FROM THE OFFICE OF PUBLIC AFFAIRS

Chairman Oxley, Ranking Member Towns, 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.

In November 1999, the President's Working Group on Financial Markets presented its report Over-the-Counter Derivatives Markets and the Commodity Exchange Act to the Congress. In this report, the Working Group, which is chaired by Secretary Summers and includes the Chairmen of the Federal Reserve, the Commodity Futures Trading Commission and the Securities and Exchange Commission, set forth a series of unanimous recommendations designed to reform the legal and regulatory framework affecting the OTC derivatives market. The legislation before you today would enact many of those important recommendations.

I would like to begin by providing some background on OTC derivatives and the recommendations of the President's Working Group on Financial Markets. I will then turn to H.R. 4541 more specifically, including the bill's treatment of OTC derivatives, regulatory relief for the futures exchanges, and the reform of the Shad-Johnson restrictions on the trading of single stock and narrow-based stock index futures.

Mr. Chairman, our 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 required a more diverse and effective set of 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 an important 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.

The benefits to the American economy of OTC derivatives would continue to grow within a proper and appropriate framework of legal certainty. 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 feed 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. It was with the importance of OTC derivatives in mind that, last year, the Congress requested that the Working Group conduct a study of the OTC derivatives market and recommend changes required to ensure that we continue to reap such benefits.

In response, the Working Group developed its set of unanimous recommendations designed to achieve four objectives:

• First, 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.
• Second, 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 and, in turn, would stimulate greater competition, transparency, liquidity, and efficiency and deliver stronger benefits to US consumers and businesses.
• Third, 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 through foreign currency transactions.
• And fourth, 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 promote the continued leadership of American capital markets.

Given the scope of the bill before you today - 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.

While seeking to accomplish these objectives, 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 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.

Let me now turn to the legislation before you today, H.R. 4541. Mr. Chairman, we believe that this bill incorporates many of the recommendations of the Working Group with respect to OTC derivatives which, if enacted, would promote greater legal certainty for these instruments and help to advance the Working Group's other objectives. In particular, with respect to legal certainty, we believe that this bill, with minor changes, would strike the appropriate 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.

Moreover, we believe that it is important to move forward with appropriate legislation as soon as possible. A failure to act in this area would risk a situation in which the existing legal framework for our financial markets would lag significantly behind 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 promote. We also risk an erosion of the competitiveness of American 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.

With this in mind, I would like to address the three major areas of the bill:

• First, the bill's approach to OTC derivatives;
• Second, the provisions of the bill designed to provide regulatory relief for futures exchanges; and
• Finally, the provisions of the bill providing for the repeal of the Shad-Johnson restrictions on the trading of single stock and narrow-based stock index futures.

Let me first discuss the bill's provisions regarding OTC derivatives. H.R. 4541 would take significant steps toward achieving the Working Group's goals by enacting most of our recommendations regarding OTC derivatives. While there are a few changes which we would like to see enacted, such as amendments to the definition of eligible contract participants and of excluded commodity, we believe that the legislation takes an appropriate approach to OTC derivatives and encourage the Congress to adopt these provisions. Let me touch upon a few of the specific objectives that this bill helps to accomplish.

First, H.R. 4541 would provide legal certainty. The Working Group members spent several months studying and developing recommendations regarding the appropriate status of OTC derivatives under the Commodity Exchange Act. We focused upon areas in which the need for change had been demonstrated in our markets.

With regard to swap agreements, the Working Group sought to remove the cloud of legal uncertainty resulting from questions about the enforceability of certain swap contracts in U.S. courts. This uncertainty resulted from a lack of clarity regarding whether the CEA applies to certain OTC derivative transactions. The CEA was designed primarily to address issues of fraud, manipulation, and price discovery. Thus, the Working Group unanimously recommended that the legal status of such contracts be clarified by creating a statutory exclusion from the CEA for certain OTC derivative transactions which do not require regulation for these public policy reasons. The exclusion is limited to transactions involving qualified participants who do not require the additional protections of the CEA, and the instruments subject to the exclusion generally are not susceptible to manipulation, nor do they serve a primary price discovery function at this time.

H.R. 4541 would establish such an exclusion for certain swap agreements and thereby ensure that the U.S. OTC derivatives market can develop within the kind of innovative and legally stable environment on which the continued competitiveness of our financial markets depend.

Second, H.R. 4541 would provide for the development of appropriately-regulated 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.

H.R. 4541 provides for the development of clearinghouses, and requires that they be regulated. It thereby can provide 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.

However, we believe that H.R. 4541 could be improved by clarifying the scope of the SEC's authority to regulate clearinghouses that clear securities and that also wish to clear OTC derivatives.

Finally, H.R. 4541 takes important steps toward protecting retail customers. The Working Group recommended that the CFTC be granted explicit authority to regulate foreign currency "bucket shops" and to prosecute such entities when they attempt to defraud retail customers. H.R. 4541 provides such authority to the CFTC, thus strengthening protection for small investors. Again, this is an area in which problems have arisen, and the need for appropriate oversight clearly has been demonstrated. We are pleased to see these provisions incorporated in the bill.

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 and narrow-based stock index 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 particular, 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 for regulatory authorities 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 or narrow-based stock index 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 encourage 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. 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 and to implement the other recommendations of the Working Group.

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 public policy 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.

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 OTC derivatives 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.

In conclusion, Mr. Chairman, we have an opportunity to advance legislation that will create a modern legal and regulatory framework for OTC derivatives designed to promote innovation, protect retail customers, reduce systemic risk, maintain U.S. competitiveness, and ensure the integrity of our markets. We look forward to working with the members of this Committee, other members of Congress, and our colleagues on the President's Working Group in an effort to further advance these important objectives.