[Senate Hearing 111-246]
[From the U.S. Government Publishing Office]
S. Hrg. 111-246
REGULATORY REFORM AND
THE DERIVATIVES MARKET
=======================================================================
HEARING
before the
COMMITTEE ON AGRICULTURE,
NUTRITION, AND FORESTRY
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
__________
JUNE 4, 2009
__________
Printed for the use of the
Committee on Agriculture, Nutrition, and Forestry
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Available via the World Wide Web: http://www.agriculture.senate.gov
___________
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COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY
TOM HARKIN, Iowa, Chairman
PATRICK J. LEAHY, Vermont SAXBY CHAMBLISS, Georgia
KENT CONRAD, North Dakota RICHARD G. LUGAR, Indiana
MAX BAUCUS, Montana THAD COCHRAN, Mississippi
BLANCHE L. LINCOLN, Arkansas MITCH McCONNELL, Kentucky
DEBBIE A. STABENOW, Michigan PAT ROBERTS, Kansas
E. BENJAMIN NELSON, Nebraska MIKE JOHANNS, Nebraska
SHERROD BROWN, Ohio CHARLES E. GRASSLEY, Iowa
ROBERT P. CASEY, Jr., Pennsylvania JOHN THUNE, South Dakota
AMY KLOBUCHAR, Minnesota
KIRSTEN GILLIBRAND, New York
MICHAEL BENNET, Colorado
Mark Halverson, Majority Staff Director
Jessica L. Williams, Chief Clerk
Martha Scott Poindexter, Minority Staff Director
Vernie Hubert, Minority Chief Counsel
(ii)
C O N T E N T S
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Page
Hearing(s):
Regulatory Reform and the Derivatives Market..................... 1
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Thursday, June 4, 2009
STATEMENTS PRESENTED BY SENATORS
Harkin, Hon. Tom, a U.S. Senator from the State of Iowa,
Chairman, Committee on Agriculture, Nutrition, and Forestry.... 1
Chambliss, Hon. Saxby, a U.S. Senator from the State of Georgia.. 3
Panel I
Gensler, Gary, Chairman, Commodity Futures Trading Commission,
Washington, DC................................................. 7
Panel II
Bookstaber, Richard, New York, New York.......................... 34
Dines, David, President, Cargill Risk Management, Hopkins,
Minnesota...................................................... 36
Driscoll, Daniel A., Executive Vice President and Chief Operating
Officer, National Futures Association, Chicago, Illinois....... 41
Lenczowski, Mark, Managing Director, JPMorgan Chase & Co.,
Washington, DC................................................. 31
Masters, Michael W., Managing Member/Portfolio Manager, Masters
Capital Management, LLC, St. Croix, U.S. Virgin Islands........ 38
Stout, Lynn A., Paul Hastings Professor of Corporate and
Securities Law, University of California-Los Angeles, Los
Angeles, California............................................ 29
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APPENDIX
Prepared Statements:
Cochran, Hon. Thad........................................... 62
Bookstaber, Richard.......................................... 64
Dines, David................................................. 71
Driscoll, Daniel A........................................... 77
Gensler, Gary................................................ 80
Lenczowski, Mark............................................. 95
Masters, Michael W........................................... 101
Stout, Lynn A................................................ 131
Document(s) Submitted for the Record:
Chambliss, Hon. Saxby:
``Exchanges Warn On OTC Clearing'', article, Financial Times,
June 3, 2009............................................... 138
Dines, David:
Chesapeake Energy, prepared statement........................ 139
``The Role of Speculation in the Recent Commodity Price Boom
(and Bust)''............................................... 142
Association for Financial Professionals, written statement... 177
Commodity Markets Oversight Coalition, written statement..... 179
National Association of Manufacturers, written statement..... 183
Question and Answer:
Chambliss, Hon. Saxby:
Written questions for Gary Gensler........................... 186
Roberts, Hon. Pat:
Written questions for Gary Gensler........................... 187
Written questions for David Dines............................ 187
Gensler, Gary:
Written response to questions from Hon. Saxby Chambliss...... 188
Written response to questions from Hon. Pat Roberts.......... 189
Dines, David:
Written response to questions from Hon. Pat Roberts.......... 191
REGULATORY REFORM AND
THE DERIVATIVES MARKET
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Thursday, June 4, 2009
U.S. Senate,
Committee on Agriculture, Nutrition, and Forestry,
Washington, DC
The Committee met, pursuant to notice, at 10:05 a.m., in
room SD-106, Dirksen Senate Office Building, Hon. Tom Harkin,
Chairman of the Committee, presiding.
Present: Senators Harkin, Nelson, Casey, Klobuchar,
Gillibrand, Bennet, Chambliss, Thune, and Johanns.
STATEMENT OF HON. TOM HARKIN, A U.S. SENATOR FROM THE STATE OF
IOWA, CHAIRMAN, COMMITTEE ON AGRICULTURE, NUTRITION, AND
FORESTRY
Chairman Harkin. The Senate Committee on Agriculture,
Nutrition, and Forestry will come to order regarding a hearing
on regulatory reform in the derivatives markets.
Although we see hope in the strong economic recovery steps
we have taken, we are still struggling through a grave economic
downturn. The lack of sufficient regulatory authority and
oversight regarding the financial markets is widely
acknowledged as a key factor in the global economic crisis. It
is not credible to assert that the markets and present
regulatory system have worked. When the Federal Government has
had to inject some $4 trillion--$4 trillion--into the system to
stave off a total collapse of the economy.
Recent problems indicate the need for fundamental reform.
Fundamental reform. The 2008 run-up in oil prices left our
economy bruised, our Nation keenly aware of not only its
dependence on foreign oil but the struggle with speculation in
the markets. Volatile agricultural commodity prices, high input
costs, and problems with the wheat and cotton markets have
exposed vulnerabilities in our agriculture futures markets. But
possibly the most problematic, our national economy has been
held hostage by poorly regulated financial markets and the
irresponsible behavior of some market participants,
particularly when it comes to financial derivative products
like credit default swaps and other over-the-counter
derivatives.
I think it has become obvious that we must restore proper
regulatory oversight if we are going to get this economy built
on a solid foundation. Simply put, the derivatives markets must
work properly and in the open. Agriculture futures markets are
fundamental to the functioning of every aspect of our
agriculture economy.
Financial services now account for about as much as 20
percent of our economy, and if those markets are not healthy or
properly regulated, I think the evidence is clear our economy
suffers.
Now, the Commodity Futures Trading Commission plays a vital
role in providing oversight in keeping these players honest. If
we do not invest in the regulators and the enforces to expand
that oversight to the over-the-counter markets, I think we are
going to continue to pay a heavy price.
It is imperative that we pass strong financial regulatory
reform in this body and not just piecemeal, patchwork reform,
but comprehensive and fundamental reform that brings full
transportation and accountability back to the markets. Earlier
this year, I introduced the Derivatives Trading Integrity Act;
I think one I also introduced last year. The bill would require
all futures contracts to trade on regulated exchanges. Why do I
want that? Because exchange-traded contracts are subject to a
level of transparency and oversight that is jut not possible in
over-the-counter markets.
For many years, derivative contracts have traded very
efficiently and openly on regulated exchanges. But we have seen
the damage done by moves to circumvent properly regulated
derivatives trading.
I would also say it is not sufficient to assert, as many
swap dealers do, that the market for credit default swaps
function properly and has experienced no major problems during
the current crisis. As conceived by derivatives traders in the
mid-1990's at JPMorgan Chase--well, it was JP Morgan then--the
CDS was designed to assist in the smooth functioning of the
credit market and presumably to make it easier to raise capital
by issuing corporate bonds to fund investment in the production
of goods and services, which is what we want the financial
sector to do. What is the end means of our financial services
sector? That is for the production of goods and services to add
to our GDP. Otherwise, you are just in a gambling game.
So the fact is it was going to make it easier to raise
capital by issuing corporate bonds to fund investment in the
production of goods and services. But the facts belie that
claim. While the total face value of CDS contracts more than
tripled--tripled--between 2005 and 2008, the share of gross
private domestic investment in U.S. GDP stagnated and then fell
by more than 15 percent. That is at the end of 2008.
I have a chart. I wanted to see what it looked like, so I
have a chart. So you see here the share of investment in U.S.
GDP, and then here you have got on the red line the notional
value of the CDSs.
Now, for a while, they seemed to track pretty well, but
right here in about 2005, investment goes down and the value of
the CDSs go up. So I think you can safely say they were not
adding anything to the value of the goods and services of our
country at some point in time.
Nor do I agree with those who assert that more rigorous
regulation of these markets will discourage innovation or
hamper our economy. Well, if financial innovation improves the
ability of companies to hedge their risks or improves the
functioning of the market, then the incentive for creativity
will be there. But if the prime motivation for innovation is to
speculate, to avoid taxes, or assume reckless risks, the public
has an interest in regulating that sort of ``creativity.''
I have often asked, Where was the market demand for credit
default swaps? Where was the market demand for collateralized
debt obligations? Where was the market demand for
collateralized mortgage obligations? It was just sort of
thought up.
You know, I have to digress here a second. I was just
looking at the last issue of Newsweek magazine that has got
Oprah on the front. I guess that sells the magazine. But it is
called ``The Revenge of the Nerd,'' and it is about the quants.
How many people in this country know what a quant is and what
they did in terms of speculation, through these mathematical
geniuses that came from various and sundry place, how they
devised these financial instruments to slice and dice and make
money on things that really were not adding to the goods and
services value of this country. It is a great article. I would
recommend your reading it.
As I said, if that creativity is there just to add for
speculation purposes and for sort of gambling and for high
rollers and people making a lot of money in a short span of
time, but not really adding to the sound investment in our
country, then, quite frankly, I think the public has a big
interest in regulating that kind of creativity.
So we must protect consumers and lower systemic risk and
enhance the price discovery function of the markets, reduce
excessive speculation, give the regulators the authority and
information they need to keep the markets free of fraud and
manipulation. In doing so, we will maximize the economic value
of the derivatives markets by making sure they are structured
to manage risk rather than to magnify it and guarantee that bad
actors are held accountable.
So we have a lot of work to do on legislative reform. It is
imperative that we all work together to come up with a solution
that will bring transparency, accountability, and stability to
our derivatives markets. So I welcome this hearing and this
testimony. I thank each of the witnesses for coming here today,
and I look forward to hearing their thoughts. I cannot think of
anything that--well, this Committee has to do--we have to
reauthorize the child nutrition bill later this year. We are
going to work on that. But we have got to do this. This has got
to be done this year.
I have talked with my colleague, my counterpart in the
House, Chairman Peterson. He feels the same way. So I just do
not think that we can push this off any longer. We have got to
strengthen the hand of the Commodity Futures Trading
Commission. We have got to give them the authority, and I am
going to be asking the new Chairman about that and about any
resources that they need. But we have got to get the CFTC the
authority and the resources they need to do this kind of
regulation and oversight.
With that, I will yield to my distinguished Ranking Member,
my good friend, Saxby Chambliss.
STATEMENT OF HON. SAXBY CHAMBLISS, A U.S. SENATOR FROM THE
STATE OF GEORGIA
Senator Chambliss. Well, thank you very much, Mr. Chairman,
and you and I agree 100 percent that this is a critical issue,
and it is an issue that we have got to address and an issue
that certainly calls for more regulatory measures, but I think
regulatory measures that are not too intrusive to destroy
markets rather than to continue to create and innovate in the
markets. I know you had a conflict last night and were not able
to be there, but we had a very good meeting with Secretary
Geithner last night, along with our Senate Banking colleagues
as well as our House Agriculture and Financial Services folks.
We fully expect that the Secretary is going to come forward, I
am sure with consultation of the new Chairman, with some
recommendations in the next couple of weeks. We talked about
some ideas that we have as policymakers there last night that
are going to help influence, obviously, in a very strong way
the direction in which the administration wants to go.
I am very confident that we are going to be able to come
together with a very strong proposal that does make certain
modifications that are not overburdensome, but yet at the same
time will provide that protection that you referred to for all
consumers as well as making sure that we have stability in the
markets.
I do strongly believe that the Senate Agriculture Committee
and the CFTC must be engaged in the development of any
legislation addressing financial regulatory reform. This
Committee has a responsibility to ensure proper oversight of
the CFTC, and we must do more to fulfill this duty.
Today's hearing covers a wide range of issues: speculative
trading in the commodities markets, changes to regulation of
the over-the-counter derivatives, and the CFTC's authority over
retail off-exchange transactions. Those are all worthy
individually of hearings, and they are very complex issues that
we are going to have to be dealing with in the legislative
proposal that you alluded to and that I agree is going to have
to come forward.
Among the most complex instruments, we have recently heard
a great deal about credit default swaps, or CDS, which permit
one party to transfer the credit risk of bonds or syndicated
bank loans to another party. Given that AIG was heavily
involved in CDS, it seems simple enough just to blame swaps in
general for the current financial crisis. But, of course, it is
much more complicated than that. Failing to distinguish between
credit default swaps and the actual mortgage-related debt
securities that these swaps were referencing has resulted in an
oversimplification of the problem and subsequently an
oversimplification of the proposed solutions.
Simply banning the use of all over-the-counter derivatives
or forcing such contracts onto an exchange is unrealistic and
unlikely to even address the underlying problem; that is, is
this really a chance we are willing to take in these uncertain
times, a chance that we would make things worse, dry up more
capital, and force the cost of doing business higher?
Speaking of business functionally, curbing speculation is
the physical commodity markets--speaking functionally, curbing
speculation in the physical commodity markets is another area
that we must approach very carefully. This is also not a simple
topic. Determining how much speculation is necessary and how
much speculation is excessive is an enormous challenge and
something that we will be talking with the Chairman as well as
our other witnesses about this morning.
Some seem to have decided that all speculation is bad, but
I would like to remind folks that without speculators in the
marketplace, our farmers, ranchers, and energy users would find
very little liquidity in these markets and would thereby not be
able to utilize them effectively. Those individuals and
businesses hedging risks and physical commodities, the parties
that some claim they are trying to protect by running
speculators from the market, are the ones who are likely to be
hurt the most if speculative money dries up. I fear that this
is another example in which oversimplification may be leading
us to solutions of vast unintended consequences.
We must remember that during the past 18 months of
bankruptcies, bailouts, and Government-assumed ownerships, the
Nation's futures markets have functioned quite well. Price
discovery has occurred, consumer funds have been protected, and
there has not been a single bankruptcy of any clearing
organization.
Does this mean there is not room for improvement? Of course
not. Do I think the volatility in some markets over this
lifetime warrants extensive analysis and possibly regulatory
changes? Absolutely. While I may have concerns with some of the
proposals that have been discussed relative to regulating both
the use of over-the-counter derivatives and speculative
trading, I am absolutely convinced that the market volatility
and financial meltdown of the recent past make the case for
more market transparency.
How can we in Congress gamble on the outcome of sweeping
reforms without first properly identifying the cause of these
problems? How can we identify the cause of the problem without
authorizing and/or requiring more transparency through the
collection of necessary data?
Yes, I have seen all the press accounts claiming the evils
of indexed investments, swap dealers, and speculators, but what
statistical data is used to support these claims? From what I
can tell, many assumptions in the analysis to date are
assumptions that may very well be accurate. But how do we
verify this accuracy without access to the facts? Assumptions
are simply not good enough when it comes to the responsibility
Congress has to protect the integrity of these markets--
integrity that would be compromised by lack of market liquidity
or by increasing the cost of risk management or by forcing a
migration of these markets overseas.
While I want to understand the causes that led us here, I
do not believe anyone in this room--or anywhere else, frankly--
has all the answers to what exactly went wrong. I am not
willing to believe everything reported in the press unless the
claims can be backed up with hard, verifiable data. To do
otherwise is reckless. In fact, the data we have seen so far
actually contradicts some of the claims people are so quick to
believe and ultimately to blame for causing this mess that we
are facing today.
Beyond requiring more transparency, I also believe this
Committee should explore how most effectively to regulate
swaps, some of which are statutorily excluded from CFTC
regulation and oversight. We should review the manner in which
hedge exemptions from position limits are granted, and we need
to determine how best to encourage the clearing of certain
derivative products without jeopardizing either the use of
these risk management tools or the sustainability of our
clearinghouses.
If Congress is truly interested in addressing the problem
as opposed to politicizing a solution, we can no longer ignore
the complexities of these markets. We must devote time to
understanding these instruments and their implications. We must
seek to understand the legitimate purposes these complex
instruments serve for large and small businesses in each of our
States. That is why hearings such as this are absolutely
essential. The last thing we should be doing is contributing a
whole host of new, unappealing consequences in an already
volatile marketplace.
Mr. Chairman, I particularly look forward today to hearing
some of the practical aspects of utilization of these products
that are on the market today, and I fully expect our witnesses
to be able to tell us, No. 1, how they utilize them from the
standpoint of making the economy of this country stronger by
making their businesses stronger, and also how they think we
can move in the direction of further regulation to ensure that
confidence on the consumer side as well as stability and
liquidity in the marketplace.
So, again, I thank you for bringing this matter forward. I
know it will be the beginning of a dialog that fully recognizes
the role of the CFTC but also that of the Agriculture
Committee. I am very pleased that we have our new Chairman that
we now have in place here to kick off this hearing this
morning. Mr. Chairman, I say publicly congratulations and we
are excited about you being where you are, and we look forward
to working with you and hearing your testimony this morning.
Chairman Harkin. Thank you very much, Senator Chambliss.
Now we will move to our witnesses, and first is our new
Chairman of the Commodity Futures Trading Commission. Mr. Gary
Gensler was sworn in as Chairman of the CFTC on May 26, 2009.
Chairman Gensler previously served at the U.S. Department of
the Treasury as Under Secretary of Domestic Finance and as
Assistant Secretary for Financial Markets, subsequently served
as a senior adviser to the Chairman of the U.S. Senate Banking
Committee on the Sarbanes-Oxley Act reforming corporate
responsibility, accounting, and securities laws. Chairman
Gensler is the co-author of a book, ``The Great Mutual Fund
Trap''--which I just mentioned to him in private I have been
reading parts of it, and I recommend it highly--which presents
common-sense investment advice for middle-income Americans.
Mr. Gensler is a summa cum laude graduate from the
University of Pennsylvania's Wharton School, with a Bachelor of
Science in Economics, received a Master's of Business
Administration from the Wharton School's graduate division in
1979.
Mr. Gensler, welcome back to the Committee. Congratulations
again on your assumption of the chairmanship of the CFTC. Your
statement will be made a part of the record in its entirety,
and please proceed as you so desire.
STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING
COMMISSION, WASHINGTON, DC
Mr. Gensler. Mr. Chairman, Ranking Member Chambliss,
members of the Committee, thank you for your unanimous support
in my recent confirmation, and thank you for inviting me here
today to talk about this critical issue to the Nation's
economy.
I believe that we must urgently enact broad reforms to
regulate the over-the-counter derivatives marketplace. Such
reforms must comprehensively regulate both the derivative
dealers--those institutions that make markets in these
products--as well as the markets themselves. I think that it is
very important for the future of our economy and the welfare of
the American people, and I pledge to work with this Committee
and Congress to try to restore confidence in the financial
regulatory system.
Many of these reforms will require statutory changes, of
course, but, Senators, please also know that I have already
directed the Commission staff to present all options under our
current and existing authorities to protect market integrity
and consumers from price volatility--that price volatility that
may accompany a rebound in this overall economy as well, as we
move forward. This is particularly the case within the physical
commodities, whether it is wheat, grain, or energy markets.
A comprehensive regulatory framework governing the over-
the-counter derivatives markets and over-the-counter
derivatives dealers should apply to all dealers and all
derivatives, and I believe that it should not matter what type
of derivative is traded. That would include interest rate
products, currency products, commodity products, equities, as
well as credit default swaps, or that which cannot be foreseen
yet, and any other swap or derivative product coming in the
future.
Furthermore, it should apply to dealers in derivatives no
matter whether they are trading in standardized products or in
customized products. In my written testimony, I go further into
that. But let me mention the four key objectives that I think
we would wish to achieve here.
One is to lower systemic risk. We have to make sure that
there is less risk in the overall system. Two is promoting
transparency and efficiency in markets. Three is promoting
market integrity and preventing fraud, manipulation and other
abuses, setting position limits where appropriate. Fourth,
protecting the retail public.
To achieve this, I foresee working with Congress on two
complementary regimes: through the dealers that hold themselves
out to the public in these products, we should set capital
standards to lower risk margin requirements as they conduct
business directly with other commercial enterprises; business
conduct standards, which I want to return to; and recordkeeping
and reporting. This would be for all derivatives, whether
customized or standardized, whether they be interest rate
product or credit default swaps.
On the dealer community, there are really just 20 or 30
large dealers, the business conduct standards would protect
against fraud, manipulation, and other abuses. The
recordkeeping and reporting, importantly, would allow the
regulators to see a complete picture and aggregate this
picture.
In addition, I do believe, though, we need to regulate the
markets as well. This is a complementary regime to bring the
standardized products, those products that can be brought into
clearing and brought onto exchanges, further lowers risk.
Clearing has the attribute that no longer would the financial
system be so interconnected. Individual firms, rather than
having exposures to each other, would have the clearinghouse
that has to have the discipline of daily mark-to-market and
daily posting of collateral.
Regulated exchanges and transparent regulated trading
facilities or trading platforms bring additional transparency,
and what we are proposing--and I believe the administration
letter also spoke to this--is that there would be a real-time
reporting of those transactions of the standardized products.
So the full market could see on a real-time basis, as they do
in the corporate bond market and they do in the securities
market, the pricing of the products as clearly as they can.
Before I close this oral part, I want to say there are two
other things, I think, that we need to work together on beyond
regulating the over-the-counter derivatives marketplace and
fully bringing this under regulation.
I believe that we will need to work together on the
appropriate authorities to put in place aggregate position
limits over the marketplace, particularly as it relates to
physical commodity products, but also that we need to address
some abuses in the retail area. Last year's fix with regard to
foreign exchange trading, I think that we will need to extend
that to other physical commodities. We thank you for some of
those helps in Congress. Furthermore, to have clearer authority
for the CFTC to make sure that foreign boards of trade comply
with our transparency and position limit authorities here,
effectively in statute to close what is called ``the London
loophole.''
With that quick summary of a very complex subject, I look
forward to working with this Committee and taking your
questions today.
[The prepared statement of Mr. Gensler can be found on page
80 in the appendix.]
Chairman Harkin. Thank you very much, Chairman Gensler, and
as I said, I read your testimony thoroughly last evening, and I
just found it very enlightening, and like I said, I think I
agree with most of everything you have put in there. I have
some questions I will ask about a couple of parts of it here.
But as you know, I have expressed to you privately and I have
expressed publicly that I appreciate, first of all, that this
is the unanimous position of the Commission, as I understand.
Is that right?
Mr. Gensler. That is correct. I am pleased to report the
testimony represents a Commission document.
Chairman Harkin. I would be remiss if I did not recognize
one of your Commissioners who is here, Michael Dunn, and to
thank him for serving as the Interim Chairman of the CFTC
during this period of time. I want to thank you very much,
Commissioner Dunn, for doing that yeoman's work in that interim
chairmanship.
You and I, Mr. Gensler, I think, agree on the need to enact
significant regulatory reform--significant regulatory reform--
of the derivatives market. I do not know if this is a
divergence or not in our approach, but it has to do with over-
the-counter derivatives and whether they should be allowed to
continue.
If we do allow over-the-counter trading, then I think the
requirements that you have proposed would be at least the
minimum, I think, of what we should be doing in terms of
ensuring the integrity of those markets. But I just want to
explore with you again on the record in public whether we might
move all of this activity to a regulated exchange or an
electronic trading system.
So I want to discuss that with you, but, again, I also want
to get into what resources you might need also. I will not get
into that in detail, but at some point we have got to think
about what kind of resources you might need.
But you propose establishing criteria for determining
whether a derivative is standardized or not. Now, I wrote these
down: whether a contract is accepted for clearing by a
regulated clearinghouse, the volume, the look alike nature of
the contract, evaluating whether the difference between the OTC
contract and the exchange contract are significant
economically, or if the contract terms are disseminated to
third parties. A lot of details are left out of that.
I still ask the question, I ask you as I asked it of Mr.
Geithner, not before us but in a meeting in the Capitol: Define
a ``customized swap.'' What is a ``customized swap'' that
cannot be traded on a regulated exchange? I still am wrestling
with that.
Mr. Gensler. Mr. Chairman, I think that we share your
concern that we need to bring a regulatory regime to the entire
market, those standardized and those tailored products, and
that is why we are proposing to regulate the dealer community
and be able to get the full picture, the full recordkeeping and
reporting, even with an audit trail, so that we can police and
enforce anti-fraud and anti-manipulation provisions, enforce
position limit authority.
In terms of your question, we believe that there are tens
of thousands of commercial interests in this country that
promote their business needs by hedging within the futures
marketplace and hedging within the swaps or over-the-counter
derivatives marketplace. We need to bring regulation to that
marketplace.
Individual commercial interests and municipalities
sometimes wait to tailor a product--it might be a specific
product that hedges their risk in the interest rate markets,
but it might be on a different day, it might be a different
month than a standard product. Or it may be in the physical
commodity market where it is an airline that wants a certain
grade of jet fuel delivered at a certain location on a certain
date. It is so specific and commercially even confidential that
there is no liquidity, there are not four other parties that
would do that exact contract.
So what we are proposing is that would still be regulated,
it would still be regulated with regard to this first regime,
where the dealers that are transacting this business have to
comply with anti-fraud, anti-manipulation, that have to report
and record all of this. The regulators would see a picture of
the entire marketplace and be able to police that entire
marketplace.
That commercial enterprise would get the benefit of
transparency because the standardized products--over half the
market, though it is hard to estimate exact figures, but a
significant part of the market is standardized--would be
brought into exchanges and reported on a real-time basis, so
the commercial enterprises get the benefit. But they may still
want to tailor some features to a specific date or location in
my little example that I gave.
Chairman Harkin. I am still going to continue to press this
issue, and I will with the other witnesses who come up. Give me
an example of a customized, over-the-counter derivative
contract that is so customized that it cannot be put on a
regulated exchange.
Now, I understand that it may cost a little bit more for
them to do that. But I think to me, the cost of that may eat
into their profits a little bit. But to me, the need for the
public to know that and for others to know it, for price
discovery and transparency, it may be for a specific jet fuel,
but that may have repercussions on other aspects of the oil
market that could happen, depending upon how big that contract
is.
So when you do that, I just have a hard time understanding
what is so customized that it cannot be put out there in that
market.
Mr. Gensler. Mr. Chairman, the same reason that you are
suggesting is why we think that even the tailored or customized
products should be reported to the regulators so that the
regulators can report the aggregate positions and see even the
customized, in this case the example of the jet fuel. An
exchange generally needs parties on both sides to come with
bids and offers, and so really the key here is how much
interest in a tailored product might there be.
So we believe we have to bring regulation to the entire
marketplace, including these tailored products, and that we
must have regulation of the dealer side so that we can also
allow for commercial enterprises to still hedge their very
specific and unique risks. At the same time, the commercial
enterprises would be protected against fraud and manipulation.
Market integrity would be protected by aggregate position
limits across the markets. The regulators would be able to
police these markets with seeing a real audit trail and a
record of tailored and standard products.
Chairman Harkin. On page 4 of your testimony--and I marked
it last night--it says, ``These standards''--regarding over-
the-counter contracts--``also should require adherence to
position limits established by the CFTC on OTC derivatives that
perform or affect a significant price discovery function with
respect to regulated markets.'' But if these contracts then are
needed for price discovery, if you need price discovery, as you
say right there, that ``affect a significant price discovery
function,'' wouldn't the public interest require this price
discovery to be on an open, properly regulated exchange and not
on the over-the-counter exchange?
Mr. Gensler. Our proposal is that anything that could get
onto clearing, anything a clearinghouse would accept for
clearing would be presumptively standard. So if a clearinghouse
accepts it, it would be considered standard. We will have to
have rules of governance for these clearinghouses, and we have
called for these to be fully regulated clearinghouses. But
anything that was accepted should be out there and be exactly
what you say, Mr. Chairman, fully transparent to the public and
also on exchanges and on these trading platforms.
Chairman Harkin. Well, there is some concern about the
clearinghouses are run basically by the banks and others. This
is not an open exchange. So I am concerned about what your
regulation would mean and how we find out, again, whether these
over-the-counter derivatives are being regulated.
Mr. Gensler. I think the Chairman raises a very good point.
Right now the clearinghouses, of course, have come into being--
and, fortunately, they have come into being. There are a number
of them that have started out. But they are on a voluntary
basis. So we are talking about working with this Committee and
Congress on having mandatory and statutory provisions. Working
together we should find the right balance on governance as well
with regard to these clearinghouses so we do not have, as you
highlight, some of the conflicts that may exist. We would want
to guard against those in the governance features.
Chairman Harkin. Well, we will follow up on that. That is
pretty interesting.
I am sorry. I took almost 10 minutes, so I will recognize
other people for 10 minutes rather than 5-minute rounds. This
is a very intricate subject, and it takes a little time to
develop.
Senator Chambliss.
Senator Chambliss. Well, thank you, Mr. Chairman, and you
are right, it is certainly above my brain's capacity to
understand all the complexities of this industry. While you
raise a good issue relative to customized swaps and
derivatives, I think we are going to have some testimony from
some folks today that actually use them, and they can dwell on
the details. But I am pleased, Mr. Chairman, that you recognize
that there is going to be a need for some custom items and
products as we move forward.
We talked about this last night with Secretary Geithner,
too, and he is of the same belief. It is the folks that are in
the business every day that have the understanding of this
rather than those who deal with so many other things on a daily
basis.
Mr. Chairman, I sent a letter to--and let me compliment
Former Acting Chairman Dunn for his great work, now
Commissioner Dunn. We are pleased that obviously you were where
you were and you are where you are, because it is folks like
you and the current Chairman that understand these issues.
But I sent a letter back in April regarding several
different issues, and you handed me the response this morning,
so I am kind of going off what you just handed me here. But,
basically, when we talk about costs, there are obviously issues
on the trade side relative to costs, and we will talk more
about that. But there are going to be significant costs on your
side from the standpoint of whatever legislation we come up
with, making further demands on you.
One thing I appreciate you going into detail about is if we
are going to establish position limits and if we are going to
make it mandatory upon the Commission to oversee and regulate
items such as position limits, you have said that given the
substantial increase in the number of commodities that would be
required to have Federal speculative position limits, staff
estimates that at least 20 full-time equivalent positions would
be necessary to review the expanded scope of Federal position
limits, grant hedge exemptions, collect reports from persons
granted hedge exemptions, and monitor for violations.
In addition, you go on to respond to my letter by talking
about the further extension and regulation of speculative
limits to OTC contracts and that also would be very significant
and would require at least 60 additional staff, plus we would
need to upgrade the systems that you have in place today to be
able to handle that. Ballpark, do you have any idea what kind
of additional funding we are looking for your budget to try to
do just these things, which I think there is general agreement
that we have got to move in this direction?
Mr. Gensler. Senator Chambliss, I thank you for the letter
that was sent to my predecessor and that I was able to deliver
the estimates. The Commodity Futures Trading Commission, I
believe, even with the generous support of this Committee and
Congress is still sorely underresourced. We are in total at
about 510 people. We just got authority to move up to 572,
which just brings us back to the staffing levels that were in
place in 1999, 10 years ago.
The futures markets that we regulate have gone up five-
fold. The complexity has gone up significantly. We have six
times more contracts today. But it is not just the number of
contracts. It is global. We have gone from open outcry to
electronic trading. So hopefully we will be working together
with you and the appropriators in trying to find a way to
address these very real resource needs.
If we do go further, as your letter asked about sitting
more position limits, we made estimates of 20 or 60 people; you
had two alternatives. Rather than speaking off the cuff, if we
can get back to you on an exact sort of dollar figure that
assigns to those two numbers, we would be glad to do that as
follow-up.
Senator Chambliss. Sure. Well, I think there is going to be
general agreement that we have got to make some changes, and we
agree here that you are underresourced now. But we are not
going to put additional obligations on you without providing
you additional funding. We are simply going to have to do that.
Irrespective of what amount of money we are talking about, if,
in fact, CDS or whatever part of the commodities market
contributed to the financial collapse last year, it is going to
be a lot cheaper to fund you to regulate than it will be to go
through another situation that we are trying to recover from
now.
Mr. Gensler. Senator, I fully agree with you on that, that
it would be a good investment of taxpayer dollars to guard
against these risks.
Senator Chambliss. One thing that has been of real concern
to me from the standpoint of putting additional regulations in
place is the fact that we might stymie, No. 1, innovation on
the part of bright minds in the marketplace that are thinking
of additional products, not just for the sake of making money
on the end of selling them but providing a real service to
businesses across our country and allowing them to utilize the
marketplace, again, to offset risk.
If we, No. 1, take all the risk out of that, then I think
we are going to be hampering the markets more so than helping
them. Second, if we put in overburdensome regulations, then
there is going to be the tendency of those folks, whether they
are in my hometown of Moultrie, Georgia, or Atlanta or New
York, to simply go overseas and carry out the same transaction,
but yet on another market that may not be regulated in the way
we are talking about.
One thing that came up in our discussion last night--and I
will not expect you to be able to talk in depth, but I would
like your comment about this--is that if we re going to make
changes to our markets in order to make sure that the same
protections are in place for American consumers on overseas
markets, then we need to go to our overseas markets, and we
need to tell the Europeans that these are the changes we are
going to make, and we hope you would look at the same type of
regulatory process to try to coordinate and let us do not be
overburdensome, but yet make the necessary changes so that our
customers--or, excuse me, U.S. firm customers do not
immediately go overseas and we lose that business and that
ability to regulate those markets.
Any comments you have on the potential for that?
Mr. Gensler. Senator, I think it is absolutely critical
that we coordinate internationally with other regulators around
the globe. Just yesterday, I actually met with the head of the
European Commission on Internal Market and Services, Charlie
McGreevy, on these matters. It was fortunate he was in town.
But I know that Secretary Geithner and others are doing this.
Commissioner Dunn is actually going overseas next week to take
on some of this as well.
We need to coordinate and make sure there is not a race to
the bottom somewhere else. I am encouraged by my meeting
yesterday on that. I do think that we also have to really think
about how we protect the American public and make sure that we
get the right things in place there.
We need to not only allow but foster innovation so that the
economy can grow but protect against risks, and the risks that
we are talking about protecting against are the risk of fraud,
the risk of manipulation, the risk that sometimes from
speculation that becomes excessive speculation there may be
burdens in terms of the volatility of markets. We are talking
about protecting against the risk of unregulated actors like
the affiliate of AIG, AIG Financial Products, that did not have
any effective Federal regulation growing so large and being so
excessively leveraged.
So while this is a complex proposal, regulating the dealers
to lower risk, that means there is some capital. That means
there is more cushion in the business that they have in their
business model. That more capital may, as you suggest, lead to
some more cost, but still allow for innovation, still allow
fully for innovation, but lower the leverage in the system. I
think one of the great lessons of the crisis of last year is
the system overall, the financial system, got highly leveraged
and too leveraged. Almost all the statistics will point to
that.
So capital regimes and margin regimes lower risk; business
conduct regimes lower the risk of fraud, manipulation, and the
burdens of excessive speculation, but while still fostering
innovation, fostering, as we have said in this approach, the
allowance of tailored or customized products. So commercial
interests can still hedge their risks.
Senator Chambliss. I agree with you that certainly posting
more capital is going to lower the risk, and I will not get you
to go into any more detail than that because the other
witnesses I expect will be able to give us some more
information relative to that. But I want to make sure that we
do not require too much in the way of reduction of risk that we
just suck too much capital out of the marketplace and that we
make sure that these folks that are utilizing whether it is
over-the-counter or non-regulated today, that they still have
the capital to operate their businesses in the way that they
need to be operated.
I thank you, and I have got some more questions, but, Mr.
Chairman, I will wait until the next round.
Chairman Harkin. Thank you very much, Senator Chambliss.
The principle here we go on is time of arrival. Senator
Casey was next, but he is not here right now. Then we will turn
to Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
If I could maybe start out and do a little self-education
here, because it is a hugely complicated topic we are talking
about. But as I understand where you are kind of getting to
here is, on the one hand, there is a set of regulations or an
approach that you would like to be empowered to take relative
to people or the companies that actually do business here. As I
read the four items that you have mentioned, that really would
deal with those dealers. Are we on the same page so far?
Mr. Gensler. Yes, the dealers of which there are
internationally maybe 20 or 30 large ones, they are out in the
public domain, and by and large we know the names of those big
financial institutions.
Senator Johanns. Pretty straightforward working with them
and laying out what the standards are going to be and the
transparency and the capital that you have mentioned. So that
for me is fairly understandable and fairly straightforward.
The second piece of this, though, I think it is really
complicated, and that deals with regulation of products. How
are you going to handle that, and what kind of authority do you
want?
