[Senate Hearing 111-802]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 111-802
 
                      OVER THE COUNTER DERIVATIVES
                  REFORM AND ADDRESSING SYSTEMIC RISK

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

                                HEARING

                               before the

                       COMMITTEE ON AGRICULTURE,
                        NUTRITION, AND FORESTRY

                          UNITED STATES SENATE


                     ONE HUNDRED ELEVENTH CONGRESS

                             FIRST SESSION


                               __________

                            DECEMBER 2, 2009

                               __________

                       Printed for the use of the
           Committee on Agriculture, Nutrition, and Forestry


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



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           COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY



                 BLANCHE L. LINCOLN, Arkansas, Chairman

PATRICK J. LEAHY, Vermont            SAXBY CHAMBLISS, Georgia
TOM HARKIN, Iowa                     RICHARD G. LUGAR, Indiana
KENT CONRAD, North Dakota            THAD COCHRAN, Mississippi
MAX BAUCUS, Montana                  MITCH MCCONNELL, Kentucky
DEBBIE STABENOW, Michigan            PAT ROBERTS, Kansas
E. BENJAMIN NELSON, Nebraska         MIKE JOHANNS, Nebraska
SHERROD BROWN, Ohio                  CHARLES GRASSLEY, Iowa
ROBERT CASEY, Jr., Pennsylvania      JOHN THUNE, South Dakota
AMY KLOBUCHAR, Minnesota             JOHN CORNYN, Texas
MICHAEL BENNET, Colorado
KIRSTEN GILLIBRAND, New York

               Robert Holifield, Majority Staff Director

                    Jessica L. Williams, Chief Clerk

            Martha Scott Poindexter, Minority Staff Director

                Anne C. Hazlett, Minority Chief Counsel

                                  (ii)

  
                            C O N T E N T S

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                                                                   Page

Hearing(s):

Over the Counter Derivatives Reform and Addressing Systemic Risk.     1

                              ----------                              

                      Wednesday, December 2, 2009
                    STATEMENTS PRESENTED BY SENATORS

Lincoln, Hon. Blanche L., U.S. Senator from the State of 
  Arkansas, Chairman, Committee on Agriculture, Nutrition, and 
  Forestry.......................................................     1
Chambliss, Hon. Saxby, U.S. Senator from the State of Georgia....     3

                                Panel I

Geithner, Hon. Timothy, Secretary, U.S. Department of The 
  Treasury, Washington DC........................................     5

                                Panel II

Axilrod, Peter, Managing Director, The Depository Trust & 
  Clearing Organization (DTCC), New York, New York...............    35
Duffy, Terrence, Executive Chairman, CME Group, Chicago, Illinois    31
Masters, Blythe, Managing Director and Head of Global Commodities 
  Group, JpMorgan Chase & Co., New York, New York................    36
Okochi, Jiro, Chief Executive officer, Reval.Com, Inc., New York, 
  New York.......................................................    39
Short, Johnathan, Senior Vice President, General Counsel, and 
  Corporate Secretary, IntercontinentalExchange (ICE), Atlanta, 
  Georgia........................................................    33
                              ----------                              

                                APPENDIX

Prepared Statements:
    Brown, Hon. Sherrod..........................................    54
    Axilrod, Peter (with attachments)............................    55
    Duffy, Terrence..............................................    72
    Geithner, Hon. Timothy.......................................    91
    Masters, Blythe..............................................    97
    Okochi, Jiro.................................................   102
    Short, Johnathan.............................................   107
Document(s) Submitted for the Record:
Grassley, Hon. Charles:
    ``The Beautiful Machine'', article, The Washington Post, 
      December 29, 2008..........................................   116
    ``A Crack in The System'', article, The Washington Post, 
      December 30, 2008..........................................   127
    ``Downgrades And Downfall'', article, The Washington Post, 
      December 31, 2008..........................................   139
Question and Answer:
Lincoln, Hon. Blanche L.:
    Written questions for Peter Axilrod..........................   152
    Written questions for Terrence Duffy.........................   153
    Written questions for Hon. Timothy Geithner..................   154
    Written questions for Blythe Masters.........................   158
    Written questions for Jiro Okochi............................   159
Stabenow, Hon. Debbie:
    Written questions for Hon. Timothy Geithner..................   155
Brown, Hon. Sherrod:
    Written questions for Hon. Timothy Geithner..................   156
Roberts, Hon. Pat:
    Written questions for Hon. Timothy Geithner..................   156
Grassley, Hon. Chuck:
    Written questions for Hon. Timothy Geithner..................   156
    Written questions for Blythe Masters.........................   158
    Written questions for Johnathan Short........................   160
Axilrod, Peter:
    Written response to questions from Hon. Blanche L. Lincoln...   161
Duffy, Terrence:
    Written response to questions from Hon. Blanche L. Lincoln...   165
    Additional response to questions posed by Hon. Kirsten E. 
      Gillibrand.................................................   173
    Additional response to questions posed by Hon. Gary Gensler..   175
Geithner, Hon. Timothy:
    Written response to questions from Hon. Blanche L. Lincoln...   178
    Written response to questions from Hon. Debbie Stabenow......   181
    Written response to questions from Hon. Sherrod Brown........   182
    Written response to questions from Hon. Pat Roberts..........   184
    Written response to questions from Hon. Chuck Grassley.......   185
Masters, Blythe:
    Written response to questions from Hon. Blanche L. Lincoln...   198
    Written response to questions from Hon. Chuck Grassley.......   199
Okochi, Jiro:
    Written response to questions from Hon. Blanche L. Lincoln...   201
Short, Johnathan:
    Written response to questions from Hon. Chuck Grassley.......   204



                      OVER THE COUNTER DERIVATIVES
                  REFORM AND ADDRESSING SYSTEMIC RISK

                              ----------                              


                      Wednesday, December 2, 2009

                              United States Senate,
         Committee on Agriculture, Nutrition, and Forestry,
                                                     Washington, DC
    The Committee met, pursuant to notice, at 9:35 a.m., in 
room SH-216, Hart Senate Office Building, Hon. Blanche L. 
Lincoln, Chairman of the Committee, presiding.
    Present: Senators Lincoln, Harkin, Conrad, Stabenow, 
Nelson, Brown, Klobuchar, Bennet, Gillibrand, Chambliss, Lugar, 
Cochran, Johanns, Grassley, and Thune.

  STATEMENT OF HON. BLANCHE L. LINCOLN, U.S. SENATOR FROM THE 
    STATE OF ARKANSAS, CHAIRMAN, COMMITTEE ON AGRICULTURE, 
                    NUTRITION, AND FORESTRY

    Chairman Lincoln. The Senate Committee on Agriculture, 
Nutrition, and Forestry will now come to order.
    As always, I want to add a special thanks to Senator 
Chambliss and all of my colleagues on the Committee for coming 
together once again in the space of 2 weeks to address issues 
of financial market regulatory reform. The timing of this 
hearing is indicative of the high priority that I and others 
place on the matters that we are going to address today, and it 
also is reflective of what I perceive as the need to resolve 
these issues as promptly as possible.
    I welcome Secretary Geithner and our other panelists, and l 
look forward to hearing all of your testimonies this morning.
    Since the financial crisis last fall, I have spent a 
considerable amount of time talking to folks in Arkansas and I 
have heard from people from all walks of life about how the 
economic downturn has impacted them. I have talked with farmers 
and small business owners, wage earners, people from the city 
and the country, single parents, people who have lost their 
jobs and are looking for work, and people who still have their 
jobs but who have been stung by the rising prices of 
commodities and have had to make choices about putting food on 
the table or gas in their tank.
    What I took away from all of these conversations was that 
business as usual is simply not acceptable anymore. People are 
hurting, and we need to find answers. We also have got to 
rebuild the confidence of the American people and the investors 
out there who are our constituents.
    The financial crisis has struck at the very fiber of our 
national identity. We are not a Nation of spendthrifts or 
fraudsters or sharp dealers. We did not build our reputation as 
the premier leader in global financial markets by cutting 
corners, engaging in risky behaviors, or developing business 
strategies that are intended in large part to avoid the 
positive restraints of regulatory oversight. That is not, to 
put it simply, the American way.
    Yet somehow, somewhere along the way, we lost our compass. 
In the name of financial innovation and rampant deregulation, 
we lost sight of the clear, certain path of hard work, honesty, 
and faith, as well as fair dealing upon which this Nation and 
our national character was built. At some point, we were pulled 
off track by the lure of too-good-to-be-true financial schemes 
and scams and the myth of too-big-to-fail financial behemoths.
    We are all well aware of where this approach has gotten us. 
I believe it is time that we return to those fundamental 
characteristics of our true national identity of hard work, 
honesty, and fair dealing and look to them as guideposts as we 
go about building a new architecture for financial market 
regulatory reform in this country.
    As I see it, our problems with the financial market 
meltdown of last fall stemmed primarily from two problems: 
inadequate Federal oversight of significant sectors of our 
financial system, particularly our OTC derivatives trading, 
combined with a failure to use existing authorities to their 
fullest extent. We now have the responsibility to ensure that 
market regulators have all the tools that they need and to 
charge them with the mandate to use these tools.
    Let me reiterate comments I have made previously. I am not 
about stifling market growth, market innovation, or legitimate 
business activity in any way, shape, or form. Nor do I have any 
interest in shipping this important economic engine overseas. I 
have the greatest respect for the financial market engineers 
and participants who work in and utilize the Nation's 
commodities and securities markets.
    That being said, I want to be very clear that a certain 
amount of market reengineering will be in order as a result of 
changes in financial market oversight. To address systemic risk 
and ensure fully transparent markets, we will have to speak to 
issues relating to the scope of mandatory clearing, the 
definition of ``standardization,'' segregation of collateral, 
open access, enhanced capital and margin requirements, 
resolution authority, and conflicts of interest, just to name a 
few.
    Some of the legislative solutions to these matters will and 
should result in certain changes in the way business is done. 
We need to expect that. The way we were doing business before 
took us to the edge of the cliff. Now we need to find a better 
way to oversee these markets so that does not happen again--to 
us, to our children, or to our grandchildren.
    Let me also be clear on one last point, and I want to hear 
from every interested party on this issue. I have talked 
extensively about banks and hedge funds, indexers, energy 
companies, utilities, exchanges, clearing organizations and 
agencies, and all manner of commodity market participants. 
Their input is vital to this process. In addition, I am working 
with my colleagues in Congress, particularly here on this 
Committee, and my friend and colleague Senator Chambliss, as 
well as with regulators at the Fed, the Treasury, the SEC, and 
the CFTC to ensure that we are coordinating these complex 
issues as we should.
    We need to remember our overarching goal, which is 
increasing transparency and accountability in the Nation's 
financial markets. We must be mindful as we move forward with 
this new architecture not to create duplicative or unnecessary 
levels of prudential regulation. We need to strengthen our 
financial market oversight bodies--the SEC and the CFTC--to 
give them needed authority over currently opaque OTC markets, 
and we need to find the right balance of powers between Federal 
financial oversight authorities to ensure that both markets and 
regulators operate efficiently.
    Senator Chambliss and I will be working together to produce 
comprehensive legislation on this issue, and we will coordinate 
with our colleagues on the Senate Banking Committee in the 
context of the larger regulatory reform legislation as we 
address issues that affect matters within the jurisdiction of 
the Agriculture Committee.
    In the end, there will be no doubt in anyone's mind that 
all have had a fair opportunity to be heard. I recognize that 
is a tall order, but we will all get there. As a wise man once 
said, in matters of great importance such as this, failure is 
not an option.
    Our timetable is aggressive because, as I have noted, there 
is an urgency to act. The American people need and deserve 
financial market regulatory reform. We need to ensure that we 
have the most open, honest, and efficient markets in the world, 
and we are going to settle for nothing less.
    The scope of our hearing today focuses on systemic risk, 
particularly on clearing issues and concerns related to 
clearing. I look forward to hearing from our witnesses as they 
present their particular points of view and expertise on these 
matters, and I thank all of you for your participation today, 
both our witnesses as well as my colleagues here in the 
Committee.
    Now I will turn to my colleague Senator Chambliss.

STATEMENT OF HON. SAXBY CHAMBLISS, U.S. SENATOR FROM THE STATE 
                           OF GEORGIA

    Senator Chambliss. Thank you very much, Madam Chairman, and 
with all the critical issues that are swirling around Capitol 
Hill today, I think it is safe to say that there is no more 
important issue than the one that we are going to be 
addressing. Because of the collapse of the financial markets 
last year, it is imperative that we take the right kind of 
action--which I emphasize ``the right kind''--to make sure that 
we put tools in the hands of our regulators to allow them to be 
able to do the job of making sure that what did happen last 
year simply does not happen again. You have provided the right 
kind of leadership in making sure that this Committee gets all 
the facts that we need to try to come up with the right 
solution.
    Secretary Geithner, it is not often that the Secretary of 
the Treasury is called before the Ag Committee, but you have 
played an integral role thus far in dealing with this issue 
from a reform standpoint, and from a personal perspective, I 
appreciate the dialogue that we have had over the last several 
months, and we appreciate your expertise and participation in 
the development of the proposed legislation.
    It is imperative in my mind that the Senate Ag Committee 
should be engaged in the development of any legislation 
addressing financial regulation and, more specifically, 
derivatives. This Committee has a responsibility to ensure that 
the CFTC continues to effectively carry out its duties, 
including any new authorities and responsibilities Congress 
requires in the proposed financial regulatory reform 
legislation.
    To that end, the Department of Treasury recognized the 
important role of the CFTC in the proposal they submitted to 
Congress last August. I look forward to hearing from Secretary 
Geithner today as to how exactly he envisions applying these 
new authorities.
    In our last hearing, we heard from a number of entities 
that use derivatives to manage risks in their everyday course 
of business. They were somewhat critical of Treasury's proposal 
requiring them to clear standardized transactions, and, Mr. 
Secretary, you and I have talked about that as recently as 
yesterday, and as I told you, we want to have a dialogue on 
that this morning.
    Many end users have told me that this would add 
considerable costs that would likely be passed along to 
consumers or perhaps prevent their businesses from using swaps 
as a risk management tool altogether. These same entities were 
supportive of changes in increased transparency for the public, 
which is certainly our number one goal. They seemed perfectly 
willing to endure any additional administrative burden that may 
be presented by such reporting and recordkeeping.
    Clearly, the recent past has taught us that the regulator 
needs more data in order to view and police the entire 
marketplace. But I am not sure the lesson of the recent market 
meltdown warrants increased cost to businesses that had little, 
if anything, to do with creating this situation.
    It is my hope today that we will hear Secretary Geithner's 
rationale for requiring clearing of standardized swaps as well 
as how he envisions making the market more transparent. I am 
pleased that we will have an opportunity also to hear from a 
group of witnesses that help facilitate and service derivative 
trading, both on-exchange as well as over-the-counter 
transactions.
    It is essential that we understand how all of you will 
respond to any changes Congress makes to the regulation of 
these markets. The last thing we want to do is lessen access to 
risk management or facilitators of the necessary tools.
    Again, Madam Chairman, thank you for holding this hearing. 
The Senate and, more specifically, the Ag Committee and the 
Banking Committee have a difficult job to do. We have to weigh 
the merits of all competing viewpoints on a very complex matter 
and develop a solution that will allow risk management to 
continue while at the same time ensuring that our regulators 
have the authorities needed to police these markets for abuses.
    I look forward to the testimony this morning.
    Chairman Lincoln. Thank you, Senator Chambliss. Welcome, 
Secretary Geithner.
    For those who do not know, Treasury Secretary Timothy 
Geithner has a vast experience in the public sector. He first 
joined the Treasury Department in 1988, eventually leaving to 
spend some time as an attache at the U.S. Embassy in Tokyo, and 
during the Clinton years, he went back to the Treasury to focus 
on international affairs. In October of 2003, he was appointed 
President of the Federal Reserve Bank of New York at only 42 
years of age--no small feat. President Obama appointed him 
Secretary of the U.S. Treasury in January of this year, and he 
has played a key role in developing the administration's 
financial reform proposal.
    Secretary Geithner, thank you very much for appearing 
before the Committee today, and we welcome your testimony as 
well as your help and cooperation as we move forward.

