UNITED STATES OF AMERICA

 COMMODITY FUTURES TRADING COMMISSION

 VOLCKER RULE ROUNDTABLE

 Washington, D.C.

 Thursday, May 31, 2012
 2

 1 PARTICIPANTS:

 2 GARY GENSLER

 CFTC Chairman

 3

 JEFF ACOSTA

 4 Devon Energy Corporation

 5 KEITH BAILEY

 Barclays

 6

 SHEILA BAIR

 7 Former Chairperson of FDIC

 8 KURT BARROW

 IHS

 9

 CERA DAVID CASTILLO

 10 CalSTRS

 11 ROBERT L. D. COLBY

 David Polk & Wardwell, LLP

 12 Securities Industry and Financial Markets

 Association

 13

 JOSH COHN

 14 Mayer Brown International Swaps and

 Derivatives Association

 15

 CURTIS ISHII

 16 CalPERS

 17 MARC JARSULIC

 Better Markets

 18

 SHAWN C. D. JOHNSON

 19 State Street Global Advisors

 20 SIMON JOHNSON

 MIT Sloan School of Management

 21

 LARRY MAKOVICH

 22 IHS
 3

 1 PARTICIPANTS (CONT'D):

 2 STEPHAN MEILI

 Barclays

 3

 JOHN PARSONS

 4 MIT Sloan School of Management

 5 DAVID C. ROBERTSON

 Treasury Strategies, Inc.

 6

 DAN RODRIGUEZ

 7 Credit Suisse

 8 PAUL SHANTIC

 CalSTRS

 9

 DAVE SIMMONS

 10 Loomis Sayles

 11 MARCUS STANLEY

 Americans for Financial Reform

 12

 LYNN STOUT

 13 Cornell Law School

 14 WALLY TURBEVILLE

 Demos

 15

 LAWRENCE YOUNG

 16 Credit Suisse

 17 DAN BERKOVITZ

 CFTC

 18

 STEVEN SEITZ

 19 CFTC

 20 STEPHEN KANE

 CFTC

 21

 22 * * * * *
 4

 1 P R O C E E D I N G S

 2 (9:34 a.m.)

 3 MR. BERKOVITZ: Good morning, everyone.

 4 I'm Dan Berkovitz, General Counsel at the CFTC.

 5 I'd like to thank all of our panelists for taking

 6 time out of their busy schedule to participate in

 7 today's CFTC roundtable on the Volcker Rule. We

 8 are fortunate to have a wide range of panelists

 9 with extensive expertise in financial markets and

 10 financial market regulation. We look forward to a

 11 very productive discussion today.

 12 I have the pleasure of introducing

 13 Chairman Gensler, who will provide a few

 14 introductory remarks today.

 15 CHAIRMAN GENSLER: Thank you, and

 16 welcome to the Commodity Futures Trading

 17 Commission Roundtable on the Volcker Rule. Thank

 18 you, Dan, for that briefest of introductions.

 19 But no, thank you for working with

 20 Steven Seitz and Steve Kane -- Steven Seitz is

 21 with the Office of General Counsel, Steve Kane is

 22 with our Chief Economist Office -- in putting this
 5

 1 together. And I want to thank everybody from the

 2 Treasury Department and other financial regulators

 3 who are here as well. This task of implementing

 4 the Volcker Rule is a five agency, and with

 5 Treasury, a six agency effort and I think

 6 everybody's been working enormously well together

 7 in coordinating this effort.

 8 I also want to thank Sheila Bair, former

 9 chair of the Federal Deposit Insurance Corporation

 10 for participating here today. Sheila, it's so

 11 good to see you. Marty is doing a terrific job.

 12 We do miss you over at the FDIC. It's good to see

 13 you, Bob, too, as a former regulator as well.

 14 Former Federal Reserve chairman, Paul

 15 Volcker, was unfortunately not able to join us

 16 because he's on international travel, but I want

 17 to just acknowledge his many years of public

 18 service as we talk about a rule named for him I

 19 guess.

 20 In 2008, the financial system and the

 21 financial regulatory system failed; and the

 22 crisis, caused in part by the unregulated swaps
 6

 1 market, plunged the United States into the worst

 2 recession since the Great Depression. We know the

 3 results. Eight million jobs were lost, millions

 4 of families losing their homes, and thousands of

 5 small businesses closing their doors. And the

 6 financial storms continue to reverberate with the

 7 debt crisis in Europe. I think when history is

 8 told they'll look back and see these connections

 9 between the two. And the prospects of people

 10 around the globe are still very much at risk.

 11 In 2010, Congress and the president came

 12 together on the Dodd-Frank Act to promote

 13 transparency in the markets, but also to lower

 14 risk to the public from large, complex financial

 15 institutions, and part of that, not the only part,

 16 but part of it, was protection from the Volcker

 17 Rule which prohibits banking entities from

 18 proprietary trading and activity that may put

 19 taxpayers at risk.

 20 Now, this is our 17th roundtable at the

 21 CFTC. We do these on important topics. They add

 22 to the over 30,000 comments that we've received
 7

 1 and 1,600 meetings with the public we've held.

 2 And we'll have an 18th roundtable next week on

 3 promoting the price discovery function on the

 4 designated contract markets and some related

 5 issues on swap execution facilities. That's June

 6 5th for those who want to come. I don't know that

 7 it will be as well attended as today's.

 8 But in adopting the Volcker Rule,

 9 Congress prohibited banking entities from

 10 proprietary trading while at the same time

 11 permitting a number of other functions,

 12 importantly, risk mitigating hedging and also

 13 market making. So one of the challenges in

 14 finalizing the rules for the five regulators is

 15 somehow achieving these multiple objectives.

 16 Prohibiting one thing on one hand and then

 17 permitting at least these two: market making and

 18 hedging on the other.

 19 I'm looking forward to the lively

 20 discussion. I just wanted to take this

 21 opportunity to highlight three issues that I think

 22 will be very helpful, and then I'm going to step
 8

 1 away from this desk and sit with Commissioner

 2 Wetjen and Mark, if you want to say a few words,

 3 too. I don't know if I see other commissioners

 4 here, but certainly welcome to do so.

 5 So I'm going to just mention three

 6 things. First, as prescribed by Congress, the

 7 Volcker Rule prohibits proprietary trading while

 8 permitting risk mitigating hedging. These two

 9 provisions I think are consistent with each other

 10 in that they both are meant to lower risk in the

 11 banking entities. Prohibiting one thing and

 12 permitting the other might sound like they're in

 13 conflict, but they actually both go the same

 14 direction to lower risk.

 15 But the question is how we as regulators

 16 balance these two risk-lowering provisions. Some

 17 commenters have said that we're too prohibitive in

 18 one area and we may be limiting the banking

 19 entity's ability to engage in risk- mitigating

 20 hedging. On the other hand, if we were to follow

 21 comments of some of the banking entities, then the

 22 rule's allowances for permitted hedging might
 9

 1 actually swallow up Congress's intent to limit the

 2 risk of proprietary trading. So it's how we, you

 3 know, do both of these.

 4 Specifically, under the statute, banking

 5 entities may engage in "risk-mitigating hedging

 6 activities in connection with -- and the words are

 7 important -- and related to individual or

 8 aggregated positions, contracts, or holdings. So

 9 individual or aggregated positions, but it's

 10 risk-mitigating hedging. And to qualify as one of

 11 these hedges it has to be designed to reduce the

 12 specific risks to the banking entity in connection

 13 with such positions or contracts or holdings. So

 14 these are Congress's words. They're not our

 15 rule's words; they're Congress's words.

 16 So the criteria for the hedging

 17 exemption as included in the proposed Volcker Rule

 18 are basically as follows: Hedges must mitigate

 19 one or more specific risks on either individual or

 20 aggregate positions. They cannot generate

 21 significant new exposures. These are what we

 22 included in our proposed rules. They must be
 10

 1 subject to continuous monitoring and management.

 2 Compensation for the hedging cannot reward

 3 proprietary trading. And the hedges must be

 4 reasonably correlated to specific risk of the

 5 positions. And we're looking for comments on

 6 those types of criteria. Did we get it right?

 7 Should we change it? Should the final rule be

 8 different?

 9 I think a further question about hedging

 10 activity, and it was actually highlighted by all

 11 of the agencies --it happened to be question 109

 12 if anybody wants to look at it in our proposal.

 13 But everybody asks this, is whether "certain

 14 hedging strategies or techniques that involve

 15 hedging the risk of aggregated positions, e.g.,

 16 portfolio hedging, create the potential for abuse

 17 of the hedging exemption." That was written in

 18 October but that was a question that was out there

 19 in our proposal stage.

 20 A related question on which I think it

 21 would be helpful to hear: Is it possible, and if

 22 so, if it were possible, could a separate trading
 11

 1 desk with its own profit and loss statement engage

 2 in risk mitigating hedging? Is it possible to

 3 have somebody over here, you know, motivated by

 4 profits, solely by profits, actually still be a

 5 hedging desk? The further removed a hedging

 6 activity is from a specific position of a banking

 7 entity, isn't it more likely that such trading

 8 activity is prone to express something other than

 9 the hedging itself?

 10 As Dan will explain in a moment, we're

 11 not going to be speaking about the specifics of

 12 the credit derivative products trading at JP

 13 Morgan Chase's Chief Investment Office. I have to

 14 read that specifically as Dan wrote it. But I do

 15 think that it may be instructive for regulators as

 16 we finalize the key reforms, these lessons from

 17 this. Second, and shorter question, is it related

 18 to hedging.

 19 In addition to hedging is market making.

 20 Dodd- Frank permits market-making. That's key to

 21 well-functioning capital markets. It's also key

 22 to the economy. So the question is for the
 12

 1 regulators, once again finding balance. How on

 2 the one hand to prohibit proprietary trading and

 3 on the other hand permit market-making and finding

 4 that balance. Congress didn't give us an easy job

 5 I think on either of these.

 6 The agencies also asked a question. In

 7 this case it was our question number 89 that was

 8 very specific to this. In essence, would it be

 9 possible to permit market making without somehow

 10 overwhelming the proprietary trading ban? I mean,

 11 I'm paraphrasing question number 89. But we all

 12 asked it. It was the same question of how do we

 13 find the balance.

 14 The criteria for market-making in the

 15 proposed rule included seven requirements. I'm

 16 not going to list them, but a number of commenters

 17 suggested that these requirements may be more

 18 applicable to listed securities than they are to

 19 swaps. So I'll be listening closely today if

 20 there are suggestions how we at the CFTC should do

 21 this in the context of swaps. I think that some

 22 commenters have raised some very good points about
 13

 1 that.

 2 And then the third area that I'm

 3 particularly interested in hearing about is how

 4 this prohibition on proprietary trading should be

 5 applied to banking entities transacting in futures

 6 and swaps. And so this is a little bit narrow but

 7 this is the CFTC. And our goal, with regard to

 8 the Volcker Rule, is really within banking

 9 entities their futures commission merchants, their

 10 swap dealers. And so we're an agency that

 11 oversees derivatives. And we're interested in the

 12 rest of the rule, but that's our keen focus.

 13 And in particular, a banking entity's

 14 market-making in swaps is likely to leave them

 15 with significant open positions over many years.

 16 It's the nature of the business.

 17 And particularly in customized swaps.

 18 It's important to the economy. It's important

 19 that people can hedge particularized risk over

 20 many years. So then the question is when would a

 21 banking entity's decision not to hedge -- and I'm

 22 using the word "not to hedge" a swaps position or
 14

 1 only partially hedge an open swaps position. When

 2 would that be considered prohibited proprietary

 3 trading? That would be very helpful to the CFTC

 4 and I think all five agencies as we move forward.

 5 So I thank you. I sort of laid out

 6 three questions. I'm going to relax and remove

 7 myself but I don't know if Commissioner Wetjen or

 8 any other commissioners -- Mark, did you -- nope?

 9 I see no. You've saved a seat for me though.

 10 Right? All right. Dan.

 11 MR. BERKOVITZ: Thank you, Mr. Chairman.

 12 Before we begin the discussion into -- get some

 13 views on the questions that Chairman Gensler has

 14 asked and others, I just want to take care of a

 15 few housekeeping matters and a few notes.

 16 As the Chairman noted, the discussion

 17 today is a staff roundtable. Anything that is

 18 said today by the members of the CFTC staff, Steve

 19 or Steven or myself or any other staff

 20 participants, reflects only the views of the staff

 21 and not the views of the Commission.

 22 Additionally, because of the ongoing nature of the
 15

 1 rule-making process, the staff is not in a

 2 position to be able to answer questions about the

 3 rule itself or of the commission's decision-making

 4 process. The purpose of the roundtable here today

 5 is to help compile a record for the rule-making,

 6 both for the staff and the Commission as it

 7 formulates the final Volcker Rule.

 8 We encourage each of you to respond to

 9 the views of the other panelists. We want to have

 10 a very interactive discussion. And that will help

 11 us as we compile the record. If you would like to

 12 speak, just please hold up the name card and place

 13 it vertically. I also encourage everybody to use

 14 the microphone so everybody can hear. And also,

 15 for the first couple of times that you speak, to

 16 identify yourself so everybody in the audience can

 17 know who is speaking. And also for the court

 18 reporter so the court reporter can be familiar

 19 with everybody.

 20 As the Chairman noted, the CFTC a couple

 21 weeks ago announced that it is investigating

 22 certain recent events involving JP Morgan Chase's
 16

 1 Chief Investment Office. Therefore, we request

 2 that today's discussion not focus on the

 3 particulars, on the particular factual

 4 circumstances surrounding that event.

 5 Lastly, the transcript of today's

 6 roundtable will be included in our rule-making

 7 file. We invite the panelists and the attendees

 8 to submit written comments on the topics discussed

 9 today. We request that any further comments to be

 10 included as part of the record of this roundtable

 11 be submitted within two weeks of this date.

 12 Any other questions before we begin? At

 13 this point then I'd like to turn the first

 14 question over to Ms. Sheila Bair, the former chair

 15 of the FDIC who we are greatly honored to have

 16 here today. And ask for your views on the hedging

 17 exemption to the Volcker Rule.

 18 MS. BAIR: Well, thank you. And I guess

 19 I'm bringing the perspective of a former bank

 20 regulator but I should also note I am also I'm a

 21 former Commissioner of the CFTC and once served as

 22 the acting Chairman of this agency. So it's nice
 17

 1 to be back.

 2 If you could indulge me for a few

 3 minutes, I wanted to talk, perhaps provide just

 4 some general observations about the Volcker Rule

 5 again from a bank regulator perspective. You

 6 know, I don't think it's understood so much.

 7 Safety and soundness principles have always

 8 applied to insured banks, as well as bank holding

 9 companies. And so banks (inaudible) prior to

 10 Dodd-Frank and maybe those authorities weren't

 11 used as well as they should have been by bank

 12 regulators, but banks and bank holding companies

 13 are subject to standards of prudential supervision

 14 already. So I think some of this activity that we

 15 talk about, it may or may not have violated the

 16 Volcker Rule, probably should have violated the

 17 Volcker Rule, but it was not safe and sound to

 18 begin with so I think you really don't even need

 19 to get that far in the discussion because of that.

 20 The Volcker Rule really goes farther

 21 than basic prudential regulation, and I think it

 22 really says that there are certain types of
 18

 1 activities that we just don't think are

 2 appropriate inside banking organizations. Right?

 3 Whether they're prudential or not, we just don't

 4 think they belong in banking organizations. And

 5 the main challenge that I see with Volcker is that

 6 obviously when we repealed Glass-Steagall, banking

 7 organizations became legally entitled to engage in

 8 a full range of investment banking market-making,

 9 as Gary mentioned, and other activities that were

 10 traditionally conducted by securities firms that

 11 were outside of the safety net, and now they're

 12 back in the safety net and with the crisis with

 13 the major investment banks becoming bank holding

 14 companies, we particularly have this challenge.

 15 I think there are certain activities

 16 like market making where it is extremely difficult

 17 to distinguish between legitimate market-making

 18 and proprietary trading. And I fear if you try to

 19 fine tune this too much you are going to either

 20 allow too much or not allow enough. And as Gary

 21 indicated, market-making clearly is a legitimate

 22 function for financial organizations. So what I
 19

 1 have argued in the past and what I would argue

 2 again is that I think really part of the solution

 3 here needs to be for the regulators to use their

 4 powers not only on the Volcker Rule but their

 5 safety and soundness authorities, as well as their

 6 resolution planning authorities, to move gray

 7 areas, inevitably gray areas, like market-making,

 8 outside of the insured bank. Don't let insured

 9 deposits fund that activity. Because we don't

 10 know. It's very, very difficult to tell when it

 11 goes from legitimate market- making to other

 12 proprietary activities that would not be

 13 appropriate for insured deposits to support.

 14 I think a lot of people -- it's not

 15 generally understood that banking organizations

 16 are made up of a lot of different subsidiaries,

 17 and some are funded by insured deposits and some

 18 are not funded by insured deposits. But I think

 19 part of the solution here, to get to the problems

 20 that we're trying to tackle, is to move securities

 21 and derivatives activities outside into separate

 22 subsidiaries that are firewalled off from the
 20

 1 insured bank. My ideal world would be insured

 2 banks would be restricted to traditional

 3 commercial banking. They should take deposits,

 4 they should make loans, payments processing,

 5 wealth management. Those are the kinds of

 6 activities traditionally that have been conducted

 7 inside insured banks. There's a public policy

 8 interest in having insured deposits support them

 9 longstanding. That's not to say that those

 10 activities, certainly lending, cannot be subject

 11 to excess risk taking; they can be. But generally

 12 they're straightforward activities. There's a

 13 long experience with the bank managers, investors,

 14 and examiners. And I think those risks are much

 15 better understood by the market and the regulators

 16 than some of these other more complex, higher risk

 17 activities.

 18 Obviously, and this is what we saw, the

 19 troubles with JP Morgan Chase, is you're going to

 20 have excess deposits from time to time. You know,

 21 it's a particular problem now because there's been

 22 a flight to safety. People don't know where to
 21

 1 put their money so they're putting their money in

 2 insured deposits. And so there's a lot of excess

 3 deposits. There's not enough lending or loan

 4 demand to use all those deposits, and that's

 5 traditionally been the case. There's usually some

 6 level of excess deposits, so they had to be

 7 invested somewhere. But I would like to go back

 8 to the time where they really just invested in

 9 government-backed securities or very high grade

 10 liquid corporate debt. Derivatives: I would only

 11 allow an insured bank to hedge risk, specific

 12 risk. They should be plain vanilla derivatives

 13 products that are centrally cleared. I would ban

 14 inter-affiliate transactions with the insured

 15 banks and securities and derivatives affiliates

 16 where I'd like to push most of the activity that

 17 we'll be discussing today in terms of trying to

 18 fine tune where the Volcker line should be drawn.

 19 So I think there are ways to make sure

 20 that money is not upstreamed from banks to support

 21 other subsidiaries. You can use firewalls for

 22 that. And that's what I would like to see longer
 22

 1 term, just a general restructuring of these

 2 banking organizations, which I think can be done

 3 through regulatory authority. I don't think you

 4 need statutory authority to do that. Move this

 5 activity outside the insured banks, have the FDIC

 6 insured banks stick to those traditional

 7 activities that again we know have social and

 8 economic value and are well understood by

 9 management investors, as well as regulators.

 10 So that said, I understand that that

 11 would be a major restricting that would change

 12 certainly a big change from how megabanks

 13 currently operate. So we do need a robust

 14 application of the Volcker Rule to the entire

 15 banking organization, I think, until we can try to

 16 get some of this activity away from the insured

 17 deposit functions.

 18 So to your specific question, the way I

 19 would approach hedging is I would tighten the

 20 rule. I think a hedge should not be allowed

 21 unless you identify when you put the position on

 22 that it is a hedge. You identify the specific
 23

 1 risk that you are hedging. I think the banking

 2 organization, they should be required to show to

 3 regulators that there's a reasonable correlation

 4 between the hedge and the underlying risks that

 5 they are trying to hedge. I think the

 6 identification of the hedge and the underlying

 7 risk should be publicly disclosed. You don't have

 8 to disclose specific reference names, but I think

 9 the fact that these are hedges and these are the

 10 types of underlying risks that these are hedging

 11 should be publicly disclosed. I think the

 12 methodology that the holding company uses to

 13 determine that there's going to be a correlation

 14 to be disclosed when the position is put on, and I

 15 think there should be continuous disclosure of how

 16 that hedge is performing and the degree of

 17 correlation and whether it's panned out.

 18 I think, you know, if you could have a

 19 macro hedge that met those requirements, I'm kind

 20 of skeptical that you could, fine. If you can

 21 have a hedge that you can show is going to

 22 correlate to your entire financial institution,
 24

 1 I'm skeptical that could happen. But you would

 2 need to disclose that. You would need to show how

 3 the hedge performed over time and whether there

 4 was a variation.

 5 Again, I think also where I would really

 6 tighten the rule is in how it deal with

 7 compensation. I would ban any compensation based

 8 on hedging profits. If it's a good hedge, you

 9 probably should lose money. Right? You know, you

 10 do not want anybody in the banking organization,

 11 especially the risk managers, having their

 12 compensation in any way influenced by hedging

 13 profits.

 14 So I think with those two -- those would

 15 be the two basic principles I would apply, and I

 16 think by removing employees' financial incentives

 17 to make market bets to the guise of hedging,

 18 you're going to get rid of a lot of the problems

 19 that you're seeing right now. And similarly, a

 20 transparency and investor scrutiny of these

 21 banking organizations' hedging strategies and

 22 whether they actually perform according to the
 25

 1 methodology that they use I think will do probably

 2 a lot more than any very detailed prescriptive

 3 rules.

 4 So that is the basic approach I would

 5 take, and I do think the rule needs to be

 6 tightened in certain areas to get to that result.

 7 MR. STANLEY: I'm Marcus Stanley from

 8 Americans for Financial Reform.

 9 Just to follow up on some of the things

 10 Sheila said, I think that the Lincoln Amendment or

 11 the swaps pushout provision which is also coming

 12 down the pike and will be implemented before the

 13 Volcker Rule or before the compliance period for

 14 the Volcker Rule has ended actually, clearly shows

 15 that the Dodd-Frank Act and intention in the

 16 Dodd-Frank Act to push, as she said, non-hedging

 17 swaps out of the depository subsidiary. And

 18 there's also a hedge amendment in the Lincoln

 19 Amendment. And I think that needs to be aligned

 20 with the hedge exemption here.

 21 Just a few other things that Sheila

 22 pointed out, that hedging should not be a profit
 26

 1 center, essentially. And I know we're not going

 2 to discuss the specifics of the Chief Investment

 3 Office at JP Morgan, but it was clearly a profit

 4 center, a major profit center for the bank for

 5 years. And that should have sort of made

 6 oversight of it or the determination of whether it

 7 was engaged in hedging fairly straightforward for

 8 regulators, even though it doesn't seem to have

 9 done that.

 10 And in terms of the compensation, I

 11 think one specific change that needs to be made in

 12 the rule is right now the rule states that

 13 compensation arrangements of persons performing

 14 risk mitigating hedging exemptions are designed

 15 not to reward proprietary risk taking. And I

 16 think that word "designed" has to be changed to

 17 "do not." So do not reward proprietary risk

 18 taking, because otherwise you're in for a sort of

 19 endless legal fight over, well, it did, in fact,

 20 reward proprietary profits but it wasn't designed

 21 to do that.

 22 And just the final thing, I think the
 27

 1 list of things that Sheila listed there is

 2 actually fairly close to the conceptual list

 3 that's already in the rule. You just have to make

 4 sure that those conceptual things of not adding

 5 additional risk, being associated with a specific

 6 risk that's being hedged and so on, which are

 7 already conceptually in the rule, are enforced on

 8 a very tight basis. And the administrative

 9 requirements are in there and documentation

 10 requirements are in there to ensure that that is

 11 there for every single hedge.

 12 MS. BAIR: I would just -- I think the

 13 rule -- thank you. I really like those comments.

 14 This rule doesn't require any public

 15 disclosure as I can tell, but I want this

 16 disclosed. You require a correlation. You

 17 require that we disclose to regulators. But I

 18 think financial analysts and investors need to

 19 know what the methodology is and whether these

 20 correlations are actually performing. You also

 21 restrict, and you're right, the language on the

 22 compensation is very fuzzy, and I would say
 28

 1 betting on hedging profits, not proprietary

 2 profits, then you're going to get into a debate

 3 about whether this hedge was proprietary or not.

 4 You don't want compensation based on hedging

 5 profits period. Hedges are not supposed to be

 6 there to generate profits. They're supposed to be

 7 hedging being -- they're supposed to be there to

 8 hedge underlying risks that you already have.

 9 MR. BERKOVITZ: A couple questions on

 10 those points. One is the second point actually is

 11 what I was going to ask. If we -- if the rule

 12 would say prohibit compensation based on hedging

 13 profits, are we essentially saying, or were you

 14 essentially saying, that if it's a true hedge it

 15 shouldn't be a profit center at all, let alone

 16 whether traders are making compensation from it?

 17 MS. BAIR: You don't want people in risk

 18 management having their decisions influenced on

 19 whether the hedge is going to make money. Their

 20 focus should be on whether the hedge is going to

 21 reduce the risk. That's what the statute says;

 22 that's what good bank management says.
 29

 1 MR. BERKOVITZ: Lynn.

 2 MS. STOUT: Thank you. My name is Lynn

 3 Stout. I'm a professor at Cornell University, and

 4 I also have the qualification that I wrote an

 5 article in 1995 called "Betting the Bank: How

 6 Derivatives Trading Under Conditions of

 7 Uncertainty Erodes Returns and Increased Risks in

 8 Financial Markets." So I'm very pleased to be

 9 here today, although unhappy about the

 10 circumstances that have led us all here.

 11 I want to talk a little bit about the

 12 cost and benefits of the rule, and particularly

 13 put it in a broader context. Essentially, the

 14 reality of derivatives is that they are literally

 15 wagers between people. And it's been recognized

 16 by the law for some hundreds, perhaps thousands of

 17 years, that while wagers can be used for

 18 insurance, wagers can also be used to attempt to

 19 speculate, to earn profits by predicting the

 20 future better than other people do. The problem

 21 with speculation is that it is a zero sum game.

 22 When I am hoping to buy low and sell high and I'm
 30

 1 dealing with a counterparty who also hopes to

 2 profit from buying low and selling high, the sad

 3 truth is one of us must inevitably be wrong. This

 4 is not an Adam Smith market in which both parties

 5 have a benefit. And therefore, it is not also a

 6 socially beneficial market. So I think it's

 7 important to bear in mind in addressing regulation

 8 of derivatives that the focus of your agency

 9 should be on social costs and benefits and not on

 10 private costs and benefits. And I think that's

 11 very important to bear in mind.

 12 Now, focusing on the social costs and

 13 benefits of derivatives, when they are used

 14 primarily for speculation, there's a lot of

 15 evidence that, in fact, over-the-counter

 16 derivatives were used primarily for speculation --

 17 we've seen a lot of increase in risk and very

 18 little increase in return -- when they're used for

 19 speculation, that is clearly a dramatic social

 20 cost. And indeed, I've seen estimates of the

 21 social costs of the risk that was added to the

 22 system by deregulating over-the-counter
 31

 1 derivatives that are as high as $13 trillion. It

 2 would take a heck of a large hedging benefit to

 3 offset those social costs. And what I simply want

 4 to point out is that in looking at the so-called

 5 economic benefits of hedging, it is very easy for

 6 them to be exaggerated. Even if we focus on

 7 hedging by commercial end-users, I think it's

 8 worth bearing in mind that many of these end-users

 9 are publicly traded corporations, and hedging

 10 against specific risks does not provide any

 11 benefit to their diversified shareholders at all.

 12 But quite apart from that problem, if

 13 you have hedging, it is actually likely that that

 14 could lead to at least three kinds of problems.

 15 The first problem is that frequently hedges are

 16 likely to prove to be mistaken hedges. And

 17 indeed, we've seen several very large and

 18 expensive examples of that. People think they are

 19 adequately hedging when, in fact, unbeknownst to

 20 them, they're actually taking on more risk. This

 21 occurs because derivatives are, in economic terms,

 22 fundamentally common value assets and they are
 32

 1 being auctioned off to the highest bidder, meaning

 2 that the person who wins and ends up owning a

 3 particular derivative or hedge is likely to be

 4 afflicted by what we call the "winner's curse."

 5 In layman's terms, what that means is that hedging

 6 may not be moving risk to the person who can bear

 7 it most easily, but in fact, is moving to the

 8 person who perceives it most poorly.

 9 A second problem is that when you are

 10 hedging with someone who is not, in fact, a

 11 regulated sale of insurance, you are often trading

 12 price risk for counterparty risk because you don't

 13 know if your counterparty will be able to make

 14 good on the supposed hedge. So when you take

 15 these considerations into -- when you take account

 16 of these considerations, I think the bottom-line

 17 is we come out with recognizing that anything like

 18 a portfolio hedging exemption makes it extremely

 19 difficult to police the line between what is

 20 fundamentally speculative activity and what is

 21 true hedging. It is in the social interest,

 22 clearly, even if not in necessarily the interest
 33

 1 of all the trading parties, that the CFTC adopt

 2 rules that are very strict and err on the side of

 3 precluding activities that are described as

 4 hedging in the interest of preventing extremely

 5 socially-costly speculation. Thank you.

 6 MR. ROBERTSON: Hi. My name is Dave

 7 Robertson, and I'm a partner with Treasury

 8 Strategies. And I'm here to represent the voice

 9 of corporate treasurers. We're a consultancy that

 10 assists corporate treasurers and CFOs in managing

 11 risk and operations on a global basis. And I

 12 wanted to take issue with the concept of the

 13 social good of hedging. When it comes to an

 14 individual company, there might be a theoretical

 15 diversification of risks for a holder of equities,

 16 but for an individual company to ensure that it

 17 has adequate liquidity, that can have a stable

 18 array of profits that it can use to make capital

 19 investing decisions, these entities do need access

 20 to risk hedging instruments. And I think the

 21 biggest concern that corporate treasurers with

 22 whom we work have around the Volcker Rule is that
 34

 1 currently corporate treasurers enjoy a highly

 2 liquid, very transparent, lots of price

 3 information around hedging. And to the extent

 4 that they get better and better at getting

 5 visibility into their cash flows as they expand

 6 globally, as they take on capital projects with

 7 mismatched maturity cash flows, they are relying

 8 upon hedges to invest and create opportunities for

 9 the economy.

 10 And I think it's notable to compare the

 11 U.S. with its robust capital markets to other

 12 economies, like the European economy where there

 13 is more of a concentration of activities in the

 14 banking sector and a less robust capital markets

 15 sector. What we find is that the actual level of

 16 cash held on the balance sheets of European firms

 17 is 33 percent greater proportionally than a U.S.

 18 Firm. And in essence, while there's cash

 19 accumulating on balance sheets due to economic

 20 uncertainty and risk, what corporations do when

 21 they can't hedge risk is they hold cash on the

 22 balance sheet as a natural hedge against risk.
 35

 1 You can see where the pharmaceutical company that

 2 has massive R&D swings, all you have to do is look

 3 at the cash balances. And the biggest concern

 4 that corporate treasurers and CFOs have about the

 5 Volcker Rule is that it may impair their ability

 6 to do legitimate hedging activities. This would

 7 require them to hold greater cash on their balance

 8 sheets, and in essence, that would further

 9 contract the economy. Thank you.

 10 MR. BERKOVITZ: Wally.

 11 MR. TURBEVILLE: Thanks. Wally

 12 Turbeville, Demos.

 13 I've accumulated a couple of comments.

 14 I'll try to do them quickly.

 15 On the issue of hedging and conceptually

 16 discussing hedging, I think it's really important

 17 that the rules, as in their final form address

 18 more clearly the interplay between the concept of

 19 correlation and the concept that the chairman laid

 20 out earlier that's explicitly in the rules which

 21 says that the inception of a hedge, no significant

 22 risk that's not immediately reduced, be put on.
 36

 1 So the fact of the matter is that what purports to

 2 be a hedge can be correlated but can add risk to

 3 the entity. And a correlated position that adds

 4 risk over and above what the entity had going in,

 5 that's simply taking a position that wasn't

 6 permitted in the first place by the Volcker Rule,

 7 which is a new risk position that has to be

 8 addressed.

 9 I had the experience in the energy

 10 sector of watching trading desks -- gas,

 11 electricity, and oil products -- when their board

 12 said no more proprietary trading, just hedging,

 13 which just induced the desk to take on risks

 14 through purported hedges. And again, not going

 15 into great detail about what happened in London,

 16 that's the perfect example, just conceptually,

 17 assuming that what happened happened.

 18 So the whole notion that what purports

 19 to be a hedge is truly a hedge is truly

 20 risk-reducing and is not simply a way to take on a

 21 risk position is very, very important to weave

 22 together with a concept of correlation of other
 37

 1 things that are in the rules. And then the

 2 language now, I read it as being very effective

 3 that there's no new risk but others perhaps don't

 4 in the conversation. So obviously, clarification

 5 is needed.

