FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Ranking Member LaFalce, members of the Committee, I appreciate the opportunity to appear before you today to discuss the recommendations of the President's Working Group on Financial Markets regarding hedge funds, over-the-counter ("OTC") derivatives, and financial contract netting. I would like to thank the members of this Committee for the leadership you have demonstrated repeatedly in matters relating to financial markets and the mitigation of systemic risk.

Today, my testimony will focus on four topics: (1) The Working Group's recommendations on the OTC derivatives markets; (2) the implementation of our recommendations on hedge funds; (3) H.R. 2924; and (4) our recommendations on financial contract netting and H.R. 1161.

We are currently enjoying the longest period of economic expansion in our nation's history. The unparalleled strength and dynamism of our financial markets has made a significant contribution to this unprecedented economic performance. While we are justifiably confident about the strength of our financial industry, we must not allow our confidence to spill over into a sense of complacency. It is at times such as we are experiencing now that it is most appropriate and effective to take steps to secure the overall integrity and competitiveness of our markets.

One of the great strengths of our system is our reliance on market discipline as the first line of defense in providing the most effective constraint on excessive leverage and risk taking. To ensure that the private sector can fulfill such a role, the public sector must seek to create an environment in which market discipline can work most effectively.

Secretary Summers stated recently that the public sector has three fundamental roles in this area:

1. Enhancing private sector/market discipline;

Counterparties and creditors have more knowledge of their counterparts and customers, more skill at evaluating credit risk and strong incentives for constraining excesses and thereby collectively imposing market discipline. The government cannot impose market discipline, but it can enhance its effectiveness. It is important to craft government policy to maximize the quality and effectiveness of counterparty discipline and ensure that public sector activities do not crowd out the discipline provided by counterparties, creditors and investors. We have made a number of recommendations in this regard.

2. Promoting transparency;

Second, the public sector must promote the maximum degree of transparency, because transparency is the necessary corollary to counterparty discipline. The government can not impose counterparty discipline, but it can help to enhance the effectiveness of market discipline by creating an environment of greater transparency.

3. Ensuring the competitiveness and integrity of our markets.

Third, the public sector has a duty to maintain the competitiveness and integrity of the system as a whole. Just as there is a sharp distinction between support for the free enterprise system and support for individual enterprises, so also the task of public policy must be to ensure the stability and integrity of the market system rather than to seek to ensure the survival of individual firms or investors. Toward this end, policymakers can create a legal and regulatory framework designed to mitigate the impact of failures, for example by encouraging the development of clearing systems and improving the cross-product netting provisions of the bankruptcy laws. Such efforts could help to maintain the stability of the financial system in the face of future failures of individual institutions.

Let me now turn to the specific issues that are the focus of this hearing.

The members of the Working Group believe that a strengthened OTC derivatives market can contribute to the greater efficiency of the U.S. financial markets and the economy as a whole in several ways:

• OTC derivatives help businesses and financial institutions to hedge their risks more efficiently, enabling them to pass on the benefits of lower product costs to American consumers and businesses.
• By facilitating the transfer of unwanted risk, OTC derivatives promote more efficient allocation of capital across the economy, further increasing productivity.
• The use of OTC derivatives permits more sophisticated management of assets, including mortgages, consumer loans and corporate debt, lowering mortgages payments, insurance premiums, and other financing costs for both consumers and businesses.

As OTC derivatives have grown in importance to our economy, however, the legal and regulatory framework for these markets has significantly lagged behind the development of the markets themselves. It is within our grasp to reduce systemic risk, enhance the competitiveness of these markets and increase retail customer protection by providing an updated legal and regulatory framework. Without appropriate legal structures, innovation may be stifled by the absence of legal certainty, and U.S. businesses and consumers may be deprived of the benefits that a more appropriate legal framework would help deliver. We risk erosion in the competitiveness of U.S. financial markets, with an increasing amount of business moving offshore to jurisdictions in which the regulatory framework has kept up with the pace of change.

