MICHAEL A. WATKINS
ON BEHALF OF
THE ABA SECURITIES ASSOCIATION
H.R. 1161, H.R. 2924 AND THE REGULATORY STRUCTURE AFFECTING
OVER-THE-COUNTER DERIVATIVES TRANSACTIONS
COMMITTEE ON BANKING AND FINANCIAL SERVICES
U.S. HOUSE OF REPRESENTATIVES
APRIL 11, 2000
Mr. Chairman and members of the Committee, my name is Michael A. Watkins. I am Deputy General Counsel of First Union Corporation. First Union Corporation is a $253 billion financial holding company based in Charlotte, North Carolina. First Union is the nations sixth largest banking company with banks in 12 states from Connecticut to Florida, as well in the District of Columbia. First Union is also the nations sixth largest broker-dealer with offices in 41 states.
I appear here today, Mr. Chairman, on behalf of ABASA, the ABA Securities Association. ABASA is a separately chartered trade association subsidiary of the American Bankers Association ("ABA"), formed in 1995 to develop policy and provide representation for those bank and financial holding companies involved in, among other things, securities underwriting and dealing and derivatives activities. I should add, Mr. Chairman, that my testimony also reflects the views of the ABA.
Since beginning my career nearly two decades ago, first as a staff lawyer at the Securities and Exchange Commission ("SEC") and at the Commodity Futures Trading Commission ("CFTC"), and later in private practice and as in-house counsel, I have had an opportunity to witness the development of, and help my clients participate in, the growth of the derivatives markets. In my capacity as derivatives counsel to First Union, I am responsible for determining the legal enforceability of derivatives contracts, including the enforceability of contract netting provisions. First Union is active in the global derivatives markets as both a dealer and an end user. First Union makes markets in derivatives related to the interest rate, foreign exchange, equity, commodity and credit markets.
Mr. Chairman, I commend you for holding this hearing on the recent recommendations by the Presidents Working Group on Financial Markets, specifically those recommendations dealing with public disclosure of leverage and risk information by hedge funds; the regulatory structure affecting over-the-counter derivatives transactions; and the netting of financial contracts. These issues are very important to First Union, to the membership of ABASA and the ABA, and to the capital markets as a whole.
Hedge FundsHedge funds are limited liability partnerships or companies formed for the purpose of investing the assets of their partners or shareholders. These partners or shareholders are generally restricted to wealthy and sophisticated investors and, as a result, are largely exempt from regulation under federal law. Specifically, the funds are exempt from regulation as investment companies under Sections 3(c )(1)1 or 3(c )(7)2 of the Investment Company Act of 1940. Moreover, as the interests in these funds are not publicly offered, the interests are also exempt from securities registration under the Securities Act of 1933.3 Finally, most hedge funds are limited to fewer than 500 investors, in order to avoid the periodic reporting requirements of Section 12(g) of the Securities Exchange Act of 1934.4
Because hedge funds are exempt from investment company regulation, they can pursue any investment strategy,5 invest in any type of financial instrument,6 and are able to take concentrated positions in securities of any one issuer or industry sector. Nor are hedge funds restricted in the amount of leverage they can assume or short sale transactions in which they may engage.
Hedge funds assume leverage by engaging in derivatives transactions, repurchase agreements, short sales and borrowing. Not all hedge funds are highly leveraged, however. Indeed, some authorities estimate that 30% of hedge funds use no leverage at all and, of the 70% that do use leverage, 85% have a leverage ratio of two or less.7
It is estimated that, as of year-end 1998, there were over 5,800 hedge funds managing assets in excess of $300 billion with the average size of hedge funds pegged at $93 million.8 Almost half of all hedge funds are foreign, generally based in tax-friendly jurisdictions such as Ireland; Luxembourg; the British Virgin Islands; the Cayman Islands; and the Bahamas.9
Hedge funds provide benefits to financial markets by enhancing liquidity and efficiency. Additionally, they can play a major role in financial innovation and reallocation of financial risk.
