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S. HRG. 111–246 

REGULATORY REFORM AND 

THE DERIVATIVES MARKET 

HEARING 

BEFORE THE

COMMITTEE ON AGRICULTURE, 

NUTRITION, AND FORESTRY 

UNITED STATES SENATE 

ONE HUNDRED ELEVENTH CONGRESS 

FIRST SESSION 

JUNE 4, 2009 

Printed for the use of the 

Committee on Agriculture, Nutrition, and Forestry 

( 

Available via the World Wide Web: http://www.agriculture.senate.gov 

COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY 

TOM HARKIN, Iowa, Chairman 

PATRICK J. LEAHY, Vermont 

KENT CONRAD, North Dakota 

MAX BAUCUS, Montana 

BLANCHE L. LINCOLN, Arkansas 

DEBBIE A. STABENOW, Michigan 

E. BENJAMIN NELSON, Nebraska 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Jr., Pennsylvania 

AMY KLOBUCHAR, Minnesota 

KIRSTEN GILLIBRAND, New York 

MICHAEL BENNET, Colorado 

SAXBY CHAMBLISS, Georgia 

RICHARD G. LUGAR, Indiana 

THAD COCHRAN, Mississippi 

MITCH MCCONNELL, Kentucky 

PAT ROBERTS, Kansas 

MIKE JOHANNS, Nebraska 

CHARLES E. GRASSLEY, Iowa 

JOHN THUNE, South Dakota 

MARK HALVERSON, Majority Staff Director 

JESSICA L. WILLIAMS, Chief Clerk 

MARTHA SCOTT POINDEXTER, Minority Staff Director 

VERNIE HUBERT, Minority Chief Counsel 

(II) 

(III) 

C O N T E N T S 

Page 

HEARING(S): 

Regulatory Reform and the Derivatives Market ................................................... 1 

Thursday, June 4, 2009 

STATEMENTS PRESENTED BY SENATORS 

Harkin, Hon. Tom, a U.S. Senator from the State of Iowa, Chairman, Committee on Agriculture, Nutrition, and Forestry ................................................. 1 

Chambliss, Hon. Saxby, a U.S. Senator from the State of Georgia ..................... 3 

Panel I 

Gensler, Gary, Chairman, Commodity Futures Trading Commission, Washington, DC ............................................................................................................. 7 

Panel II 

Bookstaber, Richard, New York, New York .......................................................... 34 

Dines, David, President, Cargill Risk Management, Hopkins, Minnesota ......... 36 

Driscoll, Daniel A., Executive Vice President and Chief Operating Officer, 

National Futures Association, Chicago, Illinois ................................................ 41 

Lenczowski, Mark, Managing Director, JPMorgan Chase & Co., Washington, 

DC .......................................................................................................................... 31

Masters, Michael W., Managing Member/Portfolio Manager, Masters Capital 

Management, LLC, St. Croix, U.S. Virgin Islands ............................................ 38 

Stout, Lynn A., Paul Hastings Professor of Corporate and Securities Law, 

University of California-Los Angeles, Los Angeles, California ........................ 29 

APPENDIX 

PREPARED STATEMENTS: 

Cochran, Hon. Thad ......................................................................................... 62 

Bookstaber, Richard ......................................................................................... 64 

Dines, David ...................................................................................................... 71 

Driscoll, Daniel A. ............................................................................................ 77 

Gensler, Gary .................................................................................................... 80 

Lenczowski, Mark ............................................................................................. 95 

Masters, Michael W. ......................................................................................... 101 

Stout, Lynn A. ................................................................................................... 131 

DOCUMENT(S) SUBMITTED FOR THE RECORD: 

Chambliss, Hon. Saxby: 

‘‘Exchanges Warn On OTC Clearing’’, article, Financial Times, June 3, 

2009 ................................................................................................................ 138 

Dines, David: 

Chesapeake Energy, prepared statement ....................................................... 139 

‘‘The Role of Speculation in the Recent Commodity Price Boom (and 

Bust)’’ ............................................................................................................. 142 

Association for Financial Professionals, written statement .......................... 177 

Commodity Markets Oversight Coalition, written statement ...................... 179 

National Association of Manufacturers, written statement .......................... 183 

Page

IV 

QUESTION AND ANSWER: 

Chambliss, Hon. Saxby: 

Written questions for Gary Gensler ................................................................ 186 

Roberts, Hon. Pat: 

Written questions for Gary Gensler ................................................................ 187 

Written questions for David Dines .................................................................. 187 

Gensler, Gary: 

Written response to questions from Hon. Saxby Chambliss ......................... 188 

Written response to questions from Hon. Pat Roberts .................................. 189 

Dines, David: 

Written response to questions from Hon. Pat Roberts .................................. 191 

(1) 

REGULATORY REFORM AND 

THE DERIVATIVES MARKET 

Thursday, June 4, 2009 

U.S. SENATE, 

COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY, 

Washington, DC 

The Committee met, pursuant to notice, at 10:05 a.m., in room 

SD–106, Dirksen Senate Office Building, Hon. Tom Harkin, Chairman of the Committee, presiding. 

Present: Senators Harkin, Nelson, Casey, Klobuchar, Gillibrand, 

Bennet, Chambliss, Thune, and Johanns. 

STATEMENT OF HON. TOM HARKIN, A U.S. SENATOR FROM 

THE STATE OF IOWA, CHAIRMAN, COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY 

Chairman HARKIN. The Senate Committee on Agriculture, Nutrition, and Forestry will come to order regarding a hearing on regulatory reform in the derivatives markets. 

Although we see hope in the strong economic recovery steps we 

have taken, we are still struggling through a grave economic downturn. The lack of sufficient regulatory authority and oversight regarding the financial markets is widely acknowledged as a key factor in the global economic crisis. It is not credible to assert that the 

markets and present regulatory system have worked. When the 

Federal Government has had to inject some $4 trillion—$4 trillion—into the system to stave off a total collapse of the economy. 

Recent problems indicate the need for fundamental reform. Fundamental reform. The 2008 run-up in oil prices left our economy 

bruised, our Nation keenly aware of not only its dependence on foreign oil but the struggle with speculation in the markets. Volatile 

agricultural commodity prices, high input costs, and problems with 

the wheat and cotton markets have exposed vulnerabilities in our 

agriculture futures markets. But possibly the most problematic, our 

national economy has been held hostage by poorly regulated financial markets and the irresponsible behavior of some market participants, particularly when it comes to financial derivative products 

like credit default swaps and other over-the-counter derivatives. 

I think it has become obvious that we must restore proper regulatory oversight if we are going to get this economy built on a solid 

foundation. Simply put, the derivatives markets must work properly and in the open. Agriculture futures markets are fundamental 

to the functioning of every aspect of our agriculture economy. 

2 

Financial services now account for about as much as 20 percent 

of our economy, and if those markets are not healthy or properly 

regulated, I think the evidence is clear our economy suffers. 

Now, the Commodity Futures Trading Commission plays a vital 

role in providing oversight in keeping these players honest. If we 

do not invest in the regulators and the enforces to expand that 

oversight to the over-the-counter markets, I think we are going to 

continue to pay a heavy price. 

It is imperative that we pass strong financial regulatory reform 

in this body and not just piecemeal, patchwork reform, but comprehensive and fundamental reform that brings full transportation 

and accountability back to the markets. Earlier this year, I introduced the Derivatives Trading Integrity Act; I think one I also introduced last year. The bill would require all futures contracts to 

trade on regulated exchanges. Why do I want that? Because exchange-traded contracts are subject to a level of transparency and 

oversight that is jut not possible in over-the-counter markets. 

For many years, derivative contracts have traded very efficiently 

and openly on regulated exchanges. But we have seen the damage 

done by moves to circumvent properly regulated derivatives trading. 

I would also say it is not sufficient to assert, as many swap dealers do, that the market for credit default swaps function properly 

and has experienced no major problems during the current crisis. 

As conceived by derivatives traders in the mid–1990’s at JPMorgan 

Chase—well, it was JP Morgan then—the CDS was designed to assist in the smooth functioning of the credit market and presumably 

to make it easier to raise capital by issuing corporate bonds to fund 

investment in the production of goods and services, which is what 

we want the financial sector to do. What is the end means of our 

financial services sector? That is for the production of goods and 

services to add to our GDP. Otherwise, you are just in a gambling 

game. 

So the fact is it was going to make it easier to raise capital by 

issuing corporate bonds to fund investment in the production of 

goods and services. But the facts belie that claim. While the total 

face value of CDS contracts more than tripled—tripled—between 

2005 and 2008, the share of gross private domestic investment in 

U.S. GDP stagnated and then fell by more than 15 percent. That 

is at the end of 2008. 

I have a chart. I wanted to see what it looked like, so I have a 

chart. So you see here the share of investment in U.S. GDP, and 

then here you have got on the red line the notional value of the 

CDSs. 

Now, for a while, they seemed to track pretty well, but right here 

in about 2005, investment goes down and the value of the CDSs 

go up. So I think you can safely say they were not adding anything 

to the value of the goods and services of our country at some point 

in time. 

Nor do I agree with those who assert that more rigorous regulation of these markets will discourage innovation or hamper our 

economy. Well, if financial innovation improves the ability of companies to hedge their risks or improves the functioning of the market, then the incentive for creativity will be there. But if the prime 

3 

motivation for innovation is to speculate, to avoid taxes, or assume 

reckless risks, the public has an interest in regulating that sort of 

‘‘creativity.’’ 

I have often asked, Where was the market demand for credit default swaps? Where was the market demand for collateralized debt 

obligations? Where was the market demand for collateralized mortgage obligations? It was just sort of thought up. 

You know, I have to digress here a second. I was just looking at 

the last issue of Newsweek magazine that has got Oprah on the 

front. I guess that sells the magazine. But it is called ‘‘The Revenge 

of the Nerd,’’ and it is about the quants. How many people in this 

country know what a quant is and what they did in terms of speculation, through these mathematical geniuses that came from various and sundry place, how they devised these financial instruments to slice and dice and make money on things that really were 

not adding to the goods and services value of this country. It is a 

great article. I would recommend your reading it. 

As I said, if that creativity is there just to add for speculation 

purposes and for sort of gambling and for high rollers and people 

making a lot of money in a short span of time, but not really adding to the sound investment in our country, then, quite frankly, I 

think the public has a big interest in regulating that kind of creativity. 

So we must protect consumers and lower systemic risk and enhance the price discovery function of the markets, reduce excessive 

speculation, give the regulators the authority and information they 

need to keep the markets free of fraud and manipulation. In doing 

so, we will maximize the economic value of the derivatives markets 

by making sure they are structured to manage risk rather than to 

magnify it and guarantee that bad actors are held accountable. 

So we have a lot of work to do on legislative reform. It is imperative that we all work together to come up with a solution that will 

bring transparency, accountability, and stability to our derivatives 

markets. So I welcome this hearing and this testimony. I thank 

each of the witnesses for coming here today, and I look forward to 

hearing their thoughts. I cannot think of anything that—well, this 

Committee has to do—we have to reauthorize the child nutrition 

bill later this year. We are going to work on that. But we have got 

to do this. This has got to be done this year. 

I have talked with my colleague, my counterpart in the House, 

Chairman Peterson. He feels the same way. So I just do not think 

that we can push this off any longer. We have got to strengthen 

the hand of the Commodity Futures Trading Commission. We have 

got to give them the authority, and I am going to be asking the 

new Chairman about that and about any resources that they need. 

But we have got to get the CFTC the authority and the resources 

they need to do this kind of regulation and oversight. 

With that, I will yield to my distinguished Ranking Member, my 

good friend, Saxby Chambliss. 

STATEMENT OF HON. SAXBY CHAMBLISS, A U.S. SENATOR 

FROM THE STATE OF GEORGIA 

Senator CHAMBLISS. Well, thank you very much, Mr. Chairman, 

and you and I agree 100 percent that this is a critical issue, and 

4 

it is an issue that we have got to address and an issue that certainly calls for more regulatory measures, but I think regulatory 

measures that are not too intrusive to destroy markets rather than 

to continue to create and innovate in the markets. I know you had 

a conflict last night and were not able to be there, but we had a 

very good meeting with Secretary Geithner last night, along with 

our Senate Banking colleagues as well as our House Agriculture 

and Financial Services folks. We fully expect that the Secretary is 

going to come forward, I am sure with consultation of the new 

Chairman, with some recommendations in the next couple of 

weeks. We talked about some ideas that we have as policymakers 

there last night that are going to help influence, obviously, in a 

very strong way the direction in which the administration wants to 

go. 

I am very confident that we are going to be able to come together 

with a very strong proposal that does make certain modifications 

that are not overburdensome, but yet at the same time will provide 

that protection that you referred to for all consumers as well as 

making sure that we have stability in the markets. 

I do strongly believe that the Senate Agriculture Committee and 

the CFTC must be engaged in the development of any legislation 

addressing financial regulatory reform. This Committee has a responsibility to ensure proper oversight of the CFTC, and we must 

do more to fulfill this duty. 

Today’s hearing covers a wide range of issues: speculative trading in the commodities markets, changes to regulation of the overthe-counter derivatives, and the CFTC’s authority over retail off-exchange transactions. Those are all worthy individually of hearings, 

and they are very complex issues that we are going to have to be 

dealing with in the legislative proposal that you alluded to and 

that I agree is going to have to come forward. 

Among the most complex instruments, we have recently heard a 

great deal about credit default swaps, or CDS, which permit one 

party to transfer the credit risk of bonds or syndicated bank loans 

to another party. Given that AIG was heavily involved in CDS, it 

seems simple enough just to blame swaps in general for the current 

financial crisis. But, of course, it is much more complicated than 

that. Failing to distinguish between credit default swaps and the 

actual mortgage-related debt securities that these swaps were referencing has resulted in an oversimplification of the problem and 

subsequently an oversimplification of the proposed solutions. 

Simply banning the use of all over-the-counter derivatives or 

forcing such contracts onto an exchange is unrealistic and unlikely 

to even address the underlying problem; that is, is this really a 

chance we are willing to take in these uncertain times, a chance 

that we would make things worse, dry up more capital, and force 

the cost of doing business higher? 

Speaking of business functionally, curbing speculation is the 

physical commodity markets—speaking functionally, curbing speculation in the physical commodity markets is another area that we 

must approach very carefully. This is also not a simple topic. Determining how much speculation is necessary and how much speculation is excessive is an enormous challenge and something that we 

5 

will be talking with the Chairman as well as our other witnesses 

about this morning. 

Some seem to have decided that all speculation is bad, but I 

would like to remind folks that without speculators in the marketplace, our farmers, ranchers, and energy users would find very little liquidity in these markets and would thereby not be able to utilize them effectively. Those individuals and businesses hedging 

risks and physical commodities, the parties that some claim they 

are trying to protect by running speculators from the market, are 

the ones who are likely to be hurt the most if speculative money 

dries up. I fear that this is another example in which oversimplification may be leading us to solutions of vast unintended 

consequences. 

We must remember that during the past 18 months of bankruptcies, bailouts, and Government-assumed ownerships, the Nation’s futures markets have functioned quite well. Price discovery 

has occurred, consumer funds have been protected, and there has 

not been a single bankruptcy of any clearing organization. 

Does this mean there is not room for improvement? Of course 

not. Do I think the volatility in some markets over this lifetime 

warrants extensive analysis and possibly regulatory changes? Absolutely. While I may have concerns with some of the proposals that 

have been discussed relative to regulating both the use of over-thecounter derivatives and speculative trading, I am absolutely convinced that the market volatility and financial meltdown of the recent past make the case for more market transparency. 

How can we in Congress gamble on the outcome of sweeping reforms without first properly identifying the cause of these problems? How can we identify the cause of the problem without authorizing and/or requiring more transparency through the collection 

of necessary data? 

Yes, I have seen all the press accounts claiming the evils of indexed investments, swap dealers, and speculators, but what statistical data is used to support these claims? From what I can tell, 

many assumptions in the analysis to date are assumptions that 

may very well be accurate. But how do we verify this accuracy 

without access to the facts? Assumptions are simply not good 

enough when it comes to the responsibility Congress has to protect 

the integrity of these markets—integrity that would be compromised by lack of market liquidity or by increasing the cost of 

risk management or by forcing a migration of these markets overseas. 

While I want to understand the causes that led us here, I do not 

believe anyone in this room—or anywhere else, frankly—has all the 

answers to what exactly went wrong. I am not willing to believe 

everything reported in the press unless the claims can be backed 

up with hard, verifiable data. To do otherwise is reckless. In fact, 

the data we have seen so far actually contradicts some of the 

claims people are so quick to believe and ultimately to blame for 

causing this mess that we are facing today. 

Beyond requiring more transparency, I also believe this Committee should explore how most effectively to regulate swaps, some 

of which are statutorily excluded from CFTC regulation and oversight. We should review the manner in which hedge exemptions 

6 

from position limits are granted, and we need to determine how 

best to encourage the clearing of certain derivative products without jeopardizing either the use of these risk management tools or 

the sustainability of our clearinghouses. 

If Congress is truly interested in addressing the problem as opposed to politicizing a solution, we can no longer ignore the complexities of these markets. We must devote time to understanding 

these instruments and their implications. We must seek to understand the legitimate purposes these complex instruments serve for 

large and small businesses in each of our States. That is why hearings such as this are absolutely essential. The last thing we should 

be doing is contributing a whole host of new, unappealing consequences in an already volatile marketplace. 

Mr. Chairman, I particularly look forward today to hearing some 

of the practical aspects of utilization of these products that are on 

the market today, and I fully expect our witnesses to be able to tell 

us, No. 1, how they utilize them from the standpoint of making the 

economy of this country stronger by making their businesses 

stronger, and also how they think we can move in the direction of 

further regulation to ensure that confidence on the consumer side 

as well as stability and liquidity in the marketplace. 

So, again, I thank you for bringing this matter forward. I know 

it will be the beginning of a dialog that fully recognizes the role of 

the CFTC but also that of the Agriculture Committee. I am very 

pleased that we have our new Chairman that we now have in place 

here to kick off this hearing this morning. Mr. Chairman, I say 

publicly congratulations and we are excited about you being where 

you are, and we look forward to working with you and hearing your 

testimony this morning. 

Chairman HARKIN. Thank you very much, Senator Chambliss. 

Now we will move to our witnesses, and first is our new Chairman of the Commodity Futures Trading Commission. Mr. Gary 

Gensler was sworn in as Chairman of the CFTC on May 26, 2009. 

Chairman Gensler previously served at the U.S. Department of the 

Treasury as Under Secretary of Domestic Finance and as Assistant 

Secretary for Financial Markets, subsequently served as a senior 

adviser to the Chairman of the U.S. Senate Banking Committee on 

the Sarbanes-Oxley Act reforming corporate responsibility, accounting, and securities laws. Chairman Gensler is the co-author of a 

book, ‘‘The Great Mutual Fund Trap’’—which I just mentioned to 

him in private I have been reading parts of it, and I recommend 

it highly—which presents common-sense investment advice for 

middle-income Americans. 

Mr. Gensler is a summa cum laude graduate from the University 

of Pennsylvania’s Wharton School, with a Bachelor of Science in 

Economics, received a Master’s of Business Administration from 

the Wharton School’s graduate division in 1979. 

Mr. Gensler, welcome back to the Committee. Congratulations 

again on your assumption of the chairmanship of the CFTC. Your 

statement will be made a part of the record in its entirety, and 

please proceed as you so desire. 

