I am pleased to be here today to
underscore the importance of this committee's efforts to modernize
the Commodity Exchange Act (CEA) and to express my support for the
recommendations for amending the act that were contained in the
report by the President's Working Group on Financial Markets
entitled Over-the-Counter Derivatives Markets and the Commodity
Exchange Act.
The Need for Legislation
Over-the-counter (OTC) derivatives have come to play an
exceptionally important role in our financial system and in our
economy. These instruments allow users to unbundle risks and
allocate them to the investors most willing and able to assume
them. A growing number of financial and nonfinancial institutions
have embraced derivatives as an integral part of their risk
capital allocation and profit maximization. In particular, the
profitability of derivative products has been a major factor in
the significant gain in the finance industry's share of American
corporate output during the past decade--a reflection of their
value to nonfinancial industry. Indeed, this value added from
derivatives itself derives from their ability to enhance the
process of wealth creation throughout our economy.
In light of the importance of
OTC derivatives, it is essential that we address the legal
uncertainties created by the possibility that courts could
construe OTC derivatives to be futures contracts subject to the
CEA. The legal uncertainties create risks to counterparties in OTC
contracts and, indeed, to our financial system that simply are
unacceptable. They have also impeded initiatives to centralize the
trading and clearing of OTC contracts, developments that have the
potential to increase efficiency and reduce risks in OTC
transactions. As I shall discuss more fully later in my remarks,
rapid changes in communications technology portend that time is
running out for us to modernize our regulation of financial
markets before we lose them and the associated profits and
employment opportunities to foreign jurisdictions that impose no
such impediments.
To be sure, the Congress and the
Commodity Futures Trading Commission (CFTC) have taken steps to
address these concerns about the CEA. The Futures Trading
Practices Act of 1992 gave the CFTC authority to exempt OTC
derivatives from most provisions of the act. In early 1993 the
CFTC used that authority to create an exemption for OTC
derivatives that reduced legal uncertainty for a wide range of
transactions and counterparties. Unfortunately, some subsequent
actions by the Commission called into question market
participants' understanding of the terms of the 1993 exemption.
Now, under the leadership of Chairman Rainer, the Commission is
considering reaffirming and expanding the terms of the 1993
exemption. Nonetheless, even with such an important and
constructive step by the Commission, legislation amending the CEA
would remain critically important. The greatest legal uncertainty
affecting existing OTC transactions is in the area of
securities-based contracts, where the CFTC's exemptive authority
is constrained. Furthermore, as events during the past few years
have clearly demonstrated, regulatory exemptions, unlike statutory
exclusions, carry the risk of amendment by future Commissions.
Principles of Regulation
Imposing government regulation on a market can impair its
efficiency. Thus, when evaluating the need for government
regulation, one must clearly identify the public policy objectives
of the regulation. As the working group's report discusses, the
primary public policy purposes of the CEA are to deter market
manipulation and to protect investors against fraud and other
unfair practices.
We must of course assess whether
government regulation is necessary to achieve those objectives.
The regulatory framework of the CEA was designed for the trading
of grain futures by the general public, including retail
investors. Because quantities of grain following a harvest are
generally known and limited, it is possible, at least in
principle, to manipulate the price of grain by cornering a market.
Furthermore, grain futures prices are widely disseminated and
widely used as the basis for pricing grain transactions off the
futures exchanges. The fact that grain futures serve such a
price-discovery function means that if attempts to corner a market
result in price fluctuations, the effects would be felt widely by
producers and consumers of grain.
OTC Derivatives
The President's working group has considered whether regulation of
OTC derivatives is necessary to achieve these public policy
objectives of the CEA. In the case of financial OTC derivatives
transactions between professional counterparties, the working
group has agreed that such regulation is unnecessary and that such
transactions should be excluded from coverage of the act.
Importantly, the recommended exclusion would extend to those
securities-based derivatives that currently are subject to the
greatest legal risk from potential application of the CEA.
The rationale for this position
is straightforward. OTC transactions in financial derivatives are
not susceptible to--that is, easily influenced by--manipulation.
The vast majority of contracts are settled in cash, based on a
rate or price determined in a separate highly liquid market with a
very large or virtually unlimited deliverable supply. Furthermore,
prices established in OTC transactions do not serve a
price-discovery function. Thus, even if the price of an OTC
contract were somehow manipulated, the adverse effects on the
economy would be quite limited. With respect to fraud and other
unfair practices, the professional counterparties that use OTC
derivatives simply do not require the protections that CEA
provides for retail investors. If professional counterparties are
victimized, they can obtain redress under the laws applicable to
contracts generally.
