RECOMMENDATIONS BY THE PRESIDENT'S WORKING GROUP ON FINANCIAL MARKETS
TUESDAY, APRIL 11, 2000
U.S. House of Representatives,
Committee on Banking and Financial Services,
Washington, DC.
The committee met, pursuant to call, at 10:00 a.m., in room 2128, Rayburn House Office Building, Hon. James A. Leach, [chairman of the committee], presiding.
Present: Chairman Leach; Representatives Roukema, Baker, Biggert, Terry, Toomey, LaFalce, Kanjorski, Waters, C. Maloney of New York, Watt, Bentsen, Sherman, and Lee.
Chairman LEACH. The hearing will come to order.
Today's hearings will address three areas—over-the-counter derivatives; hedge funds; and contract netting—where legislative proposals are pending to reduce systemic risk to the financial markets. The legislation, in each case, is based upon recommendations from the President's Working Group on Financial Markets. The Working Group, which consists of the Secretary of the Treasury and Chairmen of the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission, has creatively examined system-wide issues across the legalistic and jurisdictional divides that normally separate one regulator's thinking from another's.
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The Working Group's newly established and long overdue consensus on OTC derivatives is momentous for the banking industry, banking regulators and this committee. An overwhelming majority of financial OTC derivatives transactions involve one or more banks. Not only do the largest commercial banks conduct most of the dealer activities for financial swaps or related derivatives, but banks and other financial institutions of all kinds and sizes are the largest-scale end-users of these contracts.
OTC derivatives, particularly interest-rate, foreign exchange, and credit derivatives, have become essential to risk management strategies, proprietary trading activities, international operations, and services to institutional customers. For these reasons, this committee has had a vigorous and sustained interest in derivatives issues for well over a decade.
In 1993, the then-committee Minority issued what remains the most comprehensive analysis of over-the-counter derivatives ever produced in Congress. Many of the issues addressed in the Working Group's 1999 report were raised in that report.
In the 6 1/2 years since, these markets have increased dramatically in size. According to recent OCC figures, the notional measure of U.S. commercial banks' derivatives transactions is almost $35 trillion; and, of this amount, $31 trillion represents OTC derivatives activities, yielding some $2.5 billion in revenues for the last quarter. The most recent total of banks' credit exposure from off-balance sheet derivatives contracts is $396 billion. In sum, banks are central to financial OTC derivatives markets, and these markets have become central to a wide range of banking activities.
At this point, I would like to ask unanimous consent to insert the rest of my opening statement in the record and turn to Mr. LaFalce and then to Mrs. Roukema, and then we will begin the hearing process.
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Chairman LEACH. Mr. LaFalce.
Mr. LAFALCE. Thank you very much, Mr. Chairman. I appreciate you scheduling these timely hearings. These may not be the most exotic or interesting topics for hearing discussion, debate and legislative enactment, but they are extremely important and an important part of our responsibilities.
Given the brevity of the legislative session this year, we have fewer days at our disposal than one might intuitively believe. So if we are to get legislation enacted, we would have to move very expeditiously.
Now, I realize that the most intense interest in recent days has been focused on the matter of OTC derivatives. You and I, Mr. Baker, and Mr. Kanjorski have introduced H.R. 4203 to deal with some aspects of that complex topic. However, prior to addressing that issue, I would like to turn to the matter of H.R. 1161, the Financial Contract Netting Improvement Act, which you, Mr. Chairman, Mrs. Roukema, the Chairperson of the Financial Institutions Subcommittee, and I introduced in 1999.
The netting bill is more than ready for expeditious enactment into law. If we do not seize the opportunity to move on it separately and quickly, we might create real risks that need not and should not exist.
This bill clarifies the manner in which banks and other financial institutions have quickly settled their gross obligations from and to each other at a net figure. In the case of a bank or other financial institution failure, establishing who owes what to whom quickly, within hours, is vital to prevent contagion and chaos throughout the system. The antiquity of present law, which does not square with the way markets now operate, makes this improbable, if not impossible.
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And, in slightly different form, this legislation is now incorporated in the House-passed version of the bankruptcy bill, H.R. 833. But that broader bill has been stalled in even getting to conference due to a number of reasons.
Our committee previously and unanimously reported a netting bill in the 105th Congress, which is little changed from the netting bill under discussion today. If the committee need act again—and I do not believe that essential at all—I would support simply cutting to the chase and passing out the relevant portions of the House bankruptcy bill as a substitute. The House has already agreed to these provisions. Frankly, however, I would much prefer moving immediately to the suspension calendar and not spending the committee's time on reworking old—and agreed-upon—ground.
