C. Robert Paul
Commodity Futures Trading Commission
Before the U.S. House of Representatives
Committee on Banking and
April 11, 2000
Thank you Chairman Leach and members of the Committee. I am pleased to be here to testify before you today on behalf of Chairman Rainer and appreciate the opportunity to discuss the following topics: (1) the recommendations of the President's Working Groups "Report on Over-the-Counter Derivatives Markets and the Commodity Exchange Act"; (2) the Commissions regulatory relief initiative; and (3) the recommendations of PWGs "Report on Hedge Funds, Leverage, and the Lessons of LTCM," H.R. 2924, and the Commissions proposed new Rule 4.27, governing commodity pool operator reporting.
The PWG Report on OTC Derivatives Markets and the CEA
Our country's position in the over-the-counter derivatives market is affected by uncertainty over the legal status of many derivatives transactions. This uncertainty turns on whether or not transactions could be invalidated under the CEA.
The members of the Working Group are unanimous in their assessment of Americas national economic priorities for the over-the-counter derivatives markets. The goals of the PWGs recommendations are:
The ability to achieve these goals will be enhanced by greater legal certainty for the OTC market. Congressional action to exclude OTC financial derivatives from the Act would provide such certainty. OTC derivatives transactions as we know them today do not present regulatory concerns within the scope of the CEA. Excluding this activity will not diminish the CFTCs ability to carry out the statutory mission it is charged to fulfill.
When the Commodity Exchange Act was written, Congress articulated the rationale for regulating futures transactions. First, the Act acknowledges the economic utility of futures trading, stating that futures prices "are generally quoted and disseminated throughout the United States and in foreign countries as a basis for determining prices to the producer and the consumer of commodities ." In addition to their price discovery function, futures transactions are used by commercial entities "as a means of hedging themselves against possible loss through fluctuations in price." CEA Section 3.
The second element of Congresss rationale for regulation is that the "transactions and prices of commodities are susceptible to excessive speculation and can be manipulated, controlled, cornered or squeezed ." The risks of price distortion and manipulation are the factors "rendering regulation [of these markets] imperative ...." CEA Section 3. Congress thus identified the overarching public mission of the CFTC as that of preventing price manipulation and ensuring price transparency.
Like exchange-traded futures, OTC derivatives are risk-shifting instruments. The Working Group, however, has determined that, unlike futures, "prices established in OTC derivatives transactions do not serve a significant price discovery role." PWG Report at 16. The Working Group also has concluded that "[m]ost OTC derivatives are not susceptible to manipulation." Id.
According to the Bank for International Settlements, 72 per cent of OTC derivatives are interest rate contracts and 26 per cent are foreign exchange contracts.1 A report issued recently by the Office of the Comptroller of the Currency stated that interest rate contracts constitute 79 percent of derivatives held in U.S. commercial banks. Interest rate and currency products, which together comprise 98 per cent of the OTC derivatives market, do not present the concerns Congress addressed in mandating the regulation of futures.
Moreover, OTC transactions are entered into and traded by sophisticated institutional traders, who are able to look out for themselves in these markets. Also, most dealers in the swaps market are either affiliated with broker-dealers or futures commission merchants that are regulated by the SEC or the CFTC or are financial institutions that are subject to supervision by federal bank regulatory agencies. Therefore, the activities of most derivatives dealers already are subject to direct or indirect regulatory oversight. PWG Report at 16. Because there is no manifest regulatory interest warranting CFTC oversight of most OTC derivatives, Chairman Rainer supports the exclusion proposed by the Working Group.
Congress and the CFTC have acted before to resolve legal uncertainty affecting OTC derivatives. In 1992, amid strong signals that swaps market participants feared their contracts could be declared unenforceable, Congress responded decisively, strongly encouraging the CFTC not to regulate swaps entered into by sophisticated parties. Congress authorized the CFTC to provide exemptive relief for swaps without requiring the agency to make a threshold determination that particular exempted transactions fell within its jurisdiction.2 The CFTC promptly issued a rule exempting swap agreements from most provisions of the Act except prohibitions against fraud and manipulation, provided the swaps meet certain conditions.
The CFTC's swaps exemption worked relatively well. Lately, however, evolution in the OTC derivatives market has rendered the exemption inadequate for some purposes.
The swaps exemptive rule does not apply to OTC contracts that are standardized, cleared, or executed under conditions that approximate those of an organized exchange. Technology, however, is dramatically changing the structure and nature of many aspects of the financial services industry. The rise of electronic, screen-based trading has blurred the line drawn in our swaps exemption between bilateral and multilateral trading. The growth in swaps volume and the acceptance of these contracts by a wider range of users have led to their standardization. Public policy must meet these advances in the OTC market.
