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Hearing Of The Senate Committee On Agriculture, Nutrition And Forestry - Regulatory Reform And The Derivatives Markets

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SEN. HARKIN: The Senate Committee on Agriculture, Nutrition and Forestry will come to order regarding a hearing on regulatory reform in the derivatives markets.

Although we see hope in the strong economic recovery steps we've taken, we're still struggling through a grave economic downturn. The lack of sufficient regulatory authority and oversight regarding the financial markets is widely acknowledged as a key factor in the global economic crisis. It's not credible to assert that the markets and present regulatory system have worked, when the federal government has had to inject some 4 trillion -- $4 trillion into the system to stave off a total collapse of the economy.

Recent problems indicate the need for fundamental reform -- fundamental reform. The 2008 run up in oil prices left our economy bruised, our nation keenly aware of not only its dependence on foreign oil, but the struggle with speculation in the markets. Volatile agricultural commodity prices, high input costs, problems with the wheat and cotton markets have exposed vulnerabilities in our agriculture future markets. But most -- possibly most problematic, our national economy has been held hostage by poorly regulated financial markets and the irresponsible behavior of some market participants, particularly when it comes to financial derivative products like credit default swaps and other over-the-counter derivatives.

I think it's become obvious that we must restore proper regulatory oversight if we're going to get this economy built on a solid foundation. Simply put, the derivatives markets must work properly and in the open.

Agricultural future markets are fundamental to the functioning of every aspect of our agriculture economy. Financial services now account for about as much as 20 percent of our economy. And if those markets aren't healthy or properly regulated, I think the evidence is clear our economy suffers.

Now, the Commodity Futures Trading Commission plays a vital role in providing oversight and keeping these players honest. And if we don't invest in the regulators and the enforcers to expand that oversight to the over-the-counter markets, I think we're going to continue to pay a heavy price. It's imperative that we pass strong financial regulatory reform in this body and not just piecemeal, patchwork reform, but comprehensive and fundamental reform that brings full transparency and accountability back to the markets.

Earlier this year, I introduced the Derivatives Trading Integrity Act, I think one I had also introduced last year. The bill would require all futures contracts to trade on regulated exchanges. Why do I want that? Because exchange-traded contracts are subject to a level of transparency and oversight that's just not possible in over-the- counter markets. For many years, derivative contracts have traded very efficiently and openly on regulated exchanges, but we've seen the damage done by moves to circumvent properly regulated derivatives trading.

I would also say it's not sufficient to assert, as many swap dealers do, that the market for credit default swaps function properly and has experienced no major problems during the current crisis. As conceived by derivatives traders in the mid-'90s at JPMorgan Chase -- well, it was JPMorgan then -- the CDS was designed to assist in the smooth functioning of the credit market and presumably to make it easier to raise capital by issuing corporate bonds to fund investment in the production of goods and services, which is what we want the financial sector to do and what is the end of our financial -- what is the end means of our financial services sector, that is, for the productions of good and services to add to our GDP. Otherwise, you're just in a gambling game.

So the fact is, it was going to make it easier to raise capital by issuing corporate bonds to fund investment in the production of goods and services, but the facts belie that claim. While the total face value of CDS contracts more than tripled -- tripled between 2005 and 2008, the share of gross private domestic investment in U.S. GDP stagnated and then fell by more than 15 percent. That was at the end of 2008.

I have a chart. I wanted to see what it looked like. So I had a chart. And so you see here the share of investment in U.S. GDP and then here you've got on the red line the notional value of the CDSs. Now, for a while they seemed to track pretty well. But right here, about 2005, investment goes down and the value of the CDSs go up. So I think you can safely say they were not adding anything to the value of the goods and services of our country at some point in time.

Nor do I agree with those who assert that more rigorous regulation of these markets will discourage innovation or hamper our economy. Well, if financial innovation improves the ability of companies to hedge their risks or improves the functioning of the market, then the incentive for creativity will be there. But if the prime motivation for innovation is to speculate, to avoid taxes or assume reckless risks, the public has an interest in regulating that sort of, quote, "creativity."

I'm often asked, where was the -- where was the market demand for credit default swaps? Where was the market demand for collateralized debt -- where was the credit -- where was the market demand for collateralized mortgage obligations? They just sort of thawed up.

You know, I have to digress here a second. I was just looking at the last issue of Newsweek Magazine. It's got Oprah on the front. I guess that sells the magazine. But it's called "Revenge of the Nerd" and it's about the "quants" and who -- I mean, how many people in this country know what a "quant" is? -- and what they did in terms of speculation, how they -- through these mathematical geniuses that came from various and sundry places -- how they devised these financial instruments to slice and dice and make money on things that really weren't adding to the goods and services value of this country. It's a great article. I'd recommend you reading it.

As I said, if that creativity is there just to add for speculation purposes and for sort of gambling and for high rollers and people making a lot of money in a short span of time but not really adding to the sound investment in our country, then I -- then, quite frankly, I think the public has a big interest in regulating that kind of creativity.

So we must protect consumers and lower systemic risk and enhance the price discovery function of the markets, reduce excessive speculation, give the regulators the authority and information they need to keep their markets free of fraud and manipulation. In doing so, we will maximize the economic value of the derivatives markets by making sure they are structured to manage risk rather than to magnify it and guarantee that bad actors are held accountable.

So we have a lot of work to do on legislative reform. It's imperative that we all work together to come up with a solution that will bring transparency, accountability and stability to our derivatives markets. So I welcome this hearing and this testimony. I thank each of the witnesses for coming here today, look forward to hearing their thoughts.

And I can't think of anything that -- well, this committee has to do -- we have to reauthorize the child nutrition bill later this year. We're going to work on that. But we've got to do this. This has got to be done this year. I've talked with my colleague, my counterpart in the house, Chairman Peterson. He feels the same way. And so I just don't think that we can push this off any longer. We've got to strengthen the hand of the Commodity Futures Trading Commission. We've got to give them the authority. And I'm going to be asking the new chairman about that and about any resources that they need. But we've got -- we've got to get the CFTC the authority and the resources they need to do this kind of regulation and oversight.

And with that, I'll yield to my distinguished ranking member, my good friend Saxby Chambliss.

SEN. SAXBY CHAMBLISS (R-GA): Well, thank you very much, Mr. Chairman. And you and I agree 100 percent that this is a critical issue and it's an issue that we've got to address and an issue that certainly calls for more regulatory measures, but I think regulatory measures that are not too intrusive to destroy markets rather than to continue to create and innovate in the markets.

And I know you had a conflict last night and weren't able to be there, but we had a very good meeting with Secretary Geithner last night, along with our Senate Banking colleagues, as well as our House Agricultural and Financial Services folks. And we fully expect that the secretary is going to come forward, I'm sure, with consultation of the new chairman, with some recommendations in the next couple of weeks. And we talked about some ideas that we have as policymakers there last night that are going to help influence, obviously, in a very strong way the direction in which the administration wants to go. And I'm very confident that we're going to be able to come together with a very strong proposal that does make certain modifications that aren't over-burdensome but yet at the same time will provide that protection that you referred to for all consumers, as well as making sure that we have stability in the markets.

I do strongly believe that the Senate Ag Committee and the CFTC must be engaged in the development of any legislation addressing financial regulatory reform. This committee has a responsibility to ensure proper oversight of the CFTC, and we must do more to fulfill this duty.

Today's hearing covers a wide range of issues: speculative trading in the commodities markets, changes to regulation of the over- the-counter derivatives and the CFTC's authority over retail, off- exchange transactions. Those are all worthy individually of hearings. And they are very complex issues that we're going to have to be dealing with in the legislative proposal that you alluded to and that I agree is going to have to come forward.

Among the most complex instruments, we have recently heard a great deal about credit default swaps, or CDS, which permit one party to transfer the credit risk of bonds or syndicated bank loans to another party. Given that AIG was heavily involved in CDS, it seems simple enough just to blame swaps in general for the current financial crisis, but of course it's much more complicated than that. Failing to distinguish between credit default swaps and the actual mortgage- related debt securities that these swaps were referencing has resulted in an oversimplification of the problem and subsequently an oversimplification of the proposed solutions.

Simply banning the use of all over-the-counter derivatives or forcing such contracts onto an exchange is unrealistic and unlikely to even address the underlying problem. That is, is this really a chance we are willing to take in these uncertain times, a chance that we would make things worse, dry up more capital, and force the cost of doing business higher?

Speaking of business, functionally curbing speculation is the fiscal commodity markets -- speaking functionally, curbing speculation in the fiscal commodity markets is another area that we must approach very carefully. This is also not a simple topic. Determining how much speculation is necessary and how much speculation is excessive is an enormous challenge and something that we'll be talking with -- with the chairman as well as our other witnesses about this morning.

Some seem to have decided that all speculation is bad, but I would like to remind folks that without speculators in the marketplace, our farmers, ranchers and energy users would find very little liquidity in these markets and would thereby not be able to utilize them effectively. Those individuals and businesses hedging risks in physical commodities, the parties that some claim they are trying to protect by running speculators from the market, are the ones who are likely to be hurt the most if speculative money dries up.

I fear that this is another example in which oversimplification may be leading us to solutions of vast, unintended consequences. We must remember that during the past 18 months of bankruptcies, bailouts and government-assumed ownerships, the nation's futures markets have functioned quite well. Price discovery has occurred. Consumer funds have been protected. And there hasn't been a single bankruptcy of any clearing organization.

Does this mean there isn't room for improvement? Of course not. Do I think the volatility in some markets over this lifetime warrants extensive analysis and possibly regulatory changes? Absolutely. And while I may have concerns with some of the proposals that have been discussed relative to regulating both the use of over-the-counter derivatives and speculative trading, I am absolutely convinced that the market volatility and financial meltdown of the recent past make the case for more market transparency. How can we in Congress gamble on the outcome of sweeping reforms without first properly identifying the cause of these problems? And how can we identify the cause of the problem without authorizing and/or requiring more transparency through the collection of necessary data?

Yes, I've seen all the press accounts claiming the evils of index investment, swap dealers and speculators, but what statistical data is used to support these claims? From what I can tell, many assumptions in the analysis to date are assumptions that may very well be accurate, but how do we verify this accuracy without access to the facts? Assumptions are simply not good enough when it comes to the responsibility Congress has to protect the integrity of these markets, integrity that would be compromised by a lack of market liquidity or by increasing the cost of risk management or by forcing a migration of these markets overseas.

And while I want to understand the causes that led us here, I do not believe anyone in this room or anywhere else, frankly, has all the answers to what exactly went wrong. I'm not willing to believe everything reported in the press unless the claims can be backed up with hard, verifiable data. To do otherwise is reckless. In fact, the data we have seen so far actually contradicts some of the claims people are so quick to believe and ultimately to blame for causing this mess that we're facing today.

Beyond requiring more transparency, I also believe this committee should explore how most effectively to regulate swaps, some of which are statutorily excluded from CFTC regulation and oversight. We should review the manner in which hedge exemption from position limits are granted, and we need to determine how best to encourage the clearing of certain derivative products without jeopardizing either the use of these risk-management tools or the sustainability of our clearing houses.

If Congress is truly interested in addressing the problem as opposed to politicizing a solution, we can no longer ignore the complexities of these markets. We must devote time to understanding these instruments and their implications. We must seek to understand the legitimate purposes these complex instruments serve for large and small businesses in each of our states. That is why hearings such as this are absolutely essential. The last thing we should be doing is contributing a whole host of new, unappealing consequences in an already volatile marketplace.

Mr. Chairman, I particularly look forward today to hearing some of the practical aspects of utilization of these products that are on the market today. And I fully expect our witnesses to be able to tell us, number one, how they utilize them from the standpoint of making the economy of this country stronger, by making their businesses stronger, and also how they think we can move in the direction of further regulation to ensure that confidence on the consumer side as well as stability and liquidity in the marketplace.

So again, I thank you for bringing this matter forward. I know it will be the beginning of dialogue -- a dialogue that fully recognizes the role of the CFTC, but also that of the Ag Committee. And I'm very pleased that we have our new chairman that we now have in place here to kick off this hearing this morning.

And to the chairman, I say, publicly, congratulations. And we're excited about you being where you are and we look forward to working with you and hearing your testimony this morning.

SEN. HARKIN: Thank you very much, Senator Chambliss. And now we'll move to our witnesses. And first is our new chairman of the Commodity Futures Trading Commission. Mr. Gary Gensler was sworn in as chairman of the CFTC on May 26th, 2009. Chairman Gensler previously served at the U.S. Department of the Treasury as undersecretary of domestic finance and as assistant secretary of financial markets; subsequently served as a senior adviser to the chairman of the U.S. Senate Banking Committee on the Sarbanes-Oxley Act, reforming corporate responsibility, accounting and security laws.

Chairman Gensler is the coauthor of a book, "The Great Mutual Fund Trap," which -- I just mentioned to him in private I've been reading parts of it and I recommend it highly -- which presents commonsense investment advice for middle-income Americans.

Mr. Gensler is a summa cum laude graduate from the University of Pennsylvania's Wharton School with a bachelor of science in economics, received a master of business administration from the Wharton School's graduate division in 1979.

So Mr. Gensler, welcome back to the committee. Congratulations again on your assumption of the chairmanship of the CFTC. Your statement will be made a part of the record in its entirety. And please proceed as you so desire.

MR. GENSLER: Mr. Chairman, Ranking Member Chambliss, other members of the committee, thank you for your support, your unanimous support in my recent confirmation and thank you for inviting me here today to talk about this critical issue to the nation's economy.

I believe that we must urgently enact broad reform to regulate the over-the-counter derivatives marketplace. Such reforms must comprehensively regulate both the derivative dealers, those institutions that make markets in these products, as well as regulating the markets themselves. I think that it's very important for the future of our economy and the welfare of the American people. And I pledge to work with this committee and Congress to try to restore confidence in the financial regulatory system.

Many of these will require statutory changes, of course, but, Senators, also know that I've already directed the commission staff to present all options under our current and existing authorities to protect the market integrity and consumers from price volatility, that price volatility that may accompany a rebound in this overall economy as well as we move forward. And this is particularly the case within the physical commodities, whether it's wheat, grain or energy markets.

A comprehensive regulatory framework governing the over-the- counters derivatives markets and over-the-counter derivatives dealers should apply to all dealers and all derivatives, and I believe that should be no matter what type of derivative is traded. So that would be interest rate product, currency product, commodity product, equities and -- as well as credit default swaps or that which can't be foreseen yet, but other swap or derivative products coming in the future. Furthermore, it should apply to the dealers and derivatives no matter whether they're trading in standardized products or in customized products. And in my written testimony, I go further into that.

But let me mention the four key objectives that I think we would wish to achieve here. One is to lower systemic risk. We have to make sure that there's less risk in the overall system. Two is promoting transparency and efficiency in markets. Three is promoting market integrity, preventing fraud, manipulation, other abuses, setting position limits where appropriate. And fourth, protecting the retail public.

As I said, to achieve this, I foresee working with Congress on two complementary regimes. Through the dealers -- through the dealers that hold themselves out to the public on these products, we should set capital standards to lower risk for those dealers, margin requirements as they conduct business directly with other commercial enterprises, business conduct standards -- which I want to return to -- and record-keeping and reporting. And this would be for all derivatives, whether customized or standardized, whether they be interest-rate product or credit default swaps.

But on the dealer community -- which there's really just 20 or 30 large ones -- we regulate that side. The business conduct standards would protect against fraud, manipulation and other abuses, and the record-keeping and reporting, importantly, would allow the regulators to see a complete picture and aggregate this picture.

In addition, I do believe, though, we need to regulate the markets as well. This is a complementary regime to bring the standardized products, those products that can be brought into clearing and brought onto exchanges -- further lowers risk. Clearing has the attribute that no longer would the financial system be so interconnected. Individual firms, rather than having exposures to each other, would have the clearinghouse that has to have the discipline of daily mark-to-market and daily posting of collateral.

But also, regulated exchanges and transparent, regulated trading facilities or trading platforms bring additional transparency. And what we're proposing -- and I believe the administration letter also spoke to this -- is that there would be a real-time reporting of those transactions of the standardized products, so the full market could see on a real-time basis, as they do in the corporate bond market and they do in the securities market, the pricing of the products as clearly as they can.

Before I close this oral part, I want to say there's two other things I think that we need to work together on, beyond regulating the over-the-counter derivatives marketplace and fully bringing this under regulation. I believe that we'll need to work together on the appropriate authorities to put in place aggregate position limits over the marketplace, particularly as it relates to physical commodity products, but also that we need to address some abuses in the retail area -- last year's fix with regard to foreign exchange trading, I think that we'll need to extend that to other physical commodities -- we thank you for some of those helps in Congress -- and also to have clearer authority for the CFTC to make sure that foreign boards of trade comply with our transparency and position limit authorities here -- (inaudible) -- in statute to close what's called the "London loophole."

And with that quick summary of a very complex subject, I look forward to working with this committee and taking your questions today.

SEN. HARKIN: Thank you very much, Chairman Gensler. And as I said, I read your testimony thoroughly last evening, and I just found it very enlightening. And like I said, I think I agree with most of everything you put in there. I have some questions I will ask about a couple of parts of it here.

But as you know, I have expressed to you privately and I have expressed publicly that -- that I appreciate, first of all, that this is the unanimous position of the commission, as I understand. Is that right?

MR. GENSLER: That is correct. I'm pleased to report this is a -- the testimony represents a commission document.

