THE COMMODITY FUTURES TRADING COMMISSION
BEFORE THE UNITED STATES SENATE
AGRICULTURE, NUTRITION AND FORESTRY
DECEMBER 16, 1998
Mr. Chairman and members of the Committee, the Commission appreciates the opportunity to testify concerning Long-Term Capital Management, L.P. ("LTCM")(1) and the studies on over-the-counter ("OTC") derivatives and hedge funds currently being conducted by the President's Working Group on Financial Markets ("President's Working Group").
The events surrounding the financial difficulties of LTCM raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and by other institutions in the world financial markets. The LTCM episode demonstrates the unknown risks that the OTC derivatives market may pose to the U.S. economy and to financial stability around the world. It also highlights the need to address regulatory questions in the OTC derivatives market and whether there are risks relating to trading by hedge funds and other large OTC derivatives market participants that should concern financial regulators. The Commodity Futures Trading Commission ("CFTC" or "Commission") is continuing to analyze these questions as announced in its May 12, 1998 Concept Release on OTC Derivatives and as described in Commission testimony before this Committee in July of this year.
The Commission welcomes the heightened awareness of these issues that the LTCM matter has engendered and believes it is critically important for all U.S. financial regulators to work together closely and cooperatively on them. Therefore, the Commission applauds the decision of the President's Working Group to conduct meaningful studies of the regulatory issues relating to hedge funds and the OTC derivatives market. The Commission is fully committed to working with the other members of the President's Working Group on these studies. The Commission is also working closely with foreign regulators on these issues.
CFTC Oversight of LTCM as a Commodity Pool Operator
LTCM is the operator of several hedge funds, speculative investment vehicles for large institutions and very wealthy investors. The term "hedge fund" is not defined in the Commodity Exchange Act ("CEA"). However, to the extent that a hedge fund with U.S. investors trades futures and option contracts on a futures exchange, such funds are commodity pools under the CEA, and their operators are subject to regulation as commodity pool operators ("CPOs").
Because LTCM's hedge funds trade on futures and option exchanges and accept investments from U.S. persons and entities, LTCM is registered with the CFTC as a CPO. As a CPO, LTCM is subject to registration, recordkeeping and reporting requirements and fraud prohibitions under the CEA and the Commission's regulations.
Pursuant to the CEA, the CFTC regulates the CPOs of commodity pools, but does not directly regulate the commodity pools themselves. The regulatory scheme for CPOs is designed to protect investors in commodity pools against fraud and similar abuses. Thus, the CEA specifically forbids all CPOs and their associated persons from engaging in fraudulent transactions with pool participants. In addition, it protects the investors in commodity pools by setting forth registration and other requirements for CPOs designed to ensure their fitness and to inform investors and potential investors about the material facts regarding a pool. To fulfill its statutory mandate, the CFTC has adopted registration, disclosure, reporting and recordkeeping requirements for CPOs and has delegated to the National Futures Association ("NFA"), a futures industry self-regulatory organization, direct responsibility for overseeing compliance with those requirements. NFA receives and acts upon applications for registration of CPOs. In addition, NFA reviews the disclosure documents required to be provided by CPOs to their investors and is responsible for auditing them.
Pursuant to these requirements, LTCM is registered with the Commission as a CPO and is a member of NFA. Because its funds are restricted to sophisticated investors (qualified eligible participants ("QEPs")), LTCM is exempt under Commission regulation 4.7 from certain obligations otherwise imposed on CPOs.(2) Nonetheless, it must file its funds' annual financial statements with the Commission and NFA and provide the funds' investors with copies of those annual financial statements. It must also provide quarterly reports to investors concerning the funds' net asset values, maintain books and records, and include all material disclosures in offering memoranda to prospective investors. LTCM is also subject to the antifraud provisions of the CEA and to audit by NFA.
The Commission does not attempt to ensure the safety and soundness of CPOs or commodity pools. The CEA does not impose minimum capital or other financial standards on CPOs, nor does it impose restrictions on the types of financial interests a commodity pool can trade. The CFTC does not, except when specifically sought through "special calls," receive detailed information about the off-exchange trading of hedge funds or other types of commodity pools, which often includes sizable OTC derivatives transactions. The CEA does, however, provide authority for the CFTC to enact appropriate regulations to monitor trading activities on futures and commodity option exchanges. CFTC surveillance tools include speculative position limits and required daily reporting by futures commission merchants ("FCMs") of large trader positions in exchange-traded contracts. Because many hedge funds are also large traders who fall within these reporting requirements, the CFTC is able to monitor their large exchange positions on a daily basis.
