[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


                  U.S. GOVERNMENT PRINTING OFFICE
53-020                    WASHINGTON : 2009
-----------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092104 Mail: Stop IDCC, Washington, DC 20402ï¿½090001


                        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\
---------------------------------------------------------------------------
    \1\ Food, Conservation, and Energy Act of 2008, P.L. 110-246, 122 
Stat. 2189, Title XIII.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.)
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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.)
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \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\
---------------------------------------------------------------------------
    \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.
---------------------------------------------------------------------------
    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.
---------------------------------------------------------------------------
    \1\&Commissioner Paredes does not endorse this testimony.
---------------------------------------------------------------------------
    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.