The first question I need to try to get an understanding
about is as we look back over the last 8 to 10 to 12 months, if
you were to identify the products that really were at the heart
of the problem relative to the financial crisis, the AIGs, et
cetera, what would those products have been?
Mr. Gensler. Senator, I think that there are many factors
that led to this economic and financial crisis, and only some
of that was related to the products, because I do believe a
great deal had to do with the excess leverage and excess
borrowing and imbalances in the system overall. But in terms of
specific products, I believe that the over-the-counter
derivatives markets was a contributing factor, particularly
with regard to credit default swaps explicitly. I think other
products, if I can speak more expansively also, mortgage
products specifically, the sales practices, and I think many
homeowners and the retail public, often was misled, and even
fraud in terms of the sale of those products, usually in the
subprime market, but not always.
I think the securitized products, whether it is, as the
Chairman mentioned, things called collateralized debt
obligations and other very sophisticated products there that
are not specific discussions of this hearing today, because
those are actually securities, and those are actually already
regulated by the SEC.
I do believe the second regime is about bringing regulation
to the markets, if I can use a term, rather than products. So
it is bringing centralized clearing and a benefit of lowering
risk that all of these derivatives or swaps come into a central
counterparty and no longer is this interconnected web, but we
try to have institutions use that central counterparty.
Some people say that we have had a system of too big to
fail, but actually we have grown into a system that is also too
interconnected to fail. So the central clearing is trying to
make these counterparties less interconnected. You can think of
it being less caught in a spider's web. The American public was
caught in a spider's web of interconnected relationships last
fall, and we should try to lower that as far as possible as we
go and bring transparency to the exchanges.
Senator Johanns. As I look at some of what happened--and
you are right, gosh, picking out one thing is just not going to
get you to an accurate viewpoint of what happened. But if I
look at this--and hindsight is also 20/20. The amount of bad
judgment exercised by people paid enormous amounts of money in
salaries and bonuses is kind of breathtaking to me. How will
what you are proposing protect the public from the exercise of
that bad judgment?
Mr. Gensler. Senator, I concur with you that there is a lot
of bad judgment that went around. I think that at the heart,
the way we protect the American public is having strict ability
and clear, independent ability to protect the public against
fraud and manipulation and the burdens that can come from
excess speculation but also by putting in place this very real
risk reduction, the capital and margin requirements both of the
dealers and of the markets.
The American public should not be so at risk--they were
terribly exposed by unregulated companies. AIG Financial
Products basically was not regulated at the Federal level.
Lehman Brothers and Bear Stearns derivative affiliates,
basically lightly regulated at all at the Federal level. So we
have to protect the American public. I believe this program, if
enacted by Congress, would significantly do that with regard to
over-the-counter derivatives. Certainly we need to do more
about mortgage sales and some of these other areas that we
talked about.
Senator Johanns. Using AIG as an example, because what has
happened to them is so very, very public, it was shocking to me
to find out that they had this enormous risk exposure and
basically no protect. If this thing started to implode, it was
going to risk the viability of that entire company. You would
have thought somebody would have paid attention.
If what you want to achieve here is accomplished, we give
you the authorities that you are seeking, how would that have
changed the situation with AIG, or would it have?
Mr. Gensler. Well, I think that if these authorities were
in place, and not just for this agency, the CFTC, but broadly,
because of some of these authorities would be whether they be
in a systemic regulator or elsewhere, to set capital, for
instance--then AIG's Financial Products affiliate that did
have, as you said--it was about $480 billion of credit default
swaps. They would have had to have set capital to the side.
They would have had to on a daily basis put aside margin and
value those contracts. So as those contracts were going the
other way, they would have been regulated.
I also think that while we have not studied it at the CFTC
because we do not have any authorities over those products
right now, but if you really look how the products were used
and marketed, there is really in my mind some significant
question about how they were marketed. They were largely
marketed to lower capital standards in Europe and to be related
to the products the Chairman talked about earlier, these
collateralized debt obligations.
I think the credit default swaps have such unique
features--a little bit like monoline insurance, a little bit
like securities, they are certainly derivatives--that we are
going to have to work together as regulators and with Congress
to find some clear authorities on the trade practices with
regard to credit default swaps.
Senator Johanns. Thank you.
Mr. Chairman, thank you very much.
Chairman Harkin. Thank you very much, Senator Johanns. That
was an excellent question. That last one was great.
Senator Thune.
Senator Thune. Thank you, Mr. Chairman. Thanks for holding
the hearing. Chairman Gensler, thank you for being here. You
are at the center of this storm and the historic run-up in
commodity prices and oil prices last year that sort of caught
everybody looking at how do we solve this, how do we prevent
this in the future. It seems to me that the question is there
clearly needs to be some kind of reform of the regulatory
system that we have in this country with respect to a lot of
these financial products that were sort of outside the realm of
regulation. I guess the question is; how do we do this, what is
the smart regulation? I am not someone who advocates regulation
for regulation's sake. I think we have to think about how do we
do this in a smart way, and it comes down to the fundamental
question, in my view; how do we constrain risk?
It seems to me there are a number of ways that you could do
that. You could have an exchange where there is more
transparency and more accountability and where more of these
transactions occur in the light of day. I think what happened
was there was a lot of stuff that was going on in the dark.
Second, maybe it is in the form of margin requirements or
capital standards, some of the things that you have alluded to,
but I think we have to figure out how do we do that in a way
that is responsible, that is smart, that gets at the heart of
this problem, but does not push a lot of that capital to
foreign exchanges, that does not create such an economic burden
for a lot of the folks who are making markets in this country
that they decide to go somewhere else to do it.
I think in order to make this work, it is critical, back to
Senator Chambliss' questions, that we have international
cooperation. So I guess my question is; how do we ensure that
foreign exchanges are going to follow suit with the additional
oversight and transparency regulations, specifically how do we
go about doing that?
Mr. Gensler. Senator, I share your view that this is about
limiting risk, as you say, both in terms of the excess risk
that you can limit through the capital and margin regimes, but
also risks to the American public through protecting against
fraud, manipulation, and other abuses.
I also share your view that we are going to need to and
want to work with international regulators to see that there is
not an arbitrage, meaning that people would go somewhere else
rather than in these markets to avoid regulation.
I am encouraged by some of the initial conversations that I
have had in my 8 days on the job. But I think that working
with, the Chairman of the Federal Reserve and the Secretary of
the Treasury, we are really going to have to work actively with
our international colleagues to see that we can bring these
reforms globally, and where there may be differences--because
inevitably they have different political processes and
legislative processes and regulatory processes--that we guard
against those differences, not doing exactly what you said.
Senator Thune. You have said throughout your testimony, you
stressed the importance of protecting market participants from
excessive speculation. I guess I am curious to sort of know how
you define ``excessive speculation.'' We talked about the need
for producers in States like Iowa and South Dakota to manage
their risk. They use these markets for that purpose. But
obviously speculation plays a role and did play a role, I
think, in the problems that we encountered a year ago.
How do you define that, how do you get your arms around
excessive speculation versus legitimate speculation?
Mr. Gensler. The Senator asks a very good question. I share
your view that financial investors, index funds, contributed
and participated in the asset bubble of last year. I am
concerned that as the good news of an economy that rebounds--
and we hope, we all want this economy to rebound, that we might
see a resurgence of these commodity prices. That is why I have
already directed staff to really lay out for me as Chairman and
for the Commission all the options that are available under
current authorities to guard against this.
You know, Congress in the 1930's, I believe, when they set
up our predecessor, really best defined that. They said that
there could be burdens to interstate commerce that come from
excessive speculation, and Congress wrote into our statute that
this could be unreasonable price fluctuations or the volatility
that do not bear--I cannot remember the exact statutory words,
but resemblance to the fundamentals.
Then Congress gave the Commission authorities to set
position limits, and so it is through position limits that we
try to guard against this, and we have actively used it over
this time period.
Senator Thune. Some have suggested that the CFTC and SEC
ought to be merged into one regulatory body. What is your view
on that?
Mr. Gensler. Senator, I think whether we could have a
debate here for a few days on what was the lead cause of this
financial crisis, and I do not think any of us would put on the
list that is near--I think we really have to focus for the
American public on lessons learned from this crisis, whether it
is selling this product or this risk. So a merger for merger
said to me while I think it will always be out there in the
ether and be debated and discussed is not appropriate. I think
we have a heavy agenda here working with Congress. Now, if
somebody laid out why--if Congress and the President laid out
why that would really help the American public, we would all
want to work with that. But I do not see it really in the lead
here of the reasons, and I do not think it is going to
accomplish much for the American public today.
Senator Thune. You got into a discussion earlier with the
Chairman--and I think maybe with Senator Chambliss, too--about
this distinction between standardized derivatives, customized
derivatives, tailored derivatives, and the importance of having
the ability for participants who enter into some sort of a
customized association, that there would be a different way of
regulating those. I guess the question comes back to is there a
way of creating an exchange where these transactions could all
be sort of managed in a way that is open and that is
transparent and that allows for the public to be able to know
what the pricing is and everything else.
What I heard you say was that you think it would be
difficult to have that kind of a standardized--to create the
sort of standardization of these products that would allow for
them to be traded on some sort of an exchange, did I hear you
correctly?
Mr. Gensler. Well, Senator, I think that we can bring
regulation--and it would be the identical regulation--to both
tailored products and standardized products, identical
regulation about protecting against fraud and manipulation,
identical in terms of the capital charges of the dealer
community, and we can even apply margin to both tailored
products and standardized. The standardized products could have
the margin through clearinghouses, and the tailored products
could have it through the dealer community.
So I think actually it is a broad and very full regulatory
regime--in fact, the same for tailored and standardized. What
we need to encourage is much of the standardized product to be
on centralized clearing because that continues to lower risk,
and as much as possible onto exchanges or trading platforms,
because that is an additional level of transparency, in
addition to the transparency that the regulators will see it
on, will aggregate it for the public, but additionally the
standardized product, then you can see the real-time pricing.
It is a challenge. It is just a practical challenge. If it
is tailored, you could put it on an exchange, and there would
not be another party on the other side maybe. There might not
be what is called a bid and an offer. So it is just a
challenge. If we could do it, that additional transparency is
helpful.
Senator Thune. Well, I guess the bottom line is the
transparency issue and price discovery, however those are
regulated going into the future, that those elements be a part
of any solution. So we look forward to working with you on
this. Obviously, this is--it is a complex subject and one that
many of us are trying to wrap our brains and arms around, and
we appreciate your being here today and look forward to the
testimony.
Mr. Gensler. Senator, I thank you, and I look forward to
working with you because I know these things are critical to
your constituents. We have to get everything to work in the
wheat markets and the grain markets as well, and I know that
has been a challenge, too, and we have got to focus on that.
Senator Thune. I appreciate it.
Thank you, Mr. Chairman.
Chairman Harkin. Thank you, Senator Thune.
Senator Bennet.
Senator Bennet. Thank you, Mr. Chairman. Thank you very
much for holding this hearing and for your persistence on all
of these issues.
Mr. Chairman, welcome. It is nice to see you. I enjoyed
reading your testimony. I wanted to focus on something that you
have touched on lightly in some of your responses to the panel,
because I think that the issues of the products, the issues of
fraud, transparency, and all of that are important, and we need
to make sure that we are doing a good job with these tough
issues.
If you look back at where we are today and the cause of
where we are, I think it is impossible to avoid coming to the
conclusion that what ailed us most was the amount of leverage
in our system. From the consumer level, if you look at credit
card debt and home mortgage loans, to the Federal Government
which doubled its national debt, to financial institutions on
Wall Street that went from being 12 times levered to being 30
times levered over a period of time, you cannot sustain that
unless you assume that you are going to have a hockey stick of
growth for the rest of our lives--which is not going to happen.
I was struck in Lynn Stout's testimony--Professor Stout is
here--when she wrote that her research indicated that the only
time a significant U.S. derivatives market has not been subject
to regulation was during the 8 years following the passage of
the Commodity Futures Modernization Act of 2000. I was struck
by that because I wondered as I read it how much that
deregulation was a cause of the sheer volume of leverage in the
market, because people were able to go out and create
instruments, or whether they are unrelated. I wonder if you had
a view on that.
Mr. Gensler. Senator, I think you are correct that leverage
in the American economy is one of the big causes of the crisis.
If you just look at the overall statistics, it is remarkable,
and I will just use it to summarize it. But through much of all
of our lives, the economy has had a debt of about 1-1/2 to 2
times its economy. So it is like a household that might have a
$50,000 income and have $75,000 to $100,000 of debt.
We got up to about four times, about 4 to 1, and
coincidentally, the last time we did that was in the late
1920's, the last time we got to that. These are the statistics
published by the Federal Reserve on a quarterly basis.
I think that over-the-counter derivatives were a way that
financial institutions--not the homeowners, but the financial
institutions--add to their leverage as well, and that the
capital and so forth were not charged there, and though I
believe--looking back now it is clear to me that those of us
involved earlier--and I served earlier--should have done more
to protect the American public. Over-the-counter derivatives
actually were not regulated even before that act passed in any
way, for capital or for business conduct.
So what we are really talking about today, and working with
Congress, is a full shift, because just as in the 1930's when
President Roosevelt came to Congress and said we had to
regulate the commodities markets and the securities markets for
the first time, we are talking about--the CFTC, and I believe
this is consistent with the administration, is talking about
now coming and let's do this in a thoughtful but in a full way
to regulate this market.
Senator Bennet. As you think about the systemic risk
question, moving from a world where all of our regulation--that
may be an overstatement--much of our regulation and all of our
deregulation was, in effect, procyclical, was pushing us
farther and farther and farther along this curve. How do
imagine what you are proposing here will work with some of the
suggestions that have been made by the administration, by the
Fed, about where to locate the regulator of systemic risk? How
will all these pieces fit together--your work, the Fed, the
FDIC, the SEC? Because I think only if we have some way of
looking at how these pieces fit together will we ever get the
big picture. We can do it product by product by product, but
really there is this big fundamental piece of not wanting to
put ourselves in a position again where we simply have too much
leverage on the economy and then have to go through an
incredibly agonizing contraction, which is where we are today.
Mr. Gensler. Right, right. I think that you are absolutely
right, that we have had a lot of failures in our financial
regulatory system; it failed the American public in the biggest
test in 80 years. We have to address far more than just this
over-the-counter derivatives marketplace, and part of that, as
you say, Senator, is to have a systemic regulator, to have some
ability for those largest systemically relevant institutions,
those institutions that could make the public hurt so much, to
have additional oversight.
I know that there are various approaches to it. What I
would associate at least myself--I am not speaking for the
Commission now, but just as Chair--is that we absolutely need
this in working with Congress to make sure that it has clear
authorities on those most systemically relevant. Those
authorities might just be additional authorities.
So, for instance, where the CFTC is regulating markets and
regulating clearing institutions and so forth, as a market
regulator, I think in this country, again, since President
Roosevelt and Congress worked together in the 1930's, market
regulators have had their mandate, both the SEC and the CFTC,
and that was a really important mandate, protecting the public,
protecting the integrity of these markets, but then we would
have a systemic regulator of some sort that we would have to
coordinate.
Senator Bennet. Thank you, Mr. Chairman.
Chairman Harkin. Thank you, Senator Bennet.
Now we go to Senator Nelson.
Senator Nelson. Thank you, Mr. Chairman. Thank you for
holding this hearing.
Mr. Chairman, it is nice to have you before us. I enjoyed
our conversation earlier this year. I am interested in how we
can find a way to regulate leverage, because leverage seems to
be the operative word when you look at what happened with AIG.
There was not a lack of leverage in their insurance operating
subsidiaries because they are required by law and practice to
put up reserves or capital against the commitments they made.
But through the deregulation of 1988, I believe, with the
decline of Glass-Steagall, with Gramm-Leach-Bliley, there was
an effort then to be able to do as you chose at the top outside
of the insurance operating subsidiaries.
Would you agree with that generally?
Mr. Gensler. Senator Nelson, I believe with regard to AIG,
they were regulated at the State level as an insurance company.
Senator Nelson. Exactly.
Mr. Gensler. This has been a challenge, I know, for decades
actually, and the Congress will probably want to take up in
thinking about those systemically relevant firms, what if they
are insurance companies and the relationship of Federal
regulation to State regulation of insurance companies.
So I believe that AIG was sort of a case where there was an
unregulated affiliate of an insurance company that was
regulated at the State level. That unregulated affiliate, then
it was sort of ``Katy, bar the door.''
Senator Nelson. Yes, and, in fact, the deregulation
permitted this operation that was not regulated to do whatever
it chose to do without setting aside capital to support the
obligations it incurred.
Mr. Gensler. Senator, I think that as it relates to AIG,
which was not under any--in the 1980's, as you referred, not
under, I believe back then, any Federal oversight. Later there
was some, I would say, ineffective Federal oversight by the
thrift supervisor. So I do not--I think really that it was an
unregulated affiliate of an insurance company, and we have to
make sure that going forward we regulate these derivative
dealers, whether they are affiliated with an insurance company,
whether they are affiliated with a hedge fund, affiliated with
anything, if we are able to work with Congress and get this
through.
Senator Nelson. Right, but that does not extend that
somehow the Federal Government has to begin the process of
regulating the insurance operating subsidiaries that are
currently regulated by the States.
Mr. Gensler. Not in this testimony or in my view. It is
about trying to make sure that the derivative dealers come
under a consistent regulatory oversight.
Senator Nelson. If they had the set-aside capital
actuarially or in some fashion to support the obligations they
were incurring, this would have been less likely to have
happened the way that it has happened throughout the industry.
Is that fair?
Mr. Gensler. I think that is correct, Senator.
Senator Nelson. So establishing a way to require that
capital will reduce the leverage that exists not only today but
in the future as well. Is that fair, too?
Mr. Gensler. I believe that is correct. I think to lower
the leverage is setting those capital standards for the
dealers, but also having margin posted, just as it is on a
futures exchange. This has worked for decades in the futures
exchange. There are problems even in regulated futures, but not
about the capital and margining.
Senator Nelson. This was not related necessarily in every
case to fraud, but in almost every instance you could say there
certainly was some greed.
Mr. Gensler. Well, I think that was the case broadly in
this economic crisis.
Senator Nelson. I hope, as you look to regulate the
tailored products as well as the standardized products, that
there will be a system established to figure out the ratio for
leverage against the obligations that are made. Do you believe
you will be able to determine what the obligation is under
tailored products?
Mr. Gensler. I think, Senator, you raise a very good
question, because one of the things about tailored products is
they tend to be less liquid. They are sometimes harder to
value.
Senator Nelson. There may or may not be much of a market
for them.
