTC derivatives used by
business end-users to be standardized, centrally cleared, executed on
exchanges, or cash collateralized--or that would increase the cost of
hedging through unreasonable capital charges--would create a
significant drain on working capital and could prevent our member
companies from accessing these important risk management tools.
The Associations appreciate the collaboration between Agriculture
Committee Chairman Peterson and Financial Services Committee Chairman
Frank, and the work of the Treasury Department in the effort to craft
proposals that attempt to reduce systemic risk, while also recognizing
the particular concerns of business end-users that utilize derivatives
to manage business risk in a responsible way.
The Associations support these dual objectives, though we believe
more must be done to ensure that the proposed legislation truly targets
systemic risk and speculation without undermining legitimate risk
management techniques for business end-users. We look forward to
working with policymakers to achieve these goals.
OF THE TREASURY REGARDING THE
REGULATION OF OVER-THE-COUNTER
DERIVATIVES MARKETS
TUESDAY, SEPTEMBER 22, 2009
House of Representatives,
Committee on Agriculture,
Washington, D.C.
The Committee met, pursuant to call, at 11:04 a.m., in Room 1300,
Longworth House Office Building, Hon. Collin C. Peterson [Chairman of
the Committee] presiding.
Members present: Representatives Peterson, Boswell, Scott,
Marshall, Herseth Sandlin, Ellsworth, Walz, Kagen, Schrader, Halvorson,
Dahlkemper, Markey, Kratovil, Schauer, Murphy, Pomeroy, Childers,
Minnick, Lucas, King, Fortenberry, Smith, Latta, Thompson, Cassidy, and
Lummis.
Staff present: Adam Durand, Tyler Jameson, John Konya, Scott
Kuschmider, Clark Ogilvie, James Ryder, Rebekah Solem, Tamara Hinton,
Kevin Kramp, Josh Mathis, Nicole Scott, Jamie Mitchell, and Sangina
Wright.
OPENING STATEMENT OF HON. COLLIN C. PETERSON, A REPRESENTATIVE IN
CONGRESS FROM MINNESOTA
The Chairman. The Committee will come to order.
Good morning, everybody, and welcome to the hearing.
Today marks the second of two hearings to review the Treasury
Department's legislative proposals on over-the-counter derivatives, and
I want to thank the Members for making it back to Washington early so
you could attend this important hearing today.
I want to welcome Chairman Gensler and Chairman Schapiro, each of
whom is making their first appearance before this Committee since they
were confirmed by the Senate earlier this year.
Chairman Gensler has been extremely busy in his new role, and I
want to commend him for the steps that he has taken, thus far, to
promote market transparencies, specifically with respect to data
reporting on index funds and swap dealers in the commodities market.
This Committee held month-long hearings on this very topic and included
similar data, disaggregation provisions in legislation that has passed
earlier this year.
We intend to bring Chairman Gensler back very soon to discuss other
issues relating to the futures markets. I look forward to working with
him, as well as Chairman Schapiro, as we finish the job in passing long
overdue legislation to bring order to the unregulated over-the-counter
derivatives market.
Last Thursday, this Committee heard from industry stakeholders
about Treasury's language as well their broader views on the practical
effects of the major financial reform proposals that have been
introduced. As I noted last Thursday, some of what has been proposed is
similar to our line of thinking, which has been using the clearing
model to mitigate the systemic risk of these over-the-counter products,
which have grown exponentially in size and complexity.
While I think there are concerns from this Committee on both sides
of the aisle about some of Treasury's language, the Administration,
overall, has put forth some useful ideas that we can work with.
In particular, one point of contention we heard from several
witnesses last week was a potential negative impact on end-users. This
is proving to be a difficult problem to deal with, as I said last
Thursday, but it is imperative that commercial users are not treated
unfairly by any statutory or regulatory changes. These entities, for
the most part, already have effective risk-management methods in place
and, by virtue of their size, do not pose a systemic risk on the
economy, like some of the market-making large banks or other financial
institutions. We shouldn't throw the baby out with the bath water by
hampering the ability of end-users to effectively hedge their price
risk when it comes to regulatory reform.
In addition, I hope Chairman Gensler and Chairman Schapiro can
offer their thoughts on financial reform as a whole, particularly the
idea of the systemic risk regulator and how such a position could
affect or take away from the missions of their respective agencies. I
have made my position clear that I do not favor a systemic risk
regulator, particularly if it is placed in the hands of the Federal
Reserve, which is accountable to no one and has enjoyed a cozy
relationship for many decades with the institutions that are largely
responsible for this mess that we are in, in the first place.
I think that it is an important point to consider as we move into a
crucial time in this debate, and I look forward to working with both
Chairmen here today, as well as Ranking Member Lucas and other
committees of jurisdiction to make sure that we don't lose sight of
what is at stake.
There are a lot of big financial players who have a great deal of
interest in maintaining the status quo, which is simply unacceptable to
me and a lot of Members of this Committee.
Once again, I welcome Chairman Gensler and Chairman Schapiro. I
look forward to their testimony.
And at this time, I would like to yield to the Ranking Member, Mr.
Lucas from Oklahoma, for an opening statement.
OPENING STATEMENT OF HON. FRANK D. LUCAS, A REPRESENTATIVE IN CONGRESS
FROM OKLAHOMA
Mr. Lucas. Thank you, Mr. Chairman, and thank you for holding this
hearing.
I also would like to extend a warm welcome to both our witnesses
today. You two are in high demand, and I have watched with interest
your appearance in front of other committees. Though this is your first
time in front of the House Agriculture Committee, I trust and suspect
it will not be your last.
On August 11, 2009, the Treasury Department released the Over-the-
Counter Derivatives Market Act of 2009. Since the release, we have met
with the exchange community, the dealer community, the end-user
community and our staffs trying to gauge the impact of this legislative
proposal. Reactions from those in the proposed regulatory community we
have met with range from general concern to downright opposition.
Most believe, as I do, that the language is rather ambiguous and
confusing. Some sections produce more questions than answers. For
instance, the plan focuses on increasing transparency and
standardization in the OTC derivatives market for all types of
products, and recommends that all standardized OTC derivatives be
cleared by a clearing organization or traded on an exchange. But the
plan does not specify what would constitute standardized as opposed to
customized derivatives. Also it does not mandate that all OTC
derivatives be either traded on regulated exchanges or cleared through
clearing organizations, only that as yet undefined standardized OTC
derivative contracts be cleared.
In addition, incentivizing people to use standardized swaps will
increase capital margin requirements on customized swaps. Here again,
the Administration's proposal doesn't provide much clarity. The
Administration's proposal is silent on how these increased costs will
be calculated, who will be charged, who will charge the increased
requirement, and who will hold the margin payment.
By no means are these the only examples of ambiguity or concerns
created by the Administration's proposal, but they are the issues most
frequently raised. I am anxious to learn from the regulators today, so
that we might be able to get some clarity as the process moves forward.
I congratulate the Chairman for not only all of his efforts on this
subject, but for having the two most important people responsible for
implementing this language in front of the Committee so early in the
process, so that we can get a common understanding of the proposals and
the intentions.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman and other Members' statements
will be made part of the record.
So, again, welcome to the Committee Chairman Gensler, Chairman
Schapiro. We very much appreciate you being with us.
And with that, Mr. Gensler, I will turn the floor over to you for
your statement, and then I think we have a lot of questions for you.
STATEMENT OF HON. GARY GENSLER, CHAIRMAN,
COMMODITY FUTURES TRADING COMMISSION,
WASHINGTON, D.C.
Mr. Gensler. Good morning, Chairman Peterson, Ranking Member Lucas,
Members of the Committee. Thank you for inviting for me here to testify
on behalf of the Commodity Futures Trading Commission regarding
regulation of the over-the-counter derivatives, and my full statement
will hopefully, if I can ask that be in the record, but it represents
the Commission's statement on which I am testifying.
One year ago at this time, the financial system failed the American
public, and the financial regulatory system as well failed the American
public. And I believe we must now do all we can to ensure that this
does not happen again. As a critical component of reform, not the only
component but a critical component, we must bring comprehensive
regulation to the over-the-counter derivatives marketplace. We must
lower risk, promote market integrity, improve market transparency,
while still allowing for this market, this risk-management market to
exist.
Comprehensive regulation of the over-the-counter derivatives
market, I believe, will require two complementary regimes: One, the
regulation of the derivatives dealers themselves; these are the actors
upon the stage. But also regulation of the key market functions or the
stages themselves. This Committee took leadership on this important
topic, derivatives regulation, when you passed H.R. 977 in February.
The joint framework for OTC derivatives legislation announced in
the summer by the Chairman and Chairman Frank also includes essential
provisions to protect the American public, and the legislation proposed
and submitted to Congress by the Treasury on behalf of the
Administration, where both the SEC and the CFTC were able to
contribute, I believe are important steps towards comprehensive
regulation of the derivatives market.
Regulating derivatives dealers is important because this financial
crisis has taught us that the derivatives trading activities of even
one firm can threaten the entire financial system and all Americans.
Every taxpayer in this room, the Members of this Committee, your
constituents, the audience, these gentlemen in front of me with their
cameras clicking, all put money into this company that most Americans
had never heard of, AIG; $180 billion of all of our money is right now
in this institution, and it didn't have effective Federal regulation.
I believe we cannot afford any more multi-billion dollar bailouts
of ineffectively regulated derivatives dealers. By comprehensively
regulating the dealers, such as AIG, we can regulate the entire
derivatives market, both standardized and customized products. The
dealers should be required to meet capital standards and margin
requirements to lower risk. I believe the dealers should also be
required to meet business conduct standards to protect against fraud
and manipulation and other abuses. And to promote transparency, the
dealers should meet comprehensive reporting requirements so that the
regulators can see all the trades and report those aggregates to the
public.
But I believe we need to do more than just watch the dealers
themselves and bring them under regulation. Congress, I believe, should
also mandate that the standard product in these markets be brought on
to centralized clearing and on to exchanges. One of the lessons we
learned through the crisis is that financial institutions were not only
too big to fail, but also too interconnected to be allowed to fail. In
that regard, moving bilateral trades into regulated clearinghouses will
reduce the risk that a failure of one firm will cause other firms to
fail.
To meet the requirements that all the standardized products be
brought on to centralized clearing, end-users have raised some
concerns, as the Chairman and the Ranking Member noted. But end-users,
I believe, should be permitted to access this clearing, bringing all
standardized products on to the clearinghouses, through a clearing
member. An end-user could use a financial institution, and that
financial institution could then bring it to the standard exchanges and
clearinghouses. Thus, we would be able to achieve a goal of bringing
standardized swaps into clearing, while at the same time allowing end-
users to enter into appropriate individualized credit terms with those
financial institutions who are clearing members.
Transparency and efficiency would also improve for all end-users if
we bring them onto regulated exchanges or trading venues. This would
give both large and small end-users pricing, better pricing, both in
standard and customized products.
I would like to also mention that we have been working very closely
with the SEC, and comprehensive regulation of these markets will
require ongoing cooperation. I believe that we are very fortunate to
have a great partner in SEC Chairman Mary Schapiro. Since our
designations were jointly announced by President-elect Obama in
December, we have had a strong working relationship, and I look forward
to working together to implement the regulatory reforms of the
derivatives marketplace, as well as bringing forth to you and the rest
of Congress recommendations as the President has asked us to do on how
we best can tailor our regulations in the interest of protecting the
American public.
Before I close, I would just like to mention, if Congress were to
move forward, as I think we must, to regulate over-the-counter
derivatives, the CFTC, and no doubt the SEC, will need additional
resources for new staff and technology.
In our case, since the late 1990s, the markets have grown fivefold;
the number of contracts we oversee and regulate six-fold, but our
agency staff was cut by over 20 percent. With Congress's help, just
this year, we are back to the staffing levels we were at in 1999.
Taking on this additional oversight responsibility, I believe we will
need to work with this Committee and the rest of Congress for
additional resources.
So I look forward to working with Congress and other Federal
regulators to bring this regulation forward for the American public,
and with that, I look forward to questions.
[The prepared statement of Mr. Gensler follows:]
Prepared Statement of Hon. Gary Gensler, Chairman, Commodity Futures
Trading Commission, Washington, D.C.
Good morning, Chairman Peterson, Ranking Member Lucas and Members
of the Committee. Thank you for inviting me to testify today regarding
the regulation of over-the-counter derivatives.
One year ago, the financial system failed the American public. The
financial regulatory system failed the American public. We must now do
all we can to ensure that it does not happen again. While a year has
passed and the system appears to have stabilized, we cannot relent in
our mission to vigorously address weaknesses and gaps in our regulatory
structure. As a critical component of reform, I believe that we have to
bring comprehensive regulation to the over-the-counter (OTC)
derivatives markets. We must lower risk, promote greater market
integrity and improve market transparency.
The need for reform of our financial system parallels what we faced
as a nation in the 1930s. In 1934, President Roosevelt boldly proposed
to the Congress ``the enactment of legislation providing for the
regulation by the Federal Government of the operation of exchanges
dealing in securities and commodities for the protection of investors,
for the safeguarding of values, and so far as it may be possible, for
the elimination of unnecessary, unwise, and destructive speculation.''
The Congress responded to the then clear need for reform by enacting
the Securities Act of 1933, the Securities Exchange Act of 1934 and the
Commodity Exchange Act of 1936.
We need the same type of comprehensive regulatory reform today.
Just as we then brought regulation to the commodities and securities
markets, we now need to bring regulation to markets for risk management
contracts called over-the-counter derivatives.
Comprehensive Regulatory Framework
Comprehensive regulation of the OTC derivatives markets will
require two complementary regimes--one for regulation of the
derivatives dealers, or the actors, and one for regulation of the
derivatives markets, or the stages.
This regulatory framework must cover both standardized and
customized swaps. This should include all of the different products,
such as interest rate swaps, currency swaps, commodity swaps, equity
swaps and credit default swaps, as well as all of the derivative
products that may be developed in the future. We should eliminate
exclusions and exemptions from regulation for OTC derivatives. Congress
should extend the regulatory regimes of the Commodity Exchange Act
(``CEA'') and the Federal securities laws to fully cover OTC swaps in
all commodities. I believe that the law must cover the entire
marketplace, without exception.
Only with two complementary regimes that regulate both the
derivatives dealers and the derivatives markets can we ensure that
Federal regulators have full authority to lower risks, promote
transparency and prevent fraud, manipulation and other abuses.
This Committee took leadership on OTC derivatives regulation by
passing H.R. 977 in February. The joint framework for OTC derivatives
legislation announced by Chairmen Peterson and Frank also includes
essential provisions to protect the American public.
The legislative proposal submitted to Congress by the Treasury
Department on behalf of the Obama Administration is a very important
step toward comprehensive regulation of the OTC derivatives markets.
The CFTC and the Securities and Exchange Commission worked with the
Treasury Department on many of the most important provisions of the
Administration bill.
Regulating Derivatives Dealers
Only by comprehensively regulating the institutions that deal in
derivatives can we oversee and regulate the entire derivatives market.
Through regulating the dealers, we can ensure that regulations apply to
both standardized and customized products.
Derivatives dealers should be required to meet capital standards
and margin requirements to help lower risk. Imposing prudent and
conservative capital and margin requirements on all derivatives dealers
will help prevent derivatives dealers or counterparties from amassing
large or highly leveraged risks outside the oversight and prudential
safeguards of regulators. Many of these dealers, being financial
institutions, are currently regulated for capital. I believe, however,
that we need to explicitly have in statute and by rule capital
requirements for their derivatives exposure. This is even more
important for those dealers who are not currently regulated or subject
to capital requirements.
Customized derivatives are by their nature less standard, less
liquid and less transparent. Therefore, I believe that higher capital
and margin requirements for customized products are justified. This
Committee addressed the issue of standardized versus customized swaps
in H.R. 977.
Congress also should explicitly authorize regulators to require
derivatives dealers and counterparties to segregate, or set aside, from
their own funds the margin collected from counterparties. This would
help ensure that counterparties are protected if either counterparty to
the customized OTC transaction experiences financial difficulties.