Chairman Rainer shares the belief with the other members of the Working Group that the development of regulated clearing systems should be encouraged. Clearing systems can employ a variety of risk management tools, such as mutualizing risk and offsetting multiple obligations. Consequently, clearing systems help reduce systemic risk by lowering the possibility that the failure of a single market participant could disproportionately disrupt the overall market.
Apart from legal certainty issues regarding OTC derivatives, the Working Group report contains recommendations aimed at clarifying the regulatory framework for Treasury Amendment products. To address the problems associated with foreign currency bucket shops, the Working Group recommended that the CEA be amended to give the CFTC explicit jurisdiction over unregulated entities that sell foreign exchange instruments to the retail public at large.
Abusive promoters have exploited regulatory gaps to sell foreign currency contracts to financially unsophisticated individuals, making exaggerated claims of profit opportunities and failing to disclose the risks of these inherently volatile instruments. Promoters often prey upon senior citizens, recent arrivals in this country and other vulnerable segments of society. Many of these enterprises simply pocket investor funds; others channel funds to currency markets, but typically do so without adequate segregation or disclosure. As fraudulent foreign exchange companies proliferated, the agency in 1998 issued a consumer advisory through the mass media warning the public about these schemes. Cases filed by the CFTC against illegal foreign currency operations during the 1990s have involved more than $250 million in customer funds.
Courts in which the CFTC has brought enforcement actions have reached varying decisions regarding our jurisdiction over these instruments. In those jurisdictions where we have not been foreclosed judicially from enforcement action, we continue to move aggressively against retail foreign currency fraud. We also cooperate with state, local and other federal authorities to bring a halt to this activity. The Working Group asks Congress to clarify the CFTC's authority to regulate these instruments so that it may provide a stronger deterrent to fraud and abuse while providing a zone of comfort and rational oversight to legitimate enterprises that want to offer foreign currency contracts to the retail public.
The CFTCs Regulatory Relief Initiative
The Working Group also acknowledged that the CFTC should conduct an inquiry into whether the current regulatory scheme is appropriately tailored to today's environment for exchange-traded futures. During the past several months, the agency has undertaken a serious effort to answer the question: what degree of exchange-traded regulation is necessary to serve the public interests entrusted to us?
Chairman Rainer has identified three public policy goals on which the CFTC should focus in evaluating its approach to regulating derivatives markets: first, creating a comfortable climate for competition in all sectors of the industry; second, removing any regulatory barriers that hamper these markets from fully exploiting innovations in technology; and third, decreasing the level of systemic risk in domestic and international derivatives trading. To achieve these goals, it is imperative to modernize the way we regulate futures markets.
Accordingly, a staff task force of the Commission has been directed to scrutinize the continued vitality and viability of the one-size-fits-all regulatory structure that currently applies to all futures transactions. While that process is not yet complete, two clear principles have emerged: one, the historic needs of traditional physical commodities should not be the basis for regulating every futures contract traded today; two, institutional market participants do not require all of the protections designed for retail traders.
The staff task force has proposed a new regulatory framework that would change the regulatory structure for derivatives. The proposed framework is intended to promote innovation, maintain U.S. competitiveness, reduce systemic risk, and protect derivatives customers. At its core, this plan will afford market participants the opportunity to operate in a regulatory environment suited to the product traded and the participants trading it. The key policy elements of this plan include a move from direct to more oversight regulation; a move from prescriptive rules to flexible performance standards; and the increased use of disclosure-based regulation.
This plan will not impair the agencys ability to assure the fundamental market integrity that is expected when conducting futures exchange transactions in the United States or when relying upon the prices set in U.S. exchange-traded markets. The Commission will continue to exercise its authority to oversee the continued integrity of markets and their prices. Any proposal ultimately adopted will not be tailored to the desires of any special interest or driven by jurisdictional concerns. We want to find solutions that serve the public interest.
The new framework is a work in progress; it is a staff document on which there has been no Commission action. The CFTC will hold at least one public hearing on this proposal to get as much input as possible from markets and participants. But we also recognize that time is not our ally. In spite of the difficulty of developing answers to questions of regulatory architecture, we must work together to expeditiously reach conclusions suitable for these markets and the public interest. Technology offers us tangible benefits that are imminent: faster and better execution; significantly lower transaction costs; cross-market clearing, netting and offsetting systems; and increased liquidity. The U.S. futures industry must embrace technology without reservation to build stronger markets if they expect to remain competitive.
