Testimony of Mark C. Brickell\
Chief Executive Officer\
Blackbird Holdings, Inc.\
Before the\
Committee on Agriculture

U.S. House of Representatives

February 4, 2009

Mr. Chairman and Members of the Committee:

Thank you very much for inviting Blackbird Holdings, Inc. to testify at
this hearing about the \"Derivatives Markets Transparency and
Accountability Act of 2009\". We are grateful to the Committee for
asking for our views as it seeks a wide perspective on the benefit and
drawbacks of legislation affecting privately negotiated derivatives. For
more than two decades, swaps and related derivatives contracts have made
an important contribution to improvements in risk management at banks,
in the financial sector, and in the economy. The benefits of these
transactions are sufficiently important that any measures adopted by the
committee or the Congress should not reduce the availability or increase
the cost of these valuable tools.

**About Blackbird**

Blackbird Holdings, Inc. is a privately held corporation headquartered
in Charlotte, North Carolina. It was founded by swap traders from JP
Morgan & Co. who developed an electronic trading platform for the
negotiation of interest rate and currency swaps. Our innovative
technology has been patented three times by the U.S. government. The
benefits of electronic trading have already been achieved in the
execution of most types of financial transactions, including foreign
currency, equities, U.S. Treasury bonds and corporate bonds, and futures
contracts. When swap contracts are executed electronically in greater
numbers, swaps will have greater transparency, and accurate electronic
records will be created at the moment the trade is executed so that
error-free straight through processing, including accurate
record-keeping, will be a hallmark of the business. Blackbird is still a
small company, but we are global, and we help swap counterparties find
each other and execute swaps either across our electronic platform, or
through our people in Singapore, Tokyo, London, and New York.

I have served as Chief Executive Officer of Blackbird since 2001. Before
that, I served for 25 years at JP Morgan & Co., Inc., where I was a
Managing Director and worked in the derivatives business for 15 years.
During that time, I served for four years as Chairman of the
International Swaps and Derivatives Association, and for two years as
Vice Chairman, during more than a decade that I served on its board of
directors. ISDA represents participants in the privately negotiated
derivatives business, and is now the largest global financial trade
association, by number of member firms. ISDA was chartered in 1985, and
today has over 850 member institutions from 56 countries on six
continents. These members include most of the world\'s major
institutions that deal in privately negotiated derivatives, as well as
many of the businesses, governmental entities and other end users that
rely on swaps and related contracts to manage efficiently the financial
market risks inherent in their core economic activities. As a result, I
was involved in discussions about all federal swaps legislation between
1988 and 2000.

**Why Swaps?**

The moment that companies open their doors to do business, they become
exposed to financial and other risks that they must manage. Changes in
foreign currency rates can affect the volume of their exports; interest
rate volatility the level of investment returns, and commodity price
fluctuations the cost of raw materials---or sales revenue. Managing
these risks was an essential part of decision-making in business and
finance before swaps were developed, and would remain so if swaps did
not exist.

Custom-tailored swap transactions were developed to make it easier to
manage these risks. They allow a party to shed a risk that he does not
want to take, in return for assuming another risk to which he would
rather be exposed, or for making a cash payment. By tearing apart and
isolating the strands of risk that are entwined in traditional business
and financial transactions, they make it possible to manage risks with
greater precision, and allow businesses to focus on the things they do
best. A company that sells hamburgers around the globe can use swaps to
shift its exposures to interest rates and foreign currencies to other
parties, and concentrate on managing its operations, raw materials
costs, and real estate holdings, if it believes that these are the
source of its comparative advantage. Similarly, the counterparties to
its swap trades believe that they are better able to manage the interest
rate and currency risks being shed by the other enterprise.

