[Congressional Record Volume 140, Number 92 (Friday, July 15, 1994)]
[Extensions of Remarks]
[Page E]
From the Congressional Record Online through the Government Printing Office [www.gpo.gov]


[Congressional Record: July 15, 1994]
From the Congressional Record Online via GPO Access [wais.access.gpo.gov]

 
            INTRODUCTION OF DERIVATIVES DEALERS ACT OF 1994

                                 ______


                               speech of

                         HON. EDWARD J. MARKEY

                            of massachusetts

                    in the house of representatives

                        Wednesday, July 13, 1994

  Mr. MARKEY. Mr. Speaker, today I am joining with the gentleman from 
Oklahoma [Mr. Synar] in introducing the Derivatives Dealers Act of 
1994. This legislation is aimed at providing a framework for improved 
supervision and regulation of previously unregulated derivatives 
dealers and assuring appropriate protections for their customers.
  Derivatives are financial products whose value is dependent on--or 
derived from--the value of some underlying financial asset such as a 
stock, bond, foreign currency, commodity, or an index representing the 
values of such assets. Some derivatives have been around for many 
years, such as the exchange-traded futures and options used by 
investors and dealers seeking to hedge positions taken in the stock and 
bond markets, or to speculate on future market movements.
  Within the last few years, however, such exchange-traded futures and 
options have been supplemented by a vast and dizzying array of over-
the-counter [OTC] derivatives. These include forwards, swaps, options, 
swaptions, caps, flowers, and collars that may be linked to the 
performance of the Japanese stock market, the dollar-deutsche mark 
exchange rate, the S&P 500, or virtually any other asset. Today, the 
total outstanding value of the principal underlying such over-the-
derivatives is estimated to be over $12 trillion.
  The dynamic growth of the OTC derivatives market is the direct result 
of developments in computer and telecommunications technology and 
breakthrough in modern portfolio management theory that have created a 
new world of cyber-finance that is reshaping U.S. and global financial 
markets. These new financial instruments are an important component of 
modern financial activity and provide useful risk management tools for 
corporations, financial institutions, and governments around the world 
seeking to respond to fluctuations in interest rates, foreign currency 
exchange rates, commodity prices, and movements in stock or other 
financial markets.
  While OTC derivatives are frequently used to hedge foreign currency 
or interest rate risks or to lower borrowing costs, there has been a 
proliferation of increasingly exotic, customized financial contracts or 
instruments that enable dealers and end-users to make speculative 
synthetic side bets on global financial markets. This development has 
raised concerns over the potential for OTC derivatives to increase, 
rather than reduce risk of financial loss or contribute to a future 
financial panic. In addition, the concentration of market-making 
functions in a small number of large banks and securities firms, the 
close financial inter-linkages OTC derivatives have created between 
each of these firms, and the sheer complexity of the products being 
traded raise serious concerns about the potential for derivatives to 
contribute to serious disruptions in the fabric of our financial 
system.
  I believe that the public interest demands that regulators have 
adequate tools on hand to minimize the potential for OTC derivatives to 
contribute to a major disruption in the financial markets, either 
