FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman, Senator Harkin, Members of this Committee, thank you for giving me the opportunity to discuss the report of the President's Working Group on Financial Markets on Over-the-Counter Derivatives Markets and the Commodity Exchange Act. The issues covered in the report have been a focus of this Committee, and on behalf of the members of the Working Group, we thank you for the leadership you have demonstrated on these important issues.

The over-the-counter derivatives market is an important component of the American capital markets and a powerful symbol of the kind of innovation and technology that has made the American financial system as strong as it is today. Yet the continued development of this market will depend a great deal on the development of a clear and effective regulatory environment.

The report of the President's Working Group contains the unanimous recommendations of a group that included, among others, the Chairmen of the Federal Reserve, the Commodity Futures Trading Commission and the Securities and Exchange Commission. It recommends the enactment of legislation to reform the legal framework affecting the OTC derivatives market. Taken together, these changes would provide legal certainty, contribute to the reduction of systemic risk, protect retail customers, stimulate the competitiveness of America's financial markets, and thereby help to create jobs and lower costs for American consumers and businesses.

Let me divide my remarks into three parts:

• First, the growing importance of OTC derivatives in the US economy.
• Second the objectives that guided Members of the Working Group when deciding on its recommendations and the importance of enacting those recommendations within the shortest reasonable time frame.
• Third, the six recommendations that the Working Group has produced.

Mr. Chairman, the financial sector is the central nervous system of the American economy. As our economy and our financial markets have evolved over the past two decades, so too have the needs of the financial sector. Most notably, in an era of globalization, volatility of interest rates, increased securitization and the growth of the bond markets relative to the traditional loan markets, businesses and financial institutions have needed more and better tools for managing risk.

In that sense, the over-the-counter derivatives market has grown directly in response to the needs of the private sector. An OTC derivative is an instrument that allows a party seeking to reduce its risk exposure to transfer that exposure to a counterparty that wants and may be in a better position to assume the risk. This is a potent development that has significantly enhanced the ability of businesses to manage their risk profiles, to compete more effectively in the global marketplace, and to deliver more efficiently and at lower cost a wide range of services and products to the American consumer.

Because of these rising demands, the notional value of global OTC derivatives has risen more than five-fold over the past decade, to more than $80 trillion according to estimates produced by the Bank for International Settlements.

Operating within a proper and appropriate framework of legal certainty, the benefits to the American economy of OTC derivatives would continue to grow. For example:

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

Thus, OTC derivatives have the potential to bring important benefits to our economy. The goal of the recommendations of the President's Working Group is to ensure that these benefits can be realized. At the same time, we need to recall that the emergence of the OTC derivatives market has come during an era of unprecedented economic strength and prosperity.

It is to be expected that in times of distress some participants in this market, as in other financial markets, will be adversely affected. What needs to be protected are not individual institutions, but the system as a whole. The challenge is to strike the appropriate balance between the creation of a regulatory regime of legal certainty that allows the economy to realize the benefits of OTC derivatives while still providing appropriate protection for retail customers and the system. In our judgement, the best protection against systemic risk is market discipline.

Now let me turn to the more specific goals of the Working Group in producing the report.

Mr. Chairman, the members the President's Working Group believe that a strengthened OTC derivatives market can contribute to the greater efficiency of the US economy. They further believe that a failure to act in this area would risk a situation in which the existing legal framework for our financial markets would seriously lag the development of the markets themselves.

In the absence of an updated legal and regulatory environment, needless systemic risk might jeopardize the broader vitality of the American capital markets; innovation might be stifled by the absence of legal certainty; and American consumers might be deprived of the benefits that a more appropriate legal framework would deliver. We also risk an erosion of the competitiveness of American financial markets, with an increasing amount of business moving offshore to jurisdictions where the regulatory framework has kept up with the pace of change.

It was with these priorities in mind, Mr. Chairman, that last year you requested the Working Group to study the OTC derivatives market and recommend what changes were required. The Working Group worked on the assumption that legislative action would be required within a timeframe appropriate to the growing importance of the OTC derivatives market - and taking into account this market's potential contribution to the efficient functioning of the American financial sector and to that of the economy as a whole.

Accordingly, the Working Group sought to achieve four objectives:

• 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 greater competition, transparency, liquidity, and efficiency and deliver stronger benefits to US 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 US 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 American capital markets.

Before outlining the Working Group's recommendations in greater detail, it bears emphasis that the Working Group did not reach its conclusions lightly. In view of the technical nature and history of many of the issues considered, the unanimous nature of our recommendations is very significant. It is our firm belief that the situation calls for legislation at the soonest appropriate opportunity. I will now turn to the recommendations.

The Working Group is recommending that an exclusion for certain swaps between eligible counterparties be codified by Congress in the Commodities Exchange Act. This exclusion would be similar to the CFTC's 1993 rule exempting swaps. It would not, however, extend to agreements involving non-financial commodities with finite supplies that could potentially be subject to manipulation, such as agricultural commodities. The CFTC would retain exemptive authority for these types of swaps including swaps related to agricultural commodities. The exclusion would cover equity swaps, a category of swaps where there is also some amount of legal uncertainty.

Mr. Chairman, this recommendation would provide legal certainty by excluding interest rate and equity swap agreements from the scope of the CEA, and remove doubts about the enforceability of these contracts in the courts. It is clear to the Working Group that this exclusion is the best approach to assure that the OTC derivatives market can develop within the kind of innovative and legally stable environment on which the continued competitiveness of our financial markets will depend. The exclusion would also contribute to the permanent clarification of the status of OTC derivatives that is essential for the integrity of the market.

