BROOKSLEY BORN, CHAIRPERSON,
COMMODITY FUTURES TRADING COMMISSION
ROUND TABLE ON SECURITIES MARKETS
ORGANIZATION FOR ECONOMIC COOPERATION AND
THE ASIAN DEVELOPMENT BANK INSTITUTE
APRIL 9, 1999
I am very pleased to be here today to participate in these discussions
and to share with you my thoughts on the role of both regulators and
market participants in stabilizing world financial markets. In
particular, I would like to focus on the events surrounding the
financial difficulties of Long-Term Capital Management L.P.
("LTCM") last September. The LTCM episode raises a number of
important issues relating to hedge funds and to the increasing use of
over-the-counter ("OTC") derivatives by those funds and
other highly leveraged institutions. To date, the international
response to these issues has been to encourage the development of
improved management controls by hedge fund lenders. However, the LTCM
episode 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.
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 history of profitable trading. It entered into enormous positions in both 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 than $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 potential risks that use of OTC derivatives may pose to financial stability in our global markets. Many of the regulatory issues posed by the LTCM episode were foreshadowed in the CFTC's May 1998 Concept Release on OTC Derivatives, which initiated a Commission study of the OTC derivatives market. The CFTC study and the LTCM episode, in turn, led to joint studies of the regulatory needs of the OTC derivatives market and hedge funds by the U.S. financial regulators that participate in the President's Working Group on Financial Markets ("President's Working Group") -- the Secretary of the Treasury and the chairs of the Board of Governors of the Federal Reserve System, the Securities and Exchange Commission, and the CFTC. The CFTC has made these studies a top priority and is working closely on them with the other U.S. federal financial regulators.
Let me address four of the major regulatory issues posed by the LTCM episode and suggest possible responses. These issues are lack of transparency, excessive leverage, insufficient prudential controls, and the need for greater coordination and cooperation among international regulators. I offer these suggestions for consideration based on my belief that we, as regulators, have an obligation to examine whether hedge funds, other large, highly leveraged institutions and the OTC derivatives market itself should continue to remain exempt from the controls that have effectively mitigated risks in our regulated derivatives markets.
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 trader position reports, no U.S. 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, the nature of their investment strategies and the 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 regulatory authority.
Many hedge funds are private entities outside of regulatory regimes and thus not subject to any financial disclosure requirements. Moreover, because derivatives transactions have traditionally been treated as off-balance sheet transactions, financial reports if available do not usually fully reveal OTC derivatives positions, exposures and strategies. Furthermore, there are no requirements that a hedge fund like LTCM provide disclosure of such information to its counterparties or investors.
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 success of the U.S. futures markets.
Many commentators are now suggesting that more transparency is necessary for hedge funds and other large participants in the OTC derivatives market. 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' 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.
For many years the Basle Committee on Banking Supervision ("Basle Committee") and the Technical Committee of the International Organization of Securities Commissions ("IOSCO") jointly have encouraged financial institutions and securities firms to enhance the transparency of their trading and derivatives activities. The two Committees also have recently revised the common framework of information needed by securities regulators and banking supervisors to assess the risk of their regulated institutions' trading activities. Moreover, in its January 1999 report on Banks' Interactions with Highly Leveraged Institutions, the Basle Committee suggests, among other things, consideration of a credit register that would collect information on the exposures of international financial intermediaries to counterparties such as hedge funds that have the potential to create systemic risks.
To date, there has been no similar report addressing the risks to regulated markets posed by the trading activities of hedge funds and other highly leveraged institutions, particularly with regard to their OTC derivatives transactions. As noted above, in the U.S. both the CFTC and the President's Working Group are studying these issues. In addition, IOSCO's Technical Committee is undertaking such a study through a task force on hedge funds and its working parties. I am hopeful that a careful evaluation of appropriate regulatory responses will result from these important studies.
Certainly regulated derivatives exchanges and other markets are vulnerable to the unknown activities in the OTC derivatives market, ranging from financial risks resulting from the default of a large player such as LTCM to manipulative activities. For example, Sumitomo Corporation of Japan manipulated the price of copper in U.S. cash and futures markets through a combination of transactions on the London Metal Exchange and the OTC market. As a result of the Sumitomo experience, the London Metal Exchange recently proposed new rules requiring periodic reports by exchange traders on their OTC activities.
Because of the impact such activities may have on the integrity of regulated exchanges, the Commission has long supported the ability of market regulators to obtain information about off-exchange transactions. Currently in the U.S., the CFTC has the authority to obtain information about OTC and cash positions related to traders' exchange positions that exceed a specified threshold, and the exchanges themselves may seek confirming information on off-exchange positions related to hedge and arbitrage strategies.
