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Testimony 

“Review of Credit Derivatives” 

Oral Testimony of CFTC Acting Chairman Walter Lukken Before the 

House Committee on Agriculture 

October 15, 2008 

Good morning Chairman Peterson, Ranking Member Goodlatte, and other distinguished 

Members of the Committee and thank you for the invitation to be here today to discuss 

credit default swaps. 

The current financial crisis is requiring policymakers to rethink the existing approach to 

market regulation and oversight. Many observers have singled out the $58 trillion dollar 

credit default swap (CDS) market as needing greater scrutiny and transparency. These 

over-the-counter (OTC) swap transactions are largely unregulated and have 

exacerbated the counterparty and systemic risk in the financial system during this crisis. 

The most common credit derivative—the credit default swap contract—works by a 

“protection buyer” agreeing to pay a premium to a “protection seller” for the obligation 

that the seller will pay the buyer a specified amount in the event of a default of a 

corporation or index of corporations. It functions similar to insurance and was intended 

to be used as a hedge by those with exposure to the issued debt of an underlying 

corporation. As we have read, however, many participants in these markets were 

“naked” and did not have exposure to the underlying debt obligation of the companies. 

With respect to the CFTC, the Commodity Exchange Act (CEA) excludes most OTC 

financial derivatives, including CDS, from its regulatory and enforcement jurisdiction. 

But if we are to avoid repeating the mistakes of the past, we must strive to increase the 

transparency of these transactions and find ways to mitigate the systemic risk created 

by firms that offer and hold these off-exchange instruments. While wholesale regulatory 

reform will require careful consideration, centralized clearing is one immediate and 

proven response that will help mitigate the current crisis. 

Clearinghouses have been functioning for many years as a means for mitigating the 

risks associated with exchange-traded financial products. Whether securities, options, 

or futures, centralized clearinghouses ensure that every buyer has a guaranteed seller 

and every seller has a guaranteed buyer, thus minimizing the risk that one 
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counterparty’s default will cause a systemic ripple through the markets. The 

clearinghouse is able to take on this role because it is backed by the collective funds of 

its clearing members. 

This clearing guarantee goes to the root of the problems we are confronting today – the 

constriction of credit due to fear of default. Indeed, for futures contracts—the 

standardized on-exchange predecessor of OTC derivatives—clearing has worked 

extraordinarily well in managing credit risk. For regulated futures exchanges, the 

clearing and settlement mechanism serves to lessen the likelihood that large losses by 

a trader will cause a contagion event. At least twice daily, futures clearinghouses 

collect payments from traders with losing positions and credit traders with profitable 

positions. This twice-daily “mark-to-market” prevents the buildup of significant losses 

and effectively wipes clean the credit risk inherent in the system. Importantly, no U.S. 

futures clearinghouse has ever defaulted on its guarantee. 

Just as significant, the clearing process provides transparency to regulators. When 

transactions are cleared, government and exchange regulators receive daily trader and 

pricing information, which helps them to police for manipulation and fraud and to uphold 

the integrity of the market. 

Clearing has been proven to work for OTC derivatives. After Enron’s demise in 2001, 

the OTC energy derivatives markets “locked up” because many energy companies 

lacked the requisite financial standing to back their off-exchange trades. In response, 

the New York Mercantile Exchange (NYMEX) sought and received approval from the 

CFTC in 2002 to clear OTC energy products for the first time. Today, a significant 

number of OTC energy derivatives are cleared through regulated clearinghouses, which 

has reduced systemic risk and allowed regulators a greater window into this 

marketplace. Clearing for OTC products now extends beyond energy products to 

financial products such as forward rate agreements and foreign currency swaps. 

Under existing law, any derivatives clearing organization (DCO) that is registered with 

the CFTC may clear OTC derivatives without further registration or subjecting itself to 

any additional regulatory requirements. Pursuant to the CEA, the CFTC regulates 

DCOs and has the statutory mandate to ensure the financial integrity of transactions 

subject to the CEA and to safeguard against systemic risk. The CFTC relies on the 14 

core principles for DCOs set forth by Congress in the CEA as a means of evaluating 

whether DCOs comply with U.S. law. 

