Statement of
Shawn A. Dorsch
President and Chief Operating Officer
DNI Holdings, Inc.
concerning
Re-authorization of the Commodities Exchange Act
before the
Committee on Agriculture, Nutrition and Forestry
U.S. Senate
September 23, 1999
DNI Holdings, Inc. ("DNI") is grateful for the opportunity to present this written statement to the Senate Committee on Agriculture, Nutrition and Forestry (the "Committee") in connection with the Committee's hearings held on September 23, 1999 and DNI's oral testimony given in connection therewith.
DNI is a Delaware corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate a computerized communications and information system (known as "Blackbird" or the "Blackbird system") to help major financial institutions find, negotiate and agree to custom-tailored interest rate and currency derivatives transactions (for ease of reference, "swaps") directly with each other. The founders of DNI are experienced swaps professionals. The Blackbird system is newly operational and successfully serving major swaps dealers in the U.S.
The fundamental goal of DNI is to provide its financial institution customers with a computerized system that will bring greater speed, precision, safety and security, and lower costs, to the very same business activities that are now taking place every day in numerous U.S. financial institutions. These activities are unregulated or exempt from regulation under the Commodity Exchange Act ("CEA"). Yet the Commodity Futures Trading Commission (the "CFTC" or "Commission") has indicated its concern that Blackbird might be subject to some unknown, unspecified regulatory regime under the CEA, apparently because Blackbird utilizes computer technology.
DNI believes it apparent that regulatory concern should be focused not on the medium of communication or information transfer, but on the activities accomplished with the medium. The Blackbird system does not suddenly invest activities long outside the scope of CEA jurisdiction with new characteristics warranting government involvement. Nonetheless, the CFTC's stated concern and the general atmosphere of uncertainty that exists as to the CFTC's intentions with respect to increased electronics systems use in financial commerce has the obvious capacity to slow Blackbird's progress, and to generally dampen innovation and growth in the U.S.
It is a given that technological progress can upset previously established businesses and practices. It is equally certain, however, that technological progress cannot be stopped, that it has repeatedly enriched this country and all its people, and that our Government should be particularly sensitive to the need to encourage technological progress which, like Blackbird, serves the public good.
The Committee has asked DNI for its view on (a) how technological advances will change the derivatives industry and (b) which electronic trading activity should be regulated under the CEA and which should not. The following description of the Blackbird system will be responsive to the Committee's request for insight into how the derivatives industry (or at least the custom-tailored swaps portion of the industry served by Blackbird) is coming to look in the very near term as a result of advances such as Blackbird. This description is set within the currently existing regulatory context, showing that Blackbird brings its many electronic advantages while fitting easily and appropriately within existing exemptions and exclusions from the jurisdiction of the CEA. Blackbird is an example of a trading-related electronic enhancement that does not disturb the existing regulatory scheme and should not be regulated.
The Committee has also invited DNI to comment upon how to regulate an electronic exchange within the jurisdiction of the CEA. DNI is not close enough to being an exchange to be able to offer a view, other than to suggest that government involvement be sparing enough to preserve market freedom and efficiency, while protecting the public from fraud.
Simply stated, the Blackbird system is the electronic analog of the "voice brokers" who now serve swaps dealers. Blackbird fulfills the same functions, but with far greater efficiency and benefit to the financial system than the voice brokers. Blackbird is not an exchange or a clearing house. Blackbird does not enter into transactions, provide credit support or take or add credit risk. Blackbird does not change the individual customized nature of swaps. Blackbird does not introduce preference or bias into negotiations. Blackbird simply provides sophisticated dealers (and not the public) with a computer-based electronic communications alternative for the direct negotiation and agreement of bilateral transactions. It offers an improved electronic method for a dealer to identify other dealers who may, subject to the resolution of credit and other terms, be willing to enter into a transaction having particular economic terms desired by the first dealer. Through Blackbird, a dealer can circulate to other Blackbird participants the vital facts reflecting its own proposed transaction, or it can review other dealers' invitations to negotiate. Blackbird helps a dealer find a transaction that matches the dealer's needs and gives the dealer a means of communication to negotiate and agree to the basic economic and other terms of the transaction. Use of Blackbird will promote competition, improve transparency, record-keeping and risk control, and reduce costs. Blackbird will bring substantial private and public benefit, without changing any meaningful feature of custom-tailored swaps activities as they currently operate, and without creating any need for novel regulation.
