TESTIMONY
of a
COALITION
of
INVESTMENT AND COMMERCIAL BANKS
regarding
THE REPORT OF THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS
entitled
OVER-THE-COUNTER DERIVATIVES MARKETS AND
THE COMMODITY EXCHANGE ACT
before the
COMMITTEE ON AGRICULTURE, NUTRITION AND FORESTRY
UNITED STATES SENATE
FEBRUARY 10, 2000
Chairman Lugar, members of the Committee, this testimony is submitted by Edward Rosen, a partner with Cleary, Gottlieb, Steen & Hamilton, on behalf of an ad hoc coalition of investment and commercial banks (the "Coalition"). The Coalition is comprised of the following institutions:
The Chase Manhattan Bank
Citigroup Inc.
Credit Suisse First Boston Inc.
Goldman, Sachs & Co.
Merrill Lynch & Co., Inc.
Morgan Stanley Dean Witter & Co.
This Coalition is grateful for the opportunity to present the Committee with the Coalition's views regarding the report of the President's Working Group on Financial Markets (the "Working Group") entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act (the "Report"). The Coalition supports the recommendations set forth in the Report and urges the Committee to incorporate the Report's recommendations in legislation during this session.
I. The Coalition
The six Coalition firms are major participants in all U.S. financial markets, including the securities markets, government securities markets, foreign currency markets, futures markets and derivatives markets. These firms are in the forefront of financial product innovation and compete globally with non-U.S. financial institutions for international business in all financial markets.
These firms have established the Coalition for one purpose: to present to Congress a consensus, market-sensitive view on necessary revisions to the Commodity Exchange Act ("CEA"). As major participants in all financial and derivatives markets, and as members of nearly every major trade association affected by the CEA, this group is able to provide a singular perspective that cuts across product lines and reflects the integrated character of the global markets for these products.
The Coalition welcomes and endorses the Committee's reexamination of the CEA in light of the evolving needs of the markets and market participants, and we particularly support the Committee's interest in developing amendments to the CEA designed to remove barriers to innovation and to resolve issues of legal certainty that affect the use of over-the-counter ("OTC") derivative instruments under the CEA.
The Coalition commends the members of this Committee in particular for their leadership role in addressing these issues.
II. Overview
The Coalition applauds the success achieved by the Working Group in reaching consensus positions on the difficult issues presented by OTC derivatives in the context of the CEA. The unanimous recommendations embodied in the Report represent an extraordinary accomplishment. The Coalition strongly endorses the Working Group's recommendations to provide greater legal certainty for OTC derivatives transactions and to remove obstacles to the development and use of clearing and electronic trading systems in the OTC derivatives markets.
As noted below, the Coalition recommends that the Committee consider certain additional steps, beyond the scope of the Report, to foster legal certainty, reduce systemic risk and promote technological and financial innovation.
As background for the Committee's consideration of the Report, the Coalition would like to make several general observations:
· There is an urgent need for Congressional action during this session. The Working Group has characterized its recommendations as "necessary" and "important". We agree.
· The Working Group has presented Congress with valuable and constructive solutions to urgent problems. No solution, however, will be perfect from all perspectives. We must not allow perfection to be the enemy of that which can be achieved.
· We must not be seduced by superficial allusions to asymmetrical regulation and allow these to prevent us from accomplishing what can be accomplished. Historically, progress on legal certainty has been held hostage to other legislative objectives. This strategy can no longer be tolerated.
I. Enhancing Legal Certainty for Swaps
The Coalition strongly supports the Working Group's recommendation that bilateral swap agreements involving financial commodities between institutional counterparties be excluded from regulation under the CEA. This exclusion will enhance legal certainty and enhance the position of the United States as a major financial center.
In addition to the recommendations of the Working Group, the Coalition would support further relief for transactions involving non-financial commodities and a clarification that individually negotiated bilateral transactions, including those involving non-financial commodities, are not subject to regulation under the CEA.
II. Electronic Trading Systems
The Coalition supports the Working Group's recommendation to exclude from regulation under the CEA electronic systems for trading financial derivatives which limit participation to institutional counterparties trading for their own accounts. This exclusion would remove a significant barrier to financial and technological innovation in the United States, eliminate legal uncertainty and improve the global competitive position of the U.S. financial sector.
Beyond the Working Group's recommendation, the Coalition would further encourage Congress to create an appropriate "light-handed" regulatory framework for those electronic trading systems that do not operate as exchanges and that would not otherwise qualify for exclusion from the CEA under the Working Group's recommendations. This new framework would create a legal basis for the future evolution of electronic trading systems, whether developed by exchanges or by other market participants. We would be happy to work with the Committee to develop such a framework.