7 

STATEMENT OF GARY GENSLER, CHAIRMAN, COMMODITY 

FUTURES TRADING COMMISSION, WASHINGTON, DC 

Mr. GENSLER. Mr. Chairman, Ranking Member Chambliss, members of the Committee, thank you for your unanimous support in 

my recent confirmation, and thank you for inviting me here today 

to talk about this critical issue to the Nation’s economy. 

I believe that we must urgently enact broad reforms to regulate 

the over-the-counter derivatives marketplace. Such reforms must 

comprehensively regulate both the derivative dealers—those institutions that make markets in these products—as well as the markets themselves. I think that it is very important for the future of 

our economy and the welfare of the American people, and I pledge 

to work with this Committee and Congress to try to restore confidence in the financial regulatory system. 

Many of these reforms will require statutory changes, of course, 

but, Senators, please also know that I have already directed the 

Commission staff to present all options under our current and existing authorities to protect market integrity and consumers from 

price volatility—that price volatility that may accompany a rebound in this overall economy as well, as we move forward. This 

is particularly the case within the physical commodities, whether 

it is wheat, grain, or energy markets. 

A comprehensive regulatory framework governing the over-thecounter derivatives markets and over-the-counter derivatives dealers should apply to all dealers and all derivatives, and I believe 

that it should not matter what type of derivative is traded. That 

would include interest rate products, currency products, commodity 

products, equities, as well as credit default swaps, or that which 

cannot be foreseen yet, and any other swap or derivative product 

coming in the future. 

Furthermore, it should apply to dealers in derivatives no matter 

whether they are trading in standardized products or in customized 

products. In my written testimony, I go further into that. But let 

me mention the four key objectives that I think we would wish to 

achieve here. 

One is to lower systemic risk. We have to make sure that there 

is less risk in the overall system. Two is promoting transparency 

and efficiency in markets. Three is promoting market integrity and 

preventing fraud, manipulation and other abuses, setting position 

limits where appropriate. Fourth, protecting the retail public. 

To achieve this, I foresee working with Congress on two complementary regimes: through the dealers that hold themselves out 

to the public in these products, we should set capital standards to 

lower risk margin requirements as they conduct business directly 

with other commercial enterprises; business conduct standards, 

which I want to return to; and recordkeeping and reporting. This 

would be for all derivatives, whether customized or standardized, 

whether they be interest rate product or credit default swaps. 

On the dealer community, there are really just 20 or 30 large 

dealers, the business conduct standards would protect against 

fraud, manipulation, and other abuses. The recordkeeping and reporting, importantly, would allow the regulators to see a complete 

picture and aggregate this picture. 

8 

In addition, I do believe, though, we need to regulate the markets as well. This is a complementary regime to bring the standardized products, those products that can be brought into clearing 

and brought onto exchanges, further lowers risk. Clearing has the 

attribute that no longer would the financial system be so interconnected. Individual firms, rather than having exposures to each 

other, would have the clearinghouse that has to have the discipline 

of daily mark-to-market and daily posting of collateral. 

Regulated exchanges and transparent regulated trading facilities 

or trading platforms bring additional transparency, and what we 

are proposing—and I believe the administration letter also spoke to 

this—is that there would be a real-time reporting of those transactions of the standardized products. So the full market could see 

on a real-time basis, as they do in the corporate bond market and 

they do in the securities market, the pricing of the products as 

clearly as they can. 

Before I close this oral part, I want to say there are two other 

things, I think, that we need to work together on beyond regulating 

the over-the-counter derivatives marketplace and fully bringing 

this under regulation. 

I believe that we will need to work together on the appropriate 

authorities to put in place aggregate position limits over the marketplace, particularly as it relates to physical commodity products, 

but also that we need to address some abuses in the retail area. 

Last year’s fix with regard to foreign exchange trading, I think that 

we will need to extend that to other physical commodities. We 

thank you for some of those helps in Congress. Furthermore, to 

have clearer authority for the CFTC to make sure that foreign 

boards of trade comply with our transparency and position limit 

authorities here, effectively in statute to close what is called ‘‘the 

London loophole.’’ 

With that quick summary of a very complex subject, I look forward to working with this Committee and taking your questions 

today. 

[The prepared statement of Mr. Gensler can be found on page 80 

in the appendix.] 

Chairman HARKIN. Thank you very much, Chairman Gensler, 

and as I said, I read your testimony thoroughly last evening, and 

I just found it very enlightening, and like I said, I think I agree 

with most of everything you have put in there. I have some questions I will ask about a couple of parts of it here. But as you know, 

I have expressed to you privately and I have expressed publicly 

that I appreciate, first of all, that this is the unanimous position 

of the Commission, as I understand. Is that right? 

Mr. GENSLER. That is correct. I am pleased to report the testimony represents a Commission document. 

Chairman HARKIN. I would be remiss if I did not recognize one 

of your Commissioners who is here, Michael Dunn, and to thank 

him for serving as the Interim Chairman of the CFTC during this 

period of time. I want to thank you very much, Commissioner 

Dunn, for doing that yeoman’s work in that interim chairmanship. 

You and I, Mr. Gensler, I think, agree on the need to enact significant regulatory reform—significant regulatory reform—of the 

derivatives market. I do not know if this is a divergence or not in 

9 

our approach, but it has to do with over-the-counter derivatives 

and whether they should be allowed to continue. 

If we do allow over-the-counter trading, then I think the requirements that you have proposed would be at least the minimum, I 

think, of what we should be doing in terms of ensuring the integrity of those markets. But I just want to explore with you again 

on the record in public whether we might move all of this activity 

to a regulated exchange or an electronic trading system. 

So I want to discuss that with you, but, again, I also want to get 

into what resources you might need also. I will not get into that 

in detail, but at some point we have got to think about what kind 

of resources you might need. 

But you propose establishing criteria for determining whether a 

derivative is standardized or not. Now, I wrote these down: whether a contract is accepted for clearing by a regulated clearinghouse, 

the volume, the look alike nature of the contract, evaluating whether the difference between the OTC contract and the exchange contract are significant economically, or if the contract terms are disseminated to third parties. A lot of details are left out of that. 

I still ask the question, I ask you as I asked it of Mr. Geithner, 

not before us but in a meeting in the Capitol: Define a ‘‘customized 

swap.’’ What is a ‘‘customized swap’’ that cannot be traded on a 

regulated exchange? I still am wrestling with that. 

Mr. GENSLER. Mr. Chairman, I think that we share your concern 

that we need to bring a regulatory regime to the entire market, 

those standardized and those tailored products, and that is why we 

are proposing to regulate the dealer community and be able to get 

the full picture, the full recordkeeping and reporting, even with an 

audit trail, so that we can police and enforce anti-fraud and antimanipulation provisions, enforce position limit authority. 

In terms of your question, we believe that there are tens of thousands of commercial interests in this country that promote their 

business needs by hedging within the futures marketplace and 

hedging within the swaps or over-the-counter derivatives marketplace. We need to bring regulation to that marketplace. 

Individual commercial interests and municipalities sometimes 

wait to tailor a product—it might be a specific product that hedges 

their risk in the interest rate markets, but it might be on a different day, it might be a different month than a standard product. 

Or it may be in the physical commodity market where it is an airline that wants a certain grade of jet fuel delivered at a certain location on a certain date. It is so specific and commercially even 

confidential that there is no liquidity, there are not four other parties that would do that exact contract. 

So what we are proposing is that would still be regulated, it 

would still be regulated with regard to this first regime, where the 

dealers that are transacting this business have to comply with 

anti-fraud, anti-manipulation, that have to report and record all of 

this. The regulators would see a picture of the entire marketplace 

and be able to police that entire marketplace. 

That commercial enterprise would get the benefit of transparency 

because the standardized products—over half the market, though 

it is hard to estimate exact figures, but a significant part of the 

market is standardized—would be brought into exchanges and reVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00013 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
10 

ported on a real-time basis, so the commercial enterprises get the 

benefit. But they may still want to tailor some features to a specific 

date or location in my little example that I gave. 

Chairman HARKIN. I am still going to continue to press this 

issue, and I will with the other witnesses who come up. Give me 

an example of a customized, over-the-counter derivative contract 

that is so customized that it cannot be put on a regulated exchange. 

Now, I understand that it may cost a little bit more for them to 

do that. But I think to me, the cost of that may eat into their profits a little bit. But to me, the need for the public to know that and 

for others to know it, for price discovery and transparency, it may 

be for a specific jet fuel, but that may have repercussions on other 

aspects of the oil market that could happen, depending upon how 

big that contract is. 

So when you do that, I just have a hard time understanding 

what is so customized that it cannot be put out there in that market. 

Mr. GENSLER. Mr. Chairman, the same reason that you are suggesting is why we think that even the tailored or customized products should be reported to the regulators so that the regulators can 

report the aggregate positions and see even the customized, in this 

case the example of the jet fuel. An exchange generally needs parties on both sides to come with bids and offers, and so really the 

key here is how much interest in a tailored product might there be. 

So we believe we have to bring regulation to the entire marketplace, including these tailored products, and that we must have 

regulation of the dealer side so that we can also allow for commercial enterprises to still hedge their very specific and unique risks. 

At the same time, the commercial enterprises would be protected 

against fraud and manipulation. Market integrity would be protected by aggregate position limits across the markets. The regulators would be able to police these markets with seeing a real 

audit trail and a record of tailored and standard products. 

Chairman HARKIN. On page 4 of your testimony—and I marked 

it last night—it says, ‘‘These standards’’—regarding over-thecounter contracts—‘‘also should require adherence to position limits 

established by the CFTC on OTC derivatives that perform or affect 

a significant price discovery function with respect to regulated markets.’’ But if these contracts then are needed for price discovery, if 

you need price discovery, as you say right there, that ‘‘affect a significant price discovery function,’’ wouldn’t the public interest require this price discovery to be on an open, properly regulated exchange and not on the over-the-counter exchange? 

Mr. GENSLER. Our proposal is that anything that could get onto 

clearing, anything a clearinghouse would accept for clearing would 

be presumptively standard. So if a clearinghouse accepts it, it 

would be considered standard. We will have to have rules of governance for these clearinghouses, and we have called for these to 

be fully regulated clearinghouses. But anything that was accepted 

should be out there and be exactly what you say, Mr. Chairman, 

fully transparent to the public and also on exchanges and on these 

trading platforms. 

11 

Chairman HARKIN. Well, there is some concern about the clearinghouses are run basically by the banks and others. This is not 

an open exchange. So I am concerned about what your regulation 

would mean and how we find out, again, whether these over-thecounter derivatives are being regulated. 

Mr. GENSLER. I think the Chairman raises a very good point. 

Right now the clearinghouses, of course, have come into being— 

and, fortunately, they have come into being. There are a number 

of them that have started out. But they are on a voluntary basis. 

So we are talking about working with this Committee and Congress on having mandatory and statutory provisions. Working together we should find the right balance on governance as well with 

regard to these clearinghouses so we do not have, as you highlight, 

some of the conflicts that may exist. We would want to guard 

against those in the governance features. 

Chairman HARKIN. Well, we will follow up on that. That is pretty 

interesting. 

I am sorry. I took almost 10 minutes, so I will recognize other 

people for 10 minutes rather than 5–minute rounds. This is a very 

intricate subject, and it takes a little time to develop. 

Senator Chambliss. 

Senator CHAMBLISS. Well, thank you, Mr. Chairman, and you are 

right, it is certainly above my brain’s capacity to understand all the 

complexities of this industry. While you raise a good issue relative 

to customized swaps and derivatives, I think we are going to have 

some testimony from some folks today that actually use them, and 

they can dwell on the details. But I am pleased, Mr. Chairman, 

that you recognize that there is going to be a need for some custom 

items and products as we move forward. 

We talked about this last night with Secretary Geithner, too, and 

he is of the same belief. It is the folks that are in the business 

every day that have the understanding of this rather than those 

who deal with so many other things on a daily basis. 

Mr. Chairman, I sent a letter to—and let me compliment Former 

Acting Chairman Dunn for his great work, now Commissioner 

Dunn. We are pleased that obviously you were where you were and 

you are where you are, because it is folks like you and the current 

Chairman that understand these issues. 

But I sent a letter back in April regarding several different 

issues, and you handed me the response this morning, so I am kind 

of going off what you just handed me here. But, basically, when we 

talk about costs, there are obviously issues on the trade side relative to costs, and we will talk more about that. But there are 

going to be significant costs on your side from the standpoint of 

whatever legislation we come up with, making further demands on 

you. 

One thing I appreciate you going into detail about is if we are 

going to establish position limits and if we are going to make it 

mandatory upon the Commission to oversee and regulate items 

such as position limits, you have said that given the substantial increase in the number of commodities that would be required to 

have Federal speculative position limits, staff estimates that at 

least 20 full-time equivalent positions would be necessary to review 

the expanded scope of Federal position limits, grant hedge exempVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00015 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
12 

tions, collect reports from persons granted hedge exemptions, and 

monitor for violations. 

In addition, you go on to respond to my letter by talking about 

the further extension and regulation of speculative limits to OTC 

contracts and that also would be very significant and would require 

at least 60 additional staff, plus we would need to upgrade the systems that you have in place today to be able to handle that. Ballpark, do you have any idea what kind of additional funding we are 

looking for your budget to try to do just these things, which I think 

there is general agreement that we have got to move in this direction? 

Mr. GENSLER. Senator Chambliss, I thank you for the letter that 

was sent to my predecessor and that I was able to deliver the estimates. The Commodity Futures Trading Commission, I believe, 

even with the generous support of this Committee and Congress is 

still sorely underresourced. We are in total at about 510 people. We 

just got authority to move up to 572, which just brings us back to 

the staffing levels that were in place in 1999, 10 years ago. 

The futures markets that we regulate have gone up five-fold. The 

complexity has gone up significantly. We have six times more contracts today. But it is not just the number of contracts. It is global. 

We have gone from open outcry to electronic trading. So hopefully 

we will be working together with you and the appropriators in trying to find a way to address these very real resource needs. 

If we do go further, as your letter asked about sitting more position limits, we made estimates of 20 or 60 people; you had two alternatives. Rather than speaking off the cuff, if we can get back to 

you on an exact sort of dollar figure that assigns to those two numbers, we would be glad to do that as follow-up. 

Senator CHAMBLISS. Sure. Well, I think there is going to be general agreement that we have got to make some changes, and we 

agree here that you are underresourced now. But we are not going 

to put additional obligations on you without providing you additional funding. We are simply going to have to do that. Irrespective 

of what amount of money we are talking about, if, in fact, CDS or 

whatever part of the commodities market contributed to the financial collapse last year, it is going to be a lot cheaper to fund you 

to regulate than it will be to go through another situation that we 

are trying to recover from now. 

Mr. GENSLER. Senator, I fully agree with you on that, that it 

would be a good investment of taxpayer dollars to guard against 

these risks. 

Senator CHAMBLISS. One thing that has been of real concern to 

me from the standpoint of putting additional regulations in place 

is the fact that we might stymie, No. 1, innovation on the part of 

bright minds in the marketplace that are thinking of additional 

products, not just for the sake of making money on the end of selling them but providing a real service to businesses across our country and allowing them to utilize the marketplace, again, to offset 

risk. 

If we, No. 1, take all the risk out of that, then I think we are 

going to be hampering the markets more so than helping them. 

Second, if we put in overburdensome regulations, then there is 

going to be the tendency of those folks, whether they are in my 

13 

hometown of Moultrie, Georgia, or Atlanta or New York, to simply 

go overseas and carry out the same transaction, but yet on another 

market that may not be regulated in the way we are talking about. 

One thing that came up in our discussion last night—and I will 

not expect you to be able to talk in depth, but I would like your 

comment about this—is that if we re going to make changes to our 

markets in order to make sure that the same protections are in 

place for American consumers on overseas markets, then we need 

to go to our overseas markets, and we need to tell the Europeans 

that these are the changes we are going to make, and we hope you 

would look at the same type of regulatory process to try to coordinate and let us do not be overburdensome, but yet make the necessary changes so that our customers—or, excuse me, U.S. firm 

customers do not immediately go overseas and we lose that business and that ability to regulate those markets. 

Any comments you have on the potential for that? 

Mr. GENSLER. Senator, I think it is absolutely critical that we coordinate internationally with other regulators around the globe. 

Just yesterday, I actually met with the head of the European Commission on Internal Market and Services, Charlie McGreevy, on 

these matters. It was fortunate he was in town. But I know that 

Secretary Geithner and others are doing this. Commissioner Dunn 

is actually going overseas next week to take on some of this as 

well. 

We need to coordinate and make sure there is not a race to the 

bottom somewhere else. I am encouraged by my meeting yesterday 

on that. I do think that we also have to really think about how we 

protect the American public and make sure that we get the right 

things in place there. 

We need to not only allow but foster innovation so that the economy can grow but protect against risks, and the risks that we are 

talking about protecting against are the risk of fraud, the risk of 

manipulation, the risk that sometimes from speculation that becomes excessive speculation there may be burdens in terms of the 

volatility of markets. We are talking about protecting against the 

risk of unregulated actors like the affiliate of AIG, AIG Financial 

Products, that did not have any effective Federal regulation growing so large and being so excessively leveraged. 

So while this is a complex proposal, regulating the dealers to 

lower risk, that means there is some capital. That means there is 

more cushion in the business that they have in their business 

model. That more capital may, as you suggest, lead to some more 

cost, but still allow for innovation, still allow fully for innovation, 

but lower the leverage in the system. I think one of the great lessons of the crisis of last year is the system overall, the financial 

system, got highly leveraged and too leveraged. Almost all the statistics will point to that. 

So capital regimes and margin regimes lower risk; business conduct regimes lower the risk of fraud, manipulation, and the burdens of excessive speculation, but while still fostering innovation, 

fostering, as we have said in this approach, the allowance of tailored or customized products. So commercial interests can still 

hedge their risks. 

14 

Senator CHAMBLISS. I agree with you that certainly posting more 

capital is going to lower the risk, and I will not get you to go into 

any more detail than that because the other witnesses I expect will 

be able to give us some more information relative to that. But I 

want to make sure that we do not require too much in the way of 

reduction of risk that we just suck too much capital out of the marketplace and that we make sure that these folks that are utilizing 

whether it is over-the-counter or non-regulated today, that they 

still have the capital to operate their businesses in the way that 

they need to be operated. 

I thank you, and I have got some more questions, but, Mr. Chairman, I will wait until the next round. 

Chairman HARKIN. Thank you very much, Senator Chambliss. 

The principle here we go on is time of arrival. Senator Casey was 

next, but he is not here right now. Then we will turn to Senator 

Johanns. 

Senator JOHANNS. Thank you, Mr. Chairman. 

If I could maybe start out and do a little self-education here, because it is a hugely complicated topic we are talking about. But as 

I understand where you are kind of getting to here is, on the one 

hand, there is a set of regulations or an approach that you would 

like to be empowered to take relative to people or the companies 

that actually do business here. As I read the four items that you 

have mentioned, that really would deal with those dealers. Are we 

on the same page so far? 

Mr. GENSLER. Yes, the dealers of which there are internationally 

maybe 20 or 30 large ones, they are out in the public domain, and 

by and large we know the names of those big financial institutions. 

Senator JOHANNS. Pretty straightforward working with them and 

laying out what the standards are going to be and the transparency 

and the capital that you have mentioned. So that for me is fairly 

understandable and fairly straightforward. 

The second piece of this, though, I think it is really complicated, 

and that deals with regulation of products. How are you going to 

handle that, and what kind of authority do you want? 

