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34–134 PDF 2007

S. HRG. 109–839

GROWTH AND DEVELOPMENT

OF THE DERIVATIVES MARKET

HEARING

BEFORE THE

SUBCOMMITTEE ON 

INTERNATIONAL TRADE AND FINANCE

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

EXAMINATION OF THE GROWTH AND DEVELOPMENT OF THE DERIVATIVES MARKET, FOCUSING ON THE ROLE OF DERIVATIVES AS A 

PART OF RISK MANAGEMENT FOR CORPORATIONS AND FINANCIAL 

ENTITIES

OCTOBER 18, 2005

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/senate/senate05sh.html 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

RICK SANTORUM, Pennsylvania 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

PAUL S. SARBANES, Maryland 

CHRISTOPHER J. DODD, Connecticut 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

DEBBIE STABENOW, Michigan 

JON S. CORZINE, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel 

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel 

MARK OESTERLE, Counsel 

JUSTIN DALY, Counsel 

ALEX STERNHELL, Democratic Professional Staff 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

GEORGE E. WHITTLE, Editor

SUBCOMMITTEE ON INTERNATIONAL TRADE AND FINANCE

MIKE CRAPO, Idaho, Chairman 

EVAN BAYH, Indiana, Ranking Member 

CHUCK HAGEL, Nebraska 

MICHAEL B. ENZI, Wyoming 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

TIM JOHNSON, South Dakota 

JON S. CORZINE, New Jersey

GREGG RICHARD, Staff Director 

CATHERINE CRUZ WOJTASIK, Democratic Staff Director

(II)

CONTENTS

TUESDAY, OCTOBER 18, 2005

Page

Opening statement of Senator Crapo ..................................................................... 1

WITNESSES 

James Newsome, President, New York Mercantile Exchange, Inc. .................... 3

Prepared statement .......................................................................................... 24

Joseph P. Bauman, CEO, JB Risk Consulting, LLC ............................................ 5

Prepared statement .......................................................................................... 27

Paul Bennett, Senior Vice President and Chief Economist, New York Stock 

Exchange ............................................................................................................... 7

Prepared statement .......................................................................................... 30

Charles Smithson, Managing Partner, Rutter Associates LLC ........................... 8

Prepared statement .......................................................................................... 33

(III)

(1)

GROWTH AND DEVELOPMENT 

OF THE DERIVATIVES MARKET 

TUESDAY, OCTOBER 18, 2005

U.S. SENATE, SUBCOMMITTEE ON INTERNATIONAL TRADE AND FINANCE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Subcommittee met at 2:30 p.m., in room SD–538, Dirksen 

Senate Office Building, Senator Mike Crapo (Chairman of the Subcommittee) presiding. 

OPENING STATEMENT OF SENATOR MIKE CRAPO 

Senator CRAPO. The hearing will come to order. 

This afternoon, the Subcommittee on International Trade and Finance will examine the growth and development of derivatives 

markets. 

Derivatives have come to play an extremely important role in our 

financial system and our economy. As Chairman Alan Greenspan 

has said, ‘‘derivatives have especially contributed, particularly over 

the past couple of stressful years, to the development of a far more 

flexible, efficient, and resilient financial system than existed just a 

quarter-century ago.’’ Over the last three decades, the use of derivatives has grown rapidly. Some estimates of the current size of 

the market for derivatives exceed $200 trillion, an amount based 

on ‘‘notional value’’ or the underlying amount of all derivatives contracts, which is more than 100 times what it was 30 years ago. 

Congress played a role in the growth of this important market by 

first regulating commodity futures, then securities, including options on securities, and finally clarifying the law to allow the 

growth of newer and more complex OTC derivatives. 

The more common types of derivatives include: Forwards, futures, options, swaps, caps, collars, and swaptions to name a few. 

And I am not going to profess that I am capable of discussing those 

at a high level of sophistication, although I have had occasion, over 

the past few years, as we have battled out some of the issues 

around here, to dig into just how derivatives are utilized in the 

market. And that is the purpose of this hearing as well. Some are 

traded over-the-counter, such as forwards and swaps. Some types 

are traded both on and off exchange. Some products are regulated, 

such as commodity futures and securities options. Some are not 

regulated, such as the OTC interest rate swaps. Dealers and customers may be regulated or unregulated. Both institutions and persons may trade derivatives, through the OTC markets tend to be 

institutional. 

2

What all derivatives have in common, no matter what the label, 

how they are traded, or who regulates the trading, is that they are 

instruments designed to manage risk, allocating it to investors 

most able and willing to take it. Companies of all sizes use derivatives to manage all kinds of risk. Individuals use their derivatives 

primarily through options and futures exchanges. Financial institutions are major users of both exchange-traded and OTC derivatives. 

Energy companies, farmers, and hedge funds also represent some 

of the many diverse users of this multifaceted financial tool. 

Airlines may hedge a risk on jet fuel, and manufacturers may 

hedge a risk of the price of their raw materials going up. And there 

is no end to the list of those who use derivatives. 

One of the reasons for the growth of the derivatives market was 

the careful balance that was struck by the Commodity Futures 

Modernization Act of 2000, or what we all call the CFMA. Last 

month, the Banking Committee discussed issues relating to the 

pending reauthorization from 12 witnesses, including representatives from the agencies that make up the President’s Working 

Group on Financial Markets. It is critical that we not undo the excellent work that was based largely on the President’s Working 

Group back in 1999. 

The United States has been a leader in the innovation and 

growth of derivatives, and American businesses were among the 

earliest to benefit from these important management tools. We are 

fortunate to have a group of experts with us today who are going 

to help us understand first the growth of the derivatives market 

and their role in the U.S. economy; second, the regulatory developments and the role of market discipline; and, third, how historically 

agriculture commodity markets became the centers of financial 

product trading. 

Our witnesses today include James E. Newsome, who is the 

President of the New York Mercantile Exchange. Previously, Dr. 

Newsome served as the Chairman of the Commodity Futures Trading Commission from 2001 to 2004. In addition to his responsibilities at the CFTC, Dr. Newsome served as a Member of the President’s Working Group on Financial Markets, and he was serving 

along with the Secretary of the Treasury, the Chairman of the Federal Reserve Board, and the Chairman of the SEC. 

We also have Joseph P. Bauman, who is the CEO of JB Risk 

Consulting. Mr. Bauman has been in the derivatives business for 

20 years. He served as the Chairman of ISDA from 1993 to 1994 

and was a Member of ISDA’s Board of Directors from 1989 through 

1999. Mr. Bauman is also a founding Director of the International 

Association of Financial Engineers. He received his B.A. from Rutgers University and M.P.A. from the Wharton School of the University of Pennsylvania. 

Paul Bennett, who is also with us, is the Chief Economist and 

Senior Vice President of the New York Stock Exchange. Prior to 

joining the New York Stock Exchange in 2001, Dr. Bennett served 

for over 22 years in a variety of research and operational positions 

at the Federal Reserve Bank of New York. He holds a Ph.D. in economics from Princeton University and an A.B. in economics from 

the University of Chicago. 

3

And, finally, we have with us Charles Smithson, who is the Managing Partner of Rutter Associates. Dr. Smithson taught economics 

at Texas A&M University and is the author of numerous articles 

in professional and academic journals. Mr. Smithson is best known 

as the originator of the ‘‘building block approach’’ to financial products. He is the author of five books, including the best-selling text 

‘‘Managing Financial Risk and Credit Portfolio Management.’’ Mr. 

Smithson served as a member of the working group for the Group 

of Thirty Global Derivatives Project, the output of which is often 

referred to as ‘‘Sound Practices for Derivatives.’’

I want to thank each of you who will be here this afternoon testifying, and we look forward to your testimony and the help that you 

will give us on this Committee. I assume you have all been given 

the instructions. We like to ask you to try to keep your presentations to about 5 minutes, but as you can see, we are not going 

to have a full array of questioning from the Senators here. I think 

we do expect some to make it. But with the reconciliation battles 

going on and all the other fights going on right now in Congress, 

this is my fifth hearing today, and I think I am probably one of 

those with a smaller number. So what I am getting at is we may 

have time for you to slop over a little bit in your time. Now, that 

does not mean I want you to get carried away. So, I would like you 

to try to keep it to around 5 minutes, but if you are not done right 

at 5 minutes, I will give you a couple of minutes to finish up rather 

than cutting you right off like I usually do. 

With that, why do not we start in the order I announced you, 

and, Dr. Newsome, you can begin. 

STATEMENT OF JAMES NEWSOME

PRESIDENT, NEW YORK MERCANTILE EXCHANGE, INC. 

Mr. NEWSOME. Thank you, Mr. Chairman. The New York Mercantile Exchange is the world’s largest forum for trading and clearing physical-commodity-based futures contracts, including energy 

and metals products. We have been in the business for 135 years 

and are a federally chartered marketplace, fully regulated by the 

Commodity Futures Trading Commission. 

Futures markets provide important economic benefits. NYMEX 

energy futures are highly liquid and transparent, representing the 

views and expectations of a wide variety of participants from every 

sector of the energy marketplace. As derivatives of cash markets, 

they reflect cash market prices and as a result are used as a hedging and price discovery vehicle around the globe. The price agreed 

upon for sale of any futures contract trade is immediately transmitted to the Exchange’s electronic price reporting system and to 

the news wires and information vendors who inform the world of 

accurate futures prices. In addition to continuously reporting prices 

during the trading session, NYMEX reports trading volume and 

open interest daily and deliveries against the futures contracts 

monthly. Transparent, fair, and orderly markets are critical to the 

NYMEX’s success as the most reliable hedging vehicle for physical 

transactions and financially settled over-the-counter transactions. 

The Commodity Futures Modernization Act of 2000 was landmark Federal legislation that provided legal certainty, regulatory 

streamlining, flexibility, and modernization to U.S. futures and deVerDate 0ct 09 2002 22:13 Apr 02, 2007 Jkt 000000 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 S:\DOCS\34134.TXT SBANK4 PsN: KEVIN
4

rivatives markets. It provided a reasonable, workable, and effective 

oversight regime for the regulated exchanges, while enhancing the 

abilities of exchanges to compete in a rapidly changing global business environment. Product innovation such as new platforms for 

trading futures and clearing OTC products are a direct result of 

the ability to respond to constantly changing industry demands. 

Market participants have benefited from more useful risk management tools, better use of technology, greater liquidity, more efficient pricing, and better customer service. Trading facilities have 

been able to provide more alternatives in trading platforms, products, and business models. 

The CFMA, contrary to some beliefs, did not diminish the regulatory oversight responsibilities of the CFTC. All exchange actions 

remain subject to CFTC review and oversight and enforcement action. It remains the CFTC’s responsibility to assure that all futures 

exchanges are enforcing their rules and remain in compliance with 

the core principles. As intended, the level of regulation established 

for designated contract markets is appropriate for the nature and 

participants of the markets. Therefore, the CFMA effectively ensures the market and financial integrity of regulated futures exchanges. 

Volatility and high prices in crude oil, natural gas, and gasoline 

futures contracts have triggered unwarranted criticism of NYMEX. 

While a significant amount of energy trading occurs in other forums, such as in the OTC market, on electronic facilities, and on 

exempt markets, NYMEX is targeted largely due to its highly liquid and transparent markets. A new bill passed in the House 2 

weeks ago calls for an investigation of NYMEX by the Federal 

Trade Commission. The General Accounting Office currently is 

studying the CFTC’s oversight of NYMEX, and there is consideration of yet another independent study of NYMEX in the context 

of CFTC reauthorization. Misinformation spread by groups who do 

not understand the futures markets has led certain Members of 

Congress to draft legislation that potentially would roll back many 

of the significant advancements achieved under the CFMA. Generally, supporters of the legislation mistakenly believe that the bill 

will limit volatility and reduce prices of natural gas. A number of 

proposals have been discussed that would apply only to NYMEX 

natural gas futures contracts, including: Artificial price limits on 

natural gas futures contracts; a price limit that triggers an investigation of the market by the CFTC; and prior CFTC approval for 

NYMEX rule changes that expand price limits beyond 8 percent of 

the prior day’s settlement price. 

Prices are market driven and must be allowed to find their true 

level consistent with market fundamentals. Artificial restrictions 

prevent futures markets from reflecting true market value and prevent the use of the market as a dependable hedge against price volatility. Without NYMEX or other exchanges as a price discovery 

market, conducting business in the cash market will be severely 

impaired. Higher costs to do business quickly translate into higher 

prices for consumers. 

The threat of investigative action each time a price limit is hit 

potentially would have a chilling effect on the markets. Moreover, 

and I think more importantly, the CFTC should have the flexibility 

5

to use its limited enforcement resources in the areas deemed most 

protective of the public interests. 

Finally, NYMEX does not believe that the rule amendment process established under the CFMA for futures exchange products, 

other than agricultural commodities, should be repealed for one 

commodity on one exchange. There is clear evidence that the selfcertification process has been a huge benefit to exchange growth 

and development without indications to date of regulatory risks. 