Dealers should have to comply with business conduct standards to
protect market integrity and lower risk. The CFTC and the SEC should be
authorized to apply the same enforcement authority that we currently
have over the futures and securities markets to OTC derivatives and
those who trade them. Both the markets and the public benefit when
there is a cop on the beat.
Business conduct standards also should ensure the timely and
accurate confirmation, processing, netting, documentation and valuation
of all transactions. These standards for ``back office'' functions will
help reduce risks by ensuring derivatives dealers, their trading
counterparties and regulators have complete, accurate and current
knowledge of their outstanding risks.
To promote transparency and market integrity, a comprehensive
reporting and record-keeping regime should be established for swaps,
including swap repositories--for both standardized and customized
products. This should include mandatory public disclosure of aggregate
data on swap trading volumes and positions. A complete audit trail of
all transactions should be available to the regulators.
The financial crisis has taught us that the derivatives trading
activities of a single firm can threaten the entire financial system.
Every single taxpayer in this room--both the Members of this Committee
and the audience--put money into a company that most Americans had
never even heard of. Approximately $180 billion of the tax dollars that
you and I paid went into AIG to keep its collapse from further harming
the economy. The AIG subsidiary that dealt in derivatives--AIG
Financial Products--was not subject to any effective Federal regulation
of its trading. Nor were the derivatives dealers affiliated with Lehman
Brothers, Bear Stearns, and other investment banks. We must ensure that
this never happens again. We cannot afford any more multi-billion-
dollar bailouts.
Regulating Derivatives Markets
To effectively regulate OTC derivatives and protect the American
public, Congress also should establish a comprehensive regulatory
regime for the markets in which OTC derivatives trade.
Centralized Clearing: All derivatives that are accepted by central
counterparty clearing should be considered ``standardized'' and thus
required to be cleared. This is important to lower risk. The CFTC and
SEC should be granted rule writing authority to ensure that dealers and
traders cannot change just a few minor terms of a standardized swap to
avoid clearing and the added transparency of exchanges and trading
platforms. This is a key component of the bill this Committee passed in
February, the Treasury proposal and the regulatory framework announced
by Chairmen Peterson and Frank.
Requiring clearing of standardized products will protect the
American public by lowering risk. One of the lessons learned from the
crisis was that financial institutions were not only too big to fail,
but too interconnected to fail. In that regard, moving bilateral trades
into regulated clearinghouses will reduce the risk that a failure of
one firm will cause other firms to fail.
When a contract is submitted for clearing, the clearinghouse is
substituted as the counterparty for both the buyer and the seller. The
clearinghouse guarantees the performance for each counterparty,
reducing risk for both the buyer and the seller.
Clearinghouses should be required by statute and regulatory action
to establish and maintain robust margin standards and other necessary
risk controls and measures. It is important that we incorporate the
lessons from the current crisis as well as the best practices reflected
in international standards. Thus, the Treasury bill includes provisions
strengthening the statutory core principles for derivatives clearing
organizations.
To promote transparency and competition, central counterparties
should be required to have fair and open access criteria. First, to
promote competition among exchanges and trading platforms,
clearinghouses should be required to take on OTC derivatives trades
from any regulated exchange or trading platform on a nondiscriminatory
basis. Second, clearinghouses should accept as clearing members any
firm that meets objective, prudent standards to participate, regardless
of whether it is a dealer or another type of trading entity.
Clearinghouses also should have open governance that incorporates a
broad range of viewpoints from members and other market participants.
To meet the requirement that all standardized products be brought
into centralized clearing, end-users should be permitted to access
clearing through a clearing member. This would establish a client
relationship between end-users and clearing members whereby the
clearing member would clear the transaction in a client account on
behalf of the end-user. This is very similar to what currently exists
in the futures marketplaces. I believe it would be appropriate for
clearing members, most of whom would be financial institutions, to have
the ability to enter into individualized credit arrangements with end-
users that are not major market participants to satisfy the margin
obligations of such end-users. Thus, we would be able to achieve the
goal of bringing all standardized swaps to clearinghouses while
concurrently allowing end-users to enter into appropriate,
individualized credit terms with a clearing member.
Ever since President Roosevelt called for the regulation of the
commodities and securities markets in the early 1930s, the CFTC (and
its predecessor) and the SEC have each regulated the clearing functions
for the exchanges under their respective jurisdiction. This well-
established practice of having the agency which regulates an exchange
or trade execution facility also regulate the clearinghouses for that
market should continue as we extend regulations to cover the OTC
derivatives market.
Exchanges: I believe market transparency and efficiency would be
further improved by moving the standardized part of the OTC markets
onto regulated exchanges and regulated trade execution facilities.
Exchanges greatly improve the functioning of the existing securities
and futures markets. We should bring the same transparency and
efficiency to the OTC swaps markets.
Transparency in pricing is critical to economic activity.
Increasing transparency--including a consolidated reporting tape--for
standardized derivatives would give both large and small end-users
better pricing on standard and customized products. A corn or wheat
farmer, for example, could better decide whether or not to hedge a risk
based upon the reported pricing from the exchanges. As customized
products often are priced in relation to standard products, I believe
that mandated exchange trading will enhance the ability of all end-
users to effectively manage their risk, whether hedging or trading with
standardized or customized swaps.
Position Limits: The CFTC should be granted statutory authority to
set aggregate position limits across all markets and trading platforms
on all persons trading OTC derivatives that perform or affect a
significant price discovery function with respect to regulated markets
that the CFTC oversees. This will ensure that traders cannot evade
position limits by moving to a related exchange or market. Exemptions
to position limits should be limited and well defined.
Enforcement and Rulemaking Authority: The Congress should
strengthen the CFTC's rulemaking, oversight and enforcement authorities
with respect to registered exchanges and clearinghouses. Further, the
Congress should extend the ``Zelener fraud fix,'' which was included in
last year's farm bill with respect to CFTC enforcement authority over
off-exchange retail foreign currency transactions, to similar contracts
in other commodities. I am pleased that these provisions are included
in the Administration's proposal.
Foreign Boards of Trade: As part of regulatory reform legislation,
the Congress should provide the CFTC with clear statutory authority to
regulate U.S. traders on foreign boards of trade. Parties using
terminals in the U.S. to trade a contract that settles against the
price of a contract traded on a U.S. exchange should be subject to
position limits and reporting requirements. Those limits would be
consistent with limits that apply to the U.S. exchange. Such
requirements were passed by this Committee in February and are included
in the Administration bill.
Working With the SEC
Comprehensive regulation of OTC derivatives will require ongoing
cooperation between the CFTC and the SEC. The President asked that our
agencies provide recommendations to Congress and the Administration on
how to best tailor our regulations in the interest of protecting the
American public. We recently held two unprecedented joint meetings to
look into the gaps that exist between the two agencies' financial
regulatory authorities, overlap of regulatory authority and
inconsistencies when the two agencies' regulate similar products,
practices and markets. The President asked the CFTC and the SEC to
propose legislative initiatives, where appropriate, to best harmonize
our regulations. It is my hope that some of these proposals will be
available to this Committee while you consider legislation regulating
the OTC derivatives markets.
We are fortunate to have a great partner in SEC Chairman Mary
Schapiro. Since our designations were jointly announced by then
President-elect Obama, we have had a strong working relationship. As
Chairman of the SEC, former Chairman of the CFTC and CEO of FINRA,
Chairman Schapiro brings invaluable expertise in both the securities
and commodity futures areas. Our mutual understanding, dedicated staffs
and respective Commission support gives me great confidence that we
will be able to get the job done.
Resources
The CFTC will need additional resources for new staff and
technology to effectively regulate the OTC markets. The Commission is
just this year getting back to the staffing levels that it had in the
late 1990s. Since then, the markets grew five-fold and the number of
contracts grew six-fold, but the agency's staff was cut by more than 20
percent. To take on additional oversight responsibilities, we will
continue to work with this Committee, the Appropriations Committees,
Congress and the Office of Management and Budget to secure additional
resources.
Conclusion
I look forward to working with the Congress and other Federal
regulators to apply comprehensive regulation to both derivatives
dealers and the markets in which they trade. The United States thrives
in a regulated market economy. This requires innovation, competition
and regulation to ensure that our markets are fair and orderly. We have
a tough job ahead of us, but it is essential that we get it done to
protect the American public.
Thank you for inviting me to testify today. I would be happy to
answer any questions you may have.
The Chairman. Thank you very much, Chairman Gensler.
Chairman Schapiro, welcome to the Committee and look
forward to your testimony as well.
STATEMENT OF HON. MARY L. SCHAPIRO, CHAIRMAN, U.S. SECURITIES
AND EXCHANGE COMMISSION, WASHINGTON, D.C.
Ms. Schapiro. Thank you very much, Chairman Peterson,
Ranking Member Lucas, and Members of the Committee.
It has actually been 15 years since I last testified before
the House Agriculture Committee when I was Chairman of the
CFTC. So I really do appreciate this opportunity to come back
and testify on behalf of the Securities and Exchange Commission
concerning the Over-the-Counter Derivatives Markets Act of 2009
proposed, in August, by the Treasury Department.
I am especially pleased to appear with CFTC Chairman Gary
Gensler, with whom I have worked closely over the last several
months on a variety of issues. Indeed, our two agencies already
have begun an ambitious program to better harmonize our roles
and procedures, and we recently held joint hearings
highlighting key differences in our approaches. Both of our
Commissions are eager to address these issues and ensure that
remaining differences are justified by meaningful distinctions
between markets and products.
As you know, the recent financial crisis revealed serious
weakness in U.S. financial regulation, including gaps in the
regulatory structure. Both the SEC and CFTC are fully committed
to filling the gaps and shoring up the system.
One significant gap is the lack of regulation of OTC
derivatives, which were largely excluded from the regulatory
framework by the Commodity Futures Modernization Act of 2000.
OTC derivatives present a number of risks that can facilitate
leverage, enable concentrations of risk, and behave
unexpectedly in times of crisis. And while some derivatives can
also reduce certain types of risks, they can also cause others.
Importantly, these risks are heightened by the lack of
regulatory oversight of dealers and other market participants,
a combination that can lead to insufficient capital, inadequate
risk-management standards and associated failures cascading
through the global financial system.
Last, the largely unregulated derivatives market can also
undermine the regulated securities and futures market by
serving as a less regulated alternative, facilitating a flow of
funds out of regulated markets into shadow markets.
The Treasury proposal is an important step forward in
improving transparency and establishing the necessary
regulatory framework. While it would go a long way towards
improving the regulation of OTC derivatives, I believe it
should be strengthened in several ways.
First, to minimize regulatory arbitrage, regulate swaps
like their underlying references. Market participants often use
derivatives and the underlying assets they reference as
substitutes. Whether to participate in the fortunes of a public
company directly, as through the purchase of its common stock,
or indirectly, as through the purchase of an equity swap or a
credit default swap, this has become a matter of choice.
Whether the participation is direct or indirect, the same or
similar economic effects can often be achieved. As a result,
even subtle differences in the regulation of economic
substitutes can lead to gaming and advantages for any one
participant. But that participant's regulatory arbitrage
activities, and a general migration to the less regulated
derivatives market, can undermine the interests of other
participants as well as everyone's interest in minimizing fraud
and systemic risk.
Second, provide the tools needed to appropriately enforce
the anti-fraud authority retained by the bill. Treasury's
proposal would retain the SEC's existing anti-fraud authority
over all securities-related swaps but, unfortunately, does not
currently provide the tools needed to adequately police all of
these swaps. To be effective, enforcement also requires
examination authority over entities dealing in securities-
related swaps, direct access to real-time data, and
comprehensive anti-fraud and anti-manipulation rulemaking
authority.
Third, clarify that the definition of securities-based swap
includes not only single- and narrow-based CDS but broad-based
CDS where payment is triggered by a single security or small
group of securities. For example, payment is triggered under
many so-called index CDS by the event of default of a single
security referenced in the index. These CDS raise the same
policy concerns under the securities laws as single-named CDS.
Fourth, clarify that a swap is not considered a mixed swap
simply as a result of a swap having a floating interest rate
component.
Fifth, close the unregulated foreign bank loophole by
identifying banking products. Treasury's proposal inadvertently
would exclude from the new swap regulatory framework OTC
derivatives offered to U.S. persons by unregulated foreign
banks and their subsidiaries if the products are characterized
as bank products.
Sixth, provide the CFTC and the SEC with clear authority to
require that swaps intermediaries segregate counterparty funds
and securities. Recent events have focused attention on
bankruptcy protections with respect to resolution regimes for
OTC derivatives dealers and other major participants in the
market. Chairman Gensler suggests that legislation should
provide for an insolvency framework that protects first and
foremost customers, and I completely agree.
And finally, direct regulators to adopt stronger business
conduct rules to protect less sophisticated investors and end-
users.
In closing, the Treasury proposal makes significant strides
towards addressing current problems in the OTC derivatives
marketplace. I look forward to continuing to work with this
Committee, the Congress, the Treasury, and the CFTC to enact
strong legislation in this area. Again, I appreciate the
opportunity to be here, and I look forward to answering your
questions.
[The prepared statement of Ms. Schapiro follows:]
Prepared Statement of Hon. Mary L. Schapiro, Chairman, U.S. Securities
and Exchange Commission, Washington, D.C.
I. Introduction
Chairman Peterson, Ranking Member Lucas, Members of the Committee:
Thank you for the opportunity to testify on behalf of the
Securities and Exchange Commission&\1\ concerning the regulation of
over-the-counter (``OTC'') derivatives and, in particular, the Over-
the-Counter Derivatives Markets Act of 2009, which was proposed in
August by the Department of the Treasury. I am pleased to appear with
CFTC Chairman Gary Gensler with whom I have worked closely over the
last several months on a variety of issues. As you know, our two
agencies have already begun an ambitious program of joint work to
better harmonize our rules and procedures. Earlier this month, we held
2 days of joint hearings that highlighted some of the key differences
in our regulatory approaches. We are eager to address these issues.
Although some differences may remain over time, I believe this process
will help ensure that any differences are justified by meaningful
distinctions between markets and products and the others will be
harmonized and improved. I also look forward to continuing our joint
efforts to push for real regulatory reform.
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\1\&Commissioner Paredes does not endorse this testimony.
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The recent financial crisis has revealed serious weaknesses in U.S.
financial regulation. Among them were gaps in the existing regulatory
structure; failures to enforce existing standards; and failures to
adapt the existing regulatory framework and provide effective
regulation over traditionally siloed markets that had grown
interconnected through globalization, deregulation and technological
advances. Fixing these weaknesses is vital, particularly in the current
market environment, and it is a goal to which the SEC is absolutely
committed.
One very significant gap in the regulatory structure was the lack
of regulation of OTC derivatives, which were largely excluded from the
regulatory framework in 2000 by the Commodity Futures Modernization
Act.
It is critical that we work together to enact legislation that will
bring greater transparency and oversight to the OTC derivatives market.
The derivatives market has grown enormously since the late 1990s to
approximately $450 trillion of outstanding notional amount in June
2009.
This market presents a number of risks. Chief among these is
systemic risk. OTC derivatives can facilitate significant leverage,
result in concentrations of risk, and behave unexpectedly in times of
crisis. Some derivatives, like credit default swaps (CDS), can reduce
certain types of risk, while causing others. For example, CDS permit
individual firms to obtain or reduce credit risk exposure to a single
company or a sector, thereby reducing or increasing that risk. In
addition to obtaining or reducing exposure to credit risk, a CDS
contract participant will take on counterparty and liquidity risk from
the other side of the CDS. Through CDS, financial institutions and
other market participants can shift credit risk from one party to
another, and thus the CDS market may be relevant to a particular firm's
willingness to participate in an issuer's securities offering or to
lend to a firm. However, CDS can also lead to greater systemic risk by,
among other things, concentrating risk in a small number of large
institutions and facilitating lax lending standards more generally.
These risks are heightened by the lack of regulatory oversight of
dealers and other participants in this market. This combination can
lead to inadequate capital and risk management standards. Associated
failures can cascade through the global financial system.