In view of the foregoing, DNI finds its situation peculiar. Its product and services offer great benefits in a hugely important, innovative area of finance. As Alan Greenspan said in his March 19, 1999 remarks to the Futures Industry Association, "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives [which unbundle risks]. . . . While the value of risk unbundling has been known for decades, the ability to create sophisticated instruments . . . had to await the . . . development of computer and telecommunications technologies." Although technological advances underly the entire development of swaps, DNI's use of electronic technology to make swap dealing safer, fairer and more efficient arouses troubled concern, and not praise, in the CFTC.
Overview of the Blackbird System
Users of the Blackbird System
DNI markets the Blackbird system exclusively to large banks and affiliates of broker-dealers that are active as dealers in swaps. There is no public access to Blackbird.
Users are not "members" of Blackbird and neither DNI nor Blackbird enters into, clears, or provides credit support for the bilateral transactions that are entered into by users of Blackbird. User's pay for Blackbird according to their use. They are not committed to use Blackbird.
Use of the Blackbird System
As indicated above, Blackbird is designed to compete directly with the existing voice brokers by providing a computer-based alternative for communicating with other dealers in swaps. As voice brokers telephone transaction invitations to prospective counterparties, users of the Blackbird system can post on the screens provided by the system the economic terms of a variety of interest rate swaps, basis swaps, forward rate agreements and other similar derivative transactions. They can also use Blackbird screens to review the terms offered by other users. The Blackbird system offers a wide range of transaction types with potentially infinite variability of transaction terms. Most importantly, users of Blackbird, unlike users of voice brokers, also input directly into the system their detailed credit preferences for each other user of the Blackbird system. These credit preferences may be transaction-specific. The Blackbird system uses this individualized information to create for each user a screen that indicates whether the terms of each transaction offered by other users of the system meet or exceed the particular credit preferences of the first user. In this way, the Blackbird system provides each user with a set of screens that is unique to that user. The credit standards of each user are applied on a confidential basis by Blackbird. Other users of the system cannot use Blackbird to discover these parameters.
Negotiating and Agreeing to Transactions Using Blackbird
When a user is initially reviewing the terms offered by other users on a Blackbird screen, the identities of the offering counterparties are not disclosed, although as noted above, the result of the application of the user's own credit and transaction standards to each transaction is indicated. If a user wants to suggest modified transaction terms, that user can do so directly by anonymously countering on-screen with new terms or by using other means of anonymous communication that provide for complete negotiating flexibility.
A new transaction agreed through Blackbird is subject to whatever documentation requirements the parties otherwise have with each other. This will typically involve the need for the parties to execute confirmations under a master agreement that has been separately agreed between them. In this way the process is much like what occurs with the existing voice brokers, except that parties are able to communicate directly with each other in a far more efficient way. Additionally, the Blackbird system will provide an electronic record of the parties communications that is far superior to the audiotapes that now often record the conversations of traders with voice brokers and counterparties. This should result in fewer misunderstandings and a far better audit trail for management and regulators of each institution that uses the Blackbird system. With Blackbird's electronic data, financial institutions should be able to process the resulting transaction information more quickly and so facilitate the updating and monitoring of risk positions.
