FROM THE OFFICE OF PUBLIC AFFAIRS

I appreciate the opportunity to appear before this Committee to present the views of the Treasury Department on certain issues relating to the over-the-counter ("OTC") derivatives markets -- in particular, on the recent concept release issued by the Commodity Futures Trading Commission ("CFTC") and on the legislative proposal made jointly by the Secretary of the Treasury and the Chairmen of the Federal Reserve Board and the Securities and Exchange Commission ("SEC").

I would like to begin by saying that we at the Treasury greatly appreciate the efforts of Chairman Leach, as well as members of the Agriculture Committee, to bring about an agreement among the interested parties on this matter. The markets would be well served by such an agreement, but, in the absence of an agreement, we believe that legislation is essential to cure the uncertainty that has been engendered in this area.

Before turning to the issues raised by the concept release, I would like to address briefly a separate issue in which the Chairman has expressed an interest. This is the legislative proposal made by the President's Working Group on Financial Markets relating to certain bankruptcy and financial institution insolvency issues the "Financial Contract Netting Improvement Act of 1998." I am pleased to report that all the Working Group participants support this legislative initiative to improve the U.S. legal regime governing netting and termination of certain financial contracts in insolvency situations. Improvements in this area can help to reduce systemic risk in financial markets.

We are appreciative that Chairman Leach has introduced our legislative proposal and are pleased to report that we have negotiated compromise language with industry participants who wanted somewhat broader legislation than we were prepared to propose. We look forward to working with this Committee and the Congress in order to enact this important legislation.

Now let me turn to the principal subject of today's hearing. The issuance of the CFTC's concept release is a serious development for the OTC derivatives market. While the market appears to have been somewhat reassured by the prompt expression of grave concern by Secretary Rubin, Chairman Greenspan, and Chairman Levitt immediately following issuance of the release, market participants remain worried about what the concept release may portend.

The concept release suggests that the CFTC is at least considering imposing significant new regulatory requirements on the OTC derivatives market. The problem is that any attempt to use the Commodity Exchange Act ("CEA") in its current form to accomplish this increases legal uncertainty about certain types of existing contracts and raises anew difficult jurisdictional questions. This serves to weaken, rather than strengthen, financial markets. It also may encourage more of this business to migrate overseas. That is why the Treasury, the Federal Reserve, and the SEC have disagreed with the CFTC's actions in this area, and it is why the agencies have jointly come to Congress for legislation providing legal certainty, while at the same time permitting a comprehensive review of these markets and consideration of whether or not changes in the regulatory regime should be effected through legislation. Currently, there is no clear consensus in the government or in the private sector concerning any possible additional regulation for this market, nor is there any consensus that the CFTC currently has the legal authority to regulate this market. We submit that the issue of major changes in the regulatory regime for OTC derivatives is ultimately for Congress to decide.

The law in this area is not clear. For the past ten years, there has been an implicit consensus that the OTC derivatives market should be allowed to grow and evolve without deciding the difficult jurisdictional questions concerning the potential applicability of the CEA to any of these transactions. At the heart of that consensus has been a recognition that "swap" transactions should not be regulated as contracts subject to the CEA, whether or not a plausible legal argument could be made that any of these transactions are covered by the CEA. The CFTC release, even though it purports to do no more than pose questions, upsets that consensus because the inescapable inference is that it is premised on the CFTC's apparent conclusion that many swaps are subject to their jurisdiction as futures contracts and can be appropriately regulated as such. We do not concur with that conclusion. It is our collective view that swaps are not futures under the CEA, and that the Congress did not intend that swaps, or those who arrange swap transactions, should be subject to futures regulation. It is our judgment, and the judgment of the Federal Reserve and the SEC, that, in the absence of an agreement such as the one the Chairman has proposed, temporary legislation should be enacted as soon as possible to alleviate the current legal uncertainty created by the CFTC action while more permanent solutions are considered.