The first question I need to try to get an understanding about 

is as we look back over the last 8 to 10 to 12 months, if you were 

to identify the products that really were at the heart of the problem relative to the financial crisis, the AIGs, et cetera, what would 

those products have been? 

Mr. GENSLER. Senator, I think that there are many factors that 

led to this economic and financial crisis, and only some of that was 

related to the products, because I do believe a great deal had to do 

with the excess leverage and excess borrowing and imbalances in 

the system overall. But in terms of specific products, I believe that 

the over-the-counter derivatives markets was a contributing factor, 

particularly with regard to credit default swaps explicitly. I think 

other products, if I can speak more expansively also, mortgage 

products specifically, the sales practices, and I think many homeowners and the retail public, often was misled, and even fraud in 

terms of the sale of those products, usually in the subprime market, but not always. 

I think the securitized products, whether it is, as the Chairman 

mentioned, things called collateralized debt obligations and other 

15 

very sophisticated products there that are not specific discussions 

of this hearing today, because those are actually securities, and 

those are actually already regulated by the SEC. 

I do believe the second regime is about bringing regulation to the 

markets, if I can use a term, rather than products. So it is bringing 

centralized clearing and a benefit of lowering risk that all of these 

derivatives or swaps come into a central counterparty and no 

longer is this interconnected web, but we try to have institutions 

use that central counterparty. 

Some people say that we have had a system of too big to fail, but 

actually we have grown into a system that is also too interconnected to fail. So the central clearing is trying to make these 

counterparties less interconnected. You can think of it being less 

caught in a spider’s web. The American public was caught in a spider’s web of interconnected relationships last fall, and we should 

try to lower that as far as possible as we go and bring transparency 

to the exchanges. 

Senator JOHANNS. As I look at some of what happened—and you 

are right, gosh, picking out one thing is just not going to get you 

to an accurate viewpoint of what happened. But if I look at this— 

and hindsight is also 20/20. The amount of bad judgment exercised 

by people paid enormous amounts of money in salaries and bonuses 

is kind of breathtaking to me. How will what you are proposing 

protect the public from the exercise of that bad judgment? 

Mr. GENSLER. Senator, I concur with you that there is a lot of 

bad judgment that went around. I think that at the heart, the way 

we protect the American public is having strict ability and clear, 

independent ability to protect the public against fraud and manipulation and the burdens that can come from excess speculation but 

also by putting in place this very real risk reduction, the capital 

and margin requirements both of the dealers and of the markets. 

The American public should not be so at risk—they were terribly 

exposed by unregulated companies. AIG Financial Products basically was not regulated at the Federal level. Lehman Brothers and 

Bear Stearns derivative affiliates, basically lightly regulated at all 

at the Federal level. So we have to protect the American public. I 

believe this program, if enacted by Congress, would significantly do 

that with regard to over-the-counter derivatives. Certainly we need 

to do more about mortgage sales and some of these other areas 

that we talked about. 

Senator JOHANNS. Using AIG as an example, because what has 

happened to them is so very, very public, it was shocking to me to 

find out that they had this enormous risk exposure and basically 

no protect. If this thing started to implode, it was going to risk the 

viability of that entire company. You would have thought somebody 

would have paid attention. 

If what you want to achieve here is accomplished, we give you 

the authorities that you are seeking, how would that have changed 

the situation with AIG, or would it have? 

Mr. GENSLER. Well, I think that if these authorities were in 

place, and not just for this agency, the CFTC, but broadly, because 

of some of these authorities would be whether they be in a systemic 

regulator or elsewhere, to set capital, for instance—then AIG’s Financial Products affiliate that did have, as you said—it was about 

16 

$480 billion of credit default swaps. They would have had to have 

set capital to the side. They would have had to on a daily basis put 

aside margin and value those contracts. So as those contracts were 

going the other way, they would have been regulated. 

I also think that while we have not studied it at the CFTC because we do not have any authorities over those products right 

now, but if you really look how the products were used and marketed, there is really in my mind some significant question about 

how they were marketed. They were largely marketed to lower capital standards in Europe and to be related to the products the 

Chairman talked about earlier, these collateralized debt obligations. 

I think the credit default swaps have such unique features—a little bit like monoline insurance, a little bit like securities, they are 

certainly derivatives—that we are going to have to work together 

as regulators and with Congress to find some clear authorities on 

the trade practices with regard to credit default swaps. 

Senator JOHANNS. Thank you. 

Mr. Chairman, thank you very much. 

Chairman HARKIN. Thank you very much, Senator Johanns. That 

was an excellent question. That last one was great. 

Senator Thune. 

Senator THUNE. Thank you, Mr. Chairman. Thanks for holding 

the hearing. Chairman Gensler, thank you for being here. You are 

at the center of this storm and the historic run-up in commodity 

prices and oil prices last year that sort of caught everybody looking 

at how do we solve this, how do we prevent this in the future. It 

seems to me that the question is there clearly needs to be some 

kind of reform of the regulatory system that we have in this country with respect to a lot of these financial products that were sort 

of outside the realm of regulation. I guess the question is; how do 

we do this, what is the smart regulation? I am not someone who 

advocates regulation for regulation’s sake. I think we have to think 

about how do we do this in a smart way, and it comes down to the 

fundamental question, in my view; how do we constrain risk? 

It seems to me there are a number of ways that you could do 

that. You could have an exchange where there is more transparency and more accountability and where more of these transactions occur in the light of day. I think what happened was there 

was a lot of stuff that was going on in the dark. 

Second, maybe it is in the form of margin requirements or capital 

standards, some of the things that you have alluded to, but I think 

we have to figure out how do we do that in a way that is responsible, that is smart, that gets at the heart of this problem, but does 

not push a lot of that capital to foreign exchanges, that does not 

create such an economic burden for a lot of the folks who are making markets in this country that they decide to go somewhere else 

to do it. 

I think in order to make this work, it is critical, back to Senator 

Chambliss’ questions, that we have international cooperation. So I 

guess my question is; how do we ensure that foreign exchanges are 

going to follow suit with the additional oversight and transparency 

regulations, specifically how do we go about doing that? 

17 

Mr. GENSLER. Senator, I share your view that this is about limiting risk, as you say, both in terms of the excess risk that you can 

limit through the capital and margin regimes, but also risks to the 

American public through protecting against fraud, manipulation, 

and other abuses. 

I also share your view that we are going to need to and want to 

work with international regulators to see that there is not an arbitrage, meaning that people would go somewhere else rather than 

in these markets to avoid regulation. 

I am encouraged by some of the initial conversations that I have 

had in my 8 days on the job. But I think that working with, the 

Chairman of the Federal Reserve and the Secretary of the Treasury, we are really going to have to work actively with our international colleagues to see that we can bring these reforms globally, 

and where there may be differences—because inevitably they have 

different political processes and legislative processes and regulatory 

processes—that we guard against those differences, not doing exactly what you said. 

Senator THUNE. You have said throughout your testimony, you 

stressed the importance of protecting market participants from excessive speculation. I guess I am curious to sort of know how you 

define ‘‘excessive speculation.’’ We talked about the need for producers in States like Iowa and South Dakota to manage their risk. 

They use these markets for that purpose. But obviously speculation 

plays a role and did play a role, I think, in the problems that we 

encountered a year ago. 

How do you define that, how do you get your arms around excessive speculation versus legitimate speculation? 

Mr. GENSLER. The Senator asks a very good question. I share 

your view that financial investors, index funds, contributed and 

participated in the asset bubble of last year. I am concerned that 

as the good news of an economy that rebounds—and we hope, we 

all want this economy to rebound, that we might see a resurgence 

of these commodity prices. That is why I have already directed 

staff to really lay out for me as Chairman and for the Commission 

all the options that are available under current authorities to 

guard against this. 

You know, Congress in the 1930’s, I believe, when they set up 

our predecessor, really best defined that. They said that there could 

be burdens to interstate commerce that come from excessive speculation, and Congress wrote into our statute that this could be unreasonable price fluctuations or the volatility that do not bear—I 

cannot remember the exact statutory words, but resemblance to the 

fundamentals. 

Then Congress gave the Commission authorities to set position 

limits, and so it is through position limits that we try to guard 

against this, and we have actively used it over this time period. 

Senator THUNE. Some have suggested that the CFTC and SEC 

ought to be merged into one regulatory body. What is your view on 

that? 

Mr. GENSLER. Senator, I think whether we could have a debate 

here for a few days on what was the lead cause of this financial 

crisis, and I do not think any of us would put on the list that is 

near—I think we really have to focus for the American public on 

18 

lessons learned from this crisis, whether it is selling this product 

or this risk. So a merger for merger said to me while I think it will 

always be out there in the ether and be debated and discussed is 

not appropriate. I think we have a heavy agenda here working with 

Congress. Now, if somebody laid out why—if Congress and the 

President laid out why that would really help the American public, 

we would all want to work with that. But I do not see it really in 

the lead here of the reasons, and I do not think it is going to accomplish much for the American public today. 

Senator THUNE. You got into a discussion earlier with the Chairman—and I think maybe with Senator Chambliss, too—about this 

distinction between standardized derivatives, customized derivatives, tailored derivatives, and the importance of having the ability 

for participants who enter into some sort of a customized association, that there would be a different way of regulating those. I 

guess the question comes back to is there a way of creating an exchange where these transactions could all be sort of managed in a 

way that is open and that is transparent and that allows for the 

public to be able to know what the pricing is and everything else. 

What I heard you say was that you think it would be difficult 

to have that kind of a standardized—to create the sort of standardization of these products that would allow for them to be traded on 

some sort of an exchange, did I hear you correctly? 

Mr. GENSLER. Well, Senator, I think that we can bring regulation—and it would be the identical regulation—to both tailored 

products and standardized products, identical regulation about protecting against fraud and manipulation, identical in terms of the 

capital charges of the dealer community, and we can even apply 

margin to both tailored products and standardized. The standardized products could have the margin through clearinghouses, and 

the tailored products could have it through the dealer community. 

So I think actually it is a broad and very full regulatory regime— 

in fact, the same for tailored and standardized. What we need to 

encourage is much of the standardized product to be on centralized 

clearing because that continues to lower risk, and as much as possible onto exchanges or trading platforms, because that is an additional level of transparency, in addition to the transparency that 

the regulators will see it on, will aggregate it for the public, but 

additionally the standardized product, then you can see the realtime pricing. 

It is a challenge. It is just a practical challenge. If it is tailored, 

you could put it on an exchange, and there would not be another 

party on the other side maybe. There might not be what is called 

a bid and an offer. So it is just a challenge. If we could do it, that 

additional transparency is helpful. 

Senator THUNE. Well, I guess the bottom line is the transparency 

issue and price discovery, however those are regulated going into 

the future, that those elements be a part of any solution. So we 

look forward to working with you on this. Obviously, this is—it is 

a complex subject and one that many of us are trying to wrap our 

brains and arms around, and we appreciate your being here today 

and look forward to the testimony. 

Mr. GENSLER. Senator, I thank you, and I look forward to working with you because I know these things are critical to your conVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00022 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
19 

stituents. We have to get everything to work in the wheat markets 

and the grain markets as well, and I know that has been a challenge, too, and we have got to focus on that. 

Senator THUNE. I appreciate it. 

Thank you, Mr. Chairman. 

Chairman HARKIN. Thank you, Senator Thune. 

Senator Bennet. 

Senator BENNET. Thank you, Mr. Chairman. Thank you very 

much for holding this hearing and for your persistence on all of 

these issues. 

Mr. Chairman, welcome. It is nice to see you. I enjoyed reading 

your testimony. I wanted to focus on something that you have 

touched on lightly in some of your responses to the panel, because 

I think that the issues of the products, the issues of fraud, transparency, and all of that are important, and we need to make sure 

that we are doing a good job with these tough issues. 

If you look back at where we are today and the cause of where 

we are, I think it is impossible to avoid coming to the conclusion 

that what ailed us most was the amount of leverage in our system. 

From the consumer level, if you look at credit card debt and home 

mortgage loans, to the Federal Government which doubled its national debt, to financial institutions on Wall Street that went from 

being 12 times levered to being 30 times levered over a period of 

time, you cannot sustain that unless you assume that you are going 

to have a hockey stick of growth for the rest of our lives—which 

is not going to happen. 

I was struck in Lynn Stout’s testimony—Professor Stout is 

here—when she wrote that her research indicated that the only 

time a significant U.S. derivatives market has not been subject to 

regulation was during the 8 years following the passage of the 

Commodity Futures Modernization Act of 2000. I was struck by 

that because I wondered as I read it how much that deregulation 

was a cause of the sheer volume of leverage in the market, because 

people were able to go out and create instruments, or whether they 

are unrelated. I wonder if you had a view on that. 

Mr. GENSLER. Senator, I think you are correct that leverage in 

the American economy is one of the big causes of the crisis. If you 

just look at the overall statistics, it is remarkable, and I will just 

use it to summarize it. But through much of all of our lives, the 

economy has had a debt of about 1–1/2 to 2 times its economy. So 

it is like a household that might have a $50,000 income and have 

$75,000 to $100,000 of debt. 

We got up to about four times, about 4 to 1, and coincidentally, 

the last time we did that was in the late 1920’s, the last time we 

got to that. These are the statistics published by the Federal Reserve on a quarterly basis. 

I think that over-the-counter derivatives were a way that financial institutions—not the homeowners, but the financial institutions—add to their leverage as well, and that the capital and so 

forth were not charged there, and though I believe—looking back 

now it is clear to me that those of us involved earlier—and I served 

earlier—should have done more to protect the American public. 

Over-the-counter derivatives actually were not regulated even before that act passed in any way, for capital or for business conduct. 

20 

So what we are really talking about today, and working with 

Congress, is a full shift, because just as in the 1930’s when President Roosevelt came to Congress and said we had to regulate the 

commodities markets and the securities markets for the first time, 

we are talking about—the CFTC, and I believe this is consistent 

with the administration, is talking about now coming and let’s do 

this in a thoughtful but in a full way to regulate this market. 

Senator BENNET. As you think about the systemic risk question, 

moving from a world where all of our regulation—that may be an 

overstatement—much of our regulation and all of our deregulation 

was, in effect, procyclical, was pushing us farther and farther and 

farther along this curve. How do imagine what you are proposing 

here will work with some of the suggestions that have been made 

by the administration, by the Fed, about where to locate the regulator of systemic risk? How will all these pieces fit together—your 

work, the Fed, the FDIC, the SEC? Because I think only if we have 

some way of looking at how these pieces fit together will we ever 

get the big picture. We can do it product by product by product, but 

really there is this big fundamental piece of not wanting to put ourselves in a position again where we simply have too much leverage 

on the economy and then have to go through an incredibly agonizing contraction, which is where we are today. 

Mr. GENSLER. Right, right. I think that you are absolutely right, 

that we have had a lot of failures in our financial regulatory system; it failed the American public in the biggest test in 80 years. 

We have to address far more than just this over-the-counter derivatives marketplace, and part of that, as you say, Senator, is to have 

a systemic regulator, to have some ability for those largest systemically relevant institutions, those institutions that could make the 

public hurt so much, to have additional oversight. 

I know that there are various approaches to it. What I would associate at least myself—I am not speaking for the Commission now, 

but just as Chair—is that we absolutely need this in working with 

Congress to make sure that it has clear authorities on those most 

systemically relevant. Those authorities might just be additional 

authorities. 

So, for instance, where the CFTC is regulating markets and regulating clearing institutions and so forth, as a market regulator, I 

think in this country, again, since President Roosevelt and Congress worked together in the 1930’s, market regulators have had 

their mandate, both the SEC and the CFTC, and that was a really 

important mandate, protecting the public, protecting the integrity 

of these markets, but then we would have a systemic regulator of 

some sort that we would have to coordinate. 

Senator BENNET. Thank you, Mr. Chairman. 

Chairman HARKIN. Thank you, Senator Bennet. 

Now we go to Senator Nelson. 

Senator NELSON. Thank you, Mr. Chairman. Thank you for holding this hearing. 

Mr. Chairman, it is nice to have you before us. I enjoyed our conversation earlier this year. I am interested in how we can find a 

way to regulate leverage, because leverage seems to be the operative word when you look at what happened with AIG. There was 

not a lack of leverage in their insurance operating subsidiaries beVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
21 

cause they are required by law and practice to put up reserves or 

capital against the commitments they made. But through the deregulation of 1988, I believe, with the decline of Glass-Steagall, 

with Gramm-Leach-Bliley, there was an effort then to be able to do 

as you chose at the top outside of the insurance operating subsidiaries. 

Would you agree with that generally? 

Mr. GENSLER. Senator Nelson, I believe with regard to AIG, they 

were regulated at the State level as an insurance company. 

Senator NELSON. Exactly. 

Mr. GENSLER. This has been a challenge, I know, for decades actually, and the Congress will probably want to take up in thinking 

about those systemically relevant firms, what if they are insurance 

companies and the relationship of Federal regulation to State regulation of insurance companies. 

So I believe that AIG was sort of a case where there was an unregulated affiliate of an insurance company that was regulated at 

the State level. That unregulated affiliate, then it was sort of 

‘‘Katy, bar the door.’’ 

Senator NELSON. Yes, and, in fact, the deregulation permitted 

this operation that was not regulated to do whatever it chose to do 

without setting aside capital to support the obligations it incurred. 

Mr. GENSLER. Senator, I think that as it relates to AIG, which 

was not under any—in the 1980’s, as you referred, not under, I believe back then, any Federal oversight. Later there was some, I 

would say, ineffective Federal oversight by the thrift supervisor. So 

I do not—I think really that it was an unregulated affiliate of an 

insurance company, and we have to make sure that going forward 

we regulate these derivative dealers, whether they are affiliated 

with an insurance company, whether they are affiliated with a 

hedge fund, affiliated with anything, if we are able to work with 

Congress and get this through. 

Senator NELSON. Right, but that does not extend that somehow 

the Federal Government has to begin the process of regulating the 

insurance operating subsidiaries that are currently regulated by 

the States. 

Mr. GENSLER. Not in this testimony or in my view. It is about 

trying to make sure that the derivative dealers come under a consistent regulatory oversight. 

Senator NELSON. If they had the set-aside capital actuarially or 

in some fashion to support the obligations they were incurring, this 

would have been less likely to have happened the way that it has 

happened throughout the industry. Is that fair? 

Mr. GENSLER. I think that is correct, Senator. 

Senator NELSON. So establishing a way to require that capital 

will reduce the leverage that exists not only today but in the future 

as well. Is that fair, too? 

Mr. GENSLER. I believe that is correct. I think to lower the leverage is setting those capital standards for the dealers, but also having margin posted, just as it is on a futures exchange. This has 

worked for decades in the futures exchange. There are problems 

even in regulated futures, but not about the capital and margining. 

22 

Senator NELSON. This was not related necessarily in every case 

to fraud, but in almost every instance you could say there certainly 

was some greed. 

Mr. GENSLER. Well, I think that was the case broadly in this economic crisis. 

Senator NELSON. I hope, as you look to regulate the tailored 

products as well as the standardized products, that there will be 

a system established to figure out the ratio for leverage against the 

obligations that are made. Do you believe you will be able to determine what the obligation is under tailored products? 

Mr. GENSLER. I think, Senator, you raise a very good question, 

because one of the things about tailored products is they tend to 

be less liquid. They are sometimes harder to value. 

Senator NELSON. There may or may not be much of a market for 

them. 

