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50–408 2010

S. HRG. 110–1007 

REDUCING RISKS AND IMPROVING OVERSIGHT 

IN THE OTC CREDIT DERIVATIVES MARKET 

HEARING 

BEFORE THE

SUBCOMMITTEE ON 

SECURITIES AND INSURANCE AND INVESTMENT 

OF THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

SECOND SESSION 

ON 

REDUCING RISKS AND IMPROVING OVERSIGHT IN THE OTC CREDIT 

DERIVATIVES MARKET 

WEDNESDAY, JULY 9, 2008 

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

( 

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


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(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

BOB CORKER, Tennessee 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DEAN V. SHAHINIAN, Counsel 

DAVID STOOPLER, Professional Staff Member 

ANDREW OLMEM, Republican Counsel 

DAWN RATLIFF, Chief Clerk 

SHELVIN SIMMONS, IT Director 

JIM CROWELL, Editor 

SUBCOMMITTEE ON SECURITIES AND INSURANCE AND INVESTMENT

JACK REED, Rhode Island, Chairman 

WAYNE ALLARD, Colorado, Ranking Member 

ROBERT MENENDEZ, New Jersey 

TIM JOHNSON, South Dakota 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

ROBERT P. CASEY, Pennsylvania 

DANIEL K. AKAKA, Hawaii 

JON TESTER, Montana 

MICHAEL B. ENZI, Wyoming 

ROBERT F. BENNETT, Utah 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

BOB CORKER, Tennessee 

DIDEM NISANCI, Staff Director 

TEWANA WILKERSON, Republican Staff Director 


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C O N T E N T S 

WEDNESDAY, JULY 9, 2008 

Page 

Opening statement of Chairman Reed ................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Allard ................................................................................................... 5 

WITNESSES 

Patrick M. Parkinson, Deputy Director, Division of Research and Statistics, 

Board of Governors of the Federal Reserve System .......................................... 3 

Prepared statement .......................................................................................... 34 

Response to written questions of: 

Senator Reed .............................................................................................. 136 

James A. Overdahl, Chief Economist, Securities and Exchange Commission ... 6 

Prepared statement .......................................................................................... 47 

Kathryn E. Dick, Deputy Comptroller for Credit and Market Risk, Office 

of the Comptroller of the Currency ..................................................................... 7 

Prepared statement .......................................................................................... 54 

Response to written questions of: 

Senator Reed .............................................................................................. 141 

Senator Crapo ............................................................................................ 146 

Darrell Duffie, Dean Witter Distinguished Professor of Finance, Graduate 

School of Business, Stanford University ............................................................ 23 

Prepared statement .......................................................................................... 100 

Response to written questions of: 

Senator Reed .............................................................................................. 147 

Senator Crapo ............................................................................................ 151 

Robert Pickel, Chief Executive Officer, International Swaps and Derivatives 

Association ............................................................................................................ 25 

Prepared statement .......................................................................................... 105 

Response to written questions of: 

Senator Reed .............................................................................................. 152 

Senator Crapo ............................................................................................ 152 

Craig S. Donohue, Chief Executive Officer, Chicago Mercantile Exchange 

Group Inc. ............................................................................................................. 27 

Prepared statement .......................................................................................... 110 

Edward J. Rosen, Cleary Gottlieb Steen & Hamilton LLP, Outside Counsel 

to The Clearing Corporation ............................................................................... 29 

Prepared statement .......................................................................................... 121 

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Prepared statement of The Managed Fund Association ....................................... 154 

Letter from the Board of Governors of the Federal Reserve System and 

Federal Reserve Bank of New York ................................................................... 160 

Letter from the Commodity Futures Trading Commission .................................. 164 

Letter from the Securities and Exchange Commission ........................................ 166 


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smartinez on DSKB9S0YB1PROD with HEARING
(1) 

REDUCING RISKS AND IMPROVING OVERSIGHT IN THE OTC CREDIT DERIVATIVES 

MARKET 

WEDNESDAY, JULY 9, 2008 

U.S. SENATE, 

SUBCOMMITTEE ON SECURITIES, INSURANCE, AND INVESTMENT, COMMITTEE ON BANKING, HOUSING, AND URBAN

AFFAIRS, 

Washington, DC. 

The subcommittee met at 2:02 p.m., in room SD–538, Dirksen 

Senate Office Building, Senator Jack Reed (Chairman of the Subcommittee) presiding. 

OPENING STATEMENT OF CHAIRMAN JACK REED 

Chairman REED. I will call the hearing to order. Senator Allard 

is on his way. We have a vote or a series of votes that is scheduled 

to begin at approximately 2:15. So I would make my opening statement, and then I will recognize the panel. But when Senator Allard 

arrives, we will interrupt or conclude that statement and give him 

the opportunity to make his opening statement. Although we do 

not have any additional colleagues here yet, I would ask them to 

defer their opening statements so we can get into the heart of the 

matter. 

Let me welcome the witnesses, the first panel and the second 

panel. I will introduce them individually in a moment. But let me 

begin. 

Since its inception, the credit derivatives market has grown exponentially—in trading volume, in total value of outstanding contracts, and also in the potential risks that these instruments pose. 

According to the International Swaps and Derivatives Association, 

the credit derivatives market has exploded with the total notational value of contracts growing from $919 billion in 2001 to over 

$62 trillion in 2007. Though some argue that total losses could be 

less than this, perhaps at around $2 trillion to replace all existing 

contracts in the event of widespread default, this remains a staggeringly high number. 

The tremendous growth in this market occurs in an environment 

of incidental regulation and an infrastructure that has not kept 

pace with trading volumes and product complexity. Today’s hearing 

is an opportunity to explore a number of issues, including the risks 

that these products pose to the financial system and the proposed 

approaches to reducing such risks through a central clearing entity 

or an exchange. 


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Counterparty risk in this market is now a major concern. It 

played a significant role in problems surrounding Bear Stearns and 

paved the way for the new ‘‘too interconnected to fail’’ standard. 

The lack of information and transparency with regard to this market led to inadequate monitoring of risk in credit default swaps. As 

some have suggested, this issue of counterparty risk has become a 

ticking time bomb. These products are traded from one 

counterparty to another to another, making it virtually impossible 

to know who is holding what and complicating regulators’ ability 

to oversee concentration of risks that buildup in the system. 

Infrastructure problems have also long plagued the credit derivatives market. This complex market has not been completely automated to confirm trades and track overall risks. Though the industry has made progress in automating risks, highly structured and 

customized contracts are still difficult to automate and confirm. 

Since 2005, regulators, led by the New York Federal Reserve 

Bank, have been coordinating efforts with the industry to reduce 

risk in this market and have been gathering data about the backlogs in confirmations. Though progress has been made, it seems 

that whenever we have seen increased trading volumes or fear that 

a major counterparty might go bankrupt, like with Bear Stearns, 

suddenly all the progress fades away, and we have spikes in the 

confirmation backlogs and in trade novations, which strains the 

system and increases risk. 

After 3 years of efforts, there has been some progress, but are 

we becoming too complacent in our efforts to fully address these 

risks and make the market more efficient and resilient? 

Additionally, as the credit derivatives market plays an increased 

role in setting the course of corporate debt, it becomes critical that 

these prices reflect the actual risk of default. For example, the interest that some companies pay for their revolving credit is beginning to be based upon price fluctuations in credit derivatives. However, there are no regularly and publicly reported prices for credit 

derivatives, leaving room for perception and rumor to factor into 

pricing more than true economic fundamentals. 

What information is used to set these prices and should they be 

made public to avoid manipulation is another serious question. The 

current proposals to handle these emerging risks center on a proposed clearing entity with the main dealers as members. But who 

will oversee this entity, and who determines what trades will be 

cleared through this entity? If we have a clearinghouse that lacks 

oversight, coupled with inadequate risk management, does that 

really reduce the risk in the marketplace? 

Any new actions in this market must include improved regulatory oversight. Have the regulators considered the importance of 

price discovery in this market? And whether it can be achieved 

through the clearing entity or whether it requires an exchange is 

another important question. 

With the recent sobering experience in the subprime mortgage 

market, we must do more than hope that there isn’t another next 

big problem. Rather than just hoping, this hearing is an attempt 

to explore these issues and bring them out on the table in an effort 

to help move the industry and regulators forward in resolving these 

difficult challenges. 


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And as I indicated, when Senator Allard arrives, he will be recognized, but let me introduce the witnesses of our first panel and 

then ask them to make their statements. 

Mr. Patrick Parkinson is the Deputy Director, Division of Research and Statistics, Board of Governors of the Federal Reserve 

System. 

Mr. James Overdahl is the Chief Economist and Director, Office 

of Economic Analysis, United States Securities and Exchange Commission. 

And Ms. Kathryn E. Dick is the Deputy Comptroller for Credit 

and Market Risk, Office of the Comptroller of the Currency. 

Your statements will be made part of the record. If you would 

like to refine them, compress them, that is completely up to you. 

And as I said, we are going to try to get through as many statements as we can before the vote is called. But first let me recognize 

Mr. Parkinson. 

Could you bring the microphone forward and turn it on? 

STATEMENT OF PATRICK M. PARKINSON, DEPUTY DIRECTOR, 

DIVISION OF RESEARCH AND STATISTICS, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM 

Mr. PARKINSON. Thank you. Chairman Reed, other Members of 

the Subcommittee, I am pleased to appear today to discuss the 

over-the-counter derivatives market. 

Estimates of the size of the global market for such instruments 

indicate that it has been growing very rapidly. The very rapid 

growth of the market reflects their perceived value for managing 

credit risks. But use of credit derivatives entails risks as well as 

benefits. Of particular importance is counterparty credit risk. 

Although the credit derivatives market often is described as unregulated, by its nature it is subject to significant regulatory oversight. All transactions in the market are intermediated by dealers, 

and all major dealers are commercial or investment banks that are 

subject to prudential regulation by U.S. or foreign banking regulators or by the SEC. The prudential supervisors devote considerable attention to the dealers’ management of the risks associated 

with activities in the credit derivatives market and other OTC derivatives markets, especially to their management of counterparty 

risk. 

In addition, prudential supervisors, under the leadership of the 

Federal Reserve Bank of New York, have been working with dealers and other market participants since September 2005 to 

strengthen arrangements for clearing and settling OTC derivatives 

transactions. For too many years, post-trade processing of OTC derivatives transactions remained decentralized and paper-based despite enormous growth in transactions volumes. Among other adverse consequences, dealers reported large backlogs of unconfirmed 

trades. By making greater use of available platforms for electronic 

confirmation of CDS trades, just a year later, by September 2006, 

they had reduced confirmations outstanding more than 30 days by 

85 percent. 

Nonetheless, the financial turmoil during the summer of 2007 

convinced prudential supervisors and other policymakers that further improvements in the market infrastructure were needed. In 


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their reports on the financial market turmoil, both the President’s 

Working Group on Financial Markets and the international Financial Stability Forum asked prudential supervisors to take further 

actions to strengthen the OTC derivatives market infrastructure. 

The New York Fed convened a meeting of supervisors and market participants on June 9th to discuss how to address the PWG 

and FSF recommendations. They agreed on an agenda for bringing 

about further improvements in the OTC derivatives market infrastructure. With respect to credit derivatives, this agenda includes 

developing well-designed central counterparty services to reduce 

systemic risks. Several plans were already under development to 

provide CCP services to the credit derivatives market. 

A central counterparty has the potential to reduce counterparty 

risks to OTC derivatives market participants and risks to the financial system by achieving multilateral netting of trades and by 

imposing more robust risk controls on market participants. However, a CCP concentrates risks and responsibility for risk management in the CCP. Consequently, the effectiveness of a CCP’s risk 

controls and the adequacy of its financial resources are critical. If 

its controls are weak or it lacks adequate financial resources, introduction of its services to the credit derivatives market could actually increase systemic risk. 

A CCP that seeks to offer its services in the United States would 

need to obtain regulatory approval. The Commodity Futures Modernization Act of 2000 included provisions that permit CCP clearing of OTC derivatives, but at the same time require that a CCP 

be supervised by an appropriate authority, such as a Federal banking agency, the Commodity Futures Trading Commission, or the 

SEC. 

If a CCP for credit derivatives sought to organize as a bank subject to regulation by the Federal Reserve or if we were consulted 

by any other regulator of a proposed CCP, we would evaluate the 

proposal against the Recommendations for Central Counterparties, 

a set of international standards that were agreed to in November 

2004. 

An exchange is a mechanism for executing trades that allows 

multiple parties to accept bids or offers from other participants. Exchange trading requires a significant degree of standardization of 

contracts. But where exchange trading of OTC credit derivatives is 

feasible, it can produce several benefits, including intermediation 

by a well-designed CCP, elimination of confirmation backlogs, increased market liquidity, and increased transparency with respect 

to bids and offers, and the depth of markets at those bids and offers. 

For these reasons, policymakers should encourage greater standardization of contracts, which would facilitate more trading on exchanges. However, they should not lose sight of the fact that one 

of the main reasons the credit derivatives market and other OTC 

markets have grown so rapidly is that market participants have 

seen substantial benefit to customizing contract terms to meet their 

individual risk management needs. 

I will be pleased to answer any questions you may have. Thank 

you. 

Chairman REED. Thank you very much, Mr. Parkinson. 


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Now I would like to recognize Senator Allard for his opening 

statement. 

STATEMENT OF SENATOR WAYNE ALLARD 

Senator ALLARD. Mr. Chairman, thank you very much. Sorry I 

was late. I was in a very important meeting that I could not get 

away from, and I appreciate your commitment to starting on time. 

I had the same commitment. And I think that is the way we need 

to run our committees. It is all too frequently that we sit around 

and sit around and wait for somebody to show up for a committee 

meeting to start. 

I would like to thank you, Chairman Reed, for convening this 

hearing of the Securities Subcommittee to examine the over-thecounter derivatives market. The recent turmoil in the credit markets and the demise of Bear Stearns have caused many to scrutinize the role of credit derivatives and banks’ exposure to these potentially risky financial instruments. Even though credit derivatives and the OTC market have existed since the mid-1990s, they 

are still relatively new and trade on an immature market that 

lacks substantial infrastructure and transparency compared to 

other markets. 

Since 2005, the Federal Reserve Bank of New York has taken an 

active role in bringing together market participants and supervisory agents in order to improve the OTC credit derivative clearing and settlement process and to better ensure risk management 

practices. This proactive approach was the result of a backlog in 

the confirmation of credit derivatives trades. A backlog totaling 

over 150,000 unconfirmed trades was the result of relying on an inefficient manual confirmation process that failed to keep up with 

growing volume and because of the difficulties in confirming information for trades. 

Through initiatives and innovation in the marketplace, the number of credit derivatives confirmation outstanding more than 30 

days has been reduced by 86 percent. That number will hopefully 

continue to increase as we go forward. 

I am pleased to see market participants and regulators have 

agreed on an agenda that will continue to foster further improvements in the OTC derivatives market’s infrastructure. This agenda 

will include developing a central counterparty for credit swaps that 

will have a strong risk management organization that can help reduce systemic risk. 

The Clearing Corporation expects to start guaranteeing OTC 

credit derivatives contracts in the third quarter of 2008, increasing 

the credit default swaps products covered through 2008–2009. Not 

only will the introduction of a central counterparty help reduce systemic risk, but it will also help bring more transparency into the 

market. 

While regulators and participants have taken some necessary 

steps to improve the transparency and infrastructure of the OTC 

credit derivatives market, further steps are still needed. Just yesterday, at an FDIC conference on mortgage lending, Chairman 

Bernanke said the infrastructure for managing these derivatives 

still is not as efficient or reliable as other markets. As was evident 


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last summer when a surge in credit default swaps, trading volume 

greatly increased backlogs of unconfirmed trades. 

I would like to take this time to welcome our distinguished panelists for joining us today and thank them for their testimony as 

we continue our look into the credit market. 

Again, thank you, Chairman Reed, for convening today’s important hearing. I look forward to hearing from our witnesses. 

Chairman REED. Thank you very much, Senator. 

Mr. Overdahl, your statement, please. 