Mr. Gensler. There may not be much of a market, as the
Chairman was talking about. I do think it is appropriate to
take into consideration as regulators that if they are less
liquid and they are tailored, that might lead to higher capital
charges, just as any product that is less liquid and harder to
value, because capital is meant to be a cushion against the
risk if a firm fails or there are problems in the system.
So liquidity is a key, and just as the Chairman was talking
earlier about whether the tailored products would be regulated,
they would be consistently regulated; but if they are less
liquid, it may be appropriate that the regulators say, well,
you have to put a little bit more cushion aside on that.
Senator Nelson. Would you do this in the same way, let us
say, that the National Association of Insurance Commissioners,
which I used to head in a previous life, the way they do it
through the Securities Valuation Office in New York that is
part of the NAIC?
Mr. Gensler. Senator, I dare say you are far more familiar
with how that works. I am not familiar with the specifics
there.
Senator Nelson. Well, they do value securities that do not
have a market value based on one of the markets; in other
words, private placements and the like. So tailored securities
probably as much as standardized securities would fit into that
sort of a category, where analysts would work their way through
establishing what the leverage is, and then establishing
capital requirements for that leverage.
Mr. Gensler. I think, though I am not familiar with the
specifics of that, I think that there should be consistently
applied capital rules for the over-the-counter derivatives.
Those that are on markets and those that are liquid, just like
other products, the more liquid a product is, then----
Senator Nelson. The easier to value.
Mr. Gensler. Easier to value, and it may necessitate a
little less cushion, a little less margin. Certainly even in
the futures markets right now there are different margins
depending upon the volatility and liquidity.
I think one of the great lessons of this crisis is I
believe that our overall capital regimes--and this is not
within the CFTC, but our overall capital regimes let the
American public down, and that we need to take, as Federal
regulators, a closer look at those capital regimes and make
sure that they take into consideration particularly the less
liquid instruments like collateralized debt obligations or
structured product. Maybe they should have higher cushions or
higher capital, and those that are easier to value, that are
liquid instruments----
Senator Nelson. But you will have to have some mechanism,
some way of--an analysis of establishing those values in an
objective fashion, and I suppose you are going to be bothered
by those that turn over too quickly to value them for any
length of time, because you had them, they are gone, they have
been sold. I just hope that you will find a way to consistently
do that so that there is some objectivity and some reliability
for establishing what the leverage requirements would be.
Mr. Gensler. Right. Thank you, Senator.
Senator Nelson. Thank you, Mr. Chairman.
Mr. Gensler. I thank you for your support.
Chairman Harkin. Thank you, Senator Nelson.
Senator Gillibrand.
Senator Gillibrand. Thank you, Mr. Chairman, for holding
this hearing, and thank you, Chairman Gensler, for being here
and for testifying. These are very important issues. Few, if
any, cities in the country have really felt the effects of the
economic collapse more acutely than New York, New York City,
the State that I represent. I want to talk to you a bit about
how we can move forward so that we can create confidence in our
markets and create a regulatory framework that will ensure
success not only with the U.S. financial services industry but
our economy overall, because we really do need to address the
8.5-percent employment rate nationwide, and we have to make
sure our small businesses have the resources they need to grow
and create jobs.
As we work to sustain the companies that form the backbone
of our financial industry, we must ensure that the structures
and the regulatory framework institute proper oversight and
capital requirements while still promoting significant growth
and expansion.
There has been a tremendous focus on the extraordinary
losses that have resulted from the unregulated derivatives
market, in particular the credit default swap markets, and
rightly so. However, there also needs to be now significant
attention paid to the regulation of these financial
instruments, which have become an integral part of our
financial system. We have to ensure that capital reporting
requirements will allow derivatives to exist for legitimate
participants, but discourage excessive speculation and protect
our investors.
It is essential that we fully understand the implications
on the end users, such as industrial companies who rely on
derivatives to hedge commodity prices, interest rates, and
foreign exchange rates. We must have an efficient and effective
regulatory structure to ensure a vibrant economy, economic
growth, adequate liquidity, and appropriate oversight and
accountability.
So I first want to talk about what do you think and how do
we allow legitimate participants versus those who are trying to
game the system, and what sort of capital reporting
requirements would allow custom derivatives to exist for
legitimate purposes and participants, but would discourage the
excessive speculation and still be able to protect our
investors.
Mr. Gensler. Senator, if I might first start with thanking
you for your support of my recent confirmation, and it is good
to meet you. I lived in New York for 15 years. My three
daughters were born in New York. Though I live in Maryland now,
I have great affection and affinity for your State.
I think it is important to bring, as you say, greater
regulation to this whole over-the-counter derivatives
marketplace. I think we should best do that in two
complementary regimes that would address, as you say, the
legitimate interest of commercial parties to hedge their risks,
but also have capital standards to lower the risk.
One is to have a regulatory regime of the dealer
community--many that are in your great State--but of the dealer
community so that those dealers have to have the capital to
lower risk, to set margin, but also have business conduct
standards to protect against fraud and manipulation. That
regime covering the dealers would cover both standardized and
tailored product. Tailored product or customized product would
be allowed, but it would cover both of these as well.
I think that it is important, as you say, that commercial
users have legitimate needs to do that, but we would want to
bring as much of this product into centralized clearing and
regulate the markets as well for that centralized clearing,
because additionally that lowers risk. If we can lower risk
through centralized clearing, that frees up capital in the
dealer community, because if they can move product over to
centralized clearing, that is a way to lower risk.
It also helps raise transparency to put that on exchanges
where it is standardized product, and we would want to work
with Congress to get this. So the presumption was if it could
be on a centralized clearing, it could be on an exchange, we
would do that.
Senator Gillibrand. What do you see at the upsides or
downsides for actually requiring it to be on an exchange as
opposed to just having it go through clearing?
Mr. Gensler. We think that there are real benefits to also
having it on an exchange. Of course, one of the features of our
market system here in the U.S. is transparency, and the
transparency of markets promotes economic efficiency. So we
would have transparency by having information on 100 percent of
the product, both tailored and standardized, available to the
regulators. Making transactions available to the public lowers,
we believe, some of the cost to the end users that you spoke
about.
So bringing the standardized product onto exchanges means
that any commercial user can see, Aha, 15 minutes ago, this is
where--it might just be an interest rate swap, a standard
product to hedge an interest rate for 5 years. They can see
where that was. If you are a small hospital or municipality,
you can say, Aha, that is where the pricing is and we should do
the same.
Senator Gillibrand. But if you do require exchange trading,
then you are really not going to have an opportunity for
customized derivatives. So do you think you are going to lose
enormous markets to overseas markets because you cannot
accommodate that here?
Mr. Gensler. Senator, we actually foresee that this
approach would allow for, as you call it, customized or
tailored product. Much of the derivatives marketplace right now
is standardized, but there is still a very real need for end
users to tailor their products.
So what we are calling for is 100 percent of the product,
tailored and customized would be regulated through regulating
the dealers. The product that could be brought onto exchanges
would benefit because it would add transparency, but we would
still foresee that end users would be allowed to tailor their
needs. They might have a risk. I used earlier an example; it
could be an airline that has a risk around a particular jet
fuel to be delivered on a particular date in a particular
location, that we would still allow for that, but still
regulate and protect against fraud and manipulation and that
the regulators would see it aggregated and publicly report the
aggregated data.
Senator Gillibrand. I would like to turn specifically to
one industry area, the trading of carbon permits, and the
derivative products that may be based on them, and this may
obviously become a major growth center for these markets.
How would these proposals affect the shape and the nature
of carbon trading markets? Does the potential market for carbon
derivatives have unique needs from other derivative products?
What unique skills might the CFTC or another regulator need to
effectively regulate this market?
Mr. Gensler. Senator, I think that the CFTC has over many
years developed a skill set and has a mission to oversee the
derivatives marketplace, which we have called the ``futures
marketplace'' for these years. In fact, there is already a
small market in these permits or similar markets in Chicago
called the Chicago Climate Exchange. There was a similar market
that came up, oh, I think it is over 20 years ago now, out of
some of the permits that came out of acid rain legislation of
Congress.
As Congress moves forward and possibly further develops
this, I would look forward to working with you and the Congress
on how to get this right. But I think it would be important to
protect against the same thing we protect against in the
futures markets--fraud and manipulation. We should have the
authority to set position limits, because these would be
physically limited, these contracts would have a limited
supply. So, again, hopefully bringing the same transparency and
protections that we have currently to the futures markets.
Senator Gillibrand. Thank you, Mr. Chairman.
Chairman Harkin. Thank you very much, Senator Gillibrand.
Now we will turn to Senator Klobuchar.
Senator Klobuchar. Thank you very much.
Mr. Gensler, you have had a long morning. It looks like I
am the last one here for you. I just wanted to thank you again,
and I am glad that you are joining us. I think I expressed my
frustration last time at your predecessor when I asked about
more tools that he could have in his job. He did not seem
interested, and yet we saw at the time oil prices going up, due
in part to speculation and other problems with the regulation
of the market. I do believe--I appreciate what you said about
transparency and that we need to also take steps to minimize
speculation when it is done not to benefit consumers or the
market, but instead to benefit a certain small segment of those
that are doing the trading.
We need an effective CFTC, and then we also need to do
something about some of these instruments, financial
instruments that cause some of this problem. Specifically, when
I talked with you during your confirmation hearing, we talked
about credit default swaps. Now that it is a little calmer
here, I wondered if you could talk about what you think needs
to be done to better regulate credit default swaps.
Mr. Gensler. Senator, again, thank you for your support in
my confirmation process.
I believe that we need to bring regulation to the entire
over-the-counter derivatives marketplace, so credit default
swaps but also the interest rate product, currency swaps,
commodity swaps that this Committee certainly has talked a lot
about in the last 2 years, and equity products.
I believe that we can best do that, as I was just saying
with the Senator from New York, that we have a regime to
regulate the dealers. There are internationally maybe 20 or 30
major dealers. I do not mean to limit them, but that work in
these products. Many of regulated for other reasons, but we
need to explicitly regulate them for business conduct, capital,
margin, and reporting for credit default swaps and the products
for tailored and standardized products.
I think second we need a regime that brings as much of the
product as possible, the standardized product, into centralized
clearing to lower risk. There are some voluntary features of
that now, but we also need greater transparency through
exchanges, while still recognizing there will be tailored and
customized products that would be fully regulated in the first
regime, but might not get the added risk reduction in the
second regime and the added transparency in the second regime.
I think credit default swaps might have some unique
features. In addition to what we have laid out in testimony
today, I think the regulators, certainly the CFTC and the SEC
working together, really have to consider additional features
even with regard to credit default swaps, because they perform
so many functions like securities.
Senator Klobuchar. You mentioned the systemic risks. What
do you think of this idea of having some kind of systemic risk
regulator at the Federal Reserve or someplace that looked at
the market as a whole?
Mr. Gensler. Senator, I think that there are many lessons
out of this crisis that developed in the last several years,
but I think one of the lessons is that we need at the Federal
level some clear authorities and mandates from Congress as to
when a regulator can step in to protect against systemic risk.
All of the regulators, the CFTC included, primarily were
put in place not to protect against systemic risk but to
protect against very important risks to the public, but other
risks. I think if Congress, working with the administration,
moves forward, we should have a party or a mechanism such that
the most relevant firms that could lead to crises might have
additional standards and additional risk limitations to be less
interconnected to protect the American public.
Senator Klobuchar. As we head into the summer now--a lot of
my constituents have cabins; this one is for them--they start
to see the oil prices going up again. Why do you think oil is
going up, what do you think we can best do to protect
ourselves?
Mr. Gensler. I think at the core of the mission of the
Commodity Futures Trading Commission is to make sure that the
markets are fair and orderly and that there is integrity. In
the energy markets, I do believe that in the past asset run-up
that financial institutions participated in that asset bubble.
I think as this economy starts to recover--and we all hope for
and are working hard for it to recover--that we will see some
movement in commodity prices.
But I have said to the staff already--I have been there 8
days--that we have to look at every available option within our
current authorities to see how we can protect the public and
assure that there are not--as is our mandate, to make sure that
there are not burdens from excessive speculation. And though it
is not well defined in statute, it is a key mission of ours. I
have asked for every option to be on the table, and I
appreciate that as the summer moves forward, we might see more
movement in these prices.
Senator Klobuchar. Thank you.
Chairman Harkin. Mr. Gensler, thank you very much for being
here today and for your very open and frank discussion of these
issues. It is very refreshing to have that kind of openness and
just frank responses and answers. I appreciate it very, very
much.
As we move ahead in this, we will be taking action this
year, as I said at the beginning. We need your input to us on
authority, which you just mentioned here; if there is
additional authority that you need to carry out your mission,
we need to know that, and what additional resources that you
need to carry out some new responsibilities that I think that
we may be giving you at the CFTC, charging you with. So we need
to know that.
I know budgets are tight. I do not want to promise the sun,
the moon, and the stars and everything like that. But I think
the public is aware of the need for better regulation and
whatever small amount of cost that might be I think will be
more than outweighed by the public benefits that come through a
better regulatory regime.
So we need to keep our lines of communication open on those
two things--authority and resources. And I would yield to
Senator Chambliss.
Senator Chambliss. Thank you, Mr. Chairman, and I think all
of my questions have been answered. I did want to make just one
comment, though.
The Chairman as well as Secretary Geithner have both
expressed, as we have talked about, this customized versus
standardized transactions, that a transaction should be deemed
standardized if a clearinghouse is willing to accept it for
clearing, and we talked about there are some clearinghouses out
there now that are voluntarily accepting some of these
transactions.
There was an interesting article in the Financial Times
yesterday where three of these voluntary exchanges--the New
York Exchange, the ICE Exchange, and the London Exchange--were
warning Congress to be careful about this and careful about
mandating and forcing too much of the over-the-counter
derivatives into the clearinghouses, particularly because these
tailored OTC derivatives being forced into clearinghouses that
are ill equipped will really create a problem. And I would
simply like to ask that a copy of that article be inserted into
the record.
Chairman Harkin. Without objection.
[The following information can be found on page 138 in the
appendix.]
Chairman Harkin. I could get into that, but we would
probably get into a debate, and I do not mean to engender that
right now. But I would say that I sat here in 1999 and 2000--I
was not Chairman then, but I sat here and listened to all the
reasons why we could not regulate. And I have the record. The
question I asked of Mr. Greenspan when he sat here--not in this
room--about the exposure and the regulation of these and what
would happen if we did not do that. I am proud of the fact I am
one of nine Members of the Senate who voted against
deregulation of Glass-Steagall.
But I asked him that on the record, and I remember his
answer. It is on the record. I have got it. He said do not
worry--and I am paraphrasing. He said not to worry. He said
these are smart people, and they will self-regulate because it
is in everybody's interest to make sure that nobody else
cheats.
Well, fooled once, your mistake. Fooled twice, my mistake.
Thank you very much, Mr. Gensler, for being here.
Mr. Gensler. Thank you, Mr. Chairman. Thank you, Ranking
Member Chambliss and members of the Committee. I look forward
to working with you on this very important agenda for the
American public.
Chairman Harkin. I appreciate that very much, Mr. Gensler,
and I want to thank the members of the Committee that showed
up. I think this is one of the most important hearings that we
are going to have this year. I thank the members of the
Committee that showed up. I know everyone is busy around here,
but I just cannot think of anything more vitally important that
we are going to do this year than to address this issue.
Thank you very much, Mr. Gensler. Congratulations again.
We will call our second panel up; Ms. Lynn Stout, Professor
at UCLA School of Law in Los Angeles, California; Mr. Mark
Lenczowski--I hope I pronounced that right--Managing Director
at JPMorgan Chase & Company; Dr. Richard Bookstaber, from New
York; Mr. David Dines, President of Cargill Risk Management,
and I will yield to Senator Klobuchar for purposes of
introduction there; Mr. Michael Masters--oh, I understand he
was traveling and evidently his connecting flight was canceled
due to weather problems. He is on his way? OK.
Now Mr. Daniel Driscoll, Executive Vice President and Chief
Operating Officer of the National Futures Association in
Chicago.
If you will all take your seats, and, again, I would yield
to Senator Klobuchar for the purposes of an introduction.
Senator Klobuchar. Well, thank you very much, Mr. Chairman.
I am just here to welcome Mr. Dines to the panel. He is from
the Cargill Company, which is a very successful company located
in Minnesota, the biggest private company in the country. He
was named President of Cargill Risk Management in April 1999.
Cargill Risk Management is responsible for providing risk
management products to producers, consumers, and investors in
the agriculture and energy areas. He joined Cargill's Financial
Markets Division in 1992, and in May 1994, he was asked to help
start Cargill Risk Management, which is a new business venture
for Cargill. And so we look forward to his words today.
Welcome to Washington.
Mr. Dines. Thank you, Senator Klobuchar. It is very nice to
be here today. Thank you.
Chairman Harkin. Well, we thank you all for being here. I
know you have heard our interchange with Chairman Gensler. At
the outset, I will say that all your statements will be made a
part of the record in their entirety. I would like to ask if
you could perhaps sum it up in 5 minutes, maybe, so we can have
a round of questioning from the Senators.
I will just start in the order in which I introduced
everyone, so we will start with Dr. Stout, and then we will
move across the panel. Dr. Stout, please proceed. Welcome.
STATEMENT OF LYNN A. STOUT, PAUL HASTINGS PROFESSOR OF
CORPORATE AND SECURITIES LAW, UNIVERSITY OF CALIFORNIA-LOS
ANGELES, LOS ANGELES, CALIFORNIA
Ms. Stout. Thank you, Mr. Chairman, thank you, members, for
inviting me to testify today. My name is Lynn Stout. I am the
Paul Hastings Professor of Corporate and Securities Law at the
University of California at Los Angeles. My scholarly expertise
actually includes the theory and the history of derivatives
regulation. I also serve as an independent trustee of a large
mutual fund that uses derivatives, so I have practical
experience with the derivatives markets. And I have actually
published several rather lengthy and, at the time to many
people, I am sure, boring articles on derivatives regulation.
Please allow me to note that in these articles, which I
published in the 1990's, I predicted that deregulating
financial derivatives was likely to result in increased market
risk, reduced investor returns, and price distortions and
bubbles. I am as distressed as anyone that these predictions
proved to be correct. However, I made the predictions because
if you study the history and the theory of derivatives markets,
you will inevitably reach four basic conclusions.
The first conclusion is that, despite industry claims--the
industry seems to have a very short memory--derivatives are not
new and they are not particularly innovative. There were
derivative markets in the United States in the 19th century.
Derivatives, of course, frequently go by many different names.
The jargon that surrounds them is unnecessarily complicated. In
the 19th century, however, they were called ``difference
contracts,'' they were regulated by contract law.
I can cite to you the 1884 Supreme Court case of Irwin v.
