TESTIMONY OF

I am pleased to represent the Commodity Futures Trading Commission ("CFTC" or "Commission") here today to testify concerning the over-the-counter ("OTC") derivatives market. It is particularly timely that this Subcommittee has chosen to hold hearings on this subject. In recent years the OTC derivatives market has grown dramatically in both volume and variety of products offered and has attracted many new end-users of varying degrees of sophistication. This market has also changed, with new products being developed, some products becoming more standardized, and systems for centralized execution or clearing being considered and proposed. For these reasons, the Commission and other financial regulators are currently examining the market and their oversight of it to determine whether any regulatory adjustments are necessary.

Derivative instruments are contracts whose value depends upon (or derives from) the value of one or more underlying reference rates, indexes or assets. The classes of underlying assets from which a derivative instrument may derive its value include physical commodities (e.g., agricultural products, metals, or petroleum), financial instruments (e.g., debt and interest rate instruments or equity securities), indexes (e.g., based on interest rates or securities prices), foreign currencies, or spreads between the value of such assets. Derivative contracts may be listed and traded on organized exchanges or privately negotiated between the parties. Derivatives executed off of an exchange or board of trade are referred to as over-the-counter derivatives.

OTC derivatives are similar in structure and purpose to exchange-traded futures and options. Like exchange-traded derivatives, OTC derivatives are used to perform a wide variety of important risk management functions. End-users employ OTC derivatives to hedge risks from volatility in interest rates, foreign exchange rates, commodity prices, and equity prices, among other things. OTC derivative instruments may permit users greater flexibility in their risk management activities by allowing greater customization of contract terms than the more standardized exchange-traded derivatives. These instruments also can be used to assume price risk in order to speculate on price changes. Participants in the OTC derivatives market include banks, other financial service providers, commercial corporations, insurance companies, mutual funds, pension funds, colleges and universities, governmental bodies and individuals with significant assets.

A simple example will illustrate how exchange-traded and OTC derivatives operate in a similar fashion in order to achieve the same purpose. Consider a business that has issued a note with a fixed rate of interest payable semiannually over a fixed time period. If the firm becomes concerned that interest rates will fall over the remaining life of the note and that it will therefore be paying higher than current market rates for its funds, the firm may wish to consider ways in which it can transform its fixed rate liability into a variable rate liability based on market rates.

One way of doing this would be for the firm to buy a series of exchange-traded Eurodollar futures contracts, each of which matured on or about one of the note’s interest payment dates. Because the value of a Eurodollar futures contract rises as interest rates fall, profits from the futures position could be used to cover the difference between current market rates and the firm’s original fixed rate. Alternatively, the firm could enter into a swap agreement in the OTC derivatives market in which it paid a variable interest rate based on the market rate and received a fixed interest rate with payment dates corresponding to the interest payment dates of the note.

Either method would allow the firm to convert its fixed rate exposure to a floating rate that would fluctuate with changes in the interest rate market. The firm might choose exchange-traded futures for reasons of liquidity and transparency. In addition, if the firm chose exchange-traded futures, the risk of counterparty default would be assumed by the exchange’s clearinghouse, which serves as the counterparty to both buyer and seller in every exchange transaction. If the firm chose to enter a contract on the OTC market, it would have to bear that risk of counterparty default itself. On the other hand, the OTC market permits parties to negotiate greater customization of terms. This may be a significant consideration if the size of the firm’s exposure, or the dates on which it becomes due, do not correspond to the standardized terms of exchange-traded contracts.

Use of OTC derivatives has grown at a rapid rate over the past few years. According to the most recent market survey by the International Swaps and Derivatives Association ("ISDA"), the notional value of new transactions reported by ISDA members in interest rate swaps, currency swaps, and interest rate options during the first half of 1997 increased 46% over the previous six-month period. The notional value of outstanding contracts in these instruments was $28.733 trillion worldwide, up 12.9% from year-end 1996, 62.2% from year-end 1995, and 154.2% from year-end 1994. ISDA’s 1996 market survey noted that there were 633,316 outstanding contracts in these instruments as of year-end 1996, an increase of 47% from year-end 1995, which in turn represented a 40.7% increase over year-end 1994. An October 1997 report by the General Accounting Office ("GAO") suggests that the market value of OTC derivatives represents about 3 percent of the notional amount. Applying the 3 percent figure to the most recent ISDA notional value for contracts outstanding for the first half of 1997 indicates that the worldwide market value of these OTC derivatives transactions is over $860 billion.