It was with these concerns in mind that the Working Group undertook its study of the OTC derivatives markets and the changes required. With a recognition that most of the dealers in the OTC derivatives markets are regulated financial institutions or are affiliated with such institutions, the Working Group sought to achieve four objectives:

• To reduce systemic risk in these markets by removing legal impediments to the development of appropriately regulated clearing systems;
• To promote innovation by providing legal certainty for OTC derivatives and electronic trading systems;
• To protect retail customers by closing existing loopholes that allow unregulated entities to engage in unfair practices; and,
• To maintain U.S. competitiveness by providing a modernized framework that will lead participants in these markets to continue to conduct their operations in the U.S., fostering the continued leadership of the U.S. capital markets.

For the first time, the Working Group unanimously recommended a set of measures that the members believe are necessary to achieve these objectives. In view of the technical nature and history of many of the issues that the Working Group considered, this unanimity represented a very significant step forward in and of itself.

The Working Group had four primary recommendations:

• First, to create an exclusion under the Commodity Exchange Act (CEA) for certain swaps transactions between eligible counterparties. Enactment of such an exclusion would promote the legal certainty that is essential to ensure the integrity of these markets.
• Second, to create an exclusion from the CEA for electronic trading systems that trade excluded swaps and that limit participation to eligible counterparties trading for their own accounts. This would allow sophisticated parties to organize trading of OTC derivatives in ways that are most efficient for them and that promote transparency.
• Third, to permit use of appropriately regulated clearing systems for OTC derivatives. The development of well-designed clearinghouses could reduce systemic risk by facilitating netting of contractual obligations and by mitigating the effects of the failure of any individual market participant.
• Fourth, to clarify the scope of the Treasury Amendment. This would clarify that OTC trading in government securities and foreign exchange are not regulated under the CEA, but would facilitate the prosecution by the CFTC of foreign currency "bucket shops" that defraud retail customers.

The legislation that has been introduced by Chairman Leach and Ranking Member LaFalce, H.R. 4203, would address some of the concerns that are the subject of the Working Group's recommendations. We are supportive of the objectives which underlie this bill designed to mitigate systemic risk and to promote legal certainty, innovation, and competitiveness in the OTC derivatives markets. At the same time, we believe that a comprehensive approach encompassing amendments to the Commodity Exchange Act is important to fully accomplish all of the objectives outlined in the Working Group's report. We look forward to continuing to work with this Committee and others to assure the advancement of these objectives.

Let me now focus on the second subject of this hearing - the Working Group's recommendations from its April 1999 report Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management.

The near collapse of LTCM highlighted the possibility that problems at one financial institution - (i.e. a hedge fund or other highly leveraged institution) - could be transmitted to other institutions and potentially pose risks to the financial system. The Working Group concluded that excessive leverage in such institutions could increase the likelihood of a general breakdown in the functioning of financial markets.

In making its recommendations, the Working Group concluded that hedge funds per se did not pose a threat to the financial system. Active market participants such as hedge funds can provide benefits to financial markets by enhancing liquidity and promoting market efficiency and price discovery. Additionally, they can play a role in financial innovation and the reallocation of financial risk. In the absence of effective market discipline, however, the failure of one of the largest hedge funds, like that of any other large highly leveraged institution, also has the potential to create market disruptions.

To this end, the Working Group set forth a series of recommendations designed to promote private market discipline in order to best constrain excessive leverage and thereby to reduce the likelihood that future failures of individual institutions could pose a threat to our financial markets more broadly. Recognizing that private market discipline is the best first line of defense, the Working Group's recommendations emphasized the promotion of sound risk management practices by all market participants and improvements in transparency designed to allow individual market participants to make more informed investment and credit decisions.

Since the Working Group's report was issued, important progress has been made toward implementing the report's recommendations. New bank guidelines have been issued to address weaknesses in banks' existing risk management policies, procedures, and internal controls. Additionally, private sector groups have published detailed recommendations for improved risk management standards. These reports have led to positive developments and have helped to advance the dialogue between the public and private sectors on a number of issues including public disclosure.

International groups also are taking a hard look at highly leveraged institutions and their effect upon markets worldwide. The Highly Leveraged Institutions (HLI) Working Group of the Financial Stability Forum released a report last week that broadly supports the thrust of the proposals of the President's Working Group, including the legislation being discussed today.

