Mr Chairman, thank you for giving me the opportunity to discuss issues raised recently regarding the regulation of the OTC derivatives market -- notably, the concept release issued last May by the Commodity Futures Trading Commission ("CFTC") and the subsequent legislative proposal put forward jointly by Secretary Rubin and the Chairmen of the Federal Reserve Board and Securities and Exchange Commission ("SEC").
As you know, Mr Chairman, the CFTC's recent concept release has been a matter of serious concern, not merely to Treasury but to all those with an interest in the OTC derivatives market. In our view, the Release has cast the shadow of regulatory uncertainty over an otherwise thriving market -- raising risks for the stability and competitiveness of American derivative trading. We believe it is quite important that the doubts be eliminated.
Let me devote my remarks to three aspects of this issue:
- the CFTC's concept release and the immediate risks to the American derivatives market that were posed by that release;
- the rationale for temporary legislation to allay the immediate uncertainties triggered by the release and to enable Congress to undertake careful consideration of these issues;
- some of the broader, conceptual considerations that should be taken into account when analyzing questions of the proper regulation of this market going forward.
I. Concerns Raised by the CFTC's Concept Release
Mr Chairman, the American OTC derivatives market is second to none. In a few short years it has assumed a major role in our own economy and become a magnet for derivative business from around the world. The dramatic development of this market has occurred on the basis of complex and fragile legal and legislative understandings -- understandings which the CFTC release put into question.
Let me first explain the principal legal and regulatory uncertainties created by the CFTC's concept release that was made public on May 7. I will then briefly explain the potential economic and financial concerns posed by the creation of this kind of legal uncertainty.
Legal and regulatory uncertainties created by the concept release
The CFTC concept release raises important issues concerning the regulatory regime governing the OTC derivatives market. Without doubt, the CFTC release has raised legitimate questions that merit study, discussion, and debate. I will be returning to some of these longer term questions in a moment. However, by raising these questions in the manner it has, two major problems have been caused.
First, the concept release implicitly assumes that the CFTC has broad jurisdiction over the OTC derivatives market. This is far from clear. The concept release has thereby increased concern about the legal status of OTC derivatives, particularly those based on so-called non-exempt securities -- that is, those securities that are not exempt from the registration provisions of the securities laws. These derivatives include some equity derivatives, emerging market security derivatives, and credit derivatives, among others.
If the CFTC did have broad jurisdiction over the OTC derivatives market, it would have to be based on a judgment that many swaps are the principal type of contract covered by the Commodities Exchange Act (CEA) -- namely futures contracts. This, in turn, would call into question the legality of swaps involving non-exempt securities, because the CFTC does not have the authority to exempt futures contracts based on non-exempt securities from the exchange trading requirement of the CEA that is embedded in the Shad-Johnson Accord. Consequently, if OTC derivatives based on non-exempt securities are deemed to be futures contracts, they could be viewed as illegal and unenforceable.
Second, the concept release causes uncertainty for other types of OTC derivatives -- even those that would clearly be covered by the CFTC's exemptive authority if they were deemed to be futures contracts -- since it raises the possibility of increased regulation over this market.
Mr Chairman, for the past ten years, there has been an implicit consensus that the OTC derivatives market should be allowed to grow and evolve without deciding the various questions concerning the potential applicability of the CEA to any of these transactions. At the heart of that consensus has been a recognition that "swap" transactions should not be regulated as contracts subject to the CEA, whether or not a plausible legal argument could be made that any of these transactions are covered by the CEA.
The CFTC concept release, even though it purports to do no more than pose questions, upsets this fragile consensus because it suggests that the CFTC is at least considering imposing a significant new regulatory requirements on the OTC derivatives market. This, in turn, can only be based on a belief that many swaps are subject to CFTC jurisdiction as futures contracts and might appropriately be regulated as such.
As I have indicated, we do not agree with this conclusion. It is our view, and that of both the Federal Reserve and the SEC, that swaps are not futures under the CEA. Thus, the Administration proposed temporary legislation to alleviate the legal uncertainty created by the release while more permanent solutions are considered.
Potential economic and financial costs of market disruption
Mr Chairman, we believe that the uncertainties created by the release posed risks to the American OTC derivatives market. This is not a possibility to be taken lightly when one considers the critical importance of these activities to the growth and efficiency of our economy.
The OTC derivatives market is a vast, increasingly global industry. By some estimates, the market now has a notional value of around $26 trillion, with contracts of more than $4 trillion undertaken in 1997 alone. The dramatic growth of the market in recent years is testament not merely to the dynamism of modern financial markets, but to the benefits that derivatives provide for American businesses.