STATEMENT OF HON. TIMOTHY GEITHNER, SECRETARY, U.S. DEPARTMENT 
                OF THE TREASURY, WASHINGTON, DC

    Secretary Geithner. Thank you, Chairman Lincoln, Ranking 
Member Chambliss, and members of the Committee. Thanks for 
giving me the chance to come before you today. I am going to 
focus my remarks today on a critical component of comprehensive 
financial reform, which is the challenge in designing a 
framework of oversight for the derivatives markets.
    This is a $600 trillion market. These markets grew up 
largely on the financial frontier, without the basic 
protections and oversight that existed in much of the rest of 
the financial system. Market participants were in many ways 
allowed to set their own rules. The SEC and the CFTC had 
limited ability to police fraud and manipulation. Firms were 
able to write massive amounts of credit protection without 
capital to back up those commitments, making huge bets they 
were unable to cover when the recession hit. These markets 
operated largely in the dark, with little or no transparency.
    Now, these problems did not cause the crisis, but they made 
the crisis much more severe, much harder to manage.
    Now, in designing a set of reforms to these markets, we 
have attempted to achieve three broad objectives. The first is 
to prevent these markets from posing risk to the stability of 
the financial system. The second is to bring transparency to 
these markets. The third is to prevent manipulation, fraud, and 
other abuses, with greater protections for consumers and 
investors.
    Now, the legislation we have proposed provides a 
comprehensive approach, and any effective reform has to include 
the following key elements. I want to list these briefly.
    First, we need to require standardized derivatives to be 
cleared through well-regulated clearinghouses. Exceptions for 
customized derivatives should be carefully limited, with 
protections against evasion and with higher capital and margin 
requirements reflecting the greater risk.
    Second, all OTC derivatives dealers and other major market 
participants need to be subject to tough prudential supervision 
and regulation, including conservative capital requirements. 
This is necessary to ensure that these major market 
participants have the resources they need to back up the 
commitments they make.
    Third, these derivatives markets need to be made fully 
transparent. Standardized derivatives should be essentially 
cleared and traded on exchanges or on appropriate alternative 
trading facilities. Derivatives that cannot be centrally 
cleared should be reported to a regulated trade repository on a 
timely basis so that supervisors and regulators have access to 
the information they need to do their jobs.
    The fourth key element, the CFTC and the SEC need to have 
strong authority to police fraud, manipulation, and other 
abuses.
    Now, it is very important to recognize that any effective 
framework for U.S. markets requires a level playing field 
internationally, so we are working very hard with our 
international counterparts to help ensure that a comprehensive 
regime in place in the U.S. is matched by similarly tough 
standards in other countries.
    I want to emphasize also that these changes are 
prospective. We need to preserve legal certainty around the 
hundreds of thousands of contracts that now exist in this $600 
trillion market.
    Now, these reforms, if enacted, will force very 
consequential changes in these markets, so it is no surprise 
that you are going to hear some market participants fighting to 
weaken these reforms. They will work to create loopholes that 
will help or enable them to evade these basic protections, and 
I hope you will resist these pressures.
    I believe, though, that because of the work of you and your 
colleagues, work underway in the Banking Committee, in the 
House Committee on Agriculture, and in the House Financial 
Services Committee, we now can see--we see in prospect, I 
think, a very good chance of a comprehensive set of sweeping 
reforms of these markets for the first time ever. I think we 
have the chance of creating more transparent, more fair, more 
stable markets, and I look forward to working with you in 
support of that objective in the coming weeks.
    I just want to close by emphasizing, Chairman, what you 
have said. We have seen a catastrophic loss of basic faith and 
confidence in our financial system. It caused enormous damage 
to our credibility internationally and to the confidence of 
Americans in the basic fairness and justice of our system. It 
is very important that we move quickly to fix what was broken 
in our system.
    We have a lot at stake. Much of what is good in the U.S. 
economy, much of what makes us still among the most resilient, 
most productive economies in the world, is that we had a 
financial system that was remarkably good at taking the savings 
of Americans and matching them to the ideas of someone who 
wanted to build a growing company and made it possible for 
firms to innovate and compete, to hedge complicated risks. We 
were in many ways among the best in the world at doing that. 
But we have systematic failures in our system of regulation, 
and we have to work very hard to fix those. We have a huge 
obligation to do that, and I think we need to do it quickly.
    I do not think time is with us. I think the longer we wait, 
the harder it is going to be. The forces who will always fight 
reform will have better capacity to fight it because the memory 
of the damage caused will fade. So we need to do this 
carefully, and it is a complicated challenge, but I think we 
need to move to try to get it done.
    [The prepared statement of Mr. Geithner can be found on 
page 91 in the appendix.]
    Chairman Lincoln. Thank you, Mr. Secretary. I would 
certainly reiterate those concerns that you have mentioned. I 
think last year the American taxpayers propped up the global 
economy and footed the bill for Wall Street's poor choices and 
the failure of Government oversight. But they still have not 
gotten the regulatory reform, and I have to tell you, it has 
not faded--not in States like Arkansas, where people have a 
real sense of how difficult this economy is. I would just say 
to you that your leadership is pivotal in helping us fix this 
problem, and as we move through legislation in this Committee, 
I would just ask that you work with us together so we can pass 
some strong financial regulatory reform and make sure that we 
can get our markets back in action and certainly our people 
back to work. I think that is going to be really important.
    With that said, I just have a few specific questions about 
the administration's reform proposal.
    With regard specifically to the foreign exchange 
transactions in the CFTC, the CFTC has commented that it has 
serious concerns about the exclusion for the foreign exchange 
swaps or the foreign exchange forwards in the administration's 
proposal, and that those exclusions will simply be used to 
evade regulation.
    Frankly, given how we have seen sharp operators in 
derivative markets use just this kind of loophole to get around 
Federal regulation, I can certainly understand their concern.
    I would like for you to try and explain why we should not 
close this loophole and simply limit or more narrowly tailor 
the exclusion.
    Secretary Geithner. Well, a very important issue, and you 
have made the central key point, which is that there are 
aspects of these markets where, for very important reasons, we 
are going to have to have a slightly different approach. But 
the important thing is not to allow those carefully crafted 
exceptions to undermine the basic protections, to be exploited, 
to undermine, to become the device for evading those 
protections. That is the core thing. I am confident we will 
work this out and come to a place where the CFTC and the Fed 
and the Treasury together believe we have found the right 
balance. We are not quite there yet, but we will get there.
    The FX markets are different from these, and they are not 
really derivatives in this sense, and they do not present the 
same set of risks, and there is an elaborate framework in place 
already, put in place starting 20 years ago, to limit 
settlement risk and the other sets of risk that occur. These 
markets have actually worked quite well.
    So, like in anything, we have got a basic obligation to do 
no harm, to make sure as we reform we do not make things worse, 
and our judgment is that because of the protections that 
already exist in these foreign exchange markets and because 
they are different from derivatives, have different risks, 
require different solutions, we will have to have a slightly 
different approach. But the basic commitment I will make to you 
is that we are not going to allow, we would not support 
exceptions that would allow the potential to evade the basic 
protections we have put in place for the rest of the market as 
a whole. Again, we are working very closely with Gary Gensler. 
He is doing an excellent job in this area, and I am confident 
that Treasury, the Fed, and the SEC will work through this 
problem. We will try to come to you sooner with a solution that 
meets all of our interests.
    Chairman Lincoln. Well, maintaining loopholes is definitely 
not the objective we want here, and I think we look forward to 
working with you.
    In the context of the broader regulatory reform proposals, 
specifically looking at Title II with regard to the financial 
holding companies, and then also Title VIII, with regard to 
payment clearing and settlement supervision, I have questions 
about the terms such as ``the systemically relevant 
institutions.'' Is it the intent that entities such as CME and 
the New York Stock Exchange, certainly systemically relevant 
institutions, be covered under these titles? If so, 
particularly with regard to the reach of Title VIII, isn't 
there an issue of duplicative prudential regulation? I mean, 
the CME and the New York Stock Exchange already have prudential 
regulators that oversee their clearinghouses. Do you intend 
that the Feds take the place of those regulators?
    Secretary Geithner. A very important issue and thanks for 
giving me a chance to clarify. Let me describe the basic 
objective.
    There are a set of institutions in our markets that today 
and in the future will pose unique risks to the stability of 
the system. We need to make sure that those institutions--these 
are banks, investment banks, and a limited number of other 
types of entities we saw, like AIG. They need to have a 
consolidated supervisor who is accountable for constraining 
risk. That is vitally important. That will help make crises 
less likely in the future and make it more likely the system 
can withstand failures that might happen when these firms screw 
up.
    But you also have to make sure that in the markets where 
firms come together--in derivatives markets, in the secured 
lending markets, in the repo markets, we need to make sure that 
in those markets, where there is central clearing, where there 
is a change, and where there is not, we need to make sure there 
is a set of standards and protections in place to prevent 
contagion.
    Now, in our system, we had two basic huge gaps that were 
devastating in effect. One is we let large firms operate with 
no effective constraints, outside the basic protections we put 
in place for banks, and we cannot let that happen going 
forward. But we also had nobody in charge and accountable with 
authority for making sure in those markets where firms come 
together which can spread contagion, make the fire spread with 
brutal force, there needs to be somebody in charge of setting 
basic standards, level playing field protections, margin, 
capital, the basic cushions against shocks.
    So what we have proposed is to make sure that retaining the 
authority of the SEC and the CFTC have now over exchanges and 
clearinghouses, that there is level playing field, that they do 
not compete to lower standards to get more business away from 
each other. So we have proposed this to make sure that there is 
one entity in charge for making sure that those standards are 
strong enough and there is a level playing field. That is the 
balance we are trying to achieve. We think we can do that 
without creating duplicative regulation, and, again, the basic 
protection, if you have a system, which we are going to 
preserve, where you have multiple agencies with multiple 
responsibilities, there needs to be a basic level playing field 
in place.
    Chairman Lincoln. Well, I know that those titles, 
particularly Title VIII and Title II, do come under some of our 
jurisdiction, and I still remain concerned that we do not 
overregulate. So, hopefully, we will work with you, and there 
may be some reevaluation there in terms of how we go. I just 
think it is important for those entities to know who their 
regulators are and that there is no confusion or, again, 
overregulation or duplicative regulation, regulatory regimes 
there.
    Secretary Geithner. I completely agree, and, again, the 
basic objective is you do not want to have a situation where 
the standards are different so that the risk all migrates to 
where the standards are lower. There needs to be some 
protection against risk that regulators compete to lower 
standards, race to the bottom. You saw that in thrifts. You saw 
that in parts of the banking system, non-banks competing with 
banks. You see some risk of that in these other markets, too, 
and so that is the thing we want to prevent. So we want to have 
some basic level proliferation floor on things, for example, 
that prevent that race to the bottom.
    Chairman Lincoln. Well, we will be glad to work with you. I 
am sure we can find a meeting of the minds, so thank you very 
much, Mr. Secretary.
    Senator Chambliss.
    Senator Chambliss. Thank you, Madam Chairman.
    Let me drill down on that issue a little bit more. You have 
proposed moving more transactions into a clearinghouse in order 
to reduce systemic risk. While this may make sense for 
systemically risky institutions, you are certainly aware that 
many end users of derivatives who are not contributing to the 
systemic risk do not wish to endure the expense of clearing and 
have asked for an exemption from any such mandate.
    I recognize that oftentimes a counterparty to an end user 
is, in fact, a large financial institution who may be 
systemically risky. But these transactions are a very small 
percentage of the overall swaps market when compared to the 
swaps business occurring among large financial dealers.
    Now, I understand transactions involving true end users may 
only account for 15 percent of the swaps market. Do we really 
need to force these transactions into a clearinghouse when we 
would already be capturing the bulk of OTC swaps currently on 
the books of large systemically risky institutions? If so, how 
does this reduce systemic risks?
    Secretary Geithner. Senator, your colleagues in the Senate 
and your colleagues in the House have been working to design a 
carefully crafted exception for a certain class of end users 
that would protect their ability to hedge particular risks they 
face, again, without undermining the basic protection we are 
trying to put in place for the entire system. I am not sure we 
have got that balance right yet, but I think there is probably 
going to be a good case for some carefully crafted limited 
exception for non-financial end users for the reasons you said. 
So we would like to work with you to design that, but, again, 
the thing we all need to be worried about a little bit is to 
make sure that those carefully designed limited exceptions for 
good economic reasons do not end up gutting the rest of the 
framework.
    But I think you are right. Our focus should be on trying to 
make sure we are fixing the things that cause deep risk of 
systemic instability of collapse and still preserving the 
hugely economically important value of innovation in hedging. 
That is the balance we are trying to strike.
    Senator Chambliss. Yes. Well, I think we agree with you on 
that point, and I am curious about your thoughts on the 
language that is in the House bill that is currently out there. 
Does that in any way infringe or seek to, as you say, gut the 
basic bill from the standpoint of systemic risk?
    Secretary Geithner. Senator, I think that it is going to be 
very important that when that bill comes out of committees--the 
House Financial Services or House Agriculture Committee--we 
need to step back a little bit and look at it in its full 
scope, look very carefully at these provisions, because this is 
enormously complicated. It is very hard to know until you look 
at the full thing. But, you know, we may need to tighten it up 
a bit. It is possible we need to tighten up a bit, because, 
again, the basic balance we have to strike is, you know, we 
protect the legitimate justification for an exception without 
undermining it.
    I cannot tell you yet, though--and I think we cannot really 
tell until we have it come. We need to let the dust settle a 
little bit and take a look at it.
    Senator Chambliss. You and I have previously discussed the 
fact that whatever we do from an additional regulatory 
standpoint, we have to be very careful because if we are not 
careful, then what we are going to do is overregulate the U.S. 
markets and drive U.S. customers as well as foreign customers 
of U.S. institutions offshore. While you made a comment in your 
statement and we have talked before about the fact that there 
is going to be a collateral effort to secure additional 
regulations that are comparable from international markets, 
where are we there? Because I am not encouraged by some of the 
statements I have heard from some of our international partners 
on this.
    Secretary Geithner. You are right to be concerned about 
seeing the details, because it is all about the details. But at 
the basic level of objectives and core elements of the 
framework, I actually think there is very broad consensus among 
the relevant authorities for the critical major markets. But it 
is all going to be in the details, and we are going to work 
very hard to make sure that what we do here is complemented by 
equally tough things internationally, because, otherwise, if we 
do not do that, then, you know, this stuff will just shift to 
where the standards are lower, and that is not something we can 
afford to take.
    Now, just in support of your basic premise, which I 
completely share, at the New York Fed I helped lead a global 
effort that brought together, starting in 2004, the 14 largest 
dealers in derivatives from around the world--the United 
States, U.K., continental Europe, Switzerland, Japan--and their 
primary supervisors to get them around the table to try to 
begin the process of cleaning up what was a remarkably 
antiquated set of basic controls and protections in these 
markets. That process had a huge impact in getting the basic 
infrastructure stronger, better, more automated. It went from 
pen and paper and pencils and faxes for confirmation to a much 
more automated process for confirmation, and that is what has 
allowed us to be in a position now where we can basically 
compel the standardized part of these markets onto central 
clearing. That worked only because we have got the primary 
supervisor around the world with us setting the basic same 
constraints, objectives, targets on their firms, too, so that 
U.S. firms were not put at a disadvantage and our markets were 
not put at a disadvantage.
    So I deeply believe in the importance of that approach, and 
I think we are actually in a pretty good place to achieve that. 
But it is all going to be in the details.
    Senator Chambliss. Lastly, swaps and derivatives have been 
around for a while, but there were new products that were 
created over the last several years that at least participated 
to a great extent in the meltdown that we saw last year. As we 
move forward, we want to make sure that we are putting the 
right kind of regulations in place to ensure that our 
regulators have the ability to make sure that we do not have 
additional products that are developed that will cause other 
issues down the road. It may be a little unfair to be asking 
you this right now, but just know that that issue is in the 
back of our minds and that we want to make sure that we have a 
level of comfort from you, from CFTC, from SEC, every other 
entity that has the potential to regulate these markets, that 
we do not overstep our bounds, but yet we do make sure that we 
are giving you the authority to regulate future products that 
may cause problems down the road.
    Secretary Geithner. I could not agree with you more, and 
this is, you know--to borrow the security metaphor that the 
generals use in war, you cannot just make this about fighting 
the last war. You have to make sure you go back and close the 
things that were critical weaknesses in our current system, but 
you have to do that in a way that gives us all confidence we 
are going to do a better job of preventing the next crisis.
    Now, it will never be perfect. No system will be perfect, 
and it needs to be able to adapt more quickly so it does not 
lag so far behind the growth in these markets. Our system 
lagged way behind the basic fundamental changes in the 
structure of these markets in derivatives and elsewhere, and 
the system has got to make sure it can adapt more quickly. But 
the basic theory, philosophy, approach underpinning our 
approach is to make sure that the basic shock absorbers in the 
system--capital and margin--are much more conservatively 
designed, provide much thicker cushions, shock absorbers 
against risk, and that the people we look at to police these 
markets have authority and accountability to do their jobs.
    Those are two simple principles. Transparency can play a 
big role--it is not just about transparency, though--and I 
think it will give us a better chance to worry about the next 
crises, not just make sure we are fighting the last war.
    Senator Chambliss. Yes. You know, one thing that has 
developed in recent years is online trading. Do you see online 
trading as any factor in the crisis that we had last year?
    Secretary Geithner. I do not. But that is an issue I know 
that Chairman Schapiro at the SEC is looking carefully at, and, 
again, this is a time where we have to look at everything and 
look at it with a skeptical eye, all the basic aspects of 
protection in our markets, to make sure that we are doing a 
better job of fixing the weaknesses. But I think she is doing 
an excellent job, and I am sure she would be happy to talk to 
you more about those risks. But I do not think they were 
central to this crisis.
    Senator Chambliss. Thank you very much.
    Chairman Lincoln. Senator Nelson.
    Senator Nelson. Thank you, Madam Chairman. My compliments 
to you and Ranking Member Chambliss for holding these hearings 
and my appreciation to Secretary Geithner for your being here.
    I come from an insurance background, and as a former 
insurance regulator and insurance commissioner, capital 
insolvency regulation is second nature. In the insurance 
business, if you make a promise, an insurance regulator is 
going to be standing right behind you to make sure that you can 
have the resources to back up that promise, particularly if an 
occurrence that you have insured against in fact occurs.
    Recognizing that there are differences in the two markets, 
there are also a lot of similarities, and I look forward to 
working with my colleagues to get an adequate amount of capital 
behind derivatives contracts to control the risk the market 
poses to the financial system and, as we have unfortunately 
learned, the American taxpayer. It is one thing if the 
shareholder is interested in taking a risk. It is another 
matter altogether if that risk fails and the risk then is 
transferred as a cost to the taxpayer.
    So I think we should do this while recognizing and 
preserving the benefits of the derivatives market. We should 
have regulation without strangulation. We need to be mindful of 
and work to address the input and concerns of the companies who 
have used the over-the-counter market as a successful hedging 
tool for years. We must not regulate in a vacuum. We need to 
consider the economic impact and the global nature of these 
markets as well.
    It seems to me that increasing transparency, as you have 
indicated, in the market will help, but also getting capital 
behind the obligations is critical as well.
    I have a question on a matter that I believe to be an area 
where clarity in the law is absolutely essential, and you and I 
have spoken about this: the issue of how reform legislation 
will affect existing contracts. We understand that it will be 
prospective for sure with future contracts, but existing 
contracts. I know that we need the tighter regulation to 
control systemic risks, but I am concerned that any uncertainty 
over the prospective or retroactive application would have 
negative consequences.
    So my question is: What is the administration's view on how 
the various OTC derivatives reform proposals you mentioned 
should affect existing contracts?
    Secretary Geithner. A critically important issue, and as I 
said in my opening statement, the law needs to be crystal clear 
that it leaves in place existing contracts, does not change 
their legal nature, does not add to uncertainty about the legal 
nature of those claims.
    One exception to this is that we are proposing that for 
that existing stock of contracts that they be reported to trade 
repository, but that information reporting, recordkeeping 
obligation we think creates no risk to legal certainty to these 
contracts, but without exception, our view is that these 
reforms should be prospective.
    Senator, can I just go into one qualification on this? We 
are working very hard--and I think are making a lot of 
progress--to try to move that existing stock of contracts onto 
central counterparties, and if we can do that, also, again, 
without taking any risk that we are going to add legal 
uncertainty to existing contracts. So I think we can do a lot 
to reduce the risks in the current stock of contracts without 
impinging on any legal certainty. That is our commitment. The 
law needs to do that carefully.
    Senator Nelson. I am relieved to hear that. I think we all 
understand that going back and taking exception with existing 
contracts or trying to reform existing contracts has all kinds 
of both intended and unintended consequences, and I think that 
should definitely be avoided.
    In your testimony, you mentioned the administration's 
proposal to extend the scope of prudential regulation to cover 
all financial firms whose failure could pose a threat to 
financial stability. Of course, we are talking about the 
bright-line test for systemically significant firms.
    What will be the impact of this proposal on those firms 
that are already well managed, non-bank companies that did not 
contribute to the financial crisis? Can we establish this 
bright-line statutory test that would set forth high standards 
that a firm could meet to clearly demonstrate that it does not 
pose a systemic risk? I am more concerned about the bureaucracy 
taking over and applying things on a one-size-fits-all 
approach, which simply does not make sense. We want fairness 
and equity, but we also want to be able to distinguish between 
those situations that pose risk and those that do not pose risk 
as well as a level of risk that they pose.
    Secretary Geithner. This is one of the hardest things to 
get right, and you described the challenge very well. We have 
to have a system that allows us to tell the American people, 
tell investors around the world, that if there is a firm that 
develops to the point where it has got that level of potential 
risk to the system because it is too leveraged or it is funded 
too vulnerably, does not have enough capital, vulnerable to a 
run, then we need to make sure that somebody is accountable for 
putting limits on risk taking by that firm. We will not know 
with certainty in advance what firms may pose that potential 
risk.
    But, of course, it is hard to define this with a bright-
line test. It is hard to know with perfect confidence in 
advance what type of firms might pose that risk. But our sense 
it is going to be a relatively limited number of firms. They 
are going to be financial institutions that do things we call 
