U.S. GOVERNMENT PRINTING OFFICE

67–569 CC WASHINGTON : 2000

S. HRG. 106–826

PRESIDENT’S WORKING GROUP REPORT OF OTC

DERIVATIVES—CEA RE-AUTHORIZATION

HEARING

BEFORE THE

COMMITTEE ON AGRICULTURE,

NUTRITION, AND FORESTRY

UNITED STATES SENATE

ONE HUNDRED SIXTH CONGRESS

SECOND SESSION

ON

PRESIDENT’S WORKING GROUP REPORT OF OTC DERIVATIVES—CEA REAUTHORIZATION

FEBRUARY 10, 2000

Printed for the use of the

Committee on Agriculture, Nutrition, and Forestry

(

For sale by the U.S. Government Printing Office

Superintendent of Documents, Congressional Sales Office, Washington, DC 20402
COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

RICHARD G. LUGAR, Indiana, Chairman

JESSE HELMS, North Carolina

THAD COCHRAN, Mississippi

MITCH MCCONNELL, Kentucky

PAUL COVERDELL, Georgia

PAT ROBERTS, Kansas

PETER G. FITZGERALD, Illinois

CHARLES E. GRASSLEY, Iowa

LARRY E. CRAIG, Idaho

RICK SANTORUM, Pennsylvania

TOM HARKIN, Iowa

PATRICK J. LEAHY, Vermont

KENT CONRAD, North Dakota

THOMAS A. DASCHLE, South Dakota

MAX BAUCUS, Montana

J. ROBERT KERREY, Nebraska

TIM JOHNSON, South Dakota

BLANCHE L. LINCOLN, Arkansas

KEITH LUSE, Staff Director

DAVID L. JOHNSON, Chief Counsel

ROBERT E. STURM, Chief Clerk

MARK HALVERSON, Staff Director for the Minority

(II)
(III)

C O N T E N T S

Page

HEARING:

Thursday, February 10, 2000, President’s Working Group Report of OTC

Derivatives—CEA Re-Authorization .................................................................. 1

APPENDIX:

Thursday, February 10, 2000 ................................................................................. 49

Document(s) submitted for the record:

Thursday, February 10, 2000 ................................................................................. 113

Questions and answers:

Thursday, February 10, 2000 ................................................................................. 135

Thursday, February 10, 2000

STATEMENTS PRESENTED BY SENATORS

Lugar, Hon. Richard G., a U.S. Senator from Indiana, Chairman, Committee

on Agriculture, Nutrition, and Forestry ............................................................. 1

Fitzgerald, Hon. Peter G., a U.S. Senator from Illinois ....................................... 3

Harkin, Hon. Tom, a U.S. Senator for Iowa, Ranking Member, Committee

on Agriculture, Nutrition, and Forestry ............................................................. 4

Conrad, Hon. Kent, a U.S. Senator from North Dakota ...................................... 3

WITNESSES

Panel 1: Head of the President’s Working Group

Summers, Laurence, Secretary, U.S. Department of the Treasury, accompanied by Lewis A. Sachs, Asst. Secretary for Financial Markets, U.S.

Department of Treasury ...................................................................................... 5

Panel 2: Members of the President’s Working Group

Greenspan, Alan, Chairman, Board of Governors of the Federal Reserve System ......................................................................................................................... 13

Rainer, William, Chairman, Commodity Futures Trading Commission ............. 14

Nazareth, Annette, Director of Market Regulations Securities and Exchange

Commission ........................................................................................................... 17

Panel 3: Representatives of the Futures Exchange and OTC derivatives

community

Brennan, David, Chairman, Chicago Board of Trade ........................................... 29

Salzman, Jerry, Chicago Mercantile Exchange ..................................................... 32

Grove, Richard, Chief Executive Officer, International Swaps and Derivatives

Association (ISDA) ............................................................................................... 34

Rappaport, Daniel, Chairman, New York Mercantile Exchange ......................... 30
Page

IV

Rosen, Edward, Counsel, Ad Hoc Coalition of Commercial and Investment

Banks .................................................................................................................... 36

APPENDIX

PREPARED STATEMENTS:

Lugar, Hon. Richard G. .................................................................................... 50

Grassley, Hon. Charles E. ................................................................................ 52

Brennan, David ................................................................................................. 81

Greenspan, Alan ............................................................................................... 61

Gordon, Scott .................................................................................................... 100

Grove, Richard .................................................................................................. 106

Nazareth, Annette ............................................................................................ 73

Rainer, William ................................................................................................. 68

Rappaport, Daniel ............................................................................................ 92

Rosen, Edward .................................................................................................. 108

Summers, Laurence .......................................................................................... 54

DOCUMENT(S) SUBMITTED FOR THE RECORD:

Statement of the International Swaps and Derivatives Association, Inc. ... 114

Statement submitted by Robert R. Champion, on behalf of Champion

Securities ....................................................................................................... 128
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PRESIDENT’S WORKING GROUP REPORT OF

OTC DERIVATIVES—CEA RE-AUTHORIZATION

THURSDAY, FEBRUARY 10, 2000

U.S. SENATE, COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY, Washington, DC.

The Committee met, pursuant to notice, at 9:05 a.m., in room

SH–216, Hart Senate Office Building, Hon. Richard G. Lugar,

(Chairman of the Committee), presiding.

Present or submitting a statement: Senators Lugar, Fitzgerald,

Grassley, Harkin, and Conrad.

OPENING STATEMENT OF HON. RICHARD G. LUGAR, A U.S.

SENATOR FROM INDIANA, CHAIRMAN, COMMITTEE ON AGRICULTURE, NUTRITION, AND FORESTRY

The CHAIRMAN. This meeting of the Senate Agriculture Committee is called to order. Today the Committee holds its first hearing

of this year on the reauthorization of the Commodity Exchange Act.

This hearing with its distinguished list of witnesses will discuss

the unanimous findings of the President’s Working Group regarding the proper treatment of over-the-counter derivatives markets.

In late 1998, House Agriculture Committee Chairman Bob Smith

and I wrote Treasury Secretary Rubin requesting that the President’s Working Group study and make recommendations to Congress regarding these instruments. Our request came on the heels

of an economically turbulent period which witnessed a Russian default of debt, the devaluing of the ruble and the near collapse of

Long Term Capital Management Hedge Fund.

In addition, the CFTC was making overtures through its concept

release on the over-the-counter derivatives that it might seek to

unilaterally regulate these instruments. In requesting this report,

we sought to bring certainty to these markets and to build a broad

consensus on the Government’s role, if any, in regulating them. I

have stated that one of my goals for the Commodity Exchange Act

reauthorization is to provide legal and regulatory certainty to the

over-the-counter market. With its recommendations on the legal

certainty of swaps, the Treasury Amendment, and electronic trading, I am confident this unanimous report will provide Congress

with the guidance it needs for achieving this important goal.

But the Working Group’s recommendations cannot exist in a vacuum. Another important goal of reauthorization is providing regulatory relief for those entities that fall within the Commodity Exchange Act. The Working Group recognized that its recommendations regarding the over-the-counter market must be implemented
2

simultaneously with the lessening of regulation for the futures exchanges.

Along with other members from the House and Senate Agriculture Committees, I have requested the CFTC make its recommendations on regulatory relief by February 14. I understand

that Chairman Rainer will meet this deadline and intends to brief

members on the proposal shortly.

Addressing the Shad-Johnson Accord is also a priority. The

President’s Working Group agreed that the current prohibition on

single stock futures can be repealed if issues regarding the integrity of the underlying securities market and regulatory disparities

can be resolved. Senate Banking Committee Chairman Phil

Gramm and I have written Securities and Exchange Commission

[SEC] Chairman Levitt and CFTC Chairman Rainer requesting

that the agencies study this issue and make recommendations by

February 21.

Senator Gramm and I have pledged to work together throughout

this process including the possibility of holding joint hearings to

ensure that both over-the-counter and on-exchange instruments are

appropriately and consistently treated under our laws. Although it

would be premature today to discuss in detail the reform of ShadJohnson Accord without the benefit of the agencies’ input, I would

emphasize that this issue remains a priority with the Committee.

Now this committee is finally faced with the daunting task of

drafting this complicated legislation in a year drastically shortened

by a full congressional calendar and a presidential election. In my

view, given at least the advice of our Senate leadership on scheduling, we may have only a 3-month period to pass this bill or to resign ourselves to the fact that it will not get done until next year.

However, the ramifications of waiting until next year are considerable given the fact that we will have a new administration, a new

Congress, even possibly a new chairman of this committee. The

present time appears to be most opportune and we are hopeful that

we will have consensus in the industry for comprehensive reauthorization legislation promptly and I intend to actively promote passage this year.

Turning toward today’s discussion, our first witness will be the

Treasury Secretary Lawrence Summers, head of the President’s

Working Group, who will outline, first of all, the unanimous findings of the commission.

Our second distinguished panel will consist of other members of

the Working Group including Chairman Alan Greenspan of the

Federal Reserve; Chairman Bill Rainer of the CFTC; and Ms. Annette Nazareth, Director of Market Regulations of the SEC.

Our final panel will contain members from the private sector including representatives from the futures exchanges and the overthe-counter derivatives community. I would say in advance that we

have been advised that a roll call vote will occur at 11 o’clock. We

will have a short recess so that members may do their duty and

then we will return so that we can have a full hearing of all the

witnesses and questions by the Senators.

[The prepared statement of Senator Lugar, can be found in the

appendix on page 50.]
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Before I ask for our distinguished first witness to commence his

testimony, I would turn to Senator Conrad for any opening comment he might have.

STATEMENT OF HON. KENT CONRAD, A U.S. SENATOR FROM

NORTH DAKOTA

Senator CONRAD. Thank you, Mr. Chairman. Special thanks for

your leadership in this area. Obviously this is critically important,

important to our country, important to world financial markets as

well. This is something we simply have to get right. The world is

changing everyday around us. Last night I was hooked up to my

Web TV surfing the net and going to various financial sites. It is

just remarkable the information and the access to markets that are

now available to everybody everywhere in the world that has access

to the internet.

This changes everything and we have got to be very mindful of

two things. One, we have got to protect those who are participants

in the market and, second, we have got to make certain that our

industry can be fully competitive. We do not want to do things unintentionally that will prevent our companies from being able to

compete on a global basis. I think those of us who have passed

around the book, The Lexus and the Olive Tree, understand how

globalization is altering the speed with which everybody has to respond, those who are in the private sector and those of us who are

in government. Government moves much more slowly than does

the private sector and we are going to have to speed up because

things are changing everyday in every way and if we do not respond quickly, we are going to leave our people at a competitive

disadvantage.

So again, Mr. Chairman, we are going to have to strike a balance. We are going to have to find how we balance the competing

interests of making certain that our companies are competitive and

at the same time protecting participants in the market. I again

want to thank you, Mr. Chairman. I look forward to the panels

that you have called before us.

The CHAIRMAN. I thank the Senator for his faithful work on this

issue as well as all other issues and his prompt attendance at these

nine o’clock hearings. I now call upon Senator——

Senator CONRAD. You know in North Dakota, we usually are up

by five so it is a little late to get started.

The CHAIRMAN. I understand. Senator Fitzgerald.

STATEMENT OF HON. PETER G. FITZGERALD, A U.S. SENATOR

FROM ILLINOIS

Senator FITZGERALD. Well, thank you, Mr. Chairman, and if I

could have leave of the Committee to introduce my remarks to the

record, I would appreciate that.

The CHAIRMAN. They will be published in full.

Senator FITZGERALD. Well, thank you, and I would just like to

make a couple of comments. Obviously, as the Senator from Illinois

who represents Chicago and LaSalle Street and the futures business there, I have a great interest in these particular hearings. I

thought the Working Group’s report was very thorough and had

many good elements and I was impressed that it left open the pos-
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sibility of a level regulatory playing field for technically futures

products and financial derivatives that are not technically futures.

It left open the possibility of a level regulatory playing field where

only institutional counter parties were involved. That is an interesting issue and we will want to pursue that more.

What I would be concerned of at the outset is fragmenting the

market between the retail and institutional customers. I think we

have to ask whether there is a public policy interest sufficient to

justify taking retail customers out of having access to that large institutional market and that is something that we need to focus on.

But as I read the Working Group’s reports and some of the testimony that has been submitted beforehand, there seemed to be an

openness on the part of most of the members of the Working Group

to have that level regulatory playing field between traditional futures products and over-the-counter off-exchange financial derivatives but only in the case of institutional parties. I think we are

going to have to pursue that a little bit more, but with that, I

would like to welcome Secretary Summers to the Committee and

thank the Chairman, Senator Lugar, for holding these important

hearings.

The CHAIRMAN. I thank the Senator for his special interest in

this subject and we look forward to working with you. Let me ask

that the first witness, Secretary Summers, attempt to summarize

remarks in a 10-minute period. We will not be overly rigorous because the report is very important. Your testimony will be published in full and it is an important statement. Likewise with our

second panel of those who have been working with you as members, we will ask each to have a 10-minute opportunity and that

would allow for questions as members come and go from the hearing, but we want to make certain that we have plenty of dialogue

with all of us. It is a pleasure to have you, Secretary Summers. I

see that you are accompanied by a distinguished fellow alumni of

mine at Denison University, Lee Sachs, also a trustee of that institution, which gives him special standing as you are sitting there.

[Laughter.]

We are grateful for your participation as always. Your leadership

in this has been extremely important and you have been most

forthcoming with members of the Committee. Senator Harkin has

arrived and I will ask, do you want to make a comment now or

maybe later?

Senator HARKIN. Have others made remarks?

The CHAIRMAN. Yes. Senator Conrad made a comment.

Senator HARKIN. Just briefly.

The CHAIRMAN. Very well. Go ahead.

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

IOWA, RANKING MEMBER, COMMITTEE ON AGRICULTURE,

NUTRITION, AND FORESTRY

Senator HARKIN. Thank you, Mr. Chairman. I am sorry. I just

had a previous engagement. I am sorry for being a little late, but

I want to thank you, Mr. Chairman, for holding this important

hearing on the report of the President’s Working Group on the

over-the-counter derivatives markets. I, first of all, take my hat off

to you for chairing on three consecutive days two hearings on dairy
5

policy and one on financial derivatives, two of the most esoteric and

mystifying subjects to ever come before this committee.

So I very much look forward to receiving the testimony from Secretary Summers and others who are here and working with you,

Mr. Chairman, to craft legislation that we can enact this year. We

have made a good effort at it. Three years ago we worked together

in a bipartisan fashion toward a consensus bill, but for some reason

the stars were not quite aligned at that time. I am optimistic now

that the circumstances are more auspicious that we can move

ahead on new legislation. The report of the President’s Working

Group should be very helpful to us in that regard.

Again, with the rapid changes that we see in the technology and

in the financial markets, it is essential that the CEA is updated to

reflect these changes that have occurred and again to just make

sure that we accommodate some of the future changes that are

coming.

Any regulatory system becomes counterproductive if it inhibits

innovation and the creation of new and beneficial products and

services. So again I just want to underscore the importance of

avoiding action that would help the financial markets but in any

way damage the functioning of the agricultural markets.

Finally I want to stress that when we pass legislation, we take

responsibility for its consequences. So as we work on regulatory reform legislation, we have to be sure we do all we can to guard

against unforeseen risks, especially systemic risks to the broader financial system that could come back to haunt us later on. Thank

you very much, Mr. Chairman.

