Mr. Chairman and members of the Committee, I am pleased to testify before you today regarding the President's Working Group Over-the-Counter Derivatives Study and Long-Term Capital Management. I thank you for this opportunity. My comments will be brief and general, and I would request that my submission of written comments be included in the record of this hearing. The issues we are addressing today are at the forefront of discussions among and between financial market regulators and participants, and I applaud the Committee's efforts to bring clarification and direction to this ongoing debate. Additionally, I look forward to hearing comments from the Committee on these issues.
Over the past decade, the over-the-counter marketplace has become increasingly important and attractive to the risk management requirements of financial market participants, not only in this country, but worldwide. The expanding nature of these markets, in size and complexity, has been driven by the necessities of global financial and business enterprise. The United States has enjoyed a vital role in this expansion and innovation, and I believe that with appropriate regulation, mindful of the free market principles that have given our economy its vitality and stability, such leadership by the United States in this area can and will continue. However, I believe just as adamantly that inappropriate or heavy-handed regulation will surely stifle financial market innovation, and send these important markets overseas. Accordingly, let me state the central and most important theme of my comments today: I believe it is imperative that legal certainty be restored to these vitally important markets. To that end, I reiterate the commitment in the September 11, 1998 letter to you, Mr. Chairman, in which Commissioner Spears and I affirmed that we would not vote to propose or issue any new rules, regulations, interpretations or policy statements to regulate swaps or hybrid instruments prior to Congress having the opportunity to review and analyze issues relating to OTC derivatives. I am gratified that this commitment of a majority of the Commission was subsequently codified by Congress, inasmuch as this gives concrete reassurance to markets and market participants, and serves considerably to decrease regulatory and legal uncertainly. Also, I agree with the proviso that the moratorium not interfere with the Commission's ability to take action in furtherance of any determination by the President's Working Group, and I am committed to prompt implementation of any action that the Working Group and Congress deem appropriate. Once again, let me emphasize my firm belief that these fundamental issues of regulation should be determined by Congress prior to any intervening regulatory activity.
Furthermore, I commend and fully support the requests made of the President's Working Group on Financial Markets to undertake studies on OTC markets and on hedge funds. I look forward to cooperating with the other members of the Working Group and with the Steering Committee as we work on these studies, and I believe that these documents will provide significant insight and guidance on various issues to facilitate Congressional deliberation and determination. It is my understanding that several sections of both studies have been drafted, and that the hedge fund study should be completed early in the new year. It is my hope that the OTC study will subsequently be completed as soon thereafter as possible. Although neither I nor my staff have been personally involved in the Working Group or Steering committee discussions, at the appropriate time I would welcome such interaction, and I look forward to reviewing drafts of both studies, and to a joint effort by the Working Group members and their staffs.
As an important caution to this discussion, let me say that I believe it is premature to make any predictions about the conclusions of these studies prior to their completion. Similarly, I believe it imprudent to state overly broad opinions regarding the possible hazards or deficiencies of particular transactions or entities, prior to having the facts at hand to the fullest extent possible. Mr. Chairman, too often, the predicting of imaginable jeopardies becomes a self-fulfilling prophecy, and the issues we are contemplating are too important to put at risk with prognostication or supposition. With those qualifying factors in mind, I believe it may be beneficial to review certain questions as we proceed to carry out our work on these studies, such as promotion of best practices standards, possible enhanced disclosure of credit concentration, and study of risk modeling. Most importantly, I believe it is imperative to keep in mind that less intrusive, rather than more intrusive regulation is the desirable outcome of these endeavors.
Again, thank you Mr. Chairman for the opportunity to make these comments,
and I would be happy to answer any questions.
Mr. Chairman and members of the Committee, I am pleased to testify before you today regarding the President's Working Group Over-the-Counter Derivatives Study and Long-Term Capital Management. I thank you for this opportunity. These issues are at the forefront of discussions among and between financial market regulators and participants, and I applaud the Committee's efforts to bring clarification and direction to this ongoing debate.