SEN. HARKIN: I would be remiss if I didn't recognize one of your commissioners who is here, Michael Dunn, and to thank him for serving as the interim chairman of the CFTC during this period of time. I want to thank you very much, Commissioner Dunn, for doing that yeoman's work in the interim chairmanship.

But you and I, I think, Mr. Gensler, agree on the need to enact significant regulatory reform, significant regulatory reform of the derivatives market. I don't know if this is a divergence or not in our approach, but it has to do with over-the-counter derivatives and whether they should be allowed to continue. If we do allow over-the- counter trading, then I think the requirements you have proposed, at least -- would be at least a minimum, I think, of what we should be doing in terms of assuring the integrity of those markets.

But I just want to explore with you again on the record in public today whether we might move all of this activity to a regulated exchange or an electronic trading system. So I want to discuss that with you.

But, again, I also want to get into what resources you might need also. I won't get into that in detail, but at some point we've got to think about what kind of resources you might -- you might need.

But you proposed establishing criteria for determining whether a derivative is standardized or not -- now, I wrote these down -- whether a contract is accepted for clearing by a regulated clearinghouse, the volume, the look-alike nature of the contract, evaluating whether the difference between the OTC contract and the exchange contract are significantly -- significant economically, or if the contract terms are disseminated to third parties. I think there's a lot of details left out of that. I still ask the question -- I ask you as I asked it of Mr. Geithner when he -- not before us, but in a meeting in the Capitol -- define a customized swap. What is a customized swap that cannot be traded on a regulated exchange? I still am wrestling with that.

MR. GENSLER: Mr. Chairman, I think that we share your concern that we need to bring a regulatory regime to the entire market, those standardized and those tailored products. And that's why we're proposing to regulate the dealer community and be able to get the full picture, the full record-keeping and reporting, even with an audit trail so that we can police and enforce anti-fraud and anti- manipulation, enforce position limit authority.

In terms of your question, we believe that there are thousands, tens of thousands of commercial interests in this country that promote their business needs by hedging within the futures marketplace and hedging within the swaps or over-the-counter derivatives marketplace. We need to bring regulation to that marketplace. But individual -- individual commercial interests and municipalities sometimes want to tailor a product -- it might be a specific product that hedges their risk in the interest-rate markets, but it might be on a different day; it might be a different month than a standard product; or it may be in the physical commodity market, where it's an airline that wants a certain grade of jet fuel delivered at a certain location on a certain date.

And it's so specific and commercially -- even confidential that there's no liquidity, there's not four other parties that would do that exact contract.

So, what we're proposing is that would still be regulated. It would still be regulated with regard to this first regime, where the dealers that are transacting this business have to comply with anti- fraud, anti-manipulation. They'd have to report and record all of this. The regulators would see a picture of the entire marketplace and be able to police that entire marketplace.

And that commercial enterprise would get the benefit of transparency, because the standardized products -- over half the market, though we don't, it's hard to estimate exact figures but a significant part of the market is standardized, would be brought into exchanges and reported on a real-time basis, so the commercial enterprises get the benefit.

But, they may still want to tailor some features to a specific date or location, in my little example that I gave.

SEN. HARKIN: Well, I'm still going to continue to press this issue -- and I will with the other witnesses who come up, give me an example of a customized, over-the-counter derivative contract that is so customized that it cannot be put on a regulated exchange.

Now, I understand that it may cost a little bit more them to do that. But, I think, to me, the cost of that -- it may eat into their profits a little bit, but, to me, the need for the public to know that, for others to know it for price discovery and transparency -- it may be for a specific jet fuel, but that may have repercussions on other aspects of the oil market that could happen, depending upon how big that contract is.

So, when you do that, I just have a hard time understanding what is so customized that it can't be put out there on that (on that market. ?)

MR. GENSLER: And, Mr. Chairman, for the same reason that you're suggesting, that's why we think that even the tailored or customized products would be reported to the regulators; and that the regulators, and these, can report the aggregate positions and see even that customized -- in this case, the example of the jet fuel.

An exchange generally needs parties on both sides to come with bids and offers. And so, really, the key here is how much interest in a tailored product might there be? And so we believe we have to bring the regulation to the entire marketplace, including these tailored products; and that we must have the regulation of the dealer side so that we can also allow for commercial enterprises to still hedge their very specific and unique risks.

But, at the same time the commercial enterprises would be protected against fraud, manipulation. The market integrity would be protected by aggregate position limits across the markets. And the regulators would be able to police these markets with seeing a real audit trail and a record of tailored and standard products.

SEN. HARKIN: On page four of your testimony -- and I marked it last night, it said "These standards" -- regarding over-the-counter contracts, said "also should require adherence to position limits established by the CFTC on OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets."

But, these contracts, then, are needed for price discovery. If you need price discovery -- as you say right there, "that affect a significant price discovery function," well, wouldn't the public interest require this price discovery to be on an open, properly regulated exchange, and not on the -- not on the over-the-counter exchange?

MR. GENSLER: Our proposal is that anything that could get onto clearing -- anything a clearinghouse would accept for clearing would be presumptively standard. So, if a clearinghouse accepts it -- and we'd have to have open and, rules of governance of these clearinghouses, and we've called for, in this testimony, that these be fully regulated clearinghouses -- but anything that was accepted should be out there and be exactly what you say, Mr. Chairman, fully transparent to the public, and also on exchanges, and on these trading platforms.

SEN. HARKIN: Well, there's some concern about, you know, the clearinghouses are run, basically, by the banks and others. I mean, this is not -- this is not an open exchange. And so I'm concerned about what your regulation would mean, and how we find out, again, whether these over-the-counter derivatives are being regulated.

MR. GENSLER: I think, Mr. Chairman raises a very good point. Right now, the clearinghouses, of course, have come into being -- and fortunately they've come into being, there's a number of them that have started out, but they're on a voluntary basis.

So, we're talking about working with this committee and Congress on having mandatory and statutory provisions; and that those -- I think, working together, we should find the right balance on governance as well, with regard to these clearinghouses, so we don't have, as you highlight, maybe some of the conflicts that may exist. We'd want to guard against those in the governance features.

SEN. HARKIN: Well, that's -- we'll follow up on that. That's pretty interesting.

I'm sorry, I took almost 10 minutes, so I will recognize other people for 10 minutes, rather than five-minute rounds. This is a very intricate subject and it takes a little time to develop it.

Senator Chambliss.

SEN. CHAMBLISS: Well, thank you, Mr. Chairman. And, you're right, it's probably -- certainly above my brain's capacity to understand all the complexities of this industry.

And while you raise a good issue, relative to customized swaps and derivatives, I think we're going to have some testimony from some folks today that actually use them, and they can -- I won't dwell on the details, but I am pleased, Mr. Chairman, that you recognize that there is going to be a need for some custom items and products as we move forward.

And we talked about this last night with Secretary Geithner too, and he's of the same belief. And it's the folks that are in the business every day that have the understanding of this, rather than those who deal with so many other things on a daily basis.

Mr. Chairman, I sent a letter to -- and let me compliment former acting-Chairman Dunn for his great work, and now Commissioner Dunn. We're pleased that, obviously, you were where you were, and you're where you are, because it's folks like you, and the current chairman, that understand these issues. But, I sent a letter back in April regarding several different issues, and you handed me the response this morning, so I'm kind of going off of what you just handed me here.

But, basically, when we talk about costs there's obviously issues on the trade side, relative to costs -- and we'll talk more about that, but there are going to be significant costs on your side, from the standpoint of whatever legislation we come up with, making further demands on you.

And one thing I appreciate you going into detail about is: If we're going to establish position limits, and if we're going to make it mandatory upon the commission to oversee and regulate items such as position limits, you have said that, given the substantial increase in the number of commodities that would be required to have federal speculative position limits, staff estimates that at least 20 full- time equivalent positions would be necessary to review the expanded scope of federal position limits, grant hedge exemptions, collect reports from persons granted hedge exemptions, and monitor for violations.

And, in addition, you go on the respond to my letter by talking about the further extension in regulation of speculative limits to OTC contracts, and that that also would be very significant and would require at least 60 additional staff, plus we'd need to upgrade the systems that you have in place today to be able to handle that.

Ballpark, do you have any idea what kind of additional funding we're looking at for your budget to try to do just these things, which I think there's general agreement that we've got to move in this direction?

MR. GENSLER: Senator Chambliss, I thank you for the letter that was sent to my predecessor, and that I was able to deliver the estimates.

The Community Futures Trading Commission, I believe, still, even with the generous support of this committee and Congress, this year's funding is still sorely under-resourced. We're at about, in total, about 510 people, where we just got authority to move up to 572, which just brings us back to the staffing levels that were in place in 1999 -- 10 years ago.

And the futures markets that we regulate have gone up five-fold. The complexity has gone up significantly. There's six times more contracts today. But, it's not just the number of contracts, it's global. We've gone from open-outcry to electronic trading. So, hopefully, we'll be working together with you and the appropriators in trying to find a way to address these very real resource needs.

If we do go further -- as your letter asked about regulating more position limits, we made an estimate of 20 or 60 people, (and ?) you had two alternatives. And rather than speaking off the cuff, if we can get back to you on an exact, sort of, dollar figure that assigns to those two numbers, we'd be glad to do that as follow-up.


Well, I think there's going to be general agreement that we've got to make some changes. And we agree here that you are under- resourced now. But, we're not going to put additional obligations on you without providing you additional funding. We're simply going to have to do that.

And. irrespective of what amount of money we're talking about, if, in fact, CDS, or whatever part of the commodities market contributed to the financial collapse last year, it's going to be a lot cheaper to fund you to regulate than it will be to go through another situation that we're trying to recover from now.

MR. GENSLER: Senator, I fully agree with you on that, that it would be a good investment of taxpayer dollars to guard against these risks.

SEN. CHAMBLISS: One thing that's been of real concern to me, from the standpoint of putting additional regulations in place, is the fact that we might stymie -- number one, innovation on the part of bright minds in the marketplace, that are thinking of additional products not just for the sake of making money on the end of selling them, but providing a real service to businesses across our country and allowing them to utilize the marketplace again to offset risk. And if we, number one, take all the risk out of that, then I think we're going to be hampering the markets more so than helping them.

And secondly, if we put in over-burdensome regulations then there's going to be the tendency of those folks -- whether they're in my home town of Moultrie, Georgia, or Atlanta or New York, to simply go overseas and carry out the same transaction, but yet on another market that may not be regulated in the way we're talking about.

And one thing that came up in or discussion last night -- and I won't expect you to be able to talk in-depth but I would like your comment about this, is that if we're going to make changes to our markets, in order to make sure that the same protections are in place for American consumers on overseas markets, then, we need to go to our overseas markets.

And we need to tell the Europeans that these are the changes we're going to make, and we hope you would look at the same type of regulatory process to try to coordinate. And let's don't be over- burdensome, but yet make the necessary changes so that our customers -- or, excuse me, U.S. (firm ?) customers don't immediately go overseas, and we lose that business and that ability to regulate those markets.

Any comments you have on the potential for that?

MR. GENSLER: Senator, I think it's absolutely critical that we coordinate internationally with other regulators around the globe. Just yesterday I actually met with the head of the European Commission internal oversight, Charlie McGreevy, on these matters -- it was fortunate he was in town.

But, I know that Secretary Geithner and others are doing this. Commissioner Dunn is actually going overseas next week to take on some of this as well. So, we need to coordinate and make sure there's not a race to the bottom somewhere else. And I'm encouraged by even my meeting yesterday on that.

But, I do think that we also have to really think about how we protect the American public and make sure that we get the right things in place there. We need to still not only allow, but foster innovation so that the economy can grow, but protect it against risks. And the risks that we're talking about protecting against is the risk for fraud, the risk of manipulation, the risks that, sometimes from speculation that becomes excessive speculation.

There may burdens, in terms of the volatility of markets. We're talking about protecting against the risk of unregulated actors like the affiliate of AIG -- AIG Financial Products that didn't have any effective federal regulation, growing so large and being so excessively leveraged.

And so while this is a complex proposal, regulating the dealers to lower risk, lower -- that means there's some capital. That means there's more cushion in the business that they have in their business model. And that more capital may, as you suggest, lead to some more cost, but still allow for innovation -- still allow fully for innovation, but lower the leverage in the system.

And I think one of the great lessons of the crisis of last year is the system overall -- the financial system -- got highly leveraged and too leveraged. I mean, almost all the statistics will point to that. So capital regimes and margin regime lower risk, business conduct regimes lower the risk of fraud and manipulation and the burdens of excessive speculation, but while still fostering innovation, fostering -- as we've said in this approach -- the allowance of tailored or customized products so commercial interests can still hedge their risks.

SEN. CHAMBLISS: I agree with you that certainly posting more capital is going to lower the risk -- and I won't get you to go into any more detail than that, because our other witnesses, I expect, will be able to give us some more information relative to that.

But I want to make sure that we don't require too much in the way of reduction of risk, that we just suck too much capital out of the marketplace. And that we make sure that these folks that are utilizing the -- whether it's over-the-counter or non-regulated today -- that they still have the capital to operate their businesses in the way that they need to be operated.

So I thank you.

And I've got some more questions, but Mr. Chairman, I'll wait until the next round.

SEN. HARKIN: Thank you very much, Senator Chambliss.

I like that the principle here we go on time of arrival. Senator Casey was next, but he's now right now. Then we'll turn to Senator Johanns.

SEN. MIKE JOHANNS (R-NE): Thank you, Mr. Chairman.

If I could maybe start out and do a little self education here, because it's a hugely complicated topic for talking about.

But as I understand what you're kind of getting to here is on one hand, there's a set of regulations or an approach that you would like to be empowered to take relative to people or the companies that actually do business here. And that's -- as I read the four items that you've mentioned, that really would deal with those dealers.

Are we on the same page so far?

MR. GENSLER: Yes. The dealers, which there are internationally maybe 20 or 30 large ones and they're out in the public domain. And we know the names of those big financial institutions by and large.

SEN. JOHANNS: Pretty straightforward working with them and laying out what the standards are going to be and the transparency and the capital that you've mentioned. And so that for me is fairly understandable and fairly straight forward.

The second piece of this, though -- I think it's really complicated -- and that deals with regulation of products. How are you going to handle that and what kind of authority do you want?

The first question I need to try to get an understanding about is as we look back over the last eight to 10 to 12 months, if you were to identify the products that really were at the heart of the problem relative to the financial crisis -- the AIGs, et cetera -- what would those products have been?

MR. GENSLER: Senator, I think that there's any factors that led to this economic and financial crisis. And only some of that was related to the products, because I do believe a great deal had to do with the excess leverage and excess borrowing and imbalances in the system overall.

But in terms of specific products, I believe that the over-the- counter derivatives markets was a contributing factor, particularly with regard to credit default swaps explicitly. I think other products, if I can speak more expansively, also mortgage products specifically; the sales practices and I think many homeowners and the retail public often was misled and even fraud in terms of the sale of those products -- usually in the subprime market, but not always.

I think the securitized products -- whether it's as the chairman mentioned things called collateralized debt obligations and other very sophisticated products there that are not the specific discussions of this hearing today, because those are actually securities and those are actually already regulated by another -- by the SEC.

I do believe the second regime is about bringing regulation to the markets, if I can use the term, rather than products. So it's bringing centralized clearing and the benefit of lowering risk of that that all of these derivatives or swaps come into a central counterparty and no longer is this interconnected web -- but we try to have institutions use that central counterparty.

Some people say that we've had system of "too big to fail" but actually, we've grown into a system also of "too interconnected to fail". And so the central clearing is trying to make these counterparties less interconnected. You can think of it being less caught in a spider's web. The American public was caught in the spider's web of interconnected relationships last fall and we should try to lower that as far as possible as we go -- and bring transparency to the exchanges.

SEN. JOHANNS: As I look at some of what happened -- and you're right. Picking out one thing is just not going to get you to an accurate viewpoint of what happened.

But if I look at this -- and hindsight's always 20/20 -- the amount of bad judgment exercised by people paid enormous amounts of money in salaries and bonuses is kind of breathtaking to me. How will what you're proposing protect the public from the exercise of that bad judgment?

MR. GENSLER: Senator, I concur with you that there's a lot of bad judgment that went around.

I think that at the heart, the way we protect the American public is having strict ability and clear unimpeded ability to protect the public against fraud and manipulation and the excesses that can come from excess speculation some times. But also by putting in place this very real risk reduction -- the capital and margin requirements both of the dealers and of the markets.

The American public should not be so at risk. I mean, they were terribly exposed by unregulated companies. AIG Financial Products basically wasn't regulated at the federal level. Lehman Brothers and Bear Stearns derivative affiliates -- basically, lightly regulated at all at the federal level.

So we have to protect the American public. I believe this program, if enacted by Congress, would significantly do that with regard to over-the-counter derivatives. Certainly, we need to do more about mortgage sales and some of these other areas that we've talked about.

SEN. JOHANNS: Using AIG as an example, because what has happened to them is so very, very public, it was shocking to me to find out that they had this enormous risk exposure and basically, no protection. I mean, if this thing started to implode, it was going to risk the viability of that entire company, you would have thought somebody would have paid attention.

If what you want to achieve here is accomplished -- we give you the authorities that you are seeking -- how would that have changed the situation with AIG -- or would it have?

MR. GENSLER: Well, I think that if these authorities were in place -- not just for this agency, the CFTC, but broadly, because some of these authorities would be -- you know, whether they be at a systemic regulator elsewhere to set capital, for instance -- then AIG's financial products affiliate that did have, as you said, it was $480 billion of credit default swaps, would have -- they would have had to set capital to the side. They would have had to, on a daily basis, put aside margin and value those contracts. And so as those contracts were going the other way, they would have been regulated.