 6 Just quickly, Mr. Robertson's discussion

 7 was analytically sound in that a derivative is

 8 designed to offset a risk. The tradeoff is

 9 between a derivative and cash. But it's

 10 fundamentally unsound, with all due respect,

 11 because the way I look at a derivative is it's a

 12 synthetic form of borrowing money. And so the

 13 tradeoff between cash reserve and hedging a risk

 14 by the derivative, and the literature, in the

 15 academic literature basically it's a push,

 16 although I looked at the leading article on it and

 17 found five different valuation issues associated

 18 with the derivatives that the leading academics in

 19 the field missed. So that valuation tradeoff is

 20 very important and very ill understood by

 21 corporate treasurers throughout the United States

 22 and by even the leading academics. So I think we
 38

 1 should not be shy about addressing the fact that

 2 derivatives are not necessarily the be all and end

 3 all.

 4 MR. BERKOVITZ: We had Jeff first.

 5 MR. AGOSTA: This is Jeff Agosta. I'm

 6 the CFO of Devon Energy, and we are a North

 7 American oil and natural gas producer. And I take

 8 exception to Mr. Turbeville's characterization of

 9 derivatives as a form of borrowing money. I think

 10 that they are, in fact, an instrument that we

 11 implement and use to ensure a base level of cash

 12 flow for our firm. Contrary to public opinion, we

 13 don't get to pick the price of oil and natural gas

 14 that we produce and sell, and so to have the

 15 ability to lock in a certain level of cash flows

 16 is very important for our firm to be able to make

 17 capital allocation decisions.

 18 And I agree with Mr. Robertson's

 19 characterization that if we don't have that

 20 ability, then we are going to be more conservative

 21 in our capital allocation decisions and our

 22 budgeting decisions, and therefore, we're going to
 39

 1 be less willing to expose and expand our activity.

 2 MR. BERKOVITZ: I think we had Simon

 3 next.

 4 MR. SIMON JOHNSON: Thanks. I wanted to

 5 ask David Robertson to clarify the remarks he made

 6 just now because I found that somewhat puzzling.

 7 First of all, perhaps you could share with us the

 8 study, the details with regard to the European

 9 firms having excess cash, and particularly how

 10 that's related to the lack of hedging availability

 11 or restrictions on the activities of, I guess,

 12 European banks, or perhaps there's some

 13 segmentation between those banks and the other

 14 global megabanks.

 15 Certainly, what we know about the

 16 European banks -- some of whom are represented

 17 here today, they can speak for themselves -- what

 18 we know is they have a very large integrated

 19 banking and securities operation. And they have

 20 some of the biggest exposures to over-the-counter

 21 derivatives in the world, and many of these banks

 22 are quite frankly in serious jeopardy now, partly
 40

 1 through their own mismanagement and partly through

 2 circumstances beyond their control.

 3 Now, to Sheila Bair's point about the

 4 need for a firewall, I completely agree. If

 5 Morgan Stanley, for example, moves derivatives

 6 from its trading operation to its insured bank,

 7 which it reportedly has done and under

 8 circumstances that have not been explained by the

 9 Federal Reserve or any other responsible

 10 regulator, I don't see how that makes the economy

 11 safer. If you were putting a subsidy -- these are

 12 insured deposits -- you're subsidizing these

 13 trading activities. You are building up danger.

 14 The worst thing that can happen to your companies

 15 is another financial crisis. That's what's

 16 debilitated the economy. That's what Chairman

 17 Gensler talked about. That's eight million jobs

 18 lost. That's thousands of companies smashed. You

 19 don't want that. You want a safe market-based

 20 trading system, not the ability of the megabanks

 21 to blow themselves up with excessive subsidies.

 22 Thank you.
 41

 1 MS. BAIR: Yeah, just to build on that.

 2 I think we do need to distinguish between

 3 constraining activity that is supported by insured

 4 deposits and constraining activity generally.

 5 What I'm suggesting is market-making derivatives

 6 and securities be moved and firewalled away from

 7 the insured bank. They can still -- and I don't

 8 think anybody's taking about restricting in any

 9 major way legitimate hedging by non-financial

 10 commercial entities-- but I would like to see

 11 that. I don't think insured deposits should

 12 support that. I think they should go to the

 13 private market and raise capital, get market

 14 participants to support, to provide the funding

 15 they need for that service. I don't think insured

 16 deposits should support that. That is not to say

 17 we don't think it should happen at all, but the

 18 insured deposits skew economic allocation. And if

 19 they're using borrowed money that's backed by the

 20 government, you know, I've had -- without

 21 mentioning any names -- I started making some

 22 inquiries about whether a certain bank their very
 42

 1 large positions and CDS indices whether those were

 2 centrally cleared. And I was told, well, for

 3 (inaudible) CDS indices, clearing houses won't

 4 take them. They don't know how to manage the

 5 risk. So I'm thinking to myself, why is that

 6 going on inside an insured bank? If a

 7 clearinghouse cannot figure out how to manage the

 8 risk, why in the world are we allowing that to

 9 happen inside an insured bank supported by insured

 10 deposits? I think that's really the issue.

 11 MR. BERKOVITZ: Kurt.

 12 MR. BARROW: I just wanted to -- sorry,

 13 Kurt Barrow with IHS. I just wanted to reiterate

 14 and build on something Jeff said, and that is I

 15 think there is a lot of negativity, you know,

 16 around the word "derivative." But the reality is

 17 what we found is that energy companies, both

 18 producers and energy consumers, including, you

 19 know, major industries like airlines, trucking

 20 companies, railroads, actually use these hedging

 21 instruments in a very professional and very useful

 22 way. And I don't think I have to explain to
 43

 1 everybody the volatility in energy prices that we

 2 have in our world today. And what we found really

 3 is that a lot of the activities that we take for

 4 granted, in particular, the very low price of

 5 natural gas, it's really stimulating manufacturing

 6 activity in this country. You know, a lot of that

 7 wouldn't have come about. It would be a lot more

 8 difficult for companies to do that. And we would

 9 have higher energy prices really without some of

 10 the risk management services that these banking

 11 entities provide. And I guess in our discussions

 12 with some very smart people in the industries,

 13 primarily I'm speaking to the energy industries,

 14 it's not clear to us, you know, exactly, you know,

 15 what would happen if the banks exited this space.

 16 And really, the way the exemptions are written

 17 now, they're really so narrow that a lot of that

 18 activity, you know, would likely get curtailed.

 19 So, thanks.

 20 MR. BERKOVITZ: I'd like to recognize

 21 Dan, and also thank Dan and Credit Suisse for

 22 participating in the panel discussion today.
 44

 1 MR. RODRIGUEZ: Thank you, Dan. I

 2 appreciate the opportunity to come here and speak

 3 to you on this very important topic and also to

 4 meet a lot of the principals involved in

 5 developing these new rules.

 6 To give you guys a flavor of kind of

 7 where we've been moving, I tend to agree. I mean,

 8 I think Simon Johnson just made a, you know,

 9 pretty passionate point for making the system

 10 safer.

 11 By way of background, I'm the chief risk

 12 officer for America's Equities. So I am involved

 13 in making sure that we do have correct hedges and

 14 I'd have to agree with a lot of the points that

 15 Ms. Bair just made. Correlation is important.

 16 The methodology for evaluating those hedges is

 17 important. Those should be examined by the

 18 regulators. I would support that. And I think

 19 anybody who is involved in those hedging

 20 activities should be able to answer those

 21 questions with a fair degree of confidence. I

 22 will say though that hedging in general,
 45

 1 correlations are very idiosyncratic. They can be

 2 fairly challenging of how to do that and implement

 3 that in reality.

 4 So, you know, how do you measure

 5 correlation? Should it be daily, weekly, monthly,

 6 over what time period should you measure that

 7 correlation? So a lot of, you know, challenges

 8 are involved in doing effective hedging. But

 9 because something is challenging, you know, having

 10 a business, operating a major oil and gas producer

 11 is challenging. You know, being a power

 12 generation company is challenging. We have to

 13 deal with challenges every day that we go to work.

 14 What I'd say is that derivatives and hedging

 15 activities help us meet a lot of those challenges.

 16 So I vehemently disagree with the

 17 comment made earlier that the derivatives -- you

 18 know, two comments, I guess. One comment, the

 19 derivatives are a way of borrowing money. For a

 20 lot of our clients, we actually provide

 21 derivatives, especially now in the recent

 22 environment, for protection on their portfolio.
 46

 1 We're providing risk- mitigating instruments for

 2 clients and we are reducing the risk. In addition

 3 to that, we're reducing the risk -- have been

 4 reducing the risk in our own portfolio by an

 5 emphasis more -- not necessarily more on the

 6 spirit of the Volcker Rule, which is to make the

 7 system safer. And I would just emphasize the

 8 whole Basel III approach. And there's a very good

 9 paper by Darrell Duffie on the Volcker Rule, which

 10 emphasizes, you know, three alternatives for

 11 making things much safer. One, there's much more

 12 capital for the banks. Two is better liquidity,

 13 funding liquidity for the banks. And three is

 14 just increase supervision of the banks. So those

 15 three items I think are difficult.

 16 I'm from a bank. I'm a banker and I'm

 17 saying that yes, we need more capital. Yes, we

 18 need better funding liquidity. Yes, supervise us,

 19 come in and ask us more questions about what we're

 20 doing and how we're doing it. We need all those

 21 things. Why? Because of what Simon just said, is

 22 that, you know, the world, the global financial
 47

 1 system now has to continue to become safer. I

 2 think that the Volcker Rule is an opportunity to

 3 move in that direction. I think Basel III and

 4 those requirements are a better way potentially of

 5 doing that or a complementary way with the Volcker

 6 Rule.

 7 So to answer the questions earlier that

 8 the chairman had posed -- can you have a hedging

 9 desk that focuses on idiosyncratic risk and

 10 aggregated portfolio risk? Can that been an

 11 effective desk? And I would say yes. It has to

 12 be managed very carefully and it should be

 13 monitored and supervised very carefully by the

 14 regulators. So I would say there are challenges

 15 in there and I'm happy, you know, to go into more

 16 detail separately. But there are challenges

 17 involved in hedging both a portfolio and

 18 idiosyncratic risk.

 19 Two examples of idiosyncratic risk I

 20 think that might be relevant for this panel, we

 21 have a number of energy folks here. You know, the

 22 major airlines have to hedge out their jet fuel
 48

 1 exposure. Right? If they are effective at

 2 hedging out their jet fuel through jet fuel swaps

 3 and derivatives, you know, puts and calls on jet

 4 fuel, that actually smoothes out their earnings

 5 stream and actually reduces ticket prices.

 6 I was able to fly down this morning from

 7 New York to D.C., you know, a relatively

 8 inexpensive flight, coach, of course, on Delta.

 9 And I think about that and I look at the energy

 10 guys here. Why is that? Why was that flight so

 11 cheap? Part of the reason is because of

 12 derivatives. Derivatives are not, you know, an

 13 evil instrument. They're an instrument for good.

 14 They can be used as an instrument for evil as

 15 well. You know, so when you're cutting fruit with

 16 a knife, that knife can be a very effective tool

 17 for cutting fruit, but it can also be used

 18 incorrectly and cause problems. So in order to

 19 mitigate the problems that can be caused by

 20 derivatives, you need better supervision, better

 21 understanding of how those instruments are used.

 22 And I agree, in the past the industry has tended
 49

 1 to misuse those instruments and we have to be

 2 more, you know, cognizant of the potential

 3 problems that can arise from that. And how do you

 4 mitigate the problems that can arise from bad

 5 hedging? More capital, better liquidity, more

 6 supervision.

 7 MR. BERKOVITZ: What I'm going to try to

 8 do is get everybody in the first round before we

 9 go to second round. Shawn, I think.

 10 MR. SHAWN JOHNSON: Thank you. And

 11 thank you for having me today. My name is Shawn

 12 Johnson. I'm the chairman of the Investment

 13 Committee for State Street Global Advisors, and

 14 I'm here today representing the Association of

 15 Institutional Investors, a collection of the

 16 largest and oldest buy-side shops. And I thought

 17 I would give a slightly different perspective than

 18 what you've heard today.

 19 We collectively manage money for

 20 retirement funds, 401(k) plans, individuals

 21 throughout the United States, certainly more than

 22 100 million people across all of our association
 50

 1 members. At SSGA, just to give you some

 2 perspective, we manage approximately $400 billion

 3 in cash, about $260 billion in other fixed income

 4 instruments, and about $900 billion in equities.

 5 So as you're starting to restructure how the

 6 financial markets work, we have a vested interest

 7 in that on behalf of our clients.

 8 And I've been trying to think about the

 9 best way to explain what worries us. And the best

 10 perhaps way to do that is through an example. And

 11 that would be if we had a client call us and say

 12 we need a billion dollars today because we're

 13 making an asset allocation change and we want to

 14 pay some retirees; our traders will get a list of

 15 150 CUSIPs. We'll send it over to maybe a Credit

 16 Suisse and Barclays who I think is here as well.

 17 They'll give us a bid. They'll give us a billion

 18 dollars and we'll make our client happy.

 19 In this proposed regulation I'll give

 20 them both the list but first, they're going to see

 21 who they can sell it to immediately. So maybe

 22 they can move a half a billion dollars, and the
 51

 1 other half a billion they're going to have to take

 2 down themselves, which means they have to put

 3 principal capital at risk to take that trade in a

 4 market- making activity.

 5 Now, it was my understanding of the way

 6 this is going to impact them, the next thing he'll

 7 do is he'll call me back and say, okay, I've got

 8 500 placed. Give me a minute. I've got to figure

 9 out how to hedge the other 500. And the bid on

 10 the other 500 is going to involve the cost of all

 11 of his required hedging and compliance and

 12 everything else. So I'm going to turn around and

 13 those costs will be borne by the retirees as they

 14 (inaudible) spreads in the marketplace, assuming

 15 he can even find adequate hedges for what I'm

 16 asking him to hedge. So it may be that I have to

 17 call the client back and say, sorry, I can only do

 18 500 today. You're going to have to wait until I

 19 can get the rest of the 500 placed. So the

 20 practical implications of what you're trying to do

 21 falls on a very interesting population set that I

 22 don't think has had a voice yet in the debate.
 52

 1 I also think wearing a different hat, we

 2 are one of the largest shareholders. In fact,

 3 we're a top 10 shareholder of every large bank in

 4 the United States. As a shareholder, I have an

 5 interest in how banks mitigate their risk, not the

 6 first of which is to define what risk is. I think

 7 regulators and folks in Washington have a short

 8 memory. The last time banks were simply -- or

 9 bank-like entities were simply taking deposits and

 10 making loans, we had the savings and loan crisis.

 11 The fact is, a diversified bank is a safer bank.

 12 It is safer as an investor and it is safer as a

 13 regulator. So I'm concerned if banks go backwards

 14 to be concentrated as only deposit institutions

 15 and lending institutions. I think we'll just have

 16 another savings and loan-like crisis. It'll just

 17 be 15 years from now.

 18 So I wanted to give two different

 19 perspectives -- one as an investor and one as

 20 making trades for our clients, which I don't think

 21 has been articulated in the debate yet.

 22 MR. BERKOVITZ: John, I think you've had
 53

 1 your card up.

 2 MR. PARSONS: Yeah, John Parsons from

 3 MIT. And thank you very much for the opportunity

 4 to be here and participate.

 5 I'm a little taken aback. We were

 6 talking about the Volcker Rule and now we're

 7 talking briefly about corporations being able to

 8 hedge. And I frankly didn't really see exactly

 9 how that's related. The United States pioneered

 10 the derivatives markets and made them a major

 11 institution in American in the 20th century before

 12 that, but also in the 20th century. Pre-repeal of

 13 Glass-Steagall when financial institutions were

 14 not doing the kind of -- the depository financial

 15 institutions that Sheila Bair was talking about --

 16 were not doing the kind of proprietary trading

 17 that we're talking about here. Non-financial

 18 corporations were able to find financial

 19 intermediaries to assist them in hedging without

 20 needing to put taxpayer funds at risk. I don't

 21 see any conflict between those two things at all.

 22 As Simon pointed out, trying to create a safe
 54

 1 financial system serves the interests of

 2 non-financial corporations.

 3 In September 2008, one energy company,

 4 Constellation, was in a financial crisis because

 5 it needed an injection of cash. But September

 6 2008 was a tough time to go looking for cash. If

 7 we could avoid a financial crisis, we could serve

 8 the interests of non-financial corporations

 9 hedging and doing all of the other things that

 10 they do much more successfully.

 11 So I think the issue at hand is how to

 12 make a safe financial system precisely so that we

 13 can serve the interests of companies in all of the

 14 various different financial services that they

 15 need.

 16 I want to then just make a couple more

 17 technical points in response to some of the

 18 questions that have been raised. Mr. Robertson

 19 mentioned a study, and I'd be very interested in

 20 seeing it. It's not a study I'm familiar with.

 21 It sounds very odd. I'm not sure what distinction

 22 I'm talking about between European and U.S.
 55

 1 Corporations. Is BP a European corporation? If

 2 so, it does a vast majority of its trading in

 3 derivatives inside the United States. Shell does

 4 the same thing. Statoil is a state-owned oil

 5 corporation and one of the leading risk managers

 6 in the energy markets. So I'm just not sure where

 7 we're coming from in trying to blame the

 8 distinction between European and U.S. corporations

 9 on the availability of depository institutions

 10 providing taxpayer backstop to derivative

 11 transactions.

 12 And then the last point I'd like to just

 13 touch on is one of the very specific questions

 14 that introduced this discussion about portfolio

 15 trading -- portfolio hedging and the statutory

 16 language about single or aggregate positions.

 17 Technically, it seems to me you certainly can

 18 hedge an aggregate position and there's no

 19 conflict between the terminology of hedging and

 20 hedging being portfolio hedging. They're not

 21 necessarily a conflict. As long as we do the type

 22 of things that Sheila Bair was describing about
 56

 1 placing requirements on what defines a hedge,

 2 something that can be specified, something where

 3 the correlation is quantified, something where

 4 it's monitored, you can do that on a single or an

 5 aggregate position. The public needs to be aware,

 6 however, that it is true that the industry tends

 7 to utilize the term "portfolio hedging" in an

 8 entirely different way. The industry uses that

 9 term to describe trading and transactions that it

 10 can't quite quantify, specify, and prove are

 11 hedges. And it's important that the regulators

 12 who are writing these rules, write them in a way

 13 so that portfolio hedging is truly hedging, it

 14 satisfies the type of criteria that were being

 15 described, and not allow in a term which basically

 16 allows anything to go under the label of hedging.

 17 Thank you.

 18 MR. BERKOVITZ: Josh.

 19 MR. COHN: I'm Josh Cohn for Mayer Brown

 20 here today on behalf of the International Swaps

 21 and Derivatives Association.

 22 This has been thus far a very
 57

 1 interesting and wide-ranging conversation. I'd

 2 like to try to bring it back to a specific statute

 3 because we do have a specific statute. And the

 4 specific statute, of course, protects the swaps

 5 intermediation business in banks in covered

 6 banking entities. Let's just say covered

 7 entities. It also protects the hedging function

 8 in those entities. That's specific in the

 9 statute. We also have, of course, in the statute

 10 a specific reference to hedging aggregate risk.

 11 Aggregate has a plain meaning. I think that Mr.

 12 Parsons just spoke to the plain meaning and the

 13 ability of that plain meeting to encompass

 14 portfolio hedging. And portfolio hedging is, in

 15 fact, practiced and for the most part practiced

 16 effectively in many financial institutions right

 17 now. In fact, I would refer us all to the CFTC

 18 final rule on swap dealer recordkeeping and

 19 reporting at 77 Federal Register 20136, which

 20 specifically recognizes the virtues in some

 21 institutions of consolidated hedging and provides

 22 for consolidated risk management programs.
 58

 1 Moving along to hedging as a function, I

 2 think it's important to remember there are no

 3 perfect hedges. There is no hedge that you can

 4 put in place that doesn't create another risk

 5 unless you sell exactly the same transaction that

 6 you bought or vice versa. You're always creating

 7 a new risk. The question is: what is the risk?

 8 How risky is it? Fundamentally, what is the cost

 9 benefit of that risk in a hedging analysis? That

 10 is, has it made things safer? Has it not made

 11 things safer?

 12 Now, hedge needs and values change.

 13 There's recognition in the preamble to the release

 14 accompanying the proposed regulation that's quite

 15 clear on the ability, in fact, the need of an

 16 institution to dynamically hedge, to be changing

 17 its hedge positions over time. Each time a hedge

 18 position is changed there's P&L. There's profit

 19 and loss. We can't be saying -- we can't really

 20 be saying that we want derivatives dealers to lose

 21 money each time.

 22 Which brings me to a third point about
 59

 1 the derivatives market, and that is that

 2 derivatives markets are low liquidity markets.

 3 We're not talking about markets where there is a

 4 regular pair in bid ask or revenue from customers.

 5 We're talking about relatively infrequent trades.

 6 If we're expecting dealers to run their businesses

 7 on a fundamentally economically efficient

 8 inefficient basis, we're going to find ourselves

 9 with far fewer dealers and far higher prices.

 10 Lastly, where does that leave us? We

 11 have a statute. We have a statute that says no

 12 proprietary trading on the one hand. On the other

 13 hand it says yes to hedging and it says yes to

 14 intermediation in derivatives. Where I think it

 15 leaves us is with a regulatory conversation that

 16 each swap dealer, each swap market maker as it

 17 were, needs to have. The market maker has to be

 18 discussing what its activities are in connection

 19 with its market making. It has to be discussing

 20 what its hedging is. It has to be describing

 21 reasonable correlation. It has to be describing

 22 specific risks. And our regulators have to be
 60

 1 involved in the process of overseeing how a

 2 covered entity deals with these challenges, and

 3 there has to be a process of accord going forward.

 4 I think perhaps along the lines, Dan, that you

 5 were describing.

 6 So I've probably taken enough time for

 7 first round.

 8 MR. BERKOVITZ: Marc.

 9 MR. JARSULIC: Just a couple of points.

 10 First of all, I think one of the things that is

 11 sometimes lost in the discussion of the Volcker

 12 Rule and the motivation for it is the historically

 13 demonstrated risk that this poses to large bank

 14 holding companies. And I think one really good

 15 index of the risk that it poses is the amount of

 16 funding that had to go out the door from the

 17 Federal Reserve to preserve the dealer banks. So

 18 if you add up the funding from the term

 19 securities' lending facility, primary dealer

 20 credit facility, and the repo lending that the Fed

 21 did, at its peak there was about $433 billion

 22 outstanding. So there's pretty good evidence
 61

 1 that, in times of stress, the trading operations,

 2 the big trading operations in dealer banks are

 3 highly unstable and pose a real source of systemic

 4 risk. So there's not just a risk to firms,

 5 there's a risk to the financial system as a whole.

 6 So there's a very strong motivation for trying to

 7 limit the risk that the dealer functions inside

 8 banks shift onto the public and onto the financial

 9 system.

 10 I would say that in terms of the

 11 specific thing we're addressing this morning,

 12 which is the permitted hedging inside the banks

 13 that will be done by these dealers, the two points

 14 that were raised by Sheila Bair were

 15 extraordinarily important. The incentives for

 16 people to make large gains from trading, of

 17 course, extend to hedging behavior. And so the

 18 notion that compensation for the people who are

 19 executing the hedging function can't come from

 20 gains and losses in hedging, is extraordinarily

 21 important. But I think it's also important that

 22 the hedging function not be a long-term profit
 62

 1 source for the bank as a whole and that the

 2 regulations explicitly say that.

 3 Secondly, the notion of reasonable

 4 correlation is something that truly needs to be

 5 spelled out. In common law, you know, there's a

 6 well defined legacy of what a reasonable man is.

 7 Right? You can look to a long history of case law

 8 and say, you know, this person acted reasonably,

 9 this person didn't. In terms of reasonable

 10 correlation or reasonable risk reduction that a

 11 hedging position exhibits, I think there is no

 12 history here. So since we're starting de novo, we

 13 really need to say what's a reasonable reduction

 14 in risk that a hedging position needs to take in

 15 order for it to qualify for this exemption. And I

 16 know that's very difficult, but it seems to me

 17 that if it's not possible for the firms that are

 18 putting on hedges to initially demonstrate what

 19 the hedge is related to and how risk is being

 20 reduced, then it doesn't qualify.

 21 So one of the things that you might do

 22 when you're looking at the regulations as their
 63

 1 written is to go beyond saying you must document

 2 the hedge and what it's related to, but you must

 3 document how the risk is being reduced. And if I

 4 may, the notion that this could all be handled by

 5 capital in the bank, I would say, yeah, if you can

 6 get the leverage ratio for big bank holding

 7 companies down to five, then I think that you're

 8 going a long way to controlling the risk posed by

 9 broker-dealers. If Basel III does that, that

 10 would be great. It doesn't look like it's going

 11 to come anywhere near that. But there is an

 12 option inside the statute that would allow you to

 13 impose leverage limitations on the dealer

 14 function.

 15 If you look at 619(d)(2), I think, or

 16 2(d), there are provisions which say that no

 17 permitted activity can threaten the safety and

 18 soundness of the bank or financial stability. So

 19 if you look back at the history of the instability

 20 of the dealers inside bank holding companies, they

 21 have historically posed a real threat so you might

 22 consider say margin -- sorry, leverage
 64

 1 requirements for the dealers in order to reduce

 2 the risk that they pose to the holding companies

 3 in the financial system as a whole. Thank you.

 4 MR. BERKOVITZ: Okay, why don't we go

 5 Wally, then Simon, then David, and Dan.

 6 MR. TURBEVILLE: Yeah, thanks. The

 7 point was raised about dynamic hedging and the

 8 language that's in the regulations concerning

 9 dynamic hedging. Again, I think there's

 10 correlation and then there's different types of

 11 correlation. Correlation isn't all one kind of

 12 thing. So the challenge is to take a very

 13 explicit part of the proposed regulation that says

 14 this must be risk reducing, meaning at the

 15 inception of the hedge, no additional risk should

 16 be introduced into the bank by virtue of doing the

 17 hedge. And then you have to look at the other

 18 discussion of dynamic hedging and what that means.

 19 I think it's a bit of a "strawman" to articulate

 20 that there's no perfect hedge. There are perfect

 21 hedges. Not every hedge is going to be perfect

 22 and there's going to be residual risk associated
 65

 1 in the underlying position once a hedge is put on

 2 from time to time for sure.

 3 But the real question is whether you're

 4 going to put on a position, a risk position, and

 5 thereby avoid and evade the Volcker Rule just

 6 because you've said, oh, no hedges are perfect,

 7 which is not true actually and is very dangerous

 8 if you let that sort-of intellectually migrate out

 9 to the circumstance where you allow a purported

 10 hedge to create a great new risk. Again, that

 11 large financial institution operating out of

 12 London, that's the kind of thing that's really,

 13 really problematic. So I think that we need to

 14 get past a simple sort-of talking point that no

 15 hedges are perfect and really talk about how this

 16 should work in the real world so that no

 17 significant risk is introduced at the inception of

 18 the hedge when it occurs. That does beg the

 19 question of what dynamic hedging means in the

 20 rules. We can go into great detail about that

 21 because dynamic hedging is supposed to manage

 22 risks that were laid on at the time the purported
 66

 1 hedge existed. That contravenes the other

 2 language that talks about no new risk. But

 3 dynamic hedging can mean other things, too,

 4 because actual, real-world correlations might

 5 change from time to time as opposed to risks

 6 introduced at the time the purported hedge was

 7 laid on. I think this is a very important point

 8 and one that shouldn't be just glossed over by

 9 generalized statements.

 10 MR. SIMON JOHNSON: Thanks. I would

 11 just like to reinforce the point made by Marc just

 12 a moment ago about leverage limitations. I think

 13 we're actually agreeing that these are very risky

 14 operations. In fact, Josh laid out the reasons

 15 why hedging can create volatility in earnings.

 16 And we know from recent historical experience that

 17 this volatility can be big relative to the macro

 18 economy. So the most sensible way to deal with

 19 this is to require -- is to have tough leverage

 20 limitations, to require more equity and less debt.

 21 And if Sheila Bair was still here I think she

 22 would also make these points about overall balance
 67

 1 sheet. We should be looking more at leverage

 2 ratios and less at risk-weighted assets.

 3 Just to, also for the record, perhaps

 4 Mr. Chairman, Dan mentioned the paper by Darrell

 5 Duffie. I think we should recognize that there

 6 was a paper commissioned by SIFMA, even though

 7 Darrell Duffie is an independent academic. He

 8 does, and I have the same issue actually with the

 9 IHS paper which I understand was commissioned by

 10 Morgan Stanley. Kurt can correct me. In both of

 11 these papers, I don't find any explanation or

 12 analysis of why markets won't evolve to, as John

 13 Parsons said, draw on this deep tradition of

 14 strong, independent markets as opposed to having

 15 so much of the derivatives business concentrated

 16 over-the-counter in banking entities or

 17 bank-related entities.

 18 And to Shawn's point, I'm sure you're

 19 right that we'll always have banking crises, and

 20 perhaps in the future there will be another

 21 version of the savings and loans crisis. But the

 22 savings and loans crisis did not threaten to bring
 68

 1 down the world economy. The crisis of 2008

 2 centered around large diversified banks, almost

 3 brought this financial system to its knees. And

 4 as Chairman Gensler said at the beginning, still

 5 threatens a third of the world's economy in

 6 Europe. So I don't understand how taking these

 7 risks onto the balance sheet, these dealer-

 8 intense repeated, clearly demonstrated, dealer

 9 risks onto the balance sheets of banks and

 10 bank-related entities with a great deal of

 11 leverage, leverage at current levels, or leverage

 12 even close to Basel III. We should be talking

 13 more about the capital requirements of

 14 Switzerland, which has moved far ahead of Basel

 15 III. I would go even further than what's

 16 currently required for Credit Suisse and UBS in

 17 the U.S. context. Thank you.

 18 MR. ROBERTSON: Thank you. I just

 19 wanted to address two points. One was just to

 20 provide some background on the study around the

 21 corporate cash since there have been a couple

 22 questions about that. Each quarter Treasury
 69

 1 Strategies monitors the level of corporate cash.

 2 We also go out, and we interview and survey

 3 corporations in Europe and the U.S. as to what's

 4 going on with their cash, how is it composed,

 5 where are they getting the uses of it, what do

 6 they plan to do with it? And we've been tracking

 7 this before the crisis and following the crisis

 8 and it's quite fascinating because as you might

 9 expect, cash is accumulating on balance sheets.

 10 It's doing that obviously for economic

 11 uncertainty, lack of prospects, but also due to

 12 higher risk in the environment. And if you were

 13 to look today, the U.S. corporations hold about 14

 14 percent of their GDP on the balance sheets of the

 15 legal entities in the U.S. as compared to Europe

 16 where it's 21 percent of the legal entities of

 17 GDP. So in essence, proportionally there's a

 18 third greater holding in Europe.

 19 Now, you could analyze all kinds of

 20 reasons for that. We've really dug into this, and

 21 as far as we can tell, there are several aspects

 22 to the U.S. economy that make it a more liquid
 70

 1 market and enables corporations to do their

 2 business and conduct their business with less cash

 3 on the balance sheet. Some of this is actually

 4 due to very robust secondary markets. To the

 5 extent that the Volcker Rule impairs the ability

 6 of banks to underwrite or others to underwrite

 7 securities and hold them in inventory, that would

 8 reduce the access to liquidity. And as well, to

 9 the extent that financial risk cannot be hedged,

 10 we do see companies put cash on their balance

 11 sheet to hedge risks. And all you have to do is

 12 actually look at the proportion of cash to

 13 revenues by industry segment and correlate that to

 14 the level of operating risk and cash flow

 15 volatility of those firms and you'll see a very

 16 clear correlation between the level of cash on the

 17 balance sheet and the level of un-hedgeable risk

 18 flowing through that firm's cash flows.

 19 So that's the primary point that we're

 20 most concerned about. I think we don't want to

 21 conflate the idea that because corporate treasury

 22 wants access to robust financial markets, that
 71

 1 means that they don't want prudent regulation and

 2 that they want to see another financial crisis.

 3 Clearly, that's not the case. However, I think

 4 corporate treasurers and CFOs do want access to

 5 these instruments and I think as many of the

 6 practitioners in this room have pointed out,

 7 there's quite a bit of activity that goes into the

 8 liquidity of these markets, the accessibility, the

 9 speed of executing the transactions. Keep in mind

 10 that a corporation that's going to engage in a

 11 hedge needs to figure out the accounting for it

 12 under FAS133. And they need to be able to do that

 13 quickly, so they can't wait for prices to come

 14 around and be created. They need the pricing in a

 15 very liquid market.

 16 So our concern again is not that this

 17 market should not be regulated, but that it be

 18 regulated in a manner that preserves the

 19 liquidity, the speed, the transparency, and the

 20 price robustness of the market. Thank you.