Over the past decade, the over-the-counter marketplace has become increasingly important to the risk management requirements of financial market participants, not only in this country, but worldwide. A comprehensive study undertaken by the Bank for International Settlements in 1997 placed the estimates of the notional/contract amount outstanding of OTC derivatives as of March 1995 at $47.5 trillion globally, and at $11 trillion for the United States.(1)
The notional value of OTC derivatives is regularly reported in the press at well over $30 trillion. By any measure, these are clearly substantial and significant markets. The expanding nature of these markets, in size and complexity, has been driven by the necessities and exigencies of global financial and business enterprise. The United States has enjoyed a vital role in this expansion and innovation, and I believe that with appropriate regulation, mindful of the free market principles that have given our economy its primacy, vitality, and stability, such leadership by the United States in this area can and will continue. However, I believe just as adamantly that inappropriate or heavy-handed regulation will surely stifle financial market innovation, and send these important markets overseas. Accordingly, let me state the central and most important
theme of my comments today: I believe it is imperative that legal certainty be restored to these vitally important markets. To that end, I reiterate the commitment manifested in the September 11, 1998 letter to you, Mr. Chairman, in which Commissioner Spears and I affirmed that we would not vote to propose or issue any new rules, regulations, interpretations or policy statements to regulate swaps or hybrid instruments prior to Congress having the opportunity to review and analyze issues relating to OTC derivatives. I am gratified that this commitment of a majority of the Commission was subsequently codified by Congress, inasmuch as this gives concrete reassurance to markets and market participants, and serves considerably to decrease regulatory and legal uncertainty. Also, I agree with the proviso that the moratorium not interfere with the Commission's ability to take action in furtherance of any determination by the President's Working Group, and I am committed to prompt implementation of any action that the Working Group and Congress deem appropriate. Once again, let me emphasize my firm belief that these fundamental issues of regulation should be determined by Congress prior to any intervening regulatory activity.
For the past five years, OTC markets have been able to grow and innovate in a relatively benign regulatory atmosphere. That is to say, the 1993 Swaps Exemption allowed the vast majority of OTC transactions to occur without undue regulatory or legal uncertainty. However, this exemption, and the 1992 law that enabled its promulgation, have been called "truces" rather than "peace treaties," inasmuch as the fundamental questions regarding whether swaps transactions constituted futures contracts remained unanswered.(2)
Accordingly, I believe it entirely correct and appropriate that, as a matter of public policy, the time and opportunity has come for Congress to make these and other fundamental determinations. The myriad federal regulators involved in this debate -- members of the Federal Reserve Board, the Treasury Department, the Securities and Exchange Commission, and the Commodity Futures Trading Commission -- cannot and should not attempt at this juncture to preempt what is clearly the province of the Congress, that is, the formulation of basic legal and policy determinations that we as regulators must carry out.
To that end, I believe that the regulatory bodies that formulate the President's Working Group on Financial Markets will provide a signal service to Congress in reviewing and analyzing data relating to the OTC marketplace, as well as information regarding market users and participants. Gathering and synthesizing this information will afford a good foundation of data and experiential information on which to make appropriate decisions. Currently, I believe a brief outline of the OTC study includes a list of objectives, a suggested analytical approach, an overview of the background of the OTC markets, public policy objectives, and an assessment of the necessity and appropriateness of government regulation. I believe that most of the sections have been assigned to various regulators for drafting, and indeed some sections have already been drafted. It is my understanding that the OTC study will be completed subsequent to completion of the hedge fund study, which would be submitted early in the new year. I commend and fully support the requests made of the President's Working Group to undertake the studies on OTC markets and on hedge funds, and I look forward to cooperating with the other members of the Working Group and the Steering Committee as we work on these studies. As noted, I believe that these documents will provide significant insight and guidance on various issues to facilitate Congressional deliberation and determination.