basics of banking, and that is what we are going to focus our 
efforts. But this is a challenging thing. We are happy to work 
with you on how to do it in a way that provides the right 
balance of confidence to us and to the American people that we 
are going to have a system that is more stable without too much 
uncertainty from market participants about whether they are 
going to be swept unfairly into the system of more conservative 
constraints. That is the difficulty.
    If you look back, with the benefit of hindsight, you would 
have wanted the system to capture the major investment banks--
AIG----
    Senator Nelson. Absolutely.
    Secretary Geithner. A limited number of other non-financial 
but financial entities. So you can go back with hindsight and 
say should have covered these. The challenge is to do it 
looking forward in a way that does not create too much 
uncertainty.
    Senator Nelson. Isn't the most interesting point about AIG 
that the financial problems that it incurred were not 
downstream within their insurance operations, which were 
required to carry capital, have surplus to be able to respond 
to their obligations, but because of the extraordinary 
situation of creating within that holding company system at the 
top the opportunity for unleashing derivative obligations 
without capital to back them up?
    Secretary Geithner. Exactly. Yes, Senator, exactly right, 
and it was not just AIG. It was a set of monoline insurance 
companies that did exactly the same thing, and the basic 
protections that the insurance regime is supposed to provide 
did not ensure that they held enough capital against those 
commitments. That is an important thing to fix, and that is 
something we can fix. I mean, this is not beyond the capacity 
of the U.S. Congress and your regulators to fix.
    Chairman Lincoln. Senator Harkin.
    Senator Harkin. Well, there seems to be a common theme 
coming through here now, and I think it is focused on those 
entities that would somehow be off of central trading. If we 
are on central trading, we have got margins. That is fine. We 
have the transparency and everything. You said in your written 
testimony, ``We should also require that regulators carefully 
police any attempts by market participants to use spurious 
customization to avoid central clearing.'' That has been a 
sticking point for me for a long time. I introduced a bill last 
year, as you know, that would put all of this on central 
trading.
    Well, now, we had subsequent hearings on that, and people 
said, well, there are certain customs, swaps that do not lend 
themselves to the trading floor. So I got to thinking about 
this, and then just hearing the questions that the two previous 
Senators were questioning about, it kind of comes down to 
this--doesn't it?--that if you are going to have some custom 
swaps out there that are not centrally traded, there is going 
to have to be regimes set up on which there are margins 
required, because you just said the problem with AIG is they 
did not have enough capital to cover the thousands and 
thousands of swaps that they were dealing in.
    So if you are going to have a custom situation, how do you 
know how much capital they are going to need unless you do have 
a margin requirement? Is that where you are headed?
    Secretary Geithner. Yes, so let me try it this way.
    Senator Harkin. Okay.
    Secretary Geithner. The firms that make these commitments, 
whether they are for standardized products that can be 
centrally cleared or traded on exchanges, or whether they are 
for customized products that cannot be centrally cleared or 
traded on exchanges, they need to hold capital, be forced to 
post margin against those commitments.
    Now, central clearing has this great benefit because you 
can set margin requirements in a way to give you confidence 
that by concentrating risk you are not increasing risk, you are 
going to reduce it. But we are proposing to make sure that 
there are higher margin requirements and capital requirements 
held against positions that cannot be centrally cleared.
    So if you are going to do a customized swap--and there 
would be very good economic reasons for doing that--they often 
have more complexity, harder-to-manage risk and measure the 
risk in that, they have to have higher-margin capital 
requirements against that.
    If you do those two things, you will increase the 
incentives to centrally clear the standardized stuff, and you 
will reduce the systemic risk to the system of having some 
customized things that cannot be centrally cleared.
    Now, regulators need to have the information that they can 
police that. You need to make sure the standards are clear so 
that people can evade that requirement through, as we said, 
spurious customization. That is the challenge.
    Senator Harkin. Yes. Mr. Secretary, I was just thinking, 
when you were talking about that, you talked about capital and 
margins. Margins, I think by their very nature, are liquid in 
form. Capital may be or may not be. It seems to me that AIG may 
have said they had a lot of capital, but it was tied up in 
insurance contracts and every other thing. They did not have it 
in liquid form to be readily available in case there was a 
downturn. So tell me again, how do we provide that requirement 
in a more liquid form rather than just saying, well, we have 
enough capital and our balance books show that we have capital? 
I mean, it may not be readily available.
    Secretary Geithner. I agree with you. There is capital, 
there are reserves, and there is margin. They are not perfect 
substitutes for each other. You need to have all of them in 
place. Initial margin and the margin regime has to be more 
conservative. It has to capture more of the risk in extreme 
events than it did in our system. We did not generally have 
people with authorities to really police margin or to set 
margin across the system in that case, and we are proposing to 
change that.
    But you are right. It is not just about capital. Capital 
central--I am a capital hawk in these areas. But it is about 
margin and the full scope of cushions we have against risk. But 
the principle is they need to be thick enough to capture risk, 
and they have to be more conservative for the more risky 
products, particularly for the customized.
    Senator Harkin. So are you saying that for these custom 
swaps that there will be margin requirements and in back of 
that also some capital requirements? Is that what you are 
saying?
    Secretary Geithner. Yes.
    Senator Harkin. Ah. I like what I hear. Thank you very 
much.
    Chairman Lincoln. Senator Bennet.
    Senator Bennet. Thank you, Madam Chairman. Thank you, Mr. 
Secretary, for being here and for your service.
    We have all learned the hard way how our derivatives market 
has spun out of control over the last decade. It is my 
understanding that between 2000 and 2008 the number of 
outstanding over-the-counter derivatives contracts rose by 522 
percent, and at the same time, as we have heard you testify 
here and in the Banking Committee, our regulators had little 
meaningful information about how these contracts were affecting 
the financial market and our broader economy, and now we know. 
You know, in this entire episode, I think, the most searing 
unfairness has been that our parents remain--you know, their 
retirement accounts are still in terrible shape, our kids 
remain unhired, and we, the taxpayers, had to bail out, among 
others, AIG. Mindful of your observation that we are not here 
to fight the last war, I think it is helpful for people to 
understand how things might have been different had these rules 
been in place that you are proposing 10 years ago. What effect 
would it have had on AIG's ability to engage in the credit 
default swaps that it did? Would it have ever been able to meet 
its margin requirements? Would our regulators have been in a 
stronger position to deal with it? How would the 
administration's plan have affected other institutions like 
Lehman Brothers?
    Secretary Geithner. Excellent questions, and I think that 
any reform has to meet that test, which is, if you look back 
and replayed history, if these reforms were in place, would 
they have given us a reasonable prospect of limiting the damage 
of the crisis, and I believe they would have. Just to make it 
as simple as possible, it would not have been possible for AIG 
and a set of insurance companies to write hundreds of billions 
of dollars of commitments without capital to back those up. Our 
major investment banks would have been less leveraged, less 
vulnerable to runs. Those two things would have made the system 
less vulnerable to collapse. They would not have been 
sufficient, but they would have been very helpful in making the 
system more resilient.
    It would have been much less likely--you could have had a 
whole bunch of non-bank finance companies compete business away 
from banks in the mortgage market and the consumer credit 
market and in the broader leveraged lending market in a way 
that left the system where we have put in place almost 100 
years ago a set of protections to protect the economy from bank 
runs and bank collapse, we had a whole system emerge outside of 
banks without those protections. So we would have--and we would 
have had better tools to manage the failure of a major 
institution. We would have been able to let that failure happen 
without intervening and without putting the taxpayer at risk, 
and we would have been able to wind down safely and dismember 
safely institutions that had managed themselves to the brink 
failure and could not survive without the Government.
    So that is the basic objective. We would have had better 
protection for consumers, a system strong enough to withstand 
the failure of large institutions, better tools to manage their 
failure without leaving the taxpayers exposed, and those are 
things we can do.
    Now, we will not prevent all crises, and we want to have a 
system in which failure can happen. People can innovate, they 
can make mistakes, but they bear the consequences of those 
mistakes, and we do not put the taxpayer on the hook for 
protecting the economy from their mistakes.
    Senator Bennet. Thank you. As you know, I am on the Banking 
Committee, as some of my colleagues are here, and we have 
recently released a proposal on derivatives, and the language 
says the CFTC can exempt certain companies from clearing 
requirements if they are not ``major swap participants'' and 
their contracts are ineligible to be processed by a 
clearinghouse. The bill defines a major swap participant as a 
company ``whose outstanding swaps create net counterparty 
credit exposures to other market participants that would expose 
those other market participants to significant credit losses in 
the event of a default.''
    At the same time, the legislation proposes to give the SEC 
and the CFTC joint rulemaking authority to further define what 
a major swap participant is.
    I wonder if you could enlighten us about what your thinking 
is about how those rulemakers ought to be defining what a major 
swap participant is. What are the factors that they ought to 
consider?
    Secretary Geithner. I do not think I can do justice to this 
now, Senator. I would be happy to spend some time talking to 
you about it. I think the broad approach that is in that bill, 
and I think in the language that this Committee is considering, 
looks very good.
    Now, as I said before, this is terribly complicated, and we 
need to make sure we step back and look at it very carefully so 
we get the balance right and we are not leaving outside these 
protections institutions or participants that could put the 
system at risk in the future, and it is hard to do. But I am 
happy to walk through it with you, and I think the language 
looks pretty strong. But, again, the challenge is to make sure 
that these exceptions do not become the rule.
    Senator Bennet. Thank you, Mr. Chairman.
    Senator Harkin. [Presiding.] Thank you, Senator Thune.
    Senator Thune. Thank you, Mr. Chairman. Mr. Secretary, 
thank you for being here. Our interest in this piece of this at 
this Committee, of course, is CFTC, and with regard to the 
markets, I represent agricultural producers. Corn farmers, 
soybean farmers, all want to manage their risk, and what they 
need to know is that they are going to have markets that are 
fair, transparent, effective, not manipulated by speculators. 
So that is what we all want to achieve in this and try to deal 
with the issue of systemic risk.
    I want to ask you a couple philosophical questions with the 
issue of systemic risk, which we all have an interest in, and, 
that is, in your opinion, what types of entities represent 
systemic risk and should be subject to the unique oversight 
from regulatory agencies?
    Secretary Geithner. Well, two broad types of entities. Let 
us talk about firms first. Firms that are major dealers play a 
critical role in credit markets generally whose stability is 
vital to the stability to the system, they are systemic. There 
is no science in defining who meets that test. It will change 
over time. But if they are in the business of providing credit, 
making markets work, central to market functioning, then they 
are presumptively going to be systemic when things are under 
acute stress.
    But as I said earlier, it is not just the firms. Where risk 
is centralized, like in clearinghouses or sometimes exchanges, 
or where markets come together in the OTC markets or in repo 
markets, those markets, too, can be critical to the stability 
of the system. That is why it is important there be a level of 
margin so there are standards in those markets that provide 
better protections against contagion, against the fire 
spreading more quickly.
    There is no bright line, though. You will never know in 
advance what mix of factors could make a firm or a market 
vulnerable to a run and whose failure might cause systemic 
damage. You saw in this crisis firms that were not very large--
Bear Stearns, Lehman, Countrywide were not very large firms, 
but they played a role in these markets at a time where their 
failure caused a broader run on the system as a whole, and that 
is why it makes it hard. It is not just about size. It is more 
about risk. It is something you will not ever know with perfect 
certainty in advance.
    Senator Thune. Let me follow up with that, then. Do you 
believe that labeling an entity ``too big to fail'' implies 
that the Government is going to prop up those entities if they 
become overleveraged?
    Secretary Geithner. Exactly, right, and I would never do 
that. But here is the basic challenge: Simple proposition. The 
riskiest firms have to be held to tougher standards, because 
when they fail they cause much broader damage. It is not just 
the shareholders that bear the costs of that damage. It is the 
system as a whole. So they have to be held to tougher 
standards. So if you are going to make that distinction between 
a community bank, it is less risky, better managed, and a large 
complex global institution, have to be held to higher 
standards, then you have to make that distinction. We do that 
now. Major globally active banks in the United States were 
subject to somewhat tougher standards than for other banks--not 
tough enough, frankly, in my view. We make that distinction 
now. We have to make that distinction. I think we can do that 
in a way that does not create the moral hazard risk you are 
referring to. I think we can do that.
    The critical complement of that, though, is to make sure 
that when they manage themselves to the edge of the abyss, you 
can let them fail without bringing the system down. That is why 
we need this kind of bankruptcy regime for banks, for bank-type 
entities that gives us a credible capacity to let them fail 
without putting the taxpayers in this. So that is the balance.
    But you are absolutely right. I would not ever support a 
regime where we created the expectation we created for Fannie 
and Freddie that in the end the Government would be there no 
matter what. I would not create that, and we have to--and I 
think we can avoid that.
    Senator Thune. I hope so. That is one of the questions I 
get probably more than anything else from constituents that I 
represent, is this issue of too big to fail and how can these 
institutions get on a level where we, the taxpayers, have to 
step in and support them. I want to shift gears on that note 
for a moment.
    As I think you perhaps know, I have a bill that would end 
the TARP program at the end of this year, and I have noted that 
you have not endorsed it yet. I want to give you an opportunity 
to do that today. But I think it ties into this question of too 
big to fail, because the TARP program now, it was designed--and 
many of us held our noses and voted for it because we thought 
it was designed to prevent imminent financial collapse. It has 
now sort of evolved into something more than that. It has got 
banks, insurance companies, auto manufacturers. I will tell 
you--and you have probably seen, too, news reports--my 
colleagues have lots of ideas about how to use unspent funds. 
It seems to me the best way to make sure that does not happen 
is to end the program.
    I am interested in your thoughts on that, whether or not 
you are going to extend it. You have the authority to do that 
at the end of the year. I would like to see us end it, and I 
would want to see you endorse that.
    Secretary Geithner. It may surprise you to hear me say 
this, but nothing would make me happier than to end this as 
quickly as possible. We are actually close to the point where I 
think we can wind down this program, stop making new 
commitments, and put it out of existence. We are close to that 
point. We are not quite there yet, and let me just explain why 
we are not quite there yet.
    We have now brought stability back to the U.S. financial 
system. Banks can issue capital now, and we have forced them to 
raise substantial amounts of capital. We have ended the 
temporary guarantees we put in place to break the back of the 
panic. We have been able to wind down most of the emergency 
steps we took and you authorized, and you did the right thing 
in doing it. You saved the country in authorizing those steps.
    But if you look at the U.S. financial system today, there 
are parts of it that are still very damaged. It is very hard to 
find a small business in America today that will tell you that 
they are not facing a very, very difficult time getting credit, 
holding onto the credit they had, getting new credit to expand 
their business. Housing markets are still very damaged. 
Commercial real estate, a huge source of ongoing pressure on 
our system. Community banks across the country, still under a 
lot of pressure.
    So we have to be very careful to make sure we are not 
prematurely taking steps that would intensify those financial 
head winds, weaken the recovery, reignite the kind of pressures 
we saw last year. That is the balance we are trying to strike.
    But I think we are at the point now where we are going to 
be able to return very, very substantial amounts of money to 
address the critical economic needs, long-term fiscal needs of 
this country, because we have been able to achieve stability at 
much, much lower expected costs than we initially envisioned 
back in February. You are going to see--the President and I 
will be making some suggestions to the Congress in the coming 
weeks about what to do with this program, how to end it safely, 
and we are getting closer to that point.
    Senator Thune. If I might, Mr. Chairman, just as a closing 
comment, I just think that--and I know there are some of those 
issues that are still out there. But it seems to me, at least, 
that, you know, when you start sort of veering into these other 
areas, and people now are describing the TARP program as a 
political slush fund, and taxpayers are--they did not like it 
in the first place. They like it even less now. You hear about 
it everywhere you go. Why is the Federal Government, why are my 
tax dollars going to bail out these companies? You get this 
issue where you have the auto companies coming before the 
Commerce Committee here recently, and you have got 535 Members 
of Congress asking them about where they are going to close 
dealerships or where they are going to have-- you know, what 
they are going to do with executive pay and issues like that.
    It seems to me the best way to avoid that is to end this 
program, and any payments that come back in can go to pay the 
Federal debt. I----
    Senator Harkin. Excuse me. I have to cut you off. We have 
other Senators. The Senator is 3-1/2 minutes over, and we try 
to be respectful of time as much as possible. Let us go to 
Senator Conrad.
    Senator Conrad. I thank the Chairman and I thank Secretary 
Geithner for being here, and thank you for your leadership 
during this extraordinarily challenging time for the country. I 
believe what you said earlier is correct. Had we not done what 
we did, I believe there would have been a global financial 
collapse, and I believe the history of this period will 
demonstrate that that was the case.
    Part of the reason that occurred, I will never forget being 
called to a meeting in the Leader's office one night, an 
emergency meeting, and there was the previous Secretary of the 
Treasury, the head of the Federal Reserve, and they were there 
to tell us they were taking over AIG the next day. They were 
not there to consult us. They were there to inform us. In no 
uncertain terms, they told us they believed, if they did not 
take these steps, that there would be not just economic 
wreckage here, but there would be global economic wreckage of 
staggering proportion. They swore us to secrecy and then gave 
examples of companies that would go down, and go down very 
quickly. It was, I think, one of the most sobering meetings I 
have ever attended.
    So I believe that it is clear to me that we would have had 
a global financial collapse had we not taken the steps. However 
unpopular they are now, they were the right steps. Were they 
done perfectly? No. When people are dealing in a crisis 
circumstance, you do not have time to get everything exactly 
right. But, by and large, the decisions were critically 
important.
    In the jurisdiction of this Committee--we have sort of gone 
beyond the jurisdiction of this Committee in questions from 
colleagues, and we understand it is a rare opportunity we have 
to have the Secretary of the Treasury, and so it is important 
for us to be able to discuss things that are beyond the scope 
of this Committee.
    We do have a special responsibility for CFTC. Let me just 
say put me down as one person that is skeptical of the notion 
of a super regulator. I am very concerned, as a long-term 
member of this Committee, that we will find CFTC down at the 
end of a long, dark hallway somewhere at a super regulator and 
that the people then calling the shots would not have the kind 
of deep knowledge of commodity markets that are essential.
    We have a different set-up in terms of what Committees have 
jurisdiction, what agencies have jurisdiction, for a reason, 
and they are good reasons, and they are reasons that have, by 
and large, stood the test of time. This collapse did not occur 
under the jurisdiction of this Committee and under the 
jurisdiction of, I might say, CFTC.
    So what can you say to assure us that we would not find 
ourselves in a circumstance in which the commodity markets 
would be regulated by people that really do not have a deep 
understanding of them?
    Secretary Geithner. Well, as you know, we have proposed to 
preserve the CFTC and the SEC as independent entities. We have 
proposed to strengthen both of the authorities they have 
because I think both of them need a little strong authority, 
not just in these markets but generally. We are committed to 
that. I would be very supportive of making sure they have the 
resources, not just the number of people but the talent they 
need to do that job well. We are not--I think the simplest way 
to say this is there are different specialized functions that 
we want to make individual agencies accountable for. We would 
not support and I would never support trying to mush those all 
together in one entity. You want to make sure that they are 
accountable for a clear set of responsibilities, have the 
authority to--you do not want to mix that all up, and you 
cannot give that to a Committee.
    Senator Conrad. Is ``mush'' a legislative term?
    Secretary Geithner. It is a technical term, a financial 
term.
    [Laughter.]
    Secretary Geithner. But, you know, you cannot have 
committees supervise, you cannot have committees enforce, you 
cannot have committees police, you cannot have committees put 
out fires. You need to have clear accountability.
    So the model we have proposed is to say you have strong 
market integrity, investor protection, anti-manipulation 
entities in the SEC and the CFTC; you have somebody who does 
consumer protection, wakes up every morning and all they care 
about is consumer protection, doing that better, because we 
need that terribly. You have a good firehouse for managing 
failure in the resolution authority of the FDIC. You have 
people doing bank supervision better, accountability for that. 
Somebody has to be in charge of the major systemic 
institutions.
    Those are very different functions, and we can do that in a 
way that does not weaken them individually. The council we have 
proposed is just designed to making sure there is a level 
playing field. We do not have big gaps. There is not 
competition to erode standards. You let the system evolve over 
time that it is tough enough that it basically works. But it 
leaves the individual entities accountable.
    Senator Conrad. If I can take 30 seconds more, I would just 
ask--I had two prominent North Dakotans in to see me yesterday, 
people who are deeply involved in the Farm Credit System, both 
in our State and nationally, and very concerned about effects 
on the Farm Credit Administration of having a regulator that 
would sweep up their responsibilities and not be attuned to the 
special circumstances of farm credit markets.
    What would you say to people like that?
    Secretary Geithner. Well, I would like to hear from them 
and talk to you about it, because I am not aware of anything in 
our proposals that would have that risk. If they do, then we 
should be able to fix that problem.
    I have talked to Tom Vilsack many times about the broader 
challenges farmers face in the United States getting access to 
credit, but I have not heard from him or his colleagues on this 
particular concern about mushing up accountability and 
responsibility. But I would be happy to talk to you about it 
and talk to him about it.
    Senator Conrad. All right. I thank the Chair.
    Chairman Lincoln. [Presiding.] Senator Johanns has left us. 
He will be back, I bet. Senator Stabenow--Senator Klobuchar.
    Senator Klobuchar. All right. Thank you very much. Thank 
you, Secretary. I was thinking this hearing seems a little more 
pleasant than when I last saw you at the Joint Economic 
Committee hearing, if you remember that.
    Secretary Geithner. All hearings are pleasant.
    Senator Klobuchar. It was on the House side. It just seems 
a little calmer here today back over in the Senate.
    I wanted to focus on the issue at hand with CFTC, and I 
know when Chairman Gensler came last time, we discussed what 
needs to be done with credit default swaps and other OTC 
derivatives, and I would just first ask you if you believe that 
there is a class of OTC derivatives that poses a greater risk 
than other over-the-counter derivatives.
    Secretary Geithner. You know, it is hard to say, but I do 
not think that--I think the risks are more similar than they 
are different, and I do not think you can see in any particular 
type of credit derivatives risks that are that unique. That is 
a newer market. It grew much more rapidly. It grew in a world 
that was much more stable, sort of untested by crises and 
recessions, untested by the major real estate collapse, and 
that is what caused the crisis more than the particular nature 
of those instruments. That is my sense.
    Senator Klobuchar. Well, as we look at these necessary 
regulation, what needs to be done here, I know that some points 
of debate that we have had is how to regulate, and, in 
