[Senate Hearing 112-163]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 112-163

 
        DERIVATIVES CLEARINGHOUSES: OPPORTUNITIES AND CHALLENGES

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

                                HEARING

                               before the

                            SUBCOMMITTEE ON
                 SECURITIES, INSURANCE, AND INVESTMENT

                                 of the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED TWELFTH CONGRESS

                             FIRST SESSION

                                   ON

       EXAMINING THE OPPORTUNITIES AND CHALLENGES OF DERIVATIVES 
                             CLEARINGHOUSES

                               __________

                              MAY 25, 2011

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


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            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  TIM JOHNSON, South Dakota, Chairman

JACK REED, Rhode Island              RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York         MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey          BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii              JIM DeMINT, South Carolina
SHERROD BROWN, Ohio                  DAVID VITTER, Louisiana
JON TESTER, Montana                  MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin                 PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia             MARK KIRK, Illinois
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina

                     Dwight Fettig, Staff Director

              William D. Duhnke, Republican Staff Director

                       Dawn Ratliff, Chief Clerk

                     Levon Bagramian, Hearing Clerk

                      Shelvin Simmons, IT Director

                          Jim Crowell, Editor

                                 ______

         Subcommittee on Securities, Insurance, and Investment

                   JACK REED, Rhode Island, Chairman

              MIKE CRAPO, Idaho, Ranking Republican Member

CHARLES E. SCHUMER, New York         PATRICK J. TOOMEY, Pennsylvania
ROBERT MENENDEZ, New Jersey          MARK KIRK, Illinois
DANIEL K. AKAKA, Hawaii              BOB CORKER, Tennessee
HERB KOHL, Wisconsin                 JIM DeMINT, South Carolina
MARK R. WARNER, Virginia             DAVID VITTER, Louisiana
JEFF MERKLEY, Oregon                 JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado          ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
TIM JOHNSON, South Dakota

                Kara Stein, Subcommittee Staff Director

         Gregg Richard, Republican Subcommittee Staff Director

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, MAY 25, 2011

                                                                   Page

Opening statement of Chairman Reed...............................     1

Opening statements, comments, or prepared statements of:
    Senator Toomey...............................................     2
    Senator Crapo................................................     3

                               WITNESSES

Christopher Edmonds, President, ICE Trust........................     5
    Prepared statement...........................................    37
    Responses to written questions of:
        Chairman Reed............................................    61
Terrence A. Duffy, Executive Chairman, CME Group Inc.............     6
    Prepared statement...........................................    39
Benn Steil, Senior Fellow and Director of International 
  Economics, Council on Foreign Relations........................    19
    Prepared statement...........................................    46
Chester S. Spatt, Pamela R. and Kenneth B. Dunn Professor of 
  Finance, Tepper School of Business, Carnegie Mellon University.    21
    Prepared statement...........................................    49
Clifford Lewis, Executive Vice President, State Street Global 
  Markets........................................................    23
    Prepared statement...........................................    52
Don Thompson, Managing Director and Associate General Counsel, 
  JPMorgan Chase & Co............................................    24
    Prepared statement...........................................    53
James Cawley, Cofounder, Swaps and Derivatives Market Association    25
    Prepared statement...........................................    59
    Responses to written questions of:
        Chairman Reed............................................    71

              Additional Material Supplied for the Record

Letter submitted by Thomas C. Deas, Jr., Vice President and 
  Treasurer, FMC Corporation.....................................   113

                                 (iii)


        DERIVATIVES CLEARINGHOUSES: OPPORTUNITIES AND CHALLENGES

                              ----------                              


                        WEDNESDAY, MAY 25, 2011

                                       U.S. Senate,
     Subcommittee on Securities, Insurance, and Investment,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.
    The Subcommittee met at 9:35 a.m., in room SD-538, Dirksen 
Senate Office Building, Hon. Jack Reed, Chairman of the 
Subcommittee, presiding.

            OPENING STATEMENT OF CHAIRMAN JACK REED

    Chairman Reed. Let me call the hearing to order, and I want 
to welcome everyone to the hearing this morning on 
``Derivatives Clearinghouses: Opportunities and Challenges.'' 
The financial crisis revealed some significant weaknesses in 
our financial sector, and one of the most problematic was the 
over-the-counter derivatives market. Derivatives contracts 
involve the transfer of risk from one party to another.
    The total notational value of over-the-counter derivatives 
outstanding at year end increased 645 percent from 1998 to 
2008, a significant increase. Looking at it another way, back 
in 1998 and 1999, derivatives were a relatively small part of 
the market, but by 2008 they were a huge and continue to be a 
huge part of the market.
    According to the Bank of International Settlements, in 
December 31, 2010, the total notional amount outstanding was 
$601 trillion with a market value of $21 trillion, so there are 
huge potential benefits or dangers to the financial system.
    The sheer number and amount of over-the-counter derivatives 
transactions which were not regulated by the SEC or CFTC proved 
to be an accelerant during the financial crisis. 
Uncollateralized losses built up. By September 2008, one of the 
world's largest insurers, AIG, was on the verge of bankruptcy, 
triggered by its tremendous investment in credit default swaps. 
AIG had agreed to pay counterparties in its derivatives 
transactions if certain credit events occurred. A series of 
market events required AIG to post billions in collateral--
collateral it did not have. The imminent default of AIG would 
have cascaded throughout the U.S. economy, encompassing private 
companies, local and State governments, and retirement plans. 
Accordingly, the Government provided hundreds of billions of 
dollars in extraordinary relief to AIG, most of which was paid 
to AIG counterparties. American taxpayers were exposed to 
billions of dollars in potential losses.
    As a result of that incident, and others, the Dodd-Frank 
Wall Street Reform and Consumer Protection Act of 2010 
developed new rules for the over-the-counter derivatives market 
to insulate both the U.S. economy and the American taxpayer 
from any future extraordinary losses in this area. The new 
rules of the road require the use of centralized derivatives 
clearing organizations, or clearinghouses. Clearinghouses are 
not a new invention. They have been a part of financial 
transactions for a long time, dating back to European coffee 
and grain exchanges of the late 19th century and in the United 
States the 1883 creation of the Chicago Board of Trade and the 
futures market. It later became the Board of Trade Clearing 
Corporation and serves as the counterparty in all transactions 
on the exchange.
    Clearinghouses place themselves in the middle of 
transactions, reducing counterparty risk by mutualizing 
exposure. Clearinghouses transact business with clearinghouse 
members, and customer losses are absorbed by these members. 
Clearinghouses deal with risk by constantly evaluating and 
requiring the posting of margin or collateral as insurance.
    In the deficiency Wall Street Reform Act, the mandate to 
creating clear standardized derivatives is the foundation upon 
which a more transparent and competitive swaps market may begin 
to flourish. Clearinghouses and swap execution facilities, 
SEFs, should allow for better price discovery, more efficient 
allocation of capital, and a healthier and more resilient 
derivatives sector.
    The purpose of this hearing is to examine both the 
opportunities and challenges posed by a marketplace dependent 
upon clearinghouses.
    How do we ensure that the clearinghouses themselves do not 
become significant risks to our economy? What issues affect 
their safety and soundness? What are the best practices of 
structuring, governing, and controlling derivatives 
clearinghouses? How do we minimize conflicts of interest? What 
barriers to clearinghouse membership or services exist?
    All of us have a vested interest in making sure these new 
derivatives clearinghouses function safely and fairly, and we 
know from past experience that market players are concerned 
principally with their own positions and do not always think of 
the market as a whole when they recommend what the new rules of 
the road should be. Hopefully our hearing this morning will be 
focused and help everyone focus on the bigger issue: making 
sure that these risks do not again overflow onto the American 
taxpayer.
    I look forward to hearing from all of our witnesses this 
morning on these issues.
    Before I introduce our first panel, I would like to 
recognize Senator Toomey, if he has any comments, and then our 
other colleagues.

             STATEMENT OF SENATOR PATRICK J. TOOMEY

    Senator Toomey. Thank you very much, Mr. Chairman, and 
thank you for deciding to do this hearing. I think this is a 
very important topic. I want to thank the witnesses for being 
here. I will just make a brief observation.
    I might be the only former derivatives trader on this 
panel--on this side, anyway--and as such, I just want to 
observe that with the obvious and very significant exception of 
AIG, I think the reality of the derivatives market during the 
financial crisis was that both the OTC derivatives market and 
the exchange-traded derivatives actually for the most part 
functioned extremely well. They both have played an enormously 
important role in allowing financial and nonfinancial 
institutions to manage risk, and as such, the evolution of 
derivatives since I was involved in this industry back in the 
1980s to more recent days has been enormously constructive for 
our economy, for the allocation of capital, and for the 
management of risk.
    We have now decided, for better or for worse, that all 
over-the-counter derivatives--or I should say most over-the-
counter derivatives are going to be cleared and executed 
through exchanges going forward. And I just think it is very, 
very important that we do this in a very cautious fashion, that 
we have--this is a very complex process. It has enormous 
implications, and I just hope that we will do this in a very 
thoughtful, careful, and I would say, in terms of the 
implementation of these regulations, Mr. Chairman, I think it 
is very important that we do this sequentially rather than 
trying to do this all at once because the sheer volume of 
regulations is staggering. And in addition to doing it 
sequentially, I think it is important that we do it over a 
period of time that is long enough for us to work out the kinks 
and to allow the market participants to adjust to this very, 
very new regulatory environment.
    I am confident we can do that. I think it is necessary that 
we take that approach so that the tremendous benefits to the 
economy from these tools do not get eroded.
    Thank you very much, Mr. Chairman.
    Chairman Reed. Thanks, Senator Toomey.
    Before I recognize Senator Moran, the Ranking Member has 
arrived, and I would like to recognize Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Well, thank you, Senator Reed. I apologize. 
I got hung up, and I appreciate you going ahead and not 
waiting. I apologize for any inconvenience.
    Federal Reserve Chairman Ben Bernanke's speech in April 
provides a good perspective, I think, on both the opportunities 
and the challenges of clearing. He said, `` . . . by 
centralizing and standardizing specific classes of financial 
transactions, clearinghouses reduce the costs and operational 
risks of clearing and settlement among multiple market 
participants . . . . However, the flip side of the 
centralization of clearing and settlement activities in 
clearinghouses is the concentration of substantial financial 
and operational risk in a small number of organizations, a 
development with potentially important systemic implications.''
    In formulating clearinghouse regulations and conducting 
oversight, regulators need to fully understand the complexity, 
the interconnectedness, and the potential for systemic risk for 
clearinghouses. The decisions that regulators and 
clearinghouses make regarding risk management will have 
significant implications for the soundness of our financial 
system.
    It is important that the regulators and the market 
participants look carefully at both the individual proposed 
rules and how the overall interaction of all the proposed 
regulations designed by the different regulators either fit 
together or cause unintended consequences. This is not a simple 
task, and I would encourage the regulators to take the 
necessary time to get the rules right by incorporating the 
meaningful public comments and economic analysis in their 
proposed rules.
    I remain concerned that the mandatory clearing requirement 
could force clearinghouses to take on risk that is not 
adequately understood or managed. Some of the international 
regulators have indicated a preference that derivatives 
denominated in their respective countries or traded by entities 
subject to their authority be cleared via clearinghouses in 
their respective jurisdictions.
    What kind of systemic risks and regulatory challenges does 
this create? American manufacturing companies, energy 
producers, and farming groups, otherwise known as end users, 
have testified before Congress that if they were required to 
clear their over-the-counter risk management transactions, they 
would lose the benefits of customization, and the cost to them 
of cash collateralization would be much more significant and in 
some cases insurmountable.
    At this point the regulators continue to send mixed signals 
on how end users will be treated. Our witnesses today will 
provide a broad spectrum of views on these and other issues, 
and I appreciate their time and thoughtfulness in answering 
these questions. And, again, Mr. Chairman, I appreciate your 
holding this hearing today.
    Chairman Reed. Thank you very much, Senator Crapo.
    Senator Moran.
    Senator Moran. Chairman Reed, thank you very much. I have 
no opening statement. I am interested in hearing what our 
witnesses have to say. I have a 10 o'clock Financial Services 
and General Government Subcommittee on a similar topic, and I 
will be departing shortly.
    Chairman Reed. Thank you very much, Senator.
    I think just to reinforce what both Senator Crapo and 
Senator Toomey said, this is an opportunity and a challenge in 
terms of getting this right. I think we want to have it done 
right. That is why we are having this hearing and will have 
other hearings because we have to listen to industry experts 
and experts from academia and from other areas. And I suspect 
after this hearing we will have more questions, and we will 
have other hearings, but I think we have to get it right. I 
concur.
    Let me just say that all the testimony of the witnesses 
will be made, without objection, part of the record, so there 
is no need to read every word. If you would like to summarize 
or abridge in any way, please feel free to do that. Your 
testimony will be part of the record. Let me introduce the 
first panel.
    Chris Edmonds is president of the ICE Trust, the wholly 
owned credit default swap clearinghouse of international 
exchange. Mr. Edmonds was named to his post in February 2010. 
As president of ICE Trust, Mr. Edmonds oversees ICE's U.S. 
credit derivatives clearing operations. Prior to joining ICE, 
Mr. Edmonds was chief executive officer of the International 
Derivatives Exchange Group, LLC, a clearinghouse for interest 
rate swaps.
    Terrence Duffy has served as the executive chairman of CME 
Group since 2006 when he first became an officer of CME. 
Previous to his current position, he served as chairman of the 
CME Board from 2002 to 2006 and as vice chairman from 1998 to 
2002. He also has been president of TDA Trading Incorporated 
since 1981.
    Mr. Edmonds, you may begin.

     STATEMENT OF CHRISTOPHER EDMONDS, PRESIDENT, ICE TRUST

    Mr. Edmonds. Chairman Reed, Ranking Member Crapo, I am 
Chris Edmonds, president of ICE Trust, a limited purpose New 
York bank operating as a clearinghouse for credit default 
swaps. I very much appreciate the opportunity to appear before 
you today to testify on clearing over-the-counter derivatives.
    As background, ICE Trust serves as the leading U.S. 
clearinghouse for credit default swaps, having cleared 
approximately $11 trillion in gross notional value since March 
9, 2009. Globally, ICE Trust and our European counterpart have 
cleared more than $18 trillion in CDS since the financial 
crisis.
    ICE's experience in energy and credit derivatives 
demonstrates that when clearing is offered to a market, the 
market overwhelmingly chooses to clear its products. Over the 
next few months, the mandatory clearing and trading provisions 
of Dodd-Frank should take effect, and market participants will 
be forced to clear over-the-counter derivatives as a matter of 
law.
    While ICE supports the clearing principles of Dodd-Frank, 
we respectfully submit that the regulators responsible for 
determining which contracts must be cleared should consider any 
mandate carefully. ICE believes the best path to meet this goal 
is to allow clearinghouses and market participants to find the 
best way to clear markets within defined principles, as opposed 
to promulgating prescriptive rules. In addition, regulators 
should make certain unnecessary regulatory hurdles and other 
impediments are removed.
    For example, one key regulatory hurdle to clearing is 
cooperation between regulators. Many over-the-counter 
derivatives, especially credit default swaps, have 
characteristics of securities and commodities. Close regulatory 
cooperation between the CFTC and the SEC is necessary, and 
required by law, in order to make sure that market participants 
have legal certainty, including bankruptcy certainty. This is 
particularly important in regards to portfolio margining 
allowing security-based and commodity-based derivatives to be 
held in the same account and margined in a holistic manner and 
subject to a single bankruptcy regime. Historically, the CFTC 
and SEC have had little success creating portfolio margining. 
Without portfolio margining relief for CDS specifically, the 
unintended regulatory divide will create significant and 
noticeable setbacks for the implementation of Dodd-Frank.
    Appropriate regulation of clearinghouses is of utmost 
importance to the financial system. Pursuant to Dodd-Frank, 
clearinghouses will be a key part of the efforts to decrease 
systemic risk in the derivatives markets. In overseeing 
clearinghouses, regulators must be prudential, understanding 
their markets, and tailoring regulation to ensure market 
integrity and consumer protection.
    It is also vital to recognize that the over-the-counter 
derivatives markets are global. The U.S. regulators must work 
within international regulators from a common set of regulatory 
principles. Dodd-Frank has created significant uncertainty over 
whether a transaction will be subject to U.S. regulation or 
foreign regulation. This lack of clarity may begin to have an 
impact on markets, reducing liquidity and hampering regulatory 
reform efforts because market participants are unsure which 
laws apply. Therefore, harmonizing regulatory systems across 
geographies and giving market participants clarity is of utmost 
importance.
    Earlier this month, the CFTC and SEC held a roundtable to 
hear views on the implementation of Dodd-Frank. As the CFTC and 
SEC have come to realize, the legislation cannot take effect 
all at once.
    ICE believes that regulators should pursue an aggressive 
timetable to implement most sections of Dodd-Frank as soon as 
possible. While Dodd-Frank requires an enormous effort from 
both market participants and regulators, the cost of 
uncertainty is much greater. ICE has suggested to regulators 
that they pursue a phased implementation plan. This approach 
has broad-based support from market participants and should 
motivate quicker adoption by the industry.
    Flexibility is central to meeting the implementation goals. 
Regulators have an immense burden to implement Dodd-Frank, but 
creating a one-size-fits-all prescriptive system of regulations 
will only increase the burden as regulators will be required to 
constantly consider exemptions for markets that do not quite 
fit the proposed model.
    Likewise, market participants will have an easier time 
meeting implementation goals if they have the freedom to meet 
the goals of Dodd-Frank without radically modifying their 
operations to meet prescriptive rules.
    Mr. Chairman, thank you again for the opportunity to share 
our views with you. I would be happy to answer any questions 
you or this Committee may have.
    Chairman Reed. Thank you.
    Mr. Duffy.

 STATEMENT OF TERRENCE A. DUFFY, EXECUTIVE CHAIRMAN, CME GROUP 
                              INC.