I also think that while I -- we haven't studied it at CFTC, because we don't have any authority over those products right now, that if you really look at how the products were used and marketed, there's really, in my mind, some significant question about how they were marketed. They were largely marketed to lower capital standards in Europe and to be related to these products the chairman talked about earlier -- these collateralized debt obligations.

And I think the credit default swaps have such unique features -- a little bit like monoline insurance, a little bit like securities, certainly derivatives -- that we're going to have to work together as regulators and with Congress to find some clear authorities on the trade practices with regard to credit default swaps.

SEN. JOHANNS: Mr. Chairman, thank you very much.

SEN. HARKIN: Thank you very much, Senator Johanns. That was an excellent question. That last one was great.

Senator Thune.

SEN. JOHN THUNE (R-SD): Thank you, Mr. Chairman. Thanks for holding the hearing.

Chairman Gensler, thank you for being here. And you are at the center of this storm and the historic run-up in commodity prices and oil prices last year that sort of caught everybody looking at how do we solve this, how do we prevent this in the future?

And it seems to me that the question is there clearly needs to be some kind of reform of the regulatory system that we have in this country with respect to a lot of these financial products that were sort of outside the realm of regulation.

I guess the question is, how do we do this? What is the smart regulation? I mean, I'm not someone who advocates regulation for regulation's sake. I think we have to think about how do we do this in a smart way? And it comes down to the fundamental question, in my view, is how do we constrain risk? And it seems to me there are a number of ways that you could do that.

You could have an exchange where there is more transparency and more accountability and where more of these transactions occur in the light of day. I think what happened was there was a lot of stuff that was going on in the dark.

And secondly, maybe it's in the form of margin requirements or capital standards -- some of the things that you've alluded to. But I think we have to figure out how do we do that in a way that is responsible, that is smart, that gets at the heart of this problem, but doesn't push a lot of that capital to foreign exchanges, that doesn't create such an economic burden for a lot of the folks who are making markets in this country that they decide to go somewhere else to do it.

And I think in order to make this work, it is critical -- back to Senator Chambliss's questions -- that we have international cooperation. So I guess my question is: How do we ensure that foreign exchanges are going to follow suit with the additional oversight and transparency regulations? I mean, specifically, who do we go about doing that?

MR. GENSLER: Senator, I share your view that this is about limiting risk, as you say, both in terms of the excess risk that you can limit through the capital and margin regimes, but also risk to the American public through protecting against fraud and manipulation and other abuses.

I also share your view that we're going to need to and want to work with international regulators to see that there's not an arbitrage -- meaning that people would go somewhere else rather than in these markets. I'm encouraged by some of the initial conversations, at least that I've had in my eight days in the job.

But I think that working with, you know, the chairman of the Federal Reserve and the secretary of the Treasury, that we're really going to have to work actively with our international colleagues to see that we can bring these reforms globally. And where there may be differences -- because inevitably, they have different political processes and legislative processes and regulatory processes -- that we guard against those differences, not doing exactly what you've said.

SEN. THUNE: You've said throughout your testimony, you've stressed the importance of protecting market participants from excessive speculation. And I guess I'm curious to sort of know how you define excessive speculation.

We talked about the need for producers in states like Iowa and South Dakota to manage their risk. They use these markets for that purpose. But obviously, speculation plays a role and did play a role in the problems that we encountered a year ago.

How do you define that? How do you get your arms around excessive speculation versus legitimate speculation?

MR. GENSLER: Senator, that's a very good question. I share your view that financial investors, index funds contributed and participated in the asset bubble of last year.

And I'm concerned that as the good news of an economy that rebounds -- and we hope, we all want this economy rebounded -- we might see a resurgence of these commodity prices and that's why I've already directed staff to really lay out for me as chairman and for the commission all the options that are available under current authorities to guard against this.

You know, Congress, in the 1930s I believe, when they set up our predecessor really best defined that. They said that there could be burdens to interstate commerce that come from excessive speculation and Congress wrote into our statute that this could be unreasonable price fluctuations or the volatility that don't bear -- I can't remember the exact statutory words but resemblance to the fundamentals. And then Congress gave the commission authorities to set position limits, and so it's through position limits that we try to guard against this and we've actively used it over the -- this time period.

SEN. THUNE: Some have suggested that the CFDC and SEC ought to be merged into one regulatory body. What's your view on that?

MR. GENSLER: Senator, I think, you know, whether -- we could have a debate here for a few days on what was the lead cause of this financial crisis and I don't think any of us would put on the list that's near -- I mean, I think we really have to focus for the American public on what lessons learned from this crisis, whether it's selling this product or this risk. And so a merger for merger's sake to me while I think it will always be out there in the ether and be debated and discussed is not -- I think we have a heavy agenda here working with Congress that -- now, if somebody laid out why -- if Congress and the president laid out why that would really help the American public, you know, we'd all, I think, want to work with that. But I don't see it really in the lead here of the reasons and I don't think it's going to accomplish much for the American public today.

SEN. THUNE: You got into the -- in a discussion earlier with the chairman and I think maybe with Senator Chambliss too about this -- the -- this distinction between, you know, standardized derivatives, customized derivatives, tailored derivatives, and the importance of having the ability for participants who enter into some sort of a customized association that there would be a different way of regulating those, and I guess the question comes back to is there a way of creating exchange and that where these transactions could all be, you know, sort of managed in a way that is open and that is transparent then that allows for the public to be able to know what the pricing is and everything else. And what I heard you say was that you think it would be difficult to have that kind of a standardized -- to create this sort of standardization of these products that would allow for them to be traded on some sort of an exchange. Is that -- did I hear you correctly?

MR. GENSLER: Well, Senator, I think that -- I think that we can bring regulation and it would be the identical regulation to both tailored products and standardized products -- identical regulation about protecting against fraud and manipulation -- identical in terms of the capital charges of the dealer community, and we can even apply margin to both tailored products and standardized. The standardized products could have the margin through clearinghouses and the tailored products could have it through the dealer community.

So I think actually the -- it's a broad and very full regulatory regime and in fact the same for tailored and standardized. What we need to encourage is much of the standardized product to be on centralized clearing -- because that continues to lower risk -- and as much as possible onto exchanges or trading platforms because that is an additional level of transparency, in addition to the transparency, that the regulators will see it on will aggregate it for the public but additionally the standardized product then you can see the real time pricing.

It's a challenge. It's just a practical challenge if it's tailored. You can put it on an exchange and there wouldn't be another party on the other side maybe. There might not be a -- what's called a bid and an offer. So it's just a challenge, I mean, if we could do it. I mean, that additional transparency is helpful.

SEN. THUNE: Well, and I guess the bottom line is the transparency issue and price discovery and however those are regulated going into the future that those elements be a part of any solution. So we look forward to working with you on this. Obviously, this is a -- it is a complex subject and one that many of us are trying to wrap our brains and our arms around and we appreciate your being here today and look forward to the testimony --

MR. GENSLER: Senator, I thank you and I look forward to working with you because I know these things are critical to your constituents. I mean, we have to get everything to work in the wheat markets and the grain markets as well, and I know that that's been (a challenges ?) too and we've got to focus on that.

SEN. THUNE: Appreciate it. Thank you, Mr. Chairman.

SEN. HARKIN: Thank you, Senator Thune. Senator Bennet?

SEN. MICHAEL BENNET (D-CO): Thank you, Mr. Chairman. Thank you very much for holding this hearing and for your persistence on all these issues. Mr. Chairman, welcome. It's nice to see you. I enjoyed reading your testimony. I wanted to focus on something that you've touched on lightly in some of your responses to the panel because I think the issues of the products, the issues of fraud, transparency, and all of that are important and we need to make sure that we're going a good job with that.

But if you look back at the -- where we are and the cause of where we are, I think it's impossible to avoid coming to the conclusion that what ailed us most was the amount of leverage in our system. I mean, from the consumer level, if you look at credit card debt and home mortgage loans, to the federal government, which doubled its national debt, to financial institutions on Wall Street that went from being 12 times levered to being 30 times levered over a period of time.

You can't sustain that unless you assume that you're going to have a (hockey stick ?) of growth for the rest of, you know, our lives, which isn't going to happen. And I was struck in Lynn Stout's testimony -- Professor Stout is here -- when she wrote that her research indicated that the only time a significant U.S. derivatives market has not been subject to regulation was during the eight years following the passage of the Commodity Futures Modernization Act of 2000. And I wonder -- I was struck by that because I wondered as I read it how much that deregulation was a cause of the sheer volume of leverage in the market because people were able to go out and create instruments or whether they're unrelated. I wondered if you had a view on that.

MR. GENSLER: Senator, I think you're correct that leverage in the American economy is one of the big causes of the crisis. I mean, if you just look at the overall statistics it's remarkable, and I'll just (use it to ?) summarize it. But through much of -- much of all of our lives the economy has had a debt about one-half to two times its economy. So it's like a household that might have a $50,000 income and have 75,000 (dollars) to $100,000 of debt.

We got up to about four times, about four to one, and coincidentally the last time we did that was in the 19 -- late 1920s -- the last time we got to that, and these are the statistics published by the Federal Reserve on a quarterly basis. I think that over-the-counter derivatives were a way that financial institutions -- not the homeowners but the financial institutions add to their leverage as well and that the capital and so forth weren't charged there.

And though I believe looking back now it's clear to me that those of us involved earlier -- and I served earlier -- should have done more to protect the American public. Over-the-counter derivatives actually weren't regulated even before that act passed in any way for capital or for business conduct. So what we're really talking about today and working with Congress is a full -- a shift because just as in the 1930s when President Roosevelt came to Congress and said we had to regulate the commodities markets and the securities markets for the first time, we're talking about the CFTC and I believe this is consistent what the administration is talking about now coming and let's do this in a thoughtful but in a full way to regulate this market.

SEN. BENNET: And as you think about that -- the systemic risk question, the moving from a world where all of our regulation -- that may be an overstatement -- much of our regulation and all of our deregulation was in effect -- pro-cyclical, was pushing us farther and farther and farther along this curve, how do you imagine what you're proposing here will work with the -- some of the suggestions that have been made by the administration, by the Fed about where to locate the regulators' systemic risk?

I mean, how will all these pieces fit together -- your work, the Fed, the FDIC, the SEC? Because I think only if we've got some way of looking at the whole picture will we ever get the big picture. We can do it product by product by product but really there's this big fundamental piece of not wanting to put ourselves in the position again where we simply have too much leverage on the economy and then have to go through an incredibly agonizing contraction which is where we are today.

MR. GENSLER: Right. Right. I think that you're absolutely right, that we -- we've had a lot of failures in our financial regulatory system. It failed the American public in the biggest test in 80 years, and we have to address far more than just this over-the- counter derivatives marketplace and part of that is, as you say, Senator, is to have a systemic regulator to have some ability for those largest systemically-relevant institutions -- those, you know, institutions that could make the public hurt so much -- to have additional oversight, and I know that there's various approaches to it.

What I would associate at least myself -- I'm not speaking for the commission now but just as chair -- is that we absolutely need this and working with Congress to make sure that it's -- has clear authorities on those most systemically relevant, and those authorities might just be additional authority. So, for instance, where the CFDC is regulating markets and regulating clearing institutions and so forth as a market regulator, I think in this country, again, since President Roosevelt and Congress worked together in the 30s, market regulators have had their mandate, both the SEC and the CFTC, and those are really important mandates, protecting the public, protecting the integrity of these markets. But then we'd have a systemic regulator of some sort that would -- we'd have to coordinate.

SEN. BENNET: Thank you, Mr. Chairman.

SEN. HARKIN: Thank you, Senator Bennet. Now we'll go to Senator Nelson.

SEN. BEN NELSON (D-NE): Thank you, Mr. Chairman. Thank you for holding this hearing. Mr. Chairman, it's nice to have you before us. I enjoyed our conversation earlier this year. I'm interested in how we can find a way to regulate leverage because leverage seems to be the operative word when you look at what happened with AIG. There wasn't a lack of leverage in their insurance operating subsidiaries because they were required by law in practice to put up reserves or capitals against the commitments they made.

But through the deregulation of '88, I believe, with the Glass or with the decline of Glass-Steagall with Gramm-Leach-Bliley there was an effort then to be able to do as you chose at the top outside of the insurance-operating subsidiaries. Would you agree with that generally?

MR. GENSLER: Senator Nelson, I believe with regard to AIG they were regulated at the state level as an insurance company --

SEN. NELSON: Exactly.

MR. GENSLER: -- and so -- and this has been a challenge, I know, for decades actually and that Congress will probably want to take up and thinking about those systemically-relevant firms -- what if they're insurance companies and the relationship of federal regulation to state regulation of insurance companies. So I believe that AIG was sort of a case where there was an unregulated affiliate of an insurance company that was regulated at the state level and that unregulated affiliate then it was sort of "Katy, bar the door."

SEN. NELSON: Yeah. In effect, the deregulation permitted this operation that was not regulated to do whatever it chose to do without setting aside capital to support the obligations that incurred.

MR. GENSLER: Senator, I think that as it relates (just ?) to AIG, which was not under any -- in the 80s, as you referred, not under, I believe, back then any federal oversight. I mean, later there was some I would say ineffective federal oversight by the thrift supervisor but the -- so I don't -- I don't -- I think it's really that it was an unregulated affiliate of an insurance company. And we have to make sure that going forward that we regulate these derivative dealers whether they're affiliated with an insurance company, whether they're regulated -- whether they're affiliated with a hedge fund, affiliated with anything if we're able to work with Congress and get this through.

SEN. NELSON: Right. And -- but that doesn't (extend ?) that somehow the federal government has to begin the process of regulating the insurance-operating subsidiaries that are currently regulated by the states.

MR. GENSLER: Not in this testimony or in my view. It's about trying to make sure that the derivative dealers come under a consistent regulatory oversight.

SEN. NELSON: If they'd had to set aside capital actuarially or in some fashion to support the obligations they were incurring, this would have been less likely to have happened the way that it's happened throughout the industry. Is that fair?

MR. GENSLER: I think that is correct, Senator.

SEN. NELSON: So establishing a way to (us ?) require that capital will reduce the leverage that exists not only today but in the future as well. Is that fair too?

MR. GENSLER: I believe that's correct. I think to lower the leverage is setting those capital standards for the dealers but also having margin posted just as it is on a futures exchange. This has worked for decades in the futures exchange, and there's problems even in regulated futures but not about the capital (and margining ?).

SEN. NELSON: Yeah, and this wasn't related necessarily in every case to fraud but in almost every instance you could say there certainly was some greed.

MR. GENSLER: Well, I think that that was the case broadly in this economic crisis.

SEN. NELSON: And I hope as you look to regulate the tailored products as well as the standardized products that there'll be a system established to figure out the ratio for leverage against the obligations that are made. Will -- do you believe you'll be able to determine what the obligation is under tailored products?

MR. GENSLER: I think that, Senator, you raise a very good question because one of the things about tailored products is they tend to be less liquid. They're sometimes harder to value. I do --

SEN. NELSON: May or may not be much of a market for them.

MR. GENSLER: May not be much of a market, as the chairman was talking about. I do think it's appropriate to take into consideration as regulators that if they're less liquid and they're tailored that might lead to higher capital charges just -- just to -- as any product that's less liquid and harder to value because capital is meant to be a cushion against the risk if a firm fails or there's problems in the system.

So liquidity is the key, and just as the chairman was talking earlier about whether the tailored products would be regulated, they'd be consistently regulated but if they're less liquid it may be appropriate that the regulators say well, you have to put a little bit more cushion aside on that.

SEN. NELSON: Would you do this in the same way, let's say, that the National Association of Insurance Commissioners, which I used to head in a previous life, the way they do it through the Securities Valuation Office in New York that is a part of the NAIC?

MR. GENSLER: Senator, I dare say you're far more familiar with how that works. I'm not familiar with their specifics there.

SEN. NELSON: Well, they do value securities that don't have a market value based on one of the markets -- in other words, private placements and the like. So tailored securities probably as much as standardized securities would fit into that sort of a category where analysts would work their way through, establishing what the leverage is and then establishing capital requirements for that leverage.

MR. GENSLER: I think -- though I'm not familiar with the specifics of that I think that there should be consistently-applied capital rules for the over-the-counter derivatives. Those that are on markets and those that are liquid -- just like other products, the more liquid a product is then --

SEN. NELSON: Easier to value.

MR. GENSLER: -- easier to value and it may necessitate a little less cushion, a little less margin. Certainly, even in the futures markets right now there's different margins depending upon the volatility and liquidity. I think one of the great lessons of this crisis is I believe that our overall capital regimes -- and this is not within the CFTC -- (inaudible) -- but our overall capital regimes let the American public down and that we need to take, as federal regulators, a closer look at those capital regimes and make sure that they take into consideration particularly that less liquid instruments -- less liquid instruments like collateralized debt obligations or structured products -- maybe should have higher cushions or higher capital.

And those that are easier to value that are liquid instruments --

SEN. HARKIN: But you will have to have some mechanism some way of analysis of establishing those values in an objective fashion. And I suppose you're going to be bothered by those that turn over too quickly to value them for any length of time because you had them, they're gone, they've been sold. I just hope that you'll find a way to consistently do that so that there is some objectivity and some reliability for establishing what the leverage requirements would be. Thank you. Thank you, Mr. Chairman.