 21 MR. CASTILLO: David Castillo from

 22 California State Teachers Retirement System.
 72

 1 As an end-user, we just want to

 2 encourage better disclosure in the derivatives

 3 market. I mean, we're all talking about

 4 significant changes. We don't know yet whether

 5 it's going to make a better market, a worse

 6 market. We do know there's not very good

 7 disclosure and information in derivatives,

 8 especially OTC markets. We were talking about

 9 banks and balance sheets. A lot of this stuff

 10 doesn't start off on the balance sheet. It's only

 11 when it comes out of the shadows that it's on the

 12 balance sheet. And I think we need to have

 13 regulators in a marketplace that has much better

 14 information about what all the participants are

 15 doing, but especially banking institutions and

 16 institutions that stretch globally. And the

 17 markets do stretch globally and we want to

 18 encourage disclosure and getting better

 19 information flow about what's out there. And then

 20 we can evaluate whether or not these participants

 21 are adding value or detracting value, adding risk,

 22 taking away from risk. But our position is to get
 73

 1 better disclosure out there. Thank you.

 2 MR. BERKOVITZ: Curtis, you had yours

 3 up.

 4 MR. ISHII: I'm Curtis Ishii. I run the

 5 fixed income operation at CalPERS.

 6 I want to just make sure and pretty much

 7 restate some of the things that have been said

 8 before. I think we're very supportive of what

 9 Sheila was talking about. We think it's very

 10 important for alignment of interests to be

 11 properly done and I think her thought of not

 12 making or making sure that compensation is not

 13 tied to profitability of hedges but to what

 14 they're supposed to be doing, which is risk

 15 reduction, is important. And I think David had

 16 some really good points. We would argue that

 17 transparency and the development of quantifiable

 18 measures, some ways in which you can monitor from

 19 multiple viewpoints of what is going on in this

 20 area, we find that disclosure in this area is very

 21 minimal. We would recommend that institutions

 22 disclose more and not just -- this will help you
 74

 1 as regulators because if you allow the investment

 2 community to know more, there's more eyes on

 3 what's going on and you'll have greater scrutiny

 4 and then you need to probably have some sort of

 5 group that begins to have a discussion early on

 6 what people are beginning to see in the markets.

 7 MR. BERKOVITZ: When you're talking of

 8 disclosure, are you talking about disclosure to

 9 regulators or public disclosure or both types of

 10 disclosure?

 11 MR. ISHII: We are -- I think we're

 12 both, but what I was speaking to more is public

 13 disclosure. We find that the current disclosure

 14 by various financial institutions to be

 15 tremendously wide. If you look at the disclosure

 16 document by Bank of America, it's very extensive

 17 because they're under a lot of scrutiny. You

 18 compare that to someone like Goldman or something

 19 like that and it's very nebulous. We find that

 20 there aren't a lot of quantifiable measures being

 21 disclosed to investors and we would encourage an

 22 establishment of much more standardization across
 75

 1 the industry so that we can understand or at least

 2 begin to quantify some of the risks that are going

 3 on and we would, you know, it would help, I think,

 4 this entity monitor. And then we're talking about

 5 volume discussions. We're talking about net

 6 exposures. We're talking about it could be even

 7 something about counterparty, their counterparty

 8 exposures. The more quantifiable measures that

 9 you have and the greater scrutiny, the greater

 10 transparency we find in a number of markets, it

 11 helps bring more eyes to bear and it exposes more

 12 of the potential risks that are in various

 13 markets.

 14 MR. CASTILLO: Yeah, I just back exactly

 15 what Curtis said. We've gone from a market that

 16 has none of the above when it comes to disclosure,

 17 and we want to go to all of the above. And let's

 18 move that paradigm from disclosing nothing to

 19 maybe we'll get too much disclosure, but that

 20 would be a welcome change from where we are today.

 21 MR. STANLEY: A bunch of points have

 22 been made, and I just want to start out by saying
 76

 1 a lot of the things I'm about to say are also in

 2 Americans for Financial Reform's written comment

 3 on the Volcker Rule.

 4 But the first thing I wanted to say is

 5 very connected to what David and Curtis -- the

 6 point David and Curtis just made, which is the

 7 issue of liquid markets, especially in customized

 8 and over-the-counter derivatives. And I was sort

 9 of concerned to hear various comments that seemed

 10 to imply that continued activity in highly

 11 illiquid markets would be permitted under the

 12 Volcker Rule. It's sort of a general thrust of

 13 the Dodd-Frank Act, all of Title 7 of the

 14 Dodd-Frank Act, that we want to move derivatives

 15 onto exchange-trade markets where possible. Deep

 16 liquid markets with good transparency because they

 17 occur through exchanges with transparency of

 18 counterparty risk because they are cleared. So

 19 you just need to know about the exposure to the

 20 clearing house and not necessarily the entire web

 21 of counterparty risk that happens when you get

 22 uncleared derivatives.
 77

 1 And I think that's a risk reduction

 2 focus in Title 7, and that focus needs to also be

 3 picked up in the Volcker Rule by trying to limit

 4 bank activities to exchange-traded standardized

 5 transparent types of derivatives with deep liquid

 6 markets. And I think I'm not going to be able to

 7 be here for the market-making discussion, but I

 8 think it gets very difficult to enforce the

 9 various market-making metrics if you don't do that

 10 because there isn't good pricing information. I

 11 mean, as we sit here there is a big international

 12 bank whose London office cannot get out of its

 13 derivatives positions because it's in an illiquid

 14 market. It can't find anyone to take the other

 15 side of the trade. So that, you know, if we

 16 needed any illustration, that's, you know, the

 17 issue.

 18 And I was kind of concerned to hear

 19 Chairman Gensler in the opening discussions say

 20 that it's necessary for swaps dealers to hold

 21 large, unhedged positions as dealers. In other

 22 words, not to maintain a balanced book for long
 78

 1 periods of time. And I suppose that might be

 2 connected to dealing in over-the-counter kinds of

 3 markets. But that to me, it becomes very

 4 difficult to tell the difference between dealing

 5 and market-making and proprietary speculative

 6 trading when you do not have a balanced book.

 7 And just some of the other points I

 8 wanted to make quickly. Correlation. A couple of

 9 people have touched on this. I think an

 10 over-emphasis on correlation alone instead of a

 11 real economic connection between what's the

 12 instrument that's being hedged, the position being

 13 hedged and the hedge would be a real problem.

 14 There's all kinds of software out there right now

 15 that just sort of searches through all the assets

 16 and instruments on the market to see what's the

 17 cheapest instrument that has a correlation that's

 18 over a certain level, even if there is no economic

 19 connection whatsoever. You know, if, so I think

 20 it would be a big mistake to just rely on some

 21 kind of mechanical correlation number and not have

 22 some kind of requirement for a real underlying
 79

 1 economic connection because the primary worry of

 2 the regulator needs to be about stressed markets.

 3 And in stressed markets, correlations that aren't

 4 based on fundamental economic connections

 5 disappear and they disappear quickly.

 6 And one thing, when we talk to traders

 7 about this, and it's kind of unfortunate Occupy

 8 the SEC isn't here because they've got some really

 9 good ex-traders on their staff, but when we talk

 10 to traders, one thing they say, including hedge

 11 fund traders, is that we know when there's a

 12 hedge. We know when a position is a hedge and

 13 when it's not a hedge. There are very

 14 standardized kinds of hedges for different asset

 15 classes, and I think one thing that should be

 16 considered is just building up a database of what

 17 those standardized hedges are based on real

 18 underlying economic connection and providing a

 19 safe harbor for really trustworthy, reliable

 20 hedges that are just on their face, hedges.

 21 MR. BERKOVITZ: Shawn.

 22 MR. SHAWN JOHNSON: I just wanted to
 80

 1 give an example of sometimes hedging isn't a good

 2 idea and also very hard to do. For example, if we

 3 try to sell a $500 million five-year CD in a

 4 French bank, I need to get liquid in that. And I

 5 have somebody on the other side trying to take it

 6 down, somebody at Credit Suisse perhaps. Under

 7 the current proposal, they'll look at that.

 8 They'll either try to sell it or they're going to

 9 have to hedge the fact that they've got a

 10 five-year CD position against a French bank.

 11 Now, I can think of some things that

 12 might be correlated, to your point, but there

 13 isn't a good one. I mean, but his risk department

 14 and his regulatory department is going to force

 15 him to hedge. So what's he going to do? Buy a

 16 five-year credit default swap against SocGen? You

 17 know, I don't -- which is about 100 times more

 18 volatile than the security of asking him to take

 19 on a principal basis.

 20 So what we wrote in our comment letter

 21 is that there needs to be a distinguishing

 22 definitional issue between what is proprietary
 81

 1 trading and what is principal-based market-making

 2 activities. And perhaps it's under that

 3 definition of "you know it when you see it." But

 4 the regulators could very easily distinguish those

 5 types of activities so that he can take a

 6 principal-based position in certain types of

 7 securities and maybe you have to limit leverage

 8 and these other things. I have no problems with

 9 that. But the idea is there needs to be principal

 10 capital being placed into the market. They need

 11 to be able to make a reasonable economic return

 12 for having placed that capital in the market. If

 13 they don't, over time they will exit those

 14 markets, find some other place to make money, and

 15 the liquidity that's provided into the

 16 marketplace, both in the form of derivatives or in

 17 the form of cash-based securities will wane.

 18 There may eventually be other market participants

 19 that come in to provide that liquidity. It may be

 20 hedge funds. It may be other types of capital.

 21 And maybe at very, very different prices. But

 22 they need to be able to on that bank side, be able
 82

 1 to take principal-based activities.

 2 MR. BERKOVITZ: Lynn, you had your card

 3 up.

 4 MS. STOUT: I want to make just a few

 5 short points. One thing is that I've been looking

 6 at this issue for a good decade, and one thing

 7 that has struck me as extremely odd is the absence

 8 of any dollar figures that are attached to the

 9 supposed value of allowing derivatives trading

 10 generally for hedging and particularly by deposit-

 11 taking banks. So it's not because the industry

 12 has not spent money or is not willing to spend

 13 money generating studies. So I think that when

 14 you're looking and weighing the costs and benefits

 15 of a rather strong regulation that takes a very

 16 restrictive view of what is hedging as opposed to

 17 a more lax regulation, I think it's certainly

 18 within your rights to consider the fact that the

 19 industry has had a decade and lots of money to

 20 generate some sort of evidence that would allow

 21 you to attach an actual dollar figure to the cost

 22 side.
 83

 1 I will just repeat, once I was

 2 testifying for the Senate Agriculture Committee on

 3 very much this issue and I was astonished to hear

 4 someone from Cargill get up and testify that the

 5 absence or restricting their ability to use

 6 derivatives to hedge would require them to

 7 maintain a larger cash amount. And this would

 8 cost them $7 million a year. And to hear someone

 9 complaining about $7 million a year increased cost

 10 at a time when we were in the middle of a $1

 11 trillion bailout was somewhat shocking to me. So

 12 I'd really like, and I invite the industry to

 13 produce some studies that attach an actual dollar

 14 figure to the supposed economic benefits of

 15 hedging, particularly hedging that is done through

 16 deposit-taking banks.

 17 As a second point, I just want to second

 18 what John Parsons and Simon Johnson have both

 19 side. History teaches us that it's not as if

 20 there are people who are going to disappear and be

 21 unwilling to offer hedging services if

 22 deposit-taking banks are not allowed to do it.
 84

 1 Let me just point out that we've had two

 2 longstanding industries that have performed the

 3 function of offering hedging opportunities. One

 4 is called the Commodities Futures Exchanges and

 5 the other one is called the insurance industry.

 6 So it's not as if there's any shortage of private

 7 actors who would be willing to perform these

 8 services if taxpayer subsidized banks were not

 9 willing to perform them. There might be a

 10 temporary period of adjustment until competitors

 11 arise, but I am quite confident based on business

 12 history that competitors will arise.

 13 Number three, I want to reinforce Sheila

 14 Bair's point that the best way to judge whether a

 15 division in a bank is truly hedging or, to the

 16 contrary, indulging in speculative proprietary

 17 trading is to look ex ante at whether that

 18 division is generating profits. If they are

 19 generating profits, I think that's prima facie

 20 evidence that they are not, in fact, hedging.

 21 Hedging is buying insurance; insurance costs

 22 money.
 85

 1 And my last point is I just want to

 2 simply respond to the suggestion people have made

 3 that there is no such thing as a perfect hedge.

 4 We call it insurance. The hedging/trading

 5 distinction is one that has been dealt with by

 6 insurance law, again, for centuries. Insurance

 7 law takes a very restrictive view, will not treat

 8 something as a hedge that is an enforceable

 9 insurance contract unless you actually own the

 10 underlying that you have essentially bet against.

 11 So there are more restrictive definitions

 12 available to the Commission should it want to

 13 adopt them. Thank you.

 14 MR. RODRIGUEZ: I just want to give a

 15 couple of examples. I'm sorry, yeah. I want to

 16 give a couple of specific examples on the perfect

 17 hedge. I've just been writing down a bunch of

 18 notes. First, on the perfect hedge argument

 19 brought up by several of the participants here,

 20 two specific examples that Credit Suisse has been

 21 involved in this year. I think it's out there in

 22 the public record. We took on I think about $6
 86

 1 billion of the mortgage-backed securities that the

 2 Federal Reserve wanted to get out into the

 3 marketplace. I think it's an example where the

 4 Volcker Rule is already working. I mean, we were

 5 already kind of under the guise that we were going

 6 to go ahead and try to lay off as much of that as

 7 possible. And as Shawn has illustrated in several

 8 very good examples of how the real market works.

 9 I know there's a lot of faculty here. You know, I

 10 respect the faculty. I used to be a faculty

 11 member myself in a former life, and I think it's

 12 very important to have outstanding research when

 13 you're actually conducting transactions and doing

 14 these in the marketplace on a day in, day out

 15 basis. You know, it's a little bit different than

 16 I think what's being suggested here.

 17 If there is -- I'll give an example,

 18 that $6 billion of mortgage-based securities. At

 19 that point in time, very difficult to hedge out

 20 that entire risk other than to lay it off. So our

 21 goal is to get rid of as much as possible as

 22 quickly as possible. And whatever little residual
 87

 1 there is, to hedge that out as effectively as

 2 possible. Our goal is not to take on a lot of

 3 risk onto our book. Our goal in that case is to

 4 be a true market maker, to facilitate the

 5 transaction, and help taxpayers get their money

 6 back.

 7 The second transaction was with AIG.

 8 There was a large block trade. Credit Suisse,

 9 Morgan Stanley, Citibank, the first round. Each

 10 of us took $1 billion of AIG stock. That's a

 11 matter of public record. So what do you do with a

 12 billion dollars of AIG stock? How do you hedge

 13 that? Where's the perfect hedge for that? The

 14 perfect hedge is to sell a lot of the AIG stock.

 15 The other hedges are, you know, there are some

 16 correlations. A number of instruments, as

 17 mentioned here earlier, you know, and we're going

 18 to use those instruments to the best of our

 19 ability to manage our risk, and to keep that risk

 20 profile as tight as possible, which we have been

 21 doing.

 22 And to Shawn's other point here which I
 88

 1 like, measuring risk, how do you measure risk? It

 2 is something that I'm involved in on a daily

 3 basis. There are a number of different ways to

 4 measure risk. I like the approach. We've been

 5 talking to the Fed on a number of Volcker metrics.

 6 How do you measure these various risk metrics

 7 across a portfolio? And doing that on an

 8 interactive basis, you know, iterative basis. So

 9 what's a good risk measure for this type of

 10 activity? There's going to be multiple risk

 11 measures and I think -- and the optimal risk

 12 measures evolve over time and it is, in fact,

 13 dynamic. And the problem is some of these

 14 correlations in a stress environment do disappear

 15 or appear. So you may actually have a hedge on

 16 that doesn't look like it has a correlation now

 17 but if you have a stress event, all of a sudden

 18 you do get a correlation. So these things have to

 19 be looked at on an interactive basis, dynamic

 20 ongoing basis. And I do believe there has to be a

 21 continuous dialogue between the supervised

 22 entities and the supervisors.
 89

 1 And I would say on the deposit, you

 2 know, I hear the phrase "taxpayers subsidize

 3 deposit-taking banks." Now, at Credit Suisse,

 4 we're here and I guess we'd come under the Volcker

 5 Rule not because we're FDIC -- we have FDIC-backed

 6 deposits, but because we're interested in -- we do

 7 have access, I guess, to the Fed window, the

 8 discount window. And in that case there is some

 9 indirect subsidy through that channel. We don't

 10 have any FDIC-backed deposits. However, we are

 11 very much in favor of a safer, you know, financial

 12 system. But I think supporting these activities

 13 and supporting banks to continue to provide those

 14 markets is going to be very important. If you ask

 15 a lot of our clients -- I would say go to our

 16 clients -- you know, CalPERS, State Street, a lot

 17 of the energy companies that are conducting this

 18 hedging -- ask them if they want to not have

 19 access to these activities. And I will say, as

 20 has already been indicated, that that's not the

 21 case.

 22 Now, to address Simon's point about
 90

 1 Darrell Duffie, I just wanted to make sure for the

 2 record here, you know, this paper, it was

 3 commissioned by SIFMA. However, the commission

 4 for that was donated to the Michael J. Fox

 5 Foundation for Parkinson's Research. And he made

 6 that very clear when he came to present that

 7 paper, you know, for risk managers across the

 8 industry a few months back. And the title of that

 9 paper, "Market Making under the Proposed Volcker

 10 Rule." I know in the morning session we were

 11 talking about hedging. He does address that. And

 12 I just wanted to read his section. He's a Dean

 13 Witter distinguished professor of finance at the

 14 Graduate School of Business at Stanford

 15 University. And his statements on this, the

 16 agency's proposed implementation of the Volcker

 17 Rule in the most stringent case would reduce the

 18 quality and capacity of market-making services

 19 that banks provide to U.S. investors. Investors

 20 and issuers of securities would find it more

 21 costly to borrow, raise capital, invest, which is

 22 -- to Shawn's point about the retirees being
 91

 1 impacted and basically every corner of the capital

 2 market is being impacted -- hedge risk and obtain

 3 liquidity for their existing positions.

 4 Eventually, nonbank providers of market-making

 5 service would fill somewhere all of this lost

 6 market-banking capacity but with an unpredictable

 7 and potentially adverse impact on the safety and

 8 soundness of the financial system.

 9 Basically, pushing a lot of that

 10 risk-taking into the unregulated, unsupervised

 11 segments of the marketplace. Now, you know, that

 12 could lead to a lot of other problems that we're

 13 not aware of. So the issue is: do you want to

 14 have good visibility of the risk taking that's

 15 going on on the system? Or do you want to push it

 16 out to the corners and dark reaches of the

 17 financial system and have random blowups that

 18 we're not going to be aware of? You know, we're

 19 here today -- I know Barclays did show up but the

 20 other banks have not shown up -- we're here today

 21 because we're here to engage. Right? We want to

 22 have a dialogue, and I think this is pretty
 92

 1 constructive. And from my seat here it seems that

 2 we're a lot closer than people think. We, more

 3 than anyone, want a solid financial system. We're

 4 trying to do things to move that.

 5 And to refer back to 2008, you know, the

 6 system is very different. Yes, in 2008, there was

 7 far too much risk-taking. In 2012, you know, who

 8 knows the optimal level of risk taking for the

 9 global capital markets? I don't think that's a

 10 very tall order to know what that level is. We

 11 know they were too high in 2008. We don't know

 12 where we are. We need to get lower. We are

 13 moving lower.

 14 And just one last comment on this.

 15 Consistent profits. The one comment was made that

 16 if you have a hedge desk and it makes profit, then

 17 it's not a hedge desk. It so happens to be the

 18 case that the hedge, you know, a lot of hedge

 19 desks right now have been making profits over the

 20 last four to five weeks. Now, why is that?

 21 Because there's been a pretty dramatic sell-off in

 22 the marketplace. So just because a hedge desk
 93

 1 happens to make money for one month or one

 2 quarter, when the market was selling off very

 3 sharply, it does not necessarily mean that's a

 4 profit center. It means it's a hedge. Hedges

 5 sometimes make money and sometimes they lose

 6 money. Now, if you have a hedge desk that is

 7 consistently generating outsize profits, then

 8 that's something on an ongoing basis over an

 9 extended period of time, then that's something

 10 that probably should be investigated further by

 11 the regulators. Thank you.

 12 MR. BERKOVITZ: Now we have Kurt and

 13 Jeff and Josh.

 14 MR. BARROW: Thanks. Yeah, I just want

 15 to respond to a couple points. I guess first on

 16 our study. It was commissioned by Morgan Stanley.

 17 It was an independent piece of work, and we

 18 completely stand behind all its findings. And I

 19 guess Professor Stout, I'd point you to our study.

 20 It's one where we did actually try to quantify

 21 with real numbers, 200,000 jobs in just a

 22 subsector of the energy space. So this is not the
 94

 1 total commodity space, certainly not any of the

 2 activities that the bank, the Volcker Rule would

 3 impact outside of the commodity space. It really

 4 looked at just the subsector of the energy space,

 5 and we came up with an impact around 200,000 jobs

 6 if the current regulations were to curtail the

 7 bank's activity in the risk management space.

 8 So I think, you know, one key point to

 9 bring up is a lot of discussion about should the

 10 banks be in this business. Right? Should banks

 11 be doing hedging and market making? The reality

 12 is Congress's intent, firmly stated intent, was to

 13 maintain market making and hedging services by the

 14 banks. The client-facing businesses they provide.

 15 They're very important and they have real world

 16 consequences in the real world to real companies,

 17 real consumers in terms of energy prices is the

 18 area we looked, but I'm sure that extends beyond

 19 energy markets.

 20 And to the point of illiquid markets and

 21 whether banks, you know, should not be writing OTC

 22 contracts in illiquid markets, the reality is
 95

 1 that's where the customers need it. That's where

 2 the customers need the help. It's pretty easy to

 3 write, you know, to get a hedge on WTI. I can go

 4 out and get one of those. Big deal. Right? If

 5 you're a producer or a power producer in Wyoming

 6 or you're drilling for natural gas in Colorado,

 7 those futures markets, listed exchanges don't do

 8 you a lot of good. And if you do use them, all

 9 you're doing is adding basis risk. And so that's

 10 a key function of the OTC markets and the banks in

 11 their client-facing business.

 12 I guess finally, you know, the idea of

 13 markets will evolve, that's certainly a nice

 14 hypothetical academic approach. And it certainly

 15 might be true over time. The reality is if you

 16 talk to the people in the industry, the users, is

 17 that nobody else has that client-facing model.

 18 It's in the markets that we can really step in.

 19 And so I think even outside of the fact that

 20 Congress wants them to stay there, even if you

 21 were to write regulations as they are currently

 22 written, would largely impact those markets in a
 96

 1 dramatic way. You know, the reality is there is

 2 nobody there, and so I think you're taking a leap

 3 of faith, a large leap of faith as the regulations

 4 are written today. Thanks.

 5 MR. AGOSTA: Again, Jeff Agosta with

 6 Devon. Just to build on Kurt's point and to

 7 address Mr. Stanley's point about exchange traded

 8 derivatives. If they exist in large liquid

 9 quantities and it actually does facilitate hedging

 10 one of our risks. That's great. But in many

 11 instances they don't. They're not plain vanilla

 12 to Kurt's point exactly. You know, we do have oil

 13 and gas operations in Wyoming and that's not a

 14 deep liquid market. And we do use our financial

 15 institutions to help facilitate hedging those

 16 risks. And I could give you a number of other

 17 examples where we do not use plain vanilla type

 18 derivatives that are not going to be traded in an

 19 exchange traded firm. And it allows us to better

 20 plan our business.

 21 Second point, I'd like to build upon Mr.

 22 Johnson from State Street's example about the
 97

 1 importance of having financial institutions to

 2 take securities into inventory. We are a very

 3 large issuer in the commercial paper market as are

 4 most large corporations. That's how we fund our

 5 day-to-day liquidity needs. And it's often times

 6 our commercial paper dealers, one of which is

 7 Credit Suisse, cannot find a buyer for that

 8 security immediately and they take it into

 9 inventory. And that gives us the cash that we

 10 need to fund our operations that day. And they

 11 hold it on their balance sheet. And if they're

 12 not allowed to do that, they're unable to do that,

 13 it's going to push up the cost of borrowing for

 14 all of corporate America and slow things down

 15 frankly.

 16 MR. COHN: Thank you again. Josh Cohn

 17 for International Swaps and Derivatives

 18 Association.

 19 The suggestion was made, I think, that

 20 Dodd-Frank is pushing derivatives out of illiquid

 21 markets into the liquidity of clearing. I think

 22 that's wrong. Dodd-Frank provides for clearing of
 98

 1 adequately liquid derivatives and it provides for

 2 a remaining OTC market.

 3 The phrase has been used by people on --

 4 let's call it both sides of the room -- real

 5 world. And I'd just like to mention a couple of

 6 points that I see as real world. One, we have a

 7 statutory mandate as others have mentioned and

 8 that statutory mandate is to protect certain

 9 functions within banks. Two, real world economic

 10 concerns. I think that we've heard from David,

 11 Kurt, Jeff, and Dan Rodriguez about what are

 12 actual real world concerns. And I think we need

 13 to take heed of those.

 14 What I think we, as a derivatives

 15 industry, need to see in the Volcker context in

 16 the way of rules are reasonable and not chilling

 17 rules. And I'll give you an example of a

 18 particular statement in the draft preamble that I

 19 think resounds in the context of the conversation

 20 that we've just had. It is: regardless of the

 21 price degree of correlation, if the predicted

 22 performance of the hedge position would result in
 99

 1 a banking entity earning appreciably more profits

 2 on the hedge position than it stood to lose on the

 3 related position, the hedge would appear like to

 4 be a proprietary trade rather than an exempt

 5 hedge. Now, I question whether that proposition,

 6 the proposition stated in that passage, is

 7 actually possible. But assuming it is possible,

 8 we have a hedge that is perfectly correlated and

 9 contains risks and yields profits. It's

 10 absolutely a magical transaction. We should want

 11 that. We should actually want that. We have

 12 fulfilled our risk reduction obligation and yet we

 13 are providing for profit in the institution.

 14 What we're looking for is a rule that

 15 does not establish impossible cases and

 16 unnecessary and chilling admonitions. We need

 17 reasonable and not chilling rules that will lead

 18 to real continuing regulatory dialogues between

 19 covered banking entities and their regulators,

 20 between experts on the regulatory side and within

 21 the institutions, that will have an obligation of

 22 tracing reasonably correlated hedging on either a
 100

 1 portfolio or on an individual basis according to a

 2 mix of business judgment and cost benefit

 3 analysis. I think that's really what we're

 4 looking for and very much hoping the regulators

 5 will produce.

 6 MR. BERKOVITZ: Okay. I think we'll do

 7 Simon, and Wally, and Lynn, and Marcus, and then

 8 we'll take a break.

 9 MR. SIMON JOHNSON: Thanks. Dan said

 10 that he sees a lot of faculty here and it sounded

 11 like a bad thing the way he said it. I see

 12 special interest represented here, a powerful

 13 special interest that receives a government

 14 subsidy. And it is natural. In fact, I think you

 15 have a fiduciary responsibility to your

 16 shareholders to seek to maintain that subsidy. I

 17 think you would probably be remiss and they would

 18 reprimand you if you didn't see it. I think it is

 19 in the interests more broadly of society to assess

 20 whether or not providing you with that subsidy is

 21 worth it. There are costs and there are benefits.

 22 And the representatives of the non-financial
 101

 1 sector here, I think I'd put IHS in the financial

 2 camp given who paid for the study, but

 3 representatives of the non-financial sector here I

 4 think have highly relevant evidence. And there I

 5 would take up the point made by Lynn Stout, which

 6 is, how much exactly is being saved here? How do

 7 we weigh that against the catastrophic costs of

 8 allowing excessive risk to be concentrated in and

 9 around banks?

 10 Now, Dan, when I have more time we can

 11 review my resume and my qualifications and my real

 12 world experience in a little more detail. Let me

 13 just mention that, among other things, I am the

 14 former chief economist of the International

 15 Monetary Fund. I don't see other IMF

 16 representatives here. Let me tell you their

 17 perspective and how they see the crisis and saw

 18 the crisis.

 19 This is about banks. This is about

 20 allowing these risks to be unduly concentrated

 21 generating a massive negative social cost. The

 22 increase -- Chairman Gentler talked about many of
 102

 1 the costs at the beginning. The increase in the

 2 government debt, federal government debt held by

 3 the public -- oh, I'm also a member of the Panel

 4 of Economic Advisors of the Congressional Budget

 5 Office but these are not my numbers; these are

 6 their numbers. The CBO estimates that the cost to

 7 us as American taxpayers of this financial crisis

 8 when all is said and done will be about 50 percent

 9 of GDP. Call that $7.5 trillion in today's money.

 10 So we have to look at the cost. We have

 11 to go through David's study and we have to take up

 12 Jeff's very important interesting point, and we

 13 have to look at how big those costs are and how

 14 much you're sharing in a subsidy from the banks.

 15 I understand that. And we have to weight that

 16 against the measurable, repeatedly demonstrated

 17 social costs of these arrangements and having

 18 excessive risk in this way.

 19 And to Josh's point that allowing some

 20 of these risks to continue is congressional

 21 intent, that's fine. But the question is how much

 22 risk and how are you going to manage that and what
 103

 1 are the leverage requirements you're going to have

 2 and what will be the overall supervisory and

 3 regulatory position on how much you trust the

 4 banks to manage their own risk, particularly in

 5 the light of their repeated and even apparently

 6 recently demonstrated inability to manage,

 7 understand, and control these risks.

 8 MR. TURBEVILLE: Thanks. I think one of

 9 the things that's important to take away from the

 10 discussion is that when you do a swap, you don't

 11 destroy risk, you shift consequences from one

 12 party to another. And what you're really doing is

 13 shifting the consequences of some price movement

 14 from the balance sheet of one company to another

 15 company. The other company being a bank. And so

 16 what's happening is that that risk is being

 17 transferred onto the bank balance sheet.

 18 So not only are the banks being

 19 subsidized, their customers are being subsidized

 20 because when they shift the cost of shorting onto

 21 the bank balance sheet, it ends up being a

 22 subsidized cost. And I think that's what the
 104

 1 Volcker Rule is really -- is an important feature

 2 of the Volcker Rule, which is that shifting these

 3 things onto the bank balance sheets is something

 4 that's a very risky proposition because of the

 5 consequences if things go bad.

 6 Now, whether it's a rule -- whether the

 7 rules say you can't do that activity or whether

 8 with capital rules and with leverage rules you say

 9 the consequences of doing that activity are very

 10 expensive, you tend to get to sort of the same

 11 place. But the point here is that yes, there will

 12 be a chilling effect. I think the Volcker Rule by

 13 definition says there will be a chilling effect on

 14 activities and one way or the other, whether it's

 15 activity prohibitions or whether it's increased

 16 capital it will have that consequence. And both

 17 the banks will have to address that and actually

 18 customers who have big positions to lay off or

 19 highly illiquid risks that they want to address.

 20 MR. STANLEY: I just wanted to take up

 21 this issue of illiquid assets again since it seems

 22 to have created interest among the panel. I
 105

 1 thought Dan's example of an un-hedgeable asset was

 2 actually really telling and interesting. I don't

 3 question that the Maiden Lane assets may well be

 4 un-hedgeable, but we need to remember what those

 5 assets were. Those Maiden Lane assets were

 6 precisely the assets that created the last

 7 financial crisis. They were the assets that

 8 brought down Bear Stearns and AIG. And in the

 9 case of the Bear Stearns Maiden Lane assets, they

 10 were the assets that were so illiquid, so opaque,

 11 and so risky that JP Morgan refused to take them

 12 on in the Bear Stearns bailout.

 13 So, you know, it's entirely true.

 14 Assets like that can be very hard to hedge. But

 15 the question is do you want a bank making markets

 16 in those kinds of assets or is that a more

 17 appropriate business for a hedge fund? Because as

 18 soon as you're invested in those assets, you know,

 19 there's no two-sided market. So inherently

 20 there's a proprietary risk.

 21 And going to some of the points made by

 22 the energy companies here, it's perfect, or
 106

 1 actually let me mention this real world issue

 2 which is related. The point of the Volcker Rule

 3 is to change the real world. If you get done with

 4 the Volcker Rule and banks are not required to get

 5 out of at least some of their current businesses,

 6 lines of business, then you will have failed. The

 7 Congressional intent of the Volcker Rule, they're

 8 not putting you to all this trouble just so banks

 9 can maintain all their current lines of business.

 10 And one thing that I really saw in the bank

 11 comments and I'm hearing a little bit again today

 12 is that if a bank currently does something for a

 13 customer, then they have to be permitted to

 14 continue doing that thing for the customer under

 15 the Volcker Rule. And that's just not

 16 congressional intent and that's not the point of

 17 the Volcker Rule. The point of the Volcker Rule

 18 is to change the financial system.