    Mr. Duffy. Chairman Reed, Ranking Member Crapo, Members of 
the Subcommittee, I am Terry Duffy, executive chairman of CME 
Group, which includes our clearinghouse and four exchanges: the 
CME, the CBOT, NYMEX, and COMEX.
    The clearing mandate for OTC swaps should be staged in 
measured steps. The Committee asked five important questions 
that deserve direct answers.
    First, the safety and soundness of clearinghouses is a 
major focus of Dodd-Frank. The core principles compel 
clearinghouses to have adequate financial resources, 
comprehensive risk management procedures, and safeguards 
against system failures. In addition, Dodd-Frank includes eight 
core principles dealing with the safety and soundness of 
clearinghouses. The CFTC is authorized to bring a clearinghouse 
into compliance. However, the CFTC's proposed new rules are so 
rigid that many impair the flexibility necessary to preserve 
the safety and soundness of clearinghouses. Indeed, the CFTC's 
proposed rules governing systemically important clearinghouses 
increase this systemic risk.
    Regarding the second question, swaps clearing and futures 
clearing are variations on the same theme. If a swaps contract 
and a futures contract have similar volatility and trade in a 
mature liquid market, the considerations for clearing the 
contracts are identical. This should be the case for major 
plain-vanilla swaps. Thinly traded swaps present more difficult 
problems. Our clearinghouse aims to overcome these problems 
through its admission and risk management processes.
    The third question in regards to unique attributes of 
certain asset classes that should be highlighted, the key to 
safety and soundness is risk management based on volatility, 
liquidity, and other characteristics of the market for a swap 
in a normal and stressed circumstance. Futures on U.S. debt and 
eurodollars are easy to liquidate in the event of a default. 
The same should hold true for interest rate swaps based on 
U.S., UK, and European Union instruments.
    As we look at the fourth question, the CFTC should hold off 
implementing the proposed rules respecting ownership, 
governance, and control of clearinghouses. They can and should 
wait until there is evidence that specific limitations in Dodd-
Frank do not adequately control the potential problem.
    The core principles for clearinghouses provide ample 
protections against potential conflicts of interest. They are 
clear, comprehensive, and easily enforced by the Commission as 
needed. Section 5(b) of the Commodity Exchange Act specifically 
ensures fairness respecting participant and product 
eligibility, appropriate governance and fitness standards, 
prevention of conflicts of interest, and appropriate 
composition of governing boards. Dodd-Frank's core principles, 
coupled with CFTC's enhanced enforcement powers, are sufficient 
to guard against conflicts of interest.
    The fifth question, end users of swaps with sufficient 
credit and resources to enter into a swap will experience no 
barrier to clearing under Dodd-Frank. A firm that seeks to act 
as a clearing member of a swaps clearinghouse must meet the 
operational and financial requirements of that clearinghouse. 
These requirements should be set sufficiently high to meet the 
clearinghouse's obligations under Dodd-Frank's core principles 
for DCOs.
    Dodd-Frank's requirements regarding safety and soundness 
modify a clearinghouse's obligation to grant open access to any 
potential clearing member. The issues of managing a default 
involving immature or illiquid swaps contracts require higher 
admission standards than those for a futures clearinghouse.
    I appreciate the time this morning. I look forward to 
answering your questions.
    Chairman Reed. Thank you very much, gentlemen, for both of 
your excellent testimonies.
    We are all concerned about safety and soundness. I think 
that is a point of departure. We do not want to create a 
structure in response to a financial crisis that could 
precipitate another financial crisis if it is not handled well, 
so that is the starting point.
    But there are some other aspects, too, in terms of the 
overall scheme of Dodd-Frank. The notion was to pull as many 
possible derivatives onto, first, a clearing platform, and then 
within the authority of Dodd-Frank, the regulators could direct 
that the standardized products--some could be specifically or 
should be traded. So there is that progression to a trading 
platform.
    But both of you have alluded to the issue of potential 
conflicts of interest in bringing particular products on to the 
clearing platform. Right now over-the-counter derivatives are a 
very lucrative business, specialized derivatives, and there 
have been at least questions raised about whether there are 
proper incentives, proper rules so that the maximum number of 
derivatives products will be cleared; i.e., people making the 
decisions have an incentive perhaps to keep things off because 
there is a more lucrative product over the counter rather than 
a clearing platform and a trading platform.
    Both gentlemen, Mr. Edmonds and Mr. Duffy, can you address 
this issue of how do you ensure that there is the fullest 
possible universe of products being cleared?
    Mr. Edmonds. Mr. Chairman, I believe the way to answer that 
question is these are points-in-time conversations. The 
standardization of the credit default swap market, for example, 
has been an evolution going on for, you know, we will call it 
10 years or so to get to the standardization product set that 
you put in there, investment grade pieces of an index, the 
investment grade single names, and then there is a whole list 
of other names that we may want to clear in the future that at 
the end of the day do not lend themselves to clearing based on 
the current tool sets that are available to clearinghouses.
    If you ask me the question of where we are going to start, 
we have done a lot to get started in that direction. Where we 
go is all about innovation and competition between, you know, 
the different service providers that act in those markets. I am 
certain that, you know, every day those that Mr. Duffy and I 
compete with are looking for new ways to bring something else 
to the clearing which will require us to respond, and the same 
thing happens to Mr. Duffy on other products that they have a 
dominant market share in at this point in time.
    So for us, this is about what do we need to get the most 
systemic risk out of the gate to begin with. If you look at the 
creation of ICE Trust back in the fall of 2008 and in the first 
quarter of 2009, the products that represented the most 
liquidity, the most systemic risk, we were trying to put in the 
clearinghouse impacting the most active market participants at 
that point in time. Things will evolve, and we will manage that 
evolution through commercial reasons because it is good for our 
shareholders and good for our business.
    Chairman Reed. Well, one of the aspects particular with ICE 
is that the owners--that might not be the most precise term--
are also the broker-dealer banks generally, and they have, I 
would think, conflicting incentives. One is to get 
standardization products onto your platform, but also to keep 
lucrative over-the-counter products in their own trading, which 
does not have to be cleared. And that is a tension that would 
not exist if your organization was composed not of the broker-
dealer banks but of other financial entities if it was a truly 
independent entity.
    Does that sort of compound or complicate your specific 
dilemma?
    Mr. Edmonds. Well, I want to take issue with who the owners 
are, and we are a wholly owned subsidiary of a publicly traded 
company, so there are all sorts of rules and regulations 
around, you know, who owns what. I mean, certainly we have a 
partnership with our membership, not dissimilar to any other 
clearinghouse that operates in the United States or, for that 
matter, around the globe. There are only 120-plus or so 
entities registered with the CFTC that can be a clearing 
member. We started with nine. We are up to 15. We continue to 
grow that, and make no mistake, we want as many of those 
clearing members as we possibly can.
    That does not mean all of those clearing members actually 
use the product that we offer. Some will over time. Some will 
make the decision to make the investment to enter these markets 
as time progresses. Some have not made that decision today. 
Others are being opportunistic, seeing that the opportunity 
represented by the changes with regard to Dodd-Frank are the 
time for them to make that investment and come that direction.
    You know, we are completely open access. Our rule book has 
said we are open access from day one. You provide us with two 
matched trades an accountants gets, we clear and reduce the 
systemic risk associated with that.
    So, you know, I appreciate the point. I think you will have 
an opportunity on the second panel to ask folks what motivates 
them of what they want to keep cleared versus noncleared. From 
the commercial aspects of ICE Trust, we absolutely are 
incentivized to clear as much as we possibly can, both in 
product and the number of times that product is cleared.
    Chairman Reed. Mr. Duffy.
    Mr. Duffy. Well, there are a couple questions I would like 
to answer for you, sir, on what should be cleared and what 
should not be cleared. The plain-vanilla swaps that are being 
traded today over the counter are obviously prepared to be 
cleared, so my colleague over here has already demonstrated 
some of the numbers that they have done in the credit market. 
The interest rate market is obviously much easier to even 
clear. So some of those plain-vanilla swaps are prepared to be 
cleared.
    Some of the illiquid products or the products that Senator 
Crapo had mentioned that are really some of the issues that we 
have, and I'm sure ICE also. If we today are going to collect 5 
days' margin for some of these products that we are going to 
have in our clearinghouse, that might not even be the tip of 
the iceberg for some of these illiquid products. So you just 
cannot bring them into clearing to blow up the whole system.
    So we do a very rigorous risk management system, so we 
think that bringing the plain-vanilla swaps in first--and as it 
relates to what some have alleged is a cartel or whatever you 
want to call the banks in these clearinghouses, I think you are 
not giving the customer enough sophistication here. When these 
products become more vanilla-like, they want more transparency 
associated with them. They will demand that that happen with 
that product. It is really the illiquid products that are not 
conducive for clearing today. So I do not think anybody is 
trying to hold them out from clearing. I think if the customer, 
when they trade them, they know what is being traded. The more 
that is being traded, they want to make certain that they are 
getting the best possible price also. And the only way they can 
do that is to seed the market.
    So I do think there is an incentive for the clearinghouses 
and the owners of those clearinghouses to bring them in as they 
see fit.
    Chairman Reed. Just one other point. Sometimes the 
complexity of these products is such that the customer, even 
sophisticated customers, are not quite sure what their best 
choice is, and many times the information or the structuring is 
being done not by the customer but by the broker-dealer or the 
financial institution.
    Again, I guess the heart of this question is, Is there real 
sort of pressure by the market and by you to demand more 
simplified products that can, in fact, be usually identified by 
customers and preferred by customers? Is that----
    Mr. Edmonds. The simple answer to that is yes. The more 
standard we can make the products, the easier it is for those 
products to move into the systems. I mean, there are other 
service providers that link up to our clearinghouse, both for 
Mr. Duffy and myself, that they have a responsibility to take 
this information to perform analytics on this information and 
to take it downstream to the other user base, the folks you are 
talking about that need access to this.
    The more simplified we can make those standards, the easier 
it is for them to more quickly adopt those types of instruments 
and put them into the supported category. When they are in the 
supported category, we have the opportunity to realize our 
commercial interest and generate more revenue from that. So 
certainly the interests are aligned from that perspective.
    Chairman Reed. Thank you very much. Thank you.
    Senator Crapo, please.
    Senator Crapo. Thank you, Mr. Chairman, and Mr. Edmonds and 
Mr. Duffy, I appreciate you being here.
    I want to focus my questions on the end user issue. 
Frankly, as I try to navigate what the regulators are saying 
with regard to end users, I am not sure that I understand 
exactly what the proposal on the table is as to how we will 
treat end users. So my first question to you is, how do you 
understand the treatment of end users under what we see now 
from the various proposed rules?
    Mr. Duffy. My understanding, Senator, is that any 
nonfinancial party would be considered an end user and thus 
exempt from the clearing mandate. So, example, IBM, a company 
like that, would be exempt from the clearing mandate. If they 
make the trade, obviously, with a dealer, both parties are 
exempt because you cannot put one side of the trade into the 
clearinghouse and leave the other side out, so it would leave 
an unbalanced book. My understanding is anybody that is 
nonfinancial is exempt in the end user category.
    Senator Crapo. Mr. Edmonds, is that your understanding, as 
well?
    Mr. Edmonds. That would be my understanding. I would add to 
that, there are some requirements in there for those types of 
transactions Mr. Duffy----
    Senator Crapo. Like the margin requirements?
    Mr. Edmonds. You would have margin requirements between the 
broker-dealer and the end user. So the cost to the end user 
still has an upward trend under that model.
    Senator Crapo. And with regard to the margin requirements, 
is it clear to you what that is among the various regulators in 
the proposals we have out today? In other words----
    Mr. Edmonds. I do not think we have enough clarify of what 
direction they are headed. I mean, there have been some 
conversations at this point in time as it relates to, you know, 
it cannot be any less than what a similar product on the 
clearinghouse or some benchmark that the regulators could look 
to to begin establishing those, but I do not think that we have 
gotten to a point where it is final enough for people to do the 
cost-benefit analysis yet.
    Senator Crapo. So if I were to look at two of the important 
issues related to end users, one, their ability to have a 
customized product, and two, the impact of margin requirements, 
would you say that you feel that there is adequate protection 
for those who need a customized product, that they would not be 
subject to the requirement?
    Mr. Duffy. That would be my understanding of the way the 
law reads, sir.
    Senator Crapo. So, then, the real question would be, what 
is the impact of the margin requirements, whatever they may be, 
on this portion of our market. Is that a fair question?
    Mr. Edmonds. I do not see any way that it cannot increase 
the cost of trade.
    Mr. Duffy. Well, I would also suggest that even though they 
would be exempt from the margin requirements under the end user 
exemption, there are still capital requirements they have to 
face with the broker-dealer that could be simply called 
something else, such as margin. So it may be that they are 
pledging their cornfields instead of capital or cash for 
margin, but they are still putting up something on behalf of 
those transactions.
    Senator Crapo. And you would agree, also, Mr. Duffy, 
though, that it will undoubtedly drive up the cost of these 
transactions?
    Mr. Duffy. I do not know if margin will drive up the cost 
of these transactions, only because I have looked at the growth 
in the futures business that has had margin with it 
historically and we have been able to grow at 20-some-odd 
percent year over year for the last 40 years, 35 years now, and 
people have participated in the marketplace, been able to do 
risk management just fine with the margin requirements that we 
have in place today.
    Senator Crapo. Mr. Edmonds, would you----
    Mr. Edmonds. I would agree with Mr. Duffy on the growth of 
the futures market. The difference here is, these same types of 
customized transactions are happening today and this margin is 
not being collected. So at least there is a time value of money 
associated with the collateral they are going to have to post 
in some form or fashion, or the lien they are going to put on 
the cornfield or whatever that is going to put in there. There 
is an intrinsic cost, whether it is the drafting of a legal 
agreement, the execution of that legal agreement, you know, the 
lien and things that you need in order do that. So while they 
may not be a direct cost as the picture that Mr. Duffy wants to 
paint, there is going to be some intrinsic cost associated with 
just managing the additional requirements that are forthcoming.
    Senator Crapo. It seems to me that that is going to be a 
significant impact on capital formation in these companies, 
that at least a lot of them are claiming this to be the case. 
Do you believe that this increased cost that you see, Mr. 
Edmonds, would increase safety or soundness of the transactions 
over the current status quo?
    Mr. Edmonds. Just to clarify the question, for the end user 
or for the market as a whole?
    Senator Crapo. I would say for the market as a whole.
    Mr. Edmonds. Certainly, more collateralized positions have 
a safety benefit and a soundness benefit associated with that. 
I mean, if you take the earlier comments by the Chairman as it 
related to AIG and the developments we experienced there, that 
was a market that was under-collateralized, or not 
collateralized at all in some cases, and they were very 
customized products, that at some point in time had collateral 
been associated with those positions and there had been an 
adequate mark-to-market based of those positions based on the 
collateral on hand, we would have seen the difficulties being 
perpetrated by those positions sooner.
    Senator Crapo. I understand that. I guess the way I am 
looking at this, though, I can understand that if you were to 
require 100 percent collateral for every transaction, you would 
certainly increase safety and soundness of the overall market 
for those transactions. You might not be increasing it in 
incrementally justifiable levels by doing so. And those in the 
end user community often disagree with being lumped in with the 
AIG situation, claiming that their industries and their markets 
had nothing to do with the crisis we faced and that the safety 
and soundness issues that we are seeking to solve there simply 
do not exist, or to any significant level, in their markets. 
How would you address that?
    Mr. Duffy. Well, I would agree with that, and I think that 
the end users have put on a very good case why they should have 
exemptions to the Dodd-Frank Act, and I think, obviously, they 
are getting them. Our position at CME has been from the 
beginning, for the last several years, we never believed that 
there should be a mandatory clearing component to Dodd-Frank. 
We thought there should be capital incentives for clearing and 
then a different capital charge for noncleared products. So we 
never supported it. But the law is what the law is today and we 
are dealing with it.
    So I think that the end users being carved out the way they 
are, they have done a good job putting their case forward and 
they deserve the exemption. They did not cause it, I agree with 
that, nor did the futures industry cause this problem. We had a 
housing bubble and under-capitalized credit default swaps.
    Senator Crapo. Thank you. Mr. Edmonds, do you want to say 
anything before----
    Mr. Edmonds. The only thing I would say to that is to do 
the cost-benefit analysis, Senator, you are looking for, I 
think the rules around margin need to come out.
    Senator Crapo. Thank you. I appreciate that observation.
    Chairman Reed. Senator Merkley.
    Senator Merkley. Thank you, Mr. Chair, and thank you all 
for your testimony.
    Mr. Duffy, in your testimony, you noted that the futures 
market performed flawlessly during the financial crisis, and I 
was wondering if you could take and expand on what went right 
and what insights that might give us in seeking to regulate the 
rest of the derivatives markets.
    Mr. Duffy. And again, the futures market is different from 
the OTC market. The plain vanilla swaps are closer to the 
futures market. Some of the products that got us in trouble are 
these illiquid products that even a clearinghouse today would 
not be able to risk manage during the crisis.
    So we were able to function flawlessly during the crisis 
because of a couple things that we have deployed for over 100 
years, and that is to do risk management on a real-time basis. 
So we make certain that the people who are losing money put up 
the money. The people who are ahead in the market receive that 
money. So we would go back and forth all day long at a zero sum 
outcome, and I think that is very important when you have this 
type of notional values going back and forth in both futures 
markets and over-the-counter markets. So that is why we 
operated flawlessly, because the risk management discipline 
that we have put into our company over the last 100-plus years.
    Again, I do not know if that would have stopped the crisis, 
sir, of 2008, because the problem, as I said earlier, was not 
futures markets. It was not plain vanilla swaps. It was 
illiquid swaps. It was illiquid credit default swaps. It was 
under-collateralized swaps in a bubble in some other markets.
    Senator Merkley. My colleague was asking about kind of the 
impacts on capital formation and putting up margins. I was 
reading in this article, the CEO of Robinson Oil who noted that 
when he uses derivatives like swaps and options to create fixed 
plans, he just has no idea how much lower his prices possibly 
should be because the fees are not disclosed, there is not a 
clearing function. And he says, quote, ``At the end of the day, 
I do not know if I got a fair price or really what they are 
charging me.'' How does one tradeoff kind of understanding 
essentially the efficiencies of an open competitive market in 
providing derivatives risk management, if you will, at a lower 
price, versus the issues of capital formation margins that was 
being raised by my colleague?
    Mr. Duffy. I think the gentleman that asked the question 
has a very good question because it is very hard to distinguish 
what the costs are when you are doing an over-the-counter 
transaction such as that. On a regulated futures exchange, it 
is completely transparent. All the fees and everything are seen 
up front so you know exactly what you are doing ahead of time.
    So in our world, sir, he would not have that same question. 
And I cannot answer the question in the over-the-counter only 
because there has been a lack of transparency in these markets.
    Senator Merkley. OK, great. Anything you would like to add, 
Mr. Edmonds? OK.
    Chairman Reed. Senator Toomey.
    Senator Toomey. Thank you very much, Mr. Chairman.
    A couple of things I just wanted to follow up on from the 
previous questions. One, would it be fair to say that--and Mr. 
Duffy in particular, I think you alluded to this--that there 
are some kinds of transactions that probably just never belong 
on a clearinghouse, right? If they are not uniform, if there is 
not sufficient liquidity, then it is just not a good fit. Is 
that a fair statement?
    Mr. Duffy. That is exactly fair, sir.
    Senator Toomey. Yes. So it seems to me that we will always 
have a category of over-the-counter derivatives and it would be 
up to end users to decide whether the customization that they 
get in return for something over the counter outweighs the fact 
that there is not as much transparency, and that is a decision 
that individuals will make.
    Mr. Duffy. We agree.
    Senator Toomey. OK. The other point I wanted to make, 
follow up on my colleague, Senator Crapo's point, is I do think 
it is--and I know this does not directly affect you gentlemen. 
My understanding, though, is that the promulgation of the 
regulations does create the possibility that end users will 
have margin requirements in some cases, but not necessarily be 
required to use clearinghouse, but have margin requirements, 
and I do think that is a potentially big problem.
    As to whether or not an end user should have a margin 
requirement, I think that is a credit decision that should be 
made by the counterparty. The counterparties are capable of 
making that decision, and the cost to an end user that is not--
especially a nonfinancial that does not have ready access to 
the kind of cash that is necessary for a margin call, could 
actually make the hedging exercise prohibitively impractical. 
And so I am very concerned. In fact, Senator Johanns and I have 
introduced legislation that would deal with this which would 
really specify and make it clear that this requirement would 
not apply to end users. But I digress.
    To get to the point that I wanted to ask of you, Davis Polk 
has put together a memo that suggests that there are 175 new 
derivatives provisions coming out of Dodd-Frank. I do not think 
that is comprehensive yet. I think that is what we have so far. 
And it just seems to me that it is really, really important 
that we sequence the implementation in a thoughtful way and 
over a long enough period of time that this is manageable, 
because it strikes me that it could be very problematic if we 
tried to do this too suddenly.
    Now, you have both indicated importance of sequencing and I 
know you have given a lot of thought to that, but could you 
just underscore, how important is it that the sequencing be 
right, and specifically, could there be some market disruptions 
if the sequencing is not done appropriately?
    Mr. Edmonds. I do believe there will be market disruptions 
if it is not done appropriately. Certainly, doing it all at 
once, the problems with going all at once is you are going to 
have everyone scrambling with a finite bandwidth, both from 
service providers and both their own internal allocation of 
resources. We talk about the cost it would take for folks to 
respond to that. It would be insurmountable at that point in 
time. So what you will see is you will see liquidity, I think, 
move away at that point in time. That is a real risk.
    The purpose of Dodd-Frank was to remove systemic risk. We 
have got to get to a point that we understand what products 
have the systemic--represent the systemic risk, how they can be 
cleared, how they can be standardized or not standardized, and 
if they are not standardized, what are the capital charges 
associated with that. And then once you get those things 
figured out, then you have got some opportunity for people to 
see that in a transparent manner, whether it is standard or 
nonstandard. That means more products being traded in a listed 
environment, other products not being traded but being reported 
to the STR function that was in Dodd-Frank, and things of that 
nature.
    Then you get to a point where execution becomes a lot 
easier to implement over time, because people know what the 
product is. They know what the product specification requires 
them to do as a buyer or seller. They know how it is going to 
be margined. They can properly do capital planning around that.
    Mr. Duffy. I agree with what Mr. Edmonds said, sir. I think 
if we do not implement sequencing properly, such as putting 
plain vanilla swaps out first and making certain that it is not 
only dealer-to-dealer, but dealer-to-client at the same exact 
time so there is no disadvantage to the client to get forced 
into going where the dealer wants him to go, I think that is 
important.
    But also, there are some provisions that the CFTC, that 
they are trying to put forward, such as systemically important 
DCOs which would require a firm like ours, if we were in that 
category, to put up two of our largest clients' defaults. So 
what would it do? It would introduce a participant to go to a 
less capitalized clearinghouse that would not have the onerous 
of CME because we are a systemically important organization. 
That is in there.
    There is also risk that if we have the $50 million, which 
Chairman Gensler would like to have, put forward to allow 
people to participate in the clearing of swaps and we had that 
implemented and we were to have a default and these people were 
not able to participate in the default, this is another issue 
that could introduce more systemic risk to the system.
    So there are a couple flaws. We are trying to get away from 
systemic risk. We are concerned that if we push this without 
doing the proper sequencing, we will introduce more systemic 
risk.
    Senator Toomey. Thank you, Mr. Chairman.
    Chairman Reed. Thank you, Senator Toomey.
    Senator Kirk.
    Senator Kirk. Thank you. I am obviously representing the 
Chicagoland area, where these markets, and be able to set up a 
database and exchange where buyers', sellers' prices are 
disclosed in real time is critical to real-time risk 
management.
    I wonder, Mr. Duffy, if you could specifically describe 
your foreign competition. If we have a danger of over-
regulating, customers will simply manage their risk in markets 
overseas. Who is on your heels and who is hoping that the 
Congress gets this wrong so that you are too heavily encumbered 
to serve customers and then would pick up the business 
overseas?
    Mr. Duffy. Well, I think there are a couple that would like 
to see that. Maybe one sitting to my right would like to see 
that with his London operation. There are obviously 
participants throughout Europe that compete with the CME Group, 
that compete with Intercontinental Exchange, also. They have 
not gone forward with any regulation whatsoever. We have passed 
Dodd-Frank in this country. I believe that we have to be very 
careful. I like being a leader, but at the same time, let us do 
it in a judicious fashion. Let us just not overreact, try to 
implement the whole Act in 2 days.
    I am very concerned about the regulatory arbitrage, 
Senator, that could occur, and the business getting taken off 
of the U.S. markets, putting onto foreign jurisdictions. These 
banks have books all over the world. They do not need to be in 
the U.S. So if they are a non-U.S. bank, they can be in Europe 
participating in these markets without being subjected to the 
laws of Dodd-Frank. Not only do they put CME at a disadvantage, 
they are going to put U.S. banks at a disadvantage.
    Senator Kirk. Right. And then correct me if I am wrong, but 
my impression of European and Chinese interests are that their 
feeling about Dodd-Frank-related regulation is we are 
completely for it, but ``apres vous, Gaston.'' You guys go 
ahead and kill your markets first. Oh, by the way, we are right 
behind you. We are going to kill our markets as fast as you 
kill yours----
    Mr. Duffy. I think----
    Senator Kirk. ----fully knowing that they are not going to 
do that, and then they will pick up this business and the 
employment will transfer outside the United States.
    Mr. Duffy. I absolutely think that is the most realistic 
fear that we have, and I think if people do not recognize it, 
they are just in denial. These markets have grown. They have 
matured throughout Asia. They have grown and matured throughout 
Europe. They are looking for us to make this gigantic mistake. 
That is why it is critically important that we implement this 
law in the way that makes sense.
    Senator Kirk. So can you describe--characterize the 
implementation of Dodd-Frank-related activities affecting 
similar markets in Europe.
    Mr. Duffy. Do you want to address that or do you want me 
to?
    Mr. Edmonds. You can start.
    Mr. Duffy. OK. So the question would be, how does Dodd-
Frank affect----
    Senator Kirk. No. Tell me the progress of them putting 
similar regulations----
    Mr. Duffy. There is no progress there. There is no progress 
in Europe. The G20 has made some noise that they are going to 
come up with a proposal sometime this summer. I have seen 
nothing coming out of the European Commission or regulators 
that they are going to support any particular new laws. One of 
the things they did say as it relates to position limits that 
obviously affects both of us, that they have recognized if, in 
fact, they see a problem in a market, they have the right to 
step in. That is about all I have seen coming out of Europe, 
and as far as Asia goes, I have seen absolutely zero----
    Senator Kirk. And have any of them been open about saying, 
we are hoping the Americans cripple their markets?
    Mr. Duffy. I do not know if they have been open about it, 
but I am pretty certain a lot of the participants in London and 
other places of the world are very much hoping that happens.
    Mr. Edmonds. Senator, they hold a free option right now. I 
mean, we are sprinting down to this implementation, trying to 
get as much done as possible, trying to get the market to 
behave. They get a full menu. They are going to have the chance 
to pick what they like and what they do not like. There is no 
obligation for them to implement that.
    Mr. Duffy. Right.
    Mr. Edmonds. But they have already said that their time 
line is much further than ours. They have already said that 
this is a 2012 and after type of event. I mean, if you look at 
the G20 comments that Mr. Duffy made reference to, this is not 
something they are trying to get done yet this calendar year. 
This is something they are going to start talking about in 
earnest next year, and that was to give us complete time to 
create the menu for them to choose from.
    Senator Kirk. So would you rather be them or us right now 
if you were trying to build a business and add clients?
    Mr. Edmonds. I believe that the, from my personal--my 
personal belief is that we ought to let the commercial 
competition that takes place with very established businesses 
with very clean track records take--and do that. And there will 
be other innovators that come into this market. There will be 
others who step in. But if they are going to rely on 
prescriptive rules to step in, well, we had better hope that 
the prescriptive rules have captured everything that could 
possibly go wrong----
    Senator Kirk. Which----
    Mr. Duffy. I would rather be us, sir. I mean, I think this 
is obviously the greatest country in the world. It has got a 
great, dynamic financial services industry. I would hope that 
the Congress recognizes that and lets the regulators know that. 
Let us compete globally. I like being a leader. I think that if 
we implement small portions of Dodd-Frank, like I said, in a 
judicious way, I think the rest of the world would have no 
choice but to follow on a few of these things. I think if we 
overreach, which has been what the regulator has been doing, 
that is when our European competition will destroy us, on the 
overreaching of the regulators. So right now, I would rather be 
us, if we do it right.
    Senator Kirk. Thank you, Mr. Chairman.
    Chairman Reed. Thank you, Senator Kirk.
    Gentlemen, thank you for your excellent testimony. I 
presume and I know that we will be meeting again, because this 
issue of implementation is critical and your advice and your 
insights are absolutely essential to get this right, so thank 
you both very much.
    Mr. Edmonds. Thank you, sir.
    Chairman Reed. Let me call up the second panel.
    [Pause.]
    Chairman Reed. I would like to welcome the second panel and 
begin by introducing Dr. Benn Steil. Dr. Steil is Senior Fellow 
and Director of International Economics at the Council of 
Foreign Relations in New York. He is also the founding editor 
of International Finance, a scholarly ISI accredited economics 
journal, as well as a cofounder and managing member of 
Efficient Frontiers LLC, a markets consultancy. Dr. Steil's 
most recent book, Money, Markets, and Sovereignty, was awarded 
the 2010 Hayek Book Prize. Welcome, Dr. Steil. Thank you.
    Dr. Chester Spatt will be introduced by my colleague, 
Senator Patrick Toomey of Pennsylvania.
    Senator Toomey. Thank you very much, Chairman Reed, for 
this opportunity to welcome Dr. Chester Spatt, the Pamela R. 
and Kenneth B. Dunn Professor of Finance at the Tepper School 
of Business at Carnegie Mellon University and Director of its 
Center for Financial Markets. The Tepper School consistently 
ranks among the Nation's very best business schools and Dr. 
Spatt has taught at the university since 1979. Dr. Spatt also 
served as the Chief Economist and Director of the Office of 
Economic Analysis at the SEC from 2004 through 2007.
    In addition to that, he has served as Executive Editor and 
one of the founding editors of the Review of Financial Studies, 
President and a member of the founding committee of the Society 
for Financial Studies, and President of the Western Finance 
Association. His coauthored 2004 paper in the Journal of 
Finance on asset allocation won TIAA-CREF's Paul Samuelson 
award for the best publication on lifelong financial security.
    Dr. Spatt earned his Ph.D. in economics from the University 
of Pennsylvania and his undergraduate degree from Princeton 
University.
    Dr. Spatt, we are pleased that you could be with us today 
and I look forward to your testimony.
    Mr. Spatt. Thank you for that very kind introduction.
    Chairman Reed. Our next witness is Mr. Cliff Lewis. Mr. 
Lewis is Executive Vice President of the State Street Global 
Markets, State Street's investment research and trading arm. In 
that capacity, he is responsible for the e-Exchange business, 
which provides electronic trading solutions for foreign 
exchange, precious metals, cash, U.S. Treasury securities, 
futures, money markets, and exchange traded funds. Mr. Lewis 
joined State Street in 2006 as part of the acquisition of 
Currenex, where he served as Chief Executive Officer. Welcome.
    Mr. Don Thompson is Managing Director and Associate General 
Counsel at JPMorgan Chase and Company. He is cohead of JPM's 
Derivatives Practice Group and Legal Department and cochair of 
the ISDA Documentation Committee. Since 1985, he has 
represented JPM in its full range of derivatives activities, 
with a focus on regulatory documentation and litigation 
matters.
    Mr. James Cawley is a founder of the Swaps and Derivatives 
Market Association, an industry trade group with over 20-plus 
dealer and clearing broker members that advocate open access 
and transparency in centrally cleared interest rate swap and 
credit derivatives markets. He is also the CEO of Javelin 
Capital Markets, an electronic execution venue of OTC 
derivatives that expects to register as a Swaps Execution 
Facility, or SEF. Previously, Mr. Cawley was the founder and 
CEO of IDX Capital, a New York-based electronic trading 
platform for credit default swaps executed between dealers, so 
welcome, Mr. Cawley.
    Dr. Steil, please begin.

    STATEMENT OF BENN STEIL, SENIOR FELLOW AND DIRECTOR OF 
     INTERNATIONAL ECONOMICS, COUNCIL ON FOREIGN RELATIONS

    Mr. Steil. Thank you, Mr. Chairman----
    Chairman Reed. Could you turn on your microphone, Doctor, 
and let me for the record once again state, all of your 
statements are part of the record. Feel free to summarize and 
abridge.
    Dr. Steil.
    Mr. Steil. Thank you, Mr. Chairman, Ranking Member Crapo, 
Members of the Committee. I appreciate the opportunity to 
testify here this morning.
    The collapse of Lehman Brothers and AIG in September of 
2008 highlighted the importance of regulatory reforms that go 
beyond trying to prevent individual financial institutions from 
failing. We need reforms that act to make our markets more 
resilient in the face of such failures, what engineers and risk 
managers call ``safe-fail'' approaches to risk management. Well 
capitalized and regulated central derivatives clearinghouses to 
track exposures, to net trades and to novate them, to collect 
proper margin on a timely basis, and to absorb default risk 
have historically provided the best example of successful safe-
fail risk management in the derivatives industry.
    Encouraging a shift in derivatives trading from OTC markets 
without central clearing to organized Government-regulated 
markets with central clearing is challenging, however, for two 
reasons. First, the dealers that dominate the OTC derivatives 
business have no incentive to accommodate such a shift. Dealers 
earn approximately $55 billion in annual revenues from 
bilateral OTC derivatives trading. Some of the largest can earn 
up to 16 percent of their revenues from such trading. It is 
natural that dealers should resist a movement in trading 
activity onto exchanges and clearinghouses.
    Where compelled by regulation to accommodate it, dealers 
can also be expected to take measures to control the structure 
of and limit direct access to the clearing operations. The use 
of measures such as unnecessarily high capital requirements in 
order to keep smaller competitors or buy-side institutions from 
participating directly as clearinghouse members are to be 
expected. Indeed, trading infrastructure providers organized as 
exclusive mutual societies of major banks or dealers have a 
long history of restricting market access.
    For example, in the foreign exchange markets, the bank-
controlled CLS settlement system has long resisted initiatives 
by exchanges and other trading service providers to prenet 
trades through a third-party clearing system prior to 
settlement. Such netting would significantly reduce FX trading 
costs for many market participants, but would also reduce the 
settlement revenues generated by CLS and reduce the trade 
intermediation profits of the largest FX dealing banks.
    There are, therefore, solid grounds for regulators to apply 
basic antitrust principles to the clearing and settlement 
businesses in order to ensure that market access is not being 
unduly restricted by membership or ownership limitations that 
cannot be justified on safety and soundness grounds.
    Second, some types of derivatives contracts do not lend 
themselves to centralized clearing as well as others. 
Customized contracts or contracts which are functionally 
equivalent to insurance contracts on rare events are examples. 
Since it can be difficult for policy makers or regulators to 
determine definitively whether given contracts, new types of 
which are being created all the time, are well suited for 
central clearing, it is appropriate to put in place certain 
basic trading regulations in the OTC markets that will serve 
both to make such trading less likely to produce another AIG 
disaster and to encourage the movement of trading in suitable 
products onto central clearinghouses. Two such measures would 
be to apply higher regulatory capital requirements for 
noncleared trades in consequence of the higher counterparty 
risk implied by such trades and to mandate trade registration 
and collateral management by a regulated third party, such as 
an exchange.
    In establishing the regulatory standards for the clearing 
of derivatives transactions, it is imperative for lawmakers and 
regulators to be fully conscious of the fact that the 
derivatives market is effectively international rather than 
national and that it is exceptionally easy for market 
participants to change the legal domicile of their trading 
activities with a keystroke or a simple change of trading 
algorithm.
    In this regard, I would highlight two important areas of 
concern. First, the three major world authorities controlling 
the structure of the derivatives clearing business--the SEC, 
the CFTC, and the European Commission--each take a very 
different view of the matter. Historically, the SEC has applied 
what I would term the utility model to the industry. The CFTC 
has applied what I would term the silo model. And the European 
Commission has applied what I would term the spaghetti model.
    The SEC's utility model favors institutions operated 
outside the individual exchanges, in particular the DTC and the 
equities markets and the OCC and the options markets. This 
approach has generally performed well in terms of safety and 
soundness and in encouraging competition among exchanges. It 
performs poorly, however, in terms of encouraging innovation in 
clearing and settlement services.
    The CFTC's silo model allows the individual exchanges to 
control their own clearinghouses. This approach has also 
performed well in terms of safety and soundness. The CFTC's 
model also encourages innovation in product development in a 
way in which the SEC's model does not. This is because CFTC-
regulated futures exchanges can capture the benefits of product 
innovation in terms of generating trading volumes, whereas SEC-
regulated options exchanges risk seeing trading volumes in new 
products migrate to other exchanges, all of which use clearing 
services provided by the OCC. On balance, I believe the CFTC's 
model is the more appropriate for the derivatives industry.
    The second point I would like to make regarding the global 
nature of the derivatives trading industry is that certain 
measures to curb speculative activity being debated here in 
Washington are likely to push trading activity off-exchange, 
precisely the opposite of Congress' intent. For example, a so-
called Tobin tax on futures transactions at the level being 
discussed last year, two basis points or 0.02 percent, would be 
equivalent to over 400 times the CME transaction fee on Euro-
dollar futures. It should go without saying that a tax this 
large relative to the current transaction fee on the underlying 
contract would push all of this activity into alternative 
jurisdictions.
    Likewise, commodity market position limits, if not 
harmonized with UK and other national authorities, will merely 
push such trading outside the CFTC's jurisdiction. There is 
already an active regulatory arbitrage on oil and natural gas 
futures between the CME's NYMEX exchange, which trades such 
contracts under CFTC regulation, and the Intercontinental 
Exchange, which trades such contracts under FSA regulation in 
London. In short, we must be extraordinarily cautious not to 
undermine Congress' worthy goal of bringing more derivatives 
trading under the purview of U.S.-regulated exchanges and 
clearinghouses by inadvertently providing major market 
participants incentives to do precisely the opposite.
    Thank you, Mr. Chairman.
    Chairman Reed. Thank you.
    Dr. Spatt, please.