MR. GENSLER: And I thank you for your support.

SEN. HARKIN: Senator Nelson and Senator Gillebrand.

SEN. KIRSTEN GILLEBRAND (D-NY): Thank you, Mr. Chairman. And thank you, Mr. Chairman, for being here and testifying. Thank you, Mr. Chairman, for holding this hearing.

And thank you Chairman Gensler for being here and for testifying. These are very important issues. Few if any cities in the country have really felt the effects of the economic collapse more acutely than New York, New York City, the state that represent. And I want to talk to you a bit about how we can move forward so that we can create confidence in our markets and create a regulatory framework that will ensure success, not only with the U.S. financial services industry but our economy overall, because we really do need to address the 8.5 percent unemployment rate nationwide. And we have to make sure our small businesses have the resources they need to grow and create jobs.

As we work to sustain the companies that form the backbone of our financial industry, we must ensure that the structures and the regulatory framework institute proper oversight and capital requirements while still promoting significant growth and expansion. There's been a tremendous focus on the extraordinary losses that have resulted from the unregulated derivatives market and particularly the credit default swap markets, and rightly so.

However, there also needs to be now significant attention paid to the regulation of these financial instruments which have become an integral part of our financial system. We have to ensure that capital reporting requirements will allow derivatives to exist for legitimate participants but discourage excessive speculation and protect our investors. It's essential that we fully understand the implications on the end users such as industrial companies who rely on derivatives to hedge commodity prices, interest rates and foreign exchange rates.

We must have an efficient and effective regulatory structure to ensure a vibrant economy, economic growth, adequate liquidity, and appropriate oversight and accountability. So I first want to talk about what do you think, and how do we allow legitimate participants versus those who are trying to gain the system? And what sort of capital reporting requirements would allow custom derivatives to exist for legitimate purposes and participants but would discourage the excessive speculation and still be able to protect our investors?

MR. GENSLER: Senator, if I might first start with thanking you for your support in my recent confirmation, and it's good to meet you. I lived in New York for 15 years. My three daughters were born in New York, and though I live in Maryland now I have great affection and affinity for your state.

I think it's important to bring, as you say, greater regulation to this whole over-the-counter derivatives marketplace. I think we should best do that in two complimentary regimes that would address, as you say, legitimate interests of commercial parties to hedge their risks but also have capital standards to lower the risk.

One is to have a regulatory regime of the dealer community, many that are in your great state. But of the dealer community, so that those dealers have to have the capital to lower risk, to set margin, but also have business conduct standards to protect against fraud and manipulation. And that regime covering the dealers would cover both standardized and tailored product. Tailored product or customized product would be allowed, but it would cover both of these as well.

I think that it is important as you say that commercial users have legitimate needs to do that, but we'd want to bring as much of this product into centralized clearing and regulate the markets as well for that centralized clearing because additionally that lowers risk. And if we can lower risk through centralized clearing, that frees up capital in the dealer community, because if they can move product over to centralized clearing that's a way to lower risk.

It also helps raise transparency to put that on exchanges where it's standardized product, and we'd want to work with Congress to get this so the presumption was if it could be on a centralized clearing, it could be on an exchange, we would do that.

SEN. GILLEBRAND: Um-hum. What do you see as the upsides or downsides for actually requiring it to be on an exchange as opposed to just having it go through clearing?

MR. GENSLER: We think that there's real benefits to also having it on an exchange. Of course, one of the features of our market system here in the U.S. is transparency, and the transparency of markets promotes economic efficiency. So we have transparency by having 100 percent of the product, both tailored and standardized, that information available to the regulators. But also making transactions available to the public lowers, we believe, some of the cost to the end users that you spoke about.

So bringing them on to exchanges, the standardized product—that means that any commercial user can say, "Aha, 15 minutes ago this is where it might just be an interest rate swap, a standard product to hedge an interest rate for five years," and they can see where that was. And if you're a small hospital or municipality, you can say, "Aha, that's where the pricing is, and we should do the same."

SEN. GILLEBRAND: But if you do require exchange trading then you're really not going to have an opportunity for customized derivatives. So do you think you're going to lose enormous markets to overseas markets because you can't accommodate that here?

MR. GENSLER: Senator, we actually foresee that this approach would allow for, as you call it, customized or tailored product. Much of the derivatives marketplace right now is standardized, but there's still a very real need for end users to tailor their products. So what we're calling for is 100 percent of the product, tailor and customized, would be regulated through regulating the dealers.


MR. GENSLER: The product that could be brought on to exchanges would benefit because it would add transparency, but we would still foresee that end users would be allowed to tailor their needs. They might have a risk. I used earlier an example, it could be an airline that has a risk around a particular jet fuel to be delivered in a particular date and a particular location—that we would still allow for that but still regulate, protect against fraud and manipulation; and that the regulators would see it's an aggregated and publicly report the aggregated data.

SEN. GILLEBRAND: I'd like to turn specifically to one industry area, the trading of carbon permits --

MR. GENSLER: Um-hum.

SEN. GILLEBRAND: -- and the derivative products that may be based on them. And this may obviously become a major growth center for these markets. How would these proposals affect the shape and the nature of carbon trading markets? And does the potential market for carbon derivatives have unique needs from other derivative products? What unique skills might the CFTC or another regulator need to effectively regulate this market?

MR. GENSLER: Senator, I think that the CFTC has over many years developed a skill set and has a mission to oversee the derivatives marketplace which we've called the futures marketplace for these years. And in fact there's already a small market in these permits, or similar markets, in Chicago called the Chicago Climate Exchange. There was a similar market that came up, oh, I think it's over 20 years ago now, out of some of the permits that came out of asset rain legislation of Congress.

As Congress moves forward and possibly further develops this, I would look forward to working with you and the Congress on how to get this right, but I think it would be important to protect against the same thing we protect against in the futures markets. I mean fraud and manipulation, possibility of setting position limits because these would be physically limited; these contracts would be, you know, to have a limited supply.

So again, bringing the same, hopefully, transparency and protections that we have currently to the futures markets.

SEN. GILLEBRAND: Thank you, Mr. Chairman.

SEN. HARKIN: Thank you very much, Senator Gillebrand. And now we'll turn to Senator Klobuchar.

SEN. AMY KLOBUCHAR (D-MN): Thank you very much, Mr. Gensler. You've had a long morning. It looks like I'm the last one here for you. I just wanted to thank you again, and I'm glad that you are joining us. I think I expressed my frustration last time at your predecessor when I asked about more tools that he could have in his job. He didn't seem interested, and yet we saw at the time oil prices going up due in part to speculation and other problems with the regulation of the market.

And I do believe, I appreciate what he said about transparency and that we need to also take steps to minimize speculation when it's done, not to benefit consumers or the market but instead to benefit a certain small segment of those that are doing the trading. We need an effective CFTC, and then we also need to do something about some of these instruments and financial instruments that cause some of those problems.

And specifically when I talked with you during your confirmation hearing we talked about credit default swaps. And now that it's a little calmer here, I wondered if you could talk about what you think needs to be done to better regulate credit default swaps.

MR. GENSLER: Senator, again, thank you for your support in my confirmation process. I believe that we need to bring regulation to the entire over-the-counter derivatives marketplace, so credit default swaps but also the interest rate product, currency swaps, commodity swaps that this committee certainly has talked a lot about in the last two years, and equity products. I believe that we can best do that, as I was just saying with the senator from New York, that we have a regime to regulate the dealers.

There is internationally maybe 20 or 30 major dealers. I don't mean to limit them, but that work in these products. Many are regulated for other reasons, but we need to explicitly regulate them for business conduct, capital, margin and reporting for credit default swaps and the products, for tailored and standardized products.

I think secondly we need a regime that brings as much of the product as possible, the standardized product, into lower risk through what's called "centralized clearing," and there's some voluntary features of that now; but also greater transparency through exchanges, while still recognizing there will be tailored and customized products that would be fully regulated in the first regime but might not get the added risk reduction in the second regime and the added transparency in the second regime.

I think credit default swaps might have some unique features, some unique features that in addition to what we've laid out in testimony today I think that the regulators, certainly the CFTC and the SEC working together, really have to think over is there some additional features even with regard to credit default swaps because they perform so many functions like securities.

SEN. KLOBUCHAR: You mentioned the risk, systemic risk. What do you think of this idea of having some kind of systemic risk regulator at the Federal Reserve or some place that looks at the market as a whole?

MR. GENSLER: Senator, I think that there are many lessons out of this crisis that developed in the last several years, but I think one of the lessons is, is that we need at the federal level some clear authorities and mandates from Congress as to when a regulator can step in to protect against systemic risk. All of the regulators, the CFTC included, primarily were put in place not to protect against systemic risk but to protect against very important risk to the public, but other risk. I think if Congress working with the administration moves forward, we should have a party or a mechanism such that the most relevant firms that could lead to crises might have additional standards, additional risk limitations, and additional standards to be less inter-connected to protect the American public.

SEN. KLOBUCHAR: As we head into the summer now, and a lot of my constituents have cabins—this one is for them—they start to see the oil prices going up again. Why do you think oil is going up, and what do you think we can best do to protect ourselves?

MR. GENSLER: I think at the core of the mission of the Commodity Futures Trading Commission is to make sure that the markets are fair and orderly and there's integrity. And the energy markets—I do believe that in the past asset run-up that financial institutions participated in that asset bubble. I think as this economy starts to recover, and we all hope for that and are working hard for it to recover, that we'll see some movement in commodity prices.

But I've said to the staff already—I've been there eight days—that we have to look at every available option within our current authorities as our mandate to see how we can protect the public and make sure that they're not burdens from excessive speculation. And though it's not well-defined in statute, it's a key mission of ours. I've asked for every option to be on the table, and I appreciate that as the summer moves forward we might see more movement in these prices.

SEN. KLOBUCHAR: Thank you.

SEN. HARKIN: Well, Mr. Gensler, thank you very much for being here today and for your very open and frank discussion of these issues. It's very refreshing to have that kind of openness and just frank responses and answers. I appreciate it very, very much. As we move ahead in this, we will be taking action this year as I said at the beginning. We need your input to us on authority, which you just mentioned here, on if there's additional authority that you need to carry out your mission we need to know that and what additional resources that you need to carry out some new responsibilities that I think that we may be giving to you in the CFTC, charging you with.

So we need to know that. I know budgets are tight. I don't want to promise the sun, the moon and the stars, anything like that, but I think the public is aware of the need for better regulation and whatever small amount of cost that might be I think will be more than outweighed by the public benefits that come through a better regulatory regime.

So we need to keep our lines of communication open on those two things, authority and resources. And I would yield to Senator Chambliss.

SEN. CHAMBLISS: Thank you, Mr. Chairman. And I think all of my questions have been answered. I did want to make just one comment though. The chair as well as Secretary Geithner have both expressed, as we've talked about this, customized versus standardized transactions, that a transaction should be deemed "standardized" if a clearing house is willing to accept it for clearing. And we talked about there are some clearing houses out there now that are voluntarily accepting some of these transactions.

And there was an interesting article in the Financial Times yesterday where three of these voluntary exchanges, the New York Exchange, the ICE Exchange, and the London Exchange, were warning Congress to be careful about this, be careful about mandating and forcing too much of the over-the-counter derivatives into the clearing houses, particularly because these tailored OTC derivatives being forced into clearing houses that are ill-equipped will really create a problem.

And I'd simply like to ask that a copy of that article be inserted into the record.

SEN. HARKIN: Without objection. And I could get into that, but we'd probably get into a debate, and I don't mean to engender that right now. But I would say that I sat here in 1999, in 2000. I wasn't chairman then. But I sat here and listened to all the reasons why we couldn't regulate, and I have the record. The question I asked of Mr. Greenspan when he sat here, not in this room, about the exposure and the regulation of these and what would happen if we didn't do that, and I'm proud of the fact that I'm one of nine members of the Senate that voted against deregulation of Glass-Steagall. But I asked him that on the record. And I remember his answer. It's on the record. I've got it. He said, "Don't worry." I'm paraphrasing. He said, not to worry. He said, "These are smart people, and they will self-regulate because it's in everybody's interest to make sure that nobody else cheats." Well, fooled once, your mistake. Fooled twice, my mistake.

Thank you very much, Mr. Gensler, for being here.

MR. GENSLER: Thank you, Mr. Chairman. Thank you, Ranking Member Chambliss, members of the committee. I look forward to working with you on this very important agenda for the American public.

SEN. HARKIN: I appreciate that very much, Mr. Gensler. And I want to thank the members of the committee that showed up. I think this is one of the most important hearings that we are going to have this year. I thank the members of the committee that showed up. I know every one is busy around here, but I just can't think of anything more vitally important that we're going to do this year than to address this issue. Thank you very much. Congratulations again.


SEN. HARKIN: We'll call our second panel up. Ms. Lynn Stout, professor of UCLA School of Law in Los Angeles California. Mr. Mark Lenczowski—I hope I pronounced that right—manager, director at J.P. Morgan, Chase and Company. Dr. Richard Bookstaber, New York. Mr. David Dines, president of Cargill Risk Management. And I will yield to Senator Klobuchar for purposes of introduction there. And Mr. Michael Masters -- oh, he was traveling and evidently his connecting flight was cancelled due to weather problems. He's on his way. Okay. And then Mr. Daniel Driscoll, executive vice president and chief operating officer of the National Futures Association in Chicago.

And go take your seats. And again I would yield to Senator Klobuchar for the purposes of an introduction.

SEN. KLOBUCHAR: Well, thank you very much, Mr. Chairman. I was just here to welcome Mr. Dines to the panel. He is from the Cargill company, which is a very successful company located in Minnesota, the biggest private company in the country. He was named president of Cargill Risk Management in April 1999. Cargill Risk Management is responsible for providing risk management products to producers, consumers and investors in the agricultural and energy areas. He joined Cargill Financial Markets Division in 1992, and in May 1994 he was asked to help start Cargill Risk Management, which is a new business venture for Cargill. And so we look forward to his words today.

Welcome to Washington.

MR. DINES: Thank you, Senator Klobuchar. It's very nice to be here today. Thank you.

SEN. KLOBUCHAR: Thank you.

SEN. HARKIN: Well, we thank you all for being here. I know you've heard our interchange with Chairman Gensler. At the outset I will say that all your statements will be made a part of the record in their entirety.

I'd like to ask if you could perhaps sum it up in five, 10, 15, 20—5 minutes maybe, so we can have a round of questioning from the senators? And I'll just start in the order in which I introduced everyone, so we'll start with Dr. Stout, and then we'll move across the panel.

So Dr. Stout, please proceed. And welcome.

DR. STOUT: Thank you, Mr. Chairman. Thank you members for inviting me to testify today. My name is Lynn Stout. I am the Paul Hastings professor of Corporate and Securities Law at the University of California at Los Angeles. My scholarly expertise actually includes the theory and the history of derivatives regulation. I also serve as an independent trustee of a large mutual fund that uses derivatives, so I have practical experience with the derivatives markets. And I've actually published several rather lengthy and at the time to many people I'm sure boring articles on derivatives regulation.

Please allow me to note that in these articles which I published in the 1990s I predicted that deregulating financial derivatives was likely to result in increased market risk, reduced investor returns and price distortions and bubbles. I am as distressed as anyone that these predictions proved to be correct.

However, I made the predictions because if you study the history and the theory of derivatives markets you will inevitably reach four basic conclusions. The first conclusion is that despite industry claims, the industry seems to have a very short memory—derivatives are not new and they are not particularly innovative. There were derivative markets in the United States in the 19th century. Derivatives of course frequently go by many different names. The jargon that surrounds them is unnecessarily complicated. In the 19th century however they were called "difference contracts." They were regulated by contract law. I can cite to you the 1884 Supreme Court Case of Irwin versus Williar, 110 US-499, which essentially held that: "Off-exchange derivatives were legally unenforceable unless the party entering the derivatives trade could prove they had a bona fide economic risk that they were hedging against."

So this is not a new issue, and the regulation of derivatives is not new.

Second, I can testify from my study of the history of derivatives that healthy economies regulate derivatives markets. This was true in Japan in the 15th century, and it was true in the United States all the way up until the passage of the Commodities Futures Modernization Act of the year of 2000.

Third, studying the theory of derivatives, it is true that derivatives trading can provide some economic benefits to the economy. Let me make a note. Clearly, derivatives trading can provide benefits to individual derivatives traders, just as gambling can provide benefits to individual gamblers. My focus, and I suspect the committee's focus, is on the public good. And from the public's perspective, the primary economic benefit that you can get from derivatives trading is from risk hedging.

However, although the industry routinely claims that there are enormous risk-hedging benefits, not to mention some off-hand liquidity and price discovery benefits from derivatives training, my research was unable to uncover any significant empirical evidence of the magnitude of these benefits. So this is a claim I've been seeing be made by the industry for 20 years now. I thought I'd update my research for this hearing. They still have not generated any empirical evidence, any statistical evidence, that demonstrates that the economic scope of these benefits is worth the costs that go along with them.

And history teaches us that unregulated derivatives markets carry some very significant economic costs including a very strong historical association with asset price bubbles, a very strong historical association with increased market risk and the failure of institutions. This goes back 500 years. We don't need to just focus on Orange County, Barings Bank, Long Term Capital, Enron, AIG and Bear Stearns.

Third, derivatives regulation has historically been justified in part on the theory that encouraging speculation actually reduces economic productivity by diverting valuable resources, especially human creativity, time and energy—away from more productive industries that contribute more to social welfare.

