[Senate Hearing 111-248]
[From the U.S. Government Publishing Office]
S. Hrg. 111-248
OVER-THE-COUNTER DERIVATIVES: MODERNIZING OVERSIGHT TO INCREASE
TRANSPARENCY AND REDUCE RISKS
=======================================================================
HEARING
before the
SUBCOMMITTEE ON
SECURITIES, INSURANCE, AND INVESTMENT
of the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION
ON
MODERNIZING THE REGULATION OF THE OVER-THE-COUNTER DERIVATIVES MARKETS
AND THE INSTITUTIONS THAT PARTICIPATE IN THESE MARKETS
__________
JUNE 22, 2009
__________
Printed for the use of the Committee on Banking, Housing, and Urban
Affairs
Available at: http: //www.access.gpo.gov /congress /senate/
senate05sh.html
U.S. GOVERNMENT PRINTING OFFICE
54-589 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; DC
area (202) 512-1800 Fax: (202) 512-2104 Mail: Stop IDCC, Washington, DC
20402-0001
COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
CHRISTOPHER J. DODD, Connecticut, Chairman
TIM JOHNSON, South Dakota RICHARD C. SHELBY, Alabama
JACK REED, Rhode Island ROBERT F. BENNETT, Utah
CHARLES E. SCHUMER, New York JIM BUNNING, Kentucky
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey MEL MARTINEZ, Florida
DANIEL K. AKAKA, Hawaii BOB CORKER, Tennessee
SHERROD BROWN, Ohio JIM DeMINT, South Carolina
JON TESTER, Montana DAVID VITTER, Louisiana
HERB KOHL, Wisconsin MIKE JOHANNS, Nebraska
MARK R. WARNER, Virginia KAY BAILEY HUTCHISON, Texas
JEFF MERKLEY, Oregon
MICHAEL F. BENNET, Colorado
Edward Silverman, Staff Director
William D. Duhnke, Republican Staff Director
Dawn Ratliff, Chief Clerk
Devin Hartley, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
______
Subcommittee on Securities, Insurance, and Investment
JACK REED, Rhode Island, Chairman
JIM BUNNING, Kentucky, Ranking Republican Member
TIM JOHNSON, South Dakota MEL MARTINEZ, Florida
CHARLES E. SCHUMER, New York ROBERT F. BENNETT, Utah
EVAN BAYH, Indiana MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey DAVID VITTER, Louisiana
DANIEL K. AKAKA, Hawaii MIKE JOHANNS, Nebraska
SHERROD BROWN, Ohio BOB CORKER, Tennessee
MARK R. WARNER, Virginia
MICHAEL F. BENNET, Colorado
CHRISTOPHER J. DODD, Connecticut
Kara M. Stein, Subcommittee Staff Director
William H. Henderson, Republican Subcommittee Staff Director
Layth Elhassani, Legislative Assistant
Gregg Richard, Republican Legislative Assistant
Sarah Novascone, Republican Legislative Assistant
(ii)
C O N T E N T S
----------
MONDAY, JUNE 22, 2009
Page
Opening statement of Chairman Reed............................... 1
Opening statements, comments, or prepared statements of:
Senator Bunning.............................................. 2
Senator Crapo................................................ 3
Prepared statement....................................... 43
WITNESSES
Mary L. Schapiro, Chairman, Securities and Exchange Commission... 5
Prepared statement........................................... 44
Responses to written questions of:
Chairman Reed............................................ 88
Senator Schumer.......................................... 93
Senator Bunning.......................................... 96
Gary Gensler, Chairman, Commodity Futures Trading Commission..... 7
Prepared statement........................................... 51
Responses to written questions of:
Chairman Reed............................................ 105
Senator Schumer.......................................... 107
Senator Bunning.......................................... 108
Patricia White, Associate Director, Division of Research and
Statistics, Board of Governors of the Federal Reserve System... 8
Prepared statement........................................... 56
Responses to written questions of:
Chairman Reed............................................ 110
Senator Schumer.......................................... 114
Senator Bunning.......................................... 115
Henry T. C. Hu, Allan Shivers Chair in the Law of Banking and
Finance, University of Texas Law School........................ 25
Prepared statement........................................... 58
Responses to written questions of:
Chairman Reed............................................ 117
Senator Bunning.......................................... 119
Kenneth C. Griffin, Founder, President, and Chief Executive
Officer, Citadel Investment Group, L.L.C....................... 27
Prepared statement........................................... 64
Responses to written questions of:
Chairman Reed............................................ 121
Senator Bunning.......................................... 127
Robert G. Pickel, Executive Director and Chief Executive Officer,
International Swaps and Derivatives Association, Inc........... 29
Prepared statement........................................... 66
Responses to written questions of:
Chairman Reed............................................ 140
Senator Bunning.......................................... 145
Christopher Whalen, Managing Director, Institutional Risk
Analytics...................................................... 31
Prepared statement........................................... 69
Responses to written questions of:
Chairman Reed............................................ 161
Senator Bunning.......................................... 163
Additional Material Supplied for the Record
Letters submitted by Senator Crapo............................... 172
(iii)
OVER-THE-COUNTER DERIVATIVES:
MODERNIZING OVERSIGHT TO INCREASE TRANSPARENCY AND REDUCE RISKS
----------
MONDAY, JUNE 22, 2009
U.S. Senate,
Subcommittee on Securities, Insurance, and
Investment,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Subcommittee met at 3:03 p.m., in room SD-538, Dirksen
Senate Office Building, Senator Jack Reed (Chairman of the
Subcommittee) presiding.
OPENING STATEMENT OF CHAIRMAN JACK REED
Chairman Reed. Let me call the hearing to order. I want to
thank all of our witnesses for joining us this afternoon. I am
particularly happy to welcome back Chairman Schapiro. Thank
you. And also I want to thank Chairman Gensler for asking to
testify before us on the derivatives issue, which gives us a
chance to talk directly to you about this issue which
transcends several different agencies, and also Pat White from
the Federal Reserve. Thank you.
I also, obviously, want to recognize Chairman Harkin and
his colleagues on the Agriculture Committee for their
longstanding work on derivatives issues, and I look forward to
having both Committees coordinate closely as we work to provide
transparency and reduce risk in the financial sector.
This week, we find ourselves more focused than ever on the
important work of modernizing an outdated financial regulatory
system. I have called this hearing to explore one of the key
aspects of such reforms: to modernize the regulation of the
over-the-counter derivatives markets and the institutions that
participate in these markets.
Both exchange-traded and over-the-counter markets have
grown extremely rapidly over the past decade. Until the recent
downturn of the economic markets, every category of derivatives
saw almost a decade of extreme growth, in many cases more than
tripling or quadrupling trading volumes. According to data
compiled by the Congressional Research Service, between 2000
and 2008, the number of financial futures contracts traded on
exchanges rose by 425 percent, and the total notional amount of
over-the-counter contracts outstanding rose by 522 percent over
that period, representing trillions of dollars of trading.
This afternoon's hearing will focus in particular on over-
the-counter derivative markets which today are subject to no
direct regulation. One of the key questions we will examine is
the extent to which existing and emerging derivatives markets
should be subject to regulatory oversight. Until recently, the
prevailing presumption was that market discipline alone largely
protected us from any potential risks we faced from OTC
derivatives. But we received a wake-up call, having had to
seize AIG to keep its credit default swaps, worth trillions of
dollars, from greatly exacerbating the financial crisis.
It is now clearer than ever that we need to find ways to
make these markets much more transparent and to ensure that the
dealers and other users of these markets do a better job than
AIG of ensuring that their derivative activities do not
threaten the stability of the overall financial system.
But we face difficult questions as we move forward in
accomplishing this goal. These products are often extremely
complex, and there is an equally complex history of regulation,
or lack thereof, of such products. As a result, we need to take
a careful and thoughtful approach to these issues. There is no
doubt that improving the regulation and oversight of
derivatives markets, and those who trade in them, is a key part
of modernizing our financial regulatory system. I hope my
colleagues and our witnesses will help us identify the key
steps that we can and should take right now to address the
serious problems that we are confronting.
For example, what key decisions need to be considered as
Congress weighs proposals to move more over-the-counter
derivatives to central counterparties or exchanges? How do
various proposals to enhance oversight of OTC derivatives
affect different market participants? How does the issue of
improved OTC derivatives regulation relate to broader
regulatory reform issues, such as the creation of a new
systemic risk regulator? And to what extent do U.S. efforts
require international coordination? And these are just a few of
the challenging questions that we will face together, and we
will rely on your expertise and your insights as we go forward.
At this time, I would like to call on the Ranking Member,
Senator Bunning, for his comments. Senator Bunning.
STATEMENT OF SENATOR JIM BUNNING
Senator Bunning. Thank you, Mr. Chairman. I appreciate all
of our witnesses coming here today for this very important
hearing. It is important for everyone to understand the
financial nature of derivatives and, thus, the Banking
Committee's interest in overseeing them.
Let me say at the beginning that I do not know what
regulations and restrictions we should put on these products.
Figuring that out is the purpose of this hearing. But it should
be clear to everyone that the current regulations are not
enough.
I understand the desire of firms to hedge their risks,
whether those risks are interest or exchange rates, commodity
prices, credit exposure, or something else. Genuine hedges that
are accurately priced can provide the risk management that
firms need. But it is not clear that all derivative products
are genuine hedges or accurately priced. In fact, some look a
lot more like a way to get around regulations and proper risk
management, or just plain gambling.
Regulators in the public need a better understanding of all
the exposures of firms to eliminate uncertainty and the
justification for further bailouts. Increased transparency and
standardization of derivative contracts will help and must be
accomplished. How far standardization requirements should go
depends on whether there are true economic benefits to the
custom products that outweigh the costs and risks associated
with them. So far, specific and credible evidence on that point
is thin.
Credit derivatives may present the toughest questions.
Should these products be treated as insurance with proper
reserves? Should the buyer have an insurable interest and have
to suffer actual losses or deliver the reference assets? How do
we make sure credit protection does not undermine credit
research or lead creditors to push debtors into bankruptcy?
Should they even exist if not traded on an exchange?
Someone has to bear the risk of every financial transaction
so we must not allow the wizards of finance to pretend it has
disappeared.
Finally, just like with banks, we must eliminate the
opportunity to avoid or choose favorable regulators or
regulations. Similar activity must be regulated the same way by
the same regulator. Otherwise, firms will be able to game the
system, and regulators will not be able to effectively enforce
the rules.
Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Bunning.
Senator Crapo, do you have an opening statement?
Senator Crapo. I do, if I could, Mr. Chairman.
Chairman Reed. Please.
STATEMENT OF SENATOR MIKE CRAPO
Senator Crapo. First of all, Mr. Chairman, let me thank you
for holding this hearing. I believe that although there is a
breadth of derivative action in our economy, I believe that a
significant amount, if not the significant majority of the
amount of those transactions falls under the jurisdiction of
this Committee, and I appreciate your attention to that fact.
I also agree with the comments that both the Chairman and
Ranking Member have made. Recent events in the credit markets
have highlighted the need for greater attention to risk
management practices, and counterparty risk in particular; and
although I agree with the need to focus on where we can
standardize and the types of risk reduction and better
practices that we need to address, I also want in my remarks to
just focus very quickly on one specific part of it, and that
is, not letting the pendulum swing too far to the other side to
where we cause damage to an efficient economy.
The creation of clearinghouses and increased information to
trade information warehouses are positive steps to strengthen
the infrastructure for clearing and settling credit default
swaps. While central counterparty clearing and the exchange
trading of simple standardized contracts has the potential to
reduce risk and increase market efficiency, market participants
must be permitted to continue to negotiate customized bilateral
contracts in over-the-counter markets.
Many businesses use over-the-counter derivatives to
minimize the impact of commodity price, interest rate, and
exchange rate volatility in order to maintain stability in
earnings and predictability in their operations. If Congress
overreaches or bans or generates significant uncertainty with
regard to the legitimacy of decisions to customize individual
OTC derivatives transactions, I believe there could be very
significant negative implications on how companies manage risk.
In the contemplation of this hearing and this issue, Mr.
Chairman, I actually requested that a number of the end users
of these types of transactions respond to a question about what
increased flexibility or reduction of flexibility would do, and
at this time, I would like to just share three or four examples
of the responses that I received.
David Dines, the President of Cargill Risk Management,
indicates, ``While margining and other credit support
mechanisms are in place and utilized every day in the OTC
markets, there is flexibility in the credit terms, the credit
thresholds and types of collateral that can be applied. This
flexibility is a significant benefit for end users of OTC
derivatives such as Cargill in managing working capital. Losing
this flexibility is particularly concerning because mandatory
margining will divert working capital from investments that can
grow our business and idle it in margin accounts. While it
depends on market conditions, the diversion of working capital
from Cargill for margining could be in excess of $1 billion.
Multiply this across all companies in the United States and the
ramifications are enormous, especially at a time when credit is
critically tight.''
Kevin Colgan, the Corporate Treasurer of Caterpillar: ``Our
understanding of currently pending regulation in this area is
that it would require a clearing function which would
standardized terms like `duration' and `amount.' Any
standardization of this type would prohibit us from matching
exactly the terms and underlying exposure we are attempting to
hedge. Thus, in turn it would expose us to uncovered risk and
introduce needless volatility into our financial crisis.''
I have a number of other examples which I will insert for
the record, Mr. Chairman.
Chairman Reed. Without objection.
Senator Crapo. And if possible, I would like the permission
of the Committee to insert the letters that I received in
response to these inquiries into the record. I may get another
in the next couple of days.
The bottom line, Mr. Chairman, is I completely agree with
the need to do as much as we can to assure that we have covered
the risks in our economy that have been created by the
utilization of these types of derivatives, the different types
of derivatives, credit default swaps, for example. I just
believe that we want to pay very careful attention to making
sure that we do what is necessary to protect and strengthen our
markets and that we leave flexibility where it is necessary and
helpful for the utilization of these credit instruments to
advance the interests of our businesses.
Chairman Reed. Thank you, Senator Crapo. I think you have
illustrated the challenges ahead very well in terms of that
balance.
Senator Bennet, do you have an opening statement?
Senator Bennet. I do not, Mr. Chairman. Thank you for
holding the hearing, and I am very appreciative that the
witnesses are here.
Chairman Reed. Senator Johanns, do you have an opening
statement?
Senator Johanns. I do not. I am ready for witnesses.
Chairman Reed. Thank you very much.
Let me at this juncture introduce our witnesses. We are
very pleased to be joined today first by the Honorable Mary
Schapiro, Chairman of the Securities and Exchange Commission.
Prior to becoming SEC Chairman, she was CEO of the Financial
Industry Regulatory Authority, FINRA, the largest
nongovernmental regulatory for all securities firms doing
business within the United States. Chairman Schapiro previously
served as a Commissioner of the SEC from December 1988 to
October 1994 and then as Chairman of the Commodity Futures
Trading Commission from 1994 until 1996. Thank you, Chairman.
Next is the Honorable Gary Gensler. Gary Gensler is the
Chairman of the Commodity Futures Trading Commission. He
previously served at the U.S. Department of the Treasury as
Under Secretary of Domestic Finance from 1999 to 2000 and as
Assistant Secretary of Financial Markets from 1997 to 1999.
Prior to joining the Treasury, Chairman Gensler worked for 18
years at Goldman Sachs, most recently as a partner and cohead
of finance.
Our third witness is Ms. Patricia White, Associate Director
of the Federal Reserve Board's Division of Research and
Statistics. Ms. White has oversight responsibilities for
sections that analyze risk and process microeconomic data, and
she has participated in domestic and international working
groups on central counterparties, securities settlement, and
financial regulation.
I very much thank all of you joining us here this
afternoon, and, Chairman Schapiro, would you begin your
testimony?
STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Ms. Schapiro. Thank you very much, Chairman Reed.
Mr. Chairman, Ranking Member Bunning, and Members of the
Subcommittee, I am very pleased to have this opportunity to
testify on behalf of the Securities and Exchange Commission
concerning the regulation of over-the-counter derivatives. The
severe financial crisis that has unfolded over the last 2 years
has revealed serious weaknesses in the structure of U.S.
financial regulation. One of these gaps is the gap in
regulation of OTC derivatives, which under current law are
largely excluded or exempted from regulation.
The current regulatory framework has permitted certain
opaque securities-related OTC derivatives markets to develop
outside of investor protections afforded by the securities
laws. The SEC is committed to working closely with this
Committee, the Congress, the Administration, and our fellow
regulators to close this gap and restore a sound structure for
U.S. financial regulation.
I am pleased to be able to report to you that U.S.
regulatory authorities have reached a broad consensus on the
pressing need for a comprehensive regulatory framework for OTC
derivatives. This consensus covers all of the basics of sound
financial regulation in the 21st century, including record
keeping and report requirements, appropriate capital and margin
requirements, transparent and efficient markets, clearing and
settlement systems that monitor and manage risk, business
conduct and disclosure standards to protect the interests of
market participants, and vigorous enforcement against fraud and
other wrongdoing.
The SEC is also strongly supportive of ongoing initiatives
to promote the standardization and central clearing of OTC
derivatives. The SEC, working in closing consultation with the
Board of Governors of the Federal Reserve System and the
Commodity Futures Trading Commission, and operating under the
parameters of the current legislative structure, already has
taken a number of actions to help further centralized clearing
for OTC derivatives, including providing temporary conditional
exemptions for three central counterparties to begin centrally
clearing credit default swaps.
More needs to be done, however, and in building a new
regulatory framework for OTC derivatives, it is vital that the
system be designed to protect the public interest, manage
systemic risk, and promote capital formation and general
economic welfare.
Treasury Secretary Geithner's May 13th letter to the
congressional leadership outlined the Administration's plan for
establishing a comprehensive framework for regulating OTC
derivatives. Multiple Federal regulatory agencies will play
critical roles, including those represented here today.
In fashioning a regulatory framework for OTC derivatives,
it is crucial to recognize the close relationship between the
regulated securities and futures markets and the now mostly
unregulated markets for OTC derivatives. For example, with
respect to the securities markets, when an OTC derivative
references an issuer of securities, such as a public company or
a security itself, it can be used to establish synthetic long
or short exposures to an underlying security or group of
securities. In this way, market participants can replicate the
economics of either a purchase or sale of securities without
purchasing or selling the securities themselves. Because market
participants can use these securities-related OTC derivatives
to serve as synthetic substitutes for securities, the markets
for these OTC derivatives are interconnected with the regulated
securities markets.
Moreover, the markets for these securities-related OTC
derivatives implicate the policy objectives for capital markets
that Congress has set forth in the Federal securities laws,
including investor protection, the maintenance of fair and
orderly markets, and the facilitation of capital formation.
For this reason, it is important that Congress carefully
consider whether securities-related OTC derivatives should be
subject to the Federal securities laws so that the risk of
arbitrage and manipulation is minimized. And, certainly, a
similar analogy can be made to the futures markets by the CFTC.
My goal today is to assist the Congress in its efforts to
craft legislation that empowers the respective regulatory
authorities to do their jobs effectively and cooperatively. I
am confident that, working together, we will meet the challenge
that is so important to the financial well-being of individual
Americans.
I would be pleased to answer your questions. Thank you.
Chairman Reed. Thank you very much, Chairman Schapiro.
Chairman Gensler.
STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY FUTURES TRADING
COMMISSION
Mr. Gensler. Chairman Reed, Ranking Member Bunning, other
Members of the Subcommittee, thank you for inviting me here to
talk to you today about the over-the-counter derivatives
market. I would like my full testimony to be entered into the
record, if that is all right. I, too, am speaking on behalf of
the full Commission.
I believe we must urgently move to bring the over-the-
counter derivatives marketplace under regulation, and there are
four key objectives in accomplishing this goal. One is to lower
systemic risk. Two, we need to provide the transparency and
efficiency to these markets that we believe we have in our
securities and futures and options markets. Three, we need to
ensure integrity in these markets, preventing fraud,
manipulation, and other abuses. And, four, we need to protect
the retail public in these markets as we do in other markets we
oversee. Meeting these objectives will also require close
coordination between the CFTC, SEC, and other Federal
regulators.
Senators, I believe that we must establish a regulatory
regime that governs the entire over-the-counter marketplace, no
matter who is trading them, what type of derivative is traded,
whether it is standardized, tailored, or highly customized. I
think this should include interest rate product, currency
product, commodity product, equities product, credit default
swaps, and those swaps that we have not yet thought of that are
just a blip on the horizon.
As the Administration laid out in its May 13th letter, I
believe this can best be accomplished with two complementary
regimes: one to regulate the derivative dealers, or the actors,
so to speak; and another regime to regulate the big market
functions, or the stages upon which the actors perform their
duties.
For the dealers in this marketplace--the large financial
institutions--we should set capital standards and margin
requirements to help lower the risk in the system. We should
set business conduct standards to make sure that the market is
free from fraud, manipulation, and other abuses. And, third, we
should set record keeping and reporting, with audit trails, so
that we have transparency. So lower risk, promote market
integrity, and enhance transparency.
But I think this dealer regime will not really be enough.
It is important, and it gets all the markets customized and
standardized. We can further lower risk by having central
clearing on standardized products, and also bringing the
standardized products onto regulated trading venues, whether
they be full exchanges or electronic platforms. This will lower
risk and further enhance transparency.
To fully achieve these objectives, we must enact both of
these complementary regimes. Regulating both the traders and
the trades will ensure that we cover both the actors and the
stages upon which they create the significant risks.
I am fortunate to have a partner in this effort in SEC
Chair Mary Schapiro. She brings invaluable expertise that gives
me great confidence that we will be able to work together on
what is bound to be many challenges moving forward. We will
also work together to advise Congress and the rest of the
Administration on how we can best harmonize some of the rules
between the securities and futures world and cover gaps in our
regulatory oversight.
President Obama has called for action to strengthen market
integrity, lower risk, and protect investors, and I look
forward to working with Members of this Committee and others in
Congress to accomplish this goal.
I thank you again for the opportunity to testify, and I
look forward to answering any of your questions.
Chairman Reed. Thank you very much, Chairman Gensler.
Ms. White.
STATEMENT OF PATRICIA WHITE, ASSOCIATE DIRECTOR,
DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE
FEDERAL RESERVE SYSTEM
Ms. White. Chairman Reed, Ranking Member Bunning, and other
Members of the Subcommittee, I appreciate this opportunity to
provide the Federal Reserve Board's views on the development of
a new regulatory structure for the over-the-counter, or OTC,
derivatives market.
The events of the last 2 years have demonstrated the
potential for difficulties in one part of the financial system
to create problems in other sectors and in the macroeconomy
broadly. Centralized clearing of standardized OTC products is a
key component of efforts to mitigate such systemic risk.
The Board believes that moving toward centralized clearing
for most or all standardized OTC products would have
significant benefits. If properly designed and overseen,
central counterparties, or CCPs, offer an important tool for
managing counterparty credit risk. The benefits from
centralized clearing will be greatest if CCPs are structured so
as to allow participation by end users within a framework that
ensures protection of their positions and collateral.
Infrastructure changes in OTC markets will be required to
move most standardized OTC contracts into centralized clearing
systems. Such changes include agreement on key terms that
constitute standardization and development of electronic
systems for feeding data to CCPs. For their part, CCPs must
have in place systems to manage the risk from this new
business. Of particular importance are procedures to handle
defaults because OTC products are likely to be less liquid than
the exchange-traded products that CCPs most commonly handle.
Although implementation challenges no doubt lie ahead, the
Board will work to ensure that these challenges are addressed
quickly and constructively. Major dealers have committed to
making improvements in back-office systems that are important
prerequisites for centralized clearing.
Dealers also have committed to clearing standardized OTC
products, and they will be expected to demonstrate progress on
this commitment even as the broader regulatory reform debate
evolves.
Substantial progress in improving the transparency of the
credit default swap, or CDS, market occurred with the creation
of the Trade Information Warehouse, a contract repository that
contains an electronic record of a large and growing share of
CDS trades. The Board supports creating contract repositories
for all asset classes and requiring a record of all OTC
derivative contracts that are not centrally cleared to be
stored in these repositories.
Aggregate data on volumes and open interests should be made
public by repositories, and more detailed data should be made
available to authorities to support policy objectives related
to the prevention of manipulation and systemic risk.
Although the creation of CCPs will provide an important new
tool for managing counterparty credit risk, enhancements to
risk management for individual market participants will
continue to be a high priority for supervisors. If the reforms
outlined here are implemented, the firms currently most active
in bilateral OTC markets will become the firms most active as
clearing members of CCPs. As such, the quality of their
internal risk management is important to the CCP. Supervisory
efforts are already underway to improving collateralization
practices and to examine whether the current capital regime can
be improved.
Policy issues associated with OTC derivatives are not
limited to the United States. The markets are global, and
issues are unlikely to be fully addressed without international
coordination.
Much work must be done, but with effective oversight by
supervisors, prudent risk management by end users and dealers,
and appropriate changes in the regulatory structure,
derivatives can continue to provide significant benefits to
businesses and investors who use them to manage financial
market risks.
Thank you very much. I look forward to answering your
questions.
Chairman Reed. Thank you very much. This is an issue of
great complexity and great importance, and so this is the
beginning of a process, I think, not the conclusion of one, in
trying to determine what Congress must do and will do to
provide adequate regulation for a complicated part of our
financial markets.
Let me begin by saying that one aspect that we have to get
right is to cover the whole waterfront, if you will, to make
sure that there are no gaps, that there is an effective and
efficient way to do this, and I wonder if all of you in turn
could give your comments about how we ensure there is a
comprehensive approach, that we don't create these areas where
there is an opportunity to operate outside of the framework. We
will start with Chairman Schapiro.
Ms. Schapiro. Thank you very much, Mr. Chairman. I agree
with you completely that it is really important that as we seek
to solve the existing gaps, we not create any additional ones.
So I think there are several mechanisms for that.
The first is to encourage and use the tools like capital
and margin, standardization and central clearing, to the
greatest extent possible and even encourage exchange trading of
currently OTC derivatives. That will give us, as Chairman
Gensler said, some control over the stage and it will allow us
to have a centralized view of what is happening in these
markets and the benefits of capital and margin requirements
with respect to those institutions.
But it is also critically important that we have regulation
of the dealers who participate in the marketplace, meaning, in
my view, registration, capital requirements, margin
requirements, record keeping, reporting to regulators,
reporting at least aggregated information to the public, and
very tight risk management processes within the dealers,
including governance, risk controls, trading limits, all of the
things we would normally think about as being important for
dealers to control the risks that they are undertaking.
I also think that whether we have a systemic risk regulator
at the end of this process or a council or a combination as in
the Administration proposals, it will be very important for the
regulators to share as much information on a continuing basis
as possible so that as new products are being developed, and I
am sure that as we sit here, somebody is developing a new
product that perhaps falls between the regulators' current
authorities, that we know about those products as quickly as
possible, understand their implications for the system, and
bring them under the Federal regulatory umbrella, either by
moving that into a central clearinghouse or exchange platform
or through the regulation of the dealers who participate in
those transactions on a bilateral basis.
Chairman Reed. Thank you.
Chairman Gensler.
Mr. Gensler. I think that Chair Schapiro summed it up well,
but I think, if I might say, one of the great lessons out of
this financial crisis is that we had large financial
institutions that were, by and large, outside of the regulatory
regime. I mean, some had ineffective Federal oversight, but AIG
is Exhibit A, and I think, frankly, the derivative dealers that
were affiliated with Lehman and Bear Stearns and others were
only modestly regulated. I think we all now feel we have to
bring them under regulation.
By regulating the dealers, we get nearly 100 percent of the
marketplace. It would be possible to be outside this
regulation. Senator, if you and I entered into a derivative
contract, neither one of us is a dealer. But any dealer that
holds themselves out to the public and offers these types of
transactions, I think we can lower risk by having the capital
and margin requirements, and increase transparency with record
keeping reporting.
We can let the tens of thousands of users of these products
take greater comfort by regulating the stages, or moving the
standard products onto exchanges and onto central clearing
while at the same time recognizing there will still be some
tailored products. There could be an airline company that needs
a certain grade of jet fuel delivered in a certain location on
a certain day. That would still be regulated because the dealer
offering that product would have to put aside capital and
margin and not participate in manipulation and fraud.
Accordingly we allow some customization so the tens of
thousands of users could still use those products.
Chairman Reed. Well, thank you. In Senator Crapo's comments
and your comments, there seems to be a range of real economic
arrangements. I mean, there is a specific thing. They need the
fuel on a certain day. They are hedging a certain price. And
there is a whole category, as Chairman Schapiro said, of
synthetics that are mimicking the Dow, that are more sort of
the creations and almost an infinite supply of them. Is that
one dimension that you would consider in terms of putting items
on an exchange?
Mr. Gensler. I believe, Mr. Chairman, that anything that a
clearinghouse would accept for clearing under prudent risk
reduction should be accepted for clearing as standardized. The
regulators could also be given authority, working with
Congress, to list additional contracts as standardized such as
a high-volume product or similar product, so that customization
it is not just used to avoid centralized clearing.
I also believe that those products that are not on central
clearing and not on exchanges are by their definition less
liquid and thus should appropriately have higher capital or
margin requirements. So if a dealer wants to retain that
customized product, it might have to meet higher capital
requirements or require higher margin from their customers.
Chairman Reed. Chairman Schapiro.
Ms. Schapiro. I would just add to that that one of the
benefits of higher capital and margin might be to encourage
more transactions into central clearing or onto exchanges. But
I do think the challenge will be standardization and how do we
achieve a significant proportion of this market moving into
central clearing. There was clearly a need for customized
bilateral transactions, as Senator Crapo has said and as
Chairman Gensler has mentioned. The key thing is that they be
brought into the regulatory umbrella through the regulation of
the dealers and that there is adequate margin for those
positions and adequate capital on behalf of the dealers, and
again, the regulators have the ability to see what is happening
between counterparties.
Chairman Reed. Before I recognize Senator Bunning, Ms.
White, do you have a comment?
Ms. White. The Board has been focusing on the aspects of
the market that relate to systemic risk and how to fill gaps
there, and in particular what infrastructure would be helpful.
One thing we would like to point to is the creation of Trade
Information Warehouses for all asset classes and all contracts.
That will provide an important base of knowledge for the
authorities as they try to evaluate what is standardized enough
to next move into a cleared environment.
In addition, I would want to add that in terms of gaps, it
is important to keep in mind that these are really
international markets and we are going to need a lot of
international coordination to make sure all the gaps are
filled.
Chairman Reed. Thank you very much.
Senator Bunning.
Senator Bunning. Thank you, Mr. Chairman.
As I said in my statement, I think similar activities
should be regulated the same way by the same regulator. In
other words, we need just one regulator for derivative
products. Do you agree or disagree with that statement? Go
right ahead.
Ms. Schapiro. Thank you. I think my greater concern than
having a single regulator for all derivative products is
disconnecting securities-related derivatives from securities
markets, because as I go on to probably in too great length in
my written statement, the concern is that you can create a
synthetic securities position utilizing derivative products
that are intimately tied to the securities markets for which we
have primary concern. They are important for capital formation.
They are important to millions of investors in the United
States. And so the impact that these securities derivatives can
have on the primary securities market is a concern that I would
hate to see be decoupled. It has been, as many derivatives have
been decoupled from their primary markets over the last 15 or
20 years or so. But I think, to me, that is the more important
linkage, is between the securities derivatives and the
securities markets, and the same would be true for the markets
that CFTC regulates.
Senator Bunning. Go right ahead.
Mr. Gensler. Well, I think, Senator, you raise a very
important point. We have two market regulators--the securities
and options markets that the SEC regulates and the futures
markets that the CFTC regulate. Now we are bringing this market
of derivatives, hopefully, with Congress' help, under
regulation. Derivatives have a lot of attributes of securities
and a lot of attributes of futures. In some cases derivatives
have more attributes toward futures on those products, I think
we have broad agreement, that they would be best regulated by
the CFTC. Some are far more similar to securities and can
clearly influence the markets for an individual company's stock
or be used in insider trading. That would really be an area
where the SEC can best protect the investor.
So I think working together and with this Committee and
Congress as a whole, we aren't going to leave any gaps, but
recognize that these derivatives have attributes sometimes more
similar to securities and sometimes more similar to futures.
Under your basic concept----
Senator Bunning. Well, I am trying to prevent any from
slipping through the cracks.
Mr. Gensler. And we, I think, both agree with that goal,
and I think we can achieve that goal together.
Senator Bunning. Ms. White, does the Fed have some opinion
on this?
Ms. White. The products in the market have a lot of
diversity to them and both the CFTC and the SEC will bring
different skills to the regulatory oversight of those products.
For the Board, what is most important is that we try to avoid
jurisdictional overlaps and harmonize the treatment of
products.
Ms. Schapiro. Senator, if I could just add one point
there----
Senator Bunning. Go ahead.
Ms. Schapiro. I think that where you have products that are
effectively economic substitutes for each other under the
jurisdiction of different regulators, it is really critical
that we work as closely as we can to try to harmonize our
regulatory regimes.
Senator Bunning. But isn't that where we failed in the last
15 years?
Ms. Schapiro. Well, except that with respect to most over-
the-counter derivatives, they have been exempted from or
excluded from virtually all regulation.
Senator Bunning. But that is because we have had two
Chairmen of the Federal Reserve who said to us at the Banking
Committee that they shouldn't be regulated. I can go back and
get you the testimony----
Ms. Schapiro. Oh, I am sure that is right. That is
certainly not the position of the Securities and Exchange
Commission. We believe that these products absolutely should be
regulated and need to be regulated effectively because of the
impact that they can have on the economy broadly, but also on
particular markets, like the equity market.
Senator Bunning. There seems to be agreement that all
derivatives need to be reported to someone. Who should the
trades be reported to, and what information is necessary to be
reported, and is there any information that should not be
available to the public? Anybody?
Mr. Gensler. Senator, I think that we need to bring a great
deal more transparency to the markets, and I think this will
actually lower the pricing for the tens of thousands of users.
What we have found over many decades is that when you have
greater transparency, markets are more efficient.
All of the products that dealers trade in should be
reported into a central trade repository that regulators can
monitor so that we can police for fraud and manipulation. The
public should also get to see anything that could be on an
exchange or a trading platform. I fully subscribe to what
Secretary Geithner's letter says. There should be a real-time
reporting, a development of sort of like a consolidated tape
very similar to what is in the over-the-counter bond market----
Senator Bunning. What do we do about the derivative or
credit default swap or that individual, personalized hedge? Use
Delta Airlines as an example and the delivery at a certain date
at a certain price and that personalized derivative that they
use for hedging against the market.
Mr. Gensler. I believe, sir, that that should be reported
to all the regulators and certainly aggregated in the aggregate
positions by underlying commodity. In that way, jet fuel
derivatives should be reported to the public. I think working
together, we have to think through whether that should also be
part of this consolidated tape or whether there are some that
would be so unique that the commercial attributes of, as you
said, Delta Airlines might be put at risk. But they, I believe,
should be----
Senator Bunning. I think----
Mr. Gensler. ----aggregated in part, seen clearly by the
regulators, and possibly be part of the consolidated tape.
Senator Bunning. I can't see how Delta Airlines would be
put at risk if they are smart enough to hedge against the
market's advance in future oils or future jet fuel or whatever
it might be----
Mr. Gensler. Right, and in that case, I would recommend
that it be part of that consolidated tape. But I recognize
there may be some transactions----
Senator Bunning. Thank you, Mr. Chairman.
Chairman Reed. Thank you, Senator Bunning.
Senator Bennet.
Senator Bennet. Thank you, Mr. Chairman.
I just had a couple of questions. The first goes back to
this question of the clearing of centralized contracts versus
customized contracts, because on both the Agriculture Committee
and the Banking Committee, we have had some similar
conversations, and I heard you today, Chairman Gensler, talk
about how, well, it might be OK if we can't put the customized
on a centralized clearinghouse because we will have different
capital requirements, I think, or some capital requirements,
which I think makes a great deal of sense.
My question is what, as you think about this--all of you
think about this--what incentives there might be, if any, for
people to structure around the clearinghouse for no good
business purpose. I mean, what really would the incentives be
to create a customized hedge here that didn't have a business
purpose of some kind?
Mr. Gensler. I would hope that once there is a fully
running central clearinghouse, there would be great benefits to
moving all the transactions that a dealer could into clearing
because it does lower risk for them, instead of having this
interconnected spider's web. One of the lessons we learned is
not only are institutions too big to fail, but they are too
interconnected to fail. Centralized clearing helps lower their
risk, and that is why I subscribe to maybe lower capital or
margin. But it may well be that some dealers don't agree with
my point of view and that they would want to keep some product
outside of that standardized central clearing. I think that
clearing actually would help lower risk for their institutions
and lower risk for the system.
Also, it would enhance transparency. The public would see
it if it were on an exchange or trading platform. It may well
be that some dealers would like to keep the information
advantage, but many decades of markets have taught that broad
commerce and the economy benefit by having that type of
information. And if you see the standard transaction in jet
fuel--we were talking about jet fuel--if you see the standard
transaction in jet fuel or interest rates--it could be a very
plain vanilla interest rate--and I think the small municipality
or the small hospital that wants to hedge a four-and-a-half-
year interest rate instead of a 5-year interest rate would
benefit by seeing that on an open and transparent exchange.
Senator Bennet. Do either of you----
Ms. Schapiro. The only thing I can think of is the
informational advantage that one has from not trading in a
transparent market and the benefits, to the extent there are
some, of anonymity. That is why I think it is so important that
the dealer regulation include full transparency, at least to
the regulators, and then over time, a decision, I think, by
regulators about how much information needs to be made publicly
available.
I think what is really critical is that we not structure
the regulatory regime in any way that creates unintended
incentives to go off exchange or off central clearing and stick
with bilateral contracts.
Senator Bennet. I completely agree with that, and I think
that as we proceed here with this and much of the other
regulation that we are talking about, we need to be very
careful that we aren't creating perverse incentives that end up
doing more harm than good. I was just trying to scratch my head
to think about--I get the point on transparency, but on the
other hand, if it is reported to the regulator, I am not sure
there is much of an issue, but we will keep working on it.
The other question I had, and it may go back to the
systemic risk regulator proposals that we have seen in the last
week or so around here, you talked, Chairman Gensler, about the
swap that hadn't yet been invented and I started to sweat again
about what we might be facing, because the American people are
so tired of having us look in the rearview mirror and say what
happened while there is all this carnage out there. And I just
wondered whether, on a going forward basis, all of you felt
that we were going to be in a better position, not to predict
the future necessarily, but in a better position to monitor
when things are starting to move in a certain way in our
financial markets.
My understanding, for example, is that between 2000 and
2008, the number of over-the-counter derivatives contracts grew
by 522 percent, but during that time, our regulatory
authorities had little power to examine any of that. I wasn't
here to know whether you asked Congress for that or not. But
prospectively, is this some of the work that this council is
meant to do? How are we going to keep track of these swaps that
have no name?
Mr. Gensler. I think, as it relates to over-the-counter
derivatives, that the Federal regulators should have broad
authority. If somebody holds themselves out to the public as a
dealer, whether it is in the known derivatives, from interest
rates to securities to credit default swaps, or something that
is not yet known, we should work together to make sure the
statute gives broad authority to also bring that into this
regulatory regime. I think that is important. It is one of the
big lessons of the past, certainly that I have learned.
I think in terms of a systemic regulator, what the
Administration has put forward is to make sure that the largest
financial institutions, those that are either interconnected or
by scale or scope, that can affect the American public have to
be under prudential regulation, meaning you can set capital and
margin and so forth. And I think that is very important.
Ms. Schapiro. The only thing I would add to that is in
addition to the systemic regulator, the continuing role of the
functional regulators, the SEC and the CFTC, or bank regulators
looking at the business of the dealers in a way that really we
have never been able to before because of the exemptions that
exist under existing law, ought to make a big difference in our
ability to understand what kind of products are being developed
and marketed, and I think the business conduct rules that
really try to get to how these derivative products might be
marketed and sold, whether to State and local governments or
pension funds or even less sophisticated institutions, will
give us real insight into what is happening within the firms
and the ability, hopefully, to shut down problematic practices
before they grow out of control.
Senator Bennet. Thank you. Thank you, Mr. Chairman.
Chairman Reed. Thanks, Senator Bennet.
Senator Crapo.
Senator Crapo. Thank you very much, Mr. Chairman.
Each of you in your testimony have indicated, as I
indicated in my opening remarks, that there are circumstances
in which nonstandard products are very legitimate and that
there are legitimate reasons for us to engage in customized
transactions. Obviously, the question that I am interested in
here today is how do we make sure that we regulate to the
extent possible in such a way that makes certain that we don't
basically engender greater inefficiencies and risk in our
economy as a result of the way we treat these types of
customized transactions?
As I have read your testimony, Ms. White, for example,
indicates that these nonstandard products can pose significant
risk management challenges because they can be complex, opaque,
illiquid, and difficult to value, and in your testimony,
Chairman Schapiro, you indicate that one way to deal with these
nonstandard types of arrangements is to impose appropriate
margin and capital requirements on the participants in these
customized transactions to reflect the risk that they pose to
the system in general.
The question I have when we get to that point is do these--
can we evaluate the level of risk that these transactions pose?
I think that you would each agree with me that as we have
watched derivatives operate in the last few years, that there
have been some incredible abuses that have put incredible
systemic risk in our economy, but there have also been a
phenomenal number of very effective uses of credit default swap
and of other derivatives that have helped to create
efficiencies and strength in our economy.
So the question I am getting at is can we evaluate these
nonstandard arrangements in such a way that we can tell whether
they are truly generating risk that should then be subjected to
greater margin and capital requirements?
Ms. Schapiro. I think we can. Can we do it perfectly?
Probably not, but I think through imposing risk limits on
dealers, stress testing, ensuring that the margin levels are
sufficiently conservative and high and stress tested so that we
can have some comfort about that, requiring operational
controls, it is things as simple as separation of duties and
trading limitations on individual traders, requiring that they
have robust compliance systems, that the firms have credit
policies that they are required to know their counterparty and
understand the risks of a bilateral arrangement with that
particular counterparty. I think through real vigilance on the
part of dealers, which will come mostly with real vigilance on
the part of the regulators overseeing the dealer conduct, I
think we can certainly do a much better job than has been done
historically.
Senator Crapo. Mr. Gensler.
Mr. Gensler. I think we can. It certainly poses challenges.
Much of the marketplace is standardized. There are various
estimates, and I haven't seen any very good data, but more than
half of the market is certainly standardized and some would say
a lot more. Even on the tailored or customized side, sometimes
it is just that it is 1 month off. But on the truly exotic, you
know, if it is highly customized, I think it will be
appropriate to have higher capital and higher margin standards
for that dealer.
You mentioned the letter earlier from Caterpillar. I think
they could absolutely customize and make sure that they hedge
their risk. But if their risk is a little different than the
standard, well, it is probably almost the same capital. But if
their risk is really quite different, then it is hard to value
that risk, and the dealer on the other side might have to put
up even more capital in that regard. But risk, if I might say,
is risk. If it is really highly standardized, we want to make
sure that dealers have enough cushion in tough markets to
survive.
Senator Crapo. So are we saying, then, that our inability
to standardize the risk means that the risk is higher?
Mr. Gensler. Well, it generally does mean that. It is not
always the case, but generally, if you can't standardize a
product or you don't see other people trading in that product,
that risk is a little harder to unwind--it is not a technical
term. If a commercial enterprise wants to enter into a
transaction and standardize it, it probably means there are 10
or 20 or maybe hundreds of other parties that want to either
speculate on that risk or hedge that risk. The greater
difficulty is when there is no other party on the other side,
and frankly, that is also the problem in crisis, when there are
no other parties to take the other side.
Senator Crapo. Thank you.
Ms. White.
Ms. White. The Board believes that there is value in these
nonstandardized products, but it also recognizes that there are
challenges in managing the risk associated with a
nonstandardized product, both from the standpoint of the firms
and from the standpoint of the supervisors.
Clearly, improvements need to be made, and there are
projects already underway in the supervisory community
evaluating, for example, the appropriateness of the capital
standards associated with them to make sure that the capital
charges attached to nonstandardized products fully reflect the
risks of those products.
Senator Crapo. Thank you.
Chairman Reed. Thank you, Senator Crapo.
Senator Johanns.
Senator Johanns. Let me thank the witnesses for being here.
Chairman Gensler, let me follow up on some things that
Senator Crapo was asking, and I will be very blunt. Your
testimony worries me. So if I have a very standardized product,
it is going to go through this system lightning speed. We are
going to know exactly what the rules are. But if I have a
little bit or maybe even significantly different product, it is
going to hit a barrier, because you are going to have to
analyze the risk. Some bureaucracy is going to have to shake it
and bake it and figure it out and discuss it. And then somebody
is going to have to say, well, it is not standardized, and,
therefore, it has got to be XYZ in terms of the capital
requirement.
Isn't that kind of what you are getting us to?
Mr. Gensler. Senator, I appreciate your concern. What we
are recommending is that clear rules of the road would be put
out by the regulators that are best at setting capital. For
these dealers, it is most likely going to be either their bank
or other prudential. In some cases it would be the Securities
and Exchange Commission or possibly the systemic regulator.
Those capital standards set by rule would be set out for
customized and standardized products as well.
So I would not envision a trade-by-trade circumstance or a
contract-by-contract, as you asked.
Senator Johanns. No, but the nature of this system and the
reason why it got some legs underneath it is because it was so
darn adaptable. Now, in the end, that had its downside, too,
and then you add stupidity to it, and greed, and it really went
south.
But as Senator Crapo points out, many companies and,
therefore, many shareholders got great benefit from this
process. And it seems to me that if you run into anything that
is not standardized, you run into the bureaucracy.
Mr. Gensler. Well, I appreciate your concern and I share
that concern, but I think that through clear rules of the road,
the Federal regulators can lay out what capital and margin is
appropriate for the customized products.
I do believe that we benefit as an economy and a society
that commercial enterprises can hedge their risks and focus on
producing a product or a service for the public. That is what
the CFTC has been overseeing for decades in the agriculture,
energy, and financial markets. I think we have to promote that,
but at the same time recognize that if it is not standardized,
it might be appropriate to have a little higher margin and
higher capital, but set, again, by a public process where you
do not have to come in and check each contract.
Senator Johanns. OK. What if I am a competitor and you have
gone through your process, however long it takes, and you have
now set the new capital requirements, and I want to challenge
that and appeal it because I think your capital requirements
are too low. Are we going to have--will I have the benefit to
do that? Can I slow the process down even further?
Mr. Gensler. Well, I think it will probably be--it might
not be the CFTC, but it might be the Federal Reserve or the SEC
that is setting capital in this regime, so I would defer to----
Senator Johanns. Chairman Schapiro.
Ms. Schapiro. I guess I would like to add that even the
practice today among counterparties is to analyze the risk of
our doing business with each other and to demand collateral
against the position that they are creating. So much of that
analysis that would be required here is an analysis that I
think the dealers are very comfortable doing.
The difference would be that there would be----
Senator Johanns. Government oversight.
Ms. Schapiro. Government oversight, but not--I do not think
we will have the capacity to second-guess every transaction and
whether the risk was analyzed appropriately. But we would
expect the firms to stress test their models and to ensure that
their risk management procedures were really first class.
The difference, I think, will be that there will be capital
standards, as there already are for banks and broker-dealers,
that will help them, given what their risk analysis shows,
determine what the appropriate level of capital is to hold
against those positions or potentially the appropriate level of
collateral or margin to seek with respect to each transaction.
Senator Johanns. I am running out of time. We never have
enough time in a hugely complicated area, but let me ask this
question: As AIG was ramping up its exposure and risk--and
hindsight is always 20/20, and we can look back and say, Boy,
that was really dumb. What about your system would have stopped
that? Would your system have kicked in at some point and you
would call the CEO of AIG and say, ``Whoa, you are at $200
billion,'' or whatever, ``you are done. You are out of the
marketplace. You cannot do this anymore''? Would we have
stopped AIG?
Mr. Gensler. Senator, it is always hard in hindsight, but I
think that a number of features here would have slowed down and
maybe even stopped it.
AIG put on an enormous book of business without putting
aside capital or margin. And what happened just last fall, when
the rating agencies downgraded AIG, all of a sudden they had to
post significant collateral. I think it was over $30 billion
within a day or two. They would have to have done that across
the daily basis. It is a harsh discipline, I know. It is one
that I learned when I was in the investment banking business.
But it is one I think is an important one--to value on a daily
basis or weekly basis the risks that a firm has and put aside
appropriate capital margin, and AIG was not doing that.
There were a lot of other problems in AIG as well that I
think the system would have highlighted earlier.
Chairman Reed. Senator Johanns, we are going to do another
round.
Senator Johanns. OK, great.
Chairman Reed. Because you are right, this is a complex
topic, and we are extraordinarily fortunate to have the
Chairmen and Ms. White from the Federal Reserve.
Let me just ask one question, though, and that is: We are
engaged in a very complicated regulatory reform process which
is going to touch many, many different areas. So I would ask
you to just tell us what do you believe are the two or three
most important legislative changes that we have to enact given
the fear that it is going to be so big and so broad that every
detail will be considered. But we need to know what you think
the most important priorities are in terms of the legislative
changes.