Derivatives markets contribute to the efficient allocation of resources in the economy because the price, which is derived through 

a highly liquid, transparent, and competitive market, influences 

production, storage, and consumption decisions. These markets 

touch many aspects of the U.S. and global economy and, therefore 

consequently, our lives. They can only effectively serve their economic purpose if they are allowed to trade and respond to market 

fundamentals without artificial restraints. 

I thank you, Mr. Chairman, for the opportunity to share the 

viewpoint of the New York Mercantile Exchange. 

Senator CRAPO. Thank you very much, Dr. Newsome. 

Mr. Bauman. 

STATEMENT OF JOSEPH P. BAUMAN

CEO, JB RISK CONSULTING, LLC 

Mr. BAUMAN. Thank you, Mr. Chairman. My name is Joseph 

Bauman, and I am honored to appear before the Subcommittee 

today. Throughout my career, I have been involved in the derivatives business and am currently a consultant to participants in the 

derivatives industry. In my career, I have worked for Chemical 

Bank, Citibank, and Bank of America, and I have also served as 

Chairman of the International Swaps and Derivatives Association, 

the global industry association that represents the privately negotiated industry, and was a Member of the ISDA Board for 10 years. 

Although this is my first testimony before this Subcommittee, I 

have testified previously on matters related to the derivatives market before other Congressional Committees and Subcommittees. 

In the many roles that I have played in the industry and in the 

several institutions for which I have worked, I have observed the 

phenomenal growth in the derivatives business. In my written remarks to the Subcommittee, I highlight the important role that the 

regulatory framework in the United States for swaps and other privately negotiated derivatives, with the components of market discipline and legal certainty, has played in that growth. 

In a way, market discipline and legal certainty are a check and 

balance on the effective functioning and growth of any market. In 

brief, market discipline provides an environment in which all parties to a transaction understand that they are accountable for both 

the profits and losses that result from their decisions, and legal 

certainty is the core principle by which participants to a transaction know that the terms of their agreement will be binding and 

enforceable under law. But it is the regulatory framework through 

which market discipline and legal certainty are reflected that could 

have the greatest impact on all market participants. 

In my remarks today, I would like to emphasize the need for this 

Subcommittee and other relevant Committees of Congress to enVerDate 0ct 09 2002 22:13 Apr 02, 2007 Jkt 000000 PO 00000 Frm 00009 Fmt 6633 Sfmt 6633 S:\DOCS\34134.TXT SBANK4 PsN: KEVIN
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sure that when it comes to a regulatory framework for the derivatives markets, the Congressional intent as embodied in critical provisions of the Commodity Futures Modernization Act, continue to 

be carried out. 

OTC derivatives are built on a foundation of bilateral, privately 

negotiated, contractual relationships. Anything that calls into question any piece of that foundation can have serious adverse effects 

on the willingness of parties to engage in transactions. From the 

enforceability of essential contractual provisions to the essential 

right of two parties to engage in derivative transactions, ISDA’s 

primary concern has been to ensure that when two parties agree 

to a transaction they have the certainty that their rights and obligations will be enforced. 

In the United States, a major focus of ISDA’s efforts for over 15 

years has been the recognition, confirmed in the Commodity Futures Modernization Act, that swaps are not appropriately regulated as futures under the Commodity Exchange Act. If swaps were 

futures, then swap transactions would be considered unenforceable 

as illegal, off-exchange futures. Throughout my tenure on the ISDA 

Board, which began at the time of the promulgation of the 1989 

swaps statement by the CFTC and ended just prior to enactment 

of the CFMA, the potential of a court determination that swaps for 

futures was a significant concern for the industry. The substantial 

growth of the business during that period was, in no small part, 

due to the consistent view of regulators, including the CFTC, and 

the intent of Congress, as embodied in the 1992 Futures Trading 

Practices Act, that swaps were not appropriately regulated as futures contracts. 

It is worth highlighting that the only action inconsistent with 

those longstanding policies was the issuances of a CFTC concept 

release in 1998 which raised questions about the possible need to 

regulate the OTC derivatives market. Congress acted promptly to 

prevent the CFTC from proceeding with that initiative and directed 

the President’s Working Group on Financial Markets to produce a 

report on OTC derivatives. That report, published in 1999, served 

as the basis for many achievements in the CFMA. 

But the experience of the 1998 CFTC concept release demonstrates that concerns about legal certainty are neither academic 

nor speculative. It is also instructive as an example of the need for 

Congress, regulators, and the industry to remain vigilant to ensure 

that Congressional intent continues to be carried out. 

The 5 years since the passage of the CFMA have proven the 

law’s wisdom. In those 5 years, privately negotiated derivatives 

have continues to thrive and product innovation has proceeded 

unabated. Even more importantly, thanks in no small part to derivatives, the markets have been able to withstand significant 

shocks to the financial system. The legal certainty provided by the 

CFMA has been an important part of this success. 

The CFMA provided broad exclusions and exemptions from provisions of the CEA for many different types of OTC derivative products. Recently, significant concerns have been raised within the financial community regarding developments that threaten to set 

back that progress. These concerns arose in testimony before the 

Senate Banking Committee, in a recent report of the Senate AgriVerDate 0ct 09 2002 22:13 Apr 02, 2007 Jkt 000000 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 S:\DOCS\34134.TXT SBANK4 PsN: KEVIN
7

culture Committee in connection with the CFTC reauthorization 

legislation, and in a recent judicial decision, specifically the case of 

CFTC v. Bradley. These have raised questions regarding the scope 

of the exemptions and exclusions for over-the-counter derivatives 

enacted in the CFMA, suggesting that the relevant exemptions and 

exclusions are somehow limited in scope to the underlying transactions and do not cover the persons engaged in those transactions 

or their related conduct and activities. 

This view, which is clearly contrary, we believe, to the CFMA, if 

unaddressed, could resurrect the very legal concerns that led to enactment of the CFMA. Steps by the Subcommittee to clarify this 

issue should be prominent in the Subcommittee’s consideration of 

CFTC reauthorization and related issues. 

I should also emphasize that the success of the CFMA is not limited to the legal certainty it provides to over-the-counter derivatives. By and large, the CFMA remains a crowning achievement of 

financial services law. By creating flexible rules for organized exchanges, providing legal certainty for sophisticated market participants, and encouraging the growth and development of new financial products, the CFMA has positioned the United States to remain a financial innovator for years to come. 

Thanks very much for allowing me to address the Subcommittee 

this afternoon. I appreciate your continued leadership in ensuring 

the legal certainty for privately negotiated transactions, and I look 

forward to answering any questions you may have. 

Senator CRAPO. Thank you very much, Mr. Bauman. 

Mr. Bennett. 

STATEMENT OF PAUL BENNETT

SENIOR VICE PRESIDENT AND CHIEF ECONOMIST,

NEW YORK STOCK EXCHANGE 

Mr. BENNETT. Thank you. I am Paul Bennett, Chief Economist 

of the New York Stock Exchange. On behalf of the NYSE and our 

Chief Executive John Thain, I want to thank you for inviting me 

to testify today before the Subcommittee. The NYSE greatly appreciates your leadership in overseeing the international aspects of our 

Nation’s evolving financial markets and the ability of U.S. companies to successfully and fairly compete on a global basis. The NYSE 

is both a nationally and internationally focused organization. We 

list the stocks of U.S. companies valued at $12 trillion, plus we also 

list the stocks of non-United States companies valued at $9 trillion 

in Asia, Europe, Africa, and Latin America. 

Because we compete with stock exchanges around the world, 

many of which trade a variety of products, including financial derivatives, we believe strongly that to service our customers competitively in this environment we need to continue to have well 

thought out and effective regulation in the United States. This implies, among other things, regulatory parity between cash and derivatives markets, including an intelligent policy of portfolio margin requirements for a full range of instruments. 

Servicing our customers is also the driving force behind our new 

hybrid market which will give a greater range of choices about how 

to trade stocks than is offered by any other equity market in the 

world. In addition, our planned merger with Arca will provide our 

8

customers with another choice of trading platform, an opportunity 

to trade options in addition to cash equities, and the ability to expand the range of business activities we pursue as a newly public 

company, both domestically and internationally. 

Thank you. 

Senator CRAPO. Thank you very much, Mr. Bennett. 

Dr. Smithson. 

STATEMENT OF CHARLES SMITHSON

MANAGING PARTNER, RUTTER ASSOCIATES LLC 

Mr. SMITHSON. Chairman Crapo, thank you for the opportunity 

to testify about a market that is crucial to both industrial firms 

and financial institutions, but one that is widely misunderstood. 

Over the more than 20 years I have been involved in derivatives 

and risk management, I have been collecting empirical evidence 

generated by my academic colleagues on the impact of derivatives 

on the markets and on the firms that use them. The best way I 

know to share that evidence with you is through the answers to 

four important questions. 

The first question is: What happens to the volatility of financial 

prices when derivatives appear? I sometimes hear it said that the 

introduction of derivatives leads to increased price volatility. While 

the story has a ring of plausibility, the empirical evidence does not 

bear it out. The 39 academic studies on this topic that I was able 

to find indicate that the introduction of derivatives reduces price 

volatility in the underlying markets. 

Question two: What happens to the bid-ask spread and trading 

volume for the underlying assets? The academic studies indicate 

that the bid-ask spreads in the underlying markets decline after 

the introduction of derivatives and that the introduction of derivatives is associated with either no change or an increase in trading 

volumes in the underlying markets. 

Question three, shifting from the markets to the firms that use 

them: If a firm uses risk management, does the market regard the 

firm as being less risky? If a publicly traded firm is exposed to financial price risk, the returns to that firm’s equity would be

sensitive to changes in interest rates, foreign exchange rates, or 

commodity prices. Consequently, question number three could be 

rephrased as: If such a firm uses derivatives to manage one or 

more of those risks, do the exposures decline? 

As we reported in a recent article, Professor Simkins of Oklahoma State Univeristy and I found 15 studies that examined this 

question—6 focused on financial institutions and 9 focused on industrial companies. Overwhelmingly, the studies indicated that the 

use of risk management led to a decrease in the perceived riskiness 

of the firm. 

Finally, we are to the payoff question, question four: What impact does the use of derivatives have on the value of the firm? This 

is the newest question to get examined by our academic colleagues. 

So far, there are only 10 studies, the oldest of which was published 

in 2001. Six of the studies examined the impact of managing interest rates and foreign exchange rates. The other four examined commodity price risk management, with one looking at commodity 

users and the others looking at commodity producers. 

9

What do they say? Managing interest rate and foreign exchange 

rate risk with derivatives is associated with higher firm values. 

Similarly, the study of commodity price risk management by commodity users found that fuel price hedging by airlines is associated 

with higher firm values. The three studies that looked at commodity price risk management by commodity producers found either no effect or a negative effect on equity values, which suggests 

that investors buy the equity of these commodity producers to gain 

exposure to the commodity price and, therefore, would not reward 

the firm for reducing that exposure. 

I believe the answers to the four questions are important enough 

that they bear repeating. 

Number one, the introduction of derivatives reduces price volatility. 

Number two, the introduction of derivatives decreases bid-ask 

spreads and does not reduce volume in the underlying markets. 

Number three, firms that use risk management are perceived by 

the market to be less risky. 

Number four, the use of derivatives to manage interest rate risk, 

foreign exchange rate risk, and commodity price risk by commodity 

users is rewarded by the market with higher values. 

Derivatives have dramatically reduced the cost of transferring 

risk to market participants who have a comparative advantage in 

bearing them; that is, from individual firms to well-diversified institutional investors. 

Derivatives are often described as a ‘‘zero sum game,’’ and they 

are. But even though one party’s gain is another’s loss in an individual transaction, the more efficient risk sharing afforded by derivatives reduced total risk for all market participants. 

In order for derivatives to deliver the benefits that they are capable of providing, there must be a high degree of certainty as to 

their enforceability and their regulatory treatment. Congress made 

extraordinary progress in ensuring such certainty in 2000 with the 

enactment of the CFMA. The growth in the depth and breadth of 

the derivatives since 2000 is a testament to the importance of legal 

certainty and the success of Congress’ efforts. 

Mr. Chairman, thank you again for the opportunity to testify. As 

I began, I indicated that derivatives are widely misunderstood. 

Your Subcommittee is making progress toward removing those misunderstandings. 

Senator CRAPO. Thank you very much, Dr. Smithson, and to the 

entire panel, I want to thank you. 

When I was elected to Congress, I did not know I was going to 

eventually become—I was going to say ‘‘an expert.’’ I am nowhere 

close to being an expert on derivatives, but become thrown into the 

business of learning about derivatives, because they are so important to our markets. I can still remember the first floor debate that 

we had on a critical battle we had over how to manage derivatives 

and how to regulate derivatives. And the training that I had tried 

to put myself through to even just talk lucidly about derivatives on 

the floor of the Senate was somewhat foreboding. I imagine it was 

like what Harriet Miers might be trying to go through right now 

to get ready to go before the Judiciary Committee. 