**Benefits of Swap Activity**

As thousands of swap counterparties make individual decisions about
which risks to take and which to transfer to others, several useful
things happen. First, the risk profiles of the firms improve every time
they make a correct decision. This strengthens them, and makes it
possible for them to serve their customers better and grow more rapidly.
A bank that has a strong relationship with a borrower might find that
the size of its loans to that customer was becoming so great that its
loan portfolio was becoming poorly diversified. By entering into credit
default swaps, the banker can transfer enough of the loan risk to make
room for more loans to its customer, strengthening its business
relationship and helping credit to flow. That's good for business, jobs,
and the economy.

Second, as thousands of swap transactions have been executed in the past
three decades, bankers and finance professionals have gained access to
new information about financial risks. This allowed better measurement
and management of risks, first in swap portfolios and, as time passed,
in the other financial portfolios. I watched that process take place in
the 1980s as the risk management techniques developed on the swap desks
of ISDA member banks, including my own, were adopted by the managers of
the same risks that had long been embedded in other financial portfolios
at their institutions, including the portfolios of loans and deposits.
This process was so constructive that swap professionals were asked in
1993 by the Group of Thirty, to write down their best principles and
practices for managing financial risks. The report that we produced was
disseminated through the global banking system and other parts of the
financial world, and was also used by banking supervisors and financial
system regulators to improve their supervisory practices. As Paul
Volcker, the Chairman of the Group of Thirty wrote in the introduction
to our report, "...there can be no doubt that each organization's
conscious and disciplined attention to understanding, measuring, and
controlling risk along the lines suggested should help ensure that the
risks to individual institutions and to markets as a whole are limited
and manageable."

As swap transactions are executed, the prices of these deals reveal the
beliefs of thousands of individuals about the future course of interest
rates, or the creditworthiness of borrowers, which are collected and
distilled in the price of the deals. This information can be used even
by parties who do not enter into the transactions. Central bankers now
use swaps prices to understand interest rate expectations and help them
make decisions about monetary policies. Rating agencies have begun to
track the information about the credit quality of borrowers that is
contained in the price of credit default swaps to identify changes in
market opinion, and alert their analysts to changes in the condition of
companies that they rate, so that they can drill down on potential
problems and strengthen the quality of their ratings. If credit default
swaps had existed a decade earlier, to sound a tocsin of warning,
current problems in the financial system might not be so grave.

Of course, no type of financial transaction or system of risk management
can prevent all investment losses. The good judgment of financial
professionals remains the essential element in sound financial
management. Swaps simply make it easier and less expensive to create the
risk management profile that a company prefers.

You might expect a business that does so much good for so many people to
grow quickly, and the swaps business has. While I have been a
participant in the swaps business, I have seen it grow by roughly 25%
per annum for more than 20 years. As a result, there are now according
to the BIS almost \$684 trillion of swaps outstanding, mainly on
interest rates and currencies As of January 27, there were some \$28
trillion of credit default swaps outstanding. It is worth noting that,
even when other financial activities become illiquid, the swap business
tends to be resilient. Credit default swaps dealers, for example,
indicate that there has been liquidity in swaps even when traditional
cash markets have become illiquid at times in the past year.

**Public Policy for Swaps in the United States**

These are important benefits. They exist in part because Congress has
legislated carefully and wisely with respect to swaps on at least five
earlier occasions since 1988. We all want to preserve benefits like
these, and I am grateful to you for identifying in legislation now
before the committee several policy ideas that have been floated in
recent months, and for your careful consideration of those ideas at this
hearing. With careful action, this committee can continue to play an
essential role in building a sound framework for swap activity.

The policy consensus about swaps that is embodied in the statutory and
regulatory framework reflects the fact that swap activity arose not in
the exchange traded, centrally cleared business of standardized futures
contracts regulated by the Commodity Futures Trading Commission, but in
the banking sector. Swap contracts are custom-tailored transactions that
are often designed to match the exact cash flows that a corporation
wants to hedge; this makes them harder to construct, to value, and to
transfer, than the futures contracts regulated by the CFTC, in much the
same way that a bank loan is different from a corporate bond. This is
why the first policy adopted by the CFTC with respect to swaps, in its
May 1989 Swaps Policy Statement, after more than 18 months of study, was
that swaps are not appropriately regulated as futures. That original
CFTC Policy reflects a policy consensus that has lasted two decades,
reaffirmed and strengthened by the 1991 CFTC Statutory Interpretation,
the 1992 Futures Trading Practices Act, and the Commodity Futures
Modernization Act enacted in 2000 and signed into law by President
Clinton, as well as other legislation. That is why swaps are defined in
federal law as banking products.

