Statement of Dr. Wendy L. Gramm, Distinguished Senior Fellow

Director, Regulatory Studies Program

Mercatus Center, George Mason University

Fairfax, Virginia

On The Regulation of Over-the-Counter Derivatives

Before the Committee on Agriculture, Nutrition, and Forestry

United States Senate

December 16, 1998

Mr. Chairman and Members of the Committee: Thank you for inviting me to testify on the regulation of the over-the-counter derivatives market. As former chairman of the Commodity Futures Trading Commission (CFTC), I hope to provide some historical perspective on the issues you are addressing, since these are essentially the same issues we worked together on during the agency's last (rather painful) reauthorization.

My current position is Director of the Regulatory Studies Program at the Mercatus Center at George Mason University. The purpose of this program is to advance knowledge about regulations and their impact on society. Please note that this testimony reflects my own views and not necessarily those of the Mercatus Center or George Mason University.

Swaps and the Futures Trading Practices Act of 1992: Some Recent History

CFTC interest in the regulation of over-the-counter (OTC) derivatives is not new, as you well know. In December 1987, the CFTC issued an Advance Notice of Proposed Rulemaking (ANPRM) that suggested that the Commodity Exchange Act (CEA) applied to swaps and to hybrid instruments, which are securities or depository instruments that have futures or option-like components. The agency was also investigating whether the oil swaps of a major money center bank were futures, and therefore illegal, off-exchange futures. These actions caused the developing commodity swap business in the U.S. to move overseas and created uncertainty in the more established markets for interest rate swaps and other financial products.

The commodity swap business did not return to the U.S. until the CFTC released a Swaps Policy Statement which removed some of the regulatory cloud surrounding swaps. The market for oil swaps was thus allowed to develop again in the U.S., and this growth helped to fuel the growth of the Nymex energy futures market. The CFTC took other steps to provide more legal certainty in the over-the-counter markets. These steps to clarify regulatory jurisdiction took the form of regulations, statutory interpretations, and "no-action" letters. These efforts culminated in Congress passing the Futures Trading Practices Act of 1992 (FTPA).

The jurisdictional section of the FTPA was crafted with the help and input of all relevant Congressional Committees, all relevant agencies, and all parts of industry. The purpose of this section was to provide some regulatory certainty to market participants. The FTPA established some clear boundaries -- within which swaps markets could develop. The boundaries were not meant to limit development, however. It was envisioned that if firms wanted to develop new products and new ways of doing business that were not within the safe harbors established by the FTPA, they would do so, working with the CFTC or other agencies as appropriate to determine if any regulations needed to be added or changed.

The FTPA also gave the CFTC much-needed flexibility through new exemptive authority to tailor a regulatory scheme to accommodate change and innovation. Unfortunately, this exemptive authority has not been utilized much.

Growth of the OTC Markets Since the FTPA

Much has been said about the growth of the OTC swaps market and indeed all the OTC markets for financial products since the passage of the FTPA and issuance of the implementing regulations. In its May 1998 Concept Release, the CFTC pointed to the rapid growth and changes in the marketplace during the past five years as reasons for reviewing its regulatory approach to OTC derivatives.

It is important to point out that this growth is not surprising. Indeed, the objective of the jurisdictional provisions of the FTPA, along with the earlier Swaps Policy Statement, hybrid regulations and related interpretations was to provide more regulatory and jurisdictional guidance in order to ensure that these markets could and would develop. In other words, these markets developed because some of the legal uncertainty that hampered development of these markets in the U.S. was removed. We should be surprised if these markets had NOT grown.

As for change -- change is a fact of life in a competitive and dynamic world. Those who do not adjust will be eliminated by competitors. In the world of exchange-traded products, for example, we have seen dramatic examples of active markets for financial products moving to other locations.

Conditions can change rapidly, and market participants can move their capital and business quickly in response to the cost and risk of doing business in a specific market. It is therefore essential that policy makers remain sensitive to unnecessary costs and legal risk they can impose on market participants.