particular, we have had some people come and talk to us about 
the end user definition. Who, in your view, should be treated 
as an end user?
    Secretary Geithner. A limited number of non-financial 
companies that are using this to hedge particular risks. But--
--
    Senator Klobuchar. That would be like an airline locking in 
on jet fuel or----
    Secretary Geithner. That might be one example, but there 
are many. I think that you have done a very good job of saying 
that you approach this--you do not want to listen just to New 
York; you do not want to listen just to Chicago. You want to 
listen to people that are making things and selling things 
across the country and listen to how to make sure you can meet 
their economic needs in a way that is safe and efficient. So 
there is a range of things to make that test, but, again, we 
have got to be very careful we do not create an exception that 
would weaken the rest of the framework.
    Senator Klobuchar. Exactly. But do you think there could be 
some accommodations made to certain end users that are in that 
group that you talked about?
    Secretary Geithner. I do think there are ways to do that, 
but, again, I want to err on the side of caution just because, 
you know, this is a very technical, complicated area, and there 
are people who will come and say that this is a legitimate, 
noble exception whose interests are less noble.
    Senator Klobuchar. I have seen that happen before. But I do 
think that we are going to have to differentiate some based on 
what is going on and what really caused our problems before.
    I am one of the sponsors of the Fraud Enforcement Recovery 
Act which President Obama signed into law, and I believe just 
from my former role as a prosecutor that it is very important 
to have these tools that we can use. I believe we have already 
seen some increase in white collar and we are going to see 
more.
    Could you talk about what role the Treasury Department is 
going to play in this task force and how it will be working 
with CFTC's fraud enforcement efforts?
    Secretary Geithner. I am sorry, Senator. Are you referring 
to the task force that the Attorney General and I announced 2 
weeks ago?
    Senator Klobuchar. Yes.
    Secretary Geithner. Well, thank you for drawing attention 
to that. We are going to try to make sure that law enforcement 
authorities and regulators and supervisors are working together 
at the Federal level and the State level, that they take a much 
more proactive approach to catching this stuff earlier, that we 
break the past pattern where enforcement authorities escalate, 
frankly, long after the peak of the wave of fraud that happens. 
We are going to try to do that by marshaling much more 
effectively the particular resources that we have access to at 
the Treasury through suspicious activity reports in particular 
on financial transactions that could provide early-warning 
indicators of widespread fraud.
    So our role will be a coordinating catalytic role and 
making sure we are getting enforcement resources mobilized 
early with enough force and coordination and not the kind of 
negative competition we have seen sometimes that gets in the 
way of effective policing.
    Senator Klobuchar. So you are kind of going to be looking 
for these hot spot areas or things that you see as problems, 
and then you work together with the Justice Department?
    Secretary Geithner. Exactly. I will give you one example. 
In March or April of this year, as we saw, the latest new wave 
of innovation in fraud was mortgage scams, people calling 
people and saying, ``If you give me a lot of your money, I will 
help you participate in this program with the Federal 
Government to reduce your monthly payments.'' Just a classic 
financial scam. So we got Justice and the State AGs working 
together early to go after those even before the mortgage 
modification programs went into place. That is a good example. 
But we want to extend that model across consumer credit and a 
range of other opportunities for that. But, again, the basic 
thing you want to break is the late response, the fact when 
people start to move once the peak has already passed. We want 
to bring it earlier.
    Senator Klobuchar. Right. Could I say that I think not only 
putting some good regulations in place, but also that kind of 
early response actually makes a huge difference in the fraud 
area, white collar, and could have prevented some of this. If 
you look at the Madoff case at the SEC, that is the most 
glaring example. But if you get in there early, I think it 
sends a message to others, and you actually can prevent 
wholesale problems throughout the system. So thank you.
    Chairman Lincoln. Senator Lugar.
    Senator Lugar. Thank you, Madam Chairman.
    Secretary Geithner, in Indiana, most businesses, as well as 
citizens are not involved in business, are very pleased that 
the Congress is taking these projects seriously. The only 
mitigating factors--and these are ones you have touched upon, 
but I want to reiterate the question of firms that are in 
business, principally manufacturing, who use derivatives to 
execute and mitigate economic risk and claim that they are in 
foreign business, particularly with foreign exchange, and are 
concerned that the Senate banking bill offers, they believe, a 
scope that might include them as major users. They like the 
House Agriculture bill, which they feel does not have those 
risks.
    Without your drafting either bill, is it going to be 
possible for the Treasury Department, you or your associates, 
maybe to draw up some general guidelines for those of us who 
are citizen amateurs at this as to which major users really we 
are aiming at? It could very well be that these manufacturing 
firms, in Indiana or elsewhere, could be engaged in practices 
that are not simply mitigating their particular risk of foreign 
exchange transactions or what have you. But, in any event, they 
would claim that they would have to set aside a margin that 
would be substantial, in the tens of millions of dollars. In 
this particular climate, they are saying this might affect job 
production, that we are going to have margins instead of jobs, 
which makes it a very acute political problem.
    I am just wondering what kind of listing clarification 
guidelines can you give so those of us who finally are going to 
be voting on the final product rather than participating maybe 
in the legislation without knowing whether Madam Chairman is 
going to produce a bill or not--she might--so in that case, we 
will talk about it here, we could be better guided.
    Secretary Geithner. I think the best thing for us to do is 
come to you with the CFTC together, and the Fed and the SEC, 
with a common recommendation. Now, we may not be able to get 
complete unanimity in views because, as you know, it is 
complicated and people have slightly different perspectives on 
these things. But I think we can get quite close, and I think 
we can help you make the choices where we do not have 
unanimity.
    But I think you framed the objective we all share. I do not 
believe, Senator--all these bills are slightly different. They 
all have slightly different approaches to managing this risk. 
But I do not think there is any risk that these approaches are 
going to impose a level of economic costs on end users that 
would create the risk you said.
    You know, the markets as a whole probably charged too 
little for these risks for too long a period of time. That is 
not healthy for the system because when things change, they 
overcorrect. That is not good for manufacturers either, or for 
farmers who have to hedge these risks. So I think everybody has 
an interest in trying to make sure that these risks have enough 
margin against them that you are measuring those risks, you are 
paying for those risks, and that will make the system more 
stable.
    I think the broad thrust of these reforms by encouraging 
central clearing should give end users, too, a better balance. 
But you have got the challenge right, and we would be happy to 
try to come to you with as close to a common position as we can 
across these agencies.
    Senator Lugar. That would be very helpful, and I think it 
could be included, just the sentence you had, that if we do not 
take care of risks, that ultimately it is costly to the 
manufacturers, in addition to the Wall Street financial firms, 
that this has to be a practical aspect of this.
    I wanted to ask about what has been described as the 
potential competition between the SEC and the CFTC in which 
some financial commentators that you would be the referee of. 
Maybe you perceive that is your role and Treasury would do 
this, but how do we deal with an age-old problem?
    Secretary Geithner. I do not think they really want us to 
be the referee, actually, is my sense. But I do think the 
Congress and the executive branch do have an obligation to try 
to make sure that the individual interests of these agencies as 
they see them do not produce a set of gaps or weaknesses in the 
system as a whole. So what we have tried to do is have a system 
where there is this council that would help look at the whole 
framework of rules to make sure they really work and there is 
not a bunch of competition that would erode standards. That is 
the balance we are trying to effect.
    Now, informally, we can do a lot of things to try to make 
sure we work out these differences, and we have encouraged, as 
you know, the CFTC and the SEC to work closely together to try 
to bring convergence to basic rules and approaches across a set 
of markets where they engage together, and they are doing--both 
Chairmen are doing an excellent job in laying a foundation for 
more consistent, more convergent approaches across their 
various statutes. We have encouraged that, but it actually has 
not required a lot of intervention by us so far, and I think 
that is encouraging.
    Senator Lugar. Finally, let me ask a broadly philosophical 
question. There are many who philosophically believe that the 
market works and the market ought to be allowed to work. Now, 
this has led to a great number of brilliant people in financial 
circles--many are acquaintances of your own--who really, 
because of their brilliance, have out-thought the market, have 
out-thought the regulators, have out-thought the legislators.
    Secretary Geithner. Or thought they out-thought them.
    Senator Lugar. As you say, we do not want to be fighting 
other wars in the past and so forth. But are you going to be 
able to bring about a systematic regulation here that even the 
most brilliant of persons beating the whole system somehow 
comes into focus and is regulated?
    Secretary Geithner. Markets will innovate around any 
regulation. They will do it with great speed and cleverness if 
the returns are high to doing that and the system allows that 
to happen. So your system has to be able to catch up to prevent 
that, but it will never prevent that fully. We cannot design a 
system that offers the prospect of preventing all failure or 
constraining innovation to the point where we live with a 
system that was stable, and he says, well, that would be a 
system none of us would want to live in.
    So the theory we have tried to bring to this is to try to 
make sure that with capital and margin, with more conservative 
decisions and risk taking, you have a set of basic cushions in 
the system that makes it safe for innovation, safe for failure. 
It does not require us to have a system where Government 
officials are expected to anticipate and prevent any future 
crisis. We will never be able to do that. So you want to have a 
system that is more safe for ignorance, safe for failure, and 
the best way to do that is to make sure you have these thicker 
shock absorbers in the system against a broader range of 
foreseeable storms. That is the basic philosophy that underpins 
this.
    Senator Lugar. Thank you very much.
    Chairman Lincoln. Senator Gillibrand.
    Senator Gillibrand. Thank you, Madam Chairwoman, for 
holding this hearing.
    Thank you, Secretary Geithner, for coming to meet with our 
Committee and talk to us about so many important issues, and 
thank you for your leadership over these many months of great 
need.
    Obviously, we have all heard from our manufacturers and 
energy and transportation companies about the great need for 
derivatives, for budgeting, hedging risk, hedging cost, and 
managing cash flows. I can understand that a company, you know, 
anywhere in America, let us say Pepsi, might need to lock in 
the cost of a key ingredient or may need to hedge against 
swings in foreign currency. However, I want to continue the 
line of questioning that Senator Klobuchar started, which I 
agree with and I think was an excellent area of focus.
    Some derivatives are considered by many experts to be more 
dangerous instruments and would be in need of perhaps different 
regulation. Credit default swaps in particular--and I intend to 
hopefully ask Blythe Masters some questions on that, who is the 
leading world expert on this issue, to talk a little bit more 
about it. But many people, many investors, many experts have 
described them as having no social value. It is my 
understanding that clearing facilities have had to create an 
entirely new risk modeling paradigm from the ones used on other 
derivative contracts to properly insulated themselves from the 
CDS risk.
    When you look at an instrument that has enormous binary 
outcome and is often used as a directional or naked bet against 
a company, shouldn't this be regulated in a dramatically 
different fashion? How do regulators set capital requirements 
for a book of derivatives that can go up 100 percent in the 
money overnight? So I do think there are--you know, you said 
they are more similar than different. I do not truly believe 
that is the case, but I would like your thoughts more 
specifically.
    Secretary Geithner. All right. I am not sure I can do 
justice to this, but let me try it this way. Derivatives 
provide the capacity to hedge against all sorts of different 
risks: risk of a rise in interest rates; a fall in the value of 
the crops you are producing; a rise in the value of oil, 
something you have to use to produce; the risk of failure of a 
major counterparty; risk of a collapse in the system. Those 
risks are very different; they are very diverse. All those are 
different. The principle has to be that capital and margin 
requirement are designed in a way that captures those risks.
    Now, there is a lot of focus on credit derivatives, which 
is appropriate, because that is the market that has grown the 
fastest. Again, it grew up largely in a more stable world 
untested by the kind of collapse we saw here. It was the scene 
at the crime, and those present at the scene of the crime 
attributed a lot of source of damage. But I think the better 
way to think about the risk in this case is where the losses 
were most acute, everywhere, were in exposure people took to 
the real estate market or to risks that were associated with 
the collapse in housing, because very, very few people built in 
any expectation to the risk management system, how they priced 
risk, that actually captured the risk of the fall in housing 
prices we saw.
    Senator Gillibrand. Right.
    Secretary Geithner. That is a different kind of risk than 
affects risk or interest rate risk. But the principle is the 
risk should be captured to the greatest extent you can in the 
margin risk management system capital requirements against 
those risks.
    But, of course, they are slightly different risks, but if 
that is the philosophy that underpins the approach across 
derivatives, we will have a stronger system.
    Senator Gillibrand. But do you see a change in how you 
would regulate the CDS market over other derivatives?
    Secretary Geithner. Again, I think the basic principle is 
standardize things----
    Senator Gillibrand. Just because they are binary.
    Secretary Geithner. Well, again, it means that the risk 
management challenges, margin capital requirements need to be 
different because there are slightly different risks. But the 
principle we are trying to bring across these markets is you 
want to have shock absorbers designed to capture those risks 
better. A simple principle is stuff that is standardized that 
could be centrally--should be centrally cleared because that 
will make the system as a whole a little less vulnerable to 
contagion. Instead of me having to decide what your exposure 
is, not just my exposure to you but your exposure to a bunch of 
other counterparties I have exposure to, to try to unscramble 
that egg in a crisis, try to sort through that bowl of 
spaghetti in a crisis, you can reduce those exposures to a 
single number of exposures to the clearinghouse. That can bring 
a lot of benefits to the system in terms of stability if the 
clearinghouse has got good margin capital requirements behind 
it.
    Senator Gillibrand. Well, let me follow that up with a 
question about the clearinghouses. As we look at bringing large 
numbers of currently unregulated derivatives into central 
clearing, how do you decide what will be cleared in a way that 
does not jeopardize the current clearing system? For example, 
the member firms that guarantee clearinghouses do so at their 
own discretion, and to the extent they cannot adequately assess 
risk perhaps in some of these kinds of derivatives, do we risk 
the enormous financial backstop to the clearinghouses?
    Secretary Geithner. We do, and that is why, as you said, 
when you centralize risk like that, you take it from a 
bilateral market where it is more dispersed and you centralize 
it in a central counterparty, for that to reduce risk to the 
system as a whole, you have got to make sure that central 
counterparty has the kind of financial safeguards against 
default by a major participant that, again, we are strong 
enough in very bad states of the world. That is central for 
this working. If you do not do that, you will make the system 
less stable, not more stable. You are right, doing that for 
credit derivatives, like all sorts of other derivatives, is a 
complicated task. But that is not beyond our capacity.
    But it is not true to say that the world will be safer if 
we left this all in the bilateral over-the-counter market. We 
had a test of how well the system withstood that, and it was 
not a great experience for the system as a whole because it 
made the level of uncertainty and crisis much more acute, it 
made contagion worse, it made it much harder for anybody in the 
face of the storm to really understand what the risk is, and we 
think we can improve on that.
    Senator Gillibrand. Thank you, Madam Chairwoman.
    Chairman Lincoln. Senator Grassley.
    Senator Grassley. Yes, thank you, Secretary Geithner, for 
being here. I am for transparency, and so whatever goes along 
the lines of transparency I am probably skeptical of 
regulation. I think you can have greater transparency without 
more regulation, but from this standpoint, one of the 
recommendations of the administration is to aggregate data of 
OTC trades and make them available to the public.
    So this is a problem I would like to have you explain. How 
can you make this available to the public but at the same time 
safeguard information that could be used to manipulate the 
markets?
    Secretary Geithner. I agree with you completely. I think 
that you--it is very, very hard to aggregate in a sensible way, 
and you want to make sure that you are giving supervisors and 
regulators a real window into these kind of transactions. That 
is a necessary thing because their authority, their ability to 
police fraud, to deter fraud, to go after manipulation does 
depend on better transparency into those transactions and 
firms.
    The challenge for the public is a more difficult challenge, 
and you are right to emphasize it. I do not want to be part of 
a system that tries to--how should I put it?--that puts at risk 
the proprietary information that a firm has to husband to 
compete effectively in these markets. But I think we can do 
that.
    Senator Grassley. Well, are you saying that the 
recommendations make sure that this will not happen, or we pass 
a piece of legislation and it is dependent upon the people out 
there in the various agencies administering it?
    Secretary Geithner. Well, I think that we may not have 
gotten perfect in our language, and I would be happy to work 
with you to make sure we respond to that concern. But I think 
we can design the law, the legislation in a way that ensures 
that regulation does not make your concern worse.
    But there are two different types of transparency. I want 
to distinguished between access for regulators to information 
to allow them to do their job and greater transparency for the 
public that will help make these markets work better. They are 
different, and we can make that distinction in a way that I 
think is responsive to your concerns.
    Senator Grassley. You think your recommendations have made 
that distinction?
    Secretary Geithner. I think it has, but if it has not done 
it adequately, we will improve it.
    Senator Grassley. Okay. On another issue, your testimony 
includes support for a trade repository that would assist 
regulators. Could you expand on who and how this repository 
would be administered? But more importantly than that 
explanation is how will this be kept independent from market 
players?
    Secretary Geithner. Excellent questions. Fortunately, there 
is a model that is actually doing this today, and the market is 
having more and more experience with how that is working. I 
think that can help provide some reassurance against the 
concern you have expressed that it is going to be to the 
advantage of a more limited number of institutions. But this is 
sort of set up like a utility today, a market utility today. It 
exists today, and I think that people have enough experience 
now to make sure that it is not vulnerable to the concern you 
raised.
    Senator Grassley. I am going to get to a little word called 
greed, and I am going to refer to some Washington Post articles 
that I would like to have in the record. These were a three-
part series on AIG. After reading these articles, it is not 
clear to me that a systemic risk regulator would have prevented 
AIG's demise. It seems to me that AIG's failure was driven in 
large part by greed of certain executives. There was too much 
money to be made from credit default swaps.
    So how do you think your concept of systemic risk 
regulators can police such greed if you agree with me that 
greed was behind it?
    Secretary Geithner. Greed is what makes markets work and 
can make markets fail. It is what drives so much of what you 
see in markets. You are absolutely right. That is why you have 
to have protections in place, and we have for decades and 
decades and decades to constrain risk taking by institutions 
that perform the function of banks in our system. So it is very 
important that institutions like AIG, which came to play a role 
in markets that was critical to how the system works as a 
whole, that they are subject to constraints on risk taking. 
That is why we have capital requirements. That is why we need 
margin requirements.
    The market itself cannot police and discipline that 
adequately, even where there is a dramatically better 
transparency. That is the basic lesson of financial crises in 
the United States and across countries over time, and that is 
why we try to have in place capital requirements that try to 
constrain that kind of risk taking as a basic check against the 
excess that you described.
    Senator Grassley. Thank you, Madam Chairman.
    Chairman Lincoln. Senator Grassley, your articles will be 
made a part of the record.
    Senator Grassley. Thank you very much.
    [The articles can be found on pages 116, 127 and 139 in the 
appendix.]
    Chairman Lincoln. Senator Cochran.
    Senator Cochran. Madam Chairman, thank you very much for 
convening this hearing of the Committee. Mr. Secretary, we 
welcome you and thank you for your service in the Government.
    I am concerned about the mandatory clearing of all swap 
transactions, the implications that this has for end user 
margin requirements in particular. While more transparency may 
be needed, I think we must avoid overreaching and eliminating 
the opportunity for participants to enter contracts. Many 
industries utilize these markets, as you well know, to enhance 
profitability, but we must be aware of the impacts to all end 
users. Congress should not adversely affect the ability of 
market participants to adequately hedge risk.
    My question, if there is one in that, is: What is your 
reaction to those comments?
    Secretary Geithner. I agree with everything you said except 
your first sentence, because we are not proposing to force all 
derivatives onto clearinghouses or exchanges. Our proposal is 
to say there is a set of products that are standardized. The 
markets would be safer if those were centrally cleared and 
traded on exchanges or electronic trading platforms. But we 
think there is a useful role still for the capacity for people 
to benefit from customized hedges that cannot be centrally 
cleared.
    We want to make sure that there is transparency into those 
products, that there is adequate margin and capital held 
against them. That will make the system safer, make sure that 
exception does not erode the basic protections around the rest 
of the system. But I think we can find the balance, and I agree 
with everything you said except for-- and I think we are not 
disagreeing--that we are not proposing to ban non-standardized 
products, and we are not proposing, therefore, to force all 
products onto exchanges.
    Senator Cochran. Well, thank you very much for helping us 
understand the implications of these suggested changes.
    Madam Chairman, thank you.
    Chairman Lincoln. Well, Mr. Secretary, thank you so much 
for joining us today. We appreciate you being here, and we look 
forward to working with you as we move forward in solving these 
very complicated issues.
    Secretary Geithner. Thank you all very much, and we look 
forward to working through these remaining things. We will try 
to come with, as I said, a somewhat closer position on these 
remaining issues that separate us so that you can make some 
choices.
    Chairman Lincoln. Great. Thank you, Mr. Secretary.
    We would like to call our second panel to the table, and I 
want to thank them for appearing today. As you are coming to 
the table, I will briefly introduce our next panel.
    On the panel we have Mr. Terrence Duffy, the Executive 
Chairman, CME Group, here with us today. Mr. Duffy has a long 
history with CME and has served as Executive Chairman since 
July of 2007. From 1981 to 2002, he was President of TDA 
Trading, Incorporated, and was confirmed by the U.S. Senate in 
2003 as a member of the Federal Retirement Thrift Investment 
Board.
    We also are joined by Mr. Johnathan Short today, Senior 
Vice President, General Counsel, and Corporate Secretary of 
ICE, the IntercontinentalExchange. Mr. Short oversees ICE's 
legal and government affairs in addition addressing corporate 
governance matters.
    Also, Mr. Peter Axilrod is currently a Managing Director at 
the Depository Trust & Clearing Organization, or the DTCC, as 
it is known. Mr. Axilrod spent years working in risk management 
at the National Securities Clearing Corporation, one of DTCC's 
predecessor organizations, Fidelity Investments, and finally 
with the DTCC in 2000.
    Having started at JPMorgan in 1991, Ms. Blythe Masters has 
had a long and distinguished career in the derivatives field 
and is currently a Managing Director and the head of Global 
Commodities at JPMorgan Chase, serving on the Executive 
Committee. She is also currently the Chair Emeritus of the 
SIFMA, the Securities Industry and Financial Markets 
Association, and the former Chair of ISDA, the International 
Swaps and Derivatives Association, Credit Derivatives Market 
Practices Committee. So welcome, Ms. Master.
    Our last panelist is Mr. Okochi, the Chief Executive 
Officer and co-founder of Reval, a derivatives risk management 
and hedge accounting firm. Mr. Okochi has a long history 
working in the derivatives world and brings a valuable 
perspective to round out our panel today.
    So we thank you all for your patience and appreciate having 
you today, and, Mr. Duffy, we will begin with your testimony.

