REMARKS OF
BROOKSLEY BORN,
CHAIRPERSON,
COMMODITY FUTURES TRADING
COMMISSION
ROUND TABLE ON SECURITIES MARKETS
REFORM -
ORGANIZATION FOR ECONOMIC COOPERATION
AND
DEVELOPMENT AND
THE ASIAN DEVELOPMENT BANK INSTITUTE
TOKYO, JAPAN
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.
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 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 Communiqu� 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.
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 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.]
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.
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.
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 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.