It is apparent that there is no basis for regulation of the Blackbird system by the CFTC under current law. To make this clear, we would like to review the main features of the Blackbird system in light of the requirements of Part 35 of the Commission's regulations (the "Swaps Exemption", promulgated by the CFTC pursuant to Congress's direction stated in the Futures Trading Practices Act of 1992) and the Commission's 1989 Policy Statement Concerning Swaps Transactions (the "Policy Statement", which articulated a non-exclusive "safe harbor" intended to distinguish unregulated swaps from their exchange-traded counterparts). We would also like to note the applicability of the Treasury Amendment to the transactions available through the Blackbird system.
The Blackbird System
Swaps Exemption
Background. Blackbird is a bilateral electronic negotiation system developed by DNI for the swaps dealer community. The system covers a wide variety of interest rate and currency swaps involving most major currencies. Within these transaction parameters, Blackbird does not limit the range of terms that may be agreed. The Blackbird system is neither a clearinghouse nor an exchange. Rather, it provides an efficient, screen-based alternative to the current activities of inter-dealer voice brokers. Blackbird involves only dealers entering into non-fungible transactions after having negotiated material economic and credit terms in their governing agreements, with a similar negotiation opportunity or requirement in their individual transactions. The creditworthiness of counterparties is not only a material consideration for each transaction, it is literally programmed into the system, based upon each individual participant's specifications.
DNI understands that voice brokers match dealers seeking to enter into interest rate and currency derivatives over the telephone. Any dealer that wants to make an offer informs the broker through a direct telephone link. Employees of the broker then communicate the offer to other dealers either through direct telephone links or on computer screens that typically display standard transactions of standard sizes. A dealer wishing to accept the offer uses a direct telephone link to the broker to do so and the broker informs the dealer that made the offer. The dealers are then told who they are dealing with, credit is checked, deal tickets are sent out by the broker and all further administrative tasks (including confirming the transaction) are handled by the dealers. Blackbird operates in essentially the same manner except that no standard transactions exist or are displayed, each dealer's credit requirements are confidentially programmed into the system and offers and acceptances take place electronically rather than via telephone links through the broker. All further administrative tasks (including confirming the transactions) are handled by the dealers. The Blackbird system is not available to the general public.
The Blackbird system offers only individualized bilateral dealing. Fundamentally, Blackbird's innovation is to bring a well designed, technologically current means of communication to the privately negotiated swaps businesses now in place. This alone, however, substantially benefits the participants, the swaps community and the financial system as a whole because it reduces delay and miscommunication, enhances credit management and improves audit trails. This in turn should reduce costs, as well as the risks associated with unhedged or mishedged positions.
1. "Swap Agreement" Categories. The transactions to be negotiated via Blackbird include only various kinds of interest rate and currency swaps and interest rate options all of which qualify as "swap agreements" under § 35.1(b)(1) of the Swaps Exemption.
2. Eligible Participants. All entities participating in Blackbird must be swaps dealers that are "eligible swap participants" under § 35.1(b)(2) of the Swaps Exemption. The Blackbird system will not be available to the general public.
3. Non-Standardized Agreements. The Blackbird system begins with a universe of non-standard transaction possibilities. The range and features of transactions actually proposed through the system then inevitably vary widely from day to day, reflecting individual users' needs and changing market conditions. The Blackbird system allows such customization of both transaction proposals and responses that it is a truly interactive system, and not a simple auto-matching device. In addition, the Blackbird screen has features that allow users to probe summary screen terms to verify in detail all the terms and conditions of the transactions they are considering. As a result, dealers can make fully informed decisions on displayed deal terms, and propose different terms if they wish. Finally, the parties are responsible for their own underlying agreements (typically, ISDA masters), confirmations and collateral arrangements, if any, on a purely bilateral basis. For these reasons, transactions negotiated through Blackbird are not part of a fungible class of agreements that are standardized as to their material economic terms for purposes of § 35.2(b) of the Swaps Exemption.