  STATEMENT OF TERRENCE DUFFY, EXECUTIVE CHAIRMAN, CME GROUP, 
                       CHICAGO, ILLINOIS

    Mr. Duffy. Well, thank you, Chairman Lincoln and Ranking 
Member Chambliss, for inviting me to testify today. This 
Committee's role in the success of U.S. futures markets should 
be the starting point for any discussion of the various pending 
bills and the importance of central counterparty clearing for 
OTC derivatives.
    After years of intense scrutiny, this Committee concluded 
that U.S. futures exchanges operated in a global market and 
that the existing outdated regulatory system clearly puts us at 
a significant disadvantage to foreign competitors. This was 
apparent from the large shift of volume from U.S. exchanges to 
foreign exchanges. This Committee performed a careful cost/
benefit analysis on the restrictive rules-based regulatory 
regime in the United States. It concluded that a competitive 
position of U.S. markets could be improved with no loss of 
safety or soundness if the CFTC acted in a true oversight 
right.
    CFMA, or Commodity Futures Modernization Act, was put into 
place in 2000 and was an unqualified success so far as 
regulated futures markets and clearinghouses were concerned.
    As has been reported to this Committee on many occasions by 
independent observers, CFMA encouraged U.S. futures exchanges 
to innovate and compete on a level playing field in the global 
market. U.S. futures exchanges are more efficient, more 
economical, and safer and sounder under the CFMA than at any 
time in their history. If CFMA went too far in any direction, 
it was with respect to the deregulation of many aspects of the 
OTC market, not regulated exchanges.
    Last year's financial crisis has drawn substantial, well-
warranted attention to the lack of regulation of OTC financial 
markets. A number of critical lessons were learned which should 
permit this Committee to craft legislation that reduces the 
likelihood of repetition of that near disaster. However, it is 
important to note two positives we are seeing throughout the 
recent turmoil.
    First, regulated futures markets and futures clearinghouses 
operated flawlessly. Futures markets performed all of their 
essential functions without interruption and despite failures 
of significant financial firms. Our clearinghouse, for example, 
experienced no default. No customers on the futures side lost 
their collateral or were unable to immediately transfer 
positions and continue to manage their risk. Second, central 
counterparty clearing with proper collateralization could have 
prevented some of the worst losses in the OTC market.
    CME's announced offering to clear credit default swaps will 
be an open-access platform. We employ very strict quality 
standards respecting the OTC derivatives we will accept for 
clearing. This in turn will ensure the safety and soundness of 
the CME clearinghouse.
    The success of the regulatory regime for futures, 
exchanges, and clearinghouses during the worst of the crisis is 
clear evidence that the principles of the CFMA should be 
reaffirmed. Unfortunately, there is much in pending legislation 
that reverses the CFTC's role as an oversight agency. It 
creates a highly intrusive role which would impair effective 
exchange innovation, require substantial new staffing at the 
CFTC, and add hundreds of millions of dollars to the agency's 
budget, adding additional burden to the American taxpayer.
    The agency would become the arbiter of new contracts and 
new rules. Principles-based regulation would be eliminated; 
margin setting and position limits would be politicized, 
impairing liquidity and efficiency. Layers of additional 
regulators would be added. Dual registration and regulation 
would operate to stifle the most important growth parts in our 
industry--the clearing of OTC transactions. Even the threat of 
such policies has already driven major customers to move 
business off U.S. exchanges.
    We support the administration's goals to reduce systemic 
risk through central clearing and exchange trading of 
derivatives to increase data transparency and price discovery, 
and to prevent fraud and market manipulation. Legislation needs 
to accomplish the following to achieve those goals:
    First, clearinghouses should be permitted to clear all 
categories of OTC swaps, subject to oversight by a single 
regulator, and the CFTC as our primary regulator should not be 
subordinate to the Federal Reserve or any other agency. The 
ability of a clearinghouse to respond immediately to swap 
dealer defaults must not be stayed or otherwise impaired. 
Customer collateral must be protected in the event of a swap 
dealer bankruptcy. Clearing should be encouraged to the 
appropriate capital charges and tailored regulation for 
participating in the swap market makers. Finally, the Federal 
Reserve should be permitted to provide a liquidity facility in 
the event of a market emergency.
    My written testimony includes clear and concise 
recommendations to accomplish these goals. We look forward to 
working with this Committee to shape the important regulatory 
reform, and I thank you for this opportunity and look forward 
to answering your questions.
    [The prepared statement of Mr. Duffy can be found on page 
72 in the appendix.]
    Chairman Lincoln. Thank you, Mr. Duffy.
    Mr. Short.