Moreover, OTC derivatives markets directly affect the regulated
securities and futures markets by serving as a less regulated
alternative for engaging in economically equivalent activity. The
regulatory arbitrage possibilities can facilitate a flow of funds out
of the regulated markets and into the unregulated shadow markets. The
lack of transparency and oversight also enables bad actors to hide
trading activities that would be more easily detected if done in the
regulated markets. These issues must be addressed, and I am committed
to working closely with this Committee, the Congress, the
Administration, and the CFTC to close this gap and restore a sound
structure for U.S. financial regulation.
The Treasury proposal would establish a comprehensive framework for
regulating OTC derivatives. The framework is designed to achieve four
broad objectives: (1) preventing activities in the OTC derivatives
markets from posing risk to the financial system; (2) promoting
efficiency and transparency of those markets; (3) preventing market
manipulation, fraud, and other market abuses; and (4) ensuring that OTC
derivatives are not marketed inappropriately to unsophisticated
parties. Importantly, it emphasizes that the securities and commodities
laws should be amended to ensure that the SEC and CFTC, consistent with
their respective missions, have the authority to achieve--together with
the efforts of other regulators--the four policy objectives for OTC
derivatives regulation.
The proposed legislation is an important step forward. It would
bring currently unregulated swaps, swaps dealers, and swaps markets
under a comprehensive regulatory framework, thereby improving
transparency and regulatory oversight. It also would facilitate the
standardization and central clearing of swaps, thereby fostering a
``better'' market and reducing counterparty risk.
II. Strengthening Treasury's Proposal
While Treasury's proposal would go a long way towards bringing OTC
derivatives under a comprehensive regulatory framework, I believe it
should be strengthened in several ways to further avoid regulatory gaps
and eliminate regulatory arbitrage opportunities. I agree with Chairman
Gensler that Treasury's proposal can be enhanced to prevent the
exclusions for foreign currency swaps and forwards from being used by
market participants to avoid regulation and from undermining the CFTC's
enforcement authority over retail foreign currency fraud. I also agree
that the proposal can be enhanced to bolster protections against
insolvency risk, and on other matters.
In addition, I offer the following suggestions:
A. Minimize Regulatory Arbitrage and Gaming Opportunities by Regulating
Swaps Like Their Underlying ``References''
Market participants often view derivatives and the ``underlying''
assets they reference almost interchangeably. Thus, a participant may
well decide to take a position in the fortunes of a company by entering
into transactions in OTC derivatives like equity swaps rather than
through the purchase of common stock. When carefully structured, the
economic payoffs could be similar, if not virtually identical. Yet the
legal consequences attached to these alternatives may be different.
Gaming--regulatory arbitrage--possibilities abound when
economically equivalent alternatives are subject to different
regulatory regimes. An individual market participant can have
incentives to migrate to products that are subject to lighter
regulatory oversight.
Treasury's proposal would for the first time bring the OTC
derivatives market under a regulatory umbrella by establishing a new
regulatory framework for OTC derivatives. Treasury's proposal would
divide regulatory responsibility for securities-related OTC derivatives
between the SEC and the CFTC, and provide regulatory responsibility for
other OTC derivatives to the CFTC. Although we believe this approach
would do much to eliminate differences within the broad and varied
world of ``swaps,'' it could result in significant regulatory
differences between ``swaps'' products and the currently ``regulated''
securities and futures products. For example, energy swaps would not be
regulated in the same way as energy futures, and securities swaps would
not be regulated in the same way as securities. This is significant
because, in evaluating whether to engage in a swap transaction, market
participants are far more likely to focus on the choice between a swap
and regulated alternatives (e.g., between a Microsoft swap on the one
hand and a Microsoft option or Microsoft stock on the other, or between
an oil swap and an oil future), than between swaps involving different
``underlying'' assets (e.g., a Microsoft swap and an oil swap). Thus,
these regulatory differences could perpetuate existing regulatory
arbitrage opportunities that encourage the migration of activities from
the traditional regulated markets into the differently regulated swaps
market.
In addition, Treasury's proposal would create regulatory arbitrage
between narrow-based security index swaps and broad-based security
index swaps. For example, market participants could engage in the
synthetic transactions in the swaps market, or craft swaps specifically
to fall within the broad-based category instead of the narrow-based
category. These risks are particularly high in customized over-the-
counter transactions where individual market participants can self-
select the particular securities in one or more swaps.
Accordingly, Congress should consider modifying the proposal so
that all securities-related OTC derivatives are regulated more like
securities; and commodity and other non-securities-related OTC
derivatives are regulated more like futures. At the core of this
approach is the principle that similar products should be regulated
similarly, or equivalently, if possible. This straightforward approach
would result in securities-related OTC derivatives--which can be used
to establish either synthetic ``long'' exposures to an underlying
security or group of securities, or synthetic ``short'' exposures to an
underlying security or group of securities--and the underlying
securities being regulated consistently. Similarly, commodity-related
OTC derivatives, such as swap contracts for oil and natural gas, would
be regulated in a similar manner as the underlying oil or natural gas
futures.
This approach also would be simpler to implement. Congress should
extend the Federal securities laws to all securities-related OTC
derivatives and extend the Commodity Exchange Act to all commodity-
related and non-securities related OTC derivatives. This would
significantly reduce the arbitrage opportunities between the regulated
markets (securities or futures) and the differently regulated swaps
market, as well as between narrow-based security index swaps and broad-
based security index swaps, while building off the existing regulatory
framework. Although some differences would likely remain (as they
currently do between the SEC and CFTC regimes), these differences could
be addressed through the harmonization process that we already have
underway.
B. Strengthen Existing Anti-Fraud and Anti-Manipulation Authority
Treasury's proposal also attempts to retain the SEC's existing
anti-fraud authority over all securities-related OTC derivatives, even
those securities-related OTC derivatives over which the SEC would not
have regulatory authority. This authority is essential to policing
fraud in the securities markets; to be effective, though, enforcement
also requires: (1) examination authority over entities dealing in
securities-related swaps; (2) direct access to real-time data on these
swaps; and (3) comprehensive anti-fraud and anti-manipulation
rulemaking authority for these swaps.
For example, in investigating possible market manipulation during
the financial crisis, the SEC sought to use its anti-fraud authority to
gather information about transactions both in securities-related OTC
derivatives and in the underlying securities. Investigations of
securities-related OTC derivative transactions, however, were far more
difficult and time-consuming than those involving cash equities and
options. In contrast to the audit trail data available in the equity
markets, data on securities-related OTC derivative transactions were
not readily available and needed to be reconstructed manually. The
SEC's enforcement efforts were seriously complicated by the lack of a
mechanism for promptly obtaining critical information--who traded, how
much, and when--that is complete and accurate.
If Congress determines to split regulatory responsibility over
securities-related OTC derivatives, Congress should provide these tools
to help ensure effective anti-fraud enforcement over all securities-
related OTC derivatives.
C. Credit Default Swaps and Regulatory Arbitrage
As we saw first hand during the financial crisis, trading practices
in the CDS market have a direct effect on the underlying securities
markets. Both narrow- and broad-based index CDS can be used as
synthetic alternatives to debt--and even equity--securities of one or
more companies. In addition, market participants may use CDS to
establish a short position with respect to the fortunes of a specific
company. In particular, a market participant may be able even to use a
broad-based index CDS that includes the company as a way to short that
company's debt or equity. In brief, debt and equity securities and
single-name and narrow- and broad-based index CDS are all economic
substitutes, and therefore ripe for regulatory arbitrage.
Under current law, the Commission has stated that exchange-traded
CDS on securities, whether on one security or a basket of securities,
are securities. To avoid gaming by financial engineers under the new
regulatory regime, Congress should consider clarifying that the
definition of ``security-based swap'' includes not only single-name and
narrow-based index CDS, but also broad-based index CDS, and other
similar products, when payment is triggered by a single security or
issuer or narrow-based index of securities or issuers. This also would
be consistent with the approach advocated above to extend the Federal
securities laws to all securities-related OTC derivatives.
D. Business Conduct Standards and Eligible Contract Participants
One of the lessons learned from the most recent financial crisis is
that certain smaller and less sophisticated institutions need
protections from abusive practices by their swaps intermediaries. There
is a need for more stringent business conduct standards. This is an
area in which I believe we and the CFTC are largely in agreement.
Treasury's proposal would require the SEC, the CFTC, and other
regulators to adopt business conduct rules for dealers and major
participants in the OTC derivatives markets. This is an important
component of regulatory reform, and we fully support it. But these
provisions should be stronger. We believe that Congress should
strengthen this authority so that the SEC and CFTC may adopt stronger
and more protective rules in certain situations--for example, where a
swaps dealer is selling OTC derivatives to smaller or less
sophisticated participants, including certain municipalities, in the
OTC derivatives market.
In addition, Congress should consider revising the qualification
standards for participation in the OTC derivatives markets. The
standards for being an ``eligible contract participant'' (``ECP'') are
important under Treasury's proposal because only ECPs may trade
derivatives over-the-counter. All other market participants must trade
on exchanges, which provide better protections for less sophisticated
participants. More specifically, Congress should consider raising the
qualification standards for a governmental entity or political
subdivision--such as a municipal government--to qualify as an ECP.
Higher standards may also be appropriate for individuals, corporations
and other entities.
E. Protecting Customer and Counterparty Assets
One key issue is how best to protect customer and counterparty
assets in the event of insolvency. I agree with Chairman Gensler that
it would be prudent for legislation to address this issue. Recent
events have focused attention on bankruptcy protections with respect to
resolution regimes for OTC derivatives dealers and other major
participants in the OTC derivatives market. Chairman Gensler suggests
that legislation should provide for an insolvency framework that
protects, first and foremost, customers. I absolutely agree. I believe
that a resolution regime should provide legal restrictions on how
counterparty assets held by OTC derivatives dealers and other major
market participants would be treated in the event of an insolvency, as
well indicate the extent to which counterparties would have a prior
claim on the other assets of the estate. Without legal certainty, the
insolvency of an OTC derivatives dealer or other major OTC derivatives
participant could result in further market disruptions and systemic
risk.
F. Ensuring That the ``Identified Banking Products'' Exception Is Not
Abused
Treasury's proposal contains an exclusion from the regulatory
scheme for OTC derivatives for products that are ``identified banking
products.'' Although this exclusion may make sense for banks that are
regulated in the U.S., we believe that this exclusion could allow
foreign banks (and their subsidiaries) that are not subject to
oversight by any Federal banking regulator, to offer OTC derivatives to
U.S. persons in the guise of ``bank products.'' I believe this
exclusion should be revised to make clear that it is not available to
foreign banks or their subsidiaries that are not subject to Federal
banking oversight.
III. Conclusion
The Treasury proposal is a significant step toward addressing
current problems in the OTC derivatives marketplace. It provides a
comprehensive regulatory framework that addresses risks to the
financial system and promotes efficiency and transparency in the
markets. I strongly encourage Congress to build off this proposal and
enact legislation that will bring even more vital transparency and
oversight to this market.
Thank you for the opportunity to address issues of such importance
for the strength and stability of the U.S. financial system, and the
integrity of the U.S. capital markets. I look forward to answering your
questions.
The Chairman. Thank you very much, Chairman Schapiro, and
again, I thank both of you for being here.
The Treasury proposal presumes a swap is standardized and,
therefore, must be cleared if the clearinghouse will accept it.
And then it layers on top of that presumption a joint
rulemaking to come up with a definition of standardized, which
is only effective if the clearinghouse is willing to clear the
so-deemed standardized swap.
So why shouldn't the only standard be whether a
clearinghouse will accept the swap products and can clear it in
a safe and sound manner in the context of the agency's role as
safety and soundness regulator at the clearinghouses? Both of
you.
Mr. Gensler. The benefit of bringing the marketplace into
transparent exchanges and on to clearinghouses is very
important, but it can be done only if we also make sure that
the clearinghouses have strong risk management. And so if a
clearinghouse were able to accept a contract for central
clearing, the Treasury proposal, and one that I support in this
regard, would say that that should be on central clearing. But
we would still allow end-users to tailor products that
sometimes are not so standardized that they can be brought into
this risk management of a central clearinghouse, and in that
regard, that should be still allowed.
But the Treasury proposal also adds one other thing which
is rulemaking authority. So the presumption is, if a
clearinghouse, not a mom-and-pop clearinghouse but a real
clearinghouse, could accept a contract for clearing and they
deem it to be a prudent under their risk management, it should
be deemed to be standard. But also, then have a rulemaking, so
if they were high-volume contracts or look-alike contracts that
at least the regulators could look at it. I think it is similar
to what you had in your bill, H.R. 977, in February, to still
take a second look.
Ms. Schapiro. I would only add that we have to have an
overriding concern that the integrity of a clearinghouse not be
compromised by the acceptance of a particular contract for
clearance and settlement if, in fact, they don't have, as
Chairman Gensler points out, the risk-management procedures to
appropriately manage that contract, and be prepared if there is
a default with respect to that contract. So, I think, it is
more than just the acceptance of a contract that makes it
susceptible to clearing. There is a layer of risk management
and other protections that we, as regulators, need to be
concerned about because the failure of a clearinghouse would
really, potentially, be a catastrophic event.
The Chairman. For a customized swap or a standardized swap
that can't be cleared, what does the Treasury proposal say will
happen with regard to those swaps?
Mr. Gensler. They would still be fully regulated but
regulated through the dealer regulation. They would be reported
to central repositories and to the market regulators, so that
the cop on the beat can protect against fraud and manipulation;
and also to the bank regulator if it was by a bank. The bank or
dealer would also have to have appropriate capital to mitigate
against the risk at that financial institution. Finally, there
would still be anti-fraud, anti-manipulation, other business
conduct standards to protect against abuses. So fully regulated
but allowed because it is really important that end-users be
able to hedge even customized risk.
Ms. Schapiro. I think that is a very complete answer. The
legislation actually lays out an entire list of actions that
would need to comprise the dealer regulation component, and
that is how we would approach the customized products, through
dealer regulation.
The Chairman. Who, if anyone, will check the financial
integrity of the swap participants and ensure the proper risk
management practices, margin capital, are applied?
Mr. Gensler. I think that the oversight of the financial
institutions who are swap dealers would still be the
traditional prudential regulators, whether that is a bank
regulator, or the SEC, has prudential regulation. We, at the
CFTC have a smaller role in that regard over futures commission
merchants, but I think that most of these swap dealers would
end up likely either under the bank regulator or the SEC with
regard to what the Chairman asked about their risk management
at that swap dealer.
Ms. Schapiro. The dealer obviously would have
responsibility for ensuring the capability of their
counterparty, who may well be a major swap participant, to
ensure they can meet the terms and conditions of the contract
into which they have entered.
The Chairman. All right. Thank you. My time is up. Mr.
Lucas.
Mr. Lucas. Thank you, Mr. Chairman.
Along that general line, I am concerned about the
Administration's OTC derivatives proposal which would,
seemingly, force non-financial dealers to meet certain capital
requirements in order to provide legitimate risk services on
the OTC commodity derivatives markets. Given that these non-
financial dealers do not have deposits, unlike the large
financial institutions, and in many cases no systematic risk
profile, has the Administration considered what the
consequences of that would be?
And let me ask one more question and let the panel address
both of them along that line. Are you concerned that such a
requirement could unintentionally create a bank monopoly in the
OTC commodity derivatives market and thereby, of course, reduce
competition, reduce liquidity, raise prices, increase
systematic risk?
Mr. Gensler. Congressman Lucas, one of the lessons out of
this crisis is that there were significant gaps of institutions
not covered like nondeposit institutions. AIG, as I referenced
earlier, was not a deposit-taking institution. So the
Administration approach, and I support this and believe we must
cover anyone who holds themselves out to the public as a
derivatives dealer, whether they are a traditional deposit-
taking institution, whether they are another type of financial
institution, or for that matter, even if it was a large oil
company who actively holds themselves out to the public as a
derivatives dealer. There is a difference between that and
somebody who is just participating in the markets, to hedge
their own risk, of course.
So, it would consistently apply, and in fact, I believe
there would not be a monopoly in the banks because you would
have consistent regimes that others would participate, and be
allowed to participate, in a nondiscriminatory way.