10

But my point is that when this issue first started becoming 

prominent just in the last couple of years—I know it was very 

prominent back in the late 1990’s as the President’s Working 

Group was working on it, but the public did not really pay a lot 

of attention to that. That was below the surface. After Enron and 

some of the other circumstances where derivatives were blamed as 

a part of the problem, it started to get more public attention. And 

as that developed, it became very evident to me that not only I and 

other Members of Congress but that the public in general needs to 

start learning a lot more about what derivatives are and how they 

work. 

The first time I asked Alan Greenspan a question about it to explain derivatives, he was in his gentlemanly way very succinct. He 

just said, ‘‘Senator, I could probably go on a long time trying to answer that question, but the easiest way to think about it is that 

it is a way that markets allocate risk from those who can bear it 

least to those who can bear it most if they work efficiently.’’ And 

it may be that that is how I am going to have to—that one level 

I have gotten internalized. It may be that I will have to just stick 

at that level of understanding, but I think that I and the rest of 

us can get a much better understanding, and we certainly need to 

as we go forward with this issue. 

To help a little bit on that, I would like to have the first part 

of our discussion just focus on kind of explanations of how derivatives work, and maybe I would ask each of you just in your own 

mind to maybe come up with an example of how a derivative could 

be used to manage a risk. And feel free to discuss this whole question in a little more broad terms than that if you want to in your 

answer, but could you each just by way of example help share with 

me how derivatives work? Do you want to start out, Dr. Newsome? 

Mr. NEWSOME. I would be more than glad to, Mr. Chairman. I 

will use an example from the energy sector, and Dr. Smithson 

made a comment about the airline industry and hedging the risk 

with regard to fuel prices. 

There was an article in Time magazine maybe 2 months ago that 

analyzed a number of the airlines, those who were using derivatives contracts to manage risk and those who were not. And I think 

it is a pure example of placing a hedge to create a floor for a price 

into the future. 

Southwest hedged 85 percent of their fuel costs and had a price 

per barrel locked in at $26. They had a breakeven price per barrel 

at $65.30. 

On the other side of the spectrum, you have Delta, who hedges 

0 percent of their fuel. Prices at the time were $50 a barrel, so they 

had a breakeven price per barrel of $13.80. So, I think that is a 

pretty real-life example of how companies can use these markets 

to hedge risk. 

Senator CRAPO. I read that same article, and the analysts, if I 

remember the article, were saying that you could buy Southwest 

stock safely—they were giving it a ‘‘buy’’ ranking. But they were 

not giving that to very many other airlines. And basically, if I understand it right, that is because Southwest was able to use—well, 

tell me, what did Southwest do? 

11

Mr. NEWSOME. I think when you look at particularly today’s industry, where you have volatility in the energy markets and you 

have people complain about the level of volatility and the higher 

prices, the reality of the business is that the exchanges and other 

instruments are there to protect customers against the very price 

volatility that they are complaining about. So, I think this is a perfect example of Southwest having the feeling that fuel prices were 

probably going to go higher because of the political volatility in the 

Middle East, uncertainty in Venezuela, and other energy-producing 

areas, and the recognition that energy markets have become global. 

What happens in corners of the world does have a dramatic impact 

on energy prices here. Southwest saw the opportunity to lock in 

what they thought was a fair price with an upward trending market and certainly have benefited because of that now. 

Senator CRAPO. And now somebody is losing in that transaction, 

if Southwest is buying gas at $26 a barrel. 

Mr. NEWSOME. Yes. 

Senator CRAPO. Where is that playing out in the market? 

Mr. NEWSOME. As I think Dr. Smithson said, again, it is a zero 

sum game, so for every winner there is an equal and offsetting 

loser. But typically, as you would see a bank take the opposite position of, say, a Southwest Airline, then they would enter into other 

transactions to spread their risk. So, I think that is what Chairman Greenspan was referring to, when the risk gets allocated 

among those who are better able to stand it. 

Senator CRAPO. Thank you. 

Mr. Bauman, do you want to weigh in? 

Mr. BAUMAN. I will take it back to my banking experience in the 

sense that banks around the country—and this is not the large 

banks, this is the thousands of community and even savings 

banks—generally are characterized by bearing interest rate risk in 

their activities. They generally are raising funds, paying depositors 

on the long-term basis, and maybe lending money on a short-term 

basis, meaning their interest rates that they will receive will vary 

over time. And that leaves them imbalanced and open to the risk 

of their income shrinking significantly if that interest rate gap reduces or reverses, and certainly if that occurs, it impinges on what 

those banks could do going forward with their customers. 

The interest rate swap market allows those banks to equalize 

to—as you started off this hearing pointing out, using these products as a risk management tool allows the banks to smooth out 

their imbalances and their interest rate exposures. And to the 

point of where that risk goes, there are certainly many corporations 

that are looking at essentially making investments in fixed cost 

plant and equipment, fixed cost assets, but borrow to produce those 

assets on a short-term basis from the point of interest rate exposure, and they too could benefit or be hurt by a change in that relationship. Their way of managing that risk is to try and eliminate 

it, and therefore, they have the opposite interest of many of the 

banks. And it is the matching of those two interests that the derivatives market facilitates. 

Senator CRAPO. Thank you. 

Mr. Bennett. 

12

Mr. BENNETT. Let me give you an example from the equities 

market. If I were a money manager managing a portfolio of equities on behalf of customers, and I received perhaps unexpectedly 

some cash to invest, if I had no derivative type instruments available to me, then I would either be sitting there with cash with the 

risk that the market would move up before I had a chance to invest 

it, which would harm my customers, or alternatively, I would have 

to try and hurry up and pick stocks very fast, faster than I was 

comfortable with, which would create an allocation of capital which 

was not optimal. 

By being able to hedge the cash with index futures, being long 

on index futures, that hedges me against fluctuations in the overall 

market, and then I can take a little bit more time and make a little 

bit more of a thoughtful selection of stocks to invest. I would still 

have risk in terms of how each of those stocks performs relative to 

the index while I am making the investments, and I also have to 

manage the purchase of those stocks in an orderly way. 

However, in a fundamental way in terms of the broader market 

risk, it hedges me against that and allows me to make a more efficient set of decisions. 

Senator CRAPO. Thank you. 

Dr. Smithson. 

Mr. SMITHSON. Given that we have talked about managing commodity price risk, interest rate risk, and equity risk, I probably 

should talk about foreign exchange risk management. Instead, I 

am going to shift to a different dimension from those we talked 

about so far—asset liability managements or managing the ongoing 

operation of firm. Another place where firms find derivatives and 

risk management practices to be useful is in getting access to 

funds. 

My second favorite debt issue, of all I have ever seen, was issued 

in the late 1980’s by Magma Copper Company. Magma was a new 

organization. They needed to borrow $200 million; but they knew 

that, if they issued a straight bond, nobody was going to buy it. 

The reason nobody was going to buy it is because everybody knew 

that they were making a ‘‘copper play’’: If copper prices went up, 

Magma would pay the coupon; if copper prices went down, Magma 

was going to tell you where ‘‘they left the keys’’—they were going 

to default. And so a straight bond was not going to work. 

What Magma did was issue ‘‘copper interest index debt.’’ What 

that means is that the coupon floated but, it did not float with 

LIBOR, it floated with the price of copper. If copper prices moved 

higher, Magma paid a higher coupon. If copper prices fell, the coupon went down. 

What Magma had done was use options. They had sold options 

as a paying way of part of the coupon on the debt. 

Everybody won on that issue. Magma’s management credited 

that bond with getting them the breathing room that they needed 

to get the mine refitted and working. The investors won. I used to 

try to check the price on that bond and never could really get very 

firm quotes on it, because it went into investment portfolios and 

stayed. The investors liked it; and they kept it. As a matter of fact, 

when I said that Magma would have had trouble raising the $200 

million with a straight bond, this ‘‘copper interest indexed’’ bond 

13

was oversubscribed when it was issued. And the shareholders won. 

It turned out that Magma got their house in order—got that mine 

in Arizona working well. It was eventually bought by Broken Hill 

Properties, and I think the shareholders are still smiling about the 

price they received. 

Senator CRAPO. Thank you. I think all of those examples are very 

good, and I note from the examples that—well, first of all, I think 

we all know that—you probably know if I am right about this, but 

it seems that agriculture was where all of this started, is that 

right? And we did not have an agriculture example, but that is obviously one area where it is a big issue. 

Dr. Smithson, you talked about metals. We have had energy, interest rates, equities, cash. Is there any commodity or industry in 

which derivatives are not now a very significant part of the industry? Can you think of any? 

Mr. BAUMAN. I do not think so, Senator. I think that derivatives 

are used in one context or another by all aspects, all industries. 

Senator CRAPO. Just economy wide. I do not know why, it was 

hard for me to get my head around trading interest rates, but 

when I realized that it had expanded to the point where literally 

exchange rates, cash, interest rates, whatever, that these types of 

transactions could work in those arenas, it became evident to me 

that it could work anywhere. And it is working virtually everywhere. Would that be accurate? 

Mr. NEWSOME. Yes. 

Mr. BAUMAN. Correct. 

Mr. BENNETT. Yes. 

Mr. SMITHSON. Yes. 

Senator CRAPO. I would like to ask each of you if you agree with 

this. Again, back when we were having the Enron—in fact, I want 

to speak specifically about Enron. In fact, when the Enron debacle 

occurred, Enron used derivatives, as I think does virtually every 

major company these days. But some people were making the argument that Enron’s collapse was because of its use of derivatives. I 

disagree with that then, disagree with it now, and I do not know 

the extent to which any of you understand the details of what happened at Enron. 

But do any of you disagree with that, and could any of you comment more specifically about that? 

Dr. Newsome. 

Mr. NEWSOME. Mr. Chairman, I was involved in a lot of the 

Enron situation. 

Senator CRAPO. You were regulator at that time. 

Mr. NEWSOME. Yes. And I think it is important to look at not 

only Enron, but REFCO is a more current scenario. 

Senator CRAPO. Right. I was going to get to that, so go right 

ahead. 

Mr. NEWSOME. And in many instances the derivatives industry, 

just because the company is involved in certain aspects of trading 

derivatives, gets painted with a black brush, and that is certainly 

not the case. I think particularly if you look at REFCO, which we 

brought up, certainly there is one aspect of the legal entity of 

REFCO, Inc. that has filed for bankruptcy, but when you look at 

other segments, both regulated and nonregulated, the company, at 

14

least those in the regulated divisions, have operated within the 

guidelines of the law. REFCO, LLC, which is the registered FCM 

for REFCO, continues to be a member in good standing of all the 

major exchanges, continues to be not only properly capitalized, but 

also has excess revenue on hand at NYMEX. 

When you start looking at the problems there, you go back to accounting fraud, regardless of what business the company may have 

been in. But certainly, specifically to your question, I do not think 

there is any evidence whatsoever that points to Enron’s uses of derivatives as a cause to their collapse. 

Senator CRAPO. Thank you. As I indicated to you at the beginning, there are critical things going on all over the Capitol right 

now, and I have just been given an urgent message that I have to 

make a communication right now. So, I am going to have to recess 

the Committee for just 5 minutes, slip out and get on the phone, 

and I will be right back. I apologize for this. 

This Committee will stand in recess for 5 minutes. 

[Recess.] 

This hearing will come to order. I want to thank everybody very 

much for that brief recess. We are trying to put together the reconciliation bill for this Congress, and it is one tough deal, and I 

happened to just end up sitting on three Committees that are in 

critical postures right now. 

Before I left I had just raised the issue of Enron, and I appreciated your answer, Dr. Newsome. I do not expect that any of the 

others, necessarily, because Dr. Newsome was the regulator at the 

time. But do any of the others of you want to comment on the 

Enron situation? 

Mr. BAUMAN. Senator, the only additional comment I would add 

is maybe on the other side of the question is how the markets 

themselves were able to react to situations such as Enron, and 

there I would point to in my remarks focused on the CFMA and 

the strength of legal certainty that was provided by that Act. 

Even in an Enron situation, where a company is on the ropes, 

what the CFMA allowed is a very orderly understanding of market 

participants of what transactions, what exposures they had with 

that company that was in difficulty. And, really, the markets were 

able to absorb that much better than they could have or might 

have before the CFMA was enacted. 

Senator CRAPO. Mr. Bauman, you actually just led right in to 

what my next line of questioning was going to be. And the reason 

I brought up Enron was to kind of set the stage for a question that 

I asked back then to Chairman Greenspan at a hearing like this, 

where I asked him, about Enron, and then about derivatives. His 

response was that—in fact, this response I think was not only in 

the context of Enron but the stock market collapse and a lot of the 

economic downturn that we had seen in the turbulent times there. 

I do not recall if this was before or after September 11, but we 

had had a number of serious shocks to the economy and we were 

in a tailspin and were starting to stabilize and grow back. And 

Chairman Greenspan’s remark with regard to derivatives was that 

had we not had a strong, stable derivatives market and a good regulatory climate relating to it, that we would not have had as strong 

15

a build-back in the economy. We were able to stabilize quicker and 

recover better because of it. 

Any comment on that from the witnesses? 

Dr. Smithson. 

Mr. SMITHSON. I think the analogy that most comes to mind to 

me is to think about dropping a rock into a pond of water and 

watching the ripples as they hit the shore. If you can make the 

pond bigger, by the time the ripples get to the shore, they are 

smaller than they were. 