 STATEMENT OF JOHNATHAN SHORT, SENIOR VICE PRESIDENT, GENERAL 
  COUNSEL, AND CORPORATE SECRETARY, INTERCONTINENTALEXCHANGE 
                    (ICE), ATLANTA, GEORGIA

    Mr. Short. Madam Chairman, Ranking Member Chambliss, I am 
Johnathan Short, Senior Vice President and General Counsel of 
the IntercontinentalExchange, Inc., or ICE. ICE very much 
appreciates the opportunity to appear before you today to share 
its views on financial market reform.
    ICE has an established track record of working with market 
participants and regulators alike to introduce transparency and 
risk intermediation into OTC markets. Along with the 
introduction of electronic trading in OTC energy markets in 
2000, ICE also pioneered clearing of OTC energy swaps in 2002, 
and in March of 2009 became the first clearinghouse to clear 
credit default swaps, having now cleared over $4 trillion in 
notional value.
    Appropriate regulation of OTC derivatives markets is of 
utmost importance to the long-term health and viability of our 
financial system and to our broader economy. ICE has four 
recommendations for improvements to the proposed financial 
reform legislation.
    First, while clearing and electronic trading of 
standardized swaps would be appropriate for large portions of 
the market, it may not be appropriate for all portions of the 
market.
    Second, clearinghouses should have ultimate control over 
their risk management subject to meeting minimum safety 
standards. Provisions such as fungible clearing or open access 
could impact a clearinghouse's ability to properly manage risk.
    Third, Congress should act to protect and encourage 
competition, and any market-wide position limits should be set 
by the Commodity Futures Trading Commission on a venue-neutral 
basis.
    Fourth, Congress should adopt a flexible principles-based 
approach, much like what was adopted in the CFMA, in any new 
regulation and endeavor to avoid duplicative or overlapping 
regulation.
    Briefly turning to each of these recommendations, mandated 
electronic trading and clearing may result in significant 
unintended consequences by attempting to force transactions 
that are not readily amenable to clearing into clearinghouses, 
or by forcing commercial market participants--including those 
who would rather, for a price, outsource their risk management 
to an OTC swaps dealer--to incur the cost and expense of 
trading in standardized contracts that may not perfectly fit 
their risk management needs. Instead of forcing all derivative 
transactions to be exchange traded and cleared, Congress should 
focus on the segments of the market where risk is greatest like 
the inter-dealer and major swaps participants market. Mandating 
that inter-dealer and major swaps participant trades be cleared 
would eliminate the bilateral counterparty risk that was 
central to the financial crisis that occurred last year and 
achieve many of the risk reduction and transparency objectives 
that Congress is seeking. Combined with prudential regulatory 
oversight of the remaining bilateral risk exposure of dealers 
and major market participants, this proposal would strike an 
appropriate balance between safety and serving market end user 
needs.
    Second, under the current regime, clearinghouses handle 
risk management under the supervision of their respective 
regulator, and ICE favors minimum standards that would avoid a 
proverbial race to the bottom. That said, some of the proposed 
bills pending before Congress could inhibit a clearinghouse's 
ability to properly control and manage risk. Clearinghouses 
have been some of the few institutions that have operated well 
in the financial markets during the time of crisis. However, 
forcing clearinghouses to take contracts from other 
clearinghouses or to provide margin offsets with other 
clearinghouses could present significant systemic risk issues, 
making it more difficult to track positions and counterparty 
risk exposure, and creating significant problems in the event 
of a default of a major market participant. In this regard, 
interconnected clearinghouses might not have been very 
different from interconnected banks, with problems in one 
clearinghouse impacting other clearinghouses.
    Third, competition. Every financial reform proposal pending 
before Congress gives the CFTC the authority to set aggregate 
position limits across all markets--that is, exchanges, OTC 
venues, and foreign boards of trade offering contracts linked 
to a domestic market. Should such limits be deemed to be 
desirable, Congress and the CFTC should be careful to protect 
competition. Some proposals pending before Congress would 
require exchanges to set position limits based upon the 
relative size of their market share, allowing an exchange with 
a large percentage of the market to have higher position limits 
than an exchange with a smaller market share. Such provisions 
would only work to limit competition by inhibiting the 
development of the liquidity necessary to run an efficient 
market. This would be contrary to the CFTC's statutory mandate 
to promote competition among exchanges.
    Fourth, and finally, appropriate regulation. Regulation 
should be principles based and flexible to accommodate future 
changes in the derivatives markets. ICE believes that a broad 
set of core principles governing markets would allow domestic 
and foreign regulators to work toward the goal of protecting 
market integrity and reducing systemic risk on a global basis 
in financial markets that span jurisdictions. Congress should 
endeavor to avoid overlapping and duplicative regulation and 
should work towards a common set of principles that would apply 
to all markets.
    Madam Chairman, thank you for the opportunity to share our 
views with you today, and I would be happy to answer any 
questions.
    [The prepared statement of Mr. Short can be found on page 
107 in the appendix.]
    Chairman Lincoln. Thank you, Mr. Short.
    Mr. Axilrod.

 STATEMENT OF PETER AXILROD, MANAGING DIRECTOR, THE DEPOSITORY 
    TRUST & CLEARING ORGANIZATION (DTCC), NEW YORK, NEW YORK

    Mr. Axilrod. Chairman Lincoln, Ranking Member Chambliss, 
and members of the Committee, thank you for having me. I 
currently oversee DTCC's OTC derivatives services, and, by the 
way, we are the unnamed utility to which Secretary Geithner 
referred, and more on that later.
    We broadly support the administration's proposal regarding 
reform of the OTC derivatives markets. In the area of regulated 
repositories, however, our experience to date leads us to 
conclude that the administration's initial proposal does not go 
far enough and could have serious unintended consequences in 
the area of systemic risk. I will get to those in a minute.
    DTCC is a market-neutral, member-owned cooperative which is 
the primary clearance and settlement infrastructure for the 
U.S. capital markets. Last year, DTCC settled about $1.88 
quadrillion in securities transactions across multiple asset 
classes. As the central counterparty for the U.S. Government 
and mortgage-backed securities markets, as well as the U.S. 
equities and corporate and municipal debt markets, DTCC proved 
its value during the last year's global financial crisis as it 
guaranteed and was able to liquidate over half a trillion 
dollars of Lehman's open trading positions in these markets 
without giving rise to market disruption or loss and avoiding 
any burden on taxpayers.
    In addition, DTCC operates the only central repository for 
the global credit default swap market. This repository 
currently maintains and centrally services nearly all CDS 
contracts traded worldwide, whether cleared or not. This, by 
the way, largely resulted from the activities of the group of 
international regulators that Mr. Geithner sort of led while he 
was President of the New York Fed.
    With respect to the central question before this 
Committee--that is, reform of the OTC derivatives market and 
reducing systemic risk--our suggestion is simple: Require a 
single central repository of transaction data for each OTC 
derivatives asset class; that is, one for credit derivatives, 
one for rates derivatives, one for equities, and so on.
    While the administration's initial proposal would ensure 
that all transactions are reported somewhere, which is a huge 
step forward, the potentially fragmented nature of the 
reporting could seriously erode market safety and soundness. 
The legislation should mandate that all transactions in any 
class, whether cleared through a central counterparty or not, 
be reported to a single central repository. Why? The collapse 
of Lehman Brothers and the bailout of AIG provide adequate 
examples.
    In the case of the Lehman collapse, there was false 
speculation of payouts required on credit default swaps written 
on Lehman rising to the $400 billion level. In fact, by having 
all contracts on Lehman registered in our repository, we were 
quickly able to assure regulators and the market that while $72 
billion in contracts were actually written on Lehman, there was 
only a maximum of $6 billion in exposure; and, in fact, net 
payouts on these contracts were $5.2 billion.
    The important point here is that if the credit default 
swaps on Lehman were spread throughout multiple repositories 
and central counterparties, or CCPs, and not centrally 
reported, the aggregate exposure from Lehman could have been 
reported, misleadingly and probably inaccurately, to be as high 
as $72 billion depending on the distribution of transactions 
among the reporting entities. Misleading reporting on CDS 
exposures, during times of market stress or otherwise, should 
not be acceptable.
    As a result of this experience, by the way, and at the 
urging of the Federal Reserve, DTCC began publishing aggregate 
data on CDS activity on our website, including aggregate 
exposures to the top 1,000 names traded worldwide.
    With respect to AIG, the salient point for this hearing is 
that the AIG bailout might have been avoided altogether had, 
one, an adequate regulatory structure been in place for 
systemically important firms; two, position reporting to a 
single central repository been mandatory at the time AIG's 
positions were taken; and, three, excessive AIG exposure was 
flagged by the repository to the relevant regulators early on.
    Here again it should be emphasized that the position 
reporting would have had to be centralized to be effective. If 
the AIG positions were spread across multiple CCPs and trade 
repositories, very possibly nothing would have been flagged to 
regulators because no single entity would have been in a 
position to recognize the magnitude of the exposure.
    In light of these considerations, DTCC suggests that there 
should be one central repository for asset class globally. This 
is the situation that exists, finally, in the global credit 
default swap market, and we should not go backwards.
    Thank you for having me, and I am happy to answer any 
questions.
    [The prepared statement of Mr. Axilrod can be found on page 
55 in the appendix.]
    Chairman Lincoln. Thank you, Mr. Axilrod.
    Ms. Masters.

  STATEMENT OF BLYTHE MASTERS, MANAGING DIRECTOR AND HEAD OF 
 GLOBAL COMMODITIES GROUP, JPMORGAN CHASE & CO., NEW YORK, NEW 
                              YORK

    Ms. Masters. Chairman Lincoln, Ranking Member Chambliss, 
and members of the Committee, thanks for having me to testify 
today. I appreciate the opportunity.
    JPMorgan believes that reform of the regulatory framework 
for over-the-counter derivatives markets is necessary. The 
experience with OTC derivatives during the financial crisis 
highlighted at least three major issues that will be addressed, 
by and large, completely by the proposed reforms currently 
under consideration: lack of transparency in the market; 
excessive interconnectedness amongst major financial 
institutions; and the absence of a systemic risk regulator to 
intervene in the event of excessive risk taking by 
underregulated, but systemically relevant, companies, such as 
AIG.
    There is a welcome degree of consensus among market 
participants and regulators about what needs to be fixed. As 
the Committee considers the detail of these reforms, it is 
critical for legislation to recognize the essential role that 
derivative markets play in helping companies across the Nation 
hedge their risks and thereby gain access to the credit 
necessary for economic growth and job creation.
    Two of the key legislative proposals to reform the market 
are clearing and exchange trading requirements, and while we 
agree with the need for clearing and for improved transparency, 
in these particular areas we believe that some elements of the 
proposals will have significant unintended consequences on U.S. 
companies' ability to transact in these markets.
    Let me turn first to clearing. Clearing of OTC derivatives 
transactions through regulated clearinghouses provides critical 
stability benefits to the global financial system and should be 
mandated; however, that mandate must take into account two 
important facts: first, not all OTC market participants are 
capable of clearing; and, second, not all OTC derivatives are 
capable of being cleared.
    In making determinations about clearing, we should ask two 
questions: Who has to clear? What should be cleared? JPMorgan 
believes that clearing should be required amongst dealers and 
major swap participants--that is, those systemically important 
institutions whose failure could destabilize the financial 
system and, thus, threaten our economy.
    Most U.S. companies are commercial end users that need OTC 
derivatives but do not pose systemic risk to the financial 
system. While there is no benefit to be gained from requiring 
them to clear, U.S. companies, as they have testified, will 
incur a significant cost if that is required. We believe they 
should be exempted from this requirement.
    Nonetheless, there have been arguments made that these 
entities still should be required to clear because the credit 
risk from their derivatives transactions, in the aggregate, 
could imperil the dealers with whom they transact. Those 
arguments are wrong; they misstate the size and the nature of 
the risk. For example, JPMorgan's aggregate derivatives-related 
credit risk to non-financial entities as of the fourth quarter 
of 2008 was approximately $59 billion. Our Tier 1 capital as of 
that time was approximately $120 billion, twice the size of our 
exposure. To put our derivatives credit risk in context, our 
total loan exposure at that time was $745 billion. Derivatives 
credit risk is qualitatively the same as loan credit risk. We 
make loans to companies, and using the same credit analysis, we 
provide risk management products to companies. Both are forms 
of lending and are essential to U.S. companies and to the U.S. 
economy.
    There have also been proposals suggesting that end users be 
required to clear and that the requisite collateral would be 
lent to them by banks under margin financing arrangements. As 
discussed by companies at a hearing before this Committee just 
2 weeks ago, these arguments ignore the balance sheet impact 
that margin loans would have on end users as well as the costs 
of such loans, not to mention the fact that the net amount of 
credit risk in the system would not be reduced as a 
consequence.
    As for what has to be cleared, we believe that the focus 
should not be on defining ``standardized'' transactions which 
will always be challenging and will always be subject to 
arbitrage. Rather, we believe that the focus should be on 
maximizing each dealer's and each major swap participant's 
cleared exposure. This would address the interconnectedness 
between these entities that cause systemic risk. Specifically, 
we propose that the prudential and derivative regulators 
together determine the appropriate percentage that should be 
cleared by asset class and according to that asset class and 
the clearability of the product.
    Let me turn to trade execution. Many are of the opinion 
that we oppose a requirement to trade on exchanges because of 
our profit motive. Nothing could be further from the truth. We 
oppose it because it will harm our ability to manage risk and 
it will harm end users' ability to transact in these markets. 
Mandatory exchange trading would require dealers to post their 
risk positions through the central limit order book operated by 
an exchange. Posting large or longer-term risk--that is, the 
kind of risk that arises in OTC derivatives transactions and 
the kind of risk for which there is not a natural pool of 
liquidity on exchange--would alert the rest of the market to a 
dealer's position and would move the market against that 
dealer, making it much more risky to execute its transaction. 
The result would be fewer transactions executed for end users 
and at higher cost.
    The primary reason used to justify a mandatory exchange-
trading requirement is transparency. While we support efforts 
to increase transparency, that cannot be the only goal. The 
policy objective should be a well-functioning market for risk 
management measured by transparency but also liquidity, 
volatility, transaction costs, and other factors. It does not 
benefit market participants to have complete transparency when 
the result is a poorly functioning market, which is the 
inevitable result of mandating exchange trading for products 
which do not lend themselves to being traded on exchanges.
    Another important point is that OTC derivative markets are 
extremely competitive. There are 15 to 20 dealers at any given 
time competing fiercely primarily on the basis of price. That 
pricing information is already accessible to all market 
participants through electronic screens and pricing services 
that are widely available through trade information warehouses, 
through brokerage firms that provide execution services to end 
users, and even through daily newspapers and websites. In fact, 
both the Wall Street Journal and the Financial Times publish 
daily pricing information for OTC derivatives. Simply puts, the 
facts do not support the rationale for mandating exchange 
trading of OTC derivatives.
    In conclusion, JPMorgan is committed to working with 
Congress, regulator, and other market participants to create a 
21st century regulatory framework for OTC derivatives. To that 
end, we support comprehensive regulation of dealers and major 
swap participants. We support reporting requirements for all 
transactions. We support mandatory clearing requirements for 
dealers and for major swap participants who have significant 
outstanding exposures. We support end-of-day position reporting 
to the public of the aggregate positions of dealers and major 
swap participants. As always, we believe regulators should have 
access to whatever information they need at any time and in any 
form.
    Thank you, Chairman Lincoln and Ranking Member Chambliss. I 
appreciate the opportunity to testify and look forward to your 
questions.
    [The prepared statement of Ms. Masters can be found on page 
97 in the appendix.]
    Chairman Lincoln. Thank you, Ms. Masters.
    Mr. Okochi.