The perceived threat from the CFTC's concept release to the OTC derivatives market is a serious issue because of the importance of this market. However measured, the OTC derivatives market is a huge, global market, which, when properly used, enables participants, including many businesses, to manage their risk exposures and lower their financing costs. For example, a small U.S. business involved in exporting or importing goods can use derivatives to protect against fluctuations in foreign exchange rates. OTC derivatives also serve as an alternative mechanism for participants to take positions based on their market views, which can increase the liquidity and narrow the bid-ask spreads in the underlying cash markets. These functions of the OTC derivatives market serve to facilitate domestic commerce and international trade, capital formation, and international investment flows and, thus, ultimately, economic growth.

Developments that disrupt this market are clearly not desirable. Such disruption can inhibit the use of an important risk management tool. Also, the perceived threat has global implications because of the linkages among markets worldwide. At some point, disruption can increase systemic risk, especially if a fear develops that obligations will not be honored on a large scale.

In addition, the perceived threat has implications for the future of the derivatives market in the United States. Many of these transactions can easily be shifted to foreign financial centers. In testimony presented to the House Agriculture Subcommittee on Specialty Crops and Risk Management in April of last year, a representative of the International Swaps and Derivatives Association ("ISDA") pointed out that actions considered by the CFTC a decade ago had raised questions that undermined legal certainty in the U.S. market. ISDA said: "In response to these concerns, large segments of U.S. swap activity moved offshore, and some U.S. firms ceased development of swaps entirely, reducing the ability of U.S. businesses to manage the risks inherent in their businesses and inhibiting the growth of these activities at U.S. institutions."

Because of the serious implications of the CFTC action, we and other members of the President's Working Group on Financial Markets concluded that a prompt response to the CFTC concept release was necessary. On May 7, the day the concept release was made public, the Secretary of the Treasury and the Chairmen of the Federal Reserve Board and the SEC expressed in a joint statement their grave concern about the CFTC's action, a concern stemming in part from reports about the possibility of increased legal uncertainty for certain types of OTC derivatives. The joint statement also indicated a willingness to pursue, if appropriate, legislation providing greater certainty concerning the legal status of OTC derivatives.

Since the CFTC's issuance of the concept release, the Treasury, the Federal Reserve, and the SEC have carefully considered what an appropriate next step should be. We concluded that we should seek narrowly targeted legislation, and, to this end, Secretary Rubin and Chairmen Greenspan and Levitt transmitted a legislative proposal to Congress on June 5. H.R. 4062, introduced by Chairman Leach, is based on our proposal.

In order to provide legal certainty to the market while the jurisdictional and regulatory issues are considered, our legislative proposal would do three things. First, it would require the President's Working Group to conduct a study of OTC derivatives and hybrid instruments and to report to Congress the results of this study within one year. Second, it would prohibit the CFTC from restricting or regulating any swap or hybrid instrument eligible for exemption under current CFTC rules until the enactment of reauthorization legislation. Third, it would make clear that OTC derivative instruments based on non-exempt securities that meet the conditions of the existing CFTC exemptive rule and that are entered into prior to the enactment of reauthorization legislation will not be deemed to be illegal under the CEA.

Chairperson Born has made the criticism that our legislative proposal could impede the Commission's enforcement efforts. That was certainly not our intention, and we have suggested that the CFTC provide drafting suggestions to ameliorate their concern. We feel confident that, working with the Congress and the CFTC, we can devise language that achieves the objective of bringing certainty to the market without having an overbroad and unintended effect.

I would like to underscore that we at Treasury do not underplay the importance of looking carefully at the derivatives markets. Our immediate concern is that the manner in which the CFTC has chosen to look at this market, which implies that many OTC derivatives are subject to its jurisdiction, causes substantial legal uncertainty about the validity and enforceability of certain derivatives. Other ways of considering the issues involved, including a study by the Working Group and consideration of proposed legislation by Congress, avoid the legal uncertainty that can be caused by interpreting the CEA in a very broad manner.

