Commodity Futures Trading Commission 

Office of External Affairs 

 Three Lafayette Centre 

 1155 21st Street, NW 

 Washington, DC 20581 

 202.418.5080 

Testimony 

Written Testimony of Acting Chairman Walter Lukken Before 

the House Committee on Agriculture 

October 15, 2008 

Chairman Peterson, Ranking Member Goodlatte, and other distinguished Members of 

the Committee, I am pleased to have this opportunity to appear today to discuss risk 

management for credit default swaps (CDS). The Commodity Futures Trading 

Commission (CFTC) welcomes the opportunity to discuss over-the-counter (OTC) 

derivatives and the benefits derived from clearing such products.

OTC Swaps and Regulated Futures Transactions 

From the beginning of U.S. futures trading in the mid-1800s until recently, regulated 

futures exchanges offered the primary means by which commercial entities could 

manage their physical market price risks. During the 1980s, however, financial 

institutions began to develop non-exchange-traded derivatives contracts that offered 

similar risk management benefits. In 1981, the World Bank and IBM entered into what 

has become known as a currency swap. The swap essentially involved a loan of Swiss 

francs by IBM to the World Bank and the loan of U.S. dollars by the World Bank to IBM. 

The motivation for the transaction was the ability of each party to borrow the funds they 

were loaning more cheaply than the counterparty, thus reducing overall funding costs 

for both parties. This structure of swapping cash flows ultimately served as the 

template for swaps on any number of financial assets and commodities.

The development of the OTC swap industry is related to the exchange-traded futures 

and options industry in that a swap agreement can function as a competitor or 

complement to futures and option contracts. Market participants often use swap 

agreements because they offer the ability to customize contracts to match particular 

hedging or price exposure needs. Conversely, futures markets typically involve 

standardized contracts that, while often traded in very liquid markets, may not precisely 

meet the needs of a particular hedger or speculator. The OTC swap market has grown 

significantly because, for many financial entities, the OTC derivatives products offered 

by swap dealers have distinct advantages relative to futures contracts. 
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Yet, these OTC swap transactions are largely unregulated. With respect to the CFTC, 

the Commodity Exchange Act (CEA) excludes most OTC financial derivatives, including 

CDS, from its regulatory and enforcement jurisdiction.1

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 OTC credit 

derivatives, including CDS, as needing greater scrutiny and transparency. 

OTC credit derivatives emerged in the mid-1990s as a means for Wall Street financial 

institutions to buy insurance against defaults on corporate obligations. Specifically, 

OTC credit derivatives are bilateral off-exchange instruments that allow one party (the 

protection buyer) to transfer credit-related risks associated with the actual or synthetic 

ownership of a “reference asset” to another party (the protection seller) for a price.2 The 

reference asset associated with an OTC credit derivative may be a corporate debt 

obligation (such as a bond or a bank loan), a sovereign debt obligation, an assetbacked security (such as commercial mortgage-backed securities), or any other 

obligation or debt. Credit derivatives transfer the credit risks attendant to the actual or 

synthetic ownership of a reference debt obligation. 

The most common credit derivative product is the CDS. Under a CDS, the protection 

seller promises to compensate the protection buyer for the economic loss associated 

with a material decline in the value of a reference asset that is triggered by the 

occurrence of a pre-determined “credit event,” such as a filing for bankruptcy or default 

on a debt payment by the issuer of the reference asset. In some CDS contracts, the 

protection buyer pays the protection seller a “periodic premium” for the protection.3 If a 

triggering credit event occurs, then the protection buyer would receive a full lump-sum 

payment that is some fraction of the par value of the reference asset, to compensate the 

buyer for the asset’s devaluation. In turn, the protection buyer would deliver the 

devalued asset to the protection seller. 

