Second, the fast-evolving derivatives markets have created new challenges for risk management. All financial market participants need effective systems to monitor and manage market risk, credit risk, and counterparty relations for derivative products. In addition, firms face liquidity risk, operating risk, and the risk that legal uncertainty could impel a counterparty to repudiate a contract. As evidenced in last year global financial crisis, enhanced credit risk management is of particular importance for financial institutions entering into derivatives transactions with other financial institutions.

Third, derivatives can allow market participants to assume substantial leverage. The amount of cash or collateral that needs to be put up on entering into a derivatives contract is often relatively small in comparison to the amount of risk being assumed.

Fourth and finally, questions have also been raised about the potential for systemic risk associated with derivatives. The Working Group is studying whether the features of derivatives trading pose special risks to the financial system.

Treasury believes that Congress should modernize the CEA, in order to clarify the status of legitimate products and markets. Troublesome questions have been raised about the legality of certain portions of the OTC derivatives market. Derivatives contracts are based on a certain understanding of the law; however, if this interpretation is wrong, then these contracts become unenforceable. The current legal uncertainty may also impede certain initiatives, such as the development of clearinghouses, which can reduce systemic risk. The Working Group is examining the overall regulatory structure, including what sort of regulation for OTC derivatives markets may be appropriate, and by whom.

The statute that is now the Commodity Exchange Act was originally enacted in the 1920s to establish a basis for the federal regulation of the agricultural futures markets. At that time, regulators primary concern was the potential for manipulation of agricultural commodities that are in finite supply, such as wheat and corn. For the most part, the CEA has served these markets well.

The current confusion and uncertainty concerning the scope of the CEA has roots in the 1974 legislation that created the CFTC. That legislation significantly broadened the CEA by amending the definition of so that the term is essentially open-ended. However, the legislation left the term undefined. As a consequence, to take an example, interest rates are now a commodity for purposes of the CEA, but it is unclear what types of off-exchange transactions tied to interest rates are futures contracts. Because it is possible to interpret the CEA, after the substantial amendments made in 1974, in a very broad manner, jurisdictional and interpretive disputes have occurred among interested parties, which include both federal regulators and private industry groups. These disputes have been accentuated by provisions of the CEA that give the CFTC exclusive jurisdiction over transactions governed by the statute.

Moreover, significant changes have occurred in derivatives markets over the past 25 years, creating new legal and jurisdictional issues that were not foreseen in 1974. Financial derivatives now far surpass agricultural contracts in notional value. Bilaterally negotiated contracts on the OTC markets now dwarf trading on the exchanges. Additionally, electronic trading systems have been introduced, and clearing and netting systems have been improved.

There have been good-faith efforts to resolve some of these disputes, such as the Shad-Johnson Accord, which was enacted into law in 1982, and the CFTC exemptive statement, published in 1993 in accordance with the Futures Trading Practices Act of 1992.

Several key issues related to legal certainty are still unresolved, however. The Working Group will address these issues in its study of the OTC derivatives market.

First, the modification of the Treasury Amendment by Congress is needed, in order to clarify that certain markets are excluded from the CEA. Enacted at the request of the Treasury Department in 1974, the Treasury Amendment currently excludes from the coverage of the CEA all transactions in foreign currency, government securities, and certain other instruments, unless the transactions involve a sale for future delivery conducted on a "board of trade." This exclusion prevents duplicative regulation of markets that are vital to international trade and the financing of government operations, thereby strengthening the U.S. economy and lowering the cost of government borrowing. Unfortunately, the Treasury Amendment has been the subject of a spate of litigation in recent years, and the courts have succeeded in resolving only some of the issues presented.

In order to clarify the status of legitimate markets under the Treasury Amendment, we believe that Congress should clarify that the term board of trade, as used in the Treasury Amendment, means an organized exchange. In addition, Treasury has in the past suggested that Congress should provide the CFTC with anti-fraud authority over foreign currency "bucket shops" that prey on unsophisticated retail investors.

Second, the CFTC Swap Exemption, which provides the legal basis for much of the OTC derivatives market, has been only partially successful in alleviating legal uncertainty. The Swap Exemption reflects the implicit consensus that has existed for the past ten years: swap transactions should not be regulated under the CEA, whether or not a plausible legal argument could be made that any of these transactions are potentially covered by the CEA. It is our view, and that of both the Federal Reserve and the SEC, that swaps are not futures under the CEA, and that the rigidity of the CEA is not well suited to regulation of the institutional swaps market. In light of these considerations, Congress should amend the CEA to clarify the legal status of swap agreements.

A conclusion that the CEA is not suited to regulation of swap transactions does not necessarily imply a conclusion that such transactions should be unregulated, however. The Working Group is wrestling with many of the questions raised by the CFTC in its Concept Release, to determine what sort of regulation for these markets may be appropriate. The Working Group is also examining the issues surrounding the development of electronic trading systems and clearinghouses for swaps. These innovations have the potential to enhance market liquidity and reduce systemic risk, but some would argue that they blur the lines between swaps and futures markets.

Third, the Working Group is considering a special set of legal certainty questions faced by swaps that involve securities governed by the federal securities laws. The CFTC lacks the legal authority to exempt most futures based on securities from the CEA. Therefore, the market for swaps based on non-exempt securities is based on a conclusion that these instruments are not futures contracts. Statements in the CFTC's Concept Release cast doubt on this conclusion. Treasury believes that a more permanent legislative clarification of the status of these instruments is necessary.

The derivatives market has grown and evolved without resolving these CEA jurisdictional issues, but this arrangement is fragile. Markets operate best in an environment of legal certainty. Market participants must be able to ascertain readily the regulatory requirements that apply to them and have confidence in the enforceability of their own obligations and those of their counterparties.

The President Working Group on Financial Markets is also addressing, as part of its report on derivatives, a number of other topics related to derivatives markets. Many of these topics were raised by the CFTC in its Concept Release.

• Market manipulation. The Working Group is studying whether regulation is appropriate to deter any potential manipulation that may exist in the OTC derivatives market.

• Fraud and customer protection. The Working Group will examine whether there is a need for specialized anti-fraud or customer protection rules in certain markets, or for certain market participants.

• Regulatory parity. Some valid questions have been raised concerning parity among market participants. For example, is it appropriate to make the current regulatory distinctions between on- and off-exchange trading, or between cash and derivatives markets?

• Systemic risk. The Working Group is examining how the derivatives markets may affect financial stability, and whether supervisory or regulatory policies can reduce the potential for systemic risk.

• International Harmonization. The Working Group is examining how best to achieve international harmonization of regulation of OTC derivatives.

We caution, however, that the Working Group may not be able to reach a consensus on all of the very complex jurisdictional and regulatory issues that will be addressed by the study. Whether or not the agencies are able to reach a consensus on a set of recommendations, we will endeavor to provide a comprehensive assessment of the issues to aid Congress in its efforts to design a workable structure for the oversight of the financial markets going forward.

We appreciate the concerns that have been raised about the need for a level playing field among derivatives markets participants. The Working Group will need to consider important issues regarding the regulation of exchange-traded derivatives and OTC derivatives. There are important differences, however, between exchange-traded derivatives and OTC derivatives that may justify different regulatory approaches. For example, we believe that special aspects of the institutional markets for instruments covered by the Treasury Amendment should continue to be excluded from the CEA.

We look forward to working with this Committee, and with other members of Congress and interested parties as we work to resolve these issues in a way that safeguards America position in this fast-developing global market.

I would be happy to respond to any questions the Committee may have. Thank you.