 STATEMENT OF CHESTER S. SPATT, PAMELA R. AND KENNETH B. DUNN 
   PROFESSOR OF FINANCE, TEPPER SCHOOL OF BUSINESS, CARNEGIE 
                       MELLON UNIVERSITY

    Mr. Spatt. Thank you, Chairman Reed and Ranking Member 
Crapo. I am pleased and honored to have an opportunity to 
present my views to the Senate Subcommittee this morning. As 
Senator Toomey's introduction indicated, I am a chaired 
professor at the Tepper School of Business at Carnegie Mellon 
University in Pittsburgh and I also served as Chief Economist 
of the U.S. Securities and Exchange Commission from July 2004 
to July 2007. My expertise as a faculty member include such 
areas as trading mechanisms, derivative securities, asset 
valuation, financial regulation, and the financial crisis.
    I think the focus on clearing through central 
counterparties is a natural one and one in which I am 
sympathetic, potentially both to reduce contagion associated 
with counterparty risk and to make the structure of risk more 
transparent. However, it is unclear to me whether the extent of 
use of clearinghouses, especially the extent of mandatory 
clearing currently envisioned, will lead ultimately to a 
reduction in systemic risk in the event of a future crisis. I 
think it is very important to manage carefully the risk within 
the clearinghouse. I also think it is important that fees for 
holding uncleared derivatives reflect economic costs and not be 
punitive to avoid creating artificial concentration of risk 
within the clearinghouse.
    The clearinghouse is subject to considerable moral hazard 
and systemic risk, because (a) there is a strong incentive for 
market participants to trade with weak counterparties, (b) 
concentration of risk in the central clearinghouse, and (c) 
margining would likely need to ratchet up in the context of a 
crisis. I believe that central clearing could potentially raise 
systemic risk substantially.
    In fact, Federal Reserve Chairman Ben Bernanke attributed 
the lack of failure of a clearinghouse during the financial 
crisis to ``good luck'' in an important speech that he 
presented at the Atlanta Federal Reserve conference in April. 
In fact, he quoted a Mark Twain character as emphasizing the 
theme, that ``if you put all your eggs in one basket, you had 
better watch that basket.'' I think that is the core of the 
issue involving clearinghouses.
    Now, I think everyone agrees that it is important that 
clearinghouses not receive ``too big to fail'' types of 
guarantees. In fact, Chairman Gensler testified before the full 
Committee to that effect in mid-April. But I think that 
emphasizes the importance of having strong risk management. I 
think strong risk management is absolutely essential to the 
potential success of the clearinghouse model. And indeed, while 
it is a delicate balance, I would emphasize the importance of 
strong risk management, even at the expense of other values.
    The governance of the clearinghouse should reflect strong 
incentives to control risk. It is important that the leadership 
and the governance of the clearinghouse reflect strong 
incentives, and in particular, I think artificial requirements 
that most of the directors be independent directors are a push 
in the wrong direction. It is important that governance, 
including board governance and risk committee composition, 
reflect incentives. Much of the commentary of regulators has 
focused upon more abstract notions of ``conflict of interest.''
    Incentives are very important. Proposals to absolve small 
members of the clearinghouse of their duties or to allow them 
to outsource their duties, are illustrative of some of the 
incentive problems that I would envision potentially in terms 
of the operation of the clearinghouse. Incentives are 
absolutely crucial.
    Analogously, regulators are focused upon access to the 
clearinghouse by investing firms. Indeed, I think access is an 
important issue but I would resolve tradeoffs in favor of 
strong risk management. It is actually interesting that in the 
equity context, the SEC actually adopted last fall a role 
basically eliminating direct unfettered customer access because 
of the importance in the equity context of managing risk and 
making sure orders were properly vetted by member firms; I view 
that as an analogous type of issue to those in the 
clearinghouse space.
    There are strong analogies, as well, with respect to the 
payments system. My Carnegie Mellon colleague Marvin 
Goodfriend, for example, points out how both in the private 
clearinghouse system before the creation of the Federal Reserve 
and then in the Federal Reserve System itself, direct access is 
not allowed to the payments system essentially as a mechanism 
to protect the integrity of the system.
    Finally, my underlying view on these issues is also 
strongly informed by the relevance of economic principles for 
the structuring of the clearinghouse, and I do think it is 
important that we be sensitive to the economic consequences of 
these contemplated rulemakings as we move forward on these 
important issues.
    Chairman Reed. Thank you very much, Doctor.
    Mr. Lewis, please.

 STATEMENT OF CLIFFORD LEWIS, EXECUTIVE VICE PRESIDENT, STATE 
                     STREET GLOBAL MARKETS

    Mr. Lewis. Thank you, Senator. Chairman Reed, Ranking 
Member Crapo, other Members of the Committee, thank you for the 
opportunity to testify today. Let me also express my 
appreciation for the work that has been done by your staff and 
yourselves and Congress, the CFTC, and the SEC on the Dodd-
Frank implementation.
    State Street is one of the world's largest custodial banks. 
We administer over $21 trillion--that is trillion with a 
``t''--dollars of other people's money. That makes us one of 
the world's largest processors of derivative transactions today 
and it is why we are very interested in the topic you all are 
working on.
    Now, let me say at the outset that we at State Street 
support the Dodd-Frank mandates for both derivatives clearing 
and execution. We believe that if the rules are properly 
implemented, these changes will bring big benefits to our 
customers who are investors, investors like pension funds, 
endowments, and mutual funds. At the same time, we have to 
report that our investor clients are extremely concerned by 
current regulatory uncertainty and the potentially significant 
incremental costs that may result from the new rules.
    Now, let me also emphasize that in relation to central 
clearing, the key issue for State Street is effective 
implementation of Dodd-Frank's requirement that clearinghouses, 
and I quote, ``permit fair and open access.'' A couple specific 
comments.
    First, we support the CFTC's participant eligibility rules 
as proposed. Specifically, we are very concerned that some 
clearinghouses could try to carry forward their current 
restrictive membership requirements that bear no relationship 
to risk reduction, in direct contradiction of Dodd-Frank.
    Second, clearing members obviously need the financial and 
operational resources to execute their duties to customers and 
the clearinghouse. But strong capital rules should be risk-
based rather than arbitrary. Senator Toomey rightfully 
emphasized that the current model of futures markets 
clearinghouses worked well during the crisis. The successful 
wind-down of Lehman as well as other such disasters indicates 
that that model, which includes participation in the 
liquidation process of an open auction system, not limited to 
one subset of market participants, is unsurprisingly the most 
successful and reliable.
    Third, both the clearing and execution mandates, we 
believe, should go into effect at the same time. Clearing is 
most value adding and, frankly, safest only when tied to 
execution. We do not really see how a safe central 
clearinghouse exists independent of liquid and transparent 
markets.
    Fourth, regulations governing clearinghouse memberships 
obviously have to be coordinated globally. A number of you have 
already recognized the fact that there are a tremendous amount 
of U.S. jobs at stake. There is also the fact that regulatory 
arbitrage would completely undermine and perhaps, in fact, 
worsen the current risk situation.
    Finally, we would make an operational point as sort of 
plumbers in the financial market, which is that at least 6 
months is going to be required--at least 6 months is going to 
be required--once the rules are completely finalized for our 
customers to be ready to actually implement them, and I say at 
least 6 months.
    In conclusion, let me just emphasize that we at State 
Street stand ready to help Congress, the Administration, and 
the regulators as the process of rule writing and 
implementation goes forward. And let me also point out that 
State Street, and obviously we are not alone in that, is 
spending very, very large amounts of money to prepare for the 
implementation of Dodd-Frank and that we are investing this way 
because we believe these rules, again, if properly implemented, 
will bring major benefits to our investor clients.
    Thank you.
    Chairman Reed. Thank you very much.
    Mr. Thompson.

  STATEMENT OF DON THOMPSON, MANAGING DIRECTOR AND ASSOCIATE 
             GENERAL COUNSEL, JPMORGAN CHASE & CO.

    Mr. Thompson. Chairman Reed, Ranking Member Crapo, and 
Members of the Subcommittee, my name is Don Thompson. Thank you 
for inviting me to testify today.
    JPMorgan has been an active participant in the development 
and management of clearinghouses. We have direct membership in 
77 clearinghouses covering a variety of markets, such as listed 
and over-the-counter OTC derivatives and equity and fixed-
income securities. We are committed to clearing over-the-
counter derivatives transactions, have been clearing dealer-to-
dealer OTC transactions for over a decade. Today, we clear over 
90 percent of the eligibility interdealer interest rate and CDS 
transactions that we execute. At the same time, we have also 
made significant investments in our client clearing franchise, 
which we expect to grow as requirements of clearing under Title 
VII become implemented.
    While there are a number of critical issues to consider in 
determining the appropriate market structure and governance for 
clearinghouses, the most critical is guarding against systemic 
risk. Questions of membership criteria, risk committee 
structure and governance all implicate safety and soundness, so 
it is essential that the regulations carefully weigh those 
considerations, and I commend the Committee for holding this 
hearing to ensure that these proposals are well considered.
    As you are aware, the migration of products that were once 
traded and managed bilaterally to CCPs will concentrate the 
risk for those transactions at clearinghouses. Clearinghouses 
do not eliminate credit and market risk arising from over-the-
counter derivatives. They simply concentrate it in a single 
venue in significant volume. This concentration of risk, 
combined with an increase in aggregate credit and operational 
risk at clearinghouses, will result in these institutions 
becoming systemically important.
    Since these institutions are private for-profit entities, 
it is critical that regulations guard against an outcome that 
would privatize profits but potentially socialize losses. 
Attempts to increase clearing member access or lower clearing 
member capital requirement can be responsibly implemented only 
if they are coupled with requirements for sound risk management 
practices, including appropriate limits on the types of 
transactions subject to the clearing mandate, requirements for 
members of clearinghouses to have capital contributions 
proportional to the risk that they bring into the 
clearinghouses, elimination of uncapped liability of clearing 
members, and requirements for clearing members to be able to 
risk manage transactions they bring into clearinghouses.
    We strongly support open access to clearinghouse membership 
and believe it can be achieved without compromising risk 
management standards. Two critical controls must be in place at 
each clearinghouse to support open access, a clear liability 
framework that caps member exposure and risk limits that are 
real time and proportional to each member's capital.
    The approach we advocate here is consistent with the 
approach taken by the FSA in their recent comment letter to the 
CFTC. The foundation we are proposing would allow clearing 
membership to be prudently expanded to firms with modest levels 
of capital, including the $50 million minimum requirement 
proposed by the CFTC.
    Absent proper oversight, clearinghouses are at greater risk 
of failure, which could have significant systemic impact. 
Failure could result for a number of factors, such as lack of 
proper risk management on the part of members from clearing 
complex products that cannot be properly valued by the 
clearinghouse or for from competitive actions resulting from a 
race to the bottom among for-profit CCPs.
    Given these risks, we believe that as long as CCPs are 
structured as for-profit entities, the primary regulatory focus 
should be to ensure that proper risk management, governance, 
regulatory oversight, and incentive structures are in place.
    It is also worth noting that because derivatives trading 
and clearing is a global business, in order to prevent 
regulatory arbitrage, rigorous regulatory standards should be 
applied consistently in each of the major global markets, 
including uniform operating principles and consistent on-the-
ground supervisory approach.
    We believe that no institution, including clearing members 
and clearinghouses, should be too big to fail. The policy 
objectives of the Act would be well served by promoting 
systemic stability and ensuring safety and soundness of 
clearinghouses and by requiring that these institutions have 
adequate capital to absorb losses and sufficient liquidity to 
safeguard the system.
    JPMorgan is committed to working with Congress, regulators, 
and industry participants to ensure that Title VII is 
implemented appropriately and effectively. I appreciate the 
opportunity to testify before the Subcommittee and look forward 
to answering any questions you may have.
    Chairman Reed. Thank you, Mr. Thompson.
    Mr. Cawley, please.

  STATEMENT OF JAMES CAWLEY, COFOUNDER, SWAPS AND DERIVATIVES 
                       MARKET ASSOCIATION

    Mr. Cawley. Thank you, Mr. Chairman. Chairman Reed, Ranking 
Member Crapo, Members of the Subcommittee, my name is James 
Cawley. I am CEO of Javelin Capital Markets, an electronic 
trading venue of OTC derivatives that will register as a SEF, 
or Swap Execution Facility, under the Dodd-Frank Act. I am also 
here to represent the interests of the Swaps and Derivatives 
Market Association, which is comprised of multiple independent 
derivatives dealers and clearing brokers, some of whom are the 
largest in the world.
    To ensure that the U.S. taxpayer is never again required to 
bail out Wall Street, we must move away from ``too 
interconnected to fail,'' where one bank pulls another three 
with it in the event of its failure. Equally important, we must 
remove the systemic sting currently associated with each 
bilateral derivatives contract and that connects financial 
firms to each other and thus compel these contracts into 
clearing.
    In order to have safe and successful central clearing of 
OTC derivatives, certain remaining impediments must be removed 
such that clearinghouses ensure that they have truly 
representative governance structures, offer objective and 
proportionate risk models, provide open access to properly 
qualified and noncorrelated clearing members, and accept trades 
on a real-time and execution-blind basis such that systemic 
risk is mitigated while transparency and market liquidity are 
increased.
    With regard to clearinghouse governance, we support CFTC 
core principles O, P, and Q, that require that governance 
arrangements be transparent, fair, and representative of the 
marketplace. Such governance bodies should represent the 
interests of the market as a whole and not just the interests 
of a few.
    Importantly, clearinghouse membership requirements should 
be objective, publicly disclosed, and permit fair and open 
access, as Dodd-Frank requires. This is important, because 
clearing members act as gatekeepers to clearing, and without 
open access to clearing, you will not have universal clearing 
adoption, increased transparency, and less than systemic risk. 
Clearinghouses should seek to be inclusive and not exclusive in 
their membership criteria.
    We should dispense with the myth that swaps are somehow 
different from other cleared markets and we should not ignore 
the vast experience from those markets, that they have to 
offer. Importantly, clearinghouses should learn from their own 
experience in the listed derivative space of futures and 
options. In those markets, central clearing has operated 
successfully since the days of post-Civil War reconstruction in 
this country, nearly 150 years ago, long before spreadsheets 
and risk models. In those markets, counterparty risk is spread 
over 100 disparate and noncorrelated clearing firms. It works 
well, and no customer has ever lost money due to a clearing 
member failure.
    To complement broad participation, clearinghouses should 
not have unreasonable capital requirements. Capital should be a 
function of the risk a member contributes to the system. Simply 
put, the more you or your customers trade, the more capital you 
should contribute.
    The SDMA supports the CFTC's call for clearing broker 
capital requirements to be proportionate in scale relative to 
the risk introduced to the system. We support the CFTC's call 
that a clearing firm's minimum capital be closer to $50 million 
rather than closer to the $5 billion or $1 billion threshold 
that certain clearinghouses have originally suggested.
    Certain clearinghouse operational requirements for 
membership that have no bearing on capital or capability should 
be seen for what they are, transparent attempts to limit 
competition. Specifically, clearing members should not be 
required to operate swap dealer desks just so that they can 
meet their obligation in the default management process. These 
requirements can easily be met contractually through 
arrangements with third-party firms or other dealers.
    With regard to trade acceptance, clearinghouses and their 
constituent clearing member firms should accept trades on an 
execution-blind basis. Clearing firms and their constituent 
FCMs should be prevented from discriminating against certain 
customer trades simply because they dislike the manner in which 
they have been executed or the fact that they may be anonymous. 
Certain trade counterparties should be precluded from 
exploiting current market position to impose documentary 
barriers to entry that restrict customer choice of execution 
venue, execution method, and dealer choice. Regulators should 
remain vigilant to such restrictions on trade and ensure that 
they do not manifest themselves in a post-Dodd-Frank world.
    The SDMA joins the MFA and supports the CFTC requirement 
that trades be accepted into clearing immediately upon 
execution. Regulators should be mindful not to allow 
clearinghouse workflows to increase and not decrease trade 
latency. Such workflows are nothing more than clear attempts to 
stifle successful OTC derivative clearing.
    In conclusion, the CFTC and the SEC should be commended for 
their excellent work. Both agencies have been transparent and 
accessible through the entire process and they have adapted to 
the industry's suggestion where appropriate. We must move away 
from ``too interconnected to fail,'' and as an industry, we 
must work together to ensure that OTC derivatives clearing is a 
success and that Wall Street never again has to come to Main 
Street for another bailout.
    Thank you for your time.
    Chairman Reed. Thank you very much, gentlemen, for 
excellent testimony.
    We will proceed with our first round, and if appropriate, 
since we have a large panel, we will entertain a second round 
if there are additional questions, but let me begin.
    Dr. Steil, one of the recurring themes of all the witnesses 
has been the globalization of these markets. From your 
perspective at the Council on Foreign Relations, I presume you 
spend a lot of time looking at overseas markets, as well as 
U.S. markets. How would you sort of rate what is going on 
overseas relative to what Dodd-Frank is trying to create here 
in the United States at this time?
    Mr. Steil. I used to be on the board of a European 
exchange, so I got to see some of that firsthand. I would 
describe the situation in most of the European Union as being 
confusion. First of all, there are contradictions across 
national jurisdictions. For example, the UK is taking very 
different approaches on certain issues, such as bank capital 
requirements, from the rest of the European Union.
    Second of all, there were regulatory approaches that were 
put in place before the financial crisis that are widely seen 
now as being inappropriate, but are still being pushed forward 
by inertia. I had referred briefly in my testimony, for 
example, to the European Commission's spaghetti model approach 
for clearinghouses. Prior to the financial crisis, the European 
Commission wanted to see clearinghouses compete more against 
each other and they felt that the way to do that was to compel 
them to provide interoperability, technological linkages, one 
to another.
    My concern is that that could produce enormous operational 
risk that could spread from one institution to another and 
could lead to a situation where the clearinghouses compete by 
lowering their margin requirements and other prudential 
requirements and could undermine their ability to make sure 
that we have a safe and sound securities trading system.
    So I think we are more advanced over here right now in 
terms of having a coherent approach, and although I have 
differences on some approaches, I think the thrust is going in 
the right direction and it is a matter of refining individual 
details.
    Chairman Reed. Let me just follow up and ask perhaps the 
same question a different way, and also ask Dr. Spatt to 
comment. There is a real issue here of, going forward, are we 
advantaged by these reforms or disadvantaged, particularly with 
the competition with the European Community and with some of 
our Asian financial centers. And so your sense going forward, 
then I will ask Dr. Spatt.
    Mr. Steil. It depends on the individual issue. Let us take 
the issue of clearing certain contracts that are traded in 
multiple jurisdictions. I mentioned briefly in my testimony 
natural gas and oil futures contracts. These contracts are 
traded both by the NYMEX exchange, which is owned by the CME, 
which is regulated by the CFTC, and by the Intercontinental 
Exchange, which interestingly enough, although it is an 
American exchange, trades certain of these contracts out of 
London, so to speak. Of course, this is a keystroke that 
determines jurisdiction----
    Chairman Reed. Right.
    Mr. Steil. ----under FSA regulations. Margin requirements 
can differ on contracts that are traded in different 
jurisdictions.
    And in terms of the current debate, for example on position 
limits on certain commodities, you have seen in the markets 
evidence that any time it looks like position limits may be 
instituted in the U.S. markets, say in natural gas and oil 
contracts, open interest shifts from NYMEX to ICE. I do not 
think this is coincidental. There is great concern in the 
markets here that if position limits are implemented here and 
not overseas, institutions will be forced to liquidate 
positions in order to get under those requirements, and so they 
start increasing their open interest overseas, and I think that 
is the sort of regulatory arbitrage we need to be concerned 
about.
    Chairman Reed. Dr. Spatt, your comments, and then there 
will definitely be a second round because I have questions for 
the other panelists, but I want to give my colleagues a chance. 
Dr. Spatt?
    Mr. Spatt. Thank you, Senator Reed. I share the concerns 
about the competitiveness issues. I am certainly struck by the 
discussion today about how little movement there has been in 
Europe and certainly in Asia on these issues. Even the language 
of the G20 has certainly used a much more extended window than 
is present in the Dodd-Frank legislation, and there does not 
seem to be much movement by Europe and Asia even relative to 
the longer window used by the G20.
    This whole issue reminds me of a strong parallel that I 
observed when I was Chief Economist at the SEC. At the time, 
there was a lot of concern about the consequences of Sarbanes-
Oxley for listings and lots of interest on the part of European 
companies to de-register from the U.S. environment and a lot of 
discussion and debate about that. To the extent that we get it 
wrong--and I have fears that we may be getting it wrong--to the 
extent that we get it wrong, the concern is basically that a 
lot of the business will flow overseas, that the complications 
in trading overseas are tiny. There are obviously major market 
centers in London and Hong Kong and it is relatively easy for 
most sophisticated traders to redirect their orders to what 
they consider to be a more appropriate environment.
    Chairman Reed. I thank you.
    Just before I recognize Senator Crapo, I cannot help but 
think this is somewhat ironic, because, of course, AIG's 
financial products were located in London so that they could 
avoid the ``onerous,'' quote-unquote, regulation and they 
began--they were sort of the self-destructive aspect of the 
company.
    Mr. Spatt. Well, I do think, to the extent that the 
Administration views the G20 as an important group, I think it 
is important that there be alignment, that does not necessarily 
mean to simply match the current form of Dodd-Frank, but I 
think it is important that there be regulatory alignment 
between the framework in the U.S. and the framework overseas, 
and that may involve movement in both directions.
    Chairman Reed. Thank you, Doctor.
    Senator Crapo.
    Senator Crapo. Thank you, Senator Reed.
    Mr. Thompson, I would like to return to the end user issues 
that I discussed with the first panel a little bit and ask you 
if you could explain how the margin requirements on uncleared 
groups or swaps will impact end users.
    Mr. Thompson. Thank you for that, Senator Crapo. I would 
love to be able to do that. The impediment to doing that is as 
many times as I have read the regulations, I still do not 
entirely understand them because there seems to be an internal 
inconsistency in the regulations themselves.
    They seem to say, on the one hand, we will not require the 
collection of margin from end users by swap dealers. On the 
other hand, it says that swap dealers are required to negotiate 
agreements with end users which will provide for the mechanics 
of transfer of margin with respect to their liabilities under 
uncleared swaps.
    It seems to me difficult to square those two statements, 
and the regulations, as many times as I have read them, do not 
square the circle there, so I remain a little confused about 
exactly what they require in terms of requiring swap dealers to 
collect margin from end users on uncleared swaps.
    Senator Crapo. And is this a conflict between the approach 
of the SEC and the CFTC versus the approach of the banking 
regulators?
    Mr. Thompson. I believe that that issue is present both in 
the margin release from the banking regulators as well as the 
margin release from the CFTC. Both of them require this concept 
of swap dealers establishing what they call thresholds, 
presumably which will govern the requirement to collect margin 
once you get above the threshold. There is very little, 
virtually no discussion of how those thresholds are set, 
whether they are done in accordance with banks' ordinary and 
customary credit practices, whether they will be imposed by 
regulators, whether they can be changed by regulators in a 
financial crisis. There is a whole level of detail around that 
question which is lacking in both releases.
    Senator Crapo. From my perspective, and I do not propose 
that I am anywhere close to the expert that you or the others 
on the panel are to these regulations, but it seems to me from 
what I am hearing that--it appears that although there is the 
confusion you described, that there seems to be an 
understanding that there will be somehow an increased margin 
requirement imposed either as a margin requirement or as some 
kind of other fee on end users. Is that a fair assumption?
    Mr. Thompson. I think it is natural when you have that kind 
of ambiguity in otherwise very long and comprehensive 
regulatory releases that people who would be affected by that, 
most significantly the end user community, would be naturally 
suspicious that there is not going to be some requirement 
imposed in some form or fashion in connection with their 
liabilities under uncleared swaps. So, yes, I think I agree 
with you.
    Senator Crapo. And if that is the case, I believe, and I do 
not want to speak for him, but I believe Mr. Edmonds in the 
first panel indicated that that increased margin requirement 
would be a cost on end user transactions that would not 
necessarily be justified by any appropriate increase in safety 
and soundness. He may or may not have intended that. That is 
what I heard him say. But what do you think about that? Do you 
think that the increased margin costs that would come from what 
we have been discussing would be justified in an improvement of 
safety and soundness?
    Mr. Thompson. Well, when I think about that question, which 
is an excellent question, I go back to the statute which 
authorizes and directs the prudential regulators to set margin 
requirements for uncleared swaps, and in that requirement under 
Section 731, there is a requirement that it be appropriate for 
the risk.
    When you think about end users, your typical corporate 
nonfinancial entities, there is no evidence that they 
contributed in any significant way to the financial crisis. 
Their use of over-the-counter derivatives is almost invariably 
risk reducing hedging transactions.
    Furthermore, unlike financial firms, which tend to be very 
highly correlated, such that when Lehman Brothers gets in 
trouble, people start to get the sweats about other financial 
entities, when you think about the end user world, it is a 
whole host of entities whose credit risk has very low 
correlation.
    So in my mind, that means that imposing onerous margin 
requirements on those types of entities gets you very, very 
little reduction in systemic risk and, I would argue, is not 
appropriate for the risk.
    Senator Crapo. Well, thank you. As I see it, to put it my 
way, it seems to me like we are raising the cost of capital and 
reducing the availability of capital for very little benefit.
    Mr. Thompson. That is certainly what we are hearing from 
our clients.
    Senator Crapo. Thank you.
    Chairman Reed. Senator Merkley.
    Senator Merkley. Thank you, Mr. Chair.
    Mr. Lewis, I wanted to understand a little bit better the 
exchanges that have been set up, CME and ICE. An article from 
December in the New York Times noted that State Street has not 
yet gained full entry into the derivatives trading club, and it 
mentioned other groups like the Bank of New York, MF Global, 
Newedge. Is that still pretty much the case, or have things 
changed in the course of the last few months?
    Mr. Lewis. It varies, and we are talking to the 
clearinghouses. I mean, existing clearinghouses, there was no 
problem when State Street decided to enter. The new 
clearinghouses, many of which that were set up with relatively 
limited membership that consisted of the major swap dealers 
today, who, as Dr. Steil said, make about $40 billion a year 
from market making activities, curiously did not have 
membership requirements that would allow State Street to 
participate, notwithstanding the fact that our capital ratios 
are better than any of the other top 20 banks in the United 
States.
    Senator Merkley. Right. So I am trying to get a sense, 
then, of how does State Street respond. Do you end up utilizing 
those exchanges but having to do the deals through those that 
are members, or do you simply operate through the other 
exchanges?
    Mr. Lewis. This is a prospective problem, really, more now. 
We find ourselves in the ironic situation of handling the back-
office processing for some of our clients, sort of test trades 
at clearinghouses that we were not allowed to join. I think CME 
and ICE have got proposals in place, with help from some of the 
existing members, including JP, that would let us participate. 
I think we still have a continuing problem with SwapClear at 
LCH, which apparently has a different model.
    Senator Merkley. And so, Mr. Thompson, you do not see any 
systemic issues or problems with State Street participating?
    Mr. Thompson. Generally speaking, we are supportive of open 
access. I am not intimately familiar with the State Street 
legal entity which is seeking to join ICE and CME, but I would 
just reiterate what I said in my opening statement, which is as 
long as clearinghouse membership is proportional to the risk 
that clearing members bring into the clearinghouse and as long 
as clearing members have demonstrated risk management 
capabilities such that they can assist actively in the 
management of a clearing member default, we would have no 
problem with an entity like that becoming a clearing member of 
a clearinghouse that we are a clearing member of.
    Senator Merkley. There is a fair amount of discussion of 
the question as to whether risk management arguments are being 
used really out of proportion to keep other players out of the 
exchanges. Do you see kind of an evolution in that argument or 
kind of a movement toward risk assumptions that are reasonable 
in terms of other folks participating?
    Mr. Thompson. Well, what I see in that is, on the part of 
many market participants, a recognition, much of which came out 
of the experience we had with Lehman Brothers' default and how 
the risk management process worked in the LCH, that having the 
ability to independently manage risk contributed to a very 
successful resolution of the Lehman Brothers bankruptcy with 
respect to the $9 trillion of derivatives that it had in LCH.
    The LCH mechanic requires all clearing members to be active 
bidders for portions of the portfolio of a defaulting clearing 
member, which is what Lehman was, and in the LCH Lehman 
situation, we were able to reallocate their portfolio among 
existing clearing members without going through the first level 
in the default waterfall, which is the initial margin posted by 
Lehman, thus not putting any member guarantee fund 
contributions at risk, and most critically, not imperiling the 
solvency of the clearinghouse. So we think risk management is a 
very important feature of the landscape.
    Senator Merkley. Mr. Lewis, I am going to turn back to you 
on this. I mean, one issue is membership in the exchange. 
Another is membership in the Risk Committees. The Risk 
Committees have a key role in deciding what gets traded on the 
exchange, in other words, how broadly, what kind of swaps 
derivatives are there.
    In terms of the other exchanges that you are members of, do 
you also have a role in the Risk Committee, being able to kind 
of help shape what gets traded on the exchange?
    Mr. Lewis. Yes, and we are most concerned not only for 
ourselves, but for the buy-side customers that need to 
participate in this who ultimately are at risk in pension funds 
and mutual funds need to be represented in these.
    I think there is a very complicated aspect as to how to run 
the worst-case situation, which is the default of a clearing 
member, and that is where there is a distinction between the 
practice in the U.S., which worked very successfully, and the 
practice which Mr. Thompson just alluded to in LCH in London. 
In the U.S., it is essentially an open auction, and indeed, in 
the U.S., the majority of the Lehman positions, not 
surprisingly, were bought by nonclearing firms. We would argue 
that the most open auction, most market-oriented process for 
handling a liquidation makes sense. We would also think that, 
occasionally, some of these restrictions have less to do with 
safety and more to do with limiting profit opportunity.
    Senator Merkley. Thank you very much. Thank you, both of 
you.
    Chairman Reed. Well, thank you, Senator Merkley.
    Let me just address a general question. I will start with 
Mr. Thompson, but I wish to call in Mr. Lewis, also, and this 
might be terribly unsophisticated, but it strikes me that in an 
over-the-counter derivative arrangement, there are substantial 
fees charged by the broker-dealer, and part of those fees are 
equivalent to margin. They are an attempt to price the risk in 
every transaction as risk.
    And so when we talk about the end user being assessed a 
margin requirement or not assessed a margin requirement, is it 
not the reality that there is a built-in risk premium or 
something like margin in there, and the question really is, if 
there is a requirement under these rules to have a formal 
margin or even a contingent margin, the question is really, is 
that paid for by the issuing broker-dealer or is it paid for by 
the customer, and in these situations where there are no 
competitive market, it could be fully passed on to the 
customer. Is that more of the question we are dealing with 
here, who pays rather than who is covering the risk?
    Mr. Thompson. I think there are a couple of levels to that, 
so let me just address each of those in turn.
    Chairman Reed. Sure.
    Mr. Thompson. First of all, the term ``fees'' is often 
used, but it is really misleading in the over-the-counter 
business, which is not what we call an agency business, where I 
sell you a security issued by another. We call it a principal-
to-principal business, where you and I enter into transactions. 
And so if we are entering into an interest rate swap, what we 
are really--what you are paying is the rate on the fixed rate 
that you want to pay on your interest rate swap, for example. 
So if you are in open competition with other dealers, you would 
select the dealer who requires you to pay the lowest fixed 
rate.
    Now, embedded in that fixed rate, as you correctly 
identify, for transactions that do not involve margin, is 
something that we call a credit spread, compensation to the 
dealer for the possibility that you may default, and in the 
derivatives markets, those credit spreads are risk based. If 
you are a hedge fund, you would pay a higher credit spread than 
if you are a AAA corporate. That is essentially how it works.
    Now, when people talk about the cost of margining 
transactions, that is not a cost which is embedded in the fixed 
rate of the transaction. What people are referring to there is 
the cost to you of coming up with $10 million or $20 million or 
whatever the margin requirement is in order for you to be able 
to fund the margin requirement that I am going to impose on 
you. I hope that clears it up.
    Chairman Reed. I think I am going to ask Mr. Cawley to help 
clear it up and Mr. Lewis to help clear it up. I think it is an 
excellent answer, but your comments, please.
    Mr. Cawley. It would be my pleasure, Mr. Chairman, to clear 
it up. There are essentially two types of fees that the end 
user is charged, some of which are not transparent and some of 
which are. There are--and there has been--Senator Toomey and 
Senator Crapo correctly discussed the clearing fees, the margin 
or, indeed, the capital fees that get held aside for each 
individual trade, whether it be within a clearinghouse where it 
is an objective fee that is dictated by the risk model of that 
clearinghouse or whether it be a subjective fee set by the 
broker-dealer that extends a credit relationship to that 
entity.
    And it is, indeed, the subjectivity of that fee 
relationship that got us into trouble in 2008, because dealers, 
incumbent dealers essentially extended open fee relationships 
to entities such as AIG and then requested the bailout.
    But, you know, from the end user standpoint, from what I 
have heard from Chairman Gensler, as we participated in 
roundtables and had meetings with him and read his public 
comments, it is our understanding that there is an exemption 
for end users vis-a-vis margin. That said, end users still have 
to pay their own way. They do not get a free ride on every 
trade that they do. They have to set aside the appropriate 
amount of capital for each trade, and that is only fair, and 
appropriate within the marketplace.
    The argument against that, then, is, well, you know, is 
capital formation. Well, is this not going to take money off 
our balance sheets if we really had nothing to do with AIG? And 
we would say this. Well, you are trading derivatives, so you 
have to come in the same way as everybody else.
    What you should also look, though, is at the benefits of 
the lessened execution fees that can occur. For example, if you 
take a standard credit default 5-year trade, if I want to buy 
default protection on GECC and I get charged five basis points 
in the bid-offer spread for a five million round lot trade, 
that is $21,000 per trade. Now, likewise, in the futures world, 
the execution fees are ten, maybe $10, $15, $20. So you can see 
the contrast between a transparent liquid marketplace and the 
lack of transparency in the CDS and the interest rate swap 
markets.
    Now, the way to benefit, then, is to bring these markets 
into a transparent, open, competitive marketplace such that 
that $21,000 fee, as one of the gentlemen on the panel 
correctly surmised that it is about $40 or $50 billion of 
execution fees, you go after--you create competition. You bring 
transparency into the marketplace. You bring multiple dealers, 
not just five or six or ten dealers, but 30 or 40 or 50 dealers 
in to compete. And you open up clearinghouses away not just 
from five or six or ten constituent clearing members who also 
have execution desks, as well, so there may or may not be a 
conflict of interest there, but what you do focus on is the 
benefit of taking that $50 billion worth of execution fees and 
driving it downwards to ten, leaving the resultant $40 billion 
on the balance sheets of corporate America so they can go out 
and, indeed, hire people and invest in their respective 
companies and industries.
    Chairman Reed. Thank you. And, Mr. Lewis, I want your 
perspective.
    Mr. Lewis. Just very briefly, we talk about end users, as I 
say, that are financial institutions that are in this. I think, 
by and large, they view this, unfortunately, as completely an 
incremental cost. And what I think has been lost is the genius 
of the approach, which is really the genius of futures that has 
proven this for 100 years, lots of academic research, which is 
that a more transparent market is a more efficient market. The 
biggest beneficiary of that are the price takers, the 
noncorrelated flow, the investors, if you will. The savings of 
America are better off if you have a transparent market.
    And that is one of the reasons we emphasize so much that 
you have to see both sides of the coin between clearing and the 
exchange piece, or SEFs, as it is called in this case. I think 
the measure of success will be that improved efficiency. The 
more rapidly that the clients see that efficiency, the less 
political problems there will be. The more obvious the benefits 
will be. And I think that it is a win-win.
    Alternatively, frankly, if there is not a big improvement 
in efficiency, then probably some of these risk products may 
not become as important as they are. In fact, some may 
disappear.
    And the final point I would just observe is that I think 
the least likely outcome and a very uncertain outcome is that 
the market and the products are going to look like they look 
like today. The effect of this is going to be to change things 
fundamentally, and I think if you hold to your guns, change 
things for the better.
    Chairman Reed. Thank you.
    Mr. Thompson. Senator Reed, if I might just close with one 
additional observation----
    Chairman Reed. Sure, and then Professor Spatt. Absolutely.
    Mr. Thompson. Yes. When people talk about transparency in 
the context of clearing, I think they are confusing things 
because you are confusing the clearing side of it, which is how 
trades settle and clear, with the execution side of it. And I 
think it is worth, on the execution side, to keep in mind that 
Dodd-Frank implements a full pretrade transparency for 
execution and post-trade transparency for both SEF-executed as 
well as non-SEF-executed transactions.
    So I think from a public policy perspective, the 
transparency argument has been had and decided in favor of full 
market transparency. That is a conclusion that we are totally 
comfortable with. And so I do not see how changing the clearing 
model really can add to the transparency debate which has 
already been resolved in favor of full transparency as required 
by the statute.
    Chairman Reed. Professor Spatt.
    Mr. Spatt. Yes, so on two points. First, on the issue of 
the SEFs and the CCPs, to the extent that the statute is 
obviously requiring post-trade transparency but not universal 
exchange trading, the prices from post-trade transparency can 
clearly inform collateral issues vis-a-vis the CCP, and those 
do not even have to be real time. That is a separate issue from 
whether it is real-time disclosure. Those prices could be 
disclosed a day later if real-time disclosure is a severe 
impediment with respect to liquidity. It seems to me those are 
separate.
    There is one other point I also wanted to make with respect 
to access. The issue of access is not a unique issue with 
respect to the derivatives market. In other contexts, there 
have been concerns about unfettered access. The SEC late last 
year promulgated a rule barring unfettered access by customers 
that do not go through intermediaries because of concerns that 
that would impose systemic risk on the system, if those orders 
were not vetted but had basic kinds of errors. Analogously, in 
the history of payment system clearinghouses, both the private 
clearinghouse systems prior to the Federal Reserve and the 
Federal Reserve, also control access because of issues 
associated with default.
    Chairman Reed. Thank you.
    Dr. Steil, you have a comment. You will get the last word.
    Mr. Steil. Two brief observations on end users. First, 
generally speaking, I do not like the approach of taking a 
certain class of market participants, carving that class out 
and saying that exemptions apply there, because traditionally, 
when that has been used in other markets, it has produced a 
regulatory arbitrage that has itself produced significant 
complications and inefficiencies.
    Just very briefly, for example, in the UK markets, you have 
stamp duty on equity trading and you have a carve-out for 
market makers. They do not pay it. So the market makers trade 
the stocks, but other sophisticated investors trade substitutes 
for the stocks called CFDs, or Contracts for Differences, and 
this has led to endless debate about corporate governance. For 
example, how do we deal with entities that have significant CFD 
exposures to a given company? So I do not like that general 
approach.
    Second, I think a lot of these end users are either 
overstating or misstating their cases in some cases. FMC 
Corporation, an end user, testified before your parent 
Committee back in April, and I would like to read just one 
sentence that the Treasurer said. He said, ``Our banks do not 
require FMC to post cash margin to secure mark-to-market 
fluctuations in the value of derivatives, but instead price the 
overall transaction to take this risk into account.''
    Now, this means there is no free lunch. First of all, if 
you post margin, you get paid interest on it, so it is not 
uncompensated.
    Second of all, as you yourself pointed out, if you do not 
post margin, you expect the bank to take account of this risk 
and, therefore, build it into its price, the bid-ask spread. 
And in an untransparent market, you do not know exactly what 
that price is.
    From my experience with the mutual fund industry, many 
traders on the buy side did not like when NASDAQ shifted from 
an opaque dealer market structure in the 1990s to a transparent 
electronic market structure because then trading cost analysis 
was able to distinguish between good traders and bad traders. 
And it is my perception that a lot of corporate treasurers do 
not want to be subjected to that sort of scrutiny which would 
naturally emerge in a more transparent marketplace.
    Chairman Reed. Well, thank you very much, gentlemen. This 
has been very thoughtful and excellent testimony which will 
help us, and it will not be, I am sad to say, the last word on 
this topic, but these were all very, very thoughtful words and 
I thank you very much.
    With that, I would just simply say, some of my colleagues 
may have written questions that they would like to submit. One 
week from today will be the deadline for my colleagues. We 
would ask you, if you do receive written questions, to respond 
as quickly as possible.
    And again, thank you, and with that, I will adjourn the 
hearing. The hearing is adjourned.
    [Whereupon, at 11:27 a.m., the hearing was adjourned.]
    [Prepared statements, responses to written questions, and 
additional material supplied for the record follow:]