Ms. Schapiro. I would really agree with that. I think if we
don't cover all dealers regardless of whether they are deposit-
taking institutions and, therefore, invoke the Federal Deposit
Insurance Fund, we will see business migrate from well-
regulated institutions to less well-regulated institutions. We
won't have solved the problem that we are all attempting to
solve through this bill or through some similar approach to
bringing all the players and the products under the regulatory
umbrella.
Mr. Lucas. Don't you think it is a fair statement,
depending on what kind of capital requirements we put together,
unintentionally, I will say, that we won't ultimately drive
this market into this one set of hands that have the deepest
pockets to be able to manage the requirements, and consequently
really dramatically shrink the competition out there? Isn't
that----
Mr. Gensler. I actually--I understand that question, but I
don't see it that way, with all due respect. I think that if it
is a bank, currently a financial institution, they have capital
charges already. If it is a non-bank and they are not setting
aside any capital, yes, you are absolutely correct. But, I
believe that we want to protect the American public, that non-
bank derivative dealers do have some capital behind what they
are doing.
Mr. Lucas. Considering the number and volume of non-bank
dealers who participate in the OTC commodity derivative
markets, should capital requirements at least be limited to
firms whose failure would create systematic risk in the U.S.
economy? And that is teeing off just a moment ago, I think, of
where you have been headed, but let me ask one more in addition
to that.
What result does the Administration hope to achieve by
imposing these capital requirements on these non-financial
companies that use the markets to legitimately hedge their
commodity risk and offer risk-management services to others?
Doesn't this still help reduce the overall risk to the economy?
Mr. Gensler. It most certainly does, in that there is a
broad array of derivative dealers, but if a company holds
themselves out to the public as a dealer, as actively trading
these and risk management for others, they right now are
unregulated. Their chief financial officers, their risk
management, they put capital aside and may even be capital that
is also committed to other things in that business. And so it
is just important that they do have that buffer, that cushion,
so we don't find ourselves, again, if I can come back to AIG,
where this market migrates to an unregulated participant, and
there is then an advantage that the unregulated participant has
to the regulated participant.
Ms. Schapiro. I would just add that even the failure of a
non-systemically-important institution creates a lot of havoc
and harm in the marketplace for its counterparties and for
other institutions. So I would be uncomfortable with limiting
capital requirements to just those that are systemically
important, because capital provides an important cushion
against losses for all institutions. This is why we require,
obviously, banks and broker dealers and futures commission
merchants to have capital regardless of how large they are;
although capital is geared towards the size and the risk of the
institution.
Mr. Lucas. Thank you, Mr. Chairman.
Mr. Gensler. If I might add also, I know it is outside our
remit, but the Administration has talked about those
institutions that are so systemically relevant that they are
called tier-one institutions. There may be other provisions
that this Committee and Congress considers, that those might
have additional capital. But what we are working with here is,
if you hold yourself out as a derivatives dealer, there is some
concept that there is capital or cushion there that is not
necessarily as high as what might be there for these tier-one
institutions.
Mr. Lucas. Mr. Chairman, indulge me for just one more
moment.
My concern is that we don't, in the effort to be so
protective and to avoid the tier-one, the tremendous
institutions, that we strangle out the whole industry, the
whole series of products that fall at that lower tier where a
failure would be borne out by the company, not by the whole
economy.
Thank you, Mr. Chairman.
The Chairman. Well, if the Committee would indulge, I think
this might be the right--it is just my understanding that these
people are paying for this. Maybe they don't put the margin up
or the capital up, but somehow or another, they are paying for
this. A counterparty isn't going to give them that protection
without extracting something for it, right? So, I mean, they
are already doing it. If they don't put the money up, then they
are maybe getting a bigger spread or something to cover it.
Isn't that what is actually going on here?
Mr. Gensler. The Chairman is correct. The dealer currently
charges counterparties for extending credit through these
contracts. Whether it is 5 cents a million cubic foot or a few
basis points on an interest swap, they certainly do.
The Chairman. As you guys put this together, I mean, you
are going to probably allow that to continue as long as you
think that whatever they are doing is adequate to cover the
risk, right? You are not going to be so prescriptive that you
are going to force them to change?
Mr. Gensler. That is what we are recommending as relates to
margin, that the end-users, not the dealers, but the end-users
would be allowed to enter into arrangements with dealers, and
the dealers could have individualized credit arrangements, but
the dealer would still have to post margin at the central
clearinghouse.
Mr. Lucas. Thank you, Mr. Chairman.
The Chairman. All right, thank you.
The gentleman from Iowa, the Chairman of the Subcommittee,
Mr. Boswell.
Mr. Boswell. Well, thank you, Mr. Chairman. I just say to
other Members of our Committee that we all ought to appreciate
the personal interest that our Chairman and Ranking Member put
into this subject. You can tell that from what has already gone
on.
So not to repeat some of that, but I would like to add my
appreciation to you both being here. You have an awesome
responsibility, and the whole country is looking right over
your shoulder. And I guess we are going to all get acquainted
better as time goes on. So I appreciate your accepting the
responsibility and what you bring to the table, and we look
forward to that.
I think I will digress a little bit because there are a
number of Members here that will get into a lot of detail that
I could as well, and I may yet. But last week, it was called to
my attention by a constituent, which was most unexpected, some
of the things that are going on in the life insurance side. And
there was quite an article written on September 6 in The New
York Times entitled, Wall Street Pursues Profit in Bundles of
Life Insurance.
I trust you are familiar with that. I see you nodding your
head. So, with that, I won't read from it, but I could. I am
concerned about it, and I would like to know if you are.
The article says many things, but would you elaborate for
me--does this securitization of life settlements not only add
another element of possible risk to an investor that was
already in need of more transparency and consumer safeguard,
but it is something that we should even allow? What are your
thoughts?
Ms. Schapiro. It is a wonderful question. It is an area I
am actually profoundly worried about. And about a month and a
half ago, I asked the SEC staff to form a task force to explore
all of the issues that surround the process of securitizing
life insurance policies. It is becoming a very large business.
It is a multi billion dollar business to sell life insurance
policies for more than the surrender value but less than the
cash value, and then bundle those up together and then cut them
into pieces of securities and sell them.
They raise all sorts of issues with respect to the Privacy
Act because underlying information about the health of
individuals whose policies are part of the securitized product
may be made available to investors. They raise issues about the
ability of the people who sold their life insurance policies,
to ever get policies again. They raise tax implications for
them. So there are multiple sales practice issues, and there
are multiple issues around the whole securitization process.
None of these securitized products have yet been registered
with the SEC. They have been done with private placements, but
we are aggressively exploring the issues. We are working with
other interested parties, like the National Association of
Insurance Commissioners, and we will proceed to take this
process apart very carefully.
Mr. Boswell. Maybe you could comment about why aren't they
regulated? What have you got in mind?
Ms. Schapiro. Well, we need to understand the full range of
issues because, as I say, there are sales practice issues when
people are convinced to give up their life insurance policies,
and what is the price they are getting for that, and is it
fair?
Mr. Boswell. If I could, my time is going fast. I like what
you are saying, and I want follow up on this.
Ms. Schapiro. Okay. I don't know where we will land in
terms of policy yet.
Mr. Boswell. I am sure you don't, but I want you to keep us
very closely in touch of what is going on, and let's keep this
dialogue going.
Ms. Schapiro. I would be happy to.
Mr. Boswell. Okay. And we put it into the record last week
about this issue and made several points, but you know, some of
these--this bittersweet side of it, kind of and others, maybe
there is some opportunity for people who don't need the
insurance anymore, but they lapse in all these details.
However, if it is put on the market and sold in a sense, then
they are going to keep paying out the premiums. And maybe the
criteria that the insurance company used to figure out what it
is going to cost no longer is valid. So there are all kinds of
possibilities here that needs attention, as I can say the least
of.
Mr. Chairman, with your concurrence, thus----
Mr. Pomeroy. Would the gentleman yield just for a moment on
that?
Mr. Boswell. I will.
Mr. Pomeroy. There are tax incentives underwriting the
fundamental life products, and I believe that when it is a
securitized issue spread around with no remote concept of
insurable interest, you raise profound questions about whether
or not this tax incentive ought to apply anymore. I believe
that they are placing the fundamental industry at risk with
this whole track they have gone down, and it does deserve the
kind of examination by regulatory authorities and Members of
Congress alike.
I thank the gentleman for raising it.
Mr. Boswell. You are welcome, and I will just finish with
this statement, which you already know. There are trillions of
dollars invested out there. Possibly, some say $26 trillion, I
don't know what it is. It is humongous, and so it is very huge.
So, it deserves your attention, and I appreciate what you have
said, and so let's keep in touch.
I yield back.
The Chairman. I thank the gentleman.
The gentleman from Iowa, Mr. King.
Mr. King. Thank you, Mr. Chairman.
And I thank the witnesses.
As I listened to this discussion, I would like to return a
little bit to the AIG, which was brought up a number of times.
And I want to say the words out loud that you were talking
about using different definitions, but improperly defined, too
big to be allowed to fail. And so I think that the specter of
that hangs over our discussion here.
And I haven't heard very much discussion about what you
view the consequences might have been if we had not invested
that huge sum of money into holding up AIG. How that might have
broken out, and what would be the results today, short from the
prediction of the global financial collapse, what would it look
like in the United States today if we had just simply let them
fail and let the markets do the adjustment? And I would ask
first Chairman Gensler.
Mr. Gensler. Well, you ask a very difficult question
because it is running history parallel in two regimes. I do
think that what we were facing last fall was quite uncertain,
that AIG had a book of business that was over $450 billion of
just credit default swaps. They had other books of business,
but it was with significant European banks, as well as about a
third of that book was here in the states backing up mortgage
securitization products, all very lightly regulated. If it had
triggered, there was tens of billions of dollars that would
have cascaded around the system and other institutions.
Recall, also, that was the same week that Lehman Brothers
failed. That was the same week that, for the first time in
decades, a money fund was worth something less than a dollar;
it broke the buck. So there was a run on money markets. There
was a run on investment banks. There was a classic run on the
whole financial system. I don't know exactly what would have
happened, but that run would have accelerated, in my opinion,
over those next several days.
Mr. King. Mr. Chairman, would we have recovered, you
believe, and would it have rearranged our financial markets in
a fashion that would have sent a message out through the
investment community to, let's say, restrain their investments
unless there was better capital behind the traders, rendered
unnecessary by regulators?
Mr. Gensler. I was a private citizen and not a government
official at the time, but I would certainly say it would have
rearranged things. I am not sure if it would have rearranged
things calamitously or not, but it would certainly have
rearranged things. But these were very difficult decisions that
the regulators at the time faced.
Mr. King. Thank you.
Mr. Gensler. And if I might say, we shouldn't have to face
those decisions again. That is why we are both here to say,
let's bring regulation to the over-the-counter derivatives.
Mr. King. I do hear that, and I thank you.
And I direct a similar question to Chairman Schapiro.
Ms. Schapiro. Thank you, Congressman.
I also was a private citizen last fall, so I have no
particular insights other than those that I have gained at the
SEC in the meantime. But I do think that given the number of
counterparties that AIG had, there likely would have been
multiple other failures in the system if they had collapsed.
And the process that we have been going through painfully for
the past year likely would have been prolonged and more
difficult. It is hard to, obviously, say exactly.
Mr. King. Thank you.
And the question I posed here really sets up the follow-up
question, and I will come back to you, ma'am, and that is, is
there any discussion about requiring reinsurance on the part of
the traders? You know, I describe it as being bonded to do a
certain dollars worth volume of business. If that discussion
had a viable path that could be part of this dialogue, then how
do we avoid the reinsurance companies from becoming too big to
be allowed to fail?
Mr. Gensler. Well, I am intrigued by your suggestion. I
think that is why we have proposed that there be capital, and
capital by the dealers, as well as margin which is sometimes
similar to capital by the counterparties, and so the concept of
reinsurance is another concept one might add to this. But
capital is a big cushion and important cushion to this and
margin.
Mr. King. And Chairman Schapiro?
Ms. Schapiro. I agree with that. I think margin essentially
collateralizing the positions in many ways, and can have the
same impact without worrying about the further integrity of
other financial institutions that have now become intertwined
in the process.
Mr. King. Have either of you considered an alternative that
might be more of a free market alternative that would not
require the Federal Government to be the regulator of first
resort and setting the standards of capital at the over-the-
counter level, or----
Mr. Gensler. Well, the American public benefits by a
regulated market economy----
Mr. King.--another alternative?
Mr. Gensler. Well, this is both--I think we need the
regulation. The other alternative to me is more costly to the
American public.
Now, it is true that, just as we do in the securities and
futures market, we do rely on some self-regulation of the
exchanges, but if the regulators set the overall rules,
exchanges can then help and clearinghouses, obviously, can help
in implementing those rules.
Mr. King. Chairman Schapiro.
Ms. Schapiro. The securities regulatory regime really
relies very heavily on self-regulatory organizations, primarily
the exchanges in this context. The key to which those are
successful though is strong governmental oversight of the self-
regulatory organizations so that they continue to act in the
public interest. If they are publicly owned entities, as they
are increasingly in both commodities and securities markets,
they are not diverted from their public interest
responsibilities by their desire for shareholder return. So, we
can have reliance on clearing organizations to perform certain
functions, but it has got to be under the oversight of the
Federal Government.
Mr. King. Thank you.
I thank the witnesses.
Mr. Chairman, I yield back.
The Chairman. I thank the gentleman.
The gentleman from Georgia, Mr. Scott.
Mr. Scott. Thank you, Mr. Chairman.
I want to ask a question about the CFTC's authority over
foreign boards of trade, but before we do, a couple of my
colleagues raised some points that I would just like for you to
respond to.
On the AIG situation, there is a question here that we need
to examine and answer that has not been done, and that question
is that for the Financial Products Division of AIG, there was
no effective Federal regulation. That same situation was true
for Bear Stearns, Lehman Brothers, all down the line. So the
question is, why? Why was there not any Federal regulation? Who
and how was the ball dropped there? Why didn't we see this? Why
wasn't there effective Federal regulation?
Ms. Schapiro. Let me take the first stab at that. I don't
know the answer with respect to AIG and how it was structured.
With respect to Lehman Brothers and Bear Stearns, there was
ineffective, honestly, Federal regulation through basically a
voluntary regulatory program at the Securities and Exchange
Commission called the Consolidated Supervised Entity Program.
And it was essentially voluntary for those institutions through
their holding companies to be regulated in this way.
The lessons learned coming out of that really suggest that
the capital rules were not adequate to deal with the liquidity
stresses that were created when these institutions began to
fail. There was a lack of appreciation that secured funding;
even that funding that was backed by high quality collateral
such as Treasury bills, could become unavailable and really
impair liquidity. Without liquidity, institutions couldn't
continue to do business.
I think we learned that there is a much greater need at
these financial institutions for supervisory focus on the
quality of the assets they are holding and their liquidity.
We certainly learned that valuation models that were relied
upon for capital purposes and other purposes were wholly
inadequate, not up to the task, and were not sufficiently
stress-tested so that we could understand in a really bad
situation how these institutions would perform. And it was a
neglect of looking at the low probability but really extreme
events to understand their impact.
So, from my perspective, these are all lessons coming out
of the failure of those institutions, and, hence, the need for
regulators to have clear authority to require changes when
necessary in the conduct of a business that is threatening
systemic integrity.
Mr. Scott. Okay. Well, thank you for that answer. I just
think we should know the why.
Let me go to another point. The Treasury proposal seemingly
gives the CFTC authority over foreign boards of trade, which I
am concerned may invite regulatory retaliation against U.S.
markets and businesses by foreign regulators. Foreign boards of
trade will need to register with the CFTC in order to provide
electronic access to its U.S. participants. So, in order to
register with the CFTC, the foreign boards of trade must adopt
position limits for contracts that are linked to a contract
traded on the U.S. DCM. But, the Treasury proposal goes further
than limited contracts, however, and also gives the CFTC the
authority to set position limits on any contract traded on a
foreign board of trade that is offered to U.S. market
participants, regardless of whether or not there is a linkage
of a U.S. contract. So where does the Treasury derive their
authority to regulate transactions on a foreign exchange?