Pursuant to the large trader reporting requirements, LTCM's funds' large positions on U.S. futures exchanges have been reported daily to the CFTC, and both the CFTC and U.S. futures exchanges have had full and accurate information about LTCM's funds' reportable on-exchange futures positions. Moreover, LTCM has been promptly and fully paying margin on its funds' on-exchange futures positions, which are marked to market daily. However, neither the CFTC nor the U.S. futures exchanges had comprehensive or timely information on LTCM's funds' positions, exposures and investment strategies in the OTC derivatives market since no reporting of that information is routinely required.
CFTC Actions in Light of LTCM's Financial Difficulties
On Wednesday, September 23, 1998, the Department of the Treasury informed the Commission that LTCM was in serious financial difficulty. Press reports state that its funds' capital at that time had dipped well below $1 billion. However, prior to its financial difficulties and based on the reputation of its principals and its history of profitable trading, LTCM had been able to leverage the funds' capital to invest in securities valued at about $125 billion and had entered into derivatives contracts with a notional value of about $1.25 trillion. Most of these derivatives were OTC transactions, while the rest consisted of exchange-traded futures on domestic and foreign exchanges.
Because of concern that LTCM was about to default on margin calls on its derivatives positions and other loans, the Federal Reserve Bank of New York facilitated a meeting of LTCM's major creditors and swaps counterparties--some of the largest U.S. and European commercial banks and investment banks--resulting in contributions of more than $3.6 billion in capital to LTCM's largest fund in return for a 90% ownership interest in it. This infusion of capital prevented LTCM's collapse and the possible disruption of the global economy.After learning of LTCM's difficulties on September 23, 1998, the Commission staff quickly determined the nature and value of the positions LTCM's funds held on U.S. futures exchanges and took steps to identify and address any dangers to the exchanges and their clearing houses resulting from LTCM's problems. The staff determined that LTCM had promptly and fully paid all margin obligations on its funds' futures positions on U.S. exchanges and that LTCM's funds' positions on those exchanges were cleared by two well-capitalized FCMs, Bear Stearns and Merrill Lynch, which were responsible for margin payments to the exchange clearing houses on the LTCM funds' accounts.
The Chairperson immediately contacted senior officials of certain U.S. futures exchanges and international regulatory authorities to alert them about possible problems related to LTCM's funds' derivatives positions. The Commission promptly sent audit staff to LTCM to conduct a review and also to Bear Stearns and Merrill Lynch to inspect LTCM's accounts. The staff also contacted NFA and has coordinated with NFA in reviewing LTCM's financial condition. On an ongoing basis the staff continues to monitor the situation closely and to verify that LTCM and its clearing FCMs are meeting their margin requirements on U.S. futures exchanges. Commission staff also is exploring whether the CEA or any Commission regulations have been violated. The Commission has been in close communication on the LTCM matter with other members of the President's Working Group and has worked with them to respond fully and promptly to Secretary of the Treasury Robert Rubin's call for a study on hedge funds.
Since there are no reporting requirements concerning OTC derivatives positions, the extent to which other hedge funds or large OTC derivatives market participants may pose dangers to the economy is unknown. Commission staff has taken steps to try to identify other traders whose positions in the OTC derivatives market may affect U.S. regulated markets or financial stability. The staff has been in close touch with the CPOs of certain hedge funds that have reportedly suffered large losses. In addition, the staff has recently collected and is analyzing detailed information from a number of other CPOs of large hedge funds. The staff has also requested information from certain FCMs that may reveal those hedge funds or other large participants in the OTC derivatives market which pose significant risks and has alerted FCMs, futures exchanges and NFA to ensure that they pay particular attention to these issues and that they report potential dangers to the Commission.
The Commission is examining the CEA and the Commission's regulations on CPOs to determine whether improvements are necessary. The Commission is also continuing its ongoing study of the OTC derivatives market and the adequacy of its current regulations relating to that market and its participants.
LTCM's Funds' Audited 1997 Financial Statements
As a registered CPO, LTCM filed annual financial statements for its funds for the year ending December 31, 1997, with the Commission on March 16, 1998. The financial statements were audited by Price Waterhouse LLP. LTCM also filed those statements with NFA. LTCM provided copies to the funds' investors and lenders, among others.