4. Creditworthiness Considered. Each user of Blackbird acts as principal. Consideration of credit, therefore, is a fundamental component of Blackbird. Transactions are only possible between counterparties where the proposed transaction/counterparty combination satisfies the credit policies of both parties as to both counterparty acceptability and counterparty credit line capacity. There is a credit enhancement feature which enables parties to negotiate additional credit features on a bilateral basis for individual transactions. Blackbird is designed to facilitate the evaluation of credit, but it does not alter the need for each party to evaluate the credit of its counterparty in relation to each transaction.
The Blackbird system's credit capabilities allow each participant to rate other dealers for credit purposes. These ratings can be changed by a participant as often as it wishes. The system maintains the anonymity of a dealer's credit ratings of other dealers, and in the usual course a counterparty is identified only when a transaction has been agreed. Of course, in addition to the transactional credit controls in the Blackbird system, each pair of counterparties must negotiate their own underlying agreement, including credit terms.
From the above it is clear that creditworthiness is a material consideration for each transaction entered into using the Blackbird system for purposes of § 35.2(c) of the Swaps Exemption.
5. No "Multilateral Transaction Execution Facility". The final requirement of the Swaps Exemption is that the transaction "is not entered into and traded on or through a multilateral transaction execution facility." § 35.2(d) of the Swaps Exemption. This requirement was intended to make it clear that organizations acting as exchanges or clearing houses, but called by other names, would not be eligible for the Swaps Exemption. The Blackbird system offers no clearing, no credit support and no standardization or fungibility of transactions or agreements. The Blackbird system requires its users to make individual credit decisions about each other user. Blackbird users are not "members" in any sense and are contractually bound to each other only through their individually-negotiated, bilateral underlying agreements. Blackbird is simply an electronic facilitator of individualized swaps transactions, not an exchange, clearinghouse or multilateral transaction execution facility.
Policy Statement
Not only does Blackbird meet the requirements of the Swaps Exemption, it also meets the requirements of the Policy Statement. The Commission has consistently reaffirmed that the Policy Statement survived the promulgation of the Swaps Exemption as an additional safe harbor for swaps from any potential regulation as futures or commodity option transactions under the CEA and Commission regulations. In the Policy Statement, the Commission articulated five requirements, which are described in the following paragraphs in the context of the Blackbird system.
1. Individually-Tailored Terms. As described above, Blackbird users are responsible for negotiating their own master agreements, with the same "individually-tailored terms" they would ordinarily use were they not enjoying the benefits of the Blackbird system. We expect most users will simply continue using master agreements already in place to document all transactions with other users, including those achieved through Blackbird. Transaction terms are not standardized and a virtually unlimited variety of terms is available. As noted above, we believe Blackbird promotes the ability of dealers to customize transactions.
2. Absence of Exchange-Style Offset. Users of Blackbird have no right to "offset". As in a conventionally-brokered or non-brokered transaction, the two parties to a transaction must secure each other's consent (and possibly negotiate a special payment) prior to any pre-maturity termination or assignment to another party. The consent of any two parties using the Blackbird system is also required to establish any position that is economically opposite to any pre-existing position between such parties.
3. Absence of Clearing Organization or Margin System. DNI and the Blackbird system are not parties to transactions achieved through the system. They provide no credit support for transactions. They are in no sense a "clearing organization or margin system".
4. Line of Business. DNI is interested in involving only swaps dealers in the Blackbird system. Their participation will clearly be "in conjunction with their lines of business" of providing financial intermediation services.
5. Prohibition Against Marketing to the Public. As a system limited to swaps dealers, Blackbird is not marketed to the public and will not serve as a vehicle for "marketing to the public".
In sum, transactions negotiated through the Blackbird system readily satisfy all requirements of the Policy Statement.
