Shawn A. Dorsch
President and Chief Operating Officer
DNI Holdings, Inc.
Recommendations by the Presidents Working Group
Committee on Banking and Financial Services
United States House of Representatives
April 11, 2000
DNI Holdings, Inc. ("DNI") is very pleased to have been invited to deliver this written statement to the Committee on Banking and Financial Services.
Although the Committee has three important topics before it, we have been asked to focus our testimony on one, rationalizing the legal and regulatory environment for the electronic trading of swaps and related financial derivatives. We are happy to address this topic, although we would like to note in passing how important the netting of financial contracts is to industry-wide risk and cost reduction. We would add our voice in support of improvements in netting legislation.
We have a strong view on the desirability of rationalizing the legal and regulatory environment in which we operate. We are one of a small number of companies that has survived what to some may have appeared to be major legal uncertainty. We say "appeared to be" because we have never felt that our business was anything but consistent and compliant with all conceivably applicable law and regulation. We have never felt the least bit of uncertainty and we do not believe there is any real basis for uncertainty now. Nonetheless because of the perception of uncertainty by some, including a then negatively-activist CFTC, our company and product were nearly ridden out of town on a rail. Had that journey begun in earnest, it would no doubt have ended safely for us in a new headquarters in London. We certainly would have felt the distance, however, and we suggest that the U.S. swaps community also would have experienced a loss.
DNI is a corporation based in Charlotte, North Carolina. It was formed in 1996 to build and operate a computerized communications and information system (known as "Blackbird" or the "Blackbird system") to help major financial institutions find, negotiate and agree to custom-tailored interest rate and currency derivatives transactions (for ease of reference, "swaps") directly with each other. The founders of DNI are experienced swaps professionals. The Blackbird system is operational and successfully serving major swaps dealers in the U.S. The Blackbird system serves only financial institutions. The public cannot access Blackbird.
The fundamental goal of DNI is to provide its financial institution customers with a computerized system that will bring greater speed, precision, safety and security, and lower costs, to the very same interest rate and currency risk management business activities that are now taking place every day in numerous U.S. financial institutions.
In spite of this goal, DNI initially found itself subject to searching regulatory review by the CFTC and harsh criticism from some of the traditional exchanges subject to the CFTC's jurisdiction. It was (and remains) DNI's understanding that the types of transactions that may be negotiated on Blackbird are exempt from CFTC jurisdiction under the Commodity Exchange Act. Nonetheless, DNI was to learn two lessons. First, DNI learned that the computerized enhancement through Blackbird of services now commonly provided over the telephone by swaps brokers unregulated by the CFTC might lead to an assertion of CEA jurisdiction, even though there existed no plausible regulatory structure applicable to Blackbird and no demonstrated need for any regulation of Blackbird. Second, DNI found that certain entities actually subject to CEA jurisdiction would do all they could to exploit the CFTC's own jurisdictional uncertainty by focusing CFTC attention on DNI. These entities did so even though they never have offered the kinds of transactions that might be negotiated through Blackbird.
In April 1999, DNI was on the verge of making Blackbird operational. DNI received a letter from the CFTC asking DNI to provide certain information so that the CFTC could make an assessment of its own jurisdiction over Blackbird. Certainly, the CFTC is not to be faulted for making due inquiry to assure itself that it is fulfilling its regulatory responsibilities. This CFTC, however, was the same CFTC that had issued a "concept release" read by many as proposing that it take jurisdiction over the swaps community. This was the same CFTC which was at loggerheads with the Treasury, the SEC and the Federal Reserve Board and which was admonished by Congress not to take action following from its concept release. Fortunately, it is not the same CFTC today. If it were, we might now be speaking sadly of DNI as a U.S. entity in the past tense. U.S. banks and investment banks, which presently occupy a leadership role in providing interest rate and currency risk management products, might have been deprived of access to leading edge technology that will help them compete.
DNI recognized the potential difficulties in its situation with the CFTC. What followed, however, was a truly bewildering lesson in the very real, bottom-line effect of perceived legal uncertainty. DNI, a small North Carolina company, and its computer system were mentioned in multiple Congressional hearings, only one of which DNI attended. The fact of the CFTC inquiry became general industry knowledge. Even our product name, "Blackbird", which had resulted from one of our principal's admiration, as an amateur pilot, for a fast, high-flying U.S. airplane, was publicly ridiculed as an indication of evil, evasive intent.