Senator CRAPO. Good example. 

Mr. SMITHSON. That is what derivatives do. They make the 

‘‘pond’’ bigger. 

Senator CRAPO. I appreciate that, because like I say, I think just 

in a very basic way we, as a public, need to begin understanding 

how derivatives work a little better because they are so significant, 

and because we are more and more getting into policy issues relating to how we manage and regulate—hopefully not overregulate—

these important parts of our economy. 

Many, if not all of you, have mentioned the CFMA. It is my opinion that in order—first of all, it is my opinion that the work that 

the President’s Working Group and then Congress, following the 

recommendations of it, did in passing the CFMA was extremely 

valuable, and actually helped to facilitate the strong growth in the 

utilization of derivatives. Anybody disagree with that on the panel? 

[No response.] 

Everybody seems to agree. It is also my belief that in order that 

we not undo the significant achievements of the CFMA, as we are 

now looking at its reauthorization, that the reauthorization should 

be very limited, and should be formulated to avoid creating barriers or undue burdens for legitimate business, undermining legal 

certainty or creating any unintended consequences. 

I would appreciate it if each of you would discuss with me, in 

your mind, are there issues outstanding with regard to the CFMA 

that we need to address? 

In one sense, I think that we could just have a straight reauthorization as is, but I think Mr. Bauman and some others, you may 

have raised some questions about some improvements, and certainly we want to look at the improvement, if we can, without creating any additional problems. 

So the question I have is what is the scope, what should we be 

looking at as we look a reauthorization of the CFMA? 

Dr. Newsome. 

Mr. NEWSOME. I will start first, Mr. Chairman, and admit to the 

Committee that I am somewhat biased in my view of the CFMA. 

Bill Rainer as Chairman of the CFTC at the time, had the opportunity to work with numerous committees to develop the legislation, and I had the honor of implementing the CFMA, and worked 

very closely with the Congress to make sure that we implemented 

the Act following the intent of the Congress. 

I think a couple of the primary segments of the CFMA have been 

brought out in earlier discussion. Certainly legal certainty for overthe-counter markets was a critical point of the CFMA. Flexibility 

for the exchanges to operate outside the old traditional regulatory 

box was also another important part. But clarifying the CFTC overVerDate 0ct 09 2002 22:13 Apr 02, 2007 Jkt 000000 PO 00000 Frm 00019 Fmt 6633 Sfmt 6633 S:\DOCS\34134.TXT SBANK4 PsN: KEVIN
16

sight of the off-exchange forex fraud was also an important part of 

the Act. 

I had the opportunity to utilize that authority very aggressively. 

I think during my tenure we brought actions against some 40 forex 

bucket shops, and even after I left, the Agency continued to use 

that authority aggressively. 

As I think everyone knows, a Federal court has thrown some uncertainty into whether or not the CFTC maintains that authority, 

and there has been a big discussion over how to clarify that authority to the Agency, and whether that authority should be expanded 

to go beyond forex. I have not been involved in a lot of those discussions that have been held by the Congress, but I do feel that clarifying the Agency’s authority over that type of fraud was important. 

Whether the Congress chooses to specifically look at that type of 

fraud and try to find a way to reclarify the Agency’s authority or 

whether it gets broadened, I guess is less important to me, but simply that without that kind of authority, you have some major fraud 

activity that is basically going to go unchallenged just because of 

resources by the Justice Department or others who do not have the 

expertise to dig in. 

So, I guess the only thing I would look at in terms of primary 

changes would be to make sure that we, if anything, enhance and 

strengthen the enforcement abilities of the Agency to go after those 

who are involved in fraud. 

Senator CRAPO. Thank you. 

Mr. Bauman, did you have any thoughts? 

Mr. BAUMAN. I guess the one thought I would have would be 

that—not that I see reason to change. I think that there is a very 

good bill there, and probably all other things being equal, I would 

not recommend any changes to it. 

But to the extent that we are seeing, either through policy or 

through court decisions, some either erosion around the edges of 

loosening of what were thought to be the standard set up by the 

CFMA and the legislative history behind it, the only changes I 

would see would be things that would close down those frayed 

edges, to make sure that legal certainty stays the goals of the system. 

Senator CRAPO. Thank you. 

Mr. Bennett. 

Mr. BENNETT. I agree. I think that the CFMA has set up a very 

productive and balanced regulatory process, and so at the most it 

would need to be just tweaked and looked at like any other piece 

of legislation. I think that the President’s Working Group, if there 

were going to be any changes, I would seek their advice on them 

because they were obviously very valuable in the initial legislation, 

and they have a very well-informed set of views. 

I think that on particular issues that are I think on the table 

now, the margin rules for single-stock futures, I think that it is important that they stay harmonized with the margin rules in the 

cash market, so that there is no inequality there. I also think that 

the portfolio margining is a very sound concept, and it is very 

workable, and I think it should be extended to the broader range 

of financial assets. 

17

Senator CRAPO. Thank you. I appreciate that very much and you 

may know, I also believe we have to be very careful to let the President’s Working Group do its job today and weigh in on these 

issues, and they are working on those issues. 

Dr. Smithson. 

Mr. SMITHSON. I defer to Dr. Newsome on the fraud aspects that 

he brought up. The aspect that keeps coming to mind for me is how 

well the Act has worked since 2000—it has been tested since 

2000—and how much effort went into getting us to this point. I 

guess I have to come back to the point that it would be marvelous 

to have a one-sentence reauthorization. 

Senator CRAPO. Thank you very much. 

One of the battlegrounds that I—I was going to say ‘‘I think.’’ I 

do not even need to think this, it is already developing. One of the 

developing battlegrounds is going to be energy, and with all of the 

recent market activity in both the cash and futures markets for energy commodities, crude oil, gasoline, and natural gas in particular, 

there are some who have suggested that narrow price limits be applied to futures markets as a way to decrease volatility. 

Now, that reminds me of one of your points, Dr. Smithson, that 

the derivatives can actually accomplish that on their own, but can 

you—and this is open to the panel—can you tell us what the likely 

effects of mandating a price limit for energies futures products 

would be, and probably for NYMEX. You might want to start out 

on that, Dr. Newsome. 

Mr. NEWSOME. Again, I would probably be a bit biased in my answer, so I will make a few comments and then turn it over to my 

colleagues. But I think putting on the old CFTC hat, the CFTC 

itself is not even supportive of narrow price limits. In fact, there 

are no Federal rules that require price limits. The only directive 

from the CFTC is that if the exchanges choose to use price limits, 

that they not set those price limits so tightly that it disallows the 

market to function and to operate. 

Certainly, from my personal standpoint, I am not a big proponent 

of price limits. I think that the role of the markets is to discover 

the true price, and if that is your goal, then you have to allow the 

markets the flexibility to move based upon fundamentals. 

I think the reality is, even if, say, the Congress chose to put tight 

price limits on contracts and NYMEX, that action will have no effect on energy volatility or energy prices. It will simply drive that 

activity to over-the-counter or to exempt markets to operate and to 

take place outside of the regulated exchange. 

Senator CRAPO. Thank you. Any other input on that? 

Mr. BAUMAN. I would certainly agree with Dr. Newsome’s comments, particularly the last part of it. I would analogize it to the 

balloon that you are squeezing in one sector, and it is going to expand out in another sector. Trading will either go offshore or to 

other markets or find other ways of being reflective of the true 

price. 

Mr. BENNETT. I agree with that except just to add a point, is that 

if there are certain types of transactions that really are more comfortable in the futures markets, if you put an abrupt end to the 

trading in those markets, it may actually generate more volatility 

than would have otherwise happened outside in the overall market 

18

and for the underlying market. And it depends on which commodity we are talking about. 

Senator CRAPO. Right. 

Dr. Smithson. 

Mr. SMITHSON. So far, I have told you about empirical evidence. 

There are some of my colleagues who do experimental economics, 

which is an interesting area. As they have told me about their experiment, and they have actually looked at what happens, when 

you try limits where prices could only move in a certain range during a certain period of time. It turns out that the price followed the 

same pattern that would have existed in their absence. 

What I am trying to say in a long-winded way is that the evidence, so far, is that they do not do a very good job. If anything, 

they kick a little extra volatility in instead of taking it out. 

Senator CRAPO. Thank you. Last month before the Banking Committee, the witnesses representing the agencies that make up the 

President’s Working Group, said that it was unnecessary to offer 

any kind of additional regulation of the energy and natural gas derivatives, as we look at reauthorization of the CFMA. How would 

you respond to those who think that we should expand the regulatory reach of the CFMA and extend and create additional regulation of energy and gas derivatives? 

Mr. NEWSOME. Mr. Chairman, I think those who are wanting to 

add layers of regulation, particularly in energy, are trying to do 

two things, and both are misguided. They are trying to decrease 

volatility and trying to decrease prices. All the proposals that have 

been laid on the table that I am aware of to this point would do 

neither. 

Senator CRAPO. Any disagreement? 

[No response.] 

Certainly, there are lots of people looking to try to figure out how 

to reduce the price of petroleum or gas products, but I tend to be 

one who believes—and I think your previous answers indicate 

this—that the price is going to be reached by a world economy, and 

neither this Congress, nor the CFTC is going to be able to dictate 

what the price of oil is going to be. We need to look to better energy 

policy maybe to deal with that issue. 

How do each of you—and I know Dr. Smithson’s answer here, 

but you are welcome to amplify on it—respond to the suggestion 

that the CFMA somehow contributes to price spikes and volatility 

in markets? There are those who are making that claim. 

Mr. NEWSOME. You know, sometimes when you have a comment 

that is made so off base, it is hard to come back with a logical explanation. I find myself in that situation now. I think when you 

look at the exchanges, you look at the CFMA, the CFTC, they are 

all price neutral. The goal is to provide the marketplace and the 

regulation around that marketplace to allow true prices to be discovered. So how anyone can say that the regulatory scheme adds 

volatility is beyond me. 

I would have to assume that they are referring to the Agency not 

creating position limits tight enough or price limits tight enough 

that it allows this volatility to take place, but we discussed that 

just a moment ago. 

19

Mr. BAUMAN. I was hesitating I think for many of the same reasons as Dr. Newsome. It is a hard idea to get one’s mind around 

from our side of the table. But maybe a practical example of why 

I hesitate on it is that for the last couple of years I have actually 

gotten close to the credit derivatives market, as opposed to the interest rate and currency markets of old. When I started, when I left 

working for the banks in 2000, there were what we would call 

maybe 15 individual credits that were actively quoted in the market. And if a bank wanted to hedge its risk against a specific credit 

exposure, it really had to search around for somebody who could 

provide them with that hedge, and prices were very far disbursed, 

not very visible, transparent, and few transactions were done. A 

good deal of that uncertainty related by the marketplace on what 

a credit derivative was in a legal context. 

With the CFMA making clear that credit derivatives fell into the 

regime of over-the-counter derivative contracts, the activity built 

up, the liquidity built up, many more names were quoted, bid offer 

spreads became narrower, and it became very easy for a bank to 

hedge its position in an individual credit. So just the opposite, I 

think actions such as the CFMA have contributed to the transparency and liquidity of the markets, and not made them more 

volatile as such. 

Senator CRAPO. Thank you. 

Mr. Bennett. 

Mr. BENNETT. I would agree with that assessment also. I think 

that these good rules help coordinate the markets, makes it much 

more likely that you are not going to have spikes and volatility for 

that particular reason. You will have volatility for other reasons, 

but I think you just have to say that it reduces the likelihood of 

spikes and excessive volatility. 

Senator CRAPO. Anything else, Dr. Smithson? 

Mr. SMITHSON. I think it has all been said. 

Senator CRAPO. I want to come back for a moment now to the 

REFCO case, and I do not expect that any or all of you will be experts on this, but to the extent that you do understand what has 

been happening with regard to REFCO, some of the press accounts 

regarding the recent events at REFCO have suggested that the unreported related transaction between REFCO’s CEO and its unregulated entity, REFCO Capital Markets, may have been more 

difficult to detect because over-the-counter derivatives trading is 

exempt from Federal regulation. I personally think that this is—

when we have problems like Enron or REFCO or some of these 

things, and they are engaging in derivatives transactions, which as 

we have indicated, any major company is going to be doing, and 

people do not quite understand what derivatives are, then all of a 

sudden they tend to become the culprit. 

It is important to note that this kind of trading is subject to very 

rigorous market discipline, and there is also the various antifraud 

aspects of the regulatory regime we have in place. 

But that having been said, the question I raise to you, to the extent that you may know enough about it to express an opinion, is, 

does the issue, failure to disclose between REFCO’s CEO and its 

trading entity, have anything to do with derivatives trading? 

20

Mr. NEWSOME. Not at all. In fact, we are talking about two separate legal entities within the umbrella of REFCO, REFCO, Incorporated, REFCO Capital Markets, versus REFCO, LLC, which was 

the futures commission merchant, or the regulated entity of the 

CFTC and of all the exchanges in which they traded. We have no 

indication that any of the fraudulent activity was related to overthe-counter markets, certainly not the futures markets, and that it 

looks like a serious case of accounting fraud. 

