WRITTEN STATEMENT OF THE
SECURITIES AND EXCHANGE COMMISSION
REGARDING THE REGULATION OF THE
OVER-THE-COUNTER DERIVATIVES MARKET
AND HYBRID INSTRUMENTS
JUNE 10, 1998
The Securities and Exchange Commission ("SEC" or
"Commission") appreciates the opportunity to express its views on
issues relating to the federal regulation of transactions
involving over-the-counter ("OTC") derivatives and hybrid
instruments.  These issues involve significant questions of
public policy that require the attention of Congress, members of
the financial regulatory community, and interested industry
participants.
Benefits of OTC Derivative Instruments
It is widely recognized that OTC derivative instruments are
important financial management tools that, in many respects,
reflect the unique strength and innovation of the American
capital markets.  In fact, U.S. markets and market professionals
have been the global leaders in derivatives technology and
development.
OTC derivative instruments provide significant benefits to
corporations, financial institutions, and institutional investors
by allowing them to manage risks associated with their business
activities or their financial assets.  These instruments, for
example, can be used by corporations and local governments to
lower funding costs, or by multinational corporations to manage
risk associated with fluctuating exchange rates.  They can also
be used by portfolio managers to manage volatility in investment
portfolios or to obtain exposure to different assets without
actually taking a position in the cash market.  Because of the
benefits these products offer, the OTC derivatives market has
grown significantly during the past two decades.
The growth in activity involving this market has come, in
part, as a result of the careful approach to regulation taken by
Congress and by U.S. financial regulators.  That approach has
focused on promoting legal certainty for OTC derivative
transactions and encouraging the development of sound industry
practices.[1]  That approach has also relied on building
consensus among U.S. financial regulators through their
participation in the President's Working Group on Financial
Markets.
Concerns Regarding the CFTC Concept Release on OTC Derivatives
The recent concept release on OTC derivative instruments
issued by the Commodity Futures Trading Commission ("CFTC")
represents a significant departure from the careful approach
taken by the SEC and other regulators to the OTC derivatives
market.[2]  In its concept release, the CFTC raises the
possibility of applying a comprehensive regulatory regime to
transactions involving swaps and hybrids as a condition for
exempting such products from the requirements of the Commodity
Exchange Act ("CEA").  Such a regulatory regime would necessarily
be based on the CFTC's conclusion that swaps and hybrids are
futures contracts or commodity options and, as such, are subject
to CFTC jurisdiction under the CEA.
Chairman Levitt joined the other members of the President's
Working Group -- Treasury Secretary Rubin and Chairman Greenspan
of the Federal Reserve Board -- in objecting to the issuance of
the CFTC's concept release, citing grave concerns about the
possible consequences of the CFTC's action.[3]  In particular,
these concerns focus on the risk that the CFTC's action may
increase the legal uncertainty concerning swaps and other OTC
derivative instruments and, thus, destabilize what has become a
significant global financial market.
Any consideration of the issues facing the OTC derivatives
market, such as legal certainty, the concerns of industry
participants, and the role of U.S. financial regulators, must
begin with a long, hard look at how this market has evolved and
which products are involved in the bilateral transactions
conducted between market participants.  A convincing argument has
not been made that developments in the OTC derivatives market
since 1994 -- when the members of the Working Group last
testified before Congress on this market -- or since
1995 -- when the SEC and CFTC worked with the Derivatives Policy
Group to develop a framework for voluntary oversight of OTC
derivatives -- merit the CFTC's consideration of a vast, new
scheme to regulate this market.  Moreover, even if a case for new
regulation were made, it is not appropriate for the CFTC to
assert jurisdiction over a market outside the scope of the CEA.