The OTC derivatives market is substantially larger than the ISDA survey data indicate since they are limited to transactions involving ISDA members only and to transactions in only three kinds of instruments among the many instruments being traded. With a growing market has come growing profits for OTC derivatives dealers. According to an industry publication, OTC derivatives trading revenues reached a record $2.35 billion during the first quarter of 1998, exceeding the previous record by $100 million.

The Commodity Exchange Act ("CEA" or "Act"), which traces its origins to the Futures Trading Act of 1921, vests the CFTC with exclusive jurisdiction over futures and commodity option transactions. The reach of the CEA historically has extended to both exchange-traded derivatives and derivatives that are sold over the counter. The Act generally contemplates that futures and commodity options are to be sold through Commission-regulated exchanges which provide the safeguards of open and competitive trading, a continuous market, price discovery and dissemination, and protection against counterparty risk. Thus, the Act and CFTC regulations establish a regulatory framework for exchange-trading of futures and options and provide for Commission oversight of intermediaries engaging in such transactions on behalf of customers.

Transactions in OTC futures and options, in contrast, generally have been prohibited unless explicitly excluded or exempted from the exchange-trading requirement of the CEA. Throughout the years, the Commission’s enforcement docket has included numerous proceedings against trading in OTC derivatives that were outside the scope of any exemption or exclusion.

The CEA specifically excludes certain types of OTC derivatives from the requirements of the Act. The so-called "Treasury Amendment" to the CEA provides that the CEA does not apply to OTC transactions in foreign currencies, government securities and certain other financial instruments. Options on securities and options on securities indexes also are excluded from the Act and are subject to the jurisdiction of the Securities and Exchange Commission ("SEC").

In addition, the Commission itself has exempted certain types of OTC derivative transactions from specific provisions of the CEA. For example, under Section 4c of the Act, the Commission has the authority to allow options to be traded over the counter under such terms and conditions as the Commission may prescribe. Pursuant to this authority, the Commission has exempted certain trade options from most provisions of the Act pursuant to specified terms and conditions.

The Futures Trading Practices Act of 1992 gave the Commission additional authority to exempt specific transactions or categories of transactions from certain provisions of the Act, including the requirement in Section 4(a) of the Act that futures must be traded on exchanges. Section 4(c)(2) of the Act provides that the Commission may not grant any exemption unless the Commission determines that (i) the transaction would be entered into solely between defined "appropriate persons"; (ii) the exchange trading requirements of the Act should not be applied; (iii) the transaction would not have a material adverse effect on the ability of the Commission or any contract market to discharge its regulatory or self-regulatory duties under the Act; and (iv) the exemption would be consistent with the public interest and the purposes of the Act. Section 4(c)(5) explicitly authorizes the Commission to grant exemptions for swap agreements and hybrid instruments. The Commission may grant exemptions "either unconditionally or on stated terms or conditions." The ability to impose conditions on the grant of exemptive relief gives the Commission the flexibility and authority to tailor its regulatory program to fit the changing realities of the marketplace and the changing needs of market participants.

Pursuant to Section 4(c), the Commission adopted regulations in 1993 exempting certain swap agreements and hybrid instruments from some -- but not all -- provisions of the Act subject to specified terms and conditions. Part 35 of the Commission’s Regulations exempts certain swaps from provisions of the Act other than the antifraud provisions, the anti-manipulation provisions, and Section 2 (a)(1)(B). To be eligible for exemptive treatment under Part 35, an agreement: (1) must be a swap agreement as defined in Rule 35.1(b)(1); (2) must be entered into solely between eligible swap participants; (3) must not be a part of a fungible class of agreements that are standardized as to their material economic terms; (4) must include as a material consideration in entering into the agreement the creditworthiness of a party with an obligation under the agreement; and (5) must not be entered into and traded on or through a multilateral transaction execution facility.