By helping participants manage their risk exposures better and lower their financing costs, derivatives facilitate domestic and international commerce and support a more efficient allocation of capital across the economy. They can also improve the functioning of financial markets themselves by potentially raising liquidity and narrowing the bid-asked spreads in the underlying cash markets. Thus, OTC derivatives directly and indirectly support higher investment and growth in living standards in the United States and around the world.
Any disruption to this market brings two large potential costs. First, it could inhibit the use of an important risk management tool, thus reducing the efficiency our financial markets in channeling capital to its most effective use.
Second, uncertainties of this kind threaten the position of the United States relative to other global trading centers, thereby depriving our economy of the multiple benefits which this activity affords. This concern is not hypothetical. From the opening of the Lloyds coffee shop in 17th century London to the creation of the Eurodollar market in the early 1960s, the history of world financial markets offers plentiful cases in which chance differences in location or national regulation have brought major long-term consequences that could never have been predicted at the start. The lesson is that early dominance of a fast-moving industry should not be ceded lightly -- and even small regulatory changes should be considered very carefully indeed.
Our discussions with market participants suggest that derivatives business is beginning to be shifted abroad because of the legal uncertainty in the U.S. We also understand from market participants that the move to curtail U.S. derivatives business and to shift much of this business abroad could accelerate if it becomes obvious that we are unwilling to address this issue.
Let me stress that this is not simply a matter of parochial Wall Street concern. Quite apart from the potential loss of key decision-making positions in the financial services industry and a decline in the depth and liquidity of our financial market, the broader economy would be adversely affected as firms would find it more costly -- impossible, even -- to obtain these financial products to support their growth and investment plans.
In fact, anecdotal evidence suggests that the uncertainties created by the release had begun to spread beyond Wall Street to a broad range of industries -- all of which are being deprived of an important risk management tool. For example:
- derivatives dealers who previously offered major agribusinesses with customized agriculture risk management products have reportedly begun to pull back from this line of business as a result of the current legal uncertainty;
- major U.S. corporations are reportedly delaying or reconsidering OTC derivatives transactions in their own stock that they would otherwise have used to hedge certain balance sheet risks;
- a software company developing a product to support the OTC derivatives business is said to have decided to do this business in the United Kingdom -- because of a perception that the U.S. regulatory environment is inhospitable and unstable.
Mr Chairman, none of this is to suggest that markets are threatened every time that an agency reviews its regulations. The CFTC has put out numerous releases in which it has reviewed various parts of its rules with no unsettling impact on financial markets. It is only this concept release that raised such concern.
In the presence of such uncertainty about the CFTC's jurisdiction, we believe that it is up to Congress to decide whether there should be additional regulation of the OTC derivatives market in the U.S. That is why Treasury, the Federal Reserve, and the SEC have disagreed with the CFTC's actions -- and the agencies jointly proposed legislation providing legal certainty, while at the same time permitting a comprehensive review of these markets and consideration of whether or not changes in the regulatory regime should be effected through legislation.
II. The Joint Treasury/Federal Reserve/SEC Proposal
Mr Chairman, the market appeared to have been somewhat reassured by the prompt expression of concern by Secretary Rubin, Chairman Greenspan, and Chairman Levitt immediately following issuance of the concept release. But market participants remain worried about what the concept release may portend. As a consequence, some business is reportedly not being done and other business is beginning to be transferred abroad.
The longer that legal uncertainty persists, the greater the risk of market problems developing and the greater the risk that the U.S. will see its leadership position in derivatives erode as market participants seek jurisdictions with more certain legal and regulatory regimes.
It was for this reason that Secretary Rubin and Chairmen Greenspan and Levitt transmitted a legislative proposal on June 5 that was designed to provide legal certainty to the market until Congress could study the issues:
- first, the proposal would temporarily prohibit the CFTC from issuing new rules regulating any swap or hybrid instrument;
- second, it would give some limited legal protection to OTC derivative instruments based on non-exempt securities; and
- third, it would require the President's Working Group to conduct a study of OTC derivatives and hybrid instruments and to report to Congress the results of this study within one year.
We understood the seriousness of making this proposal. To question an independent agency's concept of its jurisdiction and then to propose legislation that would temporarily curtail that agency's ability to act is not something we do lightly. We concluded, however, that such legislation was necessary to avoid disruption and dislocation in the market while the underlying issues were being considered by Congress.