And, fourth, derivatives trading is very clearly associated with increased levels of fraud and manipulation in the underlying markets.

Finally, the last lesson that the history of derivatives regulation can teach us is that successful derivatives trading regulation is possible and has been done. Generally it has been accomplished quite successfully through a web of complex procedural rules that include reporting requirements, listing requirements, margin requirements, position limits which I think are very important, insurable interest requirements, and limits on enforceability.

The joy of these rules is that they can be put in place ex ante so that derivatives traders know what is and is not required of them and can make plans. It does not call for excessive discretion on the part of an omniscient government regulator.

And the rules are very time-tested. They have done historically a very good job of permitting legitimate socially beneficial derivatives trading for risk hedging purposes while weeding out excessive speculation, excessive risk, and excessive manipulation.

If you'll indulge me just briefly, I do think one thing that's really worth saying is, people frequently discuss how complicated this issue is and in the weeds it is complicated. But the basic problem that we face from a policy perspective is actually quite simple. Although Wall Street surrounds derivatives with jargon, they are essentially one thing. They are a bet or a gamble on something that's going to happen in the future.

And when I bet on a horse to win a race, my race ticket is my derivative contract. When I bet on the credit-worthiness of a corporate borrower, my credit default swap is my derivative contract. Betting can obviously be used to hedge against risk, so if I actually own a corporate bond and then I purchase a credit default swap, I've reduced my risk because if my bond goes down in value my credit default swap goes up.

But it is very important to recognize that derivatives can also be used and are especially attractive purely for speculative purposes. There actually is a clear economic definition of speculation. It's "trying to make money, not by producing something or providing investment funds to someone who is producing something, but instead by trying to predict the future better than someone else can."

As a practical matter, it can be difficult to establish so that a particular derivatives trade is speculative in nature simply because traders are really good at making up alleged risks that they are supposedly hedging against. However, for 200 years regulators have succeeded in coming up with ways to weed out true risk hedging through speculation, and this can be done for example at the macro level.

I simply want to cite to you, we may not know with exactitude which credit default swaps were exact hedges and which ones were speculation. We can be quite certain by 2008 the CDS market was overwhelmed by speculation. We know this because the notional value of credit default swaps in 2008 was approximately $67 trillion, whereas the notional value of the bonds—both mortgage-backed bonds and corporate issue bonds—that the credit default swaps were being written on was less than one-fourth that size. It was $15 trillion.

When the derivatives markets are four and a half times the size of the market for the underlying thing you're supposedly hedging a risk of, you know the market has been swamped by speculation with, I would say, sadly predictable results that we are now trying to sort through today.

So I think that's probably a good enough start.

SEN. HARKIN: Whew. That's a great start. Okay. Thank you, Dr. Stout.

And we now turn to Mr. Lenczowski, managing director of J.P. Morgan Chase. Mr. Lenczowski.

MR. LENCZOWSKI: Thank you, Chairman Harkin, Ranking Member Chambliss, and members of the committee. My name is Mark Lenczowski, and I am a managing director and assistant general counsel at J.P. Morgan, Chase and Co. Thank you for inviting me to testify at today's hearing.

For the past 30 years, American companies have used OTC derivatives to manage interest rate, currency, and commodity risk. Increasingly many companies incur risk outside their core operations that left unmanaged would negatively affect their financial performance and possibly even their viability. In response to marketplace demand, financial products such as futures contracts and OTC derivatives were developed companies to manage risk. OTC derivatives have become a vital part of our economy. According to the most recent data, 92 percent of the largest American companies and over 50 percent of midsized companies used OTC products to hedge risk.

J.P. Morgan's role in the OTC derivatives market is to act as a financial intermediary. In much the same way financial institutions act as a go-between with investors seeking returns and borrowers seeking capital, we work with companies looking to manage their risk and with entities looking to take on those risks.

Recently clients such as Chesapeake and Medtronic have expressed great concern about the unintended consequences of recent policy proposals, particularly at a time when our economy remains fragile. In our view, the effect of forcing such companies to face an exchange or a clearing house would limit their ability to manage the risks they incur in operating their businesses and have negative financial consequences for them via increased collateral posting.

These unintended consequences have the potential to harm an economic recovery.

Let me first discuss some of the benefits of OTC derivatives. Companies today demand customized solutions for risk management, and the OTC market provides that. Customization does not necessarily mean complexity. Rather, it means the ability to tailor every aspect of this transaction to the company's needs to ensure that the company is able to match its risks exactly.

For example, a typical OTC derivative transaction might involve a company that is borrowing in the loan market at a floating interest rate. To protect itself against the risk that interest rates will rise, the company will enter into an interest rate swap. These transactions generally enable the company to pay an amount tied to a fixed interest rate, and the financial institution will pay an amount tied to the floating rate of the loan. If rates rise steeply, they have some protection and can focus on their core operations.

OTC derivatives are used in a similar manner by a wide variety of companies seeking to manage volatile commodity prices and foreign exchange fluctuations. In addition to customization, the other main benefit of OTC derivatives is flexibility with respect to the collateral that supports a derivative transaction.

In the interest rate swap example, the financial institution may ask the company to provide credit support to mitigate the credit risk that it faces in entering into this transaction. Most often that credit support comes in the same form as the collateral provided for the loan agreement. Thus, if the loan agreement is secured by property or equipment, that same collateral would be used to secure the interest rate swap. This collateral is high quality. It is the basis for the extension of credit in the loan agreement.

As a result, the company does not have to incur additional costs in obtaining and administering credit support for the interest rate swap. This is a very significant benefit, and without it many companies will chose not to hedge their risks because they can't afford to.

It is important to note that although derivatives currently are offered on U.S. exchanges, few companies use these exchange trade of contracts for two main reasons. Exchange traded products are by necessity highly standardized and not customized. As a result, companies are unable to match the products that are offered on exchanges to their unique risks.

Secondly, clearly house collateral requirements are onerous and necessarily so. Clearing houses require that participants pledge only liquid collateral, such as cash or short-term government securities, to support their positions. However, companies need their most liquid assets for their working capital and investment purposes.

While we believe that exchanges play a valuable role in risk management, not all companies can or want to trade on an exchange. Currently companies have the choice of entering into their hedging transactions on an exchange or in the OTC market. For most companies, OTC derivatives are critical to their risk management, and risk management is critical to their operations in volatile times.

We believe that companies should continue to be allowed to have the choice to use these products. This discussion of the benefits of OTC derivatives is not to deny that there have been problems with their use, and it is essential that policy makers examine the causes of the financial crisis to ensure it is never repeated.

We have noticed reports in the press that derivatives dealers are working to avoid regulation. This is absolutely wrong. The efforts that have been reported on are part of a four-year effort with regulators to enhance practice in the OTC derivatives market. The latest letter is just the last quarterly submission outlining our efforts to enhance market practice.

To that end, we propose the following which is consistent with the administration's position and Chairman Gensler's testimony today. First, financial regulation should be considered on the basis of function, not form.

Second, a systemic risk regulator should oversee all systemically significant financial institutions and their activities.

Third, all standardized OTC derivative transactions between major market participants should be cleared through a regulated clearing house.

And lastly, enhanced reporting requirements should apply to all OTC derivatives transactions.

J.P. Morgan is committed to working with Congress, regulators, and other industry participants to ensure that an appropriate regulatory framework for derivatives is implemented. I appreciate the opportunity to testify, and I look forward to your questions. Thank you.

SEN. HARKIN: Thank you very much, Mr. Lenczowski.

And now we turn to Dr. Richard Bookstaber. Dr. Bookstaber.

MR. BOOKSTABER: Mr. Chairman and members of the committee, I thank you for the opportunity to testify today. My name is Richard Bookstaber. During my career I've worked extensively in risk management. And I was also one of the pioneers in the development of derivative products on Wall Street. I'm the author of the book, A Demon of Our Own Design, Markets, Hedge Funds, and the Perils of Financial Innovation. That book, published in April of 2007, warned of the potential for financial crises from derivatives and other innovative products.

Although I have extensive experience in both investment banks and hedge funds, I come before the committee in an unaffiliated capacity and represent no industry end risks. My testimony will focus on reducing complexity, increasing transparency in the derivatives markets through standardization and exchange trading.

Derivative instruments, and I use the term to include option swaps in structured products, can improve financial markets. They can allow investors to mold returns to meet their investment objectives to more precisely meet contingencies of the markets. They can isolate and package risks to facilitate risk sharing.

However, derivatives also can be used for far less lofty purposes like allowing firms to lever when they aren't supposed to lever, take exposure in markets where they are not supposed to take exposure, and avoid taxes that they are supposed to pay. In short, derivatives are the weapon of choice for gaming the system.

These objectives are best accomplished by designing derivatives that are complex and thus opaque, so that the gaming will not be readily apparent.

Such complexity, as I pointed out in my book, makes the financial markets crisis-prone. Complexity hides risks and creates unexpected linkages between markets. Because derivatives are the primary source of this complexity, to reduce the risk of crisis we must address the derivatives markets. We need a flight to simplicity.

The proposed centralized clearing corporation, while a welcome step, is not sufficient to do this. It may address counterparty concerns but will not sufficiently address issues related to standardization, transparency, price discovery and liquidity. To do that, we need to have standardized derivative products and have those products traded on an exchange.

Standardization will address the complexity of derivatives. Exchange trading will be a major improvement for transparency and efficiency. And it will foster liquidity by drawing in a wider range of speculators and liquidity suppliers. These steps will shore up the market against the structural flaws that a derivative-induced complexity create.

Now one stated objection to standardization of exchange trading is that having some products out in the light of day will only increase the demand for the more shadowing and opaque products.

Another objection is that the push toward standardization will reduce innovation. These concerns lead to demands by some to abolish all OTC derivatives and by others to shrink from exchange trading.

There is no need to move toward either of these two extremes. We can have a combination of standardized exchange traded instruments along with the continued development in the customized OTC instruments.

Abolishing OTC derivatives is not wise. There will be legitimate reasons for customized derivatives, and no doubt innovations will emerge with broad value to the financial markets. The point is not to stifle innovation but to assure it is directed toward an economic rather than a gaming end.

Standardized exchange trade derivatives will create a hurdle for any nonstandard over the counter product. The over the counter product will have worse counterparted characteristics, be less liquid, have higher spread, and have inferior price discovery. To overcome these disadvantages the nonstandard OTC product will have to demonstrate substantial improvements in meeting investment needs compared to the standardized product.

Also, and importantly, stricter controls can be placed on nonstandard OTC derivatives. For example, the regulator may mandate the disclosure of OTC positions and require demonstration of why they are being used instead of a standard product.

While there will still be the opportunity for innovation and for the application of the more complex derivatives, I believe that for most legitimate purposes, the standardized products will be found to be adequate.

Now financial institutions might have to be pulled less than willingly into any initiative to standardize derivatives or to move derivatives from over the counter on to an exchange. They have an incentive to keep derivatives over the counter and not standardized. For the bank, the more complex the instrument the greater the chance the bank can price in profit for the simple reason that investors will not be able to readily determine the fair value. And if the bank creates its customized product, then it can charge a higher spread when an investor comes back to trade out of the product.

For the trader, the more complex the instrument, the more leeway he has, because it will be harder for the bank to measure his risk and price his book.

And for the buyer, the more complex the instrument, the easier it is to obfuscate everything from the risk and leverage of their positions to the non-economic gaming objectives they might have in mind.

In conclusion, we should move toward standardization in exchange trading of derivatives, and we should do this because it is the reasonable direction to go, not as a reaction to the current crisis and not predicated on whether derivatives were the villains of this crisis or merely innocent bystanders.

Now the argument for standardization in exchange trade in derivatives is compelling, but there remains much that we do not know. Therefore it is important to move slowly, learning by doing rather than pushing for quick wholesale solutions. There are markets that are beyond the purview of the CFTC and indeed that are beyond our borders, so the natural pace will be a gradual one.

Thank you for the opportunity to provide this testimony, and I look forward to your questions.

SEN. HARKIN: Thank you very much, Dr. Bookstaber.

Now we turn to Mr. David Dines, president of Cargill Risk Management. Mr. Dines, welcome.

MR. DINES: Thank you, Mr. Chairman. My name is David Dines, president of Cargill Risk Management. I am testifying on behalf of Cargill, Incorporated. And I want to thank you for the opportunity to be here today.

Cargill is an extensive end user of derivatives and relies heavily upon efficient, competitive and well-functioning futures and over the counter markets. One of the major challenges for policy- makers and regulators is that the term 'over the counter' covers a vast array of products across a number of markets. This broad definition highlights why it is extremely difficult to seek a one- size-fits-all regulatory or legislative solution that still allows all interested parties to manage or hedge their genuine economic risks.

One major concern with the recent proposal by the Treasury Department is that it appears to seek a regulatory solution for all OTC products in response to systemic risk posted by one particular market, credit default swaps.

It is important to note that while we witnessed the greatest economic crisis in 80 years, OTC contracts and the agriculture, energy, and foreign exchange markets performed well, did not create systemic risk, and in fact helped many end users manage and hedge their risk during this very difficult time.

In today's hearing, we will focus our comments on three of the four objectives of the recent Treasury proposal. We support the stated objectives and believe that steps can be taken to meet these goals without denying end users access to an effective and competitive market.

The Treasury Department's first objective is to prevent activities in the OTC markets from posing risk to the financial system. The outline seeks to apply mandatory clearing of all standardized products and impose robust margin requirements to meet this objective. The imposition of mandatory clearing and mandatory margining of tailored hedges will have a significant drain on working capital. Mandatory margining will have the unintended consequence of actually increasing financial risks as companies choose not to hedge due to the working capital requirements.

The potential magnitude of this drain on working capital should be carefully weighed by all policymakers. I'd like to submit for the record a letter from the National Association of Manufacturers as well as a recent letter from Chesapeake Energy, an Oklahoma-based end user of OTC derivatives and the largest independent producer of natural gas.

The Chesapeake Energy letter provides an excellent example of how imposing mandatory margining could severely drain capital that could otherwise invested to grow a business. In the one example provided here, over $6 billion would have been taken away from running and expanding a job-creating business and instead by left idle in a margin account until the maturation of the OTC contract, a contract which had already been secured with collateral.

Expand this example across all businesses that use OTC products, and the amount of capital diverted from growing the U.S. economy would be severe unless companies reduce their hedging and risk management.

There is a misconception that OTC products do not have credit provisions and are never collateralized or margined. A significant number of OTC transactions are collateralized, margined or make use of credit agreements to secure the contract with collateral being moved daily to adjust for the change in market value.

With regard to mandatory clearing of standardized products, defining which products are standard and which products are customized is a complex issue that must be thoroughly examined by the appropriate federal regulator to avoid disrupting market segments that continue to perform well.

The loss of tailored hedging tools will also greatly impact the ability of companies to comply with current accounting standards.

The Treasury Department outline continues and also indicates that substantial capital requirements could be placed on all OTC dealers. There is a concern that the new regulatory framework could be developed such that only financial institutions could remain active dealers. The agriculture and energy hedging sectors have non- financial institution OTC dealers who offer healthy competition in the market, and it would be inappropriate to eliminate these competitors fro the OTC market through legislative or regulatory action.

To meet the Treasury Department's first objective of protecting the financial system, regulatory requirements should be risk based and not one-size-fits-all. Additional monitoring and transparency is warranted; however, restricting working capital through major increases in mandatory margining in these markets is counter- productive.

The Treasury Department's outline seeks to impose more record- keeping and force trades on regulated exchanges to promote efficiency and transparency within the OTC markets. We recommend more record- keeping and better disclosure, although the regulators should be directed to focus on areas with the greatest risk.

As previously mentioned, mandatory movement activities from the OTC market to an exchange-traded market does not seem warranted in those markets that have not created systemic risk to the financial system.

Objective three. The Treasury Department's outline seeks clear authority to police fraud and market manipulation and the authority to set position limits on OTC derivatives. Cargill recently filed comments with the CFTC on a proposed rulemaking that addresses this objective where we support position limits for non commercials, much greater transparency in reporting for over the counter markets, and we offered detailed suggestions for implementation.

In summary, Cargill recommends that additional legislative and regulatory actions in the OTC market are risk-based and not treat all products identically, seek to add minimal cost and disruptions to those products that have not posed systemic risk to the financial system.

Two, mandatory clearing and margining would severely reduce hedging activity, would greatly restrict working capital at a time when it's in very short supply, and is not warranted for OTC products that have not created systemic risk.

And three, the CFTC, through its existing rulemaking, is proposing much needed steps and should continue to work on ensuring enforcement of position limits in related exchange traded markets, principally agriculture and energy products, and improving transparency and reporting of OTC products.

We appreciate the opportunity to testify today, and look forward to working with the members of the Senate Agriculture Committee and other policy-makers as this issue develops.

Thank you.

SEN. HARKIN: Thank you very much, Mr. Dines.

And now we'll turn to—Mr. Michael Masters did show up.

MR. MASTERS: Coming from the West Coast.

SEN. HARKIN: I understand you took an overnight flight.

MR. MASTERS: Yeah. I had a little trouble getting in with the thunderstorms last night.

HA: Listen, welcome, Mr. Masters. Masters Capital Management. And as I said earlier, your statements will be made a part of the record in their entirety. And please if you'd take 5 to 7 minutes, I'd appreciate it very much. Thank you, Mr. Masters.

MR. MASTERS: Sure. Thank you. Good morning, Chairman Harkin, and members of this committee.

The derivatives markets present Congress with two very critical and very distinct problems. Systemic risk and excessive speculation.