H.R. 2924, "The Hedge Fund Disclosure Act"H.R. 2924 implements some of the recommendations issued by the Presidents Working Group on Financial Markets in its report entitled, Hedge Funds, Leverage and Lessons of Long-Term Capital Management. In that report, the Working Group concluded, in the wake of the near collapse of Long-Term Capital Management ("LTCM"), that the principal policy issue to be addressed involved the use of excessive leverage. In addition, the Working Group made several recommendations designed to limit the use of excessive leverage among market participants.
Two of those recommendations form the basis for H.R. 2924, introduced by Congressman Baker and co-sponsored by many members of this Committee, including yourself, Mr. Chairman. Specifically, H.R. 2924 would implement the Working Groups recommendations regarding enhanced disclosure in a simple and straightforward manner. First, large unregulated hedge funds would, under the bill, be required to make additional public disclosure regarding the funds use of leverage. Second, the bill, through a sense of the Congress resolution, declares that all public companies should be required to disclose additional information about their material financial exposures to significantly leveraged institutions, including commercial banks, investment banks, finance companies, and unregulated hedge funds.
Despite our industrys fundamental belief that market forces should provide the necessary discipline to limit the use of excessive leverage by financial institutions, including unregulated hedge funds, the disclosures required for large unregulated hedge funds appear appropriate to address many of our members concerns. For example, amendments made during markup by the Subcommittee on Capital Markets, Securities, and Government Sponsored Enterprises make clear that information to be shared publicly regarding an unregulated hedge fund will not involve any proprietary or trade secret information.
Moreover, the hedge fund disclosure requirements apply to only the largest of hedge funds or families of hedge funds. Specifically, only those funds or fund families with aggregate total assets of $3 billion or more or aggregate net assets of $1 billion or more would be required to submit reports to the Board. This cut-off is appropriate, as smaller funds would not have a significant economic impact.
The bill provides for an exclusion from the definition of unregulated hedge fund for pooled funds that are registered with the SEC; pooled funds that are operated by CPOs, and pooled funds that are subject to supervision by,10 or the reporting requirements of, a federal banking agency. All of these entities are subject to some degree of federal supervision and oversight. Members of ABASA and their affiliates that operate pooled funds would be excluded from the definition of unregulated hedge fund because they are subject to supervision by, or reporting requirements of, a federal banking agency. Further reduction in the burdens imposed by this provision could be achieved, however, if the exclusion from the definition of unregulated hedge fund were expanded to include pooled funds operated by both registered broker-dealers and affiliates of such broker-dealers. This could be accomplished by adding to the list of excluded firms broker-dealers registered with the SEC and their affiliates subject to Section 17(h) of the Securities Exchange Act of 1934. Section 17(h) requires registered broker-dealers to maintain records regarding their policies, procedures or systems for monitoring and controlling financial and operational risks to the broker-dealer firm resulting from their affiliates activities. The SEC can require reporting of this and other additional information if market conditions or the financial and operational risks to the brokerage firm warrant it.
With respect to the provision of the bill that suggests that all publicly traded companies should disclose publicly any material exposures to significantly leveraged financial institutions,11 ABASA would suggest that the Committee delete this provision while the Financial Accounting Standards Board ("FASB") considers the effectiveness of financial disclosures generally. It is our understanding that FASB is studying whether there is too much financial disclosure and whether that disclosure is effective. ABASA would submit that it would be wiser for the Congress to refrain from adding more financial disclosure while the FASB is studying this issue.
Finally, ABASA would urge the Committee to amend Section 5 to provide for appeal of district court orders. Section 5 authorizes the Board, in order to ensure compliance with the bills reporting requirements, to seek enforcement orders from the U.S. district court where the unregulated hedge fund is located. If a hedge fund located in a foreign country borrows from, accepts investments from, or is a counterparty to any person who resides within or is organized under U.S. law, the Board is authorized to seek an enforcement order from the U.S. District Court for the District of Columbia. Section 5 specifically prohibits further judicial review of these orders.