Mr. Gensler. Maybe this one is for the CFTC. What we are
trying to address is something that you all also addressed in
your bill in February, that we have some foreign futures
exchanges now--but in the future, it may also be swaps
markets--that access U.S. customers, also link those contracts,
in what you may be familiar with which became known as the
London Loophole.
So we want to address that in statute, just as you did in
February, so that if terminals are placed here or if they are
not physical terminals but there is access to investors here,
contracts are linked, then we bring that regime under
regulation.
We currently are somewhat limited in the statute, and we
use something called No Action letters to do it. And that has
been somewhat more effective. We have just revised such a
letter with the largest foreign board of the trade, the ICE
Europe, we did that, but we had to do it with a lot of
diplomacy with foreign regulators, and I think it would be good
to have it also in statute.
Mr. Scott. Are you all concerned that these foreign
regulators may retaliate against U.S. markets?
Mr. Gensler. That is always a legitimate concern. That is
why we worked so closely with the FSA in London and have a very
good relationship with the head of that, Adair Turner. We have
just recently entered into two Memoranda of Understanding in
those regards to oversee clearing and this ICE Europe in a more
tight regulation because, as well, they also oversee some of
our exchanges over there.
Mr. Scott. Thank you, sir.
I yield back, Mr. Chairman.
The Chairman. I thank the gentleman.
The gentleman from Nebraska, Mr. Fortenberry.
Mr. Fortenberry. Thank you, Mr. Chairman.
And I am sorry, I regret I didn't have the benefit of your
earlier testimony, but let's go back to some fundamentals here.
Let's ask ourselves, what is the purpose of a commodities
market? And then I want you to answer, what percent of people
in the market now are hedgers, have commodity possession versus
speculators?
Mr. Gensler. The commodity markets, which go back over 150
years in regulated or in regular futures exchanges, help
hedgers, whether they be farmers or ranchers or, later on, oil
producers to hedge a risk, and then speculators take on that
risk.
Mr. Fortenberry. I know the answer to this, this is just an
exercise, as you understand.
Mr. Gensler. I understand, but I am trying to give you the
best answer, and so they are both very important pieces of the
market.
Depending upon the underlying commodity, some markets are--
have significantly more hedgers; some more significantly
speculators. We recently broke out more of our data between
producers and merchants, what you might consider a traditional
hedger and swap dealers, money-managed funds and the like. And
generally speaking, less than half--but it depends on the
market--less than half is usually the traditional hedger or
producer merchant category.
Mr. Fortenberry. Less than half since when?
Mr. Gensler. I am just--I am just referring to the most
recent data. We can certainly follow up.
Mr. Fortenberry. Well, the reason I ask is, the purpose of
the commodities market clearly is to hedge risk, to decrease
market volatility so that we have--the vagaries of the economy
are smoothed out. That we have less potential disruptions
because of the risky nature of growing crops or producing oil
and the other production capabilities that we have in our
country. If that system is broken and the market itself
actually increases risk for the overall economy, do we have a
fundamental problem here?
Now, last year, when we were dealing with this issue and
were going over and over it trying to figure out, where is the
smoking gun? Why are oil prices shooting through the roof when
the underlying fundamentals seem to indicate that supply-and-
demand variables were not consistent with such a run-up in the
price? And of course, that leads to an increase in price of the
other commodities that are trailing behind, particularly
agriculture commodities, which ends up turning hog markets and
ethanol markets and all types of production capabilities upside
down. Now we are back home dealing with farmers who are in very
dire straits because of something that they had no control
over.
We have a fundamental crack or a problem in our foundation
here in that the system designed to hedge risk, to ameliorate
risk, actually has caused risk in the economy; what is the
underlying solution to that? And I know you are talking about
increasing capital, transparency in all swaps, all types of
derivative markets that are out there, will that solve this
problem? That is my point.
I am sorry to be a little bit testy with you here. That
wasn't my intention, but just try to get to the fundamental
point.
Mr. Gensler. I think you are right. All derivatives
markets, whether futures or these things we call derivatives,
OTC derivatives are risk-management contracts and price-
discovery markets so people can discover the price of bearing
that risk, the price of hogs or corn or wheat.
We are recommending that we bring regulation and
transparency to the big part of the market that doesn't have it
right now, the over-the-counter swaps marketplace, that we
regulate the dealers and that we bring the standard part of the
market onto transparent exchanges.
I think that goes a far way to the Congressman's question
but also to have the ability to set aggregate position limits,
not only in the futures market, but across these markets where
it affects the markets, particularly for products that have
finite supply.
Mr. Fortenberry. Do you think, applying a test backwards in
time, that a regulatory framework that you just described with
increased transparency and requirements on all trades, no
matter how you define them, no matter how they are sliced up,
no matter how they are derived, having them open and clear as
to what is going on, would have actually prevented the type of
run-up in oil prices and other commodities that went along with
that? Because even though there are underlying supply-and-
demand fundamentals, they didn't indicate the need for such or
indicate a future possibility of prices reaching that level. In
other words, the market that is designed to hedge risk, to take
care of market vagaries, actually caused the run-up in markets
and the severe disruption to the economy.
Mr. Gensler. I think that given more tools, and this is
true of both our agencies----
Mr. Fortenberry. Can you do that--I am sorry, I am out of
time. Can you apply in real-time what you are projecting into
the future back to the situation last year, would it have been
prevented?
Mr. Gensler. I am not able to do the hypothetical. It is a
good hypothetical, but I am not able to do that. I think we
bring good transparency and lower risk to the system, and we
have the tools to police against manipulation and corners and
squeezes and other abuses that might be at the center of what
you are saying.
But we are also not price-setting agencies, neither of us.
So there are going to be times that there are trends in
investor psychology or in market psychology that also happens.
We are there to make sure they are fair and----
Mr. Fortenberry.--you should try to get to that issue.
Mr. Gensler. Yes.
Mr. Fortenberry. All right. Thank you, Mr. Chairman.
Mr. Marshall. Thank you, Mr. Chairman. I guess picking up
on where Mr. Fortenberry left off, the position limits
authority that you would like the CFTC to have which would run
across all markets. Do you plan to give the CFTC sufficient
discretion to make judgments concerning limits that would vary
from participant to participant? Those participants that in
your judgment are really truly assisting with price discovery
and market liquidity and those sorts of things, it seems to me
you might at some point want to permit them to have larger
position limits than other participants. And it is simply a
matter of math, it is simply a matter of numbers. We have had
that discussion before. I would be, interested in maybe a
written response in this instance.
My question actually today has more to do with this
clearing process. You have referenced what others have already
talked about, and that is this possibility that clearing
members would provide financing that would assist end-users in
using the new system. The pushback we have been getting, of
course, is that end-users, folks who really need to hedge, just
aren't going to be able to do it, they are not going to be able
to afford it.
And it would be helpful if, perhaps, the CFTC could get
together with those who are proposing to have clearing
operations and sort of flesh out how this would work and what
impact--assuming that it works well and that financing is
available for margining, et cetera--what impact this would have
on end-users? Would we lose a lot of end-users or wouldn't we
lose a lot of end-users? And that will help us out a lot if
basically there is a small additional cost but people are still
able to hedge, and that additional cost is something that
generally protects the system, that protects the public, then
that is something we can live with.
If, on the other hand, people aren't going to be able to
hedge, they are just going to not be able to have access to the
market, then we are going to have problems. We are going to
have to try to redefine who is going to be covered by clearing
requirements.
Mr. Gensler. Congressman, it is good to be back with you. I
think that end-users will benefit and actually take some of the
cost out of the system for them by the transparency, that they
will see the price as somebody else trades it. And that is the
truth in securities and futures markets today.
As it relates to the other question about central clearing,
central clearing will lower risk, but many end-users have
raised the question, well, does that apply to me? Does that
mean that I, too, as a small company in Georgia or in Iowa or
anywhere. I have to post margin. And what I believe we can do
to satisfy both goals, to satisfy the goal that we bring
everything into central clearing, is require the clearing
member, the large financial institution, the dealer, to do so;
but then they can enter into an individualized credit
arrangement. And right now derivatives do have costs in them.
All the end-users have a cost for credit extension. A credit
extension is one of the two pieces of these risk management
contracts.
Mr. Marshall. It would be very helpful to us if you, your
agency, maybe teaming up with the proposed clearing agencies,
could help us understand what the real impact will be. We
understand the theory, and that these folks will have help that
they are not really mentioning when they object to the clearing
requirement.
It would be very helpful to us if you could sort of put
some numbers down that might guide us. I don't know whether you
can do that, but it would be very helpful. I will just make
that statement.
Mr. Gensler. I certainly would like to follow up with you
on that.
Mr. Marshall. That would be wonderful.
Page 7, first full paragraph of your testimony, you talk
about central counterparties being required to have fair and
open access criteria, and that the clearinghouses should be
required to take on OTC derivative trades from any regulated
exchange or trading platform on a nondiscriminatory basis.
As I think how this clearing process is probably going to
evolve, I thought that it was probably going to--you know,
exchanges that--or that clearinghouses would become familiar
with particular kinds of trades, particular products, as has
happened where exchanges are concerned. I mean that one
exchange winds up being the main exchange for doing X. And the
product consequently--and the reason it is is because of
liquidity, or because of comfort, or something like that, there
is a better deal to be offered. And I am wondering whether or
not that isn't the same with these clearinghouses.
Clearinghouses that are more familiar with a particular product
are going to be able to offer a better price, better margining
rules, those sorts of things. And if they are required to
accept products that they are not familiar with, then they are
going to be less likely, it seems to me, to offer those, be
able to offer those products the same way that somebody else
familiar with the product would, and costs would go up.
Mr. Gensler. It is actually the reverse we are trying to
do. We are trying to promote competition amongst exchanges and
trading venues. And so what we are saying is that a
clearinghouse could not be vertically integrated in such a way
with an exchange or trading platform so that the only product
they accept is from that exchange or trading platform. And so
thus we want to promote competition, somewhat like what is in
the options market right now, where there is one clearinghouse
but many exchanges.
Ms. Schapiro. I was just going to add, if I could, that
there is a competitive clearing model where there are multiple
exchanges and multiple clearinghouses, and there is competition
to keep price down. The securities model really is a utility
model of a clearinghouse, very much along the lines you
suggest; the Options Clearing Corporation clears the options
transactions for all of the options exchanges; DTCC in New York
clears for all the securities exchanges. And it is a very
efficient model because they become highly expert in handling
the products, just as you suggest.
Mr. Marshall. And I am not entirely sure that the models
that you just offered will fit very well with these things that
are essentially futures. And I worry that the organizations
that are offering clearing are going to have to pay a lot more
attention post the actual event, the actual purchase, the
actual swap. And they know they are. They have to understand
the market, and they are going to be worried about costs
associated with that. And they are going to become familiar
with particular products.
So that is what I was worried about, and that they be able
to offer better price and better service for particular
products, and consequently you get concentration.
Mr. Gensler. And we would only recommend that a
clearinghouse accept a contract that they can legitimately
risk-manage and accept. But once they have accepted product A,
from Congressman Minnick's exchange, if I might say, if
somebody wants to take it to Representative Lummis' exchange,
if you had a different one, they could take it off. But the
clearinghouse would have to accept each of their exchanges once
they have accepted a product for clearing.
Mr. Marshall. I thank the Chairman for his indulgence. I am
over my time. Thank you.
The Chairman. I thank the gentleman. The gentleman from
Pennsylvania, Mr. Thompson.
Mr. Thompson. Thank you, Mr. Chairman. I am going to switch
gears just a little bit and move to the other end of this
process. Let's assume the Treasury proposal becomes law. What
will be the additional resource needs of your respective
agencies in terms of personnel, equipment and other needs, and
how much will that cost? Any estimates?
Ms. Schapiro. We don't have estimates at this point, though
we would be happy to provide them to the Committee. I would say
the rule harmonization process and the joint rulemaking
initiative will require significant amounts of time and staff
to build the joint rule through the rulemaking time frame that
is laid out in the statute.
Then, of course, there will also will be the process of
approving clearinghouses, setting up the regulatory framework,
overseeing them through an inspection program. And the same
would be true with respect to oversight of the dealers either
by the bank regulators, the SEC or the CFTC. So that is an
examination program, although I don't expect that there will be
huge numbers of dealers.
And then there will be the reporting capabilities that will
have to be through a repository or other mechanisms, reporting
systems that must be developed, that will collect transaction
data and make it available to the public and to the regulators.
And then, of course, once we have all that data, we have to
be in a position to analyze it and understand what kinds of
activities are taking place that may need a further response.
So there is a lot to do here. We are creating an entirely
new regulatory program around products that are valued at
trillions and trillions of dollars. So I don't have specific
numbers for you, but it will not be insignificant, I don't
believe.
Mr. Gensler. And I was just going to say, though we don't
have a specific number because we don't know the scope of the
legislation. This Committee included, I believe in your bill in
February, authorization for 100 new staff, if it were to move
forward in that regard. And so we have been using your wisdom
and guidance a little bit internally to think about how to do
this.
I don't know if the 100 on top of--we have approximately
570, 580 people now. We need to be much larger just to do our
current mission. But it has given us some guideposts as we are
thinking about this, your own guidance from February.
Mr. Thompson. Thank you. Just recently, the power producers
weighed in on the derivatives debate and expressed a fear that
the proposed changes, as defined currently, would make it
harder to protect against swings in commodity prices. And
obviously commodities they are looking at are specific to
energy.
Do you in your view--I would offer this to both Chairmen--
how will this legislation impact energy markets and overall
prices? Do you share their concern or do you see the validity
of their concerns?
Mr. Gensler. Well, I think that it will bring greater
transparency to energy markets. One of the great challenges
market participants have is that the over-the-counter
derivatives market is opaque. And that may have developed by
history, but there are many people that actually want to keep
it opaque. They are many of the people who we are looking to
regulate. They have advantages in keeping it opaque. So I think
they and all of their associations would benefit by that
transparency.
They have also raised some concerns about would they have
some costs with regard to posting margin. And then, as I tried
to address in my written statement, there is a solution to that
where clearing members would post margin and then enter into
individual credit arrangements with these gas companies and
utilities.
Ms. Schapiro. While it is not a perfect analogy by any
means, it has been my experience when we have made markets more
transparent, spreads have tightened, volatility has been less
of an issue, because there is generally available information
about the price, for example, of corporate bonds. So, again,
not a perfect analogy, but I would agree with what Chairman
Gensler has said.
Mr. Thompson. Okay. Thank you. And my final question is
just straightforward. Do you believe this legislation will
cause additional drying up of liquidity in any way, or any
threat of that?
Mr. Gensler. I think actually it will enhance liquidity.
That when you bring transparency to markets, as was done
through the Securities and Exchange Act in the 1930s and the
Commodity Exchange Act that enhances market liquidity, it might
take some of the advantages away from certain big dealers.
Ms. Schapiro. I would say that I think the facility of
exchange trading has generally enhanced liquidity in markets.
Mr. Thompson. Thank you. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from
Wisconsin, Mr. Kagen.
Mr. Kagen. Thank you, Mr. Chairman for holding this very
important hearing. And I was very pleased to hear in your
opening remarks that you were steadfastly against providing the
Federal Reserve with the authority to be the systemic risk
regulator. And I just want to confirm that our guests here
would confirm that they would also agree with this. So I will
give you an opportunity to say yes or no, that you would be in
agreement in opposing the Federal Reserve's opportunity to be
the systemic risk regulator.
Ms. Schapiro.
Ms. Schapiro. Well, like most questions, I can't answer it
yes or no. My perspective on this is slightly different than
the Administration's or some of the other proposals that you
have heard. I think we do have a need for a systemic risk
regulator, and it could be the Fed. But what is almost more
important is that we have a very empowered systemic risk
council that is comprised of the CFTC, the SEC, the Fed, the
FDIC, OCC, the full panoply of regulators who can take on the
role of really the macroprudential view of risk in a system,
can set capital standards if they need to be higher than what
the primary regulators have done, and can direct the systemic
risk regulator to act in an emergency.