Last fall the world financial system teetered on the brink of collapse. This near-meltdown had a catastrophic effect on our nation's economy, causing the loss of trillions of dollars in retirement savings and millions of American jobs. At the peak in 2008, the notional amount of over the counter derivatives outstanding totaled over two-thirds of a quadrillion dollars.

These positions formed an interlocking spider web of enormous exposures amongst the 20 to 30 largest swaps dealers and represented an extreme amount of leverage since very little margin collateral backed up these huge bets.

This unregulated shadow banking system was effectively destroyed in the fall of 2008. It threatened to destroy the regulated financial system with it. However, regulators pumped trillions of dollars into the shadow banking system to allow OTC derivatives dealers to make each other whole on their bets. This was necessary to prevent a domino effect of dealer collapses that would have destroyed the world's financial system.

Congress owes it to the American people to ensure that this never happens again. The risk of a financial system collapse must be eliminated, not regulated.

Everyone agrees that clearing needs to take place in order to increase the transparency of these markets. But not all clearing is created equal. This clearing process must include two important provisions. First, clearing must involve novation wherein the derivatives clearing organization becomes the central counter party to both sides of the trade. This will eliminate the interlocking spider web of exposures among swaps dealers because every dealer's exposure will be to the central counter party and not to each other.

And second, clearing must involve daily margin where every day the central counter party collects margin payments from those dealers whose bets are going against them. This ensures we never have another AIG.

If this system had been in place in 2008 then it would have been virtually impossible for the financial system to melt down. Wall Street will seek to block mandatory exchange clearing by arguing that swaps are highly customizing and cannot clear. This is false. The standard that regulators should adopt is not one of standardization versus customization but one of clearable versus non-clearable.

Chairman Gensler said during his confirmation hearing that if an OTC derivative can clear, then it should clear. Treasury Secretary Geithner said, If an OTC derivative is accepted for clearing by one or more fully regulated CCPs, it should create a presumption that it is standardized contract and thus require it to be cleared."

This is the right standard and will result in a vast majority of swaps clearing through an exchange. Exchange clearing will lead to price transparency, tighter beta ask threats, and greatly reduced cost for end users of the swap markets. There will also be greater liquidity due to lower trading cost and reduced emphasis on credit concerns.

Now lets look at excessive speculation. America experienced a bubble in food and energy prices during 2008. This was caused by excessive speculation in the derivatives market for these commodities. These markets have become dominated by speculators and prices no longer reflect supply and demand.

Now in 2009 the problem is once again raising its ugly head. Today the supply of crude oil in the U.S. is near a 20-year high while the demand is near a 10-year low according to the IEA. Yet the price of oil has risen an amazing 85 percent this year from the mid $30s to the mid $60s. There has been a chorus of voices from oil market participants, economists and even OPEC, squarely pinning the blame on speculators for unjustifiably driving oil prices higher.

If Congress allows this to continue, then high oil prices threaten to throw our economy back into the double-dip recession and potentially ruin the Obama stimulus.

Your constituents are flat on their backs financially and will not tolerate gasoline prices raising to $3.00 or $4.00 again. The excessive speculation problem can be eliminated by imposing aggregate speculative position limits. These limits must cover all trading venues which will require closing all the existing loopholes to ensure that every venue is regulated equally.

The swaps loophole is an exemption granted by the CFTC which gives swaps dealers free reign to buy and sell commodity futures in unlimited quantities. The best way to close it is to mandate that all OTC commodity derivatives clear through an exchange. This needs to happen to eliminate systemic risk, but it also needs to happen so that regulators can actually apply position limits. When a swap clears, the exchange breaks that transaction into component parts and becomes the central counter party to both sides of the trade. This enables regulators to see both sides and enforce aggregate speculative position limits.

The London loophole occurs between foreign boards of trade, are permitted to trade contracts that are virtually identical to U.S. futures contracts. The solution is simple. Foreign exchanges must be required to supply all the same data that designated contract markets provide to the CFTC, and they must enforce speculative position limits.

Right now the possibility for cross-border regulatory coordination is at all-time high. G8 ministers issued a statement last week along with OPEC calling for greater regulation to crack down on excessive speculation in the energy markets.

The CFTC must set the limits for all consumable commodities, not the exchanges. Speculative position limits should be set for the commodity as a whole rather than one particular grade or delivery or location. For instance, crude oil, not just West Texas intermediate. Speculative position limits need to be aggregated across trading venues.

In summary, the best way to eliminate the risk of another financial system collapse is to mandate that all OTC derivatives clear through an exchange with a novation and daily margin. And the best way to prevent another bubble of excessive speculation is to make aggregate speculative position limits apply across all trading venues.

The CFTC has 70-plus years of experience regulating exchange clearing and policing markets for excessive speculation. The SEC and Federal Reserve had little to no experience in these two key areas. In fact, the SEC has allowed passive commodity investments in ETFs, ETNs and commodity mutual funds. They have signed off on double- leveraged crude oil ETFs like the DXO that allow any investor to make leveraged speculative bets in crude oil within their retirement accounts.

This does not show good judgment from a consumer protection or a market protection standpoint. For these reasons, the CFTC is the best and most appropriate regulator for the job.

Thank you. I look forward to your questions.

SEN. HARKIN: Well, thank you very much, Mr. Masters, for summarizing a very extensive statement you had here, which I read last night, which I found extremely interesting. And now we turn to our final person here. This is Mr. Daniel Driscoll, executive vice president and chief operating officer of the National Futures Association. Mr. Driscoll, welcome.

MR. DRISCOLL: Thank you very much, Chairman Harkin, Ranking Member Chambliss, and all the members of the committee for allowing us to participate here and to ask you to close the loophole where fraudsters are able to offer over the counter derivative contracts to the retail public.

NFA is the industry-wide self-regulatory organization for the U.S. futures industry, and we also regulate over-the-counter retail 4X products. NFA is first and foremost a customer protection organization, and we take that mandate very seriously.

Now the other witnesses today have talked primarily about OTC derivative products that are offered to and traded by large, sophisticated institutions. But I am here to tell you that there's also a growing aspect of the OTC derivatives markets that's directed towards the retail public. And those customers are being victimized in a totally unregulated environment.

Now for many years retail participants in the futures markets have enjoyed all of the benefits of the Commodity Exchange Act. Their contracts were traded on regulated exchanges and cleared on regulated clearing organizations. Their brokers had to meet the fitness standards of the act and were regulated by the CFTC and NFA.

However, today there are too many customers that don't receive any of the benefits of regulation. And we need to do something about that.

The main problem stems from a court case called -- that is often referred to as the Zelener case, which was a Seventh Circuit Court of Appeals case involving a CFTC enforcement case alleging forex fraud.

In that case, the district court ruled that the customers were, in fact, defrauded, but the CFTC didn't have jurisdiction because the contracts weren't futures contracts.

In that particular case, the contracts were offered to the retail public for speculative purposes. They were rolled over and over again so that delivery never took place. And basically they were the functional equivalent of a futures contract.

Unfortunately, the Seventh Circuit ignored those characteristics and ruled that the written contract itself should determine the nature of the contract. And because the contract didn't guarantee a right of offset, they ruled that they weren't futures contracts, and the CFTC lost that particular case.

There were other courts that came up to -- that followed the Zelener decision and came up with similar rulings over the next several years.

Last year, Congress closed the forex loophole. But unfortunately, the loophole isn't limited to forex, so that customers dealing in other OTC products, such as gold and silver, are still in a regulatory mine field.

And we need to bring regulatory protections to those customers as well.

Back in 2007, NFA predicted that if Congress plugged the Zelener loophole but left it open for other products, depositors would simply move over to Zelener-type contracts and other commodities. And that's exactly what has happened.

Now, we can't quantify the exact numbers of that fraud, because these firms aren't regulated and aren't registered. But we are aware of dozens of firms that offer Zelener contracts in metals and energy.

Recently we received a call from a man who lost over $600,000 -- substantially all of his savings -- investing with one of these firms. We have seen a sharp increase in customer complaints and mounting customer losses involving these products since Congress closed the loophole for forex.

NFA and the exchanges had previously proposed a fix which would close the Zelener loophole for these non-forex products. Our proposal codifies the approach the Ninth Circuit took in CFTC v. CoPetro, which was the accepted state of the law until Zelener.

In particular, our approach would create a statutory presumption that leveraged or margin transactions offered to retail customers are futures contracts, unless delivery is actually made within seven days or the retail customer has a commercial use for the commodity.

This presumption is flexible and could be overcome by showing the delivery actually occurred or the transactions were not primarily marketed to the retail customers or were not marketed to those customers as a way to speculate on price movements.

The statutory presumption would not cover securities and banking products; it would not interfere with interbank currency markets, and it wouldn't cover the retail forex contracts that are currently covered or exempt under Section 2(c).

I would also say that our proposal would not invalidate a 1985 interpretive letter issued by the CFTC, which Monex and other similar firms currently rely on to sell gold and silver to their clients.

Essentially that letter set forth a factual pattern which culminated in the actual delivery of the precious metals within seven days, and (title ?) to those metals going over to the retail customer, so that it would not be covered under our statutory proposal.

In conclusion, while we support Congress's efforts to deal with systemic risk and create greater transparency in the OTC markets, Congress shouldn't forget that there's a very real risk to the retail public participating in another segment of these markets.

The Committee can play a leading role in protecting customers from the unregulated boiler rooms that are currently taking advantage of the Zelener loophole for metals and energy products.

We look forward to further reviewing our proposal with Committee members and staff and working with you on this important matter.

Thank you.

SEN. HARKIN: Thank you very much, Mr. Driscoll. Thank you all for your testimony. I can't help, Mr. Driscoll -- to comment upon your statement.

I offered an amendment on the last Farm Bill to close Zelener. We passed it in the Senate. (The broad. ?)

MR. DRISCOLL: (Chuckles.) Yes. Thank you very much --

SEN. HARKIN: Well, we did it. And we went to conference and lost it in conference. And all we were able to keep out of that was just the forex contracts that you're talking about.

And again, I think that was a mistake. I said so at the time, but -- didn't have the votes.

So I'm glad to hear your testimony again today calling for a broader closure of the Zelener loophole that the Seventh Circuit opened up for everybody and went beyond currency, and they applied it to everything else.

So I appreciate your comments today, and hopefully maybe if we move some legislation this year we can also finally close that loophole.

MR. DRISCOLL: Thank you, Senator Harkin.

SEN. HARKIN: But I just couldn't help but comment on that.

It seems like everyone here is basically saying that there is a legitimate need for derivatives trading, I think, if I'm not mistaken, but that it should be well regulated, transparent. But there's some need for some liquidity in the marketplace that might be provided by that.

I'm reminded of what one person said to me, a congressman said to me -- a former congressman said to me one time about liquidity. He said, you know, liquidity is good. But too much liquidity can be bad. He said it's like -- he said, I take an aspirin every day. My doctor says I should take an aspirin every day for liquidity. But if I took a whole bottle every day, it might be kind of dangerous to my health.

So I've often thought about that kind of an analogy. I also think about the analogy that Dr. Bill Black testified to last fall when we had our first hearing on this.

Someone had commented upon, well, we don't want to stifle the free flow of capital. To which Dr. Black responded, well, I don't know, he said, if we really want the free flow of capital. Maybe we want the more efficient flow of capital.

And he used the analogy of traffic flow. He said if we want the free flow of traffic, do away with all the stop lights. Do away with the stop signs. Do away with speed limit signs. You'll have a very free flow of traffic, but you're going to have a lot of wrecks.

And he analogized that to the financial markets, that we need regulation. We need the stoplights and the slow-down signs and the danger signs and things like that -- not so much for the free flow of capital, but for the more efficient flow of capital.

Now, with that as a backdrop, I understand the need for liquidity. I also appreciate, Dr. Stout, your testimony.

A lot of this gets clouded in jargon. We say, oh, this is complex, and all that. But it kind of boils down to certain essentials all the time.

And I'll start here with what Mr. Lenczowski testified to, and that is that many banks relied on credit default swaps instead of fully meeting capital requirements.

So we've heard a lot of discussion here about, well, we shouldn't have to come up with capital requirements too much. I think maybe Mr. Dines -- maybe testified to that. Maybe -- I think maybe somebody else did, that --

Requiring too much capital requirements might stifle the transactions and the more open flow of capital and hedging.

But many banks (revolved ?) upon -- on these credit default swaps, instead of meeting the capital requirements under the Basel II rules -- I had to learn this, too, what Basel II was -- thus contributing to the buildup of excessive leverage and risk.

So I guess the question for all of you, basically, is this: How do we control the risk to the financial system and our broader economy when institutions rely on derivatives too much, and we don't have as much capital coming forward?

So that's really what we're trying to wrestle with here.

Now, again, I'll make another statement as a sort of a backdrop to what I'm getting at here, is that there've been a couple of articles in the Wall Street Journal and New York Times recently.

In a recent article they concluded that the banks and other over- the-counter swaps dealers oppose certain reforms for the basic reason that the greater transparency and disclosure involved in exchange trading would impair their ability to make profits.

That is if the parties on the other side of transactions had a better idea of what prevailing prices are for swaps then the banks and swap dealers would not be able to charge as much as they can if they kept them off the exchange, in the dark and out of sight.

I want to state emphatically I'm not opposed to the financial sector making profits. They've done very well in the last few years, I might note. But I think there's also a countervailing, tremendous public interest at stake here.

When we have to come up with $4 trillion to rescue the economy, a bill that we'll be paying and our kids and our grandkids will be paying for some time, then I think it argues that we have to balance this desire for making profits -- which is fine -- with the countervailing balance of the public interest here.

So I don't see this as a really complex issue. What it basically is, is on the one hand we have the public interest in protecting the economy from these risks; on the other hand, the quest of the financial sector to make maximum profits.

And to me, that's just how I see it. It's not much more complex than that. And as I delved more into derivatives and credit default swaps, I then found out that all these things, whether they're credit default swaps, collateralized debt obligations, collateralized mortgage obligations, all these things; hardly any of those existed before 1990. Most of them came up in the '90s.

And there weren't -- I keep asking the question where was the demand? Where was the demand for these products? But I found out there really wasn't any. Just that these quants that I referred to earlier came up with ingenious ways of slicing and dicing all these little derivatives, selling these tranches. And no one really knew what the value of them were.

I often said, jokingly, that I never knew when I was growing up that someday I would need Honey Nut Cheerios. (Scattered laughter.) I thought Cheerios was just find. But all of a sudden I found out I need Honey Nut Cheerios.

Well, that's okay. I don't mind that. That's an innovation; they were able to sell that. No one's hurt; that's fine.

But if innovation does not -- in this financial sector, does not pertain to some underlying value or benefit to the goods and services of the GDP, then it just seems to me to beg for more regulation and oversight.

So -- I didn't mean to go on so long on that, but -- so if I had a basic question for all of you, and I'll just go down the line -- how do we balance this off? How do we provide for liquidity -- the aspirin a day, but not a bottle a day?

How do we provide for innovation that might pertain to underlying value, but not in innovation that just allows someone to gamble and make a lot of money and keep our markets regulated in the public interest?

How do we balance those off?

Dr. Stout?

MS. STOUT: I think that history gives us some very good guidelines, because we actually did that pretty well between 1933 and 1934 and the mid-1990s.

And I think the legislation that you're proposing which, in many ways, reinstates some of those old-fashioned, time-tested, highly successful strategies is a very good start.

I want to just point out, it is interesting; Simon Johnson of the MIT Sloan School has estimated that between 1973 and 1985 the finance sector of the U.S. economy accounted for 16 percent of corporate profits, and that in the last decade that has increased to 41 percent of all corporate profits were earned by the finance industry.

Although I don't have the exact breakdown, I suspect that many of those profits were actually trading profits earned by hedge funds and by the proprietary divisions of investment banks.

Where did they come from? I will simply point out that hedge funds were earning between 10 (percent) and 20 percent annual returns over the last decade.

Average investors, who are my investors -- I am a trustee of a mutual fund; that's the moms and the pops who buy our mutual fund interests -- they got 3 (percent) to 4 percent a year.

I don't think that you can assume that that's a coincidence.

SEN. HARKIN: Mr. Lenczowski, how do we balance these?

MR. LENCZOWSKI: Well, thank you again, first, Chairman, for allowing me to testify.

I think -- first I'd like to state that at J.P. Morgan we broadly support the initiatives of the administration and of Chairman Gensler to undertake regulatory reform.

SEN. HARKIN: By the way, I would be remiss if I didn't compliment J.P. Morgan, because you're the ones back in the '90s that didn't get involved in that credit default swap mess. And I think you were very prescient on that.

So I would be remiss if I didn't compliment you on that.

MR. LENCZOWSKI: On behalf of our institution, thank you. The --

But to go back to the points we were making, Chairman Harkin, the first thing on capital, and I think I would (just state ?), as a bank we are subject to very stringent capital requirements already.

And I think, if I might, that the capital that Mr. Dines was referring to, and perhaps Senator Chambliss was referring to earlier, that -- we're talking about capital that's coming out of non-banks, out of the end-users, the companies in our country that create jobs.

And if they were to trade on exchange -- which they currently have the right to do -- but if they were to be forced to trade on an exchange, they would have to take capital out of their corporations and pledge it to the exchange. That's the way the exchange operates.

So when we talk about a drain on capital, it's not our capital. It's the capital of companies like Cargill, of Chesapeake, and they've told you how much that would be. It's billions of dollars.