Derivatives are extremely useful when properly used. They can also be abused. Also, there have clearly been large specific problems in the recent past in both the OTC and exchange-traded derivatives markets, as well as problems arising from inappropriate investments in complex securities with embedded derivatives. There are also issues relating to whether the derivatives markets could exacerbate a large, sudden market decline which merit continued study and vigilance. Having said that, though, it is not immediately apparent what the government's role should be in this international market. It is clear, however, that the current jurisdictional confusion in the United States is not helpful; in fact, it has become a significant problem. That is why we are asking Congress for time to study these issues without causing unnecessary legal uncertainty, which is not in anyone's interest.

We understand the seriousness of making this proposal. To question an independent agency's concept of its jurisdiction and then to propose legislation that would temporarily curtail that agency's ability to act is not something we do lightly. We have concluded, however, that, in the absence of an agreement such as the Chairman has proposed, such legislation is necessary to avoid disruption and dislocation in the market while the underlying issues are being considered by Congress.

Concerns with the Concept Release

The CFTC concept release raises important issues concerning the regulatory regime governing the OTC derivatives market. Without doubt, the CFTC release has raised legitimate questions that merit study, discussion, and debate. However, by raising these questions in the manner it has, two major problems have been caused.

First, the concept release appears implicitly to assume that the CFTC has broad jurisdiction over the OTC derivatives market. This is far from clear and is subject to dispute. The concept release has thus increased concern about the legal status of OTC derivatives, particularly those based on so-called non-exempt securities -- that is, those securities that, subject to the jurisdiction of the SEC, are not exempt from the registration provisions of the securities laws. These derivatives potentially include some equity derivatives, emerging market security derivatives, and credit derivatives, among others. This concern is created because of limitations on the CFTC's authority to exempt futures contracts based on non-exempt securities from the CEA.

The problem arises because the unavoidable implication of the release is that the CFTC has decided it has jurisdiction to regulate the OTC derivatives market. If such jurisdiction exists, it must be based on the conclusion that many swaps are the principal type of contract covered by the CEA -- that is, futures contracts. If this conclusion is correct -- and we believe it is not -- it would call into question the legality of swaps involving non-exempt securities.

Under a technical provision of the Futures Trading Practices Act of 1992 designed to preserve the Shad-Johnson Accord, which demarcated certain jurisdictional lines between the CFTC and the SEC, the CFTC does not have the authority to exempt futures contracts from the provisions of the CEA that prohibit all futures contacts based on non-exempt securities, except for futures contracts on security indices trading on a designated contract market. Consequently, if those OTC derivatives based on non-exempt securities are deemed to be futures contracts, they could be viewed as illegal and unenforceable.

Second, the concept release causes uncertainty for other types of OTC derivatives -- even those that would clearly be covered by the CFTC's exemptive authority if they were deemed to be futures contracts -- since it raises the possibility of increased regulation over this market or new, restrictive interpretations of existing exemptions. As a result, in the absence of any reassurance to market participants, some business may not be undertaken in this market and other business may be shifted abroad. The United States could lose its leadership role in the OTC derivatives business as such business is moved to foreign financial centers perceived as providing more hospitable legal and regulatory climates for these transactions.

We do not by any means suggest that there is a market threat anytime an agency reviews its regulations. The CFTC has put out numerous releases in which it has reviewed various parts of its rules with no unsettling impact on financial markets. However, it is only this concept release that has raised such enormous concern. This concern stems from controversy over the need for regulation of this market and over the reach of the CEA. Also, concern arises because the CEA, in its current form, cannot be used to regulate this market without causing an increase in legal uncertainty about certain contracts. This last issue concerns even those who may otherwise believe that some increased federal regulation or oversight of OTC derivatives is desirable.

Because there is significant uncertainty about the CFTC's jurisdiction, we believe that it is Congress that should decide whether there should be additional regulation of the OTC derivatives market in the U.S. The ability of many market participants to shift business abroad should be a consideration in any decision to increase or alter the regulatory regime for OTC derivatives. If, after careful consideration and debate, there is a decision that some more regulation is necessary, it should be accomplished in a way that provides legal certainty to market participants.