Chairman Gensler, you seemed poise to answer.
Mr. Gensler. I was poised to let Chair Schapiro answer
first.
[Laughter.]
Mr. Gensler. You know, it is a very appropriate question.
It is hard when one's President lays out a bold agenda, and I
think it is very bold agenda that President Obama laid out. But
I think it is incumbent upon all of us to address over-the-
counter derivatives. So if I am allowed two, I would say one
priority is absolutely over-the-counter derivatives and
protecting the consumers. I mean, the whole approach to having
a strong, vigorous oversight of the mortgage--I think the
mortgage sales practices in this country failed, failed
terribly, all the way through the process of mortgage
securitization. But I would say the second big one for me--
there are others, but I would say it is the consumer side.
Chairman Reed. I should be more specific. Within the
context of regulating over-the-counter derivatives or the
derivatives market, any specifics?
Mr. Gensler. Mr. Chairman, it is hard to break it down
because I really do think these are complementary regimes. I
think that if we are not able to fully regulate the dealers, we
will not give the American public the comfort they need, and it
will feel like we leave a loophole. If we just did central
clearing, which is a good idea, a very good idea, and even if
we mandate it, I think we will not have covered the legitimate
concern of covering the risk of the customized products.
Chairman Reed. Well, let me turn to Chairman Schapiro now,
but also will there be a definitional debate about who is a
CFTC dealer and who is an SEC dealer? Because I think that
there is agreement among both of you that the dealers have to
be regulated.
Ms. Schapiro. I would agree with that, and actually I would
go so far as to say that if we do not regulate the dealers, we
will realize Senator Bennet's concern that there is not really
any reason to go the standardized route because you can really,
with anonymity and in a very opaque way, continue to engage in
OTC derivatives through unregulated dealers or dealers at least
that we cannot adequately examine and inspect.
I think that to the extent there are disagreements between
the SEC and the CFTC--first of all, most dealers will be
regulated by the bank regulators, frankly, and certainly if the
Administration's plan to create a systemic risk regulator is
effectuated, that systemic risk regulator is likely to
regulate, in addition to the functional regulator, any OTC
derivatives dealer of any size at all.
Chairman Reed. Thank you.
Ms. White, do you have a comment?
Ms. White. My portfolio is much narrower than the Chairmen
of the two Commissions. But I would point out that we really do
think it is important to move on these trade information
warehouses so that we have the data for all of the contracts,
nonstandardized as well as standardized.
Chairman Reed. Thank you very much.
Senator Bunning.
Senator Bunning. Thank you.
For the Chairman of the SEC, can and should the Securities
and Exchange Commission require all reporting companies to
disclose counterparties and reference entities and assets in
their derivative portfolios?
Ms. Schapiro. Require public disclosure? If their
relationships are material and they have material contracts
with counterparties, they should be disclosed--at the risk of
saying something incorrect here--in their public filings if
they are material to the company.
Senator Bunning. I am talking--you are talking about
someone to regulate these people. I am talking about----
Ms. Schapiro. For example, if Boeing were to enter into a
customized----
Senator Bunning. Customized, or even--yes, a customized
one.
Ms. Schapiro. If they were regularly engaged in this
market, I think that that should bring them under the umbrella
of being regulated. But, otherwise, I believe our view would be
that we could get at the information through the dealer's
requirement to keep records about counterparties, an audit
trail of the transaction, all of the terms of reference of the
transaction.
Senator Bunning. In other words, I am asking about any
entities.
Ms. Schapiro. Other than just dealers?
Senator Bunning. That is correct.
Ms. Schapiro. I believe that we think we can get the
information through access to all the dealer information about
who they were--who their counterparty was.
Senator Bunning. I am worried about people slipping
through, like we had for the last 10 years.
Ms. Schapiro. I share that concern very much with you. I
think to the extent anybody did not have a dealer as their
counterparty, so a Boeing or another commercial company, and
they were engaged in this market with any frequency at all, we
could get at that directly. But I believe we could get the
information very clearly through our regulation of the dealer
and access to the complete books and records of the dealer,
where they would show that they were transacting with Boeing.
And, of course, if the information is in a trade
information warehouse or the transaction is done through a
central counterparty, we would have access to the information
in that method, in that way as well.
Senator Bunning. This is one for all of you. How do we
prevent a clearinghouse or an exchange from being too big to
fail? And should they have access to Fed borrowing?
Mr. Gensler. Senator, I think that we actually already have
a number of clearinghouses that have been very well and
successfully regulated for decades in the securities, options,
and futures markets. But if they were to fail--and they have
been successfully regulated--they're systemically relevant
already.
We are hoping that we will have large clearinghouses for
derivatives, so I think all will be somewhat systemically
relevant. And we, as you say, will need to sort of address this
in statute as to that possibility.
Senator Bunning. Tell me how.
Mr. Gensler. Well, I think that they should be regulated,
as they have been for decades, by the principal----
Senator Bunning. The clearinghouses.
Mr. Gensler. The clearinghouses and exchanges should be
regulated by the principal market regulators, as each of our
agencies has for decades, and the derivative regulation should
embody that similarly. They should be regulated for risk
management, making sure they have capital and margining and
various practices on how they net the contracts and also
regulation about their clearing members. At the same time, I
recognize there may be something for the systemic regulators'
interest to make sure that if they are going to be called upon
in an extreme case to lend money, that they also have some
authorities.
Senator Bunning. In other words, you would not rule out the
Federal Reserve as being a source they could go to in case of
emergency?
Mr. Gensler. Well, I think that--it has never happened, but
we cannot rule it out, and we should make sure that--and it is
one of the lessons of this crisis, is that we have to make sure
that our statutes are up to date so that in an extreme
circumstance----
Senator Bunning. That is all we are trying to go through.
Mr. Gensler. Right, so I am agreeing with you, Senator.
Senator Bunning. OK.
Ms. Schapiro. I do not have much to add to that. I would
say that the securities clearinghouses did work very well in
the last year over really extraordinary circumstances, but I
think the last year also taught us that almost anything can
happen that we have not anticipated historically.
I think the real key for clearinghouses will be very robust
risk management, so that they are very well capitalized, they
have effective oversight, and real vigilance from the
regulators, whether it is the Fed as a backstop regulator to
clearance and payment systems or the functional regulators, the
SEC and the CFTC. It will be important for them to have
conservative margin requirements and very important for them to
have procedures that are well understood, very transparent for
how they will resolve the default of a participant in the
clearinghouse.
Senator Bunning. Ms. White, would you like to comment
anyway?
Ms. White. The Board believes that CCPs are critical
utilities in the financial markets and they need to be
regulated and they need to have risk management that would
ensure that they carry out their functions in a sound manner.
They are, as you pointed out, subject to the possibility of
needing liquidity in extreme situations. The Administration has
proposed broadening the Fed's ability to provide liquidity in
extreme situations, and the Board supports that.
Senator Bunning. Thank you very much.
Chairman Reed. Senator Johanns.
Senator Johanns. Thank you, Mr. Chairman.
One of the observations at least that I have made as I look
back over the last months is it seems to me the big got bigger,
they got more tangled up in so many parts of the economy. Very,
very bad decisions were made, and you are off to the races. And
then the taxpayer was asked--or told, as in General Motors'
case--that, guess what, they bailed them out.
If you are adding more regulation, capital requirements,
transparency, somebody is going to have to comply with that
within the dealer's organization, and there is going to be a
cost to that.
Where, in your judgment, will the cost of that be borne? I
mean, somebody has to pay for it. If it is the airline industry
and they are hedging against the rising cost of fuel for their
jets, won't consumers pay for that in higher ticket prices?
Ms. Schapiro. I will take a stab at that. The cost of
regulation clearly will ultimately be borne by consumers, and I
think that is just a given historically and going forward.
It would be my fervent hope that the costs of regulation
going forward would pale in comparison to the costs of what we
have been through in the last year or two. But it does, I
think, point out, very rightfully so, that we have to be
sensitive to the costs of the requirements that we may end up
proposing----
Senator Johanns. You know, and, Chairman, I am not--gosh, I
am not debating that. I think some response to this is
absolutely necessary. You know, I am one of the people
screaming about General Motors. I thought it was a very bad
decision to buy the company. But having said that, we now own
it. I would hate to think that we are not doing something here
that will protect taxpayers in the future. So that is not even
really a debating point.
But one of the things I found out as Secretary of
Agriculture, once you try to do these overarching regulations
and press those down upon the agricultural system, the large
operators who had access to capital, et cetera, they tended to
survive and get bigger, because they needed to get bigger to
pay the cost of the regulations. The small operators went out
of business. They just could not endure what you were asking
them to endure. And over time you ended up with exactly what we
are trying to deal with here, is the big got bigger.
Ms. Schapiro. Right. I completely agree with that, and I
think we have to be sensitive to costs going forward. One of
the segments of our financial services industry that actually
weathered the past year reasonably well were smaller and
medium-size financial institutions. And so I think it--which
shows to me that the diversity of financial institutions in
this country is an important safety and soundness feature in
and of itself. And I think it is going to be very important for
the regulators, as we create a new regulatory structure if
Congress empowers that, to be sensitive to costs, particularly
those that will be borne by smaller and medium-size businesses
that are very important ultimately to access to financial
services for millions of Americans who will not be going to the
largest dealers.
Mr. Gensler. If I might, Senator, I am actually quite the
optimist at this table. I believe for small firms that this
will actually lower costs of doing the standard product. Most
small firms hedging an interest rate risk or shipping a product
to Europe and want to hedge a currency risk do not have
transparency right now. And even a few basis points, which is a
hundredth of 1 percent, costs something over the years.
I think lending greater transparency to these markets will
benefit the many thousands of small businesses and
municipalities in this country, particularly on a standard
product.
Senator Johanns. The transparency is not the issue. You can
bring up the transparency and I think everybody would love
that. The issue is what they have to deal with every day to try
to get their transaction done. And I will just tell you, having
worked with overarching regulations, I think in the end you
hammer the little guy. It just seems to me that the little guy
is going to look at this and say, ``I cannot make it. I do not
have enough where I can pass it on to the consumer,'' just like
the person with a hundred cows today is struggling to survive.
And I just worry that what you are doing here, unless you do
something in that area, you are going to put the little guys
out of business.
Mr. Gensler. Well, I think that you raise a very important
point, and as we work together on this regulation and
legislation, I look forward to talking more. I think that they
will also greatly benefit by lowering some of the risk and
increasing transparency in these markets.
Senator Johanns. Thank you, Mr. Chairman.
Chairman Reed. Thank you very much.
Thank you for your excellent testimony. There may be
additional questions that will be submitted to you for the
record, and we would ask you to respond in a very timely
fashion. But thank you very much, and let me call forward the
second panel.
Mr. Gensler. Thank you.
Ms. Schapiro. Thank you.
Chairman Reed. Welcome, gentlemen. Let me introduce our
second panel.
Our first witness is Dr. Henry Hu, the Allan Shivers Chair
in the Law of Banking and Finance at the University of Texas
School of Law. His research centers on corporate governance and
financial innovation. A 1993 Yale Law Journal article showed
how sophisticated financial institutions may make big mistakes
as to derivatives. His work on the decoupling of debt and
equity rights from economic interests has attracted wide
attention, including, coincidentally, a story in the current
issue of The Economist. So welcome, Dr. Hu. Thank you.
Our next witness is Mr. Kenneth C. Griffin. He is the
founder, President, and Chief Executive Officer of Citadel
Investment Group, L.L.C., a global hedge fund and asset
management firm. Citadel operates in the world's major
financial centers, including Chicago, London, New York, Hong
Kong, and San Francisco. Mr. Griffin is also a member of
several philanthropic boards, including service as Vice
Chairman of the Chicago Public Education Fund. Thank you, Mr.
Griffin.
Our next witness is Mr. Robert G. Pickel. He is the
Executive Director and Chief Executive Officer of the
International Swaps and Derivatives Association, or ISDA, which
is the global trade association for over-the-counter
derivatives. Previously, Mr. Pickel was the General Counsel of
ISDA, serving in that capacity since November 1997. Prior to
joining ISDA, Mr. Pickel was Assistant General Counsel in the
Legal Department of Amerada Hess Corporation, an international
oil and gas company, from 1991 to 1997. Welcome, Mr. Pickel.
Our fourth witness is Mr. Christopher Whalen, the Managing
Director of Institutional Risk Analytics, a Los Angeles-based
provider of risk management tools, but Mr. Whalen is a proud
resident of Croton-on-the-Hudson, New York. They provide
consulting services to auditors, regulators, and financial
professionals. Mr. Whalen leads the company's risk advisory
practice and consults for global companies on a variety of
financial and regulatory issues. He is also the regional
director of the Professional Risk Managers International
Association and is a board adviser Eye on Asia, a global
business security and risk consultancy based in Hong Kong.
Thank you, Mr. Whalen.
Dr. Hu, would you please begin?
STATEMENT OF HENRY T. C. HU, ALLAN SHIVERS CHAIR IN THE LAW OF
BANKING AND FINANCE, UNIVERSITY OF TEXAS LAW SCHOOL
Mr. Hu. Mr. Chairman and distinguished Members of the
Subcommittee, thank you for this opportunity. My name is Henry
Hu. I teach at the University of Texas Law School and my
testimony reflects my preliminary views as an academic. In the
interest of full disclosure, I recently agreed to begin working
soon at the Securities and Exchange Commission. I emphasize
that I am currently a full-time academic, have been so for over
two decades, and after this forthcoming government service will
return to my normal academic duties. What I will say today does
not reflect the views of the SEC and has not been discussed
with, or reviewed by, the SEC. I have submitted written
testimony. I ask that it also be included in the record.
This is a seminal time for the regulation of over-the-
counter derivatives. My understanding is that the Subcommittee
wanted me to offer a broad perspective as to undertaking this
task instead of analyzing specific elements of the President's
proposal.
Almost from the beginning of the OTC derivatives markets in
the late 1970s, two overarching visions have animated the
regulatory debate. The first vision is that of science run
amok, of a financial Jurassic Park. In the face of relentless
competition and capital market disintermediation, big financial
institutions have hired financial scientists to develop new
financial products. Often operating in an international
wholesale market open only to major corporate and sovereign
entities--a loosely regulated paradise hidden from public
view--these scientists push the frontier, relying on powerful
computers and esoteric models laden with incomprehensible Greek
letters.
But danger lurks. As these financial creatures are created,
evolved, and mutate, exotic risks arise. Not only do the
trillions of mutant creatures destroy the creators in the
wholesale capital market, they escape to cause havoc in the
retail market and economies worldwide.
This first vision focuses on the chaos that is presumed to
result from the innovation process. The chaos could be at the
level of the entire financial system. This motivated, of
course, the Federal Reserve's intervention in 1998 of Long-Term
Capital Management--perhaps they should have called this hedge
fund something else--and the intervention in 2008 as to AIG.
There could also be chaos at the level of individual market
participants. Witness the bankruptcy of Orange County in 1994,
and also in 1994, the huge derivatives losses at Proctor and
Gamble--but perhaps that company's name was appropriate.
But there is also a second vision, one that is the converse
of the first vision. Here, the focus is on the order, the
sanctuary from an otherwise chaotic universe made possible by
the innovation process. The notion is this. Corporations and
others are subject to volatile financial and commodities
markets. Derivatives, especially OTC derivatives, can allow
corporations to hedge against almost any kind of risk. This
allows corporations to operate in a more ordered world.
If the first vision is that of a Jurassic Park gone awry,
the second vision is that of the soothing, perfect, hedges
found in formal English and Oriental gardens. While the first
vision focuses on the private and social costs of derivatives,
the second vision emphasizes the private and social benefits of
OTC derivatives.
In fact, there are elements of truth to both visions and
the essential task ahead is to try to reduce the costs of such
derivatives without losing their benefits.
Now, that is easily said. How can we actually accomplish
this?
Well, in my academic articles on this matter, I stress one
theme. We must not just focus on the characteristics of
individual OTC derivatives, but also on the underlying process
of financial innovation through which products are invented,
introduced to the marketplace, and diffused. That is, the
financial innovation process itself, not just individual
derivatives, has regulatory significance.
Because of time limitations, I simply refer to two or three
examples, and only very briefly. First, the innovation process
can lead to chaos by causing important market participants to
make big mistakes. In an article published in 1993 in the Yale
Law Journal entitled ``Misunderstood Derivatives,'' I argued
that the particular characteristics of the modern financial
innovation process will cause even the most sophisticated
financial institutions to make big mistakes as to derivatives.
Second, the gaps in information as to this innovation
process between the regulators and the regulated are
extraordinary. Regulators may not even be aware of the
existence of certain derivatives, much less how they are
modeled or used. And so beginning in 1993, I have urged the
creation of a centralized informational clearinghouse as to OTC
derivatives.
Third, let's focus on one particular example of the
innovation process, the so-called ``decoupling'' process. I
have--beginning in 2006--been the lead or sole author as to a
series of articles suggesting that this decoupling process can
affect the core disclosure and substantive mechanisms of our
economic system. In the initial 2006 articles, the focus was on
the equity side. Those articles showed how you could have an
``empty voter'' phenomenon. For instance, the person holding
the highest number of votes in a company could be somebody with
no economic interest or a negative economic interest. And
similarly, there is a ``hidden morphable ownership'' issue.
Those 2006 articles showed how some hedge funds and others have
used cash-settled equity swaps in efforts to try to avoid
making disclosures under Section 13(d) of the Securities
Exchange Act of 1934.
In 2007, it suddenly occurred to me that the same kind of
decoupling process can work on the debt side. For instance,
using credit default swaps, you could have creditors who are
``empty creditors.'' With this empty creditor situation, these
creditors might often have weaker incentives than traditionally
to make sure that their borrowers stay out of bankruptcy.
Indeed, if they hold enough credit default swaps, they might
benefit from their borrowers going into bankruptcy. In these
times, this is deeply troubling.
Let me conclude. Three econometricians went hunting in the
wilds of Canada. They were getting hungry and they suddenly see
a deer. One econometrician shoots and misses three feet to the
right. The second econometrician shoots and misses three feet
to the left. The third econometrician doesn't shoot but shouts,
``We got it! We got it!''
It is very difficult to come up with a good model, much
less one that would actually put food on the table. The task of
coming up with a good model for regulating derivatives is no
less difficult, and we now all know that this task is essential
to making sure that food is indeed on the table for everyone.
Thank you very much.
Chairman Reed. Well, thank you very much, Dr. Hu.
Mr. Griffin, please.
STATEMENT OF KENNETH C. GRIFFIN, FOUNDER, PRESIDENT, AND CHIEF
EXECUTIVE OFFICER, CITADEL INVESTMENT GROUP, L.L.C.
Mr. Griffin. Chairman Reed, Senator Bunning, Members of the
Committee, I am Kenneth Griffin, President and CEO of Citadel
Investment Group and I appreciate the opportunity to testify
and share our views regarding effective oversight of the OTC
derivatives market.
The appropriate oversight of the OTC derivatives market is
of paramount importance to the safety and soundness of our
financial system. The events of recent months have made it
abundantly clear that large financial firms are not too big to
fail, but rather too interconnected to fail. The idea that
extreme measures must be taken to prevent the failure of a
single firm, such as Bear Stearns, which had just over $10
billion of shareholders' equity and a few thousand employees,
drives home the point that greater regulation of our financial
markets is warranted.
Derivatives serve an incredibly important role in our
financial markets. Current notionals exceed several hundred
trillion dollars and reflect the important role of these risk
transference contracts. The commercial justifications for this
market are well established and well understood.
Regretfully, as this market has grown to almost
unimaginable scale, the regulatory framework and market
structure have not kept pace. Now is the time to put an end to
the antiquated practice of bilateral trading. The use of
central clearinghouses open to all market participants will end
the era of too interconnected to fail. The use of central
clearinghouses will bring considerable value to society in the
form of far greater price transparency; fairer executions for
all users of these instruments, and in particular for less
frequent users, such as municipalities, smaller corporations,
and local banks; far greater ease of regulatory oversight; and
reduced responsibility for any systemic risk regulator.
In addition, a central clearinghouse will create a stronger
regulatory framework for all users, including regional banks,
insurance companies, pension plans, and other pools of
investment capital. For example, margin requirements and daily
mark-to-markets will apply to all users of the clearinghouse.
Capital requirements on the trading of derivatives not cleared
through a central clearinghouse should reflect the significant
systemic risk they create and should be substantially higher
than those in existence today.
Citadel has a vested interest in seeing this modernization
of our financial markets. We and several of the largest asset
managers in the world have united behind the CME group in the
development of a neutral, open access, central counterparty
clearing solution for credit default swaps. As part of a larger
community of investors, we are committed to the improvement of
the safety and soundness of our financial markets.
The commitment of many of the leading buy-side firms to a
central clearinghouse reflects the inherent weaknesses in
today's dealer-centric bilateral trading model. For example,
customers are often required to post initial margin to their
counterparties to initiate a trade. These funds are commingled
with the dealer's other assets. Because customer margin is not
segregated, customer funds could be lost in a dealer default.
In times of stress, customers will rush to close out positions
to recover their margin. This can intensify a liquidity crisis,
as we saw last fall. And last fall, when customers sought to
mitigate credit risk by closing out positions with dealers, the
prices at which they could terminate contracts were often
extremely unfair.
Customers do not have access to high-quality market data in
today's paradigm, such as transaction prices. This information
is closely held and not broadly available. Customers require
transaction data and accurate prices to understand the
riskiness of their portfolios. Without this information, the
ability of customers to prudently manage their portfolios is
substantially limited.
The large dealers earn extraordinary profit from the lack
of transparency in the marketplace and from the privileged role
they play as credit intermediaries in almost all transactions.
The current market structure suits their interests and leaves
their customers at a significant disadvantage. But the memories
of AIG, Bear Stearns, and Lehman Brothers, to name a few,
should prompt, in fact, demand, a swift and thoughtful response
from our regulators and legislators.
Today, the vast majority of credit default and interest
rate swap contracts have standardized terms and trade in large
daily volumes. Arguments have been advanced about the
importance of customized derivatives, which represent a small
percentage of total activity. Customized derivatives are
important, but they come with significant operational risk,
model risk, and financial risk. We should permit the continued
use of customized derivatives with appropriately heightened
regulatory capital requirements and far clearer risk
disclosures to nonfinancial institutions and users.
In the end, I strongly believe these arguments are nothing
more than a strategy to obfuscate the real issues at hand,
principally the need to bring much overdue modernization to our
marketplace. This problem has an international dimension. We
must work to coordinate our actions with foreign regulators.
Otherwise, we face the risk of cross-border capital and
regulatory arbitrage. The status quo cannot be allowed to
continue. We must work together to drive market structure,
reform that fosters orderly and transparent markets, that
facilitates the growth and strength of the American economy and
protects taxpayers from losses, such as those that we have
witnessed in the last year.
Thank you for the opportunity to testify today. I would be
happy to answer your questions.
Chairman Reed. Thank you very much, Mr. Griffin.
Mr. Pickel, please.
STATEMENT OF ROBERT G. PICKEL, EXECUTIVE DIRECTOR AND CHIEF
EXECUTIVE OFFICER, INTERNATIONAL SWAPS AND DERIVATIVES
ASSOCIATION, INC.
Mr. Pickel. Chairman Reed, Ranking Member Bunning, and
Members of the Subcommittee, thank you very much for inviting
ISDA to testify today. We are grateful for the opportunity to
discuss public policy issues regarding the privately
negotiated, or OTC, derivatives business. Our business provides
essential risk management and cost reduction tools for many
users. Additionally, it is an important source of employment,
value creation, and innovation for our financial system.
In my remarks today, I would briefly like to underscore
ISDA and the industry's strong commitment to identifying and
reducing risks in the privately negotiated derivatives
business. We believe that OTC derivatives offer significant
value to the customers who use them, to the dealers who provide
them, and to the financial system in general by enabling the
transfer of risk between counterparties.
OTC derivatives exist to serve the risk management and
investment needs of end users. They include over 90 percent of
the Fortune 500, 50 percent of mid-size companies, and
thousands of other smaller American companies. The vast
majority of these transactions are interest rate and currency
swaps and equity and commodity derivatives. These are privately
negotiated, bilateral contracts that address specific needs of
thousands of companies.
We recognize, however, that the industry today faces
significant challenges and we are urgently moving forward with
new solutions. We have delivered and are delivering on a series
of reforms in order to promote greater standardization and
resilience in the derivatives markets. These developments have
been closely overseen and encouraged by regulators who
recognize that optimal solutions to market issues are usually
achieved through the participation of market participants. As
ISDA and the industry work to reduce risk, we believe it is
essential to preserve flexibility to tailor solutions to meet
the needs of customers, and the recent Administration proposals
and numerous end users agree.
Mr. Chairman, let me assure you that ISDA and our members
clearly understand the need to act quickly and decisively to
implement the important measures that I will describe in the
next few minutes.
Last week, President Obama announced a comprehensive
regulatory reform proposal for the financial industry. The
proposal is an important step toward much-needed reform of
financial industry regulation. The reform proposal addressed
OTC derivatives in a manner consistent with the proposals
announced on May 13 by Treasury Secretary Geithner. ISDA and
the industry welcomed in particular the recognition of industry
measures to safeguard smooth functioning of our markets and the
emphasis on the continuing need for the companies to use
customized derivatives tailored to their specific needs.
The Administration proposes to require that all derivative
dealers and other systemically important firms be subject to
prudential supervision and regulation. ISDA supports the
appropriate regulation of financial and other institutions that
have such a large presence in the financial system that their
failure could cause systemic concerns.
Most of the other issues raised in the Administration's
proposal have been addressed in a letter from ISDA that ISDA
and various market participants delivered to the Federal
Reserve Bank of New York earlier this month. As you may know, a
Fed-industry dialogue was initiated under Secretary Geithner's
stewardship of the New York Fed nearly 4 years ago. Much has
been achieved and much more has been committed to, all with the
goal of risk reduction, transparency, and liquidity. These
initiatives include increased standardization of trading terms,
improvements in the trade settlement process, greater clarity
in the settlement of defaults, significant positive momentum
central counterparty clearing, enhanced transparency, and a
more open industry governance structure.
In our letter to the New York Fed this month, ISDA and the
industry expressed our firm commitment to strengthen the
resilience and robustness of the OTC derivatives markets. As we
stated, we are determined to implement changes to risk
management, processing, and transparency that will
significantly transform the risk profile of these important
financial markets. We outlined a number of steps toward that
end, specifically in the areas of information transparency and
central counterparty clearing.
ISDA and the OTC derivatives industry are committed to
engaging with supervisors globally to expand upon the
substantial improvements that have been made in our business
since 2005. We know that further action is required and we
pledge our support in these efforts. It is our belief that much
additional progress can be made within a relatively short
period of time. Our clearing and transparency initiatives, for
example, are well underway with specific commitments aired
publicly and provided to policy makers.
As we move forward, we believe the effectiveness of future
policy initiatives will be determined by how well they answer a
few fundamental questions. First, will these policy initiatives
recognize that OTC derivatives play an important role in the
U.S. economy? Second, will these policy initiatives enable
firms of all types to improve how they manage risk? Third, will
these policy initiatives reflect an understanding of how the
OTC derivatives markets function and their true role in the
financial crisis? Finally, will these policy initiatives ensure
the availability and affordability of these essential risk
management tools to a wide range of end users?
Mr. Chairman and Committee Members, the OTC derivatives
industry is an important part of the financial services
business in this country and the services we provide help
companies of all shapes and sizes. We are committed to
assisting this Committee and other policy makers in its
considerations of these very important policy initiatives. I
look forward to your questions. Thank you.
Chairman Reed. Thank you very much, Mr. Pickel.
Mr. Whalen, please.
STATEMENT OF CHRISTOPHER WHALEN, MANAGING DIRECTOR,
INSTITUTIONAL RISK ANALYTICS
Mr. Whalen. Mr. Chairman, Senator Bunning, thank you for
inviting me to be with you today. I am going to summarize a
couple of the key points in my remarks, which are part of the
record. I would also like to ask that an interview we published
today in the Institutional Risk Analyst with Ann Rutledge, who
is a great colleague of mine and an expert on derivatives and
structured finance, be included in the record, as well. I will
be happy to submit that.
Chairman Reed. Just submit it to us, please, Mr. Whalen.
Mr. Whalen. I agree with many of the things that have been
said in previous testimony and I am very encouraged by what I
hear. I hope you will take this as an initial fact finding
session today because I think it is important that the Congress
build a complete public record on this issue and that will take
some time.
You have heard a lot about centralized clearing. I don't
think anybody is opposed to that. It makes sense. It is part of
the evolution of markets. Whenever financial markets start, the
first few people who figure out an opportunity never want
standardization. They don't want too many people to know what
they are doing because they are harvesting the biggest returns
that you will ever see in that new market. And over time, as
the crowd gets bigger, they all agree that standardization and
a certain degree of consistency is important for the
participants. This is the way all of our markets have evolved
in this country over the last century or more.
But I would tell you that I think that clearing is a bit of
a canard. I don't think it really is the problem. I think it is
part of the problem. It was manifest in many ways over the last
few years. I also think that a lot has been said today about
information, about a lack of transparency. And again, who
disagrees with transparency? It is like motherhood and apple
pie. Everybody is for it.
But I think in working with our clients and talking through
these issues--and my views on these issues have changed over
the last 20 years, I will be the first to admit, that is part
of the learning process--but I think that everything we deal
with today, the systemic risk, the concern that is felt by buy-
side investors today who are basically on strike--hinges on
valuation. Investors don't want to know about any of these
toxic products until the sell side of the street meets their
concerns about transparency and price discovery--I particularly
appreciate Ken's comments from Citadel. I totally agree with
what they are saying. But to me, the basic problem is not with
most of the over-the-counter derivatives for currencies or
interest rates. These are all fine. They have a visible cash-
basis market that everybody can see, the buyer and the seller.
Both parties can validate the derivative contract price
immediately.
Where I think we have a big problem that may not be
surmountable is when you allow the investment community to
create derivatives where there is no visible cash market. In
other words, we are creating the derivative of something that
can only be validated with a model. And as we all know, all
models are always wrong. They are right at a certain point in
time, but if they are not dynamic, the next day, the next week,
the next month, it is off base.
So I think the key question we have to ask, and this goes
back to the basic principles that underlie all of the futures
and forward OTC markets in our country, is if you can't see a
real price, a cash price and a price that reflects volume,
reflects a large community of interest so that that price means
something, how do you validate a derivative that is supposedly
based on that asset?
Classic example, single name credit default swaps. These
products essentially let you create a hedge for a corporate
bond that is illiquid, or even a completely illiquid loan for
that corporation. Now, CDS is a wonderful thing. Everybody in
the market agrees, this is a great facility to have, to be able
to hedge an exposure with a short position that I can't create
in a cash market. I can't borrow that bond to deliver it
against a short position. It is illiquid. So we have decided
that instead of that price that we don't see, that we can't
observe, we are going to use models instead. I think that is a
very tenuous, speculative basis for a derivatives market. Now,
there may be a certain class of market participants who can
participate in such activities, but I think for federally
insured banks, for pension funds, for State and local agencies,
that is probably a bridge too far.
I am a simple guy. I started off in the early, early days
of asset swaps and currency swaps working in the London office
of Bear Stearns in the mid-1980s. But the beautiful thing about
that time is that you never had any question what the swaps
were worth. And frankly, I don't even worry about
customization. If I have a visible cash basis, I don't mind if
someone wants to customize a contract. I don't see what the
problem is there.
But the problem I do see is that when you allow
sophisticated organizations that are a lot smaller than most of
us to create vehicles that cannot be validated in the cash
marketplace, we have created risk that I think is very, very
difficult to address, and particularly for the vast majority of
companies and individuals who really are not competent to make
investment decisions without professional advice.
I have worked as a supervisor of investment bankers,
traders, and researchers, and things like suitability and
``know your customer'' mean something to me. I worked for two
firms that have very large retail branch networks and we always
had to ask ourselves the question when we priced a deal, were
we serving the banking customer and were we serving the retail
investors that we were going to release securities to when we
did a deal. We had a duty to both sides of the trade. And it is
that basic element of fairness, not just transparency, not just
functionality and risk management, but fairness that I think
this Committee has to think about.
I look forward to your questions.
Chairman Reed. Well, thank you very much, gentlemen, for
excellent testimony and focusing on a range of issues.
Let me start off with asking each one of you, there appears
to be a commonality between both the SEC and the CFTC about the
need to register dealers as one of the basic starting points
for at least partial reform of the system, and we all recognize
that this is a long road and a challenging one. So starting
with Professor Hu, your sense of the dealer registration. How
central is it? Is that one of the top legislative items we
should pursue?
Mr. Hu. Yes. I think----
Chairman Reed. If you could put your microphone on,
Professor.
Mr. Hu. Yes, I think the prudential supervision of dealers
is extremely important. I think that the experience with AIG
and the decision-making errors that AIG had while acting as a
CDS dealer tend to illustrate how it is important for the
Federal Government to get involved as to how these decision-
making errors can occur. As another example, the government
should also consider the payoff structures, including highly
asymmetric compensation structures sometimes seen within
derivatives units. Sometimes, the rocket scientist gets a big
payoff if some product works while, at most, may lose his job
if it does not work.
One might also ask about the financial literacy of the
people who are supposed to be supervising the rocket scientists
developing these products? Moreover, when do the risks arise?
As we all know, in terms of the derivatives personnel, there
tends to be high turnover. The risks may not arise until they
are three banks away.
So that as part of this process in terms of prudential
supervision, I think that we really need to look very carefully
in terms of how these errors can arise at ``sophisticated''
derivatives dealers. In fact, there are error issues as well--
and this came up earlier--in connection with end users. In
terms of end users, there has been a pattern throughout the
history of OTC derivatives of very unsophisticated entities
basically gambling and losing. We do not need to even look at
the examples of some of today's municipalities getting into
trouble as to complex products. There are some famous examples
from the late 1980s involving English local councils such as
Hammersmith and Fulham. These councils basically decided that
the way to keep taxes down is by speculating on interest rates
through interest rate swaps.
So that I think in terms of this area, certainly one of the
things that we ought to look at is the prudential supervision
of derivatives dealers and suitability and related sales
practice matters. But we also ought to look at the end-user
side, including as to the adequacy of end-user disclosures of
their derivatives activities and the like. Substantive
questions can also arise. What was Procter & Gamble or what was
Gibson Greetings doing engaged in LIBOR-squared interest rate
swaps?
So I think that there are issues all around in this area.
Chairman Reed. Thank you, Dr. Hu.
Mr. Griffin, please, your comment.
Mr. Griffin. Thank you. So on the topic of--sorry about
that. I would take a step back on the question and ask, ``How
do I simplify the regulatory oversight problem as much as
possible?'' And central clearinghouses create a tremendous
opportunity to reduce the size and scope of the regulatory
oversight problem.
First of all, the notionals in existence today dramatically
overstate the amount of economic risk being transferred, but do
not overstate both the operational risk and credit risk
inherent in the system. Central clearinghouses will
dramatically reduce, because of their inherent netting, the
amount of notional risk in the marketplace, and that reduces
both operational risk and materially reduces counterparty risk.
The market's understanding of cleared products is
dramatically higher than the market's understanding of the
paper contracts that define the market today. As ISDA pointed
out, we have worked on reducing settlement problems in the
system today, but we need to go back only a few years to when
dealers had weeks and weeks of backlogs of unconfirmed and
unprocessed trades--trades that could total into the hundreds
of billions of dollars. Trades for which no one had taken the
time to ensure were properly recorded on the books and records
of the institution.
Central clearinghouses with straight through processing
eliminate that dramatic operational risk. This will then allow
the regulators to focus their efforts around the customized
derivatives that do have a role in the dealers' portfolios. It
will allow the regulators to spend their time focusing on the
handful of contracts for which no standardized solution is
appropriate. I believe that our regulators will have the
ability and will acquire the abilities over time to find the
people to understand the risk in the customized portfolios.
To the extent they cannot, those products are not
appropriate for regulated institutions to deal in. You cannot
call an institution that is regulated ``well regulated'' if no
one actually understands the risks inherent in their portfolio
other than the 20-some-year-old traders that run the trading
floors.
Chairman Reed. Mr. Pickel and then Mr. Whalen.
Mr. Pickel. Yes, I think what I would focus on in terms of
the priority is systemic risk issues, and specifically how do
we prevent another AIG type situation? And while regulation of
dealers could be helpful in that, I think most importantly is
having some window for regulators into risk, and that will be
achieved partly by these trade information warehouses that have
been talked about, getting the information there where,
frankly, all regulators could have access to that, not just a
systemic risk regulator but all regulators. And, second, what
happened with AIG is many of the counterparties were dealers,
and many of them were banks and overseen by banking regulators.
They were each building up risk, but nobody was there to
connect all the different dots, like a systemic risk regulator
could, if established by the Congress, to give that window into
risk and to put on the brakes or make changes when they see
that risk building up in the system.
Chairman Reed. Thank you.
And, Mr. Whalen, your comment?
Mr. Whalen. I think it is an effective practical question.
The chief purpose of regulation should be to focus on things
like suitability and the customer-focused issues. Obviously,
systems and controls, risk management, all that are very
important within a dealer, there is no question. But as I was
saying before, there are certain classes of instruments that
you really cannot risk manage. You were talking before about an
airline that wants to put together a complex, customized swap
for fuel. There is no problem with that. Everybody knows what
the price of fuel is today. And you do the work, you calculate
the optionality in the complex structure, and you can figure
out what it is worth.
The trouble comes if you look at the subprime complex
structured asset market of a couple years ago, that we had
everybody in agreement, much like playing Liar's Poker. The
model became the definition of value for this class of
instruments. But one day a number of people on the buy side
started to question that assumption of ``mark-to-model.'' They
started backing away from these securities. So did the dealers.
So at some point--it is hard to say when--the consensus
about value for that class of asset broke down. And that is
where we are today. The buy-side customer still does not want
to know about securities that have no visible cash market basis
and effectively rely upon ``mark-to-model'' for price
discovery.
So I question really how effective risk management can be
in those cases where we do not have a completely separate,
independent reference point for value such as a liquid, cash
market.
Chairman Reed. Thank you.
Senator Bunning.
Senator Bunning. Yes. Messrs. Griffin, Whalen, and Pickel,
should parties to derivative contracts be required to post cash
collateral? Or is other collateral acceptable? And is there any
reason not to require segregation of customer collateral?
Mr. Griffin. Senator, I believe that one of the hallmarks
of mature markets is a well-functioning margin paradigm where
customer assets are segregated. If we look at the futures
markets, we have had great success. The CME, for example, in
over 100 years, through wars, through the Great Depression, has
never had a loss that needed to be mutualized because of their
appropriate margin requirements.
Now, what should be postable as collateral? At the CME, for
example, you can post cash, you can post treasuries, you can
post a variety of liquid, well-understood assets as collateral,
and that is the right paradigm, in my opinion.
Senator Bunning. Mr. Pickel.
Mr. Pickel. Yes, as far as the types of collateral, I think
similarly cash and liquid instruments would be appropriate.
There have been discussions about other types of securities
that might be taken as collateral, but you would have to have
significant haircuts apply to those to even consider them, you
know, 50 percent or something, in order to take them in.
I think as far as segregation of customer collateral, in
the OTC--and I am talking about the customized piece of the
business--the use of margin is extensive in that business, and
I think that one of the reasons it is used so effectively is
that there is an ability to, as I say, rehypotheticate or pass
on collateral and use it for your own positions. But I think
there is certainly room for greater exploration of segregation
of collateral so that customers can have the confidence that
when something like a Lehman Brothers situation should happen,
they can get a hole of their collateral. So I think there is a
lot of focus on that going forward.
Senator Bunning. Mr. Whalen.
Mr. Whalen. I agree with the other speakers. Segregation of
collateral is one of those evolutions we badly need. But I
think the other issue that we ought to touch on briefly. The
dealers amongst themselves tend to rely on overarching credit
agreements and treaties to deal with all manner of collateral
and exposure back and forth; whereas, if you move to an
exchange type model, everyone is treated the same and everyone
must independently post collateral with the exchange. Whether
you are a dealer or a customer, you have different tiers of
collateral requirements, but the point is there is a third
party who holds the money. You do not have the dealer holding
the collateral. You actually have the clearinghouse or a trust
company that is separate from the dealer. And I think that is
an important distinction.
Senator Bunning. This is for anybody. What economic value
outweighs the social cost of allowing someone to buy insurance
in the form of swaps for assets they do not own? Turn it on,
please.
Mr. Hu. Ranking Member Bunning, this issue is really very
interesting. In terms of credit default swaps, some State
insurance regulators have argued that you should not be able to
buy credit default swaps unless you have an insurable interest.
Well, interestingly, the problems may actually be more complex
if you do have an insurable interest than if you did not. Let
me explain.
When you think about owning a bond or owning a loan and you
are a creditor, you traditionally have economic rights,
principal and interest; you have various control rights, the
various affirmative covenants and negative covenants into a
loan agreement or bond indenture; and you have various rights
given to you under bankruptcy law, securities law, and other
laws. And sometimes you have obligations, too. This is the
package of rights that you classically get as a creditor.
Now, traditionally and in market practice, you typically
assume that it is a single-bundled package. So a borrower is
willing to give to the creditor these control rights because he
thinks the creditor would like to see it survive to pay back
the creditor.
Well, in today's world, what if the creditor has lent, say,
$100 million and, to conjure up a really extreme example, buys
$200 million notional of credit default swaps? This would be an
extreme version what in 2007 I called an ``empty creditor.''
This is a really extreme version. It probably does not happen
often. But in this extreme example, you would have a creditor
who, rather than wanting to work with the borrower for the
borrower to avoid bankruptcy, might want to grease the skids to
make sure that the person goes into bankruptcy.
Now, even if you do not have that extreme situation,
problems can arise with an empty creditor. That creditor has
much weaker incentives to work with the borrower to avoid
bankruptcy. And certainly if a troubled borrower is not aware
that the creditor has bought credit default swaps he may not
understand the true incentives of the creditor with whom he is
negotiating. And if the borrower actually goes into bankruptcy,
there are all kinds of complications, disclosure and
substantive, that arise within bankruptcy proceedings.
Do ``empty creditor'' situations actually happen in the
real world? As some of you know, I wrote an op-ed in the April
10 Wall Street Journal about the possible relationship of
Goldman Sachs to AIG. There was a really curious incident
that--an incident that became curious in retrospect.
In September, as you will recall, Lehman had collapsed. AIG
was teetering. The Fed felt compelled to intervene to prevent
AIG from collapsing. That September 16th, Goldman Sachs said
its exposure to AIG was ``not material.''
But come the middle of March, it turns out that of the
initial $85 billion of Federal bailout money that AIG received,
about $7 billion went to Goldman.
Well, how do you reconcile that? That is, Goldman receiving
$7 billion, and yet, hey, it had no material exposure to AIG.
It turns out, and I suggest in the op-ed, Goldman may well
have been an empty creditor. That is, Goldman had bought credit
default swaps on AIG from ``large financial institutions.'' As
a result it did not care as much about what happened to AIG as
it would have in the absence of such swaps. Indeed Goldman was
vigorous in terms of calling for collateral from AIG.
However, I am not saying Goldman did anything improper.
Senator Bunning. No, but it did not work.
Mr. Hu. What was interesting was the swaps did work for
Goldman, but this situation helps suggest some of the social
dimensions of credit default swaps. Do we really want----
Senator Bunning. Well, we are still--as you know,
Professor, we are still wondering where the bottom is on AIG.
Mr. Hu. I am only using this situation to illustrate
matters related to the concerns you have; that is, you know, do
we really--as a public policy matter----
Senator Bunning. That is right.
Mr. Hu. ----shouldn't we be concerned about these creditors
who used to really care about ensuring that their borrowers
stay out of bankruptcy, that they can sometimes have much less
of an incentive to do that, and that in today's world----
Senator Bunning. We had better correct that.
Mr. Hu. We might want to consider correcting that, yes,
sir.
Senator Bunning. Thank you very much, Mr. Chairman.
Chairman Reed. Senator Johanns.
Mr. Griffin. Actually, I would like to add to that answer,
if that is OK, for a moment.
Senator Bunning. Go right ahead. I am over my time.
[Laughter.]
Mr. Griffin. It is important that we think about all the
different reasons why a company might want to use credit
default swaps--or a bank, for that matter. I, for example,
could be in the supply chain of an industry and worried that
the company to whom I have supplied goods or services may not
actually perform. They may go into default. The ability to buy
credit default swaps against that company makes it much more
economically attractive for me, for example, to enter into a
long-term sales agreement to provide goods and services to that
company. I do not own the bonds, but I do have a position over
time as being a creditor of that company as a supplier to them.
Another example--and this one strikes home at Citadel
because we lend money to a variety of companies around the
world, in the United States from small companies up to the
biggest, the Fortune 500. There is often no market for credit
default swaps for mid-sized companies. If I want to be a
significant lender to a portion of the economy where I absorb a
substantial industry risk, for example, to the airlines, let us
say I wanted to lend money to a regional carrier, I cannot buy
a credit default swap on that regional carrier, but I can buy a
credit default swap on the majors--American Airlines, Delta,
and others. It will help me to manage the industry-specific
risk that I have and that, most importantly, reduces the cost
of capital for the mid-size company vis-a-vis the large
company. So credit default swaps play a very important role in
allowing banks, pension plans, and other lenders to mid-sized
companies in America, to allow them to reduce their industry-
specific risk and to reduce the cost of capital of the
companies in America that have created the most jobs over the
last 30 years.
Chairman Reed. Mr. Pickel, I think everyone wants to ask
more questions, and Senator Bunning deserve a good answer from
everyone. But as briefly as possible.
Mr. Pickel. All right. I would say that in the derivatives
space--and this has been around for 25 years--a lot of the
developments were on market risk--interest rates, currencies,
equities, commodities, where you are managing a market risk.
Credit risk is a new, a relatively new derivative, and I would
say that we are still understanding some of the implications of
that. And I think that Professor Hu's work has been very
interesting in that regard.
I would say that, regarding that empty creditor issue, the
fact is that every time somebody is going to into the market
and buying protection, which is he suggested somebody is doing,
they are sending signals to that company: Your business plan is
not working; your business plan is not working. The yellow
light is getting brighter and brighter and brighter. And so
when it comes to the end and somebody says, ``Time is up; I am
not going to continue to lend to you,'' I think that is a
natural evolution of this market, but let us certainly
understand that.
I would also just mention that credit default swap spreads
are becoming embedded in various ways. They are being used for
pricing loans. It was done with the rollback of Scotland
extension of credit by the U.K. Government, and just today in
the Wall Street Journal, it was mentioned that S&P has
developed an additional means of providing information on
credit exposure to the marketplace that incorporates a credit
default swap spread. So we see continuing evolution here, and I
think it ought to be encouraged, but, understood, certainly.
Chairman Reed. I am going to recognize Mr. Whalen very
quickly. Senator Johanns deserves his round. And then at the
end if we have time, we will----
Mr. Whalen. I am not ever worried about two people on one
side or another of a market. So if somebody wants to buy and
sell, you know, you have heard some very good examples of the
utility of credit default swaps. The concern I have is that,
again, the small airline, the small company, does not have a
traded market and its debt that we can use the price these
contracts.
So we have, again, the Liar's Poker scenario, which is you
have got a trader in one firm and a trader in another, and they
have decided that the implied spread on the debt of this
company is a good way to price a default contract. OK?
The trouble is most people on Wall Street trade these
instruments like bond options. They use them for delta hedging
various exposures in debt or even equity markets, and, again,
these are wonderful examples. They have great utility. But the
problem is I suspect the pricing is wrong. In other words, CDS
is not priced like default insurance. So when that contract
goes into default and the provider of protection has to come up
with the money, you have got to ask yourself, going back to the
question about the supervision of dealers, is that person doing
the work so that they are actually cognizant of what the cost
of default is versus the spread on a bond?
Lehman Brothers--you could have bought protection on Lehman
Brothers a week before it failed at 7 percent. The next week
you had to come up with 97 percent worth of cash per dollar of
exposure to Lehman.
So, you know, it is the pricing issue that I think is at
the core here. It is not whether there is utility in CDS. There
is obvious utility in all of these strategies.
Chairman Reed. Thank you.
Senator Johanns.
Senator Johanns. I am hoping somebody can answer this
question. Of this whole bank of business, kind of an inartful
term, but of this entire business arena, what percentage would
be of that classification that is not easily valued?
Mr. Whalen. Oh, I think most over-the-counter contracts do
not have a problem in that regard. If you are talking about
energy, currency, whatever it is, if there is a rigorous traded
cash market, it is easy to come up with a derivative, even if
it is a very complex derivative. But when you are talking about
illiquid corporate bonds or even loans to corporations, if you
are talking about a complex structured asset that is, let us
say, two or three levels of packaging away from the reference
asset that it is supposed to be ``derived'' from, that creates
complexity in terms of pricing that I think is rather daunting.