The criteria contained in the swaps exemption were designed to assure that exempted swap agreements meet the requirements set forth by Congress in Section 4(c) of the CEA and "promote domestic and international market stability, reduce market and liquidity risks in financial markets, including those markets (such as futures exchanges) linked to the swap market and eliminate a potential source of systemic risk." The current criteria restrict OTC swap transactions to bilateral, customized transactions between financially sophisticated persons or institutions. The Part 35 exemption does not extend to transactions that are subject to a clearing system where the credit risk of individual counterparties to each other is effectively eliminated, nor does it extend to transactions executed via exchange-like systems, which in Part 35 are called multilateral transaction execution facilities.

Part 34 of the Commission’s Regulations exempts certain hybrid instruments from specified provisions of the Act. Under the rules, a hybrid instrument is defined as a financial instrument that combines elements of an equity, debt or depository instrument with elements of a futures or option contract. Part 34 exempts hybrid instruments from most requirements of the CEA to the extent that they are predominantly securities or depository instruments and are regulated as such.

When Congress gave the Commission its Section 4(c) exemptive authority in 1992, the Conference Committee expressly intended to permit the Commission to review its exemptions to "respond to future developments." The CFTC strongly believes that, in order to carry out its statutory mandate responsibly, it must keep its regulatory system in tune with changes in the market it oversees. Failure to keep pace with the changing market would stifle the capacity of U.S. firms to meet global competitive challenges, would create a cloud of legal uncertainty over the applicability of outdated rules to new products and innovative transactions, and would erode the regulatory system’s ability to protect customers and to preserve the financial integrity of that market.

Consistent with these responsibilities, the CFTC has been engaged in a comprehensive regulatory reform effort designed to update, to modernize and to streamline its regulations and to eliminate undue regulatory burdens. I detailed many of these regulatory reform measures in my October 22, 1997 testimony before this Subcommittee on the CFTC’s Strategic Plan. The Commission’s review of its regulatory system would be incomplete in an important respect if it did not address the Commission’s rules regarding OTC derivatives.

The exemptions described above were adopted in January 1993, more than five years ago. As noted earlier, the intervening five years have been characterized by dramatic growth in the volume and value of OTC derivative transactions. Furthermore, the structure of the OTC derivatives market has changed significantly, creating a potential divergence between the Commission’s regulations and the realities of the marketplace. For example, since 1993 the proliferation of OTC instruments has resulted in broader participation in the swaps market, encompassing new end-users of varying degrees of sophistication. This evolution in the market requires the Commission to evaluate whether it should broaden the definition of eligible swaps participants contained in its current rule and whether recordkeeping, sales practice, or other protections may now be appropriate.

The swaps market also has experienced a proliferation of new products and proposed new trading systems. While the Part 35 exemption does not extend to swap agreements that are part of a fungible class of agreements, market information indicates that swap agreements have become increasingly standardized, indicating a need to consider broadening the exemption under appropriate terms and conditions. Furthermore, the swaps exemption does not permit clearing of swaps or trading through multilateral transaction execution facilities, but developments in the marketplace have indicated a significant demand for both. Clearing and execution facilities would pose regulatory issues concerning systemic risk and price discovery that are not involved in privately negotiated bilateral off-exchange transactions. Any consideration of permitting clearing and execution facilities must also take into account the need to promote even-handed regulation and fair competition between any such new facilities and existing derivatives exchanges.

An additional concern is the legal uncertainty that may result from trading in instruments that do not comply with the terms and conditions of the current swaps exemption. To the extent that such instruments are futures and options and are not subject to another exemption in the Act, they violate the CEA. Moreover, Section 12(e)(2)(A) of the Act was enacted in order to "provide legal certainty under . . . state gaming and bucket shop laws for transactions covered by the terms of an exemption" by preempting the application of such state laws. OTC instruments that are outside the Commission’s exemptions are also outside the protective umbrella of that preemption. In the absence of applicable CFTC exemptions, OTC derivatives transactions could be subject to the vagaries of fifty states’ gaming and bucketshop laws.

Another factor suggesting a need to solicit information about the OTC derivatives market arises from the number of large, well-publicized financial losses in the OTC derivatives market since the 1993 exemptions were adopted. While OTC derivatives serve important economic functions, these products, like all complex financial instruments, can present significant risks if misused or misunderstood by market participants. The 1997 GAO Report, entitled OTC Derivatives: Additional Oversight Could Reduce Costly Sales Practice Disputes chronicles 360 end-user losses.

