End-Users of Derivatives Council
Association for Financial Professionals
U.S. House of Representatives
Banking and Financial Services Committee
James A. Leach, Chairman
Tuesday, April 11, 2000
William P. Miller, II
Senior Vice President and Independent Risk Officer
Commonfund, and Chairman
End-Users of Derivatives Council
STATEMENT OF END-USERS OF DERIVATIVES COUNCIL OF THE
ASSOCIATION FOR FINANCIAL PROFESSIONALS BEFORE THE
UNITED STATES HOUSE OF REPRESENTATIVES
COMMITTEE ON BANKING AND FINANCIAL SERVICES
JAMES A. LEACH, CHAIRMAN
April 11, 2000
Good Morning, Mr. Chairman and members of the Committee on Banking and Financial Services. I am William P. Miller, Senior Vice President and Independent Risk Officer of Commonfund, which provides investment management services for educational institutions. I am honored to offer this statement on behalf of the End-Users of Derivatives Council of the Association for Financial Professionals (AFP), formerly the Treasury Management Association.
Founded in 1994, the Council has represented over sixty organizations that use derivatives to manage risk, and has been in the forefront of end-user development in the derivatives market since its inception.
AFP represents over 12,000 finance and treasury professionals who, on behalf of over 5,000 corporations and other organizations, are significant participants in the nations payment systems, credit and capital markets. Many members are responsible for their organizations' derivatives activities with the primary objective of risk management. Organizations represented by members are drawn generally from the Fortune 1000 and the largest of the middle market companies, and they have an active interest and sizable stake in any regulatory and legislative changes affecting usage of derivatives.
Our statement addresses H.R. 2924 regarding the public disclosure of leverage and risk information by hedge funds, and the Report of the Presidents Working Group on Financial Markets on Over-the-Counter Derivatives Markets and the Commodity Exchange Act (CEA). We commend the Committee for focusing on the difficult and important issues related to hedge funds and the issues put forth in the Report of the Presidents Working Group. The fast changing market for financial services in general, and derivatives in particular makes your considerations very timely. We have attached to our statement two surveys conducted by the Association for Financial Professionals1 which should help you in your deliberations: "The 1999 Survey of OTC Derivatives Use and Risk Management Practices", and "The Internet and the Changing Financial Services Marketplace".
With regard to H.R. 2924, a "bill to require hedge funds to submit regular reports to the Board of Governors of the Federal Reserve System, to make such reports available to the public to the extent required by regulations prescribed by the Board, and for other purposes." There are three reasons why our members are interested in this bill. First, as financial professionals, we are concerned about the environment in which we operate on behalf of the organizations that employ us. We need a stable financial environment with safe and sound financial institutions to provide financial services. Second, as users of derivatives, we are concerned that the actions of large hedge funds which use derivatives for trading and investment purposes might have negative effects on the markets for derivatives in general. The development of many derivative instruments has been a major advance for our members in the management of risk. We want to make sure that these advances are maintained. Finally, some of our members may occasionally invest in hedge funds.
We support the disclosures H.R. 2924 seeks to promote in section four public reports about the financial positions of unregulated hedge funds. Such disclosures would assist regulators in assessing potential dangers that might arise for the financial system at large because of the positions of large unregulated hedge funds. They could also assist individual market participants in deciding whether a particular hedge fund is an appropriate investment. The availability of such reports would act as a disciplinary force on the hedge funds that is absent in todays markets. Both uses of this disclosure would be positive for our members and the public at large.
We have some concerns about the different types of disclosure called for in section six. This section would require, through regulations to be prescribed by the Securities and Exchange Commission (SEC), that "every public company should regularly and publicly disclose a summary of direct material exposures to significantly leveraged financial institutions ." Most of our companies that are publicly traded have experience with disclosing direct material exposure to financial institutions. However, they may not have experience with disclosing exposures to "significantly leveraged institutions. Presumably the SEC will determine the definitions of "significantly leveraged institutions" and "direct material exposures." It is our hope that such definitions can be formulated in a way that would be fair to all financial institutions and informative to investors in public companies. Also, it is important that the information about institutions that are significantly leveraged be made public and easily available to companies that have direct material exposures. If these two objectives cannot be met, the regulations may be so burdensome and distorting in their character as to be counterproductive and inhibit the efficient flow of capital and the management of risk. If these objectives can be met, the proposed disclosure may also have the effect of properly disciplining financial institutions without inhibiting the efficient flow of capital.