Other efforts also are underway to implement the Working Group's recommendations on transparency. The Commodity Futures Trading Commission (CFTC) is drafting proposed regulations to require large commodity pool operators to submit more relevant and frequent information on the funds they operate and to make this information public. Additionally, the Securities and Exchange Commission (SEC) is studying ways to implement the disclosure recommendation for public companies and has indicated that they will introduce a draft for public comment in the near future.

H.R. 2924, which was introduced by Representatives Baker and Kanjorski, would further enhance the transparency of our financial system.

H.R. 2924 would implement the Working Group's recommendations regarding public disclosure of more frequent and meaningful information on the largest hedge funds. The bill would require that the largest unregulated hedge funds disclose publicly certain summary, non-proprietary financial information, including meaningful and comprehensive measures of risk. Disclosure of such information would allow market participants to make more informed credit and investment decisions.

One of the primary areas of concern expressed by the private sector has been the challenge of balancing the disclosure necessary to enhance market discipline with the need for protection of information essential to the firms' ability to engage competitively in proprietary trading. The members of the Working Group are quite sensitive to this concern and believe that H.R. 2924 strikes the appropriate balance by providing for a rulemaking process through which the concerns of all relevant parties could be voiced in determining what information is both relevant and useful without compromising the firms' ability to engage in business transactions. That balance is tremendously important to the efficient functioning of the financial markets, and the members of the Working Group look forward to continuing to work with the private sector and Congress to assure that it is maintained.

Consistent with the findings of the Working Group, H.R. 2924 does not call for direct regulation of hedge funds. Rather, it provides for increased transparency and disclosure to allow market discipline to operate more effectively. It is our view that investors in highly leveraged institutions are generally high net worth individuals or institutional investors, and the usual investor protection grounds for such regulation are not relevant. Moreover, a direct regulatory regime could create a form of moral hazard in which investors and counterparties, knowing that a highly leveraged institution is regulated and supervised for systemic reasons, might reduce their normal due diligence and relax their risk management standards. Thus, rather than imposing regulation, H.R. 2924 provides for enhanced public disclosure only by those hedge funds that are large enough such that, if one were to fail, that failure could potentially pose risk to the financial system more broadly.

The government cannot impose market discipline, but it can help to enhance the effectiveness of market discipline by creating an environment of greater transparency. Indeed, the long history of public disclosure and transparency in our financial system has been a source of great strength and a leading factor in establishing and maintaining the high degree of confidence the world has in the integrity of the U.S. financial markets. This confidence, in turn, increases investment in our markets, lowering the cost of capital for American businesses and individuals, and thereby helping to strengthen the U.S. economy.

As some have suggested, enhancing transparency and disclosure and providing information to market participants does not guarantee that those participants will process or use the information effectively. It is equally true, however, that if certain basic information is not made available to market participants, it cannot be processed or used at all.

Finally, I would like to turn to the important topic of netting of financial contracts. The Working Group's reports on hedge funds and on OTC derivatives both included strong recommendations for adoption of legislative proposals designed to improve the close-out netting regime for derivatives and other financial instruments under the Bankruptcy Code and bank insolvency law. The availability of cross product netting arrangements enhances market stability, limits counterparty exposure and can help to preserve market stability in the event of a failure of a financial institution.

The specific legislative proposals recommended by the Working Group were originally transmitted to Congress in 1998, and were introduced in this Congress by Chairman Leach and Representatives LaFalce and Roukema in the form of H.R. 1161. The proposed legislation would improve the netting regime under the Bankruptcy Code by expanding and clarifying the definitions of the financial contracts eligible for netting and by explicitly allowing eligible counterparties to net across different types of contracts. Further, provisions of the bill would clarify the netting regime for certain financial contracts in the case of a bank failure.

The Working Group believes that adoption of its legislative proposal would help to reduce systemic risk by minimizing the impact of the failure of an individual institution on the system more broadly. We strongly urge Congress to adopt these financial contract netting provisions.

We believe that adoption of the Working Group's recommendations would strengthen the legal framework of our financial markets. We commend the Chairman, Ranking Member LaFalce and other members of the Committee for your attention to these important and extremely complex issues. We look forward to working with you and others in Congress to advance legislation that will strengthen the competitiveness and stability of the U.S. financial markets.

Mr. Chairman, that concludes my prepared remarks. I would be pleased to address any questions you may have.