Senator CRAPO. We are not necessarily prejudging anything here, 

but let us say that the problem here is accounting fraud, which is 

what the early indications are. That is illegal already and heavily 

regulated, is it not? 

Mr. NEWSOME. Correct. 

Senator CRAPO. So the fact that the fraud occurred in an arena 

in which derivatives were being utilized does not mean that the derivatives caused the fraud or that there was anything with regard 

to derivatives regulations that would have changed it, am I correct? 

Mr. NEWSOME. I think not only are you correct, Mr. Chairman, 

but I also think there is argument to be made that the accounting 

fraud did not even occur within the derivatives regulated entity of 

REFCO, so even more separation. 

Senator CRAPO. We had the same point under Enron, if I remember correctly. When we ultimately got into the bottom of it, it was 

not even the derivatives which were at issue, although they were 

blamed. I just think it is important that we start getting into these 

kinds of things, because we are going to face these kinds of questions as we move forward. 

Another question: Have REFCO’s difficulties caused any broader 

disruptions in financial markets? 

Mr. NEWSOME. I will only speak specifically to NYMEX, and I 

would say that in terms of REFCO, LLC, the registered entity, that 

they currently are in a good member status standing as a member 

at NYMEX and all the other future exchanges, that they are not 

only appropriately margined, but they have excess capital on hand 

at the exchanges. So we have seen no activity in terms of REFCO, 

LLC or their trading that has created concern. 

I think the credibility issue of the parent company has created 

enough uncertainty that a number of their customers have started 

unwinding positions on the exchanges, a number of their customers 

have started leaving REFCO as their clearing member, transferring their accounts to other clearing members on the exchange, but 

all of those have occurred in a very orderly manner and certainly 

have had no negative impact on the markets themselves. 

Senator CRAPO. Any difference there? It seems to me that what 

you just described is a good example of market discipline helping 

to be a part of the ultimate resolution of these kinds of issues. 

Mr. NEWSOME. Correct. 

Senator CRAPO. Let me turn to the international situation. How 

best can we—this is a broad question, I just want to get a discussion going on the international context here. How best can we position the U.S. markets to compete internationally in the context of 

derivatives? That should be open-ended enough for you to jump in 

any way you want. 

21

Mr. NEWSOME. Certainly, the CFMA gave the CFTC the flexibility that it needed to embrace international companies to do business in the United States. We do not quite have the same amount 

of flexibility for U.S. companies trying to do business offshore. The 

NYMEX just opened a fully regulated entity in London to participate in the European marketplace. It was a matter of months before we received that regulatory approval. We are currently seeking 

approval in Dubai to develop a crude benchmark to openly and 

transparently trade Middle Eastern crude, and we have yet to experience that process, but certainly I can tell you it is not quite as 

easy going offshore as it is welcoming participants onshore. 

Mr. BAUMAN. I think there are probably two things, one of which 

we have talked a good deal about, which is legal certainty, which 

continues I think to be a reason for companies, for trading firms 

to look to trade in the United States under its legal regime. 

But one we have not talked too much about—I am sure any of 

us could—is innovation, and that we want to maintain an environment that encourages innovation in financial products, and that in 

and of itself is something that is a competitive tool for the U.S. 

economy to exercise. 

Senator CRAPO. Thank you. 

Mr. BENNETT. What I would add to that is that having a good 

regulatory environment in the United States and a level playing 

field is one very important thing. Also U.S. companies have to go 

out and expand aggressively globally. The stock exchange is in the 

middle of changing over our trading systems to our hybrid market 

to merging with Arca, and this will create a public company, and 

I think these will give us the tools to compete domestically much 

better, but also internationally, because the stock exchange business is becoming a lot more international as well, not only in trading stocks but also in trading various types of equity-linked derivatives or other derivatives. 

Senator CRAPO. Dr. Smithson. 

Mr. SMITHSON. Coming back to the question you posed—how 

could the U.S. markets be able to compete more effectively internationally? If you look back to see where we have been successful, 

you find that we have been successful as innovators, and so I echo 

what Joe Bauman just said: Make sure that nothing is done that 

blocks innovation, and that we keep in mind that the innovators 

should enjoy the fruits of that innovation. 

Senator CRAPO. Would it be fair to say that right now the United 

States is, as far as policy with regard to derivatives, that the 

United States is not over regulating to the extent that we are pushing derivatives business or businesses that are derivatives related 

out of the country or pushing them offshore? Is that fair to say, we 

have not overdone it? 

[All nod.] 

Senator CRAPO. Let me ask the other side of that. Is it fair to 

say that we have a better climate here? I mean are we at the cutting edge in the derivatives arena so that we are a desired place 

to do business globally? 

Mr. NEWSOME. I think that is exactly the case, Mr. Chairman. 

The CFMA was the right legislation at the right time. Not only did 

it create the environment for the flexibility that my colleagues at 

22

the table have mentioned, but it also created a regulatory environment in which global banks and global businesses want to do business. I mean we just signed on a clearing member that is one of 

the largest Japanese banks because they want to increase business 

in the United States. They want to do it as clearing member of exchanges. I think we are going to continue to see more and more of 

that type of activity. 

Senator CRAPO. Anybody else want to add anything there? 

I just have one more question, and again, it is going to be a 

broad open-ended question, maybe so broad that there is no answer 

to it. But the question is: Where do you see the derivatives market, 

the derivatives issue going in the next 4 or 5 years? Any prescient 

thoughts as to where you think we are headed with this? Feel free 

anybody to jump in if you would like. 

Mr. NEWSOME. I think it is a hard question to answer because 

probably 5 years ago, no one would have envisioned that the business would have exploded as much as it has during that time period. I do not think it is an accident that the tremendous growth 

in the derivatives business and the passage and implementation of 

the CFMA occurred at relatively the same time. I think in fact the 

two are very connected. 

As long as the flexibility and the certainty provided for in the 

CFMA is maintained, we are going to continue to see tremendous 

innovation, tremendous usage of the markets. Even though the 

markets have grown two- and three-fold since the passage of the 

CFMA, there is still a lot of cash market participants who do not 

utilize the derivatives industry, and I think we have a lot of opportunity to expand and reach those type of customers. 

Senator CRAPO. Okay. 

Mr. BAUMAN. I certainly agree with that. In fact, I probably 

would have said it a little bit differently. I have observed that all 

of the statistics about online retailing show phenomenal rates of 

growth, yet it is still only a very small percentage of retailing in 

general. I think there is still growth in the risk management disciplines that could take the use of these instruments far above levels that we think are quite high today. 

Senator CRAPO. Good. 

Mr. Bennett. 

Mr. BENNETT. I would add to that that I think the integration 

of the cash and the derivatives markets will probably continue, so 

5 years from now they will be much more integrated in terms of 

the way people use them. 

I also think that this will show up as we move to more electronic 

platforms, which really unify the trading of those two types of assets in a more integrated fashion. They will move very quickly and 

be very tightly linked. 

Senator CRAPO. Dr. Smithson, we will give you the last word if 

you want to take it. 

Mr. SMITHSON. Thank you. It is clear that derivatives use is becoming standard operating procedures inside firms. No longer will 

we ask a firm, ‘‘Do you use them,’’ rather we will ask questions 

about ‘‘How do you use them?’’ and ‘‘How do you track them?’’

It is clear that we are going to see new applications of derivatives technology. Since I did not predict credit derivatives, I am 

23

probably the wrong one to ask what the new applications will be, 

but the technology will move to the next step. 

So most of what I would see for the next 5 years is very positive, 

but I will also add a little leavening: I am afraid that over the next 

5 years we will still see The Wall Street Journal, every time they 

mention the word ‘‘derivatives’’ put ‘‘complex’’ in front of it. 

Senator CRAPO. I probably contribute to that a little bit myself. 

When I read that list at the beginning, that was a complex list, and 

I bet if we have this hearing in 5 years, it will be a longer list. That 

list that I just read was forwards, futures, options, swaps, caps, collars, and swaptions. 

[Laughter.] 

I am going to learn what a swaption is before the next hearing. 

These guys know over here already. 

[Laughter.] 

I think we have accomplished a lot of the objectives of this hearing. This obviously is a very critical issue with immense potential 

for our economy, and the decisions that we are embarking upon 

making here in Congress with regard to the regulatory policy 

which we will adopt relating to them is critical. I think that you 

have helped significantly not just the Committee, but the public, to 

understand a little better what this issue is all about, and hopefully help us make the right policy decision. 

I would like to thank again all of the witnesses for the time that 

you put in to preparing your testimony and coming here and sharing your wisdom with us. 

And without anything further, this hearing is adjourned. 

[Whereupon, at 3:53 p.m., the hearing was adjourned.] 

[Prepared statements, response to written questions, and additional material supplied for the record follow:] 

24

PREPARED STATEMENT OF JAMES NEWSOME

PRESIDENT, NEW YORK MERCANTILE EXCHANGE, INC.

OCTOBER 18, 2005

Mr. Chairman and Members of the Committee, my name is Jim Newsome and I 

am the President of the New York Mercantile Exchange (NYMEX or Exchange). 

NYMEX is the world’s largest forum for trading and clearing physical-commodity 

based futures contracts, including energy and metals products. We have been in the 

business for 135 years and are a federally chartered marketplace, fully regulated 

by the Commodity Futures Trading Commission (CFTC). 

On behalf of the Exchange, its Board of Directors and shareholders, I thank you 

and the Members of the Committee for the opportunity to participate in today’s 

hearing on ‘‘Growth and Development of the Derivatives Market.’’

Introduction 

Futures markets provide important economic benefits. NYMEX energy futures are 

highly liquid and transparent, representing the views and expectations of a wide variety of participants from every sector of the energy marketplace. As derivatives of 

cash markets, they reflect cash market prices and as a result are used as a hedging 

and price discovery vehicle around the globe. The price agreed upon for sale of any 

futures contract trade is immediately transmitted to the Exchange’s electronic price 

reporting system and to the news wires and information vendors who inform the 

world of accurate futures prices. In addition to continuously reporting prices during 

the trading session, NYMEX reports trading volume and open interest daily and deliveries against the futures contracts monthly. Transparent, fair, and orderly markets are critical to the NYMEX’s success as the most reliable hedging vehicle for 

physical transactions and financially settled over-the-counter (OTC) transactions. 

A key attribute of these products is their leverage. For a fraction of the cost of 

buying the underlying asset, they create a price exposure similar to that of physical 

ownership. As a result, they provide an efficient means of offsetting exposures 

among hedgers or transferring risk from hedgers to speculators. The leverage and 

low trading costs in these markets attract speculators, who play a valuable role as 

liquidity providers enabling commercial traders to get in and out of the market as 

needed. As liquidity increases, so does the amount of information absorbed into the 

market price, leading to a more broadly based market in which the current price 

corresponds more closely to its true value. 

Impact of the Commodity Futures Modernization Act 

The Commodity Futures Modernization Act of 2000 (CFMA) was landmark Federal legislation that provided legal certainty, regulatory streamlining, flexibility, and 

modernization to U.S. futures and derivatives markets. It provided a reasonable, 

workable, and effective oversight regime for the regulated exchanges, while enhancing the abilities of exchanges to compete in a rapidly changing global business environment. Product innovations such as new platforms for trading futures and clearing OTC products are a direct result of the ability to respond to constantly changing 

industry demands. Market participants have benefited from more useful risk management tools, better use of technology, greater liquidity, more efficient pricing, and 

better customer service. Trading facilities have been able to provide more alternatives in trading platforms, products, and business models. 

Most importantly, these major changes to the regulatory landscape have not compromised the integrity of the marketplace in any respect. Support for this notion is 

demonstrated by the routine reviews of NYMEX’s self-regulatory programs conducted by the CFTC. Exchanges remain at the top-tier of CFTC regulation, subject 

to 18 core principles covering all aspects of exchange operations, including customer 

protection, financial integrity, market integrity, recordkeeping, and conflicts of interest. Moreover, the NYMEX’s Derivatives Clearing Organization is subject to 14 

additional core principles. The core principles establish broad performance standards that must be met by the regulated entity, but gives the entity the flexibility 

as to how it complies with these standards. 

NYMEX’s Compliance Department ensures that the core principles are enforced 

and the Exchange disciplines violative activity by its members. The Department is 

staffed with highly experienced individuals and equipped with cutting edge technology to conduct market surveillance, trade surveillance, and financial surveillance 

to monitor market activity for abusive behavior. Automated surveillance systems are 

used to detect market manipulation, wash trading, prearranged trading, trading 

ahead of customer orders and violations of position limits. Staff also monitors trading activity during volatile markets to determine if a participant’s activity is disruptive or manipulative. 

25

The CFMA did not diminish the regulatory oversight responsibilities of the CFTC. 

All exchange actions remain subject to CFTC review and oversight and enforcement 

action. It is the CFTC’s responsibility to assure that all futures exchanges are enforcing their rules and remain in compliance with the core principles. As intended, 

the level of regulation established for designated contract markets is appropriate for 

the nature and participants of the markets. Therefore, the CFMA effectively insures 

the market and financial integrity of regulated futures exchanges. 