Major OTC derivatives losses relating to the recent instability in Asian financial markets are currently being reported, and more may be anticipated. According to a recent press report, J.P. Morgan "last year declared it had $659 million in nonperforming assets, 90% of which were defaults from Asian derivative counterparties." The same article states that Chase Manhattan "saw its ‘nonperforming’ assets in Asia triple in the first three months of 1998, to $243 million, due in part to derivatives."

Concerns have also been raised regarding the potential effect of derivatives losses on the investing public and on the financial system as a whole. As Alan Greenspan, the Chairman of the Board of Governors of the Federal Reserve System, stated on May 7, 1998:

"the major expansion of the over the counter derivatives market has occurred in [a] period of unparalleled prosperity . . . [in] which losses generally, in the financial system, have been remarkably small . . . And as a consequence of that, I don’t think that one will fully understand or know how vulnerable that whole structure is until we have it really tested. And eventually that’s going to happen."

Allegations of serious sales practice abuses by OTC derivatives dealers have been made in recent years in a number of cases involving major losses by derivatives end-users. For example, an affiliate of Bankers Trust was charged with fraud in the sale of OTC derivatives in some well publicized cases involving Proctor and Gamble, Gibson Greeting Cards, and other large entities. Just last week, Merrill Lynch paid $400 million to Orange County, California to settle claims involving sales of derivatives that caused Orange County’s bankruptcy. Furthermore, the 1997 GAO Report recommended that the SEC and the CFTC examine the experience of the members of the Derivatives Policy Group, an organization of large OTC derivatives dealers, with respect to the voluntary sales practice standards they have adopted and also recommended a comprehensive review of sales practices and counterparty relationships in the OTC derivatives market. Obviously, regulation cannot and should not seek to eliminate market losses, but under the circumstances it is appropriate to solicit information regarding industry practices to assess whether they merit a regulatory response.

For many of these same reasons, other federal regulators are reviewing and revising their regulatory requirements in response to the evolution of the OTC derivatives market. For example, on April 23, 1998, the Office of Thrift Supervision of the Department of the Treasury proposed what it termed "a comprehensive revision" of its "outmoded regulations" in response to "the development of new financial derivative instruments." In addition, the SEC proposed rules in December 1997 that would create for the first time a comprehensive SEC regulatory regime for certain very large OTC derivatives dealers.

In order to examine whether its regulatory framework relating to OTC derivatives remains appropriate in light of market developments since that framework was first adopted, the Commission issued a Concept Release on OTC Derivatives on May 7, 1998. (See Attachment 1.) The purpose of the Concept Release is to generate information and data and to solicit comments on whether the Commission’s regulatory structure applicable to OTC derivatives should be modified in any way in light of recent developments in the marketplace.

The Concept Release seeks public comment on whether the Commission’s current exemptions for swaps and hybrid instruments remain appropriate as to, among other things, the definitions of eligible transactions and eligible participants and the prohibitions against fungible swaps, swaps clearing and multilateral swaps transaction execution facilities. It asks whether the current prohibitions on fraud and manipulation are sufficient to protect the public or whether the Commission should consider additional terms and conditions relating to registration, capital, internal controls, sales practices, recordkeeping or reporting. The Concept Release also asks whether, if additional oversight of those markets were required, such oversight would best be administered by the Commission itself or through self-regulatory organizations.

The Concept Release does not propose any modification of the Commission’s regulations, nor does it presuppose that any modification is needed. It merely asks for information about current realities in the marketplace and views as to the appropriate Commission response, if any. Public comments filed pursuant to the Concept Release will constitute an important source of relevant data and analysis that will assist the Commission in determining how best to maintain adequate regulatory safeguards without impairing the ability of the OTC derivatives market to continue to grow and the ability of U.S. entities to remain competitive in the global financial marketplace. The Commission wishes to draw on the knowledge and expertise of a broad spectrum of interested parties including OTC derivatives dealers, end-users of derivatives, futures and option exchanges, other regulatory authorities, and academicians. The Commission would also welcome the comments of the members of this Subcommittee and their constituents.

