FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member Condit, members of this Subcommittee, I appreciate the opportunity to appear before you today to discuss H.R. 4541, the Commodity Futures Modernization Act of 2000. The introduction of this legislation is an important step in the modernization of the regulatory structure of the U.S. derivatives markets. I would like to commend you, Mr. Chairman, for the leadership and interest you have demonstrated in addressing these complex but very important issues. They are fundamental to the competitiveness and integrity of our markets.

After a brief discussion of the Over-the-Counter (OTC) derivatives markets, I would like to focus my remarks on H.R. 4541 and its potential effect on the regulatory structure of the derivatives and other financial markets.

In previous testimony before this Subcommittee, I have highlighted the importance of the OTC derivatives markets to our economy.

• By helping businesses and financial institutions to hedge their risks more efficiently, derivatives enable them to pass on the benefits of lower costs to American consumers and businesses.
• By allowing for the transfer of unwanted risk, derivatives promote more efficient allocation of capital across the economy, increasing productivity.
• By providing better pricing information, derivatives can help promote greater liquidity and efficiency in the underlying cash markets.
• Finally, by enabling more sophisticated management of assets, including mortgages, consumer loans, and corporate debt, derivatives can help lower mortgage payments, insurance premiums, and other financing costs for American consumers and businesses.

To continue to reap such benefits, however, we must ensure that our regulatory and legal framework keeps pace with rapid progress in the marketplace. While the current framework here in the U.S. remains outdated, markets overseas are developing in a legal and regulatory environment that allows greater efficiency, transparency and liquidity. This is not simply the result of less regulation, but rather of more rational regulation and an environment of legal certainty.

Unless our laws and regulations relating to derivatives are modernized, we run the risk that innovation will be stifled by the absence of legal certainty, depriving the American economy of the benefits that the derivatives markets can provide, and hampering the efforts of our OTC and exchange-traded markets and businesses to compete globally.

While it is important to update these laws, it is important to do so with the recognition that the emergence of these markets has occurred during an era of unprecedented economic growth and prosperity. It is to be expected that in times of distress some participants in these markets, as in other financial markets, will be adversely affected. The recommendations we have made, and the provisions in this bill will not prevent these situations from occurring, nor are they intended to do so. What needs to be protected, however, is the financial system as a whole, and not individual institutions. We believe that our recommendations with respect to clearing and those designed to enhance transparency and legal certainty and to clarify the treatment of derivatives in the case of bankruptcy or insolvency can contribute to enhancing the stability of the system more broadly.

The challenge before this Subcommittee and the Congress is to establish a regulatory regime that will strike a balance between allowing the economy to realize more fully the benefits of derivatives and, at the same time, ensuring the integrity of the underlying markets, providing appropriate protection for retail customers, and where possible, taking steps to mitigate systemic risk.

When I last testified before this Subcommittee, I outlined the primary objectives of the Working Group with respect to legislation in this area. They are:

• To reduce systemic risk in the OTC derivatives market by removing legal impediments to the development of clearing systems and ensuring that those systems are appropriately regulated.
• To promote innovation in the OTC derivatives market by providing legal certainty for OTC derivatives and electronic trading systems. This would strengthen the overall legal framework governing the OTC derivatives market that, in turn, would stimulate even greater competition, transparency, liquidity, and efficiency and deliver stronger benefits to U.S. consumers and businesses.
• To protect retail customers by ensuring that appropriate regulations are in place to deter unfair practices in all markets in which they participate and by closing existing legal loopholes that allow unregulated entities to pursue such unfair practices.
• To maintain U.S. competitiveness by providing a modernized framework that will lead those engaged in the financial services industry to continue the operations of their businesses in the United States, and thereby assuring the continued leadership of our capital markets.

Given the scope of this bill - providing legal certainty to OTC derivatives, reforming the Shad-Johnson Accord, and providing regulatory relief for futures exchanges - today I would add a fifth important objective:

• To protect the integrity of the markets underlying the derivatives in question - in particular, the securities markets.

A balanced bill should meet these important objectives.