Commission staff reviewed these financial statements, along with more than 1,000 such statements received from CPOs annually, to check for compliance with the reporting provisions of the Commission's regulations. As the funds' CPO, LTCM was found to be in compliance. The financial statements of LTCM's largest fund (in which the other funds invest) showed total assets of about $129 billion, total capital of about $4.67 billion and net income from operations of about $1.4 billion. Footnotes to the statements showed that the fund held swap agreements with a notional value of about $697 billion and U.S. and foreign exchange-traded futures with a notional value of about $471 billion.
Nothing in the financial statements indicated reason for concern about the funds' financial condition. LTCM's largest fund had 1997 income from operations of about 30% of its year-end capital, and its asset to capital ratio was about 28 to one. During 1995 and 1996, its annual rate of return on capital had exceeded 40%, and the amount of its leverage had been approximately the same. The fund was well capitalized and very profitable. Its asset to capital ratio was similar to that of some other hedge funds as well as many major investment banks and commercial banks.
It was not until many months later -- in August and September 1998 -- that LTCM suffered the enormous losses that brought it to the brink of insolvency. By that time its capital had shrunk to well below a billion dollars, its leverage had increased to more than 100 to one, and its 1997 financial statements were outdated. Federal regulators and LTCM creditors then received up-to-date financial information from LTCM reflecting its current financial situation.
The Commission freely shares information with other federal regulators whenever it receives a request from them for such information. Section 8(e) of the CEA permits information to be released to other federal agencies only upon request. In fact, the Commission solicits a request from another agency if it believes that information in its possession is needed by the other agency. The statutory requirement of a request is not an impediment to meaningful information sharing with other regulators, and it was not any impediment in the case of LTCM.
The Commission did not draw the attention of other regulators to LTCM's 1997 financial statements because they did not trigger concern, for the reasons discussed above. Moreover, other federal financial regulators had access to these financial statements at about the same time as they were filed with the Commission by virtue of the fact that they had been provided to LTCM's investors, lenders, and other creditors. For example, the Commission understands that commercial banks which were LTCM's creditors and counterparties received copies of these statements, which were thus available to federal banking authorities.
Regulatory Questions Raised by LTCM
The LTCM episode raises a number of important regulatory questions relating to hedge funds and to the OTC derivatives market. Most of these questions are raised by the Commission in its Concept Release on OTC Derivatives.(3) These questions include lack of transparency, excessive leverage, and insufficient prudential controls.
1. Lack of Transparency
While the CFTC and the U.S. futures exchanges had detailed daily information about LTCM's funds' reportable exchange-traded futures positions through the CFTC's required large trader position reports, no federal regulator received detailed and timely reports from LTCM on its funds' OTC derivatives positions and exposures. Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives market participants, the nature of their investment strategies and the extent of their risk exposures potentially allows them to take positions that may threaten our regulated markets without the knowledge of any federal regulatory authority.
Furthermore, there are no requirements that a CPO like LTCM provide disclosure documents to its funds' investors or counterparties concerning its OTC derivatives positions, exposures and 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 operators of hedge funds are registered with the Commission as CPOs and are required to file annual financial reports with the Commission, those reports do not fully reveal their funds' OTC derivatives positions, exposures and strategies.
Unlike futures exchanges, where bids and offers are quoted publicly and positions are marked to market at least daily, the OTC derivatives market generally 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 by their counterparties. It 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 CEA 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 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 are now being asked 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. Many commentators are now suggesting that more transparency is necessary for hedge funds and other large participants in the OTC derivatives market.
Most notably, an October 1998 report by the G-22 group of developed and emerging market countries (of which the U.S. is a member) calls 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.(4) Regulators in many countries are now calling for disclosure and reporting requirements relating to hedge funds.(5)
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. LTCM reportedly managed to borrow $125 billion (more than 100 times its capital at the time of its rescue) and to use those borrowings to enter into derivatives positions with a notional value of approximately $1.25 trillion (more than 1,000 times that capital). Its swaps 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 could pose potentially serious dangers to our economy.
The London Clearing House has submitted a petition to the Commission to permit clearing of swaps, which is not currently permitted under the Commission's regulations. Clearing of OTC derivatives transactions could be a useful vehicle for addressing issues relating to extensions of credit, reducing counterparty credit risk and increasing transparency.