The CHAIRMAN. Thank you very much, Senator Harkin.

Secretary Summers.

STATEMENT OF HON. LAWRENCE SUMMERS, SECRETARY, U.S.

DEPARTMENT OF TREASURY, ACCOMPANIED BY LEWIS A.

SACHS, ASSISTANT SECRETARY FOR FINANCIAL MARKETS,

U.S. DEPARTMENT OF TREASURY

Secretary SUMMERS. Mr. Chairman, Senator Harkin, Senator

Fitzgerald, Senator Conrad, thank you very much for giving us the

opportunity to discuss the report of the President’s Working Group

on Financial Markets on Over-the-Counter Derivatives and the

Commodity Exchange Act. Let me say that we very much share

your view on both the importance and the urgency of these issues

for the Nation’s financial markets and for the economy.

This report reflects a great deal of effort on the part of the members of the President’s Working Group including the Chairmen of

the Federal Reserve, CFTC and SEC. After a great deal of effort,

we were able to reach unanimous recommendations and it is my

very great hope that they can be enacted into law this year.

Let me address three subjects in my remarks this morning. First,

the importance of OTC derivatives to the economy, then the objectives that guided members of the Working Group in formulating

their recommendations, and third, the six recommendations of the

Working Group.

OTC derivatives now represent more than $80 trillion in notional

value. They perform a crucial function in helping to share and allocate risk around our nation’s economy. This confers a number of
6

benefits. It helps businesses and financial institutions to hedge

risks and lower their costs, thereby reducing prices for American

businesses and consumers. It promotes more efficient allocation of

capital across different sectors of the economy. It encourages better

information with respect to the risks of various contingencies and

promotes transparency which leads to better planning, and it permits the development of more imortive financial products by allowing for wider sharing of risk.

The market is a valuable one and it can deliver many benefits

to those who make proper use of it. For example, the agricultural

sector benefits considerably from OTC derivatives used by importers and exporters of agricultural commodities. By using these products, they hedge their exposure to volatile movements in foreign

currency markets and can build on the certainty to invest more in

their businesses, allowing farmers to export more of their products

to overseas markets.

Mr. Chairman, I think we all have an obligation to work as rapidly as possible to develop a legal framework that is as modern as

the market that it addresses. It is our judgment that because the

counter parties to OTC transactions are highly sophisticated and

because the issues involved are enormously complex, government

can best contribute by promoting a framework for market discipline

based on the principle of transparency. The objective of government

should not be to protect individual institutions but to protect the

system. And, of course, government should have a continuing role

with respect to the protection of retail customers.

With these broad principles in mind, our report had four objectives in developing a legal framework for this market: First, the reduction of systemic risk; second, the promotion of innovation; third,

the protection of retail customers; and fourth, ensuring U.S. competitiveness in an important industry where there is a great deal

of innovation taking place.

With these four considerations, systemic risk, innovation, retail

protection, and U.S. competitiveness, we developed six recommendations. Let me highlight, Mr. Chairman, that a failure to

enact legislation along these lines would, in our judgment, carry

important risks with respect to each of our objectives: the mitigation of systemic risk, the promotion of innovation, the protection of

retail customers, and the competitive of the U.S. financial industry.

Our six recommendations. First, to create an exclusion from the

CEA for most swaps agreements. Because the combination of the

broad definition of commodity and the absence of any definition of

futures contracts implies that the CEA may apply to transactions

that no one anticipated in 1974, we believe that the exclusion for

certain swaps between sophisticated counterparts is appropriate,

consistent with market discipline, and should be put into law. I

would add that the enactment of an exclusion promotes legal certainty that is essential for the integrity of the market.

Second, to create an exclusion for electronic trading systems. And

third, to permit the use of appropriately regulated clearing systems

for OTC derivatives. These two recommendations both go to the objective of allowing sophisticated parties to organize together to

trade OTC derivatives in ways that are most efficient for them, in

ways that promote transparency to each other and in ways that
7

permit clearing arrangements which mitigate systemic risks in the

event of counter party default.

Fourth, to clarify the original intent of the Treasury Amendment.

As you will recall, Mr. Chairman, the Treasury Amendment goes

to the question of regulation of trading in foreign exchange and

government securities. The proposal here would clarify their exclusion from regulation on an organized exchange, but it would at the

same time recognize the CFTC’s authority with respect to bucket

shops and other practices affecting retail customers.

The fifth and sixth recommendations are highly technical with

respect to the exempt status of hybrid securities. These recommendations address some jurisdictional disputes, but I am

pleased to report that the jurisdictional disputes have been resolved with the unanimous agreement of the parties involved.

Mr. Chairman, these are highly technical issues. But for being

highly technical, they are nonetheless very important issues for the

U.S. financial services industry and the contribution that the financial sector can make to the maintenance of a sound economy. We

look forward to answering your questions and speaking on behalf

of all the members of the Working Group hope it will be possible

to enact these recommendations this year. Thank you and thank

you for your leadership.

The CHAIRMAN. Thank you very much, Mr. Secretary. First, a

technical question. Has the Department of the Treasury been working on any legislative language that reflects the findings of this

Working Group?

Secretary SUMMERS. We do not have a full set of legislative language to share, but we have been thinking through ways in which

various of these ideas can be expressed in legislative language and

we would be very pleased to have our staffs be in touch regarding

these issues.

The CHAIRMAN. I appreciate that because that will be a great

help in making certain that the Working Group’s findings and the

conclusions you have reported today are appropriately reflected

when we finally get to the language. Mr. Secretary, a broader question, and this was certainly a question before initial hearings on

this subject. Now, clearly not only the financial markets but the

public as a whole was intrigued and correspondingly alarmed by

the failure of the Long Term Capital Management Hedge Fund and

likewise the steps that were taken to try to bring that situation

into some balance. At one of our hearings there was considerable

argument over whether that failure meant that there were a lack

of proper credit standards, a lack of appropriate regulation by

someone.

Now, in essence, in the sophisticated ways in which the financial

community deals in an international way, as you pointed out, are

things simply at some point beyond our scope and if so what kind

of jeopardy does this bring to the American economy, quite apart

from financial markets, and to what extent has your group, the

Working Group, thought about all of that and how are your recommendations appropriate, given those risks?

Secretary SUMMERS. I think you have raised a very important set

of issues, Chairman Lugar, and they are a set of issues we gave

a great deal of thought to in formulating our recommendations.
8

The Working Group, as you know, had prepared a separate report

on issues raised by highly leveraged institutions. I would leave to

others an attempt to fully analyze the LTCM episode, but I think

most would feel that it represented a combination of leverage and

illiquidity that led to those very serious difficulties. The approach

that we have advocated in both the highly leveraged institutions

report and this one is one based on the principle of promoting market and counter party discipline through greatly increased transparency and that is the focus of our recommendations.

We believe that the best discipline, the most informed discipline,

on institutions can come from counter parties in the context of

transparent sharing of information. Some of the recommendations

that are contained in this report, though, to some degree do go crucially to the objective of systemic risk, including in particular the

proposals to allow clearinghouses to be set up with respect to overthe-counter derivatives that will promote netting and therefore

make large outstandings smaller and contribute to systemic stability.

I believe that we do, and I think this was the tone of several of

the opening statements, do need to find a balance between assuring

a framework that protects against systemic risk, on the one hand,

and promoting innovation on the other, but I would hasten to say

that we need to be very careful of establishing public regulation in

a way that crowds out what is potentially more effective private

regulation by counter parties.

The CHAIRMAN. Well, the private regulation idea is clearly an important one and if there is a bias in the report or at least a trend,

it really moves toward more of that as opposed to public regulation.

This is an age-old dispute in our own governmental system with

the pendulum going backward and forward; clearly I favor that

move toward more private regulation. This appears to be the way

the CFTC and perhaps the SEC are moving, but at the same time,

let me just ask this question.

Much of the Working Group’s findings discuss what should remain outside of the Commodity Exchange Act. What policies should

we focus on in determining instruments that should remain within

the Commodity Exchange Act? In other words, what is sort of the

core of that situation, as you see it, with regard both to innovation

and growth and international competitiveness, but at the same

time the basic public function of regulation which that commission

and our oversight try to provide?

Secretary SUMMERS. I think the core rationales for public regulation in this area go to three things. They go to the protection of

retail customers. Where retail customers are going to be substantially involved, there is certainly a case for strong regulation.

Where price manipulation is a significant risk, particularly because

of finiteness of supply, there is a very strong case for regulation.

There will be cases where regulation can be constructive in terms

of the promotion of transparency and the price discovery function.

The balance that has to be struck involves a balance of recognizing

when the need for regulation with respect to those considerations

exceeds the costs, potential costs, in terms of reduction of innovation and loss of international competitiveness.
9

In general, where it is highly sophisticated and experienced parties trading with one another, we believe that the promotion of

market discipline based on counter party scrutiny is likely to be

most effective.

The CHAIRMAN. I thank you. I will ask each of our colleagues to

stay within a 5-minute time limit on a first round. If there are additional questions, we will have a second round. I call on the ranking member, Senator Harkin.

Senator HARKIN. Thank you, Mr. Chairman. Mr. Secretary, you

know, you said it very aptly when you said that we should be looking at the system itself and that government should not be picking

winners and losers within the system but look at the system itself.

I have been wrestling with this for a long time on the derivatives

market. You see—and this is a question I am going to ask everyone

that comes up here—right now we have an exemption. CFTC gives

exemptions. What the Working Group has proposed is an exclusion.

What I wonder is if you have a problem that crops up, that signals that some kind of regulation or action needs to be taken?

Something where you have tremendous leveraging, for example,

going on like we had in the hedge funds, if you have an exclusion,

then it would take an act of Congress to do something about it.

That takes a long time. If you have an exemption, then the CFTC

could respond more readily to something like that, that cropped up.

That is an issue that I wrestle with a lot.

Now I understand the need for an exclusion, the certainty of contracts. I understand that. But I am wondering if within the framework of an exemption, you could not accomplish the same thing?

I just throw that out as a question for you to ponder and if you

have any response. In other words, with the exemption, they could

impose a regulation right away to stop something that may be

going out of control. With an exclusion, you have to have an act of

Congress.

Secretary SUMMERS. Senator Harkin, I think in the latter part of

your remarks, you forecast correctly what would be my response,

which is you are clearly correct that an exemption provides more

flexibility than an exclusion, but it is precisely the presence of that

flexibility and the recognition that it might be used that undermines legal certainty and creates a greater possibility that these

transactions will take place and be booked abroad where they will

not be subject to American law. It is precisely that flexibility and

the expectation that it might be used that is potentially reducing

of confidence with respect to these transactions.

I do not think we would responsibly, nonetheless, favor exclusion

in areas where strong public regulation would confer large benefits

even despite that legal certainty consideration, but it is our judgment and the judgment of the staffs whose work went into this

that in a range of financial transactions between very large and sophisticated institutions, the impact of public regulation in reducing

the pressure for market discipline might actually be counterproductive and therefore the clear signal that an exclusion provides

both would contribute to legal certainty and would contribute to

greater pressure for the strongest possible market regulation.

Senator HARKIN. Thank you, Mr. Secretary. Thank you, Mr.

Chairman.
10

The CHAIRMAN. Thank you very much, Senator Harkin. Senator

Fitzgerald.

Senator FITZGERALD. Thank you, Mr. Chairman. I want to follow

up on a question by Senator Lugar. He asked about where you

thought regulation was necessary. If I remember correctly, you said

essentially that you felt public regulation was necessary where retail customers were involved and where you are trading a product

such as a commodity which theoretically at least could be susceptible to market manipulation. Somebody in theory could corner the

market on grain. I took that to mean that cornering the market on

financial derivative products is not as much of a possibility as

where you have a finite commodity.

If that is your test for the necessity of public regulation, and we

had a situation in which institutional parties are trading a future

on a financial product as opposed to an agricultural commodity or

some other commodity on an exchange, would you support having

no public regulation and just allowing those counter parties in that

case to police the market?

Secretary SUMMERS. Senator, I prefer not to comment in any real

detail on issues that fall within the CFTC and Chairman Rainer’s

bailiwick. But I would say this. I think it is very important that

while this report has focused, in line with the Chairman’s request,

on the OTC derivatives market, there are obviously a set of issues

that arise with respect to exchange-traded products and that the

same basic principles of motivating innovation, protecting retail,

avoiding systemic risk, and being internationally competitive that

we have stressed with respect to OTC derivatives also arise with

respect to exchange-traded instruments and the same kind of balances need to be struck.

As the Chairman indicated in his opening statement, this is

something that Chairman Rainer and the CFTC have been very

much involved in and will be reporting on soon, and I would certainly support their efforts to remove any regulation which proves

to be unneeded.

I would say that I think the merits with respect to the OTC derivatives market are very strong. The economic importance is very

great. I would hope that, that important issue would not be held

hostage to debates, whatever the merits on both sides are, with respect to the proper regulation of the exchanges.

Senator FITZGERALD. Now with respect to the swaps exclusion

where institutional customers only are involved and retail customers are not involved, would that exclusion operate to deny retail

customers access to the most liquid markets? Would it not encourage the creation of markets with pools of liquidity that are only

available to the institutional participants?

Secretary SUMMERS. That clearly is a source of concern that has

to be balanced, Senator Fitzgerald, but while I have said a number

of things here that have suggested that in certain circumstances,

regulation may not be constructive, I think it is important to remember that the premise of a view like the one you described is

that regulation is all an excessive punitive burden, and in many

cases, regulation can be a source of strength and integrity to markets. Indeed if you look at American financial markets, one of their

strengths and one of the reasons why companies, for example, come
11

to list here is the strength of our regulation. There has been some

important recent economic research comparing securities markets

in a number of the transition economies that have demonstrated

that in certain cases, proper regulation with respect to issues like

insider trading and the behavior by insiders can promote integrity,

encourage people to trade there and promote liquidity.

So I think the conclusion that I would draw is that we need everywhere to avoid unnecessary and unconstructive regulation but

that proper constructive regulation can strengthen a market’s integrity, confidence and thereby promote its liquidity, and my hope,

and I have great confidence that with Chairman Rainer’s leadership the CFTC will get there, would be to take an approach of that

kind with respect to the exchange-traded markets.

Senator FITZGERALD. Well, thank you and I do agree with your

comment with respect to proper regulation. I think we have the

best capital formation markets here in the United States because

we have outstanding securities laws, and my hope would be that

we could come up with a similarly outstanding model to cover our

derivatives market. Thank you.

The CHAIRMAN. Thank you very much, Senator. Senator Conrad.

Senator CONRAD. Thank you, Mr. Chairman. I would like to follow up on the question by Senator Fitzgerald because I think it

really goes to the heart of the controversy here and the questions

that have to be answered by this committee. We had in Long Term

Capital a situation in which there was enormous risk. There was

huge leverage there and we saw a very fast action by government

to bring together private parties to stem the tide there, to stop the

hemorrhage. That could have become a very, very serious situation

for the financial market and the confidence in financial markets.

Let me ask you this. You are talking about counter party scrutiny as being what we should we look to for these large sophisticated financial traders. What would you say to the public who is

listening here to give them comfort in light of Long Term Capital?

What happened to counter party scrutiny in that case? Why did it

fail? What is before us now that is going to prevent a future failure?