Let me now turn to H.R. 4541, the specific bill before this Subcommittee. Mr. Chairman, while much of my testimony today will focus on specific concerns that we have with certain provisions of this bill, we are supportive of your efforts to ensure that these important issues are addressed in a timely manner. We are committed to working closely with you, your staff, and other members of Congress to facilitate the enactment of this important legislation. It is in this spirit of cooperation that the Treasury Department has identified a number of specific concerns in the three main components of this bill that we believe must be addressed in order to ensure that the final legislation maintains the integrity of our markets and satisfies the objectives set forth by the President's Working Group.

Let me first address OTC derivatives. This bill largely incorporates the recommendations of the Working Group with respect to OTC derivatives which, if enacted, would create an environment of greater legal certainty for these instruments. We do, however, have two concerns in this area.

Clearinghouses: Our primary concern relates to the treatment of clearinghouses. The Working Group's report recommended that Congress enact legislation to provide a clear basis for the development of appropriately regulated clearing systems for OTC derivatives. Well-designed clearinghouses can help to reduce systemic risk: first, by diminishing the likelihood that the failure of a single market participant can have a disproportionate effect on the market as a whole; and second, by facilitating the offsetting and netting of contract obligations. In addition to these benefits, however, clearing tends to concentrate risks and certain responsibilities for risk management in a central counterparty or clearinghouse. Therefore, appropriate regulation of clearing systems is essential to ensure that they indeed serve to mitigate systemic risk.

Under the Working Group framework, regulatory oversight could be provided by the CFTC, SEC, a federal banking regulator, or by a recognized foreign regulatory authority, depending on the structure of the clearinghouse and its activities. Legislative action could have the beneficial effects of reducing systemic risk by encouraging the development of such systems through the clarification of their legal status and by subjecting them to appropriate supervision. The bill, as currently drafted, permits the development of clearinghouses, but does not ensure that they will be appropriately regulated.

This bill allows but does not require entities that meet certain standards to register with the CFTC as Derivative Clearing Organizations ("DCOs") and grants the CFTC exclusive jurisdiction with respect to such registered DCOs. We have two concerns with this approach: first, regulatory oversight is optional on the part of the clearinghouse; second, the exclusive jurisdiction of the CFTC may preclude securities regulators from maintaining oversight of organizations that clear securities- related transactions.

Consistent with the Working Group's report, we believe H.R. 4541 should be amended to make regulation of clearinghouses mandatory, and to permit the regulation to be carried out by the appropriate functional regulator. This recommendation is consistent with current practice, in which clearing systems for other markets operate under regulatory oversight.

Eligibility: Our second concern relates to part of the definition of eligible participant. The bill, as drafted, maintains a lower threshold for the definition of eligible participant than that recommended by the Working Group. We maintain that participation in this market should be limited to institutions, or individuals with substantial resources. The provision contained in the bill does not meet this standard. Therefore we recommend that the Subcommittee adopt the threshold contained in the Working Group's report.

Let me now turn to the section of the bill addressing reform of the Shad-Johnson Accord. The members of the Working Group agreed that the current prohibition on single-stock futures could be repealed if issues about the integrity of the underlying securities markets and regulatory arbitrage are resolved. Our view remains unchanged.

The provisions contained in this bill regarding futures on non-exempt securities are a good starting point, although a number of issues remain unresolved. The bill addresses some of the customer protection and enforcement concerns identified by the CFTC, the SEC, and others as necessary conditions for repealing the prohibition on single-stock futures. However, there are a number of concerns that the regulatory agencies consider important, but that have not been resolved in the legislation. We hope that the SEC and CFTC can provide specific comments on these issues in the near future so that they can be incorporated into this bill.

In addition, certain issues related to the harmonization of margin requirements will need to be clarified. While we do not see the need to establish margin requirements in statute, it will be important to establish margin levels that do not encourage regulatory arbitrage or lead to a substantial increase in leverage in our financial system.