 STATEMENT OF JIRO OKOCHI, CHIEF EXECUTIVE OFFICER, REVAL.COM, 
                    INC., NEW YORK, NEW YORK

    Mr. Okochi. Good morning, Chairman Lincoln, Ranking Member 
Chambliss, and members of the Committee. Thank you for the 
opportunity to testify today on the topic of the OTC derivative 
reform.
    My name is Jiro Okochi, and I am the CEO and co-founder of 
Reval. We provide web-based solutions that help over 375 
companies better handle their use of derivatives to hedge 
business risks. We help our clients with risk management and 
specialize in accounting for derivatives under U.S. GAAP and 
international financial reporting standards. Our clients range 
from the Fortune 10 with thousands of derivatives down to the 
middle market company with just a handful of OTC derivatives.
    As I may be the last person to testify representing end 
users, I would like to take this opportunity to state that non-
financial corporations using OTC derivatives to hedge specific 
business risks were not the cause of the recent financial 
crisis, and every consideration should be given to this class 
of users so that they are not penalized for using OTC 
derivatives properly.
    While a majority of our clients understand the need for 
better regulation of the OTC derivatives market, there are 
three areas of concern for corporate end users of derivatives:
    Standardization of OTC derivative contracts could result in 
mismatches between the terms of the derivative and the specific 
terms of the business risk they are trying to hedge, resulting 
in improper hedging results. Standardization may also result in 
failing the hedge effectiveness testing requirements around 
derivative accounting under U.S. GAAP, called FAS 133. As a 
result of failing these tests, additional P&L volatility could 
arise.
    The reform may also lead to higher costs to hedge. There is 
a concern that the pending legislation will result in fewer 
swap dealers and, therefore, less competition as smaller 
dealers and foreign dealers may find the new regulations too 
onerous to comply. Furthermore, additional capital and 
margining requirements for swap dealers will ultimately be 
passed on to the end user, resulting in a higher cost to enter 
into these transactions.
    The third major concern is margin requirements are costly 
to provide as well as to maintain. Companies will either have 
to raise cash, which would impact their balance sheets and 
potentially their credit ratings, or their liquidity would be 
impacted as most companies invest in highly liquid securities 
that could be sold at any time instead of being held and tied 
up in a margin account. Furthermore, the cost to maintain and 
post daily margin would be new in terms of systems and people 
for most companies.
    Some of the legislation to date has indeed exempted non-
swap dealers and non-major swap participants from having to 
clear their OTC derivatives and to post capital and margin. 
However, it is our concern that if swap dealers will be 
required to post capital and margin against all uncleared 
trades, then ultimately the swap dealers may in turn require 
their end users to post margin to them, defeating the purpose 
of allowing exemptions for margin posting by end users.
    With these points in mind, I would like to make the 
following suggestions which will not only benefit the end users 
of OTC derivatives, but hopefully help in the long-term success 
of implementing the reform.
    Swaps sold to end users by swap dealers should also be 
exempt from margining and additional capital to avoid the 
likelihood that these costs and margining to the swap dealers 
will then be passed on to end users.
    It appears there is a need to narrow the scope of who may 
benefit from any exemptions from requirements to like 
margining. One approach may be by defining the term ``swap end 
user.'' Companies that hedge have specific risk management 
policies that clearly state they do not use OTC derivatives to 
speculate and also are required to define their hedging 
strategies and their use of derivatives in handling U.S. GAAP. 
This policy could be used as one of the cornerstones to define 
a swap end user.
    Certain non-event-related transactions pose minimal risk to 
the system, so I hope the Committee will not only include the 
exemption for foreign exchange forwards and swaps outlined in 
other proposals, but will also consider exemptions for single 
currency interest rate swaps and commodity swaps less than 12 
months.
    Finally, I would like to reiterate and clarify that our 
clients understand the need for the regulation of the OTC 
derivatives market. Our clients feel that, given their 
relatively limited and simple use of OTC derivatives, the 
current legislative proposals to have regulated trade 
repositories would go a long way towards alleviating systemic 
risks, provide much better transparency, and address the 
business conduct issues outlined in the current reform 
proposals.
    Despite some of the negative perceptions around OTC 
derivatives, corporate end users are able to lower their 
capital costs, raise profit margins, which is not only 
beneficial to shareholders but also to consumers, who otherwise 
would have unhedged costs and risks passed on to them instead 
of them being intermediated to swap dealers.
    I look forward to addressing any questions from the 
Committee, and thank you for the honor of testifying today.
    [The prepared statement of Mr. Okochi can be found on page 
102 in the appendix.]
    Chairman Lincoln. Thank you, Mr. Okochi. I will begin my 
questions, and then turn it over to Senator Chambliss.
    Mr. Duffy, it has been proposed that clearinghouses should 
be the decisionmaker in determining what types of contracts can 
and, therefore, should be cleared. Just a couple questions on 
that. What are your standards for determining whether a 
transaction is clearable? Do you think there is a role for 
Federal regulators in that process?
    Mr. Duffy. Well, first, I do believe that the exchanges 
should be the ones, the clearinghouses should be the ones to 
decide what they are going to accept into their clearinghouses 
and not the regulators, as proposed by some of the regulation. 
We have the deep domain expertise of clearing and risk 
management. You look at some of the standards that we are going 
to apply, we are not going to accept customized type OTC 
transactions, only standardized.
    Now, the big question that has been raised here today, What 
is standardized? Nobody has actually defined what is 
standardized, and it is very difficult to do.
    Senator, you and I can make a trade and just because we did 
it, we decide it is standardized. But, unfortunately, Senator 
Chambliss is not quite sure what we did, so he does not know 
how to participate in that. So it is customized.
    So it is a very difficult process. So what we are going to 
do in turn is look to see where we have highly liquid, index-
type, over-the-counter transactions and credit default swaps 
and other OTC contracts that we believe that we can risk-
manage. We also own a company at the CME called CMA, Credit 
Market Analytics, who gets a lot of information on pricing OTC 
contracts.
    So if we cannot risk-manage a product properly, we will not 
accept it for clearing.
    Chairman Lincoln. Mr. Axilrod, your organization has got 
long experience in providing clearing and settlement services 
in the OTC marketplace. Certainly we think your expertise is 
helpful in the context of our hearing today. Maybe you could 
comment on issues related to segregation of swaps margin. 
Several market participants have noted that they believe such a 
requirement is not necessary. However, I note that this is an 
indispensable part of the financial responsibility regime under 
commodities law.
    Should we require clearinghouses and counterparties to 
segregate their swap margin funds? How important is segregation 
of the initial and the variation margin in mitigating the 
counterparty and the systemic risk?
    Mr. Axilrod. Well, I guess I would like to respond just to 
clarify what the argument is and what motivated this. As 
everybody knows, when a lot of hedge funds lost a lot of money 
because they had margin sort of at Lehman, unsegregated, and 
they had a very difficult time getting it back from Lehman when 
Lehman went under, this is a controversial topic, to say the 
least.
    Chairman Lincoln. There are a few of them in this basket we 
are dealing with.
    Mr. Axilrod. I guess from DTCC's point of view, I would 
sort of like to demur. We do not have a company view on what 
the best solution is for the market. I do think that any 
solution that is finally adopted by the market ought to be able 
to assure non-defaulting counterparties that they get their 
margin back in the event that the counter--excess margin back 
in the event that their counterparty defaults.
    I am not sure that I can tell you that--segregation 
certainly does that. I am not sure I can tell you that is the 
only way of doing it. But I can tell you that it ought to be 
the case that your excess margin, your initial margin should 
not be at risk if your counterparty defaults.
    Chairman Lincoln. So you are not exactly endorsing that, 
but you are saying it is one way or there are----
    Mr. Axilrod. That is one way of accomplishing this. I have 
not done a detailed study of all the potential ways.
    Chairman Lincoln. So you do not really have a 
recommendation of how we achieve that ability to----
    Mr. Axilrod. Not right now.
    Chairman Lincoln. Mr. Short, you made several points 
regarding the position limits and the open-access issues. The 
CFTC is considering position limits on various energy 
commodities and has been reaching out to persons in the energy 
industry and the trading world. It is my understanding that it 
will issue a proposed rule later this year on those limits.
    Are you comfortable with how that process has been handled? 
Do you support or oppose position limits generally? What should 
we keep in mind as we put forward regulatory reform in that 
regard?
    Mr. Short. I think the CFTC has done a good job in hearing 
from all parts of the market about whether position limits 
should be imposed. I think position limits are widely 
misunderstood, in all candor. I mean, position limits have 
traditionally been used to prevent delivery squeezes and market 
corners, and I think what is being proposed now is to use 
position limits to limit the overall level of speculative 
activity in markets.
    I think that is somewhat problematic in that I do not think 
there have been any studies that have really shown that 
speculation has driven markets, at least in the energy markets, 
and you have a lot of market participants like index funds, for 
example, that are widely misunderstood. These are passive 
investors in markets. They have actually been shown to lessen 
volatility in markets. If you impose position limits on those 
types of market participants or dealers, you could have--we are 
afraid of dislocation in markets. Basically those people would 
be forced to go to the opaque OTC bilateral markets where they 
might have to pay to get exposure to a given derivative or 
commodity.
    Chairman Lincoln. Well, in----
    Mr. Axilrod. Can I add a little bit, if that is okay?
    Chairman Lincoln. Sure.
    Mr. Axilrod. One thing I would just note is that with 
multiple exchanges, multiple trading platforms, and multiple 
clearinghouses, position limits simply are not going to be 
effective, again, without a central place where all the 
positions are reported.
    Chairman Lincoln. Mr. Short, in regard to that open-access 
issue, how would you suggest that we best design our regulatory 
reform architecture to benefit consumers? Do you have any 
recommendations there?
    Mr. Short. To benefit consumers? I mean, we are definitely 
incented to take in trades from a variety of venues. I think 
our point is that that decision should be left--is best left to 
the clearinghouse. But something like a legal mandate, you 
know, we would oppose. We would note that there is no legal 
mandate in the futures world right now, and if we are saying 
that a lot of these swaps are the economic equivalent of 
futures, I do not see why they would be treated differently.
    Chairman Lincoln. Ms. Masters, you discussed in your 
testimony an interesting idea that I want to explore, a ratio 
of non-cleared to cleared trades that could be used to drive 
the OTC transactions to clearinghouses and exchanges. First of 
all, I am glad you are thinking about outside the box. That is 
a good thing. We always need that. A regulator, I think, in 
your plan would allow the swap dealers and the major swap 
participants to have a certain small percentage of their trades 
to be customized or non-cleared.
    How would the dealer determine which of those trades to 
move through a clearing solution? In your plan, what regulator 
would set the ratio and how would they set it?
    Ms. Masters. In terms of the question of who would set the 
ratio first, our thought is that it would need to be a 
combination of the relevant derivatives regulator, so either 
CFTC or SEC as appropriate, and the prudential regulator for 
the relevant entity in question, so a banking regulator if it 
was a bank.
    The reason for believing that both those regulators have a 
role to play is that the value judgment that is required there 
needs to take into account factors that are both specific to 
the entity in question, how leveraged they are, what systemic 
risks they create, as well as the characteristics of the 
products and activities themselves, and, hence, the role for 
both regulators.
    The question around how one would decide what to clear or 
not to clear I think under this framework is simplified a lot. 
The reason for making this suggestion is that as we have tried 
to come up with words to describe what is a standardized versus 
a non-standardized contract, we immediately realized that even 
if you had that wonderful ``Aha'' moment--which has not yet 
happened, I might add-- shortly thereafter the markets would 
evolve and products would change, and the perfect definition on 
day one would have no longer served the purpose.
    Furthermore, even if you take a very simple contract like a 
swap, you can break it into two pieces, neither of which are 
simple, which add up to one simple total and then have a 
rationale for not clearing either of those two sub-
transactions, if you will. So the opportunity for regulatory 
arbitrage is, frankly, gigantic.
    We think it is a waste of regulators' time and market 
participants' time and legislators' time to try to come up with 
that definition if an alternative can be found. So by setting 
percentage targets, our view is that the combination of dealers 
working with service providers in the clearinghouse sector 
would be incentivized to maximize that which they clear in 
order to meet those targets, and by definition, they would 
clear those things which, as you have heard, are most liquid 
and which most naturally lend themselves to being cleared and 
would, therefore, be most likely to be accepted for clearing by 
the clearinghouses.
    I think that is a symbiotic approach. I think it leaves the 
dealers' and the clearinghouses' and the regulators' incentives 
all aligned rather than in conflict; whereas, the prior 
suggestion that we attempt to define ``standardized'' in some 
sense actually I think leave all sorts of conflicts of interest 
out there that are not in anybody's best interest.
    So I think the other advantage of the suggestion is that 
percentage target can vary by asset class. For example, if you 
take the credit derivatives asset class, there are a far lower 
proportion of corporate end users, almost none, in that asset 
class than, for example, in the commodities asset class where 
corporate end users are much more active. So a higher 
percentage would be applicable and appropriate in credit 
derivatives than perhaps in commodity derivatives.
    So you could tailor the approach based on the regulators' 
knowledge of the product--hence, the role for the SEC and the 
CFTC--and the prudential regulators' understanding of the risks 
created by the individual entity in question.
    Chairman Lincoln. Thank you.
    Senator Chambliss.
    Senator Chambliss. Let me ask all of you to comment on the 
issue of speculation. Do we need speculators in the 
marketplace? What is going to happen to the market if we 
overregulate speculators?
    Mr. Duffy.
    Mr. Duffy. Well, Senator, there is no question that if we 
did not have a composition of speculators in the market, we 
would not have a market. So the simple answer is, yes, we do 
need to have them. If we restrict them, they have alternatives 
to where they can go outside of the United States, and they are 
doing that by example after example.
    Deutschebank's large commodity index that they had when 
their no-action letter was revoked by the CFTC is basically now 
coming off regulated exchanges. They are trading their corn, 
wheat, soybeans, and other products. They are going to 
reconstitute in Europe, and so there are examples such as that.
    If you start to get liquidity to move overseas, I assure 
you liquidity follows liquidity. There are no barriers to entry 
from the United States into Europe or from Europe into the 
U.S., and, conversely, with Asia also.
    U.S. Oil is another prime example. U.S. Oil was asked to 
ratchet down their regulated positions on the New York 
Mercantile Exchange. They are reconstituting their funds to 
trade in the Brent market in London outside of the reach of the 
United States. There is no question there are multiple, 
multiple examples of how, if you take speculators out of the 
marketplace, they are going to find the ability to get access 
to these types of markets.
    Senator Chambliss. Has the movement by Deutschebank been 
dictated by what is going on with respect to this legislation?
    Mr. Duffy. Not with respect to this legislation. It was 
with respect to the CFTC revoking their no-action letter, 
basically not allowing them to carry the positions in the 
agricultural products at the Chicago Board of Trade.
    Senator Chambliss. Mr. Short.
    Mr. Short. I agree with much of what--well, basically all 
of what Mr. Duffy just said. I think speculators are an 
important part of any market. They have largely been, I think, 
improperly demonized in the last year with a lot of wild 
allegations about the effects of speculation in markets, and I 
just do not think the facts, you know, shore up those 
statements suggesting that speculators were the major problem 
here.
    Senator Chambliss. Mr. Axilrod.
    Mr. Axilrod. I am in broad agreement with my two 
colleagues. I would just point out generally the more liquid 
markets are, the better, especially in the basic capital-
raising markets. You want very liquid secondary markets. Trying 
to define speculation and hold them out of the market is going 
to reduce liquidity. It may turn out to be a necessary evil, 
but I think they need to be there.
    Senator Chambliss. Ms. Masters.
    Ms. Masters. It is important to ask the question, you know, 
why you would want to exclude investors or speculators from 
these markets. I have seen no credible evidence that supports 
the argument that speculators or investors were responsible for 
the high commodity prices that occurred during the summer of 
2008. Those high prices were entirely supported by factors of 
supply and demand. If you want to in the long run depress 
commodity prices, you need to have policies that impact the 
supply of and demand for those commodities, or prices will 
continue to rise.
    With respect to the negative impact of withdrawing the 
presence of investors from these markets, ultimately the people 
who will pay the consequence for that will again be the man on 
the street because the end user, the producer, the consumer, 
will no longer be able to use these markets effectively to 
hedge their exposures because they will not be able to find the 
other sides of the trades that presently investors provide for 
them.
    We should remember that investors in these markets are as 
likely to be short as they are to be long. They tend to 
position themselves as a function of their view and their 
expectations, and typically when prices rise, they will start 
to sell, and vice versa. So they can be a strong stabilizing 
effect in markets. By removing their ability to access markets, 
you will end up with less liquidity, more activity in 
unregulated markets, and more activity outside the United 
States.
    Mr. Short. Could I just add one point there? One other 
thing that I think has not been largely explored is the price 
discovery or price signaling effects of markets. These markets 
do send important price signals, and when we talk about the 
United States becoming energy independent and developing 
alternative energy, et cetera, you know, some of these signals 
that are being sent out 2 years down the road, I mean, these 
are important things that, say, an alternative energy company 
would need to prove in order to get an alternative project 
financed. Eliminating speculators from the market is, in my 
view, the equivalent of kind of sticking our head in the sand. 
We may not like, you know, what the thermometer is saying, but 
ultimately it is probably accurate about what the market thinks 
the future will look like. I think that is very important 
information for Government and business to have.
    Mr. Okochi. I would like to comment that, you know, again, 
corporate end users of derivatives are not speculating. They 
are not paid to speculate. Their bonuses are not tied to, you 
know, profitability against derivative hedges.
    I would agree with Ms. Masters that while the end users are 
not necessarily always happy about some of the speculation that 