And I will tell you now, there are very few firms on the street
that have the people, the resources, and the money to do that
work. Let me give you an example----
Senator Johanns. Mr. Whalen, doesn't that get us to the
point that I was raising in previous questioning? You know, you
have now got a whole regulatory scheme. You have got somebody
that is going to regulate it. They are hired and paid----
Mr. Whalen. That is right, and----
Senator Johanns. ----probably not very much money. And they
are probably going to take the safe route here and say, ``Boy,
I am not sure I understand this. I am not sure it can be
valued. It is a $100 million contract. We want capital.''
Mr. Whalen. And that is appropriate.
Senator Johanns. Yes. OK, so isn't that just another way
just another way of getting to the--I mean, how will capital be
posted in a circumstance like this?
Mr. Whalen. Indeed.
Senator Johanns. If you had the capital, you would probably
either loan it or not loan it. If it is a bad deal, you would
not loan it.
But, anyway, what I am getting to is this: Doesn't that
basically put that segment of this arena out of business?
Mr. Whalen. It may, and I am not sure that would not be
inappropriate, and I am sure my colleagues will disagree with
me. But let me just put it to you this way: I do not think at
the end of the day that most people on Wall Street are
competent to be a rating agency. And if you are talking about
calculating the probability of default of a company or a
security, that is not a trivial exercise. It takes a lot of
work. And I do not think most people on Wall Street do it. They
look at the Bloomberg terminal and by consensus they have all
agreed that the spread on the Bloomberg terminal, when you put
it in this model, is the price you are going to deal on,
whether it is right or not.
Senator Johanns. You know, and I would say to you, Mr.
Whalen, listening to your testimony just from a sterile
standpoint and saying, ``Well, you know, if it is that kind of
risk maybe it should be out of business,'' that is probably OK
unless that is the only regional airline in town. And when that
one goes away, guess what? Air transportation for half of
western Nebraska goes away.
Mr. Whalen. Well, I do not know any airlines that cannot
hedge their fuel costs in the standard forward market.
Senator Johanns. Well, I am not talking about fuel costs.
But you know what I am getting at here. There are always
unintended consequences, and I just want to understand them. If
we are going to put a lot of little guys out of business, tell
me that, somebody.
Mr. Whalen. Well, here is the thing. I want your little guy
to have the same facility of pricing a contract as the dealer.
Senator Johanns. How do we do that?
Mr. Whalen. Ahh, that goes to transparency, but you know
what? If I have transparency of an instrument that is still
opaque, even after I have legislated transparency, then I have
a problem.
Senator Johanns. And the tool we have been given, I think
in the end is going to be the capital requirement. That is the
ultimate protection. And boy, when you talk about what we
require, you are talking about cash, Treasuries. It sounds to
me like you are really talking about cash. You are probably not
going to take something very risky here, right?
Mr. Whalen. I think the standardized market could bring
those costs down, though, over time. I really do.
Senator Johanns. Yes, Mr. Pickel?
Mr. Pickel. Senator, yes. In the credit default swap area,
we have introduced a very high degree of standardization, to I
think your first point about which of these contracts would be
most standardized. And I think that in the credit default swaps
base, we do have contracts that will be very easy to move into
a cleared environment, perhaps more so into an electronically
traded or even exchange-traded environment. So those things are
in place. And yes, I mean, people look to the Bloomberg
screens, but it is the collective view of the marketplace, I
mean, that arrives on Wall Street. We have got very active
dealers around the world who are expressing views on these
contracts and it is that collective reflection of the market
judgment that indicates the spread at any particular point in
time.
Mr. Griffin. I think the question that you were posing
about capital and will the regulation of this market increase
the amount of capital required in the marketplace, the answer
to that question is not as clear-cut as one might imagine. The
reason for it is because of today's silly market structure. If
I buy credit protection from Goldman Sachs, I am likely to
eliminate my economic risk but not my counterparty risk by
closing that contract out with Morgan Stanley. I will still be
posting margin as a customer to both of those firms. It is
incredibly inefficient.
If I had a central clearinghouse, I would open the contract
with Goldman, clear it through a clearinghouse, close it with
Morgan Stanley, clear it through a clearinghouse, and I would
have no capital as a customer out the door any longer. I would
actually have capital that comes back to me net-net. I think it
is a very important concept to understand when we think of
clearinghouses, this will not in any way necessarily increase
the amount of capital demanded of the system as a whole because
of the tremendous efficiency inherent in netting.
The other key concept that we should keep in mind is that
price transparency will most favor the smaller, less frequent
users of derivatives. Citadel, is one of the world's largest
alternative asset managers. We can price all of the derivatives
that we commonly trade with a great degree of precision, but we
have a tremendous investment in infrastructure to do so. For
smaller companies, that is outside their range of capability.
But on an exchange, a visible exchange traded price gives the
CFO of a small company confidence that he is getting a fair
deal, and part of what we want our capital markets to do is to
create confidence in all Americans that our markets are fair,
they are transparent, and they are just, because that reduces
the cost of capital for every company in America.
Senator Johanns. You know, Mr. Griffin--and I will wrap up
with this, Mr. Chairman, I appreciate your patience--nobody is
going to disagree with your last speech. Boy, that is about as
motherhood and apple pie as we can possibly get. Nobody
disagrees with that. It is like I said. I just want to know if
this is where we are headed, what impact is it going to have on
the marketplace from the very small to the very large? My
experience is the very large survive and they get bigger.
Mr. Griffin. Actually, you would be surprised where our
analysis on this ends up. Today, the largest dealers have a de
facto monopoly in the business. It is because of their credit
rating and privileged position as credit intermediaries to
almost every contract, they earn extraordinary economic
profits. Where there is a clearinghouse, for example in the
options market, the U.S. options market, the OCC acts as a
clearinghouse for all listed transactions, you find that there
is a vibrant, an incredibly vibrant market of smaller trading
firms that add a tremendous amount of liquidity to the
marketplace.
Citadel, for example, is the single largest options market
maker in the United States. We started out from scratch 7 years
ago with zero market presence. Our ability to get to number one
was because of a lack of barriers to entry. We were allowed to
compete on a level playing field with other incumbents. In the
credit default swap or interest rate markets, the barriers to
entry are enormous. Who would want to take as a counterparty
anyone but, quote-unquote, the firms viewed today as
systemically important or too big to fail?
Senator Johanns. Here is--again, to wrap up the second
time--here is what I would ask. If there are that many small
firms out there that are going to benefit from this, my address
is online. My phone number is online. Mr. Pickel, you probably
represent some big and small people. Boy, I hope they overwhelm
me with letters over the next 72 hours or e-mails saying, Mike,
this is great, we want this to happen, because I am worried and
concerned and I don't want this in the end to create a
situation where literally by our regulatory effort we have
damaged and created the very phenomena that this hearing is
for, and that is the big just got bigger, to the point where
literally we are all scratching our head about too big to fail.
I think if we look back in 20 years and found out that is where
we ended up here, that would be a tragedy.
Thanks for your patience. I really appreciate it.
Chairman Reed. Thank you, Mr. Chairman. I want to thank you
all, gentlemen. If there are additional questions by our
colleagues--I think also that Dr. Hu has been trying to get
recognized. Can I give you a minute?
Mr. Hu. I will go under a minute.
Chairman Reed. All right. Put on your microphone and go
ahead.
Mr. Hu. I think that these clearinghouse arrangements that
we are moving to will reduce systemic risk. They will also
reduce the profits now available to derivatives dealers. It
will be cheaper for everybody in terms of standardized
products.
I think that one of the very interesting issues to think
about in connection with these clearinghouse arrangements
relates to the data that we are now going to be requiring of
all derivatives. In terms of customized derivatives, for
instance, one of the real questions is how this requirement
might be used to help to reduce this informational asymmetry
between the regulators and the regulated.
So, for instance, in terms of this general movement to more
information being provided to regulators, to what extent should
regulators actually ask for model information? Regulators can't
understand how to value some of these products, unlike Citadel.
To what extent should they actually require this kind of
proprietary information? And if we require this kind of
proprietary information, how do we maintain safeguards in terms
of respecting its proprietary nature? So I think that this is
the start of a very long process.
Chairman Reed. Well, thank you. Have the last word this
evening, but not the last word because it is a long process.
But this testimony has been excellent.
Some of my colleagues might have written questions which
they will forward to you. We would ask you within 2 weeks to
please respond.
All of your written testimony is part of the record and I
thank you all for excellent testimony and for your presence
this afternoon and I will adjourn the hearing.
[Whereupon, at 5:23 p.m., the hearing was adjourned.]
[Prepared statements, responses to written questions, and
additional material supplied for the record follow:]
PREPARED STATEMENT OF SENATOR MIKE CRAPO
Recent events in the credit markets have highlighted the need for
greater attention to risk management practices and the counterparty
risk in particular. The creation of clearinghouses and increased
information to trade information warehouses are positive steps to
strengthen the infrastructure for clearing and settling credit default
swaps. While the central counterparty clearing and exchange trading of
simple, standardized contracts has the potential to reduce risk and
increase market efficiency, market participants must be permitted to
continue to negotiate customized bilateral contracts in over-the-
counter markets.
Many businesses use over-the-counter derivatives to minimize the
impact of commodity price, interest rate, and exchange rate volatility
in order to maintain stability in earnings and predictability in
operations. If Congress overreaches and bans or generates significant
uncertainty regarding the legitimacy of decisions to customize
individual OTC derivatives transactions there will be enormous negative
implications on how companies manage risk.
At this time I would like to highlight a few examples from end
users about what are the possible effects of severely restricting
access to customized over-the-counter derivatives on companies' ability
to manage risk and on the prices they charge customers.v
David Dines, President of Cargill Risk Management: ``While
margining and other credit support mechanisms are in place and utilized
every day in the OTC markets, there is flexibility in the credit terms,
credit thresholds and types of collateral that can be applied. This
flexibility is a significant benefit for end users of OTC derivatives
such as Cargill in managing working capital. Losing this flexibility is
particularly concerning because mandatory margining will divert working
capital from investments that can grow our business and idle it in
margin accounts. While it depends on market conditions, the diversion
of working capital from Cargill from margining could be in excess of $1
billion. Multiply this across all companies in the U.S. and
ramifications are enormous, especially at a time when credit is
critically tight.''
Kevin Colgan, Corporate Treasurer of Caterpillar: ``Our
understanding of currently pending regulation in this area is that it
would require a clearing function which would standardize terms like
duration and amount. Any standardization of this type would prohibit us
from matching exactly the terms of the underlying exposure we are
attempting to hedge. This, in turn, would expose us to uncovered risk
and introduce needless volatility into our financial crisis.''
Mark Grier, Vice Chairman of Prudential Financial: ``Without
customized OTC derivatives, Prudential would be incapable of closely
managing the risks created in selling life insurance, offering
commercial loans, and proving annuities for retirement.''
John Rosenthal, Chief Hedging Officer of MetLife: ``Standardized
derivatives cannot be used effectively to hedge all types of financial
risk. Any increased risks would result in higher costs to offer and
maintain these products. In either situation the increased costs of an
inefficient derivatives market would be reflected in the pricing to our
customers. To the extent the costs and/or risks associated with an
inability to appropriately hedge these products became prohibitive;
these products could be no longer available to customers.''
Janet Yeomans, Vice President and Treasurer of 3M: ``Not all OTC
derivatives have put the financial system at risk and they should not
all be treated the same. The OTC foreign exchange, commodity, and
interest rate markets have operated uninterrupted throughout the
economy's financial difficulties. We urge policy makers to focus on the
areas of highest concern.''
At this time, I would like to submit into the record the complete
letters. It is possible that I will receive additional letters in the
next few days and I would also like to enter those letters in the
record.
While the derivatives market may seem far removed from the
interests and concerns of consumers and jobs that is clearly not the
case. Legislative proposals to alter the regulatory framework of over-
the-counter derivatives is a very technical subject matter and the
potential for legislation to have unintended consequences of legitimate
transactions is considerable.
We need to better understand the following questions:
How do businesses use customized OTC derivatives to help
stabilize prices and mitigate risk?
What are the possible effects of severely restricting
access to customized OTC derivatives on businesses ability to
manage risk and on the prices they charge customers?
What safeguards are in place to ensure that derivatives
portfolios are a tool for hedging risk, rather than a source of
risk?
What does standardized mean, and how much of the OTC
markets can and should be shifted on exchanges?
______
PREPARED STATEMENT OF MARY L. SCHAPIRO
Chairman,
Securities and Exchange Commission
June 22, 2009
Introduction
Chairman Reed, Ranking Member Bunning, and Members of the
Subcommittee: I am pleased to have this opportunity to testify on
behalf of the Securities and Exchange Commission concerning the
regulation of over-the-counter (OTC) derivatives. The severe financial
crisis that has unfolded over the last 2 years has revealed serious
weaknesses in the structure of U.S. financial regulation. One of these
is the gap in regulation of OTC derivatives, which under current law
are largely excluded or exempted from regulation. The SEC is committed
to working closely with this Committee, the Congress, the
Administration, and fellow regulatory agencies to close this gap and
restore a sound structure for U.S. financial regulation.
My testimony today on the regulation of OTC derivatives will
reflect the SEC's perspective as the country's capital markets
regulator. First, I will give an overview of the OTC derivatives
markets, with particular focus on those derivatives products that are
directly related to or based on securities or issuers of securities and
therefore directly connected with the SEC's statutory mandate. Second,
I will outline an approach that would address the existing gaps in
regulatory oversight of these securities-related OTC derivatives.
I must tell you right at the start that, given the current limited
regulation of OTC derivatives, no regulatory authority can give you a
complete picture of OTC derivatives and how they have affected the
regulated securities markets. One reason that we need legislation is
that our sources of information about securities-related OTC
derivatives products, participants, and trading are limited,
particularly when contrasted with the tools we have to monitor the
markets for other securities products subject to the Federal securities
laws.
The good news, however, is that the U.S. regulatory authorities
have reached a broad consensus on the pressing need for a comprehensive
regulatory framework for OTC derivatives. As reflected in Treasury
Secretary Geithner's letter to the Congressional leadership on May 13,
2009, this consensus covers all of the basics of sound financial
regulation in the 21st century, including record keeping and reporting
requirements, appropriate capital and margin requirements, transparent
and efficient markets, clearing and settlement systems that monitor and
manage risk, business conduct and disclosure standards to protect the
interests of market participants, and vigorous enforcement against
fraud and other wrongdoing.
One important aspect of a new regulatory framework will be well-
regulated central counterparties (CCPs). CCPs address concerns about
counterparty risk by substituting the creditworthiness and liquidity of
the CCP for the creditworthiness and liquidity of counterparties. For
this reason, CCPs contribute generally to the goal of market stability.
Through uniform margining and other risk controls, including controls
on market-wide concentrations that cannot be implemented effectively
when counterparty risk management is decentralized, CCPs help protect
the broader financial system. It is important to note that achieving
standardization, a prerequisite for centralized clearing, may present
significant challenges.
U.S. regulators agree on the objectives of a new regulatory
framework for OTC derivatives that will protect the public interest,
manage systemic risk, and promote capital formation and general
economic welfare. Any new regulatory framework, however, should take
into consideration the purposes that appropriately regulated
derivatives can serve, including affording market participants the
ability to hedge positions and effectively manage risk. My goal today
is to assist the Congress as best I can in its efforts to craft
legislation that empowers the respective regulatory authorities to do
their jobs effectively in any new framework. I am confident that,
working together, we will meet the challenge that is so important to
the financial well-being of individual Americans.
Overview of Securities-Related OTC Derivatives
A derivative is a financial instrument whose value is based on the
value of an underlying ``reference'' (e.g., an asset such as a
commodity, bond, equity, or currency, or an index of such assets, or an
event). For example, in exchange for $100 today, financial institution
``A'' will pay counterparty ``B'' $150 if ``something'' happens
(something can be almost anything: Z company defaults on its debt
payments; the S&P 500 falls 10 percent; the Dow rises 5 percent). A
derivative is ``OTC'' when it is not traded on a regulated exchange. An
OTC derivative is ``securities-related'' when the reference is to an
entity that is an issuer of securities (such as a public company), to a
security itself (or a related event such as a dividend payment), to a
group or index of securities or issuers, or based on related aspects of
a security or group or index of securities or issuers, such as price,
yield, volatility, dividend payments, or value.
An OTC derivative is an incredibly flexible product that can,
essentially, be engineered to achieve almost any financial purpose
between two parties. Indeed, as I will discuss later, an OTC derivative
can enable market participants to replicate the economics of either a
purchase or sale of securities without purchasing or selling the
securities themselves. Transactions occurring in the OTC derivatives
markets can serve important economic purposes such as allowing market
participants to hedge exposure and manage risk. When market
participants engage in these types of transactions in the OTC
derivatives markets, the transactions, which are substantially similar
to traditional securities transactions, and the parties engaged in
them, would fall outside the current reach of key provisions of the
Federal securities laws.
OTC derivatives are largely excluded from the securities regulatory
framework by the Commodity Futures Modernization Act of 2000. \1\ In a
recent study on a type of securities-related OTC derivative known as a
credit default swap, or CDS, the Government Accountability Office found
that ``comprehensive and consistent data on the overall market have not
been readily available,'' that ``authoritative information about the
actual size of the CDS market is generally not available,'' and that
regulators currently are unable ``to monitor activities across the
market.'' \2\
---------------------------------------------------------------------------
\1\ Section 2A of the Securities Act, Section 3A of the Exchange
Act, and related provisions prohibit the SEC from: (1) promulgating,
interpreting, or enforcing rules in a manner that imposes or specifies
reporting or record keeping requirements, procedures, or standards as
prophylactic measures against fraud or manipulation with respect to any
security-based swap agreement; and (2) registering or requiring the
registration of any security-based swap agreement. As noted below, some
OTC derivatives products, such as certain equity-linked notes, always
have been considered securities and currently are covered by the
securities regulatory regime.
\2\ Government Accountability Office, ``Systemic Risk: Regulatory
Oversight and Recent Initiatives to Address Risk Posed by Credit
Default Swaps,'' GAO-09-397T (March 2009), at 2, 5, 27.
---------------------------------------------------------------------------
One source of information on OTC derivatives volume is the data
collected by the Bank for International Settlements (BIS). BIS data
cover the OTC derivatives exposure of major banks and dealers in the
G10 countries. For all OTC derivatives in December 2008, BIS reported a
notional amount outstanding of $592 trillion and a gross market value
outstanding of $34 trillion. Interest rate contracts and foreign
exchange contracts are the two largest sources of OTC derivatives
volume. For those types of products that appear to be securities-
related credit derivatives and equity derivatives in December 2008, BIS
reported a notional amount outstanding of $48.4 trillion and a gross
market value outstanding of $6.8 trillion. A notional amount of $70
trillion and a gross market value of $5 trillion are ``unallocated''
for December 2008. Clearly, this volume of largely unregulated
financial activity is enormous, even when just considering the
relatively small volume component that is securities-related.
Who are the major participants in the securities-related OTC
derivatives markets? First, the markets are concentrated and appear to
be almost exclusively ``dealerintermediated''--that is, one of a small
number of major dealers is a party to almost all transactions, whether
as a buyer or a seller. The customers of the dealers appear to be
almost exclusively institutions. Many of these may be highly
sophisticated, such as large hedge funds and other pooled short-term
trading vehicles. As you know, many hedge funds have not been subject
to direct regulation by the SEC and, accordingly, we have very little
ability to obtain information concerning their trading activity at this
point.
Other customers in the securities-related OTC derivatives markets
have been institutions for which derivatives products may not be a
suitable investment. In this regard, there is consensus among U.S.
regulators reflected in Secretary Geithner's letter is to ensure that
OTC derivatives are not marketed inappropriately to unsophisticated
parties. The SEC and CFTC staff, together with other financial
regulators, currently are considering a tiered approach to regulation,
with scaling that could be based in the first instance on indicia of
sophistication and financial thresholds, with requirements for
additional disclosure and standards of care with respect to the
marketing of derivatives to less sophisticated counterparties.
Implementation of such a regulatory approach would depend on a
Congressional grant of authority in this area.
Finally, what are the purposes for which securities-related OTC
derivatives may be used? One example of a useful purpose for
securities-related OTC derivatives is to manage the risk associated
with a particular securities position. An investor with a large
position in the debt of a company may seek to reduce or hedge some of
the risk associated with that investment by purchasing credit
protection in the CDS market. In addition, market participants also may
use a securities-related OTC derivative to establish a short position
with respect to the debt of a specific company. In particular, a market
participant that does not own a bond or other debt instrument of a
company may purchase a CDS as a way to short that company's debt.
Market participants take positions in a wide range of exchange-
traded and OTC instruments. It is a market participant's overall (or
net) economic exposure that plays a role in determining the risks to
which it is exposed. Because OTC derivatives can be customized, a
market participant could take a long position in an index--such as the
S&P 100 index--through a securities-related OTC derivative and a short
position through another OTC derivative on a subset of the securities
in the S&P 100 index. The flexibility to tailor OTC derivative
contracts allows a participant to create an economic exposure to as
large or small a portion of the market it chooses through one or a
combination of contracts. This flexibility allowed by OTC derivatives
is one of these contracts' strengths. Because of the link to regulated
securities market, however, it is important that the SEC have the tools
to see all related activity so that it is in the best position possible
to detect and deter market abuses that can disrupt the integrity of the
market.
Filling Regulatory Gaps in Oversight of Securities-Related OTC
Derivatives
Secretary Geithner's May 13 letter to the Congressional leadership
outlined the Administration's plan for establishing a comprehensive
framework for regulating OTC derivatives. The framework is designed to
achieve four broad objectives: (1) preventing activities in the OTC
derivatives markets from posing risk to the financial system; (2)
promoting efficiency and transparency of those markets; (3) preventing
market manipulation, fraud, and other market abuses; and (4) ensuring
that OTC derivatives are not marketed inappropriately to
unsophisticated parties.
Secretary Geithner recognized that multiple Federal regulatory
agencies would play critical roles in implementing the proposed
framework, including the SEC and the CFTC. He emphasized that the
securities and commodities laws should be amended to ensure that the
SEC and CFTC, consistent with their respective missions, have the
necessary authority to achieve--together with the efforts of other
regulators--the four policy objectives for OTC derivatives regulation.
The final part of my testimony today is intended to follow up on
Secretary Geithner's letter by recommending a straightforward and
principled approach for achieving these policy objectives. Stated
briefly, primary responsibility for ``securities related'' OTC
derivatives would be retained by the SEC, which is also responsible for
oversight of markets affected by this subset of OTC derivatives.
Primary responsibility for all other OTC derivatives, including
derivatives related to interest rates, foreign exchange, commodities,
energy, and metals would rest with the CFTC.
Under this functional and sensible approach to regulation, OTC
derivatives markets that are interconnected with the regulated
securities markets would be incorporated within a unified securities
regulatory regime. The direct link between securities-related OTC
derivatives and securities is such that SEC regulation of the former is
essential to the effectiveness of the SEC's statutory mission with
respect to the securities markets. The securities regulatory regime is
specifically designed to promote the Congressional objectives for
capital markets, which include investor protection, the maintenance of
fair and orderly markets, and the facilitation of capital formation. It
is important that securities-related OTC derivatives be subject to the
Federal securities laws so that the risk of arbitrage and manipulation
of interconnected markets is minimized.
Over the years, Congress has fashioned a broad and flexible
regulatory regime for securities that long has accommodated a wide
range of products and trading venues. The products include equities,
debt, other fixed income securities, options on securities, exchange-
traded funds and other investment companies, and many other types of
derivative contracts on securities. Some of these securities products
are among the most actively traded financial products in the world,
with exchange-listed U.S. equities currently trading approximately 11
billion shares per day. Many other securities products trade rarely, if
at all. In addition, securities products trade in many different ways
in a wide variety of venues, depending on the particular features of
the product. These venues include 11 national securities exchanges with
self-regulatory responsibilities, more than 70 alternative trading
systems that execute OTC transactions, and hundreds of broker-dealers
that execute OTC transactions. Finally, securities products are cleared
and settled in a variety of ways depending on the particular
characteristics of the product.
The current securities laws are broad and flexible enough to
regulate appropriately all of these varied securities products and
trading venues. The regulatory requirements are specifically tailored
to reflect the particular nature of products and venues and to promote
the Congressional objectives for capital markets. Accordingly,
securities-related OTC derivatives could be brought under the same
umbrella of oversight as the related, underlying securities markets in
a relatively straightforward manner with little need to ``reinvent the
wheel.'' Specifically, Congress could make a limited number of discrete
amendments to the statutory definition of a security to cover
securities-related OTC derivatives. With these definitional changes,
securities-related OTC derivatives could be incorporated within an
existing regulatory framework that is appropriate for these products.
The rest of my testimony will elaborate on this basic approach. I
first will discuss the close relationship between the regulated
securities markets and the markets for securities-related OTC
derivatives and then sketch an overview of how oversight of such
instruments could be integrated with the SEC's existing oversight of
the securities markets.
Relationship Between the Securities Markets and Securities-Related OTC
Derivatives
In fashioning a regulatory framework for OTC derivatives, it is
crucial to recognize the close relationship between the regulated
securities markets and the now mostly unregulated markets for
securities-related OTC derivatives. Securities-related OTC derivatives
can be used to establish either a synthetic ``long'' exposure to an
underlying security or group of securities, or a synthetic ``short''
exposure to an underlying security or group of securities. In this way,
market participants can replicate the economics of either a purchase or
sale of securities without purchasing or selling the securities
themselves.
For example, an equity swap on a single equity security or on an
index, such as one of the Dow stocks or the Dow itself, would give the
holder of the ``long'' position all of the economic exposure of owning
the stock or index, without actual ownership of the stock or index.
This would include exposure to price movements of the stock or index,
as well as any dividends or other distributions. Similarly, credit
default swaps (CDS) can be used as synthetic substitutes for the debt
securities of one or more companies. Indeed, any exchange of cash for a
security can be structured as an OTC derivatives contract.
Because market participants can readily use securities-related OTC
derivatives to serve as synthetic substitutes for securities, the
markets for these OTC derivatives directly and powerfully implicate the
policy objectives for capital markets that Congress has set forth in
the Federal securities laws. These objectives include investor
protection, the maintenance of fair and orderly markets, and the
facilitation of capital formation.
Investor Protection
The current regulatory framework has permitted certain opaque
securities-related OTC derivatives markets to develop outside of
investor protection provisions of the securities laws. These provisions
include requiring the disclosure of significant ownership provisions
and record keeping and reporting (including those that serve as
prophylactic measures against fraud, manipulation, or insider trading)
that helps to promote enforcement of the securities laws.
The exclusion of certain securities-related OTC derivatives from
most of the securities regulatory regime has detracted from the SEC's
ability to uphold its investor protection mandate. For example, in
investigating possible market manipulation during the financial crisis,
the SEC has used its antifraud authority over security-based swaps to
gather information about transactions in OTC derivatives as well as in
the underlying securities. Yet investigations of these OTC derivative
transactions have been far more difficult and time-consuming than those
involving cash equities and options. Audit trail data on OTC derivative
transactions is not readily available and must be reconstructed
manually, in contrast to the data available in the equity markets. The
SEC's enforcement efforts have been seriously complicated by the lack
of a mechanism for promptly obtaining critical information--who traded,
how much, and when--that is complete and accurate.
In addition, the SEC believes that it is important in the OTC
derivatives market, as in the market for securities generally, that
parties to transactions have access to financial information and other
disclosures so they can evaluate the risks relating to a particular
investment to make more informed investment decisions and can value and
evaluate their OTC derivatives and their counterparty exposures. For
example, this information assists market participants in performing
adequate due diligence on their investments and in valuing their OTC
derivatives and their other risks.
A basic tenet of functional regulation of securities markets is to
have a regulatory regime under which similar products and activities
should be subject to similar regulations and oversight. Currently,
securities are subject to transparency, active enforcement, and
appropriate regulation of business conduct. Whereas securities-related
OTC derivatives, which are interconnected with the securities markets
(and in some cases are economic substitutes for securities) are not
subject to most of these investor protection requirements. The
securities laws are uniquely designed to address these issues and
should be extended to OTC derivatives.
Fair and Orderly Markets
Trading in securities-related OTC derivatives can directly affect
trading in the securities markets. From an economic viewpoint, the
interchangeability of securities and securities-related OTC derivatives
means that they are driven by the same economic forces and are linked
by common participants, trading strategies, and hedging activities.
For example, credit default swap, or CDS trading is closely related
to trading in the underlying securities that compose the capital
structure of the companies on which protection is written. Trading
practices in the CDS market, whether legitimate or abusive, can affect
the securities markets. The CDS market, however, lacks the level of
transparency and other protections that characterize the regulated
securities markets. As a result, the SEC has been unable to monitor
effectively for trading abuses and whether purchasers of CDS protection
on an issuer's debt have sold short the equity securities of that
company as a trading strategy, effectively linking activities and
changes in the CDS market with those in the cash equity market. These
activities in the CDS market could adversely impact the regulated
securities markets. Any regulatory reform that maintained distinct
regulatory regimes for securities markets and markets for securities-
related OTC derivatives would suffer from this same limitation.
The SEC is considering whether reporting under the Exchange Act
should apply to security-based OTC derivatives so that the ownership of
and transactions in security-based derivatives would be considered
ownership of and transactions in the underlying equity security. We are
further evaluating whether persons using equity derivatives, such as an
equity swap, should be subject to the beneficial ownership reporting
provisions of the Exchange Act when accumulating substantial share
positions in connection with change of control transactions.
Capital Formation
Facilitating capital formation depends on the existence of fair and
efficient secondary markets for investors. Purchasers in the primary
offering of a company are attracted by secondary markets that enable
them to liquidate their positions readily. Less efficient markets can
cause potential investors in companies either to find other uses for
their funds or to demand a higher rate of return to compensate them for
a less efficient secondary market. If a disparity in the regulatory
requirements for securities and securities-related OTC derivatives
cause securities markets to operate less efficiently, it will harm
those companies that depend on the U.S. securities markets to access
the capital that is essential for innovation and growth, as well as
harming investors and the capital markets as a whole.
Because many securities-related OTC derivatives are allowed to
trade outside of the securities regulatory regime, the SEC generally is
unable to promote transparency in the trading of these products and
efficiency in pricing. As noted above, companies whose securities are
affected by the excluded products could suffer from the absence of
transparency and efficiency. Moreover, manipulative activities in the
markets for securities-related OTC derivatives can affect U.S. issuers
in the underlying equity market, thereby damaging the public perception
of those companies and raising their cost of capital. To protect the
integrity of the markets, trading in all securities-related OTC
derivatives should be fully subject to the U.S. regulatory regime
designed to facilitate capital formation. Nevertheless, it is important
to remember that derivatives transactions, including OTC derivatives
transactions, allow parties to hedge and manage risk, which itself can
promote capital formation. To the extent the ability to manage risk is
inappropriately limited, it can discourage market participation,
including by investors.
Regulatory Oversight of Securities-Related OTC Derivatives
To provide a unified, consistent framework for securities
regulation, Congress should subject securities-related OTC derivatives
to the Federal securities laws. This result can be achieved simply by
clarifying the definition of ``security'' to expressly include
securities-related OTC derivatives, and removing the current express
exclusion of swaps from that definition. The SEC then would have
authority to regulate securities-related OTC derivatives regardless of
how the products are traded, whether on an exchange or OTC, and
regardless of how the products are cleared.
Definition of Securities-Related OTC Derivatives
OTC derivatives can be categorized generally as securities-related
or nonsecurities-related, based on the different types of underlying
assets, events, or interests to which they are related. Securities-
related OTC derivatives would include equity derivatives and credit and
other fixed income derivatives. Nonsecurities-related derivatives would
include interest rate derivatives, foreign currency derivatives, and
all nonfinancial derivatives. By including securities-related OTC
derivatives under the umbrella of the Federal securities laws, the SEC
would have responsibility over the portion of the OTC derivatives
market that is vital to promote its mission of investor protection, the
maintenance of fair and orderly markets, and the facilitation of
capital formation.
In addition, the SEC would continue to regulate those types of OTC
derivatives that always have been considered securities, such as OTC
security options, certain OTC notes (including equity-linked notes),
and forward contracts on securities. These particular types of OTC
derivatives always have been included in the definition of security and
current law recognizes this fact by excluding these derivatives from
the definition of ``swap agreement'' in Section 206A of the Gramm-
Leach-Bliley Act.
Regulation of OTC Derivatives Dealers and Major OTC Participants
Under our recommended approach, major participants in the OTC
derivatives markets would be subject to oversight and supervision to
ensure there are no gaps. To reduce duplication, OTC derivatives
dealers that are banks would be subject to prudential supervision by
their Federal banking regulator. All other OTC derivatives dealers in
securities-related OTC derivatives would be subject to supervision and
regulation by the SEC. The SEC would have authority to set appropriate
capital requirements for these OTC derivatives dealers. This approach
would permit existing OTC derivatives dealers that are banks to
continue to engage in OTC derivatives activities without being subject
to the full panoply of broker-dealer regulation, while ensuring that
all currently unregulated OTC derivatives dealers in securities-related
OTC derivatives are subject to appropriate supervision and regulation.
Should Congress establish a new systemic risk regulator or systemic
risk council, that entity also could help monitor institutions that
might present systemic risk.
In addition, the SEC would have authority to establish business
conduct standards and record keeping and reporting requirements
(including an audit trail) for all securities-related OTC derivatives
dealers and other firms with large counterparty exposures in
securities-related OTC derivatives (Major OTC Participants). This
``umbrella'' authority would help ensure that the SEC has the tools it
needs to oversee the entire market for securities-related OTC
derivatives. Major OTC Participants also would be required to meet
appropriate standards for the segregation of customer funds and
securities.
Trading Markets and Clearing Agencies
Trading markets and clearing organizations for securities-related
OTC derivatives would be subject to registration requirements as
exchanges and clearing agencies. Importantly, however, the conditional
exemption from exchange registration the SEC provided under Regulation
ATS would be available to trading systems for securities-related OTC
derivatives. Among other things, Regulation ATS lowers barriers to
entry for trading systems in securities because the systems need not
assume the full self-regulatory responsibilities associated with being
a national securities exchange. Both registered exchanges and ATSs are
subject to important transparency requirements. Consequently, expanding
the SEC's authority over securities-related OTC derivatives would
promote improved efficiency and transparency in the markets for
securities-related OTC derivatives.
Similarly, the regulatory regime for securities clearing agencies
would ensure that CCPs for securities-related OTC derivatives impose
appropriate margin requirements and other necessary risk controls. The
SEC's historic regulation of clearing agencies under Section 17A of the
Exchange Act has resulted in the most efficient, lowest cost clearing
in the world. Indeed, the solid performance of securities clearing
systems during the financial crisis bears out that they have the
resilience to withstand difficult economic conditions. In addition, the
regulation of securities clearance and settlement would directly affect
market structure and competition in the trading markets for securities-
related OTC derivatives. For example, the SEC's statutory mandate
governing clearing agencies prohibits clearing agencies from engaging
in anticompetitive practices, such as imposing unreasonable limitations
on access to services. Clearing agencies cannot exclude participants
merely for executing their trades in a cleared product in a particular
venue. This fair access requirement allows for multiple, competing
markets, including OTC trading systems and OTC dealers, to trade the
same securities and clear through a single clearing organization. The
securities clearing system would support both the goal of having the
greatest number of OTC derivatives centrally cleared, while retaining
flexibility to allow variation in trading venues to meet the trading
needs of different instruments and participants.
The SEC already has taken a number of actions to help further the
centralized clearing for OTC derivatives, including exempting three
CCPs from the requirement to register as securities clearing agencies.
These exemptions were issued to speed the operation of central clearing
for CDS. They are temporary and subject to conditions designed to
ensure that important elements of Commission oversight apply, such as
record keeping and Commission staff access to examine clearing
facilities. In addition, to further the goal of transparency, each
clearing agency is required to make publicly available on fair,
reasonable, and not unreasonably discriminatory terms end-of-day
settlement prices and any other pricing or valuation information that
it publishes or distributes.
One important issue is how to deal with those OTC derivative
contracts that may be ineligible for central clearing. OTC derivatives
may be ineligible for clearing for a variety of reasons, including
customized terms and an inability of CCPs to effectively manage the
risks. In many cases, there are legitimate economic reasons to engage
in customized transactions. Participants in individual transactions,
however, should not be permitted to externalize the costs of their
decisions, such as by creating additional systemic risk. Regulatory
requirements often have costs, but they are costs incurred to protect
the public interest and the general economic welfare. One way for
regulators to help ensure market participants incorporate all the risks
in the terms of a transaction would be to impose appropriate margin and
capital requirements on the participants in customized transactions to
reflect the risks they pose to market systems generally. This is an
area in which the various functional regulators for particular entities
could consult closely with any systemic risk agency that Congress might
establish.
In addressing all of these issues with respect to OTC derivatives,
moreover, the U.S. must coordinate its efforts with those of regulatory
authorities abroad as they seek to address similar issues. The global
financial crisis is a potent reminder of the extent to which economies
around the world are linked by financial practices and market
participants. A sound regulatory approach for managing the systemic
risk of such practices and participants benefits from the
implementation of complementary measures on an international basis.
Conclusion
Bringing securities-related OTC derivatives under the umbrella of
the Federal securities laws would be based on sound principles of
functional regulation, would be relatively straightforward to
implement, and would promote Congressional policy objectives for the
capital markets. A clear delineation of primary regulatory
responsibility for OTC derivatives also would help avoid regulatory
gaps from arising in the future. Finally, integrating oversight of
securities-related OTC derivatives with oversight of the related,
underlying securities markets would minimize the extent of dislocation
with respect to existing participants and current practices in the OTC
derivatives markets, while still achieving the objectives for OTC
derivatives regulation set forth in Secretary Geithner's letter to the
Congressional leadership.
Thank you for the opportunity to address issues of such importance
for the strength and stability of the U.S. financial system, and the
integrity of the U.S. capital markets. I would be pleased to answer
your questions.
PREPARED STATEMENT OF GARY GENSLER
Chairman,
Commodity Futures Trading Commission
June 22, 2009
Good morning Chairman Reed, Ranking Member Bunning, and Members of
the Committee. I am here today testifying on behalf of the Commission.
The topic of today's hearing, how to best modernize oversight of
the over-the-counter derivatives markets, is of utmost importance
during this crucial time for our economy. As President Obama laid out
last week, we must urgently enact broad reforms in our financial
regulatory structure in order to rebuild and restore confidence in our
overall financial system.
Such reforms must comprehensively regulate both derivative dealers
and the markets in which derivatives trade. I look forward to working
with the Congress to ensure that the OTC derivatives markets are
transparent and free from fraud, manipulation and other abuses.
This effort will require close coordination between the SEC and the
CFTC to ensure the most appropriate regulation. I'm fortunate to have
as a partner in this effort, SEC Chair Mary Schapiro. She brings
invaluable expertise in both the security and commodity futures area,
which gives me great confidence that we will be able to provide the
Congress with a sound recommendation for comprehensive oversight of the
OTC derivatives market. We also will work collaboratively on
recommendations on how to best harmonize regulatory efforts between
agencies as requested by President Obama.
Comprehensive Regulatory Framework
A comprehensive regulatory framework governing OTC derivative
dealers and OTC derivative markets should apply to all dealers and all
derivatives, no matter what type of derivative is traded or marketed.
It should include interest rate swaps, currency swaps, commodity swaps,
credit default swaps, and equity swaps. Further, it should apply to the
dealers and derivatives no matter what type of swaps or other
derivatives may be invented in the future. This framework should apply
regardless of whether the derivatives are standardized or customized.
A new regulatory framework for OTC derivatives markets should be
designed to achieve four key objectives:
Lower systemic risks;
Promote the transparency and efficiency of markets;
Promote market integrity by preventing fraud, manipulation,
and other market abuses, and by setting position limits; and
Protect the public from improper marketing practices.
To best achieve these objectives, two complementary regulatory
regimes must be implemented: one focused on the dealers that make the
markets in derivatives and one focused on the markets themselves--
including regulated exchanges, electronic trading systems and
clearinghouses. Only with these two complementary regimes will we
ensure that Federal regulators have full authority to bring
transparency to the OTC derivatives world and to prevent fraud,
manipulation, and other types of market abuses. These two regimes
should apply no matter which type of firm, method of trading or type of
derivative or swap is involved.
Regulating Derivatives Dealers
I believe that institutions that deal in derivatives must be
explicitly regulated. In addition, regulations should cover any other
firms whose activities in these markets can create large exposures to
counterparties.
The current financial crisis has taught us that the derivatives
trading activities of a single firm can threaten the entire financial
system and that all such firms should be subject to robust Federal
regulation. The AIG subsidiary that dealt in derivatives--AIG Financial
Products--for example, was not subject to any effective regulation. The
derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and
other investment banks were not subject to mandatory regulation either.
By fully regulating the institutions that trade or hold themselves
out to the public as derivative dealers we can oversee and regulate the
entire derivatives market. I believe that the our laws should be
amended to provide for the registration and regulation of all
derivative dealers.
The full, mandatory regulation of all derivatives dealers would
represent a dramatic change from the current system in which some
dealers can operate with limited or no effective oversight.
Specifically, all derivative dealers should be subject to capital
requirements, initial margining requirements, business conduct rules
and reporting and record keeping requirements. Standards that already
apply to some dealers, such as banking entities, should be strengthened
and made consistent, regardless of the legal entity where the trading
takes place.
Capital and Margin Requirements. The Congress should explicitly
require regulators to promulgate capital requirements for all
derivatives dealers. Imposing prudent and conservative capital
requirements, and initial margin requirements, on all transactions by
these dealers will help prevent the types of systemic risks that AIG
created. No longer would derivatives dealers or counterparties be able
to amass large or highly leveraged risks outside the oversight and
prudential safeguards of regulators.
Business Conduct and Transparency Requirements. Business conduct
standards should include measures to both protect the integrity of the
market and lower the risk (both counterparty and operating) from OTC
derivatives transactions.
To promote market integrity, the business conduct standards should
include prohibitions on fraud, manipulation and other abusive
practices. For OTC derivatives that come under CFTC jurisdiction, these
standards should require adherence to position limits when they perform
or affect a significant price discovery function with respect to
regulated markets.
Business conduct standards should ensure the timely and accurate
confirmation, processing, netting, documentation, and valuation of all
transactions. These standards for ``back office'' functions will help
reduce risks by ensuring derivative dealers, their trading
counterparties and regulators have complete, accurate and current
knowledge of their outstanding risks.
Derivatives dealers also should be subject to record keeping and
reporting requirements for all of their OTC derivatives positions and
transactions. These requirements should include retaining a complete
audit trail and mandated reporting of any trades that are not centrally
cleared to a regulated trade repository. Trade repositories complement
central clearing by providing a location where trades that are not
centrally cleared can be recorded in a manner that allows the
positions, transactions, and risks associated with those trades to be
reported to regulators. To provide transparency of the entire OTC
derivatives market, this information should be available to all
relevant Federal financial regulators. Additionally, there should be
clear authority for regulating and setting standards for trade
repositories and clearinghouses to ensure that the information recorded
meets regulatory needs and that the repositories have strong business
conduct practices.
The application of these business conduct standards and the
transparency requirements will enable regulators to have timely and
accurate knowledge of the risks and positions created by the dealers.
It will provide authorities with the information and evidentiary record
needed to take any appropriate action to address such risks and to
protect and police market integrity. In this regard, the CFTC and SEC
should have clear, unimpeded oversight and enforcement authority to
prevent and punish fraud, manipulation and other market abuses.
Market transparency should be further enhanced by requiring that
aggregated information on positions and trades be made available to the
public. No longer should the public be in the dark about the extensive
positions and trading in these markets. This public information will
improve the price discovery process and market efficiency.
Regulating Derivatives Markets
In addition to the significant benefits to be gained from broad
regulation of derivatives dealers, I believe that additional safety and
transparency must be afforded by regulating the derivative market
functions as well. All derivatives that can be moved into central
clearing should be required to be cleared through regulated central
clearinghouses and brought onto regulated exchanges or regulated
transparent electronic trading systems.
Requiring clearing and trading on exchanges or through regulated
electronic trading systems will promote transparency and market
integrity and lower systemic risks. To fully achieve these objectives,
both of these complementary regimes must be enacted. Regulating both
the traders and the trades will ensure that both the actors and the
actions that may create significant risks are covered.
Exchange-trading and central clearing are the two key and related
components of well-functioning markets. Ever since President Roosevelt
called for the regulation of the commodities and securities markets in
the early 1930s, the CFTC (and its predecessor) and the SEC have each
regulated the clearing functions for the exchanges under their
respective jurisdiction. The practice of having the agency which
regulates an exchange or trade execution facility also regulate the
clearinghouses for that market has worked well and should continue as
we extend regulations to cover the OTC derivatives market.
Central Clearing. Central clearing should help reduce systemic
risks in addition to the benefits derived from comprehensive regulation
of derivatives dealers.
Clearing reduces risks by facilitating the netting of transactions
and by mutualizing credit risks. Currently, most of the contracts
entered into in the OTC derivatives market are not cleared, and remain
as bilateral contracts between individual buyers and sellers. In
contrast, when a contract between a buyer and seller is submitted to a
clearinghouse for clearing, the contract is ``novated'' to the
clearinghouse. This means that the clearinghouse is substituted as the
counterparty to the contract and then stands between the buyer and the
seller.
Clearinghouses then guarantee the performance of each trade that is
submitted for clearing. Clearinghouses use a variety of risk management
practices to assure the fulfillment of this guarantee function.
Foremost, derivatives clearinghouses would lower risk through the daily
discipline of marking to market the value of each transaction. They
also require the daily posting of margin to cover the daily changes in
the value of positions and collect initial margin as extra protection
against potential market changes that are not covered by the daily
mark-to-market.
The regulations applicable to clearing should require that
clearinghouses establish and maintain robust margin standards and other
necessary risk controls and measures. It is important that we
incorporate the lessons from the current crisis as well as the best
practices reflected in international standards. Working with Congress,
we should consider possible amendments to the CEA to expand and deepen
the core principles that registered derivatives clearing organizations
must meet to achieve these goals to both strengthen these systems and
to reduce the possibility of regulatory arbitrage. Clearinghouses
should have transparent governance arrangements that incorporate a
broad range of viewpoints from members and other market participants.
Central counterparties should also be required to have fair and
open access criteria that allow any firm that meets objective, prudent
standards to participate regardless of whether it is a dealer or a
trading firm. Additionally, central clearinghouses should implement
rules that allow indirect participation in central clearing. By
novating contracts to a central clearinghouse coupled with effective
risk management practices, the failure of a single trader, like AIG,
would no longer jeopardize all of the counterparties to its trades.
One of the lessons that emerged from this recent crisis was that
institutions were not just ``too big to fail,'' but rather too
interconnected as well. By mandating the use of central clearinghouses,
institutions would become much less interconnected, mitigating risk and
increasing transparency. Throughout this entire financial crisis,
trades that were carried out through regulated exchanges and
clearinghouses continued to be cleared and settled.
In implementing these responsibilities, it will be appropriate to
consider possible additional oversight requirements that may be imposed
by any systemic risk regulator that Congress may establish.
Under the Administration's approach, the systemic regulator, would
be charged with ensuring consistent and robust standards for all
systemically important clearing, settlement and payment systems. For
clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC
or SEC would remain the primary regulatory, but the systemic regulator
would be able to request information from the primary regulator,
participate in examinations led by the primary regulator, make
recommendations on strengthening standards to the primary regulator and
ultimately, after consulting with the primary regulator and the new
Financial Services Oversight Council, use emergency authority to compel
a clearinghouse to take actions to address financial risks.
Exchange-Trading. Beyond the significant transparency afforded the
regulators and the public through the record keeping and reporting
requirements of derivatives dealers, market transparency and efficiency
would be further improved by moving the standardized part of the OTC
markets onto regulated exchanges and regulated transparent electronic
trading systems. I believe that this should be required of all
standardized contracts. Furthermore, a system for the timely reporting
of trades and prompt dissemination of prices and other trade
information to the public should be required. Both regulated exchanges
and regulated transparent trading systems should allow market
participants to see all of the bids and offers. A complete audit trail
of all transactions on the exchanges or trade execution systems should
be available to the regulators. Through a trade reporting system there
should be timely public posting of the price, volume and key terms of
completed transactions. The Trade Reporting and Compliance Engine
(TRACE) system currently required for timely reporting in the OTC
corporate bond market may provide a model.
The CFTC and SEC also should have authority to impose record
keeping and reporting requirements and to police the operations of all
exchanges and electronic trading systems to prevent fraud, manipulation
and other abuses.
In contrast to long established on-exchange futures and securities
markets, there is a need to encourage the further development of
exchanges and electronic trading systems for OTC derivatives. In order
to promote this goal and achieve market efficiency through competition,
there should be sufficient product standardization so OTC derivative
trades and open positions are fungible and can be transferred between
one exchange or electronic trading system to another.
