Mr. Chairman and Members of the Committee, I am pleased to have the opportunity to testify before you today on over-the-counter (OTC) derivatives and hedge funds. Although I cannot offer particular testimony on the progress of the studies on these subjects being conducted by the President's Working Group, I am happy to offer my perspectives as a former member of the Board of Governors of the Federal Reserve System and as former Chairman of the Commodity Futures Trading Commission (CFTC). I might mention that this is the first time I have testified on CFTC matters since leaving the Commission in 1987, except as representing the Federal Reserve Board during my tenure as Member. Today, I represent no one but myself.
 

I believe that the questions and issues that are raised by OTC derivatives and hedge funds are best examined within the context of the economic function of futures and options markets on physical commodities, their historical development as well as the Commodity Exchange Act (CEA). Futures and options are contracts to accomplish price risk management, including but not limited to the traditional functions of hedging and risk assumption or speculation. Other risk management functions which can involve futures and options as well as other derivative transactions include cash and liquidity management, portfolio management and even facilitation of various investment or capital formation strategies. Deep and liquid exchange trading of futures and options on physical commodities also provides the valuable function of centralized price discovery for the underlying cash commodity. That is, as internationally dispersed market participants actively buy and sell futures contracts, the market price for the commodity on both current (or spot) and future terms is "discovered". This pricing function along with risk transfer capabilities are the attributes that have traditionally made futures exchanges not only economically viable, but also appropriate for federal oversight, some might even say federal protection. To the extent that exchange risk management or price discovery mechanisms break down, the pricing capability for basic cash commodities is impaired, thereby interrupting the pricing efficiency of agriculture or commerce.
 

Financial futures and options provide many of the same economic functions as physical commodity futures and options, but there are some major differences. First, because financial futures and options generally have actively traded cash markets, cash prices are generally not discovered in the futures market. In fact, futures contracts are often settled from cash or indexes of cash prices.
 

A second major difference between financial and physical commodity futures contracts which particularly bears on the issue of need for federal oversight is the delivery or settlement process. A particularly useful function of exchanges is the facilitation and oversight of contract expirations and the related settlement, delivery or exchange of physicals for futures (EFP). Exchanges not only set the terms of delivery, but also oversee the actual delivery as well as the credit verification of members making or taking delivery. In addition, exchanges perform other financial services related to trading, delivery, clearing, credit extension, margining and collateral. For financial derivatives transactions, exchange delivery mechanisms or oversight are less necessary and can be alternatively accomplished through other institutions or inter-institutional arrangements. I believe this largely explains the growth of OTC financial derivatives. Indeed, since delivery or contract close-out occurs by financial transactions similar to other ordinary commercial payments, no special oversight, facility or federal protection is necessary. To take the argument a step further, exchange traded futures and options could also be considerably deregulated.
 

My recollection of particular challenges during my tenure as CFTC Chairman relates to physical commodity deliveries; for example, corners, squeezes, or other types of manipulations, supply distortions, delivery bottlenecks or natural disasters. Although I will not dispute the possibility that supply distortions could occur with financial contract deliveries, the chance is much smaller. Moreover, alternative or substitute arrangements can be made more easily since the delivery mechanism is cash or marketable securities.
 

A third distinction between physical commodity and financial derivative markets is that the participants in the latter are often otherwise supervised or regulated by the banking agencies or the Securities and Exchange Commission (SEC). If those supervisory structures provide adequate protection, then duplicative market (or functional) and institutional oversight are not both necessary.
 

I might mention that the supervisory or regulatory approach of the banking agencies has been somewhat reoriented in recent years to adjust to a revised legislative and regulatory framework which contemplates additional powers and broader geographical scope. In addition, adjustments have been made to accommodate enhanced financial theory and technological capabilities which render the use of derivative transactions and risk management internal control models quite practical and economically viable. The speed at which transactions can occur means that market participants can change their positions quickly and can make or lose money in large amounts fairly quickly. Recognizing these changed circumstances, the banking agencies have moved to make the supervisory process more reliant on risk-adjusted capital adequacy and transparency. To the extent that both parties adequately assess, price and capitalize their risk positions, all transactions will be better informed and more efficiently priced. The SEC has always relied on transparency as the backbone of its regulatory structure.
 

