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Senate Eyes on the OTC Market

By Robert Hunter

The narrowly averted blowup of Long-Term Capital Management last September created a cottage industry of pundits prognosticating about the pitfalls—and benefits—of unfettered over-the-counter derivatives markets. Last December 16, while politicos wrestled with the question of Presidential impeachment, a group of market regulators—the four Commodity Futures Trading Commission commissioners, the staff of the President’s Working Group on financial markets and the former chairpersons of the CFTC—and a couple of financial policy wonks testified before the Senate Agriculture Committee on an issue almost as rancorous in some circles of the financial world as impeachment: hedge fund and over-the-counter derivatives regulation.

The debate centered on the lessons learned from the LTCM disaster. But in the end, these lessons seemed only to polarize the opposing camps more—particularly within the CFTC, where chairperson Brooksley Born and commissioner Barbara Holum, already on opposite sides of the OTC regulation debate, turned up the intensity of their rhetoric.

The CFTC has pledged to wait until September to move in any way toward increased regulation. But all eyes will be on the full report of the President’s Working Group on hedge funds, expected to be presented to Congress soon, and its report on OTC regulation, due out this spring. The group’s findings could mobilize Congress to examine the possibility of OTC regulation vigorously, stirring once again the hornet’s nest of opinions expressed before the Agriculture Committee last December.

What follows is some of the key testimony presented in the December hearing.

Brooksley Born

  • “Notably, no reporting requirements are imposed on most OTC derivatives market participants. This lack of basic information about the positions held by OTC derivatives market participants, the nature of their investment strategies and the extent of their risk exposures potentially allows them to take positions that may threaten our regulated markets without the knowledge of any federal regulatory authority.”
  • “The London Clearing House has submitted a petition to the Commission to permit clearing of swaps, which is not currently permitted under the Commission’s regulations. Clearing of OTC derivatives transactions could be a useful vehicle for addressing issues relating to extensions of credit, reducing counterparty credit risk and increasing transparency.”
  • “LTCM now stands as a cautionary tale of the fallibility of some of the most sophisticated value-at-risk models. The prudential controls of LTCM’s OTC derivatives counterparties and creditors, the parties that seemingly had the greatest self-interest in assessing LTCM’s financial wherewithal, apparently failed.”

Barbara Holum

  • “The real cause of LTCM’s losses are not the markets in which they invested, but a fallible investment strategy combined with an overextension of credit. Concluding that the LTCM collapse dictates expanded regulation of the OTC market would misinterpret the message of the firm’s failure.”
  • “The inescapable conclusion so far is that neither the [May 12, 1998] CFTC Concept Release nor the LTCM collapse should serve as a predicate for extensive regulation of OTC markets. In addition, functional evolution has continued to narrow the distinctions between on- and off- exchange markets. Because of this convergence, a continuing program of regulatory relief for exchange markets will eliminate competitive imbalances, and at the same time produce public policy benefits by encouraging trading in the more transparent exchange environment.”

James Newsome

  • “I believe it is imperative to keep in mind that less intrusive, rather than more intrusive, regulation is the desirable outcome of these endeavors.”
  • “Let us not engage in polemics about the world coming to an end; it did not, and, I believe, would not have, even absent the [Federal Reserve] Board’s intervention.”
  • “Hedge funds can and do provide positive benefits to financial markets. Their trading can increase market efficiency, in that positions taken to profit from temporary price discrepancies can reduce such gaps. Indeed, the risk-taking engaged in by hedge funds and major market participants can serve to correct incongruities in market valuations. I believe that attempts to eliminate or stifle this market activity will result in less efficiency and liquidity in the marketplace.”

Susan Phillips
former chairman

  • “Bank supervisors are coming to recognize the most effective form of supervision relies on disclosure, risk-adjusted capital and the risk assessment and risk management systems of the participants. That case-by-case risk analysis by market participants is likely to be more effective than arbitrary ratios or balance sheet limitations, which can become dated very quickly or not take into account the firm’s total portfolio. Reliance on regulatory protections can create the proverbial ‘moral hazard’ and ultimately end up being an ineffective way to protect the financial system.”
  • “Futures-style regulation of financial OTC derivatives is unnecessary and exchange-traded financial futures and options can be deregulated.”

William Albrecht
professor of economics
University of Iowa

  • “The CFTC should not regulate hedge funds.”
  • “The confusion surrounding regulation stems from the substances and structure of our system for regulating futures and options exchanges …Nothing short of a major overhaul of the [Commodity Exchange] Act has any chance of resulting in a regulatory system that can deal effectively with today’s and tomorrow’s financial markets.”

Martin Mayer
guest scholar
The Brookings Institution

  • “The law gives CFTC jurisdiction over commoditized financial derivatives—many of which would otherwise, let me note, be illegal under the gaming and anti-bucket-shop laws of some states, including New York, which provides the governing law for most international swap contracts. And our current situation demands at the least that the CFTC study reassertion of its role in the creation and sale of these instruments, which properly emplaced can make significant contributions to financial structures, but improperly applied can blow up with severe damage to the foundations of economic activity.”
  • “Given our experiences in this decade and the weight of the argument that promiscuous creation of OTC derivatives can imperil the world financial structure, it is preposterous, even sinister, that the CFTC, charged with regulating this area, should be prohibited from undertaking a study of its responsibilities.”

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