               PREPARED STATEMENT OF CHRISTOPHER EDMONDS
                          President, ICE Trust
                              May 25, 2011

    Chairman Reed, Ranking Member Crapo, I am Chris Edmonds, President 
of ICE Trust, a limited purpose New York bank that operates as a 
clearinghouse for credit default swaps. I very much appreciate the 
opportunity to appear before you today to testify on clearing OTC 
derivatives.

Background
    ICE has a long, successful, and innovative history in clearing, 
including clearing previously ``unclearable'' over-the-counter (OTC) 
derivatives such as energy and credit default swaps. ICE owns and 
operates five derivatives clearinghouses: ICE Clear US, a Derivatives 
Clearing Organization (DCO) under the Commodity Exchange Act, located 
in New York and serving the markets of ICE Clear US; ICE Clear Europe, 
a Recognized Clearing House located in London that clears ICE Futures 
Europe, ICE's OTC energy markets and European credit default swaps 
(CDS); The Clearing Corporation, a DCO and ICE Clear Canada, a 
recognized clearinghouse located in Winnipeg, Manitoba, that serves the 
markets of ICE Futures Canada. ICE Trust serves as the leading United 
States clearinghouse for CDS, having cleared approximately $11 trillion 
in gross notional value since it launched on March 9, 2009. Globally, 
ICE has cleared more than $18 trillion in credit default swap volume 
since the financial crisis.
    Clearing is the cornerstone of U.S. and global regulators' 
financial reform efforts. Clearing greatly reduces counterparty and 
systemic risk in the derivatives markets for standardized contracts. As 
an example, since our service came to market we have reduced the 
outstanding risk exposure by greater than 90 percent for the products 
we offer. In addition, clearing brings transparency, and transparency 
is a prerequisite for efficient markets and effective regulation. 
Increased liquidity from clearing results in lower transaction costs 
and tighter bid/ask spreads, reducing the cost of hedging price risk 
and lowering operating costs for businesses. Companies operating DCOs, 
like ICE, have led this effort and have been very successful in their 
efforts to clear OTC derivatives.

Clearing Over the Counter Derivatives
    ICE's experience in energy and credit derivatives demonstrates that 
when clearing is offered to a market, the market overwhelmingly chooses 
to clear its products. While convincing market participants of the 
advantages of clearing is easy, however, the process of clearing an OTC 
derivative is difficult. For example, in order to clear an OTC 
derivative, the clearinghouse must be able to properly price the 
contract for an accurate mark to market. Marking-to-market is a process 
common to clearinghouses whereby a clearing participant's position is 
priced (marked) on at least a daily basis, and to the extent that the 
clearing participant has incurred a loss, the clearing participant must 
pay the clearinghouse the amount of the loss. The daily making-to-
market of positions, and the commensurate daily collection of any loss 
(known as variation margin), is a unique discipline of clearinghouses 
that reduces systemic risk by eliminating the accumulation of losses. 
In addition, a clearinghouse must determine the correct size and type 
of contract that it will clear, balancing the risk management 
objectives of the clearinghouse with the needs of market participants. 
Finally, the clearinghouse must model risk for the market in order to 
determine how to properly set margin rates. We do this by working in 
concert with our clearing firms, who are required to provide accurate 
pricing information for OTC products.
    For Credit Default Swaps (CDS), which we have cleared since March 
2009, we require clearing members to provide accurate and reliable 
prices on a daily basis. If a clearing member submits a price that is 
out of line with the prices submitted by other clearing members, the 
clearing member is subject to being required to enter into a 
transaction at the out of line price. Requiring clearing members to 
submit to ``executable'' prices compels clearing members to carefully 
price the CDS contract. Furthermore, requiring clearing members to 
submit accurate and reliable prices limits risk to the clearinghouse by 
ensuring that one clearing member can assume another's position in the 
event of default. Over the past 10 years, ICE has gained extensive 
experience with the clearing process--allowing ICE to grow its business 
and reduce system risk by finding new markets and product to clear.
    Over the next few months, the mandatory clearing and trading 
provisions of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (Dodd-Frank) should take effect, and market participants will be 
forced to clear OTC derivatives as a matter of law. ICE respectfully 
submits that the regulators responsible for determining which contracts 
must be cleared should consider any mandate very carefully. Many 
contracts not cleared now are not cleared for good reasons. Some 
markets have structural issues where illiquidity makes the contracts 
difficult to price. Other markets have regulatory hurdles where two or 
more regulators have different ideas on how the market should operate.
    ICE generally supports the clearing principles of Dodd-Frank. ICE 
believes, however, that the best path to meet this goal is to allow 
clearinghouses and market participants to find the best way to clear 
markets within defined principles, as opposed to promulgating 
prescriptive rules for clearinghouses. Many of the proposed rules 
attempt to design a perfect market. Attempts at such market design are 
not very likely to work and may delay implementation of clearing 
services. At the very worst, these efforts may destroy liquidity in 
certain markets. The best way to quickly achieve the clearing 
objectives of Dodd-Frank is to make sure those unnecessary regulatory 
hurdles and other impediments are removed and to give clearinghouses 
and market participants the freedom to create cleared OTC markets.
    For example, one key regulatory hurdle to clearing is cooperation 
between regulators. Many OTC derivatives, like CDS, have 
characteristics of securities and commodities. Close regulatory 
cooperation between the CFTC and SEC is necessary, and required by law, 
in order to make sure that market participants have legal certainty. 
This is particularly important in regards to portfolio margining--
allowing security-based and commodity-based derivatives to be held in 
the same account and margined together. Historically, the CFTC and SEC 
have had little success creating portfolio margining. After the 
implementation of Dodd-Frank, the absence of a clear and economical 
portfolio margining regime will discourage CDS clearing.

Regulation of Clearinghouses
    Appropriate regulation of clearinghouses is of utmost importance to 
the financial system. Pursuant to Dodd-Frank, clearinghouses will be a 
key part of the efforts to decrease systemic risk in the derivatives 
markets. In order to accomplish this important mission, clearinghouses 
must be open and transparent, while exercising proper risk management 
controls. However, given the scope, complexity and importance of the 
OTC derivatives, ``one-size-fits-all'' regulation will not work. 
Flexibility is important, because regulators must be able to anticipate 
and respond to future problems--and not just yesterday's crises. 
Prescriptive laws and regulations will hamper flexibility and create 
regulatory gaps. To be flexible, regulators must be prudential, 
understanding their markets and tailoring regulation to ensure market 
integrity and consumer protection.
    Regulators need clear lines of jurisdiction. Regulators need to 
provide certainty that they have the power to take actions to uphold 
the public good. Likewise, market participants need the certainty that 
their business transactions will not be held to conflicting standards 
of conduct. Further, regulatory certainty reduces the possibility of 
regulatory arbitrage, or long-term damage to the U.S. financial sector 
in a highly competitive global environment.
    The need for certainty extends beyond U.S. borders. It is vital to 
recognize that the OTC derivatives markets are global: most large 
companies in the developed world use derivatives, and they conduct 
these transactions with U.S. counterparties. Thus, U.S. regulators must 
work with international regulators from a common set of regulatory 
principles. Right now, Dodd-Frank has created significant uncertainty 
over whether a transaction will be subject to U.S. regulation or 
foreign regulation. This lack of clarity may begin to have an impact on 
markets, drying up liquidity and hampering regulatory reform efforts 
because market participants are unsure which laws apply. Therefore, 
harmonizing regulatory systems across countries and giving market 
participants is of utmost importance.

Timing of Implementation
    Earlier this month, the CFTC and SEC held a roundtable to hear 
views on the implementation of Dodd-Frank. Dodd-Frank's effective date 
is July 16th or at least 60 days after a final rulemaking, if one is 
required. As the CFTC and SEC have come to realize, the legislation 
cannot (effectively or practically) take effect all at once.
    ICE believes that regulators should pursue an aggressive timetable 
to implement most sections of Dodd-Frank as soon as possible. While 
Dodd-Frank requires an enormous effort from both market participants 
and regulators, the cost of uncertainty is much higher. ICE has 
suggested to regulators that they pursue a three-phase implementation 
plan. Phase 1 would implement transparency initiatives, including the 
important swap reporting and swap data repository regulations. Phase 2 
would implement the mandatory clearing and trading requirements, 
building on the transparency created by Phase 1. Phase 3 include 
everything else, such as non spot month-position limits, which could 
constrain the mandatory trading and clearing requirements. This 
timeline is similar to what other organizations are suggesting, such as 
the Managed Fund Association.
    Flexibility is central to meeting these implementation goals. 
Regulators have an immense burden to implement Dodd-Frank. Creating a 
one-size-fits-all prescriptive system of regulations will only increase 
that burden, as regulators will be required to continually consider 
exemptions for markets that do not quite fit the regulator's model. 
Likewise, market participants will have an easier time meeting 
implementation goals if they have the freedom to meet the goals of 
Dodd-Frank without radically changing their operations to meet 
prescriptive rules.

Conclusion
    ICE has always been and continues to be a strong proponent of open 
and competitive markets, and of appropriate regulatory oversight of 
those markets. As an operator of global futures and OTC markets, and as 
a publicly held company, ICE understands the importance of ensuring the 
utmost confidence in its markets. To that end, we have continuously 
worked with regulatory bodies in the U.S. and abroad in order to ensure 
that they have access to all relevant information available to ICE 
regarding trading and clearing activity on our markets. We have also 
worked closely with Congress and regulators at home and abroad to 
address the evolving regulatory challenges presented by derivatives 
markets and will continue to work cooperatively for solutions that 
promote the best marketplace possible.
    Mr. Chairman, thank you for the opportunity to share our views with 
you. I would be happy to answer any questions you may have.
                                 ______
                                 
                PREPARED STATEMENT OF TERRENCE A. DUFFY
                   Executive Chairman, CME Group Inc.
                              May 25, 2011

    Chairman Reed, Ranking Member Crapo, Members of the Subcommittee, 
thank you for the opportunity to respond to the Subcommittee's 
questions respecting clearing of swap contracts. I am Terry Duffy, 
Executive Chairman of CME Group (``CME Group'' or ``CME''), which is 
the world's largest and most diverse derivatives marketplace. CME Group 
includes four separate exchanges--Chicago Mercantile Exchange Inc., the 
Board of Trade of the City of Chicago, Inc., the New York Mercantile 
Exchange, Inc., and the Commodity Exchange, Inc. (together ``CME Group 
Exchanges''). The CME Group Exchanges offer the widest range of 
benchmark products available across all major asset classes, including 
futures and options based on interest rates, equity indexes, foreign 
exchange, energy, metals, agricultural commodities, and alternative 
investment products. CME also includes CME Clearing, a derivatives 
clearing organization (DCO) and one of the largest central counterparty 
clearing services in the world; it provides clearing and settlement 
services for exchange-traded contracts, as well as for over-the-counter 
(OTC) derivatives transactions through CME Clearing and CME 
ClearPort'.
    The CME Group Exchanges serve the hedging, risk management and 
trading needs of our global customer base by facilitating transactions 
through the CME Globex' electronic trading platform, our 
open outcry trading facilities in New York and Chicago, as well as 
through privately negotiated transactions executed in compliance with 
the applicable Exchange rules and cleared by CME's clearinghouse. In 
addition, CME Group distributes real-time pricing and volume data 
through a global distribution network of approximately 500 directly 
connected vendor firms serving approximately 400,000 price display 
subscribers and hundreds of thousands of additional order entry system 
users. CME's proven high reliability, high availability platform 
coupled with robust administrative systems represent vast expertise and 
performance in managing market center data offerings.
    The financial crisis focused well-warranted attention on the lack 
of regulation of OTC financial markets. We learned a number of 
important lessons and Congress crafted legislation designed to reduce 
the likelihood of a repetition of that disaster. However, it is 
important to emphasize that 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 experienced no default 
and no customers on the futures side lost their collateral or were 
unable to immediately transfer positions and continue managing risk. 
Dodd-Frank was adopted to impose a new regulatory structure on a 
previously opaque and unregulated market--the OTC swaps market. It was 
not intended to engineer a new regulatory regime for the already 
robustly regulated futures markets.
    For example, while Congress granted the Commodity Futures Trading 
Commission (CFTC or Commission) the authority to adopt rules respecting 
Core Principles, it did not direct it to eliminate principles-based 
regulation. Yet the Commission has proposed specific requirements for 
multiple Core Principles--almost all Core Principles in the case of 
designated contract markets (DCMs) and DCOs--which would eviscerate the 
principles-based regime that has fostered the ability of CFTC-regulated 
entities to effectively manage risk for the past decade.
    We support the overarching goals of DFA 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. Unfortunately, DFA left many important issues 
to be resolved by regulators with little or ambiguous direction and set 
unnecessarily tight deadlines on rulemakings by the agencies charged 
with implementation of the Act. We have concerns about many of these 
proposed rulemakings, about which we have previously provided written 
testimony to the Senate Banking Committee and other committees of this 
Congress. For purposes of this hearing, we will focus on the following 
five questions posed to us by this Subcommittee:

  1.  What issues may affect the safety and soundness of 
        clearinghouses, and how should those issues be mitigated?

  2.  What are the similarities and differences with other cleared 
        products that should be considered when establishing 
        clearinghouses for swaps?

  3.  Are there unique attributes of certain asset classes that should 
        be highlighted when considering adopting a clearing paradigm? 
        How about unique attributes of certain market participants?

  4.  What best practices should be considered regarding ownership, 
        governance, or control of derivatives clearinghouses?

  5.  What structural and economic barriers affect access to swap 
        clearing? What must be done to eliminate or reduce those 
        barriers?

Question 1. What issues may affect the safety and soundness of 
        clearinghouses, and how should those issues be mitigated?
    The safety and soundness of clearinghouses is a major focus of 
Dodd-Frank. The Core Principles for derivative clearinghouses compel 
DCOs to have adequate financial resources, comprehensive risk 
management procedures and safeguards against system failures. In 
addition, Dodd-Frank includes eight additional Core Principles dealing 
with the safety and soundness of derivative clearinghouses. Moreover, 
the CFTC has been granted increased power to force a derivative 
clearinghouse to alter a procedure or implement a new procedure if it 
is not in compliance with the Core Principles, without the procedural 
steps previously required. The rigid rules being proposed by the CFTC 
with respect to risk management are unnecessary and destructive of 
innovation and competition. Such a prescriptive set of requirements 
will force clearinghouses into a rigid methodology for managing risk 
and inhibit the ability of individuals best positioned to adapt risk 
management methodologies to changing circumstances. The end result of 
this would be to increase, rather than reduce risk.
    CME Group appreciates the importance to the broader financial 
system of a regulatory regime designed to ensure that every DCO can 
perform its role as a central counterparty, including performance of 
its financial obligations during periods of market stress. In that 
regard, the Commission's DCO Core Principles have functioned admirably 
and effectively over the years, including during the 2008 financial 
crisis. CME Group can support regulations that enhance the Commission's 
existing core principle system, if they strike a responsible balance 
between establishing general prudential standards and prescriptive 
requirements.
    On March 21, 2011, CME Group, by its CEO Craig Donohue, filed a 
detailed 17-page letter commenting on an additional set of CFTC risk 
management requirements for clearinghouses. The letter, which will not 
be repeated here, may be accessed at http://comments.cftc.gov/
PublicComments/ViewComment.aspx?id=31993&SearchText=. CME's position on 
this issue can be summarized as follows:

        The Commission's Notice of Proposed Rulemaking addresses the 
        critically important topic of risk management practices at 
        DCOs. Greater use of DCOs for OTC derivatives heightens the 
        importance of ensuring that risk management at every DCO is 
        robust and comprehensive. The unique risk characteristics of 
        OTC derivatives products and markets underscore the importance 
        of DCOs retaining reasonable discretion and flexibility to 
        adapt risk management practices as products and markets develop 
        over time.