In issuing the Release, the Commission has no preconceived result in mind. The Commission is open to evidence in support of broadening its exemptions, evidence indicating a need for additional safeguards and evidence for maintaining the status quo. Serious consideration will be given to the views of all interested persons as well as the Commission’s own research and analysis. In the event the Commission believes that proposed regulatory changes might enhance the competitiveness of the OTC derivatives market or improve regulatory safeguards, such proposed changes would first be published for additional public comment before any final rules would be considered for adoption. Moreover, changes which impose new regulatory obligations or restrictions, if any, would be applied prospectively only.

The Release explicitly states that it does not in any way alter the current status of any instrument or transaction under the CEA. All currently applicable exemptions, interpretations, and policy statements issued by the Commission regarding OTC derivatives products remain in effect and may be relied upon by market participants.

Concerns have been expressed about the Concept Release. Many of such concerns reflect a lack of understanding as to the nature and purpose of the Release or a desire to avoid government oversight. The Commission wishes to address some of the concerns that have been expressed regarding the Release.

Arguments have been made that OTC derivatives do not need government regulation or oversight of any kind. These arguments ignore that the OTC derivatives market is already subject to regulation by the Commission through the terms and conditions of its exemptions and through its fraud and manipulation prohibitions. Other federal regulators also have jurisdiction over certain transactions or participants in the market and are actively regulating them. The Commission agrees that unduly burdensome or duplicative regulation of the OTC market would not be in the public interest. However, as described above, in light of the growth and change in this market in the past several years, the Commission needs to examine its current regulatory regime and to determine whether its oversight of the OTC products within its jurisdiction remains adequate.

It has been said that the Commission has created legal uncertainty by publishing the Concept Release. Indeed, some have claimed that even to seek information about this market or to ask questions about the appropriate level of its oversight will cause market disruption. The Commission does not believe that this robust, multi-trillion dollar market is so fragile that mere governmental examination of it will cause dislocation.

Rather, in the Commission’s view the market will benefit from assuring that government regulations do not ignore developments and innovations in the marketplace. Moreover, as the Commission was careful to point out in the Concept Release and as I have noted today, the Concept Release does not in any way alter the current legal status of any instrument. The Commission has thus sought to ensure that the Concept Release will not jeopardize the legal status or enforceability of any OTC derivative contract.

Some argue that, having adopted exemptions for certain OTC derivatives transactions in 1993, the Commission cannot now update those exemptions to reflect the changes in the marketplace. This argument is flatly inconsistent with the intent of Congress in passing the Futures Trading Practices Act of 1992, during which the House and Senate Conference Committee noted:

"[T]he Conferees intend for the general exemptive authority . . . to allow the [CFTC] to respond to future developments in the marketplace to avoid disruption and promote responsible economic and financial innovation, with due regard for the continued viability of the marketplace and considerations related to systemic risk in financial markets."

As the President’s Working Group on Financial Markets ("President’s Working Group") wrote to Congress in 1994 concerning the CFTC’s regulation of the OTC derivatives market,

"[I]n order to fall within the safe harbor created by the Commodity Futures Trading Commission’s (CFTC’s) exemptions from the Commodity Exchange Act for swaps and other types of OTC derivatives transactions, all market participants must comply with the access and design restrictions contained in those exemptions. The CFTC’s authority to reevaluate and impose conditions on exemptions for OTC derivative transactions can always be drawn upon if additional constraints on these instruments were determined to be warranted."

Another claim is that the Commission lacks jurisdiction with respect to OTC derivative instruments. This position is incorrect. Whether an instrument is sold on exchange or off-exchange does not alter the fundamental characteristics of the instrument. As noted previously, many OTC derivative instruments bear economic characteristics and perform economic functions indistinguishable from exchange-traded futures or option contracts. Indeed, OTC derivative instruments increasingly are marketed explicitly as direct substitutes for such exchange-traded contracts, and there is growing interest in trading them on exchanges.

The Commission and this Subcommittee both have decades of expertise dealing with such risk-shifting derivative instruments. As noted above, the CFTC has always had jurisdiction over futures and options, whether traded on an exchange or over the counter. As discussed above, Section 4c of the Act authorizes the Commission to issue rules prohibiting OTC commodity option transactions and to prescribe the terms and conditions for both exchange trading and OTC trading of commodity options. Sections 4(a) of the Act forbids OTC transactions in futures unless exempted by the Commission, and Section 4(c) authorizes the Commission to exempt futures from this requirement and other provisions of the Act on such terms and conditions as the Commission may prescribe.

