[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




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            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\
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     \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.
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     * Copyright 2009 by Henry T. C. Hu. All rights reserved.
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    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''].
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    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.
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     \1\ http://www.dtcc.com/news/newsletters/dtcc/2009/mar/
tiw_press_briefing.
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                                ------                                


       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



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