Growth and Development of Energy Derivatives 

It is well-documented that, beginning in the late 1970’s, the introduction of deregulation dramatically increased the level of competition in the energy markets. 

This competition prompted the development of the first-ever exchange-traded energy 

derivative products. The success and growth of these new contracts attracted a 

broad range of new participants to the energy markets. The addition of new participants to the markets also led to the introduction of new and wider varieties of energy derivatives. Today, the NYMEX, other exchanges and over-the-counter markets 

worldwide offer futures, futures options, swap contracts, and exotic options on a 

broad range of energy products, including crude oil, fuel oil, coal, heating oil, unleaded gasoline, and natural gas. 

The futures industry has experienced tremendous growth since the adoption of the 

CFMA in December 2000, a clear sign that the current regulatory regime is appropriate for these markets at this time. Trading volumes in 2004 for futures and options globally increased 300 percent over the 2000 volume levels. U.S. futures and 

options volume for the same timeframe increased over 200 percent. NYMEX’s futures and options volume alone as of 2004 had increased over 50 percent since year 

2000 volume levels. Individually, NYMEX’s flagship futures contracts showed significant volume increases as well, including crude oil—up 43 percent, heating oil—

up 34 percent, and gasoline—up 48 percent. 

NYMEX keeps its markets available for trading after the close of the open outcry 

trading session through the internet-based NYMEX ACCESS® electronic trading 

system. With NYMEX ACCESS®, NYMEX is open virtually around the clock. Traders can log on from any internet-enabled computer almost anywhere in the world. 

The after hours electronic trading session allows traders to protect themselves 

against exposure to price risk overnight. Total annual volume for NYMEX ACCESS® in 2004 was a record 8,239,700 contracts, breaking the previous record of 

5,880,455 contracts set in 2003. 

The CFMA, in addressing legal certainty for OTC derivatives, also permitted the 

clearing of OTC derivatives transactions by regulated futures exchanges. End-users 

and merchant energy companies that were existing customers of the NYMEX asked 

the Exchange to develop the clearing of standardized OTC energy products. NYMEX 

ClearPort® was the result of this request. During the initial period, 25 contracts 

were launched and currently the NYMEX ClearPort® program comprises over 175 

products in the electricity, coal, NatGas, oil and emissions markets. Today, over 30 

per cent of total NYMEX volume comes through the NYMEX ClearPort® system. 

This sustained growth can be linked to the addition of OTC clearing to NYMEX’s 

range of services offered, which allows energy companies to mitigate their credit 

risks. 

Additionally, NYMEX’s global expansion has recently included the addition of 

cleared futures contracts for Singapore Fuel Oil and clean petroleum products, and 

European Fuel Oil, Naptha, and Gasoline. This new clearing service has restored 

confidence, transparency, and liquidity to the marketplace and has once again allowed the economic benefits of derivatives to benefit the marketplace as a whole. 

Off-exchange contracts submitted to NYMEX for clearing are afforded the same 

protections available to other futures contracts. The clearinghouse provides market 

participants with protection against counterparty default and is backed by a $130 

million guarantee fund and a $100 million default insurance policy. The advantages 

of doing business on a regulated market are now available to any business entity 

with credit or price exposure in the energy markets. The ability of energy companies 

to now mitigate their credit risk with cleared derivatives brings liquidity, transparency, and market confidence back to the trading community. 

As a result of the demand by customers to mitigate their counter-party risk 

through new clearing products, the parent holding company of NYMEX has recently 

launched a new exchange in London to trade Brent Crude oil via open outcry. Additionally, the Exchange has announced the creation of the Dubai Mercantile Exchange—DME. The DME will bring the mitigation of counter-party risk to new contracts that will be traded in the Middle East region. In Singapore, the NYMEX has 

begun to add liquidity to regional Fuel Oil contracts through the use of the existing 

NYMEX ClearPort® Clearing system. Combined, the global expansion of the 

26

NYMEX brings the ultimate level of counterparty protection, liquidity, and transparency to derivatives and regulated futures contracts. 

New investment opportunities in the form of mini energy futures are offered by 

NYMEX for its highly liquid crude oil and natural gas futures contracts. The contracts are 50 percent of the size of the standard contracts and are financially settled 

at the settlement price of the physical commodity futures contracts on NYMEX. 

Recent Legislative Proposals 

Volatility and high prices in crude oil, natural gas, and gasoline futures contracts 

have triggered unwarranted criticism of NYMEX. While a significant amount of energy trading occurs in other forums, such as in the OTC market, on electronic facilities and on exempt markets, NYMEX is targeted largely due to its highly liquid and 

transparent markets. A new bill passed in the House 2 weeks ago, calls for an investigation of NYMEX by the Federal Trade Commission. The General Accounting

Office currently is studying the CFTC’s oversight of NYMEX and there is consideration of yet another independent study of NYMEX in the context of CFTC reauthorization. Misinformation spread by groups who do not understand the futures markets has led certain Members of Congress to draft legislation that potentially would 

roll back many of the significant advancements achieved under the CFMA. Generally, supporters of the legislation mistakenly believe that the bill will stop volatility and reduce prices of natural gas. A number of proposals have been discussed 

that would apply to only the NYMEX natural gas futures contract, including:

• Artificial price limits on natural gas futures contracts; 

• A price limit that triggers an investigation of the market by the CFTC; and 

• Prior CFTC approval for NYMEX rule changes that expand price limits beyond 

8 percent of the prior day’s settlement price.

Prices are market driven and must be allowed to find their true level consistent 

with market fundamentals. Artificial restrictions prevent futures markets from reflecting true market value and prevent the use of the market as a dependable hedge 

against price volatility. In addition, artificial restrictions in the marketplace would 

result in:

• Greatly reduced (if not completely eliminated) price transparency; 

• Higher costs; 

• Higher price volatility—in the off-exchange market where price transparency is 

at the discretion of market participants subject to their parochial business interests; and 

• Other classic symptoms of artificial price controls, such as government-induced 

shortages.

Without NYMEX as a price discovery market, conducting business in the cash 

market will be severely impaired. Higher costs to do business quickly translate into 

higher prices for consumers. 

The threat of investigative action each time a price limit is hit potentially would 

have a chilling effect on the markets. Moreover, the CFTC should have the flexibility to use its limited enforcement resources in the areas deemed most protective 

of the public interests. 

Finally, NYMEX does not believe that the rule amendment process established 

under the CFMA for futures exchange products, other than agricultural commodities, should be repealed for one commodity on one exchange. There is clear evidence 

that the rule self-certification process has been a huge benefit to exchange growth 

and development without indications to date of regulatory risks. 

Conclusion 

Five years ago, Congress took a giant step in revising the regulatory framework 

for futures trading. NYMEX has experienced first hand the business opportunities 

provided by that extraordinary law and would urge that the major provisions of that 

law remain unchanged, including the rule self-certification process and the ability 

of the futures exchange to determine the best terms and conditions of a futures

contract listed on its exchange. Derivatives markets contribute to the efficient allocation of resources in the economy because the price, which is derived through a 

highly liquid, transparent and competitive market, influences production, storage, 

and consumption decisions. These markets touch many aspects of the U.S. and global economy and, consequently, our lives. They can only effectively serve their economic purpose if they are allowed to trade and respond to market fundamentals 

without artificial restraints. 

I thank you for the opportunity to share the viewpoint of the New York Mercantile Exchange with you today. 

27

PREPARED STATEMENT OF JOSEPH P. BAUMAN

CEO, JB RISK CONSULTING, LLC

OCTOBER 18, 2005

Mr. Chairman and Members of the Subcommittee, my name is Joseph Bauman. 

Throughout my career I have been involved in the derivatives business, and I am 

currently a consultant to participants in the derivatives industry. In my career I 

have worked for Chemical Bank, Citibank, and Bank of America. I also served as 

Chairman of the International Swaps and Derivatives Association and was a Member of its Board for 10 years. Although this is my first testimony before this Subcommittee, I have testified previously on matters related to the derivatives markets 

before other Congressional Committees and Subcommittees. 

In the many roles I have played in the industry and in the several institutions 

for which I have worked, I have observed the phenomenal growth in the derivatives 

business. While there are many reasons for that growth, I believe that the regulatory framework in the United States for swaps and other privately negotiated derivatives, with the components of market discipline and legal certainty, has been 

among the most significant factors contributing to that growth. It is those factors 

that I would like to highlight for the committee. 

Role of Derivatives in the Economy 

Derivatives play a critical role in our economy. By allowing corporations to take 

certain types of risk out of their operations, derivatives allow those businesses to 

plan with greater certainty and to better withstand unexpected economic developments. As Federal Reserve Chairman Alan Greenspan noted in testimony before 

this Committee 3 years ago, ‘‘on balance they [financial derivatives] have contributed to the development of a far more flexible and efficient financial system—both 

domestically and internationally—than we had just 20 or 30 years ago.’’ Derivatives 

afford a means for a company, say an airline, to manage risks not intrinsic to the 

business itself, such as jet fuel price fluctuations. The airline can hedge the risks 

to those price fluctuations by entering into swaps or options which ensure that, regardless of developments in the oil or jet fuel markets, the manufacturer is guaranteed a certain price for its jet fuel needs or limits its exposure to rising prices. In 

other words, derivatives allow a business to focus on its core operations (in this example, flying planes and running an airline) while minimizing the chance that 

something completely outside of its control (fluctuations in jet fuel prices) will undermine its planning. Airlines, such as Southwest, actively manage this risk, which 

is, in part, a reason for their ability to thrive in the current difficult climate for airlines. In fact, an article in this past Sunday’s New York Times highlighted that 

Southwest Airlines’ fuel cost hedging contracts had protected it from spikes in the 

price of fuel and contributed to its profitability. 

Growth of the OTC Derivatives Business 

Derivatives (and in particular, privately negotiated derivatives) have become an 

indispensable part of most large and medium-sized businesses’ financial management in the last 20 years. ISDA has published figures on outstanding notional 

amounts in the interest rate and currency derivatives business since 1987 and in 

recent years has published similar information for credit derivatives and equity derivative. The chart below shows the growth in that business. I should emphasize 

that these figures demonstrate the growth in trading activity. It is important to 

keep in mind that the notional amounts reported are not a reflection of outstanding 

exposures or risk. Figures published by the Bank for International Settlements indicate that, on a net basis, outstanding counterparty credit exposures on interest rate 

and currency products are less than 1 percent of notional amounts outstanding.

28

Role of Market Discipline 

Market discipline is the most important factor influencing how derivatives activity 

functions, and is beneficial from the standpoint of both market stability and providing a high quality of service to end-users. First, market discipline benefits market stability because firms operate in an environment in which they understand 

that they are accountable for both the profits and the losses that result from their 

decisions. The result is sound risk management practice and high credit quality. 

Second, market discipline benefits end-users because of the importance of competition and reputation. Competition among dealers ensures that, if end-user concerns 

are not addressed, another dealer stands ready to step in and do so. And reputation—which takes years to build but can be destroyed in seconds— is of great importance because it provides clients a means of quality assurance in an environment 

when you only have one chance to get a deal right. 

It is also worth pointing out that, since the privately negotiated market is limited 

to firms qualifying as ‘‘eligible contract participants’’ on the basis of either asset size 

or income, there is no ‘‘market regulator’’ for over-the-counter derivatives activity 

in the same sense as there is in the United States for securities (Securities and Exchange Commission) or futures (Commodity Futures Trading Commission). At the 

same time, the majority of the derivative dealers are regulated, most of them as 

banks or as securities firms, either in the United States or across a large number 

of other jurisdictions. Since the vast majority of transactions are either between two 

dealers or a dealer and an end user, this ensures that those major institutions are 

subject to the appropriate oversight for their business focus. 

The Importance of Legal Certainty 

OTC derivatives are built on a foundation of bilateral, privately negotiated contractual relationships. Anything that calls into question any piece of that foundation 

can have serious adverse effects on the willingness of parties to engage in transactions. One of ISDA’s principal achievements has been the establishment of a 

sound contractual and documentation framework that facilitates the ability of parties to engage in these transactions. ISDA’s Master Agreement, supported by legal 

opinions from over 40 countries on the enforceability of its core provisions, is the 

global standard for documenting OTC derivatives transactions. ISDA has worked 

with legislatures and regulators around the world to enact laws that recognize the 

enforceability of these core provisions. Efforts here in the United States have led 

to several significant changes in laws relating to these core provisions, including 

most recently the changes to the Bankruptcy Code and bank insolvency laws that 

became effective on October 17 of this year. 

ISDA’s efforts on the contractual framework would be for naught if the fundamental right of parties to enter into these privately negotiated transactions was 

thrown into question by the legal or regulatory framework in which the parties operate. For example, ISDA has worked to change laws in various countries that were 

it not for these changes, would treat these transactions as unenforceable gaming 

contracts and not the legitimate hedging tools that they are. 