Mr. Chairman, I would like to take the issue of netting and bring it to the floor on the suspension calendar as soon as possible, and I would encourage your consideration of that approach.
The huge amount of work that has been done to perfect this highly technical legislation has been overwhelming. The President's Working Group has given its input and its members have been fully consulted. All the major banks, brokers, trade associations and other industry parties have had their say. Both Chambers have passed and their products vary little. In short, the netting measures are ready for final adjudication and the President's desk.
On to H.R. 4203, the OTC derivatives bill. That is a somewhat different story. I was pleased to join in co-sponsoring this bill, and I very much appreciate the Chairman's timely effort to put issues of particular concern to this committee on the table. But, advancing legislation in this area will take considerable time and effort, and the bill does raise complex legal and policy issues and a number of committees will necessarily be involved. Even in its relatively narrow form, this bill has provoked sequential referrals to a number of other committees.
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Many are aware of the derivatives traded on well-known exchanges, such as the Chicago Merc, the Chicago Board of Trade, the New York Board of Trade, and so forth. These are standardized options and futures commonly quoted in the press. But the burgeoning area is what are known as over-the-counter derivatives, sophisticated financial arrangements tailored to the needs of large and knowledgeable investors, presumably knowledgeable investors. These have evolved here and abroad into what is nominally a multi-trillion dollar market.
Last November, the President's Working Group issued an important report on oversight of this market. Our consideration of modernizing derivatives law is further driven by Congress's need to reauthorize the Commodities Futures Trading Commission, which will otherwise sunset later this year.
I do not argue, or necessarily believe, that the OTC derivatives bill we have introduced adequately addresses all the issues raised by the President's Working Group. However, since banks or their affiliates generate most of the OTC instruments, it is essential that our committee put a product on the table and begin a thorough examination of the subject if for no other reason than the bank safety and soundness concerns these financial products generate. Nor do I argue that this bill most appropriately resolves those issues it does address.
For example, if swaps are to be totally excluded from the jurisdiction of the CFTC, a position of the President's Working Group I generally favor, and which H.R. 4203 attempts to execute, we must be certain the language is crafted properly. The CFTC exclusion must be truly effective, while leaving swaps clearly open to antifraud regulation from other quarters such as the bank agencies.
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Our bill focuses primarily on the security of clearing OTC derivatives. That is the system through which one party to a derivatives contract receives assurances that another party to the contract will perform directly or indirectly. The bill is not aimed at the fundamental structure of the Commodities Exchange Act. Moreover, we have not addressed the question of whether futures of the stock of the single companies should any longer be banned by specific statute.
These issues and others must be joined if we are to legislate successfully. Ultimately, any legislative product in this area must speak to a far greater array of issues than our bill addresses, including legal certainty, regulatory issues, and Shad-Johnson, and must incorporate not only the Banking Committee's concerns, but those of the Agriculture, Commerce and Judiciary Committees. It will be difficult to achieve consensus, and it will be time consuming.
Finally, with respect to H.R. 2924, the hedge fund disclosure measure I am also co-sponsoring, considering the origins of this bill—the failure of Long-Term Capital Management, which posed a systemic threat to the liquidity of the debt markets, this is a modest response as recommended by the President's Working Group. In the subcommittee, there was much discussion of whether this was a ''camel's nose under the tent,'' potentially leading to regulation of hedge funds by the Federal Reserve, instead of a mere quarterly disclosure of non-proprietary risk information for the 25 largest hedge funds. I believe it is no more than disclosure, centering on the public's need to be informed about risks in very key institutions.
For our part, I am also interested in the right of the Congress to know something about the sizes and types of risks that are arising. When problems present themselves, this institution then tends to hear about them rather quickly. Forewarned is forearmed. I favor the benefits this bill will bring to the public, but I believe that Congress will benefit from this information as well.
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Mr. Chairman, I thank you for your indulgence on a lengthy opening statement. I look forward to the testimony.
Chairman LEACH. Thank you very much, John, for your thoughtful comments.
Mrs. Roukema.
Mrs. ROUKEMA. Thank you, Mr. Chairman. I am very sensitive to the time constraints here, and we are very anxious to hear from our panelists, so I would ask unanimous consent that my full remarks be entered into the record.