The other point I'd make, Chairman Harkin, on demand, the history of the over-the-counter business has been one that's grown in response to customer demand from the relaxation, or the dropping of the gold standard in the '70s and the responses to the oil price shocks and inflation led to unprecedented volatility in currency rates, in interest rates.

This is what led to the interest rate in currency markets to grow to serve customer needs. These are markets that exist to serve customers, and we serve as a financial intermediary.

In the -- you mentioned CEOs. In the early part of this decade we had a time of very, very low interest rates of investors looking for enhanced yield and willing to take on extra risk.

And the CDO market, the CMO market and many other structured markets arose in response to the investor demand for higher yield with higher risk. And that's -- we've seen what's happened as a result of the collapse in real estate prices.

And lastly, I would just close this part, at least, by saying that again, we support clearing. It's an important tool that we currently use. We derive great benefits from it, from a credit, a risk reduction, and operational standpoint.

But we think it would be a mistake to impose that kind of a one- size-fits-all requirement on our economy.

SEN. HARKIN: (Off mike) -- Bookstaber.

MR. BOOKSTABER: I would disagree to some extent with the last statement. I believe that a lot of the -- that there is a component of the development of, quote, "innovative products" that's very much along the lines of what you, Mr. Chairman, depicted where the banks, or investment banks, realized that they can differentiate themselves if they are selling something that other people are not selling.

And if it's sufficiently complex, they can price it in a way that people will have difficulty understanding is that the fair price or not. And they will be able to trade it with a higher spread because the client doesn't have many other avenues for trading.

So liquidity basically is a negative aspect, and complexity is a positive aspect when it comes to profit for the bank or the investment bank.

And on the other side is, I think you also pointed out, part of the investor demand that's come for some innovative products has occurred along the, hey-I've-got-a-problem sort of approach.

That is, somebody's trying to say, you know, I want to lever and I can't quite lever; can you help me out here? And on that basis, you get new innovations that are helping for these gaming purposes.

I think that the key point, if you want -- I believe that there is need for innovation, that we can have innovation, but regulators need to, number one, find a means to have innovation that's directed towards economic purposes, as opposed to gaming purposes.

And I don't know the proper method for doing that. I think that it's clear that we need to have capital margin haircuts, whatever sort of method is used to back derivatives and other exposures, rather than having them be off balance sheet without sufficient capital background.

And I agree also with one point that Mr. Dines said, that it is reasonable to have a distinction between different types of products -- not on the basis of what caused a problem in the past versus what didn't, because we don't want to drive through the rear-view mirror.

But there are some products in some markets that inherently are more systemic by nature. Interest rates, currencies, are just by nature going to be more systemic than corn, wheat, and commodities of that type.

And so we need to have the ability in those markets to control and to aggregate so that we can detect patterns of crowding that may move us from having an issue where a particular firm might face a problem to where it becomes systemic, because many firms are all on the same side of the boat.

SEN. HARKIN: Thank you very much, Dr. --

Mr. Dines.

MR. DINES: Thank you.

I guess I would start by just confirming what was said by the other panelists. And what I said in my testimony is that we, again, do not believe that you can take a one-size-fits-all approach to solving this.

And the same -- the regulatory changes that apply to credit default swaps may not -- and I don't think are appropriate for the energy and agricultural markets.

We believe that there should be greater transparency and reporting to the regulators, and we have said that we think that there should be position limits for non-commercials.

We believe that this would go a long ways toward solving the issues. We do not think that mandatory margining and clearing is necessary, and we think that that will have unintended consequences of reducing people's hedging, companies' hedging, and that will cause significant risks.

SEN. HARKIN: Unless I misinterpret what you said, Mr. Dines, you're basically proposing that we separate financials out from commodities?

MR. DINES: I'm saying that we need to --

SEN. HARKIN: (Inaudible) -- different.

MR. DINES: -- take a different approach to these different segments. And what might be appropriate for credit default swaps may not be appropriate for the energy and agriculture markets.

I think some do have more systemic-type risks than others. That's --

SEN. HARKIN: Yes. I understand.

MR. DINES: Okay. Thank you.

Mr. Masters.

MR. MASTERS: Sure. Thank you, Senator.

So I think the two parts of the question, one is liquidity and one is innovation.

SEN. HARKIN: Mm-hmm. (In agreement.)

So first of all, let's just get out the word innovation. Innovation is a word that Wall Street uses to talk about anything they do in the financial markets. Innovation by itself has sort of a positive connotation, when people think about innovation.

But innovation isn't always good. Ford had the Edsel; there's been many, many, many products, over the --

SEN. HARKIN: (Chuckles.)

MR. DINES: -- developed in our economy over the last few hundred years that were not good products.

Why is it that everything that Wall Street creates is a good product? There's a lot of bad products. So I'd just like to get that out, to begin with.

In fact, I would argue that since many of these innovative products affect consumers in a very direct and a very real way, including loss of jobs, savings, and so forth, where's the financial FDA for this?

Who's looking at what the after-effects of these products are? Because it's certainly not Wall Street. They're just looking at their bottom line.

And with regard to innovation itself, the exchanges themselves have produced plenty of innovation as well. It hasn't just come from the over-the-counter market.

So at any rate, I'd just like to get that out.

But with regard to liquidity, one of the things that some of the folks that have testified have mentioned is the whole issue on financing costs for corporations. And what many may not realize is that those financing costs are borne by someone.

When you buy a swap from someone, the other side of that swap, if it's a large investment bank, those funds aren't free.

So all that financing cost that people say oh, we're going to have financing costs and margin and so forth, you're already paying that if you're an over-the-counter customer to a bank; you just may not see it. In addition, you're paying other things that you may not see, notably, profit margins.

So the issue that we argue with regard to mandatory clearing for standardized derivatives is I think you would actually lower the cost, because you would have more people that would be able to trade with each other, with regard to swaps. You would increase the liquidity. You would certainly lower the bid and offer.

And so I actually think that contrary to raising costs for corporations, you would actually lower costs for corporations ultimately.

We had that experiment with the New York Stock Exchange when bid offers went from eighths to quarters and halves to decimals, and volume has tripled and liquidity has tripled.

So I think you look at that example and you have a better idea of really what the future could be. And you have many, many more participants in the market, not just investment banks that are allowing liquidity.

SEN. HARKIN: Excellent point. Thank you.

Mr. Driscoll.

MR. DRISCOLL: Chairman Harkin, I've been a futures regulator for almost four years, and I can tell you that when I first started out -- this is sort of the flip side of the innovation angle -- there were no such things as interest rate products in the futures markets; there were no stock index products.

There weren't the whole panoply of products out there that I think everyone, without exception, agrees are very valuable, not only to the futures markets but to the participants in the futures markets and to the American and the worldwide economy.

So there obviously is a plus side to innovation.

From the regulatory standpoint, I believe that it's key that all of these markets be subject to a prudent level of regulation. It doesn't mean that every market has to have exactly the same re

And I think the focus on systemic risk and transparency by Congress, the administration and the CFTC is exactly the right one. And I'm a big proponent of clearing organizations and exchange-traded markets. That's primarily what we regulate.

So anything that can be done to encourage moving as much business as feasible onto regulated markets and to have those instruments cleared would be a positive thing, recognizing that I'm -- and I'm not the biggest expert in that area -- that I'm sure that there are any number of more nonstandardized products that would be difficult to put on exchange.

Thank you.

SEN. HARKIN: Thank you all very much. I took an inordinate amount of time with that, but I'll yield to my friend, Senator Chambliss.

SEN. SAXBY CHAMBLISS (R-GA): Let me start with you, Mr. Lenczowski.

You mention in your written testimony that the industry is seeking to clear more credit default swaps. And would you expand on other ongoing efforts to curb system wide risk relative to CDS, in addition to the clearing?

MR. LENCZOWSKI: Yes. Thank you, Senator.

Over the past four years, the dealers have been working with investors to come up with market improvements for the credit default swap market. And several of those improvements have been made.

First, the amount of undocumented trades has been drastically reduced. there have been protocols agreed as to the way to treat innovations, or transfers of trades. There has been a huge improvement in the amount of trades that are electronically confirmed, which significantly decreases operational costs.

And then just recently there's been a major change and restructuring of the way that the market operates so as to -- so, standardized cash settlement as the form of settlement of credit derivatives, and to standardize all economic terms, essentially, for credit default swaps.

The result is that the product has become standardized to the point where we think that more and more over-the-counter credit default swaps will be cleared.

The ICE U.S. Trust Clearinghouse started operation earlier this year, already clears over $800 billion of CDS transactions. That number's going to grow. Old trades are being backlogged into the system to further increase the pervasiveness of clearing.

So all -- the entire progression of the market has been towards increasing clearing, increasing transparency, additional recordkeeping and a transparency from the standpoint of pricing.

Prices are now available on the Internet, freely accessible, for large -- for the largest entities that are traded.

So it's been a steady progress, working -- between dealers and investors, working with the regulators to improve the market.

SEN. CHAMBLISS: Does your firm use the ICE-OTC clearing?

MR. LENCZOWSKI: Yes, we do.

SEN. CHAMBLISS: And how is that working, from a practical standpoint?

MR. LENCZOWSKI: It's been working very well.

Again, clearing is distinctly in our interest to do when the transactions are standardized and when counter parties to our transactions are able to clear. We derive great benefits from clearing.

And we've used the ICE clearinghouse for credit default swap clearing, and we also use other clearinghouses for other asset classes.

So, for example, in the interest rate swap market we use the London clearinghouse called LCH Clearnet, which clears a huge volume of interest rate derivative transactions. Something like 50 percent, currently, of the dealer-to-dealer swaps are cleared.

And in the commodity markets we're clearing through facilities operated both by ICE and by the CME group called ClearPort.

So all this evidences a move towards clearing. We think it's in the -- amongst the dealers, it's definitely in the interest of everyone to reduce risk, to increase transparency.

SEN. CHAMBLISS: There seems to be a perception out there that the only derivatives that need to be customized are the very complex, and most complex products. Are there not simple foreign currency or interest rate swaps that still need to be customized for your clients?

MR. LENCZOWSKI: Yes, absolutely. And, actually, Chairman Gensler earlier described one of those transactions -- a simple interest rate swap, which has been around now for almost 30 years, is very well understood, not a complicated transaction at all. But, it's extremely customized as to every economic term. And that's to give the end-user -- the company that's entering into that swap, the maximum hedge for its risks; and also to get the best accounting treatment. An entire accounting framework has grown up around derivative transactions and hedging transactions. And over-the- counter instruments are the best way a company to take advantage of that accounting framework.

There's another example I could cite -- I know Chairman Harkin was looking for examples of why something has to be done over-the- counter. In the natural gas markets dozens -- at this point, dozens of public utilities engage in long-term natural gas purchase contracts where they're able to procure natural gas at prices below the prevailing market price, on a monthly basis, for the next 15 to 20 years. These are very long term purchase contracts.

And they're able to do that through the use of over-the-counter natural gas and interest rate derivatives. These are contracts that ultimately benefit millions of consumers of natural gas, customers of these utilities. They're well-understood; they are approved through the Tax Code -- amendments passed in 2005; and they serve an incredible benefit to communities throughout the U.S.

SEN. CHAMBLISS: There's been a lot of conversation and critique of markets over the past year with respect to what's called "excessive speculation," and that speculators drove up the physical commodities to record high prices.

Now, you deal in the market on a daily basis -- I assume, sometimes as a speculator, sometimes not. Explain what you see, with respect to speculation -- why it's necessary, and what's happening with regard to this issue of excessive speculation.

MR. LENCZOWSKI: Yes, Senator. And I might preface by first saying that we strongly support efforts to combat and prosecute manipulation. Market manipulation is in no one's interests, and certainly, from a market participant's standpoint, it is extremely detrimental to all of our activities. And -- (inaudible) --

SEN. CHAMBLISS: And, obviously, there's a difference between manipulation and speculation.

MR. LENCZOWSKI: Yes. And speculation is necessary for markets to perform.

To take a very basic example, the farmers of this country, when they farm grain, will need to sell it, ultimately, to bakeries, for example. The baker and the farmer need to match up -- one to sell grain, the other to purchase grain. The chances of them matching exactly, without -- for all of their purchases, are extremely low.

Speculators expand each side of that market -- they buy and the sell. And they provide the liquidity that's necessary for markets to operate. So, all markets require some degree of speculation. Excessive speculation certainly is something to be combated and we support that.

SEN. CHAMBLISS: Mr. Dines, you deal in the markets every day, with respect to risk management tools that you use in your business. I'd like for you to give us a practical example of one of these customized contracts that you use. And if those customized contracts were not available to you at Cargill, what effect would that have on your business?

MR. DINES: Happy to do so. Thank you.

Everyone here knows that Cargill is a processor of corn, and we're in the markets buying corn every day. And, in essence, we are buying corn at the average price, over a given period, since we're in buying it every day.

The best hedge for us, if we wanted to protect against prices going higher, would be a product against the average, not a product again a discreet point in time, which is what you can get on the exchange.

We can go into the OTC markets and buy what's known as an "average price option." An average price option comes at a 30 to 40 percent discount to what's available on the exchange. It's a more precise hedge for what we need because it's against the average.

It's real cost savings up front. And it might be that that cost savings might be the difference between what gets to hedge and what doesn't get us to hedge. So, that's a real example.

Now, we cannot go in and buy that product on the exchanges. Average price options do not exist. Furthermore, in the OTC markets we can tailor that product to give us the exact level of protection that we want and for the exact end date that we want.

Let's say that we wanted to do it on new-crop corn, but we only wanted to go through the pollination period of July. If we went to the exchange, we'd have to buy a product that ends in November. We could tailor this product to end in July. We're saving ourselves four months of time value of extra costs that goes into that product.

So, those are real examples of the types of things that you can do in the over-the-counter market that you cannot do on an exchange- traded type market.

SEN. CHAMBLISS: And what if that were not available to you? What would be the effect of that on unavailability?

MR. DINES: It would be a far less precise hedge; a more costly hedge; and I think, at the end of the day, that you would find market participants -- I know you'd find market participants doing less hedging because of the costs.

SEN. CHAMBLISS: We talked earlier about position limits, and increased margins, and whatnot. And I think you used the phrase that this could create a -- or "would create a real drain on working capital." From the standpoint of Cargill, (do) you have any idea that -- of what kind of conceivable working capital drain you'd be looking at for the volume that you do business in every day?

MR. DINES: I think at times it could be significant.

I guess maybe I would take you back to last March when we actually -- and other grain companies, had to stop buying grain -- deferred grain from farmers because of the run-up in grain prices and the working capital requirements that were so -- the demands on working capital to post margins. And, luckily, we were able to move some of our hedges to the OTC markets where we were able to put in place alternative credit arrangements and become reopened for business. And I think the important part of that is that we like to have the flexibility. We do plenty of hedging on the exchanges. We do lots of hedging in the over-the-counter markets. The idea for us is that we'd like to have the flexibility. And that's very, very important (for you ?). But, I don't have a number in mind, but I can tell you it would be significant.


Mr. Masters, you've conducted an analysis in which you extrapolated data from CFT's (sic) Commitment(s) of Trader(s) report to determine speculative activity in the crude oil market. Your analysis seems to assign values based upon index fund portfolios.

Now, do you assume that speculative activity was primarily occurring only in the index funds, as opposed to the single-name commodities?

MR. MASTERS: Thank you, Senator.

We're assuming that the index funds were a primary participant last year, with regard to commodities. There were also speculators in single-name commodities as well. We looked at the index fund data that was provided from the CFTC.

SEN. CHAMBLISS: Well, what data is used to support your assessment that oil prices should have been falling last year when most expectations and market analysis showed prices continually increasing throughout the year due to geopolitical uncertainties, record low OPEC stocks, a devalued dollar, and increase in demand during the summer last year?

MR. MASTERS: That's a good question. The issue, with regard to price in the futures market, has to do with the supply and demand of futures. In the grains and the oil markets, the futures price is the price that determines spot, unlike other derivatives, unlike many other markets.

You know, Platts, who's the largest spot pricing service, says, in part, we price off futures markets. Many spot market participants we talk to said, "We, almost entirely, price futures markets off some basis."

So, I think that what we did was we looked at the money flows going in, and the money flows going out. And our sense was, based on the data, that there was an enormous amount of money going into the crude oil markets over the time. And after Congress looked at this issue, and I think started really complaining about it, to a certain extent I think it led a great deal of money to come out of those markets.

None of which had much to do with actual supply and demand. They amplified the price on the way up, and they greatly amplified the price on the way down.


Mr. Bookstaber, we talked -- I talked with Chairman Gensler about the responsibility for determining whether or not a product is standardized or customized. And we talked about the clearinghouse that's going to clear it being the determinant of that. What's your thought about that? Are they the proper ones to determine whether something is customized or standard?

MR. BOOKSTABER: The notion of standardization, I think, is a fairly loose one. The key is whether you can construct sufficient tagging for the product so that many other products can be put into the same basket and traded in a similar way.

You know, ultimately, the decision for standardization will be: If it's on the exchange, is it sufficiently different from other products that people gravitate towards it as an item to trade? I don't know, you know, who the authority would be to say, "oh, this is standard," versus, "this is customized." It's something that still even has to be totally defined.


Mr. Driscoll, in talking about the "Zelener fix," as the chairman says, we had a very significant discussion on this issue last year during the farm bill debate, and we addressed the concerns of the "look-alike" forex contracts. And I'm not sure, in your statement that you made earlier, where you said that there has been an increase in the number of complaint since Congress closed the loophole, whether you're talking about since the farm bill -- excuse me, was enacted last year, or are you referring to some previous date where a loophole was closed?