Position Limits. Position limits must be applied consistently
across all markets, across all trading platforms, and exemptions to
them must be limited and well defined. The CFTC should have the ability
to impose position limits, including aggregate limits, on all persons
trading OTC derivatives that perform or affect a significant price
discovery function with respect to regulated markets that the CFTC
oversees. Such position limit authority should clearly empower the CFTC
to establish aggregate position limits across markets in order to
ensure that traders are not able to avoid position limits in a market
by moving to a related exchange or market, including international
markets.
Standardized and Customized Derivatives
It is important that tailored or customized swaps that are not able
to be cleared or traded on an exchange be sufficiently regulated.
Regulations should also ensure that customized derivatives are not used
solely as a means to avoid the clearing and exchange requirements. This
could be accomplished in two ways. First, regulators should be given
full authority to prevent fraud, manipulation and other abuses and to
impose record keeping and transparency requirements with respect to the
trading of all swaps, including customized swaps. Second, we must
ensure that dealers and traders cannot change just a few minor terms of
a standardized swap to avoid clearing and the added transparency of
exchanges and electronic trading systems.
One way to ensure this would be to establish objective criteria for
regulators to determine whether, in fact, a swap is standardized. For
example, there should be a presumption that if an instrument is
accepted for clearing by a fully regulated clearinghouse, then it
should be required to be cleared. Additional potential criteria for
consideration in determining whether a contract should be considered to
be a standardized swap contract could include:
The volume of transactions in the contract;
The similarity of the terms in the contract to terms in
standardized contracts;
Whether any differences in terms from a standardized
contract are of economic significance; and
The extent to which any of the terms in the contract,
including price, are disseminated to third parties.
Criteria such as these could be helpful in ensuring that parties are
not able to avoid the requirements applicable to standardized contracts
by tweaking the terms of such contracts and then labeling them
``customized.''
Regardless of whether an instrument is standardized or customized,
or traded on an exchange or on a transparent electronic trade execution
system, regulators should have clear, unimpeded authority to impose
record keeping and reporting requirements, impose margin requirements,
and prevent and punish fraud, manipulation and other market abuses. No
matter how the instrument is traded, the CFTC and SEC as appropriate
also should have clear, unimpeded authority to impose position limits,
including aggregate limits, to prevent excessive speculation. A full
audit trail should be available to the CFTC, SEC and other Federal
regulators.
Authority
To achieve these goals, the Commodity Exchange Act and security
laws should be amended to provide the CFTC and SEC with clear authority
to regulate OTC derivatives. The term ``OTC derivative'' should be
defined, and clear authority should be given over all such instruments
regardless of the regulatory agency. To the extent that specific types
of OTC derivatives might overlap agencies' existing jurisdiction, care
must be taken to avoid unnecessary duplication.
As we enact new laws and regulations, we should be careful not to
call into question the enforceability of existing OTC derivatives
contracts. New legislation and regulations should not provide excuses
for traders to avoid performance under preexisting, valid agreements or
to nullify preexisting contractual obligations.
Achieving the Four Key Objectives
Overall, I believe the complimentary regimes of dealer and market
regulation would best achieve the four objectives outlined earlier. As
a summary, let me review how this would accomplish the measures applied
to both the derivative dealers and the derivative markets.
Lower Systemic Risk. This dual regime would lower systemic risk
through the following four measures:
Setting capital requirements for derivative dealers;
Creating initial margin requirements for derivative dealers
(whether dealing in standardized or customized swaps);
Requiring centralized clearing of standardized swaps; and
Requiring business conduct standards for dealers.
Promote Market Transparency and Efficiency. This complementary
regime would promote market transparency and efficiency by:
Requiring that all OTC transactions, both standardized and
customized, be reported to a regulated trade repository or
central clearinghouses;
Requiring clearinghouses and trade repositories to make
aggregate data on open positions and trading volumes available
to the public;
Requiring clearinghouses and trade repositories to make
data on any individual counterparty's trades and positions
available on a confidential basis to regulators;
Requiring centralized clearing of standardized swaps;
Moving standardized products onto regulated exchanges and
regulated, transparent trade execution systems; and
Requiring the timely reporting of trades and prompt
dissemination of prices and other trade information;
Promote Market Integrity. It would promote market integrity by:
Providing regulators with clear, unimpeded authority to
impose reporting requirements and to prevent fraud,
manipulation and other types of market abuses;
Providing regulators with authority to set position limits,
including aggregate position limits;
Moving standardized products onto regulated exchanges and
regulated, transparent trade execution systems; and
Requiring business conduct standards for dealers.
Protect Against Improper Marketing Practices. It would ensure
protection of the public from improper marketing practices by:
Business conduct standards applied to derivatives dealers
regardless of the type of instrument involved; and
Amending the limitations on participating in the OTC
derivatives market in current law to tighten them or to impose
additional disclosure requirements, or standards of care (e.g.,
suitability or know your customer requirements) with respect to
marketing of derivatives to institutions that infrequently
trade in derivatives, such as small municipalities.
Conclusion
The need for reform of our financial system today has many
similarities to the situation facing the country in the 1930s. In 1934,
President Roosevelt boldly proposed to the Congress ``the enactment of
legislation providing for the regulation by the Federal Government of
the operation of exchanges dealing in securities and commodities for
the protection of investors, for the safeguarding of values, and so far
as it may be possible, for the elimination of unnecessary, unwise, and
destructive speculation.'' The Congress swiftly responded to the clear
need for reform by enacting the Securities Exchange Act of 1934. Two
years later it passed the Commodity Exchange Act of 1936.
It is clear that we need the same type of comprehensive regulatory
reform today. Today's regulatory reform package should cover all types
of OTC derivatives dealers and markets. It should provide regulators
with full authority regarding OTC derivatives to lower risk; promote
transparency, efficiency, and market integrity and to protect the
American public.
Today's complex financial markets are global and irreversibly
interlinked. We must work with our partners in regulating markets
around the world to promote consistent rigor in enforcing standards
that we demand of our markets to prevent regulatory arbitrage.
These policies are consistent with what I laid out to this
Committee in February and the Administration's objectives. I look
forward to working with this Committee, and others in Congress, to
accomplish these goals.
Mr. Chairman, thank you for the opportunity to appear before the
Committee today. I look forward to answering any of your questions.
______
PREPARED STATEMENT OF PATRICIA WHITE
Associate Director, Division of Research and Statistics,
Board of Governors of the Federal Reserve System
June 22, 2009
Chairman Reed, Ranking Member Bunning, and other Members of the
Subcommittee, I appreciate this opportunity to provide the Federal
Reserve Board's views on the development of a new regulatory structure
for the over-the-counter (OTC) derivatives market. The Board brings to
this policy debate both its interest in ensuring financial stability
and its role as a supervisor of banking institutions. Today, I will
describe the broad objectives that the Board believes should guide
policy makers as they devise the new structure and identify key
elements that will support those objectives. Supervision of derivative
dealers is a fundamental element of the oversight of OTC derivative
markets, and I also will discuss the steps necessary to ensure these
firms employ adequate risk management.
Policy Objectives
Mitigation of Systemic Risk
The events of the last 2 years have demonstrated the potential for
difficulties in one part of the financial system to create problems in
other sectors and in the macroeconomy more broadly. OTC derivatives
appear to have amplified or transmitted shocks. An important objective
of regulatory initiatives related to OTC derivatives is to ensure that
improvements to the infrastructure supporting these products reduce the
likelihood of such transmissions and make the financial system as a
whole more resilient to future shocks.
Centralized clearing of standardized OTC products is a key
component of efforts to mitigate such systemic risk. One method of
achieving centralized clearing is to establish central counterparties,
or CCPs, for OTC products. Market participants have already established
several CCPs to provide clearing services for some OTC interest rate,
energy, and credit derivative contracts. Regulators both in the United
States and abroad are seeking to speed the development of new CCPs and
to broaden the product line of existing CCPs.
The Board believes that moving toward centralized clearing for most
or all standardized OTC products would have significant benefits. If
properly designed, managed, and overseen, CCPs offer an important tool
for managing counterparty credit risk, and thus they can reduce risk to
market participants and to the financial system. The benefits from
centralized clearing will be greatest if CCPs are structured so as to
allow participation by end users within a framework that ensures
protection of their positions and collateral.
Infrastructure changes in OTC markets will be required to move most
standardized OTC contracts into centralized clearing systems in a way
that ensures the risk-reducing benefits of clearing are realized. Such
changes include agreement on the key terms that constitute
``standardization'' and the development of electronic systems for
feeding trade data to CCPs--in other words, building better pipes to
the CCPs. For their part, CCPs must have in place systems to manage the
risk from this new business. Of particular importance are procedures to
handle defaults in OTC products that are cleared, because these
products are likely to be less liquid than the exchange-traded products
that CCPs most commonly handle.
Although implementation challenges no doubt lie ahead, the Board
will work to ensure that these challenges are addressed quickly and
constructively. Major dealers have committed to making improvements in
back-office processes such as increased electronic processing of trades
and speedier confirmation of trades for equity, interest rate,
commodity, foreign exchange, and credit products. These back-office
improvements are important prerequisites for centralized clearing, and
efforts by supervisors to require dealers to improve these practices
have helped lay the groundwork for developing clearing more quickly.
Dealers also have committed to clearing standardized OTC products, and
they will be expected to demonstrate progress on this commitment even
as the broader regulatory reform debate evolves. Clearly there is much
to be done, and we are committed to ensuring that the industry moves
promptly. An important role of policy makers may be establishing
priorities so that efforts are directed first at the areas that offer
the greatest risk-reduction potential.
Some market observers feel strongly that all OTC derivative
contracts--not just the standardized contracts--should be cleared.
Requiring CCPs to clear nonstandard instruments that pose valuation and
risk-management challenges may not reduce risk for the system as a
whole. If, for example, the CCPs have difficulty designing margin and
default procedures for such products, they will not be able to
effectively manage their own counterparty credit risk to clearing
members. In addition, there are legitimate economic reasons why
standardized contracts may not meet the risk-management needs of some
users of these instruments. A flexible approach that addresses systemic
risk with respect to standardized and nonstandardized OTC derivatives,
albeit in different ways, is most likely to preserve the benefits of
these products for businesses and investors.
That said, however, it is particularly important that the
counterparties to nonstandardized contracts have robust risk-management
procedures for this activity. Nonstandard products pose significant
risk-management challenges because they can be complex, opaque,
illiquid, and difficult to value. Supervisors must ensure that their
own policies with respect to risk management and capital for firms
active in nonstandardized products fully reflect the risks such
products create. If supervisors are not comfortable with their ability
to set and enforce appropriate standards, then the activity should be
discouraged. I will return to a broader discussion of supervision and
risk management later.
Improving the Transparency and Preventing the Manipulation of Markets
Throughout the debates about reform of the OTC derivatives market,
a persistent theme has been concern that the market is opaque.
Discussions of market transparency generally recognize the multiple
audiences that seek information about a market--market participants,
the public, and authorities--and the multiple dimensions of
transparency itself--prices, volumes, and positions. Participants, the
public, and authorities seek different information for different
purposes. Transparency is a tool for addressing their needs and, in the
process, fostering multiple policy objectives. Transparency to market
participants supports investor protection as well as the exercise of
market discipline, which has sometimes clearly been lacking.
Transparency to the public helps to demystify these markets and to
build support for sound public policies. Transparency to authorities
supports efforts to pursue market manipulation, to address systemic
risk through ongoing monitoring, and, when necessary, to manage crises.
Substantial progress in improving the transparency of volumes and
positions in the credit default swap (CDS) market occurred with the
creation of the Depository Trust Clearing Corporation's Trade
Information Warehouse, a contract repository that contains an
electronic record of a large and growing share of CDS trades.
Participation in that repository is voluntary, however, and its present
coverage is limited to credit products. Nevertheless, major dealers,
who are counterparties to the vast majority of CDS trades, have
recently committed to supervisors that they will record all their CDS
trades in the warehouse by mid-July.
The Board supports creating contract repositories for all asset
classes and requiring a record of all OTC derivative contracts that are
not centrally cleared to be stored in these repositories. The Trade
Information Warehouse currently makes aggregate data on CDS contracts
public. Aggregate data on volumes and open interest should be made
public by other repositories that are created, and more detailed data
should be made available to authorities to support policy objectives
related to the prevention of manipulation and systemic risk.
Enhancing price transparency to the broader public through post-
trade reporting of transaction details is also an important goal. Even
where contracts are not traded on exchanges or on regulated electronic
trading systems, the prompt dissemination of information can provide
significant benefits to market participants on a range of valuation and
risk-management issues. The Board believes that policy makers should
pursue the goal of prompt dissemination of prices and other trade
information for standardized contracts, regardless of the trading
venue.
Supervision and Risk Management
Although the creation of CCPs will provide an important new tool
for managing counterparty credit risk, enhancements to the risk-
management policies and procedures for individual market participants
will continue to be a high priority for supervisors. If the reforms
outlined here are implemented, the firms currently most active in
bilateral OTC markets will become the firms most active as clearing
members of CCPs. As such, the quality of their internal risk management
is important to the CCP because sound risk management by all clearing
members is critical if centralized clearing is to deliver risk-reducing
benefits. Supervisors have recognized that financial institutions must
make changes in their risk-management practices for OTC derivatives by
improving internal processes and controls and by ensuring that
traditional credit risk-management disciplines are in place for complex
products, regardless of the form they take. Efforts already under way
include improving collateralization practices to limit counterparty
credit risk exposures and examining whether the current capital regime
can be improved to increase incentives for sound risk management.
An important parallel process involves ensuring that firms that are
large and complex enough to pose risks to the broader system are
subject to appropriate oversight and resolution authority, even if they
operate outside the traditional regulated banking system. The Board
believes that all systemically critical firms should have a
consolidated supervisor, as well as be subject to the oversight of any
systemic regulator that might be created. The scope of a firm's
activities in the OTC derivatives market will likely be an important
factor in making that assessment.
Conclusion
Policy issues associated with OTC derivatives are not limited to
the United States. The markets are global. Past work to strengthen OTC
derivatives markets has often involved a large measure of international
coordination, and the current policy issues are unlikely to be fully
and effectively addressed without broad-based input.
Despite the problems that have been associated with OTC derivatives
during the financial crisis, these instruments remain integral to the
smooth functioning of today's financial markets. Much work must be done
to strengthen the market further. But with effective oversight by
supervisors, prudent risk management by end users and dealers, and
appropriate changes in the regulatory structure, the systemic risks
stemming from OTC derivatives can be reduced, and derivatives can
continue to provide significant benefits to the businesses and
investors who use them to manage financial market risks.
______
PREPARED STATEMENT OF HENRY T. C. HU
Allan Shivers Chair in the Law of Banking and Finance,
University of Texas Law School
June 22, 2009
The Modern Process of Financial Innovation and the Regulation of
OTC Derivatives *
Introduction
Mr. Chairman and Members of the Subcommittee, thank you for the
invitation of June 15 to testify. My name is Henry Hu and I hold the
Allan Shivers Chair in the Law of Banking and Finance at the University
of Texas Law School. In the interest of full disclosure, I recently
agreed to begin working soon at the Securities and Exchange Commission.
I emphasize that I am currently a full-time academic, have been so for
more than two decades, and, after this forthcoming government service,
will return to my normal academic duties. My testimony reflects solely
my preliminary personal views and does not reflect the views of the SEC
or any other entity. The below testimony has not been discussed with,
or reviewed by, the SEC or any other entity. I ask that this written
testimony also be included in the record.
---------------------------------------------------------------------------
* Copyright 2009 by Henry T. C. Hu. All rights reserved.
---------------------------------------------------------------------------
This is a seminal time as to the regulation of credit default swaps
and other over-the-counter derivatives. \1\ Speaking on March 26,
Treasury Secretary Timothy Geithner stated that the markets for OTC
derivatives will be regulated ``for the first time.'' Last Wednesday,
as a key element in a ``new foundation for sustained economic growth,''
President Barrack Obama proposed the ``comprehensive regulation of
credit default swaps and other derivatives that have threatened the
entire financial system.'' All OTC derivatives dealers and other firms
whose activities create large exposures would be subject to ``robust''
prudential supervision. ``Standardized'' OTC derivatives would be
required to be cleared through regulated central counterparties. Record
keeping and reporting requirements would apply to both ``standardized''
and ``customized'' OTC derivatives. New steps to better ensure that OTC
derivatives are not marketed inappropriately to unsophisticated parties
would be adopted. Regulated financial institutions would be encouraged
to make greater use of regulated exchange-traded derivatives.
---------------------------------------------------------------------------
\1\ As Subcommittee Members are already aware, a ``derivative,''
at least in the classical sense, is an agreement that allows or
obligates at least one of the parties to buy or sell an asset.
Fluctuations in the asset's value would affect the agreement's value:
the agreement's value derives from the asset's value, whether the asset
is a stock, commodity, or something else. Many derivatives trade on
organized exchanges; people using such ``exchange-traded derivatives''
generally need not worry about who is on the other side of the
transaction. The exchange's ``clearinghouse'' is effectively the buyer
to every seller and the seller to every buyer. These products typically
have standardized contractual terms and exchange-traded derivatives
markets have been active in the U.S. since the 19th century.
In contrast, the market for ``OTC derivatives'' arose in the late
1970s. These agreements are individually negotiated, such as between
financial institutions or between financial institutions and their
corporate, hedge fund, or other institutional customers. In the 1970s,
a conceptual revolution in finance helped financial institutions to
price derivatives, hedge associated risks, and develop new products. At
least in the past, there were generally no clearinghouse arrangements.
Each participant relies on the creditworthiness (and sometimes the
collateral) of the party it deals with.
``Credit default swaps'' are one kind of OTC derivative. At their
simplest, they involve bets between two parties on the fortunes of a
third party. A protection buyer might, for instance, have lent money to
the third party and be concerned about repayment. For a fee (or stream
of fees), the protection seller will pay the protection buyer cash upon
a specified misfortune befalling the third party. A derivatives dealer
enters into such bets with its customers, as well as with other
dealers.
For more background, see, e.g., Henry T. C. Hu, ``Swaps, the Modern
Process of Financial Innovation and the Vulnerability of a Regulatory
Paradigm'', 138 University of Pennsylvania Law Review 333 (1989)
[hereinafter Hu, ``Modern Process'']; Henry T. C. Hu, ``Misunderstood
Derivatives: The Causes of Informational Failure and the Promise of
Regulatory Incrementalism'', 102 Yale Law Journal 1457 (1993)
[hereinafter Hu, ``Misunderstood Derivatives''].
---------------------------------------------------------------------------
Key government officials central to developing the President's
proposal are testifying today. It is my understanding that the
Subcommittee thought that, rather than similarly discussing the
specific components of the proposal, I might offer a more general
perspective on the regulation of OTC derivatives, based on some of my
past writings. In this context, perhaps the four questions set forth in
the Subcommittee's June 15 invitation revolve around a basic issue:
what's special about regulating OTC derivatives, in terms of
transparency, risk, international coordination, or other matters?
In this respect, I am reminded of something that Woody Allen once
said: ``I took a speed reading course and read War and Peace in twenty
minutes. It involves Russia.''
OTC derivatives are no less complex that Napoleonic Russia. In the
next few minutes, I will try to offer some thoughts on how to frame the
regulatory task that lies ahead. Because I have had to review the
Administration proposal and prepare this testimony in the space of only
a few days, these thoughts are preliminary and incomplete.
I suggest that it would be useful to consider not just the
characteristics of individual OTC derivatives, but also the underlying
process of modern financial innovation through which products are
invented, introduced to the marketplace, and diffused. This process
perspective may further the identification of some issues that are
important as a regulatory matter.
I start with two contrasting visions that have animated regulatory
attitudes ever since the emergence of the modern financial innovation
process in the late 1970s. (Part II) This may help ensure that, as the
Administration's proposal is reviewed or fine-tuned with respect to
such matters as ``encouraging'' a migration to exchange-traded
derivatives and distinguishing ``standardized'' from ``customized'' OTC
derivatives, consideration is given not only to the private and social
costs of OTC derivatives, but to their private and social benefits as
well.
I will then turn to how the financial innovation process results in
decision-making errors, even at the biggest financial institutions.
(Part III.A) In a Yale Law Journal article published in 1993, I
suggested that, because of compensation structure, cognitive bias,
human capital, ``inappropriability,'' and other factors characteristic
of that innovation process, ``sophisticated'' financial institutions
can misunderstand--or act as if they misunderstand--the risks of
derivatives and other complex financial products. \2\ Analyzing how
these errors occur may be helpful as the Administration seeks to
undertake, for instance, the prudential supervision of derivatives
dealers and reforms relating to compensation disclosures and practices,
internal controls, and other corporate governance matters, at such
dealers and perhaps at publicly held corporations generally.
---------------------------------------------------------------------------
\2\ Hu, ``Misunderstood Derivatives'', supra note 1.
---------------------------------------------------------------------------
The innovation process also leads to informational complexities
well beyond the usual ``transparency'' issues, and to related
difficulties. \3\ (Part III.B) Regulator-dealer informational
asymmetries can be extraordinary--e.g, regulators may not even be aware
of the existence of certain derivatives, much less how they are modeled
or used. These asymmetries are especially troubling because of the ease
with which the financial innovation process allows for the gaming of
traditional classification-based legal rules (e.g., ``cubbyholes'').
Responding to these complexities is difficult. As an example, beginning
in 1993, I have argued for the establishment of a centralized,
continuously maintained, informational clearinghouse as to all OTC
derivatives activities and outlined some of the key questions that must
be answered in creating such an informational clearinghouse. Especially
in the wake of the disasters in 2008, regulators have begun working
vigorously with derivatives dealers and others to establish data-
gathering systems with respect to credit default swaps and other OTC
derivatives.
---------------------------------------------------------------------------
\3\ As to the issues outlined in this paragraph, see Hu, ``Modern
Process'', supra note 1; Hu, ``Misunderstood Derivatives'', supra note
2; cf. Matthew Leising, ``Wall Street to Clear Client Credit Swaps by
Dec. 15'', Bloomberg, June 2, 2009 (on recent interactions between the
Federal Reserve Bank of New York and financial institutions).
---------------------------------------------------------------------------
Finally, I turn briefly to a particular example of the financial
innovation process, one that can help shape governmental responses to
credit default swaps (CDS) and securitized products, another financial
innovation that is sometimes also considered a derivative. (Part IV)
The process of what can be called ``decoupling'' or, more specifically,
its ``debt decoupling'' form, can undermine the ability of individual
corporations to stay out of bankruptcy and can contribute to systemic
risk. I discuss ``empty creditor'' and ``hidden noninterest'' issues. I
will leave aside ``empty voter'' and ``hidden (morphable) ownership''
issues on the ``equity decoupling'' side. \4\
---------------------------------------------------------------------------
\4\ As to the issues outlined in this paragraph, see, e.g., Henry
T. C. Hu & Jay Westbrook, ``Abolition of the Corporate Duty to
Creditors'', 107 Columbia Law Review 1321, 1402 (2007); Henry T. C. Hu
& Bernard Black, ``Equity and Debt Decoupling and Empty Voting II:
Importance and Extensions'', 156 University of Pennsylvania Law Review
625, 728-735 (2008); Henry T. C. Hu & Bernard Black, Debt, ``Equity and
Hybrid Decoupling: Governance and Systemic Risk Implications'', 14
European Financial Management 663, 663-66, 679-94 (2008), draft
available at http://ssrn.com/abstract=1084075; Henry T. C. Hu, ``
`Empty Creditors' and the Crisis'', Wall Street Journal, April 10,
2009, at A13; ``CDSs and Bankruptcy--No Empty Threat'', The Economist,
June 18, 2009.
---------------------------------------------------------------------------
Two Contrasting Visions of the Financial Innovation Process
From the beginning of the explosive growth of the derivatives
market in the early 1980s, two visions have animated the debate over
the regulation of derivatives and new financial products generally.
The first vision is that of science run amok, of a financial
Jurassic Park. In the face of relentless competition and capital market
disintermediation, big financial institutions have hired financial
scientists to develop new financial products. Typically operating in an
international wholesale market open only to major corporate and
sovereign entities--a loosely regulated paradise hidden from public
view--these scientists push the frontier, relying on powerful computers
and an array of esoteric models laden with incomprehensible Greek
letters.
But danger lurks. As financial creatures are invented, introduced,
and then evolve and mutate, exotic risks and uncertainties arise. In
its most fevered imagining, not only do the trillions of mutant
creatures destroy their creators in the wholesale capital market, but
they escape and wreak havoc in the retail market and in economies
worldwide.
This first vision, that of Jurassic Park, focuses on the chaos that
is presumed to result from financial science. This chaos is at the
level of the entire financial system--think of the motivation for
Federal Reserve's intervention as to Long-Term Capital Management
(perhaps inappropriately named) in 1998 or as to American International
Group in 2008--or at the level of individual participants--the
bankruptcy of Orange County in 1994 or the derivatives losses at
Procter & Gamble (perhaps appropriately named) in 1994.
The second vision is the converse of the first vision. The focus is
on the order--the sanctuary from an otherwise chaotic universe--made
possible by financial science. The notion is this: corporations are
subject to volatile financial and commodities markets. Derivatives, by
offering hedges against almost any kind of price risk, allow
corporations to operate in a more ordered world. As the innovation
process goes on, the ``derivative reality'' that corporations can buy
becomes ever richer in detail.
If the first vision is that of a Jurassic Park gone awry, the
second vision is of the soothing, perfect hedges found in a formal
English or Oriental garden. There are certainly private and social
costs associated with derivatives besides the chaos derivatives
sometimes bring. Similarly, there are private and social benefits
beyond the risk management possibilities of derivatives. \5\
---------------------------------------------------------------------------
\5\ As to some of the other benefits of derivatives, see Darrell
Duffie and Henry T. C. Hu, ``Competing for a Share of Global
Derivatives Markets: Trends and Policy Choices for the United States,''
preliminary June 8, 2008, draft available at http://ssrn.com/
abstract=1140869 (the views in said draft are solely those of the
authors and do not reflect those of anyone else).
Similarly, beyond OTC derivatives and looking at the regulation of
capital markets and institutions overall, the minimization of systemic
risk, short- or long-term, should not be the sole touchstone for
regulatory policy. In the interests of the proper allocation of
resources and long-term American economic growth, care must be taken
that our capital markets not only remain firmly rooted in full and fair
disclosure, but are perceived to be so rooted by investors worldwide.
---------------------------------------------------------------------------
I make a basic point here. In a financial crisis, especially one
with deep derivatives roots, it is too easy to focus solely on the dark
side of OTC derivatives. Directly encouraging regulated financial
institutions to migrate to exchange-traded derivatives has benefits as
well as costs. Similarly, the differing regulatory regimes for
``standardized'' and ``customized'' OTC derivatives will trigger
differing burdens. As to these and other decisions, careful
consideration of the net impact of regulatory efforts will be
necessary.
The Financial Innovation Process: Decision-Making Errors and
Informational Complexities
Decision-Making Errors
Financial institutions focused solely on shareholder interests
would generally take on more risk than would be socially optimal. At
least in the past, governments typically constrained risk-taking at
financial institutions, but not elsewhere. But as for financial
institution decision making with respect to derivatives, much more than
a gap between shareholder- and social-optimality is involved. There is
a repeated pattern of outright mistakes, harmful to shareholders and
societies alike, even at ``sophisticated'' entities.
Why? In the 1993 ``Misunderstood Derivatives'' article, I argued
that several of the factors stemmed from the underlying process of
modern financial innovation. These factors may cause even the best
financial institutions and rocket scientists to misunderstand (or
behave as if they misunderstand) derivatives. I also offered some
possible responses, both in terms of disclosure (including enhanced
compensation disclosure) and in terms of substantive measures
(including measures to encourage proper consideration of legal risks).
One factor is cognitive bias in the derivatives modeling process.
Humans often rely on cognitive shortcuts to solve complex problems;
sometimes these shortcuts are irrational.
For instance, one of the cognitive biases undermining derivatives
models is the tendency to ignore low probability-catastrophic events.
Psychologists theorize that individuals do not worry about an event
unless the probability of the event is perceived to be above some
critical threshold. The effect may be caused by individuals' inability
to comprehend and evaluate extreme probabilities, or by a lack of any
direct experience. This effect manifests itself in attitudes towards
tornados, safety belts, and earthquake insurance. My 1993 article
indicated that in the derivatives context, financial rocket scientists
are sometimes affirmatively encouraged, as a matter of model design, to
ignore low probability states of the world. I also showed how this
tendency, along with other cognitive biases, may cause risks of a legal
nature to be ignored.
Certain public AIG statements are arguably consistent with the
operation of this cognitive bias, though they do not necessarily prove
the existence of the bias. For example, in August 2007, the head of the
AIG unit responsible for credit default swaps stated:
It is hard for us, without being flippant, to even see a
scenario within any kind of realm of reason that would see us
losing one dollar in any of those [credit default swap]
transactions. \6\
---------------------------------------------------------------------------
\6\ Gretchen Morgenson, ``Behind Insurer's Crisis, Blind Eye to a
Web of Risks,'' N.Y. Times, Sept. 28, 2008, at A1.
Then again, perhaps he was right. AIG didn't lose one dollar; it lost
billions.
Similarly, AIG's Form 10-K for 2006 stated:
The threshold amount of credit losses that must be realized
before AIGFP has any payment obligation is negotiated by AIGFP
for each transaction to provide that the likelihood of any
payment obligation by AIGFP under each transaction is remote,
even in severe recessionary market scenarios.
Another factor flows from the inability of financial institutions
to capture--to ``appropriate''--all the benefits of their financial
research and development. This ``inappropriability'' can lead to the
failure to devote enough resources to fully understand the risks and
returns of these products. (This has implications for responding to
securitization that have not been considered. As to asset-backed
securities, inappropriability may well have contributed to the
sacrificing of due diligence in favor of excessive reliance on ratings
agencies.)
One of the other factors flows from the incentive structures in the
innovation process. In the derivatives industry, the incentive
structure can be highly asymmetric. True success--or the perception by
superiors of success--can lead to enormous wealth. Failure or perceived
failure may normally result, at most, in job and reputational losses.
Thus, there may be serious temptations for the rocket scientist to
emphasize the rewards and downplay the risks of particular derivatives
activities to superiors, especially since the superiors may sometimes
not be as financially sophisticated (and loathe to admit this).
Moreover, the material risk exposures on certain derivatives can
sometimes occur years after entering into the transaction--given the
turnover in the derivatives industry, the ``negatives'' may arise long
after the rocket scientist is gone. The rocket scientist may have an
especially short-term view of the risks and returns of his activities.
I do not know if any of AIG's current or past employees succumbed
to any such behavior, by reason of the incentive structure or
otherwise. That said, it is a matter that would be worth looking into.
According to the testimony of Martin Sullivan, the former CEO of AIG,
until 2007, many employees at AIG Financial Products (AIGFP) (the
subsidiary generating the losses leading to the AIG bailout) were being
paid higher bonuses than he was. The head of AIGFP, Joseph Cassano,
apparently made $280 million over 8 years. And when Mr. Cassano left
AIG in February 2008, he was given, among other things, a contract to
consult for AIG at $1 million a month--at least, if memory serves,
until a pertinent Congressional hearing came along.
The foregoing factors characteristic of the modern financial
innovation process should be considered with respect to regulatory
reforms. This applies not only with respect to how the Administration
should engage in the prudential supervision of derivatives dealers but
perhaps as well to such matters as the Federal role as to compensation
disclosure and practices at publicly held corporations generally. These
issues are quite complex, perhaps especially with respect to
substantive (as opposed to disclosure) aspects of compensation:
questions abound for any particular dealer or corporation, as well as
for the proper role of the Federal Government in respect to those
questions. How and when should ``profits'' on trades be calculated?
What are the proper models for valuing complex derivatives and
determining profits? How are risks and returns on particular types of
instruments to be quantified? How should compensation be risk-adjusted?
Informational Complexities and the Creation of an Informational
Clearinghouse
As noted earlier, a variety of informational complexities stem from
the financial innovation process. One of the complexities stems from
the fact that, historically, neither the introduction of new OTC
derivative products nor individual OTC derivative transactions were
required to be disclosed to any regulator. The informational predicate
for effective regulation is absent.
In ``Misunderstood Derivatives,'' I suggested the creation of an
informational clearinghouse involving the centralized and continuous
gathering of product information and outlined some of the key questions
as to nature and scope that would need to be answered in actual
implementation. Market participants would provide specified
transaction-specific data in computerized form. Although providing
actual market prices (transactional terms) may be sensitive, providing
theoretical pricing models are sometimes likely to be far more so. The
models the derivatives dealers use can be complex and proprietary. And
market prices may depart substantially from valuations predicted by
models.
Especially after the CDS-related AIG debacle in September 2008,
regulators have been moving aggressively to work with derivatives
dealers and others to improve OTC derivatives data-gathering,
particularly as to CDS. Perhaps there is a possibility of a fully
centralized informational clearinghouse. This would necessitate
international coordination well beyond the U.S.-U.K.-centric process
that culminated in the pioneering 1988 Basel Accord for capital
adequacy. A properly designed centralized informational clearinghouse
must consider the extent to which proprietary information should really
be required and, if or when required, reflect extensive safeguards.
Moreover, complicated decisions lie ahead as to what information
provided to regulators should be made available to the public.
The ``Decoupling'' Process
I now turn briefly to a particular example of the financial
innovation process, consideration of which should help guide policy
decisions with respect to CDS, securitized products, and other
derivatives. Certain issues relating to CDS and to securitizations have
become quite familiar. For example, everyone is by now aware of how
American International Group's CDS activities helped cause AIG's near-
collapse in September 2008. And, especially with President Obama's
Wednesday speech and its reference to the need for ``skin in the
game,'' most of us are familiar with the moral hazard, ratings agency,
principal-agent, and other issues which cause securitized products to
be mispriced or missold. And, in Part III.A, I have discussed how
``inappropriability'' issues in the financial R&D process should begin
to be considered with respect to such matters as the inadequate due
diligence done (and excessive reliance on ratings agencies) in
connection with securitizations.
Instead, I will focus here on the process that can be called ``debt
decoupling.'' In August 2007, I began suggesting that the separation of
control rights and economic interest with respect to corporate debt
through swaps can cause a variety of substantive and disclosure
problems, problems that become especially troublesome when economic
times are bad. This debt decoupling analysis has been further developed
and I rely on this analysis to illustrate these issues.
Ownership of debt usually conveys a package of economic rights (to
receive payment or principal and interest), contractual control rights
(to enforce, waive, or modify the terms of the debt contract), other
legal rights (including the rights to participate in bankruptcy
proceedings), and sometimes disclosure obligations. Traditionally, law
and real world practice assume that the elements of this package are
generally bundled together. One key assumption is that creditors
generally want to keep a solvent firm out of bankruptcy and (apart from
intercreditor matters) want to maximize the value of an insolvent firm.
These assumptions can no longer be relied on. Credit default swaps
and other credit derivatives now permit formal ownership of debt claims
to be ``decoupled'' from economic exposure to the risk of default or
credit deterioration. But formal ownership usually still conveys
control rights under the debt agreement and legal rights under
bankruptcy and other laws.
There could, for instance, be a situation involving what, in 2007,
I termed an ``empty creditor'': a creditor may have the control rights
flowing from the debt contract but, by simultaneously holding credit
default swaps, have little or no economic exposure to the debtor. The
creditor would have weakened incentives to work with a troubled
corporation for the latter to avoid bankruptcy. And if this empty
creditor status is undisclosed, the troubled corporation will not know
the true incentives of its creditor as the corporation attempts to seek
relief in order to avoid bankruptcy. Indeed, if a creditor holds enough
credit default swaps, it may simultaneously have control rights and a
negative economic exposure. With such an extreme version of the empty
creditor situation, the creditor would actually have incentives to
cause the firm's value to fall. Debt decoupling could also cause
substantive (empty creditor) and disclosure (hidden noninterest and
hidden interest) complications for bankruptcy proceedings.
Have CDS-based empty creditor situations actually happened in the
real world? Yes. On September 16, 2008, as AIG was being bailed out,
Goldman Sachs said its exposure to AIG was ``not material.'' But on
March 15, 2009, AIG disclosed it had turned over to Goldman $7 billion
of the Federal bailout funds AIG received.
Perhaps this could be referred to as ``The Curious Incident of the
Bank That Didn't Bark.'' As I suggested in an op-ed in the April 10
Wall Street Journal, one reason Goldman Sachs did not express alarm in
September is that it was an empty creditor. Having hedged its economic
exposure to AIG with credit default swaps from ``large financial
institutions,'' Goldman had lessened concerns over the fate of AIG. Yet
Goldman had the control rights associated with the contracts that it
had entered into with AIG (including rights to demand collateral).
Perhaps not surprisingly, Goldman was apparently aggressive in calling
for collateral from AIG. (I do not in any way suggest that Goldman did
anything improper. Moreover, Goldman had obligations to its own
shareholders.)
Debt decoupling issues relating to multiple borrowers can also
affect the economy. In the securitization context, servicing agents
have little or no economic interest in the debt (and limited rights to
agree to loan modifications) while senior tranche holders typically
have most of the control rights (but, in contrast to junior tranche
holders, little incentive to agree to modifications). As a result, the
relationships between debtors and creditors tend to be ``frozen'':
difficulties in modifying the debtor-creditor relationship can
contribute to systemic risk. Front page headlines suggest the
importance of loan modification difficulties in the securitization
context; analyzing how debt decoupling contributes to these
difficulties may be helpful in considering governmental policies as to
asset-backed securities.
The foregoing involves ``debt decoupling.'' ``Equity decoupling''
also occurs. Ownership of shares traditionally conveys a package
(economic, voting, and other rights) and obligations (including
disclosure). Law and contracting practice assumed that the elements of
this equity package are generally bundled together. But outside
investors and others can now decouple this link between voting (as well
as other) rights on shares and economic interest in those shares.
Financial innovations like equity derivatives and familiar tools like
share borrowing used for decoupling purposes have affected core
substantive and disclosure mechanisms of corporate governance. But
today, I will leave aside analysis of ``empty voting,'' ``hidden
(morphable) ownership,'' and related matters.
Conclusion
The President's proposal appears to offer a good starting point for
review, with respect to OTC derivatives and otherwise. I make a modest
claim: considering the special nature of the modern process of
financial innovation can be helpful in the road ahead.
Thank you.
______
PREPARED STATEMENT OF KENNETH C. GRIFFIN
Founder, President, and Chief Executive Officer,
Citadel Investment Group, L.L.C.
June 22, 2009
Chairman Reed, Senator Bunning, Members of the Committee, I am
Kenneth Griffin, President and CEO of Citadel Investment Group. I
appreciate the opportunity to testify and share our views regarding
effective oversight of the over-the-counter derivatives market.
Citadel's nearly two decades of experience in the OTC marketplace,
as well as its role as a leading liquidity provider in the equity
markets and the options market in the United States, give us insights
into the benefits of appropriate market structure. Sadly, it now also
gives us insights into the wreckage that can be wrought by opaque and
unregulated markets.
As one of the largest alternative asset managers, Citadel has a
vested interest in the safety and soundness of our financial markets
and in fostering fair, orderly and transparent markets. As an American
taxpayer, I have a vested interest in ensuring that the financial
crisis that we have experienced never happens again.
To be clear, Citadel also has an economic interest in the outcome
of this issue as a partner with CME Group in the development of a
neutral, open access, central counterparty clearing solution for credit
default swaps. CME is also supported by other institutional investors
and alternative asset managers in this initiative.
For many years, Citadel has advocated for central counterparty
clearing. I am confident that if OTC derivatives were cleared through a
properly structured and transparent central counterparty, the impact of
AIG and Lehman Brothers would have been much different. Without a
central counterparty clearing framework in place, their failures have
contributed to the loss of hundreds of thousands of jobs and the use of
hundreds of billions of dollars of taxpayer money.
Citadel is committed to maintaining the benefits of credit default
swaps products while reducing the systemic risk they present to the
market, to the economy as a whole and to American taxpayers. We
wholeheartedly support a comprehensive framework for over-the-counter
derivatives and the realignment of capital incentives as an immediate,
tangible undertaking to realize these goals. We stand ready to help
this Committee meet these goals.
Derivatives and Their Benefits
Credit default swaps and other derivatives play a crucial role in
helping American businesses prudently manage their balance sheets as
well as their interest rate and credit exposure. When used and overseen
properly, credit default swaps and other derivatives play a vital role
in helping our economy function smoothly and grow.
Examples of the benefits of derivatives abound.
Institutional investors, such as pension funds, 401k
managers, foundations and endowments make frequent use of
derivatives to achieve their portfolio objectives and to manage
risk.
A regional bank may use credit default swaps to buy credit
protection on its loan portfolio. By transferring credit risk,
the bank can free up capital and make more loans at a time of
contracting credit availability.
Manufacturers use these instruments to hedge the risk that
their key suppliers might go bankrupt and not fulfill
outstanding obligations. Suppliers may protect against the risk
that their customers might fail to pay.
The imprudent use of these instruments, however, when coupled with
(1) an antiquated and opaque market structure, (2) the lack of
comprehensive margin and capital requirements, and (3) the absence of a
central counterparty clearing framework can have devastating
consequences. This is an issue of profound importance to our capital
markets and the American people.
Reform Measures Essential to the Market
The derivatives market has grown because of its utility. Between
2003 and 2008, it is estimated the market for credit default swaps grew
from $3.8 trillion to nearly $40 trillion, and has become highly liquid
and standardized. At the end of 2008, it was estimated there were
approximately $325 trillion in gross notional value of interest rate
swaps outstanding. Yet the derivatives market today largely functions
as it did three decades ago.
The current market structure is characterized by the notable
absence of certain structural safeguards that are the hallmark of
mature and efficient markets: a central counterparty, segregation of
margin deposits and positions, price transparency, and appropriate
capital requirements for all market participants, including dealers and
highly rated counterparties. In the current market structure:
Dealers are generally not obligated to post margin to
initiate a trade.
Customers are often required to post initial margin to
their dealer counterparties to initiate a trade. These funds
are held by the dealers in accounts that are commingled with
the dealers' own funds. Because customer margin is not
segregated, customer funds could be lost in a dealer default.
In times of stress, customers will rush to close out positions
to recover their margin. This can intensify a liquidity crisis,
and may precipitate bankruptcy, as we saw with Lehman Brothers.
Market data, such as transaction prices, is closely held
and not published. As a result, many market participants cannot
accurately value their portfolios nor prudently manage their
investments. Had there been objective and real time price
transparency and a uniform margin methodology available last
fall, the AIG fiasco may never have happened.
The Right Incentives
Today, the vast majority of credit default and interest rate swap
contracts have standard terms similar to equity options, and trade in
large daily volumes. The same parties that trade credit default and
interest rate swap contracts participate in other markets that benefit
from central clearing, transparent and consistent margins, and account
segregation.
In the absence of one or more central clearinghouses available to
all market participants, a tremendous amount of risk is concentrated
with a handful of financial institutions. These financial institutions
earn extraordinary profits from the lack of transparency in the
marketplace and from the privileged role they play as credit
intermediaries in almost all transactions. Unfortunately, we have seen
the cost borne by our broader economy when one of these highly
interconnected institutions fails.
Capital requirements on the trading of over-the-counter derivatives
should reflect the significant systemic risk they create. We should
also consider the imposition of a requirement for financial
institutions to use clearinghouses for the most commonly traded over-
the-counter derivatives.
This problem has an international dimension. We must work to
coordinate our actions with foreign regulators. Otherwise, we face the
risk of cross-border capital and regulatory arbitrage.
We are hopeful that once appropriate capital requirements are
established, trading of over-the-counter derivatives will naturally
flow to regulated clearinghouses with mutualized risk and natural
netting capabilities. And with it, price transparency, reduction of
systemic risk, and continued evolution of the core market will follow.
The status quo cannot be allowed to continue. We must work together
to drive market structure reform that fosters orderly and transparent
markets, facilitates the growth and strength of the American economy
and protects taxpayers from losses such as those we have witnessed in
the last year.
Thank you for the opportunity to testify today. I would be happy to
answer your questions.
______
PREPARED STATEMENT OF ROBERT G. PICKEL
Executive Director and Chief Executive Officer,
International Swaps and Derivatives Association, Inc.
June 22, 2009
Mr. Chairman and Members of the Subcommittee: Thank you very much
for inviting ISDA to testify today. We are grateful for the opportunity
to discuss public policy issues regarding the privately negotiated, or
OTC, derivatives business. Our business provides essential risk
management and cost reduction tools for a broad swath of users.
Additionally, it is an important source of employment, value creation
and innovation for our financial system--it is one that employs tens of
thousands of individuals in the United States and benefits thousands of
American companies across a broad range of industries.
About ISDA
ISDA, which represents participants in the privately negotiated
derivatives industry, is the largest global financial trade
association, by number of member firms. ISDA was chartered in 1985, and
today has over 830 member institutions from 56 countries on six
continents. These members include most of the world's major
institutions that deal in privately negotiated derivatives, as well as
many of the businesses, governmental entities, investment managers and
other end users that rely on over-the-counter derivatives to manage
efficiently the financial market risks inherent in their core economic
activities.
Since its inception, ISDA has pioneered efforts to identify and
reduce the sources of risk in the derivatives and risk management
business. Among its most notable accomplishments are: developing the
ISDA Master Agreement; publishing a wide range of related documentation
materials and instruments covering a variety of transaction types;
producing legal opinions on the enforceability of netting and
collateral arrangements; securing recognition of the risk-reducing
effects of netting in determining capital requirements; promoting sound
risk management practices; and advancing the understanding and
treatment of derivatives and risk management from public policy and
regulatory capital perspectives
In my remarks today, I would briefly like to underscore ISDA's and
the industry's strong commitment to identifying and reducing risk in
the privately negotiated derivatives business:
We believe that OTC derivatives offer significant value to
the customers who use them, to the dealers who provide them,
and to the financial system in general by enabling the transfer
of risk between counterparties.
We recognize, however, that the industry today faces
significant challenges, and we are urgently moving forward with
new solutions rather than remaining stuck in the status quo.
We have delivered and are delivering on a series of reforms
in order to promote greater standardization and resilience in
the derivatives markets.
These developments have been closely overseen and
encouraged by regulators, who recognize that optimal solutions
to market issues are usually achieved through the participation
of market participants.
As ISDA and the industry work to reduce risk, we believe it
is essential to preserve flexibility to tailor solutions to
meet the needs of customers. Efforts to mandate that privately
negotiated derivatives business trade only on an exchange would
effectively stop any such business from being conducted.
Requiring exchange trading of all derivatives would harm the
ability of American companies to manage their individual,
unique financial risks and ultimately, harm the economy.
Mr. Chairman, let me assure you that ISDA and our member firms
clearly understand the need to act quickly and decisively to implement
the important measures that I will describe in the next few minutes.
About OTC Derivatives
OTC derivatives exist to serve the risk management and investment
needs of end users. These end users form the backbone of our economy.
They include over 90 percent of the Fortune 500, 50 percent of mid-
sized companies and thousands of other smaller American companies. OTC
derivatives allow these businesses, which employ millions of Americans,
to effectively manage risks that are not central to their lines of
business.
It is important to understand that an OTC derivative--whether it's
an interest rate swap or a credit default swap--does not in and of
itself create risk. It shifts risk from one firm, or counterparty, to
another, thereby dispersing that risk in the marketplace.
The development of OTC derivatives has followed the development of
the American economy. For centuries, foreign exchange transactions have
facilitated trade and helped American businesses expand; they were one
of the original banking powers recognized in the National Bank Act of
1863.
The first OTC derivative linked to interest rates was transacted in
the early 1980s between IBM and the World Bank, helping IBM raise funds
on more favorable terms.
Credit derivatives first appeared in the mid-1990s as a tool to
help banks diversify the credit risk in their loan portfolio. Since
then, they have grown into a vital risk management and diversification
tool.
In each case, the need for these privately negotiated derivatives
products was driven by the needs of end users. Their growth was a
direct function of their utility to end users. If end users like 3M,
Boeing, Cargill and hundreds of others did not want these products,
they would not exist.
Understanding Notional Amounts
Before I discuss current regulatory and industry initiatives, there
is one aspect of the OTC derivatives markets that bears some
explanation.
As you may know, the industry's size is usually measured in
notional amounts outstanding. The reason for using notional amounts is
that it is relatively simple to identify and gather. In addition, it is
consistent over time; that is, the notional amount for a deal does not
change except in limited cases.
While it is a useful measurement tool, notional amount overstates
the level of activity in the OTC derivatives markets. More problematic,
however, is the dramatic misinterpretation of notional amount as a
measure of risk. In fact, notional amounts are only loosely related to
risk.
In the OTC derivatives markets, a firm will often enter into one
contract to offset exposure from another contract. As it does so, it
doubles the level of notional outstanding. But it does not increase the
level of risk in the system.
Statistics compiled by the Depository Trust and Clearing
Corporation's Trade Information Warehouse illustrate this point. The
Trade Information Warehouse is a global repository and post-trade
processing infrastructure for over-the-counter (OTC) credit
derivatives. According to data that it makes publicly available, there
is currently about $5.6 billion of credit default swap protection on
Johnson & Johnson. However, after stripping away all offsetting
positions that firms may have, the net notional value of CDS on the
company is $900 million.