STATEMENT OF JAMES A. OVERDAHL, CHIEF ECONOMIST, 

SECURITIES AND EXCHANGE COMMISSION 

Mr. OVERDAHL. Chairman Reed, Ranking Member Allard, I am 

pleased to have the opportunity to testify today regarding the Securities and Exchange Commission’s efforts to encourage enhancements to the operational infrastructure of the over-the-counter 

credit derivatives market. 

The SEC has a strong interest in this topic because of its oversight of the largest internationally active U.S. securities firms 

through its voluntary consolidated supervised entities, or CSE, program. Each firm in this group—which includes Goldman Sachs, 

Lehman Brothers, Merrill Lynch, and Morgan Stanley—plays a significant role in the over-the-counter derivatives market. Strengthening the operational efficiency of this market will serve to increase the effectiveness of counterparty credit risk management 

systems used by these market participants. 

In their role as dealers, the CSEs make active markets in credit 

derivatives and rely on these instruments to hedge their dealing 

risk and to take proprietary positions. This buying and selling of 

default protection generates market credit and operational risk for 

the CSEs. At the same time, this activity generates potential credit 

risk exposure for the CSEs’ trading counterparties. A significant 

part of the Commission’s CSE program is dedicated to monitoring 

and assessing CSEs’ market and credit risk exposures that arise 

from these trading and dealing activities. 

In terms of operational risk, credit derivatives pose challenges 

for prudential supervisors. One challenge is that the efforts of the 

CSE firms to reduce market and credit risk exposures can often 

serve to increase the operational risk borne by these firms. This is 

because the easiest way to reduce risk often is to enter into new, 

offsetting trades rather than to unwind ones. This paradox, in part, 

explains why the Commission is interested in centralized clearing 

as one means for improving the operational efficiency of credit derivatives trading. 

A paramount concern of supervisors and market participants 

about proposed clearing systems for credit derivatives such as the 

system recently proposed by The Clearing Corporation will be the 

ability of a central counterparty, or CCP, to implement sound risk 

management practices. This is because the CCP concentrates risk. 

A CCP typically ‘‘novates’’ bilateral contracts so that it assumes 

any counterparty risks. Novation allows the CCP to enter into separate contractual arrangements with both of the contract’s counterparties—becoming buyer to one and seller to the other. 


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A CCP can serve a valuable function in reducing systemic risk 

by preventing the failure of a single market participant from having a disproportionate effect on the overall market. A CCP also 

may facilitate the offset and netting of obligations arising from contracts that are cleared through the system. 

While providing a number of potential benefits, a CCP for credit 

derivatives should not be viewed as a silver bullet for concerns 

about risk related to these instruments. Even with a CCP, preventing a systemic risk buildup would require that dealers and 

other market participants manage their remaining bilateral exposures effectively, a process that will require ongoing regulatory 

oversight. 

SEC staff has been addressing the question of whether a CCP 

must register as a securities clearing agency and the potential 

availability of exemptive relief. We have also been approached 

about the possibility of the Commission issuing an exemption for 

broker-dealer registration for firms that would use the CCP. We 

are currently considering how best to proceed. 

It is not uncommon for derivative contracts that are initially developed in the over-the-counter market to become exchange-traded, 

as the market for the product matures. Exchange trading of credit 

derivatives would add both pre-and post-trade transparency to the 

market and can also reduce liquidity risk by allowing market participants to efficiently initiate and close out positions. In this regard, I note that last year the Commission approved the proposal 

by the Chicago Board Options Exchange to list and trade two credit 

default products. 

As you can see, developments in the derivatives space pose significant operational and regulatory challenges, which will have to 

be addressed as this market matures. Again, thank you for this opportunity to discuss these important issues, and I welcome your 

questions. 

Chairman REED. Thank you very much, Mr. Overdahl. 

Ms. Dick, please. 

STATEMENT OF KATHRYN E. DICK, DEPUTY COMPTROLLER 

FOR CREDIT AND MARKET RISK, OFFICE OF THE COMPTROLLER OF THE CURRENCY 

Ms. DICK. Chairman Reed, Ranking Member Allard, and Members of the Subcommittee, I appreciate this opportunity to discuss 

how the OCC supervises derivative activities in national banks and 

to share our views on the risk mitigation efforts underway in the 

credit derivatives market. 

I have spent 24 years at the OCC working as a national bank 

examiner and have had the opportunity to examine the derivatives 

and trading activities at many of our largest national banks that 

function as financial intermediaries in over-the-counter derivative 

markets. I currently serve as the Deputy Comptroller for Credit 

and Market Risk supporting OCC senior management and identifying supervisory solutions for financial risk management issues in 

the national banking system. 

For over 20 years, OTC derivatives have been an important component of the risk management products and services that national 

banks offer to their clients. As noted in our first quarter 2008 deVerDate Nov 24 2008 01:25 Apr 02, 2010 Jkt 050408 PO 00000 Frm 00011 Fmt 6633 Sfmt 6602 E:\HR\OC\A408.XXX A408

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rivatives report that is attached to my written statement, the five 

largest national banks, all supervised by the OCC, account for 97 

percent of the total U.S. commercial bank derivative holdings. 

These same five banks are responsible for nearly all credit derivatives trading among U.S. commercial banks. 

We believe that these large national banks with their access to 

resources for people, technology, and capital to support trading 

businesses are best equipped to shoulder these risks. This does not 

mean they will not make mistakes. These are not risk-free businesses. But it does mean they have the wherewithal to devote the 

necessary talent and resources to establish risk management systems that meet the expectations and standards set by the OCC. 

At these large national banks, the OCC has established resident 

teams of examiners who serve as the foundation of our supervisory 

program with their continuous, onsite examination of complex 

areas such as credit derivatives. The dynamic nature of bank trading activities requires the OCC to frequently evaluate our risk 

management expectations, clearly communicate these expectations 

to our banks, and continually evaluate their compliance with our 

standards. 

From our perspective, there are two significant risks in the credit 

derivatives market: the first is counterparty credit risk; the second 

is operational risk. The OCC and other regulatory agencies are actively working to address these risks in the credit derivatives market. Given the global nature of derivative markets, these risks and 

the issues they raise cut across legal and national boundaries. As 

a result, our efforts involve both U.S. and key foreign regulators 

and are aimed at all of the major global financial market participants, commercial and investment banks. 

Through collaborative work, we have been successful in focusing 

industry attention on significantly reducing aged outstanding confirmations in the credit derivatives market, while increasing automation to ensure a stronger financial market going forward. We 

have also been successful in developing a set of risk metrics that 

improves transparency among firms and supervisors. And we have 

developed a useful forum for identifying and responding to emergent issues in a timely manner. But our work is not done. 

At our June 9th meeting between supervisors and the industry 

participants, agreement was reached on an expanded set of future 

goals. The industry is developing a new commitment letter that 

will address, among other things, new trade-processing goals, a 

proposed central counterparty clearinghouse, incorporating an auction-based settlement mechanism into standard derivatives documentation, and extending these infrastructure improvements to 

over-the-counter equity, interest rate, foreign exchange, and commodity derivatives. 

The clearinghouse proposal, which would create a central 

counterparty for the clearing of credit derivatives should reduce 

counterparty risk and operational risk by providing a mechanism 

for multilateral netting among major market participants. A related issue is the question of whether an exchange should be created for credit derivatives. From our perspective, the evaluation of 

potentially competing alternatives is appropriately being conducted 

by industry participants who will need to use these mechanisms if 


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risk mitigation objectives are to be achieved. Our role will be to ensure that large national banks who intend to participate in one or 

more of these alternatives meet our risk management standards 

and expectations. 

While the proposed clearinghouse or exchange-based solutions 

will certainly contribute to our objective of reducing counterparty 

credit and operational risks in the credit derivatives market, we 

must not lose sight of the fact that the dynamic nature of this market will require ongoing consideration of other initiatives that may 

also facilitate risk reduction. 

I appreciate the Subcommittee’s interest in the OCC’s supervisory work with respect to credit derivatives, and I look forward 

to answering any additional questions or comments you may have. 

Chairman REED. Well, thank you all very much for your excellent testimony. 

We are in the midst of two votes, so I would propose to recess 

briefly, and Senator Allard and I will go vote and return and engage in a round of questioning. Thank you all very much. 

We stand in recess. 

[Recess.] 

Chairman REED. Thank you for your patience in allowing us to 

go over and vote, and I will begin with a 7-minute round of questioning and then turn it over to Senator Allard. 

A question for all the panelists. Some major investors have 

claimed, as I indicated in my opening statement, that this is a 

major ticking time bomb, that this poses a potentially system risk 

to the market system, and I wonder if you could, starting with Mr. 

Parkinson, just comment upon that. How serious is this potential? 

And, obviously, what are the steps that you think should be taken 

to preclude the risk? 

Mr. PARKINSON. I think it is a significant risk. We have been devoting significant resources to trying to strengthen the system. I 

think in terms of a day-to-day basis the primary reason we are 

worried about the infrastructure and the backlogs is the potential 

for them to magnify market and counterparty credit risk by permitting errors in trading records to go undetected. The really good 

thing about fully confirming your trades with a counterparty is 

that then you have a good understanding of what the terms are 

and, therefore, you have good records of those trades. 

In terms of systemic risk, I think the major concern is that it 

might complicate the resolution of a default by a major market participant if one were to occur. I think, for example, we would be concerned that derivatives counterparties might have difficulty 

promptly determining what their credit exposures are to a 

counterparty if they have not confirmed all their trades with that 

counterparty. And I think if a major counterparty were to default, 

that would be a real challenge to its counterparties and a challenge 

to the system. 

Chairman REED. Mr. Overdahl. 

Mr. OVERDAHL. I would agree with that and just add that I think 

the confirms issue can pose risk in a few different ways. It can undermine the risk management capability, the effectiveness of the 

risk management—counterparty credit risk management of the 

major players. It can make that management less effective. It can 


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also pose credit risk issues in terms of just knowing who your exposure is and monitoring that counterparty credit risk, and also market risk if there is a trade that is not agreed to and has to be replaced, that that can pose significant market risk. 

So, you know, there is certainly potential here for a lot of risk, 

and I think efforts to strengthen that system can only pay off in 

more effective risk management by the firms. 

Chairman REED. Ms. Dick, please. 

Ms. DICK. I would maybe supplement the comments of my colleagues with a couple of observations from what we have seen in 

the national banking system. Again, credit derivatives are probably 

about a fifth or 20 percent of the volume of transactions, so from 

a volume standpoint, and even, quite frankly, a counterparty credit 

risk standpoint, they are somewhere around 20, 25 percent of total 

exposure. I think some of the systemic issues arise because it is a 

young market. You do not have standardization of documents. You 

have perhaps participants in that market that are less well understood and recognized in the market. So there is variabilities that 

we see in other markets. At the same time, in the national banking 

system, we have got large over-the-counter markets and interest 

rates and foreign exchange that, again, started under similar circumstances, and 20 years later are, in fact, very sound, robust markets. 

So as both Jim and Pat mentioned, I think one of the keys here 

is looking for all alternatives to improve infrastructure and the 

credit risk that is associated with these contracts so we can diminish any unwarranted exposure. 

Chairman REED. Ms. Dick, let me follow up with a slightly different question. We have just come through a very tumultuous episode with mortgage-backed securities, and there were credit default 

swaps written on these products. To what extent do these credit default swaps exacerbate the underlying problem? And were banking 

regulators—and I will turn to Mr. Overdahl also—aware early on 

that this was a potential problem with the credit default swaps? 

Ms. DICK. Well, again, we were aware that credit default swaps 

were used as part of the structured products. I will say the losses 

we have seen in the national banking system are largely associated 

with cash underlying securities. So, in fact, it really is not, again, 

from a product standpoint, a derivative. 

Now, again, a benefit is that they do allow for hedging of some 

exposures as well, so there is a plus, I guess, to the credit derivative product in some of the structured product markets. 

Chairman REED. Mr. Overdahl, you can respond to that question 

with regard to securities but also with respect to Bear Stearns. 

There was an issue there with credit default swaps, and there were 

some commentators that suggested that that was one of the principal reasons that there had to be regulatory action, just uncertainty about how that would all fall out. I think it tracks Mr. Parkinson’s response about if a major institution fails, no one quite 

knows where the ball will stop rolling. Could you comment? 

Mr. OVERDAHL. Let me take the first question first. The role of 

the SEC in its consolidated supervised entities program is looking 

at the risk controls, the risk structure, the risk management of the 

entire structure, and so to that certainly there is awareness of the 


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exposures without necessarily second-guessing the risk appetite for 

any particular firm, but making sure—or asking the questions, 

making sure that those risks are well understood and well controlled. 

With respect to Bear Stearns and the role of credit default 

swaps, I am not sure that in terms of confirmations that there was 

really an issue there. In terms of the CSEs, they exceeded industry 

standards in terms of their confirmation processing. They were also 

among the CSEs the smallest with respect to their over-the-counter 

positions outstanding, although still being a CSE that is fairly substantial. I think the big risk—one risk that we have become very 

aware of was just the scale of novations that occurred as counterparties substituted away the Bear Stearns name, and I will turn 

it over to Pat. 

Chairman REED. Let me—and I will, Mr. Parkinson. But a follow-on question is that under the general concepts of an exchange 

or a clearing mechanism, these novations would be better managed. Is that fair? Or is that one of the objectives of such a system? 

Mr. OVERDAHL. I think it can be better managed. It can certainly 

be better managed that way. Also, I think another significant thing 

is just the rumors that can start as a result of the novation process 

and that is something that could be eliminated, largely. You cannot 

eliminate rumors, but you can eliminate that source of them using 

a central counterparty or an exchange. 

Chairman REED. Mr. Parkinson, your comment, and then I will 

turn to Senator Allard, and then we will do a second 7-minute 

round. 

Mr. PARKINSON. Just on the Bear Stearns situation, I think there 

has been some confusion about this. I think the primary cause of 

Bear’s demise was a loss of confidence in its ability to meet its obligations, which triggered a classic run on the bank. And, in particular, investors who provided Bear with large amounts of secured 

overnight financing, primarily through repo agreements, refused to 

roll over that financing and demanded repayment of a substantial 

amount of money. 

Where derivatives may have played a role in that is that attempts by counterparties to novate trades with Bear to other dealers in some instances were refused, and that seems to have contributed to the initial loss of confidence. 

With respect to what we were worried about in the case of Bear, 

I think the concerns about the potential impact of Bear’s bankruptcy on its derivatives counterparties were not the primary factor 

in the decision by the Federal Reserve and other policymakers to 

facilitate its acquisition by JPMorgan. The primary fear was that 

its bankruptcy would spark a run on the other dealers who are 

equally reliant on the same kind of secured financing that Bear 

was. But we were also concerned that counterparties would have 

serious difficulty promptly determining their vulnerability to losses 

on derivatives from Bear’s default and that their efforts to replace 

the hedges with Bear would have placed additional pressures on 

markets that already were quite stressed. So the derivatives concerns were a factor but not the predominant factor in both its troubles and in our response to those troubles. 

Chairman REED. Thank you very much. 


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Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. 

It has been about a year now when we saw a large spike in the 

credit default swaps, and I think there were attempts to try in the 

past to reverse some of these backlogs that occur. And my question—I have kind of a two-fold question. What progress have market participants made to improve the infrastructure in processing 

so it operates more efficiently when we go through these sustained 

periods of high-volume and high market volatility periods? And 

what has the President’s Working Group—with their recommendations that came out in March, what do you see the results of that 

n the financial market development concerning credit derivatives? 

And I address that question to you, Mr. Parkinson. 

Mr. PARKINSON. OK. Well, I think they are sort of one and the 

same because we had this existing initiative led by the New York 

Fed involving all the supervisors at this table and many others to 

improve the infrastructure. I think significant progress had been 

made between the fall of 2005 and the summer of 2007. 

That said, as you noted, in the summer of 2007 there was a fivefold increase in the backlogs. I think if they had not made the improvements they had made over the previous year and a half, it 

could have been far worse and, indeed, might have impaired the liquidity of those markets at a critical time. But we recognize that 

further improvements are necessary. Both the President’s Working 

Group on Financial Markets and the FSF have asked that group 

of supervisors under the New York Fed’s leadership to ensure that 

specific improvements in the infrastructure are made. And at the 

June 9th meeting, agreement was reached on a set of goals for improving the infrastructure. Market participants and regulators 

agreed that participants should write a letter to the regulators by 

the end of July setting out the specific steps they are going to take. 

