DECEMBER 16, 1998

Mr. Chairman and members of the Committee, thank you for the opportunity to testify about the collapse of Long Term Capital Management and the progress of the over-the-counter derivatives study by the President's Working Group. The views I am expressing are my own and are not the views of the Commission.

I wish to commend the Committee for its prompt recognition that these issues raise important public policy questions. In my view, there should be no CFTC action until completion of the Working Group studies and until Congress has had an opportunity to evaluate the recommendations included in those studies.

The upcoming reauthorization of the CFTC offers an opportunity to update derivatives market regulation. Appropriately, this will focus on OTC markets and hedge fund activities, but it is equally important to re-examine regulation of on-exchange markets as well. The polarized regulation of OTC and on-exchange markets may have been justified in the past. But rapid market growth and technological advances have eliminated barriers between markets both institutionally and geographically. The rapid maturation of the OTC derivatives sector now compels a re-examination of on-exchange regulation.

Regulatory structures must evolve along with the markets. Regulators should not hide behind static, unchanging interpretations of statutory goals. Only through an open, unbiased approach will the US financial services industry be able to innovate and remain competitive, and retain its leadership role in the global marketplace. Indeed, with modernization of the banking laws currently under consideration by Congress, this could be an opportune time to review supervision and regulation of the entire financial services industry.

The Committee has asked for viewpoints concerning the collapse of LTCM. Quite simply, LTCM collapsed because of excess financial leverage. LTCM management mistakenly assumed that historical market relationships would continue indefinitely into the future. That mistake was compounded by a lapse in the prudential control over credit extended to the firm. But a debate over whether the losses were in cash or derivatives markets would miss the real point. The real cause of LTCM's losses are not the markets in which they invested, but a fallible investment strategy combined with an overextension of credit. Concluding that the LTCM collapse dictates expanded regulation of the OTC market would misinterpret the message of the firm's failure.

While this simple observation now seems obvious, we must also ask what public policy issues are raised by these losses. The answer, of course, is the potential spillover into systemic risk. The President's Working Group is investigating this issue as part of its hedge fund study, and we must await completion of the study for a full assessment of its recommendations. No doubt, a part of the study will focus on improving the accessibility of hedge fund credit information, allowing creditor banks to better monitor aggregate exposure levels. As Chairman Greenspan has observed, expansive regulation would run the risk of moving the market offshore and have the perverse effect of reducing, rather than increasing, supervisory and regulatory oversight.

The Committee also has asked for comment on the progress of the Working Group's study of OTC derivatives markets. Congress' request for a Working Group study is particularly appropriate given the multi-jurisdictional nature of the OTC market. Indeed, the CFTC's 1992 study of the OTC market concluded that the systemic and public policy issues were not confined to any single market or any single regulator, and that coordination among all financial regulators was necessary. If anything, given the rapid growth in the OTC market in intervening years, those conclusions are even more applicable today.

I am pleased to report that the Working Group will investigate regulatory parity between the OTC and on-exchange markets. As the work of both the Brady Commission and the Working Group has previously recognized, the analysis of OTC and exchange-traded markets cannot be divorced from one another. I believe a comparative review of OTC and on-exchange regulatory structures should lead to a relaxation of the regulatory burdens currently imposed on the derivatives exchanges.

Investigation of the regulatory parity issue must begin with a review of the main purposes of the Commodity Exchange Act -- the combined goals of financial security, market integrity, and customer protection. While these remain our goals, modern communications and other technological advances have linked markets and dramatically altered the concept of a centralized marketplace. As the markets evolve, so must the governing regulations. The evolutionary role of regulation was placed at the forefront when Congress adopted the 1992 amendments to the CEA, authorizing the CFTC to grant exemptions from many CEA requirements, including the on-exchange trading requirement.

We should continue along this more-flexible approach to market regulation and not turn back in the face of the LTCM collapse. If anything, we should hasten our journey along this more-flexible pathway. Regulators must step up their search for adaptive methods to realize regulatory goals without smothering competitive evolution of the markets. One method is to enhance exchanges' ability to implement professional market initiatives under a reduced regulatory regime. A more flexible, less burdensome version of the CFTC's Part 36 regulations could help to equalize the competitive landscape between on- and off-exchange markets. This also could bring more trading activity onto exchanges, producing a consequent reduction in systemic risk.

The inescapable conclusion so far is that neither the CFTC Concept Release nor the LTCM collapse should serve as a predicate for extensive regulation of OTC markets. Additionally, functional evolution has continued to narrow the distinctions between on- and off-exchange markets. Because of this convergence, a continuing program of regulatory relief for exchange markets will eliminate competitive imbalances, and at the same time produce public policy benefits by encouraging trading in the more transparent exchange environment.

In conclusion I wish to make two points. The first is that there should be no CFTC action until completion of the Working Group studies and until Congress has had an opportunity to evaluate the recommendations included in those studies. Second, to complete the task of modernizing and updating derivatives market regulation, there should be a re-evaluation of on-exchange regulation as well.

Thank you. I would be pleased to answer any questions members of the Committee may have.