Williar, 110 U.S. 499, which essentially held that off-exchange
derivatives were legally unenforceable unless the party
entering the derivatives trade could prove they had a bonafide
economic risk that they were hedging against. So this is not a
new issue, and the regulation of derivatives is not new.
Second, I can testify from my study of the history of
derivatives that healthy economies regulate derivatives
markets. This was true in Japan in the 15th century. It was
true in the United States all the way up until the passage of
the Commodities Futures Modernization Act of the year 2000.
Third, studying the theory of derivatives, it is true that
derivatives trading can provide some economic benefits to the
economy. Let me make a note. Clearly, derivatives trading can
provide benefits to individual derivatives traders, just as
gambling can provide benefits to individual gamblers. My
focus--and I suspect the Committee's focus--is on the public
good. And from the public's perspective, the primary economic
benefit that you can get from derivatives trading is from risk
hedging.
However, although the industry routinely claims that there
are enormous risks hedging benefits, not to mention some
offhand liquidity and price discovery benefits from derivatives
trading, my research was unable to uncover any significant
empirical evidence of the magnitude of these benefits. This is
a claim I have been seeing be made by the industry for 20 years
now. I thought I would update my research for this hearing.
They still have not generated any empirical evidence, any
statistical evidence that demonstrates that the economic scope
of these benefits is worth the costs that go along with them.
And history teaches us that unregulated derivatives markets
carry some very significant economic costs, including a very
strong historical association with asset price bubbles, a very
strong historical association with increased market risk and
the failure of institutions. This goes back 500 years. We do
not need to just focus on Orange County, Barings Bank, Long
Term Capital, Enron, AIG, and Bear Stearns.
Third, derivatives regulation has historically been
justified in part on the theory that encouraging speculation
actually reduces economic productivity by diverting valuable
resources, especially human creativity, time, and energy, away
from more productive industries that contribute more to social
welfare.
Fourth, derivatives trading is very clearly associate with
increased levels of fraud and manipulation in the underlying
markets.
Finally, the last lesson that the history of derivatives
regulation can teach us is that successful derivatives trading
regulation is possible and has been done. Generally, it has
been accomplished quite successfully through a web of complex
procedural rules that include reporting requirements, listing
requirements, margin requirements, position limits--which I
think are very important--insurable interest requirements, and
limits on enforceability.
The joy of these rules is that they can be put in place ex
ante so that derivatives traders know what is and is not
required of them and can make plans. It does not call for
excessive discretion on the part of an omniscient government
regulator, and the rules are very time tested. They have done
historically a very good job of permitting legitimate, socially
beneficial derivatives trading for risk hedging purposes while
weeding out excessive speculation, excessive risk, and
excessive manipulation.
If you will indulge me just briefly, I do think one thing
that is really worth saying is people frequently discuss how
complicated this issue is, and in the weeds, it is complicated.
But the basic problem that we face from a policy perspective is
actually quite simple. Although Wall Street surrounds
derivatives with jargon, they are essentially one thing; they
are a bet or a gamble on something that is going to happen in
the future. And when I bet on a horse to win a race, my race
ticket is my derivative contract. When I bet on the
creditworthiness of a corporate borrower, my credit default
swap is my derivative contract.
Betting can obviously be used to hedge against risk, so if
I actually own a corporate bond and then I purchase a credit
default swap, I have reduced my risk because if my bond goes
down in value, my credit default swap goes up. But it is very
important to recognize that derivatives can also be used and
are especially attractive purely for speculative purposes.
There actually is a clear economic definition of
``speculation.'' It is trying to make money not by producing
something or by providing investment funds to someone who is
producing something, but instead by trying to predict the
future better than someone else can.
As a practical matter, it can be difficult to establish
that a particular derivatives trade is speculative in nature
simply because traders are really good at making up alleged
risks that they are supposedly hedging against. However, for
200 years, regulators have succeeded in coming up with ways to
weed out true risk hedging from speculation, and this can be
done, for example, at the macro level. I simply want to cite to
you we may not know with exactitude which credit default swaps
were exact hedges and which ones were speculation.
We can be quite certain by 2008 the CDS market was
overwhelmed by speculation. We know this because the notional
value of credit default swaps in 2008 was approximately $67
trillion; whereas, the notional value of the bonds, both
mortgage-backed bonds and corporate issue bonds that the credit
default swaps were being written on, was less than one-fourth
that size. It was $15 trillion. When the derivatives markets if
4-1/2 times the size of the market for the underlying thing you
are supposedly hedging the risk of, you know the market has
been swamped by speculation with, I would say, sadly
predictable results that we are now trying to sort through
today.
So I think that is probably a good enough start.
[The prepared statement of Ms. Stout can be found on page
131 in the appendix.]
Chairman Harkin. That is a great start. OK. Thank you, Dr.
Stout.
We now turn to Mr. Lenczowski, Managing Director of
JPMorgan Chase. Mr. Lenczowski.
STATEMENT OF MARK LENCZOWSKI, MANAGING DIRECTOR, JPMORGAN CHASE
& CO., WASHINGTON, DC
Mr. Lenczowski. Thank you, Chairman Harkin, Ranking Member
Chambliss, and members of the Committee. My name is Mark
Lenczowski, and I am a Managing Director and Assistant General
Counsel at JPMorgan Chase & Co. Thank you for inviting me to
testify at today's hearing.
For the past 30 years, American companies have used OTC
derivatives to manage interest rate, currency, and commodity
risk. Increasingly, many companies incur risk outside their
core operations that, left unmanaged, would negatively affect
their financial performance and possibly even their viability.
In response to marketplace demand, financial products, such as
futures contracts and OTC derivatives, were developed to enable
companies to manage risk.
OTC derivatives have become a vital part of our economy.
According to the most recent data, 92 percent of the largest
American companies and over 50 percent of mid-sized companies
use OTC products to hedge risk.
JPMorgan's role in the OTC derivatives market is to act as
a financial intermediary. In much the same way financial
institutions act as a go-between with investors seeking returns
and borrowers seeking capital, we work with companies looking
to manage their risks and with entities looking to take on
those risks. Recently, clients, such as Chesapeake and
Medtronic, have expressed great concern about the unintended
consequences of recent policy proposals, particularly at a time
when our economy remains fragile. In our view, the effect of
forcing such companies to face an exchange or a clearinghouse
would limit their ability to manage the risks they incur in
operating their businesses and have negative financial
consequences for them via increased collateral posting. These
unintended consequences have the potential to harm an economic
recovery.
Let me first discuss some of the benefits of OTC
derivatives. Companies today demand customized solutions for
risk management, and the OTC market provides them.
Customization does not necessarily mean complexity. Rather, it
means the ability to tailor every aspect of the transaction to
the company's needs to ensure that the company is able to match
its risks exactly.
For example, a typical OTC derivative transaction might
involve a company that is borrowing in the loan market at a
floating interest rate. To protect itself against the risk that
interests rate will rise, the company will enter into an
interest rate swap. These transactions generally enable the
company to pay an amount tied to a fixed interest rate, and the
financial institution will pay an amount tied to the floating
rate of the loan. If rates rise steeply, they have some
protection and can focus on their core operations.
OTC derivatives are used in a similar manner by a wide
variety of companies seeking to manage volatile commodity
prices and foreign exchange fluctuations.
In addition to customization, the other main benefit of OTC
derivatives is flexibility with respect to the collateral that
supports a derivative transaction. In the interest rate swap
example, the financial institution may ask the company to
provide credit support to mitigate the credit risk that it
faces in entering into this transaction. Most often, that
credit support comes in the same form as the collateral
provided for the loan agreement. Thus, if the loan agreement is
secured by property or equipment, that same collateral would
also be used to secure the interest rate swap. This collateral
is high quality. It is the basis for the extension of credit in
the loan agreement. As a result, the company does not have to
incur additional costs in obtaining and administering credit
support for the interest rate swap. This is a very significant
benefit and without it, many companies will choose not to hedge
their risks because they cannot afford to.
It is important to note that although derivatives currently
are offered on U.S. exchanges, few companies use these
exchange-traded contracts for two main reasons. Exchange-traded
products are, by necessity, highly standardized and not
customized. As a result, companies are unable to match the
products that are offered on exchanges to their unique risks.
Second, clearinghouse collateral requirements are onerous, and
necessarily so. Clearinghouses require that participants pledge
only liquid collateral such as cash or short-term Government
securities to support their positions. However, companies need
their most liquid assets for their working capital and
investment purposes.
While we believe that exchanges play a valuable role in
risk management, not all companies can or want to trade on an
exchange. Currently, companies have the choice of entering into
their hedging transactions on an exchange or in the OTC market.
For most companies, OTC derivatives are critical to their risk
management, and risk management is critical to their operations
in volatile times. We believe that companies should continue to
be allowed to have the choice to use these products.
This discussion of the benefits of OTC derivatives is not
to deny that there have been problems with their use, and it is
essential that policymakers examine the causes of the financial
crisis to ensure it is never repeated. We have noticed reports
in the press that derivatives dealers are working to avoid
regulation. This is absolutely wrong. The efforts that have
been reported on are part of a 4-year effort with regulators to
enhance practice in the OTC derivatives market. The latest
letter is just the last quarterly submission outlining our
efforts to enhance market practice.
To that end, we propose the following, which is consistent
with the administration's position and Chairman Gensler's
testimony today.
First, financial regulation should be considered on the
basis of function not form.
Second, a systemic risk regulator should oversee all
systemically significant financial institutions and their
activities.
Third, all standardized OTC derivatives transactions
between major market participants should be cleared through a
regulated clearinghouse.
Lastly, enhanced reporting requirements should apply to all
OTC derivatives transactions.
JPMorgan is committed to working with Congress, regulators,
and other industry participants to ensure that an appropriate
regulatory framework for derivatives is implemented. I
appreciate the opportunity to testify, and I look forward to
your questions. Thank you.
[The prepared statement of Mr. Lenczowski can be found on
page 95 in the appendix.]
Chairman Harkin. Thank you very much, Mr. Lenczowski.
Now we turn to Dr. Richard Bookstaber. Dr. Bookstaber.
STATEMENT OF RICHARD BOOKSTABER, NEW YORK, NEW YORK
Mr. Bookstaber. Mr. Chairman and members of the Committee,
I thank you for the opportunity to testify today. My name is
Richard Bookstaber. During my career I have worked extensively
in risk management, and I was also one of the pioneers in the
development of derivative products on Wall Street. I am the
author of the book ``A Demon of Our Own Design; Markets, Hedge
Funds, and the Perils of Financial Innovation.'' That book,
published in April of 2007, warned of the potential for
financial crisis from derivatives and other innovative
products. Although I have had extensive experience in both
investment banks and hedge funds, I come before the Committee
in an unaffiliated capacity and represent no industry
interests.
My testimony will focus on reducing complexity and
increasing transparency in the derivatives markets through
standardization and exchange trading. Derivative instruments--
and I use the term to include options, swaps, and structured
products--can improve financial markets. They can allow
investors to mold returns to meet their investment objectives,
to more precisely meet the contingencies of the markets. They
can isolate and package risks to facilitate risk sharing.
However, derivatives also can be used for far less lofty
purposes, like allowing firms to lever when they are not
supposed to lever; take exposure in markets where they are not
supposed to take exposure; and avoid taxes that they are
supposed to pay. In short, derivatives are the weapon of choice
for gaming the system. These objectives are best accomplished
by designing derivatives that are complex and, thus, opaque so
that the gaming will not be readily apparent.
Such complexity, as I point out in my book, makes the
financial markets crisis prone. Complexity hides risks and
creates unexpected linkages between markets. Because
derivatives are the primary source of this complexity, to
reduce the risk of crisis we must address the derivatives
markets. We need a flight to simplicity.
The proposed centralized clearing corporation, while a
welcome step, is not sufficient to do this. It may address
counterparty concerns, but it will not sufficiently address
issues related to standardization, transparency, price
discovery, and liquidity. To do that, we need to have
standardized derivative products and have those products traded
on an exchange. Standardization will address the complexity of
derivatives. Exchange trading will be a major improvement in
transparency and efficiency, and it will foster liquidity by
drawing in a wider range of speculators and liquidity
suppliers. These steps will shore up the market against the
structural flaws that derivatives-induced complexity creates.
Now, one stated objection to standardization and exchange
trading is that having some products out in the light of day
will only increase the demand for the more shadowy and opaque
products. Another objection is that the push toward
standardization will reduce innovation. These concerns lead to
demands by some to abolish all OTC derivatives and by others to
shrink from exchange trading. There is no need to move toward
either of these two extremes. We can have a combination of
standardized exchange-traded instruments along with the
continued development of customized OTC instruments.
Abolishing OTC derivatives is not wise. There will be
legitimate reasons for customized derivatives and no doubt
innovations will emerge with broad value to the financial
markets. The point is not to stifle innovation but to assure it
is directed toward an economic rather than a gaming end.
Standardized exchange-traded derivatives will create a
hurdle for any nonstandard over-the-counter product. The over-
the-counter product will have worse counterparty
characteristics, be less liquid, have a higher spread, and have
inferior price discovery. To overcome these disadvantages, the
nonstandard OTC product will have to demonstrate substantial
improvements in meeting investment needs compared to the
standardized product. Also, and importantly, stricter controls
can be placed on nonstandard OTC derivatives. For example, the
regulator may mandate the disclosure of OTC positions and
require a demonstration of why they are being used instead of a
standard product.
While there will still be the opportunity for innovation
and for the application of the more complex derivatives, I
believe that for most legitimate purposes the standardized
products will be found to be adequate.
Now, financial institutions might have to be pulled less
than willingly into any initiative to standardize derivatives
or to move derivatives from over-the-counter onto an exchange.
They have an incentive to keep derivatives over-the-counter and
not standardized. For the bank, the more complex the
instrument, the greater the chance the bank can price in a
profit for the simple reason that investors will not be able to
readily determine the fair value. And if the bank creates a
customized product, then it can charge a higher spread when an
investor comes back to trade out of the product.
For the trader, the more complex the instrument, the more
leeway he has because it will be harder for the bank to measure
his risk and price his book. And for the buyer, the more
complex the instrument, the easier it is to obfuscate
everything from the risk and leverage of their positions to the
non-economic gaming objectives they might have in mind.
In conclusion, we should move toward standardization and
exchange trading of derivatives. And we should do this because
it is the reasonable direction to go, not as a reaction to the
current crisis and not predicated on whether derivatives were
the villains of this crisis or merely innocent bystanders.
The argument for standardization and exchange trading of
derivatives is compelling. But there remains much we do not
know. Therefore, it is important to move slowly, learning by
doing rather than pushing for quick, wholesale solutions.
There are markets that are beyond the purview of the CFTC,
indeed that are beyond our borders, so the natural pace will be
a gradual one.
Thank you for the opportunity to provide this testimony,
and I look forward to your questions.
[The prepared statement of Mr. Bookstaber can be found on
page 64 in the appendix.]
Chairman Harkin. Thank you very much, Dr. Bookstaber.
Now we turn to Mr. David Dines, President of Cargill Risk
Management. Mr. Dines, welcome.
STATEMENT OF DAVID DINES, PRESIDENT, CARGILL RISK MANAGEMENT,
HOPKINS, MINNESOTA
Mr. Dines. Thank you, Mr. Chairman. My name is David Dines,
President of Cargill Risk Management. I am testifying on behalf
of Cargill, Incorporated, and I want to thank you for the
opportunity to be here today.
Cargill is an extensive end user of derivatives and relies
heavily upon efficient, competitive, and well-functioning
futures and over-the-counter markets. One of the major
challenges for policymakers and regulators is that the term
``over-the-counter'' covers a vast array of products across a
number of markets. This broad definition highlights why it is
extremely difficult to seek a one-size-fits-all regulatory or
legislative solution that still allows all interested parties
to manage or hedge their genuine economic risks.
One major concern with the recent proposal by the Treasury
Department is that it appears to seek a regulatory solution for
all OTC products in response to systemic risk posed by one
particular market; credit default swaps.
It is important to note that while we have witnessed the
greatest economic crisis in 80 years, OTC contracts in the
agriculture, energy, and foreign exchange markets performed
well, did not create systemic risks, and, in fact, helped many
end users manage and hedge their risks during this very
difficult time.
In today's hearing, we will focus our comments on three of
the four objectives of the recent Treasury proposal. We support
the stated objectives and believe that steps could be taken to
meet these goals, without denying end users' access to an
effective and competitive market.
The Treasury Department's first objective is to prevent
activities in the OTC markets from posing risk to the financial
system. The outline seeks to apply mandatory clearing of all
standardized products and impose robust margin requirements to
meet this objective.
The imposition of mandatory clearing and mandatory
margining of tailored hedges will have a significant drain on
working capital. Mandatory margining will have the unintended
consequence of actually increasing financial risks as companies
choose not to hedge due to working capital requirements.
The potential magnitude of this drain on working capital
should be carefully weighed by all policymakers. I would like
to submit for the record a letter from the National Association
of Manufacturers as well as a recent letter from Chesapeake
Energy, an Oklahoma-based end user of OTC derivatives and the
largest independent producer of natural gas. The Chesapeake
Energy letter provides an excellent example of how imposing
mandatory margining could severely drain capital that could
otherwise be invested to grow a business.
[The following information can be found on page 139 in the
appendix.]
Mr. Dines. In the one example provided here, over $6
billion would have been taken away from running and expanding a
job-creating business, and instead be left idle in a margin
account until the maturation of the OTC contract--a contract
which had already been secured with collateral. Expand this
example across all businesses that use OTC products and the
amount of capital diverted from growing the U.S. economy would
be severe, unless companies reduced their hedging and risk
management.
There is a misconception that OTC products do not have
credit provisions and are never collateralized or margined. A
significant number of OTC transactions are collateralized,
margined, or make use of credit agreements to secure the
contract with collateral being moved daily to adjust for the
change in market value.
With regard to mandatory clearing of standardized products,
defining which products are ``standard'' and which products are
``customized'' is a complex issue that must be thoroughly
examined by the appropriate Federal regulator to avoid
disrupting market segments that continue to perform well.
The loss of tailored hedging tools will also greatly impact
the ability of companies to comply with current accounting
standards. The Treasury Department outline also indicates that
substantial capital requirements could be placed on all OTC
dealers.
There is a concern that the new regulatory framework could
be developed such that only financial institutions could remain
active dealers. The agriculture and energy hedging sectors have
active non-financial institution OTC dealers who offer healthy
competition in the market, and it would be inappropriate to
eliminate these competitors from the OTC market through
legislative or regulatory action.
To meet the Treasury Department's first objective of
protecting the financial system, regulatory requirements should
be risk based and not one size fits all. Additional monitoring
and transparency is warranted; however, restricting working
capital through major increases in mandatory margining in these
markets is counterproductive.