Although neither I nor my staff have been personally involved in the Working Group or Steering committee discussions, at the appropriate time I would welcome such interaction, and I look forward to reviewing drafts of both studies, and to a collegial and collaborative effort by the Working Group members and their staffs.
As an important caveat to this discussion, let me say that I believe it is premature to make any predictions about the conclusions of either the OTC or the hedge fund study prior to completion. Similarly, I believe it imprudent to state overly broad opinions regarding the possible hazards or deficiencies of particular transactions or entities, prior to having the facts at hand to the fullest extent possible. Too often, the presaging of imaginable jeopardies becomes a self-fulfilling prophecy, and the issues we are contemplating are too important to put at risk with prognostication or supposition. Most importantly, as we proceed with this discussion I believe it is imperative to keep in mind that less intrusive, rather than more intrusive regulation is the desirable outcome of these endeavors.
With regard to hedge funds, I would like to address certain issues relating to such funds in general and with regard to events and commentary surrounding Long-Term Capital Management in the specific. I recognize the interest that members of this committee have on this topic, and, again, I applaud efforts to draw clarity and sound analysis to these events, rather than to engage in dangerous speculation.
The request of the President's Working Group to engage in the study of hedge funds will, I think, provide needed information to the debate. As mentioned above, I believe that significant progress has been made on this study, and it should be ready for presentation early in the new year. The study will include a description of hedge funds and the types of trading they engage in, an explanation of the risks faced by hedge funds, the market impact of hedge funds, the regulatory environment of these funds, as well as discussions of credit risk management, public policy issues, and LTCM. Let me reiterate my caution that I believe predictions regarding the conclusions of this study to be improvident at this time.
Before I make certain abbreviated comments about hedge funds in general, and discuss some of the possible regulatory responses to hedge fund issues, I would like briefly to make some limited observations about LTCM. It is, I believe, very easy, and at times enticing, to exaggerate or aggrandize unfortunate events. Undeniably, the LTCM's high degree of leverage, combined with the magnitude of its positions, its trading strategies, and, I believe, a problem relating to analysis of credit concentration by counterparties, led to a difficult, negative situation. However, I think it important to note that the regulatory oversight by Federal Reserve Board led to resolution of matters without the use of public funds, and without negative impact on the markets as a whole. Let us not engage in polemics about the world coming to an end; it did not, and, I believe, would not have even absent the Board's intervention.
There has been much press reportage concerning who knew what regarding LTCM. For my part, let me say that I became aware of LTCM on September 24, 1998. I believed then, and continue to believe, that discussions regarding LTCM should not unduly prejudice debate regarding appropriate regulation of specific classes of market participants or specific types of market transactions. Better that we should take a more global look at the nature of hedge funds themselves, and frame the discussion not in terms of addressing this particular event, but rather in terms of whether and what type of regulation is appropriate.
Currently, the number of hedge funds in the United States is variously estimated to be between 3,300 and 5,500, controlling assets of between $300 billion and $375 billion.(3)
These private, closed-end investment funds are primarily vehicles for sophisticated, wealthy investors. They utilize myriad investment strategies,(4)
usually requiring large initial investments. Hedge funds attempt to improve upon the return of more traditional regulated funds by utilizing various market strategies and leverage.(5)
Leverage, a distinguishing feature of a majority of these funds, varies according to the investment strategies and styles of the funds. According to one study, approximately 50% of hedge funds use less than two-to-one leverage, approximately 16% use leverage of between two-to-one and ten-to-one, and only a very few hedge funds use leverage of greater than ten-to-one.(6)
Hedge funds tend generally to coordinate inversely the degree of leverage with the level of risk associated with their trading strategies. For example, a high risk investment strategy is normally combined with a lower level of leverage, and conversely, a lower risk strategy is usually paired with increased leverage. (For the record, I would note that LTCM was engaging in a risky trading strategy, and the same time utilizing a high degree of leverage.)