 19 So the question that you should be

 20 asking yourself is that if a bank gets out of this

 21 line of business, is somebody else who is a

 22 non-bank who is smaller, who can fail, who doesn't
 107

 1 have either an explicit or implicit subsidy, can

 2 they pick up this business? So I think it's

 3 perfectly natural that an energy company might

 4 want to sell forward some of its production for a

 5 field that's developing in Northeast Dakota or

 6 something or, you know, in South Dakota or

 7 something like that or North Dakota. And that

 8 selling that production forward might not be

 9 doable on a deep liquid exchange trading market

 10 where there's a two-sided market in energy

 11 derivates. But there are many non-banks who are

 12 going to pick up the challenge, I believe, of

 13 buying that production from that specific field.

 14 And that may not be something, a business that we

 15 want banks to be in because it is inherently very

 16 difficult to hedge and very difficult to risk

 17 manage.

 18 MS. STOUT: I'm always glad to focus on

 19 the real world. I actually view that as my

 20 specialty, not just as an academic, but also as

 21 the director of a mutual fund family where I

 22 represent hundreds of thousands of individual
 108

 1 investors who have not been doing too well lately

 2 sadly.

 3 So while we're on the real world and

 4 while we're on numbers, I think it's certainly

 5 within the commission's realm of acceptable

 6 evidence to consider that weighed against the

 7 study of the hypothetical loss of 200,000 jobs

 8 that Kurt mentioned, I believe, in 2008, the U.S.

 9 Economy lost 2.6 million jobs. So when we're

 10 weighing costs and benefits, I certainly think if

 11 we're going to measure them in terms of jobs

 12 rather than dollars, that is also a number worthy

 13 of considering. Thank you.

 14 MR. COHN: Two quick comments. It goes

 15 to several prior comments but focused on the

 16 Maiden Lane assets. I think it's important for

 17 purposes of this conversation to remember what

 18 we're talking about and the fact that the Maiden

 19 Lane assets were not hedging assets. They were

 20 not part of any bank's hedging business, nor were

 21 they part of any bank's derivatives market-making

 22 activity.
 109

 1 MR. RODRIGUEZ: Just two quick points.

 2 The banks have responded to the Volcker Rule

 3 already. A lot of proprietary trading desks are

 4 shut down completely. We're out of that business.

 5 We've been focusing on market making. We're

 6 focused on client flow. And just to read this,

 7 you know, this is from the Volcker Rule.

 8 Permitted trading on behalf of customers.

 9 Supervision on proprietary trading does not apply

 10 to the purchase or sale of covered financial

 11 positions by a covered banking entity on behalf of

 12 customers. So the notion is that we're doing

 13 transactions on behalf of customers and trying to

 14 conduct those transactions in the most

 15 risk-efficient way possible.

 16 So the Volcker Rule has already had a

 17 tremendous impact on the industry. I'll cite two

 18 quick examples. Thirty percent reduction in

 19 trading volumes across cash equities. Okay. Big

 20 reductions already as I would say part of that is

 21 due to the Volcker Rule. So they've already

 22 reduced liquidity across the industry. So these
 110

 1 deep liquid markets that we thought we had have

 2 become a lot less liquid over the last 18 months.

 3 Now, it's difficult. We would have to

 4 do a very detailed academic study to determine

 5 what the proportion is due to Volcker versus other

 6 factors out there. There's a lot of other

 7 factors. I'm very familiar with those. You know,

 8 I do know from operating in the markets that a

 9 portion of that is definitely due to Volcker.

 10 Volcker has had a non-zero impact. How big that

 11 impact is is difficult to estimate. But I think

 12 on the illiquid structured products, we do

 13 continue to do those on behalf of customers. And

 14 so I think linking the comments made by Josh and

 15 some of the other panelists here is that, you

 16 know, that's an activity that the Volcker Rule

 17 wants us to continue to do on behalf of customers

 18 in the most risk-efficient way possible and the

 19 regulators need to continue to supervise that

 20 activity. And then to understand where there's

 21 any excessive buildup of risk. And they need to

 22 measure those risks in a number of different ways.
 111

 1 And then the final comment. I think this

 2 notion of there's all this destruction in the

 3 financial markets in 2008. That was not due to

 4 proprietary trading on Apple stock or Google

 5 stock. Okay. So when people say there's millions

 6 of jobs lost because of some trading activity,

 7 that connection I think -- that connection is, I

 8 think, very difficult to make here. There were

 9 some specific trading activities that exacerbated

 10 more deep-seated structural problems that go back

 11 to the overinvestment or over allocation of

 12 capital into the U.S. housing markets. So that's

 13 a very different discussion of what caused the

 14 financial crisis. So to say that the Volcker Rule

 15 is going to fix the financial crisis or prevent a

 16 new financial crisis from happening, that's not

 17 the case. It suggests that trading equities or

 18 corporate bonds from bank trading desks caused the

 19 crisis and caused the loss of eight million jobs

 20 as Simon, you know, insinuated and Lynn over here

 21 insinuated, I think we need to make sure that we

 22 take those comments with a huge grain of salt and
 112

 1 acknowledge that the connection there is stretched

 2 at best.

 3 MR. BERKOVITZ: Okay. Why don't we take

 4 a 15-minute break until about a quarter til and

 5 we'll start off with Bob after the break. Thank

 6 you.

 7 (Recess)

 8 MR. BERKOVITZ: Okay. Why don't we get

 9 everybody to resume. If everybody wants to come

 10 back, please. I think we had a couple of

 11 participants who have comments. We'll go to

 12 those, and then we have a few questions related to

 13 the hedging that we'd like to pose to the panel

 14 which we'll get to after the next couple of

 15 comments.

 16 MR. PARSONS: Yeah, thank you. John

 17 Parsons from MIT.

 18 I wanted to address one point that has

 19 been made a couple of times having to do with

 20 whether or not if certain kinds of banks can't do

 21 certain types of activities, will anybody else do

 22 it? One comment was made that some of us perhaps
 113

 1 have too much faith in the market. Since I am an

 2 economist, it's in my union card that we're

 3 supposed to have faith in the market so I'm not

 4 exactly upset about being charged with that. But

 5 it's not an unfounded faith, and I think it's

 6 sensible to worry about whether or not new

 7 institutions, new businesses will move in because

 8 sometimes there are obstacles to that. Sometimes

 9 there are barriers to entry. Sometimes there are

 10 special subsidies. There was a long list of

 11 possible reasons why other companies might not

 12 take up the slack. And it's worthwhile to ask

 13 that. But I haven't heard any explanations of

 14 such things.

 15 So just to be concrete, let me give you

 16 two examples. So one of the studies that was

 17 discussed here where big numbers were thrown out,

 18 like 200,000 jobs by Mr. Barrows's company, IHS

 19 CERA, which analyzed the impact of the Volcker

 20 Rule on the energy industry, if you get beyond the

 21 200,000 headline number and open up the study and

 22 look at it, it has as one of its premises that if
 114

 1 the Volcker Rule stops the banks from doing all

 2 these things -- 1, 2, 3, 4, 5, 6, 7, 8, 9, 10 --

 3 and here's the big one -- and if nobody else does

 4 it, then the world collapses.

 5 But there is no explanation at all of

 6 any reason why nobody else might do that. And

 7 that's what we need in order to get a handle on

 8 this issue. Give us something. Certainly, the

 9 CFTC needs to be provided with some substantive

 10 foundation before you can take numbers like that

 11 seriously. Now, the IHS CERA study was financed

 12 by Morgan Stanley. And Morgan Stanley provided a

 13 comment letter to the CFTC focusing on some of

 14 these issues related to the Volcker Rule. And

 15 I'll just, for the sake of time, pick out one

 16 specific example. Morgan Stanley provides an

 17 example about how Morgan Stanley serves the

 18 interests of certain airlines by acting as a

 19 supplier of jet fuel. Managing the logistics of

 20 the jet fuel, managing the price risk and so on

 21 and so forth.

 22 Well, that's all well and good. It's a
 115

 1 perfect example of something that could easily be

 2 provided by somebody else. There's absolutely no

 3 imagination why a bank holding company needs to be

 4 the supplier of jet fuel oil logistic services to

 5 an airline. Shell Oil can do the same thing. BP

 6 can do the same thing. Exxon can do the same

 7 thing. Or some new company can do the same thing.

 8 There are historical reasons why it happened to be

 9 that banks chose to provide that service of late,

 10 having to do both with some expertise in price

 11 risk management but also with various subsidies.

 12 And we're talking about taxpayer subsidies for the

 13 credit risk. But there's no substantive business

 14 reason why that has to be done there.

 15 So I think as the CFTC is analyzing

 16 these supposed costs and analyzing these

 17 suggestions about particular activities that might

 18 be damaged because of the Volcker Rule, it would

 19 be wise to scrutinize and ask for is there a real

 20 barrier? So far as I've been going through the

 21 studies, like the IHS study, the barriers are

 22 assumed; they're not explained, exposited, and
 116

 1 demonstrated. And similarly, when I looked at

 2 comment letters like Morgan Stanley's comment

 3 letter, the situation is the same. There are no

 4 substantive economic barriers provided. So I

 5 think there's no reason to have unfounded fear.

 6 Excuse me, there's no reason to have unfounded

 7 trust in the market, but there's also no reason to

 8 have unfounded fear. We need to have substantive

 9 evidence-based discussions of this thing, and the

 10 ones I've seen for the particular activities like

 11 Morgan Stanley providing the jet fuel oil

 12 logistics are just the type of thing that easily

 13 can be provided outside of the taxpayer subsidized

 14 banking system.

 15 MR. BERKOVITZ: Dan.

 16 MR. RODRIGUEZ: I guess not to

 17 necessarily defend Morgan Stanley in that

 18 particular study, I haven't read that. I have

 19 read excerpts of it. And I guess the issue is

 20 that if the market has decided to -- well, first

 21 of all, the Volcker Rule is designed not

 22 necessarily to prevent banks from engaging in
 117

 1 market-making activities, customer trades, and

 2 hedging activities. So first of all, you'd have

 3 to rewrite the law if you don't want these things

 4 to occur anymore in banks. Secondly, if the

 5 marketplace has already decided to go ahead and

 6 execute these transactions in the way they're

 7 executing them right now, that is prima facie

 8 evidence that the market has decided that this is

 9 the best way that they wish to do it. No one is

 10 forcing United Airlines to hedge out their jet

 11 fuel risk with Morgan Stanley right now. They've

 12 chosen to do that. So the notion is, not to say

 13 that they couldn't do it with someone else, but

 14 right now they've chosen to remain with Morgan

 15 Stanley.

 16 MR. BERKOVITZ: Kurt.

 17 MR. BARROW: Yeah, I guess I just come

 18 back to the point of why are we talking at all

 19 about taking the banks -- taking these services

 20 away from the banks? Congress said that banks --

 21 the Volcker Rule says banks shall not participate

 22 in proprietary trading. Fine. That's clear but
 118

 1 it allowed exemptions for market making and

 2 hedging. Our understanding of how those rules,

 3 proposed rules have been set is that it's nearly

 4 impossible to do your day-to-day commodity trading

 5 business, you know, for the banks to do that and

 6 provide those services. So de facto, they're out.

 7 And so that's really -- that was really the crux

 8 of our study and the basis on which we developed

 9 our numbers. Granted, we assume the banks

 10 completely curtained their activity. At the same

 11 time we looked really just at a subset of the

 12 energy industry.

 13 So, you know, back to the point of

 14 200,000 jobs compared with millions and millions

 15 of jobs lost during the economic meltdown,

 16 completely unrelated. Completely apples and

 17 oranges. You know, we looked at a very narrow

 18 part of one specific industry, not the economy

 19 wide. And that's it. Thanks.

 20 MR. ROBERTSON: Thank you. I'd like to

 21 address the issue of who provides the services

 22 from really two perspectives. One is who might
 119

 1 step in if a bank were not to provide these

 2 financial risk mitigation products because the

 3 regulation is either too onerous or just

 4 practically they can't offer them due to

 5 restrictions. And I think we all have short

 6 memories because if there was probably one most

 7 critical point in the crisis, it was not a bank.

 8 It was AIG. And it was AIG with its credit

 9 default swaps that brought down tremendous

 10 systemic risk to the point where the government

 11 went in and subsidized it as a bailout. And so

 12 what we're talking about is taking potentially

 13 significant financial risk activity out of the

 14 banking industry and putting it into other

 15 industries that are not as transparent, are not as

 16 regulated, and in fact, intensifying the systemic

 17 risk of the industry. So my concern is not a lack

 18 of trust in the market, but it's a concern that

 19 this risk activity doesn't go away but, in fact,

 20 it does get supported outside of any prudent

 21 regulation. So that's the first point I'd like to

 22 make.
 120

 1 And then the second point I'd like to

 2 make is really from the standpoint of the social

 3 good that banks provide to corporate treasurers

 4 and CFOs. When banks have a full array of

 5 financial products and solutions they can deliver

 6 to corporations, they can work collaboratively

 7 with those corporations to structure the best

 8 approach for that particular corporation. It

 9 might be an underwritten debt instrument that

 10 might even have an embedded option in it. It

 11 might be something placed on the bank's balance

 12 sheet with some kind of a swap attached to it. So

 13 they're able to take myriad products and tailor

 14 them specifically to the needs of corporate

 15 treasurers and CFOs. And so to the extent we're

 16 talking about significantly restricting the

 17 ability of the banks to offer products that can be

 18 prudently managed, we are actually restricting the

 19 ability of the banks to deliver products that

 20 enhance the financial operations of companies.

 21 And just one final point on the jet fuel

 22 logistics, which I hope jet fuel logistics did not
 121

 1 cause the crisis -- I'm pretty sure they didn't --

 2 but one reason why you see some operating products

 3 linked with financial products is that corporate

 4 treasurers and CFOs gain great benefits from banks

 5 integrating the financial and physical supply

 6 chains together. So as an industry, the CFO chain

 7 of command spends roughly $1.8 trillion on its

 8 financial operations. Banks today provide

 9 fee-based services that are just under 10 percent

 10 of that. And by actually knitting together cash

 11 management products that help with the flow of

 12 money across borders, and pooling of cash with

 13 physical logistics and data around actual trade

 14 settlements, they're able to deliver great value

 15 to CFOs and treasurers. Thank you.

 16 MR. BERKOVITZ: Actually, while I've got

 17 you at the microphone, or any of the other energy

 18 market participants on the buy side, I was

 19 interested, in light of some of the comments on

 20 the previous discussion, in terms of whether the

 21 standards, for example, in the proposed rule is to

 22 whether compensation should be based on profits
 122

 1 from hedging, whether hedging operations should

 2 make profits, what is the practice, say, in the

 3 corporate world or in the energy companies, the

 4 companies who are actually hedging risk, not the

 5 banks, but energy companies, to what extent are

 6 the operations in the companies themselves, to

 7 what extent do they see profits from hedging? Or

 8 to an extent is it viewed as something if you're

 9 even, you're doing well as compensation of the

 10 traders or the people who put on the hedges? Does

 11 that depend upon how successful or how profitable

 12 those hedges are? So how is it done on that side

 13 of the equation?

 14 MR. AGOSTA: Well, speaking -- this is

 15 Jeff Agosta with Devon. Speaking, as far as our

 16 company goes, there is no remuneration associated

 17 with hedging profits or losses. We put in place

 18 natural gas and oil hedges in order to ensure a

 19 baseload of cash flow. It's actually in our best

 20 interest if those hedges are out of the money

 21 because that means that prices have risen above

 22 the price that we've hedged them at. And the rest
 123

 1 of our unhedged business is actually doing much

 2 better.

 3 So but, you know, we go about our

 4 hedging operations, like I said, to ensure our

 5 baseload of cash flow so that we can make

 6 investment decisions. I had a question at the

 7 break about, you know, why we do what we do. And

 8 it's because the nature of oil and gas operations

 9 -- and I'm sure it's the case with other commodity

 10 producers -- that the decisions that you make in a

 11 current year often have impacts for years in

 12 advance. And so we're making commitments today

 13 for drilling activity that we won't conduct until

 14 next year. We need to know that we have some base

 15 level of cash flow available to us to fund those

 16 operations. If we don't have that ability to do

 17 that, then what it's going to cause us to do is be

 18 much more conservative in our capital allocation

 19 decisions. And it's not just our company but

 20 every other oil and gas operator in North America.

 21 We would not be where we are today -- I forget who

 22 mentioned it before, but we would not be where we
 124

 1 are today in the growth in oil and natural gas in

 2 North America had it not been for the ability of

 3 our companies to lock in that base level of cash

 4 flow for 2008, 2009, 2010, and 2011, because

 5 commodity prices absolutely collapsed in 2009.

 6 Our company was actually unhedged in

 7 that environment. Okay, in 2009. We went into

 8 that unhedged. We took our drilling rig activity

 9 from a peak of, I think, about 124 rigs in 2008.

 10 We took it down to 24 in 2009 because we were

 11 unhedged. We didn't have that baseload of cash

 12 flow. There were other companies, our

 13 competitors, that were hedged. They were hedged

 14 at very robust prices, and their rig activity

 15 maybe declined a little bit, but it didn't decline

 16 by 100 rigs. And so you could see the dramatic

 17 effect. If our industry was unable to lock in

 18 that base level of cash flow, it would just

 19 introduce more volatility into the activity.

 20 CHAIRMAN GENSLER: Can I just follow up

 21 because I'm listening to this and you caught my

 22 attention. You went from 124 rigs to 24 rigs,
 125

 1 which I would note was probably somewhat related

 2 to the risk of Wall Street spilling out to Main

 3 Street. And I would call Devon -- you're not Wall

 4 Street, right?

 5 MR. AGOSTA: Right.

 6 CHAIRMAN GENSLER: So if I can use the

 7 vernacular, you're Main Street.

 8 MR. AGOSTA: Right.

 9 CHAIRMAN GENSLER: So Wall Street comes

 10 crashing down. We've got the financial crisis and

 11 you go from 124 rigs to 24 rigs. That's the risk

 12 or its one part of the risk that Congress was

 13 addressing of let's lower some of the risk of

 14 these very large complex financial institutions

 15 posed to the rest of society. I would note 94

 16 percent of private sector jobs are non-finance.

 17 It's only 6 percent in finance. And even of that

 18 6 percent, it's probably less than one of those

 19 six percent that is really kind of Wall Street

 20 because there's the community banking system,

 21 there's the pension fund system, the asset

 22 managers, insurance companies, et cetera. So
 126

 1 probably less than 1 percent of our jobs in

 2 America.

 3 Now, it's an enormous part of our

 4 economy, but it came crashing down when you came

 5 from 124 to 24 rigs. So I'm just noting that.

 6 That's what Congress, and that's then ultimately

 7 what we regulators are trying to accomplish. And

 8 at the same time I think there is a complete, not

 9 only acceptance, but support amongst the

 10 regulators and the administration that swaps and

 11 futures be used both in standard form and

 12 customized form to help end-users lock in a price.

 13 It could be a former rancher that's locking in a

 14 price at harvest time, and then they focus on that

 15 which they do best. They focus -- it can be an

 16 oil company or a natural gas company that's

 17 focusing on what they do best -- exploration and

 18 production and milling and conforming. And lock

 19 in a price and then focus on job creation and

 20 economic growth but when you lock in a price that

 21 the party on the other side is well regulated and

 22 isn't concentrating so much risk that might just
 127

 1 spill out so that your rig count comes down. And

 2 the Volcker Rule is one small piece of that. But

 3 I sort of wonder and it's a question, why an

 4 end-user like yourself would be, in essence,

 5 advocating for the Wall Street firms to keep so

 6 much risk on their balance sheets?

 7 MR. ACOSTA: Well, I absolutely --

 8 CHAIRMAN GENSLER: I mean, because that

 9 hurts you in your rig count in '09.

 10 MR. ACOSTA: Well, specifically to that

 11 point, to the rig count, our drilling activity, it

 12 was reduced because commodity prices dropped so

 13 dramatically. Our cash flows -- our cash flows

 14 probably were cut in half.

 15 CHAIRMAN GENSLER: It was only because

 16 --

 17 MR. ACOSTA: Right.

 18 CHAIRMAN GENSLER: But the crisis took

 19 energy prices.

 20 MR. ACOSTA: Sure.

 21 CHAIRMAN GENSLER: I mean, there was an

 22 asset bubble and the energy prices were high. But
 128

 1 then it went cascading the other way, too.

 2 MR. ACOSTA: Right. And I would argue

 3 that hedging and derivatives had almost nothing to

 4 do with the financial crisis and it was just a

 5 massive amount of leverage in the financial system

 6 overall.

 7 CHAIRMAN GENSLER: We might have a

 8 different view. Credit default swaps in AIG might

 9 be Exhibit A on the other side.

 10 MR. ACOSTA: Exhibit A, I agree with

 11 that completely. Exhibit A. And unregulated

 12 insurance, a financial products branch of an

 13 insurance company.

 14 CHAIRMAN GENSLER: It was headquartered

 15 in London.

 16 MR. ACOSTA: In London, right.

 17 CHAIRMAN GENSLER: I just want to make

 18 sure.

 19 MR. ACOSTA: Make that point. But I am

 20 absolutely all for strong regulation of the

 21 financial institutions. Please don't

 22 misunderstand me in any way, shape, or form. I am
 129

 1 absolutely for that. What we are a bit concerned

 2 with in the Volcker Rule is just the potential for

 3 hindsight 20/20 second guessing what a firm is

 4 doing. A firm may be legitimately providing us

 5 with a financial product.

 6 CHAIRMAN GENSLER: Which should be --

 7 that's at the core of making sure that the economy

 8 works, that you can hedge your risks.

 9 MR. ACOSTA: Right.

 10 CHAIRMAN GENSLER: I'll call it the 94

 11 percent.

 12 MR. ACOSTA: Right.

 13 CHAIRMAN GENSLER: And plus the

 14 insurance companies.

 15 MR. ACOSTA: I'm a bit skeptical of the

 16 fact that there would be other parties stepping in

 17 to fill a void if the banks got out of this

 18 business all-together because we saw a firm, a

 19 hedge fund by the name of Amaranth that came to

 20 visit our company in the middle part of Alaska,

 21 holding itself out to be a top five dealer.

 22 CHAIRMAN GENSLER: But, see, I think the
 130

 1 challenge for us regulators, and then I'm going to

 2 hand it back, I think the challenge for us

 3 regulators is to permit that market making to the

 4 end-user community. The end-user community can

 5 lock in a price and using swaps and futures, but

 6 not have the banking entities retain so much risk

 7 that's proprietary that it's just, well, I think,

 8 you know, I'll keep $10 billion of oil risk

 9 because I think oil is going up or down. That

 10 they properly hedge themselves as you hedge

 11 yourselves. That they run something closer to a

 12 matched book.

 13 MR. ACOSTA: Right.

 14 CHAIRMAN GENSLER: It's never going to

 15 be exactly a match but I think that's the

 16 challenge. And where we can get help from the

 17 banks and from the market participants and the

 18 investor advocates on how to do that, but I'm just

 19 sort of intrigued and it came up to the table

 20 because end-users are out of central clearing.

 21 MR. ACOSTA: Thank you.

 22 CHAIRMAN GENSLER: I believe that
 131

 1 Congress was clear in the intent that they not be

 2 caught up in any mandatory way into margin on

 3 non-cleared swaps. And we're doing everything on

 4 the international stage and with international

 5 regulators. You know where the CFTC is on that.

 6 MR. ACOSTA: Right.

 7 CHAIRMAN GENSLER: And we've given a lot

 8 of deference and thought -- hopefully

 9 thoughtfulness on the end-user issue-- when we

 10 came to the swap dealer definition and so forth.

 11 If this Volcker Rule becomes a debate about

 12 end-users, something seems to be, with all

 13 respect, a little upside down.

 14 MR. ACOSTA: Right.

 15 CHAIRMAN GENSLER: Because I think Wall

 16 Street and the financial community is why your rig

 17 count went from 124 to 24 in part. And we should

 18 be trying to get this balanced so that you can

 19 hedge, that they can market make, but they not

 20 retain what is in essence proprietary risk.

 21 MR. ACOSTA: Right.

 22 CHAIRMAN GENSLER: But absolutely that
 132

 1 they market make and that you can hedge.

 2 I'll hand it back. Sorry. Simon, do

 3 you have any view on this? (Laughter)

 4 MR. SIMON JOHNSON: Yes, I do. I think,

 5 Chairman Gensler, you asked one of the big

 6 fascinating questions of this whole debate, which

 7 is why do so many non-financial companies come out

 8 and speak in favor of pretty much the Wall Street

 9 position? And I think with all due respect to

 10 people here today that the answer goes back to the

 11 subsidies.

 12 Now, Dan, I'm also on the Systemic

 13 Resolution Advisory Panel committee of the FDIC,

 14 and I do have a lot of respect for what they're

 15 trying to do implementing Dodd-Frank in terms of

 16 resolution for the global megabanks. But

 17 honestly, it's a very tough technical problem,

 18 particularly for cross-border operations. And

 19 it's not clear to anybody that it's going to work.

 20 So there's still a potential -- there's

 21 substantial support there more than just the

 22 taxpayer support on the deposit insurance. So I
 133

 1 think that the non-financial companies are getting

 2 a piece of the subsidies.

 3 CHAIRMAN GENSLER: So you're -- I can't

 4 believe I'm having a conversation with an MIT

 5 esteemed professor because I couldn't quite go

 6 there. But you're suggesting that the

 7 non-financial participants in the market are being

 8 rational in their advocacy because they may be

 9 transacting with parties who have a subsidy, the

 10 banking entities? And that somehow these rules

 11 might be costing them because the subsidy might go

 12 down?

 13 MR. SIMON JOHNSON: That is my rational

 14 -- that is a rational explanation for what we're

 15 observing here. The end-user --

 16 CHAIRMAN GENSLER: I was just trying to

 17 explain what you were saying. I was trying to

 18 make sure -- it's your point, not my point.

 19 MR. SIMON JOHNSON: That is my point.

 20 And the End-User Coalition, so-called during the

 21 Dodd-Frank financial reform legislation, was very

 22 closely aligned with Wall Street interests. And
 134

 1 as you said though, very clear (inaudible) in

 2 Congress was adamant that you should protect

 3 exactly, as you said, the legitimate hedging needs

 4 of the non-financial corporate sector. And yet

 5 we're still finding them aligned.

 6 CHAIRMAN GENSLER: We've protected that

 7 and we'll continue to protect that.

 8 MR. ACOSTA: It's very much appreciated.

 9 CHAIRMAN GENSLER: Yeah. Yeah. I've

 10 taken the blood oath. But Simon's raising an

 11 interesting point that it might be a broader

 12 economic about subsidies.

 13 MR. SIMON JOHNSON: Yes. I'm with John

 14 Parsons and with Lynn Stout on this point that if

 15 there's value in the transaction, then somebody

 16 will be providing that. And the idea that only

 17 the big banks can provide this kind of hedging

 18 service to you just seems at odds with everything

 19 we know about economics and economic history.

 20 From an academic point of view, Dan, and from a

 21 real world point of view. But perhaps there is a

 22 subsidy that's being shared through these markets.
 135

 1 That's entirely possible. And then for a subsidy

 2 you should be assessing, as Lynn said, the costs

 3 and the benefits. And there are absolutely big

 4 social -- it's like a form of pollution. There

 5 are big social cost scores when you generate

 6 systemic risk. And the complexity and nature of

 7 derivatives, when you concentrate the risk on the

 8 balance sheet of the global megabanks it's

 9 definitely a significant systemic risk.

 10 Oh, and to your point about AIG and to

 11 Chairman Gensler's point, of course that's

 12 important. Dodd-Frank also addressed that by

 13 creating this category of systematically important

 14 financial institutions. So we can -- it is

 15 correct to worry about what goes on in the

 16 shadows. Everything should be regulated.

 17 Everything should be covered in the same way. And

 18 Dodd-Frank does that. And the regulators are

 19 absolutely on that case as well.

 20 MR. ACOSTA: And maybe I could just

 21 address the question of why we care about the

 22 banks staying in this business and why we advocate
 136

 1 similar positions. You know, it's because they're

 2 the parties that are making the market. They see

 3 oil and gas producers. They see oil and gas

 4 consumers. And I don't want to leave out all the

 5 other commodity producers because they're also

 6 very relevant. But, for example, Morgan Stanley

 7 providing jet fuel to an airline, well, they're

 8 buying oil from companies like us. And they've

 9 got some logistics, pipelines, and other

 10 infrastructure that facilities that transaction.

 11 And I don't want to necessarily get into the

 12 subsidy debate because I am a taxpaying American

 13 citizen as well and I'm not fond of bailouts

 14 either. So I'm just trying to provide maybe a

 15 rational explanation as to why they're a logical

 16 party because they deal with us, they deal with

 17 utilities, they deal with airlines. They deal

 18 with every industry in America. And we don't

 19 necessarily deal with all those.

 20 MR. SIMON JOHNSON: Can I ask a

 21 question? What is it? This is to John's point,

 22 what is it that the banks have in terms of innate
 137

 1 ability, physical capital, human capital it can't

 2 move, that makes them uniquely capable of

 3 providing those services as opposed to somebody

 4 else in the marketplace. Then they have an

 5 advantage, I think you're conceding, I think it's

 6 obvious that they have an advantage because of the

 7 backing from the taxpayer. So they get a pricing

 8 advantage. We get that. What advantage do they

 9 have other than that? If you remove the pricing

 10 advantage, why can't other people provide the same

 11 integrated bundle of services? Or you buy the

 12 services in a less integrated fashion.

 13 MR. ACOSTA: They're, in theory, far

 14 more credit worthy. I mean, I was going to give

 15 the example of Amaranth.

 16 MR. SIMON JOHNSON: Because they're

 17 backed by the U.S. taxpayer. That's the credit

 18 subsidies.

 19 MR. ACOSTA: I'm not going to debate. I

 20 don't want to debate that with you, but I want to

 21 just give you a real life example of why we prefer

 22 to transact with these firms. We also transact
 138

 1 with BP and Shell and others, but these parties,

 2 they have the technical capability, so the

 3 intellectual capacity to do these types of things,

 4 the creativity. Okay, for example, I can go out.

 5 We can all go hedge a barrel of oil at NYMEX.

 6 Okay, the WTI that we all see quoted on CNBC every

 7 day. That is for physical delivery of a barrel of

 8 oil in Cushing, Oklahoma. Okay? Not everybody

 9 produces crude oil proximate to Cushing, Oklahoma.

 10 So these firms facilitate the transactions at

 11 different delivery points throughout North

 12 America. And then they provide -- they may be

 13 buying product from us in Central Texas and they

 14 may be delivering it to a utility customer in

 15 Atlanta, for example. They just facilitate that

 16 movement of vital energy resources across our

 17 economy. And it's just that they have that --

 18 they face every industry in America. Right? They

 19 deal with everybody. And so they have a unique

 20 role that they're playing within our economy that

 21 allows them to see a need on our part to get

 22 product to market, and a need on another
 139

 1 customer's part to own it somewhere else. And

 2 they have the ability to link those two up.

 3 MR. SIMON JOHNSON: There are no

 4 measurable economies of scale in scope and banking

 5 over $100 billion in total assets. A lot of

 6 people have looked at this, including people hired

 7 by the banks. You can't find those economies of

 8 scale and scope. This country was not built on

 9 big banks, Jeff. You know this. Fifteen years

 10 ago the top six banks in the United States had

 11 total assets around 15 percent of GDP. Now

 12 they're over 60 percent of GDP. The energy sector

 13 was not built around services provided by big

 14 banks. There's 15 years of those banks becoming

 15 bigger. It's actually been associated not with

 16 the boom in the non-financial sector, not with

 17 unprecedented productivity growth. Quite the

 18 contrary. And with the buildup of these very

 19 large risks that came, unfortunately, to fruition

 20 in 2008 in you, the taxpayer, and all of us as

 21 taxpayers, massively.

 22 CHAIRMAN GENSLER: I was just going to
 140

 1 say one thing and then I'm going to step away from

 2 the table. There are costs and benefits. A lot

 3 of people focus on cost and benefits. There may

 4 be, and I think Jeff is highlighting it in Simon's

 5 discussion, there may be some costs that large

 6 complex financial institutions will do less

 7 proprietary trading. And Jeff is possibly

 8 contending by extension that if they do less

 9 proprietary trading they might do less

 10 facilitating of the market making you would like.

 11 But Congress has been pretty clear. They've

 12 weighed and balanced and they said there should be

 13 less proprietary trading. Prohibited, in fact.

 14 So, and why? It's because there were

 15 benefits. Benefits of not having eight million

 16 people, you know, out of work and your rig count

 17 going from 124 to 24, et cetera. Now, there were

 18 a lot of reasons other than proprietary trading.

 19 So Congress is sort of, you know, so our job as

 20 regulators is not to, you know, sort of

 21 re-litigate that question or re-legislate that

 22 question but to try to find the balance allowing
 141

 1 market making but prohibiting proprietary trading.