With regard to the Presidents Working Group on Financial Markets report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act (CEA), we understand Chairman Leachs draft legislation, "The Over-the-Counter Derivatives Systemic Risk Reduction Act", which we have not had the opportunity to examine in detail, is consistent with the recommendations in this report. Our members and the firms they represent generally share the view, embodied in the Presidents Working Group Report, that it is time to modernize the legal and regulatory structure governing domestic derivatives markets, including the Commodity Exchange Act (CEA). Globalization of the economy and increasing business and investment competition have intensified the needs of our membership for the essential risk management tools that over-the-counter (OTC) and exchange-traded derivatives provide. At the same time, the current regulatory structure limits the array of available products and delivery alternatives, imposes unnecessary legal risks and associated transaction costs on market participants, and unnecessarily impedes our members access to potentially significant "dealer only" trading markets.
Consequently, we urge that Congress update the CEA: (1) to give legal certainty to privately-negotiated, bilateral swap transactions - including equity swaps - covering financial commodities and entered into between "eligible swap participants" acting in a principal capacity; and (2) to encourage the innovation and growth of appropriately regulated electronic trading systems and clearing facilities. We also urge Congress: (3) to take measures to ensure that by permitting appropriately regulated OTC electronic trading systems and clearing facilities it does not impose unfair competitive disadvantages on regulated exchanges; (4) to encourage the establishment of an alternative to the OTC market for less sophisticated end-users in which they could access risk management tools in a more controlled environment; and (5) to reconsider the restrictions on futures on securities contained in the "Shad/Johnson Accord"provisions of the CEA.
We agree with the Presidents Working Group that achieving legal certainty in swap transactions is crucial. Swap market participants - especially dealer institutions in all their counterparty relationships, and end-users when they transact directly with other end-users without the intermediation of a dealer - knowingly confront real enforceability concerns. They must deal with the residual risk that their counterparties (or more likely their counterparties trustees or receivers in bankruptcy or insolvency) may seek to avoid the performance of their obligations under, or to recover losses on, contracts based solely on the contracts failure to comply with the terms of an exclusion or exemption under the CEA.
It is impossible to quantify the costs of the legal uncertainty with which markets are faced. Nevertheless, one can safely say that any legal uncertainty presents an avoidable danger to todays enormous and extremely efficient global swaps markets, which operate on thin margins and high volumes and depend on legal certainty for their economic viability. Given the size and importance of swap markets, legal uncertainty implies systemic risks and could have profound consequences in the event of future market turmoil or instability.
Because of the importance of swap markets to our members institutions and to the overall economy, we urge Congress to modify the CEA to provide for legal certainty of swap transactions. As we have previously testified, a possible solution to this legal uncertainty would be either: (1) to determine unequivocally that swaps are not covered by the CEA; or (2) to exempt swaps from the exchange-trading requirement of the CEA even if they are at some point considered to be futures.
Electronic Trading Systems and Clearing Facilities.
We agree with the Working Group that the introduction of electronic trading systems for OTC derivatives has the potential to promote efficiency, transparency and liquidity, to lower transaction costs and improve internal controls, and thus to mitigate systemic risk. Therefore we support the Working Groups conclusion that entering into or trading excluded swap agreements through electronic trading systems "does not provide a basis for regulation of the systems." In addition, we are troubled by the unintended consequences of CFTC regulations that have led the creators of new systems, in order not to violate the CEA, to exclude end-users, including those that are eligible swap participants. If valid public policy reasons for limiting electronic systems only to dealers exist, they have been neither clearly nor persuasively articulated. Given the potential efficiencies and systemic risk management benefits of electronic trading systems, we believe that the CEA should not prohibit such systems, and that steps should be taken to ensure that it does not operate to exclude from those systems any eligible swap participants.
Perhaps the most prominent new swaps system is the "Blackbird" system, an electronic "dealer only" market for the trading of bi-lateral interest rate and currency derivatives transactions, recently established by Derivatives Net. The fundamental regulatory argument of Blackbird (see, generally, Statement of Shawn A. Dorsch, President and Chief Operating Officer of DNI Holdings, Inc., concerning Re-authorization of the Commodity Exchange Act, before the Committee on Agriculture, Nutrition and Forestry, U.S. Senate, September 23, 1999) and presumably of any other dealer only electronic system is that such systems are nothing more than "electronic analogs" of existing voice brokers who now serve swap dealers. As with Blackbird, such systems would do nothing other than provide their users with computer-based electronic communications systems that serve as more efficient alternative means for the direct negotiation and agreement of bilateral transactions otherwise excluded or exempted from CEA coverage. They would not constitute exchanges or clearinghouses, nor would they enter into transactions, provide credit support, take or add credit risk, or change the individual customized nature of swaps.
