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Committee on Financial Services

United States House of Representatives

Archive Press Releases

Testimony of

Garrett Glass

Chief Market Risk Officer

Bank One Corporation

on behalf of

The Financial Services Roundtable

Before the

United States House of Representatives

Committee on Banking and Financial Services

on

Recommendations by the President's Working Group on Financial Markets

concerning

Financial Contract Netting, Hedge Fund Disclosure,

and Over-the-Counter Derivatives

 

April 11, 2000

 

My name is Garrett Glass and I am the Chief Market Risk Officer with Bank One Corporation in Chicago. I am pleased to have the opportunity today to speak on behalf of The Financial Services Roundtable. Bank One is one of the 100 financial institutions which are members of the Roundtable. Many Roundtable members are market makers or end-users in the derivatives market. My background at Bank One includes participation as a trader and manager in the derivatives market when it was developing in the early 1980s. I am the Chief Market Risk Officer for Bank One responsible for independent oversight of trading and proprietary investment activities of the corporation.

The Financial Services Roundtable is a national association whose membership is reserved for 100 companies selected from the nation=s 150 largest integrated financial services firms. The member companies of the Roundtable engage in a wide range of financial activities, including banking, securities, insurance, and other financial service activities. The mission of the Roundtable is: to be the premier forum in which leaders of the U.S. financial services industry determine and influence the most critical public policy issues that shape a vibrant, competitive marketplace and a growing national economy; to promote the interests of member companies in federal legislative, regulatory and judicial forums; and to effectively communicate the benefits of competitive and integrated financial services to the American public. The Roundtable is a CEO-driven association that advocates the interests of integrated financial institutions primarily in the Congress, the federal agencies, and federal courts.

The Financial Services Roundtable appreciates the opportunity to provide comments today on:

  • H.R. 1161, The Financial Contract Netting Improvement Act of 1999
  • The Over the Counter Derivatives Systemic Risk Reduction Act of 2000 and
  • H.R. 2924, the Hedge Fund Disclosure Act

Financial Contract Netting

First, let me express the Roundtable=s support for H.R. 1161, the Financial Contract Netting Improvement Act of 1999 introduced by Chairman Leach, Ranking Member LaFalce, and Financial Institutions Subcommittee Chair Roukema. The purpose of this Act is to strengthen the provisions of the Federal Deposit Insurance Act (FDIA) and bankruptcy laws that protect the enforceability of contractual rights to terminate and close out certain capital markets transactions, net the amounts payable by each party, and foreclose on any collateral.

As the Roundtable has indicated in previous testimony, the provisions of this legislation are more in the nature of technical changes than large substantive or policy changes. They do not extend the scope of insolvency laws beyond those envisioned by existing legislation. However, they are very important to financial institutions. They cover a variety of capital markets transactions that are vital financing and risk management tools, including foreign exchange transactions, securities contracts, forward contracts, commodity contracts, repurchase agreements (also known as repos) and swaps and options on interest and exchange rates, credit defaults, and equity and commodity prices. Although they are technical in nature, they will reduce legal uncertainty, reduce risk to individual banks, reduce systemic risk by making it less likely that a large default by a single financial institution will have a domino effect on other institutions, and enhance the liquidity of the financial markets.

Let me explain why this bill is so important. There are a number of beneficial effects the bankruptcy law governing a defaulting party allows the enforcement of close-out and netting provisions of a master agreement and doesn=t make them subject to any stays, or doesn=t allow the conservator or receiver to Acherry pick@ -- cherry picking enforces transactions that are favorable to the defaulting financial institution but repudiates transactions that are favorable to the non-defaulting party.

First, it allows credit providers under these contracts to calculate their exposure to their counterparties with certainty. At any moment in time, they can calculate the amount the counterparty would owe, without fear that the counterparty or its receiver or conservator can demand performance of transactions where the defaulting party owes money, but disavow transactions where the defaulting party is owed money.