 2 And permitting risk mitigating hedging at banks

 3 that, again, lowers risk to the taxpayers rather

 4 than increasing risk. And hopefully that's when I

 5 leave the table what it'll go back to.

 6 MR. BERKOVITZ: Dan, go ahead.

 7 MR. RODRIGUEZ: Yeah, just to echo the

 8 Commissioner's words there, I mean, this exactly

 9 -- proprietary trading has been reduced

 10 dramatically across the industry by any measure,

 11 whether you look at gross book sizes, net

 12 exposures, you know, scenario exposures, valued

 13 risk measures, by any metric. And I would, you

 14 know, suggest and Credit Suisse supports a

 15 metrics-based approach. You want to reduce risk.

 16 Let's measure it, you know, every which way that

 17 we know. Continue to evolve those risk measures

 18 over time.

 19 So, yes, we in a banking institution,

 20 want to reduce systemic risk. It's very important

 21 for us not to have dramatic systemic risk cross

 22 the industry. Banks do much better when the
 142

 1 economy is growing. 2011 was a challenging year

 2 for financial services, for banks in particular.

 3 2012 is going to be an even more challenging year.

 4 Why? There's still a lot of systemic risk right

 5 now emanating mostly out of the sovereign debt

 6 issues in Europe. I would point that by any

 7 metric, proprietary trading has been significantly

 8 reduced, and I would say in some institutions by

 9 most measures, eliminated. And I would put Credit

 10 Suisse in that category by, you know, whatever

 11 metric, you know, by an agreed-upon series of

 12 metrics that we could put out there. And I think

 13 this notion of cost and benefits is very

 14 important. So yes, we've achieved less

 15 proprietary trading.

 16 Two, there is this issue of a subsidy.

 17 We were fortunate throughout the crisis not to be,

 18 you know, participate explicitly in the TARP

 19 program. However, we understand that there is

 20 this notion of a subsidy out there. I think that

 21 the FDIC's effort to have resolution authority

 22 and, you know, the bail-in concept I think to a
 143

 1 degree can address that problem. It says, hey,

 2 let's be very explicit about mitigating that

 3 subsidy and the potential, as Simon says

 4 appropriately, there's potential negative

 5 externalities associated with excessive risk

 6 taking. So if we have negative externalities

 7 associated with that excessive risk taking, then

 8 we want to go ahead and reduce that in some

 9 efficient way, you know, without killing the

 10 positive benefits of hedging activities.

 11 So I think that we're actually much

 12 closer on this issue. The banker wants less

 13 systemic risk. We've accepted that yes, there's

 14 going to be a lot less or completely eliminate

 15 proprietary trading. However, as the law

 16 suggests, we do want to continue to support, you

 17 know, market making activities and hedging

 18 activities for our clients to the extent possible

 19 within the risk metrics and the capital

 20 requirements established under, you know, rules

 21 like Basel III.

 22 MR. BERKOVITZ: Okay, Bob.
 144

 1 MR. COLBY:: : I want to speak to a

 2 technical point but it's not very interesting so

 3 I'm happy to wait until after this conversation

 4 plays out.

 5 MR. BERKOVITZ: I think actually it may

 6 be helpful to -- we've got a couple technical

 7 points, questions to ask, too. So why don't you

 8 go ahead.

 9 MR. COLBY:: : Well, I just want to say

 10 as Chairman Gensler said, you have a difficult

 11 task because the statute puts in an express risk

 12 mitigating provision exception. And it expressly

 13 applies that to aggregate positions. So it picks

 14 up a properly construed portfolio margining as

 15 part of that. But the task is how do you then

 16 apply this in a way that's faithful to the statute

 17 but doesn't -- but also permits hedging? And it

 18 seems like Congress meant to permit hedging but do

 19 it in a way that doesn't overly constrict it but

 20 it's faithful to the purposes.

 21 I mean, this is difficult in part

 22 because a number of the hedges I think that firms
 145

 1 would have wouldn't even technically be within the

 2 rulebook but for the status test under the

 3 trading account. But because of the status test,

 4 if your bank that's a swap dealer in your world,

 5 they will be under the trading account and

 6 therefore, they have to have an exception for the

 7 hedges.

 8 I'm Bob Colby from Davis Polk speaking

 9 for SIFMA and FIA. Sorry about that.

 10 So you have to -- so the rule as

 11 expressed takes the general exception and then

 12 says there are a number of factors that you have

 13 to satisfy. And the concern as other people have

 14 said with some of the factors is that it does not

 15 introduce any significant new risks. But in your

 16 world new risks will be introduced. And sometimes

 17 they'll be significant because either you're going

 18 to have a clearinghouse that's your counterparty

 19 or you're going to be in an over-the-counter swap

 20 and you're going to have someone that has a

 21 riskiness to it as your counterparty. And that's

 22 a new risk. And sometimes, depending on the
 146

 1 nature of the counterparty, it can be significant.

 2 And it has to be reasonably correlated but

 3 correlation is not always easy to judge. And it

 4 can change. And it certainly should -- that's

 5 certainly an important part of assessing when you

 6 have a risk mitigating position. And you're going

 7 to have --

 8 And then another factor is that you have

 9 a compliance structure that's designed. And it's

 10 quite an extensive Appendix C compliance structure

 11 built up with governance and with audit

 12 responsibilities in management. And this

 13 compliance structure, if you have it work right,

 14 is going to be checking all these things and

 15 they're going to be putting on constraints based

 16 on the factors. And also, these entities are

 17 going to be intensely supervised. So if they're

 18 banks, they have bank regulators watching them.

 19 You're going to be intensely supervising them when

 20 they're swap dealers. And so the SIFMA members'

 21 point of view is that just as a technical matter

 22 the rules should be written, drafted differently.
 147

 1 It should retain the general statement about that

 2 there's risk mitigation hedging. And then the

 3 factors should be changed from something that

 4 loses the exemption for you, to guidance that's

 5 then applied by the supervisors as part of their

 6 intensive supervision.

 7 I told you it wasn't interesting.

 8 MR. BERKOVITZ: Let me also ask a

 9 technical question on the issue of portfolio

 10 hedging. The statute says that the risk

 11 mitigating hedging activities need to be designed

 12 to reduce the specific risks arising from

 13 individual or aggregate positions. And that's

 14 permitted. Some commenters have urged that it

 15 would actually be the specific desk that incurs a

 16 risk, be the one that would have to put on the

 17 hedge. If you're hedging a specific risk it

 18 should be the particular desk that puts on the

 19 risk or those aggregate risks. That's where the

 20 hedge would have to originate in order to qualify

 21 for that because some firms may have a whole

 22 separate office designed for portfolio -- to hedge
 148

 1 portfolio risks and the concern that has been

 2 raised with that is that that can just be used for

 3 virtually anything. It's not tied to specific

 4 risks. So I was wondering if there are comments

 5 on whether -- how many different levels up in an

 6 organization should these -- can these risk

 7 mitigating activities occur? Should it be at the

 8 particular office where the desk where the risks

 9 are incurred or can it be several levels up in an

 10 organization? Can you have a different office for

 11 the hedging than actually incurring the risks?

 12 Interested in any comments on that.

 13 MR. RODRIGUEZ: I mean, it really

 14 depends on the structure of the desk or the

 15 trading activity that you're supervising. If

 16 it's, you know, a fixed income desk you may have a

 17 lot of different bonds here across a number of

 18 different countries. If you have enough liquidity

 19 to hedge that effectively you may have

 20 country-specific hedges or you may want to have

 21 more generic hedges. So there are different

 22 levels. I think you need to have as much
 149

 1 flexibility as you can to allow degrees of freedom

 2 but while measuring very closely and supervising

 3 very closely the overall level of risk. So these

 4 hedging activities as people have mentioned here

 5 have to reduce the overall level of risk.

 6 And so what you really need to look at

 7 is you need to have a number of these different

 8 metrics. And I think, you know, something that we

 9 have to continually focus in on is one: how are we

 10 defining risk for these activities? Are we

 11 looking at a valued risk measure, different

 12 correlation metrics, economic relationships

 13 between different positions? You know, volatility

 14 over time. Forward-looking volatility, backward

 15 looking volatility. I mean, a lot of these

 16 different metrics that I think that we have to

 17 continually evaluate. And for just certain hedges

 18 you will do it at a lower level. Other hedges you

 19 may have to do it at a higher level. And the risk

 20 mitigation of those different hedges. But the

 21 risk mitigation of those two different hedges

 22 should be visible. It should be measurable and
 150

 1 quantifiable. And I would say that there are a

 2 number of standard, you know, industry metrics.

 3 You know, we know a lot of those -- VAR, scenario,

 4 net, delta, gross book size -- that would be

 5 helpful in supervising that. And working with the

 6 supervised entities in establishing that. I think

 7 something that we have to continuously evaluate.

 8 But you'll need to do the hedging at a number of

 9 different levels. And ideally, you should be able

 10 to see that at the, you know, say at the division

 11 level or regional level.

 12 MR. ROBERTSON: Hi. Thank you. I just

 13 wanted to switch gears a little bit and talk about

 14 how a bank treasury department has to look at

 15 risk. And if you think about it, I think we tend

 16 to think about the financial instruments being

 17 hedged where you may have a very clear instrument

 18 and the hedge is much simpler, but in fact, banks

 19 are intermediating all kinds of liquidity, credit,

 20 basis, other risk on their balance sheets. They

 21 may be putting on deposits which look to be an

 22 indeterminate maturity. They can have mortgages.
 151

 1 And what you're looking at are instruments with

 2 tremendous convexity. There are threshold impacts

 3 of how they behave under different macroeconomic

 4 scenarios. And to some extent this is a very

 5 challenging financial risk to model at a portfolio

 6 level but given the flexibility to model that at a

 7 more aggregate level can actually diversify risks

 8 better. And at some point you can't literally

 9 hedge each deposit. So a bank can't hedge the

 10 risk of a deposit from Shell or a mortgage from a

 11 very specific consumer. They do have to look at

 12 some of these things at an aggregate portfolio

 13 level. And for that reason, the more flexibility

 14 that's provided in looking at the structure of the

 15 hedge, it's going to make for better economic

 16 decisions.

 17 MR. SIMON JOHNSON: My specific

 18 suggestion is not to allow this to take place in

 19 another country, including London, for example.

 20 So we don't, I agree, know exactly yet what

 21 happened with JP Morgan Chase but we do know that

 22 the so-called hedging operation, if it was a
 152

 1 hedging operation, was in London. And we know

 2 that AIG Financial Products was in London. And I

 3 think being able to move or again "hedge" risks

 4 across jurisdictions is very problematic.

 5 Cross-border resolution is the biggest problem

 6 that the FDIC and others have to deal with when

 7 thinking about how to liquidate in an orderly

 8 fashion any of these global megabanks. And if

 9 you're allowing them to move more complicated

 10 operations across borders, that makes the whole

 11 process of anything too big to fail much more

 12 difficult and perhaps makes it impossible

 13 actually. That by itself may make it impossible

 14 depending on how big the risks are relative to

 15 that total balance sheet.

 16 MR. ACOSTA: Just to show my ignorance,

 17 if it's a hedging operation for the financial

 18 institution, it's done outside of the United

 19 States. So it's done in their London office. Do

 20 you all not have regulatory oversight over that if

 21 it's a U.S.-based financial institution?

 22 MR. BERKOVITZ: Dodd-Frank has a
 153

 1 specific extra cross-border provision specifying

 2 under what circumstances it applies to activities

 3 outside the United States. Basically, if there's

 4 a direct and significant connection. We're

 5 actually working on guidance. We want to put out

 6 guidance for comment on that in the very near

 7 future as to how the provisions would apply in

 8 that context. And so some of these are very

 9 timely issues.

 10 MR. SIMON JOHNSON: But in addition to

 11 the point of the legal jurisdiction, there is the

 12 issue of organizational span. To what extent any

 13 organization can manage and let's say they're

 14 aspiring to legitimately hedge but they're doing

 15 it across a much larger distance. Again, the

 16 anecdotal evidence that we have, which is not

 17 complete, suggests that this was part of what

 18 happened to AIG Financial Products and JP Morgan

 19 Chase. There's not lots of control within the

 20 organization for risks that are very big relative

 21 to the total balance sheet, in part because of the

 22 distance involved.
 154

 1 CHAIRMAN GENSLER: And I would note just

 2 three or four other examples. You might remember

 3 that Citicorp had something called structured

 4 investment vehicles. They were launched in London

 5 in 1988, incorporated in the Cayman Islands, and

 6 they had to be pulled back onto their balance

 7 sheet because they gave a guarantee through

 8 something called a liquidity put.

 9 MR. ACOSTA: Right.

 10 CHAIRMAN GENSLER: Though you could

 11 argue they maybe didn't have to. Bear Stearns'

 12 hedge funds, you might remember that little

 13 calamity. They were incorporated in the Cayman

 14 Islands. And Long Term Capital Management, that

 15 earlier distressed situation operating out of

 16 Connecticut but they, once again, it was the

 17 Cayman Islands. So this cross-border thing is

 18 very real. And so this recent event is just a

 19 reminder.

 20 But I'm intrigued. I'm hoping Dan would

 21 have just answered your question yes.

 22 MR. BERKOVITZ: It was yes.
 155

 1 CHAIRMAN GENSLER: Thank you. I just

 2 needed to hear him say it on the record.

 3 MR. ACOSTA: So if you all have the

 4 regulatory oversight authority to look into --

 5 CHAIRMAN GENSLER: If it has a direct

 6 and significant effect on the commerce or

 7 activities here in the U.S.

 8 MR. ACOSTA: Right. I mean, it would

 9 seem to me that the banks would need the

 10 flexibility to be able to hedge at different

 11 levels. I mean, for example, the London office

 12 may know a lot better about their aggregate

 13 exposure to Europe, for example.

 14 CHAIRMAN GENSLER: Right. But Simon's

 15 raised -- I don't know if it's in comment letters,

 16 but Simon's raising a point that if you put the

 17 hedge in one jurisdiction and you put the

 18 aggregate positions you're hedging in another

 19 jurisdiction, it might be a mismatch and get

 20 caught up in a bankruptcy regime or something like

 21 that. So it's helpful, I mean, for me to take

 22 away -- it might still be a hedge on an aggregate
 156

 1 position but you want to align it in a similar

 2 jurisdiction that the underlying positions are in.

 3 MR. SIMON JOHNSON: MF Global, now you

 4 mention other examples, would be a very good

 5 example where apparently, again, this is anecdotal

 6 and we don't have the full definitive record yet,

 7 but there is competing claims from U.K.-based

 8 customers and U.S.-based customers. And at least

 9 the payout -- the proposed payout is quite

 10 different between the U.S. and the U.K., in part

 11 because of the way that the liquidation has been

 12 handled. So that would be -- I think it's 30

 13 cents on the dollar in the U.K. and 90 some cents

 14 on the dollar in the U.S. -- dramatically

 15 different. So the hedge in that case could fall

 16 under exactly this sort of differential treatment

 17 and fail for that reason.

 18 MR. BERKOVITZ: Lynn.

 19 MS. STOUT: I think the good news is we

 20 all seem to have reached a consensus that it's not

 21 in anyone's interests for banks, especially

 22 deposit-taking banks to suddenly experience
 157

 1 enormous losses that lead them to fall. So that

 2 leads us to the question of why do banks have

 3 banks and other financial entities suddenly

 4 experience large losses that lead them to fail.

 5 And a lot of it, as we've seen, has been with bad

 6 derivatives bets. So what the Volcker Rule is

 7 designed to do is to reduce the chances that banks

 8 will suddenly experience enormous and

 9 unanticipated losses and fail. And it does this

 10 primarily by recognizing that when banks use

 11 derivatives to try and make profits, to speculate

 12 that is, they are inevitably taking on risks they

 13 weren't exposed to, thereby increasing the risk of

 14 a sudden unanticipated failure, which is why the

 15 Volcker Rule tries to prohibit proprietary trading

 16 but still protect hedging.

 17 And by the way, you know, when I raised

 18 the possibility that the benefits of hedging are

 19 easily exaggerated, I didn't mean to suggest that

 20 hedging is not beneficial, just that the magnitude

 21 of the benefits are easily exaggerated. But now

 22 when we look at the possibility of banks losing
 158

 1 money when they are doing what they say is

 2 hedging, we've got to ask ourselves how can that

 3 happen? It's understandable that you would lose a

 4 little bit of money hedging. Indeed, as Sheila

 5 points out, that's what you would expect to see;

 6 you're buying insurance. But what could have

 7 happened when a bank suddenly loses an enormous

 8 amount of money hedging? One possibility is that

 9 they were not hedging at all but in fact

 10 speculating. And that's one of the reasons why.

 11 And this is basic, but I think it's worth someone

 12 saying it. The problem with allowing banks to do

 13 portfolio hedging is that it makes it so easy for

 14 a bank to actually undertake proprietary trading

 15 for speculative profit and then after the fact

 16 claim to have been hedging. And that's why I will

 17 applaud the way the rule has gone to great lengths

 18 to try and make that more difficult by requiring

 19 banks that are doing portfolio hedging to discuss

 20 and to put in written plans for the sorts of

 21 hedging that they're attempting to do, to have

 22 compliance departments that make sure they're
 159

 1 following their plans, to make sure they identify

 2 the specific risks that they're hedging against.

 3 But even with that, the other reason why

 4 a bank that could truly be intending to hedge

 5 could suddenly find itself experiencing enormous

 6 and unexpected losses is that they just did a bad

 7 job hedging. Maybe there was a risk that they

 8 didn't appreciate and understand. Maybe

 9 circumstances changed, so something that wasn't a

 10 risk became a risk.

 11 Sorry for that long introduction but it

 12 leads to a point. If you want to prevent banks

 13 from failing due to bad hedging, as well as to

 14 what's essentially proprietary trading dressed up

 15 as hedging, then you want to have monitoring at as

 16 many levels as possible. You want to have it be

 17 done in as many levels as possible within the

 18 institution, and you want to have as much

 19 information generated and provided to regulators

 20 so it can be monitored by the regulator as well.

 21 And the reason has to do with the complexity of

 22 information theory,but basically it's much easier
 160

 1 for one person to make a mistake in judgment about

 2 a future risk than it is for a lot of different

 3 people coming with different baskets of

 4 information to collectively make the same mistake

 5 about the nature and the degree of a risk.

 6 So that's just a general point for the

 7 agency. But if you're worried not only about

 8 proprietary trading dressed up as risk -- sorry,

 9 dressed up as hedging, but also against mistaken

 10 hedging, and I don't think you need to, you know,

 11 work too hard to think of all the cases we've seen

 12 where people have suddenly lost enormous amounts

 13 of money and then said it was basically a botched

 14 hedge, what you want to do is have as much

 15 information generated as possible. You want to

 16 have it reviewed at as many levels as possible

 17 within the institution and within the agency.

 18 MR. BERKOVITZ: Wally.

 19 MR. TURBEVILLE: It might be helpful to

 20 be clear about what aggregation is. It seems to

 21 me that as you aggregate going up a food chain,

 22 what you're really doing is taking positions and
 161

 1 using them as internal hedges, one against

 2 another, so that it would be a bizarre result to

 3 allow hedging according to certain standards but

 4 then allow netting in the process of aggregation

 5 that's based on different standards. So it would

 6 seem to me helpful, especially since there's so

 7 much confusion about what does portfolio hedging

 8 mean, which was mentioned only in a footnote in

 9 the entire proposed rulemaking, but to be very

 10 explicit that in the aggregation process, that

 11 which is netted against one against the other has

 12 to comply with the same kind of standards that

 13 would be used if it were being used as a hedge in

 14 qualifying as a hedge under the rule. I think

 15 that would address some of the issues and concerns

 16 that people have.

 17 MR. BERKOVITZ: Josh.

 18 MR. COHN: We canvassed some of our

 19 members before coming down to ask about portfolio

 20 hedging to see if we could establish some

 21 principles. And what we found was that actually

 22 we couldn't; that each institution that we spoke
 162

 1 to was managing its hedging differently at

 2 different levels of the institution according to

 3 its particular views of best risk management

 4 practice and cost efficiency in its hedging

 5 function.

 6 And so what I think that says, both

 7 about the question of portfolio hedging, is that

 8 it's a varied activity and I think it has to be

 9 assessed on its merits and the context of the

 10 institution that says that it is carrying on

 11 portfolio hedging. The people we spoke to were

 12 reasonably confident that they could show the

 13 reasonable correlation that I think we all agree

 14 is required. The reasonable correlation with

 15 specific risk. But again, to come back to

 16 fundamentals, hedging is a varied activity. It's

 17 carried out in different ways in different banks.

 18 And that variety needs to be protected I think as

 19 Dan was saying. We hope to see flexible

 20 regulations out of the Volcker Rule writing effort

 21 that will fulfill the statutory mandate and also

 22 create a reasonable and a positive basis for
 163

 1 hedging in banks subject to regulatory oversight.

 2 And we see that oversight as essentially a

 3 continuing conversational process between skilled

 4 risk managers on the side of the bank and equally

 5 skilled risk analysts within the regulators who

 6 understand that hedging is a dynamic process, that

 7 risk changes over time, and that there's a

 8 constant series of judgments that need to be made.

 9 MR. BERKOVITZ: John.

 10 MR. PARSONS: Yes. Directly to your

 11 question about the level, I think most of the

 12 trouble, excepting things like international, but

 13 most of the trouble with whether it's acceptable

 14 at higher levels would be resolved if one applies

 15 a consistent principle that these things need to

 16 be hedging specifically identifiable risks,

 17 measurable, all of the things that, for example,

 18 Sheila Bair was describing earlier this morning,

 19 continuing monitoring, and so on. That -- if that

 20 principle is applied consistently no matter which

 21 level you're analyzing the hedging, I don't think

 22 there'd be as much dispute. I think what you find
 164

 1 is sometimes at these supposedly higher levels of

 2 operation, people want to be able to describe

 3 something as a hedge that doesn't satisfy these

 4 kinds of criteria. And so that's in a sense why

 5 people like to use something like portfolio

 6 hedging.

 7 Just as a minor anecdote, I do note that

 8 JP Morgan's CDSs, at least if you look at the

 9 financial statements, do not qualify as hedges

 10 under the accounting rules. They don't satisfy

 11 the various restrictions. Whatever rules one

 12 wants to implement, my point is merely that if you

 13 measure that performance independent of the level,

 14 I think you will resolve a lot of the question

 15 here.

 16 MR. BERKOVITZ: Jeff.

 17 MR. ACOSTA: Two quick points. One is

 18 just because a hedge doesn't qualify under

 19 accounting standards doesn't mean that it's not a

 20 hedge or an effective hedge. I'm a CPA so I'm

 21 allowed to say this: sometimes the accounting

 22 rules are kind of screwy.
 165

 1 So, but another point about the whole

 2 hedging and proprietary trade. I think the big

 3 task for you all is in how you define these things

 4 because you have -- the way the proposed rule is

 5 written now, there's a lot of room for 20/20

 6 hindsight, kind of gotcha kind of events to happen

 7 whereas several of the gentlemen have indicated

 8 hedging is a dynamic thing. Risk changes every

 9 minute of every day. And so having the ability to

 10 track that and having a risk management team at a

 11 financial institution that's diligent and vigilant

 12 and is closely at work monitoring that risk and

 13 working closely with you all to monitor that and

 14 report that accurately, I think that's the

 15 critical part of this. And it's a very, very

 16 difficult balancing act that you all have here to

 17 properly define these things so as to not quell

 18 the activity but actually continue to encourage it

 19 in a prudent manner.

 20 MR. BERKOVITZ: Josh, and then I've got

 21 another follow up.

 22 MR. COHN: I don't --
 166

 1 MR. BERKOVITZ: Okay. In regard to that

 2 point, in terms of what the expectation of the

 3 regulators would be and a couple points have been

 4 made regarding 20/20 hindsight and are regulators

 5 going to come in and judge everything

 6 retrospectively, I guess first just as a factual

 7 matter, CFTC, we don't have onsite examiners and

 8 we're not in the banks. We're just not set up

 9 that way. That's not how we're structured. It's

 10 not our mission. We're not certainly funded that

 11 way. And the resources that we do have, we're a

 12 small agency. We're around 700 people right now

 13 and significant new responsibilities under

 14 Dodd-Frank to monitor these types of activities on

 15 top of our additional responsibilities is

 16 certainly a challenge.

 17 In terms of what the expectation of the

 18 regulator would be and what we could be, the

 19 proposed rule sets forth a program. Firms would

 20 have compliance plans. Hedging program, how they

 21 plan to conduct their hedging. And presumably, if

 22 the firm conducts -- under the proposed rule the
 167

 1 firm conducts its hedging activities in accordance

 2 with the rule, there's flexibility in the proposed

 3 rule, the hedge recognizes, for example, what

 4 might start out reasonably correlated may evolve

 5 over time and there's accommodation made for that.

 6 But a number of panelists have expressed the

 7 concern that regulators are going to come in

 8 hindsight and that may be a deterrent to

 9 activities, entering into the activities in the

 10 first place. But given our limited resources, our

 11 inability to actually approve everything

 12 beforehand, that would be a virtual impossibility.

 13 I'm wondering is there -- what other way could

 14 this be done to address that concern given the

 15 fact that there's a program, presumably if a firm

 16 is conducting the hedging activities according to

 17 the compliance program and it's conducted in

 18 compliance, is that not a reasonable way to

 19 proceed or what suggestions -- how can we address

 20 this concern?

 21 MR. ROBERTSON: Yeah. I think that's

 22 kind of the key point which is at the end of the
 168

 1 day, within the jurisdiction of the CFTC, you're

 2 going to be much more about guidelines and

 3 frameworks and interpreting the rule. And I think

 4 this is a classic Type I, Type 2 error. Do you

 5 have very prescriptive guidelines that constrain

 6 the ability to have activities? Or are they so

 7 flexible that you allow, you know, unacceptable

 8 levels of risk into the market?

 9 And I think from a corporate treasury

 10 perspective, obviously corporate treasurers want a

 11 very robust system that's prudently regulated.

 12 They don't want to crash, but I think the major

 13 issue is with these guidelines, is that going to

 14 slow down the ability of a provider to a "risk

 15 mitigation instrument" and to make a market in it?

 16 And so if we end up with something where the banks

 17 have to document, okay, I'm doing this as a hedge

 18 and I need to stop and actually do this, the

 19 market doesn't stop; it keeps moving. So I think

 20 the concern would be something that was so onerous

 21 that there had to be a documentation of intent.

 22 There had to be all these steps to go through to
 169

 1 really almost barter each hedge one off of the

 2 other versus having a very fluid market where the

 3 market-making activities and the hedge activities

 4 are all within a trading flow that provides robust

 5 pricing. So I think the concern isn't so much

 6 somebody coming in and inspecting each individual

 7 hedge, but complying with a set of guidelines.

 8 Will those guidelines allow the market to remain

 9 fluid and dynamic?

 10 MR. BERKOVITZ: Wally?

 11 MR. TURBEVILLE: Yeah. The proposed

 12 rules are very wisely set up, I believe, to

 13 establish a set of metrics that to the extent

 14 activities deviate in terms of revenues or profit

 15 or loss, that's suggestive of activity, permitted

 16 activity that is, in fact, proprietary trading.

 17 And it's not a bright line. The results are

 18 intended to be suggestive of some activity that

 19 might be deviant. That all works great as long as

 20 the Chairman's description of taking risks and

 21 moving them off the bank book makes sense.

 22 One of the great concerns is if a bank
 170

 1 tasks a risk where there's no reasonable

 2 expectation of what the outcome might be, in other

 3 words there's no market for it and there's no

 4 hedge for it and it becomes simply a risk-taking

 5 activity and in the energy area you end up getting

 6 into Morgan Stanley running line businesses to

 7 offset the risk, as opposed to moving it off your

 8 book, then those metrics may be difficult to

 9 implement. And the reason they're difficult to

 10 implement is because permitting that kind of a

 11 transaction, a flyer kind of a transaction where

 12 there's really no reasonable expectation of what

 13 the financial outcome is going to be to the bank,

 14 is actually not market making and is, in fact,

 15 taking a proprietary risk of the greatest kind,

 16 that which you can't actually offset very well

 17 except perhaps by getting into the oil business.

 18 So the metrics are really good because

 19 they don't -- they're not intrusive, they're

 20 self-reported, and they suggest the possibility of

 21 being outside of the Volcker Rule but aren't

 22 determinative and will then simply yield to the
 171

 1 discussion after the fact to see why either

 2 profits or losses, for instance, are greater than

 3 they should be; why risks on your book are

 4 disproportionate to the kind of business you're

 5 going to be looking at.

 6 MR. BERKOVITZ: Simon.

 7 MR. SIMON JOHNSON: So perhaps there is

 8 guidance or maybe even rules you can provide to

 9 the points made by Jeff and Josh with regard to

 10 the board-level supervision or monitoring. The

 11 corporate board. The board of the bank. Now, I

 12 know you don't want to talk about JP Morgan Chase

 13 and I'm reluctant to talk about them in their

 14 absence, but I guess I have no alternative, that

 15 there are -- concerns have been raised about the

 16 composition of their risk committee and the

 17 frequency with which it met, the people who were

 18 on it, their background in risk, the flow of

 19 information to the board level. And to the point

 20 that you need to hedge, and hedging is dynamic and

 21 the world is changing rapidly, presumably there

 22 should be an expectation, and you can help set
 172

 1 that expectation, of who should be on the risk

 2 committee of a global megabank, what should be

 3 their competence, what should be the flow of

 4 information both directly to them and through

 5 ordinary managerial channels. That seems to be

 6 critical.

 7 And also in this regard, there has to be

 8 oversight, I would think, over both the de jure

 9 and de facto compensation of the people who are

 10 running these hedging schemes. Again, I have no

 11 idea what the arrangement was at JP Morgan Chase,

 12 but if the people running this CIO, the entity

 13 supposedly doing the hedging, if they were being

 14 compensated on profit and loss in that unit,

 15 they're doing proprietary trading. If they're

 16 being compensated based on the overall returns of

 17 the firm, then I think it's hedging. It's a very

 18 simple test. And it's a test that can be applied

 19 by any board. It's a test that can also be

 20 applied in real time because obviously people can

 21 shift their personal holdings and you can have

 22 your own derivative transactions if you're a
 173

 1 trader. And that needs to be watched as well with

 2 regard to determining whether or not this is

 3 prohibited proprietary trading.

 4 MR. BERKOVITZ: We'll take Jeff and then

 5 we'll break.

 6 MR. ACOSTA: Just one last point to

 7 build on Simon's point about who's involved in the

 8 risk oversight. I'm in the fortunate position

 9 that I get to deal with every financial

 10 institution on Wall Street. And I see certain

 11 institutions where the risk oversight people have

 12 also worked in the trading operations and vice

 13 versa. So there's a constant flow and so they

 14 know that at some point the traders are going to

 15 have to work in risk oversight so they treat each

 16 other with more respect, whereas others, the risk

 17 oversight committee is viewed like an internal

 18 audit or a policeman who's out to prevent the

 19 traders from making profits. And the traders will

 20 often go over their heads and get something

 21 approved outside of that risk oversight committee.

 22 So I think having the ability to move people into
 174

 1 the risk oversight and into the trading operations

 2 is pretty critical.

 3 MR. SIMON JOHNSON: And I don't want to

 4 put you on the spot, Jeff, or ask you anything

 5 uncomfortable, but at least by general reputation,

 6 JP Morgan Chase's risk control management

 7 operation was regarded as being very good until

 8 recently. So perhaps we should change a little

 9 bit the benchmark for where these organizations

 10 need to be. If a company like JP Morgan Chase

 11 could go from thinking all they had was 10 percent

 12 [inaudible] to recognize that they had -- I don't

 13 know what it is, two, three, four, but whatever

 14 the loss is, within a very short period of time,

 15 something is not going well on the frontier of

 16 technology with regard to risk management on Wall

 17 Street.

 18 MR. COHN: I'm reluctant to take any

 19 lessons from JP Morgan Chase just being reluctant

 20 to speculate and I hope other people feel the same

 21 way.

 22 MR. SIMON JOHNSON: I was hedging, not
 175

 1 speculating.

 2 MR. BERKOVITZ: Before we break, I want

 3 to clarify one point. The question I think you

 4 raised about application overseas. The response

 5 that I gave was the general CFTC's -- the

 6 application of the swaps provisions of Dodd-Frank,

 7 which is Title 7 of Dodd-Frank, our swaps

 8 regulatory authority overseas to activities

 9 outside the United States. That's a direct and

 10 significant connection. There's a separate

 11 provision, the Volcker provision, is section 619

 12 of the Dodd-Frank Act, that has its own provision

 13 talking about how it would apply to activities

 14 outside the United States. And there's a

 15 provision in the proposed rule regarding to which

 16 activities it applies. So I want to just make

 17 sure that there's two separate extraterritoriality

 18 provisions. There's one generally in the

 19 Commodity Exchange Act for the CFTC's

 20 jurisdiction; there's one specifically that states

 21 how the Volcker Rule applies. My previous answer

 22 went to the Title 7 and there's also this one in
 176

 1 the Volcker provision itself.

