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Good morning. I am glad to have this opportunity to speak to the Futures Industry Association. Your industry makes a significant contribution to our economy.

The futures industry directly employs almost 300,000 people generating enormous downstream benefits to the rest of the economy and indirectly sustaining tens of thousands more jobs. It makes up a significant proportion of US financial services exports. Even more importantly, the futures industry has played a key role in the American economic success story of the past decade: the nearly ten year-old investment-led expansion that has created a prosperity and a rate of productivity growth that few would have anticipated even a few years ago.

There are many reasons for this prosperity: our fiscal discipline; our success in managing information technology; and the vitality of entrepreneurship in the U.S. But I am convinced that an important part of the credit for our unprecedented economic performance goes to the unparalleled strength and dynamism of our financial markets.

  • No other country offers such deep and liquid capital markets or such an impressive venture capital industry.
  • No other financial market is so open to foreign competition or so quick to innovate, whether it be in the area of securitization, financial derivatives, high-yield bonds, or equity finance.
  • And no other financial system has combined so effectively the integrity of high-quality regulation with the absence of excessive state interference.


By allocating capital to its highest and best uses and by ensuring its availability to the industries of the future, our financial markets have unquestionably been major contributors to America's economic success.

Certainly, this is a very special time. We are enjoying the longest period of economic growth in our history; our markets have remained a source of opportunity while weathering a series of recent crises; and our financial sector continues to be the world leader. For these reasons, we are justifiably confident about the strengths of America's financial industry. But we must not allow our confidence to spill over into a sense of complacency. Markets are at their most vulnerable when their sense of self-belief is strongest.

That is why we must learn the lessons of previous crises so that we can minimize the likelihood of a recurrence - by working with leading market participants, both in the U.S. and elsewhere, to develop a stronger international financial architecture that will reduce the frequency of crises and lessen their impact when they do occur. The role of key members of the private sector in this effort has been as welcome as it has been constructive.

With this as a backdrop, let me divide my remarks today into four parts:

  • First, the critical importance of financial markets, including derivatives markets, to the broader economy.
  • Second, the lessons that we have drawn from the recent financial disruptions and crises.
  • Third, the role of the public sector and the need for effective self-regulation within our financial markets.
  • And fourth, our policy agenda in the years ahead.
  1. The Critical Economic Importance of Effective Capital Markets and Financial Derivatives.

As a central component of the broader capital markets, financial derivatives play a critical role in facilitating the efficient pricing and allocation of risk in the economy. They are a powerful symbol of the kind of innovation and technology that has made the American financial system as strong as it is today.

We have an enormous stake in securing the overall strength of the U.S. financial markets and in strengthening the position of the U.S. as the world's leading financial center. When business moves elsewhere we all pay a price: the private sector pays a price in lost market share and lower employment; and the public sector pays a price because the migration of business undermines its regulatory objectives. That is why all of us, Chairman Greenspan, Chairman Rainer, Chairman Levitt, and myself, are committed to maintaining the competitiveness of the U.S. financial system.

Well-functioning derivatives markets permit us three critical benefits.

  • The first benefit is better distribution and management of risk. By allowing for the transfer of financial risk and enabling American businesses and institutions to hedge their risks more efficiently, financial derivatives promote the efficient allocation of capital that further increases American productivity. For example, financial institutions routinely use Eurodollar futures contracts to reduce their exposure to movements in short-term interest rates.
  • Second, there is the benefit of lower costs for American consumers and businesses. By enabling a more sophisticated management of assets, including mortgages, consumer loans and corporate debt, financial derivatives can help lower mortgage payments, insurance premiums, and other financing costs for American consumers and businesses.
  • And third, well-functioning derivatives and futures markets help make our economy stronger. Because a well-functioning and efficient capital market broadens - and lowers the cost of - capital access for businesses and financial institutions alike, financial derivatives boost economic opportunity and growth. For example, lenders that have hedged their exposure to interest rates are able to reduce the cost of credit to businesses and consumers.

And yet, in spite of the dynamism and efficiency of our financial system, we have seen that our financial markets can also be prone to disruption and crisis. Indeed, it was only 18 months ago that the crisis at Long Term Capital Management (LTCM) raised the specter of what many believed might have been the worst financial crisis in 50 years.

  1. The Lessons of Recent Crises

LTCM was not the first accident to befall the financial markets in recent years. One need only think of Black Monday in 1987, the collapse of Barings Bank in 1995 or the crises of 1997 and 1998 in Asia and Russia. And certainly, we can be sure that other financial failures will strike in the future.

History tells us that creditors, counterparties and investors sometimes become complacent in making risk assessments in an attempt to achieve higher short-term returns. A tendency toward complacency can be particularly prevalent in good times, as creditors and investors become less concerned about risk.

In that sense the near-collapse of LTCM was perhaps a wake-up call for the markets about the need for greater transparency and better risk management practices and to keep pace with an increasingly interconnected and complex world with all the new risks that brings.

Let me highlight four primary lessons that the public and private sectors can draw from the LTCM crisis.

  • First, markets and technology may change but human psychology endures. The tendency to fall into complacency and over-optimism in good times; the tendency to assume that past relationships will hold in the future; and the tendency to assume that events that have not occurred will not occur in the future, is as old as the financial markets themselves. This is a lesson about over-confidence.
  • Second, LTCM presented us with an unusually toxic combination of excessive leverage and asset and funding illiquidity. Leverage without illiquidity does not pose serious problems because positions can be unwound. Illiquidity without leverage can be solved with time. But where a combination of illiquidity and leverage is pervasive, the risks to stability are at their greatest. The traditional law of supply and demand can be distorted: for, when the price of an asset falls, the supply can increase as those who hold it are forced to liquidate.
  • Third, there was in the LTCM crisis the combination of non-transparency and surprise. Where there is no transparency; where lenders are not aware of the basis on which they are lending, you have the greatest prospect for surprise and therefore the greatest threat of instability.
  • Fourth, and crucially, many market participants learned that modern hedging strategies and models do not necessarily work as they were intended. Hedging market risk has many positive advantages but it can be complex and comes with its own inherent risks.
  1. The Role of the Public Sector.