    Swaps
The CFTC's concept release is particularly troubling in that
the CFTC sets out a broad regulatory agenda under the guise of
exercising its exemptive authority.  We disagree with this
approach.  First, this approach necessarily involves examining
the extent to which swaps may be futures subject to regulation
under the CEA.  On this issue the SEC has been clear --
traditional swaps that are not traded through a multilateral
transaction execution facility are not futures and are not
subject to regulation under the CEA.[4]  This view is shared
overwhelmingly by the industry.
Second, as Secretary Rubin, Chairman Greenspan, and Chairman
Levitt suggested in their recent statement, we have serious
doubts as to the CFTC's authority to regulate OTC markets.  The
CEA provides for the regulation of exchange-traded futures,
making off-exchange futures transactions illegal under the
statute.  Nowhere in the CEA has Congress articulated an intent
that the CFTC regulate off-exchange markets, nor has Congress
established standards for the protection of the public interest
should the CFTC assert jurisdiction over these markets.
Third, we disagree with any plan by the CFTC to regulate
through exemption.  In enacting the Futures Trading Practices Act
of 1992, Congress gave the CFTC broad exemptive -- not regulatory
-- authority regarding OTC swap transactions.[5]  In connection
with this grant of authority, Section 4(c) of the CEA places
certain conditions on the exercise of the CFTC's exemptive
authority.  These conditions include the requirement that any
exemption be in the public interest, and that exemptions be
limited to transactions that would be effected between persons
meeting the definition of "appropriate persons" that also would
not have a material adverse effect on the ability of the CFTC or
any contract market to discharge its regulatory or self-
regulatory abilities under the CEA.  Beyond these general
requirements, Congress did not direct the CFTC to impose
substantial additional requirements as a condition for exercising
its exemptive authority, choosing instead to allow the CFTC to
either exempt transactions unconditionally or on stated terms or
conditions.
Given the willingness of Congress to allow the CFTC to
exempt transactions without imposing conditions beyond those
contained in Section 4(c), it is unlikely that Congress
anticipated that the CFTC would establish exemptive conditions
that, in effect, would require compliance with a new,
comprehensive regulatory scheme for conducting off-exchange
transactions.  In fact, Congress specifically reserved for itself
issues of regulatory policy relating to the OTC derivatives
market.  As stated in the Conference Report for the Futures
Trading Practices Act of 1992, the purpose of giving the CFTC
broad exemptive powers was to provide "a means of providing
certainty and stability to existing and emerging markets so that
financial innovation and market development [could] proceed in an
effective and competitive manner."[6]  The objective was legal
certainty for swaps, not expansive regulation of an evolving
market.
     Hybrids
The CFTC's concept release also raises significant concerns
regarding the current exemption for hybrid instruments contained
in the CFTC's Part 34 rules.[7]  Hybrid instruments are
depository instruments or securities products, such as debt or
equity securities, that have one or more commodity-dependent
components with payment features similar to commodity futures or
commodity option contracts.  Under the CFTC's Part 34 rules, such
instruments may be exempt from regulation under the CEA if the
sum of the commodity-dependent values of the commodity-dependent
components of the instrument is less that the commodity-
independent value of the commodity-independent component.
In its concept release, the CFTC indicates that some
experienced practitioners have stated that the definition of
hybrid instrument under the Part 34 rules is complex and
difficult to understand and apply.  We believe that the current
definition is working well and that the mathematical computations
required under the definition are generally well understood.
However, if industry representatives believe that the Part 34
rules are difficult to apply, we would be interested in working
with the industry, bank regulators, and the CFTC to resolve any
difficulties.
Notwithstanding the CFTC's concerns regarding the complexity
of the Part 34 rules, we have reservations about the discussion
of hybrid products in the concept release.  It seems the CFTC is
proposing to substantially narrow the scope of the current
exemption, and make the availability of the exemption dependent
upon compliance with a scheme of regulation that would be
implemented based on the CFTC's exercise of its exemptive
authority.  As in the case of swaps, we oppose any attempt to
impose a regulatory scheme on hybrids through the exemptive
process.  Moreover, all hybrids are already regulated as banking
or securities products.  Where the commodity-dependent variables
are not paramount, there is no need to add another layer of
regulation under the CEA.