Looking at the CDS business in aggregate, there is currently about
$28 trillion in gross notional outstanding. However, on a net basis,
according to DTCC, the level of exposure is $2.5 trillion, or less than
10 percent of the notional.
Obviously, this $2.5 trillion is still a large number, but please
keep in mind what it represents: every reference entity on which every
CDS contract is based would have to default for payouts to be that high
and recovery rates on underlying debt would have to be zero.
Current Regulatory and Industry Initiatives
Last week, President Obama announced a comprehensive regulatory
reform proposal for the financial industry. The proposal is an
important step toward much-needed reform of financial industry
regulation. The reform proposal addressed OTC derivatives in a manner
consistent with the proposals announced on May 13 by Treasury Secretary
Geithner. ISDA and the industry welcomed in particular the recognition
of industry measures to safeguard smooth functioning of our markets.
The Administration proposes to require that all derivatives dealers
and other systemically important firms be subject to prudential
supervision and regulation. ISDA supports the appropriate regulation of
financial institutions that have such a large presence in the financial
system that their failure could cause systemic concerns.
Most of the other issues raised in the Administration's proposal
have been addressed in a letter that ISDA and industry participants
delivered to the Federal Reserve Bank of New York earlier this month.
As you may know, a Fed-industry dialogue was initiated under
Secretary Geithner's stewardship of the New York Fed some 4 years ago.
Much has been achieved and much more has been committed to, all with
the goal of risk reduction, transparency, and liquidity. These
initiatives include:
Increased standardization of trading terms;
Improvements in the trade settlement process;
Greater clarity in the settlement of defaults;
Significant positive momentum toward central counterparty
clearing;
Enhanced transparency; and
A more open industry governance structure.
In our letter to the New York Fed this month, ISDA and the industry
expressed our ``firm commitment to strengthen the resilience and
robustness of the OTC derivatives markets.'' As we stated, ``We are
determined to implement changes to risk management, processing and
transparency that will significantly transform the risk profile of
these important financial markets . . . .''
We outlined a number of steps toward that end, specifically in the
areas of information transparency and central counterparty clearing.
Central Counterparty Clearing
In terms of clearing, the industry recognizes that it is an
important public policy consideration--and that it can provide many
benefits to the market, including helping to identify systemic risk.
Today, the industry clears the majority of inter-dealer interest
rate swaps. Plans have recently been announced to expand the risk
management benefits of the clearing to the buy-side as well.
For credit default swaps, the industry has committed to migrating
standardized contracts onto a clearing platform, as per the
Administration's proposal. It is also the industry's goal to achieve
buy-side access to CDS clearing (through either direct CCP membership
or customer clearing) no later than the end of this year.
While there is widespread recognition of the benefits of clearing,
there is also widespread acknowledgement, including in the
Administration's proposal, that there is a continued need for
customized OTC derivatives. Due to their inherent nature--as flexible
risk management tools designed specifically to meet particular needs--
not all OTC products can be cleared.
Nor, for this same reason, can all OTC products trade on an
exchange. Here's why: stocks, bonds, commodities--when you buy or sell
them, most of the trade terms are fixed. All you really need to do is
indicate the name and quantity that you want to buy, and you can
execute the trade. But with customized OTC derivatives, the trade terms
are determined by the end customer and the dealer to fit a specific
need. IBM's financial situation and needs are different from GE's, and
GE's are different from John Deere's. There is simply no way to
standardize this end customer demand.
In fact, mandating that interest rate swaps or credit default swaps
be traded on an exchange is likely to result only higher costs and
increased risks to the manufacturers, technology firms, retailers,
energy producers, utilities, service companies and others who use OTC
derivatives in the normal course of business. It will put American
businesses at a significant disadvantage to their competitors around
the world.
Information Transparency
I would next like to discuss the issue of information transparency.
The Administration's proposal is designed to ensure that regulators
would have comprehensive and timely information about the positions of
each and every participant in all OTC derivatives markets.
This new framework calls for trades to be cleared or, if not
cleared, to be reported to a trade repository. ISDA and the industry
support this framework, as it would provide policy makers with access
to the information they need to carry out their authorities under the
law.
Data repositories will be established for noncleared transactions
in the OTC derivatives markets. When combined with the information
available from clearinghouses, this should--as the Administration's
proposal noted--enable the industry to meet its record keeping and
reporting obligations and enhance transparency to regulators and to the
general public.
Any efforts taken beyond these measures would appear to be
duplicative and may add to the cost of doing business. As a result, any
such proposals should be carefully scrutinized to see whether and how
they add value beyond the provisions of the Administration's proposal
and the industry's commitment to the New York Fed.
One additional issue that has been raised in the recent policy
debate is whether standardized contracts that can be cleared should
also be traded on an exchange. The industry's view on this is two-fold.
First, we believe that the public policy goals of greater
transparency as discussed above will be met in a clearinghouse/
noncleared trade repository environment. In this sense, requiring
standardized contracts to be exchange traded would not produce any
additional information for or benefits to policy makers.
It could, however, increase the costs of doing business for
industry participants. That is why we have long believed that market
forces are best positioned to determine the most efficient and
effective way to trade OTC contracts. It's possible that there are some
contracts that would prove to be very successful if they traded on an
exchange. It's also possible that electronic execution systems may
increase in popularity due to the benefits they offer. These, however,
are properly choices for market participants.
Summary and Conclusion
ISDA and the OTC derivatives industry are committed to engaging
with supervisors, globally, to expand upon the substantial improvements
that have been made in our business since 2005.
We know that further action is required, and we pledge our support
in these efforts. It is our belief that much additional progress can be
made within a relatively short period of time. Our clearing and
transparency initiatives, for example, are well underway, with specific
commitments aired publicly and provided to policy makers.
As we move forward, we believe the effectiveness of future policy
initiatives will be determined by how well they answer a few
fundamental questions:
First, will these policy initiatives recognize that OTC
derivatives play an important role in the U.S. economy?
Second, will these policy initiatives enable firms of all
types to improve how they manage risk?
Third, will these policy initiatives reflect an
understanding of how the OTC derivatives markets function and
their true role in the financial crisis?
Finally, will these policy initiatives ensure the
availability and affordability of these essential risk
management tools to a wide range of end users?
Mr. Chairman and Committee Members, the OTC derivatives industry is
an important part of the financial services business in this country
and the services we provide help companies of all shapes and sizes.
______
PREPARED STATEMENT OF CHRISTOPHER WHALEN
Managing Director,
Institutional Risk Analytics
June 22, 2009
Chairman Reed, Senator Bunning, Members of the Committee: Thank you
for requesting my testimony today regarding the operation and
regulation of over-the-counter or ``OTC'' derivatives markets. My name
is Christopher Whalen and I live in the State of New York. \1\ I work
in the financial community as an analyst and a principal of a firm that
rates the performance of commercial banks. I previously appeared before
the full Committee in March of this year to discuss regulatory reform.
---------------------------------------------------------------------------
\1\ Mr. Whalen is a cofounder of Institutional Risk Analytics, a
Los Angeles unit of Lord, Whalen LLC that publishes risk ratings and
provides customized financial analysis and valuation tools.
---------------------------------------------------------------------------
First let me make a couple of points for the Committee on how to
think about OTC derivatives. Then I will answer your questions in
summary form. Finally, I provide some additional sources and references
to help you in your deliberations.
Defining OTC Asset Classes
When you think about OTC derivatives, you must include both
conventional interest rate and currency swap contracts, single name
credit default swap or ``CDS'' contracts, and the panoply of
specialized, customized gaming contracts for everything and anything
else that can be described, from the weather to sports events to
shifting specific types of risk exposure from one unit of AIG to
another. You must also include the family of complex structured
financial instruments such as mortgage securitizations and
collateralized debt obligations or ``CDOs,'' for these too are OTC
``derivatives'' that purport to derive their ``value'' from another
asset or instrument.
Bank Business Models and OTC
Perhaps the most important issue for the Committee to understand is
that the structure of the OTC derivatives market today is a function of
the flaws in the business models of the largest dealer banks, including
JPMorgan Chase (NYSE:JPM), Bank of America (NYSE:BAC) and Goldman Sachs
(NYSE:GS). These flaws are structural, have been many decades in the
making, and have been concealed from the Congress by the Fed and other
financial regulators.
The fact that today OTC derivatives trading is the leading source
of profits and also risk for many large dealer banks should tell the
Congress all that it needs to know about the areas of the markets
requiring immediate reform. Many cash and other capital markets
operations in these banks are marginal in terms of return on invested
capital, suggesting that banks beyond a certain size are not only too
risky to manage--but are net destroyers of value for shareholders and
society even while pretending to be profitable. \2\
---------------------------------------------------------------------------
\2\ See ``Talking About RAROC: Is `Financial Innovation' Good for
Bank Profitability?'', The Institutional Risk Analyst, June 10, 2008
(http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=286).
---------------------------------------------------------------------------
Simply stated, the supranormal returns paid to the dealers in the
closed OTC derivatives market are effectively a tax on other market
participants, especially investors who trade on open, public exchanges
and markets. The deliberate inefficiency of the OTC derivatives market
results in a dedicated tax or subsidy meant to benefit one class of
financial institutions, namely the largest OTC dealer banks, at the
expense of other market participants. Every investor in the global
markets pay the OTC tax via wider bid-offer spreads for OTC derivatives
contracts than would apply on an organized exchange. \3\
---------------------------------------------------------------------------
\3\ See ``Credit Default Swaps and Too Big to Fail or Unwind:
Interview With Ed Kane'', The Institutional Risk Analyst, June 3, 2009
(http://us1.institutionalriskanalytics.com/pub/IRAstory.asp?tag=364)
---------------------------------------------------------------------------
The taxpayers in the industrial nations also pay a tax through
periodic losses to the system caused by the failure of the victims of
OTC derivatives and complex structured assets such as AIGs and
Citigroup (NYSE:C). And most important, the regulators who are supposed
to protect the taxpayer from the costs of cleaning up these periodic
loss events are so captive by the very industry they are charged by law
to regulate as to be entirely ineffective. As the Committee proceeds in
its deliberations about reforming OTC derivatives, the views of the
existing financial regulatory agencies and particularly the Federal
Reserve Board and Treasury, should get no consideration from the
Committee since the views of these agencies are largely duplicative of
the views of JPM and the large OTC dealers.
Basis Risk and Derivatives
The entire family of OTC derivatives must be divided into types of
contracts for which there is a clear, visible cash market and those
contracts for which the basis is obscure or nonexistent. A currency or
interest rate or natural gas swap OTC contract are clearly linked to
the underlying cash markets or the ``basis'' of these derivative
contracts, thus both buyers are sellers have reasonable access to price
information and the transaction meets the basic test of fairness that
has traditionally governed American financial regulation and consumer
protection.
With CDS and more obscure types of CDOs and other complex mortgage
and loan securitizations, however, the basis of the derivative is
nonexistent or difficult/expensive to observe and calculate, thus the
creators of these instruments in the dealer community employ ``models''
that purport to price these derivatives. The buyer of CDS or CDOs has
no access to such models and thus really has no idea whatsoever how the
dealer valued the OTC derivative. More, the models employed by the
dealers are almost always and uniformly wrong, and are thus completely
useless to value the CDS or CDO. The results of this unfair, deceptive
market are visible for all to see--and yet the large dealers, including
JPM, BAC, and GS continue to lobby the Congress to preserve the CDS and
CDO markets in their current speculative form. \4\
---------------------------------------------------------------------------
\4\ For an excellent discussion of why OTC derivatives and complex
structured assets are essentially a fraud, see the presentation by Ann
Rutledge, ``What's Great about the ETP Model?'', PRMIA, June 10, 2009.
(http://www.prmia.org/Chapter_Pages/Data/Files/
3227_3508_PRMIA%20CDS_presentation.pdf)
---------------------------------------------------------------------------
In my view, CDS contracts and complex structured assets are
deceptive by design and beg the question as to whether a certain level
of complexity is so speculative and reckless as to violate U.S.
securities and antifraud laws. That is, if an OTC derivative contract
lacks a clear cash basis and cannot be valued by both parties to the
transaction with the same degree of facility and transparency as cash
market instruments, then the OTC contact should be treated as
fraudulent and banned as a matter of law and regulation. Most CDS
contracts and complex structured financial instruments fall into this
category of deliberately fraudulent instruments for which no cash basis
exists.
What should offend the Congress about the CDS market is not just
that it is deceptive by design, which it is; not just that it is a
deliberate evasion of established norms of transparency and safety and
soundness, norms proven in practice by the great bilateral cash and
futures exchanges over decades; not that CDS is a retrograde
development in terms of the public supervision and regulation of
financial markets, something that gets too little notice; and not that
CDS is a manifestation of the sickly business models inside the largest
zombie money center banks, business values which consume investor value
in multibillion dollar chunks. No, what should bother the Congress and
all Americans about the CDS market is that is violates the basic
American principle of fairness and fair dealing.
Jefferson said that, ``commerce between master and slave is
barbarism.'' All of the founders were Greek scholars. They knew what
made nations great and what pulled them down into ruins. And they knew
that, above all else, how we treat ourselves, as individuals,
customers, neighbors, traders and fellow citizens, matters more than
just making a living. If we as a Nation tolerate unfairness in our
financial markets in the form of the current market for CDS and other
complex derivatives, then how can we expect our financial institutions
and markets to be safe and sound?
For our Nation's founders, equal representation under the law went
hand in hand with proportional requital, meaning that a good deal was a
fair deal, not merely in terms of price but in making sure that both
parties extracted value from the bargain. A situation in which one
person extracts value and another, through trickery, does not,
traditionally has been rejected by Americans as a fraud. Whether
through laws requiring disclosure of material facts to investors,
antitrust laws or the laws and regulations that once required virtually
all securities transactions to be conducted across open, public
markets, not within the private confines of a dealer-controlled
monopoly, Americans have historically stood against efforts to reduce
transparency and make markets less efficient--but that is precisely how
this Committee should view proposals from the Obama Administration and
the Treasury to ``reform'' the OTC derivatives markets.
To that point, consider the judgment of Benjamin M. Friedman,
writing in The New York Review of Books on May 28, 2009, ``The Failure
of the Economy & the Economists.'' He describes the CDS market in a
very concise way and in layman's terms. I reprint his comments with the
permission of NYRB:
The most telling example, and the most important in accounting
for today's financial crisis, is the market for credit default
swaps. A CDS is, in effect, a bet on whether a specific company
will default on its debt. This may sound like a form of
insurance that also helps spread actual losses of wealth. If a
business goes bankrupt, the loss of what used to be its value
as a going concern is borne not just by its stockholders but by
its creditors too. If some of those creditors have bought a CDS
to protect themselves, the covered portion of their loss is
borne by whoever issued the swap.
But what makes credit default swaps like betting on the
temperature is that, in the case of many if not most of these
contracts, the volume of swaps outstanding far exceeds the
amount of debt the specified company owes. Most of these swaps
therefore have nothing to do with allocating genuine losses of
wealth. Instead, they are creating additional losses for
whoever bet incorrectly, exactly matched by gains for the
corresponding winners. And, ironically, if those firms that bet
incorrectly fail to pay what they owe-as would have happened if
the government had not bailed out the insurance company AIG-the
consequences might impose billions of dollars' worth of
economic costs that would not have occurred otherwise.
This fundamental distinction, between sharing in losses to the
economy and simply being on the losing side of a bet, should
surely matter for today's immediate question of which insolvent
institutions to rescue and which to let fail. The same
distinction also has implications for how to reform the
regulation of our financial markets once the current crisis is
past. For example, there is a clear case for barring
institutions that might be eligible for government bailouts--
including not just banks but insurance companies like AIG--from
making such bets in the future. It is hard to see why they
should be able to count on taxpayers' money if they have bet
the wrong way. But here as well, no one seems to be paying
attention.
CDS and Systemic Risk
While an argument can be made that currency, interest rate and
energy swaps are functionally interchangeable with existing forward
instruments, the credit derivative market raises a troubling question
about whether the activity creates value or helps manage risk on a
systemic basis. It is my view and that of many other observers that the
CDS market is a type of tax or lottery that actually creates net risk
and is thus a drain on the resources of the economic system. Simply
stated, CDS and CDO markets currently are parasitic. These market
subtract value from the global markets and society by increasing risk
and then shifting that bigger risk to the least savvy market
participants.
Seen in this context, AIG was the most visible ``sucker''
identified by Wall Street, an easy mark that was systematically
targeted and drained of capital by JPM, GS and other CDS dealers, in a
striking example of predatory behavior. Treasury Secretary Geithner,
acting in his previous role of President of the FRBNY, concealed the
rape of AIG by the major OTC dealers with a bailout totaling into the
hundreds of billions in public funds.
Indeed, it is my view that every day the OTC CDS market is allowed
to continue in its current form, systemic risk increases because the
activity, on net, consumes value from the overall market--like any zero
sum, gaming activity. And for every large, overt failure in the CDS
markets such as AIG, there are dozens of lesser losses from OTC
derivatives buried by the professional managers of funds and financial
institutions in the same way that gamblers hide their bad bets. The
only beneficiaries of the current OTC market for derivatives are JPM,
GS, and the other large OTC dealers.
CDS and Securities Fraud
One of the additional concerns that the Congress must address and
which strongly argue in favor of outlawing the use of OTC CDS contracts
entirely, is the question of fairness to investors, specifically the
use of these instruments for changing the appearance but not the
financial substance, of other banks and companies. The AIG collapse
illustrates how CDS and similar insurance products may be used to
misrepresent the financial statements of public companies and financial
institutions.
In the case of AIG, the insurer was effectively renting its credit
rating to other firms, and even its own affiliates, in return for
making these counterparties look more sound financially than their true
financial situation justified.
The use of CDS and finite insurance to window dress the financial
statements of public companies is an urgent issue that deserves
considerable time from the Congress to build an adequate understanding
of this practice and create a public record sufficient to support
legislation to ban this practice forever. For further background on the
use of CDS and insurance products at AIG to commit securities fraud,
see ``AIG: Before Credit Default Swaps, There Was Reinsurance,'' The
Institutional Risk Analyst, April 2, 2009 (Copy attached). \5\
---------------------------------------------------------------------------
\5\ See also Harris v. American International Group, et al., Los
Angeles Superior Court, Central District (Case #BC414205)
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM MARY L. SCHAPIRO
Q.1. What do you see as your agency's possible role under the
Administration's proposal in overseeing the OTC derivatives
trading activities of dealers or other market participants? Do
certain responsibilities for prudential oversight, enforcing
record keeping requirements, or others still need to be
determined?
A.1. I believe the SEC's role under the Administration's
proposal in overseeing OTC derivatives trading activities
should be the regulation of all securities-related OTC
derivatives, as well as the dealers and other major market
participants in the market for securities-related OTC
derivatives. Under this approach, OTC derivatives markets that
are interconnected with the regulated securities markets would
be incorporated within a unified securities regulatory regime.
The direct link between securities-related OTC derivatives and
securities means that SEC regulation of the former is essential
to the effectiveness of the SEC's statutory mission with
respect to the securities markets. The securities regulatory
regime is specifically designed to promote the Congressional
objectives of investor protection, the maintenance of fair and
orderly markets, and the facilitation of capital formation. It
is important that securities-related OTC derivatives be subject
to the Federal securities laws so that the risk of arbitrage
and manipulation of interconnected markets is minimized. The
securities regulatory regime is broad and flexible enough to
accommodate a wide range of products, including securities-
related OTC derivatives. If these products were defined as
securities, the SEC would be able to apply regulatory
requirements that were properly tailored to the nature of a
particular product and its trading characteristics.
Under the SEC's recommended approach, securities-related
OTC derivatives markets would be subject to oversight and
supervision to ensure there are no gaps. To reduce duplication,
securities-related OTC derivatives dealers that are banks would
be subject to prudential supervision by their Federal banking
regulator. All other dealers in securities-related OTC
derivatives would be subject to supervision and regulation by
the SEC. The SEC would have authority to set appropriate
capital requirements for these OTC derivatives dealers. This
approach would permit existing OTC derivatives dealers that are
banks to continue to engage in OTC derivatives activities
without being subject to the full panoply of broker-dealer
regulation, while ensuring that all currently unregulated OTC
derivatives dealers in securities-related OTC derivatives are
subject to appropriate supervision and regulation.
In addition, the SEC would have authority, with respect to
securities-related OTC derivatives, to establish business
conduct standards, and record keeping and reporting
requirements (including an audit trail), for all derivatives
dealers and certain other participants. This ``umbrella''
authority would help ensure that the SEC has the tools it needs
to oversee the entire market for securities-related OTC
derivatives. The SEC would have the authority to impose certain
reporting requirements and other requirements on persons
transacting in securities-related OTC derivatives.
Q.2. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
What experience does your agency have in addressing fraud and
manipulation in the markets that you regulate?
A.2. Congress has designed the Federal securities laws to
address issues related to securities. The Federal securities
laws provide a comprehensive regulatory framework, otherwise
unavailable, for the types of issues unique to securities and
securities-related OTC derivatives, such as securities fraud
(including insider trading), securities manipulation (including
abusive ``naked'' short selling), and disclosure. In addition,
the SEC has a long history of oversight of clearing agencies
that permits the development of multiple, competing markets for
the same instruments, which encourages innovation and lowers
costs to market participants. The expertise of the SEC in
administering the securities laws should be carried over to
economic substitutes for securities, including all securities-
related OTC derivatives. By contrast, CFTC regulation is not
designed to address the types of issues unique to securities
and securities markets, such as securities fraud, securities
manipulation, disclosure, and short-selling abuses.
The SEC has extensive experience addressing fraud and
manipulation in securities markets. Congress recognized that
expertise in 2000 by extending the SEC's antifraud and
antimanipulation authority to all securities-related OTC
derivatives. Unfortunately, without the other tools available
in the regulated securities markets, such as reporting and
record keeping requirements, investigations involving
securities-related OTC derivatives have been far more difficult
and time-consuming than those involving securities. Regulatory
reform should include providing the SEC with the tools
necessary to police effectively all securities-related OTC
derivatives.
Q.3. A key part of drafting any legislation in this area will
be to determine who will have jurisdiction over the OTC
derivatives markets. What are the particular areas of
jurisdiction that your agencies do not yet see eye-to-eye on?
A.3. The SEC and CFTC are in broad agreement over the
regulation of OTC derivatives markets, however, one open issue
is the regulation of broad-based securities-related OTC
derivatives. The SEC currently has antifraud and
antimanipulation authority over these OTC derivatives, and has
full regulatory authority over other broad-based OTC
derivatives, such as OTC options on broad-based indexes and
structured notes tied to broad-based indexes.
Broad-based securities-related OTC derivatives are the
functional equivalent of securities, and the direct link
between broad-based securities-related OTC derivatives and
securities is such that SEC regulation of the former is
essential to the effectiveness of the SEC's statutory mission
with respect to the securities markets. In addition, fraud and
manipulation are less likely to be detected if oversight
responsibility is divided for instruments that market
participants trade as part of a single strategy. Moreover,
differences in the regulation of these products create gaps in
the regulatory fabric that may allow bad actors to go
undetected, and create regulatory arbitrage opportunities for
others, thus undermining the legitimacy of the regulated
securities markets.
Q.4. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.4. Congress could require regulatory agencies to determine
which OTC derivatives meet criteria established by statute to
be considered ``standardized'' and clearing eligible As there
is no simple set of rules that would effectively identify which
types of OTC derivatives are sufficiently ``standardized'' to
benefit from the systemic risk reduction possible through CCP
clearing, a level of regulatory interpretation may be called
for. OTC instruments are diverse and tied to the dynamics and
information available about the underlying market.
Q.5. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.5. Disagreements among market participants about how CCPs
should operate include whether an exchange or other trading
facility should be permitted to control where a trade is
cleared and thereby dictate to the CCP whether trades executed
on different exchanges or trading facilities are fungible for
netting purposes. If an exchange or trading facility controls
the CCP, it can use this control to achieve significant
liquidity in the product for which the CCP clears, thereby
limiting competition.
The SEC has administered the securities laws by requiring
that the exchange on which a trade is executed does not mandate
the central counterparty where the trade is cleared. A market
participant may purchase a security on one exchange or trading
facility, sell it on another exchange or trading facility, and
still reap the benefits of the clearing agency for both
transactions. This process permits multiple exchanges or
trading facilities to offer the same security without
discouraging competition for trading services.
In contrast to securities clearing agencies, futures
clearinghouses are commonly linked with an affiliated exchange.
Typically, exchanges compete over the same new contract
initially, but once an exchange achieves significant liquidity
in the contract, the other exchange usually exits the market.
Some market participants believe that this has permitted
exchanges to impose ``vertical silo'' structures in which an
exchange controls the clearinghouse for its products and uses
this control to dominate trading in its products. Since the
benefit of a CCP is confined to contracts executed on the
exchange that is linked to the CCP, there is the potential that
such a system may discourage competition for trading services.
The Commission recognizes that different market
participants have different trading needs, and the frameworks
for trading derivatives should retain flexibility to allow
variation to meet those needs. The Commission believes that any
disagreements among industry participants regarding the
operations of an OTC derivatives central counterparty should be
resolved by competition and market forces, subject to oversight
by the Commission and other regulatory authorities.
Q.6. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.6. In building a framework for the regulation of OTC
derivatives the goal should be to maximize the extent to which
standardized derivatives are traded on exchanges or exchange-
like venues. The regulatory framework for trading OTC
derivatives should be designed to achieve vital public policy
objectives for such instruments, including transparency,
efficiency, and prevention of fraud and manipulation. The
regulatory framework for standardized derivatives should,
however, retain sufficient flexibility to allow market
mechanisms to develop that meet varying trading needs for
products (such as products that may lack sufficient liquidity
to be traded on an exchange), while ensuring all trading
markets are subject to a unified regulatory scheme that
establishes a framework for fair competition among markets,
protects the public interest and is sufficiently transparent to
allow for regulatory oversight.
Q.7. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.7. Customized financial derivatives appear to play an
important risk management role for pension plans, insurance
companies, and other users that have a need to hedge specific
financial risks. An insurance company, for example, may use a
customized product in connection with the management of
separate account portfolio assets to assure long-term matching
of assets and insurance liabilities, while pension plans may
use customized hedging/risk management products, including,
potentially, equity swaps and CDS to assure funding of pension
obligations over time. In addition, offerors, including mutual
funds, of guaranteed return products may use customized swaps
to hedge their long-term obligations to provide a specified
return. Similarly, customized derivatives involving foreign
currency, interest rates, and hard commodities appear to play
an important risk management role for nonfinancial companies
and other end users because customized agreements can be
tailored to address a user's specific risks over a particular
time period. Requiring the use of standardized agreements to
manage risks may introduce a mismatch between the specific
risks being hedged and the standardized agreement, thus
providing a less effective tool for addressing a user's
underlying risk.
It is unclear how much of the market comprises truly
customized products. In the OTC derivatives market, there is a
continuum of products that are standardized or could be
standardized but there is no clear dividing line currently
between standardized and customized products. In addition,
because most OTC derivatives are largely excluded from the
securities regulatory framework by the Commodity Futures
Modernization Act of 2000, the SEC currently does not have
ready access to reliable information on the volume of
transactions and how it breaks out between standardized and
customized products.
Q.8. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.8. All OTC derivatives dealers should be subject to
prudential supervision and regulation with respect to capital
and margin to ensure there are no gaps. To reduce duplication,
dealers in securities-related OTC derivatives that are banks
would be subject to prudential supervision (e.g., capital and
margin) by their Federal banking regulator. All other dealers
in securities-related OTC derivatives could be subject to
supervision and regulation with respect to capital and margin
by the SEC. Under this approach, OTC derivatives dealers that
are banks could continue to engage in OTC derivatives
activities without being subject to the full panoply of broker-
dealer regulation, while all currently unregulated OTC
derivatives dealers in securities-related OTC derivatives would
subject to appropriate prudential supervision and regulation
for capital and margin.
Key factors that should be considered in setting margin and
capital requirements for OTC derivatives dealers would include:
(1) the business of the dealers and its risks other than with
respect to OTC derivatives, (2) the liquidity and volatility of
the OTC derivative and the quality of the asset on which the
OTC derivative is based, and (3) the creditworthiness of the
dealer's counterparties.
In addition, the SEC should have authority, with respect to
securities-related OTC derivatives, to establish business
conduct standards, and record keeping and reporting
requirements (including an audit trail), for all OTC
derivatives dealers and certain other participants in the OTC
derivatives market. This ``umbrella'' authority would help
ensure that the SEC has the tools it needs to oversee the
entire market for securities-related OTC derivatives.
Q.9. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.9. Appropriate margin requirements serve the purpose of
ensuring that registered entities are adequately protected and
prevent them from having to set aside excessive amounts of
their own capital in order to manage risks. Existing margin
methodologies are designed to reflect the risk of a position
even during periods of market stress. Using these
methodologies, margin requirements can be designed to
appropriately address the risks of underlying instruments
without preventing firms from entering into otherwise
economically advantageous transactions or creating undue
burdens for companies that wish to enter into OTC derivatives
transactions.
Q.10. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.10. There is always a risk that regulation may alter the
landscape of market participants or otherwise have unintended
consequences. However, the risk of not regulating OTC
derivatives markets is likely to be far larger, as demonstrated
by recent market events. In this regard, it is important to
curtail the potential that one of the unintended consequences
will be that markets move offshore seeking lighter regulation.
As Secretary Geithner noted in his May 13th letter to Congress,
``[w]e also will need to work with authorities abroad to
promote implementation of complementary measures in other
jurisdictions, so that achievement of our objectives is not
undermined by the movement of derivatives activity to
jurisdictions without adequate regulatory safeguards or for
which it is difficult or impossible for U.S. regulators to
reach such participants under existing jurisdictional and
international law frameworks.''
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM MARY L. SCHAPIRO
Q.1. Chairman Schapiro, do you agree that it is possible for
derivatives to have a significant impact on prices in
securities and equities markets? If so, isn't it critical that
these derivative products be subject to the same regulator as
the securities and equities themselves in order to ensure
market integrity?
A.1. Yes. Securities-related derivatives are economic
substitutes for securities. As such, they have a direct and
significant impact on securities markets. The direct link
between securities-related derivatives and securities means
that SEC regulation of the former is essential to the
effectiveness of the SEC's statutory mission with respect to
the securities markets. For example, purchasers of credit
default swaps on an issuer's debt appear to have significant
incentives to aggressively sell short the equity securities of
that issuer as a trading strategy, effectively linking
activities and changes in the credit default swap market with
those in the equity market. As a result, manipulative
activities in the credit default swap market would affect U.S.
issuers in the underlying equity market. A regulatory solution
that continued a distinction between securities-related
derivatives and securities would perpetuate that problem.
To ensure market integrity, it is thus critical that these
derivative products be subject to the same regulator as the
securities themselves. Fraud and manipulation are less likely
to be detected if oversight responsibility is divided for
instruments that market participants trade as part of a single
strategy. Moreover, differences in the regulation of these
products create gaps in the regulatory fabric that allow bad
actors to go undetected and create regulatory arbitrage
opportunities for others, thus undermining the legitimacy of
the regulated securities markets.
Congress has already recognized the impact of securities-
related derivatives on securities regulated by the SEC when it
applied the antifraud and antimanipulation provisions of the
securities laws to securities-related derivatives in 2000.
Cutting back the SEC's current authority over securities-
related derivatives is not a solution to current problems in
the derivatives market. Instead, that authority needs to be
extended to provide the SEC with better tools to regulate
securities-related derivatives.
Q.2. Chairman Schapiro, do you agree that broad-based and
narrow-based derivatives products can both have an impact on
the underlying markets that they reference?
A.2. Yes. In the case of securities-related derivatives, both
broad-based and narrow-based derivatives products can have an
impact on the underlying securities market because they are
economic substitutes for the underlying securities. Both broad-
based and narrow-based securities-related derivatives can be
used to establish either a synthetic ``long'' or ``short''
exposure to an underlying security or group of securities. In
this way, market participants can replicate the economics of
either a purchase or sale of securities without purchasing or
selling the securities themselves.
For example, an equity swap on a single equity security or
on an index, such as one of the Dow stocks or the Dow itself,
would give the holder of the ``long'' position all of the
economic exposure of owning the stock or index (including
exposure to price movements, as well as any dividends or other
distributions), without actual ownership of the stock or index.
Similarly, credit default swaps can be used as synthetic
substitutes for the debt securities of one or more companies.
Because market participants can readily use both broad-
based and narrow-based securities-related derivatives to serve
as synthetic substitutes for securities, the markets for these
derivatives directly and powerfully implicate the policy
objectives for capital markets that Congress has set forth in
the Federal securities laws, including investor protection, the
maintenance of fair and orderly markets, and the facilitation
of capital formation.
Q.3. Chairman Schapiro, I am very concerned by efforts by the
European Commission to implement protectionist restrictions on
derivatives trading and clearing. A letter signed by many of
the world's largest financial institutions earlier this year
under significant pressure from European Commission, commits
them to clearing any European-referenced credit default swap
exclusively in a European clearinghouse. This kind of
nationalistic protectionism has no place in the 21st-century
financial marketplace. What steps can you and will you take to
combat these efforts to limit free trade protect free access to
markets? If Europe refuses to alter its position, what steps
can be taken to protect the United States' position in the
global derivatives markets?
A.3. Because the CDS market is global, regulators in all
jurisdictions will have an interest in being able to obtain
information about the derivatives trading in or that otherwise
may have an impact on their markets. Commission staff has
expressed the view that the focus should be on ensuring that
central counterparties (CCPs) operate according to high
standards and that all relevant regulators have access to
information held by CCPs that they need to carry out their
mandates. If this is achieved, the European Commission's
concerns would be addressed without interfering with the
market's ability to select the best venue for clearing. In the
U.S.--European Union Financial Markets Regulatory Dialogue, we
have also discussed the fact that the European Union's
requirement invites similar retaliatory regulation in other
jurisdictions, potentially leading to conflicts of law. This,
in turn, could negatively impact both the flow of cross-border
business as well as regulatory cooperation. These arguments
have not altered the European Commission's policy to date. We
will continue to monitor this situation.
As a practical matter, the Commission is participating in
international coordination with European regulators to ensure
that we can carry out our regulatory duties.
Q.4. Chairman Schapiro, one of many important lessons from the
financial panic last fall following the collapse of Lehman
Brothers and AIG, it is that regulators need direct and easier
access to trade and risk information across the financial
markets to be able to effectively monitor how much risk is
being held by various market participants, and to be able to
credibly reassure the markets in times of panic that the
situation is being properly managed. A consolidated trade
reporting facility, such as the Trade Information Warehouse run
by the Depository Trust and Clearing Corporation for the credit
default swaps markets, is the critical link in giving
regulators access to the information this kind of information.
Currently, there is no consensus on how trade reporting will be
accomplished in domestic and international derivatives markets,
and it is possible that reporting will be fragmented across
standards established by various central counterparties and
over-the-counter derivatives dealers. Do you agree that a
standardized and centralized trade reporting facility would
improve regulators' understanding of the markets, and do you
believe that DTCC is currently best equipped to perform this
function?
A.4. I agree that a standardized and centralized trade
reporting facility is one way to improve regulators'
understanding of the financial markets because it would provide
regulators the ability to view CDS position data from a central
vantage point and would provide a single source of time
critical information in the event of a firm failure or other
financial crisis. DTCC's move in November 2006 to start
warehousing a record of credit derivative trades played a
significant role in helping to restore market confidence in the
wake of the Lehman failure last year. Last October, DTCC
informed the market that, based on its warehouse records, the
credit derivative exposure to Lehman was close to a net
notional value of approximately $6 billion. This was done to
stem speculation that the credit derivative exposure from
Lehman was $400 billion. Subsequently, when the Lehman's
positions closed out, the actual value was $5.2 billion. \1\ In
addition, direct access to CDS trade information from clearing
agencies and centralized trade reporting facilities is critical
to the Commission's ability to surveil for and enforce the
antifraud provisions of the Federal securities laws.
---------------------------------------------------------------------------
\1\ http://www.dtcc.com/news/newsletters/dtcc/2009/mar/
tiw_press_briefing.
---------------------------------------------------------------------------
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM MARY L. SCHAPIRO
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. The primary function of derivatives is to facilitate the
efficient transfer of risk exposure among market participants.
Trading of risk exposure through derivatives enables parties
who have natural risk exposures as part of their business or
investment operations to reduce or eliminate that risk by
transferring it to somebody who has a natural offsetting risk,
or to somebody else who is more willing to bear that risk. Some
sources of fundamental business risk are closely related to the
prices of assets that are traded in an active cash market, such
as stock or foreign currency. Other risks lack robust cash
market pricing sources. Derivatives based on these risks,
however, can be important tools for managing these risks.
As with any derivative product, the key challenge for
policy makers will be determining when and whether the value of
these products for risk management purposes outweighs potential
concerns about the products' underlying market integrity.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. This issue raises important public policy concerns.
Products without an active cash or derivatives market may have
less robust price discovery. These products, nevertheless, may
be useful to hedge or transfer real economic risks and,
therefore can play a beneficial role in facilitating risk
management and risk transfer activities. Policy makers should
consider whether risk management and distribution purposes
outweigh concerns with weak or unreliable pricing sources.
Traditionally, the SEC has used disclosure to identify
valuation risks associated with securities.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. The best way to improve market understanding and ``value''
determinations for derivatives is to standardize and centrally
clear them (to the extent possible) and encourage them to be
traded on exchanges. This would provide great transparency.
Where standardization or exchange trading is less likely, I
believe policy makers should endeavor always to maximize market
transparency through reporting or other mechanisms.
The argument for making models public when no cash market
exists is an interesting way to provide a valuation check, but
there are costs to this approach as well. For example, would
investors continue to innovate and alter their models if they
were public and available to their competitors? Would models
become more similar--decreasing market style diversity and
increasing the risk that major participants engage in the same
trades (increasing volatility and risk)?
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. Drawing a line, based on trading positions, between
hedgers and speculators will necessarily be arbitrary because
we cannot determine the intent of a trader from their portfolio
holdings.
Some market participants will hold derivative positions as
part of a well-defined hedge (e.g., they also have large
current or anticipated exposure to the prices of securities or
debt instruments). Others have no exposure at all and hold a
derivatives position strictly to gain exposure, that is to
speculate, on price movements. However, drawing a line between
the two motives is difficult and may yield unintended
consequences. First, there are a number of entities that do not
hold large securities or debt holdings, who may, nonetheless
have a legitimate risk management purposes: For example, they
may want to hedge their ``exposure'' to a major supplier or
customer. Second, even if a reasonable line is drawn, there may
be significant market consequences: For example,
``speculators'' can often provide liquidity for hedgers--so
eliminating speculators can raise the cost of risk management
and make hedges less effective. In developing a regulatory
framework for OTC derivatives these and other complexities will
need to be addressed in a manner that seeks to prevent the
potential for market abuses while also creating a system that
facilitates legitimate transactions.
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. Clearly we need to move forward with our regulatory
framework, even if other jurisdictions do not follow. However,
financial markets today are global markets and coordinating
with our international counterparts will be critical. Absent a
response coordinated with foreign regulators exercising similar
authority, the effectiveness of any regulatory limits would be
constrained significantly by the international nature of the
derivatives market. Because there is the potential for trading
business to move to less regulated markets, we are working with
our counterparts internationally to ensure that all derivatives
dealers and large participants in OTC derivatives market are
subject to prudential regulation and supervision.
Q.5. Do over-the-counter or custom derivatives have any
favorable accounting or tax treatments versus exchange traded
derivatives?
A.5. There is no difference in the financial statement
accounting principles applied to exchange traded versus other
types of derivatives. With respect to the financial accounting
treatment, contracts or other arrangements that meet the
accounting definition of a derivative are ordinarily recognized
and measured at fair value with changes recognized in income
each period whether the derivative is exchange traded or
customized. However, accounting rules allow companies to
achieve hedge accounting and defer recognizing the impact of
changes in value of derivatives used for hedging purposes when
changes in the value of a derivative match and offset changes
in the value of the hedged item to a sufficient degree. It is
possible, in some cases, that a customized derivative may be
more likely to economically offset changes in the value of the
exposure a company is trying to hedge. Thus for certain
applications, customized derivatives may be more likely to
offset the exposure and thus may be more likely to meet the
requirements for hedge accounting. In all cases where a
derivative serves as a highly effective hedge, accounting
standards clearly permit the entity to reflect the reduction in
risk in the measurement of income.
Q.6. In addition to the Administration's proposed changes to
gain on sale accounting for derivatives, what other changes
need to be made to accounting and tax rules to reflect the
actual risks and benefits of derivatives?
A.6. Even before the credit crisis, financial accounting for
derivatives had been identified as deserving additional
consideration. In this regard, the Financial Accounting
Standards Board (FASB) issued new disclosure requirements in
2008 that provide greater transparency about derivative and
hedging activities to investors, including a substantial amount
of additional information about credit default swaps.
Derivatives accounting also represents a component of the
FASB's current project to reconsider the accounting principles
for all financial instruments, recently undertaken in concert
with the International Accounting Standards Board. This project
was added to the FASB's agenda, in part, as a response to
issues identified by the SEC and others during the credit
crisis. Many have argued that the hedge accounting rules are
overly complex and could be improved to make hedge accounting
easier to apply and more understandable to investors. While we
are supportive of such simplification, we would expect that
because of their volatile nature, derivatives will continue to
be measured at fair value each period on the balance sheet, and
significant disclosures will continue to be needed for
investors to understand the exposures, strategies, and risks of
companies that utilize them.
The tax treatment of different types of derivatives is
outside of the SEC's area of expertise and may be better
addressed by tax professionals and/or the IRS.
Q.7. Should parties to derivative contracts be required to post
cash collateral, or is other collateral acceptable? And is
there any reason not to require segregation of customer
collateral?
A.7. Provided that positions are marked to market and
collateral calls are made daily, cash collateral is one prudent
type of collateral. In certain circumstances, though, highly
liquid securities that tend to move in price consistent with
the underlying reference asset may be as desirable for
collateral as cash. Guidelines for acceptable forms of
collateral will need to reflect the risks and circumstances
associated with each type of acceptable collateral, including,
but not limited to, price volatility and liquidity, and be
agreed to by both parties to the transaction. Accordingly,
under certain circumstances, noncash collateral may be
acceptable.
A priority of a regulatory framework for OTC derivatives
should be ensuring a process that allows for the prompt return
of customer collateral. Properly constructed regulations
governing the segregation of customer collateral can provide
customer protection while still promoting the operation of
efficient OTC derivatives markets.
Q.8. Is there any reason standardized derivatives should not be
traded on an exchange?
A.8. In building a framework for the regulation of OTC
derivatives, the goal should be to encourage all standardized
derivatives to be traded on exchange or equivalent exchange-
like venues that provide full regulatory and market
transparency. The regulatory scheme for trading OTC derivatives
should be designed to achieve vital public policy objectives
for such instruments, including transparency, efficiency, and
prevention of fraud and manipulation. The regulatory scheme for
standardized derivatives should, however, retain sufficient
flexibility to allow market mechanisms to develop that meet
varying trading needs for products (such as products that may
lack sufficient liquidity to be traded on an exchange), while
ensuring all dealers and trading markets (including for
nonstandardized products) are subject to a unified regulatory
scheme that establishes a framework for fair competition among
markets, protects the public interest and is sufficiently
transparent to allow for regulatory oversight.
Q.9. It seems that credit default swaps could be used to
manipulate stock prices. In a simple example, an investor could
short a stock, and then purchase credit default swaps on the
company. If the swaps are not heavily traded, the purchase
would likely drive up the price of the swaps, indicating higher
risk of default by the company, and lead to a decline in the
stock price. Is there any evidence that such manipulation has
taken place? And more generally, what about other types of
manipulation using derivatives?
A.9. The Commission is very concerned about potential
manipulation of the equity markets through the use of credit
default swaps or other derivative instruments. Because there is
no central reporting or audit trail requirement for OTC
derivatives, including securities-related OTC derivatives,
there is no organized surveillance by any Federal regulatory
agency or self-regulatory organization. This regulatory gap
substantially inhibits the Commission's examination and
enforcement efforts, and the lack of surveillance creates
substantial risk to the markets collaterally affected by swap
transactions, such as the market for debt and equity securities
related to credit default swaps.
The antifraud prohibitions in the Federal securities laws
currently apply to all securities-related OTC derivatives,
including credit default and other swaps related to securities.
The Commission, however, needs better tools to enforce existing
prohibitions over all securities-related OTC derivatives,
including authority to promulgate reporting and record keeping
rules and prophylactic antifraud rules.
Currently, if Commission enforcement or examination staff
suspects illegal conduct in the derivatives market, staff must
engage in the time-consuming process of manually recreating
activity in this unregulated market, which is challenging in a
market without uniform documentation, transparent pricing, and
time-stamped records. Under these circumstances, it is
difficult to identify violations and prove the intent required
to support charges under the Federal securities laws. Uniform
record keeping and reporting would provide the type of
information needed to identify suspicious trading patterns and
to investigate or examine misconduct. With uniform audit trail
and record keeping requirements, Commission staff could, for
example, better pinpoint where manipulative credit derivative
trading occurs in tandem with other trading strategies, such as
short selling.
Q.10. Credit default swaps look a lot like insurance when there
are unbalanced, opportunistic sellers. However, life and
property insurance requires an insurable interest for the buyer
and reserves for the seller. Why should we not regulate these
swaps like traditional insurance?
A.10. Although credit default swaps are frequently described as
insurance (buying protection against the risk of default) and
may have certain elements similar to traditional insurance, we
believe that securities-related credit default swaps are more
appropriately considered, and regulated, as securities. The
value of the payment in the event of default is determined by
reference to a debt security, so that the payment is tied
directly to a security. As noted in the CDS example in question
#9, securities-related credit default swaps are tied directly
to the securities markets and issuers of securities. As a
result, manipulative activities in the credit default swap
market would affect U.S. issuers in the underlying equity
market.
Congress recognized the impact of these instruments on the
primary markets that are regulated by the SEC when it applied
the antifraud and antimanipulation provisions of the securities
laws to securities-related OTC derivatives, such as securities-
related credit default swaps, in 2000. That authority needs to
be extended to provide the SEC the regulatory tools to regulate
these products. Regulating securities-related credit default
swaps as insurance would actually undermine the protections
provided by the Federal securities laws by creating the
potential for arbitrage between two different types of
regulation for economically related products.
Q.11. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.11. Some commenters have identified a phenomenon they
characterize as the ``empty creditor'' problem. These
commenters have noted that credit default swaps, among other
products, allow a creditor holding a debt obligation to reduce
or eliminate its economic exposure to the debtor while still
retaining the rights as a creditor. As a result, creditors who
hold significant credit default swap positions may prefer that
the debtor enter into bankruptcy because the creditor will
receive payments in connection with its CDSs that exceed any
benefit the creditor would get if the debtor restructured its
debt.
The Federal securities laws do not establish any duties of
a creditor to a lender or to other creditors. The motivation of
a creditor to take any action with respect to its debt holdings
in a particular company may be guided by many different
economic and investment factors that are unique to such
creditor, with credit default swaps being just one such factor.
For example, a creditor that also is a significant equity
holder may have different motivations in making credit
decisions as compared to a creditor that holds only debt.
Focusing only on a creditor's actions as influenced by its
holding of credit default swaps does not take into account
these other motivating factors.
Q.12. How do we reduce the disincentive for creditors to
perform strong credit research when they can just buy credit
protection instead?
A.12. As the financial crisis illustrates, it certainly appears
that some major market participants may have used credit
protection as an alternative to engaging in more robust
traditional credit research and review regarding their credit
exposures--leading to hidden/higher credit risk and the risk
that the credit protection provider cannot perform. This
tension is real. However, this moral hazard that exists in
credit protection exists in a number of contexts in the
financial arena. For example, this hazard exists when investors
rely on a credit rating or an analyst's research report instead
of engaging in their own research. Although inherent, this
problem is exacerbated by a number of factors in the credit
arena--such as when information is limited to a small number of
creditors or unavailable to the public; when traditional credit
standards are reduced; or when investors and creditors become
less vigilant due to perceptions (or misperceptions) of market
safety. In the short term, the financial crisis itself has
certainly reduced these risks, but it is important that
regulators (as well as investors and other market participants)
remain vigilant to help avoid the next crisis. To better ensure
that vigilance, we believe more accountability and transparency
will do a lot to keep investors informed of the flaws of
overreliance on credit protection, credit ratings, or a similar
third-party validator before making investment or credit
decisions.
Q.13. Do net sellers of credit protection carry that exposure
on their balance sheet as an asset? If not, why shouldn't they?
A.13. Sellers of credit protection typically carry a liability
on their balance sheets for the obligation to compensate the
guaranteed party if a credit event occurs on the referenced
asset. Some types of credit protection are considered insurance
contracts under the accounting rules and the resulting
obligation is measured based on insurance accounting
principles. Other types of credit protection, such as credit
default swaps, meet the accounting definition of a derivative
and the resulting liability is marked to market each period.