Secretary SUMMERS. No one can sensibly sit here and assure you

that there will not be more financial crises, that there will not be

problems in the future, Senator Conrad. The Working Group’s proposals, not with respect to OTC derivatives but with respect to

highly leveraged institutions, included a variety of steps that were

intended to reduce the risk of systemic risk coming from a situation

like Long Term Capital. Those involved much greater requirement

of transparency in their reporting to their creditors.

Senator CONRAD. When you use—I am sorry to interrupt, but

when you say transparency, what do you mean by that? What is

provided for here that makes these transactions more transparent

for those who are involved? Is there more reporting of what a company’s positions are so that others could see how highly leveraged

they were?

Secretary SUMMERS. Yes. Yes, and, in particular, there is more

reporting at two levels, both with respect to the expectation of the

information that will be shared between leveraged institutions and

banks or other institutions that provide them with credit, and as
12

those institutions that are regulated by the Government are supervised, there is much closer scrutiny of their exposure to highly leveraged institutions such as hedge funds. Is this going to be totally

satisfactory? I am sure there will be problems at some points in the

future, but I think the concern, and I think it is a legitimate one,

is that we need to act in a way that ensures that the maximum

degree of responsibility is felt by counter parties who inherently

will be much closer to these situations and better able to judge

them than any set of regulators are ever likely to be.

There is a second type of policy response that is appropriate and

one area where we get into it here is the Working Group’s second

recommendation with respect to clearinghouses which provides for

arrangements in which there is some sharing of obligation and so

credit can be extended with confidence that it will be repaid. And,

greater reliance on clearinghouses, greater reliance on netting arrangements, more rapid settlements procedures, these are all very

intricate issues, but if you look back to the time after LTCM, I

think most would feel that better netting, faster settlements, more

transparency, improved contractual relations in a variety of ways

that reduce the pressure for forced liquidations are all constructive

steps. With the support of those of us in the official sector, there

have been a number of groups in the private sector that have come

together to devise procedures and move forward along those directions.

But I would hasten to distinguish somewhat the issues that we

have just been discussing, which are very important, from the

issues that are the primary focus of this hearing. It is possible to

leverage a position heavily and lose most or all of an institution’s

capital whether you are trading on an over-the-counter market or

an exchange market. A substantial amount of the LTCM positions

were actually on exchange-traded markets and the overwhelming

preponderance of the Barings positions which had some similarity

were traded on exchange markets. So, I think the set of issues involved in LTCM risk type problems is a somewhat different set of

issues than the set of issues that are involved with respect to what

type of markets we should have.

The CHAIRMAN. Thank you very much, Senator Conrad. Senator

Grassley.

Senator GRASSLEY. Mr. Chairman, I do not have any questions

but I would like permission to put an opening statement in the

record.

The CHAIRMAN. It will be published in full.

[The prepared statement of Senator Grassley can be found in the

appendix on page 52.]

Senator GRASSLEY. And I hope before I have to leave for the Finance Committee I get a chance to hear the next panel.

The CHAIRMAN. Very well. Are there other questions of senators

of our distinguished witness? If not, we thank you very much, Secretary Summers, for your testimony and for your chairmanship.

[The prepared statement of Secretary Summers can be found in

the appendix on page 54.]

The CHAIRMAN. The chair would like to call now a panel consisting of Chairman Alan Greenspan, Board of Governors of the Federal Reserve System; Chairman William Rainer of the Commodity
13

Futures Trading Commission; and Ms. Annette Nazareth, Director

of Market Regulations, Securities and Exchange Commission.

I welcome the panel and I will ask that you testify in the order

that I introduced you and that will be first of all Chairman Greenspan, then Chairman Rainer, and Ms. Nazareth. Each of you hopefully can give us 10-minutes or so of testimony and then as you noticed with the previous witness, we will have a round of questions

by senators. Chairman Greenspan, it is always a privilege to have

you before the Committee and we welcome you again today.

STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF

GOVERNORS OF THE FEDERAL RESERVE SYSTEM

Mr. GREENSPAN. Thank you very much, Mr. Chairman. I shall

endeavor to be somewhat more brief than 10-minutes, but I tend

sometimes to ramble on so I may end up in that particular area.

I am particularly pleased to be here today before you and your

committee members to underscore the importance of this committee’s efforts to modernize the Commodity Exchange Act and to express my support for the Working Group’s recommendations.

Over-the-counter derivatives have come to play an exceptionally

important role in our financial system and in our economy. These

instruments allow users to unbundle risks and allocate them to the

investors most willing and able to assume them. A growing number

of financial and non-financial institutions have embraced derivatives as an integral part of their capital allocation and profit maximization.

In considering regulation of derivatives under the CEA, we need

to keep in mind that imposing government regulation on a market

can impair its efficiency. Thus, when evaluating the need for government regulation, it is essential that the public policy objectives

be identified clearly. As the Working Group’s report discusses, the

primary public policy purposes of the CEA are to deter market manipulation and to protect investors against fraud and other unfair

practices. We must, of course, assess whether government regulation is necessary to achieve those objectives.

As Secretary Summers has already testified, in the case of financial OTC derivatives transactions between professional counter parties, the Working Group has agreed that such regulation is unnecessary and that such transactions should be excluded from coverage of the act. Furthermore, the exclusion should extend to the

electronic trading of such contracts by such participants.

The rationale for these positions is straightforward. OTC transactions in financial derivatives are not susceptible to manipulation,

and professional counter parties simply do not require the protections that the CEA provides for retail investors.

The Working Group has also concluded that government oversight of clearing systems for over-the-counter derivatives is appropriate. However, provided such government oversight is in place,

OTC transactions that would otherwise be excluded from the CEA

should not fall within the ambit of the act because they are cleared.

If market participants conclude that clearing would reduce counter

party risks in OTC transactions, concerns about legal risks associated with the potential application of the CEA should not stand in

their way.
14

The Working Group’s report does not make specific recommendations about the regulation of traditional exchange traded futures

markets. Nevertheless, it calls for a review of the existing regulatory structures, particularly those applicable to financial futures,

to ensure that they are appropriate in light of the objectives of the

act. Consistent with the principles of regulation I identified earlier,

the report notes that exchange-traded futures should not be subject

to regulations that are unnecessary to achieve the CEA’s objectives.

The report also concludes that the current prohibition on single

stock futures can be repealed if issues about the integrity of the

underlying securities markets and regulatory arbitrage are resolved.

Mr. Chairman, I want to underscore how important it is for us

to address these issues promptly. I cannot claim to speak with certainty as to how our complex and rapidly moving markets will

evolve, but I see a real risk that if we fail to rationalize our regulation of centralized trading mechanisms for financial instruments,

these markets and related profits and employment opportunities

will be lost to foreign jurisdictions that maintain the confidence of

global investors without imposing so many regulatory constraints.

My concerns on this score stem from the dramatic advances in

information technology that we see all around us. In markets in

which there are significant economies of scale and scope, like those

for standardized financial instruments, there is a tendency toward

consolidation or even natural monopoly. Throughout much of our

history, this tendency has been restrained by an inability to communicate information sufficiently quickly, cheaply, and accurately.

In recent years, however, this constraint is being essentially eliminated by advances in telecommunications. We have not yet seen

clear evidence of the trend toward natural monopoly, but the diffusion of technology often traces a so-called S-shaped curve, first diffusing slowly but then rapidly picking up speed. Once we reach the

steep segment of that S-curve, it may be too late to rationalize our

regulatory structure.

Already the largest futures exchange in the world is no longer in

the American heartland; instead, it is now in the heart of Europe.

To be sure, no U.S. exchange has yet to lose a major contract to

a foreign competitor. But it would be a serious mistake for us to

wait for such unmistakable evidence of a loss of international competitiveness before acting. As our experience with the vast eurodollar markets demonstrates, once markets with scale and scope

economies are lost, they are very difficult if not impossible to recapture.

Thank you, Mr. Chairman. I look forward to your questions.

[The prepared statement of Mr. Greenspan can be found in the

appendix on page 61.]

The CHAIRMAN. Thank you very much, Chairman Greenspan.

Chairman Rainer.

STATEMENT OF WILLIAM J. RAINER, CHAIRMAN, COMMODITY

FUTURES TRADING COMMISSION

Mr. RAINER. Thank you, Chairman Lugar, Senator Harkin, Senator Fitzgerald. I appreciate the opportunity to come here and discuss these recommendations. The goals of the Working Group re-
15

port have already been mentioned and the ability to achieve these

goals will be enhanced through greater legal certainty for the OTC

market. Congressional action to exclude OTC financial derivatives

from the act would provide such certainty. I can advocate this step

because OTC financial derivatives, as we know them today, do not

present regulatory concerns within the scope of the act. Also, excluding this activity will not diminish the CFTC’s ability to carry

out the statutory mission it is charged to fulfill.

When the Commodity Exchange Act was written, Congress articulated the rationale for regulating futures transactions. First,

the act establishes the economic utility of futures trading, stating

that futures prices are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining prices to the producer and the consumer of commodities.

In addition to their price discovery function, futures transactions

are used by commercial handlers as a means of hedging themselves

against possible loss through fluctuations in price.

The second prong of Congress’ rationale for regulation is that the

transactions and prices of commodities are susceptible to excessive

speculation and can be manipulated, controlled, cornered or

squeezed. The risks of price distortion and manipulation are the

factors rendering regulation of these markets imperative. Congress

thus identified the overarching public mission of the CFTC as that

of preventing price manipulation and ensuring price transparency.

Like exchange-traded futures, OTC derivatives are risk shifting

instruments. The Working Group, however, has determined that

prices established in OTC derivatives transactions do not serve a

significant price discovery role. The Working Group has also concluded that most OTC derivatives are not susceptible to manipulation. Moreover, OTC transactions are entered into and traded by

sophisticated institutional traders who are able to look out for

themselves in these markets, and as has been pointed out the activities of most derivatives dealers already are subject to direct or

indirect Federal oversight.

Because there is no manifest regulatory interest warranting

CFTC oversight of OTC derivatives, I support the exclusion proposed by the Working Group. Congress and the CFTC have acted

before to resolve legal uncertainty affecting OTC derivatives. In

1992, amid strong signals that swap market participants feared

their contracts could be declared unenforceable, Congress responded decisively instructing the CFTC not to regulate swaps entered into by sophisticated parties. Congress authorized the CFTC

to provide exemptive relief for swaps without requiring the Agency

to make a threshold determination that particular exempted transactions fell within its jurisdiction.

CFTC promptly issued a rule exempting swap agreements from

all provisions of the act except prohibitions against fraud and manipulation provided the swaps meet certain conditions. This exemption worked relatively well. Lately, however, evolution in the OTC

derivatives market has rendered the exemption inadequate. The

exemptive rule does not apply to OTC contracts that are standardized, cleared or executed under conditions that approximate those

of an organized exchange.
16

Technology, however, is dramatically changing the structure and

nature of many aspects of the financial services industry. The rise

of electronic screen-based trading has blurred the line drawn in our

swaps exemption between bilateral and multilateral trading. The

growth in swaps volume and the acceptance of these contracts by

a wider range of users has led to their standardization. Public policy must meet these advances in the OTC market.

I also believe that development of regulated clearing systems

should be encouraged. Clearing systems can employ a variety of

risk management tools such as mutualizing risks and offsetting

multiple obligations. Consequently, clearing systems can help to reduce systemic risk.

Finally, the commission’s rule, the swap exemption rule, exempts

bilateral swaps from all provisions of the CEA except those provisions prohibiting manipulation and fraud. The CFTC thought it

prudent to retain its jurisdiction to act in the event the Agency

learned that participants were engaging in fraudulent or manipulative conduct and that the transactions executed under the exemption were, in fact, futures.

The swaps exemption does not alter the CFTC’s responsibility to

take action against this misconduct. In a given set of circumstances, however, the Agency’s ability to act may be contingent

upon proving that transactions are futures or options. This is a

critical point to remember. At no time has Congress or the CFTC

made the definitive judgment that swap transactions are, in fact,

subject to the CEA’s jurisdiction. The combination of responsibility

with no more than contingent authority is simply bad public policy

because as a practical matter the CFTC cannot exercise its residual

enforcement authority under the swaps exemption without exacerbating the existing legal uncertainty in this area.

While examining the applicability of the act to OTC markets, we

also have conducted an inquiry into whether our current regulatory

scheme is appropriately tailored to today’s environment for exchange-traded futures. Since November, the Agency has undertaken a serious effort to answer the question what degree of exchange-traded regulation is necessary to serve the public interest

entrusted to us?

This inquiry is at the heart of the process that the CFTC has engaged in over the last several months. Impending technological and

other changes require the CFTC to scrutinize the continued vitality

and viability of its one-size-fits-all regulatory structure that currently applies to all futures transactions. While that process is not

yet complete, certain clear principles have emerged.

One, the historic needs of traditional physical commodities

should not be the basis for regulating every futures contract traded

today and, two, institutional market participants do not require all

of the protections designed for retail traders.

The key policy elements will include a move from direct to oversight regulation, a move from prescriptive rules to flexible performance standards, and the increased use of disclosure based regulation. This plan will not impair the Agency’s ability to assure the

fundamental market integrity expected when conducting futures

exchange transactions in the United States or when relying upon
17

the prices set in U.S. exchange-traded markets. The commission

will continue to exercise its authority to assure this integrity.

In conclusion, Mr. Chairman, time is not our ally in establishing

a framework that achieves our national economic priorities with respect to derivatives trading. Technology has made it increasingly

easy to establish rival markets in foreign jurisdictions. Technology

has also increased the speed with which new innovations are introduced and widely used by market participants. Because of these realities, I ask Congress to act expeditiously on the recommendations

of the Working Group. Thank you again for the opportunity to testify and I will look forward to our continued collaboration with the

Working Group and members of this committee and look forward

to your questions. Thank you.

[The prepared statement of Mr. Rainer can be found in the appendix on page 68.]

The CHAIRMAN. Thank you very much, Chairman Rainer. Ms.

Nazareth.

STATEMENT OF ANNETTE NAZARETH, DIRECTOR OF MARKET

REGULATIONS, SECURITIES AND EXCHANGE COMMISSION

Ms. NAZARETH. Thank you, Senator Lugar, Senator Harkin, Senator Fitzgerald. I am pleased today to appear to testify on behalf

of the Securities and Exchange Commission as you consider issues

pertaining to the reauthorization of the Commodity Futures Trading Commission. In my oral testimony, I will focus on the Report

on Over-the-Counter Derivatives Markets and the Commodity Exchange Act, which the President’s Working Group on Financial

Markets submitted to Congress last November.

In preparing the Report, the Working Group’s task was fairly

specific: to focus on how the CEA might be modified to address

issues related to OTC derivatives markets. Accordingly, the Report

makes recommendations in several areas. First, the report recommends that Congress amend the CEA to exclude bilateral swap

agreements among eligible swap participants acting on a principal

basis. This exclusion would not apply to transactions involving nonfinancial commodities with finite supplies.

It would also not apply to transactions that are conducted on a

multilateral transaction execution facility, as that term is defined

by the CFTC. The Commission believes that excluding qualifying

instruments from the CEA should create greater legal certainty

than the current approach that merely provides for the possibility

of exemption, thus leaving open the question of whether such instruments are futures.