These factors together - market over-confidence, the toxic combination of over-leverage and illiquidity, non-transparency and the risks that hedging strategies and models may not live up to their design - are problems of which we must all be aware. Let me be clear, it is the private sector, not the public sector, that is in the best position to provide effective supervision. Market discipline is the first line of defense in maintaining the integrity of our financial system.

The public sector, for its part, has three fundamental roles.

  • First, it needs to create an environment in which market discipline can work effectively. Counterparties and creditors have more knowledge of their counterparts, more skill in evaluating risk and greater incentives than any public regulator will ever have. The best approach to regulation is therefore to maximize the quality of counterparty discipline and to ensure that public activities do not crowd out the supervision provided by counterparties, creditors and investors.
  • Second the public sector must promote the maximum degree of transparency, because transparency is the necessary corollary to counterparty discipline. The government cannot impose counterparty discipline, but it can help to enhance the effectiveness of market discipline by creating an environment of greater transparency and disclosure. Indeed, the long history of transparency in our financial markets has been a source of great strength, and a leading factor in maintaining the integrity of U.S. markets.
  • Third, the public sector has a duty to maintain the competitiveness of the system as a whole. Just as there is a sharp distinction between support for the free enterprise system and support for individual enterprises, so also the task of public policy must be to ensure the stability and integrity of the market system rather than to seek to ensure the survival of individual firms or investors. Regulation must never hold out the prospect that it can eliminate risk or that it can prevent any individual institution from failing. Any regime that had that effect would be perverse and counterproductive and undermine market discipline.


  1. Our Policy Agenda Going Forward

We thus have a clear set of principles to guide the role of the public sector. These are: to strengthen market discipline, to promote transparency in the markets, and to promote efficient and competitive financial markets in the interests of the health of the broader American economy.

In applying these principles, we have four clear areas of priority over the coming months and years. Let me highlight the following:

First, increased transparency

We are calling on financial institutions, supported by their regulators, to improve counterparty diiscipline in general - and to disclose their exposure to highly leveraged institutions in particular. Specifically:

  • Regulatory agencies should continue to apply the recommendations of the President's Working Group report on Hedge Funds that are designed to enhance the monitoring of leverage and risk, and to improve transparency: especially the steps to increase reporting by the largest hedge funds and disclosure by public companies of direct material exposures to leveraged financial institutions.
  • We urge Congress to codify some of the recommendations of the Working Group on Hedge Funds including the bill put forward by Congressman Baker.
  • We look forward to the findings of the Financial Stability Forum working group's report on Highly Leveraged Institutions that will be published soon and will build on the findings of the President's Working Group report on Hedge Funds.

Transparency is also an international concern. It is incumbent on all countries to promote better prudential oversight.

Second, improved risk management in the private sector

We support private sector proposals to improve risk management practices such as those recommended by the CRMPG and the Hedge Fund Group. These call upon firms to institute effective risk analysis of their portfolios, conduct realistic stress testing of their models and ensure they have adequate liquidity in the event of a crisis.

To be sure, recent experience has brought a certain humility to those involved in a construction of risk management models. We have seen that what statisticians call "outliers" and what others call "freak events" can happen too often. Not only do outlier situations occur, but traditional patterns also breakdown in times of crisis. This makes it all the more essential that risk management systems be improved, updated as necessary, and subjected to rigorous stress-testing.


Third, establishment of legal certainty for derivatives markets

We are calling on Congress to take new steps, as part of its re-authorization of the Commodity Exchange Act, to provide legal certainty for the OTC derivatives market and afford some regulatory relief for the nation's futures exchanges. This will give the industry the benefits of a clear regulatory and legal environment and thus help to promote U.S. competitiveness at a critical juncture. It will also reduce systemic risk by permitting the creation of clearing houses that will provide more satisfactory netting arrangements and margin facilities. Of course, as technology reshapes our derivatives markets it will also be essential to ensure that the interests of retail customers are protected

Fourth, improved market infrastructure.

Our markets will not be fail-safe until they are safe for failure. This is an issue with respect to the failure of individual institutions, which is why it is so important that Congress enact the Financial Contract Netting provisions of the Bankruptcy Bill. It is also an issue that goes beyond the area of bankruptcy to the "plumbing" of our financial system. Improving the plumbing may not be glamorous. But it is a vital part of our objective of minimizing the effects of crises. For example, if "plumbing" measures such as proper settlement mechanisms, harmonized documentation, and contractual uniformity, had been in place, the financial environment in September 1998 would have been much more secure.

  1. Conclusion.

Our market-based economy relies primarily on the discipline provided by creditors, counterparties, and investors to constrain the leverage of both regulated and unregulated financial entities. While recent crises have prompted market participants to make some encouraging and necessary changes to their risk management practices, we must remain vigilant. The history of such crises tells us that even painful lessons quickly recede from memory. The markets are especially vulnerable to complacency when they are performing well. We must take advantage of this moment to carry out the reforms that we all agree are necessary. If we delay taking action until the next crisis is upon us, it will already be too late. Thank you very much.

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