I think the multiple perspectives that we can get from a
council as opposed to a single all-powerful systemic risk
regulator is going to be really important to the future of our
system. Because we have very different products, as you have
heard today; we have very different financial institutions
under our different jurisdictions, depository institutions,
broker-dealers, FCMs, and so we have regulators with very
different expertise. And to bring all of that talent to the
table to make some of the fundamental decisions about systemic
risk regulation, I think is very important.
That said, I do think at the end of the day some single
entity--it could be the Fed, it doesn't have to be--needs to be
in a position to be a second set of eyes over the roles of the
primary regulators.
Mr. Kagen. Would you agree that if we eliminate those
entities that are too big to fail, we may not require such a
risk regulator?
Ms. Schapiro. I think it would be good to have a risk
regulator that is constantly viewing the landscape and
understanding where risks are beginning to build, but it is
critical we eliminate the too-big-to-fail doctrine.
Mr. Kagen. Would you agree with me, if you are too big to
fail you should not exist and you should be broken up into
regional entities?
Ms. Schapiro. Let me say this carefully. I do believe that
we cannot suffer under the too-big-to-fail doctrine as an
economy for very much longer, that we must have in place
resolution mechanisms or ways to keep institutions from
becoming too big to fail for the future.
Mr. Kagen. Well, would you agree with the testimony offered
here last week from Garry O'Connor that, ``the OTC derivatives
markets currently represent a greater risk to our underlying
economy than they did before the financial crisis began.''?
Would you agree that we are in a position today, as you take a
look at the Office of the Comptroller of the Currency's report
at the end of the first quarter of this year, that we have such
a concentration of this activity that we are at greater risk
today than a year ago?
Ms. Schapiro. I don't know if we are at greater risk than a
year ago. I think we are still at risk. I think it is a
critical reason that this legislation has to move forward. We
have to bring these markets under regulation.
Mr. Kagen. Mr. Gensler.
Mr. Gensler. There were four or five questions there. If I
might address myself to the last question you just raised about
concentration, I do think that these markets have become more
concentrated. We see this in other industries as well: in the
drug industry, in the auto industry and other industries, the
movie industry. But the financial industry is increasingly
concentrated. I think it is something appropriate for Congress
to take up. And it also influences how we look at setting and
thinking about position limits as to whether markets are better
served if at least there is a minimum number of participants in
a market promoting both competition and liquidity. And if it is
highly concentrated to three or four or even five large
financial institutions, they internalize the deal flow, they
still provide important risk management but they internalize
it, probably provide less attractive pricing, ultimately
margins are a little wider, and the system as a whole is more
at risk.
Mr. Kagen. Well, last week John Damgard from the Futures
Industry Association expressed that their organization is
against the idea of position limits in terms of trading swaps
because it might push activity offshore and make things more
opaque than they are today. Would you care to comment on that?
Mr. Gensler. I think that it is important for all of us to
work very closely on the international side. I know that we can
only give a small part of it to the Commodity Futures Trading
Commission, but that all of the regulators, and even Congress,
reaching out internationally, so that we do this in
coordination and concert.
I, though, believe as it relates to the authorities we are
talking about for over-the-counter derivatives or even for
position limits, we still have to foremost protect the American
public, and that as we reach out to our colleagues in Europe
and in Asia, that we still remind ourselves that we have to
protect the investors and the markets here.
Mr. Kagen. Well, let me just in closing express the very
sincere and earnest concerns of the people of Wisconsin that I
represent, that one of the reasons that they have a lack of
confidence, not just in the economy but in their government, is
our inability to catch all the crooks that caused this economic
mess. We haven't cleaned it up yet, we are still at the
systemic risk, and we haven't yet finished our job here in
Congress about rewriting the legislation to help prevent it
from happening ever again.
So I will end by asking you to respond in writing as to how
successful the Administration has been thus far at catching the
crooks, and the rest of it I will leave up to us here to
rewrite the legislation. I yield back my time.
The Chairman. I thank the gentleman. The gentleman from
Oregon, Mr. Schrader.
Mr. Schrader. Thank you, Mr. Chairman. I guess I am not as
optimistic as most people here that we are going to be curing
the problem. All the certified smart people prior to 2007 felt
it was wise not to regulate swaps and stuff on the market, and
we got rid of Glass-Steagall a few years before that. I think
we are destined to repeat, unfortunately, the errors of the
past. And I am a little concerned when I hear that liquidity is
going to actually increase as a result of this legislation,
when I argue respectfully we have way too much liquidity. And
people began to think that risk itself was going to be solving
its own problem just by spreading the burden around.
So, we all should be thoughtful about where we are going to
end up here. We can do a few things that make sense, trying to
ensure the individual out there that doesn't understand this,
much like me, that there is some increased scrutiny going on.
And the too-big-to-fail comments, I would associate myself
with Representative Kagen. I guess I am mostly interested in
how do we gauge whatever we come up with at the end of the day
is actually performing correctly? What are our performance
outcomes, short of failure or avoiding the failure; because we
didn't have a failure in 5 years, therefore our regulations are
perfect. How do we know, going forward? What are the outcomes
you are envisioning?
And I am not talking about just auditing more companies and
clearing more trades, that sort of thing. How is the CFTC and
the SEC going to report back to Congress and the American
citizens that we are meeting our benchmarks, do we have certain
benchmarks that even people back home would understand? How are
we going to monitor success here?
Mr. Gensler. I think that is an excellent question. I think
that for your constituents in Oregon that it is important that
those who want to manage their risk or hedge their risk have
transparent markets in which they can do that. And liquidity is
part of that, but that they can actually, whether it is a small
municipality or a company of some size, can see that and not--
so spreads or the price they pay and the costs they pay would
come down. That that is available risk management for them is
key.
I think as a nation it is that these large financial
institutions are really setting aside capital for the risks
that they are taking on in these marketplaces, and that we are
able as regulators to police against the fraud manipulation,
which is inevitable given human nature, that we can police
against that effectively.
Ms. Schapiro. I would agree with all that and add just a
couple of things. I think we will also be able to measure
success if we can see that hedgers who have legitimate reasons
to be in these markets have access to the markets on a free and
competitive basis, that they are not being held to monopoly
rents or put at a disadvantage by dealers. That the risk is
well managed in dealers, which we should be able to determine
through examination and oversight programs to understand
exactly where the risks are; how they are managing them; and
that the public has information about currently quite opaque
markets and what the potential is in those markets for
something to go wrong and to be able to see what the
implications of a problem would be.
So, it is a great question and we should think more
carefully about it and come back to Congress with a report if
this legislation is passed that explains exactly why we think
it is or is not a success.
Mr. Schrader. If I may, I just would urge that we have a
set of performance measures included in whatever legislation
goes forward so we can actually track what is going on and
monitor the monitorees, if you will, or the regulators, to make
sure we feel comfortable things are going on correctly.
I yield back my time.
The Chairman. I thank the gentleman. And I apologize, Mrs.
Lummis. You were being locked out. Mr. Thompson has got wide
shoulders and must have been a fullback or defensive tackle in
his younger days.
Mr. Thompson. Lineman.
The Chairman. A lineman? So I apologize.
Mrs. Lummis. That is quite all right, Mr. Chairman.
Chairman Gensler, thanks for being here. I am from Wyoming
so I come from an energy producing state. And like Mr. Schrader
and Mr. Kagen, I have heard from my constituents. And both
large and small energy producers in Wyoming are concerned about
noncash collateral and the fact that it is an essential tool to
them for legitimate hedging in the over-the-counter market.
So my question is, how will restrictions on noncash
collateral affect the energy company's ability to manage
financial risk?
Mr. Gensler. I, like you, have met with a lot of energy
companies in these last 5 weeks, and I think that we can
achieve both goals. We can bring this market onto exchanges and
clearing, while at the same time allowing these energy
companies to continue to actively use these risk management
contracts. And what they have asked is, would they have to post
cash collateral? And I think that we can have them set up
clearing arrangements with the dealers where they could enter
into other arrangements, noncash collateral as you said, to
assure that they could meet needs if they run into bankruptcy
but, short of that, that they can use their cash to drill more
oil wells and so forth.
Mrs. Lummis. That is exactly the concern they have, so
thank you for that.
My next question is for both of you. I know you have talked
optimistically about harmonizing rulemaking, and that is a
tough thing to do. It is easier in dialogue than in practice.
Then we throw in, according to the Administration's proposal,
the Federal Reserve into the regulatory mix. Can you tell me
how the Federal Reserve fits in this regulatory puzzle?
Ms. Schapiro. I think with respect to rulemaking, the
Treasury steps in as the tie-breaker to the extent that the SEC
and the CFTC are not able to conduct joint rulemaking--tell me
if I am wrong--within specified time periods. I have some
concern about that approach as an independent agency.
Let me step back and say that I do think that while the
harmonization and the joint rulemaking that is required under
the statute by the SEC and the CFTC is not an insignificant
task. There are at least a dozen areas where we have to engage
in joint rulemaking from the definition of terms or business
conduct standards, back office standards, dealer regulation,
and so forth. And it will take an enormous amount of effort
from the staffs of both agencies.
But then the statute does provide for this tie-breaker--
which I find, as an independent agency, to be a little bit of a
concern--and creates the opportunity for industry or others who
don't like either the CFTC or the SEC's approach on dual
rulemaking to just go up to the next level and have the not yet
tie broken. So I am a little bit concerned about that.
We might offer as an alternative a provision that was
actually in Gramm-Leach-Bliley that would allow either agency
to petition the Court of Appeals for an expedited process where
there was a breakdown between the two agencies, for example, in
determining how particular rules should be made going forward.
Mr. Gensler. I am going to focus on one other piece because
it is at the core of your question as well, is with regard to
clearing. I think that since President Roosevelt and Congress
laid out these two agencies, and our predecessors, that market
regulators have overseen exchanges, clearing, customer
protection, investor protection and that has worked fairly
well. It is not without--it is not perfect but it has worked
fairly well over these decades. And that as we enter into this
new area of over-the-counter derivatives, clearing and
exchanges, we should borrow from that model, and the SEC and
CFTC, working with Congress, should find a way that we oversee
both clearing and exchanges for this new area.
And if we have joint rulemaking, which is going to be a
challenge--Chairman Schapiro and I have a great relationship
and it is working very well, but there will be other Chairmen
after us, of course, that you have to consider. But it should
be the SEC and CFTC that oversees market functions like
clearing and exchanges.
Mrs. Lummis. And I have one more question, Mr. Chairman.
There was testimony last week from Terrence Duffy of the CME
Group. And he argued that the best approach to harmonizing is
to have the CFTC regulate products that are primarily
commodities and the SEC regulate products that are primarily
securities.
In situations where neither securities nor commodities are
primary, the firm could pick their regulator. His concern--and
I share it--is that over-regulation on the commodity side will
simply drive investors to more favorable regimes, and those
were his words.
Do you share Mr. Duffy's concern and what do you think
about his suggestions regarding harmonizing?
Mr. Gensler. I think that our two agencies need to do a far
better job where we have joint oversight. And certainly Mr.
Duffy's exchange is sometimes seen where we have some jointness
that we could do better.
I think with regard to the underlying theme, the Treasury
has proposed joint rulemaking which will be a challenge, but an
alternative would be where there is primarily an interest rate
swap, or a currency swap, or commodity, or broad-based security
swap, that you would have the CFTC take a lead, and where it
was primarily the individual underlying security or narrow-
based swap, the SEC.
What we have proposed with the Administration right now is
more joint rulemaking than maybe you have quoted the witness
from last week suggesting. So the two alternatives would be
that we do a lot of joint rulemaking, as we have proposed, or
we narrow that joint rulemaking, and then you have a way to
say, well, this agency takes the lead on these and this agency
takes the lead on that.
Mrs. Lummis. Okay. Thanks.
Ms. Schapiro. I would just add, I think we have some
concerns with how you would determine what the primary
component is of a mixed swap. And so, if that is the direction
the Congress takes, we would have a lot of work to do to try to
figure out what that primary component is and whether or not it
changes on a daily or weekly basis and are we flipping
jurisdiction back and forth. I think there are some mechanical
issues to that approach, which I believe is why the
Administration went with the concurrent jurisdiction for the
mixed products.
Mrs. Lummis. Thank you both.
The Chairman. I thank the gentlelady. The gentlelady from
Pennsylvania, Mrs. Dahlkemper.
Mrs. Dahlkemper. Thank you, Mr. Chairman.
Chairman Gensler and Chairman Schapiro, as we look at
regulating systemic risk, how do you define systemic risk, and
how much of this risk can we reasonably regulate out of the
financial system without providing disincentives for risk
management?
Ms. Schapiro. Well, that is a great question. I think it is
a little of ``you know it when you see it'' kind of a
calculation. But certainly the attributes of systemic risk
regulation or systemic risk are obviously the ability of an
institution to bring down other institutions, severely disrupt
the financial markets, severely disrupt the economy, shut down
the credit markets, or disrupt the orderly trading of
securities and commodities.
So I think it is a necessarily elastic and flexible term
when we talk about systemic risk. But we mean activities or
institutions that have the potential to harm the broader
financial services and broader financial markets, and not just
that single institution. So not just that bank, not just that
broker-dealer, but the activities that have the potential to
span across the financial markets and impact more broadly on
the economy.
Mrs. Dahlkemper. Mr. Gensler.
Mr. Gensler. I was just going to add, when Congress amended
the Commodity Exchange Act so that we would have explicit
authority over clearing organizations and the like, this is now
about 8 or 9 years ago, Congress also inserted in our statute
part of our mission that the Commodity Futures Trading
Commission, I believe is--I can't remember the exact words,
that is why I asked my General Counsel--but to protect against
systemic risk. I mean that was one of the features that I am
glad to have the right staff here.
Mrs. Dahlkemper. Good staff is important.
Mr. Gensler. It is really important. In fact I want to
thank the Chairman and the whole Committee for allowing me to
have John Riley, speaking of good staff. But that one of the
missions of the CFTC and the subject of this Act is the
avoidance of systemic risk. Now, I think that we take that to
heart every day as our oversight of clearing organizations. The
futures commission merchants that we oversee generally are also
overseen by others, and there is a focus on that, in that
regard, more broadly.
Mrs. Dahlkemper. I did want to, kind of switching back
actually to Mr. Kagen, and this is to you, Chairman Schapiro.
The recent SEC Inspector General report regarding the Madoff
case did not really paint a very pretty picture of things at
the SEC, and details how inexperienced lawyers with little or
no industry experience were leading investigations into Madoff
and missing red flags, that it could have been exposed as fraud
decades earlier. Obviously many of our constituents have been
angry watching this unfold through the media.
And I just want to know what is being done to correct this
problem with your investigatory and enforcement teams and
bringing in personnel with more industry knowledge. Where are
things at so that we can feel more comfortable going forward
with the SEC?
Ms. Schapiro. Absolutely, I would be happy to answer that.
And I also would point your staff to our website where we have
put up a very detailed explanation of all the initiatives the
agency has undertaken in the last 7 months since I arrived,
that are very much focused on a response to the problems within
the agency that were exposed by the failure to prevent the
Madoff fraud and to detect it early on.
But you highlighted a couple that are really critical:
skills and training. We have made an enormous effort in the
last 6 months to try to recruit new skill sets to the agency,
not lawyers, not accountants, but others with experience in
trading, financial analysis, derivative products, forensic
accounting, to have much more current knowledge about new
products and new trading practices on Wall Street. And we are
having tremendous success now in our ability to recruit those
kind of skill sets to the agency.
We have also embarked on much more aggressive training
programs. I was very surprised when I arrived at the agency to
see the extent to which training was conducted that, in my
view, is not nearly sufficient. So we are putting hundreds of
people now through the Chartered Financial Analyst'
program and the association of Certified Fraud Examiners
program, as well as bringing in people to teach on, again, the
latest products, product development and trading strategies.
