"UNKNOWN RISKS IN THE OTC DERIVATIVES
BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
SILVER USERS ASSOCIATION
OCTOBER 28, 1998
I am pleased to be asked to speak today to members of the Silver Users Association. Having represented a client in the cases and investigations relating to the 1980 manipulation of the world silver market by the Hunt brothers and others, I continue to have a special interest in the silver market.
Today 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.
LTCM is a hedge fund that was able to borrow billions of dollars based on the reputation of its principals and its profitable trading. It entered into enormous positions in exchange-traded and OTC derivatives. When prices moved against it, it was on the verge of defaulting on its commitments. The Federal Reserve Bank of New York encouraged its major creditors and counterparties -- many of the largest U.S. and European banks and investment banks -- to infuse $3.6 billion into LTCM to prevent its collapse and the possible disruption of the global economy.
Most of the regulatory issues posed by the LTCM episode were raised by
the Commission in its Concept Release on OTC Derivatives in May 1998,
which initiated the Commission's current study of the OTC
derivatives market. The issues include lack of transparency, excessive
leverage, insufficient prudential controls, and the need for
coordination and cooperation among international regulators.
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.
Indeed, the lack of transparency in the OTC derivatives market poses other dangers for our markets. A recent example is the Sumitomo Corporation's manipulation of the copper market. Earlier this year, pursuant to a settlement with Sumitomo, the Commission entered an order finding that Sumitomo engaged in manipulation of the U.S. copper market in violation of the Commodity Exchange Act. The Commission imposed a cease-and-desist order and $150 million in civil penalties and restitution related to Sumitomo's manipulative activity involving transactions on the London Metal Exchange and also certain OTC derivatives transactions. The lack of transparency with respect to the OTC derivatives positions made it very difficult to get a comprehensive view of Sumitomo's overall strategy and 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 are raised by the Commission in its Concept Release on OTC Derivatives. In that Release, the Commission specifically seeks 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 three 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.
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
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. 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.
* * * * *
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.