A robust, innovative American financial services business has been built
on the foundation of this policy consensus. I am concerned that
provisions in the legislation before the committee would undermine that
foundation and weaken a business that helps the American economy, and
the world.

**Management of Credit Risk in Swaps Transactions**

One area of the legislation that would have that effect is the section
requiring clearing of privately negotiated derivatives. Like every
commercial and financial contract, swaps contain credit risk. One party
must be confident that his counterparty will perform according to the
terms of the contract.

Financial institutions are able to manage this credit risk in different
ways. In the banking system, where swaps originated, credit risk is
managed by experts who analyze the quality of each counterparty,
including its financial strength, the quality and character of
management, even the legal and political risk of the country where it is
based. In doing this, bankers and their counterparties often rely on
private information available to them in their special role as
creditors. The techniques used to manage the credit risk of swaps are
usually the same ones used to manage the risk of other privately
negotiated credit contracts such as bank loans or bank deposits, and
they can include the posting of collateral so that if a counterparty
defaults on a trade, the non-defaulting party will be able to enter into
a new, replacement transaction at no additional cost. Of course, if a
counterparty is not satisfied with the amount or quality of the
information he receives, or the credit enhancement techniques available,
he is not required to enter into any swap deal.

Financial institutions have developed a number of ways to manage credit
risk in privately negotiated derivatives, appropriate to their capital
levels and those of their clients.

First, there are different ways to document transactions. The simplest
method is to use an exchange of confirmations, one for each transaction.
This approach makes no attempt to reduce risks by netting, it simply
relies on well drafted confirmations and good credit judgment in the
choice of counterparties.

Risks are reduced by netting under bilateral master agreements, either
for single products---interest rate swaps against interest rate swaps,
\--or reduced further by including other derivatives under the master.
Netting across products---foreign exchange options against credit
default swaps, for example---reduces potential exposures even more than
single product netting. The ISDA Master Agreement is used around the
globe to achieve this purpose.

As you can see, we are starting to build a sort of continuum of
approaches, in which increasing the numbers of transactions netted
against each other results in greater netting benefits. Multilateral
netting of credit risks is another step along the continuum, in which a
multilateral clearinghouse substitutes its own credit for that or
others, and has a bilateral relationship with each of them. In each
bilateral relationship, the credit exposure at any moment in time is the
net value of the transactions.

At first, this might sound different from the banking model, because
futures exchanges operate multilateral clearinghouses. But the
difference is mainly one of scale. Every bank serves as a central
counterparty for its inter-bank trading partners and its clients. So, in
this sense, every swap dealer bank using netting provisions under the
ISDA Master Agreement is a clearinghouse.

Each swap dealer assesses the likelihood that his counterparty will
default, and his own ability to withstand such a default. In doing so,
he is mindful of his own capital base, and the capital strength of his
counterparty. Where capital is not high relative to risk, it is more
likely that one or both swap counterparties will demand collateral from
the other.

Now we have a more complete picture of credit risk mitigation schemes
for derivatives. Each scheme has characteristics appropriate to its
participants. On one end of the continuum are banks and insurance
companies, with traditionally strong capital cushions. At the other end
are margin-reliant entities including futures exchange clearinghouses.