Last Friday, Chairperson Born sent a letter to Cong. Smith, the Chairman of the House Agriculture Committee. In this letter, the CFTC agreed not to issue or propose new rules affecting swaps or hybrids until Congress reconvenes next year. It also reiterated something the CFTC had said in its 1989 Swaps Policy Statement -- that "swaps are not appropriately regulated as futures." Chairman Leach described this letter as going about half of the way to a resolution. While on Monday, eight market trade associations issued a statement calling the letter a "constructive step".
We think the letter improves the situation with regard to the first two points addressed by our legislative proposal. However, as Chairman Leach noted, more needs to be done. On Monday, Chairman Smith said that it was his understanding that the CFTC would not issue or propose new rules affecting swaps or derivatives until Congress had time to consider the various issues. This is indeed welcome news, which perhaps can be amplified at today's hearing. In addition, market participants need some re-confirmation of Chairman Schapiro's statement of two years ago -- that "the Commission has not taken a position on whether swap agreements are futures contracts." I believe that can be inferred from last Friday's letter, but the market would appreciate hearing it directly.
III. Longer Term Conceptual Issues Raised by Recent Debates
Even with this reassurance, Mr Chairman, there are still enormously complicated and difficult issues that Congress will have to address in next year's reauthorization. Treasury responded to the CFTC's concept release, because it poses risks to the continued strength and stability of the American OTC derivatives market. But this is not to deny that there are legitimate legal and regulatory questions involved.
As I have said, derivatives can provide important benefits to financial markets and to the economy as a whole. But clearly, they can also be abused. And there have been certain problems that have arisen in recent years in both the OTC and exchange-traded derivatives market, as well as problems arising from inappropriate investments in complex securities with embedded derivatives. More broadly, questions have been raised as to whether the derivatives markets could exacerbate a large, sudden market decline.
All of these questions merit careful study and continued vigilance. But if there is to be a broader reassessment of the regulatory and legal environment governing this market it will be important this reassessment begins from the right place -- namely with the underlying rationale for government intervention in financial markets and its applicability to OTC derivatives.
Government regulation of different financial instruments in the United States has been based on one or more of the following rationales, after a demonstration of the need for additional regulation. Such rationales are first, to protect retail investors from unscrupulous traders and second, to guard against manipulation in markets where the scope for such manipulation exists. As Chairman Greenspan has noted, these have been the major concerns guiding regulation of American commodities markets from the CEA onwards.
Once again, it is legitimate and valuable for Congress to consider whether it is necessary to make changes to the regulation of the entire OTC derivatives market. But I would note that it is not immediately obvious how either of these rationales applies in the case of the vast majority of OTC derivatives:
- first, the parties to these kinds of contract are largely sophisticated financial institutions that would appear to be eminently capable of protecting themselves from fraud and counterparty insolvencies and most of which are already subject to basic safety and soundness regulation under existing banking and securities laws;
- second, given the nature of the underlying assets involved -- namely supplies of financial exchange and other financial instruments -- there would seem to be little scope for market manipulation of the kind seen in traditional agricultural commodities, the supply of which is inherently limited and changeable.
To date there has been no clear evidence of a need for additional regulation of the institutional OTC derivatives market, and we would submit that proponents of such regulation must bear the burden of demonstrating that need. To address problems that have arisen affecting retail investors in certain foreign currency products, we would urge enactment of the provisions to amend the CEA that Treasury proposed last year. These would give the CFTC the necessary authority to protect retail investors from unscrupulous traders without harming legitimate activity in the rest of the derivatives market.
IV. Concluding Remarks
Mr Chairman, the OTC derivatives market has grown from nothing to become a highly lucrative industry of major international importance. It is reasonable to consider whether it is necessary to make changes in how this market is regulated. But there is currently no clear consensus in the government or in the private sector concerning any possible additional regulation for this market. And there is certainly no consensus that the CFTC currently has the legal authority to regulate this market or raise questions about possible regulation of this market in the future.
In this testimony I have put forward some of the considerations that Treasury believes ought to be kept in mind in approaching a resolution of these issues going forward. But this should not distract from our basic point: that any further clarification of the situation, not to mention any new regulation of this market, ought to come with the legitimacy of a clear legislative mandate from Congress.
The CFTC's letter of last Friday does not address the third leg of the joint Treasury/Fed/SEC legislative proposal: a Working Group study of the OTC derivatives market. If legislation is not forthcoming, Secretary Rubin, as Chairman of the Working Group, has asked me to assure the Committee that the Working Group will work to assist this Committee in evaluating the issues in whatever way would be helpful. We look forward to working with this Committee, with other members of Congress and interested parties as we work to resolve these issues in a way that safeguards America's position in this fast-developing global market. Thank you. I would be happy to respond to any questions you and other members of the Committee may have.