"DERIVATIVES REGULATION IN A HIGH-TECH
THE LESSONS OF LONG-TERM CAPITAL MANAGEMENT, L.P."
BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
CONFERENCE ON TECHNOLOGY IN THE MARKETPLACE
THE BROOKINGS INSTITUTION
OCTOBER 23, 1998
I am pleased to be here at the Brookings Institution to speak about the impact of technology on the regulation of derivatives markets. The Commodity Futures Trading Commission has been very busy over the past several years evaluating and adjusting its regulations in response to developments in futures markets. Many of the issues the Commission has had to tackle have been a result of technological advancements -- running the gamut from how futures firms may communicate with their customers in the age of the Internet to how the Commission should regulate electronic exchanges where the trading pit is replaced by an automated order-matching algorithm.
One of the Commission's concerns this year has been the impact of hedge funds and other large users of over-the-counter ("OTC") derivatives on U.S. and world markets. I would like to discuss recent events in the OTC derivatives market -- particularly the near collapse of Long-Term Capital Management, L.P. -- and to share some thoughts about the appropriate role of regulation in responding to these events.
Tremendous advances in computing power and in global communication networks have fostered the development of highly complicated derivative instruments and have permitted virtually instantaneous transfers of funds and execution of transactions anywhere in the world. The trend in recent years toward globalization of financial markets has included the proliferation of derivatives markets in many jurisdictions outside the United States. With the increasing efficiency of electronic communication and the rapidly expanding availability and power of computers worldwide, financial markets have transcended geopolitical boundaries -- as the experiences of the past year have vividly demonstrated. Trading is often driven by complex strategies that employ sophisticated computer models, and capital now moves around the world with astonishing speed, unconstrained by national borders.
Until recently, the regulation of derivatives markets was a local matter. This is changing. Today harmonization of financial market regulation and active communication and cooperation among regulators around the world is essential for the proper functioning of a global marketplace. No longer can governments and regulators fashion and operate their regulatory programs without regard to the effects they will have on foreign markets. Similarly, their domestic markets are affected by the regulatory regimes and actions of other jurisdictions.
As the financial marketplace has become global, some participants have sought niches where regulation is low and transparency is lacking. Hedge funds are an example of investment vehicles structured to avoid regulatory scrutiny. Similarly, the OTC derivatives market has developed across international borders and largely without regulatory oversight.
The events surrounding the financial troubles 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 CFTC in its Concept Release on OTC Derivatives in May 1998, which launched the CFTC's current study of this market. They include lack of transparency, excessive leverage and insufficient prudential controls. Moreover, the LTCM episode highlights the need for coordination among international regulators.
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 as well as those in other jurisdictions
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 trader 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 traders 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 counterparties. 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 issued three weeks ago by the
G-22 group of developed and emerging market 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 1,000 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 swaps counterparties and other creditors reportedly did not have full information about the firm's 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 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. It is
essential for federal financial regulators to consider how to reduce
the high level of leverage in the OTC derivatives market and its
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 reportedly were 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
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 securities 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 implement international regulatory standards. Increased harmonization of regulatory programs internationally is the best answer to the argument that domestic regulation of the OTC market will drive it offshore. Global cooperation is essential to avoid a race to the bottom, in which individual regulatory authorities are afraid to enact even modest regulatory protections for fear of placing their domestic markets at a competitive disadvantage.
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 and the regulatory needs of the OTC derivatives
market. Important work conducted by the International Organization of
Securities Commissions on the importance of transparency and large
position reporting for exchange-traded derivatives will be useful to
the G-22 study and the President's Working Group study.
* * * * *
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 posed by that market. Thus, regulatory solutions for exchanges are not necessarily appropriate for the OTC market. Nonetheless, the markets involve similar instruments and pose some of the same risks, and our successful experience with the U.S. futures exchanges will be invaluable in the study of the OTC derivatives market.