In our view, electronic trading systems present compelling opportunities to improve the efficiency and transparency of swap markets for the benefit of all market participants and the financial system. Participants would enjoy access to a vastly superior means than that currently provided by voice brokers of determining market prices and other contract terms. It is immensely easier and quicker to assess market demand and swaps pricing by scrolling through a list of screen generated bids and offers rather than by canvassing brokers telephonically. Furthermore, contract execution is speedier, more efficient and less prone to error when conducted electronically than when conducted either telephonically or by facsimile. Finally, electronic trading systems should enhance the integrity of users internal controls by creating real time audit trails that limit the errors that might otherwise arise from paper-based systems. And by providing real time pricing, such systems could also greatly enhance the ability of participants to monitor and control counterparty risk limits and performance assurances and to manage the risks of their entire portfolios.
Electronic systems should contribute to the efficiency of swaps markets without either distorting the price discovery function or presenting any material opportunities for market manipulation. As the Working Group notes, markets for financial derivatives, the vast majority of which are settled in cash, generally take their prices from separate markets for financial commodities. Thus they "do not serve a significant price discovery function." Furthermore, the prices of financial commodities are not easily manipulated, because the separate markets for financial commodities have a "very large or virtually unlimited deliverable supply."
For the foregoing reasons, we strongly recommend that the existing regulatory framework be modernized (1) to permit the establishment of electronic trading systems, (2) to provide at a minimum for limited regulation aimed at enhancing market transparency and price discovery and (3) to permit end-users who are eligible swap participants and act on a principal only basis to participate in those systems. Furthermore, our members would oppose any effort to establish a regulatory framework that requires electronic trading facilities to deny access to end-users that are eligible swap participants. The removal of existing artificial regulatory restrictions on the ability of all eligible swap participants to participate fully in OTC derivatives markets should improve the efficiency of the financial system and contribute to more effective market discipline and counterparty risk management.
We also agree with the Working Group that appropriately regulated clearing systems should be permitted under a modernized legislative framework. The Commodity Futures Trading Commission (CFTC) has traditionally considered "the necessity for individualized credit determinations" to be one of the hallmarks of an exempt swap transaction. By interposing a clearing organization between the two counterparties to a swap, clearing systems would obviate the need for individualized credit determinations. But in so doing they would also undermine that traditional hallmark of exempt swaps and thus jeopardize the applicability of established exemptions to contracts that are so cleared.
The question that must be asked, then, is whether the lack of individualized credit determinations due to the use of a clearing system somehow militates in favor of CEA regulation; we believe that it does not. As the CFTC itself has acknowledged in its 1989 swaps policy statement, although clearing organizations have traditionally been hallmarks of futures contracts, they are not necessary to futures contracts. Likewise, not all contracts that are subject to clearing constitute futures. Given the enormous counterparty risk management benefits of clearing systems, as well as the extent to which they promise to mitigate systemic risk, clearing of OTC derivatives ought to be permitted. However, such clearing concentrates credit risk in clearing facilities and thereby renders such facilities integral to the management of systemic risk. Since the risk reduction benefits derived from clearing depend on the viability of the clearing facilities, legislation should be enacted that establishes a clear basis for the regulation of clearing systems, particularly of clearinghouses operations and risk management systems.
Competitive Effect on Regulated Futures Exchanges.
Regulated exchanges play an important role in U.S. capital markets and in systemic risk management. Many of our members depend on exchange-traded products in their own treasury and risk management activities. Yet U.S. futures exchanges are today being bombarded by a number of serious competitive challenges, both domestically and internationally, and these events may ultimately threaten their continuing viability. Most importantly, some argue that if fully enacted, the recommendations of the Presidents Working Group would effectively authorize the development of an OTC derivatives market that would compete directly with the organized exchanges. In such a competition, the argument goes, the exchanges would be vulnerable because they are subject to heavy-handed CEA regulation.
While we do not have detailed suggestions for solving the exchanges competitive dilemma, we do urge that Congress take all precautions to ensure that it does not enact any measures that place U.S. exchanges at unfair competitive disadvantages. We further suggest that rather than not modernize the existing regulatory framework, the preferred approach, subject to our comments set forth immediately below, would be to lift many of the existing onerous restrictions to which exchanges are now subject.
In our view, many of the restrictions to which exchanges are currently subject consist of customer safeguards and protections that will likely warrant retention even in a modernized regulatory environment accessed only by eligible swap participants. We recognize that OTC derivatives markets are and must be markets in which both dealers and end-users are ready, willing and able to assume responsibility for their own actions. (See, e.g., Federal Financial Institutions Examination Council Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities, 63 Fed. Reg. 20191, 20194 (April 23, 1998) ("Irrespective of any responsibility, legal or otherwise, assumed by a dealer, counterparty, or financial advisor regarding a transaction, the acquiring institution is ultimately responsible for the appropriate personnel, understanding and managing the risks of the transaction.") Yet in reality not all end-users and prospective end-users are equally sophisticated, nor of course do they all have the same financial resources, personnel and technological capabilities. Consequently, a large number of end-users still depend heavily on their dealers for information and explanations regarding the fair value and risks of their OTC derivatives. Such dependence increases the risk, especially in times of market volatility or instability, of counterparty disputes and thus potential legal liability.