Second, the Report explores questions raised when electronic systems facilitate the trading of OTC derivatives. The Report recommends, among other things, that Congress amend the CEA to

exclude electronic systems that are clearly not multilateral transaction execution facilities. It also recommends excluding electronic

systems that limit their participants to sophisticated counter parties trading for their own accounts, as long as the systems are not

used to trade contracts that involve non-financial commodities with

finite supplies.

Electronic systems that assist eligible swap participants in communicating about or negotiating bilateral agreements would also be
18

excluded. Moreover, to avoid disadvantaging existing futures exchanges, the Report specifically states that those exchanges would

be permitted to establish these kinds of electronic systems for

swaps as well.

Third, the Report addresses systems for clearing OTC derivatives. Like electronic trading systems, clearance systems for OTC

derivatives are subject to legal uncertainty. Because of their importance, the Report urges Congress to permit regulated clearing systems used for OTC derivatives. The Report clarifies, however, that

a clearing system subject to regulation by one agency should not

become subject to regulation by another agency simply because it

also clears OTC derivatives.

Fourth, the Report focuses on providing greater legal certainty

for instruments covered by the Treasury Amendment. The Treasury proposed this amendment in 1974 out of concern that the broad

statutory definition of ‘‘commodity’’ would subject OTC markets in

government securities and foreign currency to CEA regulation. As

a result, the amendment excludes a list of instruments from the

definition of commodity. These listed instruments, however, still

may be subject to CEA regulation when traded on a ‘‘board of

trade.’’

By proposing to replace ‘‘board of trade’’ with ‘‘organized exchange,’’ the Report seeks to clearly delineate the limitation on the

exclusion. The Report also recommends clarifying the Treasury

Amendment to permit the CFTC to address problems associated

with foreign currency ‘‘bucket shops.’’

Fifth, the CFTC’s ‘‘exclusive jurisdiction’’ over certain matters

has caused confusion over the appropriate regulator and regulatory

scheme for complex derivative instruments that possess attributes

of both securities and futures contracts. In order to provide legal

certainty for these hybrid instruments, the CFTC has agreed that

it will not propose any new rule that would cover these instruments without the concurrence of the other Working Group members. The Report recommended modifying the CEA’s exclusive jurisdiction in order to eliminate questions regarding the authority of

the SEC and bank regulators with respect to hybrid instruments.

The report also urges Congress to clarify that the Shad–Johnson

Accord should not be construed to apply to hybrid instruments that

have been exempted from the CEA.

Finally, the unanimous findings of the Report reiterated the commission’s position that although single stock futures may possess

elements of traditional futures contracts, they also have characteristics of traditional securities. Accordingly, when considering the

Shad–Johnson Accord’s ban on single stock futures, it is clear that

regulatory issues associated with the introduction of such products

would be complex. Indeed, the members of the Working Group

agree that numerous issues would have to be resolved before the

ban could be reconsidered. These issues include, but are not limited

to: margin levels; insider trading; sales practices; real time trade

reporting; floor broker activities; and CFTC exclusive jurisdiction.

As you know, Chairman Lugar and Senator Gramm have asked

the SEC and the CFTC to report back to their respective committees later this month on issues associated with modifying the ShadJohnson Accord. The Commission staff has been working diligently
19

with their counterparts at the CFTC to consider the relevant

issues. We look forward to sharing our views with the Committee

on these issues when our report is submitted.

In conclusion, I would like to note that the Report only represents a beginning. In addition to implementing the Report’s recommendations, we must all continue to study the rapidly evolving

markets for OTC derivatives. With input from Congress and industry participants, we are confident that we may meet any regulatory

challenges while permitting this important market to continue to

develop efficiently. Thank you.

[The prepared statement of Ms. Nazareth can be found in the appendix on page 73.]

The CHAIRMAN. Thank you very much, Ms. Nazareth. Let me just

comment because your very thoughtful testimony touches upon a

couple of thoughts. In those you mentioned in one passage that the

CFTC would not attempt to act arbitrarily where there are at least

arguably issues that face the SEC or other Working Group members and that I like that idea.

As you recall, during the last 2-years as we have come together,

there was some question as to whether the CFTC unilaterally

would take jurisdiction feeling that it was doing its duty in behalf

of the American public and the integrity of the financial system

with some dispute of other persons who have come together in this

Working Group. Individual members of the Working Group approached this chairman to indicate their distress about that from

time to time. So it is important—you know we are all one country,

we have one administration, one president who makes appointments—to work together on this. Then the fact that this team effort has come together is significant and that it might be of some

value.

Second, each of you have pointed out that time is not our ally

in this. When I mentioned in my opening comment that we need

to act in the next 3-months, this strikes fear and panic into the

hearts of legislators, drafters, all the parties that are involved, to

want to approach this in a much more leisurely pace, sort of having

several bites at the apple, but I think we all understand I hope the

urgency of this. This is why we set some arbitrary deadlines for reports which we are hoping that each of the groups will come back

to us.

The third point touched upon by Chairman Greenspan and then

amplified by Chairman Rainer, we had during one hearing in this

room—in fact, someone sitting about where you are, Ms. Nazareth,

demonstrated with a screen here a trade. He actually made a trade

in a foreign country from this committee room. I think he sold a

contract of corn and got confirmation. That was certainly interesting for all of us who are not involved in day trading here or elsewhere hopefully in the building, but nevertheless it demonstrated

the fact that we really do not know all that is occurring. As Chairman Greenspan said, there is an S-curve here. Once you go over

the curve, it may be beside the point to deal with all of this with

the certainty that we had hoped with regulation. We still have a

responsibility to do our best.

But our confidence level probably diminishes rapidly.
20

But in that respect, do we live in a world, and Chairman Greenspan, I ask you this philosophically, in which it is anticipated by

the public that we will all be wise enough to have a regulatory

mechanism that brings confidence to our markets and we do our

very best to do that? But as I listen to your testimony and sort of

read anecdotally the other material, is this a situation that is getting really beyond our abilities to do this? And to what extent, as

we approach this, do we do so with some modesty that we do our

best but at the same time not give the impression that I think

some of us have given in the past that almost like the Food and

Drug Administration pinning down safe food and after endless

hearings and years of study we get it right? I am not certain this

is applicable in this area, but would you give some philosophical

perspective to this?

Mr. GREENSPAN. Well, Mr. Chairman, I think you are raising a

very important concern. We have been very fortunate in this country that the regulatory structure we have put in place has been

generally accepted by the American public. They have exhibited

confidence in it, and even though you periodically hear of breakdowns in the system that the press goes a little berserk on in certain areas, what is really quite remarkable is how little of that

there is. I do think that we are confronting a broader challenge to

continue that level of integrity of our system largely because, as I

point out in my prepared remarks, the technology of financial innovation has become so extraordinary, and, in many respects, almost

discontinuous.

We have seen quantum jumps in information technology in the

nature of financial products, and as a consequence, the need for financial regulation to adjust itself to the rapidly altering financial

structure which confronts us. I think the Working Group has endeavored in this particular area to recognize that a number of our

definitions and our concepts with respect to financial instruments

generally, and derivatives particularly, have got to be understood

in a rapidly changing environment.

I cannot promise you nor do I believe any of our colleagues can

that we will get this all right. But I do say, and I think it should

be emphasized, that the Working Group works very effectively. I

am myself impressed at the interaction that has occurred and our

ability to reach consensus. We do that not because each and every

member of the group agrees wholeheartedly with each and every

recommendation, but we recognize the need for consensus above

the specific solutions that each of us would prefer, other things

equal, and I take that as a very good sign.

The CHAIRMAN. I can remember just anecdotally, Chairman

Greenspan, your coming along with Secretary Rubin to Senator

Dole’s office at the beginning of the Mexican crisis, now I guess 4-

years ago or so—five—time goes by rapidly.

Mr. GREENSPAN. But memories do not fade.

The CHAIRMAN. I know. The thing that I remember about the

meeting, however, is the description of billions of dollars being electronically transferred, not just with regard to Mexico and the

United States, but as you were pointing out at that time from

Southeast Asia and strange places that we would not have thought

were necessarily involved in a bilateral crisis but at the same time
21

seeking safety presumably. I think this was impressive that unlike

most types of protectionism, where you can try to keep out something or keep it in, with regard to money and electronics, even at

that point, and as you say quantum leaps have occurred in that 5-

year period. So that this is something to say the least that is very

difficult, but it is reassuring and I like your comment that the

Working Group has gotten together. Hopefully without knowing

this is a permanent institution, there at least is enough tradition

of your working together which is extremely helpful to the relevant

committees.

In that point, I am trying to work together, and I made explicit

this morning, with Chairman Gramm of the Banking Committee.

As we have gotten through the CFTC’s situations during the last

two decades or so in which I have been involved in this, frequently

we have been in loggerheads with the Banking Committee or we

have gone through several years in which nothing happened because there was sufficient stymie either way. I think Chairman

Gramm is determined, and I am, that we have oversight over different institutions, but nevertheless we have a working group in

which you have bridged those gaps in the administration, and I

know the distinguished ranking member joins me in our attempts

to bridge them in this Senate, bipartisan and by committee or whoever else we need to work with.

In that respect, Chairman Rainer, let me ask you, you have

talked, and Senator Harkin asked a very pertinent question about

the difference between exemption and exclusion, but you have said

exclusion, and you have said it because this gets to the heart of the

legal certainty problem. You talked about a regulatory scheme that

really did not seem to be quite focused. It never quite had the authority. It was out there, however, and a part of the crisis that

brought us all together a couple of years ago was that suddenly

CFTC, vague or not, decided it was in the public interest that unilaterally it would deal with this problem.

So this then threw markets into potential turmoil. I do not want

to put too fine a point on it, but this is a very important juncture

in the legislation and would you just underline again the need for

either certainty, exclusion as opposed to exemption, how this fits

after all the studies and compromises that you may have made?

Mr. RAINER. That is a very important question, Chairman Lugar,

and not one that I have not spent a considerable amount of time

thinking about. The first thing I did was to determine whether I

agreed with everyone else in the Working Group whether or not

the instruments of the over-the-counter derivatives were not manipulable, did not serve a price discovery role, and the impact of

the types of participants with respect to regulation. I have satisfied

myself that these instruments are not readily susceptible to manipulation and do not serve a meaningful price discovery role. As a result of that and given the sort of collision that the CEA and the

over-the-counter derivatives market has more or less been on for a

long time, I thought it was time to resolve this matter, to resolve

the issue. I thought it was in the public interest to get this cleared

up and I did not see the benefits of the Commodity Exchange Act

superimposed over this market.
22

The CHAIRMAN. Those are the two major criteria, manipulation

and——

Mr. RAINER. Serving a price discovery role.

The CHAIRMAN. And price discovery.

Mr. RAINER. Since those two elements are not material with this

market, I thought that the public interest would be best served if

I agreed that we exclude this market from the Commodity Exchange Act. Exclusion versus exemption—that is not a complicated

answer for me. I was seeking the greatest clarity for legal certainty

and an exemption would provide clarity. A codified exemption

would probably provide a little more clarity, but the greatest clarity

would be an exclusion, and I support that.

The CHAIRMAN. Thank you. Senator Harkin.

Senator HARKIN. Thank you, Mr. Chairman. I had three questions. That was one of them, and that is can we provide the same

kind of legal certainty—after all, we write laws—and to provide the

same kind of legal certainty under an exemption that we can under

exclusions? I do not know why we cannot do that. Again, I get back

to what I asked Secretary Summers in the beginning. That with an

exclusion we have washed our hands of it. If anything happens,

again, you say I do not know what is going to happen out there.

I mean you say there is a notional value of about $83 trillion or

something like that worldwide. I mean that is a lot of risk out

there. These are risk instruments. That is a lot of risk.

And so if you have this exclusion and something unforeseen happens, who does something about it? You cannot, Mr. Chairman.

You cannot. You cannot. It has got to come back to us and we do

not act that fast around here. So I am wondering that within the

framework of an exemption, can you provide the legal certainty

which I understand has to be done, and this is what I wrestle with,

the legal certainty of these contracts, but keeping the hammer—I

do not know—hammer may be the wrong word—but keeping the

possibility that one of you or all of you can act rapidly to intervene

at some point? I ask all of you that. I will start with you.

Mr. RAINER. I will defer on some of these matters to Chairman

Greenspan, but one of my answers is that I think we have to keep

in mind that most of these participants are either involved in the

banking system or investment banking industry and so there is

regulation along those lines. I am not a lawyer and I cannot slice

the differences very well between codified swap exemption and exclusion, but I have been assured that exclusion does provide the

greatest clarity for legal certainty. And, if that is the case, that is

what I am supporting.

Senator HARKIN. Well, I have been told that, too, but I am not

certain I am buying it right now. I may. Chairman Greenspan.

Mr. GREENSPAN. Senator, let me repeat what Secretary Summers

says because I do agree with him on this. The problem would be

less immediate if the CFTC had 20-year terms for Commission

members, and the people in the CFTC stayed very long periods of

time and did not change their philosophy particularly. Then the

issue would be pretty much irrelevant, I would think. That is not

the case. We have changing CFTCs. Indeed, the difference between

the current CFTC and the one immediately preceding it with re-
23

spect to how the CFTC viewed the markets is really quite significantly different.

The result of that is that you have a situation where the uncertainty owing to the turnover of the commission does create a significant diminution of the degree of legal certainty, and I think

that a major concern is that it is a critical issue which unless appropriately resolved can very readily move a very substantial part

of this market, and it is a huge market, as you point out, overseas.

There is virtually no reason why a lot of these transactions that

are made by larger investors cannot be struck in London under a

different set of laws.

So I would just say basically that because of the easy ability to

move abroad, it means that the sensitivity or the particular barrier

which we have to cross with respect to degrees of uncertainty has

been lowered, and I am fearful that unless we get legal certainty,

and indeed it is the view of all of the Working Group members, we

are fearful that we may end up with another eurodollar market.

Senator HARKIN. I try to interpret in my own words. Maybe I

just wanted clarification of this, Mr. Chairman. It almost sounded

to my ears like you were saying that if we were—if in the wisdom

of Congress, we were to provide some kind of legal certainty to

these derivatives and do it under an exemption basis, that the regulatory body that would be best able to oversee that would not be

something like the CFTC, which as you say changes more rapidly,

but perhaps something like the Federal Reserve System which is

more stable and long term.

Mr. GREENSPAN. I would say that even we do not, in my judgment, fall into the category which would create the same degree of

legal certainty that a statute would do. I——

Senator HARKIN. Are my fears unfounded then that if something

happens out there, there is no one that can do anything and we

have to act here in Congress? Is that just an unfounded fear or——

Mr. GREENSPAN. Senator, no, you are certainly raising a legitimate question which really is far broader than the question of the

issue we are discussing today because all of government regulation

is either discretionary with respect to various regulatory agencies

or prohibitive. There is no capability of any element within this

government, for example, to regulate home heating oil prices, to my

knowledge. When we had this recent very sharp run-up in prices,

there indeed was no authority to deal with it. It is a market adjustment process which will eventually deal with it and, as I think we

have all argued, in the derivatives area, it is largely counterparty

surveillance which is our primary source of regulation.

I think that we have to recognize that regulation is a very difficult operation. I mean you point out that the LTCM episode was

one over which we had no particular regulatory capability, yet the

supervisory structure of this government worked. We had an ad

hoc approach. The Federal Reserve Bank of New York brought together numbers of private parties because in our judgment it was

to their interest to resolve the question. There is a great deal of

that going on.