Objective 2: The Treasury Department's outline seeks to
impose more recordkeeping and force trades onto regulated
exchanges to promote efficiency and transparency within the OTC
markets. We recommend more recordkeeping and better disclosure,
although the regulator should be directed to focus on areas
with the greatest risks. As previously mentioned, mandatory
movement of activities from the OTC market to an exchange-
traded market does not seem warranted in those markets that
have not created systemic risks to the financial system.
Objective 3: The Treasury Department's outline seeks clear
authority to police fraud and market manipulation and the
authority to set position limits on OTC derivatives. Cargill
recently filed comments with the CFTC on a proposed rulemaking
that addresses this objective where we support position limits
for non-commercials, much greater transparency and reporting
for over-the-counter markets, and we offered detailed
suggestions for implementation.
In summary, Cargill recommends that additional legislative
and regulatory actions in the OTC market are risk based and not
treat all products identically; seek to add minimal costs and
disruptions to those products that have not posed systemic risk
to the financial system.
Two, mandatory clearing and margining would severely reduce
hedging activity, would greatly restrict working capital at a
time when it is in very short supply, and is not warranted for
OTC products that have not created systemic risk.
Third, the CFTC, through its existing rulemaking, is
proposing much needed steps and should continue to work on
ensuring the enforcement of position limits in related
exchange-traded markets, principally agriculture and energy
products, and improving transparency and reporting of OTC
products.
We appreciate the opportunity to testify today and look
forward to working with the members of the Senate Agriculture
Committee and other policymakers as this issue develops. Thank
you.
[The prepared statement of Mr. Dines can be found on page
71 in the appendix.]
Chairman Harkin. Thank you very much, Mr. Dines.
Now we will turn to Mr. Michael Masters. You did show up.
Mr. Masters. Coming from the West Coast.
Chairman Harkin. I understand you took an overnight flight.
Mr. Masters. Yes, I had a little trouble getting here with
the thunderstorms last night.
Chairman Harkin. Welcome, Mr. Masters, of Masters Capital
Management, and as I said earlier, your statements will be made
a part of the record in their entirety, and please, if you
would take 5 to 7 minutes or something like that, I would
appreciate it very much.
Mr. Masters. Sure.
Chairman Harkin. Thank you, Mr. Masters.
STATEMENT OF MICHAEL W. MASTERS, MANAGING MEMBER/PORTFOLIO
MANAGER, MASTERS CAPITAL MANAGEMENT, LLC, ST. CROIX, U.S.
VIRGIN ISLANDS
Mr. Masters. Thank you. Good morning, Chairman Harkin and
members of this Committee. The derivatives markets present
Congress with two very critical and very distinct problems;
systemic risk and excessive speculation.
Last fall, the world financial system teetered on the brink
of collapse. This near-meltdown had a catastrophic effect on
our Nation's economy, causing the loss of trillions of dollars
in retirement savings and millions of American jobs. At the
peak in 2008, the notional amount of over-the-counter
derivatives outstanding totaled over two-thirds of a
quadrillion dollars. These positions formed an interlocking
spider web of enormous exposures amongst the 20 to 30 largest
swaps dealers and represented an extreme amount of leverage
since very little margin collateral backed up these huge bets.
This unregulated shadow banking system was effectively
destroyed in the fall of 2008. It threatened to destroy the
regulated financial system with it. However, regulators pumped
trillions of dollars into the shadow banking system to allow
OTC derivatives dealers to make each other whole on their bets.
This was necessary to prevent a domino effect of dealer
collapses that would have destroyed the world's financial
system.
Congress owes it to the American people to ensure that this
never happens again. The risk of a financial system collapse
must be eliminated, not regulated. Everyone agrees that
clearing needs to take place in order to increase the
transparency of these markets. But not all clearing is created
equal. This clearing process must include two important
provisions.
First, clearing must involve novation wherein the
derivatives clearing organization becomes the central
counterparty to both sides of the trade. This will eliminate
the interlocking spider web of exposures among swaps dealers
because every dealer's exposure will be to the central
counterparty and not to each other.
Secondly, clearing must involve daily margin where every
day the central counterparty collects margin payments from
those dealers whose bets are going against them. This ensures
we never have another AIG.
If this system had been in place in 2008, then it would
have been virtually impossible for the financial system to melt
down.
Wall Street will seek to block mandatory exchange clearing
by arguing that swaps are highly customized and cannot clear.
This is false. The standard that regulators should adopt is not
one of standardization versus customization, but one of
clearable versus non-clearable. Chairman Gensler said during
his confirmation hearing that if an OTC derivative can clear,
then it should clear. Treasury Secretary Geithner said if an
OTC derivative is accepted for clearing by one or more fully
regulated CCPs, it should create a presumption that it is a
standardized contract and, thus, required to be cleared. This
is the right standard and will result in a vast majority of
swaps clearing through an exchange. Exchange clearing will lead
to price transparency, tighter bid-ask spreads, and greatly
reduced cost for end users of the swap markets. There will also
be greater liquidity due to lower trading cost and reduced
emphasis on credit concerns.
Now let us look at excessive speculation. America
experienced a bubble in food and energy prices during 2008.
This was caused by excessive speculation in the derivatives
market for these commodities. These markets have become
dominated by speculators, and prices no longer reflect supply
and demand.
Now, in 2009, the problem is once again raising its ugly
head. Today, the supply of crude oil in the U.S. is near a 20-
year high, while the demand is near a 10-year low, according to
the IEA. Yet the price of oil has risen an amazing 85 percent
this year, from the mid-30's to the mid-60's. There has been a
chorus of voices from oil market participants, economists, and
even OPEC squarely pinning the blame on speculators for
unjustifiably driving oil prices higher. If Congress allows
this to continue, then high oil prices threaten to throw our
economy back into the double-dip recession and potentially ruin
the Obama stimulus.
Your constituents are flat on their backs financially and
will not tolerate gasoline prices rising to $3 or $4 again. The
excessive speculation problem can be eliminated by imposing
aggregate speculative position limits. These limits must cover
all trading venues which will require closing all the existing
loopholes to ensure that every venue in regulated equally.
The swaps loophole is an exemption granted by the CFTC
which gives swaps dealers free rein to buy and sell commodity
futures in unlimited quantities. The best way to close it is to
mandate that all OTC commodity derivatives clear through an
exchange. This needs to happen to eliminate systemic risk, but
it also needs to happen so that regulators can actually apply
position limits. When a swap clears, the exchange breaks that
transaction into component parts and becomes the center
counterparty to both sides of the trade. This enables
regulators to see both sides and enforce aggregate speculative
position limits.
The London loophole occurs when foreign boards of trade are
permitted to trade contracts that are virtually identical to
U.S. futures contracts. The solution is simple, foreign
exchanges must be required to supply all the same data that
designated contract markets provide to the CFTC, and they must
enforce speculative position limits.
Right now, the possibility for cross-border regulatory
coordination is at an all-time high. G-8 Ministers issued a
statement last week along with OPEC calling for greater
regulation to crack down on excessive speculation in the energy
markets.
The CFTC must set the limits for all consumable
commodities, not the exchanges. Speculative position limits
should be set for the commodity as a whole rather than one
particular grade or delivery or location, for instance, crude
oil, not just West Texas Intermediate. Speculative position
limits need to be aggregated across trading venues.
In summary, the best way to eliminate the risk of another
financial system collapse is to mandate that all OTC
derivatives clear through an exchange with a novation and daily
margin. And the best way to prevent another bubble of excessive
speculation is to make aggregate speculative position limits
apply across all trading venues.
The CFTC has 70-plus years of experience regulating
exchange clearing and policing markets for excessive
speculation. The SEC and Federal Reserve have little to no
experience in these two key areas. In fact, the SEC has allowed
passive commodity investments in ETFs, ETNs, and commodity
mutual funds.
They have signed off on double-leveraged crude oil EFTs
like the DXO that allow any investor to make leveraged
speculative bets in crude oil within their retirement accounts.
This does not show good judgment from a consumer protection or
a market protection standpoint. For these reasons, the CFTC is
the best and most appropriate regulator for the job.
Thank you. I look forward to your questions.
[The prepared statement of Mr. Masters can be found on page
101 in the appendix.]
Chairman Harkin. Well, thank you very much, Mr. Masters,
for summarizing a very extensive statement you had here, which
I read last night, which I found extremely interesting.
Now we turn to our final person here. This is Mr. Daniel
Driscoll, Executive Vice President and Chief Operating Officer
of the National Futures Association. Mr. Driscoll, welcome.
STATEMENT OF DANIEL A. DRISCOLL, EXECUTIVE VICE PRESIDENT AND
CHIEF OPERATING OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO,
ILLINOIS
Mr. Driscoll. Thank you very much, Chairman Harkin, Ranking
Member Chambliss, and all the members of the Committee for
allowing us to participate here and to ask you to close a
loophole where fraudsters are able to offer over-the-counter
derivative contracts to the retail public.
NFA is the industry-wide self-regulatory organization for
the U.S. futures industry, and we also regulate over-the-
counter retail forex products. NFA is first and foremost a
customer protection organization, and we take that mandate very
seriously.
Now, the other witnesses today have talked primarily about
OTC derivative products that are offered to and traded by
large, sophisticated institutions. But I am here to tell you
that there is also a growing aspect of the OTC derivatives
markets that is directed toward the retail public, and those
customers are being victimized in a totally unregulated
environment.
Now, for many years, retail participants in the futures
markets have enjoyed all of the benefits of the Commodity
Exchange Act. Their contracts were traded on regulated
exchanges and cleared by regulated clearing organizations.
Their brokers had to meet the fitness standards of the Act and
were regulated by the CFTC and NFA. However, today, there are
too many customers that do not receive any of the benefits of
regulation, and we need to do something about that.
The main problem stems from a court case often referred to
as the Zelener case, which was a Seventh Circuit Court of
Appeals Case involving a CFTC enforcement case alleging forex
fraud. In that case, the district court ruled that the
customers were, in fact, defrauded but that the CFTC did not
have jurisdiction because the contracts were not futures
contracts.
In that particular case, the contracts were offered to the
retail public for speculative purposes. They were rolled over
and over again so that delivery never took place. Basically
they were the functional equivalent of a futures contract.
Unfortunately, the Seventh Circuit ignored those
characteristics and ruled that the written contract itself
should determine the nature of the contract, and because the
contract did not guarantee a right of offset, they ruled that
they were not futures contracts, and the CFTC lost that
particular case. There were other courts that followed the
Zelener decision and came up with similar rulings over the next
several years.
Last year, Congress closed the forex loophole but,
unfortunately, the loophole is not limited to forex so that
customers dealing in other OTC products, such as gold and
silver, are still in a regulatory mine field, and we need to
bring regulatory protections to those customers as well.
Back in 2007, NFA predicted that if Congress plugged the
Zelener loophole for forex but left it open for other products,
the fraudsters would simply move over to Zelener-type contracts
in other commodities, and that is exactly what has happened.
Now, we cannot quantify the exact numbers of that fraud because
these firms are not regulated and are not registered. But we
are aware of dozens of firms that offer Zelener contracts in
metals and energy.
Recently, we received a call from a man who lost over
$600,000, substantially all of his savings, investing with one
of these firms. We have seen a sharp increase in customer
complaints and mounting customer losses involving these
products since Congress closed the loophole for forex.
NFA and the exchanges have previously proposed a fix which
would close the Zelener loophole for these non-forex products.
Our proposal codifies the approach the Ninth Circuit took in
CFTC v. Co-Petro, which was the accepted state of the law until
Zelener. In particular, our approach would create a statutory
presumption that leveraged or margined transactions offered to
retail customers are futures contracts unless delivery is made
within 7 days or the retail customer has a commercial use for
the commodity. This presumption is flexible and could be
overcome by showing that delivery actually occurred or that the
transactions were not primarily marketed to retail customers or
were not marketed to those customers as a way to speculate on
price movements.
This statutory presumption would not cover securities and
banking products, it would not interfere with inter-bank
currency markets, and it would not cover the retail forex
contracts that are already covered or exempt under Section
2(c). I would also say that our proposal would not invalidate a
1985 interpretive letter issued by the CFTC, which Monex and
other similar firms currently rely on to sell gold and silver
to their clients. Essentially, that letter set forth a factual
pattern which culminated in the actual delivery of the precious
metals within 7 days and title to those metals going over to
the retail customer so that it would not be covered under our
statutory proposal.
In conclusion, while we support Congress' efforts to deal
with systemic risk and create greater transparency in the OTC
markets, Congress should not forget that there is a very real
risk to the retail public participating in another segment of
these markets. The Committee can play a leading role in
protecting customers from the unregulated boiler rooms that are
currently taking advantage of the Zelener loophole for metals
and energy products. We look forward to further reviewing our
proposal with Committee members and staff and working with you
on this important matter.
Thank you.
[The prepared statement of Mr. Driscoll can be found on
page 77 in the appendix.]
Chairman Harkin. Thank you very much, Mr. Driscoll. Thank
you all for your testimony. I cannot help, Mr. Driscoll, but to
comment upon your statement. I offered an amendment on the last
farm bill to close Zelener. We passed it in the Senate.
Mr. Driscoll. Yes, thank you very much.
Chairman Harkin. Well, we did it, and we went to conference
and lost it in conference. All we were able to keep out of that
was just the forex contracts that you are talking about. Again,
I think that was a mistake, and I said so at the time. But it
did not have the votes. So I am glad to hear your testimony
again today calling for a broader closure of the Zelener
loophole that the Seventh Circuit opened up for everybody. It
went beyond currency, and they applied it to everything else.
So I appreciate your comments today, and hopefully maybe if we
move some legislation this year, we can also finally close that
loophole.
Mr. Driscoll. Thank you, Senator Harkin.
Chairman Harkin. I just could not help but comment on that.
It seems like everyone here is basically saying that there
is a legitimate need for derivatives trading, I think, if I am
not mistaken, but that it would be well regulated, transparent,
but there is some need for some liquidity in the marketplace
that might be provided by that. I am reminded of what one
person said to me, a Congressman said to me, a former
Congressman said to me one time about liquidity. He said, ``You
know, liquidity is good, but too much liquidity can be bad.''
He said, ``It is like I take an aspirin every day. My doctor
says I should take an aspirin every day for liquidity. But if I
took a whole bottle every day, it might be kind of dangerous to
my health.'' So I have often thought about that kind of
analogy.
I also think about the analogy that Dr. Bill Black
testified to last fall when we had our first hearing on this.
Someone had commented upon, well, we do not want to stifle the
free flow of capital, to which Dr. Black responded, ``Well, I
do not know,'' he said, ``if we really want the free flow of
capital; maybe we want the more efficient flow of capital.''
And he used the analogy of traffic flow.
He said, ``You know, if we want the free flow of traffic,
do away with all the stop lights. Do away with the stop signs.
Do away with the speed limit signs. You will have a very free
flow of traffic. But you are going to have a lot of wrecks.''
And he analogized that to the financial markets, that we need
regulation, we need the stop lights and the slow-down signs and
the danger signs and things like that, not so much for the free
flow of capital, but for the more efficient flow of capital.
Now, with that as a backdrop, I understand the need for
liquidity. I also appreciate, Dr. Stout, your testimony. A lot
of this gets clouded in jargon. We say, oh, this is complex and
all that. But it kind of boils down to certain essentials all
the time. And I will start here with what Mr. Lenczowski
testified to, and that is that many banks relied on credit
default swaps instead of fully meeting capital requirements.
So we have heard a lot of discussion here about, well, we
should not have to come up with capital requirements too much.
I think maybe Mr. Dines maybe testified to that; I think maybe
somebody else did, that requiring too much capital requirements
might stifle the transactions and the more open flow of capital
and hedging. But many banks relied on these credit default
swaps instead of meeting the capital requirements under the
Basel II rules--I had to learn this, too, what Basel II was--
thus contributing to the buildup of excessive leverage and
risk.
So I guess a question for all of you basically is this; how
do we control the risk to the financial system and our broader
economy when institutions rely on derivatives too much and we
do not have as much capital coming forward? So that is really
what we are trying to wrestle with here.
Now, again, I will make another statement as sort of a
backdrop to what I am getting at here. There have been a couple
of articles in the Wall Street Journal and New York Times
recently, and they concluded that the banks and other over-the-
counter swaps dealers oppose certain reforms for the basic
reason that the greater transparency and disclosure involved in
exchange trading would impair their ability to make profits.
That is, if the parties on the other side of transactions had a
better idea of what prevailing prices are for swaps, then the
banks and swap dealers would not be able to charge as much as
they can if they kept them off the exchange, in the dark and
out of sight.
I want to state emphatically I am not opposed to the
financial sector making profits. They have done very well in
the last few years, I might note, but I think there is also a
countervailing tremendous public interest at stake here. When
we have to come up with $4 trillion to rescue the economy, a
bill that we will be paying and our kids and our grandkids will
be paying for some time, then I think it argues that we have to
balance this desire for making profits, which is fine, with the
countervailing balance of the public interest here.
So I do not see this as a really complex issue. What it
basically is, on the one hand we have the public interest in
protecting the economy from these risks; on the other hand, the
quest of the financial sector to make maximum profits. And to
me that is just how I see it. It is not much more complex than
that. And as I delved more into derivatives and credit default
swaps, I then found out that all these things, whether they are
credit default swaps, collateralized debt obligations,
collateralized mortgage obligations, all these things, hardly
any of those existed before 1990. Most of them came up in the
1990's.
I keep asking the question; where was the demand? Where was
the demand for these products? I found out there really was not
any, just that these quants that I referred to earlier came up
with ingenious ways of slicing and dicing all these little
derivatives, these tranches, and no one really knew what the
value of them was.
I have often said jokingly that I never knew when I was
growing up that someday I would need Honey Nut Cheerios. I
thought Cheerios was just fine. But all of a sudden, I found
out I need Honey Nut Cheerios. Well, that is OK. I do not mind
that. That is an innovation. They were able to sell that, no
one is hurt, that is fine. But if innovation in this financial
sector does not pertain to some underlying value or benefit to
the goods and services of the GDP, then it just seems to me to
beg for more regulation and oversight.
I did not mean to go on so long on that, but if I had a
basic question for all of you, and I will just go down the
line; how do we balance this off? How do we provide for
liquidity, the aspirin a day but not a bottle a day? How do we
provide for innovation that might pertain to underlying value,
but not innovation that just allows someone to gamble and make
a lot of money, and keep our markets regulated in the public
interest, how do we balance those off?
Dr. Stout.