Developments Since the Issuance of the Concept Release

I need to emphasize, Mr. Chairman, that the concerns I have described are not hypothetical or academic. From our discussions with market participants, we understand that some derivatives business is already beginning to be shifted abroad because of the legal uncertainty in the U.S. We also understand from market participants that, if it becomes obvious that the Congress is unwilling to address this issue, the move to curtail U.S. derivatives business and to shift much of this business abroad will accelerate.

This is not just a parochial Wall Street concern but a problem that anecdotal evidence suggests is beginning to affect other types of businesses which are being deprived of an important risk management tool. For example, we have been told that derivatives dealers that previously offered major agribusinesses with customized agriculture risk management products have begun to pull back from this line of business as a result of the current legal uncertainty. We have also heard that major U.S. corporations are delaying or reconsidering OTC derivatives transactions in their own stock that they would use to hedge certain balance sheet risks and that a software company developing a product to support the OTC derivatives business has decided to do this business in the United Kingdom because of its perception that the U.S. regulatory environment is inhospitable and unstable.

Furthermore, the general perception that the CFTC is trying to expand its regulatory reach through aggressive interpretations of the CEA has spilled over into other areas, including one that is of enormous importance to the U.S. Treasury and taxpayers. The CFTC recently wrote to the SEC requesting more time to comment on proposed rule changes filed by the Government Securities Clearing Corporation ("GSCC") to provide netting services for repurchase agreements based on government securities. The CFTC said in its letter that it needs the additional time to review whether the GSCC proposal raises CEA legal issues. As a result, there is some concern among participants in the government securities market about the CFTC's intentions with respect to this market. In addition to the CFTC's letter, the Chicago Mercantile Exchange ("CME") sent a comment letter on the GSCC proposal that is troubling to us. If the principles enunciated in the CME letter were followed, especially those concerning the interpretation of the term "board of trade" in a provision of the CEA commonly referred to as the "Treasury Amendment," it would have a most seriously unsettling effect on the government securities market, a market whose efficient operation is crucial to the U.S. government and the taxpayers.

The Treasury Department views this threat to the market with the utmost seriousness. The CFTC letter indicates that the Commission has reached no conclusion on this issue, and we are hopeful that it will not decide to go down this dangerous path.

Background to the Jurisdictional Uncertainty

As observers of CFTC jurisdictional questions well know, the current confusion and uncertainty concerning the scope of the CEA has its roots in the 1974 legislation that created the CFTC. That legislation significantly broadened the CEA by amending the definition of "commodity" so that the term is essentially open-ended. However, the term "futures contract" remained 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 transactions tied to interest rates are futures contracts in an off-exchange context.

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. There have been good-faith efforts to resolve these disputes, such as the Shad-Johnson Accord, which was enacted into law in 1982. That accord resolved some jurisdictional disputes between the CFTC and the SEC concerning mainly exchange-traded derivatives on securities and security indices. However, no attempt at resolution has permanently solved the jurisdictional problems.

During the 1980s, the swap market developed and grew rapidly, but it did so under a cloud of legal uncertainty created by the CEA. Market participants believed they had good legal grounds for concluding that this new and growing business was not subject to the CEA ban on off-exchange futures trading. However, there was a threat that a court might disagree and decide that a swap was an illegal futures contract and hence unenforceable. If that had happened, the market could have been thrown into turmoil.

In 1989, in response to this problem, which grew in importance as the OTC derivatives market expanded, the CFTC decided to address the issue. At the time, the CFTC did not have the authority to exempt futures contracts from the exchange-trading requirement of the CEA. The CFTC therefore issued a policy statement saying it was "the Commission's view that at this time most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the Act and regulations." Given this view, the policy statement also said: "The Commission has determined that a greater degree of clarity may be achieved through safe harbor guidelines establishing specific criteria for swap transactions to which the Commission's regulatory framework will not be applied. Swaps satisfying the requirements set forth [in this statement] will not be subject to regulation as futures or commodity option transactions under the Act and regulations."