Can I envisage a problem that will emerge in which if there had

been regulatory authority, it would have been readily resolved and

that we in the event did not have that authority and would be pre-
24

sumably worse off? Absolutely. I mean those are going to happen.

I think that there is a very fundamental tradeoff of what type of

economy you wish to have. I mean you can have huge amount of

regulation and I will guarantee nothing will go wrong, but nothing

will go right either.

Senator HARKIN. My time has run out. I do not know if Ms.

Nazareth wanted to wade into this or not.

Ms. NAZARETH. Well, just briefly. I certainly agree with Chairman Greenspan and Chairman Rainer that there are very strong

benefits to the legal certainty. I also think that there, in fact, have

been a number of improvements and private sector initiatives in

addressing the risks associated with this business. The improved

transparency initiatives that came out of the President’s Working

Group Report on Highly Leveraged Institutions I think was very

important. I do think that market discipline has been and will continue to improve significantly.

I think credit standards have improved and, you know, as a result of the Working Group’s Report on Highly Leveraged Institutions, we will probably see greater transparency of exposure to

highly leveraged institutions and also the SEC asked for increased

risk assessment authority. So there are other initiatives going on

that I think will go to improving the issues of the systemic risk.

Senator HARKIN. Thank you. Mr. Chairman, I had two other, but

obviously I have used up my time. The other two, and I may just

write these in a letter to you all, number one, the exchanges are

concerned about parity. In other words, they are looking for some

regulatory relief, too, and if we do this and we do not do the other

one, they are worried about the disconnect. I think that is a fair,

rational concern on their part, and I wanted to ask you about that,

but maybe I will in a letter.

The other one was just on the clearinghouse concept. I am not

certain how that works in this regime. I know how it works on the

exchanges where you settle up and you make your marks everyday

and you clear it at the end of the day. I do not know how it works

in this setting and, again, perhaps in a letter you could outline it

for me how this clearinghouse concept might work. Thank you, Mr.

Chairman.

The CHAIRMAN. Let me just respond for a moment. Senator, in

my opening comment I mentioned that, just taking up this parity

situation comparable problems with SEC or others. Chairman

Gramm and other members of the Banking Committee have suggested and I think this may be a good idea that we may have joint

hearings of the two committees.

Senator HARKIN. That would be good.

The CHAIRMAN. To try to take a look at the level of regulation

so that things do not get too disparate. We do not have a comparable situations entirely, but some members of the Banking

Committee including the Chairman are much interested in this

question, too. So this may be a way on our side at least of trying

to do work that is comparably done by the Working Group. Senator

Fitzgerald.

Senator FITZGERALD. Thank you, Mr. Chairman. I have a question for Ms. Nazareth. I appreciate your being here and I gather

you are the Director of Market Regulation at the SEC.
25

Ms. NAZARETH. That is right.

Senator FITZGERALD. We talked with Secretary Summers about

how well our securities laws have worked in this country and I

think we have a wonderful regime that has held up well even

though it was drafted in the 1930s. It has held up well even in this

modern world. One feature of our securities laws in this country is

that the basic core statutes apply to all securities traded everywhere. There are some minor exceptions to that general rule. One

can sell stock to sophisticated parties without filing a registration

statement. However, in general, if there were ever any fraud, you

would come in under your authority under section 10(b)(5) and

wherever that market trading occurred, whether it occurred on an

exchange or out in the parking lot, you would have the authority

to act.

Furthermore, the definition of securities in the securities laws of

this country is very, very broad. It is hard to create a financial

product that does not have characteristics of a security. In fact,

stocks, bonds, promissory notes can be classified as securities, and

the scope of the securities laws is enormously broad, very hard to

escape. The laws apply everywhere.

In talking about how we are going to redo the CEA, we are talking about something completely different. Instead of having a CEA

that applies to all financial derivatives everywhere and equally and

having a broad definition of what is encompassed by the act, we

are really carving out a little narrow area of financial derivatives

that are going to bear the whole brunt of full-scale regulation;

namely financial derivatives that are called futures contracts and

traded on an exchange.

Anything that is slightly different that can be called a swap as

opposed to a future. An interest rate swap, if we call it a swap,

even if it is fungible, standardized, and not traded on an exchange,

it will not be subject to regulation. I am just wondering if that

makes sense. Do you not think there is a possibility that all financial derivatives the business is going to migrate to the swaps area

very easily because you can escape the definition of what is covered

by the act?

In fact, what is covered by the act is left really to something that

is labeled a future and traded on an official board of trade. Do you

not think a lot of that business is just going to go to where it is

unregulated? In addition do you think our securities laws should

have such kind of gaping exemptions and just apply in little narrow areas?

Ms. NAZARETH. I would not think that it would all migrate to the

over-the-counter derivatives markets because those are—they are

really not standardized products. They are bilateral contracts. They

are not fungible. They are used really for very specific financial

purposes.

Senator FITZGERALD. You do not think there is any standardization of interest rate swaps out there? I mean——

Ms. NAZARETH. Well, I think given the large market for them,

there certainly has become somewhat more of a standardization in

the sense that there obviously are agreements that people use, but

they do negotiate the terms of those agreements on a bilateral

basis.
26

Senator FITZGERALD. How would you describe the difference in

economic terms between an interest rate swap between institutional parties and institutional parties buying interest rate futures?

What is the economic difference between those two transactions?

Ms. NAZARETH. Well, there are differences in—again, I think

there are differences in the fungibility, the closeout procedures.

Currently certainly there were differences in the ability to net.

There will be some more—they will become——

Senator FITZGERALD. But what are the economic differences?

Suppose we have a different futures contract for every interest rate

swap. We change the contract in some regard so it is no longer fungible. What would be the economic difference?

Ms. NAZARETH. Well, I think in some cases they may serve a

similar economic function. I think that is one of the challenges that

we all have as regulators today is that you have a number of these

products that start to resemble each other.

Senator FITZGERALD. What would be the public policy rationale

for giving disparate treatment to similar instruments traded by

similarly situated institutions, but just happen to be trading in different venues?

Ms. NAZARETH. Well, I am not here to sort of argue what I believe is, you know, Chairman Rainer’s jurisdiction with respect to

what should the commodities laws cover, but I do think that there

are differences in that what we have done for purposes of this report is simply address over-the-counter derivatives and defined

them, defined these swap transactions in a narrow way of just talking about counter parties with $25 million in investments, bilateral

contracts, contracts that are done purely on a principal basis. So

it is a smaller subset. Certainly it does not cover, you know, retail

products and things of that nature.But again I think——

Senator FITZGERALD. Would anybody else care to address this

issue? It seems to be a distinction without a difference.

Mr. RAINER. Senator Fitzgerald, you raise very good points and

I think it is very consistent with what is actually in the Working

Group set of recommendations because there is difference paid to

the fact that these recommendations may have an impact on our

exchange-traded futures with differences in regulation for similar

products. One of the reasons I think we have such a good strategy

here is because this is not a one-part recommendation, it is a twopart recommendation.

The first part is to enact the recommendations with respect to

the over-the-counter derivatives and the other part is for the CFTC

with assistance from this committee and others to devise a regulatory framework that is more rational than the one that we have

today. With your example, if I were to say eurodollar contracts, I

would argue, although we have not made this judgment officially,

I would say there is a good case to be made that the eurodollar contract is also a contract that is not readily susceptible to manipulation. Our challenge is to come up with a comprehensive framework

that deals with the very issues that you were talking about.

Senator FITZGERALD. Thank you. Mr. Greenspan, the Federal Reserve Board regulates the banks in this country and I am sure you

have been looking very carefully at——

Mr. GREENSPAN. Some of the banks.
27

[Laughter.]

Senator FITZGERALD. Well, all bank holding companies.

Mr. GREENSPAN. Correct.

Senator FITZGERALD. You do look at the derivatives on the balance sheets, the derivative exposures of our banks. A lot of banks

have purchased interest rate swap contracts. In fact, I saw that of

that 80-trillion on OTC financial derivative markets, a large percentage of that are simply interest rate swaps, I would imagine

most of those swaps are between financial institutions laying off interest rate risks that they may have. Have many banks bought interest rate futures on a board of trade or are they all interest rate

swaps?

Mr. GREENSPAN. There is both involved, but I think the point you

are making, which I would agree with, is the fact that the proportion of derivatives which are exchange traded has been declining,

and the reason they have been declining is that the market participants perceive that the costs of exchange-traded derivatives exceed

the benefits that they create over and above over-the-counter derivatives. And, they do. I mean there are certain advantages in the

settlement and clearing processes in exchanges which are not

replicable in the over-the-counter markets and as a consequence

the exchanges do have certain benefits which the OTC markets do

not have.

If, however, we see, as we do, a decline in the share of exchangetraded instruments, it presumably means that the markets generally perceive that the costs involved, essentially regulatory costs,

are excessive relative to the benefits that are achieved. I think that

it clearly is an issue that ought to be addressed. We at the Working

Group certainly are aware of this problem and have been looking

at it. And, precisely how to come at it, I think is an issue which

does require efforts on our part and I would presume that we will

be moving in that direction as best we can.

Senator FITZGERALD. Would you be in favor of exempting exchange-traded transactions wherein the counterparties are strictly

institutional?

Mr. GREENSPAN. There has been a considerable amount of discussion and indeed certain efforts beginning to be directed in that particular area. Obviously, the concerns that a number of people have

is that if you bifurcate the market, you will create a significant

spread in at least part of the residual. That, is the bid-asked

spreads will open up because the volumes will be substantially less.

I do think we have an issue here that has got to be resolved and

I would suspect that it is not so much an exchange issue as it is

between retail customers and institutional customers. There is no

question that if you have a very large volume market, the liquidity

of that market will essentially create a very significantly lower per

unit cost of transaction than you will get in a retail market, which

by its nature is much smaller.

The question is whether or not you want to do cross-subsidization between these various types of markets. My own impression

is that if you were concerned about this issue, one vehicle which

we used to have, I guess, was in the grain pits. We used to have,

I remember, thousand bushel wheat contracts. A thousand bushel

wheat contract had a bid-asked spread which was significantly
28

wider than the conventional 5,000-bushel wheat contract. But you

had a considerable volume of retail business in the thousand bushel contract and what would happen would be is that the exchange

traders would arbitrage the difference and effectively, significantly

reduce the difference in the spreads, but not completely.

In other words, they did not effectively cross-subsidize because

that was not their business, but their arbitrage did bring down the

differences quite considerably and I think what the issue here is

not that we do not perceive of the necessity of making certain that

retail markets are as efficient and liquid as they can be, but how

do we do it without impairing the important competitive efficiencies of the large institutional markets. That is where the issue

lies as far as I can see.

Senator FITZGERALD. We have not bifurcated our securities market like that.

Mr. GREENSPAN. Well, we used to have odd lots, remember. It

was the same issue.

Senator FITZGERALD. OK.

Mr. GREENSPAN. I as a kid used to buy odd lots and some of

them were very odd stocks, I must say.

[Laughter.]

Senator FITZGERALD. Well, thank you very much. I appreciate

that testimony. I have just one question on the Treasury Amendment, if I may? I know we have run over, but the report adopts

a definition of organized exchange that has two parts. One, it permits retailer agency trades and, two, it provides for self-regulation.

Under the proposed amendment to the Treasury Amendment, could

an exchange which is open to retail customers and which trades

Treasury Amendment products other than foreign currencies opt

out of the CEA simply by either dropping its self-regulatory functions or barring the retail customers?

Mr. RAINER. Is that to me, Senator?

Senator FITZGERALD. Yes.

Mr. RAINER. That is a very complicated question and I would like

to answer it this way. The Treasury Amendment is in need of repair. The CFTC has a mission where it should and does find and

prosecute and convict entities involved with foreign exchange on retail. This is a large problem in our country. The way it works is

that for the CFTC successfully to prosecute such an entity, it must

prove that entity is a board of trade. And the way it proves, at

least one way it proves that it is a board of trade, is define the

board of trade under the category called ‘‘association of persons.’’

If it is an association of persons, it is easier to establish that this

bucket shop is a board of trade. That very act if successful has the

Catch-22 effect of potentially looping in legitimate bond dealers

into the CEA, an unintended circumstance.

So I think what the PWG is trying to solve is this problem by

converting the definition to organized exchange with retail and

SRO. I do not care to give full validity to your example, but it is

not intended, I do not think, to allow your example to happen, and

this is one of these technical details that we will be happy to work

with the Committee on.

Senator FITZGERALD. Once you write the legislation, will you

come up with the way of solving it?
29

Mr. RAINER. Yes.

Senator FITZGERALD. Well, thank you all very much. Appreciate

your time.

The CHAIRMAN. Thank you very much, Senator Fitzgerald, for

comprehensive questions and we thank each of you for giving us

your testimony and your service. This panel is dismissed.

The CHAIRMAN. We will proceed on to the final panel which will

include Mr. David Brennan, Chicago Board of Trade; Chairman

Daniel Rappaport of the New York Mercantile Exchange; Mr. Jerry

Salzman of the Chicago Mercantile Exchange; Mr. Richard Grove,

Chief Executive Officer of the International Swaps and Derivatives

Association; and Mr. Edward Rosen, counsel, Ad Hoc Coalition of

Commercial and Investment Banks.

The Committee will come to order. It is a privilege to have each

of you gentlemen here this morning for your testimony and I will

ask that you testify in the order that I introduced you and that

would be, first of all, Chairman Brennan, then Chairman

Rappaport, Mr. Salzman, Mr. Grove and Mr. Rosen. If you can, try

to summarize your testimony in 5-minutes and all of your statements will be made a part of the record so it will not be necessary

for you to ask that, that occur. It will occur because we want a

complete record of your views and the entire hearing. Chairman

Brennan, good to have you again before the Committee.

STATEMENT OF DAVID P. BRENNAN, CHAIRMAN, CHICAGO

BOARD OF TRADE ACCOMPANIED BY THOMAS R. DONOVAN,

CHIEF EXECUTIVE OFFICER AND PRESIDENT, CHICAGO

BOARD OF TRADE

Mr. BRENNAN. Thank you, Senator, and thank you for having me.

Mr. Chairman and members of the Committee, I am David Brennan, Chairman of the Chicago Board of Trade. With me today is

our President and CEO Tom Donovan. We thank you for the opportunity to discuss with you the Working Group’s report on derivatives markets.

Before I begin, I would like to mention that the new leadership

at the CFTC, Chairman Bill Rainer, has been a breath of fresh air.

He has brought market experience and creativity to the Agency. As

you have already heard this morning, under Chairman Rainer, the

CFTC is looking to transform and modernize its regulatory approach. We applaud his efforts and look forward to working with

him.

We have submitted to this committee a written statement that

describes in detail where we agree and disagree with the Working

Group’s report. Sometimes in all that detail the big picture does get

lost. I want to make sure that I emphasize that picture today.

The Working Group’s recommendations add up to a comprehensive overhaul of the Commodity Exchange Act. Broadly stated, the

Working Group’s framework would do three things: give legal certainty to over-the-counter derivatives; transform the CFTC into an

oversight agency for execution and clearing facilities; and reconsider the single stock futures ban in Shad–Johnson and its competitive implications.

