"REGULATORY RESPONSES TO RISKS IN THE
OTC DERIVATIVES MARKET"
BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
COMMITTEE ON FEDERAL REGULATION OF SECURITIES
ABA SECTION OF BUSINESS LAW
NOVEMBER 13, 1998
Thank you for inviting me to speak with you today. I have been very active in the ABA for more than twenty-five years, and I am always pleased to be able to appear before an ABA group.
The Commodity Futures Trading Commission ("Commission" or "CFTC") has jurisdiction over most futures and options, whether traded on an exchange or over the counter. In establishing the Commission in 1974, Congress decided that the very different functions served by securities markets -- capital formation and investment -- and futures markets -- risk-shifting and
speculation -- could best be overseen by separate regulatory agencies. Thus, the SEC is the functional regulator of the securities and securities option markets, and the CFTC is the functional regulator of most other derivatives markets.
Today I would like to discuss recent events in the 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.
As you know, 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 swaps counterparties -- many of the largest U.S. and European banks and investment banks -- to infuse more then $3.6 billion into LTCM to prevent its collapse and the possible disruption of the global economy.
Many 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 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 interest and whether the Commission should consider additional terms and conditions relating to registration, capital, internal controls, sales practices, recordkeeping and reporting.
The issues most directly posed by LTCM include lack of transparency, excessive leverage, insufficient prudential controls, and the need for coordination and cooperation among international regulators. I welcome the heightened awareness of these issues that the LTCM matter has engendered and believe it is critically important for all financial regulators to work together closely and cooperatively on them. Therefore, I applaud Secretary of the Treasury Robert Rubin's call for meaningful studies by the President's Working Group on Financial Markets on hedge funds and on OTC derivatives and look forward to working with him and the other members of the Working Group. I also welcome recent statements and ongoing studies by the G-7, the G-22, the International Organization of Securities Commissions ("IOSCO") and the Basle Committee on Banking Supervision. As recognized by financial regulators around the world, swift regulatory responses may well be needed to protect the U.S. and world economies.
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 them 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 are raised by the Commission in its Concept Release on OTC Derivatives, including 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 six 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 last month by the G-22 group of developed and emerging market countries 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 traders. Moreover, representatives of the hedge fund industry itself are moving in this direction. Julian Robertson, who oversees the world’s largest hedge fund manager, has acknowledged that some additional regulation in this area would be beneficial. 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 $125 billion, approximately 100 times its capital, and to use those borrowings to enter into 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 Concept 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, which is not currently permitted for under our regulations. 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 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, 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.
Financial regulators urgently need to address these failures. In response to this and other problems, two weeks ago the G-7 called for its finance ministers and central bank governors to work to strengthen prudential supervision of financial institutions and to examine the operations of highly leveraged and offshore institutions. The Basle Committee on Banking Supervision is swiftly addressing issues of prudential supervision raised by the LTCM episode. This international recognition of the need to address possible weaknesses in prudential supervision is timely and important.
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 about 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 their securities markets to the actions of large hedge funds.
The LTCM situation presents a new opportunity for the Commission and other U.S. financial regulators to work with authorities in other countries to harmonize regulation of the OTC derivatives market and to implement international regulatory standards. The recent statements by the G-7 and the G-22 are important steps in this direction and demonstrate a growing international consensus regarding the need for increased transparency, limits on excessive leverage and improved internal controls.
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 studies on the regulatory implications of the LTCM episode and the regulatory needs of the OTC derivatives market. Important recent work by IOSCO on best practices for surveillance of derivatives exchanges, including the need for transparency and large position reporting, will be useful to these studies and will form a base for additional IOSCO work. As already noted, Basle is working to address the implications of the LTCM episode for banking supervision.
Increased harmonization of regulatory programs internationally is the best answer to the argument that domestic regulation of hedge funds and the OTC derivatives market will drive them 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.
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In conclusion, financial regulators around the world have recognized 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.