Mr. GENSLER. There may not be much of a market, as the Chairman was talking about. I do think it is appropriate to take into 

consideration as regulators that if they are less liquid and they are 

tailored, that might lead to higher capital charges, just as any 

product that is less liquid and harder to value, because capital is 

meant to be a cushion against the risk if a firm fails or there are 

problems in the system. 

So liquidity is a key, and just as the Chairman was talking earlier about whether the tailored products would be regulated, they 

would be consistently regulated; but if they are less liquid, it may 

be appropriate that the regulators say, well, you have to put a little 

bit more cushion aside on that. 

Senator NELSON. Would you do this in the same way, let us say, 

that the National Association of Insurance Commissioners, which 

I used to head in a previous life, the way they do it through the 

Securities Valuation Office in New York that is part of the NAIC? 

Mr. GENSLER. Senator, I dare say you are far more familiar with 

how that works. I am not familiar with the specifics there. 

Senator NELSON. Well, they do value securities that do not have 

a market value based on one of the markets; in other words, private placements and the like. So tailored securities probably as 

much as standardized securities would fit into that sort of a category, where analysts would work their way through establishing 

what the leverage is, and then establishing capital requirements 

for that leverage. 

Mr. GENSLER. I think, though I am not familiar with the specifics 

of that, I think that there should be consistently applied capital 

rules for the over-the-counter derivatives. Those that are on markets and those that are liquid, just like other products, the more 

liquid a product is, then—— 

Senator NELSON. The easier to value. 

Mr. GENSLER. Easier to value, and it may necessitate a little less 

cushion, a little less margin. Certainly even in the futures markets 

right now there are different margins depending upon the volatility 

and liquidity. 

I think one of the great lessons of this crisis is I believe that our 

overall capital regimes—and this is not within the CFTC, but our 

overall capital regimes let the American public down, and that we 

need to take, as Federal regulators, a closer look at those capital 

23 

regimes and make sure that they take into consideration particularly the less liquid instruments like collateralized debt obligations 

or structured product. Maybe they should have higher cushions or 

higher capital, and those that are easier to value, that are liquid 

instruments—— 

Senator NELSON. But you will have to have some mechanism, 

some way of—an analysis of establishing those values in an objective fashion, and I suppose you are going to be bothered by those 

that turn over too quickly to value them for any length of time, because you had them, they are gone, they have been sold. I just hope 

that you will find a way to consistently do that so that there is 

some objectivity and some reliability for establishing what the leverage requirements would be. 

Mr. GENSLER. Right. Thank you, Senator. 

Senator NELSON. Thank you, Mr. Chairman. 

Mr. GENSLER. I thank you for your support. 

Chairman HARKIN. Thank you, Senator Nelson. 

Senator Gillibrand. 

Senator GILLIBRAND. Thank you, Mr. Chairman, for holding this 

hearing, and thank you, Chairman Gensler, for being here and for 

testifying. These are very important issues. Few, if any, cities in 

the country have really felt the effects of the economic collapse 

more acutely than New York, New York City, the State that I represent. I want to talk to you a bit about how we can move forward 

so that we can create confidence in our markets and create a regulatory framework that will ensure success not only with the U.S. 

financial services industry but our economy overall, because we 

really do need to address the 8.5–percent employment rate nationwide, and we have to make sure our small businesses have the resources they need to grow and create jobs. 

As we work to sustain the companies that form the backbone of 

our financial industry, we must ensure that the structures and the 

regulatory framework institute proper oversight and capital requirements while still promoting significant growth and expansion. 

There has been a tremendous focus on the extraordinary losses 

that have resulted from the unregulated derivatives market, in 

particular the credit default swap markets, and rightly so. However, there also needs to be now significant attention paid to the 

regulation of these financial instruments, which have become an 

integral part of our financial system. We have to ensure that capital reporting requirements will allow derivatives to exist for legitimate participants, but discourage excessive speculation and protect 

our investors. 

It is essential that we fully understand the implications on the 

end users, such as industrial companies who rely on derivatives to 

hedge commodity prices, interest rates, and foreign exchange rates. 

We must have an efficient and effective regulatory structure to ensure a vibrant economy, economic growth, adequate liquidity, and 

appropriate oversight and accountability. 

So I first want to talk about what do you think and how do we 

allow legitimate participants versus those who are trying to game 

the system, and what sort of capital reporting requirements would 

allow custom derivatives to exist for legitimate purposes and parVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00027 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
24 

ticipants, but would discourage the excessive speculation and still 

be able to protect our investors. 

Mr. GENSLER. Senator, if I might first start with thanking you 

for your support of my recent confirmation, and it is good to meet 

you. I lived in New York for 15 years. My three daughters were 

born in New York. Though I live in Maryland now, I have great 

affection and affinity for your State. 

I think it is important to bring, as you say, greater regulation to 

this whole over-the-counter derivatives marketplace. I think we 

should best do that in two complementary regimes that would address, as you say, the legitimate interest of commercial parties to 

hedge their risks, but also have capital standards to lower the risk. 

One is to have a regulatory regime of the dealer community— 

many that are in your great State—but of the dealer community 

so that those dealers have to have the capital to lower risk, to set 

margin, but also have business conduct standards to protect 

against fraud and manipulation. That regime covering the dealers 

would cover both standardized and tailored product. Tailored product or customized product would be allowed, but it would cover 

both of these as well. 

I think that it is important, as you say, that commercial users 

have legitimate needs to do that, but we would want to bring as 

much of this product into centralized clearing and regulate the 

markets as well for that centralized clearing, because additionally 

that lowers risk. If we can lower risk through centralized clearing, 

that frees up capital in the dealer community, because if they can 

move product over to centralized clearing, that is a way to lower 

risk. 

It also helps raise transparency to put that on exchanges where 

it is standardized product, and we would want to work with Congress to get this. So the presumption was if it could be on a centralized clearing, it could be on an exchange, we would do that. 

Senator GILLIBRAND. What do you see at the upsides or 

downsides for actually requiring it to be on an exchange as opposed 

to just having it go through clearing? 

Mr. GENSLER. We think that there are real benefits to also having it on an exchange. Of course, one of the features of our market 

system here in the U.S. is transparency, and the transparency of 

markets promotes economic efficiency. So we would have transparency by having information on 100 percent of the product, both 

tailored and standardized, available to the regulators. Making 

transactions available to the public lowers, we believe, some of the 

cost to the end users that you spoke about. 

So bringing the standardized product onto exchanges means that 

any commercial user can see, Aha, 15 minutes ago, this is where— 

it might just be an interest rate swap, a standard product to hedge 

an interest rate for 5 years. They can see where that was. If you 

are a small hospital or municipality, you can say, Aha, that is 

where the pricing is and we should do the same. 

Senator GILLIBRAND. But if you do require exchange trading, 

then you are really not going to have an opportunity for customized 

derivatives. So do you think you are going to lose enormous markets to overseas markets because you cannot accommodate that 

here? 

25 

Mr. GENSLER. Senator, we actually foresee that this approach 

would allow for, as you call it, customized or tailored product. 

Much of the derivatives marketplace right now is standardized, but 

there is still a very real need for end users to tailor their products. 

So what we are calling for is 100 percent of the product, tailored 

and customized would be regulated through regulating the dealers. 

The product that could be brought onto exchanges would benefit 

because it would add transparency, but we would still foresee that 

end users would be allowed to tailor their needs. They might have 

a risk. I used earlier an example; it could be an airline that has 

a risk around a particular jet fuel to be delivered on a particular 

date in a particular location, that we would still allow for that, but 

still regulate and protect against fraud and manipulation and that 

the regulators would see it aggregated and publicly report the aggregated data. 

Senator GILLIBRAND. I would like to turn specifically to one industry area, the trading of carbon permits, and the derivative products that may be based on them, and this may obviously become 

a major growth center for these markets. 

How would these proposals affect the shape and the nature of 

carbon trading markets? Does the potential market for carbon derivatives have unique needs from other derivative products? What 

unique skills might the CFTC or another regulator need to effectively regulate this market? 

Mr. GENSLER. Senator, I think that the CFTC has over many 

years developed a skill set and has a mission to oversee the derivatives marketplace, which we have called the ‘‘futures marketplace’’ 

for these years. In fact, there is already a small market in these 

permits or similar markets in Chicago called the Chicago Climate 

Exchange. There was a similar market that came up, oh, I think 

it is over 20 years ago now, out of some of the permits that came 

out of acid rain legislation of Congress. 

As Congress moves forward and possibly further develops this, I 

would look forward to working with you and the Congress on how 

to get this right. But I think it would be important to protect 

against the same thing we protect against in the futures markets— 

fraud and manipulation. We should have the authority to set position limits, because these would be physically limited, these contracts would have a limited supply. So, again, hopefully bringing 

the same transparency and protections that we have currently to 

the futures markets. 

Senator GILLIBRAND. Thank you, Mr. Chairman. 

Chairman HARKIN. Thank you very much, Senator Gillibrand. 

Now we will turn to Senator Klobuchar. 

Senator KLOBUCHAR. Thank you very much. 

Mr. Gensler, you have had a long morning. It looks like I am the 

last one here for you. I just wanted to thank you again, and I am 

glad that you are joining us. I think I expressed my frustration last 

time at your predecessor when I asked about more tools that he 

could have in his job. He did not seem interested, and yet we saw 

at the time oil prices going up, due in part to speculation and other 

problems with the regulation of the market. I do believe—I appreciate what you said about transparency and that we need to also 

take steps to minimize speculation when it is done not to benefit 

26 

consumers or the market, but instead to benefit a certain small 

segment of those that are doing the trading. 

We need an effective CFTC, and then we also need to do something about some of these instruments, financial instruments that 

cause some of this problem. Specifically, when I talked with you 

during your confirmation hearing, we talked about credit default 

swaps. Now that it is a little calmer here, I wondered if you could 

talk about what you think needs to be done to better regulate credit default swaps. 

Mr. GENSLER. Senator, again, thank you for your support in my 

confirmation process. 

I believe that we need to bring regulation to the entire over-thecounter derivatives marketplace, so credit default swaps but also 

the interest rate product, currency swaps, commodity swaps that 

this Committee certainly has talked a lot about in the last 2 years, 

and equity products. 

I believe that we can best do that, as I was just saying with the 

Senator from New York, that we have a regime to regulate the 

dealers. There are internationally maybe 20 or 30 major dealers. I 

do not mean to limit them, but that work in these products. Many 

of regulated for other reasons, but we need to explicitly regulate 

them for business conduct, capital, margin, and reporting for credit 

default swaps and the products for tailored and standardized products. 

I think second we need a regime that brings as much of the product as possible, the standardized product, into centralized clearing 

to lower risk. There are some voluntary features of that now, but 

we also need greater transparency through exchanges, while still 

recognizing there will be tailored and customized products that 

would be fully regulated in the first regime, but might not get the 

added risk reduction in the second regime and the added transparency in the second regime. 

I think credit default swaps might have some unique features. In 

addition to what we have laid out in testimony today, I think the 

regulators, certainly the CFTC and the SEC working together, really have to consider additional features even with regard to credit 

default swaps, because they perform so many functions like securities. 

Senator KLOBUCHAR. You mentioned the systemic risks. What do 

you think of this idea of having some kind of systemic risk regulator at the Federal Reserve or someplace that looked at the market as a whole? 

Mr. GENSLER. Senator, I think that there are many lessons out 

of this crisis that developed in the last several years, but I think 

one of the lessons is that we need at the Federal level some clear 

authorities and mandates from Congress as to when a regulator 

can step in to protect against systemic risk. 

All of the regulators, the CFTC included, primarily were put in 

place not to protect against systemic risk but to protect against 

very important risks to the public, but other risks. I think if Congress, working with the administration, moves forward, we should 

have a party or a mechanism such that the most relevant firms 

that could lead to crises might have additional standards and addiVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00030 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
27 

tional risk limitations to be less interconnected to protect the 

American public. 

Senator KLOBUCHAR. As we head into the summer now—a lot of 

my constituents have cabins; this one is for them—they start to see 

the oil prices going up again. Why do you think oil is going up, 

what do you think we can best do to protect ourselves? 

Mr. GENSLER. I think at the core of the mission of the Commodity Futures Trading Commission is to make sure that the markets are fair and orderly and that there is integrity. In the energy 

markets, I do believe that in the past asset run-up that financial 

institutions participated in that asset bubble. I think as this economy starts to recover—and we all hope for and are working hard 

for it to recover—that we will see some movement in commodity 

prices. 

But I have said to the staff already—I have been there 8 days— 

that we have to look at every available option within our current 

authorities to see how we can protect the public and assure that 

there are not—as is our mandate, to make sure that there are not 

burdens from excessive speculation. And though it is not well defined in statute, it is a key mission of ours. I have asked for every 

option to be on the table, and I appreciate that as the summer 

moves forward, we might see more movement in these prices. 

Senator KLOBUCHAR. Thank you. 

Chairman HARKIN. Mr. Gensler, thank you very much for being 

here today and for your very open and frank discussion of these 

issues. It is very refreshing to have that kind of openness and just 

frank responses and answers. I appreciate it very, very much. 

As we move ahead in this, we will be taking action this year, as 

I said at the beginning. We need your input to us on authority, 

which you just mentioned here; if there is additional authority that 

you need to carry out your mission, we need to know that, and 

what additional resources that you need to carry out some new responsibilities that I think that we may be giving you at the CFTC, 

charging you with. So we need to know that. 

I know budgets are tight. I do not want to promise the sun, the 

moon, and the stars and everything like that. But I think the public is aware of the need for better regulation and whatever small 

amount of cost that might be I think will be more than outweighed 

by the public benefits that come through a better regulatory regime. 

So we need to keep our lines of communication open on those two 

things—authority and resources. And I would yield to Senator 

Chambliss. 

Senator CHAMBLISS. Thank you, Mr. Chairman, and I think all 

of my questions have been answered. I did want to make just one 

comment, though. 

The Chairman as well as Secretary Geithner have both expressed, as we have talked about, this customized versus standardized transactions, that a transaction should be deemed standardized if a clearinghouse is willing to accept it for clearing, and we 

talked about there are some clearinghouses out there now that are 

voluntarily accepting some of these transactions. 

There was an interesting article in the Financial Times yesterday where three of these voluntary exchanges—the New York ExVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00031 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
28 

change, the ICE Exchange, and the London Exchange—were warning Congress to be careful about this and careful about mandating 

and forcing too much of the over-the-counter derivatives into the 

clearinghouses, particularly because these tailored OTC derivatives 

being forced into clearinghouses that are ill equipped will really 

create a problem. And I would simply like to ask that a copy of that 

article be inserted into the record. 

Chairman HARKIN. Without objection. 

[The following information can be found on page 138 in the appendix.] 

Chairman HARKIN. I could get into that, but we would probably 

get into a debate, and I do not mean to engender that right now. 

But I would say that I sat here in 1999 and 2000—I was not Chairman then, but I sat here and listened to all the reasons why we 

could not regulate. And I have the record. The question I asked of 

Mr. Greenspan when he sat here—not in this room—about the exposure and the regulation of these and what would happen if we 

did not do that. I am proud of the fact I am one of nine Members 

of the Senate who voted against deregulation of Glass-Steagall. 

But I asked him that on the record, and I remember his answer. 

It is on the record. I have got it. He said do not worry—and I am 

paraphrasing. He said not to worry. He said these are smart people, and they will self-regulate because it is in everybody’s interest 

to make sure that nobody else cheats. 

Well, fooled once, your mistake. Fooled twice, my mistake. 

Thank you very much, Mr. Gensler, for being here. 

Mr. GENSLER. Thank you, Mr. Chairman. Thank you, Ranking 

Member Chambliss and members of the Committee. I look forward 

to working with you on this very important agenda for the American public. 

Chairman HARKIN. I appreciate that very much, Mr. Gensler, 

and I want to thank the members of the Committee that showed 

up. I think this is one of the most important hearings that we are 

going to have this year. I thank the members of the Committee 

that showed up. I know everyone is busy around here, but I just 

cannot think of anything more vitally important that we are going 

to do this year than to address this issue. 

Thank you very much, Mr. Gensler. Congratulations again. 

We will call our second panel up; Ms. Lynn Stout, Professor at 

UCLA School of Law in Los Angeles, California; Mr. Mark 

Lenczowski—I hope I pronounced that right—Managing Director at 

JPMorgan Chase & Company; Dr. Richard Bookstaber, from New 

York; Mr. David Dines, President of Cargill Risk Management, and 

I will yield to Senator Klobuchar for purposes of introduction there; 

Mr. Michael Masters—oh, I understand he was traveling and evidently his connecting flight was canceled due to weather problems. 

He is on his way? OK. 

Now Mr. Daniel Driscoll, Executive Vice President and Chief Operating Officer of the National Futures Association in Chicago. 

If you will all take your seats, and, again, I would yield to Senator Klobuchar for the purposes of an introduction. 

Senator KLOBUCHAR. Well, thank you very much, Mr. Chairman. 

I am just here to welcome Mr. Dines to the panel. He is from the 

Cargill Company, which is a very successful company located in 

29 

Minnesota, the biggest private company in the country. He was 

named President of Cargill Risk Management in April 1999. Cargill 

Risk Management is responsible for providing risk management 

products to producers, consumers, and investors in the agriculture 

and energy areas. He joined Cargill’s Financial Markets Division in 

1992, and in May 1994, he was asked to help start Cargill Risk 

Management, which is a new business venture for Cargill. And so 

we look forward to his words today. 

Welcome to Washington. 

Mr. DINES. Thank you, Senator Klobuchar. It is very nice to be 

here today. Thank you. 

Chairman HARKIN. Well, we thank you all for being here. I know 

you have heard our interchange with Chairman Gensler. At the 

outset, I will say that all your statements will be made a part of 

the record in their entirety. I would like to ask if you could perhaps 

sum it up in 5 minutes, maybe, so we can have a round of questioning from the Senators. 

I will just start in the order in which I introduced everyone, so 

we will start with Dr. Stout, and then we will move across the 

panel. Dr. Stout, please proceed. Welcome. 

STATEMENT OF LYNN A. STOUT, PAUL HASTINGS PROFESSOR 

OF CORPORATE AND SECURITIES LAW, UNIVERSITY OF 

CALIFORNIA-LOS ANGELES, LOS ANGELES, CALIFORNIA 

Ms. STOUT. Thank you, Mr. Chairman, thank you, members, for 

inviting me to testify today. My name is Lynn Stout. I am the Paul 

Hastings Professor of Corporate and Securities Law at the University of California at Los Angeles. My scholarly expertise actually 

includes the theory and the history of derivatives regulation. I also 

serve as an independent trustee of a large mutual fund that uses 

derivatives, so I have practical experience with the derivatives 

markets. And I have actually published several rather lengthy and, 

at the time to many people, I am sure, boring articles on derivatives regulation. 

Please allow me to note that in these articles, which I published 

in the 1990’s, I predicted that deregulating financial derivatives 

was likely to result in increased market risk, reduced investor returns, and price distortions and bubbles. I am as distressed as anyone that these predictions proved to be correct. However, I made 

the predictions because if you study the history and the theory of 

derivatives markets, you will inevitably reach four basic conclusions. 

The first conclusion is that, despite industry claims—the industry seems to have a very short memory—derivatives are not new 

and they are not particularly innovative. There were derivative 

markets in the United States in the 19th century. Derivatives, of 

course, frequently go by many different names. The jargon that 

surrounds them is unnecessarily complicated. In the 19th century, 

however, they were called ‘‘difference contracts,’’ they were regulated by contract law. 