Exemptive Authority Should be Used to Encourage Innovation
It is important to understand that the SEC's concerns about
the regulatory approach suggested by the CFTC's concept release
do not stem, as has been suggested, from disagreement over agency
jurisdiction, nor from a fundamental opposition to the exercise
of appropriate regulation in this market.  We worked well with
the CFTC three years ago on the Derivatives Policy Group
initiative.  The SEC also believes very strongly in regulation
where necessary and appropriate, and in using its exemptive
authority to fuel market innovation and development.[8]
For example, last December the SEC issued a rulemaking
proposal that would apply to a class of broker-dealers we would
call "OTC derivatives dealers."[9]  This rulemaking proposal
would provide significant regulatory relief to broker-dealers
that seek to combine a business involving OTC derivative
instruments that are securities -- which would subject them to
full regulation as a broker-dealer -- with an OTC derivatives
business involving instruments that are not securities.  This
responds to the current concern that firms are placing their non-
securities derivatives activities in separate, unregistered
affiliates, and conducting some securities derivatives activities
from abroad, due to the costs of broker-dealer regulation.
In proposing rules for a limited class of broker-dealers,
the Commission recognized that, in some instances, fragmenting a
firm's OTC derivatives business may hinder the firm's ability to
manage risk and compete for business.  If adopted, the proposed
rules would provide U.S. securities firms with greater
flexibility in structuring their OTC derivatives activities by
allowing them to conduct transactions involving both securities
and non-securities OTC derivative products through one entity.
It should be emphasized here that flexibility is the goal.  The
proposed exemption would reduce, rather than increase, the
regulatory impediments to doing business.  Furthermore, under the
SEC's proposal, registration as an OTC derivatives dealer would
be optional.  No firm would be required to change its current
business organization or to conduct its activities in a
registered OTC derivatives dealer.
The Commission's proposal for OTC derivatives dealers is
intended to promote market development and innovation.  As noted
earlier, the OTC derivatives market has grown substantially in
recent years, and this growth is indicative of the strength and
vitality of U.S. capital markets.  In contrast, conclusions drawn
from the CFTC's concept release raise concerns regarding legal
uncertainty for OTC derivative instruments and the imposition of
new regulatory costs.  These concerns may stifle innovation or
push it offshore.  In response, legislation to provide legal
certainty to participants in the OTC derivatives market is
needed.
The Working Group's Legislative Proposal
As stated earlier, the growth in the OTC derivatives market
has resulted, in part, from the careful consideration of market
issues and consensus building among financial regulators.  To
address the legal certainty concerns raised by the CFTC's concept
release, Secretary Rubin, Chairman Greenspan, and Chairman Levitt
have requested a temporary legislative response to provide
Congress and the regulatory community time to consider the
important public policy issues raised by activities in this
market.[10]  We recognized the seriousness of this request, but
felt it was necessary to prevent any perception that the U.S.
regulatory system imposes an unreasonable amount of legal
uncertainty on transactions in the OTC derivatives market, and to
avoid litigation that could increase this uncertainty.
In particular, the requested legislation would require the
members of the President's Working Group to study the OTC
derivatives market to evaluate whether any additional safeguards
are warranted.  The scope of the study would be OTC derivative
instruments, including swap agreements, and hybrid instruments.
Following completion of the study, the President's Working Group
would develop recommendations, as may be appropriate, for changes
in statutes, regulations, and policies to improve operation of
this market and to enhance legal certainty for swap agreements
and hybrid instruments.  The legislation would require the
President's Working Group to submit a report to Congress
describing the study and setting forth any recommendations.