 2 MR. RODRIGUEZ: Before we break, I guess

 3 the notion about having split hedges, there is the

 4 definition of legal entities and where hedges that

 5 reside in different legal entities do not offset

 6 or net for capital purposes. So that split

 7 hedging issues does address the concern that Simon

 8 raised. And it's important maybe to just

 9 reinforce that as you go about your supervisory

 10 responsibilities. Split hedging is not allowed

 11 across different legal entities.

 12 MR. BERKOVITZ: Okay, with that I'd like

 13 to thank the morning panel. This has been a

 14 really lively and excellent discussion. We've

 15 touched on a lot of topics. We'll take an hour

 16 break for lunch. We'll come back at 2:00 and the

 17 afternoon panel will talk about market making.

 18 I'm looking forward to an equally lively

 19 discussion. So thank you, everybody.

 20 (Recess)

 21 MR. BERKOVITZ: Welcome back. Welcome

 22 to our afternoon session of the CFTC Volcker
 177

 1 Roundtable. The afternoon session will be talking

 2 about market making activities and some of this

 3 morning's discussion talked in this area as well.

 4 So some of this will be a continuation of this

 5 morning's discussion, but we hope to get into

 6 specifics. We have the proposed rule and how to

 7 determine whether an activity is market making or

 8 not. And I'll ask if anybody wants to start off

 9 the discussion generally, but if anyone has any

 10 general comments on the market making?

 11 David.

 12 MR. SIMMONS: I'm Dave Simmons of Loomis

 13 Sayles. My remarks will be on behalf of the

 14 Association of Institutional Investors, an

 15 organization of some of the oldest, largest, and

 16 most trusted investment advisors in the world.

 17 All our firms have a fiduciary duty to put our

 18 clients' interests first. So put simply, it's not

 19 our money. We manage pensions, 401(k), mutual

 20 funds, personal investments on behalf of more than

 21 100 million workers and retirees. Our clients

 22 include companies and labor unions, public and
 178

 1 private pension plans, mutual funds, and

 2 individuals and families who depend on us to help

 3 them provide for their retirements.

 4 So with that being said, we're really

 5 here to make sure that, you know, what I'm really

 6 here for anyway is to make sure that market making

 7 by the Street, is there's clarity for the Street

 8 for market making. Okay? I'm on the Corporate

 9 Bond Trading Desk. I have a different perspective

 10 I guess than everybody else. I'm a regular,

 11 everyday trader. I trade corporate bonds every

 12 day. So I'm on the frontlines. A significant

 13 part of the day-to-day trading that we do is

 14 dealers making markets a significant part.

 15 There's no way to put a number on that unless you

 16 actually calculate it on a day-to-day basis. We

 17 don't do that but it is more than 50 percent of

 18 the daily trades that we do are dealers making

 19 markets.

 20 Lately, agency trading versus principle

 21 trading, or principle trading being dealers making

 22 markets has gone up. There is more agency trading
 179

 1 that we've witnessed. The Street is taking less

 2 risk. We've talked about that. Dan has mentioned

 3 that. And the fact that they're taking more risk

 4 means they're doing more agency-type trading.

 5 That's been adequate. It's working. It's still

 6 nowhere near capable of facilitating the amount of

 7 trades that need to be done in the system. For

 8 example, you know, if I have 20 million of a

 9 company -- I won't say any names -- and I need to

 10 sell it to -- because we have an account -- we

 11 have a client that wants to take money and I go to

 12 the Street, excuse me, the banks and try to sell

 13 that bond, if they don't have -- they can't bid

 14 it. If they don't feel comfortable with the

 15 clarity of the rules in market making, they won't

 16 bid the bond. So I'll say, okay, well, see if you

 17 can find an end-buyer. If they can't find an end-

 18 buyer, take two, three days, four days, a trade

 19 can take a lot longer. I get the bonds back

 20 because they couldn't find an end-buyer. I have

 21 to cheapen the bonds up. So all of a sudden this

 22 company's funding costs have now gone wider -- 20,
 180

 1 30, 40 basis points potentially. And that's

 2 obviously going to be a problem for someone like

 3 Jeff over here at Devon. It's going to be a

 4 problem for us. It's going to be a problem for

 5 everybody. It's a problem all the way down

 6 through the economy. Funding costs go higher. I

 7 think we all know that.

 8 So therefore, we get the association

 9 that is concerned with not only the relative value

 10 of day-to-day trading that's going on out there,

 11 but also the funding of redemptions, the funding

 12 of capital additions. If we have mutual fund

 13 redemptions and we need to pay those out, how are

 14 we going to do that if the Street's not clear on

 15 market making? We know market making is permitted

 16 through the Volcker Rule. We understand that, but

 17 I guess the clarity of it is the big concern in

 18 the markets right now. And so we're really here

 19 to make sure that there's clarity on the rules for

 20 market making.

 21 If the rules aren't clear, the banks are

 22 going to avoid making markets and the clients,
 181

 1 corporations, are going to struggle. And the bid

 2 ask is going to go wider. So the cost to buy a

 3 bond is going to go up and the cost to sell it is

 4 going to go down, and the differential is going to

 5 be huge. That's our take anyways. Thank you.

 6 MR. BERKOVITZ: Curtis.

 7 MR. ISHII: So, I also belong to the

 8 group that was just speaking, except we have a

 9 slight different take. We agree that spreads will

 10 move wider. There will be less liquidity,

 11 although I think that if you look at a number of

 12 the charts, liquidity within the Street has been

 13 dropping for the last five to 10 years. It's just

 14 less profitable. They were making 40 percent

 15 return on equity in the '90s. It's dropped to 20

 16 and most estimates now are based on what is

 17 expected to happen is the expected returns are

 18 going to be in single digits. So capital is

 19 probably going to be less in this area.

 20 And so we as fixed income players will

 21 need to adjust. And so our take is that this is a

 22 cost. There is no doubt there's a cost that's
 182

 1 going to be born. We, CalPERS is not a high

 2 turnover account. Our belief is that as spreads

 3 widen and so there will be more costs, whether

 4 it's 25 or 50 basis points, to various entities,

 5 CalPERS will profit from that over time and we're

 6 talking long periods of time. Those that need

 7 what I call instant liquidity -- those that need

 8 to sell because there's redemptions and this could

 9 be a hedge fund, this could be a mutual fund, this

 10 could be a client who wants it and needs it

 11 quickly -- will not have that liquidity and will

 12 have to probably create some sort of buffer within

 13 their portfolio and it will affect them.

 14 So our take is it's a cost, we think,

 15 where it's an acceptable cost for CalPERS given

 16 what the goals of what you're trying to do. And

 17 we will, as we see it going forward, the market's

 18 evolving to a different model. And it's involving

 19 -- I kind of look at the equity markets and see

 20 how it's evolved in which that's the total agent

 21 market or mostly agent market. And a lot of our

 22 securities are moving towards that. The days in
 183

 1 which we can transact 50 million in a various name

 2 corporate entity are probably gone. Those were

 3 the '80s and '90s. And our desk is adjusting. We

 4 will do it over time. Either way you just adjust

 5 the way you approach it in terms of how much

 6 market impact you will have and we'll make the

 7 adjustments.

 8 So we are supportive of what you are

 9 doing. We think if you want to accomplish the

 10 separation, or you think that there's a subsidy

 11 per se going on and you want to break that, then

 12 this is the cost to the markets.

 13 MR. BERKOVITZ: Keith, I would also like

 14 to thank Barclays for participating in the

 15 afternoon panel.

 16 MR. BAILEY: Good afternoon. My name is

 17 Keith Bailey. I'm at Barclays in New York. I'm

 18 part of the Fixed Income Currencies and

 19 Commodities Group with a focus on market

 20 structure. Thank you for the opportunity to be

 21 here today.

 22 We are here because we support strong
 184

 1 regulation and well functioning markets and the

 2 ability to best serve our clients. The statute

 3 protects bona fide market making by exempting it

 4 from being a proprietary trading activity. And

 5 the purpose of this panel, which we welcome, is to

 6 explore where those lines need to be drawn between

 7 what is permitted and what is not permitted. And

 8 we read the statute as neither limiting the asset

 9 classes in which a market-making activity can be

 10 engaged, nor limiting it to particularly highly

 11 liquid products, subject in each case to

 12 appropriate risk management and supervisory

 13 oversight. We think that the statute and the

 14 rules should support a model that permits the

 15 retention of principal risk when it's assumed

 16 appropriately in a market-making capacity. And

 17 this includes holding inventory. If the store is

 18 empty, we have nothing to sell. And it involves

 19 holding that inventory over very varying degrees

 20 of time depending on the nature of the instrument

 21 in the marketplace.

 22 We don't think that one size fits all
 185

 1 for each market and we think there is a risk of

 2 that being a challenge. We also agree that

 3 clarity is terribly important. Our trading desks

 4 are very concerned about certainty, but we

 5 understand that that obviously has to be married

 6 with some degree of flexibility because of the

 7 varying asset classes involved and the liquidity

 8 spectrums so that it makes the challenge

 9 particularly difficult to articulate either

 10 linguistically within the qualitative framework or

 11 metrically within the numerical framework where to

 12 draw those lines.

 13 And we think of ourselves as making

 14 markets in products, particularly, I suppose, on

 15 the bond space. But more accurately I think we

 16 think of ourselves as making markets and risks.

 17 And clearly, in the case of derivatives, we don't

 18 see a secondary market in swaps. Every swap is

 19 treated as a risk element that's composed of an

 20 aggregate set of risks that we marry with the

 21 balance of our portfolio. And so we hedge it as a

 22 risk set and that's really what we think of
 186

 1 ourselves as transacting.

 2 So the challenge is going to be how do

 3 we marry the seven requirements that are set out

 4 in the statute in part in the rules to calibrate

 5 those in a way that will appropriately put the

 6 line between what's permitted and not permitted in

 7 a way that is both faithful to the statute and

 8 preserves the bona fide elements of the

 9 market-making activity that we believe is so

 10 important to the marketplace. Thank you.

 11 MR. BERKOVITZ: Larry.

 12 MR. MAKOVICH: Thanks. I'm Larry

 13 Makovich of IHS, a colleague of Kurt Barrow. And

 14 I want to provide some of the oversight into what

 15 we came up with as we looked into this with the

 16 study we did. And I think the bottom-line was

 17 that these market-making activities that are done

 18 within the energy sector are very, very important.

 19 And this morning's discussion tried to suggest,

 20 for example, that, you know, you could do without

 21 them and just rely on deep liquid exchange traded

 22 standardized products with continuously posted
 187

 1 prices. And those exist, those are used in the

 2 energy sector but they're only liquid, you know,

 3 for a few years out and they can do some of the

 4 risk management job but not all of it. And in our

 5 study we pointed out that this market-making

 6 activity is one of a number of things that are

 7 done in the energy sector. And in fact, in the

 8 power area we pointed out that by far the most

 9 effective risk management tool has been a

 10 diversified portfolio of generating fuel-based

 11 assets.

 12 But the problem is that the energy

 13 sector is inherently risky, and it is complex, and

 14 it's capital intensive. And so as Jeff Agosta

 15 pointed out, you've got to manage the risk on

 16 those future cash flows in order to get adequate

 17 capital deployed in this business. And so you

 18 need all of these risk management tools, including

 19 what the banks have been doing. And what they've

 20 been doing is when you've got a gas project, it's

 21 got a very frontend loaded output. You know, you

 22 drill a gas drill -- a gas project. You get a lot
 188

 1 of gas and then it starts to deplete rapidly.

 2 It's frontend loaded cash flow. If you've got a

 3 power plant, you need gas for the next 20 or 30

 4 years and year-to-year it's quite unpredictable.

 5 A market maker can get between these two

 6 players. The gas player that's long on gas, the

 7 power player that's short on gas. And it can

 8 create a transaction as an intermediary that uses

 9 those offsetting risks and can reduce risk for

 10 both parties. But the market maker ends up with

 11 some of the residual risk from the mismatch. And

 12 so if you do that once you've got an exposure, if

 13 you do that more than once, now you've got a set

 14 of positions from having enabled these

 15 transactions in the marketplace that together

 16 create an aggregate risk exposure.

 17 And so a market making bank, if

 18 Dodd-Frank works the way it was intended, banks

 19 continue to provide this function. As a result,

 20 they take on the risk associated with the

 21 residuals from making these transactions possible.

 22 And what our study also pointed out is that a
 189

 1 market maker would then have the opportunity to

 2 hedge the risk that they face in aggregate from

 3 all this. But the economics of efficient and cost

 4 effective risk management are that hedging has a

 5 cost and a benefit. And if you do it efficiently,

 6 you're going to be doing as much until you get the

 7 marginal benefits just equal to the marginal

 8 costs, which means efficient risk management by

 9 the market maker will not reduce risk to zero and

 10 create an aggregate position that has no potential

 11 for gains or losses when prices play out

 12 differently than expected.

 13 And so the rules as proposed -- and I

 14 think that Sheila Bair hit the nail on the head

 15 when we started off saying if you get the kind of

 16 market making that Dodd-Frank was intended to

 17 allow, it's going to be extremely difficult to

 18 differentiate that end state. The bank has got a

 19 risk exposure from all these transactions to

 20 commodity prices. You can't differentiate that

 21 from -- it's going to be very difficult, extremely

 22 difficult to use her term, to differentiate that
 190

 1 from proprietary trading where somebody takes a

 2 position betting that the price is going to move

 3 one way or the other.

 4 And so the proposed rules are so narrow

 5 in trying to create this differentiation that our

 6 conclusion was they will effectively eliminate

 7 banks from doing the market making. And as a

 8 result, the proposed rules don't seem likely to

 9 deliver the intended result of Dodd-Frank. Our

 10 study was actually trying to support the

 11 implementation of Dodd-Frank in a way that it

 12 would deliver the intended result.

 13 Now, the criticism that our shortcoming

 14 is that we didn't consider. So what. If you just

 15 eliminate the banks from this, somebody else will

 16 come in and do it. That's not the issue we were

 17 focused on. It is not clear that people are going

 18 to be able to come in, do it as well, as

 19 efficiently, as transparent. And what we said was

 20 we quantified how important this market making

 21 activity is, and we said in the study if other

 22 people do it and it becomes more expensive as a
 191

 1 result, naturally, the energy businesses will use

 2 less risk management and you can proportionately

 3 scale the numbers we came up with. If they do

 4 half as much risk management, the cost will be

 5 half as much as if they did none.

 6 So it isn't so much a criticism of

 7 Dodd-Frank as realization that the current

 8 definitions are too narrow. What could you do? I

 9 think you ought to consider options that don't try

 10 to tightly differentiate between how much market

 11 making is too much and spills over to proprietary

 12 trading. You obviously have stopped blatant

 13 proprietary trading. If you allow the

 14 market-making activity and quantify risk and

 15 total, something like the value at risk as a

 16 percentage and center reg as a percentage of the

 17 equity that the bank has, shareholder equity, so

 18 that the backstop is not the insured deposits that

 19 are on the balance sheet. There are other things

 20 on the balance sheet, including shareholder

 21 equity. And let that be the backstop for the

 22 positions that get created by doing efficient
 192

 1 market making on behalf of clients.

 2 MR. BERKOVITZ: Lynn.

 3 MS. STOUT: Yes. I'd like to talk a

 4 little bit about the proposed attempt to make the

 5 admittedly difficult distinction between

 6 proprietary trading and market making. And in

 7 particular, I'd like to point out some elements

 8 that the proposed rule relies on that I think will

 9 probably not be very effective, primarily because

 10 they seem to be drawn from securities law and from

 11 prior rules that attempted to find market making

 12 in secondary securities markets. And for a

 13 variety of reasons I think they're not going to be

 14 very effective at separating out market making

 15 from proprietary trading in derivatives markets.

 16 So, for example, and this is under

 17 section 2, bona fide market making. One element

 18 that is in the proposed rule is that you're more

 19 likely to be a market maker if you hold yourself

 20 out as willing and available to provide liquidity

 21 by providing quotes on a regular but not

 22 necessarily continuous basis. That's probably not
 193

 1 going to be a very effective way of distinguishing

 2 between proprietary trading and market making in

 3 derivatives because if someone is a proprietary

 4 trader in derivatives, yes, you're always going to

 5 be willing to provide a price at which you buy or

 6 sell, presumably one that would be favorable to

 7 you. Similarly, when it says that with respect to

 8 securities regularly purchasing covered financial

 9 positions from or selling the positions to

 10 clients, customers, or counterparties in the

 11 secondary market, I say that doesn't apply to

 12 derivatives but it's a good thing because, again,

 13 in derivatives, if you have what's essentially a

 14 hedge fund that's trading in derivatives, you

 15 would also regularly purchase and sell positions.

 16 Transactions, volumes, and risks

 17 proportionate to historical customer liquidity and

 18 investment needs, that's not going to be very

 19 effective in the bespoke market because, of

 20 course, since the customer is on the other side of

 21 the transaction, your volume is going to be

 22 proportionate to what appears to be customer
 194

 1 demand because on every transaction where you're

 2 on one side, it's going to be a customer on the

 3 other.

 4 So I just want to suggest that these

 5 three traditional distinctions used in the

 6 securities field may not be so apt in the case of

 7 derivatives markets. That does get to the

 8 question of what might be more effective.

 9 Certainly, I think that -- I'm looking at your own

 10 criteria -- the criteria I really like are the

 11 fifth criterion, revenues from fees, commissions,

 12 bid ask spreads, rather similar income,

 13 essentially at a functional level what

 14 distinguishes a proprietary trader from someone

 15 who is essentially a dealer or market maker that

 16 makes a living providing liquidity, is that if

 17 you're providing liquidity you can expect to make

 18 a certain return but it's not going to be

 19 particularly spectacular. So if you see very

 20 unusually large revenues coming in from what

 21 purports to be market-making activity, it's

 22 probably not market-making activity. So I like
 195

 1 that criterion.

 2 I also like the sixth criterion for

 3 similar reasons, focusing on the incentives that

 4 are created for the people who are supposedly

 5 making the markets. But I just want to say

 6 generally I think my point is that in derivatives

 7 markets, if you're going to be distinguishing

 8 proprietary trading from market making, you're

 9 going to have to be making much more of what I

 10 would describe as a functional analysis, which

 11 emphasizes what kinds of revenues are being

 12 generated by the so-called market maker. And do

 13 they look comparable to and consistent with the

 14 revenues that are typically earned by securities

 15 dealers who truly do just provide liquidity? And

 16 we know from looking at securities markets, those

 17 are actually pretty thin. Or does it look like --

 18 as our resident economist would put is -- rents

 19 that are being generated within a particular

 20 so-called market making division? Thank you.

 21 MR. BERKOVITZ: Simon.

 22 MR. SIMON JOHNSON: Thanks. I detect a
 196

 1 potential moment of agreement across the differing

 2 views here. And tell me if I'm wrong, Larry, if I

 3 misunderstood what you said. I thought I heard

 4 you say at the end that trading operations should

 5 be backed by shareholder equity, not by insured

 6 bank deposits. And if that's the basic idea, I'm

 7 in favor. In fact, that's exactly what Sheila

 8 Bair said at the beginning, that you should

 9 firewall off completely trading operations from

 10 insured banks and not allow any cross usage of

 11 capital or cross guarantees, implicit or explicit,

 12 that would enhance the credit worthiness of the

 13 trading operation.

 14 Now, I would caution or I do have a

 15 caveat which is, of course, as was mentioned

 16 before, Morgan Stanley itself recently moved a

 17 significant part of its trading operation into the

 18 insured bank. So I wonder if we really have

 19 converged on this point as fully we might. But

 20 perhaps Larry can speak to that.

 21 More generally, I would like to respond

 22 to previous comments on three points. First of
 197

 1 all, with regard to the first point made by David,

 2 perhaps we should agree or at least discuss

 3 whether liquidity per se really is the goal here.

 4 I don't think that just lowering spreads is

 5 necessarily the outcome that you want in your

 6 markets. We can think of plenty of financial

 7 products that have had great liquidity, very tight

 8 spreads during boom phases. Greek sovereign debt

 9 pops into my mind, somewhat topical. Also, I

 10 thought it wouldn't offend anyone in the room if I

 11 mentioned that. CDOs would be another one. We

 12 could mention some more modern instruments that

 13 would offend people.

 14 So I think I'm skeptical of the view

 15 that just having more liquidity, just having more

 16 trading, and I think this is to Curtis's point

 17 also which is that investors will adapt. The

 18 market will move on once you remove the subsidies.

 19 You shouldn't be subsidizing liquidity for the

 20 sake of liquidity.

 21 And building on points made by Curtis

 22 and his colleagues this morning on disclosure, I
 198

 1 would also, on picking up what Lynn just said, I

 2 testified on the Volcker Rule to the Senate

 3 Banking Committee in early 2010. John Reed, the

 4 former head of Citigroup was also on the panel.

 5 The point he made was that bank management knows

 6 when trading is proprietary versus market making,

 7 but it's very hard for anyone on the outside to

 8 know because of the complexity. And I have

 9 specific recommendations for you and we can go

 10 through the details now or later if you want

 11 regarding the disclosure information that you

 12 should require from banks on an ex post basis, not

 13 in real time. Ex post, as them to disclose the

 14 profits they made, the positions they had on all

 15 trading positions relative to derivatives,

 16 including what they label as market making and

 17 what they label as hedging or anything else.

 18 And to Lynn's point, if you are seeing

 19 very large profits coming from particular

 20 operations that are not driven by the rise and

 21 fall of the flow of business, that indicates

 22 somebody is taking a proprietary risk. Hopefully,
 199

 1 management is aware of that. If it isn't aware,

 2 that's an interesting conversation. If it is

 3 aware, of course, that's a different conversation

 4 under the Volcker Rule. So disclosure -- and I

 5 think to the corporate treasurers in the room, and

 6 the people who represent CFOs, it should be very

 7 helpful to you if you can see exactly what kinds

 8 of risks these major counterparties are taking in

 9 the financial market. So it's not just you, Jeff,

 10 talking to people and having sort of a sense of

 11 who's got a grip on their risk but actually being

 12 able to see a lot more data and having third-party

 13 independent analysis of that data. What kind of

 14 positions did they have? How did these move with

 15 the market? Again, incredibly useful for market

 16 participation. You should want it and we should

 17 regard it as a reasonable quid pro quo for the

 18 subsidies that these megabanks continue to get.

 19 Compensation can also be linked. And I

 20 think Marc Jarsulic has very good proposals on

 21 this and hopefully he will speak to them now from

 22 Better Markets.
 200

 1 And just finally, the most rewarding

 2 thing I heard today was actually the points made

 3 by Robert Colby in the morning. It did take me a

 4 while, Robert, I had to read my notes carefully,

 5 to understand, but what I think you said, and

 6 again, you can correct me, but if the idea is to

 7 move, either with regard to hedging or market

 8 making, away from having rules, and as David said

 9 you need to have rules. You need to have clarity.

 10 Moving to a situation where it's all about

 11 discretion, it's all about being able to negotiate

 12 deal by deal with the supervisor, the primary

 13 regulator, all the CFTC, I think that's really not

 14 helpful. I don't think that brings clarity to the

 15 market. I think that it actually is going to

 16 confuse people a great deal. And I think the way

 17 that the regulation is currently written in terms

 18 of these are the following activities that are

 19 allowed, and if it's not specified here it's

 20 prohibited, that is the right approach for the

 21 market clarity point of view.

 22 MR. BERKOVITZ: We have Marc next.
 201

 1 MR. JARSULIC: Marc Jarsulic from Better

 2 Markets. Yeah, let me just address the issue of

 3 distinguishing between market making and

 4 proprietary trading. I think it's probably not as

 5 difficult as is being made out and I think the

 6 solution is embedded in the proposed rules with

 7 some minor amendment.

 8 I think certainly when the academic

 9 literature thinks about market making when other

 10 people with experience in markets think about

 11 market making. Think of the market maker as

 12 someone who provides immediacy to clients. You

 13 want to buy it. You want to sell it. I'll do it.

 14 The market maker, however, is earning his return,

 15 not so much from hauling inventories but from

 16 holding whatever inventories are necessary to do

 17 the business and hedging those. And the income

 18 from market making, from a pure point of view, is

 19 from fees, commissions, and from observable bid

 20 ask spreads where they exist. So if you take that

 21 view of what market making is, then it seems

 22 perfectly reasonable to say that you want to align
 202

 1 the incentives of the people inside the bank with

 2 market making by tying their compensation and by

 3 tying the acceptable revenue from market making to

 4 the kinds of revenue that come from that activity

 5 from providing immediacy so that if you say that

 6 people who are market makers in your bank can be

 7 compensated from fees, commissions, observable

 8 spreads, if you say that the revenue that accrues

 9 to your market making activity comes from those

 10 same sources and that you will look at deviations

 11 from those rules, except for random deviations as

 12 evidence that non-market making activities going

 13 in, you are a long way toward making sure that

 14 what's going on is market making and the

 15 incentives of the people who are supposed to be

 16 engaged in market making are aligned with that

 17 mission.

 18 I think that given the way the proposed

 19 rule is structured, a couple of changes would make

 20 this -- would embed this in the rule. So as the

 21 rule is currently stated it says revenue from the

 22 trading related to market making has to come
 203

 1 primarily from fees, commissions, bid ask spreads,

 2 strike primarily saying that's where it has to

 3 come from except for some random variation. It

 4 says compensation should be designed not to reward

 5 people for proprietary trading. Say compensation

 6 should not reward people for proprietary trading.

 7 Therefore, they shouldn't be paid out of large

 8 temporary gains from the positions they've taken.

 9 I think if you make those kinds of changes it

 10 becomes very clear inside the organizations. You

 11 don't have to micromanage the behavior of people.

 12 You don't have to have really complex rules

 13 governing the behavior of individuals. And you

 14 achieve the goal of moving unacceptable risk out

 15 of the bank dealers and moving it someplace else.

 16 MR. BERKOVITZ: Josh.

 17 MR. COHN: Thank you. A few points.

 18 First, I think we agree with the need to revise

 19 the proposed rule to properly define market making

 20 in the swaps market. And we think that the CFTC

 21 has taken a pretty good shot at that actually in

 22 the entities definitions rulemaking and that's
 204

 1 probably a more appropriate starting point for

 2 discussion in any case than the section 3(a)(38)

 3 Exchange Act definition that is essentially the

 4 fundamental source of definition of market making

 5 in the proposed rule. We think it's also

 6 important that as people consider the exemption

 7 that is in the statute, that people focus on the

 8 full breadth of the language in the statute and

 9 that is the exemption protects positions taken in

 10 connection with market making related activity.

 11 That is, it is not just the act of market making

 12 and facing a customer, and it can't simply be

 13 relying on compensation from the bid offer, and it

 14 can't be relying on compensation from the bid

 15 offer because there's simply not enough of that.

 16 And another thing that the -- another

 17 thing that the rule as ultimately published should

 18 take account of is, in fact, the relative

 19 illiquidity of the derivatives markets as compared

 20 to the securities markets. And it may be helpful

 21 if I give you just a couple of examples. The most

 22 popular interest rate swap in the world, the U.S.
 205

 1 Dollar 10-year swap, there are 200 trades in that

 2 swap a day distributed over how many dealers?

 3 Unclear. But let's say there are at least 14

 4 significant dealers. And so there's appropriate

 5 distribution. All interest rate swaps globally,

 6 there are 6,800 trades a day in all currencies,

 7 and that's in caps, floors, collars, swaps, and

 8 swaptions, not just interest rate swaps. So these

 9 are in different things. All CDS. You had 6,400

 10 trades daily globally.

 11 Let's compare the London Stock Exchange,

 12 if we may. U.K. Equity books 685,000 trades a

 13 day. There's a lot more bid offer potential even

 14 at thin margins in that flow on the London Stock

 15 Exchange than one can think of with respect to

 16 derivatives trades globally. The most liquid

 17 single name CDS contract trades only 20 times per

 18 day, distributed over, again, a number of dealers.

 19 So the opportunities for dealers to make money

 20 from the bid offer are highly limited, yet dealers

 21 have to maintain their books. If they have to

 22 maintain their books, they have to be hedging,
 206

 1 which we discussed this morning. They have to be

 2 positioning and repositioning the book to try to

 3 take account of anticipated needs, anticipated

 4 market circumstances. They may engage in limited

 5 arbitrage activities for liquidity. They will

 6 provide liquidity. Where they don't necessarily

 7 get the full bid offer to other dealers at times,

 8 they will need liquidity and they will pay the bid

 9 offer to other dealers.

 10 So I don't think -- to step back and

 11 look at the proposal as the proposal stands now, I

 12 don't think the proposal takes full account of

 13 these factors. I don't think a proposal that

 14 market makers just live on bid offer alone

 15 actually has any practicality. And being mindful

 16 of the breadth of the exemption that is in

 17 connection with market-making related activities,

 18 I think there needs to be some sympathy for the

 19 fact that the dealer maintaining its book has to

 20 be undertaking different sorts of transactions as

 21 it positions, as it hedges, and that it needs to

 22 make money on these things. It can't run these
 207

 1 things as money-losing propositions. The only way

 2 to compensate for that is to jack up the price to

 3 go out of business. A dealer can, of course, make

 4 less but if a dealer makes less, ultimately, it

 5 will face those problems anyway.

 6 A word about the structure of the

 7 proposal. One of the problems with the proposal

 8 is that although the statute provides an exemption

 9 for market making, the proposal starts by saying

 10 all swap dealing is proprietary trading unless it

 11 is market making. So it creates an adverse

 12 presumption more than a presumption, a certainty

 13 against swap dealing. The release goes on to say

 14 that that presumption is based on the -- well,

 15 it's based on the assertion that swap dealer

 16 positions have short-term trading intent and are

 17 held for resale on that short-term basis. And I

 18 think we've already heard in the course of our

 19 discussion that that, in fact, is not necessarily

 20 the case.

 21 Now, there's an Appendix B to the

 22 proposed rule, and the Appendix B discussion of
 208

 1 market making is actually helpful in many

 2 respects. It better treats the illiquidity that

 3 I've already addressed. It is, however, still

 4 stated very much in the negative with presumptions

 5 against the activity. Relatively little

 6 discussion of what the activity is that is welcome

 7 and that it is, in fact, exempted from the

 8 proprietary trading bar. So it's a good start but

 9 it should be written in concert with revisions to

 10 the rule and the preamble to endorse what is

 11 appropriate market making activity to help set a

 12 metrics base. And I think that there was a

 13 helpful discussion about reflecting on how much

 14 risk can and should be allowed in a market-making

 15 business. Perhaps reflecting on the amount of

 16 compensation overall of how much extraordinary

 17 compensation can come into a market-making

 18 business. But all at the same time with the

 19 understanding that these have to be money-making

 20 businesses. Thanks.

 21 MR. BERKOVITZ: Larry.

 22 MR. MAKOVICH: When you think about some
 209

 1 of the proposed rules that Lynn and Marc discussed

 2 here about if this market-making activity produces

 3 too much profit you've got a problem, that it's

 4 prima facie evidence of proprietary trading. And

 5 that really doesn't sound right. If you've got

 6 somebody that made a market by combining two

 7 people with a short and a long position and, for

 8 example, the bank gets a residual short position

 9 and as happened, you know, in 2010, in the middle

 10 of the winter, gas was $5.32 per million BTU.

 11 This year it was 2.50. So it was half as much in

 12 just two years time. And it's because of

 13 something that most people have no ability to

 14 predict accurately. We had a terrible warm

 15 winter. So that's the kind of risk here.

 16 If a bank ends up with a short position

 17 and makes money as a result, that really isn't a

 18 problem. We've got a profitable bank. The

 19 problem, and Lynn, I think you had mentioned this

 20 earlier, is if there's a flip side to this, that

 21 if you can make that much money, you can also lose

 22 that much money, which goes to the point that
 210

 1 Simon and I seem to be agreeing on, that if you

 2 analyze this risk in aggregate and set limits so

 3 that if you stress test it and everything goes

 4 against the position the market maker has, that

 5 you're not going to be threatening the insured

 6 depositors assets, that it is limited so that the

 7 bank can survive this. But what it means is if we

 8 set those kinds of limits, I think most banks can

 9 handle some pretty substantial swings there so

 10 that we will get periods where most of the money

 11 is made because the position matured and it worked

 12 out. There will be other times when it doesn't,

 13 but I think the presumption that if you make some

 14 profits in a bank this way that there's something

 15 wrong is just a metric here that's not going to

 16 get the job done properly if we want efficient,

 17 cost-effective risk management from banks.

 18 MR. BERKOVITZ: Simon.

 19 MR. SIMON JOHNSON: I want to respond to

 20 a couple of points. On the residual short

 21 position, Larry, I think we are agreeing that what

 22 matters, certainly from a financial stability
 211

 1 point of view -- fresh stability point of view,

 2 what matters is the size of the potential downside

 3 risks relative to your balance sheet and relative

 4 to how this bill would affect the rest of the

 5 economy.