In analyzing compliance with these principles, the CFTC looks to the controls and tools 

utilized by a clearinghouse, including: (1) appropriate membership standards; (2) 

collection of position reports from large traders; (3) daily mark-to-market of all open 

positions; (4) collection of an appropriate amount of performance bond margin, which 

serves to cover any losses; (5) periodic stress-testing of open positions for extraordinary 

market moves; (6) an ability to liquidate all of a market participant’s open positions 

quickly; and (7) availability of other financial resources for use by the clearinghouse to 

cover any member default. Any clearinghouse seeking to clear CDS transactions will 

need to show in its proposal that it can bring such tools to bear. 
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The CFTC, in conjunction with other financial regulators, will continue to seek ways to 

provide clearing solutions for OTC derivatives. Last month, in its swaps report to 

Congress, the CFTC recommended the further use of clearing for OTC derivatives. 

There are several private sector clearing initiatives currently being considered by 

Federal regulators, and it is imperative that regulators work cooperatively and 

expeditiously to conduct their due diligence and allow appropriate programs to begin 

operations promptly. The CFTC will continue to closely coordinate with the Federal 

Reserve and SEC to further this important policy objective. 

While the implementation of centralized clearing for OTC products is a near-term 

solution that does not require legislative changes, broader reform of the OTC 

derivatives markets is also needed and will require decisive Congressional action. As 

Congress embarks on reform in the coming months, there are several guiding 

objectives that should be pursued by legislators to improve the oversight of these 

markets and prevent a similar economic disturbance in the future. 

First and foremost, regulatory reform should seek to improve the transparency of these 

OTC markets, particularly when their size reaches a critical mass where they play a 

public pricing role and their failure might cause a systemic event. Clearly the CDS 

market has met these criteria. Enhanced transparency through reporting or other 

means would enable regulators to properly police these markets for misconduct and the 

concentration of risk. In pursuing this objective, Congress might look to the model 

adopted in the Farm Bill for the OTC energy swaps market, which triggers additional 

oversight and transparency when a product begins to serve a significant price discovery 

function. 

Second, regulatory reform should incentivize and possibly even mandate centralized 

clearing and settlement for certain OTC derivatives. As mentioned, clearing brings 

enhanced transparency, standardization, and risk management to these products at a 

time when it is most needed. 

Third, regulatory reform should revisit the amount of risk-based capital held by dealer 

firms and large participants in these OTC markets to better account for the 

interdependent counterparty risk that now seems so evident and to prevent these 

products from being held off-balance sheet in unregulated affiliates. As clearing begins 

for these products and trading data improves, models for assessing risk will also 

progress as will the accuracy of the capital charges assigned to these firms. 

Fourth, regulatory reform should provide for clear enforcement authority over these 

products to police against fraud and manipulation. The CFTC is currently excluded by 

statute from bringing enforcement cases against OTC financial derivatives. Congress 

should rectify this by providing clear enforcement powers regarding OTC products to the 

CFTC and other appropriate regulators, such as the SEC. 

Lastly, regulatory reform of OTC products should be globally-coordinated and nonexclusionary. As this financial crisis has shown, the world’s financial system is highly 

intertwined, leaving no country’s banking system unscathed. We have also learned that 

one country’s actions to stem the crisis cannot be effective without close cooperation 

among all nations. As this crisis begins to wane and we turn to pursue long-term 

adjustments to the global regulatory structure, world legislators must work in close 
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concert with each other to ensure the steps taken by one nation to improve oversight 

are not exploited by others in the global financial community. This also means that 

domestic regulators should work in tandem and not engage in the unproductive exercise 

of defending jurisdictional lines at a time when a comprehensive and coordinated 

response by regulators is most needed. The entire regulatory community must continue 

to unite in seeking a sensible and comprehensive solution to the global financial crisis, 

which may require many of us to rethink our regulatory approaches and jurisdictional 

biases. The CFTC is committed to playing a constructive role in seeking a cooperative 

regulatory solution that improves the global regulatory structure for financial markets. 

Mr. Chairman, I appreciate your leadership on this critical issue, and I look forward to 

participating fully in Congressional and regulatory efforts to implement policies and 

practices that best serve the public interest. I look forward to your questions.