It is important for financial regulators to evaluate high levels of
leverage in the OTC derivatives market and the 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 and its lenders and counterparties. In its Concept Release, 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 dealers and their customers, including value-at-risk ("VAR") models. LTCM now stands as a cautionary tale of the fallibility of some of the most sophisticated VAR models. The prudential controls of LTCM's OTC derivatives counterparties and creditors, the parties that seemingly had the greatest self-interest in assessing LTCM's financial wherewithal, apparently failed. They reportedly were unaware of the funds' extensive borrowings and risk exposures.(6)
Cooperation With the President's Working Group on Financial Markets
The Commission is working diligently as part of the President's Working Group to study these and other regulatory issues relating to hedge funds and the OTC derivatives market. The Commission remains committed to coordinating and cooperating fully with the other members of the President's Working Group to complete the studies promptly and to report to Congress. The Commission strongly supports the interest of financial regulators, Congress and this Committee in these important and complex matters and pledges our assistance to the Committee in addressing them.
Work on the studies is proceeding in a constructive and cooperative manner. To date, the members of the President's Working Group--the Secretary of the Treasury, the Chairman of the Board of Governors of the Federal Reserve System, the Chairman of the Securities and Exchange Commission and our Chairperson--have met twice to discuss the scope and nature of the studies and the issues to be addressed. The staff of the members of the President's Working Group have prepared outlines of the studies, and each of the agencies has been assigned preparation of certain portions of the studies. Because of their importance, the Commission has made participation in these studies a top priority. It is our hope that the hedge fund study will be completed by early next year and that the OTC derivatives market study will be completed next spring.
Cooperation Among International Regulators
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 regulatory authorities in other countries to harmonize regulation of the OTC derivatives market and its participants and to implement international regulatory standards. The international regulatory community is responding to this challenge as evidenced by the statements and calls for studies by the G-7, the G-22, and the Basle Committee on Banking Supervision.
In addition, the International Organization of Securities Commissions ("IOSCO"), of which the Commission is a member, is also studying the matter. Important recent work by IOSCO on best practices for surveillance of derivatives exchanges, including the need for transparency and large position reporting, will form a useful base for additional IOSCO work. Later this week Commission representatives will be participating in a meeting of the IOSCO Technical Committee in Paris to address regulatory issues relating to the OTC derivatives market and hedge funds.
The Commission is committed to these international efforts to review the OTC derivatives market and the risks it poses. Increased harmonization of regulatory programs internationally is one answer to the argument that domestic regulation of hedge funds and the OTC derivatives market will drive them offshore.
* * *
Thank you. The members of the Commission would be pleased to answer any questions members of the Committee may have.
1 Attached hereto as Exhibit 1 is a chronological outline of events pertaining to LTCM.
2 The relief available under Rule 4.7 is: (1) exemption from the requirement to provide a Disclosure Document, provided however, that any offering memorandum or brochure distributed by the CPO must include all disclosures necessary to make the information contained therein not misleading; (2) permission to provide pool participants, in lieu of the prescribed Account Statement, a quarterly statement that indicates solely the net asset value of the pool as of the end of the reporting period, the change in net asset value from the end of the previous reporting period and the net asset value per unit; and (3) permission to provide pool participants and to file with the CFTC, in lieu of the prescribed certified Annual Report, an uncertified annual report containing, at a minimum, Statements of Financial Condition and of Income (Loss).
3 The Concept Release seeks public comment on whether the Commission's current regulations on 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 reporting, disclosure, recordkeeping, registration, capital, internal controls and sales practices.
4 Report of the G-22 Working Group on Transparency and Accountability (October 1998).
5 See, e.g., Knight-Ridder, "France, Germany to Call for Greater Regulation of Hedge Funds," Dec. 1, 1998; Knight-Ridder, "Japan MOF Official Maruyama Urges More Hedge Fund Disclosure," Nov. 28, 1998; Knight-Ridder, "Tung [Hong Kong] Wants Greater Hedge Fund Transparency," Oct. 30, 1998; Knight-Ridder, "Australia's Costello Backs Call for Global Hedge Fund Supervision," Oct. 20, 1998; Knight-Ridder, "IMF: Southeast Asia Nations Seek More on Hedge Fund Curbs," Oct. 6, 1998.
6 In response to this and other problems, the G7 nations in late October called for their finance ministers and central bank governors to work to strengthen prudential supervision of financial institutions and to examine the operation of highly leveraged and offshore institutions, such as hedge funds. (Declaration of G7 Finance Ministers and Central Bank Governors, U.S. Department of the Treasury, Oct. 30, 1998; "G-7 Plan Might Entail More Risk Disclosure," Los Angeles Times, Oct. 31, 1998.) More recently, the G7 has reportedly been considering a plan to have the Bank of International Settlements ("BIS") monitor large loans and derivatives transactions entered into by financial institutions with third parties. (Knight Ridder, "G-7 to Tighten Control of Hedge Fund Activities," Dec. 7, 1998.)