FROM THE OFFICE OF PUBLIC AFFAIRS

Chairman Lugar, Chairman Gramm, Senator Harkin, Senator Sarbanes, Members of these Committees, thank you for giving me the opportunity to discuss the Commodity Futures Modernization Act with you today. This legislation represents an important step in the modernization of the regulatory structure for the U.S. derivatives market. Let me also take this opportunity to commend both Chairmen Gramm and Lugar for the leadership and interest you have shown in this area.

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

• 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 can 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.

Clearly, it is vital that we work together to provide a regulatory framework that will ensure the continuation of a healthy and well-functioning OTC derivatives market. While the current framework here in the U.S. remains outdated, markets overseas are developing in a legal and regulatory environment that allows greater efficiency and transparency.

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.

Let me divide my remarks into two parts:

• First, I will begin by reviewing the findings of the President's Working Group on Financial Markets and our guiding principles for modernization of the U.S. legal and regulatory framework for OTC derivatives.
• Second, I will discuss in detail S. 2697, the Commodity Futures Modernization Act, and our position with respect to the bill's treatment of OTC derivatives, regulatory relief for the futures exchanges, and the repeal of the Shad-Johnson restrictions on the trading of single stock futures.

1. Modernization of our Legal and Regulatory Framework for Derivatives

As a result of concerns about the regulatory structure of U.S. derivatives markets, Congress requested that the President's Working Group 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.

The Working Group had four primary objectives for legislation in this area:

• 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, 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 help to assure the continued leadership of our capital markets.

In addition, because the scope of the legislation being considered extends beyond the areas considered in detail by the Working Group, we would add a fifth important objective:

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

The Working Group made a series of unanimous recommendations with respect to furthering these objectives.

The challenge before these Committees 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.

At the same time, we need to recall 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. What needs to be protected, however, is the financial system as a whole, and not individual institutions.

We believe that the Working Group's 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.

Mr. Chairman, in light of the Working Group's recommendations, we generally support this bill and are committed to working with these Committees and the Congress to facilitate the enactment of this important legislation.

Moreover, we believe it is important to move forward with appropriate legislation as soon as possible. In the absence of an updated legal and regulatory environment, needless systemic risk might jeopardize the broader vitality of the American capital markets. We also risk an erosion of competitiveness of American financial markets, with an increasing amount of business moving offshore to jurisdictions where the framework has kept up with the pace of change.

In that regard, we believe that this bill incorporates 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 all of the Working Group's objectives with respect to these instruments.

I would like to address the three major areas of the bill:

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

Let me first address the bill's approach to OTC derivatives. This bill largely incorporates the recommendations of the Working Group with respect to OTC derivatives. We strongly support such provisions. We do, however, have one important concern in this area.

The bill provides a broad exclusion from the securities laws for swaps, including, in particular, swaps based on securities. We are very much supportive of the objective of removing any unnecessary regulation. Let me caution, however, that there is an important distinction between the securities laws and the commodities laws in that the securities laws do not impede legal certainty. Thus, this is not a legal certainty issue.

As a general matter, we do not believe that swaps should be regulated as securities. However, it is important to preserve prohibitions against insider trading, fraud, and manipulation and also to preserve other measures which are demonstrably necessary to protect retail customers.

We are concerned that the provisions, as currently drafted, could have the unintended consequence of interfering with these vital protections that are now in place for the securities markets. I would also note that it will be important to clarify the definition of "swap agreements" so that it does not extend to certain transactions that are not customarily considered swaps and thereby raise regulatory issues that swaps do not.

Because the provisions, as currently drafted, have the potential to impact the underlying securities markets, we believe that it is imperative that they be amended to address these concerns.

Let me next turn to the regulatory relief proposals contained in the bill. 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.

In that regard, 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. Broadly, however, we are supportive of the CFTC's efforts to provide appropriate regulatory relief to the futures exchanges, consistent with the public interest.

With regard to the specific regulatory relief provisions of the bill as currently drafted, we have a concern with certain provisions that permit "exempt boards of trade". To encourage innovation and competition, 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.

To be clear: there are provisions in the bill as currently drafted which could have the perverse consequence of creating the situation where protections that are present with respect to off-exchange trades would not be present with respect to transactions that took place on an exchange. These matters have particular importance with respect to the integrity of the government securities markets. Any reduced confidence in such integrity could lead to higher financing costs for the Treasury and thus an increased burden on American taxpayers.

• The potential impact of this provision on the integrity of 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 specific 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.
• 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.

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.

Let me now turn to the question of restrictions on trading of individual stocks under 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 (corporate stocks and bonds) 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.

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.

Before closing, although it is 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 certain financial contracts, including OTC derivatives, 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 cases of bankruptcy or insolvency 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, we have an opportunity to advance legislation that will create a modern legal and regulatory framework for OTC derivatives. S. 2697 is certainly a significant step in the right direction. We look forward to working with members of these Committees, and with other members of Congress to address our remaining concerns with the bill and to pass legislation that will help to reduce systemic risk, promote innovation, protect retail customers, maintain U.S. competitiveness, and protect the integrity of our securities markets.