In this connection, an international consensus already exists among derivatives regulators, derivatives exchanges and the IOSCO Technical Committee on the need for market authorities to monitor large exchange-traded exposures and to share information with one another so as to permit an integrated assessment of market risks. Work by the IOSCO Technical Committee and the 17 regulators of commodity derivatives markets that issued the Tokyo Communiqué in 1997 makes clear that an accurate assessment of large exposures for market surveillance and risk assessment purposes cannot be accomplished unless the full extent of a large trader's exposures is known, including knowledge of the trader's related positions in the cash and OTC markets.
More study is needed to determine how best to enhance transparency in the OTC derivatives market. In my view, at the least, hedge funds and other large highly leveraged institutions should be required to provide their creditors, counterparties and investors with disclosure documents and periodic reports concerning their OTC derivatives positions, exposures and investment strategies. Serious consideration should also be given to requiring such reporting to market authorities and to government regulators. If such 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 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 the economy.
Financial regulators need to consider how to reduce the high level of leverage in the OTC derivatives market and its attendant risks. Exchange markets use many risk-limiting procedures and requirements--including mutualized clearing arrangements, marking to market, margin requirements, and capital and audit requirements. Similar protections may be needed in the OTC derivatives market. George Soros, who oversees some of the world's largest hedge funds, is among those who have recently called for the establishment of margin and capital requirements in the OTC derivatives markets.
In addition, clearing of OTC derivatives transactions could be an important vehicle for imposing controls on excessive extensions of credit, reducing counterparty credit risk and increasing transparency. A September 1998 report by committees based at the Bank for International Settlements ("BIS") recommended that derivatives counterparties should assess the potential for clearinghouses for OTC derivatives to reduce credit and other counterparty risks. The report further recommended that central banks and prudential supervisors ensure that there are no unnecessary legal or regulatory barriers to the establishment of clearinghouses for OTC derivatives. The U.K.'s London Clearing House ("LCH") is proposing such a clearing house for certain swaps transactions and has petitioned the CFTC to permit such clearing under U.S. law. [Oral presentation will provide update on current status of Commission action on the petition.]
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.
This aspect of the LTCM episode has engendered concern among both regulators and market participants. 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. A consensus has developed in the U.S. and internationally that the LTCM episode demonstrated the need for enhancements to the prudential supervision of financial institutions. As I have already noted, U.S. financial regulators are doing so through the studies of the President's Working Group as well as through recent actions of U.S. banking supervisors.
Likewise, international attention has 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 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 has also been actively addressing issues of prudential supervision of banks and other financial institutions raised by the LTCM episode. In its January 1999 report assessing banks' interactions with highly leveraged institutions, the Basle Committee made several significant recommendations for improvements in banks' risk management practices.
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 such large speculators.
These expressions of concern, however, have been met by arguments that the imposition of direct regulatory controls is impractical because the hedge funds simply would move to offshore "haven" jurisdictions. These arguments are part of a current effort by some market participants and regulators to justify inaction and the status quo. Despite that effort, I believe that international regulators have a responsibility to seek ways to control the hidden and massive risks that the LTCM episode has demonstrated may lurk in the OTC derivatives market.
Clearly, if the ongoing studies result in an international consensus on the need for more regulatory control, coordinated international action will be needed to harmonize regulation of the OTC derivatives market, to implement international regulatory standards and to prevent hedge funds based in haven jurisdictions that do not impose minimal, internationally agreed regulatory standards from raising investment funds in our countries or participating in our markets.
For example, jurisdictions could consider prohibiting hedge funds from raising investment funds or participating in their markets if the hedge fund does not comply with internationally agreed disclosure and reporting requirements. Do we seriously believe that the imposition of such investment prohibitions by the United States, the European Union, Australia and Japan would not act as an effective stimulus for regulatory compliance?
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.
Again, I recognize the difficulties of reaching international consensus on action. However, the effort to overcome those difficulties should be made. In their October 30, 1998 declaration, the G-7 Ministers stated that "[t]he reform of the international financial system is in the interest of all countries and all need to be involved in the process" and further committed to "consult widely throughout the international community to build a broad consensus in support of this declaration ." The G-7 Ministers called for reforms designed to "increase the transparency and opennesss of the international financial system; identify and disseminate international financial principles, standards and codes of best practices; strengthen incentives to meet these international standards; and strengthen official assistance to help developing countries reinforce their economic and financial infrastructures." Specifically the G-7 Ministers committed to strengthen the regulatory focus on risk management systems and prudential standards in financial sector institutions, to "examin[e] the implications arising from the operation of leveraged international financial organizations including hedge funds and offshore institutions" and to "encourage off-shore centres to comply with internationally agreed standards."
This effort is required to realize the goal of a stable international financial system which fosters market integrity and the protection of market participants. That goal cannot be reached simply through reliance on measures to enhance market discipline, admirable as those efforts may be. Market discipline failed to restrain LTCM.
Therefore, I am delighted that the issue of the needed regulatory response is now receiving the attention and study it deserves. I am optimistic that the issues I have raised today will be addressed thoughtfully and adequately in designing that response both domestically and internationally, that the lessons of LTCM will not be ignored, and that corrective regulatory and self-regulatory actions will be taken.