Unless an insurer or guarantor controls the referenced
asset, accounting rules do not permit or require the referenced
assets to be recognized on the guarantor's balance sheet. In
other words, simply guaranteeing or insuring the value of an
asset does not require a guarantor to record the insured asset
on its balance sheet under generally accepted accounting
principles. On the other hand, guarantors that control the
insured or guaranteed assets will generally be required under
new off-balance sheet accounting rules to report on their
balance sheets the controlled assets effective for 2010
financial reports.
Q.14. In your testimony you mentioned synthetic exposure. Why
is synthetic exposure through derivatives a good idea? Isn't
that just another form of leverage?
A.14. Synthetic exposure through derivatives can be a good
idea, or a bad idea--depending on the circumstances. While they
can be used to increase leverage, they can also be used to
reduce transaction costs, achieve tax efficiencies, or manage
risk. Synthetic exposure through derivatives is a component of
many arbitrage strategies that help align prices of related
assets across markets. A key question for policy makers, I
believe, will be determining how best to utilize the ``good''
aspects of derivatives use (e.g., as a risk management tool for
individual institutions); while minimizing the ``bad'' aspects
(unclear pricing, hidden leverage, and increased counterparty
and systemic risk).
It is also important to keep in mind that when synthetic
exposure through securities-related derivatives products is
used to replicate the economics of either a purchase or sale of
securities without purchasing or selling the securities
themselves, the markets for these derivatives directly and
powerfully implicate the policy objectives for capital markets
that Congress has set forth in the Federal securities laws,
including investor protection, the maintenance of fair and
orderly markets, and the facilitation of capital formation.
Given the impact on the regulated securities markets--and the
arbitrage available to financial engineers seeking to avoid
oversight and regulation--it is vital that the securities laws
apply to securities-based swaps.
Q.15. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.15. This is an interesting question. I believe policy makers
should consider carefully whether/how the creation of these
synthetics affect demand for the underlying securities.
Traditionally, the view is that dealers and other financial
intermediaries provide liquidity to the market and help make
markets more efficient by reducing the extent to which asset
prices are subject to excess volatility that may arise from
short-term trading imbalances. The ability of liquidity
providers to improve market quality is significantly enhanced
when they are able to engage in activities that involve
synthetic exposure. Constraints on the ability of
intermediaries to provide liquidity increase the propensity for
asset prices to deviate significantly from fundamental value.
These deviations can lead to a misallocation of capital, and
can be harmful to the investors. For example, investors are
harmed when they buy an asset at a price that is temporarily
inflated due to a demand shock.
Q.16. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.16. On average, large debt issues tend to be more liquid than
small ones because they tend to be held by a greater number of
investors and there are more units available for trading. This
does not mean, however, that an issuer would have the ability
to improve the liquidity of its bond issue by issuing more
debt. Market liquidity depends mainly on the ability and
willingness of financial intermediaries to take on inventory
positions in response to demand shocks.
Q.17. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.17. The primary justifications I have seen for permitting the
purchase of credit protection beyond an entity's ``exposure''
are (1) these participants provide liquidity to those who are
themselves hedging; (2) a participant may use credit protection
based on one reference asset to hedge risks on other related
assets; and (3) investors may wish to take a position
expressing a view that the market is underestimating the
probability or severity of default.
Q.18. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.18. The term ``swap'' generally refers to over-the-counter
derivative instruments, a category that encompasses a wide
range of products, including forward contracts, interest rate
swaps, total return swaps, equity swaps, currency swaps, credit
default swaps and OTC options, including both traditional and
digital (or binary) options. In contrast, futures are a
specific kind of standardized, exchange-traded derivative.
Swaps may be tailored to address specific risks in ways not
available with standardized products such as futures. For
example, customized swaps involving foreign currency, interest
rates, and hard commodities may play an important risk
management role for companies and other end users because
standardized contracts, in these circumstances, may not address
the needs of a company with respect to the specific risks being
hedged.
Q.19. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.19. Commercial businesses will often individually customize
OTC derivatives to meet the company's specific risk management
needs. Companies may use OTC derivatives to manage fluctuations
in materials prices, equity OTC contracts, commodities, fuel,
interest rates and foreign currency. For example, a company
that borrows money at a variable interest rate might enter into
derivatives contracts to turn the borrowing into fixed-rate
debt or as protection against swings in currencies or the price
of commodities such as food and oil. The company can customize
the contract to mature on a specific date or for a nonstandard
notional amount, creating a more effective hedge. The inability
to create perfect hedges can introduce basis risk. Basis risk
can also occur when the asset being hedged is different from
underlying asset of the derivative that is being used to hedge
the exposure. Allowing firms to continue to bilaterally
negotiate customized OTC derivatives contracts can help
mitigate these risks.
Standardizing OTC derivatives may increase costs in certain
instances and decrease costs in others. Standardized
derivatives, particularly those that are cleared through
central counterparties, require the posting of cash or cash
equivalent collateral. This is a cost not faced by financial
firms when they enter into OTC derivatives contracts with other
large financial firms. Conversely, standardizing OTC
derivatives could result in tightening of the bid-ask spread of
the instruments due to fewer individual terms that need to be
negotiated between counterparties. This could potentially lower
costs faced by purchasers and sellers of those contracts.
Standardization could also lead to less effective hedges, but
would allow a party to trade out of its position as opposed to
negotiating a separate termination agreement. These termination
agreements can be extremely expensive for the party seeking to
exit customized deals.
Q.20. On the second panel, Mr. Whalen suggests that Congress
should subject all derivatives to the Commodity Exchange Act,
at least as an interim step. Is there any reason we should not
do so?
A.20. To the extent that derivatives are securities-related,
the securities laws should continue to apply. Without
application of the securities laws, the derivatives market
could be used to manipulate the securities market by
circumventing securities laws protection against insider
trading and improper short selling, among other things.
Secretary Geithner recognized that multiple Federal
regulatory agencies should play critical roles in implementing
the proposed framework, including the SEC and the CFTC. In my
testimony, I recommended that primary responsibility for
``securities-related'' OTC derivatives be retained by the SEC,
which is also responsible for oversight of markets affected by
this subset of OTC derivatives. Primary responsibility for all
other OTC derivatives, including derivatives related to
interest rates, foreign exchange, commodities, energy, and
metals, could rest with the CFTC.
Q.21. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.21. We agree that all derivatives trades should be reported.
Information reported should include the identity of the
contract traded, the size of the contract, the price, the
parties to the contract (and which party was the buyer and
which was the seller), and the time of trade. Additional
analysis by appropriate regulators may identify other data
elements that should be reported.
Where a trade is reported depends on where it is traded. If
a product is traded on a regulated exchange or an exchange-like
facility (such as an alternative trading system), the details
of the trade will be captured by the trading system. If a
product is traded elsewhere, trades in that product should be
reported to another regulated entity, such as a trade
repository or self-regulatory organization.
Entities to which trades are reported could disseminate
information to the public individually. This approach would
likely be the easiest to implement in the near term. However,
it would mean that trading and reporting data would be
fragmented, and it is unclear how easily or well it could be
aggregated by private data vendors. Different entities could
adopt different standards for trade reporting and dissemination
(such as adopting different identification codes for the same
derivatives contracts). Significant regulatory efforts could be
necessary to promote uniform standards for these various
entities to obtain the full benefits of post-trade reporting
and transparency.
One way to address these potential problems would be for
the appropriate regulator to designate a central information
processor to collect trade input from various sources and to
disseminate trade information publicly in a uniform manner and
subject to regulatory standards that ensure that access to the
trade data is on terms that are fair and reasonable, and not
unreasonably discriminatory. The SEC relies on and regulates
such central information processors in the markets for cash
equities, securities options, corporate debt securities, and
municipal securities. We believe that these trade reporting and
dissemination systems work very well and deliver a robust
information stream in a timely and cost-efficient manner.
As your question notes, some information that is reported
may not be appropriate for public dissemination. One such item
may be the names of the counterparties. The systems for cash
equities, securities options, corporate debt securities, and
municipal debt securities that are regulated by the SEC
currently do not disseminate such information.
Q.22. Is there anything else you would like to say for the
record?
A.22. I appreciate the opportunity to testify on this important
topic and I look forward to working with the Committee to fill
the gaps in regulation of OTC derivatives. These efforts are
critical to furthering the integrity of the U.S. capital
markets.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM GARY GENSLER
Q.1. What do you see as your agency's possible role under the
Administration's proposal in overseeing the OTC derivatives
trading activities of dealers or other market participants? Do
certain responsibilities for prudential oversight, enforcing
record keeping requirements, or others still need to be
determined?
A.1. Answer not received by time of publication.
Q.2. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
What experience does your agency have in addressing fraud and
manipulation in the markets that your regulate?
A.2. Answer not received by time of publication.
Q.3. A key part of drafting any legislation in this area will
be to determine who will have jurisdiction over the OTC
derivatives markets. What are the particular areas of
jurisdiction that your agencies do not yet see eye-to-eye on?
A.3. Answer not received by time of publication.
Q.4. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.4. Answer not received by time of publication.
Q.5. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.5. Answer not received by time of publication.
Q.6. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.6. Answer not received by time of publication.
Q.7. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.7. Answer not received by time of publication.
Q.8. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.8. Answer not received by time of publication.
Q.9. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.9. Answer not received by time of publication.
Q.10. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.10. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM GARY GENSLER
Q.1. Chairman Gensler, isn't the same true regarding the
potential impact of derivatives on commodities markets?
Shouldn't all derivative products that impact commodities
prices be overseen by your agency?
A.1. Answer not received by time of publication.
Q.2. Chairman Gensler, do you agree that broad-based and
narrow-based derivatives products can both have an impact on
the underlying markets that they reference?
A.2. Answer not received by time of publication.
Q.3. Chairman Gensler, I am very concerned by efforts by the
European Commission to implement protectionist restrictions on
derivatives trading and clearing. A letter signed by many of
the world's largest financial institutions earlier this year
under significant pressure from European Commission, commits
them to clearing any European-referenced credit default swap
exclusively in a European clearinghouse. This kind of
nationalistic protectionism has no place in the 21st-century
financial marketplace. What steps can you and will you take to
combat these efforts to limit free trade protect free access to
markets? If Europe refuses to alter its position, what steps
can be taken to protect the United States' position in the
global derivatives markets?
A.3. Answer not received by time of publication.
Q.4. Chairman Gensler, one of many important lessons from the
financial panic last fall following the collapse of Lehman
Brothers and AIG, it is that regulators need direct and easier
access to trade and risk information across the financial
markets to be able to effectively monitor how much risk is
being held by various market participants, and to be able to
credibly reassure the markets in times of panic that the
situation is being properly managed. A consolidated trade
reporting facility, such as the Trade Information Warehouse run
by the Depository Trust and Clearing Corporation for the credit
default swaps markets, is the critical link in giving
regulators access to the information this kind of information.
Currently, there is no consensus on how trade reporting will be
accomplished in domestic and international derivatives markets,
and it is possible that reporting will be fragmented across
standards established by various central counterparties and
over-the-counter derivatives dealers. Do you agree that a
standardized and centralized trade reporting facility would
improve regulators' understanding of the markets, and do you
believe that DTCC is currently best equipped to perform this
function?
A.4. Answer not received by time of publication.
Q.5. Chairman Gensler, in response to the need for greater
transparency in the derivatives market, a joint venture between
DTCC and NYSE was recently announced called New York Portfolio
Clearing. Market innovations such as these, which intend to
provide a single view of risk across asset classes, can help
close regulatory gaps that currently exist between markets. Do
you agree that this one approach that would help increase
market efficiency and could reduce systemic risk? Should we
expect the Commission to support this initiative?
A.5. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM GARY GENSLER
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. Answer not received by time of publication.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. Answer not received by time of publication.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. Answer not received by time of publication.
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. Answer not received by time of publication.
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. Answer not received by time of publication.
Q.5. Should parties to derivative contracts be required to post
cash collateral, or is other collateral acceptable? And is
there any reason not to require segregation of customer
collateral?
A.5. Answer not received by time of publication.
Q.6. Is there any reason standardized derivatives should not be
traded on an exchange?
A.6. Answer not received by time of publication.
Q.7. It seems that credit default swaps could be used to
manipulate stock prices. In a simple example, an investor could
short a stock, and then purchase credit default swaps on the
company. If the swaps are not heavily traded, the purchase
would likely drive up the price of the swaps, indicating higher
risk of default by the company, and lead to a decline in the
stock price. Is there any evidence that such manipulation has
taken place? And more generally, what about other types of
manipulation using derivatives?
A.7. Answer not received by time of publication.
Q.8. Credit default swaps look a lot like insurance when there
are unbalanced, opportunistic sellers. However, life and
property insurance requires an insurable interest for the buyer
and reserves for the seller. Why should we not regulate these
swaps like traditional insurance?
A.8. Answer not received by time of publication.
Q.9. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.9. Answer not received by time of publication.
Q.10. How do we reduce the disincentive for creditors to
perform strong credit research when they can just buy credit
protection instead?
A.10. Answer not received by time of publication.
Q.11. In her testimony Chairman Schapiro mentioned synthetic
exposure. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.11. Answer not received by time of publication.
Q.12. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.12. Answer not received by time of publication.
Q.13. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.13. Answer not received by time of publication.
Q.14. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.14. Answer not received by time of publication.
Q.15. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.15. Answer not received by time of publication.
Q.16. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.16. Answer not received by time of publication.
Q.17. On the second panel, Mr. Whalen suggests that Congress
should subject all derivatives to the Commodity Exchange Act,
at least as an interim step. Is there any reason we should not
do so?
A.17. Answer not received by time of publication.
Q.18. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.18. Answer not received by time of publication.
Q.19. Is there anything else you would like to say for the
record?
A.19. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM PATRICIA WHITE
Q.1. What do you see as your agency's possible role under the
Administration's proposal in overseeing the OTC derivatives
trading activities of dealers or other market participants? Do
certain responsibilities for prudential oversight, enforcing
record keeping requirements, or others still need to be
determined?
A.1. Major U.S. derivatives dealers currently are subsidiaries
of bank holding companies (BHCs) that are supervised by the
Federal Reserve Board. The Board provides prudential oversight
of BHCs, and the Administration has not proposed a change in
that role. The Board envisions that the CFTC and SEC will set,
in consultation with the banking agencies, various record
keeping requirements necessary for the commissions to carry out
their market-integrity responsibilities; the banking agencies,
CFTC, or SEC could enforce these reeordkeeping requirements.
Q.2. Are there differences between the SEC's and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
A.2. There are surely significant differences in approach,
which reflect the two agencies' different histories and
origins, but both agencies have developed approaches that
address the key public policy goals of protecting customers,
guarding against fraud, and preventing manipulation in the
markets that each regulates.
The critical question going forward involves how, with both
agencies slated to play important roles in the oversight of the
over-the-counter derivatives markets, their approaches to these
instruments will be harmonized. This will be challenging as
financial market developments in recent decades have obscured
the traditional boundaries between securities and commodities.
Moving forward with enhanced oversight of the over-the-counter
derivatives markets without harmonization, and with closely
related instruments subject to significantly different regimes,
risks imposing unnecessary costs on all market participants
and, perhaps more seriously, leaving gaps between the regimes
applied to different types of over-the-counter derivatives that
could enable regulatory arbitrage and undermine the goals of
the regulatory reform effort. The Administration's legislative
proposal requires harmonization to address these types of
concerns.
Q.3. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.3. Perhaps the key feature determining whether a product is
sufficiently standardized that it can be centrally cleared is
the CCP's ability to manage the product's risk. Criteria that
will bear on this assessment include whether the product has
standard documentation and electronic confirmation templates,
accurate valuation procedures and pricing sources, and a liquid
market, as well as whether the CCP will be able to establish
procedures for handling defaults involving the product. These
features are subject to interpretation and likely will change
over time as the nature of OTC products evolve. Thus the best
approach for identifying standardized products is through a
flexible regulatory process that includes significant
consultation with central counterparties and other market
participants.
Q.4. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.4. Central counterparties (CCPs) that clear over-the-counter
contracts have taken different approaches to access both at the
clearing member level and at the end-user level. Some CCPs
limit clearing membership to dealers and only clear trades
among those dealers. These CCPs often cite procedures that
require clearing members to take an active role in managing a
default in limiting their membership to dealers.
Internationally agreed standards require access at the clearing
member level to be determined on an objective basis, to be
publicly disclosed, and to permit fair and open access. The
Board believes that all supervisors should hold CCPs to this
standard.
Some CCPs offer end users such as hedge funds or
institutional investors access to clearing through
intermediaries; that is, end users are not members of the CCP,
but a clearing member submits deals on the end-user's behalf.
CCPs that allow intermediated clearing must have a legal
structure that provides protection to end-users' positions and
collateral in the event their clearing member defaults. Events
of the last few years have demonstrated the importance of end
users as well as dealers having additional tools to manage
their counterparty credit risk. Operators and developers of
CCPs for OTC derivatives have committed to offering
intermediated clearing with suitable protections for end users.
The Board believes that the benefits from centralized clearing
will be greatest if CCPs are structured so as to allow
participation by end users within a framework that ensures
protection of their positions and collateral. Changes to
bankruptcy laws may be necessary to achieve this.
Q.5. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.5. The Board supports requiring the trading of standardized
products on exchanges or on electronic transaction systems
which (in conjunction with centralized clearing) offer similar
benefits in terms of transparency and risk reduction. Use of
these platforms aids regulators in monitoring market activity
and can assist market participants in reducing operational
risks and enhancing valuation capacities.
The more difficult issue will likely be to set forth a
definition of ``standardized'' which is sufficiently broad that
market participants cannot avoid the requirements by
incorporating twists and wrinkles in over-the-counter contracts
and sufficiently narrow that products which pose specialized
risk management challenges, and thus might pose risks to
centralized clearing systems and exchanges, are not swept in.
Q.6. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.6. Customized OTC derivatives products allow end users to
precisely hedge a risk. Standardized products may be offered on
a somewhat different underlying instrument than the end user
desires to hedge, for example, and use of the standardized
product creates what is known as basis risk when the price of
the standardized hedge moves differently from the balance sheet
exposure. Corporations report that they need the precise hedges
afforded by nonstandardized products to be permitted under the
accounting standards to recognize gains and losses from a hedge
at the same time as they recognize gains and losses from the
exposure being hedged. Many corporations also report that they
do not have the cash management facilities necessary to meet
the daily collateral calls that occur with cleared products.
No data are available on the relative importance of the
customized share of the market. The Board supports a short-term
focus on creation of trade repositories for OTC derivatives
referencing all asset classes, which would provide information
on this point.
Q.7. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.7. Within the United States, major derivatives dealers
currently are subsidiaries of bank holding companies (BHCs)
that are supervised by the Federal Reserve Board. The Board and
functional regulators of subsidiaries of the BHCs currently
have the authority to create margin and capital requirement for
these dealers. The Board believes that capital and margin
requirements should be enforced through the examination and
supervisory process.
Legislative changes would be required to create prudential
supervision, including capital, liquidity, and risk management
standards, for unregulated firms whose activity creates large
exposures in the market, and an examination process would need
to be created by the agency or agencies given responsibility
for oversight of these firms.
The Board believes that margin and capital requirements for
OTC derivatives should be commensurate with the risks they
pose. The Board is particularly concerned that, going forward,
margin and capital regimes be constructed so as not to amplify
cyclical fluctuations in financial markets. That is,
requirements should be set with regard to stress levels and
longer-run horizons, and not in a manner likely to require a
tightening of standards during periods of market dislocation.
Q.8. One concern that market participants have expressed is
that mandatory margining requirements will drain capital from
firms at a time when capital is already highly constrained. Is
there a risk that mandatory margining will result in companies
choosing not to hedge as much and therefore have the unintended
consequences of increasing risk? How can you craft margin
requirements to avoid this?
A.8. Yes, mandatory margining requirements could impose a cost
on firms' use of OTC derivatives and lead some firms to reduce
hedging. Two kinds of costs can be identified. First, if
mandatory margin requirements lead to more capital being used
to support OTC derivatives activities, that capital will not be
available for other uses. Second, nonfinancial corporate users
of OTC derivatives may not have the cash management capability
to post margin and adjust that margin on a daily basis, as is
the standard practice for interdealer trading. To avoid this,
dealers could tailor their margin requirements for less active
nonfinancial customers to the relatively modest risk and scale
of the customer's activity and ability to post collateral,
while always maintaining appropriate limits on the dealer's own
credit risk exposure.
Q.9. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.9. The proposed changes in the regulation of OTC derivative
markets are quite extensive, and this raises the possibility of
unintended consequences that are negative. Three issues are
critical to minimizing the likelihood of such negative
consequences.
First the definition of standardized contracts, which will
be required to be traded on exchanges or on electronic
transaction systems in conjunction with centralized clearing,
needs to be carefully crafted. The term ``standardized'' must
be sufficiently broad that market participants cannot avoid the
requirements by incorporating twists and wrinkles in over-the-
counter contracts and sufficiently narrow that products which
pose certain very specialized risk management challenges, and
thus might pose risks to centralized clearing systems and
exchanges, are not swept in.
Second, the regimes applied by the SEC and CFTC to the
over-the-counter derivatives market must be harmonized. Given
that contracts involving similar risks and suitable for similar
purposes will likely be regulated by each of these two market
regulators, it is critical that their approaches be consistent.
Moving forward with enhanced oversight of the over-the-counter
derivatives markets without harmonization, with closely related
instruments falling under significantly different regimes,
risks imposing unnecessary costs on all market participants
and, perhaps more seriously, leaving gaps between the regimes
applied to different types of over-the-counter derivatives that
could enable regulatory arbitrage and undermine the goals of
the regulatory reform effort.
Third, a broad definition of a major swap participant could
result in capital requirements being applied to large number of
firms that are currently unregulated, including nonfinancial
firms. It is far from clear how such requirements would be
determined and whether they would be effective.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR SCHUMER
FROM PATRICIA WHITE
Q.1. Ms. White, I am very concerned by efforts by the European
Commission to implement protectionist restrictions on
derivatives trading and clearing. A letter signed by many of
the world's largest financial institutions earlier this year
under significant pressure from European Commissions, commits
them to clearing any European-referenced credit default swap
exclusively in a European clearinghouse.
This kind of nationalistic protectionism has no place in
the 21st-century financial marketplace. What steps can you and
will you take to combat these efforts to limit free trade
protect free access to markets? If Europe refuses to alter its
position, what steps can be taken to protect the United States'
position in the global derivatives market?
A.1. The Federal Reserve is working with authorities in Europe
and other jurisdictions to improve international cooperation
regarding the regulation of OTC derivatives markets. Current
areas of focus include developing common reporting systems and
frameworks for coordination of oversight. The goal of these
efforts is to avoid duplicative and possibly conflicting
requirements from different regulators. In addition, these
efforts lay a foundation for broader recognition that policy
concerns can be addressed even when market utilities are
located in other jurisdictions.
Q.2. Ms. White, one of many important lessons from the
financial panic last fall following the collapse of Lehman
Brothers and AIG, it is that regulators need direct and easier
access to trade and risk information across the financial
markets to be able to effectively monitor how much risk is
being held by various market participants, and to be able to
credibly reassure the markets in times of panic that the
situation is being properly managed. A consolidated trade
reporting facility, such as the Trade Information Warehouse run
by the Depository Trust and Clearing Corporation for the credit
default swaps markets, is the critical link in giving
regulators access to the information this kind of information.
Currently, there is no consensus on how trade reporting will be
accomplished in domestic and international derivatives markets,
and it is possible that reporting will be fragmented across
standards established by various central counterparties and
over-the-counter derivatives dealers. Do yon agree that a
standardized and centralized trade reporting facility would
improve regulators' understanding of the markets, and do you
believe that DTCC is currently best equipped to perform this
function?
A.2. A standardized and centralized trade reporting facility
serving a particular OTC derivatives market would improve
regulators' understanding by providing them with a consolidated
view of participant positions in that market.
In general, a centralized reporting infrastructure for OTC
derivatives markets is unavailable. An exception is the credit
derivatives market, for which the DTCC Trade Information
Warehouse (TIW) serves as the de facto standard trade
repository. It provides a bookkeeping function, similar to the
role of central securities depositories in the cash securities
markets. The TIW registers most standardized CDS contracts and
has begun registering more complex credit derivatives
transactions in accordance with collective industry commitments
to supervisors. While no other OTC derivatives markets are
presently served by a trade repository, several CCPs serve an
analogous function for limited segments of OTC derivatives
markets such as LCH.Clearnet for interest rate derivatives and
NYMEX Clearport for some commodity derivatives.
There may be benefits to a single entity providing trade
reporting services for OTC derivatives, but the Board does not
believe that there is a good policy reason to force that
result. Through collective supervisory efforts, major industry
participants have committed to building centralized reporting
infrastructure for both the OTC equity and interest rate
derivatives markets. The industry has committed to creation of
a repository for interest rate contracts by December 31, 2009,
and for equity contracts by July 31, 2010.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM PATRICIA WHITE
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. Market participants use derivatives to manage and hedge
a variety of risks. Some of these risks are associated with
positions in actively traded cash instruments. For example, an
insurance company that writes equity-linked annuities may use
an equity derivative to hedge the risk of fluctuations in the
referenced equity index. Some of these risks are associated
with positions in relatively illiquid instruments. For example,
a commercial bank may use a credit default swap to hedge
against a concentrated exposure in its loan portfolio. Some of
these risks may not be associated with any cash instrument. For
example, some businesses use weather derivatives (futures
contracts listed on the CME) to hedge their financial risk
associated with fluctuations in the weather. All of these uses
of derivatives seem appropriate, so it would not appear to be
useful to limit the creation of derivatives based on the
existence of an actively traded cash market.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. The counterparties to a financial derivative contract
must agree on the manner of calculating its value at expiration
or at any intervals requiring periodic payments as part of the
negotiations related to doing the trade. The agreed upon terms
must be well-defined, and not subject to different
interpretation by different parties. In some cases, a cash
market price can be the basis for calculation of a contract's
periodic contractual payments or final value. In other cases,
such as the weather derivatives mentioned above, a calculation
based on observable characteristics is utilized (e.g.,
temperature at a particular location at a particular time of
day).
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. For OTC derivatives that are standardized and widely held
and traded, consensus generally exists regarding appropriate
valuation models. Many of these can be found in an introductory
finance textbook and often can be implemented with a personal
computer. For customized OTC derivatives, valuation methods may
be proprietary. For example, an oil company may enter into an
OTC energy derivative whose value is based on expectations
involving oil prices at particular locations, for particular
types of oil products, at various points in the future. Not
only can informed parties hold differing views regarding these
future prices, but disclosure of the exact valuation formula
could effectively reveal the oil company's future production
plans and forecasts, which it may consider to be proprietary
information. In addition to the valuation models,
counterparties may also legitimately wish to keep private other
contract provisions. Respecting a desire for confidentiality is
consistent with the approach taken to most other bilateral
contracts, which are not generally subject to public
disclosure. Transparency needs of the public can be met more
effectively in the ways described in the response to Question 4
below.
Q.3. Should parties to derivative contracts be required to post
cash collateral, or is other collateral acceptable? And is
there any reason not to require segregation of customer
collateral?
A.3. Noncash collateral, appropriately haircut, can mitigate
the counterparty credit risk associated with OTC derivative
contracts. Noncash collateral has been used successfully by
central counterparties (CCPs) for futures contracts for many
years.
The benefits from centralized clearing will be greatest if
CCPs are structured so as to allow participation by end users
within a framework that ensures protection of their positions
and collateral. Segregation is an important and common tool for
ensuring that customer positions and collateral can be
transferred to a solvent clearing member in the event the
customer's clearing firm defaults. The Board supports steps to
ensure that segregation and other customer protection regimes
have a sound legal basis so that the expected protection will
be realized in the event an end-user's clearing firm defaults.
Q.4. There seems to be agreement that all derivatives trades
Deed to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.4. The Board supports requiring all OTC derivative trades to
be reported either to a contract repository or to a central
counterparty, which could provide the information to the
relevant regulatory bodies. Both data on the flow of
transactions and data on the stock of positions may be of
interest to authorities. For example, prudential supervisors
are interested in position information insofar as it affects
the safety and soundness of the market participants whom they
directly regulate. Agencies with an interest in financial
stability have an interest in receiving position information
that would enhance understanding of the network of exposures
among major market participants. Central banks may benefit from
information on the flow of transactions to the extent that
transfers represented by OTC derivatives positions have effects
on their respective currencies and payment systems. Finally,
regulators with market integrity mandates are interested in
both position and transaction information to aid their
surveillance and enforcement activities.
A subset of the information provided to regulatory
authorities could be aggregated and reported to the public.
Public reporting should support overall market transparency by
providing investors, analysts, and the general public with a
means for better understanding the OTC derivatives market.
Until recently, there had been little or no such reporting for
OTC derivatives, but progress has been made in the CDS market.
The DTCC Trade Information Warehouse has published certain
aggregate open interest information on its Web site, including
breakdowns by category of counterparties, types of CDS products
traded, and referenced underliers of CDS trades. This
information is found on DTCC's Web site at: http://
www.dtcc.com/products/derivserv/data_table_ i.php.
Sensitive information such as the positions of individual
market participants should not be publicly reported. Such
disclosure would be undesirable as it would expose
participants' trading or risk management strategies to
competitors. Participants also may have fiduciary relationships
or confidentiality agreements with clients that may be
compromised by publishing identifiable positions. Finally,
publishing such data may raise concerns about privacy laws in
some jurisdictions.
Q.5. Is there anything else you would like to say for the
record?
A.5. No. thank you.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM HENRY T. C. HU
Q.1. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
A.1. Answer not received by time of publication.
Q.2. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.2. Answer not received by time of publication.
Q.3. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.3. Answer not received by time of publication.
Q.4. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.4. Answer not received by time of publication.
Q.5. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.5. Answer not received by time of publication.
Q.6. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.6. Answer not received by time of publication.
Q.7. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.7. Answer not received by time of publication.
Q.8. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.8. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM HENRY T. C. HU
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. Answer not received by time of publication.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. Answer not received by time of publication.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. Answer not received by time of publication.
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. Answer not received by time of publication.
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. Answer not received by time of publication.
Q.5. Do over-the-counter or custom derivatives have any
favorable accounting or tax treatments versus exchange traded
derivatives?
A.5. Answer not received by time of publication.
Q.6. In addition to the Administration's proposed changes to
gain on sale accounting for derivatives, what other changes
need to be made to accounting and tax rules to reflect the
actual risks and benefits of derivatives?
A.6. Answer not received by time of publication.
Q.7. Is there any reason standardized derivatives should not be
traded on an exchange?
A.7. Answer not received by time of publication.
Q.8. It seems that credit default swaps could be used to
manipulate stock prices. In a simple example, an investor could
short a stock, and then purchase credit default swaps on the
company. If the swaps are not heavily traded, the purchase
would likely drive up the price of the swaps, indicating higher
risk of default by the company, and lead to a decline in the
stock price. Is there any evidence that such manipulation has
taken place? And more generally, what about other types of
manipulation using derivatives?
A.8. Answer not received by time of publication.
Q.9. Credit default swaps look a lot like insurance when there
are unbalanced, opportunistic sellers. However, life and
property insurance requires an insurable interest for the buyer
and reserves for the seller. Why should we not regulate these
swaps like traditional insurance?
A.9. Answer not received by time of publication.
Q.10. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.10. Answer not received by time of publication.
Q.11. How do we reduce the disincentive for creditors to
perform strong credit research when they can just buy credit
protection instead?
A.11. Answer not received by time of publication.
Q.12. Do net sellers of credit protection carry that exposure
on their balance sheet as an asset? If not, why shouldn't they?
A.12. Answer not received by time of publication.
Q.13. In her testimony Chairman Schapiro mentioned synthetic
exposure. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.13. Answer not received by time of publication.
Q.14. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.14. Answer not received by time of publication.
Q.15. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.15. Answer not received by time of publication.
Q.16. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.16. Answer not received by time of publication.
Q.17. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.17. Answer not received by time of publication.
Q.18. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.18. Answer not received by time of publication.
Q.19. Who is a natural seller of credit protection?
A.19. Answer not received by time of publication.
Q.20. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.20. Answer not received by time of publication.
Q.21. What is insufficient about the clearinghouse proposed by
the dealers and New York Fed?
A.21. Answer not received by time of publication.
Q.22. How do we prevent a clearinghouse or exchange from being
too big to fail? And should they have access to Fed borrowing?
A.22. Answer not received by time of publication.
Q.23. What price discovery information do credit default swaps
provide, when the market is functioning properly, that cannot
be found somewhere else?
A.23. Answer not received by time of publication.
Q.24. Selling credit default swaps is often said to be the same
as being long in bonds. However, when buying bonds, you have to
provide real capital up front and there is a limit to the
lending. So it sounds like selling swaps may be a bet in the
same direction as buying bonds, but is essentially a highly
leveraged bet. Is that the case, and if so, should it be
treated that way for accounting purposes?
A.24. Answer not received by time of publication.
Q.25. Why should we have two regulators of derivatives, with
two interpretations of the laws and regulations? Doesn't that
just lead to regulation shopping and avoidance?
A.25. Answer not received by time of publication.
Q.26. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.26. Answer not received by time of publication.
Q.27. What is good about the Administration proposal?
A.27. Answer not received by time of publication.
Q.28. Is the Administration proposal enough?
A.28. Answer not received by time of publication.
Q.29. Mr. Whalen suggests that Congress should subject all
derivatives to the Commodity Exchange Act, at least as an
interim step. Is there any reason we should not do so?
A.29. Answer not received by time of publication.
Q.30. Is there anything else you would like to say for the
record?
A.30. Answer not received by time of publication.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM KENNETH C. GRIFFIN
Q.1. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
A.1. It is critical that there be clarity as to the rules that
apply to a given market sector. No confusion should exist as to
applicable rules or conflicts in overlapping rules. In view of
these principles, we would ask that Congress, in enacting any
OTC derivative legislation, ensure clean lines of regulatory
jurisdiction and consistency of rules. It is important that the
legislation eliminate and not create any new instances of
regulatory arbitrage. Capital and margin requirements, for
example, must be consistent across regulatory regimes.
As we consider the optimum design of a central clearing
structure from the perspective of the buy-side--asset managers,
corporations, pension funds, hedge funds, and all other end
users--one of the most critical components must be robust
account segregation. Buy-side accounts represent a substantial
portion of any derivative's systemic exposure. With proper
account segregation for cleared products, the buy-side's
positions and margins are protected from the bankruptcy of a
defaulting clearing member and transferred to other clearing
members, securing the orderly functioning of the markets. The
buy-side has confidence in the time-tested CFTC account
segregation rules, which were amply proven in the case of the
rapid workout, without market disruption, of Lehman's CFTC-
regulated futures positions. This was in stark contrast to the
losses suffered by end users who faced Lehman in bilateral,
noncleared positions that were (and remain) trapped in Lehman's
bankruptcy.
Q.2. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.2. Market forces have already created largely standardized
derivatives across the credit and interest rate derivative
markets, two of the largest OTC markets. In analyzing other
derivative markets, legislators and regulators should consider
the level of standardization to which such markets have evolved
and the frequency of price discovery (i.e., trading or the
placing of bids and offers) to ascertain the ability of a CCP
to clear transactions.
Legislators and regulators must not succumb to the rhetoric
of certain incumbent market participants that wish to delay the
movement to CCPs and exchange trading by arguing the market is
not standardized and by establishing excessively narrow
criteria for eligibility for clearing. To help define and
pressure test the criteria, regulators and legislators should
seek input from a broad range of market participants, which
include industry associations (e.g., ISDA, MFA, and SIFMA),
CCPs, and, most importantly, large and small sell-side and buy-
side market participants who are the ultimate holders of the
majority of the market's risk.
Regardless of the final definition of what contracts should
be centrally cleared, legislators and regulators must also
incentivize market participants to use CCPs through higher,
risk-based capital and collateral requirements for noncleared
derivative trades.
Q.3. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.3. Well-functioning markets are efficient, open, and
transparent. Well-functioning standardized derivatives markets
also utilize a CCP to significantly reduce counterparty risk
exposure, increase liquidity, protect customer collateral, and
facilitate multilateral netting and monitoring of positions.
All CCPs, however, do not deliver the same benefits to the
market. Key attributes of robust CCPs include:
A well-tested risk management framework that
includes daily mark-to-market calculations, a robust
initial margin methodology, active monitoring of
clearing member and customer positions, and a large
guaranty fund to backstop clearing member defaults;
A highly developed legal and regulatory framework
for protecting customer margins and positions in the
case of a clearing member default;
Straight-through processing of trades into clearing
immediately after execution;
Ability of participants to trade with other
participants so long as each participant is a clearing
member or a customer of a clearing member; and
Open access for all market participants to clearing
membership with time-tested and risk-based standards.
Q.4. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.4. Exchanges are an important step in the evolution of the
CDS market. Moving from the current bilateral market to a CCP
will dramatically reduce systemic risk and increase the
stability of the financial markets. The enhanced liquidity and
standardization brought about by clearing would then likely
facilitate an exchange-trading mechanism, similar to what was
seen in other markets such as energy. If it does not, however,
then regulators should intervene to remove any artificial
barriers to such market evolution.
Q.5. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.5. For CDS, customized OTC products represent approximately
5-10 percent of the notional value currently traded. Other OTC
derivatives such as interest rate and foreign exchange swaps
are also predominately standardized. In the case of interest
rate swaps, for example, customized products (i.e., products
that might at this stage be more challenging to clear
centrally) likely represent no more than 25 percent of the
notional value currently traded.
Customized OTC derivative products are most important to
end users who are trying to manage multiple risks with one
derivative contract. An energy utility for example, may want to
enter into a swap contract to purchase power at a fixed price
which is determined based upon the average temperature for a
given day. Esoteric derivatives such as this meet a real need
in the marketplace, but only account for a de minimus portion
of total activity. To reflect the higher systemic, operational
risk and counterparty risks of the noncleared CDS, higher
capital and or collateral burdens should be placed on such
products.
As noted in the answers to Senator Bunning's questions #6
and #16, there are significant benefits of migrating to the use
of standardized contracts and CCPs, such as lower total costs
of trading and deeper, more liquid markets.
Q.6. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.6. It is critical to distinguish dealer from nondealer
participants. A proposal that imposes substantial reporting and
regulatory burdens on nondealer participants as if they were
dealers, while well intended, will force many investors to
cease participating in the derivatives markets. The unintended
consequences that must be recognized are that markets will
become less efficient, the cost of capital will increase and
investors will be harmed. Today's market structure, where
incumbent OTC derivatives dealers act as unregulated central
counterparties, and extract significant economic rents from
their privileged position, creates the systemic risk that must
be addressed. The introduction of a CCP would address most of
the public policy goals, with almost no burden on investors and
on the OTC derivatives dealers (other than the loss of
oligopolistic profits).
The factors to be addressed in legislation relating to
appropriate margining and capital are these:
1. For noncleared trades, in light of the fact that
nondealer participants generally post margin, there is
no benefit, and significant harm, in imposing separate
capital burdens on nondealer participants. This would
effectively penalize the victims of the current crisis,
imposing reporting and financing burdens that will
hinder the beneficial flow of investor capital to the
capital markets and raise the cost of hedging. Dealers,
on the other hand, do not post margin for noncleared
derivatives. As such, systemic risk would be
significantly reduced by requiring dealers to hold
sufficient capital against their noncleared derivative
positions.
2. The key is central clearing, because a CCP independently
margins and risk manages the positions, requires margin
from all participants, and safeguards that margin. The
margin levels are set under strict regulatory
supervision, and are driven by the need to protect the
CCP from default, for the neutral benefit of both the
CCP and the financial system as a whole. Legislation
must therefore establish appropriate incentives and
requirements for participants to clear as much of the
derivatives market as possible.
3. As noted, the market practice for noncleared trades is
that dealers, who are on one side of every trade, do
not post margin. Legislation should ensure that for
noncleared trades, dealers set aside sufficient capital
to cover the systemic risk generated by such trades,
and to protect the dealers' customers from dealer
default. The regulators that currently supervise the
dealers should establish appropriate capital levels,
and should coordinate amongst themselves to prevent
regulatory arbitrage or gaps.
4. As also noted, the buy-side participant in every
noncleared trade, unlike the dealer, generally posts
margin. Today that margin is taken onto the dealer's
balance sheet and is subject to dealer insolvency.
Legislation should facilitate the protection of such
margin through third party trust arrangements remote
from dealer insolvency. For customer margin held in the
trust arrangement, it may be appropriate for dealers to
receive capital off-set to reflect the reduction of
counterparty risk.
Q.7. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.7. AIG has shown us that it is unacceptable for us to
continue a bilateral system that allows certain participants
not to margin when they should, or to concentrate risk without
adequate collateralization in a way that can damage a wide
range of interconnected parties. There must be fair, neutral
margin required of all participants to avoid a repetition of
the crises and losses that required government intervention in
the past year. Margin is the simple price that must be paid for
us to have a functioning central counterparty.
A well-disciplined, well-supervised CCP structure is by far
the most efficient risk management system from a margining
perspective, meaning it will come closest to requiring the
lowest reasonable amount of capital that will achieve the most
risk management protection and will do this fairly across all
market participants. This is because a well supervised CCP has
as its first mandate the need to protect its default fund, so
it will build an extensive risk management capability to ensure
that it requires adequate margin.
At the same time, that CCP is incentivized to keep the
level of such margin at the most reasonable level required to
achieve the appropriate protection, so that market participants
will clear volume through the CCP.
A CCP that has a neutral, standardized methodology will
assess the same margin from all its clearing members, which it
also continuously, rigorously assesses for credit strength.
Those clearing members may in turn assess a higher margin
requirement on the individual clearing customers they
represent, based on their individualized credit assessment of
those firms. Again clearing members have proper, balanced
incentives. On the one hand, because they guarantee the
obligations of their customers to the clearinghouse, they want
to ensure they are adequately collateralized against the risk
of any customer default. At the same time they are competing
for customer business, so will want to calibrate that margin to
be sufficiently economic to retain customers.
End users clearly benefit from these structures--unlike in
the current bilateral environment, the underlying margin system
is transparent, so end users can determine in advance the base
margin to be assessed by the clearinghouse (and of course these
end users will now no longer be exposed to the credit risk of
their counterparties, thanks to the CCP). At the same time,
competition amongst clearing members, and the standardization
of the cleared product that greatly increases end-users'
flexibility in selection of clearing member, will benefit end
users in keeping margin and fee levels competitive.
The argument that requiring margin will cause parties not
to hedge is not valid. The cost of hedging for end users will
not be raised by central clearing, but meaningfully reduced--
the increased transparency that will come with central clearing
will reduce bid-offer spreads, which go to the real economic
cost of hedging. The net capital costs associated with posting
initial margin are largely inconsequential, if not completely
offset by the multilateral netting benefits of a CCP. No market
participants should be exempt from posting adequate margin or,
in the case of dealers, sufficient capital.
Q.8. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.8. We see limited risk of detrimental unintended consequences
or a destructive alteration of the market landscape with
prudent regulation, particularly given the benefits that will
result. To the contrary, we see a grave risk in delay. The
conditions that gave rise to the interconnected losses
generated by the Lehman collapse are still present, and granted
the financial motivations of the incumbent CDS dealers, will
not be corrected without intervention immediately to require
clearing of standardized products.
As noted in our other responses, prudent regulation can
still allow for customized contracts and innovation. Customized
contracts represent a small fraction of the market. It cannot
be disputed that the parties that create increased systemic
risk through the use of customized, noncleared contracts should
be responsible for setting aside greater margin and capital to
ensure adequate systemic protection against those risks. And
even with such realigned reserves and incentives, we believe
the evidence is overwhelming that any incremental cost will not
substantially alter the market, except in the beneficial way of
motivating more trading to standardized products and CCPs.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM KENNETH C. GRIFFIN
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. No. There are many legitimate derivative instruments
that serve important economic functions that have no ``cash''
market. Examples of these include: weather derivatives, which,
for example, can be used by farmers to manage exposure to
adverse climate changes; reinsurance derivatives, which allow a
broad array of market participants to mitigate the risk of
natural catastrophes; and macroeconomic derivatives on measures
of inflation, GDP growth and unemployment which give a wide
range of firms important tools to manage their risk exposure to
changes in the broad economy.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. The value of many derivatives is determined solely by
observed values of indices, such as measures of inflation,
weather observations and other objectively determined
variables.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. The models and principals used in the pricing of OTC
derivatives are widely available. For example, the University
of Chicago's Master of Science in Financial Mathematics
describes its program as (http://finmath.uchicago.edu/new/msfm/
prospective/ourprogram_program.php):
Theory Applied to the Real World
This program teaches applied mathematics and its
applications in the financial industry. Students learn
the theoretical background for pricing derivatives and
for managing assets, but also attain a real
understanding of the underlying assumptions and an
ability to critically ascertain the applicability and
limitations of the various models. Courses are taught
by faculty of the University of Chicago and by
professionals from the financial industry.
In the CDS market, participants historically have used
arbitrage-free pricing models based on spreads, default
probabilities and recovery rates. ISDA has published a spread-
based model with standardized inputs that is widely used to
drive consistency in calculating trade settlement amounts. Of
course, many firms have spent considerable resources developing
models superior to the general market models and these models
appropriately constitute trade secrets. No end user of
derivatives should use derivative instruments without an
understanding of the risks involved in the use of the
instrument.
Note finally that, apart from the uses of models in pricing
derivatives and managing risk, over the life of the derivative
instrument, realization in value based upon the observed
underlying variables will ultimately take place.
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. Restricting the use of OTC derivatives to ``legitimate
hedges'' will significantly impair the valuable economic
function that such markets perform in allowing participants to
hedge and transfer risk. It would be a very unlikely and a
costly undertaking for a dealer to find a willing buyer and
willing seller of the same risk exposure at the same time if
trading were limited to those only with ``legitimate'' hedges.
Investors (which here, though being characterized as
``speculators,'' really represent all those who are willing to
take risk in seeking return on investment capital) and market
makers serve an important role in absorbing risk from hedgers.
Furthermore, the price discovery of the derivatives markets
send important signals to producers and consumers about the
future prices of goods, encouraging investment where
appropriate and conservation where appropriate.
In the CDS market, there are a tremendous number of
``natural'' or hedged buyers of credit protection (all those
who own bonds), but there are virtually no natural sellers of
protection who are doing so solely to hedge a specific credit
risk. As such, the CDS market would not exist if the only users
of the product would be those market participants who owned the
underlying cash bonds. Liquidity of CDS, one of the most
important financial innovations of the past two decades, would
disappear, undermining the ability to hedge risks and likely
materially raising the cost of capital for corporate America,
which could lead to additional job losses
In addition to the near impossibility of a market structure
as described above, it also is quite difficult to determine and
enforce an appropriate definition of ``legitimate'' hedging.
Consider a firm that does not own a bond of one of its
suppliers or clients. It may be a wise business decision for
that firm to buy protection against a possible bankruptcy of
that supplier or client. But what would the extent of the
``insurable interest'' have to be to qualify to trade in the
market?
What if CDS offers the best way of hedging against the
credit risks posed by a given sector to which a firm is
particularly exposed through a range of commercial
relationships? How again could the extent of ``insurable
interest'' be defined here?
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. Regulatory arbitrage is a very real issue in a global
economy where capital can flow freely. The U.S. should take the
lead and act while working with and through international
bodies such as the Financial Stability Board, the Basel
Committee on Banking Supervision, the European Union and the
G20 to ensure safe and sound markets that do not disadvantage
U.S. firms.
Regulating only contracts written in the U.S. and allowing
American firms to only buy and sell regulated contracts will
not solve the problem when U.S. firms can operate subsidiaries
or affiliates offshore free of such restrictions. Also, this
could invite a retaliatory response from non-U.S. regulators
that would put U.S. firms at a disadvantage if they, but not
their international competitors, are excluded from financial
markets and products abroad. International coordination is
essential.
Q.5. Do over-the-counter or custom derivatives have any
favorable accounting or tax treatments versus exchange traded
derivatives?
A.5. From an accounting perspective, many financial
participants follow mark-to-market accounting and therefore
recognize gains and losses on their derivative contracts in
current earnings, irrespective of whether such contracts are
exchange-traded or not. For firms that do not follow mark-to-
market accounting, however, certain accounting provisions, such
as FAS 133, may favor customization of certain derivative
instruments for certain users. A clearinghouse for derivatives
should be able to provide the level of customization needed--
for example in notional amount or maturity date--to meet the
needs of the significant portion of the users who require FAS
133 accounting treatment.
From a tax perspective, exchange-traded derivatives are
generally subject to mark-to-market treatment, whereas OTC
derivatives are governed by rules, depending on how they are
structured, for notional principle contracts, forwards or
options. Contingent swap contracts such as CDS present a
different case. Specifically, there is substantial uncertainty
as to how contingent swap contracts should be treated for tax
purposes.