Flexibility is the hallmark of the new framework. The staffs proposal recommends that the Commission replace the current one-size-fits-all regulation for futures markets with a structure that would instead apply broad, flexible "core principles," which are tailored to match the degree and manner of regulation to a variety of market structures. Under this proposal, multilateral trade execution facilities would operate in one of three categories, taking into account the nature of the underlying commodities and the sophistication of customers. While the framework invites change, it does not impose it on established futures exchanges. Existing exchanges operating as contract markets may reorganize under the terms of the framework, but they are not compelled to do so.
The framework offers the following three basic categories of exchanges or trading facilities correlating to a spectrum of regulation: recognized futures exchanges, recognized derivative transaction facilities and exempt multilateral trading facilities.
The category of recognized futures exchange ("RFE") would include multilateral transaction execution facilities that permit access to any type of customer, institutional or retail, and that trade any type of contract, including those that are based on commodities that have finite deliverable supplies or cash markets with limited liquidity. Because these markets trade products that may have a greater susceptibility to price manipulation and because the presence of non-institutional traders participating here raise deeper concerns for customer protection, RFEs would be subject to a higher level of Commission oversight than markets in either of the other two categories.
Nonetheless, the proposed RFE offers significant regulatory relief compared to the current requirements applicable to designated contract markets. Detailed, prescriptive rules would be replaced with 15 broad "core principles." These include principles relating to market surveillance, position reporting, transparency, fair trading, and customer protection. Any board of trade, facility, or entity that is currently required to be designated as a contract market would be eligible to qualify as an RFE.
The second category, the derivatives transaction facility ("DTF"), would be subject to a lesser degree of Commission oversight. A facility would be eligible to become a DTF if: (i) the contracts traded on the facility are for underlying commodities that have nearly inexhaustible supplies or for which there is no underlying cash market; (ii) the Commission determines on a case-by-case basis that the contracts would be appropriate for this level of regulation; or (iii) the facility limits access to commercial traders only.
A DTF would be required to adhere to seven core principles, including those relating to market oversight, transparency, and recordkeeping. Because a DTF would either be limited to commodities that are not susceptible to manipulation or because it would limit access to institutional or commercial participants, a DTF would not be required to adhere certain other core principles applicable to an RFE, such as those relating to position monitoring, customer protection or dispute resolution.
Finally, the third category, the exempt multilateral transaction execution facility ("Exempt MTEF"), would operate on an unregulated basis. This would be a self-effectuating exemption for transactions among institutional traders in commodities with supplies that are unlikely to be susceptible to manipulation.
These markets would be exempt from all requirements of the Act and Commission regulations except for anti-fraud and anti-manipulation. If a designated contract market chooses to trade an eligible contract on an exempt-MTEF, however, the MTEF would be required to continue to provide pricing information to the public. The terms of the exemption would also provide that transactions consummated in reliance upon the exemption would not be void as a matter of law if the transaction does not fully comply with all provisions of the exemption. Lastly, exempt MTEFs would not be permitted to hold themselves out to the public as being regulated by the Commission.
Hedge Fund Disclosure
On April 30, 1999, the PWG released its report entitled "Hedge Funds, Leverage, and the Lessons of [LTCM]." The members of the PWG unanimously recommended, among other things, that (i) registered large CPOs should be required to file with the Commission quarterly, rather than annually, reports of financial information; (ii) these reports should include more "meaningful and comprehensive measures of market risk (e.g., value at risk or stress test results), without requiring the disclosure of proprietary information on strategies or positions"; and (iii) these reports should be made available to the public.3
On September 23, 1999, Representative Baker introduced a bill (H.R. 2924) that would require otherwise unregulated hedge funds to report certain financial and risk information to the Federal Reserve Board. As amended on March 16, 2000, and referred to this Committee, this legislation would require each unregulated hedge fund or family of funds with total assets of $3 billion or net assets of $1 billion to report to the Board on a quarterly basis "[m]eaningful and comprehensive financial information (such as a complete set of financial statements )" and "[m]eaningful and comprehensive measures of risk (such as value-at-risk or stress test results)."4
Commission staff have drafted a proposed Rule 4.27 in accordance with the PWG recommendations and which parallels the requirements of the Baker legislation. Rule 4.27 would affect the operators of the largest commodity pools with respect to each pooled investment vehicle under their direct or indirect control. They would file an initial report providing summary descriptions of their risk management practices and quarterly reports that would disclose financial information and information about the exposure of the pool to market risk over the course of the quarter (but would not reveal positions or trading strategies). Such reports would be made available to the public by the CFTC via posting on the Commission website.