I will simply observe that this hearing certainly is well devised, and it touches on very essential issues of systemic risk, and the approach seems to be a comprehensive one and that it is appropriate that we observe the systemic risk problems in a comprehensive form.
That having been said, I would also like to observe and associate myself with the remarks of the Ranking Member with respect to H.R. 1161, the netting bill. I do not know, Mr. Chairman, if we should be going into some sort of a conference, but I think that is a legitimate question as to whether or not the netting bill could be taken up in a separate context. At least that is something I believe that we should confer on.
With respect to the other questions, of course, I will save my questions and comments for both the regulators as well as the representatives of the financial industries which are here. But I will observe that, as a co-sponsor of Mr. Baker's hedge fund bill, I also recognize that there are legitimate questions that have to be raised regarding the reporting levels and whether or not they should be higher and a number of other questions, but I will save those questions for the regulators so that we can get advice of those that are dealing with the subjects on a regular basis and have that kind of experience.
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Thank you, Mr. Chairman. I look forward to the testimony.
Chairman LEACH. Thank you very much, Mrs. Roukema.
Let me just make one brief comment on the netting bill, because I know there is a lot of interest in it.
I am absolutely committed to getting this bill adopted in law in one fashion or another this year. I have been in contact with the Senate side on this issue. If it does not come to pass within the context of a bankruptcy bill, it will come to pass—at least every effort will be made to ensure that it comes to pass in the context of banking legislation.
We may bring a discrete bill of our own to the floor. It looks like on the Senate side there may be a minimum number of banking bills, whether it be one or two, or it could well be only one, in which case we could well have toward the end of the session a clutter of House-passed bills taken up in the context of a single Senate-passed bill. We will probably be doing some sort of sorting out of what has not happened and what has happened toward the end of the session. That is likely to be the order coming from the Senate.
I would be very happy to bring this particular netting bill to the floor at the earliest possible time, although I have no great sense of whether the leadership wants to do it in that fashion. But I certainly am convinced that the gentleman from New York is right in wanting to do this.
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Mr. LAFALCE. Mr. Chairman, there are many tactical approaches that can be taken, and you have to make a judgment based upon your knowledge and your leadership in the Senate. To me, though, I think we have nothing but pluses in taking the netting bill up on the suspension calendar immediately. There is no downside to it, and there are potential pluses. Thank you.
Chairman LEACH. Well, let me just say, from my perspective, I am in full agreement, but I have not had conversations with our leadership on it.
Does anyone else wish to make an opening statement?
Mrs. MALONEY. Mr. Chairman, I would just like my comments in full to be put in the record.
Chairman LEACH. Let me recognize Mrs. Maloney of New York.
Mrs. MALONEY. Thank you, Mr. Chairman.
As I stated in the subcommittee hearing on the Hedge Fund Disclosure Act, I am concerned with provisions in the hedge fund bill that charge the Federal Reserve with the role of collecting and disseminating information on the risk profiles of hedge funds. Given the Fed's unprecedented behavior in organizing the restructuring or bail-out of Long-Term Capital Management, I continue to be concerned that this provision sends the wrong signal to the markets and could increase moral hazard.
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As for OTC derivatives, I am pleased that the Chairman continues to lead on the issue and is appropriately asserting the jurisdiction of the committee. OTC derivatives play a critical role in risk management, and Congress should move quickly to resolve any uncertainty as to their legality.
Thank you very much, Mr. Chairman.
Chairman LEACH. Thank you.
Mr. Toomey, did you wish to seek recognition?
Mr. TOOMEY. Thank you, Mr. Chairman.
I would just briefly mention, with respect to the Hedge Fund Disclosure Act, that while I am glad to see that we have not moved in the direction of any kind of heavy-handed direct regulatory burdens, I will nevertheless reluctantly oppose the legislation.
I think there are a couple of problems that I look forward to discussing with the panelists today. One is, I don't think the bill would be able to accomplish its objective as a practical matter, which we will discuss.
I think it is also based on the flawed premise that markets do not work in the sense that the very sophisticated participants in this market are deemed to be incapable of determining the information that they need. Hence, the necessity of legislation requiring information.
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Third, I am concerned about the moral hazard scenario the concern that there will be an illusion of regulation where regulation would not exist.
Lastly, a mechanical thing that concerns me a great deal about this bill which is the requirement for meaningful and comprehensive analysis of risk is in the bill; however, it also says that no proprietary information need be disclosed. I think that is an internal contradiction in the bill. I don't see how you can accomplish the former without also committing the latter.