through excessive speculation and overleveraging, or due to inadequate 
internal controls and risk management on the part of major derivatives 
dealers or end-users. I also believe that our financial regulatory 
structure must assure that there are appropriate customer protections 
in place in the form of full disclosure, accurate financial accounting, 
appropriate sales practices, and restrictions against fraudulent or 
manipulative activity.
  In light of the explosive growth of and the public policy issues 
raised by OTC financial derivatives, the Subcommittee on 
Telecommunications and Finance, which I chair, wrote to the General 
Accounting Office [GAO] in June 1992 to request a comprehensive study 
of the derivatives market. At that time, the subcommittee noted that 
the trading of new and complex derivative products by financial 
institutions and their customers had greatly increased in recent years, 
creating a corresponding need to assure that knowledge of how to manage 
and oversee the risks associated with these products was keeping pace. 
The subcommittee asked the GAO to examine the nature and extent of the 
use of derivative products and determine how well the dealers and end-
users of these products handled the related risks. In addition, the 
subcommittee asked the GAO to examine how well Federal regulators 
protect the Federal interest and to identify any regulatory 
inconsistencies or gaps in regulation that might result in harm to the 
financial system.
  The GAO derivatives study submitted on May 19, 1994 response to the 
subcommittee's request has identified some serious gaps in the current 
legal and regulatory structure relating to OTC derivatives.
  First, the GAO made a series of recommendations aimed at improving 
Federal supervision of bank dealers in OTC derivatives. These include 
developing consistent capital standards, requiring independent and 
knowledgeable audit committees, performing comprehensive annual 
examinations, and requiring bank dealers to provide better information 
on counterparty concentrations and the amount and type of their 
derivatives holdings. The GAO found that the bank regulators already 
have considerable legal authority to undertake such regulatory reforms.
  Second, the GAO recommended that the SEC use its existing legislative 
authorities to improve disclosure and accounting treatment of 
derivatives. The GAO recommended that the SEC take steps to ensure that 
major end-users of derivatives improve their internal controls and risk 
management systems. The GAO also recommended that the SEC, both 
directly through its review of disclosure documents filed by public 
companies and in its capacity in overseeing accounting standards set by 
the Financial Accounting Standards Board [FASB], ensure that investors 
receive full and accurate disclosures regarding the derivatives 
activities of corporations, mutual funds, and other major institutional 
end-users of derivative financial products. The SEC has broad authority 
under existing law to mandate such changes.
  Finally, the GAO identified serious gaps in the current legal and 
regulatory framework that allows derivatives dealers affiliated with 
securities firms or insurance companies to largely escape the type of 
regulations which are already in place for derivatives dealers 
affiliated with banks. GAO's testimony before the subcommittee also 
identified potential gaps in antifraud and antimanipulation enforcement 
authority, and sales practice regulation. In response, the GAO 
recommended that this black hole be plugged by granting a Federal 
regulator, such as the Securities and Exchange Commission, appropriate 
authority to conduct examinations and set capital standards for these 
currently unregulated dealers.