 

1 See, e.g., CEA, 7 U.S.C. §§ 2(d) and 2(g). Section 2(d) excludes from CEA coverage transactions involving an 

“excluded commodity” (a broad range of interest rate, currency, credit, equity, weather, and other derivatives) that 

are not executed on a trading facility and are entered into solely by eligible contract participants. Section 2(g) 

excludes from CFTC regulation transactions involving a commodity other than an agricultural commodity that are 

not executed on a trading facility if they are entered into solely by eligible contract participants and are subject to 

individual negotiation. 

 Section 2(d)(2) also excludes transactions involving an excluded commodity that are executed through an 

electronic trading facility by eligible contract participants trading on a principal-to-principal basis, or by certain 

authorized fiduciaries or investment managers. Finally, under Title IV of the Commodity Futures Modernization 

Act of 2000 (CFMA), an exclusion from the CEA was created for certain individually-negotiated swap agreements 

offered by banks to eligible contract participants. 

2

 In the OTC market, the terminology “protection seller” and “protection buyer” is used to refer to the seller and the 

buyer of a credit derivative. 

3

 CDS pricing is based on (i) the probability that the issuer of the reference asset will experience a credit event, and 

(ii) the expected recovery rate for the reference asset. Credit events are defined in Article IV of the 2003 

International Swaps & Derivatives Association’s (ISDA) Credit Derivatives Definitions. These definitions and 

standards are well established, and they have been adopted for widespread use in the OTC market. 
CFTC PAGE 3 OF 6 

The estimated notional amount of CDS transactions has nearly doubled every year 

since 2001 to reach an estimated peak of $62 trillion in 2007, before receding 12 

percent to $54.6 trillion as of June 30, 2008.4

 In all likelihood, this number somewhat 

overstates the actual size of the CDS market because many traders hold offsetting 

positions that have not been netted against each other. Nevertheless, the size of total 

CDS positions is substantial. 

The Benefits of Clearing of OTC CDS Transactions

Recent events have uncovered the risks that certain CDS transactions pose to the 

financial system. American International Group, an insurance company, reportedly 

issued CDS transactions covering more than $440 billion in bonds, leaving it with 

obligations that it could not cover in the current market conditions. This CDS exposure 

factored into the Federal Reserve’s decision to provide an $85 billion conditioned loan 

to the ailing company to prevent its failure and a possible contagion event in the broader 

economy.5 Clearly, there are major risks associated with these products that need 

further review. 

The dispersed and non-standardized nature of many OTC instruments makes finding a 

regulatory solution a challenging task. But policymakers 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 solution that could help mitigate the risks associated with these products. 

Clearing mitigates counterparty risk by substituting the credit of the clearinghouse for 

the credit of the counterparty. In addition, clearing: (1) addresses the assessment of 

market risk and price transparency by publishing a settlement price each day for each 

product; (2) increases liquidity by enabling participants to offset positions against 

entities other than the original counterparty; and (3) facilitates order processing by 

establishing standard procedures and deadlines. For these reasons, this solution has 

been advocated by CDS market participants and the President’s Working Group on 

Financial Markets (PWG). The PWG first recommended providing clearing solutions for 

OTC derivatives in a 1999 report to Congress.6

Clearinghouses have been available 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 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. 

Clearing would enable parties to a CDS transaction to focus solely on obtaining the best 

price for the transaction, without regard to whether the parties executing opposite them 

 

4

 ISDA News Release, Sept. 24, 2008 (available at http://www.isda.org/press/press092508.html). 

5

 Indeed, it now appears that AIG may be the beneficiary of up to an additional $37.8 billion in federal aid. 

6

 Over-the-Counter Derivatives Markets and the Commodity Exchange Act, Report of the President’s Working 

Group on Financial Markets, November 1999. 
CFTC PAGE 4 OF 6 

are capable of performing their obligations. Because the clearinghouse would serve as 

the central counterparty to all transactions, parties could close out their positions without 

having to seek out the original counterparties to their trades. 

Clearing would also strengthen the infrastructure of CDS trading by facilitating more 

timely and accurate post-trade processing. For many years, post-trade processing of 

OTC derivatives has been a decentralized, paper-based process. As a result, the 

enormous growth in trading volume led to massive backlogs in confirming trades. 