        Risk management is not an assembly line type of process that 
        can be commoditized, codified and deployed in such a way as to 
        ensure that risk management regimes of DCOs remain prudent and 
        agile. Indeed, very few aspects of risk management can be 
        standardized across all cleared markets to such an extent that 
        a rules-based regime can describe each potential condition that 
        can arise and the necessary actions that can and should be 
        taken to mitigate risk. CME Group is therefore very concerned 
        that certain provisions in the proposed regulations would 
        diminish CME Clearing's ability to effectively manage risk by 
        requiring each DCO to employ the same rigid, standardized risk 
        management procedures.

        Consistent with the CFTC's approach in a number of other 
        rulemakings, regulations proposed in the NPR further the CFTC's 
        retraction of the highly successful principles-based regime 
        that has permitted U.S. futures markets to prosper as an engine 
        of economic growth for this Nation, to a restrictive, rules-
        based regime that will stifle growth, innovation, and 
        flexibility in risk management. As we have noted in comment 
        letters in response to other proposals, Congress not only 
        preserved principles-based regulation in the Dodd-Frank Act, it 
        reinforced the vitality of that regime by expanding the list of 
        core principles applicable to DCOs. Although DFA granted the 
        CFTC the authority to adopt regulations with respect to core 
        principles, it did not direct the CFTC to eliminate principles-
        based regulation. Rather, DFA made clear that DCOs were granted 
        reasonable discretion in establishing the manner in which they 
        comply with the Core Principles.

        Furthermore, certain of the proposed prescriptive regulations 
        would impose significant costs not only on DCOs and their 
        clearing members, but on the CFTC, with little or no 
        corresponding regulatory benefit. In that regard, CME Group is 
        very concerned that the CFTC has not performed the required 
        cost/benefit analyses with respect to the rulemaking proposals 
        in the NPR. Aside from certain information provided in 
        connection with recordkeeping and reporting requirements, the 
        ``cost/benefit analysis'' with regard to the regulations 
        proposed in connection with the Core Principles consists of 
        little more than the following two assertions: (1) ``With 
        respect to costs, the Commission has determined that the costs 
        to market participants and the public if these regulations are 
        not adopted are substantial''; and (2) ``With respect to 
        benefits, the Commission has determined that the benefits of 
        the proposed rules are many and substantial''. In requiring the 
        CFTC to consider costs and benefits of its proposed actions, 
        Congress requires an actual and concrete estimate of costs of 
        agency action. The mere uncertainty of cost estimates does not 
        excuse the CFTC from issuing such an estimate.

        The performance of actual and concrete cost/benefit analyses is 
        particularly important for any regulator proposing to adopt 
        regulations that would increase the costs of central clearing 
        of OTC derivatives.

    One of the CFTC proposals which causes us great concern is the 
CFTC's proposal to establish lower financial resource requirements for 
nonsystemically important DCOs, an approach we believe will exacerbate 
rather than ameliorate systemic risk. The CFTC relies on Title VIII of 
Dodd-Frank in proposing Regulation 39.29, which would require a DCO 
that is deemed systemically important (a SIDCO) to comply with 
substantially different and higher financial resources requirements 
than any DCO that the Financial Stability Oversight Council does not 
designate as systemically important. As proposed, Regulation 39.29 
would: (1) require a SIDCO to maintain financial resources sufficient 
to meet its financial obligations notwithstanding a default by the two 
clearing members creating its largest financial exposures; (2) limit a 
SIDCO's use of assessment powers to cover financial resources 
requirements relating to a default by the clearing member creating its 
second largest financial exposure; and (c) for purposes of valuing its 
assessment powers, require a SIDCO to apply the same 30-percent haircut 
and 20-percent post-haircut cap on assessments as proposed for 
nonsystemically important DCOs in Regulation 39.11(d).
    Any regulation should subject all DCOs to the same substantive 
financial resources requirements, and subject systemically important 
DCOs to more frequent stress testing and reporting requirements. We 
believe this approach is better designed to achieve Dodd-Franks' 
objectives of promoting robust risk management, promoting safety and 
soundness, reducing systemic risk and supporting the broader financial 
system.
    Setting a lower bar for nonsystemically important DCOs with regard 
to financial resources requirements (and, presumably, for certain other 
DCO core principles, including Core Principle D regarding risk 
management) would allow those DCOs to offer lower guaranty fund and 
margin requirements. In addition to putting SIDCOs at an unfair 
competitive disadvantage, this approach would likely attract additional 
volume to at least some nonsystemically important DCOs and transform 
them into de facto SIDCOs. However, until such time as they were 
designated SIDCOs by the Council and given sufficient time to come into 
compliance with the higher requirements for SIDCOs, they would be 
operating under the lower and less costly standards for nonsystemically 
important DCOs. This would contravene Title VIII's stated objectives of 
promoting robust risk management, promoting safety and soundness, 
reducing systemic risk and supporting the broader financial system.
    CME Group therefore urges that all DCOs be subject to the same 
substantive financial resources requirements. We suggest that, rather 
than adopting Regulation 39.29 as proposed, the Commission should adopt 
a regulation that subjects SIDCOs to more frequent stress testing and 
reporting requirements than any DCOs the Council does not designate as 
systemically important. For example, a SIDCO might be required to 
conduct bi-monthly stress tests of its ability to cover its default 
obligations (rather than monthly stress testing, as proposed for all 
DCOs), and to submit to the Commission the reports required under 
proposed Regulation 39.11(f) on a monthly basis (rather than a 
quarterly basis, as proposed for all DCOs). This alternative approach 
comports with the Council's recent statement that systemically 
important financial market utilities should be ``subject to enhanced 
examination, supervision, enforcement and reporting standards and 
requirements.''
    CME Group is a staunch supporter of robust and comprehensive risk 
management practices throughout the cleared derivatives markets. As 
further explained below, we are supportive of those aspects of the 
proposed regulations that seek to implement appropriate and cost-
effective measures to build upon the principles-based regime the CFTC 
has overseen in recent years and that performed admirably during the 
recent financial crisis. It is that regime that should be extended to 
the cleared swaps markets, and not an untested rules-based regime that, 
at least in part, appears to be based upon arbitrary assumptions and 
rigid concepts about how DCOs should manage risk.

Question 2. What are the similarities and differences with other 
        cleared products that should be considered when establishing 
        clearinghouses for swaps?
    If a swap contract and a futures contract have similar volatility 
and trade in a mature, liquid market, which should be the case for the 
major plain vanilla swaps, the considerations for clearing the 
contracts are identical. Thinly traded swaps present more difficult 
management processes, which our clearinghouse aims to overcome through 
its admission and risk management processes.
    This similarity between swaps and futures for a large part of the 
OTC market counsels in favor of adopting the clearing rules that have 
worked so successfully in futures markets. Indeed, a focus of Dodd-
Frank is to bring the OTC swaps market into a regulatory scheme similar 
to that which allowed the futures markets to function flawlessly 
throughout the financial crisis. If the CFTC and the SEC are to meet 
the goals of Dodd-Frank to transition from the world of unregulated, 
uncleared OTC trading to a world more nearly approximating the highly 
successful futures model clearing, they should adhere to the principles 
which have already proven effective in the management of risk. Instead, 
the proposed clearing rules require a significant, untested, and costly 
revision of an approach that has proved successful in the futures model 
and require that this new model be implemented in an impossibly short 
time frame.
    For example, it does not make sense to impose an entirely new 
regime for segregation of customer assets for swap clearing, which will 
impose significant costs on participants and undermine efficient risk 
mitigation, when the existing model of futures clearing has provided 
100 percent protection against loss due to customer default. In its 
Advanced Notice of Proposed Rulemaking (ANPR), however, regarding 
segregation of customer funds, the Commission notes that it is 
considering imposing an ``individual segregation'' model for customer 
funds belonging to swaps customers. A Notice of Proposed Rulemaking on 
this subject is forthcoming and appears to impose a form of 
``individual segregation'' model for swaps clearing but not for futures 
clearing. Such a model would impose unnecessary costs on derivatives 
clearing organizations (DCOs) and customers alike. As noted in the 
ANPR, DCOs have long followed a model (the ``baseline model'') for 
segregation of collateral posted by customers to secure contracts 
cleared by a DCO whereby the collateral of multiple futures customers 
of a futures commission merchant (FCM) is held together in an omnibus 
account. If the FCM defaults to the DCO because of the failure of a 
customer to meet its obligations to the FCM, the DCO is permitted (but 
not required), in accordance with the DCO's rules and CFTC regulations, 
to use the collateral of the FCM's other futures customers in the 
omnibus account to satisfy the FCM's net customer futures obligation to 
the DCO. Under the baseline model, customer collateral is kept separate 
from the property of FCMs and may be used exclusively to ``purchase, 
margin, guarantee, secure, transfer, adjust or settle trades, contracts 
or commodity option transactions of commodity or option customers.'' A 
DCO may not use customer collateral to satisfy obligations related to 
an FCM's proprietary account.
    In its ANPR, the Commission suggests the possibility of applying a 
different customer segregation model to collateral posted by swaps 
customers, proposing three separate models, each of which requires some 
form of ``individual segregation'' for customer cleared-swap accounts. 
Each of these models would severely limit the availability of other 
customer funds to a DCO to cure a default by an FCM based on the 
failure of a customer to meet its obligations to the DCO. The 
imposition of any of these alternative models first, is outside of the 
Commission's authority under DFA and second, will result in significant 
and unnecessary costs to DCOs as well as to customers--the very 
individuals such models are allegedly proposed to protect.
    CME Group recognizes that effective protection of customer funds is 
critical to participation in the futures and swaps markets. This fact 
does not, however, call for a new segregation regime. The baseline 
model has performed this function admirably over the years, with no 
futures customers suffering a loss as a result of an FCM's bankruptcy 
or default. There is no reason to believe it will not operate as well 
in the swaps market. DFA did nothing to change this segregation regime 
as applied to futures, and as noted above, a focus of DFA is to bring 
the OTC swaps market into a regulatory scheme similar to that which 
allowed the futures markets to function flawlessly throughout the 
financial crisis. To this end, it is unreasonable to believe that 
Congress would intend to require a different scheme of segregation of 
customer funds and as a result, a different margining and default model 
than that currently used in the futures markets. Imposing such a 
conflicting model would complicate the function of DCOs intending to 
clear both futures and swaps. Indeed, the statutory language adopted in 
Section 724 of DFA does nothing to compel such a result.
    The imposition of a different customer segregation system could 
undermine the intent behind DFA by imposing significantly higher costs 
on customers, clearing members, and DCOs intending to clear swaps and 
injecting moral hazard into a system at the customer and FCM levels. A 
change from the baseline model would interfere with marketplace and 
capital efficiency as DCOs may be required to increase security 
deposits from clearing members. That is, depending on the exact 
methodology employed, DCOs may be forced to ask for more capital from 
clearing members. Based on CME Group's initial assessments, these 
increases in capital requirements would be substantial. For example, 
CME Group's guarantee fund would need to double in size. Aside from 
these monetary costs, adoption of a segregation model would create 
moral hazard concerns at the FCM level. That is, the use of the new 
proposed models could create a disincentive for an FCM to offer the 
highest level of risk management to its customers (if the oversight and 
management of individual customer risk was shifted to the 
clearinghouse) and continue to carry the amount of excess capital they 
do today.
    Imposition of the suggested systems could increase costs and 
decrease participation in the CFTC-regulated cleared-swaps market 
because customers may be unable or unwilling to satisfy resultant 
substantially increased margin requirements. FCMs would face a variety 
of increased indirect costs, such as staffing costs, new systems and 
compliance and legal costs and direct costs such as banking and 
custodial fees. FCMs would likely, in turn, pass these costs on to 
customers. Additionally, smaller FCMs may be forced out of business, 
larger FCMs may not have incentive to stay in business, and firms 
otherwise qualified to act as FCMs may be unwilling to do so due to the 
risk and cost imposed upon the FCM model by individualized segregation. 
This could lead to a larger concentration of customer exposures at 
fewer FCMs, further increases to margin and guarantee fund 
requirements, and further increased costs to customers. All of these 
consequences would lead to decreased participation in U.S. futures and 
swaps exchanges and result in loss of jobs in the United States.

Question 3. Are there unique attributes of certain asset classes that 
        should be highlighted when considering adopting a clearing 
        paradigm? How about unique attributes of certain market 
        participants?
    As noted above, a thorough understanding of the liquidity and other 
characteristics of the market for a swap in normal and stressed 
circumstances is the key to safety and soundness in clearing. Different 
swaps with different liquidity and other varied characteristics, put 
simply, carry with them different risks. Interest rate swaps based on 
U.S., UK, and EU instruments should be easy to liquidate in the event 
of a default as are futures on U.S. debt or Eurodollars. Single name 
credit default swaps are expected to require an elaborate preset 
process and direct participation for clearing members.
    These differences in swaps, as well as the simple fact that Dodd-
Frank imposes a brand new clearing regime on the OTC swaps market, 
counsels in favor of a slow phasing-in of swap clearing. The 
Commission's proposed rules for mandatory clearing and trading of swaps 
should be revised to stage the transition from the existing market 
structure so that the participants may make the technical and 
documentary changes necessary to avoid technological and legal risks. 
We believe that the following template will make the transition to 
clearing swaps under DFA the quickest, least costly and most complete 
and effective.

Stage 1: Continued Voluntary Clearing.

    The Commission's first action must be to avoid impairment 
        of the current successful clearing process for swaps and swaps 
        converted to futures.

    The Commission should promptly make the requisite finding, 
        pursuant to Section 5c(b), that a DCO, which is clearing swaps 
        as of the effective date of DFA, will be permitted to continue 
        clearing swaps of the same class and will also be permitted to 
        clear any swap that is economically equivalent to any futures 
        contract that it was clearing prior to the DFA effective date.

    The Commission should approve the collateral and risk 
        management practices and procedures that were in place as of 
        the DFA effective date pending further notice. This means that 
        the traditional form of customer segregation must continue and 
        any of the proposed alternatives to limit or eliminate fellow-
        customer risk must be delayed until all of the remaining stages 
        for implementing mandatory clearing have been approved. DCOs 
        must be permitted to operate pursuant to the Core Principles, 
        as amended by DFA, during this period.

    The CFTC should also demonstrate that it will abide by its 
        commitment to preserve the cross margining benefits currently 
        available to the users of ClearPort. The Commission should 
        adopt a regulation that treats any ClearPort product that is 
        cleared as a future as of the DFA effective date, but which is 
        subsequently cleared as a swap, as entitled to be carried in a 
        4d account with customer futures contracts.

Stage 2: Mandatory Clearing of Certain Dollar Denominated Swaps.

    Promptly after the effective date of DFA, the Commission 
        should make an initial determination, pursuant to CEA section 
        2(h)(2)(A)(i), that all U.S. dollar denominated swaps that are 
        structurally and economically equivalent to swaps that are 
        being cleared by a DCO or ICE Trust as of the DFA effective 
        date are subject to the mandatory clearing requirement. This 
        determination, if it becomes final, will subject more than 60 
        percent of the swaps market--that has not been exempted from 
        the defined term by the Department of Treasury--to mandatory 
        clearing. Next, ``the Commission shall provide at least a 30-
        day public comment period regarding any determination made 
        under clause (i).'' Section 2(h)(2)(A)(ii)

    At this point, section 2(h) provides a clear path for 
        anyone who objects to the finding to make its views known and 
        to invoke an additional review process by the Commission, 
        taking into account the factors described in section 2(h). The 
        review process should be staged so that final determinations 
        are made first for the highest volume swaps.

    The Commission should not adopt differing start dates for 
        different classes of traders for mandatory clearing of 
        particular types of swaps.

    This proposal will (i) preserve customer choice in 
        clearing, (ii) bring the largest volume of swaps into 
        clearinghouses as soon as possible, and (iii) allocate the 
        Commission's resources in an efficient manner.

Stage 3: Reconsider and Repropose Regulations Respecting the Operation 
of DCOs.

    Do not deviate from the Core Principles regulatory regime 
        without cause.

    Do not change the method of customer segregation without 
        cause (as further discussed above).

Stage 4: Registration of SEFs.

    Finalize rules respecting the structure and operation of 
        SEFs.

    Allow an adequate number of days for SEFs to become 
        operational and to test connections to DCOs, SDRs, and 
        customers.

    Implement mandatory trading requirement.

Stage 5: Mandatory Clearing of Dollar Denominated Swaps Listed for 
Clearing Post DFA Effective Date.

Stage 6: Mandatory Clearing of Swaps Denominated in G7 Currencies.
Question 4. What best practices should be considered regarding 
        ownership, governance, and control of derivatives 
        clearinghouses?
    The extensive rules proposed by the CFTC respecting ownership, 
governance and control of derivative clearinghouses can and should wait 
until there is evidence that the specific limitations in Dodd-Frank do 
not adequately control the potential problem. The Core Principles for 
derivative clearinghouses are clear, comprehensive and easily shaped 
and enforced by the Commission on an as necessary basis. Section 5b of 
the CEA specifically insures: fairness respecting participant and 
product eligibility, appropriate governance fitness standards, 
prevention of conflicts of interest and appropriate composition of 
governing boards. The CFTC drafted these provisions. In the event that 
Dodd-Frank does prove insufficient, which is highly unlikely, the 
Commission could consider drafting ``best practices'' or safe harbors 
for ownership, governance, and control rather than extremely 
prescriptive measures like those in the proposed rules.
    The Commission's proposed rules regarding the mitigation of 
conflicts of interest in DCOs, DCMs and SEFs (Regulated Entities) 
exceed its rulemaking authority under DFA and impose constraints on 
governance that are unrelated to the purposes of DFA or the CEA. 
Section 726 conditions the Commission's right to adopt rules mitigating 
conflicts of interest to circumstances where the Commission has made a 
finding that the rule is ``necessary and appropriate'' to ``improve the 
governance of, or to mitigate systemic risk, promote competition, or 
mitigate conflicts of interest in connection with a swap dealer or 
major swap participant's conduct of business with, a [Regulated Entity] 
that clears or posts swaps or makes swaps available for trading and in 
which such swap dealer or major swap participant has a material debt or 
equity investment.'' The ``necessary and appropriate'' requirement 
constrains the Commission to enact rules that are narrowly tailored to 
minimize their burden on the industry. The proposed rules are not 
narrowly tailored but rather overbroad, outside of the authority 
granted to it by DFA and needlessly burdensome.
    The Commission proposed governance rules and ownership limitations 
that affect all Regulated Entities, including those in which no swap 
dealer has a material debt or equity investment and those that do not 
even trade or clear swaps. Moreover, the governance rules proposed have 
nothing to do with conflicts of interest, as that term is understood in 
the context of corporate governance. Instead, the Commission has 
created a concept of ``structural conflicts,'' which has no recognized 
meaning outside of the Commission's own declarations and is unrelated 
to ``conflict of interest'' as used in the CEA. The Commission proposed 
rules to regulate the ownership of voting interests in Regulated 
Entities by any member of those Regulated Entities, including members 
whose interests are unrelated or even contrary to the interests of the 
defined ``enumerated entities.'' In addition, the Commission is 
attempting to impose membership condition requirements for a broad 
range of committees that are unrelated to the decision making to which 
Section 726 was directed.
    The Commission's proposed rules are most notably overbroad in that 
they address not only ownership issues but the internal structure of 
public corporations governed by State law and listing requirements of 
SEC regulated national securities exchanges. More specifically, the 
proposed regulations set requirements for the composition of corporate 
boards, require Regulated Entities to have certain internal committees 
of specified compositions and even propose a new definition for a 
``public director.'' Such rules in no way relate to the conflict of 
interest Congress sought to address through Section 726. Moreover, 
these proposed rules improperly intrude into an area of traditional 
State sovereignty. It is well established that matters of internal 
corporate governance are regulated by the States, specifically the 
State of incorporation. Regulators may not enact rules that intrude 
into traditional areas of State sovereignty unless Federal law compels 
such an intrusion. Here, Section 726 provides no such authorization.
    Perhaps most importantly, the proposed structural governance 
requirements cannot be ``necessary and appropriate,'' as required by 
DFA, because applicable State law renders them completely unnecessary. 
State law imposes fiduciary duties on directors of corporations that 
mandate that they act in the best interests of the corporation and its 
shareholders--not in their own best interests or the best interests of 
other entities with whom they may have a relationship. As such, 
regardless of how a board or committee is composed, the members must 
act in the best interest of the exchange or clearinghouse. The 
Commission's concerns--that members, enumerated entities or other 
individuals not meeting its definition of ``public director'' will act 
in their own interests--and its proposed structural requirements are 
wholly unnecessary and impose additional costs on the industry--not to 
mention additional enforcement costs--completely needlessly.

Question 5. What structural and economic barriers affect access to swap 
        clearing? What must be done to eliminate or reduce those 
        barriers?
    An end user of swaps with sufficient credit and resources to enter 
into a swap will experience no barrier to clearing under Dodd-Frank. A 
firm that seeks to act as a clearing member of a swaps clearinghouse 
must meet the operational and financial requirements of that 
clearinghouse, which should be set sufficiently high to meet the 
clearinghouse's obligations under Dodd-Frank's Core Principles for 
DCOs. Dodd-Frank's requirements regarding safety and soundness modify a 
clearinghouse's obligation to grant open access to any potential 
clearing member. The issues of managing a default involving an immature 
or illiquid swap contract require higher admission standards than for a 
futures clearinghouse.
    The Commission's proposed rules regarding submissions by DCOs 
seeking approval to clear swaps may, however, provide a barrier to 
access to clearing simply because they impose extreme difficulty and 
expense on a DCO seeking to clear a given swap. The proposed 
regulations treat an application by a DCO to list a particular swap for 
clearing as obliging that DCO to perform due diligence and analysis for 
the Commission respecting a broad swath of swaps, as to which the DCO 
has no information and no interest in clearing. In effect, a DCO that 
wishes to list a new swap would be saddled with the obligation to 
collect and analyze significant amounts of information to enable the 
Commission to determine whether the swap that is the subject of the 
application and any other swap that is within the same ``group, 
category, type, or class'' should be subject to the mandatory clearing 
requirement.
    The proposed regulation eliminates the possibility of a simple, 
speedy decision on whether a particular swap transaction can be 
cleared--a decision that the DFA surely intended should be made quickly 
in the interests of customers who seek the benefits of clearing--and 
forces a DCO to participate in an unwieldy, unstructured, and time-
consuming process to determine whether mandatory clearing is required. 
Regulation Section 39.5(b)(5) starkly illustrates this outcome. No 
application is deemed complete until all of the information that the 
Commission needs to make the mandatory clearing decision has been 
received. Completion is determined in the sole discretion of the 
Commission. This proposed regulation is one among several proposals 
that imposes costs and obligations whose effect and impact are contrary 
to the purposes of Title VII of DFA. The costs in terms of time and 
effort to secure and present the information required by the proposed 
regulation would be a significant disincentive to DCOs to voluntarily 
undertake to clear a ``new'' swap. This process to enable an exchange 
to list a swap for clearing is clearly contrary to the purposes of DFA.
    Thank you for allowing us to respond to these important questions.
                                 ______
                                 
                    PREPARED STATEMENT OF BENN STEIL
   Senior Fellow and Director of International Economics, Council on 
                           Foreign Relations
                              May 25, 2011

    Thank you Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee for the opportunity to present to you this morning my 
views on the important subject of derivatives clearing.
    The collapse of Lehman Brothers and AIG in September of 2008 
highlighted the importance of regulatory reforms that go beyond trying 
to prevent individual financial institutions from failing. We need 
reforms that act to make our markets more resilient in the face of such 
failures--what engineers and risk managers call ``safe-fail'' 
approaches to risk management. Well capitalized and regulated central 
derivatives clearinghouses to track exposures, to net trades and to 
novate them, to collect proper margin on a timely basis, and to absorb 
default risk have historically provided the best example of successful 
``safe-fail'' risk management in the derivatives industry.
    Compare the collapse of the large hedge fund Amaranth in 2006 with 
the collapse of AIG in 2008. Both were laid low by derivatives 
exposures. Yet whereas the failure of Amaranth caused barely a ripple 
in the markets, owing to its exposures having been in centrally cleared 
exchange-traded natural gas futures contracts, the failure of AIG 
precipitated justifiable concerns of widespread market contagion that 
ultimately required a massive and enormously controversial Government 
intervention and bailout to contain. Had AIG been building derivatives 
exposures on-exchange rather than in the OTC markets, its reckless 
speculation would have been brought to a halt much earlier owing to 
minute-by-minute exposure tracking in the clearinghouse and unambiguous 
mark-to-market and margining rules. The long, drawn-out wrangling 
between AIG and Goldman Sachs over the collateral required to cover 
AIG's deteriorating derivatives positions would never have been 
possible had a clearinghouse stood between the two. Furthermore, AIG's 
net exposures in the marketplace would not have been the subject of 
rumor or surmise, but a simple matter of record at the clearinghouse.
    Encouraging a shift in derivatives trading from OTC markets without 
central clearing to organized, Government-regulated markets with 
central clearing is challenging, however, for two major reasons.
    First, the dealers that dominate the OTC derivatives business have 
no incentive to accommodate such a shift. Dealers earn approximately 
$55 billion in annual revenues from OTC derivatives trading. Some of 
the largest earn up to 16 percent of their revenues from such trading. 
The movement of such trading onto exchanges and central clearinghouses 
has the potential to widen market participation significantly, to 
increase the transparency of prices, to reduce trading costs through 
the netting of transactions, and in consequence to reduce the trading 
profits of the largest dealers materially. It is natural, therefore, 
that dealers should resist a movement in trading activity onto 
exchanges and clearinghouses. Where compelled by regulation to 
accommodate it, dealers can also be expected to take measures to 
control the structure of, and limit direct access to, the clearing 
operations. The use of measures such as unnecessarily high capital 
requirements in order to keep smaller competitors or buy-side 
institutions from participating directly as clearinghouse members are 
to be expected.
    Indeed, trading infrastructure providers organized as exclusive 
mutual societies of major banks or dealers have a long history of 
restricting market access. For example, in the foreign exchange 
markets, the bank-controlled CLS settlement system has long resisted 
initiatives by exchanges and other trading service providers to prenet 
trades through a third-party clearing system prior to settlement. Such 
netting would significantly reduce FX trading costs for many market 
participants, but would also reduce the settlement revenues generated 
by CLS and reduce the trade intermediation profits of the largest FX 
dealing banks. Other settlement service providers such as DTCC have no 
incentive to offer competition to CLS, as they are owned by the very 
same banks. There are therefore solid grounds for regulators to apply 
basic antitrust principles to the clearing and settlement businesses in 
order to ensure that market access is not being unduly restricted by 
membership or ownership limitations that cannot be justified on safety 
and soundness grounds.
    Second, some types of derivatives contracts do not lend themselves 
to centralized clearing as well as others. Customized contracts, or 
contracts which are functionally equivalent to insurance contracts on 
rare events, are examples. Since it can be difficult for policy makers 
or regulators to determine definitively whether given contracts--new 
types of which are being created all the time--are well suited for 
central clearing, it is appropriate to put in place certain basic 
trading regulations in the OTC markets that will serve both to make 
such trading less likely to produce another AIG disaster and to 
encourage the movement of trading in suitable products onto central 
clearinghouses. Two such measures would be to apply higher regulatory 
capital requirements for noncleared trades, in consequence of the 
higher counterparty risk implied by such trades, and to mandate trade 
registration and collateral management by a regulated third party, such 
as an exchange.
    In establishing the regulatory standards for the clearing of 
derivatives transactions, it is imperative for lawmakers and regulators 
to be fully conscious of the fact that the derivatives market is 
effectively international, rather than national, and that it is 
exceptionally easy for market participants to change the legal domicile 
of their trading activities with a keystroke or a simple change of 
trading algorithm. In this regard, I would highlight two important 
areas of concern.
    First, the three major world authorities controlling the structure 
of the derivatives clearing business--the SEC, the CFTC, and the 
European Commission--each take a very different view of the matter. 
Historically, the SEC has applied what I would term the ``utility'' 
model to the industry, the CFTC has applied what I would term the 
``silo'' model, and the European Commission has applied what I would 
term the ``spaghetti'' model. The broad benefits of each are depicted 
in the matrix below.