Chicago Board of Trade fully endorses the need to reform the

CEA and the Working Group’s three-part framework. That should
30

not be too surprising. Restructuring Federal regulation is driven by

the same market forces-technology, globalization, innovation and

competition-which have caused exchanges to restructure themselves. The Board of Trade is no exception. This last month our

board of directors overwhelmingly adopted a bold strategy to restructure our exchange by creating two independent for-profit companies. One will focus on pit trading; the other will focus on trading electronically. Both will try to attract business by providing liquid trading markets. Both will innovate and invest in technology

to provide customers the best service. Both will provide customers

with a market that they can trust.

What our plan does is give both companies a fair chance to compete, and no business should really ask for more. Federal regulation is part of that fair chance. We believe in open markets and fair

competition. To us, similar products traded in similar circumstances should have similar government oversight. That means

privately negotiated transactions may be excluded, but all public

execution facilities should be treated alike. That is our ‘‘golden’’

rule of fair competition.

Today that rule is not being met. After almost 80-years, the Commodity Exchange Act has become unworkable. Over-the-counter derivatives, especially in the area of equity swaps, are plagued by

legal uncertainty, as the Working Group describes. Exchange markets suffer from extreme regulatory arbitrage, as the Working

Group acknowledges. For single stock futures, it is even worse. We

are barred from competing at all under a statutory provision that

we were told 18-years ago would be ‘‘temporary’’ until a regulatory

impasse could be resolved.

The Working Group recommendations cover each of these areas.

Some of those recommendations are specific statutory changes.

Some involve working with the CFTC and the SEC. We know that

many details need to be worked out and are likely to be controversial, but we are eager to help bring these issues to closure. Mr.

Chairman and members of the Committee, all we have ever asked

for is a fair chance to compete. This year’s CFTC reauthorization

may present us with our best chance to achieve that goal. We look

forward to working with you and this committee to make sure that,

that common objective becomes a legislative reality. Thank you

very much.

The CHAIRMAN. Well, thank you very much, Mr. Brennan, and

we look forward to working with you and your associates in the

Chicago Board of Trade. We noted with interest the developments

that you described there in your organization which are indicative

of some of the issues that have been a part of this hearing today.

[The prepared statement of Mr. Brennan can be found in the appendix on page 81.]

Chairman Rappaport.

STATEMENT OF DANIEL RAPPAPORT, CHAIRMAN, NEW YORK

MERCANTILE EXCHANGE

Mr. RAPPAPORT. Thank you, Mr. Chairman. Thank you, Senator

Fitzgerald. I had a number of comments that I was going to make

but I will not make, and I think I will keep my comments relatively

brief because I cannot tell you how encouraged I was sitting out in
31

the audience listening to your questions to the other panels and

after coming and going to these hearings over the last 7-years for

the time that I have been chairman of the New York Mercantile

Exchange, I see that finally we have gotten our point across because you are asking the questions that we were asking years ago

coming to you trying to make you aware of this disparity of regulation, this inequitable disparity of regulation that did not put us on

a level playing field with a marketplace that was selling the same

product to the same customers at the same exact time, and we

really appreciate the fact that you are beginning and clearly now

understand this issue.

We think that while the Working Group report begins to address

some of the issues associated with legal certainty and some of the

other related issues, I was very glad to hear your comments in

terms of this is really only half the puzzle and that the other half

of the puzzle needs to be resolved and that you have an interest

in resolving it in more of a simultaneous manner than some other

people are discussing, not permitting our side to be held hostage

to resolution of this other issue because, as you recall, when Congress passed the Futures Trading Practices Act in 1992, they also

encouraged that the commission use its exemptive authority to

take care of the exchange issue. Here we sit 8-years later not having got any real relief, although I will echo Chairman Brennan’s remarks that Chairman Rainer’s initiatives in this area in a very

short time have made incredible accomplishments and we look forward to more.

But even the report itself says that U.S. futures exchanges, on

page 21, are at a competitive disadvantage to OTC derivative markets as a result of the Commodity Exchange Act observing what

major market participants have said and the report itself goes on

to say that if the recommendations in the report are implemented

that they hold out a good possibility that it will only exacerbate

that perceived balance. And, that is really where we are today. We

are here to say that we agree with some of the recommendations

in the report. We are looking forward to seeing the commission’s

response to the rest of the puzzle and I look forward to being here

again to talk to you more about that. Thank you.

The CHAIRMAN. Well, thank you very much, Chairman

Rappaport. As you know, we have asked for specific comments on

issues that we are not taking up in great detail today from the

chairmen of CFTC and the SEC and in a fairly short time frame

because these are relevant clearly and I have stressed again the

potential cooperation with Chairman Gramm and the Banking

Committee. You cite correctly the 1992 act is one in which some

cooperation came only have a long stretch and so we are back, at

least——

Mr. RAPPAPORT. It did not really come to us though.

The CHAIRMAN.—into a different report at that point.

[The prepared statement of Mr. Rappaport can be found in the

appendix on page 92.]

Mr. Salzman.
32

STATEMENT OF JERRY SALZMAN, CHICAGO MERCANTILE

EXCHANGE

Mr. SALZMAN. Chairman Lugar and Senator Fitzgerald, I am

honored to represent the CME’s Chairman Scott Gordon who was

unfortunately too ill to get on the plane last night or this morning.

He sends his regrets to this committee. I am going to essentially

present his remarks, if I may, and, of course, as usual I may add

something of my own. I want to begin by unequivocally expressing

the CME’s support for the efforts of the CFTC under Chairman

Rainer to reexamine and reassess the regulatory structure of our

industry. The commission has made valiant initial revisions to its

very thick white book of regulations. We think that demonstrates

the commitment to bring regulatory burdens into line with regulatory needs. We are extremely happy about that.

That said and without criticism of our Regulator’s endorsement

of the President’s Working Group’s Report, it is fair to say that the

CME is extremely concerned about the focus of that Report. We

are, of course, heartened by Senator Lugar’s remarks that he is

going to ensure that we get some parity when legislation is put into

place. But it is clear to us that the Report itself unjustifiably tilts

the playing field against the existing exchanges.

Our goal, the goal of the exchanges, has been equivalent regulatory treatment for functionally equivalent execution facilities,

clearinghouses, and intermediaries. That is, if an execution facility

is performing a function, all execution facilities performing the

same function in an equivalent manner should be treated equally.

Same for clearinghouses and the same for intermediaries. We have

carefully assessed the Report and we do not think that the Report

endorses this principle. The Working Group has recognized the regulatory disparities and blurred product distinctions that handcuff

U.S. futures exchanges in today’s competitive global markets. I

think Senator Fitzgerald’s questions have been very pointed in saying what is the difference between these products? What are the

differences between the intermediaries? What are the differences

between these end users in these two markets? That has really

called the issue into a clear perspective.

We consider that omission in the Report a serious flaw. Now the

Report does call for some changes that are in accord with our principles. But it’s recommendations for regulatory relief and legal certainty we think are only going to bring immediate benefits to the

over-the-counter market and to enterprises that are now springing

up all over this country intending to operate or operating unregulated exchanges at this very point in time. All you have to do is

look on the internet or look in the newspaper clips everyday. There

is a new one every morning.

The Report itself begins with what I think we would all agree is

a conservative call for legal certainty for the over-the-counter

swaps market. We agreed with that call and we sponsored and

have made proposals to that effect beginning early last year. The

Report, however, veers from that simple principle to a more radical

realignment of markets and regulators by essentially redefining

what a swap is to include standardized, cleared, financial futures

contracts that are traded on electronic exchanges. So effectively,

while calling for legal certainty for a swap, they then redefine swap
33

and call for special treatment for special kinds of exchanges that

essentially duplicate what our exchanges are doing.

The call for legal certainty for a bilaterally negotiated swap contract, which we support, is effectively converted into a demand for

exclusion from the CEA for exchange traded and cleared financial

futures. Now this creates two problems. Senators Harkin and Fitzgerald have pointed out that the exclusion may cripple somebody

at a later point in time when action needs to be taken and it is

not clear why you need an exclusion.

There is another problem that I do not think has been raised, except in our testimony, which is that the exclusion may not lead to

the legal certainty. Legal certainty has been code for avoidance of

CFTC regulation and risks of equities or derivatives that have underlying securities from the CEA. Given the public statements of

the SEC and the statements and briefs that they filed in many

courts, there becomes a serious question as to whether these excluded derivatives are or are not securities. As Senator Fitzgerald

has noted, given the broad scope of that definition and given court

decisions that the only reason they are not securities is because of

the CFTC’s exclusive jurisdiction.

My concern is that we are not creating legal certainty but transferring uncertainty from one regulator to another regulator. I think

this issue has to be faced at a very early stage in this process. I

see my red light is on. I have a little more, but I do not want to

hog time up here so I will just stop.

The CHAIRMAN. Proceed if you can summarize.

Mr. SALZMAN. OK. I want to draw special attention to a discrepancy between the treatment that the OTC market gets in the Report and exchanges that is in respect to equity derivatives. As we

all know, the Shad-Johnson accord raises questions as to legality

of both exchange-traded single security futures and over-thecounter single security futures or derivatives. The President’s

Working Group proposes to exclude swap agreements that ‘‘reference non-exempt securities from the CEA.’’ Non-exempt securities, I believe, is a term of art for equity securities and certain

kinds of other municipals and things like that.

In fact, the Presidential Working Group urges that single stock

futures and all stock indexes be permitted both over-the-counter

and on the unregulated exchanges it describes. If that

reccomendation were enacted, we would be in this strange situation

where the places to trade derivatives on single-stock futures are either over-the-counter or unregulated markets. A regulated market

with transparent pricing and careful protection of ultimate customers is the only place left where you cannot trade the instrument. That proposal is made without any suggestion that we have

to work out regulatory issues, where we have to work out margins,

where we have to work out anything.

In fact, it is just carte blanche for unregulated exchanges and

over-the-counter markets and the same old story for the existing

regulated markets. This to us does not seem reasonable or fair.

And with that, I will stop. Thank you very much, Senator.

[The prepared statement of Mr. Gordon, submitted by Mr.

Salzman can be found in the appendix on page 100.]
34

The CHAIRMAN. Well, thank you, Mr. Salzman. Let me mention

at this point two things. First of all, I should have mentioned that

Commissioners David Spears and Jim Newsome have come to the

hearing today from CFTC and we appreciate their presence in addition to the distinguished chairman.

The other thing is that Senator Fitzgerald and I will need to go

to vote. There are 5-minutes left in the roll call on the bill that is

on the floor. Fortunately, it is a single vote and so I will ask the

patience of Mr. Grove and Mr. Rosen because we will both want

to hear the testimony from the beginning.

Senator FITZGERALD. We will be right back.

The CHAIRMAN. We will be right back. The hearing is recessed

for a moment.

[Recess.]

The hearing is called to order. We look forward now to the testimony of Mr. Grove. Will you please proceed?

STATEMENT OF RICHARD GROVE, CHIEF EXECUTIVE OFFICER, INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION

Mr. GROVE. Thank you very much, Mr. Chairman. I am the CEO

of ISDA, the International Swaps and Derivatives Association, and

before joining ISDA, I was actively engaged for many years in sales

and trading of OTC derivatives and other financial products. ISDA

has had the privilege of appearing before and working with this

committee for more than a decade and we are pleased to be here

again today. ISDA’s more than 450-members include the world’s

leading dealers in off-exchange principal-to-principal derivatives

transactions. These transactions are typically referred to as swaps

and their status under the CEA is the focal point of the report of

the President’s Working Group.

Swaps, as you know, Mr. Chairman, are powerful tools that enable American businesses and other end users in each of the 50-

states to manage the interest rate, currency, commodity, credit and

other related risks that are inherent in their activities. In this way,

businesses and other users of swaps are able to lower their cost of

capital, manage their credit exposures and increase their competitiveness both here and abroad by focusing on their core areas of expertise.

The United States has been a leader in the development of swaps

and American businesses were among the earliest to benefit from

these risk management tools. The dramatic growth in the volume

and diversity of swaps is probably the best evidence of their importance to, and acceptance by, end users. It is no coincidence that the

U.S. economy and the volume of swaps both grew dramatically during the last decade. Let me add at this point that ISDA’s membership includes many of the businesses, financial institutions, government entities and other end users that rely on swaps to manage

their financial and commodity market risks with a degree of efficiency and effectiveness that would not otherwise be possible.

The Working Group report is the product of a great deal of effort

by each of the members of the group and their colleagues. It reflects a solid understanding of, and sensitivity to, the factors that

enable the U.S. financial markets to so efficiently allocate capital
35

and so effectively sustain economic growth. The report embodies an

unprecedented consensus among four key financial regulators that

legislation should be enacted to provide legal certainty for swaps.

As you know, legal certainty simply means that parties, both

dealers and end users, must be certain that the provisions of the

swaps agreements they enter into are enforceable. Any uncertainty

with respect to the enforceability of swaps creates risks not only for

parties involved but for the financial system as a whole. For example, when unilateral actions by the CFTC in 1998 suggested that

the CFTC might treat some swaps as futures contracts, congressional action was required to preserve legal certainty for swaps and

thus ensure continued market stability.

The underlying policy considerations were not addressed by Congress in 1998, but they have now been carefully considered by the

Working Group. The Working Group concluded that financial

swaps do not present public policy concerns of the sort that the

CEA is intended to address and that legal certainty can therefore

best be provided by an exclusion from the CEA.

In one respect ISDA believes that Congress should go further

than the Working Group by excluding from the CEA swaps involving commodities with deep and liquid markets such as various energy products. Indeed, the failure to do so may stifle the continued

development of innovative energy risk management tools in the

United States to the detriment of American businesses and other

end users. That having been said, ISDA agrees with the thrust of

the Working Group’s recommendations. There is broad consensus

on the merits of the issue and I cannot emphasize too strongly

ISDA’s belief that the time for congressional action to provide legal

certainty is now.

I would also stress that legal certainty should be provided in a

manner that does not restrict financial innovation. As you know,

Mr. Chairman, U.S. financial institutions and U.S. technology companies are world leaders in their respective fields. From the broad

perspective of our national interest, we should not compromise

these leadership positions by creating or maintaining regulatory

structures that discourage financial institutions from using and

benefiting from the most efficient and innovative electronic technology available.

To summarize, ISDA hopes that the Working Group’s report will

serve as the catalyst for the enactment of bipartisan legislation this

year to provide legal certainty for swaps. As described more fully

in our written statement, ISDA believes that this legislation should

also provide appropriate regulatory relief for the futures exchanges.

Let me conclude with the promise that ISDA will remain committed to working with this committee on a cooperative and constructive basis to ensure that the key objective of legal certainty for

swaps as well as appropriate regulatory relief for the futures exchanges is translated into legislative reality this year. Thank you,

Mr. Chairman.

[The prepared statement of Mr. Grove can be found in the appendix on page 106.]

The CHAIRMAN. Thank you very much, Mr. Grove. Mr. Rosen.
36

STATEMENT OF EDWARD ROSEN, COUNSEL, AD HOC

COALITION OF COMMERCIAL AND INVESTMENT BANKS

Mr. ROSEN. Thank you, Mr. Chairman, and thank you for the

continued leadership role that you have played in this issue over

the years. The coalition believes that the most important attribute

of the President’s Working Group report is the consensus. In reaching any consensus obviously all individual views succumb to the

weight where agreement meets. Undoubtedly, left to their own devices, each of these agencies would have produced a different report, but we have something better than four different views on

this subject. We have one view. Whoever it was that first said that

less is more I think had something like this in mind.