So I think at that time we will be able to be much more specific 

on exactly what is being done to address this continuing concern. 

Senator ALLARD. Now, there has been some resistance, I understand, to the use of electronic trading platforms. How do you think 

the use of electronic platforms—why do you think it remains so 

limited? And why is there some resistance to using that when we 

have so much technological innovation being used at other exchanges? 

Mr. PARKINSON. Well, I think part of it is simply inertia. They 

have been using over-the-counter markets, they have been using 

voice brokers for many, many years, and it is hard to wean them 

from that. I think also the use of the electronic trading platforms 

does require some further standardization of the contracts. But 

that said, I think a fair amount of what is being traded is amenable to processing on electronic platforms, so I think that some 

people do not see that in their economic self-interest to make use 

of that technology. 

But, in any event, as you indicate, the take-up has been pretty 

slow. I think actually it has been a little bit better in the credit 

derivatives markets than some of the other derivatives markets, 

and for reasons that are not completely transparent to me, more 

successful, more widely used in Europe than the United States. 


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Senator ALLARD. Yes, I have noticed. I think we made a trip to 

some of the exchanges in Europe, and they seemed to be much 

more willing over there to accept electronic platform than over 

here. 

This question I want to address to all three of you on the panel, 

and that is, do you believe that as regulators you have the tools 

and the access to information that you need to oversee the OTC 

credit derivatives market? And if not, what do you need? 

Ms. DICK. I will begin that answer. 

Senator ALLARD. I think that is fair. 

Ms. DICK. Very good. I believe at the OCC we do feel that we 

have the tools and information needed to oversee the over-thecounter derivative activities in the national banking system. I had 

mentioned, I think, in my oral statement that we have got overthe-counter derivative markets, the largest there, which is interest 

rate contracts and foreign exchange, that have been in existence 

now for 20 years. We have learned over a period of time the type 

of information we need with respect to risk management. 

I will say via participation in this effort that has been initiated 

in 2005 on the credit derivatives market in particular, as well as 

some of the work that has been done on an interagency basis between regulators, both domestically and internationally, since the 

credit market turmoil began last summer, that we actually find 

ourselves sharing information on emerging issues in some of these 

over-the-counter markets earlier with colleagues and other agencies than before for instance, if we are seeing trends in the national 

banking system, we can share that information with our counterparts who might be seeing participants in another part of the market and looking for any systemic issues and identifying them earlier than perhaps we might have in the past where we have tended 

to do our work more in isolation. 

Senator ALLARD. Yes, and your comment sort of spurred another 

question. We have different accounting standards in the United 

States as well as internationally. Theirs is more conceptual. Ours 

is more detailed and more specific, regulatory. Does that make a 

difference for you to bring accountability into the system when you 

are dealing with international trades? 

Ms. DICK. I do not believe from a risk management standpoint 

that affects the information that we are looking at in our firms. 

But I know when we look at, for instance, information that is disclosed by these firms, we have our call reports in the U.S. for the 

commercial banks, which has a fair amount of information on overthe-counter derivatives, and then clearly in published financial 

statements there is more information about some of the risk aspects. 

It is very different when you start to look at foreign firms to try 

and gauge what that risk exposure is because the disclosures are 

different and, again, the accounting standards are different. 

Senator ALLARD. Mr. Overdahl, maybe you would like to comment on those two questions. 

Mr. OVERDAHL. Sure. In terms of the oversight of the market, 

our window into the market is through our authority with respect 

to the CSEs, and with respect to that authority, I think we have 

the tools we need to do the job that we do with the CSEs in the 


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oversight of risk management controls that they have, which would 

include the credit default swaps market, but it is only their piece, 

their management of the counterparty credit risk, the pricing 

issues, these type of things that directly affect those that are within our jurisdiction. 

In terms of the accounting, I cannot really see that as an issue. 

The risk numbers that we see are not really subject to that type 

of differences in accounting treatment. 

Senator ALLARD. Next. 

Mr. PARKINSON. I agree we have all the authority that we need. 

I think in particular one thing to be realized about the existing 

oversight regime, which is this cooperative effort by the prudential 

supervisors and all the major dealers, is that because it is a global 

market, that kind of cooperation is essential to accomplish anything. And if one contemplated a new regime or a different regime, 

you would have to figure out how to replicate that degree of international cooperation, which would be difficult. On accounting, I do 

not really have anything to add to that. 

Senator ALLARD. Thank you. I see my time has expired, Mr. 

Chairman. 

Chairman REED. I have a few more questions, and I will take 

them, and then I will turn to Senator Allard. 

One of the aspects of the credit derivatives issue has been the 

fact that some institutions are finding themselves on both sides of 

a transaction, in some respects, a bank loaning to a company, and 

then sells credit protection to that company, and it gets complicated. I wonder if you might respond to this, Ms. Dick, about 

this whole notion of the concentration of risk and the ability to understand the risk, your viewpoint, and if you gentlemen would like 

to add anything else, that is fine. 

Ms. DICK. Very good. With respect to credit derivatives, as you 

mentioned, they can be used as a tool both to assume credit risk 

as well as shedding credit risk, which is what our large national 

banks do. Most of the activity they report in their call reports of 

activity that they are involved in is actually financial intermediation activity, where they are taking requests from clients that 

want to either assume or shed credit risk, designing a credit derivative transaction, and then managing that risk internally. 

Clearly, as you mentioned, there is the potential for either concentrations of risk or parties finding themselves—and I think frequently it is actually not the regulated institutions, but perhaps 

some of the unregulated that are in a position where they might 

have lending exposures as well as large credit derivative exposures. 

We do require, again, you know, robust risk management systems in our firms. One of the things that they will look at when 

they look at credit exposure as one of these large banks is both 

cash exposure in the form of either securities owned or loans, as 

well as any derivative exposure. And, again, one benefit of the derivative product is the fact that it allows you to alter your credit 

risk profile. So if as a bank you are very concentrated in an industry and your lending portfolio, you can actually diversify that by 

assuming some credit risk in another industry. It is a risk that certainly has to be managed, but I see risk management tools in the 

system that I think are very capable of doing that. 


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Chairman REED. So these tools in the system in a very simplified 

way, if the lines are all crossed, loans, credit defaults, co-ops, other 

instruments at one institution, that sets a red light off, I guess, or 

some sort of warning that you have to look closely? 

Ms. DICK. Again, firms will have internal capacity for how much 

risk they are willing to take to any given name. 

Now, I would not want to leave you with the impression that 

people are pushing magic buttons and can gather all this information. As a supervisor, we wish, of course, that were the case. But 

because the business is concentrated primarily, in the national 

banking system in five large institutions, we have the ability to go 

in and where we see deficiencies in that aggregation capability, 

work with bank management to get those deficiencies resolved. 

Chairman REED. Now, your perspective, Mr. Overdahl, from 

SEC. 

Mr. OVERDAHL. I think that our perspective is very much similar 

to the banking supervisors in that we are looking at the risk management capabilities of these firms, and to the extent that these 

type of concentration issues exist, we are looking at the systems to 

make sure that they can identify and pick up that type of risk, and 

looking at how they manage that counterparty credit risk but more 

looking at the process, making sure that the process is in place 

that these risks are identified and understood. So it is very similar. 

Chairman REED. Mr. Parkinson, your comments. 

Mr. PARKINSON. Just that I think both at the level of the banks 

and the level of the regulators, we need to be looking at aggregate 

exposures to a particular corporate obligor and aggregating those 

across the cash holdings of the instrument and any derivative holdings they have, and not looking at the cost of derivative in isolation 

or failing to aggregate them. 

That can sometimes be a challenge to do. I do not know that it 

has been in the case of CDS, but I know in the case of subprime 

exposures, our banks did not always distinguish themselves in 

managing their exposures on an aggregate firm-wide basis. But 

that said, certainly that is the goal, that is the expectation. 

Chairman REED. Let me begin with Mr. Parkinson and ask another question. It seems to me there are two general institutional 

responses to this issue of CDS. One is an exchange approach, and 

the other is a clearing approach, a clearing entity. The advantages 

of one versus the other and is there any sort of institutional or regulatory preference or bias? 

Mr. PARKINSON. An exchange would employ a central 

counterparty, so the question really is what further benefits and 

what further disadvantages exchange trading per se would have 

over a CCP for the OTC markets. 

I think exchange trading does require a significant degree of 

standardization of contracts, although many of these contracts already are standardized to an important degree. But where it is feasible, it can provide additional benefits, possibly including elimination of the confirmation backlogs. I think as Jim said in his testimony, in active markets trades are basically locked in at execution, 

and the whole confirmation process is obviated. They also can increase market liquidity and they can increase transparency with 

respect to bids and offers and market depth. The major disadvanVerDate Nov 24 2008 01:25 Apr 02, 2010 Jkt 050408 PO 00000 Frm 00019 Fmt 6633 Sfmt 6602 E:\HR\OC\A408.XXX A408

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tage of exchange trading would be, again, the need to standardize 

the contracts, and that would be a concern where customization allows the OTC contracts to meet the individual risk management 

needs of counterparties that could not be met by the standardized 

contracts. But I think standardized contracts trading on an exchange and the more customized contracts trading in the over-thecounter markets might give us the best of both worlds. 

Chairman REED. Mr. Overdahl, any comments? And then Ms. 

Dick. 

Mr. OVERDAHL. I agree with Pat’s comments, and I would just 

note that there are other markets outside of the financial world 

where we have seen over-the-counter clearing, and perhaps in the 

energy area is the best example where you had a very successful 

product developed for clearing at the energy exchanges. And it is 

interesting. When there were credit disruptions in that market, 

where people were concerned about credit risk, some of the same 

type of things you are seeing today in financial markets, the people 

voted with their feet, and they moved to those systems because 

they could see the benefits of the central counterparty, and they 

could also see the benefits of the transparency that an exchange offered. 

Now, how that is going to play out is really ultimately the choice 

of markets participants of just how they value those features of 

these competing marketplaces. 

Chairman REED. Ms. Dick. 

Ms. DICK. I would echo the comments of my colleagues, and highlight that in looking at the proposed clearinghouse arrangement 

that is being discussed by the industry right now, we see clear benefits with respect to, again, the two risks we think are most important—the counterparty credit and the operational. If you have a 

central counterparty, as was mentioned by one of my colleagues, 

many of these trades that are now being layered one on top of another to actually manage your market or credit risk would no 

longer be necessary. That also reduces volume of trades, which, 

again, would address some of the operational issues. 

A drawback, however, and one we just need to recognize, is that 

it would concentrate risk in the clearinghouse, so it has got to be 

structured properly. We need to make sure there is the right capital support behind that clearing arrangement so that if there is a 

problem with one of the large participants, that, again, that does 

not actually exacerbate the credit issue. 

Near as I can tell with respect to the exchanges, Mr. Parkinson 

mentioned probably the biggest benefit, which I think also can be 

a drawback, is the standardization of contract terms. I think what 

we see right now is that with respect to index and some other 

transactions, they are actually quite standardized. But many of the 

credit derivative transaction that we see in the national banking 

system are still standard, single-name transactions that are done 

to assist some client in managing their own credit risk profile. It 

may be difficult to standardize those contracts in a form that would 

be necessary for an exchange, and in that regard, if that is the 

case, the client is looking for customized trades. If the trades do 

not occur on the exchange, you are not going to get the benefits, 

again, of the operational and credit counterparty reduction. 


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Chairman REED. Let me follow up with Mr. Parkinson and Mr. 

Overdahl. As I understand, the proposed clearing arrangement 

would take the form of a state bank, which would be supervised at 

the Federal level by the Federal Reserve. But it is the SEC that 

to date has had much more extensive experience in clearing operations. Can you comment on that, Mr. Overdahl? 

Mr. OVERDAHL. Well, certainly the SEC has had experience over 

many years in central clearing in the securities markets, and it is 

interesting that many of the operational difficulties that we are 

talking about here today were evident in the securities market at 

one time, and there was a great effort, part of the national market 

system in the mid-1970s, that addressed many of those issues at 

that time. 

In terms of this particular proposal, I am not sure that there is 

really much—in terms of the structure, there is much more I can 

add about—I mean, certainly we see the benefits, potential benefits 

of centralized clearing and, again, as Kathy said, it really depends 

on the financial safeguards that are in place and the quality of the 

guarantees that they can—the credibility of those guarantees in 

order for it to be a successful venture. 

Chairman REED. I just want to ensure that I understand. The 

proposed arrangement now of the major institutions that are setting up the clearing house would require Federal Reserve supervision. Is that correct, Mr. Parkinson? Would you be the primary 

supervisor, or the SEC? Let me clarify that. 

Mr. PARKINSON. I think that is their choice. Under existing law, 

which is the Commodity Futures Modernization Act of 2000, a CCP 

for OTC derivatives needs to be regulated. But they have their 

choice of regulators. It can either be one of the banking agencies; 

it can be the CFTC or it can be the SEC. I think you are referring 

to The Clearing Corporation, which has made a decision to organize as a bank chartered by the State of New York and a member 

of the Federal Reserve System, which would bring them under our 

supervision. And in addition, as Mr. Overdahl mentioned in his testimony, if CDS are considered securities, which they might be, then 

securities have to be cleared through an SEC-registered clearing 

agency unless the SEC grants an exemption that would allow it to 

be cleared by an entity that is not an SEC-registered clearing agency. So I infer from that that The Clearing Corporation would need 

an exemption from the SEC from their clearing agency requirements to proceed with their plan to organize as a member bank 

regulated by the Fed. 

Chairman REED. And if all of those exemptions are granted, it 

would be regulated by the Federal Reserve in its capacity as the 

clearing agent. Is that correct? 

Mr. PARKINSON. Yes, it would be regulated both by the New York 

State Banking Department as the chartering authority and by the 

Federal Reserve, by virtue of its choosing to be a member of the 

Federal Reserve System. 

Chairman REED. But it would just seem to me the expertise, the 

operational expertise is more in the realm of the SEC than the 

Federal Reserve. There would be no sort of institutional cost for 

you to chin up the regulation? 


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Mr. PARKINSON. We do not currently regulate any central 

counterparties. We do have a role in regulating securities settlement systems in the case of the Depository Trust Company, which 

is organized as a State-chartered member bank, much in the way 

that The Clearing Corporation is planning. We also regulate the 

CLS Bank which settles foreign exchange transactions, which is organized as an Edge Corporation. 

I might also mention—I think the SEC mentioned in their testimony, as we did, the CPSS IOSCO standards. We played a leading 

role in developing those standards for CCPS. So we do not have the 

specific experience that the SEC does, but we have a lot of other 

relevant experience. 

Chairman REED. Very good. Thank you. 

We have been joined by Senator Schumer. Do you have additional questions? 

Senator ALLARD. I do, if I might just briefly, and then—— 

Chairman REED. Since he has not had an opportunity—— 

Senator ALLARD. Go ahead. 

Chairman REED. OK. 

Senator SCHUMER. Thank you. I thank both of my colleagues and 

only apologize for coming in and leaving, but they are debating the 

Medicare bill on the floor, and I am very much involved in that. 

So I apologize to both my colleagues. 

First, to Mr. Parkinson, do you believe that the effort underway 

by various swap dealers to create a clearinghouse and central 

counterparty will be able to significantly reduce the risks posed by 

OTC derivative markets? 

Mr. PARKINSON. I think that a CCP has the potential to reduce 

systemic risks and risks to the counterparty participants. But that 

will be the case only if it robustly manages the risks that are concentrated in the CCP by virtue of its activities. In terms of making 

judgments as to whether a particular proposal for a CCP reduces 

systemic risk, we would apply these international standards, the 

so-called CPSS IOSCO standards, and we would apply those to any 

plan for providing CCP services to those markets. But we believe 

that if they do meet those standards—and that would be challenging given some of the unique features of OTC derivatives— 

then that would be reducing systemic risk. 

Senator SCHUMER. OK. Thank you. 

And now to all the witnesses, the question is: Will the consolidation of information about the markets and the clearinghouse offer 

you and other regulators a better view of the safety and soundness 

and systemic risks posed by these markets? And I also want to address the debate over encouraging credit default swaps and other 

derivatives to become exchange traded. While I recognize the value 

that exchange trading can offer in terms of price discovery and settlements, I am also concerned that forcing immature products onto 

an exchange will reduce innovation and competitiveness. This is 

the age-old push and pull of regulation. 