In the United States, a major focus of ISDA’s efforts has been the recognition, 

confirmed in the Commodity Futures Modernization Act (CFMA), that swaps are not 

appropriately regulated as futures under the Commodity Exchange Act (CEA). If 

swaps were futures then swap transactions would be considered unenforceable as 

illegal off-exchange futures. Throughout my tenure on the ISDA Board, which ended 


oct18-1.eps
29

just prior to enact of the CFMA, the potential of a court determination that swaps 

were futures was a significant concern for the industry. The substantial growth of 

the business during that time period was, in no small part, due to the consistent 

view of regulators, including the CFTC, and the intent of Congress, as embodied in 

the 1992 Futures Trading Practices Act (FTPA), that swaps were not appropriately 

regulated as futures. 

It is worth highlighting that the only action inconsistent with those longstanding 

policies was the release of a CFTC Concept Release in 1998 raising questions about 

the possible need to regulate OTC derivatives. Congress acted promptly to prevent 

the CFTC from proceeding with that initiative and directed the President’s Working 

Group on Financial Markets to produce a report on OTC derivatives. That report, 

published in 1999, served as the basis for the many achievements in the CFMA. 

The experience of the 1998 CFTC concept release demonstrates that concerns 

about legal certainty are neither academic nor speculative. It is also instructive as 

an example of the need for Congress, regulators, and the industry to remain vigilant 

to ensure that Congressional intent continues to be carried out. Despite the policies 

embodied in the FTPA and the position of the CFTC over the 10 years preceding 

the concept release, suggestions that the CFTC might consider changes in that regulatory treatment through administrative action raised alarm bells throughout the 

industry, the President’s Working Group, and Congress. 

Because of the continuing potential for an adverse court ruling or a change in administrative determination creating legal uncertainty of the status of swaps and 

other privately negotiated derivative transactions, participants in these transactions, both dealers and end users and both U.S. and foreign firms, welcomed the 

1999 Report of the President’s Working Group and the efforts of Congress in 2000 

to provide clarity on this issue. 

Experience Under the CFMA 

Recognizing the peril presented by a broad interpretation of the reach and scope 

of the CEA, Congress in 2000 undertook to ensure that privately negotiated derivatives contracts between sophisticated counterparties would be legally enforceable 

and subject to the normal rules of contract law, rather than forced into an ill-fitting 

Federal statutory regime originally designed for agriculture producers. The CFMA 

created the means by which financially sophisticated parties, called ‘‘eligible contract participants,’’ could continue to engage in risk management without fear that 

their privately negotiated contracts would be unenforceable. ISDA was privileged to 

help play a role in achieving this historic legislation, and is dedicated to ensuring 

that the legal certainty created by the law is not undermined. 

The 5 years since the passage of the CFMA have proven the law’s wisdom. In 

those 5 years privately negotiated derivatives have continued to thrive and product 

innovation has proceeded unabated. Even more importantly, thanks in no small part 

to derivatives; the markets have been able to withstand significant shocks to the 

financial system. The bursting of the dot.com bubble, the terror attacks of September 11, and the financial scandals and bankruptcies at Enron, WorldCom, 

Adelphia, and others would, in the past, have created serious economic dislocation 

and threatened long term prospects for growth. However, through the use of derivatives major market participants have been able to limit their exposure to losses from 

these types of events, passing on the risks that in the past would have potentially 

been concentrated in a few institutions and possibly driven one or more of them out 

of business. While the events creating these shocks may have occurred in any circumstance, modern risk management practices, and in particular the use of derivatives, have saved countless businesses and jobs over the last 5 tumultuous years by 

limiting the consequences of these events or spreading the effects to a broader category of risk takers in amounts that, while possibly painful, did not threaten their 

existence. The legal certainty provided by the CFMA has been an important part 

of this success. 

At various times since enactment of the CFMA, and currently in the CFTC reauthorization debate, there have been efforts to modify the provisions of the CFMA 

that have provided the fundamental legal certainty intended by Congress. While 

these efforts have been primarily focused on energy trading, the implications of 

those efforts go beyond energy trading into other OTC derivative products. The 

President’s Working Group on Financial Markets has consistently opposed attempts 

to roll back the legal certainty created by the CFMA, much as it did in 1998 in response to efforts to erode the protections provided by Congress and the CFTC at 

that time. The opposition of America’s top financial regulators, evidenced by letters 

going back to 2002, clearly shows a consensus view that privately negotiated derivatives transactions, far from adding to upheavals in certain commodity markets, in 

30

fact help to alleviate problems caused by dislocations and disruptions in those markets. 

The CFMA provided clear guidance regarding the scope of transactions subject to 

regulation under the CEA and, as a corollary, certainty as to the legal status of the 

institutional over-the-counter derivatives market. And the listed and OTC derivatives markets have each flourished in the aftermath of the CFMA—a testament to 

the importance of regulatory efficiency and legal certainty. 

The CFMA provided broad exclusions and exemptions from provisions of the CEA 

for many different types of OTC derivative products. Recently, significant concerns 

have been raised within the financial community regarding developments that 

threaten to set back this progress. These concerns appear to have been raised by 

testimony by the former CFTC General Counsel before the Senate Committee on 

Banking, a recent Report of the Senate Agriculture Committee in connection with 

CFTC reauthorization legislation and a recent judicial decision (in the case of CFTC

v. Bradley). As I understand it, these have raised questions regarding the scope of 

the exemptions and exclusions for over-the-counter derivatives enacted in the 

CFMA—suggesting that the relevant exemptions and exclusions are somehow limited in scope to the underlying transactions and do not cover the persons engaged 

in those transactions or their related conduct and activities. 

This view, which is clearly contrary to the CFMA, if unaddressed, could resurrect 

the very legal certainty concerns that led to enactment of the CFMA. Steps by the 

Subcommittee to clarify this issue should be prominent in the Subcommittee’s consideration of CFTC reauthorization and related issues. 

The past few years have seen tremendous upheavals in the energy sector, from 

the California energy crisis to the collapse of Enron to the current price volatility 

in petroleum-based products. There has been little evidence that shocks in one market have spilled over into others. Where in the past shortages and anticompetitive 

behavior could be expected in the wake of these upheavals, properly functioning 

markets, reinforced through effective risk transfer made possible by derivatives, 

have allowed the United States to weather the current period of difficulty more effectively than was the case previously. It would be a grave mistake to tamper with 

the regulatory framework, including the legal certainty created by the CFMA, in 

light of the success it has brought in difficult times. 

The success of the CFMA is not limited to the legal certainty it provided for OTC 

derivatives; by and large the CFMA remains a crowning achievement of financial 

services law. By creating flexible rules for organized exchanges, providing legal certainty for sophisticated market participants and encouraging the growth and development of new financial products, the CFMA has positioned the United States to 

remain a financial innovator for years to come. 

——————

PREPARED STATEMENT OF PAUL BENNETT

SENIOR VICE PRESIDENT AND CHIEF ECONOMIST,

NEW YORK STOCK EXCHANGE

OCTOBER 18, 2005

Mr. Chairman, Ranking Member Bayh, and Members of the Committee, I am 

Paul Bennett, Senior Vice President and Chief Economist at the New York Stock 

Exchange (NYSE or Exchange). On behalf of the New York Stock Exchange and our 

Chief Executive Office John Thain, thank you for inviting me to testify today before 

the Subcommittee. The NYSE greatly appreciates your leadership in overseeing the 

international aspects of our nation’s evolving financial markets. We find ourselves 

at a critical point in that evolution, and your attention to these issues could not be 

more timely as we seek to maintain the competitive leadership of U.S. financial 

markets in the world and to protect the interests of investors, both individual and 

institutional. 

Evolution of Today’s Financial Markets 

The New York Stock Exchange is the world’s largest cash equities market. We 

serve 90 million investors, the institutional community and over 2,700 of the world’s 

leading corporations. The companies listed on the NYSE have a total global market 

capitalization of $21 trillion. During the first 9 months of 2005, our average daily 

trading volume was 1.61 billion shares, worth over $55 billion a day. We are an important cog in the capital formation engine, helping to provide companies and investors with opportunities that translate into job creation and economic growth. 

31

You have asked us to speak about the growth of the derivatives market and its 

role in the U.S. economy. While the NYSE does not run a derivatives market today, 

the importance and growth of that market have had a significant impact on the 

NYSE, and have helped shape our strategy for the future. 

Equity Market 

The U.S. equity market has grown steadily in the past decade. The consolidated 

daily volume in the U.S. equity market, including both the listed market and OTC 

market, has reached about 4 to 5 billion shares a day representing $80 to $100 billion traded daily. 

Decimalization and technological innovation have continuously decreased costs for 

investors on the U.S. equity market. According to the GAO’s 2005 study on the Securities Market, costs for institutional investors have decreased by 30 percent to 53 

percent overall, and by 90 percent for individual investors. 

Today, there are more buyers and sellers than ever before. Forty-two percent of 

adults in the United States today own shares; moreover, since 1990, the portion of 

U.S. households’ assets in equities and mutual funds has nearly doubled, from 9.6 

percent to 16.8 percent at the end of the second quarter in 2005. 

The NYSE is committed to providing those investors the highest value proposition. And to do so, we must recognize the new realities of financial services. Today’s market differs greatly from that of a generation ago. The diversified products, 

the rise in electronic trading, and the globalization of our capital markets have utterly transformed the way our markets work. 

Derivatives Markets 

The biggest financial story of this era may be the bold and imaginative new ways 

we are creating to manage risk, reduce the costs of hedging, and make markets 

more efficient. For investors, the result is an explosion of new opportunities to invest in new products on new platforms. 

A derivatives market that started with futures contracts on agricultural commodities, like butter, milk, and live cattle, in the 19th century, has turned into the principal means for investors to manage their risk no matter what the investment. 

Today, options, futures, swaps, and other innovations have become widely used and 

even required risk management tools for sophisticated investors and financial intermediaries. While the $100 billion daily trading is an impressive figure in the equities market, it has not escaped our attention that the value of contracts traded on 

the Chicago Mercantile Exchange (CME) averaged over $2 trillion a day for the first 

6 months of 2004. 

And while volume on the NYSE remained relatively flat in 2004, total volume in 

equity options, both in the United States and abroad, soared by nearly 30 percent. 

From 1995 to 2004, options volume has increased by 400 percent. Over that same 

period, the total number of options contracts traded in the United States has risen 

from 288 million to 1.2 billion. 

For futures, the CME’s 2004 annual volume was more than 787 million contracts, 

representing double-digit volume gains for the fifth consecutive year. The Chicago 

Board of Trade’s (CBOT) 2004 annual volume reached nearly 600 million contracts, 

a record high for the CBOT and the third consecutive record-breaking year for the 

CBOT. 

Competitive Landscape 

In addition to the growth in new products and platforms, today’s financial markets are facing a new global challenge to the traditional leadership of U.S. capital 

markets. 

There is now greater mobility of capital, greater international participation in 

local markets, and greater competition among markets in different geographical 

areas. Financial institutions, investment firms, and other financial intermediaries 

have increased their trading across national boundaries, in numerous different markets, outside traditional exchanges, and even directly among themselves. 

Today, traditional rivals like the Deutsche Bo ̈rse are becoming better capitalized, 

and better competitors. While this is true for the equities market, it is especially 

true in the derivatives market. Eurex, which is jointly owned by Deutsche Bo ̈rse and 

SWX Swiss Exchange, is the world’s largest future and options market for euro denominated derivative instruments. In addition, according to Eurex’s monthly statistics from third quarter 2005, it has the largest market share in terms of contract 

turnover for the entire international options and futures markets—12.84 percent. 

The next four biggest players are CME (11.28 percent), CBOT (7.69 percent), Chicago Board of Options Exchange (CBOE) (5.44 percent), and the International Securities Exchange (ISE) (4.88 percent). 

32

And investors are responding to these opportunities. An increasing portion of U.S. 

portfolios is going overseas into non-U.S. investments. Since 1990, in U.S. investors’ 

portfolios, the equity portion alone of non-U.S. stocks has nearly tripled, from 6.0 

percent to 16.8 percent. 

In addition, the NYSE’s competitors have become stronger through demutualization and consolidation. In response to growing competition, many marketplaces 

in both Europe and the United States, such as the London Stock Exchange plc and 

Nasdaq, have demutualized to free themselves from the constraints of their membership structures and to provide greater flexibility for future growth. In recent 

years, the number of new market entrants, the need to respond to the globalization 

of capital markets, and the desire to provide global, cross-border services to clients 

has also led to a wave of consolidation, both in the United States and abroad. 

In order to compete effectively in this global climate, and in order to provide investors and issuers with the best possible marketplace, we must become a multiproduct, global competitor. 

We are looking at the possibility of expanding or adding new platforms in areas 

that can benefit from increased transparency. We are currently seeking an SEC exemption to expand our investor friendly corporate bond platform to trading unregistered bonds of our listed companies. 

We are also making great progress in one fast-growing asset class, U.S. Exchange 

Traded Funds (ETF’s), whose total funds have soared over 50 percent last year to 

$227 billion. ETF’s provide investors an excellent way to manage risk and diversify 

by trading a portfolio of stocks in a designated area such as gold, natural resources, 

the S&P, or Chinese-based equities. 