The Commission has long had the responsibility for bringing enforcement actions against OTC derivative transactions that violate these statutory provisions and its regulations thereunder, and a portion of its enforcement docket has historically involved such cases. For example, the Commission currently has four pending actions involving hedge-to-arrive contracts charging that the transactions constituted illegal OTC derivatives contracts. Similarly, its many cases against bucket shops are based on the fact that such operations sell OTC derivatives off a regulated board of trade and are also specifically prohibited by Section 4b of the Act.

As the Agriculture Committee stated in 1982 in approving the amendments to the CEA adopting the Shad-Johnson Accord on the respective jurisdictions of the SEC and the CFTC:

"The committee has long recognized and accepted the inherent differences between the futures industry and the securities industry and endorses the concept of separate regulation. Basically, the CFTC will retain its traditional role of regulating markets and instruments that serve a hedging and price discovery function while the SEC will regulate markets and instruments with an underlying investment purpose."

In the 1982 legislation, Congress confirmed the CFTC’s jurisdiction over futures and options, except for options on securities and on securities indexes which were placed under the authority of the SEC. Congress continued to recognize the CFTC’s statutory authority over the OTC derivatives market when it passed the Futures Trading Practices Act of 1992, which contained Section 4(c) of the Act and for the first time authorized the Commission to permit OTC trading in futures contracts subject to such terms and conditions as the Commission deems appropriate and consistent with the public interest. Section 4(c) explicitly authorized the Commission to exempt transactions in swaps and hybrid instruments from the exchange trading requirement of Section 4(a) and other provisions of the Act, subject to terms and conditions prescribed by the Commission.

Members of the House Agriculture Committee recognized the importance of the Commission’s role in oversight of OTC derivatives as recently as last month, when they ensured that a savings clause was inserted into H.R. 10, the Financial Services Act of 1998, making clear that references to derivative instruments in that Act would not supersede, affect, or otherwise limit the scope and applicability of the CEA to those instruments. Absent that savings clause, it is possible that H.R. 10 would have been interpreted to shift statutory authority over the OTC derivatives market from the CFTC to the Board of Governors of the Federal Reserve System and other federal financial regulators.

The Commission is cognizant of the fact that other federal regulatory authorities have responsibility for certain aspects of the OTC derivatives market. Some OTC derivative instruments are exempted under the CEA by the Treasury Amendment and the Shad-Johnson Accord and are regulated by the SEC, the banking regulators, or the Department of the Treasury. Large participants in the OTC derivatives market include securities brokers regulated by the SEC and financial institutions regulated by the banking regulators. Thus, coordination and cooperation among the CFTC and these agencies are very important to avoid duplication and inconsistent regulation.

However, each regulator must act within its own statutory authority and comply with its own statutory mandate. On March 11, 1998, the Secretary of the Treasury, Robert Rubin, on behalf of the President’s Working Group, wrote to the House Committee on Government Reform and Oversight that the President’s Working Group would not conduct a study and review of sales practices and counterparty relationships in the OTC derivatives market, as the 1997 GAO Report had recommended. In explaining that refusal, he stated,

"The Working Group is designed as a mechanism to exchange information about financial market issues that cross traditional jurisdictional lines. It works through its constituent agencies with no independent budget. The authority of the Federal Government to collect sales practice information from federally regulated entities rests with the appropriate federal regulators.

"In recent years, the federal financial regulators that are members of the Working Group have taken a number of measures to improve dealers’ sales practices for OTC derivatives . . . . Because the issue of the relationship of parties involves differing product classes, regulatory structures, and customer profiles, we believe there may not be a ‘one size fits all’ solution. Therefore, we believe these processes should be allowed to evolve and that, at this time, there is no need for the Working Group as a whole to take additional measures. Each financial regulatory agency will continue to decide its appropriate role."

The Commission believes that that position continues to be correct and that, in issuing the Concept Release, the Commission has appropriately decided to address OTC derivative issues within its statutory authority and in conformity with its statutory mandate.

The Commission commends the Subcommittee for conducting these hearings on the OTC derivatives market. The Commission has begun reviewing the Commission’s own regulatory regime for that market and welcomes your comments on that review.

Mr. Chairman, I would like to thank you for this opportunity to present the views of the Commission, and I would be happy to answer any questions that the members of the Subcommittee might have.