The current legal uncertainty concerning whether swaps are subject to the CEA has its roots in the 1974 legislation that created the CFTC. That legislation significantly increased the scope of the CEA by broadening the definition of what constitutes a "commodity". As a result, most interest rates, for example, are now considered a "commodity" under the CEA and exchange-traded interest rate futures are thus regulated by the CFTC. We do not believe that off-exchange transactions that are tied to interest rates are themselves futures contracts and therefore should not be subject to CFTC regulation. To some market participants, however there has been uncertainty on this critical question.

The Working Group members perceive no compelling evidence of problems involving the swaps that we are recommending for exclusion that would warrant regulation under the CEA. Rather, we believe that an exclusion is appropriate because the participants in such transactions are generally capable of making informed investment decisions and do not require the additional protections of the CEA. We further believe that the legal certainty provided by statute will be more durable and reliable than that provided by regulations, which are more easily changed.

The CEA is designed primarily to address issues of fraud, manipulation, and price discovery. Sophisticated participants can protect themselves against fraud or can seek legal redress if they are defrauded. There is little evidence to suggest that markets for financial OTC derivatives are readily susceptible to manipulation. And, in the case of derivatives based on securities, existing securities laws would in any event be applicable to any attempts to manipulate security prices. In addition, financial OTC derivatives do not yet serve a primary price discovery function. And the activities of most OTC derivative dealers are already subject to direct or indirect federal oversight.

This recommendation would create an exclusion from the CEA for electronic trading systems that limit participation to sophisticated parties trading for their own accounts. Again, the exclusion would not apply to trading systems involving non-financial commodities with a finite supply such as agricultural commodities.

By confining the exclusion to trading systems involving only qualified participants, this recommendation is designed to protect retail customers without unnecessarily obstructing innovation where regulation is not justified. Electronic trading systems promote transparency and efficiency and thus reduce the cost of trading interest rate and other types of swap contracts. In that sense the exclusion would strengthen the competitiveness of the American OTC derivatives market.

At the same time, while agreeing that an exclusion from the CEA is appropriate, the Working Group has undertaken to monitor the development of electronic trading systems for OTC derivatives going forward, with a view to evaluating whether limited regulation of these systems to enhance market transparency and price discovery should become appropriate at a later date.

The third recommendation of the report would permit the creation of clearing systems for OTC derivatives while requiring that such systems be subject to appropriate regulation. This proposal is designed to reduce systemic risk by encouraging the creation of appropriately regulated clearing systems for OTC derivatives.

Well-designed clearinghouses can contribute significantly to reducing 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. A reduction in systemic risk would in turn enhance the stability of our financial system and increase its competitive edge. Nonetheless, in view of the concentration of risk within these entities, the Working Group believes that regulation of such clearing systems is appropriate.

This recommendation would clarify the Treasury Amendment in two ways. First it would enable the CFTC to address the problems associated with foreign currency "bucket shops" by codifying the CFTC's authority to regulate such entities and to prosecute such entities when they attempt to defraud retail customers. This would support the CFTC's objective of regulating entities that allegedly defraud retail customers, thus strengthening protection for small investors.

Second, the recommendation would preserve CFTC authority over Treasury Amendment transactions on "organized exchanges" while excluding most other transactions in Treasury Amendment products from the scope of the CEA.

The Treasury Amendment was originally designed primarily to exclude trading of OTC derivatives tied to underlying government securities and foreign exchange from the regulatory scope of the CEA. The exclusion, as currently worded, applies to all such contracts unless the transaction involved the sale of futures on a "board of trade." But uncertainty persists about the precise meaning of what constitutes a "board of trade" and whether it could be interpreted to encompass entities such as investment and commercial banks.

As a result, the Working Group recommends that the term "board of trade" be replaced by the phrase "organized exchange" to provide legal certainty for OTC instruments excluded under the Treasury Amendment and that an appropriate statutory definition of "organized exchange" is provided.

The final two recommendations are highly technical in nature and designed to enhance legal certainty by clarifying that hybrid instruments that reference securities can be exempted from the CEA. The recommendations also resolve potential jurisdictional disputes between the CFTC and other regulators with respect to such instruments by limiting the exclusive jurisdiction clause of the CEA.

Mr. Chairman, the President's Working Group has presented the Congress with a set of unanimous recommendations pertaining to the growing and increasingly important market for OTC derivatives in the United States. We believe that these recommendations, taken together, would reduce systemic risk, promote innovation, competition, efficiency and transparency in our financial markets; would protect retail customers, and would maintain American leadership in OTC derivatives markets.

In this context, we believe that legislation is necessary. We suggest a paradigm for that legislation that recognizes that with the appropriate legal framework, the OTC derivatives market can make a valuable contribution to the efficient functioning of the American capital markets, with benefits for businesses and consumers. Under the existing regulatory framework, as the report makes clear, there is a risk that these benefits will not be realized.

The Working Group's report focuses on OTC derivatives. There are also important issues of regulatory relief on exchange-traded derivatives. The Working Group supports the CFTC's ongoing efforts to explore regulatory relief in this area. I look forward to working with them and other members of the Working Group to assure that our markets remain the most competitive and innovative in the world, while assuring the integrity of these markets is protected for all participants. Thank you. I would now welcome any questions that you may have.