Treasury Amendment
In addition to the foregoing, the transactions that can be agreed through the Blackbird system are within the so-called "Treasury Amendment" exclusion to the jurisdictional reach of the CEA. The Treasury Amendment excludes from CEA jurisdiction "transactions in" foreign currency and government securities. As interpreted by the Supreme Court in Dunn v. Commodity Futures Trading Commission, 117 S. Ct. 913 (February 25, 1997) ("Dunn"), the phrase "transactions in" encompasses all transactions in which the instruments exempted under the Treasury Amendment are a "fungible good whose fluctuating market price provides the motive for trading." In the case of all the transactions to be found on the Blackbird system, the fluctuating prices of foreign currencies and government securities (the prices of which are used to determine applicable interest rates) provide the motive for trading and in fact directly influence transaction rates and prices. For example, the fixed rate sides of virtually all transactions are based on a spread over the underlying government bond yield. Accordingly, Blackbird's transactions are of a kind that falls within the statutory exclusion.
Transactions constituting sales of foreign currency or governmental securities for future delivery conducted on a board of trade would not be excluded from CEA jurisdiction by the Treasury Amendment. The transactions found on the Blackbird system are of a kind that have never been determined to be futures contracts. Although the Treasury Amendment definition of "board of trade" may be even narrower, see Commodity Futures Trading Commission v. Frankwell Bullion, Ltd., 99 F.3d 299, 304 (9th Cir. 1996), the CEA, 7 U.S.C. § 1a(1), defines "board of trade" as
any exchange or association, whether incorporated or unincorporated, of persons who are engaged in the business of buying or selling any commodity . . . .
As mentioned above, Blackbird is neither an exchange nor an association. Its users are not members of any association and have no contractual or other relations with the system, other than the obligation to pay a transaction based fee to DNI if they use the system. Rather Blackbird is an electronic means by which sophisticated, independent firms that engage in individually-tailored swaps transactions can communicate with each other to effect bilateral agreements. Accordingly, Blackbird does not have any of the indicia of a "board of trade".
Transactions negotiated using the Blackbird system therefore are within the Swaps Exemption, the Policy Statement and the Treasury Amendment as a matter of law and policy.
Conclusion
Current Regulation
The Blackbird system offers many important advantages over the current inter-dealer voice broker system, including enhanced competition, improved ability to manage risk, lower commissions and processing costs, reduced operational risk, improved ability to supervise traders, greater price transparency and better control of credit limits. All these improvements and benefits serve both the swaps community and the public interest. They should be welcomed by regulators, especially in view of the sophistication of all participants and the deep and liquid cash markets for the interest rates and currencies underlying the custom-tailored swaps transactions involved. And Blackbird achieves all these improvements and benefits without having any impact on the clearance or settlement process or changing any feature of transactions being conducted today under the Swaps Exemption or the Policy Statement. As explained above, it is our belief that transactions agreed through Blackbird qualify under both the Swaps Exemption and the Policy Statement, and are within the statutory exclusion of the Treasury Amendment. As a result, they are clearly and appropriately not subject to regulation under the CEA at this time. Even so, Blackbird's growth in the U.S. may be slowed by the apparent confusion that exists as to when computerized enhancement of financial commerce is so regulated.
We hope we have offered some insight into how the swaps industry will look in the very near term as a result of innovations like Blackbird. In short, the industry will look much as it does now, but for an array of new benefits and efficiencies. As for the question of which electronic trading activity should be regulated under the CEA and which should not, we have a strong view. It is vital that our legislators and policy makers avoid the trap of thinking that use of cutting edge, electronic means of communication can turn established "good" products, services or activities into "bad" novelties requiring regulation. Actually, innovations like Blackbird can make the good products, services and activities even better. Where fundamental policy goals of protecting the public and the economic system are not adversely implicated (as is especially the case in sophisticated institutional finance), we as a nation should be encouraging the development of improved technological means of effecting commerce of all kinds. It would be ultimately ironic if this country, the world's leader in technological development, were to hamper its own economic system (which has benefitted so hugely from technological development), by hindering rather than encouraging the natural, inevitable development of electronic commerce in the financial sphere.
DNI appreciates this opportunity to express its views regarding these important issues, and looks forward to continued discussions with interested parties, including members of the Committee and their staffs, industry participants and financial regulatory bodies, including the CFTC.