I hasten to point out that not all market participants are directly regulated or supervised. In many cases, participation by an unregulated entity either in regulated markets or with a regulated entity as counterparty does mean that the protection of regulation is available indirectly. But the best protection may well be adequate disclosure and market discipline. The "sharp pencil" on the other side of the transaction may provide the best protection possible for the integrity of the transaction. In fact, bank supervisors are coming to recognize the most effective form of supervision relies on disclosure, risk-adjusted capital and the risk assessment and risk management systems of the participants. That case-by-case risk analysis by market participants is likely to be more effective than arbitrary ratios or balance sheet limitations which can become dated very quickly or not take into account the firm's total portfolio. Reliance on regulatory protections can create the proverbial "moral hazard" and ultimately end up being an ineffective way to protect the financial system. Absence of individual firm responsibility (i.e., capital) can lead to "betting the bank" with little financial consequence.
 

Of course, firms must develop their own risk management models and risk assessment techniques with adequate stress testing involving assumptions of wide interest rate moves, market volatility and liquidity. Relevant input into the models and analysis must include an assessment of counterparty risk. Specifically, how likely is default? If there is inadequate disclosure, the transaction is at risk and if large enough, the firm or even system can be at risk. Disclosure, capitalization and market discipline remain the key protectors.
 

In view of the globalization of the markets and increasingly open avenues of international trade, care must be given to assure that a domestic regulatory structure does not simply chase the business off shore. Technology and ease of financial transactions make this possibility even more likely.
 

With that background, I would now like to examine some of the CEA issues related to OTC financial derivatives and hedge funds. The CFTC has considerable latitude in interpreting the Commodity Exchange Act. In fact, I have always believed that the Act was somewhat broadly written so that regulators could interpret the Act in light of changing and developing markets. A certain amount of over-the-counter activity has always been tolerated, even encouraged, as facilitating agriculture and commerce. In almost every market imaginable, some kind of forward market activity facilitates production and distribution management. In agriculture, the concept of forward contracts for farmers is well known with entities further up the distribution chain fully utilizing the futures markets to hedge or manage the price risk associated with their forward positions. Other markets have various kinds of forward contracting conventions, and many utilize futures to manage that risk. In general, I think exchanges have supported these arrangements, because eventually the activity results in exchange business. Exchanges have particular challenges in developing financial derivative business because of the ease of contracting and settling in an inter-institutional or off exchange basis. But I am confident with their history of creativity and innovativeness that exchanges will find ways to compete. As mentioned above, a revised regulatory structure could assist in this process.
 

Although there are no precise definitions of allowable forward or even OTC activity in the CEA, I have always believed that Congress looked to the regulators to interpret allowable activity in a way which would facilitate trade, commerce and, of course, agriculture. During my own tenure at the CFTC, Congress supported leverage transactions, which were essentially OTC futures contracts in precious metals. Letters were also written by the General Counsel with the approval of the Commission indicating that no enforcement action would be taken to prohibit certain kinds of hybrid securities containing futurity or optionality features with the full knowledge and tacit approval of the Commission's Congressional oversight committees.
 

Although OTC financial derivatives were only a gleam in the eye of some enterprising financial engineers during my tenure at the Commission, it was clear they were coming. In fact, just before I left the Commission, I set up an internal staff committee to study and make recommendations to the full Commission on issues relating to developing financial OTC products. As a general matter, my own view was to allow experimentation via "no-action" letters, and then pursue safe harbour regulations (or even legislation) if the experimental activity proved economically viable and useful as a risk management tool. Based on those criteria, financial derivatives deserve to trade and deserve legal certainty.
 

During my tenure at the Federal Reserve System, I came to appreciate the great potential of OTC derivative transactions as a means for banks to manage interest rate, equity, credit and currency risk. Depository institutions ultimately have developed very sophisticated risk management systems and utilize both exchange-traded and OTC instruments quite successfully. As mentioned earlier, the supervisory structure has had to be changed to accommodate this new activity. Banks engage in derivative activities in a fashion similar to other financial transactions. In view of the protections afforded via the bank supervisory structure, it always seemed sensible to me to exempt otherwise regulated entities from the CEA. Although I recognize that some participants in the OTC derivatives market are not supervised, a large portion are and can exert market discipline through their own risk management techniques, including requiring disclosure from derivatives counterparties.
 

In conclusion, I am quite sure there are many ways to interpret the Commodity Exchange Act and I suspect that others would disagree with my assertion that futures-style regulation of financial OTC derivatives is unnecessary and exchange traded financial futures and options can be deregulated. In many cases, the market participants of OTC derivatives are otherwise regulated. Disclosure by unregulated OTC financial derivatives market participants should be increased so that arms length transactions are effected with adequate knowledge. Fully informed transaction opportunities maximize the effectiveness of market discipline.
 

Thank you very much for your attention. I will try to respond to questions you may have.