Various initiatives have been undertaken to improve the trade processing of CDS 

transactions, and progress is being made toward resolving the backlogs; however, 

much work remains to be done. By contrast, as evidenced by the performance of U.S. 

futures clearinghouses, efficient and accurate trade processing is a hallmark of clearing. 

Adopting a clearing regime for CDS would prevent such backlogs from developing in the 

future. 

Centralized clearing addresses the root problems the markets are confronting today—

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

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

extraordinarily well in managing credit risk. The first independent U.S. futures 

clearinghouse was established in 1925, and this model helped launch others. Today, 

the world’s largest derivatives clearing facility is located in the United States and 

routinely moves billions of dollars per day in mark-to-market settlements, including a 

record $12.7 billion on January 23, 2008, without any disruption. In 2007, that same 

facility traded a record 2.2 billion derivative contracts valued at more than one 

quadrillion dollars. 

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. 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. 

Current Regulation of OTC Derivatives Clearing 

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 just energy products to 

financial products such as forward rate agreements and foreign currency swaps. 
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Under existing law, any derivatives clearing organization (DCO) that is registered with 

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

any additional regulatory requirements.7

 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 avoid systemic risk. The CFTC relies on the 14 core 

principles for DCOs set forth by Congress in the CEA, 7 U.S.C. § 7a-1, 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 and 

continuing oversight of members; (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 (sometimes referred to as “margin”), which serves to cover any 

losses that cannot be met by the market participant; (5) periodic stress-testing of open 

positions; (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. 

While DCOs do not need pre-approval from the CFTC to clear OTC derivatives, any 

such initiative would be required to comply with the relevant core principles set forth in 

the CEA, and the CFTC would review it for compliance with those principles. In 

addition, the CFTC would need to approve in advance any request by a DCO to 

commingle funds associated with “cleared-only” OTC derivatives with the DCO’s 

customer segregated funds. The customer funds underlying exchange-traded futures 

and options are required to be held in a separate account and to be segregated from 

the funds of the clearing member and of the DCO. The CEA and CFTC regulations 

prevent any other funds from being held in the segregated account absent permission 

from the CFTC. This is a critical customer protection feature that is designed to ensure 

that customer funds for exchange-traded futures and options are protected and 

available for withdrawal or transfer even if the clearing firm in question experiences 

severe financial distress or goes into bankruptcy. In appropriate circumstances, the 

CFTC has permitted DCOs to commingle customer funds associated with “cleared-only” 

OTC derivatives with customer funds associated with exchange-traded futures and 

options in the segregated account. The CFTC has permitted such treatment only when 

it has concluded that the benefits of permitting such commingling outweigh the risks. 

Separate from clearing, the creation of a trading platform for CDS products also could 

be beneficial because it would enhance pricing transparency, liquidity for the product, 

and order processing. However, the utility of some of these customized off-exchange 

instruments might be lost if they become sufficiently standardized to be listed on a 

multilateral exchange trading facility. For example, two major U.S. derivatives 

 

7

 The CFMA added Section 409 to the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA), 

12 U.S.C. § 4422, which governs the clearing of OTC derivative instruments by multilateral clearing organizations 

(including DCOs). Section 409 of FDICIA prohibits a person from operating a clearing organization for OTC 

derivative instruments except if that person is registered with the CFTC or the SEC, or is supervised by certain 

approved foreign financial regulators, or unless that person is a type of banking organization. 
CFTC PAGE 6 OF 6 

exchanges listed credit derivatives products in 2007, but neither product was able to 

gain a significant market share. 

In closing, 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 policymakers work cooperatively and 

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

operations promptly. While comprehensive financial reform might take time, 

encouraging centralized clearing is one immediate step that can reduce risk in the 

markets and benefit the U.S. economy. 

Thank you for your leadership on this critical issue. We look forward to participating 

fully in Congressional and regulatory efforts to address these issues and to implement 

policies and practices that serve the public interest.