Thank you, Mr. Chairman and members of the Committee. I appreciate the opportunity to represent the Secretary of the Treasury, who is the Chairman of the President's Working Group on Financial Markets, before this Committee. I would like to report on the progress of two studies the Working Group is undertaking the first on derivatives and the second on hedge funds and to discuss some of the issues that the studies will address. I know that Secretary Rubin, Deputy Secretary Summers, and the rest of the Working Group look forward to working with you on these matters.

Two major events in the past six months underscore the necessity for action to resolve the legal and jurisdictional uncertainties that attach to over-the-counter ("OTC") derivatives and, more generally, to improve the workings of our financial markets and further the twin goals of providing legal certainty and mitigating systemic risk.

The first event occurred when the Commodity Futures Trading Commission ("CFTC") issued a concept release on OTC derivatives. The concept release raised many important questions about the derivatives market. It also, however, implicitly raised questions about the legality of portions of the OTC derivatives market, thereby highlighting troublesome ambiguity in the Commodity Exchange Act ("CEA"). The concept release, and the controversy it caused this summer, underscore the need to resolve the legal and jurisdictional uncertainties relating to OTC derivatives.

The derivatives study was requested by you, Mr. Chairman, along with Chairman Smith of the House Agriculture Committee and several other members of Congress. In this connection, let me emphasize that the CFTC's issuance of the concept release was opposed by other members of the Working Group because of the questions it implicitly raised about the legality of portions of the OTC derivatives market, not because of the questions it asked explicitly. We always agreed that there were important aspects of the derivatives market that deserved study, and we are happy to be able to address those questions in a format that does not increase legal uncertainty.

The second event was the near collapse of Long-Term Capital Management ("LTCM"), an investment partnership commonly known as a "hedge fund." The LTCM experience highlights the issue of systemic risk in global financial markets. It raises issues as to how regulators here and abroad can further the goal of mitigating systemic risk without imposing unnecessary and potentially harmful requirements on market participants. Following the near collapse of LTCM, the Secretary and various members of Congress called for a study of the potential implications of the operations of firms such as LTCM and their relationships with their creditors.

Staff from each of the members of the Working Group have been working assiduously on both these studies. The agencies have been collecting information, which is being shared and discussed with all of the other agencies. The process is quite cooperative. We hope that these studies will assist the Congress and regulators in moving toward our mutual goal of improving the workings of our financial markets, and I would like to brief you on our progress to date.

In the derivatives study, we are analyzing how the markets work, how they are regulated, and what changes, regulatory or legislative, may be appropriate to reduce systemic risk, to eliminate legal uncertainty, to curtail regulatory arbitrage, and to address the potential use of derivatives for fraud or manipulation.

One of the issues the derivatives study will address is how to clarify the jurisdictional reach of the CEA. A separate set of issues being studied concerns what, if anything, should and can be done to reduce systemic risk associated with the OTC derivatives market. We are focusing our attention on questions involving the reduction of systemic risk by decreasing legal uncertainty and on questions relating to whether derivatives trading poses special systemic risk and other market issues that should be addressed.

Let me emphasize that the goals of reducing the legal ambiguities of the CEA and of reducing systemic risk are not mutually exclusive. We believe there is a growing consensus on the need for greater legal certainty regarding the derivatives market, but precisely how to resolve the ambiguities remains a challenging question for the study. The importance of the issues, however, gives the agencies no alternative but to try to reach that goal.

An example of a source of legal uncertainty is the lack of a bright line in the law distinguishing a futures contract from a forward contract. Yet the consequences under current law are drastically different. An OTC forward contract is not subject to the CEA, while a futures contract, unless exempted, can be traded only on a designated exchange. Absent some exemption or the exclusion provided by the Treasury Amendment, an off-exchange futures contract is illegal and unenforceable. The consequence of trading what you think is a forward contract, but is later determined to be an illegal off-exchange futures contract, is that the contract is null and void. This is a drastic remedy for crossing what is a vague and uncertain line.

It was for this reason providing certainty that swaps contracts would be legal and enforceable that Congress, in 1992, granted the CFTC the legal authority to promulgate the Swaps Exemption, without ever deciding whether swaps are subject to the CEA in the first place. The protection of the Swaps Exemption, however, is incomplete.

In addition to the legal uncertainty overhanging the swaps market, the current legal uncertainty may impede certain initiatives, such as the development of clearinghouses, which can reduce systemic risk. In addition, there is controversy concerning whether or not the regulatory playing field for futures exchanges is level and whether changes in the law should be made so that they are better able to compete with the OTC market.

Another important group of questions we are addressing in the derivatives study concerns leverage. We believe that many market participants have an appetite for risk out of proportion to their capital and that this can pose risks to global financial markets and ultimately could prove damaging to the economies of the U.S. and other countries.

With respect to the hedge fund study, we are looking at a number of issues, including the issues of disclosure and leverage. There is a question whether LTCM's creditors made some decisions based upon insufficient information or inadequate analysis of information, and there is a broad consensus that creditors need to reexamine how they make such decisions. More disclosure of information by entities such as hedge funds, particularly to their counterparties and creditors, would be useful and appropriate. We understand that market participants are already demanding more disclosure from hedge funds. This is a positive development.

Among the disclosure questions we are exploring are: what additional disclosure is needed, to whom such disclosures should be made (some or all of counterparties, creditors, investors, regulators, and the public), and whether the government needs to do more to require disclosure. Additional disclosure may be one way to help lessen the chance of another LTCM situation.

The hedge fund study will also focus on the issue of leverage. It is clear that the degree of leverage in LTCM allowed the risks in its portfolio to be transmitted more rapidly to other market participants. One of the questions we are asking is whether the degree of leverage in LTCM is typical of hedge funds. We also are evaluating how the risks of what may appear to be excess leverage in financial markets can be minimized. We understand that creditors to hedge funds, and indeed creditors across the derivatives market broadly, are reducing the amount of leverage they are willing to provide. Again, we believe this is a positive development. There also seems to be a consensus among U.S. banking regulators that they need to employ their existing regulatory tools to encourage banks to make more prudent decisions.

Along these lines, we are asking whether the government needs to do more to discourage excessive leverage and, if so, what the appropriate steps might be.

We also are considering the international aspects of these questions, and various of the Working Group agencies are participating in several international studies.

It is fair to say that the Working Group has yet to achieve consensus on these somewhat provocative and complex questions. Even within Treasury, we have not yet formulated a view on many of these questions. We are working quickly, however. We expect to complete the hedge fund study this winter and the derivatives study later in the spring.

We expect to find common ground on some issues in both studies, but it would not be surprising if the agencies are not able to reach complete agreement on all the issues. We intend to provide a comprehensive assessment of the issues in both studies in order to make them meaningful tools for future action by Congress. We look forward to working with Chairman Lugar, this Committee, and others in Congress on these issues.

Thank you, Mr. Chairman and members of the Committee. I would be happy to answer any questions you may have.