 6 The easiest way to deal with this is to

 7 completely separate those activities from the

 8 balance sheet of the bank with the insured

 9 deposits. No contamination, now or at any point

 10 during the cycle. And I guess my question to you

 11 is do you agree with that? Why not, given the

 12 logic of your position, exactly, allow these

 13 trading operations but in completely separate

 14 subsidiaries, firewalled off totally with no

 15 recourse at all to the insured deposits? I leave

 16 that as a question if you come back to me.

 17 Josh, I didn't quite understand some of

 18 the economic reasoning behind what you were

 19 saying. So if -- and David can check me on this

 20 -- if a market is less liquid, I expect the

 21 spreads, the bid offer spreads to be higher. I

 22 don't understand why just the lack of liquidity in
 212

 1 the CDS means this is an inherently less

 2 profitable activity. I do take your point that in

 3 making markets there are a variety of activities,

 4 including the buying and the selling and other

 5 activities related to that. And that's exactly

 6 why I think Marc's proposal to monitor -- well, to

 7 guide compensation and to my point about data, to

 8 report on exactly how the banks made their money.

 9 And so, I guess my question to you,

 10 Josh, would be with your perspective that this is

 11 -- there's a rich new set of activities that fall

 12 under the heading of market making. Would you

 13 agree that it is entirely reasonable for the CFTC

 14 to require on an ex post basis after the fact,

 15 with a reasonable time lag but presumably somewhat

 16 actionable data from point of view of market

 17 participants, to require the disclosure of how

 18 exactly the bank made its money, on exactly which

 19 parts of these activities, which we can -- which

 20 the bank certainly -- this is self-reporting

 21 presumably -- the bank can observe and the bank

 22 can report on to the CFTC and to the market.
 213

 1 MR. BERKOVITZ: We have Dan.

 2 MR. RODRIGUEZ: Yeah, we've heard from a

 3 couple other institutions and traders here. I

 4 think we have a fixed income person also from

 5 Credit Suisse. I'm Dan Rodriguez and in my role

 6 with equities we deal in block trading,

 7 underwriting. We also trade convertible bonds on

 8 a pretty active basis globally and definitely here

 9 in the United States. And just to give a couple

 10 of examples, it seems that we haven't talked about

 11 specific market making activities, and I want to

 12 introduce just a couple of examples of how that

 13 happens and where it can become difficult as

 14 Sheila Bair said this morning, to differentiate

 15 between proprietary trading risk and market-

 16 making activity. I mentioned the block trade that

 17 we did on behalf of the Fed, which was the AIG

 18 transaction.

 19 So in that, if we break that transaction

 20 down to make the discussion here a little more

 21 concrete, there was $6 billion that the federal

 22 government needed to put out. Okay, that's a
 214

 1 fairly large size transaction. Three billion was

 2 purchased by AIG. One billion was taken on by

 3 Credit Suisse, one billion by Citigroup and one

 4 billion by Morgan Stanley. When you took that one

 5 billion down, so the activities -- we're making a

 6 market. We're doing a block trade. We take that

 7 position onto our book and obviously, as soon as

 8 we take it on we're trying to get that out to a

 9 number of other potential customers, but there's a

 10 position there and we have to manage that

 11 position. So we're making a market now in an AIG

 12 block. It's going to be a billion less the

 13 portion that we were able to sell out of. And

 14 then the question is how long do you keep that

 15 position on?

 16 Now, there's stability requirements,

 17 right? As we're making that market, the agreement

 18 is not to blow out of the position immediately.

 19 And so you're going to have that position on the

 20 book for a period of time. Now, the question is

 21 how long do you keep that position on the book?

 22 How quickly do you sell it out? What bid ask
 215

 1 spreads are you willing to take on that position?

 2 If that position is on the books for three or four

 3 weeks, is that a proprietary position or is that a

 4 market-making position? If it's on the books for

 5 25 seconds, if you keep the position on and you

 6 have to pay a dramatic, you know, you may have to

 7 pay out $25 million as the market maker to get out

 8 of that position that quickly.

 9 And that's the issue with the immediacy

 10 part and the market making. And in reality it is

 11 incredibly difficult. I would argue, as some of

 12 the Fed chairmen have said, or Fed governors have

 13 indicated, it is impossible to differentiate

 14 between bona fide market-making activities often

 15 and what is a true, you know, say a position that

 16 you're taking on by choice. You can argue that

 17 you're holding the position on for five extra

 18 days. Why? Because you think the price was

 19 overdone. To the downside, people were putting

 20 too much pressure on the price and you made a

 21 decision to wait a few days for that position to

 22 come back and to have a more liquid market to put
 216

 1 the position out in.

 2 Now, these are all decisions that happen

 3 every day when you're underwriting and when you're

 4 doing block trades. And if you're doing five or

 5 six block trades at the same time in one sector,

 6 let's say for financial firms, then the catalyst

 7 becomes even more complicated. But these are

 8 decisions and actions that have to be taken by an

 9 active market maker that's supporting block

 10 trading or market making activities.

 11 Now, how do you measure it? As Simon

 12 said, I think Credit Suisse is in that group that

 13 agrees we do not have FDIC-backed deposits. We

 14 agree that that should be segregated. So this

 15 activity is, in fact, segregated from any

 16 FDIC-backed deposits at our institution. And it

 17 is based on the equity capital of our firm as per

 18 Basel III right now and how that's measured under

 19 that regulation.

 20 So we talked about block trades. We

 21 talked about underwriting. You know, the other

 22 example we make is when we do an IPO we do a
 217

 1 convertible bond underwriting. We've done a

 2 number this year. A recent example, Annaly

 3 Capital. We go out and do that transaction and,

 4 you know, we're able to lay off some of that but

 5 some of the risk we have to retain on our books.

 6 Beforehand, we may do pre-hedging because we know

 7 we're getting ready to take on the transaction.

 8 These are all standard actions that market makers

 9 have to undertake. And it may show up on the

 10 books as, oh, this looks like a proprietary

 11 trading position. No, this is a position, a risk

 12 position taking on to support bona fide

 13 market-making activities.

 14 So I want to make sure that gets out

 15 there because there seems to be some confusion as

 16 to the fact that market making is absent any risk.

 17 No, market making entails risk, risk taking. And

 18 I think the big question for this forum and the

 19 CFTC is to ensure that that level of risk taking,

 20 monitor the level of risk-taking very closely,

 21 ensure that we have good, accurate metrics around

 22 that risk-taking activity. And if that
 218

 1 risk-taking activity appears to be excessive, the

 2 regulators should, you know, step in and say this

 3 is excessive and it needs to be reduced. And that

 4 has to be the ongoing dialogue between the

 5 supervisors and those that are being supervised in

 6 these very important market-making activities.

 7 And I just want to mention one point

 8 earlier from the gentleman from State Street who

 9 indicated that at the end of the day, the Volcker

 10 Rule has had some impacts. We've already talked

 11 about it reducing, you know, other proprietary

 12 trading, you know, not necessarily associated with

 13 market-making activities. So I think that type of

 14 trading has been for the most part eliminated. In

 15 conjunction with that we had some reduced

 16 liquidity. Bid ask spreads have gone out on

 17 certain names and it has, you know, as the

 18 gentleman from CalPERS said, it has imposed

 19 additional costs. And how are the folks, you

 20 know, how are the different pension funds, how are

 21 the insurance companies dealing with that?

 22 They're paying higher costs. The investors are
 219

 1 getting a lower return. And then retirement funds

 2 are shrinking and our pension fund deficit is

 3 increasing across the country. So I'd say we have

 4 to be careful on how strict we're going to go

 5 ahead and apply this rule and just be aware of all

 6 the dimensions around risk taking that are

 7 associated with true bona fide market- making

 8 activity.

 9 MR. MAKOVICH: David.

 10 MR. ROBERTSON: Thank you. I want to

 11 address sort of a thread that's been emerging in

 12 this afternoon's discussion which is somehow

 13 making the markets less liquid and less robust.

 14 And let's face it, over the years the markets have

 15 developed quite a bit of liquidity and price depth

 16 that that would not be a bad thing. And at the

 17 risk of being pedantic, I want to take a step back

 18 and just kind of walk through how a corporation

 19 would hedge a risk. And so if I'm a company with

 20 a global exposure and interest rate exposure, I'm

 21 actually forecasting out my balance sheet and my

 22 income statement and my cash flows over time. And
 220

 1 I'm developing a hedge horizon going out, you

 2 know, potentially two years, maybe more. And I

 3 have a hedge ratio that over time I'm hedging that

 4 risk and then each month I'm selling down the

 5 balance sheet and the income statement exposure

 6 and I'm replacing and replenishing those hedges.

 7 And part of the reason why I'm in that

 8 regular periodic management of my balance sheet

 9 and my income statement is I know there's a liquid

 10 market where I can go and get financial risk

 11 instruments at a decent price with a good bid ask

 12 spread. And I think if we go too far in

 13 restricting the ability of the market makers to

 14 make a market, what we're going to end up with is

 15 companies choosing not to hedge because why would

 16 I put on a hedge position if I think I can't

 17 manage that and adjust it over time? And so while

 18 it might be fine for a large institution like

 19 CalPERS to be able to exploit less liquidity in

 20 the market and make a profit out of it, there are

 21 hundreds of middle market corporations that are

 22 relying upon foreign contracts, options, and other
 221

 1 methods of hedging their balance sheet and income

 2 statement exposures. What happens if we take that

 3 away is we're going to end up with companies going

 4 naked, either holding more cash on their balance

 5 sheet, choosing not to expand globally, or trying

 6 to find some way of doing natural hedges. It's

 7 going to be a significant impairment to the

 8 efficiency of the economy.

 9 So we're all for the transparency of

 10 non-owners reporting. We're all for making sure

 11 that banks are taking risks that are appropriate

 12 and compensatory to their capital base, but let's

 13 not pretend that making markets less liquid and

 14 less reliable is a social good. We're actually

 15 impairing the economy when we talk about making

 16 these decisions.

 17 MR. BERKOVITZ: Bob.

 18 MR. COLBY:: : Well, as Lynn very ably

 19 said, there are difficulties in the definition of

 20 market maker when they get applied to swaps and

 21 futures markets where a number of these different

 22 factors really don't work well for you. And so --
 222

 1 and there is an active discussion in the preamble.

 2 There's a less active discussion and most swaps

 3 don't fit in either category. And then as you

 4 work your way through the preamble and the

 5 metrics, there are discussions that are really

 6 apropos of swaps but they're not very extensive.

 7 So I wanted to focus on those.

 8 So one problem you have is the swaps, as

 9 Josh said, are not very liquid. And so when

 10 you're trying to calculate a spread, many times

 11 you're not going to actually be thinking of a

 12 spread in the same way that the equity markets do

 13 or the fixed income markets do. You're really

 14 going to be looking at some swap that's hedging a

 15 swap that's put on, and the revenues are between

 16 the difference in what you get paid on the hedge

 17 and what you get paid on the initial swap.

 18 Someplace in there is your revenues and you're

 19 going to have to figure out if those are hedge

 20 returns, if they're market making spreads, or if

 21 they're something else. And partly because of

 22 that difficulty, SIMFA would recommend that you
 223

 1 take the factor, the revenue factor, and you take

 2 it down to guidance as I said earlier.

 3 So in essence, to make this work, you're

 4 going to have to have supervisors. The bank

 5 supervisors with respect to a bank affiliate or

 6 the CFTC. And let's be frank, the CFTC needs more

 7 staff. They're going to have to know these

 8 entities and learn what they're doing and what the

 9 nature of their business is so they can look at

 10 the particular business where there is principal

 11 trading and try to figure out is this supportive

 12 market making or is it not?

 13 And then the last point I'd make is I

 14 agree with Josh. I think that your definition of

 15 swap dealer captures the right concepts of what a

 16 market maker is. It's someone that's

 17 accommodating customer demand, not necessarily

 18 quoting because that's not the way this business

 19 is done, but is there across market cycles trying

 20 to accommodate customer demand. And that should

 21 be your central focus. And then you use the other

 22 things that are now factors as other indicators
 224

 1 about whether this entity is operating as a market

 2 maker.

 3 MR. BERKOVITZ: Marc.

 4 MR. JARSULIC: Yeah. I think it's

 5 important to remember that the Volcker Rule is a

 6 statute and it attempts to do something. It

 7 attempts to move high risk activity out of the

 8 banks. It doesn't intend to keep it there. And

 9 market making is permitted because market making

 10 is viewed from the point of view of the statute as

 11 a not high risk activity. So if you, you know, if

 12 you can run market making in the way that I've

 13 described, one which the risks are essentially

 14 hedged and revenues comes from the service fees

 15 that you charge, that's not a high risk activity.

 16 If the response is there are certain kinds of

 17 market making which can't be accommodated by this

 18 model, we don't do it this way, you should

 19 therefore somehow ignore the intent of the statute

 20 and widen the rulemaking so this activity can be

 21 permissible, it just flies in the face of the

 22 statute. And in fact, what the Volcker Rule
 225

 1 ultimately wants to do is to move this high risk

 2 behavior off the bank balance sheet.

 3 Now, one way to do it is the way I

 4 suggested. Simon is suggesting that this activity

 5 be walled off someplace. But I have yet to hear,

 6 you know, proposals from the banking community for

 7 doing that or for say imposing leverage

 8 limitations on a trading subsidiary that would

 9 essentially insulate both the holding company and

 10 the banking community and financial markets

 11 generally from the kinds of failures which can

 12 happen very rapidly in these kinds of trading

 13 operations.

 14 MR. BERKOVITZ: Keith.

 15 MR. BAILEY: Thanks. I have a number of

 16 points to make so I'm going to make them quite

 17 quickly.

 18 First of all, to the extent that these

 19 are non-continuous e-traded markets, we do stream

 20 prices in regular interest rate swaps and Index

 21 CDS, but they're at the other end of the spectrum.

 22 There are many prices, markets that trade very
 226

 1 occasionally. And to that extent, we absolutely

 2 support Dan Rodriguez's points about market making

 3 involves risk. And there is a discretion, a

 4 choice made by traders in the exercise of that

 5 market-making function every day, every minute of

 6 every day, in some instances as to hedge selection

 7 and timeliness of hedge selection. Do you hedge

 8 with treasuries? Do you hedge with futures? Do

 9 you hedge with bond futures? Do you -- there's a

 10 whole string of varieties you could use even in

 11 the more liquid markets.

 12 And so I respect the point about

 13 compensating, not compensating being designed for,

 14 traders that take proprietary risk. But it's

 15 important that within the tolerances that are

 16 permitted for the exercise of the limited

 17 discretion that is permitted in order to

 18 substantiate market making you need to be able to

 19 compensate traders who are good at it differently

 20 than traders who are bad at it. So I would just

 21 make that point.

 22 Secondly, we also agree that because of
 227

 1 the whole spectrum of liquidity differentials

 2 across these products, a market-making definition

 3 that contemplates some obligation to make two-way

 4 prices on a continuous basis is not as

 5 appropriate. We think the definition that you

 6 looked at in the context of the swap dealer is

 7 closer where you speak more in terms of routine

 8 market making. There are thousands of CUSIPs.

 9 There are infinite numbers of swaps. And I hope

 10 the customers that we have in the audience would

 11 recognize that we stand ready to make prices on a

 12 whole variety of products that we're not streaming

 13 prices on each and every day, especially in those

 14 less liquid markets. So I think those are points.

 15 As to certainty, I think that it's

 16 important not to lose sight of the fact that there

 17 are many other controls other than Volcker

 18 particularly in the context of market making. We

 19 have strenuous risk limits around the amount of

 20 risks that our trading desk can take. And

 21 naturally, in the less liquid risks those risks

 22 measured by VAR are proportionately smaller than
 228

 1 they would be in markets which have much more

 2 stable volatility profiles. So it is not as if

 3 there is an indifference between the character of

 4 the risk that's being take by a trading desk. And

 5 so whilst I respect the point in principle, we

 6 don't treat the measurements and the tolerance for

 7 illiquid risk at the same measure as we do for

 8 liquid risk. Thank you.

 9 MR. RODRIGUEZ: I want to respond to

 10 that comment about the banks. So the comment that

 11 the Volcker Rule is designed to eliminate risk

 12 from banks -- maybe I'm paraphrasing or misquoting

 13 -- high risk activities. So now the question

 14 becomes, so the Volcker Rule is designed to take

 15 high risk activities from banks. Market-making

 16 activities and hedging activities were both

 17 specifically included in the Volcker Rule to be

 18 preserved for banking institutions. I want to

 19 make sure that that's on the record and that's

 20 very clear.

 21 And then the next question is what's a

 22 high risk activity? And I would agree with Simon
 229

 1 Johnson on that. That a high risk activity would

 2 be any combination of activities that would put a

 3 bank at risk and would basically potentially

 4 result in losses exceeding the capital available

 5 to that institution or the equity capital. And

 6 you know, that's pretty clear. So we know what a

 7 big risk is. We measure it daily in a number of

 8 different ways. And, you know, in the front

 9 office in the equity division we have a concept

 10 called deep downside loss, which is far larger in

 11 excess of VAR. We take the VAR number and

 12 multiply it by 7, 8, 10 times, which is the worst

 13 thing that we can conceive of happening on this

 14 particular transaction, and we actually add up

 15 those numbers.

 16 And so, you know, we have processes in

 17 place that we've talked to the regulators about

 18 pretty frequently of how we manage the risk on

 19 these positions. But I want to make sure that I

 20 take exception with the notion that the Volcker

 21 Rule is designed to take, you know, risky

 22 activities away from banks. Banks continue to,
 230

 1 you know, they have to take risks in the

 2 marketplace. When you do a transaction, any

 3 transaction you do you're taking risk. And that's

 4 just something. You're not eliminating risk from

 5 the system and people need to understand that

 6 there is an optimal level of risk taking out there

 7 and that level is definitely greater than zero.

 8 If we had zero risk taking, then economic growth

 9 would basically, you know, come to a standstill.

 10 I know Simon is very familiar with the

 11 solo growth model. You know, the A there, the

 12 entrepreneurship, that technology innovation

 13 factor, that includes risk taking. You want to

 14 make sure that we preserve risk taking and risk is

 15 not something that -- an excessive risk, yes, we

 16 don't want excessive risk but we want

 17 proportionate risk. And I think the Volcker Rule

 18 needs to focus on the metrics that attempt to

 19 measure and monitor risk over time to ensure that

 20 banks are taking proportionate risk commensurate

 21 with supporting effective and efficient

 22 market-making activities. And from this morning's
 231

 1 discussion, effective hedging activities for our

 2 clients and for institutions that are operating in

 3 the capital markets.

 4 MR. BERKOVITZ: David.

 5 MR. SIMMONS: From the institutional

 6 side we'd, of course, like all our client trades

 7 to be considered market making. Of course, right?

 8 Knowing that market making involves risk, we do

 9 recognize a lot of the views that are around the

 10 table here that risk measures by banks need to be

 11 followed. You know, we agree with that. Measures

 12 that leave banks comfortable with making markets

 13 though. We need traders comfortable with what

 14 they're doing knowing that, I'll say it again,

 15 that they have clarity in what they're doing and

 16 they're not going to get penalized after the fact.

 17 We've seen evidence of the banks, just

 18 to reiterate what the banks have already said

 19 here. Evidence of the banks, reducing risk

 20 dramatically. Dealer balance sheets, inventories,

 21 DV01, VAR, all the things that have been

 22 mentioned, we've been polling the banks for the
 232

 1 last three years on this and we've seen a

 2 significant decline. We go to each dealer. We

 3 ask each dealer about all these different

 4 parameters because we like to track liquidity

 5 based on what we're seeing for dealer DV01s and

 6 balance sheets. We've seen a decline in that.

 7 That's happened. And we've been able to still

 8 trade bonds in that environment. The environment

 9 has been adequate enough to trade bonds.

 10 So holding period, fine, you know, the

 11 P&L tracking, I think that's -- knowing the guys I

 12 deal with, the traders I deal with, that's going

 13 to create confusion for them. P&L tracking, if

 14 they make a lot of money in the trade, all of a

 15 sudden that's considered proprietary. I think

 16 we're going to have traders out there that are

 17 going to be very concerned with taking the trade

 18 on at all. And that's just going to hurt,

 19 especially the more liquid bonds out there,

 20 smaller companies that don't have, you know, not

 21 AT&Ts of the world but a smaller company with

 22 maybe a 250 million bond deal outstanding. It's
 233

 1 going to hurt them more than anybody.

 2 So I think it's important to recognize

 3 that money needs to be made at the banks. We

 4 think that anyways. If they're not making money,

 5 there's no -- if they feel like they're allowed to

 6 make any money, then why are they going to trade

 7 these products at all? And if they don't trade

 8 these products at all, then we all have a problem.

 9 And our clients have a problem.

 10 MR. BERKOVITZ: As the discussion

 11 continues, I'll ask one question. Maybe a

 12 panelist can answer along with other remarks. One

 13 of the concerns in the comments about the Volcker

 14 Rule in general is it's level of complexity and

 15 detail. On the other hand, we've heard some

 16 discussion today about particular asset classes,

 17 illiquid markets need to be -- not all markets are

 18 the same. Certain aspects of the rule were

 19 written to more aptly describe equity market

 20 making rather than what the CFTC would be dealing

 21 with in commodity markets. We obviously are faced

 22 with writing our Volcker Rule but we're looking to
 234

 1 what the other regulators working with other

 2 regulators as well, should the CFTC -- should our

 3 rule differ and have special considerations for

 4 our type of markets? Or will that add a level of

 5 complexity that people are trying to avoid?

 6 Obviously, the more we target our rule to specific

 7 asset classes and to our specific type markets,

 8 then it becomes more complex. So do people favor

 9 addressing different asset classes with different

 10 sets of metrics and maybe different criteria? Or

 11 would you prefer a more consistent general higher

 12 level approach?

 13 Larry.

 14 MR. MAKOVICH: Based on the discussion

 15 today I think it points to a higher level

 16 approach. I think that, you know, there's general

 17 agreement. It's extremely difficult to

 18 differentiate this market-making activity from the

 19 results of proprietary trading. But there's also

 20 general agreement that this is a very valuable

 21 service that's provided. As Chairman Gensler said

 22 this morning, that market making is important to
 235

 1 the economy. I think that's kind of come up and

 2 that if you try to get too detailed and prescribe,

 3 it's too complicated. It's just not going to work

 4 well and it's going to be very, very inefficient

 5 and the 20/20 hindsight that people talked about.

 6 But I think we kind of got to the root of the

 7 problem here which is it's a valuable service that

 8 fills a unique position in the risk management

 9 job, but that market making is not risk free.

 10 And to Marc's point, we don't want high

 11 and unacceptable risk exposures, but Dodd-Frank

 12 seems to want to be able to allow the market

 13 making with acceptable risk. And that really gets

 14 to the question that Simon had posed. I think no

 15 one is advocating backstopping the risk associated

 16 with market making with insured deposits. I don't

 17 think anybody's saying that ought to be how it

 18 works but it does seem to appear with some general

 19 broad specifications that limit the exposure in

 20 aggregate from this activity. We can keep the

 21 risk at a level that is acceptable and that this

 22 doesn't seem to require that the banks exit this
 236

 1 activity or that they have to spin off this

 2 activity. It looks like rules could be developed

 3 that would sufficiently separate this activity and

 4 the intent of Dodd-Frank could be accomplished.

 5 MR. BERKOVITZ: Lynn.

 6 MS. STOUT: It seems to me, I agree that

 7 generally complexity is not good. Excessive

 8 involvement in detail is not good. But I do want

 9 to emphasize that in formulating rules, I think

 10 it's important to bear in mind that in many ways

 11 the social consequences, the costs and benefits of

 12 derivative markets are very different from the

 13 social consequences, the costs and benefits of

 14 secondary securities markets and that that is a

 15 distinction that's worth bearing in mind as you're

 16 trying to calculate the costs and benefits of

 17 adopting a relatively more restrictive rule that

 18 makes it harder to claim that activity is market

 19 making as opposed to a less restrictive rule.

 20 So to get specific, it's important again

 21 to bear in mind that neither derivatives markets,

 22 nor secondary securities markets, directly
 237

 1 allocate capital to what we're going to call the

 2 real economy. They're not Adam Smith's markets.

 3 And to the extent they are socially beneficial at

 4 all, and people have questioned whether either is

 5 socially beneficial, it's agreed that they're

 6 socially beneficial only indirectly.

 7 So the secondary securities markets is

 8 socially beneficial for two reasons. Number one,

 9 the existence of a secondary market makes

 10 investors interested in investing in the primary

 11 market, and it's the primary market in which real

 12 businesses raise real capital. And then to a

 13 lesser extent, a secondary securities market

 14 performs a price discovery function. By the time

 15 we get to derivatives markets, and again, just as

 16 an aside, it's very easy for people who are here

 17 who are representing industries, when they're

 18 talking about the costs and benefits to the rules,

 19 to be thinking about the costs and the benefits of

 20 the rule to their particular company or their

 21 particular firm or even their particular industry.

 22 But I think your brief is to think about the costs
 238

 1 and benefits of the rule to society as a whole.

 2 So focusing on derivatives in

 3 particular, to the extent derivatives are

 4 beneficial, they are beneficial only because they

 5 reduce risk. They obviously don't raise capital

 6 for anybody. They can't provide positive returns

 7 on the whole because they're wagers and they're by

 8 definition zero sum gains. You know, you can't

 9 have an economy that runs on a casino. It's not

 10 going to generate income. So what derivatives do

 11 is simply, if they are regulated properly, move

 12 risk to the party who can hopefully bear it most

 13 cheaply, or we have to worry is the person simply

 14 the one who is the least informed about the risk

 15 they're taking on.

 16 So that being said, we have to also look

 17 at this question of the importance of liquidity.

 18 So I'm going to disagree with Larry. I don't

 19 think everyone here actually agrees, and I'm going

 20 to agree with Simon, shockingly enough, that

 21 liquidity is always a wonderful thing and always

 22 essentially for our economy. In fact, it's not.
 239

 1 And famous economists from Keynes, through Tobin,

 2 through Jack Hirshleifer, have argued why it's

 3 not. There are plenty of situations where

 4 liquidity is either not socially beneficial,

 5 although I will concede that it's always perceived

 6 as privately beneficial to the person who wants to

 7 sell something, but it's not always socially

 8 beneficial. Sometimes it's socially harmful. And

 9 I mention this simply because, again, I think that

 10 as an agency weighing the costs and benefits from

 11 a social perspective, you can take with a grain of

 12 salt the claim that liquidity is always socially

 13 beneficial.

 14 So I'll just give you a couple of

 15 examples. One example, classic example drawn from

 16 the stock market. The fact is that it's been long

 17 established that actively managed mutual funds on

 18 average underperform the market. Why? Because

 19 they think they can beat the market and they've

 20 been statistically proven as an industry to fail

 21 to do so. If lowering the transactions costs of

 22 trading in the secondary stock market leads
 240

 1 actively-managed mutual funds to trade still more

 2 because the demand for trading is highly elastic

 3 and the data suggests it is highly elastic, the

 4 irony is the lower the trading costs, the more

 5 liquid the stock market, the more money actively

 6 managed mutual funds will lose for their investors

 7 trying to beat the market. I'm not saying that

 8 this is happening overall or in the case of any

 9 particular firm, but I'm saying that it is a

 10 logical problem that cuts against the claim that

 11 liquidity is always beneficial.

 12 And similar arguments can be made in the

 13 derivatives market. To the extent that some

 14 people who are going to those who make markets in

 15 OTC derivatives are doing so not to hedge risks

 16 but are doing so because they hope to profit from

 17 speculating on their future predictions. That

 18 again becomes a similar sort of zero sum game

 19 where greater liquidity could lead to even greater

 20 trading that actually increases the net social

 21 losses. Certainly, greater liquidity is not a

 22 benefit when many of the people who go to the
 241

 1 market, who actually think they are hedging, prove

 2 to be mistaken and to have made a hedge that

 3 didn't work. And I really don't think that we can

 4 discount the possibility, which is very, very well

 5 supported by the last 15 years of experience, that

 6 a lot of people who use derivatives to hedge are

 7 falling prey to a version of the winner's curse in

 8 that they think they're buying a more complete

 9 hedge than in fact they are. And the reality is

 10 that leads them to take on greater risk in the

 11 underlying market that turns out to be

 12 incompletely protected against leading to more

 13 institutional failures.

 14 So I'm sorry for the long-winded

 15 discussion, but the basic point is I think that

 16 it's time to stop saying that liquidity is always

 17 beneficial and is always highly valuable in

 18 markets. That may be true in spot markets for

 19 commodities being traded in the real economy.

 20 It's not always true in the secondary market for

 21 equities or bonds or in derivatives markets.

 22 MR. BERKOVITZ: Curtis.
 242

 1 MR. ISHII: So I have four points. One

 2 is that I agree with the premise that it's

 3 difficult to separate prop trading and market

 4 making. Even if you allow hedging, many of the --

 5 even a simple -- something as simple as a

 6 corporate bond, it depends on what you're going to

 7 be hedging. Are you hedging the interest rate

 8 risk? Are you hedging the equity exposure and how

 9 you go about doing it? So I think it's difficult.

 10 My last point will be a new way to kind of look at

 11 this possibly, too, is the effects on the pension

 12 fund, someone said that this would cause pension

 13 funds to not be able to make their nut. I would

 14 not worry about that. Financial repression is

 15 causing low returns and markets in general are

 16 really focusing or causing that. So I don't think

 17 this, whether you enact this will cause pension

 18 funds to either make it or not. Three is you

 19 talked about whether the rule should be

 20 differentiated between asset classes. I would

 21 argue yes. Don't treat bonds like stocks. I

 22 mean, they aren't. There are the differences and
 243

 1 I think it's been made that a corporation has one

 2 typical stock and typically in a bond it may have,

 3 you know, 10, 20 different issues. And so the

 4 issues are different.

 5 Lastly, due to the complexity,

 6 potentially, and we put this in our letter, you

 7 might want to think about a different way to

 8 handle this. And one is what I've seen some of

 9 the desks on the street do who handle risk fairly

 10 well is think about vintaging. So it allows

 11 trades to occur without immediately hedging them

 12 for a certain amount of time. But you look at the

 13 positions and begin to start to potentially raise

 14 capital unless you can define it as hedging of

 15 some sort as it stays on their books over time.

 16 And the reason I say this is many of the mistakes

 17 and many of the things that have cost many of

 18 these financial institutions quite a bit of money

 19 have been bad trades or trades that were done to

 20 make -- short-term trades became long-term trades

 21 and they get hidden in the books for quite some

 22 time and then they become proprietary and
 244

 1 eventually they blow up. But it takes quite some

 2 time. And so if you begin to sit there and can

 3 find out let's say that it's maybe a non-hedging

 4 activity but a kind of market transaction that's

 5 been on the books for a month or two, it may then

 6 require more capital and then you can begin to

 7 address it. It's just another different way to

 8 address it and it's a potential.

 9 MR. BERKOVITZ: Josh, I think you were

 10 next.

 11 MR. COHN: You asked about one rule or

 12 different rules by different regulators. And I

 13 think the way we would see it is one rule as much

 14 as possible, but ultimately there needs to be

 15 product nuance. And it can be that to the extent

 16 that different products are in fact supervised by

 17 multiple regulators as may be the case, then

 18 perhaps one regulator gets to write the first

 19 draft and the others mark it up. And ultimately,

 20 you have one rule for the product embedded in one

 21 Volcker Rule that has different product facets.

 22 There has been the point made about
 245

 1 derivatives market making being a high risk

 2 business. And I don't think that many of us on

 3 the industry side of it are thinking of it as a

 4 high risk business or of maintaining a high risk

 5 business. I think we're looking at maintaining

 6 prudent market-making businesses subject to

 7 policies and metrics that make sure these are

 8 prudent market-making businesses. I think Larry's

 9 ideas for founding the risk that can be in these

 10 businesses are good and fundamentally important

 11 ideas.

 12 MR. BERKOVITZ: Simon.

 13 MR. SIMON JOHNSON: To your question

 14 about whether you should have different

 15 requirements across different markets, I certainly

 16 think that around derivatives we need to have a

 17 lot more data and disclosure, both with regards to

 18 some of the issues we've touched on today and also

 19 more broadly about trading positions, exposures,

 20 and compensation for traders, compensation schemes

 21 and natural compensation outcomes.

 22 Let me put it to you like this, and I
 246

 1 apologize if this upsets anyone or causes them to

 2 close their positions before the trading day is

 3 over. But the European sovereign debt is

 4 currently about 8.5 trillion Euros, $11 trillion,

 5 2 trillion Euros outstanding Italian debt. I

 6 think there's a [inaudible] of a major sovereign

 7 debt restructuring coming in Europe, including

 8 default perhaps. Perhaps disorderly events around

 9 very big markets. Now, the European banks are

 10 undercapitalized, whatever with I'm sure present

 11 company excepted. The Euro zone banks, Euro zone

 12 banks, I correct myself, are notoriously

 13 undercapitalized and are likely to be severely

 14 damaged by whatever is coming. Now, how do we

 15 know? How do you know? How do we know? How does

 16 the non-financial sector of the United States know

 17 who's safe and who's not safe in this kind of

 18 coming storm? It is relatively easy to look at

 19 balance sheets and look at balance sheet

 20 exposures. Not perfect, but relatively easy.