Hedge funds can and do provide positive benefits to financial markets. Their trading can increase market efficiency, in that positions taken to profit from temporary price discrepancies can reduce such gaps. Indeed, the risk-taking engaged in by hedge funds and major market participants can serve to correct incongruities in market valuations. (7)
I believe that attempts to eliminate or stifle this market activity will result in less efficiency and liquidity in the marketplace.
That is not to say that there may not be the need to address the possibility of risk to the marketplace with regard to hedge fund activity. Given the large size of positions taken by hedge funds in different markets, the amount of leverage that is used, and the level of risk of certain trading strategies engaged in, the potential impact in the case of a "fire sale" should be reviewed and analyzed.(8)
However, I would caution against undertaking such analysis in an atmosphere of paranoia or confusion. Indeed, it has been said that the "critical challenge for policy-makers" in this debate is "distilling fact from hyperbole."(9) In that vein, I believe there are several areas that may profitably be explored concerning appropriate regulatory responses to this issue. First, I believe that improved disclosure regarding concentrations of customers' credit exposures by banks should be studied. This may allow for review of the massing of credit extensions to a specific customer to determine whether the gross exposure is excessive. Secondly, I believe that the efforts made by the Federal Research Bank of New York to develop supervisory guidance are highly beneficial. It is my understanding that the development of "best practices" standards should be completed sometime early in the next year, and I think this would go a long way toward improving the safety and soundness of banks' dealings with hedge funds. Thirdly, given the apparent failure of certain value-at-risk models in times of market stress (and, in the case of LTCM, the failure to engage in adequate stress testing), I think that further study of the appropriate risk models to be used may be helpful.
There are many who doubt the utility of traditional, direct regulation of hedge funds. Indeed, as I have stated, I believe that heavy-handed regulation will certainly drive business off the shores of the United States. Accordingly, I would agree that indirect methods, through the funding sources of hedge funds, may be more appropriate. Therefore, I think that resolutions to the concerns stated may include improved disclosure of credit concentration, improved credit analyses, and enhanced prudential oversight by lenders. Let me add that, in order to be effective, I think that these efforts should be made internationally, and that globalized resolutions are befitting the nature of the markets and market concerns.
1. 1 General Accounting Office Study on OTC Derivatives, October 1997, at 3.
2. 2 "SEC and CFTC Regulatory and Legislative Developments," Remarks of Randall Green, Chief of Staff, Senate Committee on Agriculture, Nutrition and Forestry, Practicing Law Institute Conference, New York City, November 17, 1998.
3. 3 See e.g. "Nobody Wants to Kill the Golden Goose," Forbes, December 14, 1998, at 50; "Hedge Funds and Financial Markets," study of the Organization for Economic Cooperation and Development, Directorate for Financial, Fiscal and Enterprise Affairs, Committee on Financial Markets, November 1998, at 5. Anecdotal evidence would indicate there are between 3,000 and 5,000 hedge funds globally, controlling between $300 billion and $500 billion.
4. 4 The strategies vary from usage of macro-economic trends (e.g., rising or falling exchange or interest rates), contingent event occurrence (e.g., bankruptcy or other credit default), and various types of arbitrage. Id. at 3.
5. 5 Hedge funds also exhibit various types of investments styles, for example, bond arbitrage, Asian equity hedge, global equity hedge, domestic long biased, domestic opportunistic, deal arbitrage, convertible hedge, multi-strategy, dedicated short seller, etc. Id. at 3.
8. 8 I believe it important to remember that in any discussion of these issues relating to possible systemic risk, the relative size of the hedge fund marketplace should be put into global perspective. That is to say, the amount of money under management in hedge funds is small compared to the international foreign exchange markets or the OTC derivative markets. For example, daily forex market transactions are estimated globally at $1.2 trillion and daily OTC market transactions globally at $362 billion. See Id. at 5.
9. 9 S. Ervin, "The Perils of Success: Public Policy Issues Presented by Hedge Funds," Futures and Derivatives Law Report, Vol. 16, Nos. 1 & 2, March/April 1996, at 9.