So, Mr. Parkinson, aren’t the OTC derivatives markets where the 

parties are free to negotiate and customize their contracts some of 

the most innovative and fastest-growing financial markets? If that 

is the case, while it may make sense to encourage some of the most 

mature contracts to an exchange, we should be careful to preserve 


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our financial markets’ ability to innovate and continue to compete. 

Isn’t that correct? And since these markets are so international, 

what steps are the Fed, SEC, and OCC taking to coordinate their 

oversight of the OCC derivative markets with international regulators? Are there any indications at the moment that some international markets may fail to implement regulations that are similar to the U.S.’ potentially putting us at a comparative disadvantage? 

It is a series of related questions. First, Mr. Parkinson, then Mr. 

Overdahl and Ms. Dick. 

Mr. PARKINSON. All right. I do not think we should force things 

onto exchanges, but if market participants choose to move activities 

to exchanges, we should not stand in the way. I think it will never 

be the case that all the products that are traded today in the OTC 

markets will be traded on exchanges. That would require more 

standardization in some cases than market participants would find 

in their interest. 

With respect to the question you raised about international coordination, I think there is where we have this existing initiative 

under the leadership of the Federal Reserve Bank of New York 

where they have the prudential supervisors of all the global derivatives dealers and the market participants coming together and 

working together to improve and strengthen the markets so there 

is a substantial degree of regulatory coordination internationally. 

When it comes to the specific issue of central counterparties, you 

have international standards for central counterparties, the CPSS 

IOSCO standards. Again, that provides a substantial degree of 

comfort that there will be a level playing field in that area as well. 

Senator SCHUMER. Mr. Overdahl. 

Mr. OVERDAHL. I agree with those comments in terms of the ability of market participants to choose the best venue for where they 

would trade. One thing the SEC has spent quite a bit of time 

thinking about over the last few years is the best way to streamline 

the process that products can brought to market. So when an exchange identifies an opportunity, that can be done in a quick way 

in which the risks that have been identified, the product can be 

there to help manage them. And also, with the international standards, again, the SEC has participated in many of the same forums 

that Pat just mentioned, with the CPSS IOSCO. The SEC was involved in that standard setting. So we have been involved internationally. We have been involved in discussing these issues with 

our counterparts overseas. 

Senator SCHUMER. Ms. Dick. 

Ms. DICK. I would just maybe step back to the first question you 

asked, which I think was about information we might receive as 

supervisors. In the effort we have had underway right now that 

Mr. Parkinson mentioned, led by the New York Fed, I will say we 

have achieved a great deal of information from the industry both 

about the firms we individually supervise but also their competitors, which has been extremely helpful. So we have information 

about how long it takes for a trade to be confirmed, the volume of 

transactions our firms are involved in, the ability to electronically 

process those trades. And because the global nature of the business 

is such that there are only 15 to 20 large global firms involved, it 


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is very useful as a primary supervisor to be able to go to one of 

your institutions and identify when they are an outlier in that population and push stronger and harder and really more effectively 

for some kind of change if there are risk management issues. 

So I think based on what we know about a clearinghouse, there 

is a strong probability we could get additional information that 

would be useful, and I think the structure, at least as we understand it, that is being discussed right now would also assist in reducing counterparty credit risk and operational risk. 

From the OCC’s perspective, I do not think we see strong compelling reasons for an exchange, but we would not be opposed to that 

either. The risks we are worried about are really addressed with 

the clearinghouse. 

Senator SCHUMER. Thank you, Mr. Chairman. Thank you, Ranking Member Allard. 

Chairman REED. Thank you very much. 

Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. 

You know, my understanding of derivatives is that they have to 

have some flexibility to meet the various situations that come up, 

and we have Ph.D.s that work on derivatives who in many cases 

probably know more than a regulator. 

Would you talk a little bit about how far we could standardize 

derivatives through rules and regulations, or how far your clearinghouse can go on something like this? 

Mr. PARKINSON. I do not think that we should be standardizing 

derivatives through rules and regulations, and I do not think a 

clearinghouse can standardize. It offers its services for a range of 

contracts. The range of contracts will not be unlimited, so it will 

require a certain amount of standardization of contracts for those 

to be eligible for clearing. But market participants are not compelled to participate in these arrangements, so the fact that the 

clearinghouse only clears a limited range of contracts does not stop 

them from trading contracts that do not fit the clearinghouse’s parameters. Indeed, in that regard, we have had a CCP for interest 

rate swaps in London operating since 1999 that is used by all the 

big dealers. It only clears so-called plain vanilla interest rate 

swaps. That has not stopped the dealers from customizing interest 

rate swaps where they see their customers having an interest in 

their doing that. It is just that those do not get cleared through the 

clearinghouse. So I do not really think mandating the terms of derivatives transactions is on the table. 

Senator ALLARD. Mr. Overdahl. 

Mr. OVERDAHL. Yes, I would agree that I think that it is really 

not the role of a regulator to decide how that standardization 

should occur. That is something that really is a choice of market 

participants, and they have to evaluate the advantage of standardization that comes along with liquidity, perhaps, and perhaps the 

use of a central counterparty for clearing, that advantage versus 

the advantage of getting a highly customized deal that will meet 

their specific business needs. And that is really a business decision 

of market participants and one that I think we would be extremely 

reluctant to get in the middle of. 

Senator ALLARD. Ms. Dick. 


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Ms. DICK. Yes, with regard to standardization of contracts, I 

think as my colleagues have mentioned, what we have seen in the 

over-the-counter derivative markets are perhaps larger and longerlived in the banking industry, the interest rate and foreign exchange, is that they are really not mutually exclusive. Many of 

these contracts start out in these markets in true customized contract form, and then as we have even seen in the credit derivative 

market, the documentation becomes more standardized, certain 

names become the reference names people are looking for, and 

those can be more standardized. And as I think both my colleagues 

mentioned, it is really the market participants that drive which— 

you know, that these contracts become more standardized. 

So we see the central counterparty, again, being an alternative 

to help reduce counterparty risk, operational issues. We see the 

standardization of contracts as one that we will likely see follow 

the path we have seen in other over-the-counter markets. But I believe there will be a large number of these trades that will continue 

to be over the counter because that is really the nature of the risk 

that some client, again, is trying to manage. 

Senator ALLARD. At the risk of starting an argument among the 

panelists here, I want to ask the next question. The Fed had decided to infuse cash with the secondary—or the risk—the loans 

that were high-risk loans. And, of course, though, this has had an 

impact on industrial—or investment banks, and I assume that they 

put together some of these derivatives perhaps and do the swaps 

and whatnot. And then Chairman Bernanke has just decided to extend that. 

Mr. Overdahl and Ms. Dick, do you think that is helpful? Or 

should we let these things just live and die on their own merits? 

And then maybe Mr. Parkinson would like to respond. 

Mr. OVERDAHL. I am afraid I am just really not in a position to 

make that judgment. 

Senator ALLARD. Do they feed into the derivatives and the swaps 

on the investment banks, some of the things they put together? Do 

they feed into investments in swaps? 

Mr. OVERDAHL. Well, certainly, they are major participants and 

dealers in the markets. 

Senator ALLARD. Yes. 

Mr. OVERDAHL. So I am not sure—could you help me out here 

with—— 

Senator ALLARD. Well, I am just fishing a little bit. [Laughter.] 

I admit that. But I am just wondering if there is a downside to 

this or a positive side as far as you are looking at OTC—— 

Chairman REED. Extending the—— 

Senator ALLARD. Yes, yes. 

Mr. OVERDAHL. Well, you know, our role as securities regulators 

is not to oversee the entire over-the-counter market. It is a very 

limited role in our jurisdiction. So certainly, you know, our focus 

is on the consolidated—the CSE groups of investment banks and 

making sure that their policies and procedures for risk management are in place. I am not sure beyond that there is really much 

of a role. 


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Senator ALLARD. But the Fed is starting to assume a role, and 

so does that mean you look at them a little differently as far as 

their security? 

Mr. OVERDAHL. Well, I am not sure it is looked at any differently. Certainly we have worked closely with our Fed counterparts through the MOU that was just signed the other day, information sharing, making sure that the look that we are seeing with 

our people who are on the ground in these banks, in the investment banks, are sharing information with our counterparts at the 

Federal Reserve, and that we are seeing the look that they are seeing from a bigger picture, from the primary dealers and others that 

may help us do our job better. 

Senator ALLARD. Ms. Dick, do you want to comment? 

Ms. DICK. Senator Allard, I think you have correctly noted some 

of the issues that have arisen in this period of market turmoil over 

the last 9 months, one of them, a key issue being that of liquidity— 

liquidity in markets, liquidity in institutions. And, Chairman Reed, 

you had mentioned this in your opening comments as well. Some 

of the actions we see now in financial markets that are driven by 

either other participants or perhaps facilitated by the fact that they 

have a number of tools with which to take exposures in the credit 

derivatives market would be in the individual names of firms. 

The liquidity issues, some of the issues associated with market 

stability, are all issues that I think we are regulators recognize are 

a distinct priority for each of us and ensuring that our firms can 

both manage their own risks safely and soundly but also key market participants can contribute to a stable financial market in each 

of these instruments, and perhaps more broadly with respect to the 

financial system. 

There are a number of issues, many of which we have been discussing through this forum. We have talked about at the hearing 

today with respect to the regulators both domestically and internationally that I think will have to be resolved through perhaps additional guidance or standard by the regulators, but also some risk 

management practices in the firms that will have to be enhanced 

with respect to areas such as liquidity risk management, aggregation of risk exposures for individual names, as Mr. Parkinson mentioned, reference names, and derivative counterparties. So I think 

there are a number of these types of ancillary issues that certainly 

have some implications for the credit derivative market, but also 

are going to have to be addressed by the supervisors. 

Senator ALLARD. Mr. Parkinson, do you want to comment or do 

you want to pass? 

Mr. PARKINSON. In general terms, I think there is a connection 

between the Bear Stearns episode and the actions we took to stabilize the financial system in that instance and the subject matter 

of this hearing, and that is that we recognize that in providing liquidity and facilitating the acquisition of Bear Stearns, that entails 

a certain amount of moral hazard and that people may come to expect it will take such actions and that those actions will protect 

their interests and that that might lead them to be less rigorous 

about protecting their own interests. 

So I think one of the things we are trying to do to mitigate that 

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kets so that some of the concerns that really required us to intervene would no longer be concerns because the infrastructure had 

been made stronger so that the system can better withstand the 

failure of a large firm. And one of those infrastructure initiatives— 

by no means the only one, but one of the main ones that we have 

been emphasizing is this initiative to strengthen the infrastructure 

for the OTC derivatives markets, and, in particular, the credit derivatives markets. So there is a connection there as you perceived. 

Senator ALLARD. Thank you, Mr. Chairman. 

Chairman REED. Thank you, Senator Allard. 

Thank you very much for your very thoughtful testimony and for 

your dedicated service. Thank you very much. 

I will now call up the second panel. 

Senator ALLARD. Mr. Chairman, while we are waiting for this 

panel, I wonder if I might insert some records that were requested 

be put in the record by Senator Crapo, who is a Member of this 

Subcommittee. 

Chairman REED. Without objection, the statement will be made 

part of the record, and all statements of Members of the Committee 

will be made part of the record. 

We are ready now to introduce the second panel, and we thank 

all of you gentlemen for joining us this afternoon. 

Our first witness is Dr. Darrell Duffie. Dr. Duffie is the Dean 

Witter Distinguished Professor of Finance at Stanford University, 

the Graduate School of Business. He is the author of a number of 

books and articles on topics in finance and related fields and is currently working on a paper on the global derivatives market. 

Mr. Robert Pickel is the Executive Director and CEO of the 

International Swaps and Derivatives Association, ISDA. He also 

serves as a member of the board of directors of the Institute for Financial Markets, a member of the Bretton Woods Committee, and 

a member of the board of the Capital Markets Journal. 

Mr. Craig Donohue is Chief Executive Officer of the Chicago 

Mercantile Exchange Group. Before joining CME as an attorney in 

1989, Mr. Donohue was associated with the Chicago law firm of 

McBride Baker & Coles. During his time at CME, he has been involved in the merger between CME and the Chicago Board of 

Trade. 

Our fourth witness is Mr. Edward J. Rosen of Cleary Gottlieb 

Steen & Hamilton, who is outside counsel to The Clearing Corporation. He is co-author of the two-volume book titled ‘‘U.S. Regulation 

of the International Securities and Derivatives Markets.’’ 

Gentlemen, thank you for joining us, and all your statements will 

be made part of the record, so if you would like to summarize or 

abbreviate, that is fine. 

We will start with Dr. Duffie. Dr. Duffie. 

You might want to push that button. 

STATEMENT OF DARRELL DUFFIE, DEAN WITTER DISTINGUISHED PROFESSOR OF FINANCE, GRADUATE SCHOOL OF 

BUSINESS, STANFORD UNIVERSITY 

Mr. DUFFIE. Thank you. Thank you, Mr. Chairman and distinguished Members of the Committee. 


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The financial industry got ahead of itself by allowing extreme 

growth of its credit derivatives markets before it had safe and effective ways to manage the associated risks. I have been concerned 

about inadequate methods for the pricing and risk management of 

the types of credit derivatives that played a role in the recent credit crisis, and I have also been concerned about a lack of robust 

operational infrastructure. I am going to focus now on the operational issues such as trade documentation and clearing. 

Credit derivatives are traded almost entirely in the over-thecounter market, where a dealer normally acts as a seller to buyers 

of default protection, and as a buyer to sellers of default protection. 

In order to balance their positions, dealers often take positions 

with other dealers. In addition, hedge funds often expose one dealer to another when they reassign their positions in an existing contract. As a result, dealers find themselves significantly exposed to 

the event of default by some other dealers, normally a very remote 

but potentially dangerous possibility. 

Had Bear Stearns collapsed before the 2005 initiative of the Fed 

led to reduced documentation backlogs, and had quick action by the 

Fed and JPMorgan not occurred, the unwinding of Bear Stearns’ 

derivatives portfolio could have been extremely dangerous. In the 

absence of clear and up-to-date records of derivatives positions, 

dealers would have been uncertain of their own and other dealers’ 

exposures and could have responded by a dramatic withdrawal of 

financing to each other, which could have indeed caused other dealers to fail, with potentially disastrous economic consequences. 

In addition to a lack of good records, the market has suffered 

from an unnecessary buildup of exposure of dealers to each other. 

For a simple illustrative example, suppose that Goldman Sachs, for 

example, has exposure to Merrill Lynch through a $1 billion credit 

derivatives position, while at same time Merrill Lynch has a similar $1 billion exposure to JPMorgan, and JPMorgan in turn has the 

same exposure to Goldman. If all three dealers in this circle of exposures were to reassign their contractual positions to a central 

clearing counterparty, then each dealer’s positions would net to 

zero. None of them would be exposed through these positions, nor 

would the central clearing counterparty. 

Through a new electronic confirmation platform known as 

DerivServ, I believe that the trade documentation problem has now 

been largely addressed, although even more progress should be 

made in that direction. The Clearing Corporation is likely to come 

online in the credit derivatives market later this year and will reduce dealers’ exposures to each other significantly for standardized 

credit derivatives, which constitute the bulk of dealer exposures. 

The Clearing Corporation offers roughly the benefits of exchangebased clearing, although we have yet to see the details. 

The market is achieving a more robust infrastructure through 

these and other procedural improvements, such as new protocols 

for auction-based cash settlement of contracts and for novation. 

These infrastructure improvements have come to the over-thecounter derivatives market rather late. Many of their benefits have 

been available all along through exchange trading. 

Separate from the issue of operational risks, exchanges and overthe-counter markets offer different merits as venues for finding 


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counterparties and for negotiating prices. Exchanges are more 

transparent and more easily regulated. They are natural for trading highly standardized contracts. The OTC market suffers from a 

lack of price transparency. On the other hand, the OTC market is 

more flexible and, thus, better suited to financial innovation and to 

customization for clients, especially those seeking to transfer large 

amounts of a specific type of risk. 