I can cite to you the 1884 Supreme Court case of Irwin v. Williar, 

110 U.S. 499, which essentially held that off-exchange derivatives 

were legally unenforceable unless the party entering the derivatives trade could prove they had a bonafide economic risk that they 

30 

were hedging against. So this is not a new issue, and the regulation of derivatives is not new. 

Second, I can testify from my study of the history of derivatives 

that healthy economies regulate derivatives markets. This was true 

in Japan in the 15th century. It was true in the United States all 

the way up until the passage of the Commodities Futures Modernization Act of the year 2000. 

Third, studying the theory of derivatives, it is true that derivatives trading can provide some economic benefits to the economy. 

Let me make a note. Clearly, derivatives trading can provide benefits to individual derivatives traders, just as gambling can provide 

benefits to individual gamblers. My focus—and I suspect the Committee’s focus—is on the public good. And from the public’s perspective, the primary economic benefit that you can get from derivatives trading is from risk hedging. 

However, although the industry routinely claims that there are 

enormous risks hedging benefits, not to mention some offhand liquidity and price discovery benefits from derivatives trading, my 

research was unable to uncover any significant empirical evidence 

of the magnitude of these benefits. This is a claim I have been seeing be made by the industry for 20 years now. I thought I would 

update my research for this hearing. 

They still have not generated any empirical evidence, any statistical evidence that demonstrates that the economic scope of these 

benefits is worth the costs that go along with them. And history 

teaches us that unregulated derivatives markets carry some very 

significant economic costs, including a very strong historical association with asset price bubbles, a very strong historical association 

with increased market risk and the failure of institutions. This 

goes back 500 years. We do not need to just focus on Orange County, Barings Bank, Long Term Capital, Enron, AIG, and Bear 

Stearns. 

Third, derivatives regulation has historically been justified in 

part on the theory that encouraging speculation actually reduces 

economic productivity by diverting valuable resources, especially 

human creativity, time, and energy, away from more productive industries that contribute more to social welfare. 

Fourth, derivatives trading is very clearly associate with increased levels of fraud and manipulation in the underlying markets. 

Finally, the last lesson that the history of derivatives regulation 

can teach us is that successful derivatives trading regulation is 

possible and has been done. Generally, it has been accomplished 

quite successfully through a web of complex procedural rules that 

include reporting requirements, listing requirements, margin requirements, position limits—which I think are very important—insurable interest requirements, and limits on enforceability. 

The joy of these rules is that they can be put in place ex ante 

so that derivatives traders know what is and is not required of 

them and can make plans. It does not call for excessive discretion 

on the part of an omniscient government regulator, and the rules 

are very time tested. They have done historically a very good job 

of permitting legitimate, socially beneficial derivatives trading for 

31 

risk hedging purposes while weeding out excessive speculation, excessive risk, and excessive manipulation. 

If you will indulge me just briefly, I do think one thing that is 

really worth saying is people frequently discuss how complicated 

this issue is, and in the weeds, it is complicated. But the basic 

problem that we face from a policy perspective is actually quite 

simple. Although Wall Street surrounds derivatives with jargon, 

they are essentially one thing; they are a bet or a gamble on something that is going to happen in the future. And when I bet on a 

horse to win a race, my race ticket is my derivative contract. When 

I bet on the creditworthiness of a corporate borrower, my credit default swap is my derivative contract. 

Betting can obviously be used to hedge against risk, so if I actually own a corporate bond and then I purchase a credit default 

swap, I have reduced my risk because if my bond goes down in 

value, my credit default swap goes up. But it is very important to 

recognize that derivatives can also be used and are especially attractive purely for speculative purposes. There actually is a clear 

economic definition of ‘‘speculation.’’ It is trying to make money not 

by producing something or by providing investment funds to someone who is producing something, but instead by trying to predict 

the future better than someone else can. 

As a practical matter, it can be difficult to establish that a particular derivatives trade is speculative in nature simply because 

traders are really good at making up alleged risks that they are 

supposedly hedging against. However, for 200 years, regulators 

have succeeded in coming up with ways to weed out true risk hedging from speculation, and this can be done, for example, at the 

macro level. I simply want to cite to you we may not know with 

exactitude which credit default swaps were exact hedges and which 

ones were speculation. 

We can be quite certain by 2008 the CDS market was overwhelmed by speculation. We know this because the notional value 

of credit default swaps in 2008 was approximately $67 trillion; 

whereas, the notional value of the bonds, both mortgage-backed 

bonds and corporate issue bonds that the credit default swaps were 

being written on, was less than one-fourth that size. It was $15 

trillion. When the derivatives markets if 4–1/2 times the size of the 

market for the underlying thing you are supposedly hedging the 

risk of, you know the market has been swamped by speculation 

with, I would say, sadly predictable results that we are now trying 

to sort through today. 

So I think that is probably a good enough start. 

[The prepared statement of Ms. Stout can be found on page 131 

in the appendix.] 

Chairman HARKIN. That is a great start. OK. Thank you, Dr. 

Stout. 

We now turn to Mr. Lenczowski, Managing Director of JPMorgan 

Chase. Mr. Lenczowski. 

STATEMENT OF MARK LENCZOWSKI, MANAGING DIRECTOR, 

JPMORGAN CHASE & CO., WASHINGTON, DC 

Mr. LENCZOWSKI. Thank you, Chairman Harkin, Ranking Member Chambliss, and members of the Committee. My name is Mark 

32 

Lenczowski, and I am a Managing Director and Assistant General 

Counsel at JPMorgan Chase & Co. Thank you for inviting me to 

testify at today’s hearing. 

For the past 30 years, American companies have used OTC derivatives to manage interest rate, currency, and commodity risk. 

Increasingly, many companies incur risk outside their core operations that, left unmanaged, would negatively affect their financial 

performance and possibly even their viability. In response to marketplace demand, financial products, such as futures contracts and 

OTC derivatives, were developed to enable companies to manage 

risk. 

OTC derivatives have become a vital part of our economy. According to the most recent data, 92 percent of the largest American 

companies and over 50 percent of mid-sized companies use OTC 

products to hedge risk. 

JPMorgan’s role in the OTC derivatives market is to act as a financial intermediary. In much the same way financial institutions 

act as a go-between with investors seeking returns and borrowers 

seeking capital, we work with companies looking to manage their 

risks and with entities looking to take on those risks. Recently, clients, such as Chesapeake and Medtronic, have expressed great concern about the unintended consequences of recent policy proposals, 

particularly at a time when our economy remains fragile. In our 

view, the effect of forcing such companies to face an exchange or 

a clearinghouse would limit their ability to manage the risks they 

incur in operating their businesses and have negative financial consequences for them via increased collateral posting. These unintended consequences have the potential to harm an economic recovery. 

Let me first discuss some of the benefits of OTC derivatives. 

Companies today demand customized solutions for risk management, and the OTC market provides them. Customization does not 

necessarily mean complexity. Rather, it means the ability to tailor 

every aspect of the transaction to the company’s needs to ensure 

that the company is able to match its risks exactly. 

For example, a typical OTC derivative transaction might involve 

a company that is borrowing in the loan market at a floating interest rate. To protect itself against the risk that interests rate will 

rise, the company will enter into an interest rate swap. These 

transactions generally enable the company to pay an amount tied 

to a fixed interest rate, and the financial institution will pay an 

amount tied to the floating rate of the loan. If rates rise steeply, 

they have some protection and can focus on their core operations. 

OTC derivatives are used in a similar manner by a wide variety 

of companies seeking to manage volatile commodity prices and foreign exchange fluctuations. 

In addition to customization, the other main benefit of OTC derivatives is flexibility with respect to the collateral that supports a 

derivative transaction. In the interest rate swap example, the financial institution may ask the company to provide credit support 

to mitigate the credit risk that it faces in entering into this transaction. Most often, that credit support comes in the same form as 

the collateral provided for the loan agreement. Thus, if the loan 

agreement is secured by property or equipment, that same collatVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
33 

eral would also be used to secure the interest rate swap. This collateral is high quality. It is the basis for the extension of credit in 

the loan agreement. As a result, the company does not have to 

incur additional costs in obtaining and administering credit support for the interest rate swap. This is a very significant benefit 

and without it, many companies will choose not to hedge their risks 

because they cannot afford to. 

It is important to note that although derivatives currently are offered on U.S. exchanges, few companies use these exchange-traded 

contracts for two main reasons. Exchange-traded products are, by 

necessity, highly standardized and not customized. As a result, 

companies are unable to match the products that are offered on exchanges to their unique risks. Second, clearinghouse collateral requirements are onerous, and necessarily so. Clearinghouses require 

that participants pledge only liquid collateral such as cash or shortterm Government securities to support their positions. However, 

companies need their most liquid assets for their working capital 

and investment purposes. 

While we believe that exchanges play a valuable role in risk 

management, not all companies can or want to trade on an exchange. Currently, companies have the choice of entering into their 

hedging transactions on an exchange or in the OTC market. For 

most companies, OTC derivatives are critical to their risk management, and risk management is critical to their operations in volatile times. We believe that companies should continue to be allowed 

to have the choice to use these products. 

This discussion of the benefits of OTC derivatives is not to deny 

that there have been problems with their use, and it is essential 

that policymakers examine the causes of the financial crisis to ensure it is never repeated. We have noticed reports in the press that 

derivatives dealers are working to avoid regulation. This is absolutely wrong. The efforts that have been reported on are part of a 

4–year effort with regulators to enhance practice in the OTC derivatives market. The latest letter is just the last quarterly submission outlining our efforts to enhance market practice. 

To that end, we propose the following, which is consistent with 

the administration’s position and Chairman Gensler’s testimony 

today. 

First, financial regulation should be considered on the basis of 

function not form. 

Second, a systemic risk regulator should oversee all systemically 

significant financial institutions and their activities. 

Third, all standardized OTC derivatives transactions between 

major market participants should be cleared through a regulated 

clearinghouse. 

Lastly, enhanced reporting requirements should apply to all OTC 

derivatives transactions. 

JPMorgan is committed to working with Congress, regulators, 

and other industry participants to ensure that an appropriate regulatory framework for derivatives is implemented. I appreciate the 

opportunity to testify, and I look forward to your questions. Thank 

you. 

[The prepared statement of Mr. Lenczowski can be found on page 

95 in the appendix.] 

34 

Chairman HARKIN. Thank you very much, Mr. Lenczowski. 

Now we turn to Dr. Richard Bookstaber. Dr. Bookstaber. 

STATEMENT OF RICHARD BOOKSTABER, NEW YORK, NEW 

YORK 

Mr. BOOKSTABER. Mr. Chairman and members of the Committee, 

I thank you for the opportunity to testify today. My name is Richard Bookstaber. During my career I have worked extensively in 

risk management, and I was also one of the pioneers in the development of derivative products on Wall Street. I am the author of 

the book ‘‘A Demon of Our Own Design; Markets, Hedge Funds, 

and the Perils of Financial Innovation.’’ That book, published in 

April of 2007, warned of the potential for financial crisis from derivatives and other innovative products. Although I have had extensive experience in both investment banks and hedge funds, I 

come before the Committee in an unaffiliated capacity and represent no industry interests. 

My testimony will focus on reducing complexity and increasing 

transparency in the derivatives markets through standardization 

and exchange trading. Derivative instruments—and I use the term 

to include options, swaps, and structured products—can improve financial markets. They can allow investors to mold returns to meet 

their investment objectives, to more precisely meet the contingencies of the markets. They can isolate and package risks to facilitate risk sharing. 

However, derivatives also can be used for far less lofty purposes, 

like allowing firms to lever when they are not supposed to lever; 

take exposure in markets where they are not supposed to take exposure; and avoid taxes that they are supposed to pay. In short, derivatives are the weapon of choice for gaming the system. These objectives are best accomplished by designing derivatives that are 

complex and, thus, opaque so that the gaming will not be readily 

apparent. 

Such complexity, as I point out in my book, makes the financial 

markets crisis prone. Complexity hides risks and creates unexpected linkages between markets. Because derivatives are the primary source of this complexity, to reduce the risk of crisis we must 

address the derivatives markets. We need a flight to simplicity. 

The proposed centralized clearing corporation, while a welcome 

step, is not sufficient to do this. It may address counterparty concerns, but it will not sufficiently address issues related to standardization, transparency, price discovery, and liquidity. To do that, we 

need to have standardized derivative products and have those products traded on an exchange. Standardization will address the complexity of derivatives. Exchange trading will be a major improvement in transparency and efficiency, and it will foster liquidity by 

drawing in a wider range of speculators and liquidity suppliers. 

These steps will shore up the market against the structural flaws 

that derivatives-induced complexity creates. 

Now, one stated objection to standardization and exchange trading is that having some products out in the light of day will only 

increase the demand for the more shadowy and opaque products. 

Another objection is that the push toward standardization will reduce innovation. These concerns lead to demands by some to abolVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00038 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
35 

ish all OTC derivatives and by others to shrink from exchange 

trading. There is no need to move toward either of these two extremes. We can have a combination of standardized exchange-traded instruments along with the continued development of customized OTC instruments. 

Abolishing OTC derivatives is not wise. There will be legitimate 

reasons for customized derivatives and no doubt innovations will 

emerge with broad value to the financial markets. The point is not 

to stifle innovation but to assure it is directed toward an economic 

rather than a gaming end. 

Standardized exchange-traded derivatives will create a hurdle for 

any nonstandard over-the-counter product. The over-the-counter 

product will have worse counterparty characteristics, be less liquid, 

have a higher spread, and have inferior price discovery. To overcome these disadvantages, the nonstandard OTC product will have 

to demonstrate substantial improvements in meeting investment 

needs compared to the standardized product. Also, and importantly, stricter controls can be placed on nonstandard OTC derivatives. For example, the regulator may mandate the disclosure of 

OTC positions and require a demonstration of why they are being 

used instead of a standard product. 

While there will still be the opportunity for innovation and for 

the application of the more complex derivatives, I believe that for 

most legitimate purposes the standardized products will be found 

to be adequate. 

Now, financial institutions might have to be pulled less than 

willingly into any initiative to standardize derivatives or to move 

derivatives from over-the-counter onto an exchange. They have an 

incentive to keep derivatives over-the-counter and not standardized. For the bank, the more complex the instrument, the greater 

the chance the bank can price in a profit for the simple reason that 

investors will not be able to readily determine the fair value. And 

if the bank creates a customized product, then it can charge a higher spread when an investor comes back to trade out of the product. 

For the trader, the more complex the instrument, the more leeway he has because it will be harder for the bank to measure his 

risk and price his book. And for the buyer, the more complex the 

instrument, the easier it is to obfuscate everything from the risk 

and leverage of their positions to the non-economic gaming objectives they might have in mind. 

In conclusion, we should move toward standardization and exchange trading of derivatives. And we should do this because it is 

the reasonable direction to go, not as a reaction to the current crisis and not predicated on whether derivatives were the villains of 

this crisis or merely innocent bystanders. 

The argument for standardization and exchange trading of derivatives is compelling. But there remains much we do not know. 

Therefore, it is important to move slowly, learning by doing rather 

than pushing for quick, wholesale solutions. 

There are markets that are beyond the purview of the CFTC, indeed that are beyond our borders, so the natural pace will be a 

gradual one. 

Thank you for the opportunity to provide this testimony, and I 

look forward to your questions. 

36 

[The prepared statement of Mr. Bookstaber can be found on page 

64 in the appendix.] 

Chairman HARKIN. Thank you very much, Dr. Bookstaber. 

Now we turn to Mr. David Dines, President of Cargill Risk Management. Mr. Dines, welcome. 

STATEMENT OF DAVID DINES, PRESIDENT, CARGILL RISK 

MANAGEMENT, HOPKINS, MINNESOTA 

Mr. DINES. Thank you, Mr. Chairman. My name is David Dines, 

President of Cargill Risk Management. I am testifying on behalf of 

Cargill, Incorporated, and I want to thank you for the opportunity 

to be here today. 

Cargill is an extensive end user of derivatives and relies heavily 

upon efficient, competitive, and well-functioning futures and overthe-counter markets. One of the major challenges for policymakers 

and regulators is that the term ‘‘over-the-counter’’ covers a vast 

array of products across a number of markets. This broad definition 

highlights why it is extremely difficult to seek a one-size-fits-all 

regulatory or legislative solution that still allows all interested parties to manage or hedge their genuine economic risks. 

One major concern with the recent proposal by the Treasury Department is that it appears to seek a regulatory solution for all 

OTC products in response to systemic risk posed by one particular 

market; credit default swaps. 

It is important to note that while we have witnessed the greatest 

economic crisis in 80 years, OTC contracts in the agriculture, energy, and foreign exchange markets performed well, did not create 

systemic risks, and, in fact, helped many end users manage and 

hedge their risks during this very difficult time. 

In today’s hearing, we will focus our comments on three of the 

four objectives of the recent Treasury proposal. We support the 

stated objectives and believe that steps could be taken to meet 

these goals, without denying end users’ access to an effective and 

competitive market. 

The Treasury Department’s first objective is to prevent activities 

in the OTC markets from posing risk to the financial system. The 

outline seeks to apply mandatory clearing of all standardized products and impose robust margin requirements to meet this objective. 

The imposition of mandatory clearing and mandatory margining 

of tailored hedges will have a significant drain on working capital. 

Mandatory margining will have the unintended consequence of actually increasing financial risks as companies choose not to hedge 

due to working capital requirements. 

The potential magnitude of this drain on working capital should 

be carefully weighed by all policymakers. I would like to submit for 

the record a letter from the National Association of Manufacturers 

as well as a recent letter from Chesapeake Energy, an Oklahomabased end user of OTC derivatives and the largest independent 

producer of natural gas. The Chesapeake Energy letter provides an 

excellent example of how imposing mandatory margining could severely drain capital that could otherwise be invested to grow a 

business. 

[The following information can be found on page 139 in the appendix.] 

37 

Mr. DINES. In the one example provided here, over $6 billion 

would have been taken away from running and expanding a jobcreating business, and instead be left idle in a margin account until 

the maturation of the OTC contract—a contract which had already 

been secured with collateral. Expand this example across all businesses that use OTC products and the amount of capital diverted 

from growing the U.S. economy would be severe, unless companies 

reduced their hedging and risk management. 

There is a misconception that OTC products do not have credit 

provisions and are never collateralized or margined. A significant 

number of OTC transactions are collateralized, margined, or make 

use of credit agreements to secure the contract with collateral 

being moved daily to adjust for the change in market value. 

With regard to mandatory clearing of standardized products, defining which products are ‘‘standard’’ and which products are ‘‘customized’’ is a complex issue that must be thoroughly examined by 

the appropriate Federal regulator to avoid disrupting market segments that continue to perform well. 

The loss of tailored hedging tools will also greatly impact the 

ability of companies to comply with current accounting standards. 

The Treasury Department outline also indicates that substantial 

capital requirements could be placed on all OTC dealers. 

There is a concern that the new regulatory framework could be 

developed such that only financial institutions could remain active 

dealers. The agriculture and energy hedging sectors have active 

non-financial institution OTC dealers who offer healthy competition 

in the market, and it would be inappropriate to eliminate these 

competitors from the OTC market through legislative or regulatory 

action. 

To meet the Treasury Department’s first objective of protecting 

the financial system, regulatory requirements should be risk based 

and not one size fits all. Additional monitoring and transparency 

is warranted; however, restricting working capital through major 

increases in mandatory margining in these markets is counterproductive. 

