BEFORE THE COMMITTEE ON

AGRICULTURE, NUTRITION AND FORESTRY

OF THE

UNITED STATES SENATE
 

DECEMBER 16, 1998
 

Mr. Chairman, I greatly appreciate this opportunity to offer my views on the issues being considered by the Committee today. Thank you for inviting me.

I have four points to make. They deal with more than OTC derivatives and hedge funds because the question of how to regulate these products cannot be considered independently. It is closely connected to the question of how to regulate futures and options exchanges.

1. The CFTC should not regulate OTC derivatives or hedge funds. There is, however, little doubt that it believes it should-as shown by its concept release concerning OTC markets and recent statements concerning hedge funds. I realize that the Commission's public stance is that the release only asks questions and does not indicate an intent to regulate OTC derivatives. But the comments and questions in the release make it clear that the Commission is looking for reasons to justify extending its regulatory reach to include this market. And there can be little doubt that, left to its own devices, it will find such reasons. Similarly, there can be little doubt that it would like to use LTCM's problems to justify extending its reach to hedge funds. Either development would be unfortunate. Nothing has happened to justify the CFTC's regulation of OTC products. Recent events with a few hedge funds have revealed the existence of some reckless investment and lending, but have they revealed the need for more regulation? I

am not convinced that they have, although perhaps there should be some additional rules concerning transparency. In any event, for reasons discussed below, if additional regulation of OTC derivatives or hedge funds is needed, it should not be the responsibility of the CFTC.

2. The confusion surrounding the regulation of OTC derivatives stems from the substance and structure of our system for regulating futures and options exchanges. We should, therefore, not get too upset with the CFTC for trying to regulate OTC derivatives. Given the pace of financial innovation today, several elements of the Commodity Exchange Act and the nature of regulatory agencies, something like the concept release would be issued some day-if not from today's CFTC, then from tomorrow's. That is, the problem is not so much that the CFTC has done something unwise in issuing the release, which it has, but that the statute makes this unwise behavior inevitable. As long as the CFTC exists as a separate agency it will try to be involved in regulating products that have some of the economic characteristics of futures and options contracts.

In 1982, the Shad-Johnson Accord appeared to have resolved the issue of CFTC jurisdiction, but it soon became clear that it had not. In 1992, The Futures Trading Practices Act appeared to have resolved the issue, but it soon became clear that it had not. Some minor tinkering with the Act in the upcoming reauthorization may appear to resolve the issue, but it will soon become clear once again that it has not. Nothing short of a major overhaul of the Act has any chance of resulting in a regulatory system that can deal effectively with today's and tomorrow's financial markets. This overhaul must address both the substance and the structure of regulation.

3. A number of changes in the existing rules for regulating derivatives are needed. In this regard, the bill introduced in the Senate last year, S. 257, is a giant step in the right direction. S. 257 would provide legal certainty for the OTC market, and it would provide a much improved set of rules for regulating exchange-traded derivatives. I would like to emphasize that it is important to deal with the regulation of both the OTC market and exchanges at the same time. It is neither fair nor efficient to exempt OTC products from regulation while continuing to subject futures exchanges to the current regulatory regime. But these needed changes in the substance of regulation also require a structural change-an issue not addressed by S.257. As long as the CFTC is a separate agency, it will be very difficult to maintain legal certainty with respect to the OTC market or to establish a reasonable regulatory system for futures and options exchanges. This leads to my fourth point--one that I make with great reluctance but also with great conviction.

4. The CFTC and SEC should be merged into a single agency. In the past, I have advanced three reasons for keeping the CFTC separate, but these reasons no longer seem persuasive. One reason was that functional regulation-as opposed to institutional regulation--was the better approach. That is, the CFTC should regulate markets for risk shifting instruments, the SEC should regulate markets for securities, the Fed or Treasury should regulate banks, and so on. I think it is now clear that functional regulation cannot work in today's markets. Many financial instruments and many financial firms serve a variety of functions. Functional regulation results in many firms being subject to regulation by several different agencies. Not only does this impose excessive costs on market participants, but it inevitably results in regulatory turf battles-which are also costly.

The second reason that I used previously for keeping the CFTC separate was that this enabled the CFTC to undertake some innovative approaches to regulation and, by example, keep the SEC from becoming too set in its ways. Today, however, it appears that foreign regulators play this role quite effectively. They help keep the SEC responsive to the changing nature of the market, while it is the CFTC that has become set in its ways.

My other reason for having a separate agency, and one that is very important to the Committee on Agriculture, Forestry and Nutrition, was that this would provide better protection for agricultural interests. This reason still carries significant weight, but it should be possible to merge the agencies while still protecting the interests of America's farmers. For example, the Act could direct the new Commission to continue the CFTC's surveillance program for agricultural contracts. The merged Commission could be required to continue to have an Agricultural Advisory Committee. Its chair and the chair of the Commission could be required to appear regularly before the Senate and House Agriculture Committees to report on their efforts to protect agricultural markets. Also, the Agriculture Appropriations Subcommittees could be given a role in determining the new agency's budget. Given the high costs of maintaining the current regulatory structure, I would urge the committee to consider these and other ways of safeguarding the interests of agriculture while moving to a system of regulation that better reflects the realities of today's financial and agricultural markets.

To sum up, we need a legal and regulatory framework that provides legal certainty for OTC derivatives, acceptance of institutional rather than functional regulation for those dealing in these products and more flexibility in the regulatory system for exchange-traded derivatives. Accomplishing this will require a merger of the two agencies that currently regulate exchanges in the US.