While we have no objection to the introduction of single-stock futures, it is vitally important that the integrity of the underlying markets be preserved, and that these instruments not be used as a means to avoid the regulations of the cash markets. Therefore, we continue to be supportive of efforts by the SEC and CFTC to reach an agreement on a regulatory framework for these products that preserves the integrity of the underlying securities markets. In addition, we are supportive of actions taken by Congress to urge progress in these discussions. However, if these issues cannot be resolved on a timely basis, we believe that it is important to move forward with legislation designed to clarify the legal certainty for OTC derivatives.

The third component of this bill addresses regulatory relief for the futures exchanges. The Treasury Department continues to support the view that it is appropriate to review, from time to time, existing regulatory structures to determine whether they continue to serve valid regulatory functions. Like the OTC markets, exchange trading of derivatives should not be subject to regulations that do not have a public policy justification. Broadly, we are supportive of the CFTC's efforts to provide appropriate regulatory relief to the futures exchanges, consistent with the public interest. To this end, the CFTC has recently released its regulatory relief proposal for public comment. We will be submitting a formal comment letter on this proposal in the near future.

There may, however, be unforeseen consequences to legislating such regulatory relief. Once such provisions are written into law, the regulators will have no ability to review and amend them should subsequent market developments warrant change or should other problems arise. Again, we are supportive of appropriate regulatory relief for futures exchanges, but suggest that certain aspects of that relief may be more appropriately provided through administrative action.

In particular, we are concerned with the provisions in H.R. 4541 regarding "exempt boards of trade." To encourage innovation, the Working Group recommended an exclusion from the Commodity Exchange Act for electronic trading systems that satisfy certain criteria. Although the bill contains provisions to enact this exclusion, it also contains a statutory exemption for certain electronic and physical trading facilities. These "exempt boards of trade" would remain subject to the CEA's "exclusive jurisdiction" clause, thereby precluding regulatory oversight by other agencies.

The potential impact of this provision on the government securities market is of particular concern to the Treasury Department. In 1986, Congress passed the Government Securities Act to provide an appropriate regulatory framework for the government securities markets in direct response to a number of problems in the unregulated portion of this market. In 1993, in response to incidents of wrongdoing in Treasury auctions, Congress strengthened these laws to provide additional protection against market abuses.

Under some interpretations, H.R. 4541 could allow futures on government securities to escape most of the provisions of the CEA that currently apply to them, but would block regulation under the Government Securities Act. In addition, securities market participants that are currently regulated under the Government Securities Act could potentially restructure themselves as exempt boards of trade to evade regulation under both statutes. This has the potential to undermine the laws that Congress put in place in recent years that were designed to uphold and strengthen the integrity of the government securities market. Any reduced confidence in the integrity of the government securities market could lead to higher financing costs for the Treasury and thus an increased burden on American taxpayers. For these reasons, we strongly recommend that those provisions of the bill related to exempt boards of trade be removed, or amended to preclude the trading of securities-related products on those systems.

Again, we note that the CFTC's regulatory relief proposal - the basis for the regulatory relief sections of this bill - has only recently been made available for public comment, and may be modified before implementation. We look forward to commenting on the proposal and working with the CFTC on these issues.

Mr. Chairman, although not part of this bill, I would like to take this opportunity to strongly urge Congress to adopt the President's Working Group recommendations regarding the treatment of these instruments and certain other financial contracts in cases of bankruptcy or insolvency. Rarely are there tangible steps the government can take that could have a meaningful impact on the mitigation of systemic risk. Enacting the recommendations of the Working Group designed to clarify the treatment of these instruments in bankruptcy is one of those steps. By establishing a framework through which creditors and counterparties can work out a swift resolution in cases of bankruptcy or insolvency, enactment of these recommendations can serve to reduce the impact of the failure of any one institution on the stability of the system more broadly.

Mr. Chairman, you have gone to great lengths to build consensus among the members of this Committee, the Working Group and market participants on a difficult set of issues. We appreciate the leadership you have demonstrated and want to be constructive and helpful in moving forward a bill that we can support. It is in that spirit of cooperation that we have suggested a number of changes to your bill. We hope that as you finalize this bill, we can continue to work together to strike the appropriate balance to ensure that much-needed legislative changes are made that will promote innovation, protect retail customers, reduce systemic risk, maintain U.S. competitiveness, and ensure the integrity of our markets.

Thank you.