So these are issues that I think we need to look into; and, with that, I will yield the balance of my time.
Chairman LEACH. Thank you.
Ms. Schakowsky.
Ms. SCHAKOWSKY. Thank you, Mr. Chairman.
I just wanted to acknowledge the presence today of representatives of the Chicago Board of Trade and the Chicago Mercantile Exchange and say how much I look forward to their testimony and to underscore the important role that these exchanges have played in the overall economy, but also in particular in the vibrant economy in the City of Chicago and in our region and to just note that, from all of the discussions today, I will be looking at the impact on those exchanges with great interest and concern.
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Chairman LEACH. Thank you very much.
Does anyone else seek recognition?
If not, let me welcome Chairman Baker and say that I don't know anyone who has given more thoughtful attention to a whole host of extraordinary issues that are before our committee, particularly in the securities area, but not exclusively. There is no one who I have come to be fonder of, or more appreciative of his input, than Richard.
Please proceed.
STATEMENT OF HON. RICHARD H. BAKER, A MEMBER OF CONGRESS FROM THE STATE OF LOUISIANA; CHAIRMAN, SUBCOMMITTEE ON CAPITAL MARKETS, SECURITIES, AND GOVERNMENT SPONSORED ENTERPRISES
Mr. BAKER. Well, first, thank you very much, Mr. Chairman, for your kind remarks.
I am very appreciative of this opportunity to express my concerns relative to potential systemic risk at this hearing. In my capacity as subcommittee chair, I have strongly held opinions about three principal areas that I believe could warrant additional review by this committee.
I continue to commend you, Mr. Chairman, for your leadership in all areas of financial reform, specifically H.R. 4203 relative to swaps and derivatives products, and your interest in H.R. 2924 relative to enhancing transparency of hedge funds, and your co-sponsorship of H.R. 3703 relative to agency debt.
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First, what are the public policy concerns relating to systemic risk? Why should we care about counterparty obligations in a transaction involving an Italian currency swap or whether or not some well-heeled investor in a fancy hedge fund loses money?
The answer to both of these questions, in most cases, I believe, is that Congress should not. Only in rare circumstances, when the result of potential loss would trigger events far beyond the scope of the multimillionaire's portfolio, should regulators or the Congress be prompted to act. When the potential exists for innocent third parties to be impacted by turmoil that would reach far beyond the principals of the transaction, such as to other institutions or even in the case of my own mother's pension fund, the picture becomes more serious.
Over the years, there have been various studies regarding OTC derivatives recommending modification to the rules governing the OTC derivatives market. The most significant to us, however, are the most recent recommendations of the President's Working Group in their report of November of 1999 which constituted a very sound platform for beginning this discussion.
The recommendations contained in H.R. 4203, legislation sponsored by Chairman Leach, represent a forward-thinking legal framework for the dynamically growing derivatives industry. Historically, commodity futures contracts helped to provide stability primarily in the agriculture commodities market. During my four years on the House Agriculture Committee, I came to an understanding that today the OTC derivatives are largely centered in interest rate and foreign exchange contracts. In fact, 98 percent of all transactions account for interest rate and foreign exchange contracts. Tangible commodity transactions account for less than a fraction of 1 percent. In other words, this market is no longer about pork bellies.
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To state the importance of this industry to the overall economy, at the end of 1998, the total estimated notional amount of outstanding OTC derivatives contracts was $80 trillion. Needless to say, we should ensure as best we can this market does not experience any disruption.
But there is a problem. Legal uncertainty exists as to whether these contracts are subject to the Commodity Exchange Act and, therefore, under the supervisory jurisdiction of the CFTC. Other instruments operate under an exemption to the CEA, with no guarantee the exemption will not be withdrawn. By using new technology, some contracts move jurisdictions one more time. If this is confusing to you, that is because I believe that it really is confusing.
Chairman Leach's proposal remedies these uncertainties with the establishment of multilateral clearing organizations, clarifying that an over-the-counter derivative is an instrument contract with a financial institution that cannot be held unenforceable simply based on the regulatory status of the product. In addition, the bill allows electronic trading of OTC derivatives by a broad range of financial institutions as defined in the Gramm-Leach-Bliley Act. Accordingly, these provisions will provide markets assurance of the appropriate regulatory treatment of the products and remove significant concerns as to certainty of executing the contract.