Objective 2: The Treasury Department’s outline seeks to impose 

more recordkeeping and force trades onto regulated exchanges to 

promote efficiency and transparency within the OTC markets. We 

recommend more recordkeeping and better disclosure, although the 

regulator should be directed to focus on areas with the greatest 

risks. As previously mentioned, mandatory movement of activities 

from the OTC market to an exchange-traded market does not seem 

warranted in those markets that have not created systemic risks 

to the financial system. 

Objective 3: The Treasury Department’s outline seeks clear authority to police fraud and market manipulation and the authority 

to set position limits on OTC derivatives. Cargill recently filed comments with the CFTC on a proposed rulemaking that addresses 

this objective where we support position limits for non-commercials, much greater transparency and reporting for over-the-counter 

markets, and we offered detailed suggestions for implementation. 

In summary, Cargill recommends that additional legislative and 

regulatory actions in the OTC market are risk based and not treat 

all products identically; seek to add minimal costs and disruptions 

38 

to those products that have not posed systemic risk to the financial 

system. 

Two, mandatory clearing and margining would severely reduce 

hedging activity, would greatly restrict working capital at a time 

when it is in very short supply, and is not warranted for OTC products that have not created systemic risk. 

Third, the CFTC, through its existing rulemaking, is proposing 

much needed steps and should continue to work on ensuring the 

enforcement of position limits in related exchange-traded markets, 

principally agriculture and energy products, and improving transparency and reporting of OTC products. 

We appreciate the opportunity to testify today and look forward 

to working with the members of the Senate Agriculture Committee 

and other policymakers as this issue develops. Thank you. 

[The prepared statement of Mr. Dines can be found on page 71 

in the appendix.] 

Chairman HARKIN. Thank you very much, Mr. Dines. 

Now we will turn to Mr. Michael Masters. You did show up. 

Mr. MASTERS. Coming from the West Coast. 

Chairman HARKIN. I understand you took an overnight flight. 

Mr. MASTERS. Yes, I had a little trouble getting here with the 

thunderstorms last night. 

Chairman HARKIN. Welcome, Mr. Masters, of Masters Capital 

Management, and as I said earlier, your statements will be made 

a part of the record in their entirety, and please, if you would take 

5 to 7 minutes or something like that, I would appreciate it very 

much. 

Mr. MASTERS. Sure. 

Chairman HARKIN. Thank you, Mr. Masters. 

STATEMENT OF MICHAEL W. MASTERS, MANAGING MEMBER/ 

PORTFOLIO MANAGER, MASTERS CAPITAL MANAGEMENT, 

LLC, ST. CROIX, U.S. VIRGIN ISLANDS 

Mr. MASTERS. Thank you. Good morning, Chairman Harkin and 

members of this Committee. The derivatives markets present Congress with two very critical and very distinct problems; systemic 

risk and excessive speculation. 

Last fall, the world financial system teetered on the brink of collapse. This near-meltdown had a catastrophic effect on our Nation’s 

economy, causing the loss of trillions of dollars in retirement savings and millions of American jobs. At the peak in 2008, the notional amount of over-the-counter derivatives outstanding totaled 

over two-thirds of a quadrillion dollars. These positions formed an 

interlocking spider web of enormous exposures amongst the 20 to 

30 largest swaps dealers and represented an extreme amount of leverage since very little margin collateral backed up these huge 

bets. 

This unregulated shadow banking system was effectively destroyed in the fall of 2008. It threatened to destroy the regulated 

financial system with it. However, regulators pumped trillions of 

dollars into the shadow banking system to allow OTC derivatives 

dealers to make each other whole on their bets. This was necessary 

to prevent a domino effect of dealer collapses that would have destroyed the world’s financial system. 

39 

Congress owes it to the American people to ensure that this 

never happens again. The risk of a financial system collapse must 

be eliminated, not regulated. Everyone agrees that clearing needs 

to take place in order to increase the transparency of these markets. But not all clearing is created equal. This clearing process 

must include two important provisions. 

First, clearing must involve novation wherein the derivatives 

clearing organization becomes the central counterparty to both 

sides of the trade. This will eliminate the interlocking spider web 

of exposures among swaps dealers because every dealer’s exposure 

will be to the central counterparty and not to each other. 

Secondly, clearing must involve daily margin where every day 

the central counterparty collects margin payments from those dealers whose bets are going against them. This ensures we never have 

another AIG. 

If this system had been in place in 2008, then it would have been 

virtually impossible for the financial system to melt down. 

Wall Street will seek to block mandatory exchange clearing by 

arguing that swaps are highly customized and cannot clear. This 

is false. The standard that regulators should adopt is not one of 

standardization versus customization, but one of clearable versus 

non-clearable. Chairman Gensler said during his confirmation 

hearing that if an OTC derivative can clear, then it should clear. 

Treasury Secretary Geithner said if an OTC derivative is accepted 

for clearing by one or more fully regulated CCPs, it should create 

a presumption that it is a standardized contract and, thus, required to be cleared. This is the right standard and will result in 

a vast majority of swaps clearing through an exchange. Exchange 

clearing will lead to price transparency, tighter bid-ask spreads, 

and greatly reduced cost for end users of the swap markets. There 

will also be greater liquidity due to lower trading cost and reduced 

emphasis on credit concerns. 

Now let us look at excessive speculation. America experienced a 

bubble in food and energy prices during 2008. This was caused by 

excessive speculation in the derivatives market for these commodities. These markets have become dominated by speculators, and 

prices no longer reflect supply and demand. 

Now, in 2009, the problem is once again raising its ugly head. 

Today, the supply of crude oil in the U.S. is near a 20–year high, 

while the demand is near a 10–year low, according to the IEA. Yet 

the price of oil has risen an amazing 85 percent this year, from the 

mid–30’s to the mid–60’s. There has been a chorus of voices from 

oil market participants, economists, and even OPEC squarely pinning the blame on speculators for unjustifiably driving oil prices 

higher. If Congress allows this to continue, then high oil prices 

threaten to throw our economy back into the double-dip recession 

and potentially ruin the Obama stimulus. 

Your constituents are flat on their backs financially and will not 

tolerate gasoline prices rising to $3 or $4 again. The excessive speculation problem can be eliminated by imposing aggregate speculative position limits. These limits must cover all trading venues 

which will require closing all the existing loopholes to ensure that 

every venue in regulated equally. 

40 

The swaps loophole is an exemption granted by the CFTC which 

gives swaps dealers free rein to buy and sell commodity futures in 

unlimited quantities. The best way to close it is to mandate that 

all OTC commodity derivatives clear through an exchange. This 

needs to happen to eliminate systemic risk, but it also needs to 

happen so that regulators can actually apply position limits. When 

a swap clears, the exchange breaks that transaction into component parts and becomes the center counterparty to both sides of the 

trade. This enables regulators to see both sides and enforce aggregate speculative position limits. 

The London loophole occurs when foreign boards of trade are permitted to trade contracts that are virtually identical to U.S. futures 

contracts. The solution is simple, foreign exchanges must be required to supply all the same data that designated contract markets provide to the CFTC, and they must enforce speculative position limits. 

Right now, the possibility for cross-border regulatory coordination is at an all-time high. G–8 Ministers issued a statement last 

week along with OPEC calling for greater regulation to crack down 

on excessive speculation in the energy markets. 

The CFTC must set the limits for all consumable commodities, 

not the exchanges. Speculative position limits should be set for the 

commodity as a whole rather than one particular grade or delivery 

or location, for instance, crude oil, not just West Texas Intermediate. Speculative position limits need to be aggregated across 

trading venues. 

In summary, the best way to eliminate the risk of another financial system collapse is to mandate that all OTC derivatives clear 

through an exchange with a novation and daily margin. And the 

best way to prevent another bubble of excessive speculation is to 

make aggregate speculative position limits apply across all trading 

venues. 

The CFTC has 70–plus years of experience regulating exchange 

clearing and policing markets for excessive speculation. The SEC 

and Federal Reserve have little to no experience in these two key 

areas. In fact, the SEC has allowed passive commodity investments 

in ETFs, ETNs, and commodity mutual funds. 

They have signed off on double-leveraged crude oil EFTs like the 

DXO that allow any investor to make leveraged speculative bets in 

crude oil within their retirement accounts. This does not show good 

judgment from a consumer protection or a market protection standpoint. For these reasons, the CFTC is the best and most appropriate regulator for the job. 

Thank you. I look forward to your questions. 

[The prepared statement of Mr. Masters can be found on page 

101 in the appendix.] 

Chairman HARKIN. Well, thank you very much, Mr. Masters, for 

summarizing a very extensive statement you had here, which I 

read last night, which I found extremely interesting. 

Now we turn to our final person here. This is Mr. Daniel Driscoll, Executive Vice President and Chief Operating Officer of the 

National Futures Association. Mr. Driscoll, welcome. 

41 

STATEMENT OF DANIEL A. DRISCOLL, EXECUTIVE VICE PRESIDENT AND CHIEF OPERATING OFFICER, NATIONAL FUTURES ASSOCIATION, CHICAGO, ILLINOIS 

Mr. DRISCOLL. Thank you very much, Chairman Harkin, Ranking Member Chambliss, and all the members of the Committee for 

allowing us to participate here and to ask you to close a loophole 

where fraudsters are able to offer over-the-counter derivative contracts to the retail public. 

NFA is the industry-wide self-regulatory organization for the 

U.S. futures industry, and we also regulate over-the-counter retail 

forex products. NFA is first and foremost a customer protection organization, and we take that mandate very seriously. 

Now, the other witnesses today have talked primarily about OTC 

derivative products that are offered to and traded by large, sophisticated institutions. But I am here to tell you that there is also a 

growing aspect of the OTC derivatives markets that is directed toward the retail public, and those customers are being victimized in 

a totally unregulated environment. 

Now, for many years, retail participants in the futures markets 

have enjoyed all of the benefits of the Commodity Exchange Act. 

Their contracts were traded on regulated exchanges and cleared by 

regulated clearing organizations. Their brokers had to meet the fitness standards of the Act and were regulated by the CFTC and 

NFA. However, today, there are too many customers that do not receive any of the benefits of regulation, and we need to do something about that. 

The main problem stems from a court case often referred to as 

the Zelener case, which was a Seventh Circuit Court of Appeals 

Case involving a CFTC enforcement case alleging forex fraud. In 

that case, the district court ruled that the customers were, in fact, 

defrauded but that the CFTC did not have jurisdiction because the 

contracts were not futures contracts. 

In that particular case, the contracts were offered to the retail 

public for speculative purposes. They were rolled over and over 

again so that delivery never took place. Basically they were the 

functional equivalent of a futures contract. 

Unfortunately, the Seventh Circuit ignored those characteristics 

and ruled that the written contract itself should determine the nature of the contract, and because the contract did not guarantee a 

right of offset, they ruled that they were not futures contracts, and 

the CFTC lost that particular case. There were other courts that 

followed the Zelener decision and came up with similar rulings over 

the next several years. 

Last year, Congress closed the forex loophole but, unfortunately, 

the loophole is not limited to forex so that customers dealing in 

other OTC products, such as gold and silver, are still in a regulatory mine field, and we need to bring regulatory protections to 

those customers as well. 

Back in 2007, NFA predicted that if Congress plugged the 

Zelener loophole for forex but left it open for other products, the 

fraudsters would simply move over to Zelener-type contracts in 

other commodities, and that is exactly what has happened. Now, 

we cannot quantify the exact numbers of that fraud because these 

firms are not regulated and are not registered. But we are aware 

42 

of dozens of firms that offer Zelener contracts in metals and energy. Recently, we received a call from a man who lost over $600,000, 

substantially all of his savings, investing with one of these firms. 

We have seen a sharp increase in customer complaints and mounting customer losses involving these products since Congress closed 

the loophole for forex. 

NFA and the exchanges have previously proposed a fix which 

would close the Zelener loophole for these non-forex products. Our 

proposal codifies the approach the Ninth Circuit took in CFTC v. 

Co-Petro, which was the accepted state of the law until Zelener. In 

particular, our approach would create a statutory presumption that 

leveraged or margined transactions offered to retail customers are 

futures contracts unless delivery is made within 7 days or the retail customer has a commercial use for the commodity. This presumption is flexible and could be overcome by showing that delivery actually occurred or that the transactions were not primarily 

marketed to retail customers or were not marketed to those customers as a way to speculate on price movements. 

This statutory presumption would not cover securities and banking products, it would not interfere with inter-bank currency markets, and it would not cover the retail forex contracts that are already covered or exempt under Section 2(c). I would also say that 

our proposal would not invalidate a 1985 interpretive letter issued 

by the CFTC, which Monex and other similar firms currently rely 

on to sell gold and silver to their clients. Essentially, that letter set 

forth a factual pattern which culminated in the actual delivery of 

the precious metals within 7 days and title to those metals going 

over to the retail customer so that it would not be covered under 

our statutory proposal. 

In conclusion, while we support Congress’ efforts to deal with 

systemic risk and create greater transparency in the OTC markets, 

Congress should not forget that there is a very real risk to the retail public participating in another segment of these markets. The 

Committee can play a leading role in protecting customers from the 

unregulated boiler rooms that are currently taking advantage of 

the Zelener loophole for metals and energy products. We look forward to further reviewing our proposal with Committee members 

and staff and working with you on this important matter. 

Thank you. 

[The prepared statement of Mr. Driscoll can be found on page 77 

in the appendix.] 

Chairman HARKIN. Thank you very much, Mr. Driscoll. Thank 

you all for your testimony. I cannot help, Mr. Driscoll, but to comment upon your statement. I offered an amendment on the last 

farm bill to close Zelener. We passed it in the Senate. 

Mr. DRISCOLL. Yes, thank you very much. 

Chairman HARKIN. Well, we did it, and we went to conference 

and lost it in conference. All we were able to keep out of that was 

just the forex contracts that you are talking about. Again, I think 

that was a mistake, and I said so at the time. But it did not have 

the votes. So I am glad to hear your testimony again today calling 

for a broader closure of the Zelener loophole that the Seventh Circuit opened up for everybody. It went beyond currency, and they 

43 

applied it to everything else. So I appreciate your comments today, 

and hopefully maybe if we move some legislation this year, we can 

also finally close that loophole. 

Mr. DRISCOLL. Thank you, Senator Harkin. 

Chairman HARKIN. I just could not help but comment on that. 

It seems like everyone here is basically saying that there is a legitimate need for derivatives trading, I think, if I am not mistaken, 

but that it would be well regulated, transparent, but there is some 

need for some liquidity in the marketplace that might be provided 

by that. I am reminded of what one person said to me, a Congressman said to me, a former Congressman said to me one time about 

liquidity. He said, ‘‘You know, liquidity is good, but too much liquidity can be bad.’’ He said, ‘‘It is like I take an aspirin every day. 

My doctor says I should take an aspirin every day for liquidity. But 

if I took a whole bottle every day, it might be kind of dangerous 

to my health.’’ So I have often thought about that kind of analogy. 

I also think about the analogy that Dr. Bill Black testified to last 

fall when we had our first hearing on this. Someone had commented upon, well, we do not want to stifle the free flow of capital, 

to which Dr. Black responded, ‘‘Well, I do not know,’’ he said, ‘‘if 

we really want the free flow of capital; maybe we want the more 

efficient flow of capital.’’ And he used the analogy of traffic flow. 

He said, ‘‘You know, if we want the free flow of traffic, do away 

with all the stop lights. Do away with the stop signs. Do away with 

the speed limit signs. You will have a very free flow of traffic. But 

you are going to have a lot of wrecks.’’ And he analogized that to 

the financial markets, that we need regulation, we need the stop 

lights and the slow-down signs and the danger signs and things 

like that, not so much for the free flow of capital, but for the more 

efficient flow of capital. 

Now, with that as a backdrop, I understand the need for liquidity. I also appreciate, Dr. Stout, your testimony. A lot of this gets 

clouded in jargon. We say, oh, this is complex and all that. But it 

kind of boils down to certain essentials all the time. And I will 

start here with what Mr. Lenczowski testified to, and that is that 

many banks relied on credit default swaps instead of fully meeting 

capital requirements. 

So we have heard a lot of discussion here about, well, we should 

not have to come up with capital requirements too much. I think 

maybe Mr. Dines maybe testified to that; I think maybe somebody 

else did, that requiring too much capital requirements might stifle 

the transactions and the more open flow of capital and hedging. 

But many banks relied on these credit default swaps instead of 

meeting the capital requirements under the Basel II rules—I had 

to learn this, too, what Basel II was—thus contributing to the 

buildup of excessive leverage and risk. 

So I guess a question for all of you basically is this; how do we 

control the risk to the financial system and our broader economy 

when institutions rely on derivatives too much and we do not have 

as much capital coming forward? So that is really what we are trying to wrestle with here. 

Now, again, I will make another statement as sort of a backdrop 

to what I am getting at here. There have been a couple of articles 

in the Wall Street Journal and New York Times recently, and they 

44 

concluded that the banks and other over-the-counter swaps dealers 

oppose certain reforms for the basic reason that the greater transparency and disclosure involved in exchange trading would impair 

their ability to make profits. That is, if the parties on the other 

side of transactions had a better idea of what prevailing prices are 

for swaps, then the banks and swap dealers would not be able to 

charge as much as they can if they kept them off the exchange, in 

the dark and out of sight. 

I want to state emphatically I am not opposed to the financial 

sector making profits. They have done very well in the last few 

years, I might note, but I think there is also a countervailing tremendous public interest at stake here. When we have to come up 

with $4 trillion to rescue the economy, a bill that we will be paying 

and our kids and our grandkids will be paying for some time, then 

I think it argues that we have to balance this desire for making 

profits, which is fine, with the countervailing balance of the public 

interest here. 

So I do not see this as a really complex issue. What it basically 

is, on the one hand we have the public interest in protecting the 

economy from these risks; on the other hand, the quest of the financial sector to make maximum profits. And to me that is just 

how I see it. It is not much more complex than that. And as I 

delved more into derivatives and credit default swaps, I then found 

out that all these things, whether they are credit default swaps, 

collateralized debt obligations, collateralized mortgage obligations, 

all these things, hardly any of those existed before 1990. Most of 

them came up in the 1990’s. 

I keep asking the question; where was the demand? Where was 

the demand for these products? I found out there really was not 

any, just that these quants that I referred to earlier came up with 

ingenious ways of slicing and dicing all these little derivatives, 

these tranches, and no one really knew what the value of them 

was. 

I have often said jokingly that I never knew when I was growing 

up that someday I would need Honey Nut Cheerios. I thought 

Cheerios was just fine. But all of a sudden, I found out I need 

Honey Nut Cheerios. Well, that is OK. I do not mind that. That 

is an innovation. They were able to sell that, no one is hurt, that 

is fine. But if innovation in this financial sector does not pertain 

to some underlying value or benefit to the goods and services of the 

GDP, then it just seems to me to beg for more regulation and oversight. 

I did not mean to go on so long on that, but if I had a basic question for all of you, and I will just go down the line; how do we balance this off? How do we provide for liquidity, the aspirin a day 

but not a bottle a day? How do we provide for innovation that 

might pertain to underlying value, but not innovation that just allows someone to gamble and make a lot of money, and keep our 

markets regulated in the public interest, how do we balance those 

off? 

Dr. Stout. 

Ms. STOUT. I think that history gives us some very good guidelines because we actually did that pretty well be 1933 and 1934 

and the mid–1990’s. And I think the legislation that you are proVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00048 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
45 

posing, which in many ways reinstates some of those old-fashioned, 

time-tested, highly successful strategies, is a very good start. 