III. Clearing Systems
The Coalition welcomes the Working Group's recommended clarification that qualifying swaps may be cleared without subjecting the underlying transaction to regulation under the CEA.
The Coalition also endorses the Working Group's recommendation that Congress provide a statutory basis for the oversight of clearing systems for OTC derivatives by the CFTC, federal bank and securities regulators and appropriate foreign financial regulators. We believe that creating an appropriate regulatory regime will encourage the development of clearing facilities for OTC derivatives in the U.S. and, in turn, contribute to the stability of the financial system. We would also view the codification of CFTC authority to oversee clearing of OTC derivatives as a positive and useful development.
IV. Treasury Amendment
The Coalition welcomes the Working Group's recommendation to clarify the intent of the Treasury Amendment by replacing the term "board of trade" with the term "organized exchange." This clarification alone will eliminate a great deal of uncertainty and forestall much of the litigation that has arisen in this area in the past.
We also support the Working Group's recommendation that Congress provide the CFTC with authority to address potential abuses of retail customers by foreign currency "bucket shops."
V. Hybrid Instruments
In the area of hybrid instruments, the Working Group recommended that Congress clarify that the CEA's restriction on futures on non-exempt securities does not apply to hybrid instruments that would otherwise qualify for exemption from the CEA under the CFTC's current rules. The Coalition supports this recommendation. However, the Coalition urges Congress to take additional steps to codify an exemption for hybrid instruments, including those involving non-exempt securities, similar in scope to the CFTC's current exemption for hybrid instruments. We would be pleased to work with the Committee to accomplish that objective.
VI. Single-Stock Futures; Shad-Johnson Accord
The Coalition does not believe that single-stock futures should be unlawful per se. The Coalition welcomes the CFTC-SEC dialogue on this subject requested by you, Mr. Chairman, and referenced in the Report, and stands ready to assist in any efforts to address the regulatory challenges posed by these products.
Congress must recognize that providing legal certainty for OTC derivative instruments and removing barriers to innovation are much more urgent matters for U.S. financial markets than creating a regulatory framework for single-stock futures. In the past, legislative efforts to provide legal certainty for OTC derivatives have been held political hostage to the single-stock futures issue. Congress should not allow this political strategy to undermine opportunities for concrete progress.
VII. Derivatives Dealers
The Coalition agrees with the Working Group's conclusion that no current need has been demonstrated to regulate OTC derivatives dealers, most of whom are already subject to direct and indirect regulatory oversight.
The Coalition notes that the Report reiterates the Working Group's earlier recommendation to expand the SEC's and CFTC's risk assessment authority with respect to broker-dealers and futures commission merchants.(1) The Coalition fully supports the goal of improved risk reporting to financial regulators.(2) The Coalition has some concerns, however, regarding the scope of the Working Group's recommendations in this area, and stands ready to engage in a dialogue on the relevant issues.
VIII. Conclusion
It is time for Congressional action to ensure legal certainty and remove the barriers to innovation posed by the CEA. The Working Group has unanimously urged the Congress to act and has provided Congress with a clear course of action. Moreover, the Working Group's recommendations have widespread support among financial market participants. We urge the Committee to take advantage of these rare conditions and move swiftly during this session to enactment of a bill incorporating the Working Group's recommendations.
Given the extraordinary consensus in the public and private sectors regarding the urgent need for legal certainty, market participants are carefully monitoring the reauthorization process for a signal that Congress will act on these important issues. As we have testified previously, and as financial market participants are acutely aware, the risks and obstacles to innovation posed by the CEA do not burden other major financial centers. If Congress continues to miss opportunities to modernize the CEA, the U.S. will jeopardize its position as the leading global financial center and the U.S. legislative and regulatory community will significantly diminish its own influence over the development of policy governing the global financial markets.
Congress must not allow less important issues to impede progress on these pressing matters.
The Coalition very much appreciates the Committee's interest in these issues and is committed to working with the Committee and other interested parties in an effort to solve these problems once and for all.
1 See President's Working Group on Financial Markets, Hedge Funds, Leverage and the Lessons of Long-Term Capital Management 38-40 (April 1999) 2 Each of the Coalition's members was an active participant in the Counterparty Risk Management Policy Group, a voluntary private sector initiative recommending a broad range of measures designed to enhance private sector risk management and greater transparency, including enhanced regulatory reporting.