REMARKS OF
BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
FORDHAM UNIVERSITY SCHOOL OF
LAW
1999 DERIVATIVES & RISK MANAGEMENT
SYMPOSIUM
NEW YORK, NEW YORK
JANUARY 28, 1999
I am pleased to be here today to address this symposium. Only in its second year, the symposium is making an important contribution to the informed discussion of derivatives and risk management. I am particularly pleased to have the opportunity to discuss the role of both regulators and market participants in stabilizing world financial markets, a topic that has certainly been on many people's minds since last Fall.
I would like to discuss in particular the recent events in the over-the-counter ("OTC") derivatives market 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") last September raise a number of important issues relating to hedge funds and to the increasing use of OTC derivatives by those funds and other large participants 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 LTCM and 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 commercial and investment banks -- to infuse more then $3.6 billion into LTCM's largest fund in return for a 90% ownership interest in it. This capital infusion prevented LTCM's collapse and possible disruption of the global economy.
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 a pressing need to address the appropriate role of regulation in the OTC derivatives market and whether there are unacceptable regulatory gaps relating to trading by hedge funds and other large OTC derivatives market participants.
Many of the regulatory issues posed by the LTCM episode were foreshadowed in the Commission's own May 1998 Concept Release on OTC Derivatives, which initiated a Commission study of the OTC derivatives market. These issues include lack of transparency, excessive leverage, insufficient prudential controls, and the need for greater 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. To that end, the President's Working Group on Financial Markets, which consists of the Secretary of the Treasury and the Chairs of the Federal Reserve System Board of Governors, the Securities and Exchange Commission and the CFTC, is currently working on two studies relating to the regulatory response necessary for hedge funds and OTC derivatives. In addition, the G-7, the G-22, the International Organization of Securities Commissions ("IOSCO") and the Basle Committee on Banking Supervision have each been conducting studies or issuing statements pertaining to the regulatory issues raised by LTCM and OTC derivatives. As recognized by financial regulators around the world, swift regulatory responses may well be needed to protect the U.S. and world economies.
Let me address four of the major regulatory issues posed by the LTCM episode.
1.������ Lack of Transparency
While the CFTC and the U.S. futures exchanges had full and accurate information about LTCM's U.S. exchange-traded futures positions through the CFTC's required daily 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.
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 ("CPO") and are required to file annual financial reports with the Commission, those reports do not fully reveal their OTC derivatives positions, exposures and strategies. Furthermore, there are no requirements that a CPO like LTCM provide disclosure of such information to its funds' counterparties or investors. It appears that even LTCM's major creditors did not have a complete picture.
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 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's 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 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 financial services industry are calling for more transparency. For example, Goldman Sachs Co-Chairman Jon Corzine has endorsed "greater transparency and official reporting, if not regulatory requirements, for hedge funds." Likewise, Merrill Lynch's Chairman, David Komansky, has cited lack of transparency in hedge funds' investments as an important factor in LTCM's troubles. Julian Robertson, who oversees one of the world's largest hedge fund operators, 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. 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 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 procedures and requirements 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,
who oversees some of the world's largest hedge funds, is among
those currently calling for margin and capital requirements for OTC
derivatives transactions.
The London Clearing House has applied 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 imposing controls on excessive
extensions of credit, reducing counterparty credit risk and increasing
transparency.
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 derivatives 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.
A number of large commercial and investment banks, including many of
LTCM's counterparties and creditors, announced recently that they
are forming a group to consider guidelines for enhanced risk
management practices. This recognition by the affected private parties
of the need to improve their own prudential controls is certainly
welcome.
However, financial regulators urgently need to address these problems
as well. As I have already noted, domestic financial regulators are
doing so through the studies of the President's Working Group on
Financial Markets. Moreover, international attention has now focused
on the need to improve prudential supervision.
In response to LTCM and other problems, the G-7 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 operations of highly leveraged and offshore
institutions, such as hedge funds. More recently the G-7 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; BIS would then report information about third party exposures
to national authorities and to reporting financial institutions. The
Basle Committee on Banking Supervision is also actively addressing
issues of prudential supervision of banks and other financial
institutions raised by the LTCM episode and is scheduled to release
the results of its study today. This international recognition of the
need to address possible weaknesses in prudential supervision is
timely and important.
4.������
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 authorities in other
countries to harmonize regulation of the OTC derivatives market and to
implement international regulatory standards. The international
regulatory community is responding to this challenge as shown by the
statements and actions of the G-7, the G-22, the BIS and the Basle
Committee on Banking Supervision noted earlier.
In addition, IOSCO is studying the matter. At the recommendation of
the CFTC, the IOSCO Technical Committee has formed a task force to
address regulatory issues relating to hedge funds. 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 this additional IOSCO
work.
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.
�����������������������������������
*
������������
*
������������
*
������������
*
�������������������
*
In conclusion, I am delighted that these regulatory issues are now
receiving the attention and study they deserve. I am optimistic that
they will be addressed thoughtfully and adequately both domestically
and internationally and that the potential risks that currently exist
will be reduced through regulatory and self-regulatory actions.