goes on in one direction, they need that other side of the 
marketplace to provide that liquidity. You know, sometimes 
these investors are right and sometimes they are wrong, but, 
you know, corporate end users are used to having both sides of 
the market and require that.
    Senator Chambliss. So, Ms. Masters, if we require--or if we 
exempt end users from having to clear contracts, does that mean 
that all speculators' contracts would be cleared?
    Ms. Masters. The way the current proposals address this 
question of who is and who is not a systemic entity or a major 
swap participant is to look at the amount of open positions 
they hold and whether, if they were to fail, that would have 
systemic consequences for their counterparties with knock-on 
implications in the economy.
    I think that is an appropriate definition, and I think that 
under that definition, a number of investors who maintain large 
open positions might be captured. Others that do not maintain 
systemically relevant size positions would not be captured. It 
would depend on the nature of their activity, and I think that 
is appropriate.
    Senator Chambliss. Mr. Duffy and Mr. Short, could you 
discuss how certain trading activities have moved away from the 
exchange to the over-the-counter space due to concerns CFTC may 
soon modify the manner in which exchange-traded positions are 
limited?
    Mr. Duffy. Well, I will go back to my earlier statement, 
Senator. With the Commission making innuendos that they are 
going to limit participants, participants need to get exposure 
to these particular markets, and they are going to get it. 
Every major dealer has access to the European market. Every 
major dealer has access to the Asian market. They do not need 
to worry about just being here in the United States. There are 
markets being started up every day. I made an example earlier 
about Deutschebank fleeing out of the U.S. into European 
commodity indexes. The Paris exchange today trades 10,000 
contracts each and every day of corn. If in fact, the liquidity 
starts to garner higher and higher numbers, that will make it 
very, very difficult for the people who need to manage risk in 
this country, our farmers that rely on the Chicago Board of 
Trade's prices, to manage risk. They will be beholden to what 
the price is on the Paris exchange to do their transactions to 
manage risk. I think that is a big issue. Anytime you limit 
participants, it is a bad idea. The more participants, the 
better.
    I obviously agree with Ms. Masters. Liquidity is king, and 
if you do not have the liquidity in the marketplace, the cost 
of doing business goes up significantly, so every participant 
is critical. So to limit that would be a huge mistake.
    Mr. Short. I agree with what Mr. Duffy just said. We had a 
similar experience with the U.S. Natural Gas Fund and U.S. Oil 
Fund in terms of moving off of our U.K.-regulated market, which 
has screen-based access to the United States and is subject to 
the same position limit regime as Mr. Duffy's market, as well 
as our regulated significant price discovery markets on our OTC 
platform. We are not sure the benefit that was achieved from 
making these index investors, which, when you step back and 
look at it, these are an aggregation of individual investors, 
pension funds, et cetera, people who just want some exposure to 
commodities to move them into the OTC bilateral market. It 
seems to us that as passive investors, they should have been 
able to maintain these larger positions in our markets.
    Senator Chambliss. Mr. Axilrod, do you believe that central 
repository data collection disseminated to the regulators and 
then made available to the public in aggregate form provides 
sufficient transparency? Or do we also need public reporting of 
positions as they occur through execution on an exchange or an 
alternative execution facility, as the administration has 
suggested?
    Mr. Axilrod. I think in terms of systemic risk, reporting 
of positions to a repository or aggregating this so someone can 
see the entire exposure of a particular firm is probably 
adequate. I think to have the general public know a little bit 
more about position taking as it is happening is probably a 
good thing.
    I think one thing I would emphasize is it might be good for 
regulators to know more about position taking as it is 
happening. I guess in my prior career as a risk manager, you 
get startled by how fast some of these positions go on, and 
sometimes when you see these positions building up, you can 
step in and stop it before it is too late if you have 
sufficient authority. So some transparency, maybe not--I am 
really speaking from the point of view of risk management and 
regulators. Some transparency into aggregate position taking as 
it is happening across all markets might set off alarm bells 
even intra-day that would let somebody do something about it. I 
guess I have offered another context to make sort of our 
aggregate data available to clearing corps., individual 
clearing corps., who may not actually see the entire picture 
and may not be able to see undue exposure being created intra-
day where they can actually step in and, even if they only have 
a part of it, protect themselves.
    Mr. Duffy. Senator, may I just add a little bit to that?
    Senator Chambliss. Sure.
    Mr. Duffy. I think what is important--and there are a 
couple differences between our model and the DTCC's model. 
First of all, as it relates to tracking positions, we track 
positions real time so we can see as these positions are 
building, the technology today allows us to do that. If, in 
fact, we think these positions are getting too large in a short 
period of time, we will step into the participants.
    Another issue that Mr. Axilrod raised was margin and the 
loss of margin during the Lehman default. The answer to that is 
simple. It is to deploy the futures model, which is to have 
segregation and have all these margins and positions segregated 
into the client's name, and you would avoid the bankruptcy 
issues that they would head into.
    So I just wanted to add those two points.
    Senator Chambliss. You mentioned the issue of you are in a 
position to review the transactions on a constant basis daily. 
Obviously, we have got one issue that has got to be resolved as 
to who sets position limits, whether it is going to be the 
clearinghouse or whether it is going to be CFTC. Let me throw 
that out there. Anybody want to comment?
    Mr. Short. From ICE's perspective, that should be the 
regulator if those position limits are going to be aggregate 
across markets.
    Mr. Duffy. Senator, CME Group, 160 years in business, never 
had a customer lose a penny due to a clearing member default, 
is a very strong record. We have set position limits since the 
beginning of time. The CFTC has the ability in the statute 
today to supersede what the exchange's position limits are. 
They have never done so.
    We have numerated position limits set by the Federal 
Government as it relates to our agricultural products, so that 
is already done in that manner. We are in the best position to 
set these position limits, and, again, we do not want to drive 
people off the regulated marketplace into the opaque markets. 
Anytime you look to tinker with position limits, that is 
exactly what you are going to do. You are going to either drive 
them off OTC markets, or even worse, you are going to drive 
them to OTC markets in other overseas jurisdictions.
    So I think it is very important that the exchanges continue 
to facilitate the role of position limits.
    Ms. Masters. Senator, may I add a comment?
    Senator Chambliss. Sure.
    Ms. Masters. One of the challenges with setting position 
limits in futures markets is that the way that today's markets 
operate today, futures markets and over-the-counter derivative 
markets are really seen as and used as a single continuum of 
risk execution venue. So, for example, a dealer may have a 
position over the counter with a client which is hedged or 
offset using a corresponding futures position. If you place 
position limits just on the futures markets in isolation 
without taking into account those other activities which are 
offsetting that, you will obviously interfere with the ability 
of dealers to hedge their customer business and, hence, the 
ability of customers to execute that business.
    So as Mr. Short said, the ideal situation, if position 
limits are to be imposed, is that those limits need to take 
into account not just futures activity, but the activity of 
over-the-counter derivatives in the same underlying at the same 
time. For that reason, I believe that the only entity that 
would be properly positioned to make those decisions would be a 
regulator such as the CFTC or the SEC, depending on the 
underlying rather than the exchange itself, because the 
exchange itself by definition is only seeing the futures part 
of the equation.
    Mr. Duffy. Senator, just if I may jump in for a second, we 
do give hedge offsets to OTC transactions against futures 
positions today. So that is a little bit of a misdirect because 
we can have the ability to give the hedge offset today, so we 
do see the transaction.
    Mr. Okochi. If I could just add to that, I just want to 
make sure that for end users that have, again, OTC derivative 
positions, there is actually a net position of what it is they 
are hedging on the other side. So, again, they could be long. 
Typically, corporations will go in the same direction. They are 
swapping from floating to fixed so they will have a 
unidirectional position on their swaps. So just consideration 
in terms of the net position of OTC derivative plus whatever it 
is they are hedging.
    Senator Chambliss. Okay. Thank you.
    Chairman Lincoln. Thank you, Senator Chambliss.
    Senator Gillibrand.
    Senator Gillibrand. Thank you, Madam Chairwoman.
    Thank you all for testifying. I really appreciate your 
expertise being brought to the focus of this debate. I want to 
continue my conversation with Secretary Geithner with Ms. 
Masters. You are one of the leading experts on credit default 
swaps, and as we talk about how to regulate and whether to 
regulate, many have told me that these instruments in 
particular have increased risks that are truly beyond the 
current margin and risk paradigms.
    As we look at these outsized risks, it reminds me of the 
movie ``Jaws'' when they see the shark and they say, ``We need 
a bigger boat.'' Do we need a bigger boat with regard to these 
kinds of derivatives? You know, you mentioned in your testimony 
having different frameworks for different asset classes, so I 
would like your thinking on this in particular.
    Ms. Masters. To take a step back and talk about 
nomenclature for a minute, I think one of the unfortunate 
things that has happened over the course of the recent crisis 
has been that the word ``CDS'' or the phrase ``CDS'' has been 
applied to a host of different types of derivative structures, 
many of which really do not look that much like traditional 
credit derivatives at all. In particular, the transactions that 
got AIG into trouble were not really credit derivatives. They 
were mortgage derivatives. I think that was a point that 
Secretary Geithner made in his response to your earlier 
question.
    What AIG undertook was several hundreds of billions, more 
than $400 billion of exposure where they wrote protection on 
leveraged portfolios of primarily subprime mortgages, and the 
issue with that asset class is that all of those securities 
simultaneously were vulnerable to one thing, and that thing was 
a decline in house prices in the United States. It was assumed 
that the geographical diversity of that portfolio would somehow 
offset this and that not all prices could fall together and the 
U.S. housing market could never decline 30 percent in total, 
and obviously, with hindsight, that assumption proved wrong. So 
the underlying reliance on diversification in the portfolio as 
a defense really was proved unfounded.
    If you take those types of transactions out of the picture 
for a minute and look at the rest of the credit derivative 
marketplace, first of all, those types of transactions 
represent a small percentage of the total, I would suggest 
maybe a couple of percentage points, maybe 2 or 3 percent of 
the total. More traditional credit derivatives look like 
structures where the underlyings are corporations, companies 
that you have heard of typically. When you look at the overall 
marketplace of credit derivatives, the risk that those 
contracts represent is no more or less binary than the risks 
inherent in portfolios of corporate bonds.
    For a single event to wipe out value on the scale that we 
saw in the subprime mortgage securities would be almost 
inconceivable. You would have to have corporations engaged in 
totally different industries, in totally different activities, 
in totally different regions simultaneously becoming bankrupt. 
It is obviously very hard to imagine a scenario like that.
    So my sense is that, generally speaking, in what I will 
refer to as the standardized or plain vanilla and actually the 
largest part of the credit derivative markets, the Treasury 
Secretary was correct in his characterization that they share 
the characteristics of most other derivatives. They can be 
adequately modeled and collateralized for the purpose of 
central clearing, and we have competing platforms, two of them 
represented right here, who are capable of safely clearing 
those products.
    The last point that you made when you addressed the 
Treasury Secretary earlier was whether or not these 
instruments, because they can be used to express a negative 
view or a short-selling view on companies should somehow be 
treated differently, and I think that is a very difficult 
question. It is obviously a question which came up during the 
course of the crisis, and it is no different in the context of 
short selling using credit derivatives than in the context of 
short selling in the equity markets.
    I think we all understand intuitively the reasons why 
interfering in the natural operation of the equity markets is 
distasteful, but we also understand the scenario where that 
will sometimes be necessary because of the need for Government 
to intervene in a situation where the market dynamic has become 
not constructive.
    I think it is, therefore, right and relevant that going 
forward under the proposals the SEC will have a joint role for 
regulating the product of credit derivatives and equity 
derivatives, because the two products share many of the same 
characteristics with respect to that narrow question of whether 
short selling should be allowed. I think that in certain 
circumstances, in extremis, it may be appropriate for activity 
to be constrained, but as a general matter, I think the ability 
to express a negative view on a corporation is an important 
free market function.
    Senator Gillibrand. I understand. One of the issues that 
you have all brought up a bit is the effect that the capital 
requirements will have on the liquidity in the system, and each 
of you has expressed some concern about that. So I am curious 
what impression you have on what the ultimate impact of this 
derivatives market through these kinds of regulatory frameworks 
that we have been discussing will be. Do you anticipate a 
significant change in liquidity and availability of capital? 
What impacts do you see? Blythe, go ahead.
    Ms. Masters. I think that there are several parts to the 
question. If we talk about transaction execution first, the 
question is whether or not certain activities should be 
required to be executed on exchanges, and the concern is that 
in that eventuality there would be a destruction of liquidity 
in markets because the act of forcing a market participant to 
show their hand by posting a large position on a central limit 
order book would cause the market to become dysfunctional and 
to run away in front of the proposed transaction.
    Very often, the nature of end users in OTC derivative 
markets is that they do have large size to transact. Ultimately 
and over time, that size or those risks do make their way back 
into the exchange-traded market very often, but during the 
period of execution, end users need dealers to be willing to 
commit capital so that they can execute the size and the 
structures that they need in order to manage their risks.
    If you were to force those types of activities onto a 
central limit order book, you would destroy liquidity, and 
those transactions would not be able to be conducted at all.
    The second part of the question relates to whether by 
mandating clearing you could drain liquidity out of the system, 
and really I think the issue there is that there are certain 
types of end users, mostly traditional corporate end users, who 
just do not have the credit capacity and the collateral cash 
capacity to be pledging collateral to exchanges.
    Senator Gillibrand. Like an airline.
    Ms. Masters. Like an airline, like a gas producer, like a 
refinery, those types of companies. They are not in the 
business of--they are not financial institutions. They are in 
the business of flying planes or doing whatever they do as a 
corporation. They use banks to provide those services to them. 
That is a useful social purpose of banks and dealers that 
should not be restricted. If you force that activity to be 
centrally cleared or collateralized, again, the costs will 
rise, and you will squeeze that liquidity out of the system, 
that credit capacity out of the system, to what benefit? If it 
were the case that the benefit were the eradication of systemic 
risk, then perhaps that would be an acceptable price to pay. 
But the argument that I have put forth here, and others have, 
too, is that you can eradicate systemic risk by focusing on 
those companies which were responsible for it, namely, the 
large financial institutions and the major swap participants.
    Mr. Duffy. Senator, if I may?
    Senator Gillibrand. It is up to the Chairman. My time has 
expired.
    Chairman Lincoln. Sure.
    Mr. Duffy. I would just like to make a few other comments 
on what Ms. Masters said. First of all, as it relates to 
trading, the exchanges are not what they were in 1977 or 1997. 
These are highly electronic systems that are disseminated 
around the world that have complete anonymity, and we have 
algorithms to make certain that dislocation of markets do not 
happen the way Ms. Masters was describing it. If it was an old 
open-outcry trading floor, I would not be able to make that 
argument, but it is not today.
    Also, there has been a little bit of a misdirect on balance 
sheet capital and margins. What is the difference? The 
Secretary said it today. There is a difference between balance 
sheet capital, what you have on your balance sheet, and 
margins. Margins are dedicated towards that position of that 
contract. That margin money does not go away when you exit your 
position. It goes back to the user of the marketplace. The 
dealers still charge the end users a price to come in and elect 
to do a transaction over the counter. So the margins that are 
being imposed and everybody is saying it is going to drive the 
cost up, drive unemployment up--I have heard all different 
types of scenarios what is going to happen with margin--is 
ridiculous. Margin is there to protect the system. Margin is 
there to protect against a 1-day move in a futures market. In a 
credit default swap, margin is put in for a 5-day move, 
whatever the worst-case scenario would be, and then you risk-
manage it.
    So I believe there has been a little bit of misdirects here 
on margin and the use of margin and like this margin money just 
goes away once you elect out of your position, which is 
absolutely not true.
    So there are some other benefits to trading, and, again, we 
are not promoting as the CME Group to transact business on our 
central limit order book for OTC transactions. Our offering 
will be a cleared-only solution, and we believe that if you 
have capital charges of X for clearing versus Y for non-
clearing, you will find what the definition of standardized is 
very, very quickly.
    So I would just like to add those points. Thank you.
    Chairman Lincoln. Well, we want to thank everyone for 
coming today and certainly sharing your insight, your 
expertise, your experiences with us. It seems we are all 
agreeing on one thing, and that is, we absolutely must reform 
our financial markets and our regulatory system.
    Some significant issues need to be worked out, from the 
clearing mandate to the margin requirements, but we can and we 
will get it done. Hearing your testimony today was an important 
reminder that although we must do this quickly-- and I think 
the American people are looking to us to provide these reforms 
and create greater confidence--it is more important to do it 
correctly. I would like to certainly thank my colleague Senator 
Chambliss and his staff for their help, as well as the 
Committee members for all of their time in being here today. I 
look forward to working with you all. We hope to continue to 
have conversations with you all as we move through in producing 
the solutions.
    So we will hold the record open for 5 days for Senators' 
questions and statements for those of you all on the panel and 
any additional testimony that groups would like to submit.
    With that, thank you all very much for spending your time 
with us today, and the Committee is adjourned.
    [Whereupon, at 12:18 p.m., the Committee was adjourned.]
      
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                            A P P E N D I X

                            December 2, 2009



      
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