We have also reorganized our enforcement department. We
have brought in new leadership across the agency, including the
new enforcement director and new deputy, and the head of our
New York office, and they have taken a very different approach
to enforcement. They have eliminated a layer of management, put
more front-line investigators on the job and moved people into
specialized groups that can develop great expertise in
particular areas of securities law enforcement, and so move
more quickly and more effectively, we hope, to find the
problems and bring cases.
And I could talk about this forever. I won't do that to you
and take all of your time. But again, on the technology front,
we are making changes throughout the organization, and those
are, as I said, all posted on SEC.gov.
Mrs. Dahlkemper. I appreciate that. And I will go on the
Web site and read all of that. Thank you very much. I yield
back my time.
The Chairman. I thank the gentlelady. The gentleman from
North Dakota, Mr. Pomeroy.
Mr. Pomeroy. I just want to begin, Mr. Chairman, by
thanking you for this hearing and commend this panel in
particular. This is more horsepower than I have seen in these
respective vital regulatory positions in quite a while, and I
believe you are going to play critical roles in getting us back
on track. It has just been a pleasure to listen to you this
morning.
The question I have is in terms of trying to get our--I am
wrestling with how these clearinghouses are going to work with
products that so many participants say are not standardized,
they are uniquely tailored and therefore can't be measured
adequately on an exchange.
Mr. Gensler, you have been collecting information on this
since I believe June of 2008, your agency. Are you making
headway in terms of determining the tradeable nature versus the
unique characteristic of each swap, and do you have thoughts in
that regard?
Mr. Gensler. I have anecdotal thoughts, if I might, if I am
allowed to share. But I think that each of the markets, from
interest rates all the way to credit default swaps, have a
different proportion that is able to be brought into
centralized clearing. And interest rate swaps, actually, there
is a group right now, a clearinghouse, that is able to bring
almost the entire interest rate swap market out to 30 year
swaps. They are now working to bring the options on those on.
Whereas in credit default swaps, if I can go to that, 40
percent of that market is on indices. That market is fairly
standardized. The other 60 percent that is on individual credit
names is more choppy, and some portion of that could be brought
in.
And the energy space, again, I have reached out
anecdotally, and people have talked about any ratio from, I
will say broadly, 50 to 75 percent, which is probably
standardized. Whether it is 50 percent or 80 percent that is
standard enough to be brought into a clearinghouse, and whether
these anecdotes will prove out to be correct, the markets
benefit and the public benefits to bring that in. And even this
customized product, somebody wants to hedge a risk in your fine
state, North Dakota wants to hedge a risk in a customized way,
they will benefit by being able to see the pricing on a real-
time basis on something that is fairly similar because \1/2\ or
\2/3\ of the market, maybe more, will be able to be
standardized.
Mr. Pomeroy. That makes sense to me, contrary to what we
heard last week. I believe there is much more that can be done
here.
I am interested in your thoughts, Chairman Schapiro, on a
council of regulators. I worked as an insurance commissioner at
an earlier time in my life, and across the states you would
work on issues together, you would work with the Association of
Insurance Commissioners, but we each had our state capital we
were reporting to and where we derived our authority. You know,
it wasn't easy, it wasn't pretty. But you can, regulators can
work together across jurisdictional lines.
But on the other hand, I don't understand how what just
happened in our economy happened. I can't believe the chinks
between regulators was so large that all of this activity could
go virtually unnoticed by people with their eye shades or their
blinders on. And so council regulators, I like the idea, I
believe it can work but, boy, that certainly is in contrast to
what we have seen. Why will it work going forward?
Ms. Schapiro. Well, I think it works in conjunction with a
systemic risk regulator. I appreciate the Administration's view
that they don't believe a committee can effectively make
decisions in an emergency and effectively put aside their
particular issues of jurisdiction. So we think that it does
make sense to have a systemic risk regulator who can pull the
trigger, so to speak, when it is necessary.
We think the council is really important as a
counterbalance, because residing too much authority in any
single regulator creates risks and hazards of its own,
particularly if that regulator has multiple responsibilities
and may in fact be conflicted in carrying out those different
responsibilities. So what a council can bring to a systemic
risk regulator and to each of the functional regulators is a
broad perspective of the marketplace. Garry may see risks
developing in his part of the market that we are not seeing,
but that may in fact very profoundly affect the securities
markets. So the mechanism of a council allows us to share that
information. The same would be true with the bank regulators.
Mr. Pomeroy. I also expect it might allow one regulatory
authority to learn from another regulatory authority. An
example here is brought to the floor this week by legislation
introduced by Senator Cantwell relative to a standard for
proving market manipulation. CFTC has a knowing standard, SEC
has a knowing or reckless standard. Would that be one example
of where you might learn from one another?
Ms. Schapiro. That is exactly right. And I would say that
even in just the 2 days of joint Commission meetings we held
for the first time ever, I think we walked away knowing so much
more about how each other approached issues like new product
approval, position limits, manipulation, insider trading, and
came away with a lot of ideas about how we could each go back
and do things a little bit differently and a little bit better
by adopting some of what the other had done.
I don't mean to sound overly optimistic, but I think there
is enormous benefit in it.
Mr. Gensler. And if I might just say, on that very
important narrower point about our manipulation standard, I do
look forward to working with this Committee and coming back to
you to ask for some ways to enhance what we have right now in
our statute. It might not be exactly what is over at the SEC,
because we also police and look out for corners and squeezes
and trade practices that are a little bit different in the
commodities markets and the securities markets, but we do think
that there is time now to enhance our manipulation standards so
we can better police these markets.
Mr. Pomeroy. Thank you. Thank you, Mr. Chairman.
The Chairman. I thank the gentleman. The gentleman from New
York, Mr. Murphy.
Mr. Murphy. Thank you, Mr. Chairman.
In that same vein in terms of harmonization, Chairman
Schapiro, I was very excited to see in your remarks, your
comments about some kind of segregation of assets or protection
in insolvency, because it was my sense that this was a huge
part of what snowballed this financial crisis as all of our
financial players, investors, and counterparties all ran away.
Chairman Gensler, do you also agree that we need to really
address this issue in the way that Chairman Schapiro does?
Mr. Gensler. There are many things that I would like to
address here today around over-the-counter derivatives and the
regulation of over-the-counter derivatives. I think our
financial regulatory system failed, so I would look forward to
working with however Congress addresses this issue of the
broader regulatory oversight council, systemic regulator, and
so forth. My main mission and goal here is to work with you and
other committees to get the over-the-counter derivatives
marketplace overseen and regulated under whatever structure,
super-structure is addressed.
Mr. Murphy. Sure. Maybe I wasn't clear or maybe you were
just avoiding wanting to get into that. But the question--and I
think it is very, very important for all the bilateral and
potentially customized CFTC transactions out there--is: Is this
issue of segregation of accounts or some protection of customer
accounts--okay, you were talking to staff. I wasn't sure you
knew.
So Chairman Schapiro commented that she thought that was
something important. It is something that I don't think we are
doing enough of.
Mr. Gensler. I apologize. In terms of that I do believe
that we need to do more on this regard, that customer accounts
need, if they post margin, need to be properly segregated. It
would also require some modest but important modifications to
bankruptcy law as well. And I believe that we have actually
shared with this Committee with the Chairman and Ranking
Member, but we can make it available broadly to everyone,
language to achieve that goal.
Mr. Murphy. I just want to reiterate, I think it is
incredibly important, from what I hear from all the customers,
that that was really part of the snowballing. So you testified
about it seemed to be a little bit different understanding of
the margin requirements for customers than what we are hearing
from the Treasury. And I tend to agree that we want to come up
with something where the customers can work out with their
derivatives dealers what their issues, with respect to credit
need, to be.
What is your sense about--in terms of how we are going to
work with the Treasury and some of the other agencies on that,
because it feels like they are pushing a little bit more for
harder margin requirements for customers, and you are hearing
from us that we think there needs to be a little more
flexibility for end-users.
Mr. Gensler. Well, the natural process of Congressional
oversight is a good and healthy process. I have evolved on this
as well over the last few weeks. I think that we can achieve
both goals. I think we can achieve the goal of bringing all the
standard products in the clearing, but at the same time allow
end-users to have these individual credit arrangements with the
clearing member. I think it would be a loss if we just exempted
all of these transactions from the requirement of clearing or
exempted all of the end-user transactions from the benefits of
transparent exchanges or trading platforms.
Mr. Murphy. Okay. The last thing I will try to cover, I
hear a lot, in the draft legislation, us talking about whatever
the clearinghouses will take is the definition of standard. I
am just curious practically how would that work, because if I
am the customer I don't want to have to go shop around every
clearinghouse and get a sign-off that they refused my
transaction before I can enter into it bilaterally.
Have we thought through the mechanism for that, because it
seems like that is a reasonable standard, but one that seems
hard to implement.
Mr. Gensler. Well, I think that it should be very clear and
transparent what transactions a clearinghouse accepts. It
should only be a perspective. If you have entered into a trade
and nobody is accepting it on Tuesday, and then the following
Tuesday people are, to try to retrospectively grab that
transaction would be one approach that would be healthy.
Mr. Murphy. That would still mean I have to go talk to all
the clearinghouses on Tuesday to say that they turned me down.
Mr. Gensler. Well, we could do this through rulemaking, but
that it should be very transparent and obvious which ones they
accept. And the dealers would be required to know that, too.
Ms. Schapiro. I think the dealers are the key here. They
have to take the responsibility, in my mind, of knowing what
products have been accepted for clearing and in fact are being
cleared, so that the end-user isn't ultimately responsible for
trying to figure that information out, and, potentially,
entering into a customized transaction when they could have
entered into a standardized transaction. I think the burden
needs to be on the dealers to do that.
I think the burden also needs to be, frankly, on the SEC
and the CFTC to ensure that it is widely clear and transparent
what is accepted for clearing and what isn't, and perhaps even
deemed so by either of the agencies.
Mr. Murphy. Okay. I appreciate that. Thank you.
The Chairman. I thank the gentleman. The gentleman from
Louisiana, Dr. Cassidy.
Mr. Cassidy. I am sorry, I had to leave, so it may be that
Mr. Murphy and even Mr. Peterson's earlier questions addressed
this, so I apologize at the outset if it is redundant. But as I
think about this--and you mentioned the benefits of
transparency--as I think of the smaller end-users, it seems as
if those folks are most vulnerable to this process. The smaller
end-user is going to need a clearing party to, if you will,
loan them the money to ``monitorize,'' if you will, their
balance assets or their capital assets, their balance due to
the capital assets. And I have to think that they are going to
pay a higher cost for that than a major player, if you will.
It almost seems like we are erecting barriers for smaller
end-users to participate in the market, or at least we are
going to end up penalizing them financially just by the nature
of this.
Mr. Gensler. I actually think that an opaque system as we
have now is the greatest barrier to the small end-user. The
large sophisticated hedge fund, they get pretty good pricing
out of the dealers right now. But the small commercial
enterprise--it could be a parish in your state that has to
hedge a risk, interest rate risk on a municipal bond deal--they
generally, they don't know. They might have to go out of the
parish, might go out and spend $50,000 or $100,000 for a
financial consultant so that they can discern what that is that
those folks up in New York do.
I think the greatest benefit is for the small user if we
can bring the bulk of the market into transparent exchanges.
Mr. Cassidy. Can I just take off on that? One, thank you
for knowing they are parishes and not counties.
Mr. Gensler. You are welcome.
Mr. Cassidy. That said, almost though what you just
described could be done by transparency and not by requiring
them to have, if you will, a margin. So we are mixing the two.
Mr. Gensler. But the two, you are right, I think the two
come together, because that small end-user would also benefit,
because today they already have the cost embedded in these risk
management contracts. These derivatives are just a way to
insure a risk, if I might, if Congressman Pomeroy will allow me
to use the word ``insure,'' if you insure a risk in these
markets. But right now they are also an extension of credit.
That parish or small company in Louisiana is also receiving an
extension of credit; they are not sending in checks, but even
the accountants make them put it on their balance sheet.
Mr. Cassidy. So this will just make overt which is
currently embedded with the----
Mr. Gensler. That is right, and more transparent as well.
Right now on natural gas, the largest traders tell me it is
probably $0.05 a million cubic foot. A small utility might be
more than that. The credit extension is right in that contract.
Mr. Cassidy. So just because I am learning from this, if I
can continue to pick your brain, if you will, I have a letter
from a major natural gas producer that says that they will, if
you will--their collateral is their untapped reserves. Clearly
this is something that is customized. So walk me through how
that would work for them in this process.
Mr. Gensler. How it would work if it was a--they would
enter into a derivative risk transfer contract with some
financial, usually financial dealer. It might be a big
multinational oil company as well. That dealer, if it was a
standard contract, would have to bring it to a central clearing
party. But that dealer would be allowed, if Congress went
forward with its recommendation, to enter into a credit
arrangement with that natural gas company where the natural gas
company might be posting their gas reserves in the ground as
security against that transaction, which many of them do. The
largest natural gas companies do enter into these secured
arrangements already. Smaller ones tend to have unsecured
lines.
Mr. Cassidy. But still, inherently in that, there is going
to be an increased cost for them, correct. Because if they are
doing an over-the-counter now for this company, it is not
necessarily embedded within their cost of doing business;
rather, now what was formerly not there is explicitly there.
Mr. Gensler. Well, actually, it is there if they are
currently using their physical assets in the ground and they
are posting that, then that would not change, that would be
similar under this. If currently they are not posting any
margin or taking it out, it is already priced into the
contract. It might be opaque, but it is priced into the
contract.
Mr. Cassidy. Okay. Thank you very much. I yield back.
The Chairman. If I could editorialize a little bit. It is
my impression that some of the big financial players have sent
a bunch of these end-users around to talk to you about this.
But from what I can tell out of this, somebody that doesn't
understand it as much as Mr. Gensler does, that this is
actually going to cost those big guys money and actually save
the little guys money. I really think that is what is going on
here.
Mr. Cassidy. If I can respond. Actually, I have not talked
to a single one. It is just as I read this, I keep on thinking
of Frederick Hayek who said that bureaucracies set up to
regulate corporations end up protecting corporations. And it
seems what we are doing is institutionalizing the fundamental
role of these clearing parties as central to our entire system.
The Chairman. But the thing is when you bring this out into
the open and when you standardize this or clear it, you
actually narrow the spreads. And that is why the big guys are
fighting this, bottom line, because it is going to cost them
money and it is going to help people that use it. I mean, that
is where this is. I mean, that has been at the heart of this
whole thing.
When we went to Europe, this old saw that everybody is
going to go to Europe if we get too tough, well, what we heard
over there was the reason they didn't regulate is they were
told that if they got too tough, everybody is going to go to
the U.S., and it was the same people that were telling both
sides. So I mean this has been going on, and it is part of why
we got into this trouble in the first place.
So I am just saying I am with you, I am where you are, and
we are going to get an outcome that is going to benefit these
little guys. So just bear with us and we are going to sort
through this, and I think we will be able to come to an
agreement in the end and see the big picture.
So anyway, I apologize for the editorializing. The
gentleman from Idaho, Mr. Minnick.
Mr. Minnick. Thank you, Mr. Chairman. I continue to find it
highly questionable, and personally disturbing, that both we
and the Administration are putting you in a position where,
with respect to indistinguishably identical product we are
asking--we are giving you joint authority and responsibility to
establish regulatory oversight, not just of the product, but
the dealers, the exchanges, and the clearing houses. And I am
not particularly comforted by the thought that where a product
originates originally should be a guide as to who should have
primacy with respect to establishing the derivative regulation.
I am also not enamored of the thought that it would be for
two independent agencies, if you can't agree, and it is
absolutely foreseeable that you will not, and even if you can
agree, your successors won't, that it should go, two
independent agencies should send their disputes to the
Treasury, part of the Administration, for resolution. I think
that will increase, in the future, with the areas where you
choose not to agree.
And I also question Chairman Schapiro's suggestion that it
ought to be a judicial body, which is apparently going to lack
much expertise and not be current as the resolving authority.