MR. DRISCOLL: I was referring to last year in the farm bill. So, we've seen --

SEN. CHAMBLISS: Okay, so it's --

MR. DRISCOLL: -- a large increase since a year ago today.


You mentioned gold and silver as commodities, where there the potential for fraudulent transactions. Any other commodities that need to be considered in that same respect?

MR. DRISCOLL: Precious metals are, by far, the largest product that's being used in these non-forex, Zelener-type of contracts. But, we've also seen energy-type of products as well.

And our view is that, essentially, you have to make the -- you have to close the loophole for all commodities that are traded in futures markets. Because if you close off the ones that are currently existing now, then next year we'll be coming back and saying the fraudsters have now went to those markets.

Because the people that trade these sorts of contracts and run these sorts of schemes are ones that are looking for a regulatory vacuum, and they've made careers of doing this. So, we believe all of the loophole has to be closed.

SEN. CHAMBLISS: Ms. Stout, do you feel that all OTC markets create a systemic risk?

MS. STOUT: (Off mike.) No. Probably not. I think something -- that is actually a question that is not even necessarily something we have to address. I think a proper system of regulation of derivatives trading would prevent systemic risk from arising in any particular market.

And I, personally, tend to favor what I think of as "automatic circuit-breaker rules" of this sort, rather than regulation that takes the form of creating some omniscient entity, some omniscient government overseer who's supposed to investigate things on a ad hoc basis and look for potential problems.

I think, with the right set of circuit-breakers -- the sorts that have been mentioned today, listing requirements, margin requirements, position limits, we don't have to worry about looking out for the development of systemic risk in particular markets because the system will work -- would look out for us.

SEN. CHAMBLISS: Do you agree that risk in the -- some risk in markets is a good thing?

MS. STOUT: Pardon me while I put on my "pointy-headed corporate finance professor hat." (Laughs.) No. Risk is never good. However, sometimes risk is inevitable if you want to accomplish something useful -- like curing cancer, or building a company that builds airplanes. But, no, risk itself is never good. We'd like to get rid of all of it if we could.

And the real trick, I think, is to eliminate all the unnecessary risks while not throwing the baby out with the bathwater and eliminating risk in productive areas, and with regard to productive endeavors that we want people to undertake.

SEN. CHAMBLISS: Well, having been in business myself, I've never made any money without taking a risk. And I just think it's extremely difficult, and would be extremely expensive, if we tried to take the risk out of it.

Mr. Chairman, I think that may be -- I think that's all I had, sir.

SEN. HARKIN: Thank you very much.

And, Mr. Masters, in your summary you said that "I have outlined in my testimony (are not brand new ?) solutions: One, exchange (clearing, with innovation and margin ?); and two, speculative position limits that (have) proven effective over many decades of experience."

"In many ways, what we need to do is turn back the clock on several of the deregulatory measures that were undertaken in the last 15 years. The unintended consequences of those deregulatory decisions have been devastating for America." I agree.

And now, off of that, I want to challenge you, Mr. Dines, on what you just outlined on this average price option. You say it's not offered by the exchanges. Well, why is it not offered by the exchanges? We have a chicken-and-egg thing here. See, now, I've said we ought to put all these on exchanges, you see.

Well, if you're allowed to have them on over-the-counter markets, that's where they are. But, who's to say that this average price option could not be developed as a product on a regulated exchange? That way, you have more transparency; you'd have more people involved; you'd have more liquidity, if you had more people in that game. But, as long as we have it in the over-the-counter market -- with some opaqueness, lack of transparency, of course the exchange is not going to offer it.

I had Mr. Duffy here last fall when we discussed this very thing. And I asked him that pointed question. I said -- in my terms of my legislation, to put them on a regulated exchange, I asked him very pointedly. I said, could your exchange -- could the regulated exchange, not just his, but the regulated exchanges handle this? And his answer was, yes.

So, again, I have always asked -- I keep asking this question. I ask two questions: One, define a customized swap. I still haven't had one -- real defined yet. What is customized, that doesn't have some impact someplace in the economy? If you have a customized swap -- on an interest rate, or something like that, it may be between two individuals, but it may have other effects on a lot of other investors in other places.

Same way with your hedging on the corn market -- could have a lot of effects. I would submit that if you have it on a regulated exchange, with more transparency, and people know about it, quite frankly, I think your business will do better. (Laughs.) I quite frankly think it will. And I think that the sellers will also do better too, because it'll be open and above board.

And we can call for margin requirements. Now, you have this problem with capital requirements. But, that can be -- that can be set. I mean, that can be -- we can temper that, I think, through regulation, on not having onerous capital requirements but having some capital requirements, putting some skin in that game.

So, again, I want to challenge you on why you can't do this on a regulated exchange?

MR. DINES: Well, you could put average price options on exchanges. That could very well happen. But, the degree of customization goes beyond that. And it goes to protection periods; it goes to protection levels; it goes to maybe how the average is determined. And the issue is, is that you can have multiple, multiple different variations of an average price option.

I want to be very careful, it doesn't mean that they're more complex, it means that they are tailored to precisely meet that hedger's needs.


MR. DINES: I think it's impossible for the clearinghouses and the exchanges to do this. I don't think they can handle more multiple forms. And the OTC market does it. We do it every single day. We get our customers who say, I want it to this particular day; I want it with this protection level; I want the averaging period to start here and end here.

And to put that on an exchange will require standardization. You go into the exchanges today, you can pick from a certain set of end dates; you can pick from a certain level of -- certain set of protection levels, but you do not have the degree to -- you cannot customized it. They just are not set up to do it.

So, that's -- that, I think, is the primary difference. It's the ability to really work with customers to customized the product.

SEN. HARKIN: Dr. Bookstaber.

MR. BOOKSTABER: I think a good example of the distinction -- there's a gray area between standardized and customized. Think of the equities option market. The CBOE's works, you know, exchange-traded. You can't get an exercise price of 51.3.

SEN. HARKIN: Say that again. You can't -- ?

MR. BOOKSTABER: The exercise prices for the options are in increments -- maybe a 5- or a 10-point increment(s). So, somebody could argue, "wait a minute, this isn't fulfilling my objective, because I don't want and exercise price of 50, and I don't want an exercise price of 55. I want 52.23."

Well, of course, if you go to customized, the standardization is going to limit things to some extent, but the challenge is to go to Cargill, to go to the clients of JPMorgan and to say, "Let's look at the whole lay-out of the customizations that you do." "Can we find a reasonable set of standard securities that get close enough to what people want, that, in the majority of cases, they're fairly satisfied?" Maybe somebody wants exercise -- a time-to-maturity of 11.1 months; and another wants it of 10.9 months. Eleven months may do the job for them.

So, it's true that you can't get standardization to meet every of the infinite possible numbers of times-to-maturity and the infinite number of possible exercise prices. But, once you get to (find ?) enough differentiation, that may be sufficient to deal with the large majority of what people demand.

SEN. HARKIN: Mr. Lenczowski.

MR. LENCZOWSKI: Thank you, Chairman.

I would agree with Dr. Bookstaber that there could be a degree of standardization that's achievable. But, even with that standardization, the company that's looking to hedge its risks will still have to post the margin to clearinghouse.

And you mentioned, Chairman, that we could maybe regulatorily affect that margin. It's actually incredibly important that that margin be what the clearinghouse says it is, because the clearinghouse has to act as the ultimate credit support to everyone. So, it sets its margin requirements based on what it feels -- through its risk models, the risk of a particular transaction is.

So, the clearinghouse sets that margin requirement. And then it requires the most liquid form of collateral because, as soon as a default occurs, the clearinghouse has to instantaneously apply that collateral against the defaulted position. There's no ability to wait and sell some property or land. It has to happen instantaneously. Again, that preserves the clearinghouse's stability.

So, whilst again we -- I agree that there could be standardization, and it could actually suit certain customer's needs, many customers just don't have that liquidity, that cash right now. And that's why, among other reasons, they use the OTC market.

And I think there was a mention that the OTC market is not collateralized, or that it has -- that the customers pay for that margin somehow. In fact, many times when these customers go to the OTC market, the collateral that they pledge is the exact same collateral that they've pledged to secure their loan obligations.

Many customers borrow on a secured basis. They pledge land, or equipment, fixtures, receivables, even intellectual property. That's all good collateral. It's very good. I mean, that supports or lending agreement -- our money we lend to them. It serves both as credit support for the loan, and also for the derivative.

And that's the efficiency and the flexibility that OTC derivatives provide to corporate America. And that's why we think corporate America chooses the OTC markets instead of the exchange markets. It's not because there's anything wrong with the exchange markets, it's just that the OTC markets are more flexible and are able to address exactly the risks that the company wants to hedge.

SEN. HARKIN: Did you have any observation on this at all, Dr. Stout?

MS. STOUT: (Off mike.)

SEN. HARKIN: No. -- (inaudible) --

MR. : You know, if I can just indulge on this. I think this point -- of course, it's better if you can post illiquid collateral. Of course, all of us would like to have that. But there is a problem if the instrument is highly liquid and can be liquidated very quickly. And what you have as collateral is very illiquid. This is what leads to liquidity crisis cycles.

I have $800 million that I have as collateral at a bank. I'm in a market that, for some exogenous reason, drops by 10 percent.

The bank says, come up with more capital or we'll start to liquidate. And suddenly, they say, oh, but it's land, we can't liquidate it in the same timeframe as this instrument.

So it's painful. And of course, we don't want to have it be the case. But I think if you have liquid securities, you have to have liquid collateral on the other side.

MR. LENCZOWSKI: If I could, Chairman, just to respond. The size of our loan book at JPMorgan is roughly 10 times the size of our derivatives exposure. And much of that loan book is supported by this collateral that Dr. Bookstaber mentioned.

It is relatively illiquid, but it is excellent quality collateral. We lend on that basis.

So what we allow our customers to do is to use that same collateral to support their derivative transactions. That's useful for them. It's not an unsafe and unsound banking practice. In fact, our examiners, who are on-site, would be all over us if it was anywhere close to that.

So I'd like to just clarify that. This is very good collateral that we're receiving from our customer base, and it's a very big part of what makes these transactions happen for companies.

SEN. HARKIN: Let me ask that, Mr. Lenczowski. Okay, so you admit it's not liquid. And how much can that be leveraged? How much can you leverage something that is illiquid, that is an asset or land or whatever. How much can you leverage that?

I think I can understand if it was capital, but I don't know that I can understand it if it's something else.

MR. LENCZOWSKI: That's an excellent point, Chairman Harkin. Our credit officers make that exact determination, because we have statistical models and other means of assessing what our probable exposure could be. We use many forms to do that, but we are able to decide, from a credit standpoint, how much we could do.

And again, these determinations are reviewable by our regulators. And we ensure that done within safe banking practices.

MR. : Chairman Harkin, could I just add to that point for a second? We have probably 250 to 300 institutional-type customers that we're providing products to. We margin with about 80 percent of those customers today. We're moving collateral back and forth with them. We're sending them daily position reports so they know what the value of their derivatives are.

Again, they know the value. They're moving the collateral back and forth. They're giving us liquid cash as collateral or we're giving them liquid cash as collateral. The difference is is that we don't think that a highly rated food or industrial company should be held to the same margining terms as a lower-quality, more-leveraged company.

And so we're flexible in our credit terms for them. So we may not make them post initial margin, we may give them $1 million threshold before they need to post margin. But we are still applying very strict credit standards. We're margining with them. But we're flexible in the way that we do that, and that's very, very important.

One million dollars to a company today means a lot from an investment standpoint. So that's the way that we're managing it. That's the benefit of the OTC market versus a standardized exchange. Because if you think about the standardized exchange, it has to go through the lowest-common denominator, I mean, it's dealing with different levels of credit quality. So it has to build its risk, its margining on the worst-possible credits that might be part of that clearinghouse or exchange, where in the OTC market you don't have to do that.

SEN. HARKIN: Ms. Stout.

MS. STOUT: I think the last comment is very helpful for helping keep a perspective on what we're discussing here. You referred to a $1 million savings today for Cargill. We're dealing with a crisis that I believe the figure that you mentioned this morning, Mr. Chairman, was $4 trillion. I don't think anyone would dispute that for some businesses at some times some forms of derivatives are definitely beneficial.

I think the critical question has got to be, how do we measure the benefit against the harms? I'm very sympathetic. I wish I could ensure that Cargill could always have the perfect hedge. But if maybe you have to inconvenience yourself a little bit and deal with the suboptimal hedge sometimes, and the social benefit we get is that we don't get another Lehman Brothers, another Bear Stearns, another AIG, well, sometimes you have to put up with a little bit of difficulty.

We are at a watershed moment, Mr. Chairman, I think that is comparable to the situation we faced in the 1930s. Over the past decade, I think we can argue that the finance sector of our economy came close to cannibalizing the real economy. Derivatives were definitely part, not the only part, but one of the larger parts of that cannibalization process.

It is clear that we cannot sustainably go doing things the way we have done them for the last 10 years. You know, the definition of insanity, doing the same thing and expecting different results.

Every time in history in my research that we have attempted to deregulate derivatives, we have gotten the same results. So on the theory that the perfect is the enemy of the good, any regulatory development that can begin to bring back the exposure that we have today, the exposure to systemic risk, to reduce economic productivity, to price bubbles, to fraud and manipulation, anything that can begin to ratchet that back would be a very good thing.

SEN. HARKIN: Well, anyone else?

Yeah, Mr. Masters.

MR. MASTERS: I just wanted to make a couple of points with regard to the whole notion of multiple prices, volume-weighted-average prices. In the equities business, we have probably in excess of 100 different ways on listed exchanges of trading those various kinds of orders. We can do algorithms that do all sorts of things, that can literally wait every two minutes for an order and then only take the offer or sit on the bid all day or hide or bob or weave or whatever. All those things are possible on listed exchanges. We do them every day in our own business.

Secondly, I'd like to make this point because I think it's important with regard to the notion of options and different strikes and so forth. We're one of the largest listed options traders in the United States. And one of the issues with regard to options is when you trade an over-the-counter option, there is someone on the other side that knows your position. That's a huge issue. I don't want them to know my position, because if they know my position and it's just me and him, if something goes wrong I've got a problem. And he knows exactly what my problem is. And that goes on every day.

And so there's a huge competitive advantage to a bank or a swaps dealer to have that position on with a customer, because they are able to reverse engineer the customer's knowledge and flows.

So having that liquidity, having an exchange being able to hide, if you will, I can trade on these options exchange, and people don't know who I am. And I can trade using various different orders. That's a great benefit, and it would be a great benefit to many other customers once they understand that little dynamic that goes on on Wall Street.

SEN. HARKIN: Pretty interesting.

Yes, Mr. Lenczowski. I meant to call on you.

MR. LENCZOWSKI: Thank you, Mr. Chairman. Just a couple of points. First, the exchanges have been trading equity options for quite a while now. And they're free for anyone who can open an account there. Certainly, we have no desire in monopolizing the equity market in the over-the-counter business. And any customer who feels they will do better on an exchange should trade there and should feel free to trade there.

What we don't want is to eliminate that choice from the customer. There are some customers who might choose facing an exchange-rated exact same product to trade in the over-the-counter market. And to that extent, that kind of a choice should continue to be allowed.

And then secondly, just to confirm, there's a strawman argument, I think, or some example that the banks are against regulatory reform or swap dealers are against regulatory reform. That's absolutely untrue. We support broadly the initiatives that the administration has announced and Chairman Gensler described today. I've outlined them in our written submission. And I'd just like to reassert again that we do agree completely that something has to be done. We just want it done in the right way for the economy.

SEN. HARKIN: Any last words? I thought this was a very enlightening session. We could probably go on for some time. As as a matter of fact, I've got Secretary Vilsack over in the Appropriations Committee that I've got to go over and listen to his testimony on his budget.

But as you know, we're wrestling with this. I guess I end where I started. I mean, we can't continue to do what we've been doing. We've got to make some changes, and there have got to be, I think, some fundamental changes in the way we do this.

Now, I have taken the position. You all know my bill, what I've attempted to do in that legislation. However, I'm always willing to look at other sides of that issue. But I guess my own personal standpoint, I still come down to the more open we are, the more transparent we are, the more information that people have out there in a regulatory framework, the better off we're all going to be. And somehow, we've got to, as Mr. Masters said, I think, get back to where we were before in some kind of a regulatory framework. And that's what we're going to have to wrestle with is exactly how we do that. No one wants to stifle, as I said, innovation. But we've got to ask what that innovation is for.

And secondly, no one wants to get rid of speculation. We need speculators. But we don't want that bottle of aspirins every day, we need just maybe one. And so we have to figure out how we provide that kind of liquidity in some kind of a regulated manner also.

So these are the things we're wrestling with. I think this panel added greatly to our thoughts on this in our pursuit of trying to figure out what we can do.

I just would say to all of you that as we proceed on this, any other thoughts and suggestions you may have, please let us know. And we'll be developing this legislation sometime this year, probably not until this fall. We've got the health care bill and we've got a lot of other things we've got to do. We've got to do our child nutrition reauthorization, too, this year. But this is something we've got to attend to.

And I know. I've talked to Mr. Peterson on the House side. He wants to move something this year, too. So I invite your constant input and consideration of what we're doing here.

Again, I thank you all very much for being here today. As I said, it was a great panel, appreciate it very much. Thank you. And the committee will stand adjourned.

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