Stated another way, this proposal, in my view, will ensure markets can operate as efficiently as possible. This is essential.
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Another area of dramatic growth, and subject of recent analysis by the President's Working Group, is the hedge fund industry. The Working Group has recommended several steps for legislative consideration. Although hedge funds secure their capital from high income individuals and invest in sophisticated markets, we are concerned with their scope of activity, particularly where there is potential for undisclosed, high levels of leverage. Such activity has the potential to bring harm to third parties when high leverage, market position and lack of disclosure result in the unfortunate events like those of September and October of 1998 when we all are aware LTCM had its problems.
To consider the Working Group's report, I do admit a certain bias. Since I am an advocate of free markets, I believe that markets can best regulate themselves. Nothing moves faster than an investor losing money. Regulators may look fossilized by comparison.
H.R. 2924 does nothing more than make financial statements of the large, unregulated hedge fund available to markets on a quarterly reporting basis. Keep in mind, too, that I want to ensure fair disclosure of such information. In fact, there is a clear specific prohibition to prevent the disclosure of proprietary information in H.R. 2924. In this bill, I hope that we create a fair and unbiased disclosure regime similar to other areas. For instance, the President's Working Group recommended the provisions of H.R. 2924 as a first step, with the recommendations that further action to directly regulate the industry could be taken at a later time should market conditions warrant.
In fact, I am in receipt of a letter from the Honorable Howard Davies, chair of the Financial Stability Forum, which is an organization comprised of the principal financial regulator from each of the G–10 countries which states as follows: ''The Working Group strongly supports efforts to require disclosure by large hedge funds. Both the Working Group, and the Forum as a whole, is therefore strongly supportive of the leadership you have shown in introducing H.R. 2924. I hope that other Members of Congress share your view that this is a vital measure to reduce risk in the global financial system.''
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That letter is dated April 7 of 2000, Mr. Chairman.
Let me make it very clear. I do not support regulating hedge funds directly. I do not want to take any action that would result in the relocation of this industry to an unregulated offshore domicile. This industry provides a valid and an important role in our economy, and it would be a significant loss if hedge funds left our capital markets.
But the message of the Financial Stability Forum cannot be ignored. The provisions of H.R. 2924 provide for minimal levels of enhanced transparency that should be taken to preserve the integrity of the international finance system.
I refer once again to comments by Mr. Davies: ''The Forum supported the use of market discipline as the primary means to reduce systemic risk posed by highly leveraged institutions. However, it also agreed that more interventionist measures, such as direct regulation of hedge funds, might have to be considered if the Financial Stability Forum report's recommendations to enhance market discipline were not adequately implemented.''
Recently, something profound occurred in the hedge fund industry which demonstrates the integrity of these markets. Mr. Julian Robertson, general partner of Tiger Management, announced his intention to liquidate his partner's portfolio. For twenty years Mr. Robertson was viewed as an icon of the industry. With initial capitalization of $8.8 million in 1980, the fund grew to $21 billion in size, an increase of 259,000 percent. The compounded annual rate of return after expenses was 31.7 percent. But, as he indicated, something significant in the broader markets has occurred.
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I quote from a letter to the partners: ''As you heard me say on many occasions, the key to Tiger's success over the years has been steady commitment to buying the best stocks and shorting the worst. In a rational environment, this strategy functions well. But in an irrational market, where earnings and price considerations take a back seat to mouse clicks and momentum, such logic, as we have learned, does not count for much.''
While he chose to liquidate his fund, Mr. Robertson could have pursued another strategy. What if he had abandoned his commitment to his investment plan, given the obvious market pressures, and simply enhanced leverage, pursued a different and risky strategy, without disclosing to the market his reasoning? Given its size, we would not wish to know if this speculative strategy would have failed. Fortunately, Mr. Robertson's principled business judgment has resulted in the conclusion to a terrific business enterprise. Ideally, it is the way markets should work. But as we all know, that is not the way it happens every time. His decision highlights market discipline in its proper context and function.
What is the Government's role in facilitating the efficient function of the markets? I submit that the appropriate role of Government is not just to impose regulation that will attempt to eliminate all risk. Only markets can determine what is too large, too volatile, too highly leveraged, too risky, and ultimately, what is excessive. This is what Mr. Robertson did, and this is what the market does on a daily basis.
However, what allows the market to make these decisions? I believe it is free access to accurate and timely information. Without information, the market simply cannot function effectively....
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