But ETF’s represent only a single star within the giant constellation of financial 

markets. We need to expand our universe much more broadly in order to compete 

successfully. 

NYSE is becoming a public, for-profit company to give us improved access to capital, and the ability to use stock as acquisition currency. We are merging with Archipelago, an outstanding, entrepreneurial company that is pioneering leading-edge 

trading platforms and customer focus. 

That is also why we are building the Hybrid Market; we are responding to the 

demand of many of our customers for greater ability to trade electronically. The Hybrid Market will give customers the choice of two investor-friendly paths: Either the 

sub-second speed of automatic execution, or the price improvement and best value 

that distinguish the auction market. 

Ten years ago, these changes at the NYSE would have been unthinkable. But 

today, moving forward without these changes is what would be unthinkable. We 

must respond to investors’ needs and thereby preserve the position of the United 

States as the leader in our global financial marketplace. 

Regulatory Developments 

As you can imagine, there are also regulatory considerations that affect not only 

the competitive landscape but also dictate where and how individuals and their representatives invest their money. Two such examples are capital requirements for 

broker-dealers and margin rules for brokerage accounts. 

Capital Requirements 

For years, U.S. broker-dealers have moved much of their derivatives business 

overseas because of stringent capital requirements that make conducting such business in the United States less attractive. 

In August 2004, the SEC adopted rule amendments that established a voluntary, 

alternative method for broker-dealers to compute net capital. This rule allows them 

to use internal models to calculate net capital requirements for market and derivatives related credit risk. One condition to using this alternative method is that the 

broker-dealer’s ultimate holding company and affiliates become consolidated supervised entities and consent to group wide oversight (consolidated supervision) from 

the SEC. Another condition is that the broker-dealer must maintain $5 billion of 

tentative net capital in order to participate, which limits the number of broker-dealers who are able to take advantage of this rule. 

The Exchange currently has rule proposals before the SEC to modify its capital 

rules to reflect a different level of capital and to change its margin rules to accommodate derivatives business that may come back into the United States. To date, 

five internationally active firms, including Goldman Sachs, Merrill Lynch, Bear 

Stearns, Lehman Brothers, and Morgan Stanley, have either applied or been approved for CSE (consolidated supervised entity) status. 

Relaxation of the capital rules by allowing firms to use internal models to compute charges has encouraged the firms using this alternative method to study 

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whether to bring their OTC derivative dealers back into the U.S. broker-dealer. 

There is significant benefit to the firms from a legal netting standpoint to have all 

transactions with a single counterparty in one legal entity. They are studying the 

technology issues as well as other regulations that might be applicable before reaching a final decision. 

Portfolio Margining 

Another regulatory development that affects derivatives concerns potential 

changes to portfolio margining. 

The evolution of the equities and derivatives markets puts into focus the need to 

ensure a sensible regulatory approach that will foster competition among markets 

and strengthen the U.S. position in the global marketplace. 

As the Banking Committee’s hearing last month on Commodity Futures Trading 

Commission (CFTC) reauthorization highlighted, it is essential that regulation of 

the security futures and equities markets maintain the competitive balance that 

was established by Congress in 2000 in the Commodity Futures Modernization Act 

(CFMA). 

One aspect of that regulation that has been under scrutiny is the margin rules 

that apply to different products. We strongly agree with the many participants in 

the financial markets, several of whom testified before the Committee, that portfolio 

margin rules should be developed not just for select sectors of the marketplace, but 

for all equity products. Currently, margins for security futures customers are calculated using a strategy-based approach, which computes margin requirements for 

each individual position or strategy in a portfolio. Portfolio margining, used for all 

futures contracts and for security options at the clearing level, is risk-based, and 

more accurately reflects economic exposure to the marketplace. 

The NYSE is working with the NASD, CBOE, CFTC, and other commodities exchanges and market participants to develop a portfolio margin rule that would apply 

to all equities. We consider this initiative a top priority and will be working with 

our fellow regulators to produce a rule for SEC consideration by year-end. 

Conclusion 

Today’s financial markets have evolved significantly over a relatively short period 

of time. Technological changes have increased the speed of transactions and reduced 

the costs of those transactions. The equity market has grown steadily, while the derivatives market has grown exponentially with the introduction of new products. 

The international competitive landscape has forced U.S. markets and market participants to think globally. 

While some may see this change as a threat, the NYSE sees opportunity. Investors will increasingly need platforms that can meet all of their investment needs, 

including equities, futures, options, or swaps. As the NYSE proceeds with its plans 

to become a publicly traded company and merge with Archipelago, thereby increasing our capitalization and diversifying our product offering, we are looking to take 

advantage of the opportunities that this new competitive landscape will present. 

Mr. Chairman, and Ranking Member Bayh, and Members of the Committee, 

thank you for the opportunity to present this testimony. I look forward to answering 

your questions. 

——————

PREPARED STATEMENT OF CHARLES SMITHSON

MANAGING PARTNER, RUTTER ASSOCIATES LLC

OCTOBER 18, 2005

Chairman Crapo and Members of the Subcommittee, I am pleased to have the opportunity to testify before the Subcommittee today about a market that is crucial 

to the effect functioning of both industrial firms and financial institutions, but one 

that is widely misunderstood. 

I am Charles Smithson. I am the Managing Partner of Rutter Associates, an advisory firm that specializes in financial risk management. My colleagues and I assist 

banks, insurance companies, and industrial companies in measuring and managing 

their exposures to financial price risks (that is, interest rate risk, foreign exchange 

rate risk, commodity price risk, and equity price risk), credit risk, and liquidity risk. 

While the benefits of freely functioning markets are without question, the interaction of willing buyers and sellers can lead to price volatility. Since derivatives provide market participants with a means of dealing with that price volatility, the derivatives market we are discussing here today is a consequence of the increased 

price volatility we witnessed in the 1970’s and 1980’s—increased volatility in foreign 

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exchange rates resulting from the move to floating exchange rates, increased volatility in interest rates associated with the move to damp inflation in the late 1970’s, 

and increased volatility in commodity prices associated with deregulation of those 

markets. 

What can be said about the consequences of derivatives? Over the more than 20 

years, I have been involved in derivatives and risk management, I have been collecting empirical evidence, which today I will share with you in the form of answers 

to four important questions. 

Question #1: What happens to the volatility of financial prices when the financial 

risk management products appear?

Some argue that the introduction of derivatives leads to increased volatility. John 

Shad (former Chairman, Securities and Exchange Commission), one of the more outspoken proponents of this view, saw derivatives as ‘‘the tail wagging the dog,’’ escalating price volatility to ‘‘precipitous, unacceptable levels.’’ Others suggest that there 

is no reason for the introduction of derivatives to have any effect on the volatility 

of underlying assets. Derivatives are ‘‘created assets’’ (for every long there is a

corresponding short). Thus the introduction of these contracts would have no predictable effect on trading in the underlying security. Still others argue that the introduction of derivatives should lead the volatility of the underlying assets to fall, 

not rise. After all, the newly created trading opportunity in this derivative security 

should increase market liquidity for an underlying asset. 

This question has been extensively examined by academics. When we searched 

the academic journals, my colleagues and I found 39 empirical analyses, starting 

with the Holbrook Working’s classic 1960 study of the impact of the introduction of 

futures on onion prices through a 2000 study of the impact of the introduction of 

options on share prices. While the ‘‘derivatives increase volatility’’ story seems plausible, the empirical evidence supports the contention that the introduction of derivatives reduces price volatility in the underlying markets. 

Question #2: What happens to the bid-ask spread and trading volume for the underlying assets?

My colleagues and I found 5 academic studies that examined the impact of the 

introduction of derivatives on the bid/ask spread in the underlying market. These 

studies indicate overwhelmingly that the bid/ask spreads in the underlying market 

declines after the introduction of derivatives. 

Some have suggested that the introduction of derivatives reduces volumes in the 

underlying markets. Finance theory suggests that the reduced bid-ask spread noted 

above and the ability to arbitrage one market against the other should increase volumes in the underlying markets. My colleagues and I found 6 published studies in 

which academics looked at what happens to the trading volumes in the underlying 

asset when derivatives on the asset are introduced. These studies indicate that the 

introduction of derivatives is associated with increases in unadjusted volumes in the 

underlying and either an increase or no change in market-adjusted trading volumes. 

Question #3: If a firm uses risk management, does the market regard the firm as 

being less risky?

Over the years, most of my interest has been focused on this question and on the 

‘‘payoff’’ Question #4 to follow. After all, if I am going to suggest that firms should 

manage financial price risk, I should have a pretty good idea that the market will 

reward them for doing so. What I am going to tell you about today come from an 

article Professor Betty Simkins (Oklahoma State University) and I published in the 

most recent issue of The Journal of Applied Corporate Finance.

In the context of Question #3, if a publicly traded firm is ‘‘exposed’’ to financial 

price risk, the returns to the firm’s equity would be sensitive to changes in interest 

rates, foreign exchange rates, or commodity prices. Consequently, Question #3 could 

be rephrased as: If such a firm uses derivatives to manage one or more of those exposures, does the exposure decline? 

Professor Simkins and I found 15 studies that examined this question, 6 that focused on financial institutions and 9 on industrial companies. Overwhelmingly, the 

studies indicated that the use of risk management led to a decline in the perceived 

riskiness of the firm:

• In the case of financial institutions, all 6 of the studies reported that the use of 

derivatives reduced the sensitivity of the equity returns to interest rates; 

• In the case of industrial companies, 8 of the 9 studies reported that the use of 

derivatives reduced the sensitivity of their equity returns to financial price risks.

Question 4: What impact does the use of derivatives have on the value of the firm?

All of the empirical evidence on this question is very recent. Professor Simkins 

and I found only 10 studies that focused on this question, the ‘‘oldest’’ of which was 

published in 2001. 

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Six of the studies examined the impact of interest rate and FX risk management 

(one looking at banks and 5 looking at industrial corporations). The other 4 studies 

examined commodity price risk management, with one looking at commodity users

and three looking at commodity producers.

• Managing interest rate and foreign exchange rate risk with derivatives is associated with higher firm values. 

• Similarly, the study of commodity price risk management by commodity users

found that fuel price hedging by airlines was associated with higher firm values. 

• In contrast, the three studies of commodity price risk management by commodity 

producers found either no effect or a negative effect on equity values—If investors 

take positions in commodity producers as a way to gain exposure to the commodity price, the firm should not necessarily benefit from hedging the commodity 

price risk. 

Summary & Conclusions 

We have answered four questions about risk management using empirical evidence provided by the academic community:

1. What happens to the volatility of financial prices when the financial risk management products appear? 

The introduction of derivatives has reduced price volatility in the underlying market.

2. What happens to the bid-ask spread and trading volume for the underlying assets? 

The introduction of derivatives has decreased bid/ask spreads and has had little 

effect on trading volume in the underlying market.

3. If a firm uses risk management, does the market regard the firm as being less 

risky? 

Yes—Firms that use risk management are perceived to be less risky.

4. Does the use of derivatives increase, leave-unchanged, or decrease the value of 

the firm? 

The use of derivatives to manage interest rate risk, foreign exchange rate risk and 

commodity price risk by users of commodities is associated with higher firm values.

Perhaps the principal benefit from the innovations over the last two decades has 

been the improvement in the allocation of risk within the financial system. Derivatives have dramatically reduced the cost of transferring risks to those market participants who have a comparative advantage in bearing them. As Merton Miller 

said: ‘‘Efficient risk-sharing is what much of the futures and options revolution has 

been all about.’’

Derivatives markets provide corporations the ability to hedge against currency, interest rate, and commodity price risks far more quickly and cheaply than was possible before. Derivatives have permitted the transfers of risk from individual firms 

to well-diversified institutional investors. This transfer has not only lowered mortgage rates for homebuyers, but it also should help protect the financial system from 

another disaster like the one experienced by the savings and loan industry. 

Derivatives are often described as a ‘‘zero sum game;’’ and they are. But, even 

though one party’s gain is another’s loss in an individual transaction, the more efficient risk sharing afforded by derivatives can reduce total risk for all market participants. 

Derivatives have expanded the technology available to firms and individuals to 

manage risk. They have reduced the costs of managing exposures, thereby increasing liquidity and efficiency. 

In order for derivatives to deliver the benefits that they are capable of providing, 

there must, of course, be a high degree of certainty as to their enforceability and 

regulatory treatment. Congress made extraordinary progress in ensuring such certainty in 2000 with its enactment of the Commodity Futures Modernization Act of 

2000. The substantial growth in the depth and breadth of the listed and OTC markets for derivative products in nearly all asset categories since 2000 is a testament 

to the importance of legal certainty and the success of Congress’s efforts. 

Mr. Chairman, Members of the Subcommittee, thank you once again for the

opportunity to testify before the Subcommittee on these important subjects. Our economic success depends on a clear understanding of the relationship between financial instruments, their use and their regulation, on the one hand, and the market 

consequences of their use and regulation, on the other hand. I would be pleased to 

assist the Subcommittee and its staff going forward in connection with the Subcommittee’s efforts to understand these relationships.