I am wondering if there might be a better solution in--
could we ask you to, among yourselves, come up with a
Memorandum of Understanding defining who has primacy, at least
for some period of time, based upon some other criterion of
your selection? I am thinking capital leverage, margin,
collateral, those kinds of things that are more generic and
unrelated to the character of the underlying security. Could
you work out between yourself as to which agency would have
primacy in establishing underlying resolution of these issues
so that we could have, you and we, for the future could have a
road map that would give some indication as to which agency was
going to deal with which issues?
Ms. Schapiro. Let me take a stab at that first. Let me say
that the reason we suggested the potential process through the
Court of Appeals is that one existed under prior legislation,
under Graham-Leach-Bliley, but only because I think that is a
better approach than having these elevated to the Treasury
Department.
We would certainly be willing to try to work through, and
we have MOUs ready under other circumstances, for example, with
respect to the existing central counterparties that have been
approved and so forth. But we would be more than willing to try
to work through an MOU that might set out criteria to guide
some of our decision-making as we go forward.
I think a joint rulemaking authority, as I have said, will
be enormously time-consuming. It will be very difficult; there
is no question about that. But where to draw lines, once the
decision was made not to merge these two agencies, even though
they do regulate in some cases nearly indistinguishable
products as you said, there are a thousand places to draw those
lines. And the Administration chose the ones it did, and we
think we can work through those very effectively with the CFTC.
But I don't want to underestimate for anyone the difficulty of
our getting from here to the end in that process.
Mr. Gensler. I would just add to that, I think that your
suggestion is a good suggestion. Congress is the first place
actually to draw the lines effectively, but by the way, where
there is still overlap, the suggestion of having a more
explicit Memorandum of Understanding is a good one. There will
probably still be some; we will narrow the gaps.
Mr. Minnick. Well, if we don't do it for you, I think we
are not, at least that is not our current disposition, I would
feel much more comfortable, while we do have two people of your
talent and your mutual goodwill, if you could work that out
among yourselves in a way that would provide a template for
future regulators. I think that would be extremely helpful.
Mr. Gensler. I think it is good suggestion.
Mr. Minnick. I yield back.
The Chairman. I thank the gentleman.
And Chairman Frank and I have made a commitment to try to
narrow this gap as much as we can legislatively as we go
through this process. I think we should settle this here,
frankly, but there is some question about whether we can do
that. There are some technicalities. But, I agree with the
gentleman, and we are going to do everything we can to try to
sort this out and not put them into conflict because that is
not serving anybody well.
The gentleman from Mississippi, Mr. Childers.
Mr. Childers. Thank you, Mr. Chairman.
My questions have pretty much been answered, but I would
like to say to both of the Chairmen that I certainly appreciate
on behalf of all of our colleagues here this morning both of
you being here. To use Congressman Pomeroy's words, this is a
lot of horsepower here this morning. Thank you very much for
being here. Thank you.
Mr. Gensler. I thank you for that compliment and
Congressman Pomeroy's compliment. I have never been compared to
a horse, but it is good. Thank you.
The Chairman. I thank the gentleman.
I have a couple more questions here. Both of you question
the Treasury's proposal to exclude foreign exchange swaps and
forwards from this entire scope of regulation. Treasury argues
that this exclusion is necessary to preserve the dollar's
position as the world's leading currency. Can you explain
Treasury's argument of why you believe this class of
derivatives should be regulated?
Mr. Gensler. I think as we move forward with Congress, we
want to make sure that we cover the entire marketplace, and the
Treasury proposal that was sent up, which we collaborated on,
is very strong and covers interest rate and currency
commodities, equity, credit default swaps.
What we would want to assure is that any exceptions from
that are clearly targeted and can't be used somehow to avoid
that oversight of interest rate swaps and currency swaps and
the like. And this has been a challenge Congress has wrestled
with, really, for 35 years since our agency was set up; how
does one sort of exclude forwards but cover futures? How do you
exclude some aspect of currencies for the reasons that you just
mentioned?
Our concern is that we would not want to evade--be able to
have market participants evade the oversight of these currency
swaps and interest rate swaps, and also that retail foreign
exchange transactions are fully covered.
Ms. Schapiro. This is not particularly an SEC issue, but
recalling my days at the CFTC 15 years ago, while there has
been enormous change in the regulatory regime since then, the
concern about retail forex transactions existed then. It exists
today, and that was the reason we felt very strongly that
Chairman Gensler has taken the right approach in trying to
narrow this exception.
The Chairman. At last week's hearing, we heard testimony
concerning the need for greater independence of clearinghouses
from a single or a group of swap participants. In fact, the
Justice Department is looking into whether dealers that have an
equity stake in the market, which collects price information on
credit default swaps, have an unfair advantage over other
market participants relating to CDS price information. If
Treasury's proposal goes forward, do either of you have similar
concerns regarding clearinghouse independence?
Mr. Gensler. I think it is a very important issue, the
governance of clearinghouses, as current governance of
clearinghouses, but that they have open governance and they
hear from a wide range of membership, that they are not
susceptible to control by one community, particularly the
dealer community. I think we should have clear authority to be
able to write rules and oversee those government features.
Ms. Schapiro. I would agree with that. I think it is
critical that the governance structure includes a broad range
of market participants and users, not just dealers, in order to
ensure that the clearinghouses operate in the broadest public
interest. I think it is also critical, as was said, that there
be active Federal oversight of the clearinghouses and the
government mechanism so that they do provide free and open
access.
The Chairman. Thank you.
The gentleman from Georgia, Mr. Marshall.
Mr. Marshall. Thank you, Mr. Chairman.
In my earlier questioning, Mr. Gensler, I asked if you
would be willing to maybe get together with the clearing
community and come up with some concrete models of cost savings
or costs, one of the two, with regard to clearing end-users,
their concerns. You have heard their testimony already. So
maybe you could just use them as examples and then run through
a number of different scenarios to give us actual concrete
numbers. You have described hidden costs of financing capacity
that doesn't really permit the end-user really to understand
the costs that are associated with current hedging, and the
advantages associated with certainty and price discovery and a
lot of other things. If you could crank all that in, that would
be enormously helpful to us, and so I guess my question, will
you do that is my question right now, and could you tell us how
quickly you can do it?
Mr. Gensler. I am certainly committed to meeting with the
clearing members and users. I don't know how susceptible it is
to coming down to an analytic, or a specific pennies per
million cubic foot or basis points for an interest rate swap.
But I will certainly commit to meet with any community that you
think would be appropriate for us to meet with.
Mr. Marshall. Well, I can't give you guidance on who to
meet with. It is just this has come up in almost everybody's
questioning. It is the thing where we are really getting a lot
of pushback, and so it would really help us if you can narrow
it a little bit because we get these dramatic statements that
we won't be able to hedge.
The Chairman. Would the gentleman yield?
Mr. Marshall. Yes.
The Chairman. You know, I mean, we have contracts that were
customized that ended up going to be standardized, and the
margins narrowed when that happened. So the best way to do that
would be to go back and just take some of these examples,
because you can't really tell what the market is going to do.
But I can tell you that a lot of this stuff that has been
ginned up around here has been by those guys that are on the
other side of this. When this goes on a clearinghouse or
exchange or is made transparent, their margins are going to
narrow.
Mr. Marshall. That is clear.
The Chairman. So, Mr. Gensler, am I right?
Mr. Gensler. I couldn't agree more with the Chairman. We
are talking about a paradigm shift here. We are saying that,
yes, we want to lower the risk to the American public. See, we
have mutualized this risk right now. The American public bears
a lot of risk in that crisis that we have lived through. It
feels stable right now, but we shouldn't forget, this was a
very real crisis that we have lived through. And so the
American public bears the risk. We are trying to take that and
push that back into the dealer community through more capital,
and yes, the end-users would be posting some margin on trades.
Now, what we have recommended here today is that those end-
users be able to enter into specific credit arrangements that
would be less opaque because that is already in these
contracts. But I agree with the Chairman that there will be
some in the financial community who would prefer not to have
this paradigm shift.
Mr. Marshall. May I just, there is an obvious business
opportunity here for folks to provide financing to facilitate
this clearing process. It doesn't necessarily have to be the
clearing member. It could be some other entity that actually is
formed specifically for this objective.
But again, I say, these are not abstractions. I mean,
fairly obvious things that you are talking about that are
advantages to the process that is being proposed, and I think
the Chairman is absolutely right. A lot of the pushback is
because in an opaque world, a call-around market, et cetera,
you make more fees.
And so if we can cut back on the transaction fees,
obviously it is going to benefit the general population that is
trying to hedge. But if you could just give us some concrete
examples, it would be great. And I think you can do that. It
may be you have to go plus or minus, but it would really help
us a lot in better understanding the numbers here and being
able to respond to those who are saying this is really going to
put me out of business, the business of hedging anyway, to
respond, no, it is not; here is probably what is going to
happen. Tell us why these numbers are wrong.
Mr. Gensler. We will do our best to do that, and I agree
with you that this is at the core of some of this debate right
now. So we would like to best respond to your question.
Mr. Marshall. Thank you, sir.
Thank you, Mr. Chairman.
The Chairman. I thank the gentleman.
Anybody else got anything good?
With that, we thank you very much, Chairman Gensler and
Chairman Schapiro, for being with us today, for your patience
in answering our questions, and we will continue to work on
this jointly together so we can come up with the right solution
for the American people at the end of the day, and hopefully
sooner rather than later.
Thank you very much. The Committee stands adjourned.
[Whereupon, at 1:10 p.m., the Committee was adjourned.]
[Material submitted for inclusion in the record follows:]
Submitted Statement by Independent Petroleum Association of America
Independent producers drill about 90 percent of American natural
gas and oil wells, accounting for more than 80 percent of American
natural gas and more than 65 percent of American oil. The Independent
Petroleum Association of America (``IPAA'') represents these thousands
of independent producers. Many of these producers hedge their
production to lessen the volatility in prices to better plan their
budgets for finding and producing oil and natural gas, and in turn keep
employment levels stable or growing. As end-users in the derivatives
market, independent producers strongly support increased transparency
and encourage adequate funding and authority for the Commodity Futures
Trading Commission to oversee commodity markets and prevent market
manipulation.
However, increased transparency and stronger enforcement do not
require that all trading be done through regulated exchanges. When
producers hedge, they tend to rely on the over-the-counter (``OTC'')
market, which enables hedging transactions to be customized, primarily
to rely on the producers' natural gas and oil reserves as collateral or
the producer's credit standing with its bank. Banks with loans to
producers often require producers to hedge their production. The banks
often perform this service for the producer, using the producers'
natural gas and oil reserves as collateral.
The Treasury Department's financial reform proposal recognizes the
continued importance of the OTC market. Secretary Geithner has
testified that ``[d]estroying OTC derivates would leave U.S. companies
with a terrible choice between either not protecting themselves at all
against some of their financial risks or partially protecting
themselves against financial risk with a standardized derivative and
thereby damaging their financial statement.'' IPAA is in complete
agreement with the Secretary's assessment and with the intent to
distinguish between end-users and derivative dealers or major market
participants.
Without access to the OTC market, producers would have two choices.
Producers could attempt to monetize their assets and hedge through an
exchange, which would consume cash previously reinvested in exploration
and production. Or producers simply would be unable to afford the
exchange hedging requirements and would not hedge. This choice would
subject producers to pricing uncertainty and the ensuing uncertainty to
producers' budgets for exploration, production, and employee salaries.
How and Why Producers Hedge
Many energy producers, who own the underlying physical commodities,
use hedging as a primary risk-management tool to provide cash-flow
certainty. These energy producers were not responsible for the recent
swings in futures prices. In 2000, about 17 percent of independent
producers used swaps to manage financial risk. That percentage
increased dramatically to 41.5 percent in 2007, based on a recent IPAA
survey, as detailed in its Profile of Independent Producers 2009.
Many independent producers hedge a significant portion of
forecasted future natural gas and oil production volumes to reduce
revenue risk related to ever-changing commodity prices. Wild swings in
natural gas and oil prices impede the industry's ability to stabilize
revenues and prudently manage cash flow, which is used to fund
development activities that produce vital energy resources and maximize
value for stakeholders. For many independent producers, hedging is the
primary method of ensuring that adequate cash flow is available to meet
their financial obligations. They also hedge production to provide
security to lenders that base producers' credit on the value of their
natural gas and oil reserves, reserves that are pledged as collateral
on bank loans. Conscientious hedging programs provide significant
protection for creditors. This protection, in turn, helps provide
access to capital for the long-term survival of producers.
Impact of the Proposed Reforms on Producers
The Administration's proposal appears to try to address the
concerns described above. However, the push for standardized contracts
to trade exclusively through regulated exchanges creates enormous
uncertainty as to what will constitute a standardized contract. Equally
important is the definition of major swap participant. The
Administration's proposed definition of ``major swap participant''
includes anyone who (1) is not a swap dealer, (2) maintains a
``substantial'' net position in outstanding derivative contracts, and
(3) is not using the contracts to maintain an effective hedge under
Generally Accepted Accounting Principles. Uncertainties associated with
the second and third components of the definition are likely to
undermine the deference the Administration appeared to give to end-
users. A more clear-cut exemption approach is needed.
Failure to address this uncertainty could require producers to
trade on a regulated exchange where the contrast is stark with current
hedging methods. Currently, many independent producers hedge
exclusively with the high-credit quality banks that are participants in
their lending groups and hold the mortgages on their natural gas and
oil properties. This arrangement eliminates the need for posting
collateral between the producers and their banks. Producers enter into
hedges and their banks hold those positions on their books through
settlement, at which time either producers make a payment to the banks,
or banks make a payment to producers, and the position is terminated.
Under a broad interpretation of ``standardized derivative contract'' or
``major swap participant,'' producers could be prohibited from hedging
with their banks and forced to trade directly with the exchanges, which
would require producers to post cash collateral twice daily, based on
the mark-to-market value of their hedges.
The requirement to post collateral would effectively preclude the
ability of many independent producers to hedge production and would
imperil their business in many ways, leading to the destruction of
relationships with stakeholders and harming the American consumers who
depend on natural gas and oil products for food, shelter,
transportation, medicine and other essentials of modern life. The
inability to hedge would reduce the certainty in producers' ability to
forecast cash flow to cover obligations to debt and equity holders,
including debt service and dividend payments, respectively.
Furthermore, without the assurance of receiving a certain price for
future production, creditors would lower their valuation of natural gas
and oil reserves and reduce the amount of capital available to develop
production and maintain, as well as increase, production volumes to
meet consumer demand. Without development activities, natural gas and
oil production volumes would decline, in some cases very rapidly--
leading to a supply shortage in the market. The resulting spike in
energy costs would have a decidedly negative impact on the American
economy.
The Treasury Department's proposal is encouraging, in that the
scope appears to address the importance of maintaining end-users'
access to the OTC market. The details will determine whether this
intent is actually accomplished. We thank the Administration and the
Members of the Agriculture Committee for their thoughtful consideration
of how to implement reform without serious unintended consequences.
Natural gas and oil are both vital components of our nation's energy
supply. In fact, as a resource that is clean burning, readily available
and abundant in America, it would make sense for natural gas to be
adopted as a major component of the Administration's energy policy.
America's independent producers reinvest a majority of their free cash
flow to supply the country with reliable energy that is vital to our
nation's energy security. Hedging through the OTC market helps
producers reduce risk and plan for long-term viability in a highly
capital-intensive business that depends on predictable cash flow and
access to capital.
Suggested Treatment of End-Users
At the September 17, 2009 hearing, Committee Members engaged panel
members to provide suggested language to clarify the exemption from
mandatory clearing in the Treasury Proposal. In response, the American
Public Gas Association (``APGA'') submitted a letter to the Committee
on September 30, 2009. APGA suggested inclusion of an additional
exception, in which mandatory clearing would not apply if ``one of the
counterparties to the swap is a producer, processor, merchandiser,
distributor or a manufacturer of, or user of, a commodity and enters
the swap to educe or manage risks in connection with the conduct or
management of its commercial enterprise.''
IPAA believes that this type of approach could address some of the
end-users' concerns with efforts to encourage mandatory clearing, such
as those contained in Treasury's proposal. IPAA will be giving
consideration to this proposal within its membership, and encourages
the Committee to take APGA's proposal under serious review.