    The SEC's utility model favors institutions operated outside the 
individual exchanges; in particular the DTCC in the equity markets and 
the OCC in the options markets. This approach has generally performed 
well in terms of safety and soundness, and in encouraging competition 
among exchanges. It performs poorly, however, in terms of encouraging 
innovation in clearing and settlement services.
    The CFTC's silo model allows the individual exchanges to control 
their own clearinghouses. This approach has also performed well in 
terms of safety and soundness. The recent decision of the CME to raise 
margin requirements on silver trading is evidence of the model working 
well, in terms of the exchange placing a premium on the integrity and 
solvency of its clearing operations rather than trying to maximize 
short-term speculative trading volumes. The CFTC's model also 
encourages innovation in product development in a way in which the 
SEC's model does not. This is because CFTC-regulated futures exchanges 
can capture the benefits of product innovation in terms of generating 
trading volumes, whereas SEC-regulated options exchanges risk seeing 
trading volumes in new products migrate to other exchanges, all of 
which use clearing services provided by the OCC. The CFTC model, in 
consequence, does not promote competition from new trading venues in 
the same way that the SEC model does. It does, however, promote wider 
direct market participation in clearing systems, as demutualized 
exchanges have a commercial interest in expanding such access to buy-
side institutions that dealers normally want to exclude. This reduces 
trading costs and expands market liquidity.
    The European Commission's spaghetti model, enshrined in its so-
called ``Code of Conduct'' for the industry, compels the EU's 
clearinghouses to interoperate with each other. It also encourages both 
exchanges and clearinghouses to compete against each other. Like the 
SEC's model, however, it can be expected to dampen incentives for 
product innovation, as clearing competition makes it more difficult for 
exchanges that own clearinghouses to maximize their trading and 
clearing revenue returns on new product development. More importantly, 
this model, I believe, is not conducive to ensuring safety and 
soundness, as it encourages clearinghouses to cut margin requirements 
and other prudential measures as a way to attract business from, or 
prevent business from moving to, other clearinghouses. It also injects 
a major element of operational risk into the business, in consequence 
of each clearinghouse being vulnerable to failures of technology or 
risk management in others.
    On balance, I believe that the CFTC's model is the most appropriate 
for the derivatives industry, and I believe that the unworkability of 
the European Commission's spaghetti approach will ultimately oblige it 
to move back in the CFTC's direction. Although the CFTC's approach does 
not promote interexchange competition as directly as the SEC's model, 
it is important to note that new competitors are, in fact, entering 
into the futures business. ELX, founded in 2009, and NYPC, a recent 
joint venture between the NYSE and the DTCC which facilitates cross-
margining of multiple products, are now competing with the CME in the 
financial futures space.
    The second point I would like to make regarding the global nature 
of the derivatives trading industry is that certain measures to curb 
speculative activity being debated here in Washington are highly likely 
to push trading activity ``off exchange''--precisely the opposite of 
Congress' intent. For example, a so-called Tobin Tax on futures 
transactions at the level being discussed last year, 2 basis points 
(0.02 percent), would be equivalent to over 400 times the CME 
transaction fee on Eurodollar futures. It should go without saying that 
a tax this large, relative to the current transaction fee on the 
underlying contract, would push all of this trading off the CME and 
into alternative jurisdictions.
    Likewise, commodity market position limits, if not harmonized with 
UK and other national authorities, will merely push such trading 
outside the CFTC's jurisdiction. There is already an active regulatory 
arbitrage on oil and natural gas futures between the CME's NYMEX 
exchange, which trades such contracts under CFTC regulation, and the 
Intercontinental Exchange (ICE), which trades such contracts under FSA 
regulation in London. We have seen indications of movement in trading 
from NYMEX to ICE in line with market perceptions of the likelihood of 
such limits being imposed in the United States. In short, we must be 
extraordinarily cautious not to undermine Congress' worthy goal of 
bringing more derivatives trading under the purview of U.S.-regulated 
exchanges and clearinghouses by inadvertently providing major market 
participants incentives to do precisely the opposite.
    Thank you, Mr. Chairman, for the opportunity to present my views 
today on this important issue.
                                 ______
                                 
                 PREPARED STATEMENT OF CHESTER S. SPATT

 Pamela R. and Kenneth B. Dunn Professor of Finance, Tepper School of 
                  Business, Carnegie Mellon University
                              May 25, 2011

    I am pleased and honored to have the opportunity to present my 
views to the Senate Subcommittee on Securities, Insurance, and 
Investment at its hearing today on ``Derivatives Clearinghouse: 
Opportunities and Challenges.'' I am the Pamela R. and Kenneth B. Dunn 
Professor of Finance at the Tepper School of Business at Carnegie 
Mellon University, where I have been a faculty member since 1979. I 
also served as the Chief Economist of the U.S. Securities and Exchange 
Commission in Washington, DC, from July 2004 until July 2007. My 
expertise as a faculty member includes such areas as trading 
mechanisms, derivative securities, asset valuation, financial 
regulation, and the financial crisis. In addition to my faculty 
position my current affiliations include serving as a Research 
Associate of the National Bureau of Economic Research, Senior Economic 
Advisor to Kalorama Partners, and a member of both the Shadow Financial 
Regulatory Committee and Financial Economists Roundtable. I also was 
one of the founders and the second Executive Editor of the Review of 
Financial Studies, which quickly emerged as one of the preeminent 
journals in financial economics, as well as a Past President and 
Program Chair of the Western Finance Association.
    The changes in how our financial markets trade and clear derivative 
securities and swaps that now are being implemented are fundamental to 
the design of these markets. In the aftermath of the financial crisis 
the focus on migrating standardized swaps and derivatives to clear 
through central counterparties (CCPs) is a natural one and one to which 
I am sympathetic as an attempt to reduce the contagion associated with 
counterparty risk and make the structure of risk much more transparent. 
However, it is unclear whether the extent of use of clearinghouses will 
ultimately lead to a reduction in systemic risk in the event of a 
future crisis. Additionally, it will be crucial to manage carefully the 
risks within the clearinghouses. To the extent that risks or the fees 
of the clearinghouse are lower compared to uncleared derivatives, 
market participants could choose to increase their risk exposures. Of 
course, it is important that the fees for holding uncleared derivatives 
reflect economic costs and not be punitive to create artificial 
concentration of risk within the clearinghouse and also that the 
clearinghouse be sensitive to the incentives to dump transactions into 
it that are not marked properly.
    The clearinghouse structure is potentially subject to considerable 
moral hazard as there is a strong incentive for market participants to 
trade with weak counterparties (who may offer more favorable pricing), 
subject to their eligibility to clear through a centralized 
counterparty (CCP). However, at some point a CCP may not be willing to 
clear contracts from a weak counterparty because of the risk associated 
with the counterparty being unable to deliver on its dynamic margin 
obligations on a going forward basis. Then the CCP would be subject to 
serious counterparty risk. In situations where trading with weak 
counterparties (and effectively with the CCP) is especially attractive 
to other market participants, there is a greater risk exposure to the 
overall economy. For this reason and also because of the concentration 
of risk in the CCP, it is easy to anticipate that central clearing 
actually could raise systemic risk substantially in the event of a 
financial crisis.
    A number of observers have emphasized the absence of clearinghouse 
failures in the United States during the recent financial crisis. Of 
course, not every potential financial crisis is the same with respect 
to its causes, scale or transmission. Consequently, in my judgment we 
can only take limited comfort for the future from the absence of 
failure of a clearinghouse during the recent financial crisis. Indeed, 
Federal Reserve Chairman Ben Bernanke attributed the lack of failure of 
a clearinghouse during the financial crisis to ``good luck'' \1\ in a 
speech at the recent Atlanta Federal Reserve Bank conference. Of 
course, many institutions that were previously thought to be 
essentially impervious and under various forms of Federal oversight 
either did collapse or would have collapsed without massive Federal 
guarantees (including Fannie Mae, Freddie Mac, AIG, Lehman Brothers, 
Bear Stearns, Citigroup and Bank of America). It is generally 
recognized that clearinghouses can fail, \2\ and indeed, a recent 
editorial in the Wall Street Journal \3\ cited such relatively recent 
failures as those in France in 1974, Kuala Lumpur (Malaysia) in 1984 
and Hong Kong in 1987. The regulatory and supervisory system will 
require much more of clearinghouses in the future than during the 
recent financial crisis, potentially amplifying their vulnerability. In 
his Atlanta Federal Reserve speech Chairman Bernanke summarized this 
point as follows, ``As Mark Twain's character Pudd'nhead Wilson once 
opined, if you put all your eggs in one basket, you better watch that 
basket.'' Of course, this not only highlights the potential importance 
of regulatory supervision of the clearinghouse, but also that 
clearinghouses should be properly designed to limit their risk 
exposure.
---------------------------------------------------------------------------
     \1\ Speech at the Federal Reserve Bank of Atlanta conference on 
April 4, 2011.
     \2\ Roe, M., ``Derivatives Clearinghouses Are No Magic Bullet'', 
Wall Street Journal, May 6, 2010.
     \3\ ``Pudd'nhead Wilson in Washington'', Wall Street Journal 
editorial, April 23-24, 2011, p. A14.
---------------------------------------------------------------------------
    One of the challenges confronting the supervisor of the 
clearinghouse is whether the clearinghouse could require the 
possibility of a ``bailout'' to ward off failure. At hearings of the 
Senate Banking Committee in mid-April CFTC Chairman Gary Gensler agreed 
that the clearinghouses would not receive ``too big to fail'' 
guarantees or subsidies. Arguably, this is reflective of a political 
environment, which is now quite unsympathetic to the use of such 
guarantees. But this highlights the crucial importance of strong risk 
management of the central counterparty to avoid the potential collapse 
of a major clearinghouse in a financial crisis. While it's a delicate 
balance, the importance of strong risk management potentially could be 
even at the expense of other values, such as promoting more competitive 
pricing of clearinghouse services.
    A key role of the clearinghouse is to make trading entities 
informationally insensitive to their specific counterparties. At the 
same time, there is a danger of a potentially large increase in 
systemic risk unless the risk is well managed by the clearinghouse, 
because the clearinghouse is a risk management platform that 
concentrates the risk in the economy. Thus, the governance of a 
clearinghouse must reflect a strong incentive to control risk and 
internalize the costs and benefits associated with alternative 
collateral standards. Limiting greatly the role of trading firms in the 
governance and promoting ``independent directors'' (who would lack the 
incentives to focus on managing and minimizing the risk and perhaps in 
some instances relevant experience) would create significant challenges 
and even reluctance by trading firms to allocate capital to the 
clearinghouse and back-stop the risks of the clearinghouse. 
Mutualization of risk is essential to the success of a clearinghouse 
model and affording protection against the ultimate risks being borne 
by society in the form of ``too big to fail'' guarantees. Yet the 
commentary of regulators focuses upon the more abstract notion of 
``conflicts of interest'' in governance, without explicit focus on the 
incentives to control the underlying risks that would arise in the 
clearinghouse model. In light of this it is crucial that the governance 
of the clearinghouse, including the composition of the Board and 
especially the Risk Committee, reflect the importance that the broader 
society places on the elimination of ``too big to fail'' guarantees. To 
the extent policy makers choose to concentrate risk within a 
clearinghouse, it is crucial that the risk management of the 
clearinghouse mitigate the underlying systemic risk, including a strong 
risk management structure and governance aligned with that goal.
    Incentives are crucial to ensure that there is a reasonable attempt 
to align the incentives of various parties. For example, in the event 
of a crisis clearing members would potentially contribute financial and 
human capital to the CCP. It would create incentive problems to absolve 
smaller members of these duties (except for the limits related to their 
underlying capital contribution) or to allow them to outsource these to 
third parties whose incentives would not be aligned. It also is 
important to ensure that in the event of a crisis that the clearing 
members have funding available for their contingent capital 
obligations--to the extent that individual CCPs are unable to monitor 
their clearing members along such lines, it may be important for the 
regulator to supervise this to avoid a default cascade that would 
jeopardize the clearinghouse through a sequence of defaults. In fact, 
it's important for the regulator to be sensitive to the complications 
that arise from the incentives of a set of profit-maximizing 
clearinghouses.
    Analogously, regulators are focused upon ``access'' to the 
clearinghouse by investing firms--but it is important to recognize that 
this is not a traditional trading platform, but an organization in 
which mutualization of risks by the membership is fundamental. Indeed, 
members should be required to have appropriately high capital pledged 
to protect the organization in that they are counterparties whose risk 
is being accepted by the clearinghouse and indeed, the members become 
the ultimate guarantors through the mutualization of risk.
    The issue of ``direct access'' surfaces in a number of different 
forms across markets--for example, requiring that orders be presented 
through intermediaries would be a way to protect markets against 
obvious errors in order presentation. Indeed, because of concerns about 
``direct access'' in equity trading the SEC adopted a rule late last 
year eliminating direct unfiltered customer access in the order 
transmission process due to the systemic risk that would create for our 
system of equity clearance and settlement. \4\
---------------------------------------------------------------------------
     \4\ ``SEC Adopts New Rule Preventing Unfiltered Market Access'', 
Press Release 2010-210, November 3, 2010. http://www.sec.gov/news/
press/2010/2010-210.htm; Also see, discussion in J. Angel, L. Harris, 
and C. Spatt, 2011, ``Equity Trading in the 21st Century'', Quarterly 
Journal of Finance, 1, 1-53.
---------------------------------------------------------------------------
    Another crucial policy choice is whether the clearinghouse would 
likely be a recipient of a bailout in the event of a failure in its 
risk management. The strong political consensus against the possibility 
of a bailout emphasizes the importance of strong risk management by the 
clearinghouse and a governance system, including restrictions on access 
through nonmembers and a board structure that makes risk management the 
central priority. From an economist's perspective this highlights how 
restricting direct access is a partial substitute for ``too big to 
fail.'' \5\ Using governance and access (as compared to other 
governmental regulatory tools) to enhance the competitiveness of 
pricing of clearinghouse services comes at the cost of making a bailout 
of the clearinghouse more likely.
---------------------------------------------------------------------------
     \5\ Analogously, allowing the composition of directors to focus on 
risk management incentives and expertise also is a substitute for ``too 
big to fail.''
---------------------------------------------------------------------------
    The analogy between risk management for a swaps clearinghouse and 
that for the clearinghouse for a payments system is striking. In the 
payment systems context my colleague Marvin Goodfriend [1990] writes, 
\6\ ``[I]t was efficient for private clearinghouses before the Fed to 
limit their membership to a relatively exclusive core of banks, 
allowing other banks access to the clearing system through agent-member 
banks. This suggests that it is efficient for the Fed to restrict 
direct access to its national clearing system as well, both to protect 
Fed lending generated in the payments systems and to protect the 
interbank credit market.'' Goodfriend [1990] also observes that it is 
valuable ``to restrict direct access to its national clearing system as 
well, to protect Fed daylight overdrafts and the interbank credit 
market.'' In the context of a derivatives and swaps clearinghouse 
restriction on direct access by nonmembers leads to a system in which 
the clearinghouse members are responsible to protect the integrity of 
the clearinghouse. In that sense restrictions on direct access help 
assure financial stability and protect society against bearing greater 
costs from implicit ``too big to fail'' guarantees for the 
clearinghouse. If the clearinghouse member has strong incentives to 
monitor its customers, by imposing much of the risk created by customer 
losses on the introducing member, then a strong compatible risk 
management system will result.
---------------------------------------------------------------------------
     \6\ M. Goodfriend, 1990, ``Money, Credit, Banking, and Payments 
System Policy'', in U.S. Payments System: Efficiency, Risk, and the 
Role of the Federal Reserve, edited by David B. Humphrey, Kluwer 
Academic Publishers; also reprinted in Federal Reserve Bank of Richmond 
Economic Review, January/February 1991, pp. 7-23.
---------------------------------------------------------------------------
    The absence of failures of clearinghouses in the financial crisis 
has been viewed by some as offering reassurance about the inherent 
stability of the clearinghouse model. Indeed, the clearinghouse model 
has a number of attractive features, such as, netting of exposures and 
greater transparency of risks. At the same time, this model presents 
greater sources of vulnerability due to concentration of risk and 
greater moral hazard at the customer level because there is no pricing 
differential or penalty imposed on weak counterparties as long as they 
are acceptable to the clearinghouse. In addition, to the extent that 
financial services firms believe they have essentially fully 
transferred various risks to the clearinghouse they likely will bear 
additional risks (systemic and otherwise) because of their enhanced 
risk-bearing capacity. It is extremely important to recognize and 
acknowledge the implications of the endogeneity of risk. Improvements 
in the management of collective risk potentially will incentivize 
financial services firms to take on more risk at the margin. For 
example, decisions about leverage will emerge endogenously. It is 
important to bring considerable caution and skepticism to discussions 
about risk management in the clearinghouses, especially in light of 
their broader contemplated role. \7\
---------------------------------------------------------------------------
     \7\ For example, see, ``Derivatives, Clearing and Exchange-
Trading'', Statement No. 293 of the Shadow Financial Regulatory 
Committee, April 26, 2010, http://fic.wharton.upenn.edu/fic/policy 
percent20page/Statement%20No.%20293-
%20Derivatives,%20Clearing%20and%20Exchange%20Trading.pdf.
---------------------------------------------------------------------------
    My underlying view on the relevance of economic principles to the 
structuring of clearinghouses also highlights the broader point that in 
restructuring the derivatives and swaps markets it is important to be 
sensitive to the economic consequences of contemplated rulemakings and 
undertake cost-benefit analyses that will identify these consequences 
and help to inform rule proposals.
                                 ______
                                 
                  PREPARED STATEMENT OF CLIFFORD LEWIS
         Executive Vice President, State Street Global Markets
                              May 25, 2011

    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, thank you for the opportunity to testify today regarding 
the clearing-related provisions of the Dodd-Frank Wall Street Reform 
and Consumer Protection Act.
    As an initial comment, I commend the CFTC for their efforts to date 
on Dodd-Frank implementation, where they are working on a broad range 
of highly complex issues, on a very aggressive timeframe.
    State Street is one of the world's largest custodial banks and 
processors of derivatives transactions, and we support regulations 
which will benefit our customer base of large, buy-side, institutional 
investors, such as pension funds, mutual funds, and endowments. We 
support the Dodd-Frank mandates for both derivatives clearing and 
execution, which we believe will reduce global systemic risk, and, 
properly implemented, benefit our institutional investor customer base.
    Like most market participants, our buy-side clients are concerned 
by the current regulatory uncertainty and the potentially significant 
cost and market liquidity impacts that may result from the new rules. 
At State Street, we are well positioned to provide our clients with 
full-service clearing and other services that can help them realize the 
benefits of the new derivatives regime, through enhanced transparency, 
more open execution platforms, and central clearing.
    In relation to central clearing, the key issue for State Street is 
effective implementation of the Dodd-Frank Act's requirement that 
clearinghouse membership requirements ``permit fair and open access.'' 
Open access will reduce systemic risk by avoiding concentration of 
clearing activity with a small number of existing ``dealer'' members, 
and benefit the buy-side by allowing netting across dealers on swaps 
that clear through the same clearinghouse.
    State Street intends to pursue membership in a variety of 
derivatives clearinghouses, and the Dodd-Frank requirement for open 
access is an important element in our ability to increase competition 
in the clearing services marketplace.
    I'd like to make a few specific recommendations:

    First, we support the CFTC's participant eligibility rules as 
proposed, but note these rules will require vigilant oversight by the 
CFTC. The proposed rules recognize the critical importance of strong 
clearinghouse risk management practices, while, at the same time, 
permit broader clearinghouse membership, reducing systemic risk and 
allowing buy-side market participants to benefit from alternative 
clearing member business models. As we noted in our comment letter to 
the CFTC, we are concerned that some clearinghouses will carry forward 
their current restrictive membership requirements, in direct 
contradiction of the spirit and intent of Dodd-Frank.
    Second, clearing members must be required to demonstrate the 
necessary financial and operational resources to execute their duties 
to customers and the clearinghouse. Strong capital rules are important, 
but should be risk-based rather than arbitrary dollar amounts. We have 
suggested linking capital requirements to other risk-based 
clearinghouse measures, such as a multiple of default fund 
contributions. Other arbitrary requirements linked to a dealer-specific 
business model, such as a minimum swap book, are not risk-based and 
will prohibit membership by nondealer firms. Outsourcing of certain 
functions should be allowed, provided that the execution risk 
associated with such outsourcing rests with the member firm and not the 
clearinghouse. By way of example, the current model of the futures 
markets showed itself well structured to handle such crises, as the 
successful wind-down of Lehman's futures positions by nonmembers 
demonstrated at the time of its bankruptcy.
    Third, both the clearing and the execution mandates should go into 
effect at the same time.
    Clearing is most effective when tied to execution, providing market 
participants with greater transparency, tighter spreads and cost 
reduction. Phasing-in the clearing requirement in advance of the 
execution requirement would burden market participants with increased 
costs while denying them the corresponding benefits. If some form of 
phasing is deemed necessary by the CFTC, it should be done by 
instrument and require that as each new instrument is folded under the 
regulatory regime, both the clearing and execution requirements attach 
simultaneously.
    Fourth, to the extent possible, regulations governing clearinghouse 
membership rules should be coordinated globally, to avoid regulatory 
arbitrage that could frustrate the Dodd-Frank requirements for open 
access.
    Finally, in order to allow the markets and participants to adjust 
to new ways of doing business, we suggest that a 6-month transition 
period be given between finalization of the mandatory clearing and 
execution rules and mandatory compliance. The final rules will provide 
certainty to the markets as to what the new regulatory demands are, and 
only then will businesses be in a position to plan and adapt 
accordingly.

    Again, State Street strongly believes in the importance of the 
clearing and execution mandates as spelled out in Dodd-Frank, and we 
stand ready to help Congress, the Administration and the regulators as 
the process of rule writing and implementation goes forward.
    Thank you for the invitation to testify before you today. I will be 
happy to take your questions.
                                 ______
                                 
                   PREPARED STATEMENT OF DON THOMPSON
 Managing Director and Associate General Counsel, JPMorgan Chase & Co.
                              May 25, 2011

    Chairman Reed, Ranking Member Crapo, and Members of the Committee, 
my name is Don Thompson, and I am a Managing Director and Associate 
General Counsel at JPMorgan Chase & Co (JPMC). I head our derivatives 
legal group and have been actively involved in implementation of Title 
VII of the Wall Street Reform and Consumer Protection Act (the 
``Act''). Thank you for inviting me to testify today on the 
opportunities and challenges of derivatives clearinghouses (CCPs).
    JPMC has been an active participant in the development and 
management of clearinghouses with direct membership in 77 
clearinghouses for a variety of markets including listed and over-the-
counter (OTC) derivatives, equity and fixed income securities. We are 
committed to clearing OTC derivatives transactions and have been 
clearing dealer-to-dealer OTC transactions for a decade. Today major 
swap dealers clear over 90 percent of eligible interdealer interest 
rate and CDS transactions. At the same time, we have also made 
significant investments in our client clearing franchise, which we 
expect to grow as the requirements of clearing under Title VII become 
implemented.
    While there are a number of critical issues to consider in 
determining the appropriate market structure and governance for 
clearinghouses, the most critical is guarding against systemic risk. 
Questions of membership criteria, risk committee structure and 
governance all implicate safety and soundness, so it is essential that 
regulations carefully weigh these considerations.
    As the Committee is aware, the migration of products that were once 
traded and managed bilaterally to clearinghouses will concentrate the 
risk from these transactions at CCPs. CCPs do not eliminate credit and 
market risk arising from derivatives; they simply concentrate it in a 
single location in significant volume. This concentration of risk 
combined with an increase in aggregated credit and operational risks at 
CCPs will result in these institutions becoming systemically important.
    Since these institutions are private, for-profit entities, it is 
critical that regulations guard against an outcome that would privatize 
profits but potentially socialize losses. Attempts to increase clearing 
member access or lower clearing member capital requirements can be 
responsibly implemented only if they are coupled with requirements for 
sound risk management practices. These practices should include 
appropriate limits on the types of transactions that are subject to the 
clearing mandate, requirements for members of clearinghouses to have 
capital contributions proportional to the risk they introduce to the 
CCP, elimination of uncapped liability of clearing members and 
requirements for clearing members to be able to risk manage the 
transactions they bring to the CCP. We strongly support open access to 
clearinghouse membership, and believe it can be achieved without 
compromising risk management standards. Two critical controls must be 
in place at each clearinghouse to support open access: a clear 
liability framework that caps each member's exposure, and risk limits 
that are real-time and proportional to each member's capital. With this 
foundation, the clearing membership can be prudently expanded to firms 
with modest levels of capital, including the $50 million minimum 
proposed by the CFTC.
    Absent proper oversight, CCPs are at greater risk of failure, which 
could have significant systemic implications. Failure could result from 
a number of factors, such as a member's lack of proper risk management, 
from clearing complex products that cannot be properly valued by the 
CCP, or from actions resulting from a ``race to the bottom'' among for-
profit CCPs.
    Given these risks, we believe that as long as CCPs are structured 
as for-profit entities, the primary regulatory focus should be to 
ensure that proper risk management, governance, regulatory oversight 
and incentive structures are in place, as discussed in greater detail 
below.
    It is also worth noting that because derivatives trading and 
clearing is a global business, in order to prevent arbitrage, rigorous 
regulatory standards should be applied consistently in each of the 
major global markets, including uniform operating principles and a 
consistent on-the-ground supervisory approach.

Safety and Soundness of Clearinghouses
    In considering clearinghouse membership requirements and their 
impact on clearinghouse safety and soundness, it is important for 
policy makers to keep in mind the nature of a clearinghouse. A 
clearinghouse is structured to provide for mutual sharing of 
counterparty risk among members. Each clearing member is exposed to the 
counterparty credit risk of all other members and, by extension, all 
clients clearing trades via other members. Clearinghouses themselves 
provide a very small portion of the capital which backs the performance 
of the clearinghouse, and the vast majority of the financial resources 
of a clearinghouse is provided by the members through their 
contributions to the guaranty fund as well as collateral posted by the 
clearing members. To the extent of their liability, each member is 
delegating risk management of its capital to the clearinghouse, which 
in many cases is a private, for profit entity. Each member is also 
exposed to the capital, liquidity and operational capabilities of other 
members, to the client risk introduced by every other member as well as 
the risk management processes put in place by those members and by the 
clearinghouse. A clearinghouse that is prudently managed must have 
adequate margin and guarantee fund resources and must refresh its 
calculations daily and intraday to adjust its resources to changing 
market conditions.
    There are additional measures that should be considered in order to 
enhance the safety and soundness of clearinghouses:

  1.  Clearinghouses should have a credible resolution plan, given 
        their interconnectedness to the financial markets and the 
        associated systemic risk implications. Such resolution plans 
        should be tested regularly and reviewed by regulators.

  2.  On-site inspections by regulators should be conducted at regular 
        and frequent intervals. The sufficiency of clearinghouse 
        financial safeguards should be regularly evaluated against the 
        results of such tests, and adjusted as appropriate.

  3.  The liability of clearing members to the clearinghouse should be 
        clearly ascertainable and capped. Unlimited liability of 
        members towards the clearinghouse to absorb clearinghouse 
        losses has the effect of maintaining the solvency of the 
        clearinghouse at the expense of its participants, a trade-off 
        that likely would lead to systemic risk concentration, not 
        mitigation. Unlimited liability is the worst of all worlds: 
        large financial institutions will be interconnected, but will 
        have no idea of their exposure to any other particular 
        institution, and neither the incentive nor the means to 
        mitigate the risk.

  4.  In determining the appropriateness of a clearinghouse financial 
        safeguards package there should also be an appropriate balance 
        between initial margin and guarantee fund contributions. This 
        balance should not be allowed to vary significantly across 
        clearinghouses. If initial margin is set too low, there will be 
        an incentive to push risky and unbalanced positions through the 
        clearinghouse as participants recognize that the risk 
        introduced in the clearinghouse will be subsidized by other 
        clearing members through guaranty fund contributions. The 
        amount of initial margin customers are required to post, 
        together with the degree of protection afforded such margin, 
        may adversely affect the incentives of customers to select 
        prudently managed clearinghouses, contributing to moral hazard 
        and instigating a race to the bottom.