The details of the public controversy we faced are less interesting than are some of the deeper effects of the controversy. Perhaps most importantly, senior DNI personnel had to shift their attention from building a business to explaining and defending that business. Obviously, substantial financial resources had to be focused on the regulatory situation. Potential customers needed to be reassured that transactions negotiated through Blackbird would not be void as illegal off-exchange futures. (This, of course, is the central "uncertainty" concern arising from the Commodity Exchange Act with respect to swaps.) Potential investors also needed to be helped to a level of comfort with the regulatory situation. The net effect was that the CFTC inquiry and attendant public attention significantly slowed our growth for a time.
Perhaps there is little surprising in all this until one stops to consider what was mentioned above: most, if not all, of what the Blackbird system does is now done by "voice brokers", human beings using telephones and squawk boxes, and operating without threat of sanction or illegality.
In fact, Blackbird fulfills the same functions as the voice brokers, but with far greater efficiency and benefit to the financial system. Blackbird is not an exchange or a clearing house. Blackbird does not enter into transactions, provide credit support or take or add credit risk. Blackbird does not change the individual customized nature of swaps. Blackbird does not introduce preference or bias into negotiations. Blackbird simply provides sophisticated dealers (and not the public) with a computer-based electronic communications alternative for the direct negotiation and agreement of bilateral transactions.
Blackbird offers an improved electronic method for a dealer to identify other dealers who may, subject to the resolution of credit and other terms, be willing to enter into a transaction having particular economic terms desired by the first dealer. Use of Blackbird promotes competition, improves transparency, record-keeping and risk control, and reduces costs. Blackbird brings substantial private and public benefit, without changing any meaningful feature of custom-tailored swaps activities as they currently operate, and without creating any need for novel regulation.
If Blackbird brings all these benefits, why did it encounter the problems described above? It may be helpful to the Subcommittee to consider for a moment the underlying legislative and regulatory causes of DNI's predicament. First, there is the archaic language of the Commodity Exchange Act itself. This language was stretched far beyond its originally intended use (even before the advent of new electronic technology) as "commodity" exchange-traded contracts have moved from the agricultural into the financial. This inadequate statutory language has led to the situation, bewildering to the uninitiated, where Congress has directed the CFTC to exempt certain swaps from its jurisdiction without Congress's ever deciding that these swaps were "futures" subject to the CEA to begin with. Build on top of this rickety legislative base a regulatory exemptive structure struggling for words to describe what might and might not be exempt and you have all the makings of a roadblock to progress in an era of technological innovation. In DNI's case, the existing language of the relevant regulatory exemption was read by some to deny exempted status to Blackbird essentially because Blackbird is an electronic system. This is precisely the kind of dangerously confused thinking that the electronic trading section of the draft "Over-the-Counter Derivatives System Risk Reduction Act of 2000" was designed to forestall.
When words and reality no longer mesh, it is time to restore direction by returning to basic principles. Fortunately, in the Commodity Exchange Act context, we have seen this recognized on several fronts. First, the Report of The President's Working Group on Financial Markets entitled "Over-the-Counter Derivatives Markets and the Commodity Exchange Act" explicitly recognized that the "method by which a transaction is executed has no obvious bearing on the need for regulation in markets, such as the markets for financial derivatives, that are not used for price discovery." The Report went on to note that there is no "demonstrable need for regulation" of certain electronic systems. Second, the new CFTC, reinventing itself under Chairman Rainer, has participated in the President's Working Group Report and has put forth a new regulatory proposal that attempts to build afresh on positions of policy and principle, and that attempts to encourage use of electronic systems. We are encouraged by Chairman Rainer's very constructive attitude. Finally, the Congress now seems to be well-focused on the fact that existing statutory and regulatory regimes may not adapt readily to the promise and challenge of the new technologies. The efforts of Chairman Leach, Congressmen LaFalce, Baker and Kanjorski, and this Committee (most pointedly in the draft Risk Reduction Act) and others will be invaluable in determining the direction for a redesign of our nation's statutes and regulations. We encourage Congress to watch closely to be sure that new regulatory constructs are sufficiently resilient to weather changes in administration, as well as changes in technology.
DNI's message is not that all electronic systems should be unregulated. DNI's message is that regulatory concern should be focused not on the medium of communication or, for that matter, the medium of transaction execution. Concern should be focused on the activities accomplished with the medium, and should be coupled with consideration of the inherent market discipline likely to shape those activities. If, as is the case with Blackbird, those activities do not raise serious concerns, great care should be taken to protect them from the very, very serious countervailing threats of overbroad or anticompetitive regulation.