**A Clearinghouse for Swaps?**

It should be clear at this point that creating a new clearinghouse for
swaps, or for one type of swaps like credit default swaps, or forcing
swaps into some other clearinghouse, would not exactly make order out of
chaos. A good deal of order already exists. It is the order that markets
bring to human affairs, giving participants the opportunity to choose,
and to change their choices. Today swap participants can choose among
several different methods to handle credit risk. We can keep the
contracts on our own books, netting them against other contracts, taking
collateral to support the risk as appropriate, or we can submit them to
a third party clearinghouse. A system like this allows us to make the
right judgments for ourselves and our counterparties, as capital
positions change and the mix of clients changes. Every bank changes its
mix of business along the continuum, every day.

For this reason, Section 13 of the bill is troubling. This section
requires that all currently exempted and excluded OTC transactions must
be cleared through a CFTC regulated clearing entity, or an otherwise
regulated clearinghouse which meets the requirements of a CFTC regulated
derivatives clearing organization. While the provision authorizes the
CFTC to provide exemptions from the clearing requirement, it can only
grant the relief under limited circumstances, provided that the
transaction is highly customized, infrequently traded, does not serve a
significant price discovery function and is entered into by financially
sound counterparties.

Driving swap activity into a central clearinghouse would be undesirable
for several reasons. First, it would create a central choke point for
activity that is, today, distributed across multiple locations. If a
single swap dealer has processing problems or other difficulties, they
affect only the dealer's clients. If a central clearinghouse were to
have problems, they would affect the entire system's derivatives flows.

Second, the same is true of the credit risk of such a central entity.
Pulling the credit risk of swaps out of the institutions where they
reside today, and forcing them into a central counterparty, risks
creating a new, "too-big-to-fail" enterprise that represents a new risk
to taxpayers.

Third, a centralized, collateral-reliant scheme would tend to reduce
market discipline. Because parties to bilateral netting agreements
retain some individual credit exposure, they must assess their
counterparties' credit standing, giving them an incentive to control
their positions carefully. The resulting widespread awareness of credit
risk makes the financial system safer. In contrast, clearinghouse
arrangements tend to socialize credit risk. Our financial system today
shows the ill effects of a reduction in market discipline, and federal
policies should increase it, not reduce it.

Fourth, one reason for this is that credit discipline encourages
financial institutions to strengthen their capital bases.

Finally, building a central clearinghouse may be an expensive
proposition, requiring new capital of its own. In contrast, increased
use of bilateral cross product netting under ISDA Master Agreements can
be accomplished at low cost. The marginal cost of adding another
transaction to an ISDA bilateral master agreement is zero. No other
technique offers such substantial risk reduction at such a low cost.

Since, as I indicated above, every swap dealer bank serves as a
clearinghouse for its swap trading partners and clients, the provision
would have the effect of limiting the ability of banks to engage in this
segment of the banking business without the approval of the CFTC. I do
not know of any reason to unwind the policy consensus for swaps to adopt
such a policy. The netting and close out arrangements that are in use
among swap counterparties are the result, in part, of careful work by
Congress to establish the enforceability of netting agreements under
bankruptcy law. These arrangements have been used in the marketplace and
tested in the courts and have managed the credit risk of hundreds of
thousands of swap transactions. In the last 12 months alone, the failure
or default of a major swap dealer, Lehman Brothers, two of the world's
largest debt issuers, Fannie Mae and Freddie Mac, and a sovereign
country Ecuador, in addition to the more routine failures of other
counterparties have been successfully resolved using these arrangements.
In every case the well drafted netting and close out provisions of the
ISDA Master Agreements have done what they were supposed to do. Simply
put, these arrangements work well, and there is no evidence to support a
statutory requirement for clearing of all swap agreements through
CFTC-approved central counterparties.

**Conclusion**

The privately negotiated derivatives business -- and the bilateral
infrastructure, documentation, and netting that support it -- have been
called "no less than the creation of global law by contractual
consensus." It is a system that works. It is a system that has well
served the economy and the financial markets in the US and around the
world. It is a system that has benefitted thousands of companies,
financial institutions and sovereigns. And it is a system that has an
important part to play as we work toward a solution to today's economic
weakness and financial markets uncertainty. Great care should be taken
to optimize -- and not weaken \-- this innovative and important system.