Clearinghouse Access
    We strongly support regulation aimed at mitigating conflicts of 
interest. We also support full implementation of the open access core 
principles set out by Congress in the Act with a risk-based framework 
that allows clearing members to clear client and house activity in 
proportion to their capital. We note that the Lynch amendment, which 
would have restricted equity ownership of interests in clearinghouses 
and swap execution facilities by swap dealers, was not part of the 
final text of the Act passed by Congress and signed by the President; 
however, proposed rules include such restrictions.
    We believe that all clearinghouses should provide open access to 
whoever meets certain minimum objective criteria. In our view, the fact 
that a clearinghouse relies almost exclusively on the capital of its 
members places a great emphasis on the ability of a member to absorb 
any losses resulting from: (a) the house and client risk that a 
clearing member introduces into the clearinghouse; and (b) 
mutualization of the risks introduced by every other clearing member 
and those clearing members' clients. Given the loss mutualization 
feature of clearinghouses, we believe that the financial stability of 
clearinghouses depends on the requirements that must be satisfied for a 
member to qualify as a clearing member. Those criteria, however 
defined, should require clearing members to hold a minimum amount of 
capital. In addition, it is our view that the way to provide open 
access to new clearing members while promoting the safety and soundness 
of clearinghouses would be to provide clearing members with the ability 
to clear house and client risk in proportion to the amount of capital 
available to them as well as to funded margin and guarantee fund 
contributions. We do not support any exclusionary practices.

Interaction of Corporate Governance and Risk Management
    We support regulations requiring the creation of a risk committee 
at all clearinghouses. In addition, we believe it would be appropriate 
to provide for the separation of the corporate governance function 
(Board of Directors) from the risk management function (Risk Committee) 
within a clearinghouse.

Risk Committee
    We believe that the Risk Committee should be comprised of a 
majority of clearing member representatives, with the remainder open to 
clearinghouse and client participation. We support a requirement for at 
least 10 percent of the Risk Committee to be composed of client 
representatives with relevant expertise, and the balance to be open to 
participation by independent representatives. We believe that the main 
focus of the Risk Committee should be the preservation of the guarantee 
fund that is utilized to safeguard the clearinghouse and its members 
against defaults, taking into account prudent risk management 
standards, including mitigation of systemic risk. The main focus of the 
Board would be to promote the commercial interests of the 
clearinghouse. We expect that in most cases the Risk Committee and the 
Board would be able to achieve a productive balance between those two 
interests. We support a requirement for the Board to consult with the 
appropriate regulator prior to rejecting a recommendation by the Risk 
Committee on matters of risk. In our view all matters relating to risk 
would fall within the purview of the Risk Committee. This would include 
all matters related to margin and the sizing of the guarantee fund, 
membership criteria and membership application, and the enumeration of 
products eligible for clearing. Regulators have identified sound risk 
management standards as well as open access as key factors that must be 
addressed in determining whether a particular type of swap is suitable 
for clearing.

Board of Directors
    With respect to the corporate governance function of SEFs, 
exchanges, and clearinghouses, we support encouraging a balance of 
views being represented on the Board of Directors. We think that a 35 
percent requirement for independent directors will be problematic to 
implement in practice because it will be difficult to identify a 
sufficient number of individuals who are not already involved in the 
industry and who have an appropriate level of practical market 
experience. In our view the desired balance between different interests 
can be achieved by identifying different classes of interested parties 
and encouraging a diverse representation of those interests in the 
Board of Directors. This would be done by requiring that no single 
class of interested parties achieves more than 65 percent of the seats 
on the Board. Each SEF, exchange and clearinghouse should be able to 
determine how to fill the remainder of the seats. Regulators would 
monitor compliance with the letter and the spirit of this provision. In 
our opinion, the different classes of interested parties vary depending 
on the type of entity: In the case of clearinghouses the classes would 
be: (a) clearing members whose capital is at risk if another clearing 
member or one of its clients fails; (b) end users, who have an interest 
in protecting their collateral and in keeping clearing costs low; and 
(c) other investors and infrastructure providers (e.g., technology 
providers, SEFs, exchanges, and clearinghouses), who have an interest 
in increasing profitability.
    In the case of SEFs, the classes would be: (a) liquidity providers; 
(b) liquidity takers; and (c) other investors and infrastructure 
providers (e.g., technology providers, exchanges, and clearinghouses), 
who have an interest in increasing profitability.
    In the case of exchanges, the classes would be: (a) liquidity 
providers; (b) liquidity takers; and (c) other investors and 
infrastructure providers (e.g., technology providers, SEFs, and 
clearinghouses), who have an interest in increasing profitability.
    These limitations would have the added benefit of promoting 
competition and discouraging vertical integration of exchanges, SEFs, 
and clearinghouses.

All those who bring risk into the clearinghouse or profit from the 
        operations of the clearinghouse should have ``skin in the 
        game''
    We think it is essential to the development of a sound clearing 
infrastructure that those whose capital is at risk can participate in 
the risk management of clearinghouses. Clearinghouses rely almost 
exclusively on the margin and guarantee fund contribution of clearing 
members to manage systemic risk and counterparty risk.
    In a vertically integrated model, shareholders in a holding company 
that owns clearinghouses and exchanges (and in the future may also own 
SEFs) are exposed to a fraction of the risk that clearing members are 
exposed to through loss mutualization. There is no current requirement 
for clearinghouses to provide a first loss piece to the financial 
waterfall package and in most structures the clearinghouse ``skin in 
the game'' contribution is minimal compared with the overall size of 
the guarantee fund. For this reason the large majority of the capital 
at risk of a clearinghouse is composed of the margin and guarantee fund 
contributed by clearing members.
    In addition to the financial resources required to satisfy the 
financial safeguards core principles set out in the Act we support 
introducing a requirement for clearinghouses to carry a first-loss risk 
component as well as a mezzanine risk component in the waterfall of 
financial safeguards. This would establish a direct link between the 
earnings that a clearinghouse derives from cleared activity and the 
contribution of that clearinghouse to its own financial safeguards 
package. We would support regulations that require a clearinghouse to 
retain in a segregated deposit account, on a rolling basis, 50 percent 
of the earnings from the previous four years. We observe that this 
amount would represent approximately 10 percent of the clearinghouse 
enterprise value, therefore achieving a reasonable balance between risk 
and reward for clearinghouse shareholders. In addition, it would be 
appropriate for at least 50 percent of the retained earnings to have a 
first loss position in the financial waterfall. This solution would 
accomplish the goal of greater systemic stability, and would scale over 
time the contribution by the clearinghouse to its own financial 
safeguards package without large decreases or increases at any one 
resizing date. We recommend that the clearinghouse contribution be 
subject to a minimum floor of $50 million, to provide adequate 
protection and provide increased confidence in the markets while market 
participants ramp up access to clearing services. In our view this 
would incentivize clearinghouses to manage risk in a prudent manner. We 
would also support limits on the ability of clearinghouses to upstream 
dividends resulting from clearing fees to their holding companies when 
a clearing member defaults. The introduction of a first loss position 
and the introduction on limits on the upstreaming of dividends for 
clearinghouses would result in significant benefits from a systemic 
stability point of view.

Limitations on Voting Rights
    The best way to promote a successful implementation of the clearing 
requirement of the Act is to ensure that clearinghouses are fully 
equipped to manage risk in a prudent manner, while providing open 
access to clients and clearing members. In order to achieve this 
purpose, clearinghouses should be able to attract financial and 
intellectual capital from those who have experience in the products 
that the clearinghouse intends to clear, as well as from new 
participants into the market.
    We note that the OTC derivatives market is sufficiently diversified 
at present. A market survey published by ISDA on October 25, 2010, 
shows that the five largest U.S.-based dealers hold 37 percent of the 
outstanding derivatives market (equity, rates, credit). In our view 
this data is more representative of the global nature of the OTC 
derivatives market than other data that has been quoted out of context 
in the debate regarding conflict of interest. That data was focused 
exclusively on a restricted number of U.S. institutions and was not 
intended to represent a survey of the OTC market, which is global. To 
assume that dealers would acquire shareholdings in a clearinghouse or 
otherwise gain influence over a clearinghouse with a view to impede or 
narrow the implementation of the clearing requirement would be 
inconsistent with the reality of today's markets. On the contrary some 
participants in the OTC markets have made significant investments into 
the capital of clearinghouses well in advance of a legal requirement to 
clear being introduced or proposed in the U.S. or in Europe.
    At this point in the development of market infrastructure, it is 
essential to promote competition between clearinghouses, exchanges, and 
SEFs. With respect to clearinghouses, we note that in today's markets 
there are a maximum of three clearinghouses per asset class that are 
able to clear OTC derivatives. In some asset classes there is no 
clearinghouse currently clearing. There is no specific reason to apply 
limits only to those who have the expertise and the funds to finance a 
clearinghouse and who are exposed to losses if the risk management of 
the clearinghouse fails. We believe that preventing those whose capital 
is at risk from acquiring the right to vote on the governance of the 
entities that perform a key role in the OTC markets is not necessary to 
achieve the policy objectives set out by Congress in the Act. For this 
reason we support a limit on voting rights that would apply to each 
class of market participants irrespective of whether they are clearing 
members, SEFs, exchanges, enumerated entities, or other types of 
entities or individuals. This would promote open access and greater 
competition among clearinghouses.
    Given that preference shares and other types of nonvoting shares 
are a way to provide liquidity into the clearinghouse and have no 
effect on corporate governance, we believe that it would not be 
appropriate to apply limitations on the ownership of nonvoting shares.

No Free Riding--Clearing Member Resources
    We do not believe that there should be a two-tiered approach to 
membership, where some clearing members are subject to loss 
mutualization and others are not. A clearinghouse will rely on the 
financial resources waterfall set out in CFTC proposed 39.11. This 
includes funded guarantee fund contributions by a clearing member. CFTC 
proposed 39.11 also contemplates the ability of a clearing 
organization to assess a clearing member for additional default fund 
contributions. We believe that it is important to make sure that a 
clearing member will have sufficient liquid capital to fund additional 
guarantee fund assessments, in proportion to house and client business 
cleared by that clearing member.
    We believe it would be appropriate to require that clearing members 
have the ability to provide daily executable binding quotation for all 
points in the curve for all products cleared. Clearinghouses must be 
able to mark to market all positions at the end of each trading day. 
Clearing members must provide daily prices for all points of the 
maturity curve rather than relying on whether the cleared product 
trades on an exchange or a SEF on that day.
    In our view it is essential to require that clearing members have 
the operational ability to sustain the flow of client and house 
positions into the clearinghouse, including porting books of liquid and 
illiquid positions at times of market distress. In times of market 
stress or crisis, it is imperative that clearing members be able to act 
quickly in order to address the risk management aspects of defaults. By 
way of example, if a clearing member fails, the clearinghouse will 
conduct an auction to absorb the losses caused by that clearing member 
failure. The provision of liquidity by surviving members during that 
auction is key to the survival of a clearinghouse that deals in OTC 
instruments.
    Default management is not a responsibility that can be outsourced 
without introducing new risks to the stability of the clearinghouse. We 
think third-party pricing and outsourced default management services 
can disappear quickly in a crisis, as the provider of the service may 
have to focus their resources on their own survival. For this reason we 
believe it is preferable that clearing members or their affiliates be 
able to participate in the default management process. In the 
alternative, we would support a structure that would allow a clearing 
member to outsource pricing and default management services to another 
provider so long as the third-party provider of pricing and default 
management services is not allowed to undertake the provision of those 
services to more than one clearing member (including for itself or an 
affiliate).
    To ensure the correct incentives are in place during an auction of 
a failed member's portfolio, we recommend that any loss incurred by the 
clearinghouse as a result of the auction be absorbed first by the 
guarantee fund contributions of those members that fail to submit a 
bid. Any remaining loss should be distributed among the bidding 
clearing members in reverse proportion to the strength and size of 
their bid. This mechanism will ensure that all members are treated 
equally going in to an auction, and that appropriate financial 
incentives exist to provide exit liquidity to the clearinghouse. In 
addition, we believe this mechanism creates a fair outcome for all 
members by subordinating the guarantee fund capital of any bidder that 
is subject to a failed outsourcing arrangement.

Guarantee fund assessments ensure members have appropriate liquidity to 
        meet potential capital calls in a crisis
    We support the CFTC proposal requiring clearinghouses to haircut 
the value of unfunded assessment and to cap the percentage of the 
financial resources package that can be met by the value of 
assessments.
    We note that CFTC proposed 39.11 also refers to the own capital 
contribution of a clearinghouse as a component of the financial 
resources package. We believe that it would be appropriate for the 
Commission's regulations to provide greater granularity and require 
that if a clearinghouse enumerates its own capital as part of the 
waterfall, that clearinghouse must provide sufficient assurances that 
its capital will be available to meet those obligations and will not be 
reallocated to serve other purposes at the discretion of that 
clearinghouse.
    It should be noted that a clearing member may have committed to 
additional assessments at more than one clearinghouse. We believe it 
would be appropriate for regulators to adopt a risk-based analysis to 
determine the likelihood that a clearing member will be able to meet 
its assessment obligations across all clearinghouses.

Systemically Important Clearing Houses
    We believe that in the new market structure landscape, that no 
entity should be too big to fail. In our view, this principle applies 
equally to clearing members, clearinghouses, and clients. Given the 
loss mutualization feature of clearing, it is only by requiring each 
participant to have skin in the game that we can ensure all the parties 
involved in bringing risk into the system have an incentive to act in a 
manner that is prudent, safe, and sound. We believe it is appropriate 
for members, clients and clearinghouse shareholders to have skin in the 
game. This principle is of particular relevance for those entities that 
are deemed systemically important by the Financial Stability Oversight 
Council pursuant to Title VIII of the Act.

Regulatory Coordination
    In our view, coordination between regulators who have authority 
over clearinghouses will be a key component of systemic stability. One 
significant element will be the ability of regulators to look across 
clients, clearing members, exchanges, SEFs, and clearinghouses for any 
factors that could increase systemic risks. We think it is appropriate 
to monitor the activity of clients, clearing members exchanges, SEFs, 
and clearinghouses for undue concentration with a view to identify 
those that pose a systemic risk and take action to mitigate problematic 
situations before they exert a significant impact on the financial 
systems.

Conclusion
    We believe that no institution, including clearing members and 
clearinghouses, should be too big to fail. The policy objectives of the 
Act would be well served by promoting systemic stability and ensuring 
safety and soundness of exchanges, SEFs, and clearinghouses, and by 
requiring that these institutions have adequate capital to absorb 
losses and sufficient liquidity to safeguard the system. JPMC is 
committed to working with Congress, regulators, and industry 
participants to ensure that Title VII is implemented appropriately and 
effectively. I appreciate the opportunity to testify before this 
Committee and look forward to answering any questions you may have.
                                 ______
                                 
                   PREPARED STATEMENT OF JAMES CAWLEY
          Cofounder, Swaps and Derivatives Market Association
                              May 25, 2011

    Chairman Reed, Ranking Member Crapo, and Members of the 
Subcommittee, my name is James Cawley. I am CEO of Javelin Capital 
Markets, an electronic execution venue of OTC derivatives that expects 
to register as a SEF (or ``Swaps Execution Facility'') under the Dodd 
Frank Act.
    I am also here to represent the interests of the Swaps & 
Derivatives Market Association or ``SDMA,'' which is comprised of 
multiple independent derivatives dealers and clearing brokers, some of 
whom are the largest in the world.
    Thank you for inviting me to testify today.
    To ensure that the U.S. taxpayer is never again required to bail 
out Wall Street, we must move away from ``too inter connected to fail'' 
where one bank pulls another three with it--in the event of its 
failure. Equally important, we must remove the systemic ``sting'' 
currently associated with each bilateral derivatives swap contract that 
connects financial firms to each other and thus compel these swaps 
contracts into clearinghouses as mandated under the Dodd-Frank Act.
    In order to have safe and successful central clearing of OTC 
derivatives, certain remaining impediments must be removed such that 
clearinghouses ensure that they have truly representative governance 
structures, offer objective and proportionate risk models, provide open 
access to properly qualified and noncorrelated clearing members and 
accept trades on a ``real time'' and ``execution blind'' basis such 
that systemic risk is mitigated while transparency and market liquidity 
are increased.

Clearinghouse Governance and Membership
    With regard to clearinghouse governance, we support CFTC Core 
Principles O, P, and Q, that require that governance arrangements be 
transparent, fair and representative of the marketplace. Such 
governance bodies should represent the interests of the market as a 
whole and not just the interests of the few.
    Importantly, clearinghouse membership requirements should be 
objective, publicly disclosed and permit fair and open access; as Dodd-
Frank requires.
    This is important because clearing members act as the 
``gatekeepers'' to clearing. Without open access to clearing, you will 
not have universal clearing adoption, increased transparency, and 
lessened systemic risk.
    Clearinghouses should seek to be inclusive, not exclusive in their 
membership criteria.
    We should dispense with the myth that swaps are somehow different 
from other cleared markets and thus the vast experience from those 
markets should be ignored.
    Instead, clearinghouses should learn from their own experience in 
the listed derivatives space--of futures and options.
    In those markets, central clearing has operated successfully since 
the days of post Civil War Reconstruction nearly 150 years ago; long 
before spreadsheets and risk models. In those markets, counterparty 
risk is spread over a hundred disparate and noncorrelated clearing 
firms. It works well. No customer has ever lost money due to a clearing 
member failure.
    To complement broad participation, clearinghouses should not have 
unreasonable capital requirements. Capital should be a function of the 
risk a member contributes to the system; simply put, the more you or 
customers trade, the more capital you contribute.
    The SDMA supports the CFTC's call for clearing broker capital 
requirements to be proportionate and scale relative to the risk 
introduced to the system. We support the CFTC's call that a clearing 
firm's minimum capital be closer to $50 million, rather than closer to 
the $5 billion or $1 billion threshold as certain clearinghouses have 
originally suggested.
    Certain clearinghouse operational requirements for membership that 
have no bearing on capital or capability should be seen for what they 
are--transparent attempts to limit competition.
    Specifically, clearing members should not be required to operate 
swap dealer desks just so they can meet their obligation in the default 
management process. These requirements can easily be met contractually 
through agreements with third party firms or dealers.
    With regard to conflicts of interest within a clearing member, 
Dodd-Frank is clear; dealer desks should not be allowed to influence 
their clearing member colleagues and strict Chinese walls should exist.

Derivatives Trade Integrity
    With regard to trade acceptance, clearinghouses and their 
constituent clearing member firms should accept trades on an 
``execution blind'' basis. Clearing firms should be prevented from 
discriminating against certain customer trades, simply because they 
dislike the manner in which they have been executed or the fact that 
they may be anonymous.
    Certain trade counterparties should be precluded from exploiting 
current market position to impose documentary barriers to entry that 
restrict customer choice of execution venue, execution method, or 
dealer choice. Regulators should remain vigilant to ensure that such 
restrictions on trade do not manifest themselves in a post Dodd-Frank 
world.
    With regard to trade integrity, execution venues, clearing members 
and clearinghouses should, as the regulators require, work together to 
ensure that executed trades settle or are accepted into clearing as 
quickly as possible.
    The SDMA, joins with the MFA, and supports the CFTC requirement 
that trades be accepted into clearing immediately upon execution or 
trade submission. Regulators should be mindful not to allow 
clearinghouse workflows that seek to increase and not decrease trade 
latency. Such workflows should be seen for what they are--clear 
attempts to stifle successful OTC derivative clearing.

Conclusion
    In conclusion, the CFTC and the SEC should be commended for their 
excellent work. Both agencies have been transparent and accessible 
throughout the entire process. They have adapted to industry suggestion 
when appropriate.
    We must move away from ``too interconnected to fail.'' As an 
industry, we must work together to ensure that OTC derivatives clearing 
is a success such that Wall Street never again has to come to Main 
street for another bail out.
    Thank you.

        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                    FROM CHRISTOPHER EDMONDS

Q.1. Does your swaps clearinghouse have minimum capital 
requirements as part of your ownership and governance 
standards?

A.1. Yes.

Q.2. If so, what are they?

A.2. ICE Clear Credit's Rule 201(b)(ii), in relevant part, 
currently provides that `` . . . no applicant shall be admitted 
or permitted to remain, as applicable, as a Participant unless, 
in ICE Clear Credit's sole determination:

        (1) if it is an FCM or a Broker-Dealer, (A) it has a 
        minimum of $100 million of Adjusted Net Capital and (B) 
        it has Excess Net Capital that is greater than 5 
        percent of the Participant's Required Segregated 
        Customer Funds; or (2) if it is not an FCM or a Broker 
        Dealer, it has a minimum of $5 billion in Tangible Net 
        Equity (provided that in the case of (1) or (2), this 
        requirement may, at the discretion of ICE Clear Credit, 
        be met by a Parent if such Parent provides a guarantee 
        pursuant to Rule 205);

        For purposes of this clause (ii):

        ``Adjusted Net Capital'' for a Participant that is an 
        FCM, shall be as defined in CFTC Rule 1.17 and as 
        reported on its Form 1-FR-FCM or FOCUS Report or as 
        otherwise reported to the CFTC under CFTC Rule 1.12, 
        and for a Participant that is not an FCM but is a 
        Broker-Dealer, shall be its ``net capital'' as defined 
        in SEC Rule 15c3-1 and as reported on its FOCUS Report;

        ``Excess Net Capital'' for a Participant that is an FCM 
        or a Broker-Dealer shall equal its ``excess net 
        capital'' as reported on its Form 1-FR-FCM or FOCUS 
        Report or as otherwise reported to the CFTC under CFTC 
        Rule 1.12;

        ``Participant's Required Segregated Customer Funds'' 
        shall equal (i) the total amount required to be 
        maintained by such Participant on deposit in segregated 
        accounts for the benefit of customers pursuant to 
        Sections 4d(a) and 4d(f) of the CEA and the regulations 
        thereunder and (without duplication) pursuant to the 
        rules of relevant clearing organizations for positions 
        carried on behalf of customers in the cleared OTC 
        derivative account class plus (ii) the total amount 
        required to be set aside for customers trading on non-
        United States markets pursuant to CFTC Rule 30.7.

        ``Tangible Net Equity'' shall be computed in accordance 
        with the Federal Reserve Board's definition of ``Tier 1 
        capital'' as contained in Federal Reserve Regulation Y 
        Part 225 Appendix A (or any successor regulation 
        thereto), in the case of a bank or other Participant 
        subject to such regulation, or otherwise shall be the 
        Participant's equity less goodwill and other intangible 
        assets, as computed under generally accepted accounting 
        principles.

Q.3. What role do these capital requirements play in managing 
clearinghouse and counterparty risk?

A.3. The role of capital is secondary to the initial margin and 
guaranty fund collateral that a clearinghouse collects from its 
clearing participants, nevertheless, capital requirements are a 
fundamental and important component of a clearinghouse risk 
management regime. Capital requirements are a measurement of a 
clearing participant's ability to meet its financial 
obligations to the clearinghouse.
    Section 725(c) of Dodd-Frank entitled Core Principles for 
Derivatives Clearing Organizations provides in relevant part 
that each derivatives clearing organization shall establish 
appropriate admission and continuing eligibility standards 
including sufficient financial resources to meet obligations 
arising from participation in the derivatives clearing 
organization.
    The Bank for International Settlements in its 
Recommendations for Central Counterparties (CCP) 
(Recommendation 2: Participant requirements 4.2.2) states in 
relevant part ``to reduce the likelihood of a participant's 
default and to ensure timely performance by the participant, a 
CCP should establish rigorous financial requirements for 
participation. Participants are typically required to meet 
minimum capital standards. Some CCPs impose more stringent 
capital requirements if exposures of or carried by a 
participant are large or if the participant is a clearing 
participant. Capital requirements for participation may also 
take account of the types of products cleared by a CCP . . . 
.''

Q.4. How would reducing these capital requirements impact the 
risk profile of the clearinghouse, as well as the ability of 
new potential clearing members to join the clearinghouse?

A.4. As indicated above, the clearinghouse model relies, in 
part, on having adequately capitalized clearing participants in 
order to manage its counterparty risk. There is a direct 
correlation between the level of an entities regulatory capital 
and its ability to meet its counterparty obligations to a 
clearinghouse.

Q.5. How is your clearinghouse risk committee constituted? How 
many members are there?

A.5. Pursuant to ICE Clear Credit rule 503(a), the composition 
of the Risk Committee shall be as follows:

        (i) The Risk Committee shall consist of twelve members.

        (ii) Each member of the Risk Committee shall have risk 
        management experience and expertise and shall be 
        subject to the approval of the Board, such approval not 
        to be unreasonably withheld, conditioned or delayed.

        (iii) Three of the members of the Risk Committee shall 
        be comprised of (A) a member of the Board who is 
        independent in accordance with the requirements of each 
        of the New York Stock Exchange listing standards, the 
        U.S. Securities Exchange Act of 1934, as amended, and 
        IntercontinentalExchange, Inc.'s Board of Director 
        Governance Principles (such requirements, the 
        ``Independence Requirements'' and such member, the 
        ``Independent ICE Manager'') and (B) two officers of 
        ICE Clear Credit from among the Chief Executive 
        Officer, President, Chief Financial Officer and Chief 
        Risk Officer, each appointed by ICE US Holding Company 
        L.P. (including any successor, the ``ICE Parent''), a 
        Cayman Islands exempted limited partnership, by written 
        notice to the Board;

        (iv) The other nine members of the Risk Committee will 
        be appointed as specified below (the ``Participant 
        Appointees'');

        (v) The nine Participant Appointees will include one 
        member appointed by each Participant Group that 
        includes or is Affiliated with one of the following: 
        Bank of America, N.A.; Barclays Bank PLC; Citibank, 
        N.A.; Credit Suisse Securities (USA) LLC; Deutsche Bank 
        AG; Goldman Sachs International; JPMorgan Chase Bank, 
        N.A.; Morgan Stanley Capital Services, Inc.; and UBS 
        AG. ``Participant Group'' means a Participant and its 
        Affiliates, if any, such that, if two or more 
        Participants are Affiliates, collectively they shall 
        constitute a Participant Group.

        (vi) The composition of the Participant Appointees 
        shall be reconstituted on March 14, 2012, and each one 
        year anniversary thereafter (or if any such day is not 
        an ICE Business Day, the next ICE Business Day) as 
        follows (each such anniversary, a ``Risk Committee 
        Reconstitution Date,'' and the twelve full consecutive 
        calendar months (including March through February) 
        ending at the calendar month-end prior to a Risk 
        Committee Reconstitution Date, an ``Eligibility 
        Determination Period'') (subject to paragraph (ii) 
        above):

        (A) among those Participant Groups that have an 
        incumbent member on the Risk Committee, those 
        Participant Groups that have the six highest 
        Participant Activities for the immediately preceding 
        Eligibility Determination Period (each, a ``Top Six 
        Incumbent Participant Group'') shall have the right to 
        retain such member on the Risk Committee until the next 
        Risk Committee Reconstitution Date;

        (B) among the Participant Groups that are not Top Six 
        Incumbent Participant Groups, the Participant Groups 
        that have the three highest Participant Activities for 
        the immediately preceding Eligibility Determination 
        Period (each, an ``Eligible Participant Group'') shall 
        have the right to appoint or retain, as applicable, a 
        member on the Risk Committee until the next Risk 
        Committee Reconstitution Date;

        (C) each Participant Group that has an incumbent member 
        on the Risk Committee but is not entitled to retain 
        such member as provided above shall cause its Risk 
        Committee member to resign or otherwise remove such 
        member from the Risk Committee effective as of the 
        applicable Risk Committee Reconstitution Date; and

        (D) each Participant Group that has the right to 
        appoint a member to the Risk Committee as provided 
        above and that does not have an incumbent member on the 
        Risk Committee shall notify the Board in writing on or 
        prior to the applicable Risk Committee Reconstitution 
        Date of the individual appointed by such Participant 
        Group to the Risk Committee; provided, however, that 
        the failure to provide such notice shall not result in 
        the loss of the right of such Participant Group to 
        appoint a member to the Risk Committee.