I would be concerned about the unintended consequences of a 

regulatory allocation of certain types of financial trading between 

the OTC and exchange markets. Aside from the chance of getting 

it wrong or of dampening incentives for future innovation, there is 

also the question of international competition. The United States 

has the world’s premier derivatives exchange, but is competing 

with the United Kingdom for leadership in the OTC derivatives 

market. Over several decades, the U.S. over-the-counter derivatives 

market has nevertheless served as an engine for innovation and 

economic growth in the financial services sector in a manner analogous to the role of Silicon Valley in the manufacturing sector. 

Thank you. 

Chairman REED. Thank you, Dr. Duffie. 

Mr. Pickel, please. 

STATEMENT OF ROBERT PICKEL, CHIEF EXECUTIVE OFFICER, 

INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION 

Mr. PICKEL. Chairman Reed and Ranking Member Allard, thank 

you very much for inviting ISDA to testify before the Subcommittee. ISDA represents participants in the privately negotiated derivatives industry and today has over 830 member institutions from 56 countries around the world. It is our pleasure to 

share with you our insights on ‘‘Reducing Risks and Improving 

Oversight in the OTC Credit Derivatives Market.’’ 

The vast majority of credit derivatives take the form of the credit 

default swap, which is a contractual agreement to transfer the default risk of one or more reference entities from one party to the 

other. They are the fastest-growing part of the OTC derivatives 

business and the source of a great deal of innovation. 

Credit derivatives arose in response to two needs in the financial 

industry. The first was the need to hedge credit risk. Prior to the 

existence of credit derivatives, lenders had a limited number of 

ways to protect themselves if the financial condition of a borrower 

were to deteriorate. One was to take collateral and the other was 

by selling the loan, which normally requires the consent of the borrower. A second need was diversification of credit risk. Financial 

economists have long noted the benefits of applying a portfolio approach to investments by means of diversification, but practical 

considerations made diversification difficult to achieve in the credit 

markets before credit derivatives. By allowing banks to take a 

short credit position, credit derivatives enable banks to hedge their 

exposure to credit losses without disrupting their relationship with 

their customers. And a protection seller can increase its exposure 

to certain entities, diversifying risk in a cost-efficient way. 

Two features of the market have enhanced the ability of credit 

derivatives to fulfill the two needs of hedging and diversification. 

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lished by ISDA. Along with other ISDA documentation, these definitions factiliate transactions and enhance legal certainty, which is 

a necessary condition for derivatives activity. The second is index 

trading, that is, buying and selling protection on a diversified index 

of entities instead of a single firm. By providing additional opportunities for investors to take positions in credit risk, index trading 

has vastly increased the liquidity of credit derivatives generally. 

The result is that banks and other firms seeking to hedge credit 

risk can do so more efficiently and at a lower cost. This greater efficiency in turn means that credit risk can be more widely and deeply dispersed in the economy so that the costs of default are felt less 

acutely in any one sector. 

ISDA has made continuous efforts to improve the legal documentation for credit derivatives. We have published a series of documents to cover new products and to adapt the documentation 

framework to the increasing use of automation in the marketplace. 

The success of the market and the entrance of new market participants such as investment managers and managed funds has led to 

the increasing use of novations, a process in which one party to the 

contract assigns or novates its obligations to a third party. After 

concerns were raised as to whether proper notifications to the remaining party in the trade were being widely shared, in 2005 we 

published a Novation Protocol, which has proved extremely successful in reducing the number of outstanding confirmations due to 

novations. 

Standard credit derivative documentation currently provides for 

physical settlement of transactions following the occurrence of a 

credit event. Through nine credit events over the last 3 years, 

ISDA and its members have established an alternative mechanism 

that utilizes an auction process that facilitates cash settlement 

while preserving the option of physical settlement. 

ISDA and a group of the major credit derivative dealers have 

commenced the process of incorporating this mechanism into our 

definitions. It is anticipated that this process will be completed by 

year end. 

The rapid growth in the credit derivatives market has increased 

the need to automate post-trade activities. Financial products 

Markup Language—FpML—is the technical standard developed by 

ISDA for electronic messaging covering the OTC derivatives 

lifecycle and is widely used in the industry. Currently a high percentage of trades—greater than 90 percent—are confirmed electronically, and the industry continues to strengthen the infrastructure. One example of this is the Trade Information Warehouse, a 

central repository managed by the Depository Trust & Clearing 

Corporation that keeps the legally binding version of all trades and 

to which all market participants submit their trades. 

Starting in May, ISDA has facilitated discussions among a working group to explore methods that could be used to reduce the current gross notional credit default swap market size. The process, 

known as ‘‘Portfolio Compression,’’ offers tangible benefits to CDS 

market participants through potential capital savings and a reduction in operational risk by decreasing the number of trades. 

The market for OTC derivatives has grown rapidly, thanks both 

to the usefulness of these products as a risk management tool and 


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to the strong legal and operational infrastructure that currently exists for OTC derivatives. While continued innovations will challenge existing frameworks, and while market participants and regulators alike will need to continue to be vigilant, there is no question that the infrastructure for OTC credit derivatives is strong 

and improving. 

Thank you very much for allowing ISDA to testify today. I look 

forward to answering any questions you may have. 

Chairman REED. Thank you very much, Mr. Pickel. 

Mr. Donohue, please. 

STATEMENT OF CRAIG S. DONOHUE, CHIEF EXECUTIVE 

OFFICER, CHICAGO MERCANTILE EXCHANGE GROUP INC. 

Mr. DONOHUE. Chairman Reed, thank you for inviting CME 

Group to be here today and to testify before your Subcommittee. 

You have already heard a great deal about the value and importance of these products and markets, as well as the exponential 

growth that has occurred in these markets in recent years, and so 

I will not belabor those factors. But I believe you have also heard 

today that the trading confirmation, risk management, and settlement systems in these markets have not kept pace with that 

growth or with the sophistication of market participants and the 

full range of trading strategies that they now use in these markets. 

There are solutions that can increase transparency and reduce 

risk within the credit default swaps market. For more standardized 

credit products, the transparent price discovery and multilateral 

trading and clearing mechanisms of an exchange model allow for 

monitoring risks on a current basis, reducing systemic risks, and 

enhancing certainty and fairness for all market participants. 

At the same time, an exchange model would offer regulators the 

information and transparency they need to assess risks and to prevent market abuses. An exchange model would reduce the informational asymmetries in today’s credit default swaps market and protect the broader financial markets. 

Let me provide a few specific examples of the problems inherent 

in this market and the solutions that an exchange-based model 

could offer. 

First, CDS markets are opaque. Best price information is not 

readily available as it would be on a centralized marketplace. Efficient and accurate mark-to-market practices are hindered by the 

lack of transparency in the CDS markets. Disagreements are common, leading to subjective and inconsistent marks and potentially 

incomplete disclosure to investors of unrealized losses on open positions. 

Earlier this week, as an example, Toronto Dominion Bank announced a nearly $94 million loss, believed to be related to credit 

derivative indices and index tranches that had been incorrectly 

priced by a senior trader. Traders often generation their own 

marks in the credit derivatives market due to perceived 

unreliability of some end-of-day pricing services. In an exchangebased model with transparent and reliable end-of-day marks and 

market data dissemination to all credit derivatives market participants, portfolio-based valuation errors of this type are much less 

likely to occur. 


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Second, risk assessment information is inadequate, and risk 

management procedures are inconsistent across the market. Precise information on gross and net exposures is simply not available. 

The true consequences of a default by one or more participants cannot be measured—exactly the sort of systemic risk brought to light 

by the Bear Stearns crisis, which caused major disruptions in the 

market. As Bear Stearns faltered, credit spreads for most dealers 

widened, volatility increased, and liquidity declined, and ultimately 

intervention became necessary. Transparent market information, 

combined with risk management protocols enforced by a neutral 

clearinghouse, could have mitigated this outcome. Risk managers 

would have been more accurate and timely in terms of their understanding of the firm’s positions, exposures, and collateral requirements. The clearinghouse and regulators would be able to manage 

concentration risks within a particular portfolio and stress test the 

consequences of a major default. 

Third, gross exposures for bilateral CDS transactions are far 

larger than necessary, adding to the risk of a cascading series of 

failures across the markets. Adjusting exposures through novated 

trades is overly complex and time-consuming, and such trades 

often remain unconfirmed for weeks. The benefits that an exchange 

model would bring to this market are substantial. Centralized electronic trading would offer scalable, efficient mechanisms to market 

participants and bring price transparency to the entire market, improving accounting practices and public reporting. Such systems 

would permit nearly instantaneous trade confirmation. An experienced clearinghouse could substantially reduce systemic risks. The 

CME clearinghouse currently holds more than $60 billion of collateral on deposit and routinely moves more than $3 billion per day 

among market participants. We conduct real-time monitoring of 

market positions and aggregate risk exposures, twice-daily financial settlement cycles, advanced portfolio-based risk calculations, 

and we monitor large account positions and perform daily stress 

testing. 

We are not here today to ask Congress to mandate one solution. 

Much has already been said about The Clearing Corporation proposal, although public information is limited. We believe that there 

are alternative structures that could better suit the needs of all 

market participants. We recommend that financial market regulators be encouraged to foster an open and competitive environment in which different solutions can compete. 

The best path will be one that permits multiple offerings to bring 

to market new innovations that will help the credit default swaps 

market mature and evolve, and we look forward to working with 

the appropriate regulatory community to achieve that end. 

Thank you, sir. 

Chairman REED. Thank you very much, Mr. Donohue. 

We are scheduled to have a vote at any moment, so, Mr. Rosen, 

please begin, but forgive me if I have to interrupt and recess for 

a moment. 

Mr. ROSEN. I will do that, Mr. Chairman. Thank you. 

Chairman REED. If you could bring the microphone forward and 

push the button. 


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STATEMENT OF EDWARD J. ROSEN, CLEARY GOTTLIEB STEEN 

& HAMILTON LLP, OUTSIDE COUNSEL TO THE CLEARING 

CORPORATION 

Mr. ROSEN. Thank you, Mr. Chairman. TCC welcomes this opportunity to share its plans to develop a clearinghouse for credit 

default swaps, or CDS, as they are commonly known. 

The Clearing Corporation was originally established as the Board 

of Trade Clearing Corporation more than 80 years ago, in 1925, 

and currently clears for a number of derivatives markets. This is 

an area in which The Clearing Corporation has demonstrated competence. 

Over the past 18 months, TCC and its owners have undertaken 

an intensive effort to structure and develop a CDS clearinghouse, 

and it has worked in close consultation with a number of Federal 

regulators and industry in that process. I would point out that 

CCTC, the entity that TCC intends to create for this purpose, will 

not be involved in the negotiation or the execution phase of transactions, but will accept transactions that are eligible for clearing 

once they have been executed, and it intends to do that through the 

DTCC DerivServ platform that has been the vehicle for driving 

down the backlog in confirmations over the past couple of years 

very successfully. 

Participation in the new clearing corporation, CCTC, will be open 

to all qualified participants, but there will be stringent and standard criteria for membership, including significant minimum net 

capital requirements, creditworthiness requirements, operational 

and risk management requirements, and a very significant presence in the credit default swap market. 

As has been noted before, it is contemplated that the clearing organization will be a New York State bank and a Federal Reserve 

System member bank and, as such, will be regulated by the New 

York Fed as well as the New York State Banking Department. The 

clearing organization is working diligently with those groups in 

order to accomplish the chartering of CCTC within a prompt timeframe. 

Although the qualitative and quantitative details are not nailed 

down at this early stage, I think the Committee can be very comfortable that the clearing operations will be structured in a manner 

at CCTC that conforms to all U.S. regulatory requirements, as well 

as international standards, both for banks and clearinghouses. An 

overview of that structure is outlined in our written testimony, and 

we would be pleased to elaborate on it at your request. 

I would like to give a very concrete set of examples as to how 

the OTC market will interface with the clearinghouse and what the 

implications will be. I am going to start by presuming that Senator 

Schumer runs a large New York bank and he has lent $100 million 

to the AAA Buggy Whip Company. Now, he hails from New York, 

but he ultimately comes to realize what a buggy whip is, and he 

decides that he may want to diversify or hedge his exposure to that 

company. So he calls you and says, ‘‘Mr. Chairman, I am willing 

to pay you X dollars every quarter if you are willing to agree that 

in the event that this buggy whip company fails, you will buy AAA 

Buggy Whip loans with a face value of $100 million from me for 

$100 million, regardless of what their value is.’’ Senator Schumer, 


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being a persuasive fellow, and you, being attracted to the revenue 

stream, agree. 

Now, time passes and you have second thoughts about the credit 

exposure that you have to the AAA Buggy Whip Company, so you 

call up Senator Schumer and you say, ‘‘Are you amenable to 

unwinding this transaction?’’ And Senator Schumer says, ‘‘Well, no, 

I like my position now but, in any event, would want a very steep 

price for unwinding it.’’ So you call Senator Crapo, who runs a different bank, and you make the same proposition to Senator Crapo 

that he will stand ready upon payment by you on a quarterly basis 

of X or Y dollars to buy those loans from you for $100 million, regardless of their value if the Company fails. He agrees because he 

is a supporter of liquid markets, and you are a persuasive fellow. 

Now, you look at your position and you say, ‘‘I am hedged. I have no market risk.’’ And you are right. However, you do have $200 

million in notional exposure to CDS, and I hesitate to say this, but 

in their absence I feel somewhat more comfortable, you also have 

the credit risk that Senator Schumer’s bank is not going to perform 

its obligations to pay you periodically, and you are subject to the 

risk that Senator Crapo’s bank will not be around to pay you in the 

event that the AAA Buggy Whip Company goes under. 

If you are in Wall Street in this position, you would be welcomed 

to the club because this is the position that most major banks find 

themselves in, although, obviously, the scenario is significantly 

larger in size and in consequences. 

Now, if the three of you were all participants in CCTC and you 

submit your trades to the clearinghouse, here is what happens. The 

clearinghouse steps into the middle of your transactions, so the 

credit default protection that you provided to Senator Schumer you 

are now providing to the clearing corporation and it is providing 

that in turn to Senator Schumer. The credit protection that you 

purchased from Senator Crapo you are now purchasing from the 

clearing corporation and it is purchasing it in turn from Senator 

Crapo. You are both purchasing and selling the same credit protection to the clearing corporation, and in the process of novating that 

transaction, your two transactions are utterly extinguished. You 

have no more exposure, you have no notional exposure, and you 

have no credit risk. You do not have credit risk to the clearing organization. You do not have credit risk to either of your colleagues’ 

banks. 

The benefits of this are self-evident. Of course, Senator Crapo 

and Senator Schumer both have credit risk to the clearing corporation, and the clearing corporation to them, and the infrastructure 

that is being developed for CCTC will be rigorously developed with 

state-of-the-art risk management infrastructure in order to address 

those credit risks both to protect CCTC against the default of a 

member, but also to ensure that the default of a single member 

does not cascade throughout the participants at the clearing corporation. 

I see I am over my time. 

Chairman REED. Thank you very much. 

Let me begin with a question I addressed initially to the previous 

panel, which is that some commentators and some individuals who 

are significant investors have suggested that this is the next big 


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shoe that will fall, this whole related issue of credit default swaps, 

and I wonder, just your comments and having heard the previous 

panel also, beginning with Dr. Duffie. 

Mr. DUFFIE. There is still some systemic risk associated with 

failures of dealers, but the risk has been mitigated by reduction of 

trade documentation backlog. And once the clearing corporation or 

clearing more generally along the lines described by Mr. Donohue 

has been set up—pardon me, Mr. Rosen has been set up, that will 

further reduce the systemic risk to the point that I think we will 

be much better off than we were 2 years ago. 

Chairman REED. Mr. Pickel, your comments? 

Mr. PICKEL. Yes, I think the continued efforts on the operational 

side to reduce backlogs, to put this mechanism in place for settling 

trades will be a significant focus for us. We are also focusing on 

what we have always focused on, which is the robustness of our 

documentation infrastructure, key provisions such as netting and 

collateral. Keep in mind that these credit derivatives are done 

under an ISDA master agreement, and the relationships extend between two parties beyond just credit derivatives to the whole range 

of transactions that might exist. And so it is a risk management 

proposition for participants, the two parties to the contract, to 

maintain that overall portfolio of trades, not just the credit derivatives but also the entire derivatives portfolio between them. 