 21 Derivative exposures, off balance sheet

 22 transactions of all kinds, it's extremely
 247

 1 difficult, I would say impossible. From where I

 2 sit I listen to the corporate treasurer's

 3 perspective and I'm happy to be contradicted by

 4 our banking colleagues. This is huge. This is a

 5 huge systemic risk. And, you know, VAR may well

 6 be a component in your decision-making. It's

 7 obviously got a pretty mixed reputation. I think

 8 Dan's term is deep downside loss. I'm going to

 9 start calling it double deep downside loss. It

 10 will be my perspective. Whatever you think the

 11 losses are out there, we have to worry about this

 12 much bigger impact coming through derivatives.

 13 And, you know, I understand you don't want your

 14 businesses to get swept away. And to Josh's point

 15 and to Larry's point, you believe legitimately,

 16 honestly on the basis of available information to

 17 you and your perspective of the world, that these

 18 activities you're involved in are not very high

 19 risk. Unfortunately, the financial sector has

 20 established a very robust track record of

 21 consistently getting it wrong, including some of

 22 the best names in risk management until a month
 248

 1 ago. I guess I did read in the New York Times

 2 that JP Morgan was going to attend this hearing or

 3 perhaps was interested in attending this hearing

 4 and unfortunately couldn't make it under the

 5 circumstances.

 6 This is not an isolated incident. This

 7 is a pattern of repeated large scale accidents.

 8 Or maybe it's worse than accidents. Maybe it's

 9 compensation schemes and incentive schemes. And

 10 David Robertson, to come back to you, it's a

 11 subsidy. We're providing subsidies to the bank

 12 through the taxpayer guarantees, both insured

 13 deposits and more broadly through being too big to

 14 fail.

 15 So the issue on liquidity, to build on

 16 Lynn's point, is what are you paying for it? How

 17 much additional liquidity are you getting, which I

 18 understand you like, in return for this subsidy?

 19 Do you want to subsidize liquidity at this level?

 20 And I think the intent of the Volcker Rule is

 21 clear, to back away from those subsidies, not to

 22 remove them completely, not to eliminate risk from
 249

 1 the world. There's risk in everything, including

 2 crossing the road. We get that. The question is

 3 do you want to concentrate these risks on the

 4 balance sheets or off the balance sheet of these

 5 global megabanks that pose a real and present

 6 danger to this economy and other economies with

 7 which we have very close trading and financial

 8 relationships?

 9 MR. BERKOVITZ: Dan.

 10 MR. RODRIGUEZ: A quick response on

 11 that. I think it sounds like we're all in

 12 agreement that we don't want excessive risk

 13 concentrated on the bank's balance sheet. I think

 14 we all agree on that. Us, I mean, if you work at

 15 a bank, you don't want your bank to have too much

 16 risk so it blows up and everyone becomes

 17 unemployed. So our centers are completely aligned

 18 in that regard.

 19 The issue, I think the difference in

 20 opinion regarding, you know, I think about the

 21 comment made earlier that liquidity may be bad is

 22 like saying, you know, having highways could be
 250

 1 bad because there's car accidents. And so that

 2 was the metaphor that popped in my mind when I

 3 heard that statement. And I've heard it now

 4 several times that allowing people to trade is bad

 5 because sometimes people lose money when they

 6 trade. And I think that's similar to saying, hey,

 7 driving is bad because sometimes people have car

 8 accidents. And I think we have to get out of that

 9 mindset and really think about what we're doing

 10 here. The CFTC is trying to preserve important

 11 economic capital market activities that need to be

 12 preserved in a prudent way. And I think we are

 13 all saying the same thing here at this table in a

 14 little bit different manner, and it sounds like a

 15 matter of degree, although I think, you know,

 16 parts of the table are a little bit more skewed

 17 one way or the other.

 18 We all want a safer system. We don't

 19 want taxpayer subsidies to support excessive and

 20 disproportionate risk taking. I think we're all

 21 in agreement on that. And I think the way to do

 22 that is how are you going to figure that out? I
 251

 1 agree wholly with Simon on that. It is difficult

 2 to figure it out.

 3 You know, I think I always like to say

 4 in some of my seminars on risk management is, you

 5 know, only Stephen King has enough imagination to

 6 be able to determine all the bad things that can

 7 potentially happen to you out in the marketplace.

 8 And so it is a difficult -- it's difficult to

 9 operate and function effectively out there. We do

 10 need help for the regulators. We need to

 11 continually improve our processes and continue to

 12 improve our risk management effectiveness. And

 13 you know, I think we've gotten a little bit

 14 better. We've become more prudent. Are we

 15 prudent enough? Are we good enough now? I would

 16 say we're still improving in that regard and the

 17 regulators need to continue to take a look at us.

 18 They need to continue to monitor us and continue

 19 to have these dialogues about, you know, when I

 20 say deep downside, I mean, it is a seven times or

 21 a 10 times VAR multiple. I mean, I have three

 22 different ways to measure that. And I always
 252

 1 think more metrics are better than less, although

 2 it is sometimes costly to produce these metrics.

 3 You need to have multiple dimensional views on the

 4 activities that you're taking, like having, you

 5 know, you're driving down the road, and you want

 6 to have as many mirrors as you can to see where

 7 all the potential risks can be coming from, but we

 8 don't want to do away with cars and we don't want

 9 to do away with the highways that we need and the

 10 liquidity that is very helpful and critical to

 11 capital markets.

 12 MR. SIMON JOHNSON: No one is proposing

 13 to do away with highways. The question is speed

 14 limits. If you want to drive without any speed

 15 limit at all you can go to Germany and drive on

 16 the Autobahn. That option is available. And

 17 that's also a country it turns out with a

 18 massively undercapitalized, overly leveraged

 19 banking system that's been consistently badly run.

 20 So good luck sorting that out, too.

 21 MR. BERKOVITZ: Paul.

 22 MR. SHANTIC: Paul Shantic, California
 253

 1 State Teachers. I run a credit portfolio and

 2 we've talked a lot about liquidity. As a

 3 portfolio manager, I always like liquidity. What

 4 that pretty much tells me is I can get out. Get

 5 out of a bond, get out of a position. Sometimes I

 6 want to get into a position. But for the most

 7 part I usually want to get out. And if you're

 8 levered 25 or 30 times like the investment banks

 9 were earlier on, there's plenty of liquidity. And

 10 now that we've seen that they're less leveraged,

 11 we have much less liquidity to deal with.

 12 The perfect portfolio for me would be

 13 something I could set up and walk away from for

 14 six months and not have to trade a bond in.

 15 Unfortunately, that's not the markets that we're

 16 in. What can occur and what is a little bit of a

 17 concern to me going forward, though I think it's

 18 probably been addressed, is there will be events

 19 and markets in which people will want liquidity

 20 either to get out or to get in to take advantage

 21 of a situation. I would be concerned that whoever

 22 is involved the other side, be it the investment
 254

 1 bankers or the banks themselves, would be afraid

 2 to take on risk if we have volatility in either

 3 particular names or sectors of the market and walk

 4 away from those sorts of things. I get concerned

 5 about large price drops that may not necessarily

 6 reflect reality but granted, I understand it's a

 7 market.

 8 Prop desk. Part of the reasons prop

 9 desks must have been created was the knowledge

 10 that you can see., first of all, what your clients

 11 are doing, but also must have made good money in a

 12 number of different positions along the way,

 13 whether that be Enron, WorldCom, or what have you,

 14 Time Warner, that have occurred along the way. I

 15 would be concerned that we're trying to move away

 16 from that with some of these rules. And I'm much

 17 more comfortable after hearing the discussion

 18 today that that's not where we're going.

 19 I'm also concerned a little bit in terms

 20 of swaps transactions that might be necessarily

 21 off the rack but slightly more customized. We run

 22 a pension fund. We have a number of different
 255

 1 indices. We also have occurring within those

 2 indices certain exemptions. For example,

 3 smoke-free, Sudan-free, things like that that

 4 might be slightly more difficult to hedge. I'm

 5 sure bankers will be able to figure that out and

 6 hedge those products appropriately, but that is a

 7 concern in terms of some of the customization that

 8 we might want to do either on the equity side or,

 9 for example, on the bond side. It seems that

 10 we've addressed a lot of those things here but I

 11 just wanted to reflect those positions.

 12 MR. BERKOVITZ: Keith.

 13 MR. BAILEY: This is not necessarily an

 14 official Barclays' position but my instincts on

 15 your question are that we really don't want five

 16 different rules. We think that the principles

 17 around what is proprietary trading and what is not

 18 proprietary trading should be common across

 19 markets. But I do think that the parameterization

 20 and the calibration of the metric set that you may

 21 attach to the determination of the presumption or

 22 the justification for further investigation will
 256

 1 be very different depending on the asset class and

 2 indeed within an asset class perhaps. But I think

 3 at the foundational level it seems to me that this

 4 is a tough enough issue without trying to fragment

 5 different solutions. And I think it would add

 6 certainty to know that there's any one kind of

 7 foundational rules.

 8 And I do have to say that I don't think

 9 Barclays -- this is the official rule. I don't

 10 think we're undercapitalized. I don't think we're

 11 going to do harm anybody.

 12 MR. BERKOVITZ: David.

 13 MR. SIMMONS: And back to the same topic

 14 on asset classes, just going over some statistics

 15 we have on the corporate bond market, you know, we

 16 feel that asset classes that are less liquid

 17 should be potentially treated differently from a

 18 risk metric standpoint. You know, in 2011, in the

 19 corporate bond market, 35 issuers out of over 600

 20 issuers in the corporate bond market, the actual

 21 Barclays Corporate Index, 50 percent -- so the 35

 22 issuers made up 50 percent of the overall volumes
 257

 1 in our market. The other 50 percent being the

 2 other 550 some-odd plus. It shows the difference

 3 in liquidity in our market where you've got the

 4 banks are trading a lot, the big companies, the

 5 AT&Ts, the GEs, they're trading a lot, but a lot

 6 of smaller companies aren't trading that much and

 7 they're very illiquid.

 8 It also takes about 250 to 270 days to

 9 turn over the corporate bond market, whereas in

 10 the S&P I've seen anywhere from 3 to 10 days to

 11 turn over the S&P. It's completely different

 12 markets. I think that's important to recognize

 13 when you're deciding to make your rules and

 14 figuring out how markets -- how different markets

 15 should be regulated.

 16 MR. BERKOVITZ: Larry.

 17 MR. MAKOVICH: I just wanted to try to

 18 tie together these two ideas. I think that the

 19 different asset classes are very fundamentally

 20 different in the way risk appears, its

 21 characteristics. So bonds and equities and energy

 22 commodities are all very, very different. And I
 258

 1 think that ties into Simon's point that there's I

 2 think some very clear evidence that people have

 3 had a difficult time properly assessing risk and

 4 it's not for lack of education or intelligence.

 5 We've had very smart and well educated people make

 6 huge blunders in risk management, but I think that

 7 really says we need to focus on getting the set of

 8 metrics that are properly differentiated by asset

 9 class that with some oversight here can create

 10 effective limits on what is the root cause of the

 11 problem here that banks can or, you know, anybody

 12 can -- market makers, banks, anybody -- can get

 13 over exposed on risk.

 14 And if the focus is on these metrics, I

 15 think it'll be a much more productive

 16 implementation than if the focus is trying to draw

 17 the line between when somebody's market making has

 18 crossed some gray area distinction into

 19 proprietary trading.

 20 MR. BERKOVITZ: Lynn.

 21 MS. STOUT: I just want to point out

 22 that we've been working on these metrics for some
 259

 1 20-odd years, just as we've been working on coming

 2 up with the ideal executive compensation contract

 3 for 20-some odd years. And both ventures I think

 4 it's fair to say have failed pretty dramatically,

 5 in part because it's simply -- the assumption that

 6 you can come up with a perfect metric assumes a

 7 world in which there's risk, but absolutely no

 8 uncertainty of the kind originally described by

 9 Frank Knight in 1923 and highlighted by Nassim

 10 Taleb in "The Black Swan." In a world where there

 11 is uncertainty as well as risk, it is simply

 12 impossible to come up with metrics that allow you

 13 in any way to be sure that you are perfectly

 14 hedged. The world just won't permit it.

 15 So I'm not a big fan of relying on

 16 metrics of human omniscience as a means of

 17 ensuring we will not have any future disasters.

 18 I'm much more a fan of Marc's argument. And I

 19 just wanted to get the response from some of the

 20 people in the room. I'm not sure that this is

 21 something that would be permissible within the

 22 purview of Dodd-Frank, but it would be interesting
 260

 1 to ask yourselves the following experiment. Would

 2 it be an appropriate way to distinguish

 3 proprietary trading from market making to set a

 4 limit on the amount of profit that a bank can make

 5 from its allegedly market-making activities? So

 6 you would say in essence that if you make more

 7 than a certain amount on a particular transaction,

 8 some portion of that would have to be paid out, I

 9 don't know, to the SEC or the CFTC or in the form

 10 of a confiscatory tax.

 11 I'm just looking for your reaction. I'm

 12 not proposing it, obviously. But does that arise

 13 any problems from your perspective? I would think

 14 as an end-user it might actually be attractive to

 15 have some reassurance that the bid ask spreads

 16 you're paying have a limit to them.

 17 MR. BERKOVITZ: Go ahead.

 18 MR. ACOSTA: Maybe I'll respond. This

 19 is Jeff Agosta with Devon.

 20 Let me just give you a specific example

 21 of something that we just did with a pair of

 22 financial institutions. We were going to hedge --
 261

 1 we were going to issue bonds before May 15th. So

 2 we entered into some forward starting swaps

 3 because our bonds are principally going to be

 4 priced off of underlying U.S. treasuries and we

 5 wanted to hedge our interest rate risk. Right?

 6 Because if rates went up before we issued, it's

 7 going to cost us a lot more. So we wanted to lock

 8 on those interest rates.

 9 What happened was the opposite. Okay?

 10 Treasury rates went down and we had to write a

 11 check for $15 million to get out of those trades.

 12 Were we happy to do that? Sure. Because we got a

 13 much lower rate on the bonds that we issued. So

 14 we were fine with that. They made a profit off of

 15 that trade. It was a short-term trade but it was

 16 to our benefit. I don't have a problem with them

 17 making money. I think that that's a good thing.

 18 Banks should make money.

 19 MR. BERKOVITZ: Bob.

 20 MR. COLBY:: : I don't want to change

 21 the tenor of the conversation. I have a few more

 22 technical points to make at some point in the
 262

 1 discussion.

 2 MR. BERKOVITZ: Larry, did you want to

 3 respond on Lynn's point?

 4 MR. MAKOVICH: Yeah. You know, the

 5 point here that it is possible to put together

 6 some workable metrics that would effectively limit

 7 risk. Will they be perfect? No. But we

 8 shouldn't let perfect get in the way of the good.

 9 You know, this is possible. It's not easy but

 10 it's possible to do. And I think if we do these

 11 simplistic solutions of limiting profitability

 12 we'll create these perverse incentives that if the

 13 bank on the other side of this interest hedge

 14 figures it's going to make too much money, they're

 15 going to have to find some losing proposition to

 16 offset it which just doesn't make sense. And you

 17 know, Frank Knight was the cornerstone of the

 18 Chicago school that very much believed that the

 19 profit motive was one of the primary drivers for

 20 economic efficiency. So it's just kind of a nutty

 21 idea to think that we've got a problem if we've

 22 got profitable banks. The problem here is to
 263

 1 protect ourselves against banks that lose too

 2 much.

 3 MS. STOUT: My point, I just want to

 4 emphasize, is that the large profits and the large

 5 losses are not utterly unrelated. I obviously

 6 also am not against banks making profits. The

 7 question is are they making it through proprietary

 8 trading which adds risk to the banks along with

 9 occasional individual profits?

 10 So let me, one more time, Jeff. So

 11 let's say we're not doing it on a transaction by

 12 transaction basis, which I concede probably

 13 wouldn't work. But suppose there were limits set

 14 on the amount of profit that a bank could make

 15 market making over some lengthy period of time.

 16 We could make it 12 months. We could make it a

 17 rolling 12 months. In other words, I'm asking you

 18 generally, at some point, if a bank is making 30

 19 percent margin or something, just amazing profits,

 20 are you as an end-user not concerned about that?

 21 MR. ACOSTA: If it's done legitimately,

 22 transparently, I have no problem with them making
 264

 1 money. There's nothing wrong with a bank being

 2 ultra profitable. That's fine.

 3 MR. BERKOVITZ: Simon.

 4 MR. SIMON JOHNSON: Lynn, I think the

 5 end-users are splitting the subsidies so that's

 6 why they're not too bothered. The issue is not

 7 the end-user. The issue is the social cost.

 8 There's an asymmetry in the payoffs for banks.

 9 When they get to keep the topside and the downside

 10 comes onto the taxpayer, either through the FDIC

 11 insured deposits or more broadly because the

 12 largest banks in this country are too big to fail

 13 despite the best intentions of the people who

 14 wrote Dodd-Frank and the regulators who tried to

 15 implement it. Too big to fail is a reality in

 16 this economy and around the world. And if you

 17 want to deny it, if you want to tell me that

 18 global megabanks can't actually fail today, right

 19 now, let's have that discussion. I think it's a

 20 fascinating discussion to walk through exactly how

 21 that failure would happen unimpeded. It doesn't

 22 exist.
 265

 1 I would commend to the staff and to

 2 anyone else who at all doesn't get this the work

 3 of Anat R. Admati and her colleagues at Stanford

 4 University who go through in great detail from the

 5 perspective of both corporate finance from an

 6 academic point of view and from a real world point

 7 of view and lay out for you the social costs of

 8 this asymmetric payoffs.

 9 While we're putting ideas on the table

 10 for addressing the asymmetric payoffs, not that

 11 you can move on this one by yourself, but limiting

 12 the tax deductibility of interest for highly

 13 leveraged, very big financial institutions is a

 14 good idea whose time will come.

 15 MR. BERKOVITZ: David.

 16 MR. ROBERTSON: Yeah. I just wanted to

 17 address a couple points from the standpoint of

 18 corporate treasurers. I do think that there's a

 19 difference between wanting banks to be healthy and

 20 strong and wanting access to liquid markets

 21 doesn't necessarily make the corporate treasurers

 22 a shell for the banking industry or somehow
 266

 1 enjoying subsidies. Right now in the market we

 2 have an extreme credit condition, and I think if

 3 there is a subsidy in the market it's the fact

 4 that basically everything shifted to sovereign

 5 risk. And so as you said, there are banks that

 6 are too big to fail and, in fact, those banks

 7 aren't just getting all of the deposits. They're

 8 getting larger and larger.

 9 And what we're dealing with here is a

 10 perfect example of why we have banks too big to

 11 fail, and that is we put through regulation that

 12 has one perspective. We think we're going to

 13 restrict something and in point in fact, we have

 14 unintended consequences. And I think that's

 15 probably the biggest concern of corporate

 16 treasurers is that we are laying regulation upon

 17 regulation and regulation and we've seen banks

 18 like Wachovia and National City fail, but what

 19 have we seen as a result? We've seen more

 20 concentration of financial risks in the market.

 21 So adding yet another restriction on what can

 22 happen with a smaller number of counterparties
 267

 1 with which corporate treasurers can truly do

 2 business, that's not going to help the financial

 3 markets. And I don't perceive that there is any

 4 subsidy when a bank is selling a derivative or a

 5 forward contract to a company. They're making an

 6 open market transaction. There's multiple

 7 corollary price points. There's an informed buyer

 8 and an informed seller. So I'm not buying the

 9 subsidy argument.

 10 MR. SIMON JOHNSON: The cost to capital,

 11 David, the cost to capital, sure you would agree,

 12 is lower for a financial institution that is

 13 backed implicitly by the full faith and credit of

 14 the U.S. Treasury than it is for another

 15 institution that is small enough, simple enough to

 16 fail.

 17 MR. ROBERTSON: Actually, if we see the

 18 subsidies in the banking industry, they're across

 19 the board for banks of all sizes through unlimited

 20 insurance given to the banks. If you really are

 21 managing trading risks properly, and I agree

 22 that's a big if that the industry has to address,
 268

 1 you have banks that have to set aside capital

 2 internally, even from prudent risk management, but

 3 the exposures that these trades generate.

 4 Now, we can have an argument whether

 5 they're doing it properly or not but the bank is

 6 attempting during a ROE on that swap. It has

 7 trading risk, it has credit risk embedded in that

 8 capital that's set aside for that instrument. And

 9 the corporate treasury is paying for that exposure

 10 as well. So there's no sense of a subsidy unless

 11 you believe that all the risk-based capital

 12 allocations that are going into these products are

 13 incorrect.

 14 MR. SIMON JOHNSON: The estimates of the

 15 funding cost advantage for too big to fail banks

 16 within the financial sector vary between 25 and 75

 17 basis points. I would put it around 50 basis

 18 points. That's a huge funding advantage in

 19 today's market from being too big to fail.

 20 MR. ROBERTSON: For deposits. It's a

 21 funding of mandatory deposits.

 22 MR. SIMON JOHNSON: It's being too big
 269

 1 -- it's having a balance sheet that's large enough

 2 relative to the size of the economy.

 3 MR. JARSULIC: Yeah, that's not a

 4 funding advantage to deposits. This is a funding

 5 advantage to bank holding companies and the

 6 advantage to the bank holding companies derives

 7 from the fact that there's a put option on the

 8 taxpayer that will prevent that bank from failing.

 9 And as a consequence, their cost of funds is

 10 remarkably lower. It's not just because there's

 11 an insurance on the deposits.

 12 MR. ROBERTSON: Right, but again we're

 13 talking about funding the bank; we're not talking

 14 about the balance sheet exposures.

 15 MR. RODRIGUEZ: I just want to respond

 16 to that. I think that there may be a funding

 17 advantage. I'd be interested to look into that

 18 study or follow up with you Simon afterwards. The

 19 issue here -- that's a separate discussion from

 20 the Volcker Rule. Right. I think that is, you

 21 know, too big to fail, two points or comments I

 22 would make at least from the Credit Suisse
 270

 1 perspective. I think Basel III has addressed

 2 this. Once again where you have significantly

 3 increased the capital requirements, improved the

 4 funding liquidity requirements, and also

 5 encouraged significantly greater oversight of

 6 these banking institutions, you know, the risk to

 7 weighed assets as measured by Basel II have come

 8 down from about 450 billion down to about 150

 9 billion.

 10 So if we were too big to fail before,

 11 we're not as too big to fail now for sure by any

 12 measure. And I'd also say that the balance sheet

 13 has shrunk down from about a trillion dollars to

 14 -- and this is all public information -- down to,

 15 I think, maybe south of 400 billion. I think this

 16 is about the numbers. So significant shrinkage in

 17 terms of balance sheet exposure. The size of the

 18 institution has become a lot tighter. And I think

 19 this too big to fail problem is being addressed.

 20 People in this room may not be aware of it but

 21 institutions are getting smaller. You always hear

 22 the statistic out there cited that, oh, a bigger
 271

 1 proportion of banking is being addressed or being

 2 concentrated in a fewer number of banks. But the

 3 overall size of the balance sheets and the risk

 4 associated with those banks is actually much

 5 smaller than it's been in the past.

 6 MR. SIMON JOHNSON: That may be true in

 7 Switzerland; it's not true in the United States.

 8 JP Morgan Chase, the largest bank in the country,

 9 has a balance sheet now around $2.3 trillion if

 10 you measure under U.S. GAAP. That allows a very

 11 generous definition of netting. If you put them

 12 under IFRS, it would be a $4 trillion bank, which

 13 would be larger than Citigroup was, which was the

 14 largest bank at the time in 2008. So our biggest

 15 banks are actually getting bigger. I agree that

 16 the Swiss are moving in the right direction. I

 17 wish that we had Swiss level capital and capital

 18 requirements which are much stronger than Basel

 19 III across all our banks. That would put us in a

 20 better position, although I would argue not a

 21 strong enough position with regard to capital

 22 going forward.
 272

 1 MR. RODRIGUEZ: I agree with that

 2 statement from Simon.

 3 MR. BERKOVITZ: Bob, I think you had

 4 some technical --

 5 MR. COLBY:: : Well, I don't want to

 6 bore people here.

 7 MR. BERKOVITZ: I think we've probably

 8 got about 15 minutes left.

 9 MR. COLBY:: Yeah. I won't take all

 10 that. I wanted to say three more things about the

 11 issues that you face in the market maker

 12 definition and just remind you of two other major

 13 points that you need to focus on in the Volcker

 14 Rule context. And none of this will be startling

 15 to you.

 16 The three points with respect to the

 17 swaps. The first is that because people don't, as

 18 Keith said, don't hold themselves out with a quote

 19 in a particular -- they may do a swap but you

 20 really have to think about it as being willing to

 21 accommodate customer demand in positions, a type

 22 of position as opposed to any sort of particular
 273

 1 instrument because they're too diffuse in number.

 2 The second is that I think you're going

 3 to have a higher number of interdealer trades than

 4 you would in other markets because oftentimes a

 5 market maker facilitates a customer with a swap

 6 then they may do a similar or a hedge swap with a

 7 dealer. And, you know, the customer-facing ratio

 8 counts against you but that's something that you

 9 have to pay attention to particularly. Then a

 10 topic that's very familiar to you, inter-affiliate

 11 swaps. The release doesn't discuss them. They

 12 complicate the analysis. You're going to have to

 13 look at it probably across the full range of swaps

 14 to see the full market making relationship. So

 15 those are the three things specifically here.

 16 And then I just wanted to, before we

 17 lose time all together, point out that there's a

 18 great deal of concern about including forwards in

 19 the derivative definition. And most people

 20 thought that commodities were excluded and that

 21 included commodity forwards and not just spot --

 22 when they're physically settled.
 274

 1 And then last of all you really need to

 2 pay attention to commodity pools. I think you

 3 know but it's vastly over extensive and it needs

 4 to be brought down to what I think the original

 5 purpose was.

 6 MR. SIMON JOHNSON: Just Robert's point

 7 reminds me that on the issue of inter-affiliate

 8 swaps I presume and hope that you're talking in a

 9 very deep way with the FDIC, particularly with

 10 regard to Title 2 resolution where inter-

 11 affiliate transactions are a huge part of the

 12 problem that they've identified, but also with

 13 regard to living wills. If we have a large amount

 14 of these swaps and the ability, these

 15 organizations continue to have the ability to

 16 change whether the risk is recognized or would

 17 ultimately fall or will fall in the event of a

 18 severe stress scenario, that makes the living will

 19 process much harder to implement. Makes it much

 20 harder for that to have real value to supervisors.

 21 And presumably, at least the swaps part of that is

 22 something that you should be involved in.
 275

 1 MR. BERKOVITZ: Paul.

 2 MR. SHANTIC: I would like to try to

 3 stay out of the Simon, David back and forth here.

 4 And a point I had earlier in terms of Lynn's

 5 comment about profits in terms of limiting

 6 profits, it's incumbent upon me as a portfolio

 7 manager always to try to find the best price. And

 8 it's also important that we remember that during

 9 the 2009-2010 period when most of the big banks

 10 were paralyzed for large periods of time, other

 11 banks came in, other firms were formed that took

 12 care of some of that liquidity during that period

 13 and became pretty crucial until I suspect the

 14 funding for the banks got better and took

 15 advantage of the funding advantage to restart and

 16 to take more risks for their clients. So there

 17 was a period of time, six to nine months, where

 18 the difficulty of getting a trade done was pretty

 19 substantial. And the only liquidity in many

 20 instances was, in some cases, some foreign banks

 21 and newly formed firms that were split off from

 22 some of the larger firms. That then turned around
 276

 1 as liquidity came back into the markets.

 2 MR. BERKOVITZ: Lynn.

 3 MS. STOUT: I'm just going to say how

 4 relieved I am at least to hear that Paul Shantic

 5 is concerned about the profitability of banks when

 6 he's the counterparty to the banks. But I also

 7 wanted to respond, simple point out that each of

 8 the concerns that Robert Colby brought up and that

 9 suggested your agency you should focus on, your

 10 Commission should focus on, to the extent that you

 11 take those concerns into account in your

 12 standards, I'm having a hard time seeing how you

 13 can do that without simultaneously loosening the

 14 standards in a way that would make it much easier

 15 for banks to be essentially proprietary trading

 16 while claiming to be market making.

 17 I'm not saying that you're not right to

 18 raise those concerns, Robert, but I'd be

 19 interested in hearing any suggestions from you or

 20 anyone else on how those concerns can be addressed

 21 without simultaneously making it more likely that

 22 deposit accepting banks will indeed resort to
 277

 1 proprietary trading.

 2 MR. COLBY:: : Well, so what I'm trying

 3 to address here is the disqualifying factors that

 4 will knock you out of the exception. But

 5 generally speaking, I think that because of the

 6 complexity of the whole topic that the only way it

 7 can be effectively administered is by having

 8 existing rule, having guidance about how you

 9 should be thinking about this, both for the banks

 10 and for the supervisors, and then having the

 11 supervisors having a very intense discussion

 12 looking at metrics and trying to understand what

 13 the actual activities of a particular swap dealer

 14 or FCM if they're doing business, what their

 15 particular characteristics are and trying to

 16 understand their business because the concern I'm

 17 trying to express is that the way that the rule

 18 itself has been structured now with factors that

 19 if you don't -- if any one of them -- if there's

 20 some question about whether you comply, that

 21 you'll be knocked out and you won't be in a

 22 permitted activity, then that's going to result in
 278

 1 overly restrictive compliance requirements on the

 2 part of people that are actually trying to comply

 3 with the statute. And it will ratchet up or

 4 restrict the activities more than the regulators

 5 actually intend when they try to adopt the rule.

 6 MS. STOUT: So just to make sure I

 7 understand what you're suggesting, you're

 8 suggesting that rather than try and put in place

 9 prophylactic rules that might have the admittedly

 10 undesirable consequence of discouraging or

 11 chilling transactions that perhaps were not

 12 intended to originally be covered by the statute,

 13 you would favor a system in which a combination of

 14 the industry and regulators would on a

 15 case-by-case basis try to identify potentially

 16 risk-creating dangerous situations in advance?

 17 MR. COLBY:: : I wouldn't express it

 18 that way. What we'd say is that the prophylactic

 19 rule would be that you do not -- the exception is

 20 just for market making. But after that I think

 21 the entire discussion where it's been focused on

 22 details has shown the extreme complexity of trying
 279

 1 to identify ahead of time what the difference is

 2 between market making and proprietary trading.

 3 And that, I think, says to the people that are

 4 going to have to live with the rule, that what

 5 it's going to have to be is an iterative process.

 6 And this is not one that they take lightly because

 7 it means extensive involvement with their

 8 supervisors on the details of how they engage in

 9 hedging and in market making. But that's what

 10 it's going to take and they're going to have to

 11 walk -- set up a compliance program that's going

 12 to have to identify what the mandates are and what

 13 they're allowed to do and what the risk

 14 requirements are and what the policies and

 15 procedures that control this is, and they're going

 16 to have to go through it desk by desk with their

 17 supervisors so that the supervisors understand

 18 what they do. And I don't think that most --

 19 other people can comment on this -- there's no

 20 other effective way to ensure that this is being

 21 applied in some sort of a workable but

 22 constraining manner.
 280

 1 MR. BERKOVITZ: Steven or Stephen, do

 2 you have any further questions? Any further

 3 comments? I think we've had an excellent

 4 discussion today. If there are no further

 5 comments I'd just like to thank everybody. We

 6 have a task given us by Congress which is to

 7 implement section 619 of the Dodd-Frank act, the

 8 Volcker Rule, and this discussion has been very

 9 helpful as we try to carry out Congress's intent

 10 to prohibit proprietary trading yet permit market

 11 making and risk mitigating hedging activities, and

 12 this discussion will be very helpful. It really

 13 builds upon our record and I again thank all the

 14 participants for taking time out of your busy

 15 schedules to come here and engage in a lively

 16 debate. It's been very, very informative and we

 17 again thank you very much.

 18 (Applause)

 19 (Whereupon, at 4:11 p.m., the

 20 PROCEEDINGS were adjourned.)

 21 * * * * *

 22
 281

 1 CERTIFICATE OF NOTARY PUBLIC

 2 DISTRICT OF COLUMBIA

 3 I, Christine Allen, notary public in and

 4 for the District of Columbia, do hereby certify

 5 that the forgoing PROCEEDING was duly recorded and

 6 thereafter reduced to print under my direction;

 7 that the witnesses were sworn to tell the truth

 8 under penalty of perjury; that said transcript is a

 9 true record of the testimony given by witnesses;

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 12 which this proceeding was called; and, furthermore,

 13 that I am not a relative or employee of any

 14 attorney or counsel employed by the parties hereto,

 15 nor financially or otherwise interested in the

 16 outcome of this action.

 17

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