Proposed Section 4.27(b) would define a reporting person as a commodity pool operator that, at the end of a quarter, controls one or more pools with either controlled total assets of at least $3 billion or controlled net assets of at least $1 billion. This is intended to limit reporting to those CPOs whose activities could reasonably affect systemic risk effects. To avoid excusing a CPO from reporting when it would be most critical, that is, when the CPO is experiencing severe losses, the rule would require reporting by any CPO that has met the thresholds at the end of any of the past three quarters. Based on filings received under existing rules, approximately 25 CPOs would be required to report under the proposed rule.
If adopted, the rule would require each reporting person to file two types of reports: (i) quarterly reports of quantitative financial and risk exposure information and (ii) an initial qualitative description of risk management practices. Each quarterly report would be filed within 30 days of the end of each quarter and would contain key financial information (statements of income, financial condition, changes in financial position, and changes in net asset value). The CFTC would publish the reports on its website within one business day.
To portray risk exposures accurately, the proposed rule calls for quarterly reports to contain quantitative risk information. The most widely accepted method for measuring market risk exposure is value-at-risk. VAR represents the largest dollar loss which is expected to be suffered over a given "holding period" with a given degree of certainty or "confidence level."5 VAR incorporates correlations among positions in a portfolio without revealing those positions, so it does not compromise the confidentiality of a firms trading strategies.
The proposed rule would encourage firms to use accurate and reliable VAR models by mandating disclosure of backtesting results. Backtesting is the process by which losses implied by the VAR calculation are compared to losses experienced. The results of the comparison provide valuable information about the validity of the VAR model, allowing other market participants to reach their own conclusions as to the accuracy of the VAR calculations and the adequacy of risk management practices.
VAR represents merely the loss that is not expected to be exceeded under "normal" market conditions; it provides no information about the possible extent of losses under "abnormal" market conditions. A fund can explore the potential extent of such extraordinary losses only by conducting stress tests which involve subjecting models of its positions to extreme market conditions. These might include historical conditions, such as the 1987 stock market drop or 1998 Russian loan default, or hypothetical scenarios designed specifically for the funds current positions.
The results of properly performed stress tests can show extraordinarily high hypothetical losses, however, and if reporting persons were compelled to publicly disclose stress test results they might be discouraged from performing the most rigorous stress tests. Therefore, the proposed rule does not require reporting persons to report stress test results. Rather, reporting persons would be required simply to report whether stress tests have been performed during the quarter and, if so, whether the results of such tests are communicated to an appropriate level of management.
Because no specific parameters or methodologies for monitoring risk exposures are mandated by the proposed rule, some additional information must be made available to enable the quarterly reports to be understood in proper context. The proposed rule would therefore require each reporting person to submit, along with the first quarterly report, a narrative description of their risk management practices in five areas. These areas cover the reporting persons policies, procedures, and systems for supervising, monitoring, and reviewing market risks, credit risks, and funding liquidity risks generated by its financing, trading, and investment activities. It is important to note that this would only have to be done once, with revisions required only if there is any material change in those policies, procedures, or systems.
The rule would not require reporting persons to use any particular set of tools. Rather, reporting persons would be required to disclose general information about their use of such tools. This is intended to foster improvements in private sector risk management as market discipline encourages adoption of best practices as such evolve in the industry.
The proposed rule does not require or envision that the CFTC perform any type of analysis of the CPO reports. The rule is intended to give the marketplace an enhanced level of information; the CFTC, under this proposal, acts as the conduit of that information. The public should not assume that the reporting of such information to the CFTC constitutes any agency review of the soundness of the reporting entities.
Thank you again for the opportunity to testify before you today. Chairman Rainer looks forward to continued collaboration with the rest of the Working Group and with Congress to see these recommendations enacted into law this year.
1. Bank for International Settlements, Press Release, The Global OTC Derivatives Market at End-December 1998 (June 2, 1999).
2. See Conf. Rept. 102-978, Futures Trading Practices Act of 1992, at 81-82 (Oct. 10, 1992).
3. PWG Report at 32-33.
4. H.R. 2924, 106th Cong., 1st Sess. (2000).
5. As used herein, the term "loss" means any adverse change in the value of a pools portfolio, whether realized or unrealized.