We should not really overlook the importance of this consensus

because when we look back to the not too distant past, it was clear

that we nearly compromised the vitality of our financial markets

as a result of interagency jurisdictional competition. But we now

for the first time have four agencies who are all rowing in the same

direction.

Now I think the exchanges really have it right when they say

that to some extent this is about drawing lines, and as we noted

in our written testimony, the coalition believes that there is more

that can be done in certain areas in establishing a regulatory

framework within the Commodity Exchange Act for electronic trading systems that are not eligible for one of these exclusions in the

area of hybrid instruments and legal certainty for non-financial derivatives. We also support modernization of the regulatory regime

for exchanges and we also support the trading of single stock futures.

Even though we might have drawn the line somewhat differently

had we had the luxury of drafting a report like the President’s

Working Group report, we think that it is nonetheless a very valuable starting point of departure for this legislative effort. Confirming the recommendations in the President’s Working Group alone

will be a very important step in providing legal certainty and ensuring financial innovation going forward in the U.S. financial markets, but we must maintain our perspective on what is most important in this process and what is less important in this process.

It is most important in this process to resolve the issues of legal

uncertainty and barriers to innovation that hold back the United

States financial markets and it is very important to provide a

framework for the exchanges that allows them to compete on an

appropriate basis both domestically and internationally. But there

are other issues that are somewhat less important in this debate,

issues that it would be nice to address, but it may be very difficult

to address. For too long, accomplishing the legal certainty agenda

has been held hostage to some of these other issues like the trading

of single stock futures.

This is, I think, the fourth appearance I have made before this

committee on these issues. I think we have been talking about

these issues now for 10-years. We really need to resolve these

issues. It is nice to see a general recognition that time is not our

ally on them, and I want to confirm to the Committee that the coalition is committed to participating in a process that will result in

successful legislation, but we must not allow our inability to
37

achieve a perfect result to interfere with our ability to accomplish

what can be accomplished.

I had some longer remarks prepared, but I candidly think that

the debate and discussion that has occurred prior to this panel on

issues of exemption versus exclusion, analogies to the securities

law regulatory structure, comparability of economically similar

products, has really raised the level of the debate on these issues

and I look forward to an opportunity to addressing those issues.

[The prepared statement of Mr. Rosen can be found in the appendix on page 108.]

The CHAIRMAN. Well, thank you very much. Let me commence

the questioning and I will call upon my colleague, Senator Fitzgerald. Let me address this to Chairman Brennan and Chairman

Rappaport and Mr. Salzman. The Working Group report goes out

of its way to state that futures exchanges are eligible to qualify for

both the over-the-counter derivatives exclusion and the electronic

trading system exclusion if they meet proper criteria. I am wondering has this been discussed at your exchange and what are your

general conclusions with regard to that part of the report? Do you

have a comment on that, Mr. Brennan?

Mr. BRENNAN. Yes, Senator. I think we have discussed this and

I think to crystalize it, I think we are concerned about the fragmentation when you split off either pit versus electronic or retail

versus institutional. We are very concerned about the fragmentation issue that has been discussed and maybe the ag versus the financial, you know, the finite supply versus the infinite supply, and

we are wrestling with that, but that is the framework which we

have been discussing it.

The CHAIRMAN. Do you have any comment on that, Chairman

Rappaport?

Mr. RAPPAPORT. Yes. I think we agree in that sense that we are

very concerned about what seems to be an effort to create what

some people have referred to as the two-tier market, the retail versus the institutional, and we wonder why a similar structure in the

securities law could not be created for the commodities. I think one

of the problems that we have all been struggling with, and I agree

with Ed Rosen before, I think the debate here, I think, is somewhat

elevated from some of the ones we have had in the past years, is

that we continue to struggle with this Commodity Exchange Act,

trying to make it work within this environment. That is a very difficult thing to do because the simple question is, as Senator Fitzgerald pointed out, why is it that I can buy one share of a tech

stock that has daily volatility of 500-percent, not unlike and perhaps a lot more than a lot of the commodities that we trade, and

I can trade that right next to Goldman Sachs and Morgan Stanley

and the most sophisticated investors in the world and there is no

issue with that. And it is one marketplace, price discovery, transparency, everybody knows where it is, and I cannot do that with

bond futures or I cannot do that with crude oil or gold, real global

commodities? I think that is a very simple question that needs to

be answered, and if it is, I think that will drive us to the solution.

So in response to the simple question, we are very concerned about

the fragmentation of the retail versus the institutional market.

The CHAIRMAN. Mr. Salzman.
38

Mr. SALZMAN. In addition to that fragmentation, I think we are

also concerned about the notion of whether you need a disinter mediated market or an intermediated market and why should that

make a difference. We have customers out there entering orders

through the internet, but they do not go directly to our market.

They first stop at an FCM’s computer, if you could call it stopping,

to have a credit check performed in a tenth of a second or even

less, and then they come into our market. It seems to us that there

is no good reason why that sort of a market ought to be treated

differently than one where the customer comes in directly and his

own credit is checked.

We actually think that there are very good reasons why intermediaries should exist in these markets, why they are the ones

best suited to actually give customers information and to deal with

customer credit, why it makes the market easier, more efficient to

operate and why it makes clearinghouses work better. Until we

fully understand why we would distinguish between those two markets, it does not seem to us we should be forced into the paradigm

adopted by the Working Group in order to get the exemption or exclusion even. It just does not—we have not seen the reason behind

it.

The CHAIRMAN. Mr. Grove and Mr. Rosen, I ask these questions

of you. How important is clearing to the over-the-counter community? Most of the users of the over-the-counter derivatives market

are large institutions that perhaps do not need clearing, may actually perceive clearing as an added expense. If OTC derivatives were

allowed to clear outside the CEA, would there be a demand for

those services?

Mr. GROVE. Clearing is an option that would be desirable for us

to have but not necessarily one that dealers would take advantage

of, at least not initially. There are other mechanisms that exist

now, such as bilateral netting, and increasing the use of collateral,

that serve some of the same purposes. But to prevent clearing for

reasons that are not compelling, in our view, would be a mistake,

and to the extent that clearing mechanisms evolve, we would certainly like the option to be able to take advantage of those mechanisms going forward.

The CHAIRMAN. Do you have a further comment on that, Mr.

Rosen?

Mr. ROSEN. No. I would just note that there are different forms

of clearing and there are different needs in different industry sectors. So, that informs the appetite for clearing, but I think it is

clearly something which ought to be there because it does provide

a benefit to the market and there ought to be a framework for it

if it is going to exist.

The CHAIRMAN. Senator Fitzgerald.

Senator FITZGERALD. Thank you, Mr. Chairman. Mr. Grove, Do

you believe that futures between sophisticated parties on non-agricultural or non-commodities, say on financial futures, between sophisticated parties on futures exchanges should be exempt from the

CEA? Would you support legislation to exempt them from the

CEA?

Mr. GROVE. Well, Senator, I support exclusion from the CEA of

OTC derivatives products that, as the Working Group report con-
39

cludes, are not susceptible to manipulation, do not serve a price

discovery mechanism and do not involve retail investors.

With respect to the issue of competition, which is raised in

Chairman Lugar’s initial question to my colleagues from the exchanges and which I think follows on what from in the direction

that you are going, the OTC derivatives market is one of the most

competitive segments of the financial markets. There are no barriers to entry other than the competence of the dealers, the competence of their staffs, their reputation and their credit standing.

My end user members would welcome even more competition, including from the exchanges, and our dealer members at this point

face significant competition. It would not matter to them. We certainly welcome greater competition for financial derivatives.

Senator FITZGERALD. So you could support legislation that would

exempt exchange-trades futures transactions involving an underlying financial instrument, as opposed to a commodity that could be

manipulated or susceptible to manipulation? Could you support legislation to exempt them from the CEA?

Mr. GROVE. I would support legislation that would exempt those

types of financial OTC derivatives products.

Senator FITZGERALD. You are saying OTC products. Futures by

definition are not OTC products. They are traded on a futures exchange. I am talking about an exchange-trade financial futures

contract, an interest rate futures contract, where the trading is between institutional parties.

Mr. GROVE. Senator, if Congress is of the view that those products can be appropriately deregulated, I would not oppose that legislation.

Senator FITZGERALD. OK.

Mr. ROSEN. Senator, may I chime in here?

Senator FITZGERALD. Sure.

Mr. ROSEN. Because I think you are asking an excellent question,

and candidly I think if you strip away all of the different perspectives that people bring to the President’s Working Group report, it

is a wonderful catalyst for this debate because what it is really trying to do is strip away the labels, on exchange, off exchange, swap,

future, and for the first time it is trying to say let us look at what

is happening. Let us calibrate the level of regulation to the policy

concerns that are raised. So when you say trading on an exchange,

one wonders what do you mean by that? But I think the question

is fair whether it is in an exchange environment or a non-exchange

environment, if the nature of the participants, the way they interact with each other, the nature of the risks presented by the trading and the contract are identical to what they would be in an OTC

context, there is not a legitimate basis for regulating them.

And candidly, I think this also answers the exemption versus exclusion question because if you believe that the basis for this treatment, whether you call it exemption or exclusion, is because you

have analyzed the products and concluded that they do not raise

policy issues of the type that this statutory framework was designed to address, then the question is what are you leaving for

somebody to exercise their exemptive authority to do? There is no

congressional directive or guidance for the execution or implementation of that administrative authority and you have sort of a free-
40

floating you can step into any crisis authority or you have a meaningless authority, and that is why the truth of the matter is that

Congress cannot escape the need if a situation arose that raised a

different set of concerns than are currently addressed under the

Commodity Exchange Act to establish the framework for addressing it. I think as a practical matter, though, there are other considerations that it is important to focus on.

These markets are populated mostly by regulated entities or affiliates of regulated entities who live in a regulated culture of

shared risk management and direct and indirect oversight. If you

look back at the LTCM event, what was of concern was not that

LTCM got a leverage and blew itself up. I mean who really cares?

What people really care about is what is the spillover effect to the

people in the marketplace and the financial community who might

be indirectly affected by that?

If you look at that landscape, the parties that were dealing with

LTCM were regulated. They were comprehensively supervised. But

we have all learned very important lessons from LTCM which will

contribute to preventing a reoccurrence from that and I do not

think we can escape responsibility for understanding that these are

markets that are maturing and there are some things that regulators can do in addressing these problems and there are some

things that they cannot do.

Senator FITZGERALD. I noted, Mr. Grove, in your testimony you

said that the ISDA has developed master documentation templates

for swaps transactions that are today used in the United States

and around the world by the vast majority of swaps participants

for their transactions. That sounds to me like these are pretty

standard contracts and that they are fungible. And yet historically,

the justification for disparate regulatory treatment between OTC

swaps and futures traded on an exchange has been, well, the futures, they are fungible, they are the same contract, but right in

your testimony you seem to indicate that really they are just a

word processed document and you are changing the names of parties and maybe the terms of whatever interest rate flow is being

swapped; is that correct?

Mr. GROVE. Most of my colleagues on the legal side wish it were

so, but I can assure you, Senator, that those agreements are heavily negotiated, sometimes for periods of many months and on into

years. The important point, though, is that those templates, those

master agreements, allow market participants to engage in, an infinite variety of OTC derivatives transactions. The economic terms

of each transaction differ from trade to trade and that is the important point.

Senator FITZGERALD. So if you had contracts where the economic

terms did not differ, say you are right now selling five banks interest rate swaps and they all want the same deal right now, then

there might be justification for some regulation there because they

would all be the same agreement? Theoretically, at least 5 banks

could get the same swap agreement if they are coming in the same

interest rate environment trying to hedge their current interest

rate exposure?

Mr. GROVE. The volumes are such that it could occur that there

would be identical transactions, but, it would be coincidental that
41

there would be identical transactions, and if there were five identical transactions, there would be tens of thousands of transactions

executed during that period of time that would be very different.

Senator FITZGERALD. So you would have no objection to putting

into this exclusion that would apply to interest rate swaps, for example, that the exclusion would not apply if the contracts were

identical, that some prohibitions so no two contracts be the same?

Mr. GROVE. Senator, that would not be workable because as a

party to a transaction, I would not know what other transactions

existed in the market. So it might be that two other banks or two

other parties were engaging in that same transaction or a transaction with the same exact notional amount, the same exact interest rate and the same exact maturity, but I would not know that

and it would be pure coincidence. It would be an unworkable——

Senator FITZGERALD. But the underlying legal documentation is

pretty standardized; isn’t it? We are really just talking about you

attach immense importance to changing these little things like exactly how much is the notional amount and exactly when the contract is going to end. I mean that is where you hang all this importance on those little tiny differences?

Mr. GROVE. That is because the contract deals with issues like

bankruptcy; what happens if a counterparts goes into bankruptcy?

Credit-type terms are dealt with in the master agreement. The economic terms vary from trade to trade and, not the credit terms are

not important, they are, But economic terms are quite important

as well.

Senator FITZGERALD. I notice that you also request that there be

some provision in the bankruptcy code and I take it to mean that

you would like something in the bankruptcy code that a defaulted

party under one of these swap transactions could not discharge

that debt in bankruptcy? Is that what you are looking for?

Mr. GROVE. No, what we are looking for—in fact, this provision

is included in the bankruptcy bill that has just recently passed the

Senate for which we are very appreciative. We are looking for provisions that further solidify the law as it now exists in the United

States which recognizes that swap transactions between two

counter parties in a bankruptcy situation could be netted down to

a single amount. This has the effect of reducing systemic risk.

What we are looking to do is bring more transactions within that

umbrella so that again if a bankruptcy does occur, more transactions can be netted down to a single number, thereby reducing

the exposure of the financial system as a whole to the bankruptcy

of that one entity.

Senator FITZGERALD. Throughout your testimony or in your

paper that you have submitted, you talk about the importance of

legal certainty and you say that there are three things you need:

clarity concerning how swap transactions will be treated under

U.S. law, certainty that they will be legally enforceable, and certainty that key provisions in swap transactions will be enforceable

even in the case of bankruptcy of one of those parties. So you keep

focusing on legal certainty, but is there not one thing, one other

thing that you want that you have not mentioned? You do not just

want legal certainty. We could give you legal certainty within the

ambit of CEA in their regulation. You might not like it, but you
42

would have legal certainty. You want complete exemption from the

CEA in addition to legal certainty; is that correct?

Mr. GROVE. We support the Working Group’s recommendations

that an exclusion is the best way to achieve the objectives that the

Working Group has set out in its report. We think that as Secretary Summers said earlier and as Chairman Greenspan said earlier, that bright line distinctions, absolute certainty, is important

in the financial markets. We need to know in good times and in

bad that contracts will be enforced, that the agreements that we

enter into in good faith, whether we are end users or whether we

are dealers, that those agreements will be enforced in accordance

with their terms.

We are skilled, particularly on the dealing side, skilled at managing market risk and we are skilled at managing credit risk. That

is our business. But legal risk is not a risk that we can manage

in any way. And, legal uncertainty, particularly in a time of market

volatility and market crisis, can undermine the confidence of the

public in the financial system of the United States and lead to systemic implications.

Senator FITZGERALD. Let me—I understand your position on

that—I want to pursue this area a little bit more on the exemption.

The report recommends that only principal trades be eligible for exclusions from the CEA and frequently refers to markets where

quote ‘‘principals are trading for their own account.’’ Is it always

easy to tell when somebody is a quote ‘‘principal trading for their

own account’’? If a firm acts as a buyer to customer one and turns

around and acts as a seller to customer two, has it really acted as

a principal or as an intermediary? What would be your position on

such transactions?