While we do not believe it would be in anyones best interests to create more stringent rules for derivatives markets based on the sophistication level of participants that otherwise qualify as eligible swap participants, the needs of less sophisticated eligible swap participants need to be addressed. Instead of imposing more stringenthigher sales practices and related standards on dealers who transact with less-sophisticated counterparties, Congress should encourage the development of some form of facility to serve as an alternative to existing OTC markets for those counterparties. Although we have not formulated any detailed plans for such a facility, we suggest that it would be a facility that would trade a limited range of "plain vanilla" products on standardized legal and credit terms.
The Presidents Working Group unanimously recommends that the Securities and Exchange Commission (SEC) and CFTC work together and with Congress to determine whether to permit U.S. trading of single-stock futures and, if so, under what conditions. A closely related issue is the extent to which Congress should permit trading on narrowly defined securities indexes. Our membership generally favors any measure designed to offer markets the broadest possible array of financial products and so we support the Working Groups recommendation. However, we have less certitude on some of the underlying issues.
Some concerns have been raised by our members about the possibility that futures contracts might increase volatility in the price of the underlying stocks. These concerns are tempered by the realization that equivalent volatility may develop from the trading of single-stock options, appropriate combinations of which can replicate the economics of long and short single-stock futures positions. Economic research on volatility impacts relied on by Judge Easterbrook in Board of Trade of the City of Chicago v. SEC, a case cited by the Working Group, dispels some but not all of our members concerns.
Other voices argue in favor of single-stock futures trading in the U.S. because this activity has already emerged in foreign markets. One potential unintended consequence of the current ban on single-stock futures trading is that the only market segments unable to trade single-stock futures on domestic equity securities would be those domiciled in the U.S. Lastly, our members agree generally that significant benefits would likely accrue to market participants who were able to implement risk management and investment decisions by using single-stock futures and futures on narrowly defined equity indexes.
We note that we are currently polling our members to determine, among other things, (i) whether and the extent to which the prohibition contained in the Accord against single-stock futures and futures on most narrowly-based stock indexes has an impact on their risk management practices and (ii) whether they believe that the trading of single-stock futures on securities issued by their institutions would likely increase or decrease volatility of those securities prices.
Regulatory Coordination of the Use of Derivatives Information
As it considers modernizing the Commodities Exchange Act, we urge you to consider creating an inter-agency committee responsible for aggregating and dispersing derivatives related information across each regulator that each has a more complete picture of the overall environment. Appendix II of a recently released document "Sound Practices of Hedge Fund Managers"2 describes the extensive reporting of hedge funds. However, it is clear to us from our experience that regulators would be hard pressed to fully aggregate the global derivatives positions and to assess the derivatives risk position of each major dealer or market participant. It is our understanding that swaps are not reported to any regulator. It is imperative that regulators be able to assess the nature and risks of the entire market, and the nature and risks of each major dealer. Ideally, this should be done world-wide. The inter-agency mechanism we are recommending would facilitate the start of achieving these objectives.
As end-users of derivatives, we favor a market environment in which a wide array of products is available to us, and in which we can access these products as efficiently as possible. We believe that Congress now has before it an opportunity to promote the continued growth of such a market by modernizing certain aspects of the Commodity Exchange Act in the course of reauthorizing the Commodity Futures Trading Commission. Specifically, we support changes in the Commodity Exchange Act that would:
We also urge Congress to take measures to ensure that by permitting appropriately regulated OTC electronic trading systems and clearing facilities it not impose unfair competitive disadvantages on regulated exchanges, to encourage alternative OTC markets for less sophisticated end-users, and to reconsider the restrictions on futures on securities contained in the provisions of the CEA known as the "Shad/Johnson Accord."
We also support the collection of information on the relevant positions of unregulated hedge funds and the disclosure of this information to financial institution regulators and the public.
We appreciate the opportunity to present our views on these far-reaching and complex issues.
1. Prior to October 25, 1999, The Association for Financial Professionals was called the Treasury Management Association. In June of 1999, The End-Users of Derivatives Council merged with the Treasury Management Association.
2. This document was prepared by Sullivan and Cromwell and Rutter Associates of New York with the assistance of five participating hedge funds: Caxton Corporation; Kingdom Capital Management, LLC; Moore Capital Management, Inc.; Soros Fund Management LC; and Tudor Investment Corporation.