BROOKSLEY BORN, CHAIRPERSON
COMMODITY FUTURES TRADING COMMISSION
FORDHAM UNIVERSITY SCHOOL OF
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.
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.