Hedge funds should be entitled to appeal a lower court ruling, especially if there is a dispute as to whether the fund is unregulated, meets the prescribed asset size, has made the requisite disclosure, or has done business with U.S. residents.
Regulation of Over-the-Counter Derivatives Transactions
In general, a derivative is a contract, the value of which depends on, or is derives from, the value of an underlying asset, reference rate, or index. Unlike exchange-traded futures and options contracts which have standarized terms, over-the-counter ("OTC") derivatives such as privately negotiated swaps are custom-tailored contracts. In an OTC derivative transaction, material terms such as the method to determine payments, the underlying asset, reference rate, or index and the maturity of the contract are individually tailored to fit a specific users needs. For example, the maturity of a swap contract--generally one-to-three years--can be extended to match the maturity of an asset or exposure. Payment formulas can be adjusted according to the specific risks to be managed or hedged. Because their terms are not standardized, but are instead unique to each particular transaction, these instruments are not yet traded on exchanges. Many swap transactions use terminology and forms developed during the last 15 years by the International Swaps and Derivatives Association ("ISDA") and are generally accepted as a market standard. As swap transactions involving institutions and sophisticated individuals become more common, our members anticipate that some categories of swaps may become sufficiently "standardized" to permit trading on exchanges and settlement by clearing organizations, much like their financial cousins--futures and options--are today.
Our members use derivative instruments both as end users and as dealers. As end users, commercial banks and investment banking firms, much like other corporations, use derivative instruments to manage their own institutions risks and to reduce funding costs, thereby enabling them to make credit more widely available in their local communities. As of year-end 1999, approximately 400 commercial banks held derivatives contracts for purposes other than trading.12
Many of ABASAs members, including my own organization, also serve as derivative dealers, capitalizing on, among other things, their ability to understand the financial needs and risk management objectives of their many customers, which include banks, financial services firms, corporations, and other sophisticated capital markets participants. OTC derivatives allow these customers to better manage their own particular risks, and they permit greater market innovation in response to changing customer needs.
At the request of the Congress and the Chairmen of the Senate and House Agriculture Committees, the Presidents Working Group on Financial Markets prepared last year a report entitled Over-the-Counter Derivatives Markets and the Commodity Exchange Act. In that report, the Working Group recommended a series of changes to the Commodity Exchange Act ("CEA") that would, among other things, increase the legal certainty for swaps; clarify that certain electronic trading systems for excluded swap agreements are not covered by the CEA; and provide a comprehensive regulatory framework for OTC derivative clearing systems.
ABASA strongly supports the Working Groups recommendation that legal certainty for swaps should be increased. For several years now, ABASA, along with other affected market participants, has consistently urged financial regulators to refrain from taking any action that would jepardize the legal certainty for OTC derivatives. Legal certainty for swap transactions will, we believe, solidify market confidence, decrease transaction costs and risks, and stem the flow of transactions to off-shore jurisdictions with more favorable legal climates.
ABASA is still studying the other recommendations contained in the Working Groups report. We understand that a bill introduced just last week by the Chairman, the "Over-the-Counter Derivatives Systemic Risk Reduction Act of 2000," incorporates many of the Working Groups recommendations. Specifically, this bill would:
The bill only addresses those aspects of the Working Groups recommendations that are most suited to implementation under the banking laws. The bill does not address those aspects of the Working Groups recommendations that require modifications to the CEA or the federal securities laws, including the key issue of whether or not swap transactions are to be excluded from the CEA. We recognize, however, that the Chairman has pledged to work with Chairmen Combest and Bliley in drafting broader, more comprehensive OTC derivatives legislation.
Mr. Chairman, you are to be commended for taking this very positive step toward enacting OTC derivatives legislation. This bill will surely foster discussion on these important issues and, we hope, move all parties toward implementation of many of the Working Groups recommendations. Because many of our members are still reviewing this legislation, we respectfully request the opportunity to discuss this important bill with the Committee and its staff at a later date.