Ms. Stout. I think that history gives us some very good
guidelines because we actually did that pretty well be 1933 and
1934 and the mid-1990's. And I think the legislation that you
are proposing, which in many ways reinstates some of those old-
fashioned, time-tested, highly successful strategies, is a very
good start.
I want to just point out, it is interesting, Simon Johnson
of the MIT Sloan School has estimated that between 1973 and
1985, the finance sector of the U.S. economy accounted for 16
percent of corporate profits, and that in the last decade that
has increased to 41 percent of all corporate profits were
earned by the finance industry.
Although I do not have the exact breakdown, I suspect that
many of those profits were actually trading profits earned by
hedge funds and by the proprietary divisions of investment
banks. Where did they come from? I will simply point out that
hedge funds were earning between 10 and 20 percent annual
returns over the last decade. Average investors, who are my
investors--I am a trustee of a mutual fund; that is the Moms
and the Pops who buy our mutual fund interests--they got 3 to 4
percent a year. I do not think that you can assume that is a
coincidence.
Chairman Harkin. Mr. Lenczowski, how do we balance these?
Mr. Lenczowski. Well, first, thank you, again, Chairman,
for allowing me to testify. I think first I would to state that
at JPMorgan we broadly support the initiatives of the
administration and of Chairman Gensler to undertake regulatory
reform.
Chairman Harkin. By the way, I would be remiss if I did not
compliment JPMorgan because you are the ones back in the 1990's
that did not get involved in that credit default swap mess. And
I think you were very prescient on that, so I would be remiss
if I did not compliment you on that.
Mr. Lenczowski. On behalf of our institution, thank you.
But to go back to the points you were making, Chairman
Harkin, the first thing on capital, and I think just to state
as a bank we are subject to very stringent capital requirements
already, and I think, if I might, the capital that Mr. Dines
was referring to and perhaps Senator Chambliss referred to
earlier, we are talking about capital that is coming out of
non-banks, out of the end users, the companies in our country
that create jobs. And if they were to trade on exchange--which
they currently have the right to do, but if they were to be
forced to trade on an exchange, they would have to take capital
out of their corporations and pledge it to the exchange. That
is the way the exchange operates.
So when we talk about a drain on capital, it is not our
capital. It is the capital of companies like Cargill,
Chesapeake, and they told you how much that would be. It is
billions of dollars.
The other point I would make, Chairman Harkin, on demand,
the history of the over-the-counter business has been one that
has grown in response to customer demand from the relaxation or
the dropping of the gold standard in the 1970's and responses
to oil price shocks and inflation led to unprecedented
volatility in currency rates, in interest rates. This is what
led to the interest rate and currency markets to grow, to serve
customer needs. These are markets that exist to serve
customers, and we serve as a financial intermediary.
You mentioned CDOs. In the early part of this decade, we
had a time of very, very low interest rates, of investors
looking for enhanced yield and willing to take on extra risk.
And the CDO market, the CMO market, and many other structured
markets arose in response to the investor demand for higher
yield with higher risk. We have seen what has happened as a
result of the collapse in real estate prices.
Last, I would just close, this part at least, by saying
that, again, we support clearing. It is an important tool that
we currently use. We derive great benefits from it, from credit
risk reduction and an operational standpoint, but we think it
would be a mistake to impose that kind of a one-size-fits-all
requirement on our economy.
Chairman Harkin. Dr. Bookstaber.
Mr. Bookstaber. I would disagree to some extent with the
last statement. I believe that there is a component of the
development of ``innovative products'' that is very much along
the lines of what you, Mr. Chairman, depicted, where the banks
or investment banks realize that if they can differentiate
themselves, that if they are selling something that other
people are not selling, and if it is sufficiently complex, they
can price it in a way that people will have difficulty
understanding if it is fairly priced or not, and they will be
able to trade it with a higher spread because the client does
not have many other avenues for trading. So liquidity basically
is a negative aspect and complexity is a positive aspect when
it comes to profit for the bank or the investment bank.
On the other side, as I think you also pointed out, part of
the investor demand that has come for some innovative products
has occurred along the ``Hey, I got a problem'' sort of
approach; that is, somebody is trying to say, ``You know, I
want to lever but I am not allowed to lever. Can you help me
out here?'' And on that basis, you get new innovations that are
helping for these gaming purposes.
I believe that there is a need for innovation, that we can
have innovation, but regulators need to, No. 1, find a means to
have innovation that is directed toward economic purposes as
opposed to gaming purposes. And I do not know the proper method
for doing that. I think that it is clear that we need to have
capital, margin, haircuts, whatever sort of method is used, to
back derivatives and other exposures rather than having them be
off balance sheet without sufficient capital background.
I agree also with one point that Mr. Dines said, that it is
reasonable to have a distinction between different types of
products, though not on the basis of what caused a problem in
the past versus what did not, because we do not want to drive
through the rearview mirror. But there are some products in
some markets that inherently are more systemic by nature.
Interest rates and currencies are just by nature going to be
more systemic than corn, wheat, and commodities of that type.
So we more urgently need to have the ability in those markets
to control and to aggregate so that we can detect patterns of
crowding that may move us from having an issue where it becomes
systemic because many firms are all on the same side of the
boat.
Chairman Harkin. Thank you very much, Dr. Bookstaber.
Mr. Dines.
Mr. Dines. Thank you. I guess I would start by just
confirming what was said by the other panelists, and what I
said in my testimony is that we, again, do not believe that you
can take a one-size-fits-all approach to solving this. The
regulatory changes that apply to credit default swaps may not
be and I do not think are appropriate for the energy and
agricultural markets. We believe that there should be greater
transparency and reporting to the regulators, and we have said
that we think that there should be position limits for non-
commercials.
We believe that this will go a long ways toward solving the
issues. We do not think that mandatory margining and clearing
is necessary, and we think that will have unintended
consequences of reducing people's hedging, companies' hedging,
and that will cause significant risks.
Chairman Harkin. Unless I misinterpreted what you said, Mr.
Dines, you are basically proposing that we separate financials
out from commodities.
Mr. Dines. I am saying that we need to take a different
approach to these different segments, and what might be
appropriate for credit default swaps may not be appropriate for
the energy and agriculture markets. I think some do have more
systemic type risks than others.
Chairman Harkin. Yes, I understand.
Mr. Dines. OK. Thank you.
Chairman Harkin. Mr. Masters.
Mr. Masters. Thank you, Senator. I think there are two
parts to the question. One is liquidity and one is innovation.
First of all, let us just get out the word ``innovation.''
Innovation is a word that Wall Street uses to talk about
anything they do in the financial markets. Innovation by itself
has sort of a positive connotation when people think about
innovation. But innovation is not always good. You know, Ford
had the Edsel. There have been many, many products developed in
our economy over the last few hundred years that were not good
products. Why is it that everything that Wall Street creates is
a good product? There are a lot of bad products. So I would
just like to get that out to begin with.
In fact, I would argue that since many of these innovative
products affect consumers in a very direct and a very real way,
including loss of jobs, savings, and so forth, where is the
financial FDA for this? You know, who is looking at what the
aftereffects of these products are? Because it is certainly not
Wall Street. They are just looking at their bottom line.
With regard to innovation itself, the exchanges themselves
have produced plenty of innovation as well. It has not just
come from the over-the-counter market.
So, at any rate, I would just like to get that out, but
with regard to liquidity, one of the things that some of the
folks that have testified have mentioned is the whole issue on
financing cost for corporations, and what many may not realize
is that those financing costs are borne by someone. When you
buy a swap from someone, the other side of that swap, if it is
a large investment bank, those funds are not free.
So all that financing cost that people say, oh, we are
going to have financing cost and margin and so forth, you are
already paying that if you are an over-the-counter customer to
a bank. You just may not see it. In addition, you are paying
other things that you may not see, notably, profit margins.
So the issue that we argue with regard to mandatory
clearing for standardized derivatives is--I think you would
actually lower the costs because you would have more people
that would be able to trade with each other with regard to
swaps. You would increase the liquidity. You would certainly
lower the bid and offer. And so I actually think that, contrary
to raising costs for corporations, you would actually lower
costs for corporations ultimately.
We had that experiment with the New York Stock Exchange
when bid offers went from eighths to quarters and halfs to
decimals, and volume has tripled and liquidity has tripled. So
I think you look at that example and you have a better idea of
really what the future could be, and you have many, many more
participants in the market, not just investment banks, that are
allowing liquidity.
Chairman Harkin. Excellent point. Thank you.
Mr. Driscoll.
Mr. Driscoll. Chairman Harkin, I have been a futures
regulator for almost 40 years, and I can tell you that when I
first started out--this is sort of the flip side of the
innovation angle--there were no such things as interest rate
products in the futures markets; there were no stock index
products. The whole panoply of products out there that I think
everyone, without exception, agrees are very valuable, not only
to the futures markets but to the participants in the futures
markets and to the American and the worldwide economies. So
there obviously is a plus side to innovation.
From the regulatory standpoint, I believe that it is key
that all of these markets be subject to a prudent level of
regulation. It does not mean that every market has to have
exactly the same regulations. Equity securities and futures do
not have exactly the same types of regulations. And I think the
focus on systemic risk and transparency by Congress, the
administration, and the CFTC is exactly the right one.
I am a big proponent of clearing organizations and
exchange-traded markets. That is primarily what we regulate. So
anything that can be done to encourage moving as much business
as feasible onto regulated markets and to have those
instruments cleared would be a positive thing, recognizing that
I am--and I am not the biggest expert in that area--that I am
sure that there are any number of more non-standardized
products that would be difficult to put on an exchange.
Thank you.
Chairman Harkin. Thank you all very much. I took an
inordinate amount of time with that, but I yield to my friend
Senator Chambliss.
Senator Chambliss. Let me start with you, Mr. Lenczowski.
You mentioned in your written testimony that the industry is
seeking to clear more credit default swaps. Would you expand on
other ongoing efforts to curb systemwide risks relative to CDS
in addition to the clearing?
Mr. Lenczowski. Yes, thank you, Senator. Over the past 4
years, the dealers have been working with investors to come up
with market improvements for the credit default swap market,
and several of those improvements have been made. First, the
amount of undocumented trades has been drastically reduced.
There have been protocols agreed as to the way to treat
novations or transfers of trades. There has been a huge
improvement in the amount of trades that are electronically
confirmed, which significantly decreases operational cost.
Then just recently, there has been a major change and
restructuring of the way that the market operates so as to
standardize cash settlement as the form of settlement of credit
derivatives and to standardize all economic terms, essentially,
for credit default swaps.
The result is that the product has become standardized to
the point where we think that more and more over-the-counter
credit default swaps will be cleared. The ICE U.S. Trust
Clearinghouse started operation earlier this year already
clears over $800 billion of CDS transactions. That number is
going to grow. Old trades are being backlogged into the system
to further increase the pervasiveness of clearing. So the
entire progression of the market has been toward increasing
clearing, increasing transparency, additional recordkeeping and
transparency from the standpoint of pricing, prices are now
available on the Internet, freely accessible for the largest
entities that are traded.
So it has been a steady progress working between dealers
and investors, working with the regulators to improve the
market.
Senator Chambliss. Does your firm use the ICE OTC clearing?
Mr. Lenczowski. Yes, we do.
Senator Chambliss. How is that working from a practical
standpoint?
Mr. Lenczowski. It has been working very well. Again,
clearing is distinctly in our interest to do. When the
transactions are standardized and when counterparties to our
transactions are able to clear, we derive great benefits from
clearing. And we have used the ICE clearinghouse for credit
default swap clearing, and we also use other clearinghouses for
other asset classes. So, for example, in the interest rate swap
market, we use the London clearinghouse called LCH Clearnet,
which clears a huge volume of interest rate derivative
transactions. Something like 50 percent currently of the
dealer-to-dealer swaps are cleared. And in the commodity
markets, we are clearing through facilities operated both by
ICE and by the CME group called ClearPort.
So all this evidence is a move toward clearing. We think it
is--amongst the dealers, it is definitely in the interest of
everyone to reduce risk, to increase transparency.
Senator Chambliss. There seems to be a perception out there
that the only derivatives that need to be customized are the
very complex and most complex products. Are there not simple
foreign currency or interest rates swaps that still need to be
customized for your clients?
Mr. Lenczowski. Yes, absolutely. And actually Chairman
Gensler earlier described one of those transactions, a simple
interest rate swap which has been around now for almost 30
years, is very well understood, not a complicated transaction
at all. But it is extremely customized as to every economic
term, and that is to give the end user, the company that is
entering into that swap, the maximum hedge for its risks, and
also to get the best accounting treatment. An entire accounting
framework has grown up around derivative transactions and
hedging transactions, and over-the-counter instruments are the
best way for companies to take advantage of that accounting
framework.
There is another example I could cite. Chairman Harkin was
looking for examples of why something has to be done over the
counter. In the natural gas markets, at this point dozens of
public utilities engage in long-term natural gas purchase
contracts where they are able to procure natural gas at prices
below the prevailing market price on a monthly basis for the
next 15 to 20 years. These are very long term purchase
contracts, and they are able to do that through the use of
over-the-counter natural gas and interest rate derivatives.
These are contracts that ultimately benefit millions of
consumers of natural gas, customers of these utilities. They
are well understood. They are approved through the Tax Code
amendments passed in 2005, and they serve an incredible benefit
to communities throughout the U.S.
Senator Chambliss. There has been a lot of conversation and
critique of the markets over the past year with respect to what
is called ``excessive speculation,'' and that speculators drove
up the physical commodities to record high prices. Now, you
deal in the market on a daily basis, I assume sometimes as a
speculator, sometimes not. Explain what you see with respect to
speculation, why it is necessary and what is happening with
regard to this issue of excessive speculation.
Mr. Lenczowski. Yes, Senator. And I might preface it by
first saying that we strongly support efforts to combat and
prosecute manipulation. Market manipulation is in no one's
interest, and certainly from a market participant standpoint,
it is extremely detrimental to all of our activities. And----
Senator Chambliss. Obviously, there is a difference between
manipulation and speculation.
Mr. Lenczowski. Yes, and speculation is necessary for
markets to perform. To take a very basic example, the farmers
of this country, when they farm grain, will need to sell it
ultimately to bakeries, for example. The baker and the farmer
need to match up, one to sell grain, the other to purchase
grain. The chances of them matching exactly for all of their
purchases are extremely low. Speculators expand each side of
that market. They buy and they sell. And they provide the
liquidity that is necessary for markets to operate. So all
markets require some degree of speculation. Excessive
speculation certainly is something to be combated, and we would
support that.
Senator Chambliss. Mr. Dines, you deal in the markets every
day with respect to risk management tools that you use in your
business. I would like for you to give us a practical example
of one of these customized contracts that you use. And if those
customized contracts were not available to you at Cargill, what
effect would that have on your business?
Mr. Dines. Happy to do so. Thank you.
Everyone here knows that Cargill is a processor of corn,
and we are in the markets buying corn every day. In essence, we
are buying corn at the average price over a given period since
we are in buying it every day.
The best hedge for us if we wanted to protect against
prices going higher would be a product against the average, not
a product against a discrete point in time, which is what you
can get on the exchange.
We can go into the OTC markets and buy what is known as an
average price option. An average price option comes at a 30-to
40-percent discount to what is available on the exchange. It is
a more precise hedge for what we need because it is against the
average. It is real cost savings up front, and this cost
savings might be the difference between what gets us to hedge
and what does not get us to hedge. So that is a real example.
Now, we cannot go in and buy that product on the exchanges.
Average price options do not exist. Furthermore, in the OTC
markets, we can tailor that product to give us the exact level
of protection that we want and for the exact end date that we
want. Let us say that we wanted to do it on new crop corn, but
we only wanted to go through the pollination period of July. If
we went to the exchange, we would have to buy a product that
ends in November. We could tailor this product to end in July.
We are saving ourselves 4 months of time value of extra cost
that goes into that product.
So those are real examples of the types of things that you
can do in the over-the-counter market that you cannot do on an
exchange-traded type market.
Senator Chambliss. What if that were not available to you?
What would be the effect of that unavailability?
Mr. Dines. It would be a far less precise hedge and a more
costly hedge, and I know you would find market participants
doing less hedging because of the costs.
Senator Chambliss. We talked earlier about position limits
and increased margins and what-not, and I think you used the
phrase that this could create--would create a real drain on
working capital.
From the standpoint of Cargill, do you have any idea of
what kind of conceivable working capital drain you would be
looking at for the volume that you do business in every day?
Mr. Dines. I think at times it could be significant. I
guess maybe I would take you back to last March when we and
other grain companies actually had to stop buying deferred
grain from farmers, because of the run-up in grain prices and
the demands on working capital to cover margins calls. Luckily,
we were able to move some of our hedges to the OTC markets
where we were able to put in place alternative credit
arrangements and become reopened for business. And I think the
important point here is that we would like to have the
flexibility.
We do plenty of hedging on the exchanges. We do lots of
hedging in the over-the-counter markets. The idea for us is
that we like to have the flexibility, and that is very, very
important for Cargill, but I do not have a number in mind, but
I could tell you it would be significant.
Senator Chambliss. Mr. Masters, you have conducted an
analysis in which you extrapolated data from CFTC's commitment
of trader report to determine speculative activity in the crude
oil market. Your analysis seems to assign values based upon
index fund portfolios.
Now, do you assume that speculative activity was primarily
occurring only in the index funds as opposed to the single-name
commodities?
Mr. Masters. Thank you, Senator. We are assuming that the
index funds were a primary participant last year with regard to
commodities. There were also speculators in single-name
commodities as well. We looked at the index fund data that was
provided from the CFTC.
Senator Chambliss. Well, what data is used to support your
assessment that oil prices should have been falling last year
when most expectations and market analyses showed prices
continually increasing throughout the year due to geopolitical
uncertainties, record OPEC stocks, a devalued dollar, and the
increase in demand during the summer last year?
Mr. Masters. That is a good question. The issue with regard
to prices in the futures market has to do with the supply and
demand of futures. In the grains and the oil markets, the
futures price is the price that determines spot, unlike other
derivatives, unlike many other markets. You know, Platts, who
is the largest spot pricing service, says in part, ``We price
off futures markets.'' Many spot market participants we talked
to said, ``We almost entirely price off futures markets off
some basis.''
So I think that what we did was we looked at the money
flows going in and the money flows going out, and our sense was
based on the data that there was an enormous amount of money
going into the crude oil markets over the time, and after
Congress looked at this issue and I think started really
complaining about it to a certain extent, I think it led a
great deal of money to come out of those markets, none of which
had much to do with actual supply and demand. They amplified
the price on the way up, and they greatly amplified the price
on the way down.