Chairman REED. Thank you. 

Mr. Donohue. 

Mr. DONOHUE. Sir, I think that is a difficult question to answer 

because of the lack of information about gross and net exposures 

that exist in the market. But we know from 150 years of successful 

operation of the central counterparty clearing system at the CME 

Group that the market wants confidence. They want confidence in 

the ability to have their counterparties perform, and a central 

counterparty clearing system provides and enhances that confidence to market users. 

So we do not know the answer to that question, but more transparency and the application of true central counterparty clearing 

services will help answer that question and help reduce risks in the 

market. 

Chairman REED. Thank you. 

Mr. Rosen, your comments? 

Mr. ROSEN. I agree, Mr. Chairman. I think that there is not a 

panacea. I think there are a number of steps that need to be taken, 

and I think we need to continue to take them. And I think a central counterparty system will be a major element in that effort, but 

not a panacea. 

Chairman REED. The impression that I got from the first panel 

was that they see the role of both an exchange-based approach and 

a clearinghouse approach, and the question I would have now is— 

I guess I will rephrase that. In an ideal world, market participants 

would move to those arrangements that were most favorable to 

them, most profitable to them. Are there any obstacles at the moment to that sort of smooth migration, marketplace, regulatory obstacles or other obstacles? And let me begin again with Dr. Duffie. 

Mr. DUFFIE. Well, the over-the-counter market has taken the 

first move or advantage on standardization of their major products, 


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such as the CDX contract, and they, in fact, have intellectual property rights over the use of that particular index, which is very popular. 

The exchanges might have more difficulty convincing trade to migrate to the exchange on a contract like that without the ability to 

offer precisely that contract now that liquidity has been established 

in the OTC market. 

But, generally, I think the premise of that question, that market 

participants will migrate to whatever trading venue is most suitable for them, is about right. Regulators have an important role to 

play in ensuring the systemic soundness of clearing corporations, 

whether exchange or OTC. 

Chairman REED. But, again, and not just for Dr. Duffie but for 

the rest of the panel, is there anything that you point to now that 

are obstacles to that market migration or things that should be 

done in a positive way to provide for the smooth transition to either 

exchange or clearing? 

Mr. DUFFIE. I myself am not aware of any major obstacles. 

Chairman REED. Mr. Pickel, your comments? 

Mr. PICKEL. I think it is important to keep in mind that the development of this particular product area is quite different from 

some of the other derivatives markets we have seen develop over 

the last 25 years. In many of those areas, interest rates, currencies, 

there were well-established exchange-traded markets that existed 

either before the OTC or really developed simultaneously with the 

OTC. In fact, since the CFMA we have seen, you know, both exchange and OTC business grow significantly, and there is a reason 

for that. They are related. They provide a means of—the exchange 

provides a means of offsetting risk in the OTC trades. 

Credit derivatives developed initially as an OTC market, and 

that is how it is—the liquidity is there. There is an ability to trade. 

I think we are seeing, you know, a further standardization of transactions, which might lead more naturally to exchange-traded products. There have been some efforts to establish exchange-traded 

products. We have tried to work with the exchanges. The CME has 

a product where they utilize our definitions. The recovery rates are 

fixed recovery rates, unlike the OTC products, which is a variable 

recovery rate. We have also worked with the exchanges over in Europe, Eurex and Euronex Life, to discuss with them some of the 

products that they are looking to roll out in the credit derivative 

space. 

So I think there is—you know, there is self-percolating here, and 

we will have to see where it goes and what the market reaction 

will be. 

Chairman REED. Mr. Donohue. 

Mr. DONOHUE. Mr. Chairman, if I could clarify just briefly before 

answering your specific question, I do think it is important to think 

differently. It is not, in our view, a difference between an exchange 

solution and a CCP or a central counterparty solution but, rather, 

whether we choose to bring a bundled trade execution as well as 

clearing solution to market, or, alternatively, just offer central 

counterparty clearing services while continuing to allow market 

users to transact bilaterally as well as on an exchange type of platform. 


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With that explanation, I do think it will be important for us to 

encourage the various regulators that are interested in these 

issues—and that certainly does include the Federal Reserve, the 

CFTC, and the SEC—to work together to help foster a competitive 

environment where different organizations with capability in these 

matters can offer innovative new solutions. Whether they be trading execution solutions or central counterparty clearing solutions, 

there are a variety of very complex legal issues that could prevent 

those solutions from coming to market quickly if the regulators do 

not work together to help solve those problems. 

Chairman REED. Mr. Rosen, the same question. 

Mr. ROSEN. Yes, the securities law issues that the first panel 

mentioned are issues that are important and would need to be resolved in order for the CCP clearing solution to go forward. 

Chairman REED. Well, I want to thank you gentlemen, and I 

have just been informed that we have 9 minutes left on the vote, 

and I think more importantly and significantly that Senator Kennedy is on the floor to vote. So I am going to rush over there, if 

you will forgive me. If there are additional questions from my colleagues or from the staff, they will be submitted to you in writing, 

and if you could respond no later than July 16th—we will try to 

get the questions to you by July 16th, and please respond within 

the shortest possible time. 

Thank you very much for your excellent testimony. The hearing 

is adjourned. 

[Whereupon, at 4:19 p.m., the hearing was adjourned.] 

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


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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM 

PATRICK M. PARKINSON 

Q.1. The explosion in credit derivatives basically occurred during 

a time when corporate defaults were near record historical lows. 

But a few months ago, Moody’s Investors Service projected that the 

junk-bond-default rate is likely to climb to a range of 7% to 7.5% 

in the next 12 months—substantially up from the current rate of 

less than 2%. If these projections are correct, what might the implications be for credit derivatives markets and those markets’ corollary impact on overall financial markets? 

A.1. According to the statistics published by the Bank for International Settlements (BIS) for December 2007, credit default swaps 

on below-investment-grade reference entities were 16 percent of 

total single-name credit default swaps. If the prediction for an increase in the junk-bond default rate is borne out, the number of 

settlements on credit default swaps will increase. Settling multiple 

defaults may pose a challenge to the market infrastructure. Part of 

the supervisory agenda for improving the infrastructure of OTC derivatives markets includes improving the process for settling credit 

default swaps following a default, including incorporating a cash 

settlement mechanism into standard documentation for credit default swaps. The industry has committed to achieve this by yearend 2008. 

A second implication of an increase in the junk-bond default rate 

is the potential for counterparty credit risk exposures on credit default swaps to increase. Counterparty credit risk is of particular 

importance in credit derivatives markets. Dealers manage their 

counterparty credit risks in a variety of ways, but it remains a 

challenging task which is made more challenging by the weaknesses in the market infrastructure that, as I discussed in my testimony, supervisors and market participants are working to address. 

Q.2. According to news accounts, during the leveraged-buyout 

boom in 2006 and early 2007, a number of credit default swaps 

grew substantially in value before details of certain buyout deals 

were publicly announced, raising concerns over issues of possible 

insider-trading. Please comment on this issue and what regulatory 

actions might be needed to reduce such insider trading? 

A.2. Section 10(b) of the Securities Exchange Act of 1934 and Rule 

10b–5 issued thereunder by the Securities and Exchange Commission (SEC) have been interpreted to prohibit the purchase or sale 

of a security on the basis of material non-public information about 

the security or its issuer in breach of a duty of trust or confidence. 

Congress enacted the Commodity Futures Modernization Act of 

2000 (CFMA) to, among other things, provide legal certainty for 

certain swap agreements under U.S. laws. Title III of the CFMA 

makes clear that certain SEC rules and regulations (and related judicial precedents) that prohibit fraud, manipulation or insider trading apply to ‘‘securities-based swap agreements’’ to the same extent 

as they apply to securities. As such, participants effecting transactions in credit default swaps that qualify as security-based swap 

agreements would be subject to the insider trading restrictions 

under Rule 10b–5 promulgated and enforced by the SEC. 


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Q.3. We understand that your agencies are conducting closeout 

drills to see how the market would handle the unwinding of trades 

after the default of a major counterparty, given what might have 

happened with Bear Stearns if it were to have gone bankrupt. 

• What have you seen from these exercises? 

• Do you feel that firms would be able to efficiently handle 

unwinding such trades? 

A.3. The Federal Reserve recently met with a small number of 

large, complex financial institutions to understand the processes 

they have in place with respect to closing out a major counterparty. 

We will be conducting additional meetings at other institutions in 

September along with other supervisory agencies to understand the 

full range of practices. All of the firms interviewed to date recognize that they need to have procedures in place to aggregate data 

and potentially close out a major counterparty. However, the level 

of preparedness differs from firm to firm. Some firms are still evaluating their approach while others have detailed policies and procedures in place and have stress tested potential close-outs of selected counterparties. We are encouraging firms to take the following steps: (1) develop the operational capacity to aggregate all 

counterparty exposures and payment obligations for a complex 

counterparty within a matter of hours; (2) formulate written policies and procedures for managing the relationship with a 

counterparty under stress; and (3) conduct periodic scenario analyses around the potential closeout of a major counterparty. The private-sector Counterparty Risk Management Policy Group III recently made similar recommendations to major market participants. 

Q.4. In your testimony and answers to questions, you indicated 

that you think you have the access to information that you need 

for overseeing the OTC credit derivatives market. One of the major 

concerns with Bear Stearns was that there was no clear sense of 

the counterparties that held trades, and what the impact would be 

on the market. Do you have access to counterparty positions for the 

institutions that you supervise? In other words, do you know how 

exposed your institutions are to particular counterparties? Is this 

information available in reports provided directly to you, or is this 

discovered as needed when reviewing risk management systems at 

these firms? 

A.4. Yes, we do have access to counterparty positions for the institutions we supervise. The information is available in reports provided directly and routinely to us. As needed, we obtain ad hoc updates on banks’ exposures, as well as information on the causes of 

changes in counterparty exposures. While this information allows 

us to assess the direct counterparty exposures to the banking organization in question, the assessment of indirect exposures that 

might-result from any market impact of the close-out of a major 

market participant’s positions is much more difficult to assess. 

Q.5. The issue of standardization is often raised as an impediment 

to a clearing system or an exchange paired with clearing. How 

much standardization is required for clearing as compared to an 

exchange? 


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A.5. A central counterparty (CCP) clearing service must make clear 

to its participants what types of contracts are eligible for clearing. 

At a minimum, to the extent that a CCP wants to make use of existing electronic trade confirmation services, the contracts must be 

sufficiently standardized to be eligible for confirmation using those 

services. But a CCP may choose to place further limits on eligibility, based in part on its assessment of the reliability of available 

methods for assigning valuations to contracts and quantifying potential changes in those market values. For example, 

LCH.Clearnet’s SwapClear service, which clears nearly 50 percent 

of global inter-dealer interest rate swaps, clears only ‘‘plain vanilla’’ 

interest rate swaps in major currencies and with maturities less 

than or equal to certain maximums (e.g., 30 years for U.S. dollardenominated swaps). It has chosen not to clear interest rate options. An exchange is likely to require considerably more standardization of terms for the contracts it lists. For example, exchanges 

typically standardize interest reset dates, maturities, and notional 

principal amounts. 

Q.6. Is there any one standard for reporting information about this 

market? It appears that the OCC requires data on bank call reports, the Bank for International Settlements gathers data, and the 

International Swaps and Derivatives Association (ISDA) also gathers information. Is there any movement towards an industry standard for measuring total volume, concentration risks, etc., so that 

regulators can better oversee market-wide risks? 

A.6. I believe that the best source of data on the OTC derivatives 

markets are the statistics published semiannually by the Bank for 

International Settlements (BIS). (Unlike the OCC data, the BIS 

data cover all major dealers, not just U.S. commercial banks. Unlike the OCC or the ISDA data, the BIS data are based on reporting procedures that avoid double-counting of transactions between 

dealers.) The BIS data include notional amounts and gross market 

values by contract type (foreign exchange, interest rate, equity, 

commodity, and credit), by instrument type (forwards, swaps, and 

options), and, for foreign exchange and interest rate contracts, by 

currency. Measures of market concentration for various instrument 

types also are reported, which show that the OTC derivatives markets generally are unconcentrated. (See http:// 

www.bis.orgipubilotchyo8O5.htrn) 

Q.7. What form of oversight should be established over exchanges 

in terms of credit derivatives? What are the strengths of that regulator overseeing this exchange? 

A.7. In principle, exchanges for credit derivatives can be overseen 

effectively by either the SEC or the CFTC. Both agencies have extensive experience overseeing exchange-traded derivatives. The 

particular regulations that would need to apply would depend in 

part on the nature of market participants. To date, participants in 

the CDS markets have predominantly been sophisticated parties, 

including banks, securities firms, hedge funds, and traditional 

asset managers. If this continues to be the case, the need for regulation to protect investors would be limited. Any regulatory regime 

would need to address the potential for market manipulation and 

for trading on the basis of non-public information. 


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Q.8. What are the limitations in the proposed clearing entity because membership will not be open to all market participants? 

Does this limit the risk-sharing strengths of the clearing entity if 

hedge funds and other market participants are unlikely to join as 

members? 

A.8. A critical element of any CCP’s procedures for managing its 

exposures to defaults by its participants is the establishment of 

participation requirements that require participants to have sufficient financial resources and robust operational capacity to meet 

obligations arising from participation in the CCP. Consequently, a 

CCP cannot be expected to be open to all market participants. 

Nonetheless, participation requirements should not limit access on 

grounds other than risk, so as to ensure that the benefits of CCP 

clearing are extended as widely as possible and to avoid creating 

competitive imbalances among market participants. A CCP’s exclusion of hedge funds from participation would be justifiable only if 

the CCP can demonstrate that participation of hedge funds would 

expose the CCP to unacceptable risks that cannot otherwise be 

mitigated through, for example, higher initial margin requirement. 

Q.9. Is pricing transparency in this market a public policy goal? If 

not, why not? 

A.9. Pricing transparency in the credit derivatives market is a goal. 

But the degree of pricing transparency that can or should be expected for nonstandardized contracts, which account for much of 

trading in OTC markets, is not the same as the degree of pricing 

transparency expected for standardized contracts, such as would be 

traded on exchanges. Currently various vendors collect and make 

available to subscribers quotes from dealers and other market participants on prices of a variety CDS contracts. But these are often 

indicative prices rather than firm bids or offers that market participants could execute against. Greater price transparency should be 

promoted by encouraging greater standardization of contracts, 

which would facilitate the trading of CDS on exchanges, where 

greater price transparency is feasible. Indeed, proponents of exchange trading correctly identify greater price transparency as an 

important potential benefit of such trading. 

Q.10. What is your assessment for why exchange-traded credit derivatives have not yet picked up? 

A.10. It is not entirely clear. Exchange-traded derivatives necessarily are more standardized than contracts traded in the OTC 

markets, and, in order to navigate the requirements of both the 

commodities laws and the securities laws, some exchanges have 

been forced to structure contracts in ways that may limit their appeal to market participants. No doubt some market participants 

see considerable benefit in tailoring contract terms to specific 

needs, which leads them to prefer OTC products. But many of the 

contracts traded in the OTC markets are fairly standardized. Some 

have charged that those exchange members that are OTC derivatives dealers have not encouraged their customers to use exchangetraded products because executing trades in the OTC markets is 

more profitable to the firms. But some exchange members are not 

OTC derivatives dealers, and, if there were significant demand for 


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exchange-traded contracts, one would think that those exchange 

members would be able to meet the demand. 

Q.11. What have you learned from the CDO and MBS problems 

that we can apply to the credit derivatives markets? Have you 

spotted the lessons learned and begun to apply them? 

A.11. The problems in the MBS markets and in the markets for 

CDOs collateralized by MBS had their roots in a breakdown of underwriting standards for subprime mortgages and certain other 

mortgages in recent years. The breakdown in underwriting standards was made possible by a breakdown in market discipline on 

those involved in the securitization process, which, in turn, was 

made possible by flaws in credit rating agencies’ assessments of 

those products and by excessive reliance on credit ratings by institutional investors and the asset managers that they employ. To 

some extent, the weakening of underwriting standards in the corporate credit markets over the same period reflected the 

securitization of such credit through CDOs (including synthetic 

CDOs created through use of credit derivatives). But the deterioration was not nearly as severe as in the subprime mortgage markets. Furthermore, participants in the CDS markets do not appear 

to rely heavily on credit ratings. Credit spreads typically widen 

well before ratings downgrades occur. Thus, it is not straightforward to draw lessons for the CDS markets from the problems in 

the MBS and CDO of MBS markets. 