Second, it reduces risk, by reducing the credit provider=s exposure from the gross to the net amount. This makes it more likely that creditors will continue to do transactions with counterparties whose credit is deteriorating, which can be important to allow them to manage their risks as they attempt to strengthen their financial position. It also makes it less likely that a single large default will have a ripple effect throughout the financial system. One statistic will show you how important netting can be. My own institution is a major dealer in financial products, most of which fall within the definition of swap agreements under the Act. As a result of the legal certainty provided by FDIA for close-out and netting, my institution is able to reduce its risk to domestic financial institutions in the neighborhood of 90%.

Third, under the risk-based capital rules of the banking regulators, reduction in counterparty obligations through netting of obligations and close-out and set-off of collateral enables banks to reduce their capital needs, which enables them to reduce their prices.

Finally, by increasing certainty and reducing risk and cost, it enhances the liquidity of the global financial markets.

Congress has recognized the vital economic role that these financial contracts perform by providing protections for them in the nation=s bankruptcy laws. Unfortunately, the pace of innovation in the financial markets has outstripped current law. In addition, the bankruptcy laws governing banks and those covering non-bank corporations are in two separate statutes -- the FDIA and the Bankruptcy Code, and there are now some inconsistencies between the two statutes. That means that, sometimes, the enforceability of a creditor=s rights under a master agreement can depend on what type of entity its counterparty is. That is why it is important that final legislation include changes to both bankruptcy and banking law, as H.R. 1161 would do.

Increased Legal Certainty for OTC Derivatives

The Roundtable generally supports the recommendations included in the report by the President=s Working Group on Financial Markets entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act and urges Congress to pass legislation during this session. The OTC derivatives market has for too long a period of time been subject to uncertainty over the role of the Commodity Futures Trading Commission in regulating OTC derivatives. Arguably, the current approach of the Commodity Exchange Act to allow the CFTC to exempt certain OTC derivatives could be improved, in particular by a legislative approach. The Roundtable wishes to commend Chairman Leach, Representative LaFalce and Capital Markets Subcommittee Chairman Baker and Representative Kanjorski for introducing H.R. 4203. This legislation is an important step in reducing systemic risk and does much to resolve a number of issues of concern to the OTC derivatives market. We specifically commend the sponsors for the provisions of the bill that carry out the recommendations of the President=s Working group on clearing. This legislation also reflects the spirit of cooperation that was evident in the recommendations of the President's Working Group on Financial Markets.

We believe it is important that Congress move quickly to enact these proposals since today=s markets are evolving at an increasingly rapid pace. At the same time, we believe a competitive and innovative futures industry is important for the continued growth of the derivatives market. In this regard, the efforts of CFTC Chairman Ranier to reform the regulatory focus of the CFTC into more of an oversight approach is to be commended.

The Roundtable agrees with the Working Group that bilateral swap agreements involving financial commodities between institutional counterparties be excluded from regulation under the CEA. This exclusion will enhance legal certainty and enhance the position of the United States as a major financial center. The Roundtable would also suggest that legislation clarify that all individually negotiated bilateral swap agreements that are not executed on an organized exchange, including those involving non-financial commodities, are not subject to regulation under the CEA. The Roundtable also agrees with the Working Group that the most effective way to deter and pursue fraudulent activity in the OTC derivatives market is to utilize existing supervisory structures.

The President=s Working Group Report cites the price discovery function as an element that distinguishes a futures exchange from an OTC electronic trading system. In our view, the price discovery function of a futures exchange is important inasmuch as it helps prevent market manipulation. An OTC derivative trading system may serve a price discovery function for the professional market, but this characteristic should not entail CEA inclusion or CFTC supervision. The swap market, for example, may conceivably serve as a benchmark pricing mechanism for the United States debt markets, given the current plans of the Treasury Department to retire federal government debt. It would be unfortunate if legal or regulatory uncertainty prevented the markets from exploring the possibility.

The Roundtable also supports the Working Group's recommendation that electronic systems for trading financial derivatives which limit participation to institutional counterparties trading for their own accounts be excluded from regulation under the CEA. We believe that any safety and soundness issues can be handled in a satisfactory way by the OTC derivatives market within its existing regulatory structure, and that the exclusion under discussion be applicable as well to internet-based systems. 