Q.6. In addition to the Administration's proposed changes to
gain on sale accounting for derivatives, what other changes
need to be made to accounting and tax rules to reflect the
actual risks and benefits of derivatives?
A.6. As noted, certain hedge accounting rules have the effect
of discouraging the use of standardized derivatives as compared
to more customized solutions, even when the risk profile and
economic considerations of the standardized derivatives are
equal to or better than the customized instrument. FAS 133, and
any other hedge accounting rules, should be broadened to permit
corporate users to use the standardized products, if the
hedging basis risk is minimal. The societal benefits of deeply
liquid and transparent markets, driven largely through
increased use of standardized products and CCPs, justify the
absorption of a higher level of basis risk under FAS 133.
The tax treatment of contingent swap contracts (which may
encompass CDS) should be clarified and legislators and
regulators should work with industry groups such as ISDA which
has already proposed clarifications to the tax code on this
issue.
Q.7. Is there any reason standardized derivatives should not be
traded on an exchange?
A.7. Exchanges are an important step in the evolution of the
CDS market. Moving from the current bilateral market to a CCP
will dramatically reduce systemic risk and increase the
stability of the financial markets. The enhanced liquidity and
standardization brought about by clearing will further
facilitate an exchange-trading mechanism.
Exchanges work best when there is a concurrency in interest
between natural buyers and sellers. For the liquid index CDS
product, which accounts for approximately 70 percent of all CDS
trading volume, and for the most liquid single name CDS, the
introduction of exchange trading will facilitate a more
efficient and transparent market. However, for the less liquid
single name CDS products, it will be necessary to allow market
makers to continue to play a vital role in providing liquidity
outside the exchange model, at least until the markets for
these products evolve to the stage where there is sufficient
concurrency of interest for exchange trading.
Q.8. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.8. In today's market, holders of a corporate debt security
utilize a variety of investment products that may alter debt
holders' payoffs to make bankruptcy preferable to debt
restructuring. Examples include shorting junior debt
instruments in the capital structure, shorting the underlying
stock, buying equity default swaps and buying puts or selling
call options on the stock. CDS are no different than these
other instruments in their ability to alter the economic
preference of a debt holder with respect to a bankruptcy or a
restructuring.
Although beyond the scope of this question, research
suggests that under current rules bankruptcy itself is quite
costly and reduces a firm's value, independent of and in
addition to the financial and operational problems that brought
the firm to distress. Accordingly, streamlining of the
bankruptcy process to minimize the deadweight loss incurred in
a bankruptcy proceeding would potentially more directly address
the concern raised with this question.
Q.9. How do we reduce the disincentive for creditors to perform
strong credit research when they can just buy credit protection
instead?
A.9. As there are always two sides of every trade, even if a
specific investor chooses not to perform credit research on a
particular issuer, the seller of credit protection for the debt
securities of such issuer will have a strong economic incentive
to perform extensive credit research.
Where the risks of CDS are properly managed by a central
counterparty and when a diverse set of participants create a
liquid, transparent market, CDS can also provide a benchmark
for pricing the probability of default of a firm or index of
firms. By aggregating market participants' views on
creditworthiness, CDS performs an important role in the pricing
of a wide range of vital credit instruments.
Q.10. Do net sellers of credit protection carry that exposure
on their balance sheet as an asset? If not, why shouldn't they?
A.10. Sellers of credit protection record their exposure on
their balance sheet under their applicable accounting rules.
Generally, for CDS contracts, the net seller's economic
exposure is better described as the fair market value of the
open contracts and not the notional amount. This is similar to
a wide range of traded derivatives, such as options, where the
relevant valuation for balance sheet purposes is the fair
market value of the contract, not the notional value of the
option. For financial reporting purposes, the fair market value
of the open contracts is presented in the financial statements,
often along with additional information in the financial
footnotes. GAAP accounting rules typically require disclosure
of the gross and net notional exposure for off balance sheet
derivatives.
Q.11. In her testimony Chairman Schapiro mentioned synthetic
exposure. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.11. ``Synthetic exposure'' through derivatives is a
cornerstone of our modern financial markets, enabling investors
to secure an economic exposure without needing to own the
underlying asset. For example, a retiree may want to hedge
against the risk of inflation by buying gold futures. It is far
more efficient to purchase a gold future than to acquire gold.
The leverage created by derivatives is a function of margin
and capital requirements. A central clearing solution for CDS
would establish appropriate margin and capital requirements for
the instruments, helping to reduce systemic risk.
Q.12. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.12. One of the central tenets of our economy is that supply
and demand are largely balanced through free market forces. The
same can be said of supply and demand for financial products;
that is, free market forces bring equilibrium to supply and
demand. Synthetic exposures created through derivatives are an
important means by which the market arrives at a more stable
equilibrium. Without derivatives instruments, we would be
likely to see markets characterized by much higher levels of
volatility and far lower levels of liquidity.
In addition, if there is increased demand for credit
exposure, for example, the net effects of trading in the
synthetic exposure will flow through to the owner of related
assets and the issuer of that asset. For instance, if the
market perceives a company to have a low probability of default
and the supply of credit protection outweighs the demand for
the bonds, then the cost CDS protection will decrease. When the
cost of CDS protection decreases, it is easier for investors
manage their bond credit risks, leading to an increase in
demand for the bond, resulting in a decrease in borrowing costs
for the issuer and higher bond prices for owners of the bonds.
Q.13. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.13. With respect to the credit markets, it is fundamental to
emphasize that corporations focus on achieving the capital
structure that meets the needs of their stakeholders, as
opposed to meeting ``the demand for debt securities'' of
investors. Corporate CEOs and CFOs have a fiduciary duty to
limit issuance of debt that, although potentially satisfying
investor demand, would leave the company dangerously over-
leveraged and at risk of bankruptcy. Synthetic exposure to
corporate credit through CDS thus helps to satisfy investor and
hedging demand for such risks without distorting corporate
balance sheets.
The CDS market allows investors with a viewpoint on the
price of risk for a given issuer to actively express their view
by use of CDS contracts. Such trading increases liquidity and
encourages more investors to focus on the merits of any given
issuer's creditworthiness. As noted in the response to the
preceding question, the increase in liquidity and the
broadening of investor participation works to reduce the cost
of capital for corporations. Conversely, if CDS trading was
restricted or eliminated, liquidity in the bonds would almost
certainly be reduced, leading to a higher cost of capital for
American corporations.
Q.14. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.14. There are numerous well-functioning markets where
derivative exposure exceeds the value of underlying assets;
certain equity options and commodity futures are two such
examples. The presence of this alone does not cause any
systemic risk to the economy. In fact, it very well can be a
sign of a healthy and robust marketplace where many
participants come together to provide consensus pricing.
Moreover, as noted above, there are many circumstances in which
one party may not own the reference asset but have a legitimate
demand to hedge, e.g., a firm that wants to buy protection
against the possibility of bankruptcy of a major customer or
supplier.
As stated previously, CDS in particular serve several
critical market functions that lead to stronger economic growth
by lowering the cost of capital for America's corporations.
Examples of these critical market functions include: (a) the
ability to efficiently and effectively manage credit risk,
which (i) permits investors (including financial institutions)
to diversify their holdings, and (ii) increases liquidity in
the marketplace; (b) balancing of the supply and demand for
credit risk, which helps to moderate asset prices to reflect
appropriate risk-based returns; and (c) providing credit risk
price transparency, which increases investor confidence and
market liquidity.
Events of 2008 have highlighted weaknesses in the market
structure for CDS, and underscore the valuable role of a CCP
for users of CDS. By swiftly introducing and promoting CCP
clearing of CDS, the important societal benefits of CDS can be
maintained while at the same dramatically reducing the systemic
risk inherent in noncleared derivative products.
Q.15. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.15. Futures are highly standardized contracts that are traded
on exchanges and centrally cleared by a clearinghouse. Futures
offer a proven template for operational and risk management of
standardized derivatives, providing for efficient and well-
understood processing, margining, netting and default
management. Swaps, historically, are more customized, bespoke
trades that are individually negotiated in the OTC market.
However, with the significant progress towards standardization
over the last several years, many bespoke, customized swaps
have become standardized. Examples include the CDS market where
90-95 percent of trading volume is now in ``standardized''
contracts. All the terms of such contracts are fixed by
convention, and the contracts trade purely on price and volume.
Such ``standardized'' CDS contracts can be centrally cleared in
a futures-like framework, subject to the standard rules of the
central counterparty and provide similar risk management and
customer segregation protection and portability. Individually
negotiated swaps may still be utilized to meet the limited need
for customized CDS contracts.
With central clearing of standardized CDS in a futures-like
framework, most market participants agree that electronic
trading, at least of the leading CDS indices and most highly
liquid single names, will shortly follow. If it does not, then
regulators should intervene to remove any artificial barriers
to such market evolution.
Q.16. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.16. The most liquid of the OTC derivatives markets, such as
the interest rate swap markets and CDS markets, have already
embraced standardization as a means of increasing liquidity,
reducing operational risk and reducing costs. In both the
interest rate swap markets and the CDS markets, the vast
majority of contracts are traded according to standardized
market conventions. What has not evolved is a central
clearinghouse readily available to the end users of such
products. Such a central clearinghouse would reduce the banks'
privileged role as the providers of credit intermediation (and
undermine the economic rents associated with such concentrated
power).
Depending upon the OTC market, customization may be
desirable to reflect specific underlying commodities or
instruments, delivery locations, quantity, quality or grade,
payment dates, maturity dates, cash flows or other payment
terms, any or all of which may or may not be reflected in
standardized agreements.
It is a fallacy that standardized and cleared contracts are
more costly than customized, noncleared OTC contracts. There
are three primary economic costs in trading contracts: (i)
operational costs of managing and processing such contracts;
(ii) trading costs, as measured by the bid-offer spread; and
(iii) capital and margin costs for investing in such contracts.
Standardization and clearing significantly reduces the first
two costs and can be expected to reduce the third.
Numerous studies have documented the economies of scale
that are gained by centrally processing and managing contracts
through a central counterparty. Moreover, standardized
contracts also enable standardized processes that reduce costs.
Additionally, as contracts are standardized and move to a CCP
(increasing price transparency and making it easier to transact
in such instruments), liquidity increases and the bid-offer
spread decreases--reducing the cost for all investors,
including corporations, pension funds, insurance companies and
hedge funds.
The posting of collateral for standardized cleared
contracts does not necessarily increase costs compared to
noncleared OTC contracts. Central clearing provides significant
capital efficiency through multilateral netting and the
elimination of counterparty risk.
Of greatest importance, a clearinghouse will all but
eliminate the externalities inherent in today's market
structure--externalities that are borne by taxpayers. A
clearinghouse will roll back the emergent paradigm of ``too
interconnected to fail'' and dramatically reduce the
probability of a future AIG-like financial black hole.
Q.17. Who is a natural seller of credit protection?
A.17. The natural sellers of credit protection would be best
described as the broad array of investors who generally invest
in the cash corporate bond markets. These investors generally
have demonstrated credit analysis capabilities and strong
balance sheets with which to underwrite risk.
Q.18. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.18. Cleared derivative transactions are, of course, recorded
on the books and records of the clearinghouses and details of
these transactions are readily available to regulators.
Noncleared derivative transactions should be reported to a non-
CCP based central warehouse such as DTCC to ensure that the
details of these transaction are readily available to
regulators. In addition to facilitating the appropriate
monitoring of systemic risk in the financial system, an
accurate and readily accessible warehouse of transaction
details is important to facilitate the dissolution of a
financial institution that is in financial distress. Regulators
and others, however, need to closely guard the information at
both the CCPs and trade warehouses such that no information
that would compromise the identity or specific positions of
institutions is publicly divulged. The public disclosure of
such information could have significant negative effects on
liquidity in the market.
CCPs' publishing of end of day settlement prices, and the
progressive publishing of transaction prices for liquid traded
CDS, will bring highly beneficial transparency to the CDS
market. However, for certain less-liquid contracts, immediately
releasing the details of a trade could serve to reduce
liquidity. In relatively illiquid markets, or where an
individual trade may be large relative to daily trading volume,
dealers or others may be reluctant to commit large amounts of
capital if their actions become immediately known to other
market participants. In this case, requiring such information
to be immediately disclosed could discourage trading and thus
impair liquidity. In these circumstances, such information
should be made available to the public only on a lagged basis,
and, depending on the circumstances, potentially also only on
an aggregated basis.
Q.19. What is insufficient about the clearinghouse proposed by
the dealers and New York Fed?
A.19. Well-functioning markets are efficient, open, and
transparent. Well-functioning standardized derivatives markets
utilize a CCP to significantly reduce counterparty risk
exposure, facilitate liquidity, protect customer collateral,
and facilitate multilateral netting and monitoring of
positions.
ICE U.S. Trust (ICE), the first U.S.-based clearinghouse to
be sponsored by the dealers does, to some extent, improve upon
the current market by reducing counterparty risk and
facilitating multilateral netting and the monitoring of
positions among and for the select group of 10 ICE clearing
members. At the same time, certain elements of the ICE model do
not help as much as they could to improve the CDS market
structure, because of:
Lack of regulatory and legal clarity on the
protection of customer margins and positions in the
case of a clearing member default, which dramatically
limits the value of such clearinghouse for customers;
Inability to process trades directly into clearing
without any daylight counterparty exposure post
execution;
Reliance upon bilaterally negotiated ISDA
agreements that limit the ability of one firm to trade
with another firm; and
Inability of nonbank CDS dealers to directly face
ICE as a clearing member and receive the benefits of
such clearing membership.
ICE's structural lack of straight through processing and
immediate review and acceptance for clearing creates a very
significant barrier to the evolution of electronic matching.
Additionally, ICE's clearing solution lacks buy-side
stakeholders and participation in governance. This general lack
of inclusion of buy-side firms has lead to the development of a
solution that does not currently meet the needs of most buy-
side firms, whose positions and trading volume comprise a
substantial portion of the CDS market and the vast majority of
the aggregate net risk held in the market place. It is
important for any clearinghouse or any other central industry
facility to include the voice of all market participants--buy-
side and sell-side alike.
Q.20. How do we prevent a clearinghouse or exchange from being
too big to fail? And should they have access to Fed borrowing?
A.20. CCPs have a very long track record of surviving wars,
depressions, recessions and failures of major members. In fact,
there has never been a clearinghouse failure in the U.S. in the
over 100-year history of U.S. clearing organizations. When
Lehman's default was declared, the CME as central counterparty
to Lehman's futures positions moved all futures customer
positions to other clearing members and auctioned Lehman's
positions quickly and efficiently. As a result of these actions
there was no disruption in the market and no loss to any
customer or CME clearing member or to the CME's pool of
security deposits and other assets that stand as a backstop to
protect the clearinghouse and its members against loss in
extreme scenarios. By contrast, Lehman's bilateral,
interconnected derivatives positions and counterparty margin a
year later are still locked up in bankruptcy and Lehman's
customers suffered significant losses. This is why a
clearinghouse is critical to these markets and reduces systemic
risk.
The robustness of CCPs is a testament to their independence
and incentives to be expert in managing risks. The
clearinghouse imposes a consistent, neutral margin and risk
management discipline on each counterparty, and will work very
proactively to prevent default. The clearinghouse has its own
capital at stake if the margin is insufficient. The
clearinghouse continually assesses its clearing members, and
can at any time reduce trading limits or take other measures to
reduce risk. This is not always the case in the bilateral
world, where commercial relationships, historical agreements
and other factors have been proven to lead to inconsistent
margining or credit assessment practices, as was the case with
AIG. AIG was not required by its counterparties in many
instances to post any margin, including mark-to-market margin.
While clearinghouses have grown considerably in size as
markets have flourished, their maintenance of proportionate
capital and margin has ensured their survival. The right way to
keep this track record of success unbroken is to ensure the
close regulatory supervision of clearinghouses, and the
maintenance of their independence so that their incentives
remain to be proactive and conservative.
Clearinghouses have not required the ability to borrow from
the Fed and, if they were, we believe that this would introduce
a moral hazard problem. If the CCP believed that the government
would bail out any defaults, there is the risk that clearing
members would seek to reduce their capital and ease risk-
management standards and the CCP would lose its neutral
discipline. This is exactly the opposite of what regulators and
taxpayers would call for.
Q.21. What price discovery information do credit default swaps
provide, when the market is functioning properly, that cannot
be found somewhere else?
A.21. CDS are the most accurate indicators of corporate credit
risk and provide capital market participants with robust, real-
time, and consensus-driven estimates of corporate default
probabilities and recovery rates. No other market, including
the bond market, or research institutions such as rating
agencies, can provide a similar depth of information that is so
critical to debt issuance and economic growth. This is largely
because:
CDS are in many instances far more liquid than
individual bonds, due, in part, to the fact that the
CDS represent the credit risk of the underlying entity,
whereas that entity may have many distinct bond
issuances. IBM, for example, has over 20 different bond
issuances.
The vast majority of CDS are standardized
instruments. Valuation of the CDS are not complicated
by specific market technical factors or unique
contractual features or rights that are associated with
a specific bond issue. In addition, CDS represent the
price of credit risk bifurcated from the compensation
demanded by investors for committing cash to the
acquisition of a debt security.
Rating agencies' analytics are driven by analysts
that cover the specific corporate bonds. The market
price of CDS, on the other had, reflect the market's
consensus view of real-time credit risk as determined
by investors with financial capital at risk.
Q.22. Selling credit default swaps is often said to be the same
as being long in bonds. However, when buying bonds, you have to
provide real capital up front and there is a limit to the
lending. So it sounds like selling swaps may be a bet in the
same direction as buying bonds, but is essentially a highly
leveraged bet. Is that the case, and if so, should it be
treated that way for accounting purposes?
A.22. Please see the answer to questions #11, which is restated
below for reference.
``Synthetic exposure'' through derivatives is a cornerstone
of our modern financial markets, enabling investors to secure
an economic exposure without needing to own the underlying
asset. For example, a retiree may want to hedge against the
risk of inflation by buying gold futures. It is far more
efficient to purchase a gold future rather than to acquire
gold.
The leverage created by derivatives is a function of margin
and capital requirements. A central clearing solution for CDS
would establish appropriate margin and capital requirements for
the instruments, helping to reduce systemic risk.
Q.23. Why should we have two regulators of derivatives, with
two interpretations of the laws and regulations? Doesn't that
just lead to regulation shopping and avoidance?
A.23. If we were starting with a clean sheet of paper, we might
agree to have a single regulator of derivatives. This is not
the case, however. The SEC and CFTC are two large and well-
established regulatory bodies that would be difficult and time-
consuming to combine. More could be accomplished sooner by
focusing on fixing the regulatory gaps--such as exclusion of
certain derivatives from oversight and allowing participants to
transact in markets without holding or putting up sufficient
capital and/or collateral--that contributed to the problems
seen in the markets over the past 18 months.
We believe the necessary regulatory infrastructure and
tools are in place, with support of appropriate legislation, to
rapidly implement the reforms needed. In this context, please
see the answer to Senator Reed's question #1, with an excerpt
of relevant material from that answer below, affirming the
immediate value to the market of building from the CFTC's
proven account segregation framework:
A critical feature of any central clearing structure from
the perspective of the buy-side--asset managers, corporations,
pension funds, hedge funds, and all other end users--is proven
account segregation. Buy-side accounts represent a substantial
portion of any derivative's systemic exposure. With proper
account segregation for cleared products, the buy-side's
positions and margins are protected from the bankruptcy of a
defaulting clearing member and transferred to other clearing
members, securing the orderly functioning of the markets. The
buy-side has confidence in the time-tested CFTC account
segregation rules, which were amply proven in the case of the
rapid workout, without market disruption, of Lehman's CFTC-
regulated futures positions. This was in stark contrast to the
losses suffered by end users who faced Lehman in bilateral,
noncleared positions that were trapped in Lehman's bankruptcy.
Q.24. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.24. Please see answer to question #11, which is restated
below for reference.
``Synthetic exposure'' through derivatives is a cornerstone
of our modern financial markets, enabling investors to secure
an economic exposure without needing to own the underlying
asset. For example, a retiree may want to hedge against the
risk of inflation by buying gold futures. It is far more
efficient to purchase a gold future rather than to acquire
gold.
The leverage created by derivatives is a function of margin
and capital requirements. A central clearing solution for CDS
would establish appropriate margin and capital requirements for
the instruments, helping to reduce systemic risk.
Q.25. What is good about the Administration proposal?
A.25. We support the broad principles articulated in the
Administration proposal, which include moving towards more
efficient and transparent markets, enacting necessary
regulatory oversight to prevent market manipulation and fraud,
and reducing the concentrated systemic risk that exists today.
Specifically, with regard to regulation of the OTC derivative
market, we support:
The aggressive promotion of clearing of all
standardized transactions through capital and other
incentives, with higher risk-based capital charges for
noncleared derivatives;
The need to regulate all significant OTC derivative
market participants to prevent systemic risks, while
making such regulation transparent and fair to all
market participants;
The need for greater market transparency, openness
and efficiency; and
The facilitation of exchange trading for
derivatives, where appropriate, and the removal of any
artificial barriers to market evolution towards
exchange trading if such trading has not naturally
evolved.
Q.26. Is the Administration proposal enough?
A.26. We believe the critical question is not whether the
Administration proposal is enough, but whether legislators and
regulators can quickly implement key aspects of the proposal
(as articulated in the answer to question #25 above) across a
broad OTC product set (e.g, credit default swaps, interest rate
swaps, and foreign exchange swaps). Unfortunately, certain
incumbent market participants seek to delay the movement of
noncleared products to clearing, for reasons driven by
profitability irrespective of the systemic risks created. These
interests should not drive legislative outcomes.
Legislators and regulators should not exempt certain market
participants from having to post margin or collateral. There is
no principled basis for such carve-outs. No market participant
should be exempt from posting risk-based capital and/or margin
sufficient to protect its counterparties and the market from
the risk it incurs. No counterparty should be exempt from the
requirement to clear transactions when they can be cleared. But
also no qualifying counterparty who meets these requirements
should be excluded from the benefits of CDS.
Separately, as discussed in more detail in response to
Senator Reed's question #6, because dealers today do not post
margin for noncleared trades, and buy-side participants do,
dealers should be obliged to set aside sufficient capital to
secure the exposure they take on, while buy-side participants
already meet this requirement through margin. Imposing capital
or other requirements on these buy-side firms, would therefore
only serve to create impediments to investment, increase the
cost of hedging, and reduce liquidity.
Please note answers to questions #6 and #16 above that
discuss the significant benefits of using standardized
contracts and CCPs, such as lower costs of trading and deeper,
more liquid markets. The Administration and Congress should
work closely to define the most inclusive practical standards
for trades to be subject to mandatory clearing, driven
primarily by the clearinghouses' independent willingness to
accept such trades, on reasonable commercial margining terms.
Regulatory carve outs and differential treatment of certain
participants, such as exclusion of certain derivatives from
regulatory oversight and inconsistent collateral policies,
greatly contributed to the problems seen in the derivatives
market over the past 18 months and cannot be allowed to
continue.
Q.27. Mr. Whalen suggests that Congress should subject all
derivatives to the Commodity Exchange Act, at least as an
interim step. Is there any reason we should not do so?
A.27. It is most important that all OTC derivatives be subject
to some form of robust regulation that ensures proper
transparency, adequate capital and collateral requirements, and
clearing by a strong CCP. We support whichever regulatory
regime can best and most rapidly achieve these imperatives,
provided it recognize the needs of all market participants,
including buy-side investors.
Please also see the answer to Senator Reed's question #1,
from which relevant material is restated below for reference.
A critical feature of any central clearing structure from
the perspective of the buy-side--asset managers, corporations,
pension funds, hedge funds, and all other end users--is proven
account segregation. Buy-side accounts represent a substantial
portion of any derivative's systemic exposure. With proper
account segregation for cleared products, the buy-side's
positions and margins are protected from the bankruptcy of a
defaulting clearing member and transferred to other clearing
members, securing the orderly functioning of the markets. The
buy-side has confidence in the time-tested CFTC account
segregation rules, which were amply proven in the case of the
rapid workout, without market disruption, of Lehman's CFTC-
regulated futures positions. This was in stark contrast to the
losses suffered by end users who faced Lehman in bilateral,
noncleared positions that were (and remain) trapped in Lehman's
bankruptcy.
Q.28. Is there anything else you would like to say for the
record?
A.28. The time to act is now. The experience of the current
crisis provides us with a tremendous opportunity to learn from
past mistakes and correct the fundamental flaws in the
financial system. What we saw was that participants in free
markets were subsidized, perhaps unjustly, by public resources
and investors lost substantial sums of money, not because of
their investment strategies, but because of the bankruptcy of
their counterparties. It is well established that CCPs will
mitigate or eliminate many of the weaknesses inherent in the
bilateral trading of derivatives, reducing systemic risk and
placing the ``too interconnected to fail'' genie back into the
bottle. CCPs can best meet the needs of our society and our
capital markets, and can do so now.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM ROBERT G. PICKEL
Q.1. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets.
A.1. There are differences in both the traditional roles and
approaches to regulation between the SEC and CFTC that warrant
consideration as Congress contemplates oversight of the OTC
derivatives markets. The former primarily serves an investor
protection role; the latter a market regulatory role.
Generally, the SEC relies on rule-based regulation and
enforcement actions, while the CFTC relies on principle-based
regulation.
Q.2. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.2. The industry strongly supports the clearing of OTC
derivatives contracts and believes that clearing should be
encouraged wherever feasible. In identifying those derivatives
that are standardized and therefore clearable, we suggest the
Federal regulators look to apply certain criteria or a
framework of conditions to ensure that required clearing of
standardized derivatives promotes economic efficiency, fungible
treatment of cleared contracts, clearinghouse interoperability,
choices among clearinghouses, and consistency with
international standards. In particular, the Federal regulators
should consider whether:
1. One or more regulated clearing organizations are prepared
to clear the contract in accordance with U.S.
regulatory requirements and will have the necessary
resources, capacity, operational competence,
experience, risk management infrastructure and
governance structure to clear the contract in a prudent
manner and mitigate systemic risk, taking into account
the size and specific characteristics of the market for
the relevant contract;
2. The contract is traded with sufficient frequency and
volume that the risks associated with outstanding
positions in the contract are significant with respect
to the market as a whole;
3. Liquidity in the contract is sufficient to provide
reliable price sources for the regulated clearing
organization(s) to calculate collateral requirements
consistent with prudent risk management; and
4. The contract is traded in the OTC market on terms and
trading conventions that are sufficiently standardized
to facilitate clearing without basis risk to be
regulated clearing organization(s). The clearing rules
applicable to the contract are consistent with the OTC
market's trading terms and conventions.
To the extent that mandatory clearing requirements for OTC
derivatives contracts are adopted and implemented, they should
apply only to OTC derivatives transactions between professional
intermediaries within Tier 1 Financial Holding Companies and
other systemically significant persons and should ensure broad-
based participation among the covered participants active in
the relevant market.
Q.3. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.3. An important consideration facing market participants
regarding how CCPs operate is the segregation and portability
of CDS positions and associated initial margin. A related
consideration is a CCP's criteria for clearing member (CM)
status.
ISDA, as part of an ad hoc group comprising both buy-side
and sell-side constituents, prepared a report to the
supervisors of the major OTC derivatives dealers (the Report),
which analyzes the following proposed clearing solutions: CME
Clearing, ICE Trust U.S. LLC, Eurex Clearing AG, ICE Clear
Europe, LCH.Clearnet Limited/NYSE Liffe and LCH.Clearnet SA.
The Report is available at www.isda.org/credit/buy-side-
access.html.
The Report explores the rights of ``customers''--e.g., buy-
side and other market participants proposing to clear CDS
through CMs of a CCP--in regard to the segregation and
portability of CDS positions and associated initial margin. The
Report also contains each CCP's response to a questionnaire,
which, among other things, contains detailed information on the
CCP structure and criteria for CM status. The Report also
suggests legislative and regulatory reforms that may be
particularly helpful in paving the way for effective clearing.
The industry recognizes that clearing is an important
public policy consideration and that it can provide many
benefits to the market, including helping to identify systemic
risk. It is also worth noting that along with the widespread
recognition of the benefits of clearing, there is also
widespread acknowledgement that there is a continued need for
customized OTC derivatives.
Establishing a clearing framework that maximizes the
benefits of clearing while avoiding unnecessary costs requires
the consideration of many factors. A recent paper authored by
Darrell Duffie and Haoxiang Zhu entitled ``Does a Central
Clearing Counterparty Reduce Counterparty Risk?'' analyzes many
of these factors, including whether a CCP can actually reduce
netting efficiency and thereby lead to an increase in
collateral demands and average exposure to counterparty default
and the effect of requiring multiple clearinghouses. Regarding
the latter point, the authors' conclude that whenever a single
CCP reduces average counterparty exposures, relative to
bilateral netting, it is never efficient to introduce another
central clearing counterparty for the same class of derivative.
This observation is particularly significant in light of
regulatory proposals that would ostensibly require clearing of
the same product across multiple CCPs, whether such requirement
is based on jurisdictional considerations or otherwise. Such a
requirement may not only undermine the benefits of clearing, it
would also impose considerable real costs for market
participants. The industry does not oppose multiple clearing
solutions and allowing the market to determine which should
succeed but requiring compatibility with multiple CCPs will
impose significant costs and may undermine the benefits that
clearing provides.
Q.4. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.4. There is no simple division between standardized OTC
derivatives and those that are not; instead, OTC derivatives
occupy points on a continuum ranging from completely customized
and unique to completely standardized. An example of the former
would be a credit default swap used to transfer credit risk in
a synthetic collateralized debt obligation (CDO); such a
contract might not even be executed under an ISDA Master
Agreement, and would reference a specific portfolio of credits
in the securitization issue. Moving slightly along the
continuum, one might find an option on the spread between the
crude oil price and a basket of refined product prices based on
the output mix of a specific refinery; this ``crack spread''
option would be executed under the ISDA Master Agreement but
would involve, at least for the refined product prices, a
unique basket of prices. Moving still further on the continuum,
one would find interest rate caps on bond issues or bank loans.
None of the three products described would generate sufficient
volume to trade on an exchange, nor are they sufficiently
standardized to trade on an exchange.
As a general matter, standardization is a necessary but not
sufficient condition for trading on an exchange: Standardized
derivatives can be traded on an exchange only when a product
has sufficient volume and liquidity to support reliable price
discovery for the product. If sufficient volume and liquidity
do not exist, it would be preferable to trade the products
over-the-counter, that is, execute trades privately, and then
book the trade with a clearinghouse.
Policy discussions frequently confound exchange trading--
which means that all trades must be negotiated and executed
through a central venue--with clearing--which means that trades
must be booked with a central counterparty that serves as the
counterparty to all cleared transactions. Exchange trading is
possible without clearing, although most exchanges involve
clearing as well; and clearing is compatible with both exchange
trading and over-the-counter trading.
Exchanges and clearinghouses both make use of
standardization, but for different reasons. Exchange trading
involves extensive standardization because it makes a product
easier to trade, which leads to higher liquidity. But as a
product becomes more standardized, it attracts a narrower range
of traders, which leads to lower liquidity. As a result of
these conflicting effects, only products that inherently appeal
to a large number of traders are likely to succeed on an
exchange; more specialized products generally lack liquidity
and consequently do not trade successfully on an exchange.
Clearinghouses also rely on standardization, not to make
trading easier but to facilitate valuation for the purposes of
margin setting. Although cleared products need to be
substantially standardized, they need not be highly liquid; all
that matters is that the clearinghouse can calculate contract
values and required margin in a timely manner. Clearinghouses
are therefore suitable to both OTC and exchange-traded
products.
We see no compelling public policy rationale for mandating,
as opposed to encouraging, exchange trading or clearing. To the
extent there is a consensus in favor of some mutualization of
counterparty credit risk, however, we believe that encouraging
clearing should be sufficient.
Q.5. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.5. A liquid, functioning OTC market requires the existence of
both customized and relatively standardized derivatives.
Customized derivatives are necessary in order to provide
efficient and safe risk management for clients. Relatively
standardized, known commonly as ``vanilla'' derivatives, are
necessary for dealers to trade among each other and other
market professionals in order to maintain a liquid, price
efficient market. Further, the vanilla part of the market is
likely to be substantially larger than the customized part
because continuous trading is necessary to maintain liquidity.
But the relatively low numbers of customized derivatives does
not make them any the less important to the market.
As a general rule, hedgers prefer flexible, customized OTC
derivatives, while purely financial traders, including
speculators, prefer the ease of trading standardized,
transparent products. Customized OTC derivatives are most
important to nonfinancial corporations seeking to manage the
financial risks encountered in the course of business
activities, as well as investment managers managing specific
portfolios. An American manufacturing company that exports
overseas, for example, encounters foreign exchange risks in its
activities; because the cash flows do not correspond with
exchange settlement schedules, the firm would need a customized
derivative. Another example is an oil refinery that transforms
crude oil into refined products; because each refinery has a
unique product mix, only customized derivatives can fill the
needs of the refiner. In both cases, requiring the use of
standardized, margined products would make hedging more costly
and possibly less likely because such companies do not
routinely keep sufficient cash balances to ensure that margin
calls can be met; instead, they often collateralize their OTC
derivatives along with other banking relationships such as
loans.
ISDA has only indirect, rough estimates of the proportion
of the market that is highly customized. According to a poll of
ISDA Board member firms, an average of 58 percent are with
dealers, 27 percent with nondealer financial counterparties
(e.g., regional banks and hedge funds), and 6 percent are with
end users (e.g., nonfinancial corporations); for interest rate
options, 65 percent are with dealers, 28 percent with nondealer
professionals, and 7 percent with end users. For credit default
swaps, the proportions are 75 percent with dealers, 25 percent
with nondealers professionals, and less than one percent with
end users. The primary users of the more standardized
instruments are likely to be dealers and hedge funds; the
primary users of the more customized instruments are likely to
be regional banks and corporation. Finally, a high proportion
of equity derivatives are customized, especially those based on
single equity issues.
Q.6. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.6. Prudential oversight of the OTC derivatives markets should
ensure the availability of both customized OTC derivatives and
more standardized derivatives as risk management tools. A
vibrant and healthy derivatives market plays a crucial role in
today's credit markets. Imposing capital requirements on OTC
derivatives would require policy makers to find the equilibrium
between the need for effective regulation of risk-taking and
the need for effective risk-management. Therefore, we
respectfully suggest that the setting and enforcement of
capital requirements for OTC derivatives be left to the
appropriate regulators.
Q.7. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.7. This concern is valid because nonfinancial corporations,
which make extensive use of customized derivatives, are not
geared up to routinely post cash margin as required by
clearinghouses. Instead, they customarily collateralize as part
of their overall banking relationship. If margin were made a
matter of law or regulation, the cost of funding margin might
be sufficient to lead corporations to reduce their hedging
activities and thereby increase their financial risk exposures.
We respectfully suggest that margin requirements be left to
clearinghouses and their regulators to determine, as they do
now, for cleared products.
Q.8. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.8. Yes. OTC derivatives offer significant value to the
customers who use them, to the dealers who provide them, and to
the financial system in general by enabling the transfer of
risk between counterparties. It is important that any changes
to the OTC derivatives market maintain the continued
availability and affordability of these important tools.
The recent market turmoil and today's tight credit
environment may be attributed, at least in part, to a lapse in
risk management. It is difficult to determine unintended
consequences ex ante, however, changes that would reduce the
availability of credit or restrict the ability to manage risk,
for example by restricting the ability of businesses to hedge
their unique risks via customized derivative products, would be
particularly problematic.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM ROBERT G. PICKEL
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. In general, derivatives markets tend to be more liquid
than underlying cash markets. For example, bank loans and many
bonds issues tend to be fairly illiquid. There is no good
reason to prohibit credit default swaps on such securities
because the underlying instruments do not trade in a liquid
market. Such a prohibition would only serve to reduce bank
lending capacity and the ability and willingness of investors
to purchase bonds, which would not be desirable while the
economy is in the midst of a credit crunch.
Privately negotiated derivatives are built on the
fundamental principle of freedom of contract. Two parties can
construct a mutually beneficial agreement to address their risk
management needs, which may or may not be related to the
existence of a cash market. We question whether the creation of
such an agreement should be subject to conditions specified by
law or regulation, especially since regulators can use powers
they already have to limit trading in products that are judged
to threaten systemic stability.
Q.1.b. If not, what specific objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. We do not believe it would be productive to attempt to
legislate or regulate the types of risks traded in derivatives
markets. All derivatives reference risks arising from normal
economic activity are borne by market participants. Most
securities, even the most basic types of securities such as
bonds, embody a bundle of risks. The benefit of derivatives is
that they permit the unbundling and pricing of specific risks.
For example, an investor holding a corporate bond bears
both interest rate risk and credit risk. Those individual risks
can separately be traded, and valued, using interest rate
derivatives and credit default swaps. By allowing investors to
unbundle and trade individual risks, derivatives make it
possible for investors to tailor the risks they bear. Likewise,
hedgers in commercial markets can reduce financial risk while
concentrating on managing the business risk associated with
their enterprises.
The need to manage specific risks can change as economic
conditions change. Any a priori restriction on the types of
risks that can be referenced by derivatives could easily hamper
effective risk management.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative
and the model is effectively the basis, why should the models
not be public?
A.2. As a general matter, prices are determined through trading
and not by financial models. Financial models attempt to
explain the factors determining values of financial
instruments. Many such models lend insight into the factors
that influence prices of financial instruments, which is why
some traders use financial models to inform their trading
decisions. But most existing models cannot predict asset prices
accurately enough to be used exclusively for price setting,
which is why many more traders do not rely on financial models.
In addition to informing trading decisions, models are used for
risk management purposes and to value illiquid positions for
which market prices are not readily available.
Many dealers currently publish newsletters that analyze
factors determining the behavior of credit default swap
valuation along with insights into how they model the behavior
of credit default swap spreads. Moreover, existing regulations
require regulated financial intermediaries to disclose to
regulators in detail the methods they use to value financial
instruments and to measure risk and the controls placed on such
processes. This is as it should be. But there has been no
demonstrated advantage, yet there would be great expense,
associated with a legal mandate requiring every institution to
publish the details of their own proprietary models and to
explain in detail how they apply those models in practice.
We are not suggesting that greater forms of transparency
are not desirable. For example, ISDA has recently released the
ISDA CDS Standard pricing (originally developed by JPMorgan) as
part of an effort to facilitate the central clearing of
standardized credit default swap contracts. The ISDA standard
CDS model does not determine CDS prices. It merely provides a
standardized method for calculating changes in up-front
payments for standardized credit default swaps based on changes
in credit default swap spreads. Credit default swap spreads are
still determined through trading, however, which is the
principal method of price discovery in all markets. The ISDA
model is freely available to all market participants on a Web
site maintained by Markit at www.cdsmodel.com.
As a final point, we are not aware of any derivatives
market for which there is no cash basis. We are aware that some
commentators have leveled this criticism at the credit default
swaps market, but we believe the criticism is misplaced. The
cash basis for credit default swaps is the difference between
the credit default swap spread and observed risk premium paid
by bond issuers and borrowers in the loan market. Several good
books analyzing and explaining the behavior of the credit
default swap basis have been published in recent years. These
books are publicly available to all interested parties.
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. The dichotomy between ``legitimate'' hedges and ``purely
speculative bets'' is a false one because a functioning market
requires a seller for every buyer. A person who buys a bond and
does not hedge the risk of the bond, for example, could be
characterized under an exceedingly narrow definition as
engaging in a ``purely speculative bet.'' Few would adopt such
a characterization, however, because it would imply that buying
bonds without hedging is not legitimate. Similarly, a person
who wants to hedge the risk of a bond by buying CDS protection
requires that another person be willing to sell protection,
which could itself be characterized as a purely speculative
bet.
Requiring that all hedges be offset by other hedges would
result in a ``by appointment only'' market that matches hedges,
which would be impossible in the case of credit risk because it
is unlikely that a seller of protection would meet the
definition of a hedger. Put simply, what is a seller of
protection hedging? Further, requiring an insurable interest
for purchasers of credit protection, which is meant to apply to
insurance products and not to financial derivatives, would
effectively make risk transfer impossible. Suppose, for
example, that a bondholder buys CDS protection from a bank; the
bank that sells protection will normally want to hedge the
credit risk it takes on from the bondholder by buying
protection. But if only bond owners can buy protection, the
bank will not be able to hedge its risk. In the presence of
such restrictions, few firms will be willing to act as
protection sellers. Finally, requiring delivery of the
reference asset, which was the standard means of settlement
prior to 2005, would be counterproductive and harmful to bond
market liquidity in light of the large number of index CDS
transactions found in today's market.
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. Derivatives markets are fluid and global. Any increased
regulation must take into account that certain trades will not
be done or will be done elsewhere.
A recent article shows that the concern about business
moving overseas is real: According to Euractiv.com, the
European Commission's proposed rules for derivative dealers,
which appear to be more flexible than those discussed in the
U.S., might be intended to ``court'' U.S. dealers faced with a
choice of where to conduct business.
More broadly, companies need the risk management tools that
only derivatives can supply and will respond to arbitrary
restrictions on their ability to enter into risk-shifting
contracts by seeking out venues where they can enter into such
agreements. For example, an American company with foreign
subsidiaries routinely needs to enter into a variety of
contracts with local parties as part of the conduct of
business, and these business dealings will produce risks that
they will wish to hedge. The assumption that a U.S. company
could always find a market in derivatives for any type of risk
in the United States is unfounded. Derivatives contracts are
not universal. Interest rate derivatives referencing foreign
interest rates, for example, are typically actively traded in
the home country of the currency. The demand for such contracts
inside the United States might be so limited that a U.S. market
for such contracts does not exist. Thus, restricting a U.S.
company to trade only U.S.-regulated derivatives will have the
effect of prohibiting the hedging of interest rate risks borne
by overseas subsidiaries.
At the very least, such a prohibition would effectively
make it impossible for U.S. banks to offer through overseas
subsidiaries a full complement of financial services to U.S.
firms operating outside the U.S., which would thereby hamper
the competitiveness of any U.S. company with overseas
operations.
Q.5. Do over-the-counter or custom derivatives have any
favorable accounting or tax treatments versus exchange-traded
derivatives?
A.5. Over-the-counter derivatives may enjoy favorable
accounting treatment when they are used to hedge an existing
risk. U.S. GAAP hedge accounting guidelines are extremely
rigid. Unless a company can demonstrate that a hedge employing
a derivative instrument is a nearly perfect hedge, it is
required to report the mark-to-market gains and losses from the
hedge instrument as a profit or loss, even if it does not
report changes in the value of the underlying exposure. By
their nature, standardized derivatives contracts almost never
qualify as a perfect hedge. Thus, if a company hedges the
interest rate risk using interest rate futures it must report
any gains or losses on the hedging position in its income
statement. But if the underlying instrument is held in the
investment portfolio, changes in the market value of the
instrument do not affect reported income. Such a regime creates
artificial volatility in reported earnings.
Similarly, a multinational company that wishes to use
standardized foreign exchange futures to hedge against changes
in exchange rates might find that the exercise exacerbates the
volatility of its reported income. Thus, requiring all
companies to use only standardized derivatives may have the
unintended effect of making reported income more volatile than
it really is. The ultimate result would be to discourage
legitimate hedging activity, placing U.S. companies at a
competitive disadvantage.
Over-the-counter derivatives do not necessarily enjoy
favorable tax treatment relative to exchange-traded
derivatives. To the extent that the tax treatment may differ,
it is because gains and losses on exchange-traded derivatives
are recorded daily. Whether this difference benefits the user
depends on the nature of the transaction and the ultimate
change in the value of the contract, which may be positive or
negative. As a general rule, it all depends on the type of
transaction, the terms of the contract, and what happens to
market prices and rates over the term of the contract.
Q.6. In addition to the Administration's proposed changes to
gain on sale accounting for derivatives, what other changes
need to be made to accounting and tax rules to reflect the
actual risks and benefits of derivatives?
A.6. ISDA is actively engaged with tax authorities and
accounting standard setters on rules governing derivatives. The
FASB has an active agenda, and we would encourage policy makers
to engage them in consideration of their views. ISDA is
concerned about preserving the ability of commercial end users
to customize derivatives in order to meet their particular risk
management needs. Without the ability to precisely hedge risks
in accordance with FASB 133 through customized OTC derivatives,
companies would experience increased volatility, reduced
liquidity, and higher financing costs.
Q.7. Is there any reason standardized derivatives should not be
traded on an exchange?
A.7. Standardization is a necessary but not sufficient
condition for trading on an exchange: Standardized derivatives
can be traded on an exchange only when a product has sufficient
volume and liquidity to support reliable price discovery for
the product. If sufficient volume and liquidity do not exist,
it would be preferable to trade the products over-the-counter,
that is, execute trades privately, and then manage the risk in
other ways, such as through a clearinghouse.
Policy discussions frequently confound exchange trading--
which means that all trades must be negotiated and executed
through a central venue--with clearing--which means that trades
must be booked with a central counterparty that serves as the
counterparty to all cleared transactions. Exchange trading is
possible without clearing, although most exchanges involve
clearing as well; and clearing is compatible with both exchange
trading and over-the-counter trading.
Exchanges and clearinghouses both make use of
standardization, but for different reasons. Exchange trading
involves extensive standardization because it makes a product
easier to trade, which leads to higher liquidity. But as a
product becomes more standardized, it may attract a narrower
range of traders, leading to lower liquidity. As a result of
these conflicting effects, only products that inherently appeal
to a large number of traders are likely to succeed on an
exchange; more specialized products generally lack liquidity
and consequently do not trade successfully on an exchange.
Clearinghouses also rely on standardization: not to
facilitate trading but to facilitate valuation for the purposes
of margin setting. Although cleared products need to be
substantially standardized, they need not be as liquid as
exchange-traded instruments. What matters is that the
clearinghouse can calculate contract values and required margin
in a timely manner and can unwind a position in the event of
clearing member default.
Q.8. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.8. It is debatable whether such an incentive exists at all.
It is more likely that bankruptcy and credit default swap
protection are independent of each other. Claims that bought
credit default swap protection somehow ``caused'' a bankruptcy
filing appear to be based on misunderstanding of how credit
default swaps work.
One misunderstanding is that buyers of credit default swap
protection can profit only if the reference entity actually
goes bankrupt. But if the credit quality of a borrower
deteriorates, a protection buyer need not wait for bankruptcy,
but can instead take its profit by closing out the contract
that presumably has appreciated in value.
It is even possible that the protection buyer might prefer
that the reference entity continue as a going concern instead
of fail. Consider an investor that believes that credit default
swaps are underpriced relative to the underlying bond. The
investor can buy the bond and buy credit protection, thereby
locking in a profit. If the reference entity fails, the
investor will be compensated and can then seek recovery on the
bond. But if the reference entity survives, the investor can
continue to collect the difference between the bond's interest
and the fee paid for the credit protection.
Another misunderstanding is that it is possible to game the
bankruptcy system by buying protection on distressed firms and
then somehow ``forcing'' the firms into bankruptcy. This
misunderstanding appears to be based on the assumption that the
cost of protection is independent of the likelihood of a credit
event so one can buy protection on distressed firms at a low
cost. But the price paid for credit default swap protection is
in fact related directly to the expected loss on the reference
credit. Indeed, protection on a distressed credit--one widely
expected to declare bankruptcy--requires that the protection
buyer pay a substantial amount up-front. And if the reference
entity does not declare bankruptcy, the protection buyer will
in fact incur a substantial loss.
A final misunderstanding is that, because a protection
buyer is ``made whole'' after a reference entity fails, a
protection buyer that cash settles their CDS position and
remains in possession of the underlying bond has no incentive
to maximize the recovery on the underlying bond. It is not
clear why this should be the case: A bond holder that has been
compensated and fails to pursue further recovery is in effect
``leaving money on the table,'' which does not seem in the bond
holder's interest. The way the credit default swap market
works, after settlement of a credit event, someone ends up
holding the underlying bond, and that party has an interest in
maximizing recovery.
Q.9. How do we reduce the disincentive for creditors to perform
strong credit research when they can just buy credit protection
instead?
A.9. The presumption that creditors lack incentives to perform
strong credit research belies an understanding of how hedging
works. As a general matter, it is necessary to take on risk in
order to earn a profit. Because hedging involves giving up
risk, it also generally means giving up the potential profit
from taking risk, usually by paying the cost of the hedge.
Further, routinely entering into hedged transactions is seldom
profitable unless one has knowledge superior to that of the
rest of the market, which is unlikely to be the case on a
systematic basis.
Hedging loans with credit default swaps affects
profitability as follows. A bank hopes to profit by making a
loan; its profit is based on the difference between the bank's
cost of funding and the interest charged the borrower. Before
making the loan, the bank should perform strong credit research
in order to avoid losses from default. But if the bank decides
to hedge against losses on the loan by buying credit
protection, the bank will have to pay a periodic fee for
protection, which will offset some or all of the profit from
the loan. A bank that routinely lends and then buys protection
on the loans will almost certainly run a loss-making business;
the bank has incentive to hedge only if the borrower's
condition deteriorates unexpectedly. So the bank can either
choose not to hedge and possibly profit, or to hedge but give
up the opportunity to profit, but generally cannot both hedge
and profit simultaneously.