While the CFTC policy statement was welcomed by the OTC derivatives community, there remained a degree of underlying concern about the legal status of swaps. The CFTC had made a policy statement rather than a statutory interpretation, which would have had more legal force; the leadership of the CFTC could change and have a different view on this subject; and, because there is a right of private action under the CEA, it remained possible for parties to transactions to challenge the legality of the contracts they had entered into.

In response to these concerns, Congress included provisions in the Futures Trading Practices Act of 1992 that were designed to provide greater legal certainty to this important global market. The mechanism chosen to clarify the legality of the institutional OTC derivatives market was a compromise that did not fully satisfy any of the participants in the process. Congress gave the CFTC broad exemptive authority for futures contracts from all provisions of the CEA except, importantly, the Shad-Johnson provisions. The legislative history expressed the expectation that the CFTC would use this new authority promptly to exempt the institutional OTC derivatives market from most provisions of the CEA. The CFTC exercised its new exemptive authority for OTC derivatives in January 1993. It is important to emphasize that the legislative history of the Futures Trading Practices Act and the preamble to the CFTC's exemptive rule both clearly state that no judgment was being made concerning whether the contracts that were exempted were subject to the CEA in the first place.

The effect Congress intended was achieved. While there was no resolution of whether the CEA applied to any part of the OTC derivatives market, the CFTC's creation of a non-exclusive safe harbor brought legal certainty to much of this market, and the OTC derivatives market has flourished.

This arrangement of allowing the OTC derivatives market to grow and evolve without having to resolve the CEA jurisdictional issues has worked, but it is fragile. The CFTC concept release has disturbed this arrangement, because it has raised a concern that what was intended as authority to calm the market by providing a safe harbor exemption may be expanded into a comprehensive regulatory regime. Specifically, questions raised in the concept release suggest that the CFTC may be considering:

Overseeing OTC derivatives clearinghouses;

Regulating multilateral transaction execution facilities for OTC derivatives;

Requiring registration by OTC derivatives dealers and perhaps other market participants;

Imposing capital requirements for OTC derivatives dealers;

Prescribing internal control requirements for OTC derivatives market participants;

Establishing extensive sales practice rules and disclosure requirements for OTC derivatives dealers;

Adopting recordkeeping and reporting requirements for OTC derivatives dealers; and

Requiring mandatory membership in a self-regulatory organization for OTC derivatives dealers.

We do not believe that Congress intended that the CFTC on its own should impose anything approaching such a comprehensive regulatory scheme for the OTC derivatives market when it passed the 1992 amendments to the CEA.

Conclusion

The state of the law with respect to OTC derivatives has become confused, and the concept release has heightened concerns among market participants. You heard from some of the witnesses at last week's hearing that, in light of the threat implicit in the concept release, they are considering curtailing or suspending their derivatives business in this country, and have actually begun to relocate some of their activities. Because of this and the very real danger posed to the market for non-exempt security derivatives, we believe that legislation is necessary to provide legal certainty to market participants until more permanent decisions can be made about the OTC derivatives market.

The OTC derivatives market has grown very fast, and it is reasonable to consider whether it is necessary to make changes in how this market, or its participants, are regulated. However, because of the impact on OTC derivatives based on equities and other non-exempt securities, the CEA in its current form cannot be used as a tool by the CFTC to regulate OTC derivatives without creating more serious problems than it is ostensibly solving. In addition, any new regulation of this market should have the legitimacy of a clear legislative mandate from Congress.

Our legislation does not try to resolve any of the issues permanently. That is why all of its provisions have time limits. It would simply give Congress and the Working Group agencies time to study the issues and to prevent harm to the markets while the issues are being studied.

Any changes in the regulatory structure for derivatives should be carefully studied by the financial regulatory community and by Congress, with input from market participants and other interested parties, and we look forward to participating in this exercise. In considering whether additional regulation is necessary, we would caution that this is a global financial market. It is, therefore, relatively easy for participants to shift a considerable amount of business to other jurisdictions if they believe regulatory requirements in a particular country have become too onerous.

Mr. Chairman, that concludes my prepared statement. I would be happy to respond to any questions you and other members of the Committee may have.