Q.12. If Bear had in fact declared bankruptcy, do you have a firm 

handle on how much would have had to be paid out and to whom? 

To what extent was the Fed intervention with Bear Stearns motivated by a lack of visibility into the credit derivatives market? 

A.12. We did not have information on market participants’ net positions in CDS for which Bear Stearns was the reference credit. 

However, concerns about potential losses from writing credit protection on Bear Stearns were not an important consideration in the 

decision to intervene. We were concerned about potential losses to 

firms that had acted as counterparty to Bear Stearns in credit derivatives and other derivatives. But we had access to Bear 

Stearns’s estimates of its counterparties’ exposures to Bear’s default. In any event, our greatest concern was about the potential 

for Bear’s bankruptcy to result in a loss of secured financing by 

other large firms that are critically dependent on such financing. 

Q.13. If the Federal Reserve Bank of New York were to oversee the 

new clearinghouse for OTC credit derivatives, what would this 

oversight entail? Please explain how it would ensure that the concentration of risks in this entity were offset by robust risk management processes and systems. Also, how would the New York Federal Reserve track information to review systemic risk? 

A.13. As specified in its Policy Statement on Payments System 

Risk, the Federal Reserve expects central counterparties, at a minimum, to meet the Recommendations for Central Counterparties 

that were developed by the Committee on Payment and Settlement 

Systems of the G–10 Central Banks and the Technical Committee 

of the International Organization of Securities Commissions 

(CPSS–IOSCO Recommendations). The CPSS–IOSCO RecVerDate Nov 24 2008 01:25 Apr 02, 2010 Jkt 050408 PO 00000 Frm 00144 Fmt 6602 Sfmt 6602 E:\HR\OC\A408.XXX A408

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ommendations recognize that a CCP concentrates risk and responsibility for risk management and lay out comprehensive risk management standards that are intended to ensure that CCPs address 

the concentration of risk with suitably robust risk management 

processes and systems. 

The Clearing Corporation plans to form a state-chartered bank 

to become a CDS central counterparty and to apply for that bank 

to be a member of the Federal Reserve Bank of New York. The 

Federal Reserve Board will not approve the membership application unless the Clearing Corporation is designed to meet the 

CPSS–IOSCO Recommendations. If the application is approved, the 

bank’s CDS clearing activity would be subject to Federal Reserve 

supervisory authority. The Federal Reserve would use the same supervisory tools we use for supervising other depository institutions, 

which includes both ongoing monitoring and targeted, in depth, reviews. The reviews would focus on areas identified as important in 

the CPSS–IOSCO Recommendations. Examples of such areas to be 

reviewed are: governance of the organization, risk management 

controls, liquidity arrangements, and business continuity. 

With respect to systemic risk, we would very carefully assess 

whether the Clearing Corporation meets the CPSS–IOSCO recommendation relating to the CCP’s financial resources. That recommendation requires a CCP to maintain sufficient financial resources to withstand, at a minimum, a default by a participant to 

which it has the largest exposure in extreme but plausible market 

conditions. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM 

KATHRYN E. DICK 

Q.1. The explosion in credit derivatives basically occurred during 

a time when corporate defaults were near record historical lows. 

But a few months ago, Moody’s Investors Service projected that the 

junk-bond-default rate is likely to climb to a range of 7% to 7.5% 

in the next 12 months—substantially up from the current rate of 

less than 2%. If these projections are correct, what might the implications be for credit derivatives markets and those markets’ corollary impact on overall financial markets? 

A.1. While default rates are increasing, not only for junk bonds but 

also investment grade bonds, we do not believe this is the primary 

area of supervisory concern in the credit derivatives market. This 

is because defaults will only trigger a large cash settlement if protection sellers have not posted collateral to secure their exposures. 

In practice, many protection sellers post both initial margin and 

variation margin. Initial margin helps to protect the protection 

buyer from changes in the market value of the transaction that 

may occur subsequent to the protection seller’s failure to meet a 

margin call. Variation margin is the daily collateral provided to the 

protection buyer to secure the current market value of the transaction. In normal market circumstances, as a reference entity’s 

credit quality declines, and its credit spreads increase, the protection buyer will require the protection seller to post daily variation 

margin to secure its obligation. 


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Based on recent events in the credit default swap market, we can 

see that the real credit risk in the credit derivatives market arises 

from counterparty risk exposures. In circumstances where highly 

rated entities sell credit protection and do not provide collateral to 

the protection buyers, a downgrade of the protection seller may result in the requirement to post large sums of collateral that cannot 

be raised in the short period of time required to meet margin calls. 

This can begin a negative spiral as protection sellers try to sell assets to raise cash and put downward pressure on already strained 

markets. 

Q.2. According to news accounts, during the leveraged-buyout boom 

in 2006 and early 2007, a number of credit default swaps grew substantially in value before details of certain buyout deals were publicly announced, raising concerns over issues of possible insidertrading. Please comment on this issue and what regulatory actions 

might be needed to reduce such insider trading. 

A.2. Bank trading desks are typically market makers in derivatives 

products and run a market-neutral position. This means they generally will have limited incentives to take positions based upon anticipated credit spread changes, particularly for individual reference entities. Banks’ credit managers will also use credit derivatives as part of their credit portfolio management functions to address risks associated with loan portfolios. It is our experience that 

the trading and credit groups within national banks that actively 

engage in credit derivatives transactions are kept on the ‘‘public’’ 

side of the functional information wall to minimize risk of accessibility to material non-public information. 

Our reviews of controls around the disclosure of material nonpublic information have found no evidence that national banks 

have taken advantage of trading on insider information. Financial 

institutions have both information controls and policies related to 

the use and distribution of material non-public information. Bank 

compliance departments and internal audit staff ensure compliance 

with insider trading rules and sharing of information. Controls include limited sharing of material non-public information between 

the private side and public side of the institution. In addition, compliance departments provide training, monitor inter-departmental 

communication, maintain restricted lists, and maintain records related to the institution’s compliance with policies and procedures. 

The OCC will continue to monitor the controls and will consider 

this area for expansion of scope in future examinations. If we determine there are weaknesses in controls around the distribution 

of material non-public information, we will ensure that deficiencies 

are corrected and issue guidance on the topic, as appropriate. 

Q.3. We understand that your agencies are conducting closeout 

drills to see how the market would handle the unwinding of trades 

after the default of a major counterparty, given what might have 

happened with Bear Stearns if it were to have gone bankrupt. 

• What have you seen from these exercises? 

• Do you feel that firms would be able to efficiently handle 

unwinding such trades? 


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A.3. This is an important initiative that supervisors, under the 

auspices of the Senior Supervisors’ Group, are working on with the 

industry. The close-out of a major counterparty goes beyond just 

consideration of the credit derivatives markets and must include 

assessments of interest rate, foreign exchange, equity, and commodity derivatives positions, as well as other credit exposures. We 

have seen the impact of a failure of a major counterparty in today’s 

fragile financial markets, and we believe that appropriate processes 

to close-out a large counterparty are critical to reducing systemic 

risks. 

The work underway by the Senior Supervisors’ Group is coming 

to a close and the challenges we have identified across the population of firms studied include: aggregation of exposures, accuracy 

of pricing, and discrepancies in legal documentation. We will continue working with our domestic and international supervisory colleagues to address these issues and will ensure that OCC supervised entities take remedial action, where necessary, to correct any 

system or control deficiencies that hinder their ability to efficiently 

handle the close-out of a major counterparty. 

This question highlights the need for the industry to continue 

using other means to reduce the volume of outstanding credit derivatives, including compression exercises where institutions coordinate with each other to cancel open contracts that offset each 

other. There are also several industry efforts to develop electronic 

trading and settlement platforms for derivatives in the U.S. and 

Europe. These platforms would be available to all industry participants and would provide the ability for participants to confirm 

transactions immediately. The electronic platforms would also 

allow for immediate payment and settlement between counterparties, thereby reducing operational and credit risks. 

Q.4. In your testimony and answers to questions you indicated that 

you think you have the access to information that you need for 

overseeing the OTC credit derivatives market. One of the major 

concerns with Bear Stearns was that there was no clear sense of 

the counterparties that held trades, and what the impact would be 

on the market. Do you have access to counterparty positions for the 

institutions that you supervise? In other words, do you know how 

exposed your institutions are to particular counterparties? Is this 

information available in reports provided directly to you, or is this 

discovered as needed when reviewing risk management systems at 

these firms? 

A.4. As noted in my testimony, the credit derivatives business is 

concentrated in a small number of large financial institutions. 

Through our Large Bank Supervision resident team process, our 

examiners in the largest national banks have access to 

counterparty exposure positions at the national banks they supervise. This information is readily available to the on-site examination teams and is typically prepared monthly but is also available 

on an ad-hoc basis if needed. We also routinely review aggregate 

exposure numbers for large margined and un-margined counterparties as part of our quarterly derivatives analysis. 

That said, we cannot overemphasize the challenges our large national banks face when seeking to aggregate and analyze 


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counterparty exposures in a highly volatile market environment. 

As such, we remain focused on working with our national banks 

and fellow supervisors in identifying actions that can be taken to 

improve risk identification and management. One example is the 

risk identification benefit derived from the novation protocol process implemented by the industry in 2005 as a result of the OTC 

derivatives infrastructure project. Prior to that protocol, counterparties had assigned trades to other dealers without first obtaining 

the consent of the remaining counterparty. In that environment, 

many dealers did not necessarily know who their counterparties 

were on a large number of outstanding trades. 

Q.5. The issue of standardization is often raised as an impediment 

to a clearing system or an exchange paired with clearing. How 

much standardization is required for clearing as compared to an 

exchange? 

A.5. In our opinion, some degree of standardization of contracts is 

required for both a clearinghouse and an exchange, but the level 

of standardization cannot be easily quantified. Since a clearinghouse can exist without an exchange, but an exchange must offer 

a clearinghouse, the primary benefit of an exchange over a clearinghouse is the additional price transparency. The trade-off is that 

exchange participants can lose the ability to customize contracts, 

which is often important in the management of complex financial 

risks. The current credit market crisis underscores the importance 

of reducing operational and credit risks and restoring confidence 

between credit market participants. We support the development of 

a robust solution that best meets these objectives in the quickest 

period of time. 

Q.6. Is there any one standard for reporting information about this 

market? It appears that the OCC requires data on bank call reports, the Bank for International Settlements gathers data, and the 

International Swaps and Derivatives Association (ISDA) also gathers information. Is there any movement towards an industry standard for measuring total volume, concentration risks, etc., so that 

regulators can better oversee market-wide risks? 

A.6. No, there is no one standard for the reporting of information 

in the credit derivatives market. The call report data collected by 

the OCC is for insured U.S. commercial banks and trust companies 

only. Therefore, our data does not include derivatives totals for investment banks and foreign banks, some of whom are major dealers in the OTC derivatives market. The OCC Quarterly Derivatives 

Report attempts to provide transparency around the volume of derivatives activities for U.S. insured commercial banks. The Bank 

for International Settlements (BIS) makes certain adjustments to 

their data that the OCC does not. While the absolute numbers between the OCC and BIS reports are different, these reports show 

similar trends. 

As we note in our quarterly derivatives analysis, there are a 

number of metrics that can be useful for assessing risk in derivatives markets. No single metric is perfect as a risk indicator, and 

a complement of data is typically needed to generate a meaningful 

assessment of market-wide risks. Because we have on-site examination teams in our largest national banks, we have access to a 


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significant amount of proprietary data to assist in our assessment 

of risks. Additionally, we use the sources noted above, as well as 

other information sources such as published financial reports. 

While we are not aware of any movement towards an industry 

standard for measuring derivatives risks, we do see continual improvement with regard to transparency and will continue to support such developments. 

Q.7. What form of oversight should be established over exchanges 

in terms of credit derivatives? What are the strengths of that regulator overseeing this exchange? 

A.7. As indicated in my testimony, the OCC’s principal objectives 

are to see a reduction in operational and counterparty risks in the 

OTC derivatives market. In addition to industry efforts to reduce 

manual activity and compress OTC trade volumes, exchanges as 

well as clearinghouses have both been discussed as potential solutions. The OCC does not have a position on the specific format or 

vehicle that may be implemented to mitigate these risks. The role 

of financial institution regulators in the oversight of an exchange 

would depend on the structure and features that are ultimately 

chosen by market participants. The OCC reviews the activities of 

national banks that elect to participate in clearinghouse or exchange arrangements on a case-by-case basis. 

Q.8. What are the limitations in the proposed clearing entity because membership will not be open to all market participants? 

Does this limit the risk-sharing strengths of the clearing entity if 

hedge funds and other market participants are unlikely to join as 

members? 

A.8. There are still a number of solutions under consideration and 

we continue to believe that the best solution will the one(s) that is 

most comprehensive in terms of participation, while maintaining a 

strong financial base and the appropriate risk management framework. It is our understanding that the sponsors of the current 

clearinghouse proposal are reconsidering their earlier decision to 

limit clearinghouse membership only to dealers. In addition, there 

are other solutions being proposed that would allow for open membership and the trading of credit derivatives on an exchange. This 

could allow other financial entities, such as hedge funds, to conduct 

derivative trading activity in a more efficient manner. We recognize 

the need to identify and implement a structure that will effectively 

reduce operational and counterparty risks in a timely manner and 

are engaged in frequent discussions with the management teams at 

our national banks that will be involved in such ventures. 

Q.9. Is pricing transparency in this market a public policy goal? If 

not, why not? 

A.9. Pricing transparency in any market is desirable, but its benefits must also be weighed against the needs of market participants, 

including their preference for customized derivatives solutions to 

address specific risk management needs. We recognize that pricing 

transparency certainly is one benefit of both a clearinghouse as 

well as an exchange. 

Q.10. What is your assessment for why exchange-traded credit derivatives have not yet picked up? 


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A.10. To date, there has been limited success with the use of exchange-traded credit derivatives. We believe that the primary reason for this is that users of credit derivatives desire the ability to 

customize contracts to meet specific risk mitigation needs. However, as the market develops, more standardized terms evolve and 

in some cases, such as credit derivatives index trades, there is already the ability for a high degree of standardization. 

Q.11. What have you learned from the CDO and MBS problems 

that we can apply to the credit derivatives markets? Have you 

spotted the lessons learned and begun to apply them? 

A.11. The major losses firms have taken during this turmoil have 

come from bonds and structured products with subprime mortgages 

as the underlying asset class. The problems experienced in the 

CDO and MBS markets stem from liberal underwriting practices 

which, in an environment of falling home prices, have led to significant levels of anticipated losses on bonds that contained residential 

real estate credit exposures. Other problems included investor overreliance upon credit ratings, excessively complex bond structures, 

and poor risk governance, such as the inability for some major 

dealers to aggregate sub-prime exposures across the firm. 

While the major issues in the credit derivatives market relate to 

operational infrastructure (processing, confirmations, settlement 

upon credit events, etc.), one lesson from the credit market turmoil 

is that investors must fully understand their investment risks. 

Many structured credit products (e.g., CDOs of RMBS and CDO2) 

are extremely complex, with risk profiles beyond the capacity of 

even very sophisticated investors to properly assess and value. Because of these concerns, there is no longer any market demand for 

these products. 

These lessons underscore our continued emphasis on risk governance, in particular having independent risk management and control functions in banks to assess the risks taken and to obtain timely position valuations. 

There are several initiatives underway, led by the President’s 

Working Group, the Joint Forum, the Financial Stability Forum, 

and the Senior Supervisors’ Group, to address the lessons learned 

from this current market turmoil and ensure proper risk management is in place across financial institutions. Although there are 

some recommendations for supervisors in these documents, most 

are directed to banks. Therefore, it is banks that will have to implement them. We will require banks to benchmark themselves 

against those recommendations and then evaluate their progress in 

addressing any ‘‘gaps’’ they have identified. The OCC also plans to 

supplement its guidance on derivatives to address the issues identified in these documents. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM KATHRYN E. DICK 

Q.1. Should market participants have the broadest possible range 

of standardized and customized options for managing their financial risk and is there a danger that a one-sizefits-all attitude will 

harm liquidity and innovation? 