Q.10. Do net sellers of credit protection carry that exposure
on their balance sheet as an asset? If not, why shouldn't they?
A.10. Because the value of a credit default swap is zero at
inception and the parties to the contract do not exchange a
consideration at the time the contract is initiated, as
typically happens when an asset is purchased or sold, the
potential exposure is not recorded on the balance sheet at the
time the contract is first settled. Under long-standing
accounting conventions, there is no way to record a contract as
an asset or liability when no consideration is paid or received
and the contract has a zero value. For analogous reasons, banks
do not report on their balance sheets the notional amount of
loan commitments, stand-by letters of credit and unused amounts
on revolving credit lines, which all create a similar type of
credit exposure as a credit default swap. This is why such
commitments are classified as ``off-balance sheet.''
This is not to say that financial companies are not
required to report the amount of their potential credit
exposure arising from credit default swaps, however. First,
companies must report the mark-to-market value of their
derivatives exposures as either a ``derivatives receivable'' or
a ``derivatives payable'' when the value of the contract
changes. To illustrate, if a bank sells protection on company
XYZ and the credit spreads on that company subsequently widen,
then the protection seller must record the mark-to-market loss
on the contract as a derivatives liability. Similarly, the
protection seller's counterparty will record the mark-to-market
gain as a derivatives receivable.
Second, financial companies are required to report as a
supplementary item the notional amount of any financial
guarantees they have assumed. Thus, the financial reports of
banks and other financial companies contain tables detailing
the amount of ``financial guarantees'' the entity has written,
including protection sold using credit default swaps, exposures
created through written options, and the amount of other
financial guarantees that include loan commitments, revolving
credit lines and stand-by letters of credit.
AIG, for example, did report to investors, credit-rating
agencies, and to regulators in its public financial statements
that it wrote protection on $125 billion of securities in its
2002 10k. The table below, which draws on data reported in
subsequent annual reports, documents the growth in AIG's
exposure to $527 billion by year-end 2007, the year when AIG
first began reporting losses related to its credit default swap
portfolio.
------------------------------------------------------------------------
Amount ($ in
Date Reported (at December 31) billions)
------------------------------------------------------------------------
2002................................................ 125.7
2003................................................ 203.0
2004................................................ 290.3
2005................................................ 387.2
2006................................................ 483.6
2007................................................ 527.0
------------------------------------------------------------------------
Moreover, AIG's financial reports discuss explicitly the
risk the company faced of margin calls stemming from its credit
default swap exposure. In short, investors, credit-rating
agencies and regulators all had ample prior knowledge of AIG's
credit derivatives related potential risk exposure. Like AIG's
management, however, all involved parties failed to appreciate
the impact a collapsing housing market would have on that
exposure. Opaque financial reporting was not the reason why AIG
was permitted to amass such a large risk exposure using credit
default swaps.
Q.11. In her testimony Chairman Schapiro mentioned synthetic
exposure. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.11. ``Synthetic exposure'' refers to the ability to take on a
risk by means of derivatives or a combination of derivatives
and cash instruments. Synthetic exposure is not necessarily
equivalent to leverage. For example, many investors use equity
swaps to gain synthetic exposure to foreign equities. They do
not do this to leverage their exposure. Purchasing foreign
equities can be very expensive. In many countries, it can only
be done from within the country and ownership is limited to
residents. A U.S. investor can enter into an equity swap to
gain equivalent economic, or ``synthetic,'' exposure to foreign
equities, thereby gaining diversification while holding cash in
the form of Treasury bills or other liquid investments.
More generally, equity swaps can be used to gain exposure
to baskets of equities while avoiding the brokerage fees and
other transactions costs associated with buying and selling the
cash instruments.
Another form of synthetic exposure is exemplified by
selling credit default swap protection on asset backed
securities. The motivation for doing so is to attain access to
investments that are limited in supply, but does not
necessarily constitute leverage. This form of synthetic
exposure will be discussed in the next question.
Q.12. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.12. Financial assets such as bonds represent a bundle of
risks. For a bond, that bundle of risks comprises credit risk,
interest rate risk, funding risk, and possibly foreign exchange
risk. Derivatives facilitate the unbundling of the different
types of risks embodied by securities such as bonds. Because
derivatives are not funding transactions, the act of selling
protection on a reference entity is not equivalent to buying a
bond issued by that entity and does not drain away the benefit
of access to credit from the bond issuer.
Finance is not a zero-sum game. The benefit that one party
derives from being able to trade an unbundled risk does not
necessarily diminish the benefit of access to credit by
borrowers. In the case of synthetic exposure such as credit
default swaps on securitized products, it is doubtful that
synthetic exposure occurs at the expense of the ``creators or
owners'' of the underlying assets. If access to synthetic
exposure is restricted, investors will not necessarily continue
to bid up the price of the underlying asset but will likely
turn to other, lower priced investments instead. And in many
cases, creators or owners of assets will benefit from the
existence of synthetic exposure. For instance, a bond issuer
may benefit from such activity because it indirectly promotes
the liquidity of its bonds, thereby lowering funding costs.
Also, after an investor takes on synthetic exposure on an asset
by selling protection to a dealer, the dealer will in many
cases buy the underlying asset to hedge its own position. The
economic benefit in these cases will flow to the owners.
Q.13. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.13. Financial assets are not homogeneous--that is, infinitely
interchangeable with each other--nor are they completely
elastic in supply. Instead, assets are heterogeneous and can
generally be issued only in limited amounts. Particularly in
the case of fixed income (bond) markets, many individual issues
tend to be illiquid. There is therefore demand for access to
certain assets that have attractive properties but cannot
easily be increased in supply. Restricting access to synthetic
exposure would make it more difficult for investors to benefit
from exposure to these assets.
As noted earlier, financial assets embody a bundle of
different risks. Derivatives facilitate the unbundling of risks
so that they can be managed individually. Thus, a bond
incorporates both interest rate risk and credit risk. What
derivatives cannot do is to confer the benefit of funding to
the contract's counterparties. Therefore, the act of selling
credit protection does not divert the benefit of receiving
credit from the borrower. To the contrary, the availability to
creditors of a means of hedging and trading the borrower's
credit risk in more liquid markets should facilitate the
availability of credit, thereby benefiting the bond issuer. In
general, market liquidity tends to reduce borrowing costs,
which is why interest rates paid by bond issuers tend to be
lower than interest rates on loans.
Q.14. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.14. For every buyer of protection, there is a seller of
protection. Prior to default, the terms of a credit default
swap is determined by market sentiment regarding a firm's
prospects, but has no causal influence that we are aware of on
the underlying bond's price. After default, recent experience
has shown that the vast majority of the offsetting bought and
sold protection net down to a comparatively small proportion of
the market. Harrah's, for example, has $17 billion of
outstanding debt compared with $30 billion of outstanding CDS
protection. But according to the Depository Trust Clearing
Corporation, this $30 billion of CDS protection nets down to
$1.86 billion, which is far less than the amount of outstanding
debt. Given the ISDA Credit Event Auction Mechanism, most
protection buyers need not deliver the underlying asset, so
there is little if any liquidity pressure on the underlying
asset.
Q.15. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.15. A swap is a bundle of forward contracts with different
maturity dates. In the early days of trading in interest rate
futures, the exchanges listed contracts with maturities
extending only 2 years into the future. Swaps and other OTC
derivatives originally were created in part to address the
needs of market participants who wished to hedge longer-dated
exposures.
While market participants currently have a broader choice
of standardized contracts, they typically turn to OTC markets
for longer-dated contracts and, more generally, when available
standardized products do not meet their needs. Only highly
standardized contracts can be traded on exchanges because
contract standardization facilitates liquidity by limiting
trading to just a few contracts. The Eurodollar futures
contract, for example, specifies a $1 million notional
principal. These contracts are listed for quarterly expiration
(in March, June, September, and December) on the second London
business day preceding the third Wednesday of the expiration
month.
Such standardized contracts are well suited for speculation
on changes in the general level of interest rates, but are ill-
suited to hedge the unique risk exposures borne by most market
participants. In the parlance of derivatives markets, using
exchange traded derivatives requires hedgers to take on
significant basis risk, the risk that changes in the value of
the exposure being hedged and changes in the value of the
hedging instrument might not fully offset each other. For
example, a company may have floating-rate bonds outstanding for
which the interest rate resets on the 15th of February, May,
August, and November. As noted above, however, the only
available interest rate contracts mature in the third week of
March, June, September, and December.
In such circumstances, the company would find it impossible
to hedge perfectly its interest exposure. Each interest payment
would be unhedged for over a month of the quarter. Instead of
taking on the basis risk, the company could enter into an OTC
interest rate swap, thereby effectively passing on the basis
risk to an OTC derivatives dealer. OTC dealers have a natural
advantage in managing such risks because they trade
continuously with a large number of counterparties and have the
skilled personnel and order flow necessary to manage interest
rate risk arising from mismatched contracts and exposures. For
these reasons, futures markets tend to be professional markets
while the OTC markets serve the needs of customers such as
corporates and smaller, less-sophisticated banks.
There is no easy way around this obstacle. The range of
listed contracts cannot be extended to include all contracts
because most individual contracts arising from commercial trade
are so unique as to be inherently illiquid. Simply listing a
contract on an exchange does not guarantee liquidity, and may
actually reduce the liquidity of existing contracts. Every
derivatives exchange has had experience listing new contracts
that subsequently had to be withdrawn because the contract
never acquired sufficient interest to become viable. If a
contract is illiquid, it cannot be marked to market reliably
and the exchange clearinghouse cannot manage the associated
risk as effectively as with a liquid instrument. Thus, a
blanket requirement that all derivatives be exchange traded
would have the practical effect of prohibiting most contracts
for deferred delivery, including such straightforward
transactions as the purchase or sale of fuel oil or wheat at a
negotiated price for delivery at a chosen future date.
Mandating that all risk management solutions be standard does
not reflect the hedging needs driven by the unique risks that
businesses encounter.
Q.16. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.16. As noted in the above response to Question 15,
standardized contracts list standard delivery dates, maturities
and deliverable grades that do not necessarily correspond to
the delivery dates and types of exposures market participants
need to hedge. Bank loans, for example, are illiquid by their
very nature.
A creditor bank might wish to reduce its exposure to a
particular borrower so as to expand its lending capacity. But
if the company in question is relatively small, exchanges will
not find it worthwhile to list standardized credit default
swaps against that company's loans. At the same time, there
might be some investors interested in diversifying their
portfolios by taking on an exposure to bank debt. They can do
this by buying a portion of the loan, but because bank loans
are illiquid trading loans is much more expensive than entering
into an over-the-counter credit default swap. More than any
other group, restricting trading to standardized derivatives
would hurt small businesses.
In the area of equity derivatives, investors often use
equity swaps to gain exposure to foreign equities because the
direct purchase of foreign equities can be very expensive--and
in some cases impossible--for an institution without foreign
offices (and foreign broking licenses). Thus, restricting
trading to standardized contracts traded only in the United
States would make it much more difficult and much more costly
for U.S. investors to diversify into foreign stocks.
The problem would be even more severe in commodity markets.
Airlines wishing to hedge jet fuel costs, for example, are
often forced to use heating oil futures because the market for
jet fuel derivatives is relatively illiquid. Substituting
heating oil futures for jet fuel forwards or jet fuel swaps
exposes the airline to basis risk. As noted earlier, managing
basis risk is a difficult task that typically requires the
expertise of professional traders. Simply banning trading in
OTC instruments does not guarantee that a liquid market in jet
fuel futures would emerge. Moreover, futures markets are
typically only liquid for short-term contracts, so that
companies such as airlines would find themselves without a way
to secure long-term, fixed-price delivery contracts. By
offering to provide such custom-tailored contracts, banks
supply risk management services to their corporate customers
more effectively and at a lower cost than those organizations
could do if they had to hire the staff necessary to manage
those risks themselves. Managing risks using standardized
contracts would require companies to replicate the types of
trading and risk management systems typically found only in
commodity dealers and banks, and at a very steep cost.
More generally, the ability to enter freely into a variety
of long-term contracts facilitates the conduct of business. No
one can anticipate in advance the terms of all the long-term
contracts U.S. companies will find necessary to conduct
business, which makes it impossible to list standardized
contracts that will address all the needs of all businesses.
Q.17. Who is a natural seller of credit protection?
A.17. A ``natural'' seller of protection is any entity seeking
to profit from being exposed to credit risk of a company,
region or industry. Examples of natural sellers include:
Institutional investors, pension funds, and
insurers, which also invest in corporate bonds.
Banks seeking to diversify their sources of income
in order to reduce credit concentration.
Hedge funds and other investors seeking to profit
from perceived overpricing of credit.
A seller of credit protection is in an analogous position
to a bond holder who has hedged the interest rate risk and, in
some cases, exchange rate risk bundled in the bond. The
advantage to doing so using credit default swaps instead of
buying the bond is that transactions costs typically are
smaller and credit default swaps tend to be more liquid than
the underlying debt. Credit default swaps may also be available
for maturities that would be otherwise unavailable to
investors.
Q.18. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.18. Trades across all derivative asset classes will be
reported to various trade information repositories. A
repository is accessible in full detail to anyone who regulates
the entities who have provided such information to allow the
regulator to properly access the risk inherent in the
transactions. Aggregated data on open positions and trading
volumes will be available to the public. We would direct your
attention to http://www.newyorkfed.org/newsevents/news/markets/
2009/ma090602.html, which contains a link to the most recent
industry letter outlining its commitments to the Federal
Reserve Bank of New York, which included commitments regarding
trade reporting.
Q.19. What is insufficient about the clearinghouse proposed by
the dealers and New York Fed?
A.19. Please review the ``Report to the Supervisors of the
Major OTC Derivatives Dealers on the Proposals on Centralized
CDS Clearing Solutions for the Segregation and Portability of
Customer CDS Positions and Related Margin'' for a detailed
analyses of the relevant clearinghouses. The report can be
accessed at http://www.isda.org/credit/docs/Full-Report.pdf.
The report highlights some legislative changes that would be
desirable to facilitate buy-side access to clearing.
Q.20. How do we prevent a clearinghouse or exchange from being
too big to fail? And should they have access to Fed borrowing?
A.20. These questions are matters of pubic policy that are
appropriately decided by legislative and regulatory bodies and
not by ISDA or other industry groups. Nonetheless, we
respectfully suggest that the possibility of failure is an
important element of the market process and that protecting
firms from failure can have the paradoxical effect of making
individual firms safer while making the financial system less
safe.
Congress might consider the precedent of the Federal
Deposit Insurance Corporation Improvement Act of 1991 (FDICIA),
which placed limitations on the ability of regulators to rescue
failing banks, subject to a systemic risk exception. Such
limitations put the industry on notice that they will have to
bear the consequences of unsound practices. But in order for
such a policy to be effective, the limitations must be
credible; in other words, the industry must know that
regulators will not routinely invoke a systemic risk exception
when faced with an actual failure. If such a credible policy
cannot be achieved, it is difficult to envision circumstances
in which the government would not find it necessary to rescue a
large central clearinghouse if it ever experienced financial
distress.
Access to Fed borrowing by the clearinghouse might be
necessary to cope with temporary liquidity crises but should
not be used as a bailout tool. In order to address the moral
hazard issue, policy makers could require that any lending by
the Fed could be repaid out of guarantee funds as well as loss
sharing arrangements among surviving firms so the losses would
ultimately be borne by the industry. The result would be
greater incentives for clearinghouse participants to monitor
the risks associated with the clearinghouse.
Q.21. What price discovery information do credit default swaps
provide, when the market is functioning properly, that cannot
be found somewhere else?
A.21. Credit default swaps have made credit pricing more
transparent by means of their price discovery function. First,
credit default swaps on diversified credit indexes such as CDX
in North America and iTraxx in Europe provide virtually the
only price discovery information on credit markets overall,
similar to the price discovery information for U.S. equity
markets provided by the ability to enter into contracts on such
indexes as the S&P 500 and Dow Jones indexes.
Second, both single-name credit default swaps and corporate
bond markets provide price discovery for individual corporate
debt issues, and the two are linked by means of asset swap
pricing. Credit default swaps are arguably more liquid than the
underlying bond issues, however, and are therefore likely to
provide more informative credit pricing than the underlying
cash markets.
Finally, the uneven liquidity of corporate bonds is a
primary reason not only for widespread reliance on credit
default swaps for price discovery, but for early warning about
impending credit problems as well. While it is true that
corporate bond credit spreads also provide early warning, most
corporate bonds tend to trade infrequently so the information
dispersal is generally less timely than with credit default
swaps.
Q.22. Selling credit default swaps is often said to be the same
as being long in bonds. However, when buying bonds, you have to
provide real capital up front and there is a limit to the
lending. So it sounds like selling swaps may be a bet in the
same direction as buying bonds, but is essentially a highly
leveraged bet. Is that the case, and if so, should it be
treated that way for accounting purposes?
A.22. First, it should be noted that while it is true that an
investor who holds a bond bears the same credit risk as the
seller of credit default swap protection, the protection seller
does not bear the same bundle of risks as a lender or bond
investor. In addition to credit risk, a bond investor faces
interest rate risk, possibly foreign exchange risk (in the case
of a bond denominated in a foreign currency), funding risk (it
is worth remembering that many bond investors such as banks and
insurance companies are leveraged: they must borrow the funds
they use to buy bonds), and liquidity risk (bonds tend to be
much less liquid than derivatives referencing those bonds).
Therefore, there is no compelling conceptual reason to apply
the same accounting treatment to credit default swaps and bonds
based on an equivalence of risks.
Moreover, as discussed in response to Question 10 above, it
is simply infeasible to apply the same accounting treatment to
off-balance-sheet instruments such as credit default swaps as
to transactions involving cash securities. Companies can and do
report their off-balance-sheet exposures; existing bank
regulatory capital requirements already limit the effective
leverage that can be created using derivatives. To the extent
that existing regulations have not always been applied
effectively in the past, or to the extent that they have not
been applied uniformly to financial companies in all
industries, this is an issue best addressed through more
uniform and effective regulation and supervision and more
effective risk management.
Mandating changes to accounting standards is not a
solution. Existing accounting standards were originally devised
as expense tracking systems and are not a substitute for
capital requirements. Therefore, mandating changes to
accounting standards in contravention of conventions
established by existing professional rulemaking bodies would
likely prove an ineffective method of improving risk management
practices.
Q.23. Why should we have two regulators of derivatives, with
two interpretations of the laws and regulations? Doesn't that
just lead to regulation shopping and avoidance?
A.23. Regulation of the derivatives markets is a part of the
broader public policy debate over the financial regulatory
reform. Federal regulation of securities, commodities,
exchanges, and derivatives has developed over time and reflects
the evolution of the capital markets. In its white paper
released last month, the Administration supports the
harmonization of futures and securities regulation, proposing
the CFTC and the SEC make recommendations to Congress for
changes to statutes and regulations that would harmonize
regulation of futures and securities. The SEC and CFTC are
expected to complete a report to Congress on this issue by the
end of September. As Congress considers these recommendations,
we submit that inconsistency between regulatory requirements
and enforcement of those requirements, for generally equivalent
instruments or activities leads to costly uncertainties.
Reporting requirements, filing requirements, and approval
standards should be harmonized as much as possible. Harmonized
standards are necessary to enhance the quality of regulation by
the primary Federal regulators and any systemic risk regulator.
Finally, the derivatives markets are global and require
cooperation among the international markets' regulators.
Coordination among regulators at the Federal Government level
is critical to successful coordination on the international
level. Toward this end, any regulatory reform restructuring
that will be passed by Congress should include provisions to
preempt State initiatives on the regulation of derivatives
instruments, users, and markets.
Q.24. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.24. Please see the response to Question 11.
Q.25. What is good about the Administration proposal?
A.25. The Administration's proposal is an important step toward
much-needed reform of financial industry regulation. ISDA and
the industry welcome the Administration's recognition of
industry measures to safeguard smooth functioning of our
markets and its support of the customized OTC derivatives as
tools needed by companies to meet their specific needs.
ISDA supports appropriate regulation of financial and other
institutions that have such a large presence in the financial
system that their failure could cause systemic concerns.
For nearly 4 years, the industry has been engaged in a
dialogue with the Federal Reserve that has resulted in ISDA and
the industry committing to strengthening the resilience and
robustness of the OTC derivatives markets through the
implementation of changes to risk management, processing and
transparency that will significantly transform the risk profile
of these important financial markets. Specifically, the
industry has undertaken to increase standardization of trading
terms, improve the trade settlement process, bring more clarity
to the settlement of defaults, move toward central counterparty
clearing where appropriate, enhance transparency, and enhance
openness in the industry's governance structure. All of these
initiatives are consistent with the Administration's proposals.
We would direct your attention to http://www.newyorkfed.org/
newsevents/news/markets/2009/ma090602.html, which contains a
link to the most recent industry letter outlining its
commitments to the Federal Reserve Bank of New York.
Q.26. Is the Administration proposal enough?
A.26. Please see answer to 25 above.
Q.27. Mr. Whalen suggests that Congress should subject all
derivatives to the Commodity Exchange Act, at least as an
interim step. Is there any reason we should not do it?
A.27. Here is an extract from Mr. Whalen's testimony:
``Congress should subject all OTC contracts to The Commodity
Exchange Act (CEA) and instruct the CFTC to begin the
systematic review and rule making process to either conform OTC
markets to minimum standards of disclosure, collateral and
transparency, or require that the contracts be migrated onto
organized, bilateral exchanges.''
ISDA disagrees with Mr. Whalen's suggestion, which would
turn the clock back almost two decades by reintroducing
substantial legal and regulatory uncertainty into derivatives
activity and to financial markets in general. The problem is
that the CEA is unclear about which financial instruments are
and are not futures as defined in the CEA, so extensive
discretion is left to the Commodity Futures Trading Commission
(CFTC) to decide. The extreme possibility is that an over-the-
counter derivatives will be found to be an off-exchange futures
contract and therefore illegal. Although the CFTC has the
authority to carve out exceptions to the exchange trading
requirement, the exceptions themselves are subject to
uncertainty because they can be subsequently narrowed and
possibly even revoked. The result is that parties seeking to
manage their risk with OTC derivatives are forced to do so
under the cloud that their transaction could at a later date be
declared null and void, which can have potentially disastrous
consequences for the firms involved.
We submit instead that the Commodity Futures Modernization
Act appropriately cleared up much of the legal and regulatory
uncertainty surrounding the CEA while leaving CFTC with
sufficient authority to address fraud and market manipulation
concerns. Returning to an earlier era of legal uncertainty
would unnecessarily increase the risks faced by market
participants. Further, forcing useful but relatively less
liquid products onto exchanges might in many cases doom such
products to failure because they cannot generate sufficient
volume to support continuous trading.
Q.28. Is there anything else you would like to say for the
record?
A.28. ISDA and the OTC derivatives industry are committed to
engaging with Congress to build upon the substantial
improvements that have been made in our business since 2005. We
will continue to support efforts of Congress, the regulators
and the Administration to determine the most effective
prudential regulation of this important industry.
Changes to the OTC derivatives industry should be informed
by an understanding of how the OTC derivatives market functions
as well as a recognition that OTC derivatives play an important
role in the U.S. economy. OTC derivatives offer significant
value to the customers who use them, to the dealers who provide
them, and to the financial system in general by enabling the
transfer of risk between counterparties. Ultimately, it is
important to maintain the continued availability and
affordability of these important tools.
------
RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
FROM CHRISTOPHER WHALEN
Q.1. Are there differences between the SEC and CFTC's
approaches for regulating their respective markets and
institutions that we should take into consideration when
thinking about the regulation of the OTC derivatives markets?
A.1. The CFTC should be tasked with the functional regulation
of all derivatives markets. The SEC should cooperate with the
CFTC, especially in terms of the disclosure of any derivative
that creates the economic equivalent of a position in a listed
security.
Q.2. The Administration's proposal would require, among other
things, clearing of all standardized derivatives through
regulated central counterparties (CCPs). What is the best
process or approach for defining standardized products? How
much regulatory interpretation will be necessary?
A.2. The clearing of standardized contracts is a fairly
straight-forward proposition and involves risks that may be
managed with existing regulation. Perhaps the biggest challenge
is to require the terminology used, for example, in a CDS or
CDO created from a mortgage backed security, be standardized.
As my colleague Ann Rutledge stated in the interview which I
included in the hearing record: ``The first key issue is that
we need to do to reform our markets is to have a standard
vocabulary for the definition of what is a delinquency, a
default, and loss.''
Q.3. Are there key areas of disagreement between market
participants about how central counterparties should operate?
For example, what are the different levels of access these
central counterparties grant to different market participants?
What are the benefits and drawbacks of different ways of
structuring these central counterparties?
A.3. In the OTC derivatives market, only the dealers have
access to the clearinghouse. In an exchange based market, all
of the participants face the clearinghouse and there is thus
far greater equality in terms of price discovery and execution
cost. From this perspective, an exchange type model is far
superior, especially seen from the perspective of nondealer
participants.
Q.4. One key topic touched on at the hearing is the extent to
which standardized products should be required to be traded on
exchanges. What is your understanding of any areas of
disagreement about how rigorous new requirements should be in
terms of mandating, versus just encouraging, exchange trading
of standardized OTC derivatives?
A.4. Standardized products do not have to be traded on an
exchange. The mere fact of standardization, as in the case of
currency and interest rate swaps, will have the desired
positive benefits. In many respects, the issue of
standardization is a canard and misses the true public policy
issues posed by certain OTC derivatives such as CDS in terms of
(a) the lack of an actively traded cash basis market and (b)
the creation of excessive risk in the financial system by
allowing cash settlement.
Q.5. Can you share your views on the benefits of customized OTC
derivatives products? About how much of the market is truly
customized products?
A.5. See answer to Question 15 above.
Q.6. The Administration's proposal would subject the OTC
derivatives dealers and all other firms whose activities in
those markets create large exposures to counterparties to a
``robust and appropriate regime of prudential supervision and
regulation,'' including capital requirements, business conduct
standards, and reporting requirements. What legislative changes
would be required to create margining and capital requirements
for OTC derivative market participants? Who should enforce
these requirements for various market participants? What are
the key factors that should be considered in setting these
requirements?
A.6. Under current law, the Fed and SEC already have the
ability to impose such a regime. The only lacking is the will
to regulate. The Congress does not need to pass major
legislation. What is required is congressional oversight of the
Executive Branch and, if needed, action to compel the Fed and
Treasury to serve the public interest instead of the narrow
interests of the largest dealer banks. If the Fed and Treasury
are unable or unwilling to take the lead on requiring ``robust
and appropriate regime of prudential supervision and
regulation'' for the large banks that control the OTC markets,
then the Congress should follow my recommendation and strip the
Treasury and Fed of all powers in terms of regulating and
supervising banks and create a new prudential regulator that is
insulated from the partisan politics of Executive Branch
appointments. The biggest problem facing the U.S. today in
terms of financial regulation is the capture of regulators by
the banks which they are supposed to supervise!
Q.7. One concern that some market participants have expressed
is that mandatory margining requirements will drain capital
from firms at a time when capital is already highly
constrained. Is there a risk that mandatory margining will
result in companies choosing not to hedge as much and therefore
have the unintended consequence of increasing risk? How can you
craft margin requirements to avoid this?
A.7. This seems to be a false argument. Dealers lacking capital
to cover their risk should reduce those risk and related
leverage. Why should dealers be able to access markets via OTC
markets and thereby evade the leverage, margin limits and
prudential regulations that have been long-established in
organized markets? The more leverage that is available to
market participants via OTC derivatives, the greater the
systemic risk. Thus it seems that the Congress, if it truly
wishes to limit systemic risk, must conform the margin
requirements in the OTC markets to those prevailing elsewhere
in the U.S. financial markets. To do otherwise is inconsistent
and would seem to undermine the whole purpose of financial
regulation.
Q.8. Is there a risk that regulating the OTC derivatives
markets will dramatically alter the landscape of market
participants or otherwise have unintended consequences we
aren't aware of?
A.8. As I mentioned in my testimony, the chief result of
regulation will be to lessen the supranormal returns earned by
the dealers in the OTC markets and thereby expose the
fundamental lack of profitability in these institutions. If the
Congress has the courage and sense of purpose to reject the
pretense that OTC markets for instruments such as CDS actually
enhance market stability or bank profits on a rick adjusted
basis, then we can return banks to being what they should be--
namely low-risk utilities--and end the threat of systemic risk
one and for all. So long as the Congress refuses to act, then
the most irresponsible and aggressive speculators will continue
to use our banking system to create ever more complex and
opaque securities, and systemic risk will increase and
eventually destroy our economy and our Nation.
------
RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING
FROM CHRISTOPHER WHALEN
Q.1.a. Do you believe the existence of an actively traded cash
market is or should be a necessary condition for the creation
of a derivative under law and regulation?
A.1.a. Yes. As I stated in my prepared remarks, where there is
no underlying cash market that both parties to a derivatives
transaction may observe, then the derivative has no true
economic ``basis'' in the markets, and is entirely speculative.
Where there is no cash market, there is, by definition, no
price discovery. A derivative that is created without the
benefit of an actively traded cash market is essentially a
deception. In the case of credit default swaps and other
``derivatives'' where no actively traded cash market exists,
the dealer pretends that a model can serve as a substitute for
a true cash market basis. But such a pretense on the part of
the dealer is patently unfair and, in my view, is really an act
of securities fraud that should be prohibited as a matter of
law and regulation.
Q.1.b. If not, what specific, objective means besides a cash
basis market could or should be used as the underlying
relationship for a derivative?
A.1.b. See above. To the extent that the Congress is willing to
continue to tolerate speculation in derivatives for which no
cash market basis exists and are instead based upon models,
then the dealers should be compelled to publish these models on
a monthly basis for the entire market to see and assess.
Requiring SEC registration might be another effective solution.
Enhanced disclosure of models for OTC derivatives would likely
lead to a multiplicity of new lawsuits by investors against the
OTC derivatives dealers, thus the effect of compelling the
disclosure of models used to price OTC derivatives would be to
greatly lessen the complexity of these instruments. Think of
this as a ``market based'' solution driven by the trial
lawyers.
Q.2. Why should the models to price OTC derivatives not be
published? If there is no visible cash basis for a derivative,
and the model is effectively the basis, why should the models
not be public?
A.2. See response to 1b.
Q.3. What is the best way to draw the line between legitimate
hedges and purely speculative bets? For example, should we
require an insurable interest for purchasers of credit
protection, require delivery of the reference asset, or
something else?
A.3. Allowing speculators using OTC derivatives to effectively
take positions against securities and companies in which they
have no economic interest is a form of gaming that the Congress
and Federal regulators should reject. The term ``hedge''
implies that the user has an economic position or exposure to a
form of risk. The use of cash settlement OTC contracts by
parties who have no interest in the underlying assets or
company creates perverse incentives that essentially equate an
owner of an asset with the speculator with no economic
interest. The AIG episode illustrates an extreme example of
this problem where AIG was actively using derivatives to engage
in securities fraud, both for itself and others, and apparently
with the full support and knowledge of the OTC dealers.
Allowing speculators to use cash settlement OTC derivatives to
game against real companies and real assets to which they have
no connection creates systemic risk in our financial system and
should be prohibited by law and regulation.
Q.4. Is the concern that increased regulation of derivatives
contracts in the United States will just move the business
overseas a real issue? It seems to me that regulating the
contracts written in the U.S. and allowing American firms to
only buy or sell such regulated contracts would solve the
problem. What else would need to be done?
A.4. No. Those critics who proclaim that regulation of OTC
derivatives such as CDS will force the activity offshore are
mistaken. Where will they take this vile business? London? No.
The EU? No. China? No. Russia? No. Let the proponents of this
market go where they will. The government of the U.S. should
not allow itself to be held hostage by speculators.
The fact is, the U.S. and EU are the only political
jurisdictions in the world that are sufficiently confused as
the true, speculative nature of CDS to allow their financial
institutions to serve as a host for this reckless activity.
Regulating the speculative activities of U.S. banks in the OTC
derivatives markets and banning all OTC derivatives for which
there is no actively traded bash basis market will effectively
solve the problem of systemic risk.
Q.5. In addition to the Administration's proposed changes to
gain on sale accounting for derivatives, what other changes
need to be made to accounting and tax rules to reflect the
actual risks and benefits of derivatives?
A.5. The key change that must be made is to distinguish between
true derivatives, where there is an observable cash market
basis, and pseudo derivatives based upon models such as CDS and
collateralized debt obligations (CDOs) which have no observable
basis and which have caused such horrible damage to the global
financial system. Where there is no active market price for the
underlying relationship upon which the derivative is
``derived,'' then the bank or other counterparty should be
required to reserve 100 percent of the gross exposure of the
position to cover the market, liquidity and counterparty risks
created by these illiquid, difficult to value gaming
instruments. Congress should explicitly forbid ``netting'' of
OTC contracts such as CDS and any other derivative structure
for which there is no cash basis market since there is no
objective, independent way to value these instruments. How can
any financial institution pretend to ``manage'' the risk of a
CDS instrument or CDO when the only objective means of
valuation is a private model maintained by a dealer?
Q.6. Is there any reason standardized derivatives should not be
traded on an exchange?
A.6. No. All derivatives for which there is an active cash
market basis may easily be traded on exchanges. Only those OTC
derivatives for which there is no cash market and thus no price
discovery will not be practical for exchange trading. The
problem here is a basic one since the clearing members of an
exchange are not likely to be willing to interpose their
capital to jointly and severally guarantee a market based on a
CDS model. Unless the clearing members and the customers of a
partnership exchange possess the discipline of a cash market
basis to support and validate valuations, then it is unlikely
that an exchange-based approach will be practical.
Q.7. How do we take away the incentive for credit default swap
holders to force debtors into bankruptcy to trigger a credit
event rather than renegotiate the debt?
A.7. The simple answer is to require that CDS only be held by
those with an economic interest in the debtor that is the
underlying ``basis'' for the derivative. If, as under current
law and regulation, you allow speculators with no economic
interest in a debtor to employ CDS, then all weak banks and
companies may be pushed into insolvency by parties whose sole
interest is their failure. Allowing speculators to use CDS
against debtors in which they have no economic interest
essentially voids the traditional social purpose of the U.S.
bankruptcy laws, namely a) to recover the maximum value for
creditors of the bankruptcy estate in an equal and fair way and
b) to provide a fresh start for the company, which has
historically been seen as a benefit in social terms. The
Congress needs to recall that the requirement imposed in the
18th century by our Nation's founders to establish Federal
bankruptcy courts had both a practical and a social good
component.
Q.8. How do we reduce the disincentive for creditors to perform
strong credit research when they can just buy credit protection
instead?
A.8. You cannot. CDS is essentially a low-cost substitute for
performing actual credit research. As with credit ratings,
investors use CDS to create or adjust exposures based upon
market perception rather than a true analysis of the underlying
value. And best of all, the spreads that are usually reflected
in CDS pricing often are wrong and do not accurately reflect
the true economic cost of default. Thus when speculators employ
CDS to purchase protection against a default, the pricing is
usually well-below the true economic value of the default. Or
to put it another way, AIG was not nearly compensated for the
risks that it took in the CDS markets--even though AIG was an
insurer and arguably should have understood the difference
between short-term ``price'' of an illiquid bond or loan vs.
long-term ``value'' of a default event.
Q.9. Do net sellers of credit protection carry that exposure on
their balance sheet as an asset? If not, why shouldn't they?
A.9. The treatment of CDS varies by country. All CDS positions,
long or short, should be reflected as a contingent liability or
asset, and carried on balance sheet in the appropriate way. The
treatment used in the insurance industry for such obligations
may be the best model for the Congress to consider as a point
of departure for any legislation.
Q.10. In her testimony Chairman Schapiro mentioned synthetic
exposure. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.10. Yes, it is another form of leverage and Chairman Schapiro
addressed this issue directly. When a user of CDS creates the
equivalent of a cash market position in a listed security, then
that position should be reported to the SEC and disclosed to
the marketplace. Allowing speculators to synthetically create
the functional equivalent of a cash market position using CDS
arguably is a violation of existing law and regulation. Why
should an investor be required, for example, to disclose a
conventional option to purchase listed shares but not the
economic equivalent in CDS? This dichotomy only illustrates the
true purpose of CDS, namely to evade established prudential
norms and regulation.
Q.11. Regarding synthetic exposure, if there is greater demand
for an asset than there are available assets, why shouldn't the
economic benefit of that demand--higher value--flow to the
creators or owners of that asset instead of allowing a dealer
to create and profit from a synthetic version of that asset?
A.11. Agreed. One of the pernicious and truly hideous effects
of OTC instruments such as CDS is that they equate true
``owners'' of assets with speculators who create ersatz
positions in these assets via derivatives; that is, they
``rent'' the asset with no accountability to the owner. It
could be argued that such activity amounts to an act of
thievery and one that is encouraged by Federal bank regulators,
particularly the academic economists who dominate the Fed's
Board of Governors! Since the users of cash-settlement OTC
contracts never have to deliver the underlying reference assets
to the buyer, there is no economic connection between the real
asset and the OTC derivative. Again, to repeat, this activity
is best described as gaming, not risk management.
Q.12. One of the arguments for credit default swaps is that
they are more liquid than the reference asset. That may well be
true, but if there is greater demand for exposure to the asset
than there is supply, and synthetic exposure was not allowed,
why wouldn't that demand lead to a greater supply and thus more
liquidity?
A.12. Arguments that CDS are more liquid that the reference
assets are disingenuous and stand the world on its head. As
above, why allow a derivative at all when there is no cash
reference market? Allowing speculators to create a short market
in an illiquid corporate bond, for example, via single-name CDS
does not improve price discovery in the underlying asset since
there is no market in the first place. And since the
``players'' in this ersatz market are required to neither
borrow nor deliver the underlying reference asset, the entire
exercise is pointless in terms of price discovery. The only
purpose is to allow the large dealer banks to extract
supranormal returns and increase systemic risk. Again, it is
just as easy to speculate on the outcome of a horse race as on
the price of a CDS since there is no mechanistic connection
between the wager and the actual reference ``asset'' or event.
Q.13. Is there any justification for allowing more credit
protection to be sold on a reference asset than the value of
the asset?
A.13. No. See reply to Question 12.
Q.14. Besides the level of regulation and trading on an
exchange, there seems to be little difference in swaps and
futures. What is the need for both? In other words, what can
swaps do that forward contracts cannot?
A.14. A swap and futures/options are functionally equivalent.
The OTC swaps for oil or interest rates can be and are actively
traded against the corresponding exchange traded products
because they share a common cash market basis. The advantage of
OTC contracts is that they allow for customization regarding
size and time periods for the counterparties. There is nothing
inherently wrong with maintaining these two markets, exchange
traded and OTC, side by side, so long as a cash market basis
for both exists and is equally visible to the buyer and the
seller. Only when the cash market basis is obscured or
nonexistent does systemic risk increase because (a) the pricing
is entirely speculative and thus subject to sudden changes in
liquidity, and (b) cash settlement of OTC contracts such as CDS
allows the risk inherent due to the lack of true price
discovery to expand infinitely.
Q.15. One of the arguments for keeping over-the-counter
derivatives is the need for customization. What are specific
examples of terms that need to be customized because there are
no adequate substitutes in the standardized market? Also, what
are the actual increased costs of buying those standard
contracts?
A.15. The spreads on OTC contracts generally are wider than
exchange traded instruments, a difference that illustrates the
inefficiency of OTC markets vs. exchange traded markets. That
said, the ability to specify size and duration of these
instruments is valuable to end users and the Congress should
allow the more sophisticated private participants in the
markets to make that choice. For example, if a large energy
company or airline wants to enter into a swap to hedge fuel
sales or costs, respectively, in a way the exchange traded
contracts will not, then the user of derivatives ought to have
that choice to employ the OTC instruments. Again, OTC markets
in and of themselves are not problematic and do not create
systemic risk.
Q.16. There seems to be agreement that all derivatives trades
need to be reported to someone. Who should the trades be
reported to, and what information should be reported? And is
there any information that should not be made available to the
public?
A.16. All open positions in OTC derivatives above a certain
percentage of the outstanding contracts in any market should be
(a) reported to the CFTC, and (b) publicly disclosed in
aggregate form. Such disclosure would greatly enhance market
efficiency, but it does not mitigate the concerns regarding CDS
and other contracts for which there is no liquid, actively
traded cash basis market. No amount of disclosure can address
that basic flaw in the CDS and other markets which lack a cash
basis.
Q.17. What is insufficient about the clearinghouse proposed by
the dealers and New York Fed?
A.17. The proposed clearinghouse is entirely controlled by the
dealer banks. As we wrote in The Institutional Risk Analyst in
May of this year:
In 2005, the New York Fed began to fear that the OTC
derivatives market, at that time with a notional value of over
$400 trillion dollars, was a sloppy mess--and it was.
Encouraged by the Congress and regulators in Washington, the
OTC market was a threat to the solvency of the entire global
financial system--and supervisory personnel in the field and
the Fed and other agencies had been raising the issue for
years--all to no effect. This is part of the reason why we
recommended to the Senate Banking Committee earlier this year
that the Fed be completely relieved of responsibility for
supervising banks and other financial institutions.
Parties were not properly documenting trades and collateral
practices were ad hoc, for example. To address these problems,
the Fed of New York began working with 11 of the largest dealer
firms, including Bear Stearns, Merrill Lynch, Lehman, C, JPM,
Credit Suisse, and [Goldman Sachs]. Among the ``solutions''
arrived at by these talks was the creation of a clearinghouse
to reduce counterparty credit risk and serve as the
intermediary to every trade. The fact that such mechanism
already existed in the regulated, public markets and exchanges
did not prevent the Fed and OTC dealers from leading a
multiyear effort to study the problem further--again, dragging
their collective feet to maximize the earnings made from the
existing OTC market before the inevitable regulatory clampdown.
For example, in the futures markets, a buyer and seller
agreeing to a transaction will submit it to a clearing member,
which forwards it to the clearinghouse. As the sell-side
counterparty to the buyer and the buy-side counterparty to the
seller, the clearinghouse assumes the risk that a party to the
transaction might fail to pay on its obligations. It can do
this because it is fully regulated and by well capitalized. As
the Chicago Mercantile Exchange is fond of saying, in 110 years
no futures clearinghouse has ever defaulted.
While the NY Fed believed that a central counterparty was
necessary to reduce risks that a major OTC dealer firm might
default, the banks firmly resisted the notion. After all, they
make billions of dollars each year on the cash and securities
which they required their hedge fund, pension fund and other
swap counterparties to put up as collateral. Repledging or
loaning these customer securities to other clients is very
lucrative for the dealers and losing control over the clients
collateral would dramatically impact large bank profits.
A clearinghouse would eliminate the need for counterparties
to post collateral and a lucrative source of revenue for the
dealer firms. So they bought the Clearing Corporation, an
inactive company that had been the clearinghouse for the
Chicago Board of Trade. If they had to clear their trades, the
dealer firms reasoned, at least they would find a way to profit
by controlling the new clearing firm. Such is the logic of the
GSE mindset.
Meanwhile, other viable candidates for OTC derivatives
clearing were eager to get into the business, such as the
Chicago Mercantile Exchange and the New York Stock Exchange.
Both had over 200 years experience in clearing trades and were
well suited to serve as the impartial central counterparty to
the banks and their customers.
If the NYSE and CME were to trade derivatives, the big
banks knew they would not be able to control their fees or
capture the profits from clearing. Therefore, they sold The
Clearing Corp. to the Intercontinental Exchange, or ICE, a
recent start-up in the OTC derivatives business which had been
funded with money originally provided by, you guessed it, the
banks. In the deal with ICE, the banks receive half the profit
of all trades cleared through the company. And the large OTC
dealer banks made sure, through their connections with
officials at the Fed and Treasury, that ICE was the winner
chosen over the NYSE and CME offerings. That's right, we hear
that Tim Geithner personally intervened to make sure that ICE
won over the NYSE and CME clearing units. \1\
---------------------------------------------------------------------------
\1\ See ``Kabuki on the Potomac: Reforming Credit Default Swaps
and OTC Derivatives'', The Institutional Risk Analyst, May 18, 2009.
Q.18. How do we prevent a clearinghouse or exchange from being
---------------------------------------------------------------------------
too big to fail? And should they have access to Fed borrowing?
A.18. Limit trading in OTC derivatives by (a) requiring sellers
to deliver the basis of the derivative upon expiration of the
contract and (b) ban those derivatives for which there is no
actively traded cash basis market. If such reforms are enacted,
there should be no need for the Fed to ever support a
multilateral exchange or clearinghouse.
Q.19. What price discovery information do credit default swaps
provide, when the market is functioning properly, that cannot
be found somewhere else?
A.19. None. The argument that a derivative can aid in price
discovery for an illiquid cash basis is circular and
ridiculous. Trading in CDS is merely gaming between the parties
vs. current market prices. As mentioned above, most single name
CDS trade against the short-term yields/prices of the supposed
basis, thus these contracts arguably do not provide any price
discovery vs. the true cost of insuring against default. For
example, the day before Lehman Brothers filed bankruptcy, the
CDS was trading at roughly 700bp over the Treasury yield curve
or roughly 7 percent per year (plus upfront fees totaling
another couple of percentage points) to insure against default.
Yet when Lehman filed for bankruptcy, the resulting default
required the payment of 9,700bp to the buyers of protection or
par less the 3 percent recovery rate determined by the ISDA
auction process. Clearly, receiving 7 percent and having to pay
97 percent is not an indication of effective price discovery!
The sad fact is that many (but by no means all) users of CDS
employ these instruments to trade or hedge current market
exposures, not to correctly price the cost of default
insurance.
Q.20. Selling credit default swaps is often said to be the same
as being long in bonds. However, when buying bonds, you have to
provide real capital up front and there is a limit to the
lending. So it sounds like selling swaps may be a bet in the
same direction as buying bonds, but is essentially a highly
leveraged bet. Is that the case, and if so, should it be
treated that way for accounting purposes?
A.20. That is correct. In order to sell a bond short, the
seller must be able to borrow the collateral and deliver same.
In CDS, since there is no obligation to deliver the underlying
basis for the contract, the leverage is far higher and, more
important, there is no real connection between the price
discovery in the cash market and the CDS. While services such
as Bloomberg and others use cash market yields to estimate what
they believe the valuation of CDS should be, there is no
objective confirmation of this in the marketplace. The buyers
of CDS protection should be required to deliver the underlying
instrument in order to collect on the insurance. Indeed, this
was the rule in the OTC market until the after the bankruptcy
of Delphi Corporation. \2\ At a minimum, the Congress should
compel ISDA to roll-back the template for CDS contracts to the
pre-Delphi configuration and require that buyers of protection
deliver the underlying basis.
---------------------------------------------------------------------------
\2\ See Boberski, David, ``CDS Delivery Option: Better Pricing of
Credit Default Swaps'', Bloomberg Books (2009), Pages 101-104.
Q.21. Why should we have two regulators of derivatives, with
two interpretations of the laws and regulations? Doesn't that
---------------------------------------------------------------------------
just lead to regulation shopping and avoidance?
A.21. Yes, in terms of efficiency, we should not have two
regulators of derivatives, but the purpose of the involvement
by the two agencies is not identical. When a derivative results
in the creation of the economic equivalent of a listed
security, then investors must be given notice via SEC
disclosure. It should be possible for CFTC to exercise primary
regulatory oversight of these markets while preserving the role
of the SEC in enforcing the legal duty to disclose events that
are material to investors in listed securities.
Q.22. Why is synthetic exposure through derivatives a good
idea? Isn't that just another form of leverage?
A.22. Yes, it is another form of leverage against real assets.
Like any form of leverage, it must be disclosed and subject to
adequate prudential safeguards such as collateral and
disclosure.
Q.23. What is good about the Administration proposal?
A.23. At least we are now talking about some of the important
issues, but the Administration proposal essentially mirrors the
position of the large banks and should not be taken as
objective advice by the Congress.
Q.24. Mr. Whalen, you suggest making all derivatives subject to
the Commodity Exchange Act. The SEC says some derivatives
should be treated like securities. Is that an acceptable
option?
A.24. See response to Question 21.
Q.25. Is there anything else you would like to say for the
record?
A.25. To repeat my earlier testimony, the supranormal returns
paid to the dealers in the CDS market is a tax. Like most State
lotteries, the deliberate inefficiency of the CDS market is a
dedicated subsidy meant to benefit one class of financial
institutions, namely the large dealer banks, at the expense of
other market participants. Every investor in the markets pay
the CDS tax via wider spreads and the taxpayers in the
industrial nations pay due to periodic losses to the system
caused by the AIGs of the world. And for every large, overt
failure like AIG, there are dozens of lesser losses from OTC
derivatives buried by the professional managers of funds and
financial institutions in the same way that gamblers hide their
bad bets. How does the continuance of this market serve the
public interest?
Additional Material Supplied for the Record