Because of the importance of legal certainty to market
participants, the legislation would also maintain the regulatory
status quo by imposing a temporary moratorium on the CFTC's
ability to restrict its current exemptions for hybrid instruments
and swap agreements.  More specifically, the legislation would
require that prior to the enactment of legislation reauthorizing
the CFTC, the CFTC would not be permitted to promulgate any
proposed or final rule, regulation, or order -- or issue any
interpretive or policy statement -- restricting or regulating
activity in any hybrid instrument or swap agreement currently
eligible for exemption under the CFTC's regulations.  The
legislation would also provide legal certainty to derivatives
based on non-exempt securities.
In short, the CFTC's concept release raises important policy
questions that should not be addressed by the CFTC alone, but
rather require the attention of Congress, members of the
financial regulatory community, and interested industry
participants.  The OTC derivatives market is a rapidly growing
and extremely vital global market that crosses jurisdictional
boundaries among the regulatory community.  The legislative
proposal put forward by Secretary Rubin, Chairman Greenspan, and
Chairman Levitt recognizes the need to protect the market from
unreasonable and potentially harmful legal uncertainty, while
also providing the time needed to allow the President's Working
Group to study the issues raised by activities in the OTC
derivatives market and to develop, as a group, appropriate
recommendations to Congress.
The Commission appreciates the opportunity to offer its
perspectives on the OTC derivatives market, and to re-emphasize
its serious concerns with the CFTC's concept release and the
potential harmful consequences that the concept release could
have on this market.  The President's Working Group should be
provided with the opportunity to carefully study the OTC
derivatives market and to analyze the need for any additional
regulatory action.  The Commission and its staff welcome any
questions on these issues that the Subcommittee may have, and
look forward to continued discussions with the Subcommittee, the
President's Working Group, and industry representatives on these
important issues.
**FOOTNOTES**
[1]: See, e.g., Derivatives Policy Group, Framework for Voluntary
Oversight (Mar. 1995).  The Derivatives Policy Group was
comprised of principals representing six major U.S. securities
firms, specifically, CS First Boston, Goldman Sachs, Morgan
Stanley, Merrill Lynch, Salomon Brothers, and Lehman Brothers.
[2]: Commodity Futures Trading Commission, Concept Release on
Over-the-Counter Derivatives, 63 FR 26114 (May 12, 1998).
[3]: Joint Statement by Treasury Secretary Robert E. Rubin,
Federal Reserve Board Chairman Alan Greenspan and Securities and
Exchange Commission Chairman Arthur Levitt, dated May 7, 1998.
[4]: Letter dated Jan. 4, 1993 from Jonathan G. Katz, Secretary,
SEC, to Jean A. Webb, Secretary, CFTC, commenting on CFTC
proposed rules regarding the regulation of swaps and hybrid
instruments.
[5]: P.L. No. 102-546; 106 Stat. 3590 (1992).  Using the
exemptive authority granted to it under the Futures Trading
Practices Act of 1992, the CFTC promulgated rules under Part 35
of its regulations exempting certain swap transactions from the
provisions of the CEA, other than provisions prohibiting fraud
and manipulation.  17 C.F.R. Part 35.
[6]: H.R. Rep. No. 102-978, 102d Cong., 2d Sess. 81 (1992).
[7]: 17 C.F.R. Part 34.
[8]: In 1996, the 104th Congress completed a review of the
federal securities laws and enacted the National Securities
Markets Improvement Act of 1996 (P.L. 104-290; 110 Stat. 3416
(1996)), which granted the SEC broader exemptive authority,
giving it the necessary flexibility to better address changing
market conditions.
[9]: Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940
(Dec. 30, 1997).
[10]: See Letter dated June 5, 1998 to The Honorable Newt
Gingrich, Speaker, U.S. House of Representatives, from Robert E.
Rubin, Secretary, Department of the Treasury, Alan Greenspan,
Chairman, Board of Governors of the Federal Reserve System, and
Arthur Levitt, Chairman, Securities and Exchange Commission.