I want to just point out, it is interesting, Simon Johnson of the 

MIT Sloan School has estimated that between 1973 and 1985, the 

finance sector of the U.S. economy accounted for 16 percent of corporate profits, and that in the last decade that has increased to 41 

percent of all corporate profits were earned by the finance industry. 

Although I do not have the exact breakdown, I suspect that 

many of those profits were actually trading profits earned by hedge 

funds and by the proprietary divisions of investment banks. Where 

did they come from? I will simply point out that hedge funds were 

earning between 10 and 20 percent annual returns over the last 

decade. Average investors, who are my investors—I am a trustee 

of a mutual fund; that is the Moms and the Pops who buy our mutual fund interests—they got 3 to 4 percent a year. I do not think 

that you can assume that is a coincidence. 

Chairman HARKIN. Mr. Lenczowski, how do we balance these? 

Mr. LENCZOWSKI. Well, first, thank you, again, Chairman, for allowing me to testify. I think first I would to state that at JPMorgan 

we broadly support the initiatives of the administration and of 

Chairman Gensler to undertake regulatory reform. 

Chairman HARKIN. By the way, I would be remiss if I did not 

compliment JPMorgan because you are the ones back in the 1990’s 

that did not get involved in that credit default swap mess. And I 

think you were very prescient on that, so I would be remiss if I did 

not compliment you on that. 

Mr. LENCZOWSKI. On behalf of our institution, thank you. 

But to go back to the points you were making, Chairman Harkin, 

the first thing on capital, and I think just to state as a bank we 

are subject to very stringent capital requirements already, and I 

think, if I might, the capital that Mr. Dines was referring to and 

perhaps Senator Chambliss referred to earlier, we are talking 

about capital that is coming out of non-banks, out of the end users, 

the companies in our country that create jobs. And if they were to 

trade on exchange—which they currently have the right to do, but 

if they were to be forced to trade on an exchange, they would have 

to take capital out of their corporations and pledge it to the exchange. That is the way the exchange operates. 

So when we talk about a drain on capital, it is not our capital. 

It is the capital of companies like Cargill, Chesapeake, and they 

told you how much that would be. It is billions of dollars. 

The other point I would make, Chairman Harkin, on demand, 

the history of the over-the-counter business has been one that has 

grown in response to customer demand from the relaxation or the 

dropping of the gold standard in the 1970’s and responses to oil 

price shocks and inflation led to unprecedented volatility in currency rates, in interest rates. This is what led to the interest rate 

and currency markets to grow, to serve customer needs. These are 

markets that exist to serve customers, and we serve as a financial 

intermediary. 

You mentioned CDOs. In the early part of this decade, we had 

a time of very, very low interest rates, of investors looking for enhanced yield and willing to take on extra risk. And the CDO market, the CMO market, and many other structured markets arose in 

46 

response to the investor demand for higher yield with higher risk. 

We have seen what has happened as a result of the collapse in real 

estate prices. 

Last, I would just close, this part at least, by saying that, again, 

we support clearing. It is an important tool that we currently use. 

We derive great benefits from it, from credit risk reduction and an 

operational standpoint, but we think it would be a mistake to impose that kind of a one-size-fits-all requirement on our economy. 

Chairman HARKIN. Dr. Bookstaber. 

Mr. BOOKSTABER. I would disagree to some extent with the last 

statement. I believe that there is a component of the development 

of ‘‘innovative products’’ that is very much along the lines of what 

you, Mr. Chairman, depicted, where the banks or investment banks 

realize that if they can differentiate themselves, that if they are 

selling something that other people are not selling, and if it is sufficiently complex, they can price it in a way that people will have 

difficulty understanding if it is fairly priced or not, and they will 

be able to trade it with a higher spread because the client does not 

have many other avenues for trading. So liquidity basically is a 

negative aspect and complexity is a positive aspect when it comes 

to profit for the bank or the investment bank. 

On the other side, as I think you also pointed out, part of the 

investor demand that has come for some innovative products has 

occurred along the ‘‘Hey, I got a problem’’ sort of approach; that is, 

somebody is trying to say, ‘‘You know, I want to lever but I am not 

allowed to lever. Can you help me out here?’’ And on that basis, 

you get new innovations that are helping for these gaming purposes. 

I believe that there is a need for innovation, that we can have 

innovation, but regulators need to, No. 1, find a means to have innovation that is directed toward economic purposes as opposed to 

gaming purposes. And I do not know the proper method for doing 

that. I think that it is clear that we need to have capital, margin, 

haircuts, whatever sort of method is used, to back derivatives and 

other exposures rather than having them be off balance sheet without sufficient capital background. 

I agree also with one point that Mr. Dines said, that it is reasonable to have a distinction between different types of products, 

though not on the basis of what caused a problem in the past 

versus what did not, because we do not want to drive through the 

rearview mirror. But there are some products in some markets that 

inherently are more systemic by nature. Interest rates and currencies are just by nature going to be more systemic than corn, 

wheat, and commodities of that type. So we more urgently need to 

have the ability in those markets to control and to aggregate so 

that we can detect patterns of crowding that may move us from 

having an issue where it becomes systemic because many firms are 

all on the same side of the boat. 

Chairman HARKIN. Thank you very much, Dr. Bookstaber. 

Mr. Dines. 

Mr. DINES. Thank you. I guess I would start by just confirming 

what was said by the other panelists, and what I said in my testimony is that we, again, do not believe that you can take a one-sizefits-all approach to solving this. The regulatory changes that apply 

47 

to credit default swaps may not be and I do not think are appropriate for the energy and agricultural markets. We believe that 

there should be greater transparency and reporting to the regulators, and we have said that we think that there should be position limits for non-commercials. 

We believe that this will go a long ways toward solving the 

issues. We do not think that mandatory margining and clearing is 

necessary, and we think that will have unintended consequences of 

reducing people’s hedging, companies’ hedging, and that will cause 

significant risks. 

Chairman HARKIN. Unless I misinterpreted what you said, Mr. 

Dines, you are basically proposing that we separate financials out 

from commodities. 

Mr. DINES. I am saying that we need to take a different approach 

to these different segments, and what might be appropriate for 

credit default swaps may not be appropriate for the energy and agriculture markets. I think some do have more systemic type risks 

than others. 

Chairman HARKIN. Yes, I understand. 

Mr. DINES. OK. Thank you. 

Chairman HARKIN. Mr. Masters. 

Mr. MASTERS. Thank you, Senator. I think there are two parts 

to the question. One is liquidity and one is innovation. 

First of all, let us just get out the word ‘‘innovation.’’ Innovation 

is a word that Wall Street uses to talk about anything they do in 

the financial markets. Innovation by itself has sort of a positive 

connotation when people think about innovation. But innovation is 

not always good. You know, Ford had the Edsel. There have been 

many, many products developed in our economy over the last few 

hundred years that were not good products. Why is it that everything that Wall Street creates is a good product? There are a lot 

of bad products. So I would just like to get that out to begin with. 

In fact, I would argue that since many of these innovative products affect consumers in a very direct and a very real way, including loss of jobs, savings, and so forth, where is the financial FDA 

for this? You know, who is looking at what the aftereffects of these 

products are? Because it is certainly not Wall Street. They are just 

looking at their bottom line. 

With regard to innovation itself, the exchanges themselves have 

produced plenty of innovation as well. It has not just come from the 

over-the-counter market. 

So, at any rate, I would just like to get that out, but with regard 

to liquidity, one of the things that some of the folks that have testified have mentioned is the whole issue on financing cost for corporations, and what many may not realize is that those financing 

costs are borne by someone. When you buy a swap from someone, 

the other side of that swap, if it is a large investment bank, those 

funds are not free. 

So all that financing cost that people say, oh, we are going to 

have financing cost and margin and so forth, you are already paying that if you are an over-the-counter customer to a bank. You 

just may not see it. In addition, you are paying other things that 

you may not see, notably, profit margins. 

48 

So the issue that we argue with regard to mandatory clearing for 

standardized derivatives is—I think you would actually lower the 

costs because you would have more people that would be able to 

trade with each other with regard to swaps. You would increase 

the liquidity. You would certainly lower the bid and offer. And so 

I actually think that, contrary to raising costs for corporations, you 

would actually lower costs for corporations ultimately. 

We had that experiment with the New York Stock Exchange 

when bid offers went from eighths to quarters and halfs to decimals, and volume has tripled and liquidity has tripled. So I think 

you look at that example and you have a better idea of really what 

the future could be, and you have many, many more participants 

in the market, not just investment banks, that are allowing liquidity. 

Chairman HARKIN. Excellent point. Thank you. 

Mr. Driscoll. 

Mr. DRISCOLL. Chairman Harkin, I have been a futures regulator 

for almost 40 years, and I can tell you that when I first started 

out—this is sort of the flip side of the innovation angle—there were 

no such things as interest rate products in the futures markets; 

there were no stock index products. The whole panoply of products 

out there that I think everyone, without exception, agrees are very 

valuable, not only to the futures markets but to the participants in 

the futures markets and to the American and the worldwide economies. So there obviously is a plus side to innovation. 

From the regulatory standpoint, I believe that it is key that all 

of these markets be subject to a prudent level of regulation. It does 

not mean that every market has to have exactly the same regulations. Equity securities and futures do not have exactly the same 

types of regulations. And I think the focus on systemic risk and 

transparency by Congress, the administration, and the CFTC is exactly the right one. 

I am a big proponent of clearing organizations and exchangetraded markets. That is primarily what we regulate. So anything 

that can be done to encourage moving as much business as feasible 

onto regulated markets and to have those instruments cleared 

would be a positive thing, recognizing that I am—and I am not the 

biggest expert in that area—that I am sure that there are any 

number of more non-standardized products that would be difficult 

to put on an exchange. 

Thank you. 

Chairman HARKIN. Thank you all very much. I took an inordinate amount of time with that, but I yield to my friend Senator 

Chambliss. 

Senator CHAMBLISS. Let me start with you, Mr. Lenczowski. You 

mentioned in your written testimony that the industry is seeking 

to clear more credit default swaps. Would you expand on other ongoing efforts to curb systemwide risks relative to CDS in addition 

to the clearing? 

Mr. LENCZOWSKI. Yes, thank you, Senator. Over the past 4 years, 

the dealers have been working with investors to come up with market improvements for the credit default swap market, and several 

of those improvements have been made. First, the amount of undocumented trades has been drastically reduced. There have been 

49 

protocols agreed as to the way to treat novations or transfers of 

trades. There has been a huge improvement in the amount of 

trades that are electronically confirmed, which significantly decreases operational cost. 

Then just recently, there has been a major change and restructuring of the way that the market operates so as to standardize 

cash settlement as the form of settlement of credit derivatives and 

to standardize all economic terms, essentially, for credit default 

swaps. 

The result is that the product has become standardized to the 

point where we think that more and more over-the-counter credit 

default swaps will be cleared. The ICE U.S. Trust Clearinghouse 

started operation earlier this year already clears over $800 billion 

of CDS transactions. That number is going to grow. Old trades are 

being backlogged into the system to further increase the pervasiveness of clearing. So the entire progression of the market has been 

toward increasing clearing, increasing transparency, additional recordkeeping and transparency from the standpoint of pricing, prices 

are now available on the Internet, freely accessible for the largest 

entities that are traded. 

So it has been a steady progress working between dealers and investors, working with the regulators to improve the market. 

Senator CHAMBLISS. Does your firm use the ICE OTC clearing? 

Mr. LENCZOWSKI. Yes, we do. 

Senator CHAMBLISS. How is that working from a practical standpoint? 

Mr. LENCZOWSKI. It has been working very well. Again, clearing 

is distinctly in our interest to do. When the transactions are standardized and when counterparties to our transactions are able to 

clear, we derive great benefits from clearing. And we have used the 

ICE clearinghouse for credit default swap clearing, and we also use 

other clearinghouses for other asset classes. So, for example, in the 

interest rate swap market, we use the London clearinghouse called 

LCH Clearnet, which clears a huge volume of interest rate derivative transactions. Something like 50 percent currently of the dealer-to-dealer swaps are cleared. And in the commodity markets, we 

are clearing through facilities operated both by ICE and by the 

CME group called ClearPort. 

So all this evidence is a move toward clearing. We think it is— 

amongst the dealers, it is definitely in the interest of everyone to 

reduce risk, to increase transparency. 

Senator CHAMBLISS. There seems to be a perception out there 

that the only derivatives that need to be customized are the very 

complex and most complex products. Are there not simple foreign 

currency or interest rates swaps that still need to be customized for 

your clients? 

Mr. LENCZOWSKI. Yes, absolutely. And actually Chairman 

Gensler earlier described one of those transactions, a simple interest rate swap which has been around now for almost 30 years, is 

very well understood, not a complicated transaction at all. But it 

is extremely customized as to every economic term, and that is to 

give the end user, the company that is entering into that swap, the 

maximum hedge for its risks, and also to get the best accounting 

treatment. An entire accounting framework has grown up around 

50 

derivative transactions and hedging transactions, and over-thecounter instruments are the best way for companies to take advantage of that accounting framework. 

There is another example I could cite. Chairman Harkin was 

looking for examples of why something has to be done over the 

counter. In the natural gas markets, at this point dozens of public 

utilities engage in long-term natural gas purchase contracts where 

they are able to procure natural gas at prices below the prevailing 

market price on a monthly basis for the next 15 to 20 years. These 

are very long term purchase contracts, and they are able to do that 

through the use of over-the-counter natural gas and interest rate 

derivatives. These are contracts that ultimately benefit millions of 

consumers of natural gas, customers of these utilities. They are 

well understood. They are approved through the Tax Code amendments passed in 2005, and they serve an incredible benefit to communities throughout the U.S. 

Senator CHAMBLISS. There has been a lot of conversation and critique of the markets over the past year with respect to what is 

called ‘‘excessive speculation,’’ and that speculators drove up the 

physical commodities to record high prices. Now, you deal in the 

market on a daily basis, I assume sometimes as a speculator, sometimes not. Explain what you see with respect to speculation, why 

it is necessary and what is happening with regard to this issue of 

excessive speculation. 

Mr. LENCZOWSKI. Yes, Senator. And I might preface it by first 

saying that we strongly support efforts to combat and prosecute 

manipulation. Market manipulation is in no one’s interest, and certainly from a market participant standpoint, it is extremely detrimental to all of our activities. And—— 

Senator CHAMBLISS. Obviously, there is a difference between manipulation and speculation. 

Mr. LENCZOWSKI. Yes, and speculation is necessary for markets 

to perform. To take a very basic example, the farmers of this country, when they farm grain, will need to sell it ultimately to bakeries, for example. The baker and the farmer need to match up, one 

to sell grain, the other to purchase grain. The chances of them 

matching exactly for all of their purchases are extremely low. Speculators expand each side of that market. They buy and they sell. 

And they provide the liquidity that is necessary for markets to operate. So all markets require some degree of speculation. Excessive 

speculation certainly is something to be combated, and we would 

support that. 

Senator CHAMBLISS. Mr. Dines, you deal in the markets every 

day with respect to risk management tools that you use in your 

business. I would like for you to give us a practical example of one 

of these customized contracts that you use. And if those customized 

contracts were not available to you at Cargill, what effect would 

that have on your business? 

Mr. DINES. Happy to do so. Thank you. 

Everyone here knows that Cargill is a processor of corn, and we 

are in the markets buying corn every day. In essence, we are buying corn at the average price over a given period since we are in 

buying it every day. 

51 

The best hedge for us if we wanted to protect against prices 

going higher would be a product against the average, not a product 

against a discrete point in time, which is what you can get on the 

exchange. 

We can go into the OTC markets and buy what is known as an 

average price option. An average price option comes at a 30–to 40– 

percent discount to what is available on the exchange. It is a more 

precise hedge for what we need because it is against the average. 

It is real cost savings up front, and this cost savings might be the 

difference between what gets us to hedge and what does not get us 

to hedge. So that is a real example. 

Now, we cannot go in and buy that product on the exchanges. 

Average price options do not exist. Furthermore, in the OTC markets, we can tailor that product to give us the exact level of protection that we want and for the exact end date that we want. Let 

us say that we wanted to do it on new crop corn, but we only wanted to go through the pollination period of July. If we went to the 

exchange, we would have to buy a product that ends in November. 

We could tailor this product to end in July. We are saving ourselves 4 months of time value of extra cost that goes into that product. 

So those are real examples of the types of things that you can 

do in the over-the-counter market that you cannot do on an exchange-traded type market. 

Senator CHAMBLISS. What if that were not available to you? 

What would be the effect of that unavailability? 

Mr. DINES. It would be a far less precise hedge and a more costly 

hedge, and I know you would find market participants doing less 

hedging because of the costs. 

Senator CHAMBLISS. We talked earlier about position limits and 

increased margins and what-not, and I think you used the phrase 

that this could create—would create a real drain on working capital. 

From the standpoint of Cargill, do you have any idea of what 

kind of conceivable working capital drain you would be looking at 

for the volume that you do business in every day? 

Mr. DINES. I think at times it could be significant. I guess maybe 

I would take you back to last March when we and other grain companies actually had to stop buying deferred grain from farmers, because of the run-up in grain prices and the demands on working 

capital to cover margins calls. Luckily, we were able to move some 

of our hedges to the OTC markets where we were able to put in 

place alternative credit arrangements and become reopened for 

business. And I think the important point here is that we would 

like to have the flexibility. 

We do plenty of hedging on the exchanges. We do lots of hedging 

in the over-the-counter markets. The idea for us is that we like to 

have the flexibility, and that is very, very important for Cargill, but 

I do not have a number in mind, but I could tell you it would be 

significant. 

Senator CHAMBLISS. Mr. Masters, you have conducted an analysis in which you extrapolated data from CFTC’s commitment of 

trader report to determine speculative activity in the crude oil marVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00055 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
52 

ket. Your analysis seems to assign values based upon index fund 

portfolios. 

Now, do you assume that speculative activity was primarily occurring only in the index funds as opposed to the single-name commodities? 

Mr. MASTERS. Thank you, Senator. We are assuming that the 

index funds were a primary participant last year with regard to 

commodities. There were also speculators in single-name commodities as well. We looked at the index fund data that was provided 

from the CFTC. 

Senator CHAMBLISS. Well, what data is used to support your assessment that oil prices should have been falling last year when 

most expectations and market analyses showed prices continually 

increasing throughout the year due to geopolitical uncertainties, 

record OPEC stocks, a devalued dollar, and the increase in demand 

during the summer last year? 

Mr. MASTERS. That is a good question. The issue with regard to 

prices in the futures market has to do with the supply and demand 

of futures. In the grains and the oil markets, the futures price is 

the price that determines spot, unlike other derivatives, unlike 

many other markets. You know, Platts, who is the largest spot 

pricing service, says in part, ‘‘We price off futures markets.’’ Many 

spot market participants we talked to said, ‘‘We almost entirely 

price off futures markets off some basis.’’ 

So I think that what we did was we looked at the money flows 

going in and the money flows going out, and our sense was based 

on the data that there was an enormous amount of money going 

into the crude oil markets over the time, and after Congress looked 

at this issue and I think started really complaining about it to a 

certain extent, I think it led a great deal of money to come out of 

those markets, none of which had much to do with actual supply 

and demand. They amplified the price on the way up, and they 

greatly amplified the price on the way down. 

Senator CHAMBLISS. Mr. Bookstaber, we talked with Chairman 

Gensler about the responsibility for determining whether or not a 

product is standardized or customized, and we talked about the 

clearinghouse that is going to clear it being the determinant of 

that. 

What is your thought about that, are they the proper ones to determine whether something is customized or standard? 