The Roundtable echos the clarification proposed by the Working Group to ensure that swaps may be cleared without subjecting the underlying transaction to regulation under the CEA. This will help to Amutualize@ the risk from such instruments and promote netting in the event of insolvency. The Roundtable agrees with the Working Group that such a change should include statutory oversight of clearing systems for OTC derivatives by the CFTC, Federal bank and securities regulators and appropriate foreign financial regulators.

The President=s Working Group Report cites the price discovery function as an element that distinguishes a futures exchange from an OTC electronic trading system. In our view, the price discovery function of a futures exchange is important inasmuch as it helps prevent market manipulation. An OTC derivative trading system may serve a price discovery function for the professional market, but this characteristic should not entail CRA inclusion of CFTC supervision. The swap market, for example, may conceivably serve as a benchmark pricing mechanism for the United States debt markets, given the current plans of the Treasury Department to retire federal government debt. It would be unfortunate if legal or regulatory uncertainty prevented the markets from exploring the possibility.

Another proposal by the Working Group, to replace the term "board of trade" with "organized exchange" will eliminate a great deal of uncertainty and forestall much of the litigation that has arisen in this area. We trust this legislative change will enhance the possibilities of such services being located in the United States. 

The Roundtable would also like to reiterate our support for the Working Group's conclusion that no current need has been demonstrated to regulate OTC derivatives dealers, most of whom are already subject to direct and indirect regulatory oversight.

We support the efforts of this Committee to move forward with legislation to implement the President=s Working Group recommendations and we wish to reiterate our support for the clearing provisions in the bill. We believe in the spirit of cooperation evident in the President=s Working Group report and believe that by working together these recommendations can be implemented.

We believe it is important that Congress move quickly to enact these proposals since today=s markets are evolving at an increasingly rapid pace. At the same time, we believe a competitive and innovative futures industry is important for the continued growth of the derivatives market. In this regard, the efforts of CFTC Chairman Ranier to reform the regulatory focus of the CFTC into more of an oversight approach is to be commended.

Hedge Funds

Now, let me turn to the hedge fund legislation. The Roundtable suggests several clarifying and technical changes that we believe will conform with the stated intent of this legislation. We would suggest that the definitions section be adjusted to reflect that hedge funds or private equity funds affiliated with institutions already subject to supervision or examination of a federal banking agency be exempt from the additional reporting requirements of the bill. We would also suggest that the definition in the securities section be amended to reflect that broker dealers or affiliates of broker dealers who are subject to the Holding Company Risk Disclosure Act requirements of section 17H of the 1934 Act be exempt. We would also respectfully suggest that some changes may need to be made to the Judicial Enforcement of Orders section of the bill so that an appeal of a lower court decision could be reviewed by the Court of Appeals.

The Roundtable is concerned that Section 6 of the Act would create burdensome requirements on publicly traded companies with little or no benefits. Under GAAP, all publicly traded companies must publicly disclose the amount and the nature of material and potential liabilities. Requiring disclosure of equity, loan or other credit exposures to significantly leveraged financial institutions, including Acommercial banks, investment banks, finance companies and unregulated hedge funds@ would burden financial institutions by creating separate but redundant disclosures for companies that invest or lend to such companies.

The Roundtable is also concerned with the Aextra-territorial@ issues raised by Section 5(a)(2). This section, which would allow the Federal Reserve Board to apply the requirements of Sections 3 and 4 of the bill to foreign funds, may have the unintended consequences of discouraging foreign funds from doing business with U.S. financial institutions or accepting U.S. investments. As a result, U.S. firms may be shut out from entering into swaps, taking equity positions, or providing credit to foreign funds.

If these technical changes are adopted, the Roundtable would have no objection to the passage of this legislation.

Conclusion

Mr. Chairman and members of the Committee, on behalf of the Financial Services Roundtable, I appreciate the opportunity to appear before you today and to have the opportunity to express our support for speedy action on the recommendations of the President=s Working Group. I and the Roundtable stand ready to assist you in your endeavors.



 

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