  The subcommittee has closely examined the derivatives markets and the 
findings and recommendations of the GAO study in oversight hearings 
held on May 10, 19, 25, and July 7th of this year. We have heard 
testimony from the GAO, from current and former financial regulators, 
from derivatives dealers and other experts. Based on the information 
gathered in the course of these hearings, and other inquiries 
undertaken by the subcommittee, I have crafted a piece of legislation 
which would close the most glaring legal gap affecting the derivatives 
markets--the presence of virtually unregulated OTC derivatives dealers 
in the market.
  The Derivatives Dealers Act of 1994 that Mr. Synar and I are 
introducing today represents a three-tiered approach to derivatives 
regulation.
  First, the bill would define ``derivative'' to include any financial 
contract or other instrument that derives its value from the value or 
performance of any security, currency exchange rate, or interest rate, 
or group of index thereof. It should be noted with respect to 
instruments based on currency exchange rates, that the definition would 
exclude the most common type of derivative instrument--forward rate 
contracts--but would include foreign currency swaps that have a 
duration greater than 270 days. Securities traded on an exchange or on 
the NASDAQ, futures or options on futures, and bank or savings 
institution deposits also would be excluded.
  Second, the definition of ``security'' in section 3(a)(10) of the 
Securities Exchange Act of 1934 [Exchange Act] would be amended to 
include derivatives based on the value of any security. While options 
on securities already are included within this definition, the 
amendment would bring equity swaps under the definition of ``security'' 
and subject transactions in equity swaps to regulation under the 
Exchange Act.
  Third, persons defined as ``derivatives dealers'' would become 
subject to Securities and Exchange Commission [Commission] regulation. 
Derivatives dealers that are not first, registered broker-dealers or 
second, material associated persons of registered broker-dealers that 
have filed notice with the Commission, see discussion below, would be 
required to register with the Commission and would be subject to 
Commission rulemaking and enforcement authority. Commission rulemaking 
would focus on financial responsibility and related recordkeeping and 
reporting requirements, as well as on the prevention of fraud. Such 
dealers also would be required to become members of an existing 
registered securities association, or any registered securities 
association that may be established for derivatives dealers. Rules 
adopted by a registered securities association would focus on the 
prevention of sales practice abuses and the establishment of internal 
controls.
  Derivatives dealers that are material associated persons of 
registered broker-dealers would be required, as a general matter, to 
file a form of notice with the Commission. Alternatively, such dealers 
would be permitted to register, as discussed above. Dealers that file 
notice would be regulated indirectly through their broker-dealer 
affiliate. The risk assessment provisions already in place under the 
Exchange Act, which would be amended by this bill, would be utilized 
for this purpose. In addition, the broker-dealer's net capital would be 
based, in part, on the derivatives activities of its affiliated 
derivatives dealer. The designated examining authority for the broker-
dealer would have rulemaking and enforcement authority with respect to 
the derivatives activities of both the broker-dealer and the affiliate. 
The Commission also would be authorized to adopt rules designed to 
prevent fraud.
  This bill will close the regulatory black hole that has allowed 
derivatives dealers affiliated with securities or insurance firms to 
escape virtually any regulatory scrutiny. It will give the SEC the 
tools needed to monitor the activities of these firms, assess their 
impact on the financial markets, and assure appropriate protections are 
provided to their customers against any fraudulent or abusive 
activities. It is not a radical restructuring of the derivatives 
market; it is focused laser-like on the real gaps that exist in the 
current regulatory framework that need to be closed, and closed now.
  In addition to this legislative reform package, the subcommittee has 
been strongly urging the bank regulators and the Commission to make 
full use of the authorities they have under existing law to enhance 
their oversight over the derivatives market and to assure protections 
are afforded to end-users of derivatives and to their shareholders. As 
the GAO's report indicated, the bank regulators already have 
considerable authority to take action with respect to the activities of 
bank derivatives dealers, and I believe that the bank regulators should 
continue to make use of these authorities to improve their supervision 
of the derivatives activities of banks.
  The GAO report also indicated that the SEC has considerable authority 
under existing law to enhance derivatives-related disclosures made by 
public companies, to regulate the use of derivatives by investment 
companies, and to assure the adequacy of the derivatives accounting 
standards established by the Financial Accounting Standards Board 
[FASB]. The subcommittee expects the Commission to follow through on 
the commitments made by Chairman Levitt during the subcommittee's May 
25, 1994 hearing to take a strong leadership role in assuring that 
significant improvements are made in each of these critical areas.
  In this regard, the subcommittee has recently contacted the SEC to 
requesting information regarding the Commission's ongoing activities 
and authorities, and to clarify the need for any additional legislative 
reforms. On June 15, 1994, I joined with Representative Fields to 
request certain information regarding the participation of mutual funds 
in the derivatives markets. On June 23, 1994, I joined with 
Representatives Synar and Wyden to request information regarding GAO's 
recommendations for enhancements in the role of audit committees in 
reviewing and approving the activities of OTC derivatives dealers and 
major end-users and the establishment of requirements for internal 
controls reporting with respect to derivatives. In addition, on May 23, 
1994 Chairman Dingell sent letters to the SEC, the Treasury Department, 
and the Securities Industry Association requesting their comments on 
the findings and recommendations of the GAO report. Responses to each 
of these inquiries are expected to be received shortly.
  Based on the nature of the information received from the Commission 
and other respondents in response to these and other inquiries and 
investigations, the subcommittee will need to carefully consider the 
need for further legislative reforms to the bill I am introducing today 
as it moves through the legislative process. I look forward to working 
with my colleagues on the subcommittee and with all other interested 
parties as the subcommittee undertakes this effort to improve 
regulation of the markets for financial derivatives.
  Again, I urge my colleagues to cosponsor and support this important 
legislation.

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