The working group also
considered whether the introduction of centralized mechanisms for
the trading and settling of what heretofore have been purely
bilaterally negotiated and settled transactions would give rise to
a need for additional regulation. In the case of electronic
trading systems, the working group concluded that regulation under
the CEA was unnecessary and that such systems should be excluded
from the act, provided that the contracts are not based on
nonfinancial commodities with finite supplies and that the
participants are limited to sophisticated counterparties trading
solely for their own accounts. Electronic trading of such
contracts by such counterparties, it was reasoned, would be no
more susceptible to problems of manipulation and fraud than purely
bilateral transactions. It was suggested that some limited
regulation of such systems might become necessary in the future if
such trading systems came to serve a price-discovery function. But
it was agreed that creation of a regulatory system for such
systems in anticipation of problems was inappropriate. As I have
already noted, the vast majority of OTC derivatives simply are not
susceptible to manipulation. Thus, even if those contracts come to
play a role in price discovery, regulation of the trading
mechanism might still be unnecessary.
In the case of clearing systems
for OTC derivatives, the working group concluded that government
oversight is appropriate. Clearing tends to concentrate risks and
responsibilities for risk management in a central party or
clearinghouse. Consequently, the effectiveness of the
clearinghouse's risk management is critical for the stability of
the markets that it serves. Depending on the types of transactions
cleared, such oversight might appropriately be conducted by the
CFTC under the CEA. Alternatively, it might be conducted by the
Securities and Exchange Commission, the Federal Reserve, the
Office of the Comptroller of the Currency, or a foreign financial
regulator that one of the U.S. regulators has determined satisfies
appropriate standards. Provided such government oversight is in
place, OTC transactions that would otherwise be excluded from the
CEA should not fall within the ambit of the act because they are
cleared. If market participants conclude that clearing would
reduce counterparty risks in OTC transactions, concerns about
legal risks associated with the potential application of the CEA
should not stand in their way.
Traditional Exchanges
The working group's report does not make specific recommendations
about the regulation of traditional exchange-traded futures
markets that use open outcry trading or that allow trading by
retail investors. Nevertheless, it calls for a review of the
existing regulatory structures, particularly those applicable to
financial futures, to ensure that they are appropriate in light of
the objectives of the act. Consistent with the principles of
regulation that I identified earlier, the report notes that
exchange-traded futures should not be subject to regulations that
are unnecessary to achieve the CEA's objectives. The report also
concludes that the current prohibition on single-stock futures can
be repealed if issues about the integrity of the underlying
securities market and regulatory arbitrage are resolved.
I want to underscore how
important it is for us to address these issues promptly. I cannot
claim to speak with certainty as to how our complex and rapidly
moving markets will evolve. But I see a real risk that, if we fail
to rationalize our regulation of centralized trading mechanisms
for financial instruments, these markets and the related profits
and employment opportunities will be lost to foreign jurisdictions
that maintain the confidence of global investors without imposing
so many regulatory constraints.
My concerns on this score stem
from the dramatic advances in information technology that we see
all around us. In markets with significant economies of scale and
scope, like those for standardized financial instruments, there is
a tendency toward consolidation or even natural monopoly.
Throughout much of our history this tendency has been restrained
by an inability to communicate information sufficiently quickly,
cheaply, and accurately. In recent years, however, this constraint
is being essentially eliminated by advances in telecommunications.
We have not yet seen clear evidence of a trend toward natural
monopoly. But the diffusion of technology often traces an S-shaped
curve, first diffusing slowly, but then rapidly picking up speed.
Once we reach the steep segment of that S-curve, it may be too
late to rationalize our regulatory structure.
Already the largest futures
exchange in the world is no longer in the American heartland;
instead, it is now in the heart of Europe. To be sure, no U.S.
exchange has yet to lose a major contract to a foreign competitor.
But it would be a serious mistake for us to wait for such
unmistakable evidence of a loss of international competitiveness
before acting. As our experience with the vast eurodollar markets
demonstrates, once markets with scale and scope economies are
lost, they are very difficult, if not impossible, to recapture.