[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





[GRAPHIC NOT AVAILABLE IN TIFF FORMAT]



  Available via the World Wide Web: http://www.agriculture.senate.gov


                                ___________

                        U.S. GOVERNMENT PRINTING OFFICE
54-570 PDF                      WASHINGTON : 2010
---------------------------------------------------------------------------
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512-1800
Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC 20402-0001












           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

                              ----------                              
                                                                   Page

Hearing(s):

Regulatory Reform and the Derivatives Market.....................     1

                              ----------                              

                         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
                              ----------                              

                                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

                              ----------                              


                         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.]
      
=======================================================================


                            A P P E N D I X

                              June 4, 2009



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

[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]


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


                   DOCUMENTS SUBMITTED FOR THE RECORD

                              June 4, 2009



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

[GRAPHICS NOT AVAILABLE IN TIFF FORMAT]


      