Senator Chambliss. Mr. Bookstaber, we talked with Chairman
Gensler about the responsibility for determining whether or not
a product is standardized or customized, and we talked about
the clearinghouse that is going to clear it being the
determinant of that.
What is your thought about that, are they the proper ones
to determine whether something is customized or standard?
Mr. Bookstaber. The notion of standardization is a fairly
loose one. The key is whether you can construct sufficient
tagging for the product so that many other products can be put
into the same basket and traded in a similar way. You know,
ultimately the decision for standardization will be if it is on
an exchange, is it sufficiently different from other products
that people gravitate toward it as an item to trade? I do not
know who the authority would be to say, oh, this is standard
versus this is customized. It is something that still has to be
defined.
Senator Chambliss. OK. Mr. Driscoll, in talking about the
Zelener fix, as the Chairman says, we had a very significant
discussion on this issue last year during the farm bill debate,
and we addressed the concerns of the lookalike forex contracts,
and I am not sure in your statement that you made earlier,
where you said that there has been an increase in the number of
complaints since Congress closed the loophole, whether you are
talking about since the farm bill was enacted last year or are
you referring to some previous date where a loophole was
closed?
Mr. Driscoll. I was referring to last year in the farm
bill. We have seen a large increase since a year ago today.
Chairman Harkin. You mentioned gold and silver as
commodities where there is the potential for fraudulent
transactions. Any other commodities that need to be considered
in that same respect?
Mr. Driscoll. Precious metals are by far the largest
product that is being used in these non-forex Zelener type of
contracts, but we have also seen energy type of products as
well. And our view is that essentially you have to close the
loophole for all commodities that are traded in futures markets
because if you close off the ones that are currently existing,
then next year we will be coming back and saying the fraudsters
have now gone to other markets, because the people that trade
these sorts of contracts and run these sorts of schemes are
ones that are looking for a regulatory vacuum, and they have
made careers of doing this. So we believe the loophole has to
be closed for all commodities.
Senator Chambliss. Ms. Stout, do you feel that all OTC
markets create a systemic risk?
Ms. Stout. No, probably not. I think something--that is
actually a question that is not even necessarily something we
have to address. I think a proper system of regulation of
derivatives trading would prevent systemic risk from arising in
any particular market. And I personally tend to favor what I
think of as automatic circuit breaker rules of this sort rather
than regulation that takes the form of creating some omniscient
entity, some omniscient Government oversee who is supposed to
investigate things on an ad hoc basis and look for potential
problems.
I think with the right set of circuit breakers, the sorts
that have been mentioned today--listing requirements, margin
requirements, position limits--we do not have to worry about
looking out for the development of systemic risk in particular
markets because the system would look out for us.
Senator Chambliss. Do you agree that some risk in markets
is a good thing?
Ms. Stout. Pardon me while I put on my pointy headed
corporate finance professor hat. No, risk is never good.
However, sometimes risk is inevitable if you want to accomplish
something useful, like curing cancer or building a company that
builds airplanes. But, no, risk itself is never good. We would
like to get rid of all of it, if we could, and the real trick,
I think, is to eliminate all the unnecessary risks while not
throwing the baby out with the bath water and eliminating risk
in productive areas and with regard to productive endeavors
that we want people to undertake.
Senator Chambliss. Well, having been in business myself, I
have never made any money without taking a risk, and I just
think it is extremely difficult and would be extremely
expensive if we tried to take the risk out of it.
Mr. Chairman, I think that may be--I think that is all I
had.
Chairman Harkin. Thank you very much.
Mr. Masters, in your summary, you said, ``What I have
outlined in my testimony are not brand-new solutions; one,
exchange clearing with novation and margin and, two,
speculative position limits have proven effective over many
decades of experience. In many ways, what we need to do is turn
back the clock on several of the deregulatory measures that
were undertaken in the last 15 years. The unintended
consequences of those deregulatory decisions have been
devastating for America.'' I agree.
Now off of that, I want to challenge you, Mr. Dines, on
what you just outlined on this average price option. You say it
is not offered by the exchanges. Well, why is it not offered by
the exchanges? We have a chicken-and-egg thing here. See, now,
I have said we ought to put all these on exchanges, you see.
Well, if you are allowed to have them on over-the-counter
markets, that is where they are. But who is to say that this
average price option could not be developed as a product on a
regulated exchange? That way you have more transparency, you
would have more people involved, you would have more liquidity
because you would have more people in that game. But as long as
we have it in the over-the-counter market, with some
opaqueness, lack of transparency, of course, the exchange is
not going to offer it.
I had Mr. Duffy here last fall when we discussed this very
thing, and I asked him that pointed question. I said in terms
of my legislation, to put them on a regulated exchange, I asked
him very pointedly. I said could your exchange--could the
regulated exchange, not just his but the regulated exchanges
handle this, and his answer was yes.
So, again, I have always asked, I keep asking this
question--I asked two questions. One, define a customized swap.
I still have not had one real defined yet, what is customized
that does not have some impact someplace in the economy. If you
have a customized swap on an interest rate or something like
that, it may be between two individuals, but it may have other
effects on a lot of other investors in other places. The same
way with your hedging on the corn market. It could have a lot
of effects.
I would submit that if you have it on a regulated exchange
with more transparency and people know about it, quite frankly,
I think your business will do better. I, quite frankly, think
it will, and I think that the sellers will also do better, too,
because it will be open and aboveboard. And we can call for
margin requirements. Now, you had this problem with capital
requirements. But that can be set. We can temper that, I think,
through regulation on not having onerous capital requirements,
but having some capital requirements, putting some skin in that
game.
So, again, I want to challenge you on why you cannot do
this on a regulated exchange.
Mr. Dines. Well, you could put average price options on
exchanges. That could very well happen. But the degree of
customization goes beyond that, and it goes to protection
periods, it goes to protection levels, it goes to maybe how the
average is determined. And the issue is that you can have
multiple, multiple different variations of an average price
option.
I want to be very careful. It does not mean that they are
more complex. It means that they are tailored to precisely meet
that hedger's needs.
I think it is impossible for the clearinghouses and the
exchanges to do this. I do not think they can handle multiple
forms, and the OTC market does it. We do it every single day.
Our customers will say I want it to expire this particular day,
I want it with this protection level, I want the averaging
period to start here and end here. And to put that on an
exchange will require standardization.
You go into the exchanges today, you can pick from a
certain set of end dates. You can pick from a certain level set
of protection levels. But you do not have the degree of
customization you cannot customize. They just are not set up to
do it.
So that I think is the primary difference. It is the
ability to really work with customers to customize the product.
Chairman Harkin. Dr. Bookstaber.
Mr. Bookstaber. I think a good example of the distinction--
the gray area between standardized and customized is the
equities option market. The CBOE is, as exchange traded. In
that market you cannot get an exercise price of, say, 51.3.
Chairman Harkin. Say that again? You cannot----
Mr. Bookstaber. The exercise prices for the options are in
increments, maybe 5-or 10-point increments.
Chairman Harkin. OK.
Mr. Bookstaber. So somebody could argue, wait a minute,
this is not fulfilling my objective because I do not want an
exercise price of 50 and I do not want an exercise price of 55;
I want 52.23.
Well, of course, if you go to customized, the
standardization is going to limit things to some extent, but
the challenge is to go to Cargill, to go to the clients of
JPMorgan, and to say let us look at the whole layout of the
customizations that you do. Can we find a reasonable set of
standard securities that get close enough to what people want
that in the majority of cases they are fairly satisfied? Maybe
somebody wants a time to maturity of 11.1 months, and another
wants it of 10.9 months; 11 months might do the job for them.
So it is true that you cannot get standardization to meet
every of the infinite possible numbers of times to maturity and
the infinite number of possible exercise prices. But once you
get to fine enough differentiation, that may be sufficient to
deal with the large majority of what people demand.
Chairman Harkin. Mr. Lenczowski.
Mr. Lenczowski. Thank you, Chairman. I would agree with Dr.
Bookstaber that there could be a degree of standardization that
is achievable. But even with that standardization, the company
that is looking to hedge its risk will still have to post the
margin to the clearinghouse. And you mentioned, Chairman, that
we could maybe regulatorily affect that margin. It is actually
incredibly important that that margin be what the clearinghouse
says it is because the clearinghouse has to act as the ultimate
credit support to everyone. So it sets its margin requirements
based on what it feels through its risk models the risk of a
particular transaction is.
So the clearinghouse sets that margin requirement, and then
it requires the most liquid form of collateral, because as soon
as a default occurs, the clearinghouse has to instantaneously
apply that collateral against the defaulted position. There is
no ability to wait and sell some property or land. It has to
happen instantaneously. Again, that preserves the
clearinghouse's stability.
So while, again, I agree that there could be
standardization and it could actually suit certain customers'
needs, many customers just do not have that liquidity, that
cash right now, and that is why, among other reasons they use
the OTC market.
I think there was a mention that the OTC market is not
collateralized or that it has--that the customers pay for that
margin somehow. In fact, many times when these customers go to
the OTC market, the collateral that they pledge is the exact
same collateral that they have pledged to secure their loan
obligations. Many customers borrow on a secured basis. They
pledge land or equipment, fixtures, receivables, even
intellectual property. That is all good collateral. It is very
good. That supports our lending agreement, our money we lend to
them.
It serves both as credit support for the loan and also for
the derivative, and that is the efficiency and the flexibility
that OTC derivatives provide to corporate America. And that is
why we think corporate America chooses the OTC markets instead
of the exchange markets. It is not because there is anything
wrong with the exchange markets. It is just that the OTC
markets are more flexible and are able to address exactly the
risks that the company wants to hedge.
Chairman Harkin. Did you have any observation on this at
all, Dr. Stout.
Ms. Stout. No, not on this.
Chairman Harkin. Dr. Bookstaber.
Mr. Bookstaber. If I can just indulge on this, I think this
point--of course, it is better if you can post illiquid
collateral. Of course, all of us would like to have that. But
there is a problem if the instrument is highly liquid and can
be liquidated very quickly, and what you have as collateral is
very illiquid. This is what leads to liquidity crisis cycles. I
have $800 million that I have as collateral at a bank. I am in
a market that for some exogenous reason drops by 10 percent.
The bank says, ``Come up with more capital, or we will start to
liquidate.'' And suddenly they say, ``Oh, but it is land. We
cannot liquidate it in the same timeframe as this instrument.''
So it is painful and, of course, we do not want to have it
be the case, but I think if you have liquid securities, you
have to have liquid collateral on the other side.
Mr. Lenczowski. If I could, Chairman, just to respond.
Chairman Harkin. Sure.
Mr. Lenczowski. The size of our loan book at JPMorgan is
roughly 10 times the size of our derivatives exposure, and much
of that loan book is supported by this collateral that Dr.
Bookstaber mentioned. It is relatively illiquid, but it is
excellent quality collateral. We lend on that basis.
So what we allow our customers to do is to use that same
collateral to support their derivative transactions. That is
useful for them. It is not an unsafe and unsound banking
practice. In fact, our examiners who are onsite would be all
over us if it was anywhere close to that.
So I would like to just clarify that this is very good
collateral that we are receiving from our customer base and
that it is a very big part of what makes these transactions
happen for companies.
Chairman Harkin. Let me ask that, Mr. Lenczowski. So you
admit it is not liquid, and how much can that be leveraged? How
much can you leverage something that is illiquid that is an
asset or land or whatever, how much can you leverage that?
I think I can understand it if it is capital, but I do not
know that I can understand it if it something else.
Mr. Lenczowski. That is an excellent point, Chairman
Harkin. Our credit officers make that exact determination. We
have statistical models and other means of assessing what our
probable exposure could be. We use many forms to do that, but
we are able to decide from a credit standpoint how much we
could do. Again, these determinations are reviewable by our
regulators and we ensure that are done within safe banking
practices.
Mr. Dines. Chairman Harkin, could I just add to that point
for a second? We have probably 250 to 300 institutional type
customers that we are providing products to. We margin with
about 80 percent of those customers today. We are moving
collateral back and forth with them. We are sending them daily
position reports so they know what the value of their
derivatives are. Again, they know the value. They are moving
the collateral back and forth.
They are giving us liquid cash as collateral, or we are
giving them liquid cash as collateral. The difference is that
we do not think that a highly rated food or industrial company
should be held to the same margining terms as a lower-quality,
more leveraged company. And so we are flexible in our credit
terms for them, so we may not make them post initial margin. We
may give them a million-dollar threshold before they need to
post margin. But we are still applying very strict credit
standards. We are margining with them. But we are flexible in
the way that we do that, and that is very, very important. A
million dollars to a company today means a lot from an
investment standpoint.
So that is the way that we are managing it. That is the
benefit of the OTC market versus a standardized exchange,
because if you think about the standardized exchange, it has to
go for the lowest common denominator, because it is dealing
with all sorts of companies all different levels of credit
quality. So it has to build its risk, its margining on the
worst possible credits that might be part of that clearinghouse
or exchange, where in the OTC market you do not have to do
that.
Chairman Harkin. Ms. Stout.
Ms. Stout. I think the last comment is very helpful for
helping keep a perspective on what we are discussing here. You
referred to a million-dollar savings today for Cargill. We are
dealing with a crisis that I believe the figure that you
mentioned this morning, Mr. Chairman, was $4 trillion. I do not
think anyone would dispute that for some businesses at some
times, some forms of derivatives are definitely beneficial. I
think the critical question has got to be how do we measure the
benefits against the harms.
I am very sympathetic. I wish I could ensure that Cargill
could always have the perfect hedge. But if maybe you have to
inconvenience yourself a little bit and deal with a suboptimal
hedge sometimes, and the social benefit we get is that we do
not get another Lehman Brothers, another Bear Stearns, another
AIG. Well, sometimes you have to put with a little bit of
difficulty.
We are at a watershed moment, Mr. Chairman, I think, that
is comparable to the situation we faced in the 1930's. Over the
past decade, I think we can argue that the finance sector of
our economy came close to cannibalizing the real economy.
Derivatives were definitely part--not the only part, but one of
the larger parts of that cannibalization process.
It is clear that we cannot sustainably go doing things the
way we have done them for the last 10 years. You know, the
definition of ``insanity,'' doing the same thing and expecting
different results. Every time in history in my research that we
have attempted to deregulate derivatives, we have gotten the
same results.
So on the theory that the perfect is the enemy of the good,
any regulatory development that can begin to bring back the
exposure that we have today, the exposure to systemic risk, to
reduced economic productivity, to price bubbles, to fraud and
manipulation, anything that can begin to ratchet that back
would be a very good thing.
Chairman Harkin. Anyone else? Yes, Mr. Masters.
Mr. Masters. I just want to make a couple points. With
regard to the whole notion of multiple prices, volume-weight
average prices, in the equities business we have probably in
excess of 100 different ways on listed exchanges of trading
those various kinds of orders. We can do algorithms that do all
sorts of things that can literally wait every 2 minutes for an
order and then only take the offer or sit on the bid all day,
or hide or bob or weave or whatever. All those things are
possible on listed exchanges. We do them every day in our own
business.
Second, I would like to make this point because I think it
is important. With regard to the notion of options at different
strikes and so forth, we are one of the largest option traders
in the United States, listed options, and one of the issues
with regard to options is when you trade in over-the-counter
option, there is someone on the other side that knows your
position. That is a huge issue. I do not want them to know my
position because if they know my position and it is just me and
him, if something goes wrong I have got a problem, and he knows
exactly what my problem is. And that goes on every day.
So there is a huge competitive advantage to a bank or a
swaps dealer to have that position on with a customer because
they are able to reverse engineer the customer's knowledge and
flows. So having that liquidity, having an exchange being able
to trade with perfect--being able to hide, if you will, I can
trade on these options exchange, and people do not know who I
am. And I can trade using various different orders. That is a
great benefit, and it would be a great benefit to many other
customers once they understand that little dynamic that goes
around on Wall Street.
Chairman Harkin. Pretty interesting.
Yes, Mr. Lenczowski? Then we will have to call this off.
Mr. Lenczowski. Thank you, Mr. Chairman. Just a couple of
points.
First, the exchanges have been trading equity options for
quite a while now, and they are free for anyone who can open an
account there. Certainly we have no desire in monopolizing the
equity market in the over-the-counter business, and any
customer who feels they will do better on an exchange should
trade there and should feel free to trade there. What we do not
want is to eliminate that choice from the customer. There are
some customers who might choose facing an exchange-traded exact
same product to trade in the over-the-counter market. And to
that extent, that kind of a choice should be continued to be
allowed.
Then, second, just to confirm, there is a straw man
argument or some example that the banks are against regulatory
reform or swap dealers are against regulatory reform. That is
absolutely untrue. We support broadly the initiatives that the
administration has announced and Chairman Gensler described
today. I have outlined them in our written submission, and I
would just like to reassert again that we do agree completely
that something has to be done. We just want it done in the
right way for the economy.
Chairman Harkin. Any last words? I thought this was a very
enlightening session. We could probably go on for some time. As
a matter of fact, I have got Secretary Vilsack over in the
Appropriations Committee that I have got to go over and listen
to his testimony on his budget.
But as you know, we are wrestling with this, but I guess I
end where I started. We cannot continue to do what we have been
doing. We have got to make some changes, and there have got to
be, I think, some fundamental changes in the way we do this.
Now, I have taken the position, you all know my bill, what
I attempted to do in that legislation. However, I am always
willing to look at other sides of that issue. But I guess from
my own personal standpoint, I still come down to the more open
we are, the more transparent we are, the more information that
people have out there in a regulatory framework, the better off
we are all going to be. And somehow we have got to, as Mr.
Masters said, I think, get back to where we were before in some
kind of a regulatory framework. And that is what we are going
to have to wrestle with, exactly how we do that. No one wants
to stifle innovation, as I said, but we have got to ask what
that innovation is for.
Second, no one wants to get rid of speculation. We need
speculators, but we do not want that bottle of aspirin every
day. We just need maybe one. So we have to figure out how we
provide that kind of liquidity in some kind of a regulated
manner also.
So these are the things we are wrestling with. I think this
panel added greatly to our thoughts on this and our pursuit of
trying to figure out what we can do. I just would say to all of
you that as we proceed on this, any other thoughts and
suggestions you may have, please let us know, and we will be
developing this legislation some time this year, probably not
until this fall. We have the health care bill, and we have got
a lot of other things we have to do, and we have to do the
child nutrition reauthorization, too, this year. But this is
something we have got to attend to, and I have talked to Mr.
Peterson on the House side, and he wants to move something this
year, too. So I invite your constant input and consideration of
what we are doing here.
Again, I thank you all very much for being here today. As I
said, it was a great panel. I appreciate it very much, thank
you; the Committee will stand adjourned.
[Whereupon, at 1:29 p.m., the Committee was adjourned.]
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