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A.1. While we believe that market participants should have the 

broadest possible range of standardized and customized options 

available for managing their financial risk, this flexibility must be 

balanced against the need for risk and price transparency. This is 

extremely beneficial in ensuring financial risk is managed appropriately. One of the greatest benefits of the credit derivatives market has been that it allows market participants to develop customized contracts for managing credit risk. We do not believe, however, that the development of a central clearinghouse will harm liquidity or innovation in the credit derivatives market and we do 

believe this type of infrastructure change is necessary to reduce unnecessary risks in the credit derivatives market. 

Q.2. Is there a danger that centralizing credit risk in one institution could actually increase systemic risk? 

A.2. This is why it is critical that appropriate risk management 

and controls are put in place for a central clearinghouse. The central clearing party must have strong risk controls, financial resiliency, and resources to withstand the failure of one or more large 

clearing members. A clearinghouse will not eliminate the potential 

of a large counterparty failure; if structured properly, it should reduce the systemic impact if such a failure occurs and thereby reduce the potential volatility to the credit derivatives market specifically and financial markets more broadly. In addition, a clearinghouse will improve operational efficiency by reducing the volume of 

outstanding confirmations via the ability to conduct multilateral 

netting of exposures, reduction in payment flows between counterparties, and improving the timeliness of settlements. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM 

DARRELL DUFFIE 

Q.1. The explosion in credit derivatives basically occurred during 

a time when corporate defaults were near record historical lows. 

But a few months ago, Moody’s Investors Service projected that the 

junk-bond-default rate is likely to climb to a range of 7% to 7.5% 

in the next 12 months—substantially up from the current rate of 

less than 2%. If these projections are correct, what might the implications be for credit derivatives markets and those markets’ corollary impact on overall financial markets? 

A.1. The market infrastructure, including documentation and settlement mechanisms, should be able to accommodate this increase 

in default activity, and if current improvements continue as expected, substantially higher levels of default activity within another year or so. Default by a systemically important financial institution, however, would be very disruptive. Separate from the 

issue of infrastructure, substantially more defaults would obviously 

not be good for the general stability of financial markets and the 

performance of the economy. Speculative-grade default rates exceeded 10 percent in the 1989–91 recession and the 2001–2002 recession, so the forecasted corporate-debt default rate is not an especially alarming one in an historical context. 

Q.2. Can you clarify how involved pension funds are in OTC credit 

derivatives? How equipped are pension funds to make determinaVerDate Nov 24 2008 01:25 Apr 02, 2010 Jkt 050408 PO 00000 Frm 00151 Fmt 6602 Sfmt 6602 E:\HR\OC\A408.XXX A408

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tions about the risks involved in credit default swaps, and are they 

provided with adequate disclosures about the potential risks? 

A.2. According to the best available data, from the British Bankers 

Association, pension funds are somewhat active in the credit derivatives market, but probably account for less than a few percent 

of global volumes. For reputational and legal reasons, dealers have 

some responsibility to verify that pension funds and any less financially sophisticated counterparties are aware of the risks that they 

take in derivatives positions such as these. Obviously, investors 

such as these, who are not normally specialized financial investors, 

would find it prudent to become aware of the risks on their own. 

In many cases, they have relevant internal controls. Any large entity responsible for trading on behalf of individual investors should 

have controls ensuring that trading activity conducted on its behalf 

is done by properly educated and informed representatives. Pension 

funds use credit derivatives both to offer risk protection to others, 

and also to protect themselves from default risk, by buying protection from counterparties. Even when exposing themselves to the 

risk of default of the borrowers named in the credit derivatives contract, pension funds and other protection sellers are taking much 

the same risk as if they had purchased direct debt obligations, such 

as bonds, of the named borrowers. Bonds subject to default, for example corporate bonds, are indeed normal investments for pension 

funds. From this point of view, the main distinction between direct 

bond investments and credit derivative protection selling is that 

credit derivatives do not require up-front cash. This means that the 

availability of pension fund capital is less of a brake on the risk 

appetite of the pension fund. In addition to creating exposures to 

the default of the borrowers stipulated in the credit derivatives 

contract, there is also exposure to the performance of the credit derivatives counterparty, for example a dealer. Normally, this risk is 

remote, but it should be considered, and it is present whether the 

pension fund is buying or selling protection. 

Q.3. We understand that during the leveraged-buyout boom in 

2006 and early 2007, a number of credit default swaps grew substantially in value before details of certain buyout deals were publicly announced, raising concerns over issues of possible insidertrading. Would you please comment on this issue and what regulatory actions might be needed to reduce such insider trading? 

A.3. Yes, these concerns have been raised, and there are other potential situations of moral hazard arising from private information. 

For example bank lenders may have more information about a borrower’s credit quality than the rest of the market, and participate 

in credit derivatives trading on that borrower. Members of creditor 

committees of defaulting firms are sometimes charged with representing other creditors, but may potentially not have disclosed 

that they have offset some or all of their economic exposure 

through credit derivatives. Although I am not a legal expert, it is 

my understanding that those with inside information or related 

conflicts of interest are restricted in their credit derivatives trading 

by existing laws and regulations, for example, those enforced by 

the Securities and Exchange Commission, and liable under those 

laws and regulations in much the same manner as when buying or 


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selling (or short selling) the underlying debt obligations. Disclosure 

is important in these circumstances, and it is my understanding 

that legal disclosure requirements are not as clearly defined or as 

demanding for credit derivatives as for outright asset positions. It 

would be best, however, for you to obtain more expert legal opinions, for example from the Securities and Exchange Commission. It 

is highly beneficial to have the relevant laws and regulations in 

harmony with those of other jurisdictions, because the credit derivatives market is global. 

Q.4. What have we learned from the CDO and MBS problems that 

we can apply to the credit derivatives markets? Have we spotted 

the lessons learned and begun to apply them? 

A.4. In many cases, credit derivatives were the vehicles by which 

CDO and MBS losses were transferred from one investor to another. To the extent that one wants to make it more difficult to 

transfer CDO and MBS losses, or default losses stemming from 

other asset classes in the future, one could attempt to slow down 

or reverse the growth and efficiency of the credit derivatives market. In my view, that would be a mistake. Risk transfer through 

credit derivatives allows those who want to buy protection, or to obtain diversification, to do so more efficiently. Moreover, credit derivatives prices are important sources of information on the financial health of borrowers, and on the valuation of portfolios of debt. 

(I will say more about that in response to one of your other questions.) With regard to the abuses and other failures that occurred 

in the MBS and CDO markets, it is natural to think of credit derivatives as devices that enabled investors to transfer to each other 

the losses as they occur, rather than the cause of the losses in the 

first instance. (As a matter of terminology, some would consider a 

CDO to be a form of ‘‘credit derivative,’’ although I am using the 

term ‘‘credit derivative’’ in this context in the narrower sense of a 

default swap contract, of the sort that was discussed in my testimony.) 

Q.5. What kind of data and pricing information should be available 

to regulators to help them oversee this market, especially with 

more trades going to The Clearing Corporation? Will more data be 

available by having a central clearing entity? Would even more 

data be available by having an exchange? 

A.5. Some credit derivative pricing data are already available for 

selected high-volume CDS contracts from some financial news 

sources, such as Bloomberg, from some brokers, and from specialized information vendors, such as Markit Partners. Unfortunately, 

these data are not especially comprehensive, and are often only 

suggestive of actual transaction prices. In my view, it is worthwhile 

to consider a move toward the availability of transaction-level data 

in the CDS market in a manner analogous to that already available in the over-the-counter bond market, through the system 

known as TRACE. Prices for the vast majority of OTC corporate 

bond trades are now available to essentially anyone through 

TRACE. This allows investors to more easily ‘‘comparison shop’’ 

when trading, and in principle allows regulators simpler access to 

price information for their own purposes, for example when attempting to detect potential insider trading. Dealers could in some 


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cases be adversely affected by TRACE-like transparency in their 

profit margins on credit derivatives trades. Some investors who are 

attempting to create or offset exposures would be adversely affected 

by having some of the information regarding the size and prices of 

their trades (although not their identities) revealed to the market, 

causing prices to move against them before having completed the 

change in their overall position. 

A central clearing corporation for the over-the-counter market 

would, according to the proposed design, play much the same legal 

role in a credit derivatives trade as any non-clearing counterparty. 

I am not aware of any currently proposed mechanism by which 

cleared trades would result in any more public disclosure than 

uncleared trades. A clearing corporation would presumably be a repository of a significant amount of trade information, along the 

lines of an exchange clearing corporation. Whether and how this information would be accessible to regulators is unclear to me. The 

Deriv/SERV information warehouse (which already includes the 

majority of inter-dealer credit derivative trade execution data) exists independently of the existence of a clearing corporation, and 

would presumably have much the same information, if not more information. An exchange would indeed provide much more data on 

prices and volumes for a given CDS contract than does the current 

OTC market, at least for any derivative that achieves liquid market conditions. This would be the case even with the advent of 

TRACE-like transparency for the OTC market, although the superiority of exchange-level transparency over OTC transparency 

would in that be dramatically reduced with TRACE-like OTC 

transparency. As a final note, transparency is generally desirable 

for a financial market, but there are some good reasons to allow 

investors (and the dealers that represent them) to retain a significant degree of privacy. For example, privacy creates better incentives for investing in fundamental financial research (for example, 

regarding the financial health of borrowers), and through that, 

more incentives for prices to reflect correct information. 

Q.6. In your testimony you note that a clearing entity provides 

more or less the same benefits as an exchange. Can you elaborate 

on what these benefits are? 

A.6. In my testimony, I was restricting attention on this point to 

the benefits associated with the clearing function for dealers. (A 

clearing corporation is not a trading venue like an exchange, so one 

would not compare the benefits with respect to trade execution, 

price discovery, and so on.) For each dealer-to-dealer trade, an exchange clearinghouse and an OTC central clearing counterparty effectively become the buyer to the dealer that is selling, and the 

seller to the dealer that is buying. In both cases, OTC clearing and 

exchange clearing, dealers are therefore protected from exposure to 

each other’s default so long as the clearing entity remains solvent. 

For this reason, as I indicated in my testimony, it is important to 

ensure that an OTC central clearing counterparty is well designed. 

It should be well capitalized and adhere to other high standards for 

clearing entities, such as those of CPSS–IOSCO. I presume that 

regulators will ensure this, and will monitor such a clearing corporation carefully on an ongoing basis. If this were not the case, 


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my answer would obviously be different. Exchange-based clearing 

has been extremely safe and effective over many decades, and 

OTC-based clearing can be so as well. Obviously, failure of a clearing entity (whether exchange-based or OTC-based), or even the 

onset of fear of such a failure, could be calamitous. 

Q.7. Your testimony notes that exchanges provide price transparency. Do you think that price transparency is an important feature for this market to have, given the increasing counterparty 

risks? 

A.7. Yes, price transparency is highly beneficial, not only for reasons of counterparty risk, but also for other reasons that I have 

mentioned in response to your earlier question. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM DARRELL DUFFIE 

Q.1. Should market participants have the broadest possible range 

of standardized and customized options for managing their financial risk and is there a danger that a one-size-fits-all attitude will 

harm liquidity and innovation? 

A.1. A one-size-fits-all approach would indeed harm innovation. 

Standardization allows simpler methods for mitigating some of the 

market infrastructure problems that we have experienced, through 

easier trade documentation, clearing, and settlement. The appropriate degree of standardization, however, involves a tradeoff with 

the benefits of innovation and customization to customer needs. 

Generally, I believe that the markets should be left to determine 

how much standardization is appropriate. The safety and soundness of financial markets can be regulated more effectively, in my 

view, by other methods than mandating standardization of financial contracts. 

Q.2. Is there a danger that centralizing credit risk in one institution could actually increase systemic risk? 

A.2. The centralization of risk in one institution, such as an exchange or a central clearing corporation, could increase systemic 

risk if that central institution is not carefully designed and well 

capitalized. One approach to centralizing credit risk, exchangebased clearing, has proven to be extremely safe over many decades, 

including through a number of serious financial crises. A central 

clearing counterparty for the over-the-counter derivatives market 

could be essentially as safe as exchange-based clearing if it is similarly well designed and backed by significant capital or guarantees. 

So long as the institution into which risk is centralized performs 

as designed, it will reduce systemic risk, because it reduces the average level of exposure of counterparties to each other. The performance of a risk-centralizing institution is absolutely critical, 

however, for if it experienced a failure, the systemic effects could 

be grave. Because systemic risk is a cost borne by the public for 

which no single financial institution bears responsibility, there is 

a natural and important role for regulation in monitoring the careful design and ongoing safety of risk-centralizing institutions. 


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RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM 

ROBERT PICKEL 

Q.1. Do most firms in the OTC credit derivatives market use your 

master agreement? If so, doesn’t that indicate a fair amount of 

standardization? How much standardization is required for clearing as compared to an exchange? 

A.1. The ISDA Master agreement is the standard form used between counterparties in the OTC derivatives industry. The ISDA 

Master (and the attendant schedules, annexes and related confirmations) provides standardized definitions while leaving the material economic terms of the contract to negotiation between the 

parties. It is important to remember that a Master Agreement outlines the relationship between two parties with respect to a broad 

range of bi-laterally negotiated contracts (such as a credit default 

swap or an interest rate swap). A confirmation, on the other hand, 

documents an individual contract such as a credit default swap or 

an interest rate swap. Like the Master, a confirmation will have 

many standardized definitions but will leave the material economic 

terms to be individually negotiated by the counterparties. 

Clearing would likely require a degree of standardization not required for purely bi-lateral contracts, which are dependent upon 

the creditworthiness of a counterparty. This is because in order to 

be cleared the contracts must presumably be fungible with other 

contracts in the clearinghouse. 

Q.2. Can you clarify how involved pension funds are in OTC credit 

derivatives? How equipped are pension funds to make determinations about the risks involved in credit default swaps, and are they 

provided with adequate disclosures about the potential risks? 

A.2. Pension funds, like other institutional investors, make use of 

credit derivatives to protect their portfolios against the risk of default of a major issuer of debt. Although it is difficult to generalize 

about the sophistication of pension funds it is worth noting that 

they are regulated entities and in at least some cases, such as 

CalPERS, among the largest and most sophisticated investors in 

the world. 

RESPONSE TO WRITTEN QUESTIONS OF SENATOR CRAPO 

FROM ROBERT PICKEL 

Q.1. Should market participants have the broadest possible range 

of standardized and customized options for managing their financial risk and is there a danger that a one-size-fits-all attitude will 

harm liquidity and innovation? 

A.1. ISDA believes that choice in the range of financial products is 

a fundamental principle for fostering innovation and liquidity in 

the financial markets. A flexible market structure allows innovative products to be created to address the ever-evolving needs of 

market participants. Successful products then become more standardized over time, primarily through ISDA’s efforts in the areas of 

documentation and market practice. The singular achievement of 

privately negotiated derivatives is that, by encouraging that process to take place, the needs of market participants are most effectively served, enhancing market stability and reducing risk to the 


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system. Imposing one approach to managing risk will stifle innovation and restrict the ability of liquidity to coalesce around those 

products that most directly address market participants’ needs. 

Q.2. Is there a danger that centralizing credit risk in one institution could actually increase systemic risk? 

A.2. Concentration of risk of any sort is always a cause for concern, 

and this is particularly true of counterparty credit risk. One way 

to address concerns about concentration of risk is to encourage risk 

to be dispersed through the system through contractual arrangements and risk mitigation techniques, such as the close-out netting 

and collateral provisions developed by ISDA over the years. Where 

risk is proposed to be concentrated in one institution, a high degree 

of care must be taken to minimize the possibility that concentration of risk in fact increases risk to the system. The tool kit for 

managing that risk may be clearly identified (capital requirements 

for clearing members, margin requirements for trades, back-up facilities), but it is the implementation of those tools and the creation 

of the necessary systems to reinforce their purpose that are critical 

steps to ensuring that centralizing credit risk does not have the adverse effect of increasing systemic risk. 


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