"THE LESSONS OF LONG-TERM CAPITAL
BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
CHICAGO KENT-IIT COMMODITIES LAW INSTITUTE
OCTOBER 15, 1998
I last addressed this conference two years ago, shortly after I joined the Commodity Futures Trading Commission ("Commission" or "CFTC"), and I am pleased to be back. I would like to discuss recent events in the over-the-counter ("OTC") derivatives markets and to share some thoughts about the appropriate role of regulation in responding to them.
The events surrounding the financial difficulties of Long-Term Capital
Management L.P. ("LTCM") raise a number of important issues
relating to hedge funds and to the increasing use of OTC derivatives
by those funds and other institutions in the world financial markets.
Most of these issues were raised by the Commission in its Concept
Release on OTC Derivatives in May 1998. They include lack of
transparency, excessive leverage, insufficient prudential controls,
and the need for coordination and cooperation among international
I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe that it is critically important for all U.S. financial regulators to work together closely and cooperatively on them. Therefore, I applaud Secretary of the Treasury Robert Rubin's call for a meaningful study by the President's Working Group on Financial Markets and look forward to working with him and the other members of the Working Group. Swift regulatory responses may well be needed to protect the U.S. and world economy.
1. Lack of Transparency
While the CFTC and the U.S. futures exchanges had full and accurate information about LTCM's exchange-traded futures positions through the CFTC's required large position reports, no federal regulator received reports from LTCM on its OTC derivatives positions. Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives users and about the nature and extent of their exposures potentially allows OTC derivatives market participants to take positions that may threaten our regulated markets or, indeed, our economy without the knowledge of any federal regulatory authority.
Furthermore, there are no requirements that a hedge fund like LTCM provide disclosure documents to its counterparties or investors concerning its positions, exposures, or investment strategies. It appears that even LTCM's major creditors did not have a complete picture. A hedge fund's derivatives transactions have traditionally been treated as off-balance sheet transactions. Therefore, even though some hedge funds like LTCM are registered with the Commission as commodity pool operators and are required to file annual financial reports with the Commission, those reports do not fully reveal their OTC derivatives positions.
Unlike futures exchanges where bids and offers are quoted publicly, the OTC derivatives market has little price transparency. Lack of price transparency may aggravate problems arising from volatile markets because traders may be unable accurately to judge the value of their positions or the amount owed to them by their counterparties. Lack of price transparency also may contribute to fraud and sales practice abuses, allowing OTC derivatives market participants to be misled as to the value of their interests.
Transparency is, of course, one of the hallmarks of exchange-based derivatives trading in the U.S. Recordkeeping, reporting, and disclosure requirements are established by the Commodity Exchange Act and the Commission's regulations; prices are discovered openly and competitively; and quotes are disseminated instantaneously. Positions in exchange-traded contracts are marked-to-market at least daily, thus ensuring that customers are always aware of the profit or loss on their positions. This transparency significantly contributes to the fact that U.S. futures markets are the most trusted in the world.
A number of questions that commentators are now asking about the lack of transparency in the OTC derivatives market in light of the LTCM matter were raised by the Commission in its Concept Release on OTC Derivatives. In that Release, the Commission specifically sought comment on the need for recordkeeping and reporting requirements and for disclosure by OTC derivatives dealers to their customers. At the time that the Concept Release on OTC Derivatives was published, I emphasized that neither the Commission nor I had preconceived notions of whether changes in the regulation of the OTC derivatives market were needed. Now, as a result of the LTCM episode and other developments in the global economy in the past five months, I have come to believe that more transparency is clearly necessary in the OTC derivatives market.
I am not alone in this view. A report two weeks ago by the G-22 group of industrialized and developing nations called for improved transparency in both the public and private sectors, including an examination of the feasibility of compiling and publishing data on the international exposures of investment banks, hedge funds and other large institutional traders. If reporting and disclosure requirements had been in place in the U.S., some of the difficulties relating to LTCM might have been averted.
2. Excessive Leverage
While traders on futures exchanges must post margin and have their positions marked to market on at least a daily basis, no such requirements exist in the OTC derivatives market. Reportedly, LTCM managed to borrow approximately 100 times its capital and to hold derivatives positions with a notional value of approximately $1.25 trillion or 1000 times its capital. Indeed, it has been reported that LTCM generally insisted that it would not provide OTC derivatives counterparties with initial margin. LTCM's swap counterparties and other creditors reportedly did not have full information about its extensive borrowings from others and therefore unknowingly extended enormous credit to it. This unlimited borrowing in the OTC derivatives market like the unlimited borrowing on securities that contributed to the Great Depression may pose grave dangers to our economy.
The Commission's Concept Release on OTC Derivatives describes many of the risk-limiting mechanisms of the futures exchanges including mutualized clearing arrangements, marking to market, margin requirements, and capital and audit requirements. The Release requests comment on whether similar protections are needed in the OTC derivatives market. Some market participants have already answered in the affirmative. For example, George Soros is among those currently calling for margin requirements for OTC derivatives transactions. The London Clearing House has applied to the Commission to permit clearing of swaps. Clearing of OTC derivatives transactions could be a useful vehicle for imposing controls on excessive extensions of credit. I believe that it is essential for federal financial regulators to consider how to reduce the high level of leverage in the OTC derivatives market and its attendant risks.
3. Insufficient Prudential Controls
Closely related to the issue of excessive lending to LTCM is the apparent insufficiency of the internal controls applied by the firm itself and its lenders and counterparties. In the Concept Release on OTC Derivatives, the Commission calls for comment on a number of issues relating to the sufficiency of internal controls and risk management mechanisms employed by OTC derivatives market participants, including value-at-risk ("VAR") models. LTCM now stands as a cautionary tale of the fallibility of even the most sophisticated VAR models. The prudential controls of LTCM's OTC counterparties and creditors, the parties that presumably had the greatest self-interest in assessing LTCM's financial wherewithal, also appear to have failed. They were reportedly unaware of the fund's extensive borrowings and risk exposures. U.S. financial regulators urgently need to address these failures.
4. Need for a Coordinated International Approach
International regulators have expressed concern for some time about the lack of effective oversight of hedge funds and other large users of OTC derivatives and their ability to avoid regulation by any one nation in their global operations. Indeed, several emerging market countries have attributed crises in their currencies and markets to the actions of large hedge funds. The LTCM situation presents a new opportunity for the Commission and other U.S. regulators to work with authorities in other countries to harmonize regulation of the OTC derivatives market and to implement international regulatory standards. The recent report by the G-22 is an important step in this direction and demonstrates a growing international consensus regarding the need for increased transparency. A study by the G-22 of how to implement reporting requirements will proceed more or less in parallel with the President's Working Group study on the regulatory implications of the LTCM episode. Important work by the International Organization of Securities Commissions ("IOSCO") on the need for transparency and large position reporting related to exchange-traded derivatives will be useful to the G-22 study and the President's Working Group study on OTC derivatives.
In conclusion, there is an immediate and pressing need to address
possible regulatory protections in the OTC derivatives market. The
LTCM episode not only has demonstrated the potential risks posed by
the OTC derivatives market for the domestic and global economy, but
also has highlighted the importance of the safeguards in place for
exchange-traded futures and options. Obviously, regulation must be
adapted to the particular marketplace and must address the risks to
the public interest that that market poses. Thus, regulatory solutions
for exchanges are not necessarily appropriate for the OTC market.
Nonetheless, the markets involve similar instruments and pose many of
the same risks, and our successful experience with the U.S. futures
exchanges will be invaluable in the study of the OTC derivatives