Mr. GROVE. Senator, when counter parties transact, they know

who they are transacting with. They cannot always know what

their counter party is then doing with the position and what other

trading that counter party is engaging in. And I think to suggest

that it should be the obligation of Party A to know what Party B

will do next or what other transactions Party B is entering into

would be inappropriate.

However, should there be a transaction between Party B and

Party C that raises different regulatory implications, then perhaps

a different regulatory regime should apply. In other words, if we

have an institutional transaction here and a retail transaction

there, I take your point that perhaps a different regulatory regime

ought to apply, but it is not the obligation of Party A to know what

Party B does.

Senator FITZGERALD. But put the Working Group’s report into

law, I mean it looks like there would really be nobody policing that

to make sure it is really principals trading between principals.

That one of those apparent principals is really not just an intermediary.

Mr. GROVE. Take the example of retail foreign exchange, Senator. In that case, I assume that if those recommendations of the

Working Group report were enacted into law that there would be

some mechanism in place for policing whether those transactions

were being done in accordance with the law. I would believe that,
43

that would be part of legislation or regulatory enactment following

legislation.

Senator FITZGERALD. Because then it would be governed by the

CEA?

Mr. GROVE. Because then you are into a different part of the

statute and it would be governed perhaps by CEA.

Senator FITZGERALD. But in this case, leaving aside foreign currency and so we are out of the Treasury Amendment, and you have

an interest rate swap, and you have a trade between what you

think are two principals. One of them turns around and sells to a

retail person. Who would come in to the regulate that?

Mr. ROSEN. Senator, if an exemption of an exclusion were crafted

that depended upon transactions actually being conducted as principal transactions and they were not, the CFTC has the authority

to investigate that the act is, in fact, being complied with or not.

And, if those are, in fact, not principal trades, the CFTC can take

action. The focus on the principal character of the relationship is

extremely important because there is relatively little opportunity

for abuse when you and I do not have a transaction with each

other until we have looked each other in the eye and agreed on the

terms as opposed to a situation where I ask you to represent me

in a market that is opaque to me and you come back and tell me

what you have done at the end of the day after the order has been

passed through three other hands.

If you look at the history of CFTC reparations and enforcement

and abuses, I am sure the vast majority of those problems have resided in situations where agents were representing parties and not

dealing directly with them as principal.

Senator FITZGERALD. Now this vast OTC unregulated environment that exists now and that you anticipate would continue in the

future under new legislation, I mean the exclusion would have the

effect of denying retail customers access to that market, which is

very liquid. What do you think about that? I mean what is the policy behind setting up a regime that keeps retail customers away

from that market and having no access to those available pools of

liquidity?

Mr. GROVE. Senator, this is a market, the OTC derivatives market, that is most appropriate for institutional participants. It does

involve in most cases two-way credit exposure so that if you were

a bank and I am a retail person, you would not enter into an interest rate swap with me because of my credit standing. You want to

enter into these types of transactions with entities that have a fair

degree of credit worthiness because at any given point in time the

value of the obligations could run either way.

So in that sense, it is not a market that is likely to expand into

the retail arena. But I appreciate your point about bifurcation between retail and institutional markets. Let me say, though, that to

deny the benefits of this market to American businesses, to American financial institutions, to American governmental entities, and

to prevent them from hedging their financial market and commodity market exposures in the most efficient and most effective way

possible simply to put them on a parity with individuals like me

would be an inappropriate costly step. It would deny the

benefits——
44

Senator FITZGERALD. Now you know how the exchanges feel.

Mr. GROVE. It would deny the benefits of these transactions and

that would clearly have an impact on the profitability of those companies, and those financial institutions, and on the ability of governments to deliver services as efficiently, and would obviously

have an impact on the U.S. economy.

Senator FITZGERALD. Would you guys like to comment, Chairman

Brennan or Chairman Rappaport, Mr. Salzman, from the exchange

perspective on the bifurcation of the market? Would you like to

elaborate on that a little bit more? Would you be opposed if the

Chicago Board of Trade, say the new legislation would allow you

to set up an exchange where only institutional parties could trade

financial derivatives and there would be no application of the CEA?

Would you be opposed to that?

Mr. BRENNAN. Separating out the retail from the institutional?

Senator FITZGERALD. Yes.

Mr. BRENNAN. I think we would, yes, because what drives liquidity in these markets is not only the big players, but it is all the

players I do not think that we want to get into a situation where

we exclude a certain segment of the players; everybody should have

access to that liquidity. I would be troubled by the bifurcation because some of these markets are very deep and liquid and some are

not. It depends on the product. It also depends on volatile times

and sometimes it is not always that transparent to the marketplace

who is providing that liquidity.

Senator FITZGERALD. I mean if we were to bifurcate this, I mean

you could end up just with a place for trading for institutional people or ways for institutional parties to trade and really no market

for the retail investors potentially. I mean does anybody on the

panel care to comment on that? Yes.

Mr. RAPPAPORT. Can I make an analogy that is related to the securities analogy that I made before? I mean how do you think the

securities industry would feel if the rules were that you could not

really trade stocks unless you traded above 100,000-shares and

anybody who traded less than 100,000-shares had to go through

some sophisticated entity that had good credit worthiness to trade

that? You can imagine that the price, that if you were trading

1,000-shares instead of 100,000 is not going to be as good and it

is not going to be as competitive. I think that is the situation that

we are talking about. What would happen in that situation is exactly the scenario that you laid out before is that the parties that

did not have the credit worthiness, parties like myself and Mr.

Grove, would have to go a credit worthy party and say buy this for

me.

If the marketplace were transparent enough that the price would

be readily available that we could all look at it and say, okay, buy

it for me at that price, then they would do it and then they would

do their transaction with me. How that lesser transaction would be

regulated would probably be under some more onerous level of regulation because the philosophical approach to the market would be

the retail customer has to be protected, whereas the other market

would be in this relatively unregulated environment, which by the

way we support. There are a lot of things that we disagree with

here, but it is mostly because we are at this and have historically
45

been at this regulatory disadvantage and while we understand why

the OTC marketplace is seeking this regulatory certainty and some

other advantages, clearing and some other, which I have a lot of

questions on clearing that I would like to address, you know, here

or at some other time, we understand why they are seeking that.

It is just the fact that we have never been able to get there ourselves to get that regulatory parity that sort of brings us here

today.

Mr. SALZMAN. Could I just explain? The Chicago Mercantile Exchange now operates electronic markets for its stock index products, its S&P and its Nasdaq. They are the most tremendously successful markets in terms of the time to maturity that we have ever

seen. And the great thing about these markets is that a public customer with an internet access can get the price he sees in the market by pushing a button. He can get to the front of the line by

pushing a button sooner than an institutional customer. He is exactly on a par with that customer. He sees the market equally. He

has equal access to all the prices in the market.

The only difference between him and a futures commission merchant is, as I said, his order flows through somebody else’s computer to have its credit check before it gets to our market. I think

we would be very reluctant to all of a sudden say to the retail customer you cannot have access to the same market in which the institutional people are playing because you have to have your credit

checked by somebody else’s computer or because you do not have

$10 million in net assets. So long as the person has had appropriate risk disclosure and so long as the futures commission merchant is setting a credit limit on the positions he can take, which

they do for their own protection, we do not want to see these markets fractionated. We just do not want to see them divided up. We

have nothing against what they want, I assure you.

Senator FITZGERALD. That would be much different than what we

do in the area of regular securities trading where everybody is

treated pretty much the same.

Mr. ROSEN. All of these references to the securities markets remind me of the admonition ‘‘Be careful what you wish for.’’ I think

that if the principle of securities law regulation were applied to futures, people would be very surprised with the results. Again I go

back to the President’s Working Group report, if you analyze what

the purpose of this statutory framework is, it is a different, very,

very different framework than the securities laws.

Securities laws are protective of the capital formation process.

Commodities do not give rise to information disparities in the same

way that the securities markets do and the integrity of the capital

formation process and the securities markets depends upon regulation of the informational disparities in the marketplace whoever

you are. If you go back to the history of the Commodity Exchange

Act——

Senator FITZGERALD. Well, basically inside information is legal in

trading commodities. It is legal in trading real estate. They may

know the state is going to put a new interstate right next to where

you want to put this office building. It is legal there, but we have

said it is not legal in securities.
46

Mr. ROSEN. Right. But because the essence of the use of futures

as hedging devices is trading on inside information. The very purpose of the market and the regulatory regime was to ensure that

the prices that were being discovered on the boards of trade were

accurately reflected market conditions because businesses were relying on them and the reason speculation was permitted in those

markets at all was because it contributed to the liquidity that

make those markets more vibrant, but there is a very, very great

disparity between basically commercial risk shifting transactions

and investment opportunities.

I think we have to also bear in mind that the President’s Working Group report does not require you to bifurcate the model. It allows you to build your business model. It allows you to build your

business model and says when you build your model, if you introduce factors that give rise to a legitimate public interest and regulation, then you will live with the regulatory consequences. So nobody has to drive toward that, and if the regulatory regime for the

exchange markets is rational and appropriately calibrated to the

risks and not overly burdensome, there should not be an inducement for someone to shed their traditional market participants in

order to survive.

I think that is the goal to ultimately be hoped for is that at the

end, each level of activity is appropriately regulated because as you

know, if you look at on the international dimension, you cannot get

exactly the same trade terms with every country or the same economic conditions, and if your predicate was to make all of this

playing field level, you would never have anything to do. So we

have to get focused on what the right issues are which is to make

sure that legitimate activity can be conducted with an appropriate

level of regulation that does not hold the participants back and

harm this country’s economy.

Senator FITZGERALD. I think I have gone on long enough, Chairman Lugar. So I yield to you.

The CHAIRMAN. Well, you have, I think, conducted a really very

important dialogue that has occurred I suppose behind the scenes.

It has occurred now in front of the scenes. Let me just say, and I

do not mean to diminish the importance of anything that has been

said, but some who are in the room, many of you who are participating in this hearing, will recall that about 4-years ago we attempted much more modest type of reforms principally with the

CFTC. We were not as global as the President’s Working Group,

which arose largely because of the over-the-counter difficulties that

our country and the world was facing. Of course, that was 4-years

ago. Chairman Greenspan corrected me that the Mexican was 5-

years ago—time goes by rapidly. One reason we did not progress

maybe as we should have was that, first of all, we did not have

Senator Fitzgerald who has an intense interest in the whole subject.

[Laughter.]

There was at that time, and there were other disputes, but the

board of trade and the Merc even in Chicago had very diverse

views on many of the issues, in fact, so diverse and so embattled

that most of the members of our committee were simply exhausted

by the process. They said finally our constituents are hog farmers
47

and people that are in cotton and so forth, and this is all very interesting, but by and large—this is not withstanding, Senator Fitzgerald, who is deeply interested in this—simply lost interest. They

moved on to a different agenda, but say life moves on.

Now lots of things have happened in the world subsequently, and

one of the four points of the Working Group, which is not necessarily definitive with regard to all the rest of them, is just simply

the problem of all of our markets vis-a-vis the world. In other

words, we could have a situation, I can envision, in which we are

deeply concerned defensively about who does what business on

which floor and in which way, but most if not all of it diminishes,

and as a matter of fact, we are left dealing with a smaller and

smaller pie which would be unfortunate.

Now, at this particular stage, each of you appreciate the gravity

of the issues. Everything seems to be up for grabs again, and I understand that, and Senator Fitzgerald’s questions have offered an

opportunity for advocacy and defensiveness and what have you, as

the case may be. What I hope at the end of the day might be possible, and we will hear from Chairman Rainer soon, in terms of his

recommendations, but if he has a substantial proposal that brings

significant regulatory relief to everybody that deals with CFTC,

conceivably this will be attractive.

Now other parts of the bill may be unattractive. Each of you finally have to decide at the end of the day what the pluses and

minuses are of this business because having heard this all today

and having heard it other times, I cannot find at least a path that

you weave through all of the mine fields here that will leave everybody excited about the product.

But I do think it is important to have one and so I in a general

way will say that I am determined to proceed to try to get one and

so we really appreciate the testimony you have given today as well

as very important answers on details and very specific, very technical questions. Because whether the Senate as a whole is interested in this question or not, at least the two of us are, and there

are other members, and ultimately that will probably guide whether we have a bill or not.

Now if we do not have a bill, many people would say time is not

in our favor. Maybe some of you would say, well, that is not true

of my situation, but in a way I think it probably is. Leaving aside

the jurisdiction we are talking about today, it was my privilege to

open up the New York Stock Exchange in December one day. After

I did my duty, I went down on the floor and visited with traders

and other people who are involved in that sort of thing and very

quickly they were making an argument of why what they do there

is unique and important as opposed to where else it could be done,

namely maybe on the commodity exchanges with single stock trading, for example, why New York Stock Exchange can do this better

than somebody else. I understand. I listened to their argument.

Likewise, why that stock exchange as it is important.

Now at the same time, you know, you visit, as I did the same

day, barely off the floor with people who already are envisioning

plans for handling it in a very different way. Mr. Grasso and others

understand that and they have been busy as all of you have in

managing your situations. This is changing rapidly with major
48

players who sort of pay the bread and butter of all of this and the

upkeep and so forth, but suddenly have decided the way the world

works some other way may be better. Maybe some other country.

And, that is serious.

So I take that seriously and this is why we are in the urgent

time frame of this and asking, subjecting you to all these questions.

But I appreciate your coming. Senator, do you have another comment or question?

Senator FITZGERALD. I guess we were not supposed to talk about

Shad–Johnson today. Was that the——

The CHAIRMAN. The thought was that we would take that up

after we get a report from both the SEC and the CFTC who were

asked by Senator Gramm and me and others to sort of come together jointly and they are supposed to do that I think by the 21st

of February.

Senator FITZGERALD. Well, without discussing it here, could I ask

Mr. Grove and Mr. Rosen to maybe give the Committee in writing

what their views would be on the possibility of futures on individual stocks?

Mr. GROVE. Sure.

Mr. RAPPAPORT. Be happy to do that.

The CHAIRMAN. For that matter, any of you may offer thoughts

about that. This is obviously——

Senator FITZGERALD. They like the idea.

The CHAIRMAN.—a very big issue.

Senator FITZGERALD. They do.

The CHAIRMAN. Yes. Clearly, Senator Fitzgerald points toward a

demarcation point. I know Secretary Summers asked prior to the

hearing the extent to which we would get into that and we did

mention. I mentioned in the opening statement that this is an issue

out there, but we are trying very hard once again to work on a parallel with the Banking Committee, the SEC and the CFTC in the

spirit of this Working Group, see what we can find. We have had

comments by Phil Johnson, one of the authors of the accord. My

service in the Committee and in this particular area even goes back

to visiting with Phil Johnson when he was working with John Shad

on the agreement they came up with.

Those of you who participated in our round table last year, and

Senator Fitzgerald was here, will recall some historians sort of recalling their thoughts about how permanent, how temporary, what

the conditions were, but all of this is to be revisited soon.

Well, gentlemen, I thank you very much for giving us your time

and we appreciate the attendance of all the audience that listened

in today. Thank you very much.

Mr. GROVE. Thank you, Senator.

[Whereupon, at 12:12 p.m., the Committee was adjourned.]
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