Mr. BOOKSTABER. The notion of standardization is a fairly loose 

one. The key is whether you can construct sufficient tagging for the 

product so that many other products can be put into the same basket and traded in a similar way. You know, ultimately the decision 

for standardization will be if it is on an exchange, is it sufficiently 

different from other products that people gravitate toward it as an 

item to trade? I do not know who the authority would be to say, 

oh, this is standard versus this is customized. It is something that 

still has to be defined. 

Senator CHAMBLISS. OK. Mr. Driscoll, in talking about the 

Zelener fix, as the Chairman says, we had a very significant discussion on this issue last year during the farm bill debate, and we addressed the concerns of the lookalike forex contracts, and I am not 

sure in your statement that you made earlier, where you said that 

53 

there has been an increase in the number of complaints since Congress closed the loophole, whether you are talking about since the 

farm bill was enacted last year or are you referring to some previous date where a loophole was closed? 

Mr. DRISCOLL. I was referring to last year in the farm bill. We 

have seen a large increase since a year ago today. 

Chairman HARKIN. You mentioned gold and silver as commodities where there is the potential for fraudulent transactions. Any 

other commodities that need to be considered in that same respect? 

Mr. DRISCOLL. Precious metals are by far the largest product 

that is being used in these non-forex Zelener type of contracts, but 

we have also seen energy type of products as well. And our view 

is that essentially you have to close the loophole for all commodities that are traded in futures markets because if you close off the 

ones that are currently existing, then next year we will be coming 

back and saying the fraudsters have now gone to other markets, 

because the people that trade these sorts of contracts and run these 

sorts of schemes are ones that are looking for a regulatory vacuum, 

and they have made careers of doing this. So we believe the loophole has to be closed for all commodities. 

Senator CHAMBLISS. Ms. Stout, do you feel that all OTC markets 

create a systemic risk? 

Ms. STOUT. No, probably not. I think something—that is actually 

a question that is not even necessarily something we have to address. I think a proper system of regulation of derivatives trading 

would prevent systemic risk from arising in any particular market. 

And I personally tend to favor what I think of as automatic circuit 

breaker rules of this sort rather than regulation that takes the 

form of creating some omniscient entity, some omniscient Government oversee who is supposed to investigate things on an ad hoc 

basis and look for potential problems. 

I think with the right set of circuit breakers, the sorts that have 

been mentioned today—listing requirements, margin requirements, 

position limits—we do not have to worry about looking out for the 

development of systemic risk in particular markets because the 

system would look out for us. 

Senator CHAMBLISS. Do you agree that some risk in markets is 

a good thing? 

Ms. STOUT. Pardon me while I put on my pointy headed corporate finance professor hat. No, risk is never good. However, 

sometimes risk is inevitable if you want to accomplish something 

useful, like curing cancer or building a company that builds airplanes. But, no, risk itself is never good. We would like to get rid 

of all of it, if we could, and the real trick, I think, is to eliminate 

all the unnecessary risks while not throwing the baby out with the 

bath water and eliminating risk in productive areas and with regard to productive endeavors that we want people to undertake. 

Senator CHAMBLISS. Well, having been in business myself, I have 

never made any money without taking a risk, and I just think it 

is extremely difficult and would be extremely expensive if we tried 

to take the risk out of it. 

Mr. Chairman, I think that may be—I think that is all I had. 

Chairman HARKIN. Thank you very much. 

54 

Mr. Masters, in your summary, you said, ‘‘What I have outlined 

in my testimony are not brand-new solutions; one, exchange clearing with novation and margin and, two, speculative position limits 

have proven effective over many decades of experience. In many 

ways, what we need to do is turn back the clock on several of the 

deregulatory measures that were undertaken in the last 15 years. 

The unintended consequences of those deregulatory decisions have 

been devastating for America.’’ I agree. 

Now off of that, I want to challenge you, Mr. Dines, on what you 

just outlined on this average price option. You say it is not offered 

by the exchanges. Well, why is it not offered by the exchanges? We 

have a chicken-and-egg thing here. See, now, I have said we ought 

to put all these on exchanges, you see. Well, if you are allowed to 

have them on over-the-counter markets, that is where they are. 

But who is to say that this average price option could not be developed as a product on a regulated exchange? That way you have 

more transparency, you would have more people involved, you 

would have more liquidity because you would have more people in 

that game. But as long as we have it in the over-the-counter market, with some opaqueness, lack of transparency, of course, the exchange is not going to offer it. 

I had Mr. Duffy here last fall when we discussed this very thing, 

and I asked him that pointed question. I said in terms of my legislation, to put them on a regulated exchange, I asked him very 

pointedly. I said could your exchange—could the regulated exchange, not just his but the regulated exchanges handle this, and 

his answer was yes. 

So, again, I have always asked, I keep asking this question—I 

asked two questions. One, define a customized swap. I still have 

not had one real defined yet, what is customized that does not have 

some impact someplace in the economy. If you have a customized 

swap on an interest rate or something like that, it may be between 

two individuals, but it may have other effects on a lot of other investors in other places. The same way with your hedging on the 

corn market. It could have a lot of effects. 

I would submit that if you have it on a regulated exchange with 

more transparency and people know about it, quite frankly, I think 

your business will do better. I, quite frankly, think it will, and I 

think that the sellers will also do better, too, because it will be 

open and aboveboard. And we can call for margin requirements. 

Now, you had this problem with capital requirements. But that can 

be set. We can temper that, I think, through regulation on not having onerous capital requirements, but having some capital requirements, putting some skin in that game. 

So, again, I want to challenge you on why you cannot do this on 

a regulated exchange. 

Mr. DINES. Well, you could put average price options on exchanges. That could very well happen. But the degree of 

customization goes beyond that, and it goes to protection periods, 

it goes to protection levels, it goes to maybe how the average is determined. And the issue is that you can have multiple, multiple different variations of an average price option. 

55 

I want to be very careful. It does not mean that they are more 

complex. It means that they are tailored to precisely meet that 

hedger’s needs. 

I think it is impossible for the clearinghouses and the exchanges 

to do this. I do not think they can handle multiple forms, and the 

OTC market does it. We do it every single day. Our customers will 

say I want it to expire this particular day, I want it with this protection level, I want the averaging period to start here and end 

here. And to put that on an exchange will require standardization. 

You go into the exchanges today, you can pick from a certain set 

of end dates. You can pick from a certain level set of protection levels. But you do not have the degree of customization you cannot 

customize. They just are not set up to do it. 

So that I think is the primary difference. It is the ability to really 

work with customers to customize the product. 

Chairman HARKIN. Dr. Bookstaber. 

Mr. BOOKSTABER. I think a good example of the distinction—the 

gray area between standardized and customized is the equities option market. The CBOE is, as exchange traded. In that market you 

cannot get an exercise price of, say, 51.3. 

Chairman HARKIN. Say that again? You cannot—— 

Mr. BOOKSTABER. The exercise prices for the options are in increments, maybe 5–or 10–point increments. 

Chairman HARKIN. OK. 

Mr. BOOKSTABER. So somebody could argue, wait a minute, this 

is not fulfilling my objective because I do not want an exercise price 

of 50 and I do not want an exercise price of 55; I want 52.23. 

Well, of course, if you go to customized, the standardization is 

going to limit things to some extent, but the challenge is to go to 

Cargill, to go to the clients of JPMorgan, and to say let us look at 

the whole layout of the customizations that you do. Can we find a 

reasonable set of standard securities that get close enough to what 

people want that in the majority of cases they are fairly satisfied? 

Maybe somebody wants a time to maturity of 11.1 months, and another wants it of 10.9 months; 11 months might do the job for 

them. 

So it is true that you cannot get standardization to meet every 

of the infinite possible numbers of times to maturity and the infinite number of possible exercise prices. But once you get to fine 

enough differentiation, that may be sufficient to deal with the large 

majority of what people demand. 

Chairman HARKIN. Mr. Lenczowski. 

Mr. LENCZOWSKI. Thank you, Chairman. I would agree with Dr. 

Bookstaber that there could be a degree of standardization that is 

achievable. But even with that standardization, the company that 

is looking to hedge its risk will still have to post the margin to the 

clearinghouse. And you mentioned, Chairman, that we could maybe 

regulatorily affect that margin. It is actually incredibly important 

that that margin be what the clearinghouse says it is because the 

clearinghouse has to act as the ultimate credit support to everyone. 

So it sets its margin requirements based on what it feels through 

its risk models the risk of a particular transaction is. 

So the clearinghouse sets that margin requirement, and then it 

requires the most liquid form of collateral, because as soon as a deVerDate Nov 24 2008 23:43 Mar 23, 2010 Jkt 000000 PO 00000 Frm 00059 Fmt 6633 Sfmt 6633 C:\DOCS\54570.TXT SAG2 PsN: SAG2
56 

fault occurs, the clearinghouse has to instantaneously apply that 

collateral against the defaulted position. There is no ability to wait 

and sell some property or land. It has to happen instantaneously. 

Again, that preserves the clearinghouse’s stability. 

So while, again, I agree that there could be standardization and 

it could actually suit certain customers’ needs, many customers just 

do not have that liquidity, that cash right now, and that is why, 

among other reasons they use the OTC market. 

I think there was a mention that the OTC market is not 

collateralized or that it has—that the customers pay for that margin somehow. In fact, many times when these customers go to the 

OTC market, the collateral that they pledge is the exact same collateral that they have pledged to secure their loan obligations. 

Many customers borrow on a secured basis. They pledge land or 

equipment, fixtures, receivables, even intellectual property. That is 

all good collateral. It is very good. That supports our lending agreement, our money we lend to them. 

It serves both as credit support for the loan and also for the derivative, and that is the efficiency and the flexibility that OTC derivatives provide to corporate America. And that is why we think 

corporate America chooses the OTC markets instead of the exchange markets. It is not because there is anything wrong with the 

exchange markets. It is just that the OTC markets are more flexible and are able to address exactly the risks that the company 

wants to hedge. 

Chairman HARKIN. Did you have any observation on this at all, 

Dr. Stout. 

Ms. STOUT. No, not on this. 

Chairman HARKIN. Dr. Bookstaber. 

Mr. BOOKSTABER. If I can just indulge on this, I think this 

point—of course, it is better if you can post illiquid collateral. Of 

course, all of us would like to have that. But there is a problem 

if the instrument is highly liquid and can be liquidated very quickly, and what you have as collateral is very illiquid. This is what 

leads to liquidity crisis cycles. I have $800 million that I have as 

collateral at a bank. I am in a market that for some exogenous reason drops by 10 percent. The bank says, ‘‘Come up with more capital, or we will start to liquidate.’’ And suddenly they say, ‘‘Oh, but 

it is land. We cannot liquidate it in the same timeframe as this instrument.’’ 

So it is painful and, of course, we do not want to have it be the 

case, but I think if you have liquid securities, you have to have liquid collateral on the other side. 

Mr. LENCZOWSKI. If I could, Chairman, just to respond. 

Chairman HARKIN. Sure. 

Mr. LENCZOWSKI. The size of our loan book at JPMorgan is 

roughly 10 times the size of our derivatives exposure, and much of 

that loan book is supported by this collateral that Dr. Bookstaber 

mentioned. It is relatively illiquid, but it is excellent quality collateral. We lend on that basis. 

So what we allow our customers to do is to use that same collateral to support their derivative transactions. That is useful for 

them. It is not an unsafe and unsound banking practice. In fact, 

57 

our examiners who are onsite would be all over us if it was anywhere close to that. 

So I would like to just clarify that this is very good collateral 

that we are receiving from our customer base and that it is a very 

big part of what makes these transactions happen for companies. 

Chairman HARKIN. Let me ask that, Mr. Lenczowski. So you 

admit it is not liquid, and how much can that be leveraged? How 

much can you leverage something that is illiquid that is an asset 

or land or whatever, how much can you leverage that? 

I think I can understand it if it is capital, but I do not know that 

I can understand it if it something else. 

Mr. LENCZOWSKI. That is an excellent point, Chairman Harkin. 

Our credit officers make that exact determination. We have statistical models and other means of assessing what our probable exposure could be. We use many forms to do that, but we are able to 

decide from a credit standpoint how much we could do. Again, 

these determinations are reviewable by our regulators and we ensure that are done within safe banking practices. 

Mr. DINES. Chairman Harkin, could I just add to that point for 

a second? We have probably 250 to 300 institutional type customers that we are providing products to. We margin with about 

80 percent of those customers today. We are moving collateral back 

and forth with them. We are sending them daily position reports 

so they know what the value of their derivatives are. Again, they 

know the value. They are moving the collateral back and forth. 

They are giving us liquid cash as collateral, or we are giving 

them liquid cash as collateral. The difference is that we do not 

think that a highly rated food or industrial company should be held 

to the same margining terms as a lower-quality, more leveraged 

company. And so we are flexible in our credit terms for them, so 

we may not make them post initial margin. We may give them a 

million-dollar threshold before they need to post margin. But we 

are still applying very strict credit standards. We are margining 

with them. But we are flexible in the way that we do that, and that 

is very, very important. A million dollars to a company today 

means a lot from an investment standpoint. 

So that is the way that we are managing it. That is the benefit 

of the OTC market versus a standardized exchange, because if you 

think about the standardized exchange, it has to go for the lowest 

common denominator, because it is dealing with all sorts of companies all different levels of credit quality. So it has to build its risk, 

its margining on the worst possible credits that might be part of 

that clearinghouse or exchange, where in the OTC market you do 

not have to do that. 

Chairman HARKIN. Ms. Stout. 

Ms. STOUT. I think the last comment is very helpful for helping 

keep a perspective on what we are discussing here. You referred 

to a million-dollar savings today for Cargill. We are dealing with 

a crisis that I believe the figure that you mentioned this morning, 

Mr. Chairman, was $4 trillion. I do not think anyone would dispute 

that for some businesses at some times, some forms of derivatives 

are definitely beneficial. I think the critical question has got to be 

how do we measure the benefits against the harms. 

58 

I am very sympathetic. I wish I could ensure that Cargill could 

always have the perfect hedge. But if maybe you have to inconvenience yourself a little bit and deal with a suboptimal hedge sometimes, and the social benefit we get is that we do not get another 

Lehman Brothers, another Bear Stearns, another AIG. Well, sometimes you have to put with a little bit of difficulty. 

We are at a watershed moment, Mr. Chairman, I think, that is 

comparable to the situation we faced in the 1930’s. Over the past 

decade, I think we can argue that the finance sector of our economy 

came close to cannibalizing the real economy. Derivatives were 

definitely part—not the only part, but one of the larger parts of 

that cannibalization process. 

It is clear that we cannot sustainably go doing things the way 

we have done them for the last 10 years. You know, the definition 

of ‘‘insanity,’’ doing the same thing and expecting different results. 

Every time in history in my research that we have attempted to 

deregulate derivatives, we have gotten the same results. 

So on the theory that the perfect is the enemy of the good, any 

regulatory development that can begin to bring back the exposure 

that we have today, the exposure to systemic risk, to reduced economic productivity, to price bubbles, to fraud and manipulation, 

anything that can begin to ratchet that back would be a very good 

thing. 

Chairman HARKIN. Anyone else? Yes, Mr. Masters. 

Mr. MASTERS. I just want to make a couple points. With regard 

to the whole notion of multiple prices, volume-weight average 

prices, in the equities business we have probably in excess of 100 

different ways on listed exchanges of trading those various kinds 

of orders. We can do algorithms that do all sorts of things that can 

literally wait every 2 minutes for an order and then only take the 

offer or sit on the bid all day, or hide or bob or weave or whatever. 

All those things are possible on listed exchanges. We do them every 

day in our own business. 

Second, I would like to make this point because I think it is important. With regard to the notion of options at different strikes 

and so forth, we are one of the largest option traders in the United 

States, listed options, and one of the issues with regard to options 

is when you trade in over-the-counter option, there is someone on 

the other side that knows your position. That is a huge issue. I do 

not want them to know my position because if they know my position and it is just me and him, if something goes wrong I have got 

a problem, and he knows exactly what my problem is. And that 

goes on every day. 

So there is a huge competitive advantage to a bank or a swaps 

dealer to have that position on with a customer because they are 

able to reverse engineer the customer’s knowledge and flows. So 

having that liquidity, having an exchange being able to trade with 

perfect—being able to hide, if you will, I can trade on these options 

exchange, and people do not know who I am. And I can trade using 

various different orders. That is a great benefit, and it would be 

a great benefit to many other customers once they understand that 

little dynamic that goes around on Wall Street. 

Chairman HARKIN. Pretty interesting. 

Yes, Mr. Lenczowski? Then we will have to call this off. 

59 

Mr. LENCZOWSKI. Thank you, Mr. Chairman. Just a couple of 

points. 

First, the exchanges have been trading equity options for quite 

a while now, and they are free for anyone who can open an account 

there. Certainly we have no desire in monopolizing the equity market in the over-the-counter business, and any customer who feels 

they will do better on an exchange should trade there and should 

feel free to trade there. What we do not want is to eliminate that 

choice from the customer. There are some customers who might 

choose facing an exchange-traded exact same product to trade in 

the over-the-counter market. And to that extent, that kind of a 

choice should be continued to be allowed. 

Then, second, just to confirm, there is a straw man argument or 

some example that the banks are against regulatory reform or 

swap dealers are against regulatory reform. That is absolutely untrue. We support broadly the initiatives that the administration 

has announced and Chairman Gensler described today. I have outlined them in our written submission, and I would just like to reassert again that we do agree completely that something has to be 

done. We just want it done in the right way for the economy. 

Chairman HARKIN. Any last words? I thought this was a very enlightening session. We could probably go on for some time. As a 

matter of fact, I have got Secretary Vilsack over in the Appropriations Committee that I have got to go over and listen to his testimony on his budget. 

But as you know, we are wrestling with this, but I guess I end 

where I started. We cannot continue to do what we have been 

doing. We have got to make some changes, and there have got to 

be, I think, some fundamental changes in the way we do this. 

Now, I have taken the position, you all know my bill, what I attempted to do in that legislation. However, I am always willing to 

look at other sides of that issue. But I guess from my own personal 

standpoint, I still come down to the more open we are, the more 

transparent we are, the more information that people have out 

there in a regulatory framework, the better off we are all going to 

be. And somehow we have got to, as Mr. Masters said, I think, get 

back to where we were before in some kind of a regulatory framework. And that is what we are going to have to wrestle with, exactly how we do that. No one wants to stifle innovation, as I said, 

but we have got to ask what that innovation is for. 

Second, no one wants to get rid of speculation. We need speculators, but we do not want that bottle of aspirin every day. We just 

need maybe one. So we have to figure out how we provide that kind 

of liquidity in some kind of a regulated manner also. 

So these are the things we are wrestling with. I think this panel 

added greatly to our thoughts on this and our pursuit of trying to 

figure out what we can do. I just would say to all of you that as 

we proceed on this, any other thoughts and suggestions you may 

have, please let us know, and we will be developing this legislation 

some time this year, probably not until this fall. We have the 

health care bill, and we have got a lot of other things we have to 

do, and we have to do the child nutrition reauthorization, too, this 

year. But this is something we have got to attend to, and I have 

talked to Mr. Peterson on the House side, and he wants to move 

60 

something this year, too. So I invite your constant input and consideration of what we are doing here. 

Again, I thank you all very much for being here today. As I said, 

it was a great panel. I appreciate it very much, thank you; the 

Committee will stand adjourned. 

[Whereupon, at 1:29 p.m., the Committee was adjourned.] 

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