H.R. 1161, "The Financial Contract Netting Improvement Act of 1999"
As both end users and dealers, commercial banks are subject to the insolvency provisions of the FDIA while non-bank participants are subject to the Bankruptcy Code. Congress has previously recognized the importance of having all participants in the derivatives markets operate under insolvency regimes that are consistent. To that end, the FDIA has been amended several times in the past to reduce inconsistencies between the insolvency provisions of the FDIA and the Bankruptcy Code.
Mr. Chairman, the need to update the bank insolvency laws, particularly as those laws apply to the treatment of swap agreements, repurchase agreements, securities contracts and other similar financial instruments, is acute. H.R. 1161, "The Financial Contract Netting Improvement Act of 1999," would amend the FDIA to provide greater certainty regarding the types of financial contracts eligible for netting and to explicitly permit eligible counterparties to net exposures across different types of financial contracts. The amendments suggested by H.R. 1161 are largely based upon the proposal suggested by the Presidents Working Group on Financial Markets in its report to the Congress entitled Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. Further, both the House of Representatives and the Senate have approved similar amendments to the Bankruptcy Code13 applicable to non-bank end users and derivatives dealers.
Mr. Chairman and members of the Committee, the need for amendments to both the Bankruptcy Code and the FDIA is very real. Innovation in the markets has created ambiguities as to whether certain types of instruments fit within the categories of instruments defined in the FDIA as eligible for netting. These ambiguities need to be addressed. As the Committee is well aware, netting is important because it enables parties to these transactions to reduce both their risk exposure to individual counterparties as well as their aggregate risk exposure. In reducing exposures, counterparties also reduce systemic risk, i.e., the likelihood that one counterparty failure will contribute to the failure of other market participants and eventual financial market disruption.
The credit derivatives market provides an excellent example of a market where innovation and legitimate risk management practices are hampered by a lack of legal certainty concerning the netting treatment of credit derivatives under the Bankruptcy Code and the FDIA. This lack of legal certainty has resulted in some of First Unions clients declining to enter into legitimate risk management transactions linked to credit because of the lack of certainty that their exposure to First Union under those credit-linked transactions could be netted and offset against other derivative transactions with First Union.
Without legal certainty, innovation can be stifled and the U.S. capital markets and participants placed at a competitive disadvantage to other countries that broadly recognize and give effect to netting provisions.
Amendments to the FDIA are also needed to remove legal uncertainties with respect to the ability of market participants to net one type of exposure (e.g.. under repurchase agreements) against another type of exposure (e.g., under swap agreements) under a so-called "master netting agreement." Cross-product netting reduces systemic risk and improves liquidity in the markets for these financial instruments.
By approving the proposed amendments to the FDIA, the process begun in previous Congresses of ensuring consistency between bank insolvency laws and the Bankruptcy Code will continue unabated. Consistency between the insolvency laws as they apply to all counterparties, bank and non-bank alike, will extend the benefits of netting to all market participants and maximize its benefits for our economy as a whole.
In conclusion, we urge the Committee to revise H.R. 2924 as we have suggested in our testimony. We strongly support enactment of legislation permitting netting among all types of financial contracts and across different types of financial contracts. Finally, we pledge to work closely with the Chairman, the Committee and staff toward passage of meaningful legislation that will, among other things, provide legal certainty that swap transactions are excluded from the CEA.
1. Section 3(c)(1) limits participation in exempt hedge funds to no more than a 100 investors, 15 U.S.C. 80a-3(c)(1).
11. The Working Groups report suggests that this disclosure could be incorporated into the Managements Discussion and Analysis ("MDA") or Description of Business in periodic financial statements.12. See FDIC Quarterly Banking Profile, Fourth Quarter 1999 at 28. 13. See H.R. 833, as passed by the House of Representatives 313-108 on May 5, 1999; S. 625, as passed by the Senate 83-14 on February 2, 2000. H.R. 833 would also amend the FDIA to permit netting of financial contracts.