To summarize: The CFTC scared much of the commodity swap business overseas in 1987 when this market was still relatively new and small. The Swaps Policy Statement gave some level of comfort and the swaps market in the U.S. began to develop again. The FTPA gave even greater regulatory certainty to market participants, further promoting this market's growth. This is what was expected to happen.

It was also expected that new products and innovative ways of doing business would continue to develop, and the exemptive authority of the FTPA would be used to allow continued development of markets. It was also envisioned that these new authorities would be used to carefully examine the need for existing regulations, eliminating unnecessary or obsolete regulations that had been placed on the regulated exchanges as well as other participants. This would allow exchanges more flexibility in crafting new ways of doing business, creating products or otherwise lowering the cost of operating an exchange. The FTPA has been underutilized in this regard.

The Need For Regulatory Certainty: Some Ancient History

The Concept Release of May 1998 raised concerns that the CFTC might expand its jurisdiction over OTC derivatives by unilaterally narrowing or otherwise changing the framework that had been agreed to by all parties during the agency's 1992 Reauthorization. The recent Concept Release worries market participants for the same reason that the agency's earlier actions concerning swaps sent the relatively new commodity swap business overseas. Specifically, the exchange trading requirement of the Commodity Exchange Act requires all futures contracts to be conducted on or subject to the rules of a board of trade regulated by the CFTC. Thus, if there is uncertainty surrounding what the CFTC might consider to be a futures contract, a party can avoid meeting its obligation by simply claiming that the contract is not binding because it is really an off-exchange futures product, and therefore illegal and unenforceable.

The exchange trading requirement of the Commodity Exchange Act did not present a problem until 1974. Before 1974, what was a commodity subject to the Commodity Exchange Act was specifically enumerated. All futures contracts for these specific agricultural commodities had to be traded on a regulated exchange. Forward contracts for agricultural commodities were excluded from the reach of the Commodity Exchange Act because Congress did not wish to affect ongoing agricultural commerce.

In 1974 Congress expanded the definition of "commodity" to include not just the enumerated commodities, but anything. In order to ensure that the interbank cash markets would not be inadvertently captured in the CFTC's net, the Treasury Amendment was added to the bill. Just as Congress did not expect the CFTC to regulate cash markets in agriculture, so they did not expect the CFTC to get involved in the inter-bank foreign exchange market, for example. (The Treasury Amendment has been the source of some disagreement between the CFTC and the Treasury Department over the years.)

The exchange trading requirement of the Commodity Exchange Act, when coupled with CFTC's excusive jurisdiction and the broad definition of commodity, has been a source of legal uncertainty. Exemptions, exclusions, or other actions to clarify the reach of the Commodity Exchange Act and to allow appropriate development of innovative and valuable financial products in the OTC markets have taken much time and effort over the years. Actions taken when I was Chairman of the CFTC were aimed at providing legal certainty in a rapidly developing and dynamic marketplace.

The Need for Further Regulation?

The reauthorization of the CFTC gives Congress and policy makers the opportunity to review the regulatory structure once again. The challenge of keeping laws and regulations from stifling innovation or otherwise damaging markets and institutions is even greater today than before. I would argue that the events over the past year do not indicate a need for new regulations or major changes in the law. While there might have been losses in these markets, the problems so far have not created lasting disruptions or dislocations in markets. The regulatory structure seems to be working.

I believe that the effort to eliminate unnecessary regulations that this Committee advocated in the last session of Congress is both appropriate and important. That is also the unfinished business of the CFTC's last reauthorization. Thank you for your continuing interest in these important issues.

References:

W. L. Gramm and G. D. Gay, "Scams, Scoundrels, and Scapegoats: A Taxonomy of CEA Regulation Over Derivative Instruments," Journal of Derivatives, Spring 1994.

W. L. Gramm and G. D. Gay, "Ready--Fire--Aim: An Antidote to Derivatives Regulation by Anecdote," in Derivatives Handbook:Risk Management and Control (Robert J. Schwartz and Clifford W. Smith, Jr., editors), John Wiley and Sons, 1997, pp. 433-445.