        (E) ``Participant Activity'' means, for a specified 
        Eligibility Determination Period and with respect to a 
        particular Participant Group, the aggregate volume of 
        Trades during such time submitted to, and accepted for 
        clearing by, ICE Clear Credit by members of such 
        Participant Group, which such volume shall be measured 
        in terms of aggregate notional amount of Trades so 
        submitted and accepted. In the event that a Combination 
        of Participants occurs prior to the applicable Risk 
        Committee Reconstitution Date, all Participant Activity 
        of such Participants (and their Affiliates) shall be 
        aggregated together for purposes of determining the 
        Participant Activity of the resulting Participant Group 
        for the corresponding Eligibility Determination Period.

        (F) ``Combination'' means any event in which a 
        Participant (or its Affiliate) obtains Control of 
        another Participant that was previously not an 
        Affiliate of such Participant (or any Person that 
        Controls such other Participant) or a Participant (or 
        any Person that Controls such Participant) is merged 
        with another Participant that was previously not an 
        Affiliate of such Participant (or any Person that 
        Controls such other Participant).

        (vii) Intentionally omitted in Rules for formatting.

        (viii) Notwithstanding anything to the contrary herein, 
        if at any time on or after the DCO/SCA Conversion Date 
        but prior to the first Risk Committee Reconstitution 
        Date, there is a Combination involving Participants 
        where more than one of the relevant Participant Groups 
        had the right to appoint a member of the Risk 
        Committee, then, as of the date of consummation of such 
        Combination, (A) such Participant Groups shall, 
        collectively, have the right to appoint only one member 
        of the Risk Committee and the Participant Group 
        resulting from such Combination shall take all actions 
        necessary to remove all but one of their previously 
        appointed members effective as of the date of 
        consummation of the Combination and (B) the vacanc(ies) 
        of the Risk Committee will be filled by the Participant 
        Group(s) that had the highest Participant Activit(ies) 
        (over the 12-month period from and including March 2010 
        to and including February 2011) among those 
        Participants that, as of the date of consummation of 
        such Combination, did not have the right to appoint a 
        member to the Risk Committee (in order of the level of 
        such Participant Activity, from highest to lowest) 
        effective as of the date of consummation of such 
        Combination.

        (ix) Notwithstanding anything to the contrary herein, 
        if at any time on or after the first Risk Committee 
        Reconstitution Date, there is a Combination involving 
        Participants where more than one of the relevant 
        Participant Groups had the right to appoint a member of 
        the Risk Committee, then, as of the date of 
        consummation of such Combination, (A) such Participant 
        Groups shall, collectively, have the right to appoint 
        only one member of the Risk Committee and the 
        Participant Group resulting from such Combination shall 
        take all actions necessary to remove all but one of 
        their previously appointed members effective as of the 
        date of consummation of the Combination and (B) the 
        vacanc(ies) of the Risk Committee will be filled by 
        Participant Group(s) that had the highest Participant 
        Activit(ies) (over the immediately preceding 
        Eligibility Determination Period) among those 
        Participants that, as of the date of consummation of 
        such Combination, did not have the right to appoint a 
        member to the Risk Committee (in order of the level of 
        such Participant Activity, from highest to lowest) 
        effective as of the date of consummation of such 
        Combination.

        (x) Notwithstanding anything to the contrary herein, if 
        at any time all Participants in a Participant Group 
        with the right to appoint a member of the Risk 
        Committee are in Default or have had their status as 
        Participant terminated as a result of being a Retiring 
        Participant, (A) such Participant Group shall 
        immediately lose the right to appoint a member to the 
        Risk Committee and (B) at the date of such Default or 
        termination, the Participant Group that had the highest 
        Participant Activity (over the period from and 
        including March 2010 to and including February 2011 or, 
        if on or after the first Risk Committee Reconstitution 
        Date, over the immediately preceding Eligibility 
        Determination Period) among those Participants that, as 
        of the date of such Default or termination, did not 
        have the right to appoint a member to the Risk 
        Committee, shall have the right to appoint a member to 
        the Risk Committee effective as of the date of such 
        Default or termination.

        (xi) A Participant Group may appoint an individual to 
        be a member of the Risk Committee only if such 
        individual is an employee of one of the Participants in 
        such Participant Group or an Affiliate thereof. Any 
        member of the Risk Committee may be removed at any 
        time, with or without cause, by the Participant Group 
        that appointed such member pursuant to this Rule 503. 
        In the event a vacancy occurs on the Risk Committee as 
        a result of the retirement, removal, resignation, or 
        death of a member thereof, such vacancy shall be filled 
        by an individual designated by the relevant Participant 
        Group.

        (xii) Within five ICE Business Days of the end of each 
        Eligibility Determination Period, ICE Clear Credit 
        shall, based on its books and records, deliver to each 
        Participant Group a good faith determination of the 
        identity of (A) the Top Six Incumbent Participant 
        Groups and (B) the Eligible Participant Groups, and 
        shall inform each of the Top Six Incumbent Participant 
        Groups and the Eligible Participant Groups of its right 
        to appoint a member to the Risk Committee as of the 
        next Risk Committee Reconstitution Date pursuant to 
        this Rule; provided, however, that ICE Clear Credit and 
        its Affiliates, Board and officers shall have no 
        liability with respect to the delivery of such good 
        faith determination. For the sake of clarity, such good 
        faith determination shall identify only the Participant 
        Groups mentioned above, and shall not set forth the 
        Participant Activity levels of such Participant Groups. 
        In the event any Participant Group disputes in good 
        faith ICE Clear Credit's good faith determination of 
        the Top Six Incumbent Participant Groups or the 
        Eligible Participant Groups, the disputing Participant 
        Group and the Risk Committee shall submit such dispute 
        for resolution to PricewaterhouseCoopers LLP (or, if 
        such firm shall decline or is unable to act or is not, 
        at the time of such submission, independent of ICE 
        Clear Credit, the disputing Participant Group or any 
        member of the Risk Committee, to another independent 
        accounting firm of international reputation mutually 
        acceptable to the disputing Participant Group and the 
        Risk Committee) (such firm, the ``Independent 
        Accounting Firm''), which shall, within 30 ICE Business 
        Days after such submission, determine and report to ICE 
        Clear Credit, the disputing Participant Group and the 
        Risk Committee, and such report shall be final, 
        conclusive and binding on the disputing Participant 
        Group, the Risk Committee and ICE Clear Credit. The 
        disputing Participant Group shall be solely responsible 
        for the fees and disbursements of the Independent 
        Accounting Firm. ICE Clear Credit and its Affiliates, 
        Board and officers shall have no liability in 
        connection with the determination of the Independent 
        Accounting Firm.

        (xiii) If, by written agreement of the Risk Committee 
        and the Board, ICE Clear Credit is determined to have 
        established multiple risk pools (each, a ``Risk 
        Pool''), ICE Clear Credit will create a new and 
        separate risk committee for each such Risk Pool. In 
        such event, (A) each such new risk committee will have, 
        with respect to its Risk Pool, the same rights, 
        responsibilities and operational procedures as the Risk 
        Committee has under this Chapter, and (B) to the extent 
        practicable, the composition of such other risk 
        committee will be determined on the same basis as the 
        Risk Committee is determined hereunder (taking into 
        account, instead, the applicable volume or usage metric 
        with respect to such Risk Pool as determined by the 
        Risk Committee), with the rules for such composition 
        being determined by the Board, in consultation with the 
        Risk Committee

Q.6. What role do they have in controlling access to the 
clearinghouse?

A.6. Both the Risk Management Committee and the newly 
established Risk Management Subcommittee, described below, are 
consultative committees and have no authority to accept or deny 
clearing participants.
    Importantly, the authority to accept or deny clearing 
participants vests solely with the ICE Clear Credit Board of 
Managers.
    Nevertheless, in anticipation of proposed CFTC regulations 
relating to the mitigation of conflicts of interest being 
promulgated, ICE Clear Credit recently adopted the following 
Rules 510 and 511 to establish a Risk Management Subcommittee 
that will be consulted prior to determining the standards and 
requirements for initial and continuing clearing participant 
eligibility and prior to approving or denying clearing 
participant applications.

        510. Subcommittee Specified Actions.

        ICE Clear Credit shall not take nor permit to be taken 
        any of the following actions without prior consultation 
        with the Risk Management Subcommittee (``Subcommittee 
        Specified Actions''):

        (a) Determine products eligible for clearing;

        (b) Determine the standards and requirements for 
        initial and continuing Participant eligibility;

        (c) Approve or deny (or review approvals or denials of) 
        Participant applications described in Rule 202 (or any 
        successor Rule thereto) or the other ICE Provisions;

        (d) Modify this Chapter of the Rules or Modify any of 
        the responsibilities, rights or operations of the Risk 
        Management Subcommittee or the manner in which the Risk 
        Management Subcommittee is constituted as set forth in 
        the Rules.

        511. Composition of the Risk Management Subcommittee; 
        Confidentiality.

        (a) The composition of the Risk Management Subcommittee 
        shall be as follows:

        (i) The Risk Management Subcommittee shall consist of 
        five members.

        (ii) Each member of the Risk Management Subcommittee 
        shall have risk management experience and expertise and 
        shall be subject to the approval of the Board, such 
        approval not to be unreasonably withheld, conditioned 
        or delayed.

        (iii) Two of the members of the Risk Management 
        Subcommittee shall be public directors as defined in 
        CFTC Rule 1.3(ccc) (``Independent Public Directors'') 
        appointed by ICE Clear Credit. The Board must make such 
        finding upon the appointment of the member and as often 
        as necessary in light of all circumstances relevant to 
        such member, but in no case less than annually.

        (iv) One member of the Risk Management Subcommittee 
        shall be a Non-Participant Party. Such member will be 
        nominated by the buy-side Advisory Committee of ICE 
        Clear Credit.

        (v) Two of the members of the Risk Management 
        Subcommittee shall be composed of representatives of 
        Participants who are members of the Risk Committee. 
        Such members shall be nominated by the Risk Committee.

        (vi) No member of the Risk Management Subcommittee may 
        be subject to statutory disqualification under CEA 
        Section 8a(2) or Section 3(a)(39) of the Securities 
        Exchange Act, or other applicable CFTC or SEC 
        regulations.

Q.7. How is ICE Clear Credit planning to satisfy the open 
access provisions in the Dodd-Frank Act?

A.7. Since its inception, ICE Trust, now known as ICE Clear 
Credit, has supported open access and will continue to do so 
pursuant to Dodd-Frank. (It should be noted that from a 
business model perspective, it is generally in ICE Clear 
Credit's interest to receive more transactions to clear.)
    Specifically, ICE Trust Rule 314 (Open Access for Execution 
Venues and Trade Process Platforms) previously provided:

        ICE Trust shall ensure that there shall be open access 
        to the clearing system operated by ICE Trust pursuant 
        to these Rules for all execution venues (including, 
        without limitation, designated contract markets, 
        national securities exchanges, swap execution 
        facilities and security-based swap execution 
        facilities) and trade processing platforms. ICE Trust 
        may impose (a) reasonable criteria to determine whether 
        an execution venue has the capability to deliver the 
        necessary quality of service to be granted access to 
        ICE Trust, (b) reasonable criteria to determine whether 
        a trade processing platform has the capability to 
        deliver the necessary quality of service to be granted 
        access to ICE Trust and connected through the ICE Trust 
        application programming interface, (c) reasonable 
        requirements as to risk filters and other credit risk 
        management standards with respect to transactions to be 
        submitted to ICE Trust for clearing, and (d) reasonable 
        costs on such execution venues and trade processing 
        platforms and Participants that use such venues and 
        platforms; provided that in each case such criteria or 
        costs shall not unreasonably inhibit such open access 
        and shall comply with applicable law.

    ICE Clear Credit Rule 314 was recently amended slightly to 
read as follows:

        ICE Clear Credit shall ensure that, consistent with the 
        requirements of CEA Section 2(h)(1)(B) and Securities 
        Exchange Act Section 3C(a)(2), there shall be open 
        access to the clearing system operated by ICE Clear 
        Credit pursuant to these Rules for all execution venues 
        (including, without limitation, designated contract 
        markets, national securities exchanges, swap execution 
        facilities and security-based swap execution 
        facilities) and trade processing platforms. ICE Clear 
        Credit may impose (a) reasonable criteria to determine 
        whether an execution venue has the capability to 
        deliver the necessary quality of service to be granted 
        access to ICE Clear Credit, (b) reasonable criteria to 
        determine whether a trade processing platform has the 
        capability to deliver the necessary quality of service 
        to be granted access to ICE Clear Credit and connected 
        through the ICE Clear Credit application programming 
        interface, (c) reasonable requirements as to risk 
        filters and other credit risk management standards with 
        respect to transactions to be submitted to ICE Clear 
        Credit for clearing, and (d) reasonable costs on such 
        execution venues and trade processing platforms and 
        Participants that use such venues and platforms; 
        provided that in each case such criteria or costs shall 
        not unreasonably inhibit such open access and shall 
        comply with applicable law.

Q.8. How would you expect the open access provisions to impact 
your business model, as well as the overall role of 
clearinghouses in the swaps market worldwide?

A.8. As indicated above, ICE Trust, now known as ICE Clear 
Credit, has always supported open access. ICE Clear Credit is 
agnostic with respect to the execution venue provided that the 
execution venue meets ICE Clear Credit's reasonable eligibility 
standards and submits transactions to ICE Clear Credit on 
behalf of ICE Clear Credit's authorized clearing participants.

Q.9. Given the policy objective of Title VII to increase the 
clearing of swaps, how would you structure the implementation 
of the new Dodd-Frank clearing requirements to provide the 
greatest incentives for market participants to clear their 
trades?

A.9. Specifically, clearing participants will be incented to 
clear if the Dodd-Frank provisions calling for the CFTC and SEC 
to approve portfolio margining between correlated commodity-
based swaps and security-based swaps are implemented. ICE Clear 
Credit has submitted to the CFTC and SEC its draft request for 
portfolio margin treatment with respect to the commodity-based 
swaps (CDS indices) and security-based swaps (single name CDS) 
that ICE Clear Credit clears.
    More generally, centralized clearing fundamentally reduces 
counterparty risk and provides financial stability as a result 
of sound and transparent risk management practices. All 
clearing participants are required to post collateral in the 
form of initial margin and all clearing participants' cleared 
positions are marketed-to-market on a daily basis. In addition, 
clearing participants are required to contribute to the 
clearinghouse's guaranty fund which serves as a mutualized 
financial backstop in the event that a clearing participant 
should default on its obligations. The implementation of new 
Dodd-Frank requirements should be structured in a manner that 
promotes the fundamental safety and soundness principles of 
centralized clearing.

Q.10. Are there certain entities or asset classes that should 
be cleared before others?

A.10. Generally, the more standardized and liquid swaps are 
more appropriately cleared.

Q.11. Could you describe the current policies and procedures 
used by your clearinghouse to prevent conflicts of interest in 
decision making about clearing swap trades?

A.11. See responses to Question 2 above.

Q.12. How do you expect the provisions of the Dodd-Frank Act 
that seek to minimize conflicts of interest to impact the 
governance and voting composition of your Boards of Directors?

A.12. The provisions of Dodd-Frank relating to conflicts are 
unlikely to impact ICE Clear Credit given its corporate 
governance structure. The majority of ICE Clear Credit's Board 
of Managers are independent (6/11). Three of the remaining 
Board members are representatives of ICE management. The 
remaining two Board members are representatives of the clearing 
participants.

Q.13. How do you ensure that neither a single shareholder nor a 
small group of shareholders can dominate the clearinghouse and 
determine its policies?

A.13. Technically, ICE Clear Credit has a single shareholder--
ICE Inc. ICE U.S. Holding Company L.P. is the sole member of 
ICE Clear Credit. ICE Inc. (a public company) wholly owns the 
company that serves as the General Partner (GP) of ICE U.S. 
Holding Company L.P. None of the Limited Partners have the 
right to elect the Board of Managers of ICE Clear Credit. The 
GP of ICE U.S. Holding Company L.P. elects the Board of 
Managers of ICE Clear Credit. The Limited Partners of ICE U.S. 
Holding (that include the former owners of The Clearing 
Corporation) merely maintain a limited economic interest in the 
profits of ICE Clear Credit.

Q.14. One concern is that members could restrict access either 
directly or indirectly by controlling the ability to enter into 
correspondent clearing arrangements. What are the best 
approaches to ensuring fair and open access?

A.14. As noted above, the ICE Clear Credit clearing 
participants do not govern ICE Clear Credit. Instead, the ICE 
Clear Credit Board of Managers, a majority of whom are 
independent, govern ICE Clear Credit. Moreover, as noted above, 
ICE Clear Credit has an open access policy as codified in its 
Rules.

Q.15. Some have argued that members could actually lower risk 
controls and be incentivized to take on greater risk positions 
in a clearinghouse environment. How does the clearinghouse 
management team evaluate the risk controls?

A.15. The clearing participants of a clearinghouse mutualize 
the risk of all of the clearing participants as a result of 
contributing to the clearinghouse's guaranty fund. Since each 
clearing participant's capital is exposed to the risk of other 
clearing participants, the clearing participants are 
financially incented to ensure that risk controls are 
appropriate and are not lowered. In addition, as noted above, 
the ICE Clear Credit Board of Mangers is vested with the sole 
authority to determine the risk controls of ICE Clear Credit.

Q.16. What incentives exist to ensure risks are properly 
evaluated and not exposed to influence from members?

A.16. See above response. It is in the economic interest of 
clearing members who serve on the Risk Committee to ensure that 
risks are properly evaluated. Nevertheless, at ICE Clear 
Credit, the Risk Committee has no authority and is merely a 
consultative committee. As noted above, only the ICE Clear 
Credit Board of Managers has authority to make risk-related 
decisions.

Q.17. It was recently reported that ICE Clear Credit is 
reducing its minimum adjusted net capital for members from $1 
billion to $50 million (plus $20 million in one-time guarantee 
fund contributions and a variable rate on how much the member 
exposes the clearinghouse). How does this change balance access 
with safety and soundness?

A.17. See response to Question 1 above that references ICE 
Clear Credit's current minimum adjusted net capital 
requirements. The $50 million number comes from the CFTC's 
proposed minimum adjusted net capital requirement. ICE Clear 
Credit has not considered lowering its adjusted net capital 
requirement to $50 million.

Q.18. Both the U.S. Department of Justice and the European 
Commission have become concerned about the possibility of 
anticompetitive practices in credit derivatives clearing. In 
your opinion, what factors give rise to these concerns?

A.18. ICE Clear Credit does not know and will not speculate 
regarding any factors that might give rise to concerns of the 
U.S. Department of Justice. ICE Clear Credit respectfully 
refers the Committee to the European Commission's press release 
dated April 29, 2011.

Q.19. Do those same factors extend to the clearing of other 
products? And how should we address those factors?

A.19. Again, ICE Clear Credit does not know and will not 
speculate regarding any factors that might give rise to 
concerns of the U.S. Department of Justice.
                                ------                                


        RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN REED
                       FROM JAMES CAWLEY

Q.1. What are your perspectives on the current rules proposed 
by the CFTC and SEC on the ownership and governance of 
clearinghouses? How would reducing minimum capital requirements 
for clearinghouse membership impact the risk profiles of 
clearinghouses as well as the ability of new potential clearing 
members to join clearinghouses?

A.1. Please see the attached SDMA comment regarding 
Implementation of Conflicts of Interest Policies and 
Procedures, dated June 3, 2011 (hereafter ``Conflicts 
Letter'').

Q.2. How do you anticipate clearinghouses will coordinate with 
exchanges and swap execution facilities (SEF) on the clearing 
and trading of swaps? What would be the positive and negative 
impacts of a vertically integrated clearinghouse-SEF model when 
compared with more independent role for clearing and execution 
venues?

A.2. Please see the attached SDMA comment regarding OTC 
Derivative Market Integrity and Real-Time Trade Processing 
Requirements, dated June 3, 2011.

Q.3. Both the U.S. Department of Justice and the European 
Commission have become concerned about the possibility of 
anticompetitive practices in credit derivatives clearing. What 
factors give rise to these concerns? Do those same factors 
extend to the clearing of other products? And how should we 
address those factors?

A.3. There are two key factors that indicate anticompetitive 
practices. The first factor is that all or most of the sales 
for a particular product or service are provided by a small 
number of sellers. This high concentration of market share is 
known as ``market power.'' The second factor is high barriers 
to entry into the market. Barriers to entry are anything that 
prevents a potential competitor's ability to enter the market 
and include high capital costs, control of resources and 
intellectual property.
    All of these factors give rise to concerns in the clearing 
of credit derivatives and extend to the clearing of other 
products. The clearinghouses that clear credit derivatives have 
market power. It is well established that 80 percent of the 
market is controlled by 10 dealers. These dealers and the 
clearinghouse they control are an oligopoly (i.e., a small 
group of firms that exert monopoly like control over the 
market). They have sought to maintain their market power 
through restrictive clearinghouse participant eligibility 
standards.
    For further detail on these restrictive standards, and our 
thoughts on how to address these issues, please see the 
Conflicts Letter.

Q.4. Should there be restrictions on the ownership of 
clearinghouses by major swaps dealers? Why or why not?

A.4. Please see the attached SDMA comment regarding 
Implementation of Conflicts of Interest Policies and 
Procedures, dated June 3, 2011.

Q.5. Is the clearing function a natural monopoly? Why or why 
not?

A.5. The clearing function is not a natural monopoly. A natural 
monopoly exists in a market where barriers to entry are 
substantial costs or the use of infrastructure that cannot be 
reasonably duplicated by a competitor. Two examples of this 
type of infrastructure are electrical grids and railroad 
bridges.
    This is not the case in clearing function. Clearing does 
not rely upon infrastructure that cannot be reasonably 
duplicated. It relies upon capital. There is no limit in the 
amount of capital that can be used. Please see the Conflicts 
Letter for a discussion of how the use of capital should be 
applied to clearing risk.

Q.6. While the benefits of encouraging clearing are widely 
acknowledged, increased clearing brings some risks of its own. 
What steps would you recommend our regulators take to reduce 
and contain systemic risk at clearinghouses?

A.6. Since their inception clearinghouses have played a vital 
role in the market by managing the default risk of 
counterparties and spreading that risk over the members of the 
clearinghouse. This system is most effective when the group of 
clearing members is large and uncorrelated, and conversely, 
least effective when the group is small and correlated. 
Systemic risk is especially problematic in the current 
environment where clearinghouses are monopolies controlled by a 
handful of highly correlated firms. In the event of clearing 
member default where there are a small number of correlated 
clearing members there is a greater chance that other clearing 
members may also default.
    In order to reduce systemic risk the regulators must 
require that clearinghouses have a large, noncorrelated group 
of clearing members. This can only be accomplished through 
clearing membership standards that are based upon fair and open 
access. Please see the Conflicts Letter for a further 
discussion of this topic.

Q.7. How should regulators properly oversee the dynamic risk 
management process in a real-time manner?

A.7. To oversee the dynamic risk management process in real-
time the regulators must have adequate technology resources. 
Without adequate technology there can be no real-time 
monitoring of any function. Adequate technology has three 
components. The first component is technology infrastructure 
that meets current industry standards. Second, the regulators 
must have direct connectivity to the clearinghouses. Third, the 
regulators must have software that can perform real time 
monitoring of risk management functions. The software can 
either be provided by the clearinghouses to the regulators or a 
program developed by the regulators.

ADDENDUM 1





































ADDENDUM 2











































              Additional Material Supplied for the Record

LETTER SUBMITTED BY THOMAS C. DEAS, JR., VICE PRESIDENT AND TREASURER, 
                            FMC CORPORATION

    Dear Chairman Johnson and Ranking Member Shelby, I very much 
appreciate your having given me the opportunity to present the views of 
end users on the complex topic of derivatives reform at the Committee's 
hearing on April 12, 2011. I was speaking as the Vice President and 
Treasurer of FMC Corporation, as the President of the National 
Association of Corporate Treasurers, and on behalf of the Coalition for 
Derivatives End Users, on whose steering committee I serve. I also very 
much appreciate your efforts on behalf of end users as we join with you 
to bring about sensible reform of derivatives.
    I would like to respond for the record to comments made at a 
subsequent hearing of the Subcommittee on Securities, Insurance, and 
Investment on May 25, 2011. Dr. Benn Steil, Senior Fellow and Director 
of International Economics of the Council on Foreign Relations asserted 
that margining by end users would bring about increased transparency 
and that treasurers oppose margin requirements in order to conceal the 
inefficiency of their unmargined derivatives transactions.
    We believe that Dr. Steil's analysis reflects several flawed 
assumptions. For example, he assumes that corporate treasurers do not 
have access to market pricing information and also that policy makers 
intended margin as a mechanism to address transparency gaps in the 
over-the-counter (OTC) derivatives market. Both of these assumptions 
are flat wrong.
    End users generally value the ability to customize their 
derivatives transactions. Because customized derivatives have unique 
attributes that affect their price, some have suggested that end users 
are unable to discern the appropriate price of a derivative. In fact, 
corporate treasurers today have access to tools that allow them to 
price unique transaction structures. When corporate treasurers enter 
into hedging arrangements to mitigate risk, they utilize these tools to 
identify the appropriate price prior to transacting. Moreover, like any 
consumer, corporate treasurers comparison shop to ensure they get the 
best price. They often do this by conducting competitive auctions that 
ensure the best execution is achieved.
    Although end users generally execute at the best price available to 
them, there are situations in which treasurers may opt to execute 
transactions slightly above market levels. Contrary to Dr. Steil's 
assertion, such situations are not indicative of a treasurer's 
inability to achieve efficient pricing outcomes. For example, a 
treasurer generally attempts to mitigate counterparty credit risk by 
executing transactions with multiple counterparties. If a given 
counterparty is especially competitive in other credit products such as 
letters of credit to facilitate foreign trade payments or undrawn 
credit lines committed for future use, corporate treasurers may find 
that a disproportionate amount of credit risk consisting of future 
credit commitments together with derivatives may be with a single 
counterparty. An excess concentration of counterparty credit risk will 
generally be unacceptable for an end user. In order to spread its 
counterparty credit risk across multiple banks, treasurers will often 
choose to accept a price from a bank that may be slightly wide of the 
best price. Contrary to Dr. Steil's assertion, prudence dictates that 
companies weigh not only the price of a given transaction, but also 
factors such as counterparty credit risk and even legal risks.
    A report published November 1, 2010, by the International Swaps and 
Derivatives Association (ISDA) entitled, ``Interest Rate Swap Liquidity 
Test'', found that the difference in pricing between the best and worst 
quotes for any interest rate swap in their sample was just 1.3 basis 
points (a range of from 0.0000 percent to 0.0130 percent). The average 
difference between the best and worst quotes for each swap was just 
0.38 basis points (0.0038 percent). ISDA concluded that the narrow 
spreads between the best and worst quotes attest to an extremely 
competitive marketplace for uncleared and unmargined OTC derivatives 
and that the benefits to counterparties with collateralized swap 
documentation consistent with margining would be ``extremely modest.''
    Though end users already have access to pricing information that 
enables them to secure efficient market pricing, end users have long 
supported efforts to increase transparency in the OTC derivatives 
market by increasing access to such information and lowering the cost 
of obtaining it. The Dodd-Frank Act and its associated rules employ 
several mechanisms aimed at increasing transparency. For example, 
regulators have proposed requirements for banks to disclose midmarket 
swap prices to their customers. Additionally, Dodd-Frank includes a 
real-time reporting requirement and a trading requirement, each aimed 
at increasing pricing transparency for market participants.
    However, margin was not among the policy tools implemented to 
increase pricing transparency. Rather, margin was intended to reduce 
systemic risk by dictating that certain market participants back their 
trades with cash. It is the cash and committed credit that margin 
requirements would tie up, to the detriment of productive investment in 
their businesses that concerns corporate treasurers, not any 
incremental disclosure that such requirements might bring.
    Though we appreciate Dr. Steil's desire to increase transparency in 
a manner that benefits end users, we believe his analysis inaccurately 
characterizes the motivations of corporate treasurers. In particular, 
his analysis ignores the trade-offs inherent in the decisions 
treasurers make when managing their risks.
    Thank you for your consideration of these comments. Please let me 
know if you have any questions or if I can be of assistance in further 
elaborating these ideas.
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