Message-ID: <12315675.1075859989283.JavaMail.evans@thyme> Date: Tue, 7 Mar 2000 09:02:00 -0800 (PST) From: brickell_mark@jpmorgan.com To: mark.e.haedicke@enron.com, mark.taylor@enron.com Subject: Speech by Jim Leach on CFTC Reform Proposal Mime-Version: 1.0 Content-Type: text/plain; charset=us-ascii Content-Transfer-Encoding: 7bit X-From: "Mark Brickell" X-To: mark.e.haedicke@enron.com, mark.taylor@enron.com X-cc: X-bcc: X-Folder: \Mark_Taylor _Dec_2000\Notes Folders\Notes inbox X-Origin: Taylor-M X-FileName: mtaylor.nsf Last night House Banking Committee Chairman Jim Leach gave a speech in Washington complimenting CFTC Chairman Rainer for moving to deregulate futures exchanges but expressing concern about references to swaps (OTC derivatives) in the Staff Draft "New Regulatory Framework." A copy of the speech appears below, (or use this website link: http://www.house.gov:80/banking/3600pr.htm ). Chairman Leach appears to have had some contact with banking regulators as he prepared it. House Commerce Committee staff has also weighed in with the CFTC on the issue. I hope one of you can give me a call about new info (since my discussion yesterday with Mark Haedicke): what remedies the Banking and Commerce committees will be seeking from the CFTC, and the extent to which ISDA and others are in sync with these events. In particular, my reading of the only ISDA position paper I have seen is that it leaves to the tender mercies of the CFTC swaps with retail participants negotiated on the Internet. Thanks Mark (212)-648-6605 ______________________________________________ For Immediate Release: ontact: David Runkel or Monday, March 6, 2000 rookly McLaughlin at 226-0471 Excerpts of Remarks Of Rep. James A. Leach Chairman, House Banking and Financial Services Committee Before Institute of International Bankers Annual Washington Conference Four Seasons Hotel, Washington D.C. Good afternoon. The fundamental challenge for the House Banking Committee at the close of the previous century and the start of this one has been to reform and rationalize the legal and regulatory structure of our financial sector to keep pace with monumental changes that have transformed the marketplace. In the face of revolutionary new kinds of institutions, businesses, and financial instruments, it became self-evident that the legislative framework required modernization to ensure the integrity, innovativeness, and competitiveness of U.S. finance and re-bolster the stability of the international financial system. Our most important accomplishment in this endeavor has been the passage of the financial modernization act, which obliterated obsolete barriers between various families of financial sector institutions and thereby increased access of consumers to a wider panoply of competitively-priced financial products. This was no easy task, but, at the end of the day, the will to improve the laws transcended parochial rivalries between and within various branches of government and various parties of the private sector. A similar legislative challenge in our reform efforts centers on swaps and related over-the-counter financial derivatives transactions. In the passage of the financial modernization act, the House Banking Committee successfully fought to ensure that all credit swaps and the vast majority of equity swaps are treated under U.S. law as "identified banking products" and thus can continue to be carried out within banks subject to bank regulation. With modernization legislation signed into law, however, we must direct our efforts to resolving the serious legal anomalies that continue to plague the financial derivatives markets, in which so many of the banks represented here participate so vigorously. Questions about the legal status of derivatives transactions under U.S. law must seem arcane and somewhat bizarre to foreign institutions that transact swaps business in this country. Although the discussions can get quickly mired in obscure minutiae, we must recognize from the outset that what is potentially at stake is neither obscure nor minute. Outdated statutes that raise questions about the enforceability of contracts with banks and bar risk-reducing practices pose a palpable threat to the safety and soundness of the financial system. Indeed, U.S. banking regulators warn that uncertainties and unintended consequences of federal laws could potentially turn financial disruptions in the global system into financial disasters. What I would like to do today is first outline briefly how far we have come toward consensus about the need to clarify the treatment of financial derivatives under U.S. law. I would then like to conclude by discussing, from a Banking Committee perspective, certain concerns with a regulatory proposal on derivatives issued by the Commodity Futures Trading Commission a few days ago. Since the development of swaps and many related kinds of over-the-counter derivative transactions in the U.S. in the early 1980s, banks have overwhelmingly become the dominant participants in the derivatives markets, with securities firms and their affiliates running a distant second. As most people gathered here know from personal experience, banks are counter-parties to the vast majority of over-the-counter derivatives transactions. By the same token, over-the-counter derivatives have become essential to banks? risk management strategies, their proprietary trading activities, and the services they provide their institutional customers. According to the Comptroller of the Currency, the notional amount of banks? over-the-counter derivatives transactions reached a record $35.7 trillion in the most recent quarter, and $9.9 billion of bank revenues for the past four quarters came from over-the-counter derivatives trading. For these reasons, the House Banking Committee has had a vigorous and sustained interest in derivatives issues for well over a decade. In 1993, when I was Ranking Minority Member on the Committee, the Minority issued a lengthy report that remains the most comprehensive analysis of over-the-counter derivatives ever produced in Congress. The legal issues surrounding bank derivatives activities stem from events that took place, ironically, when the financial markets for swaps and related derivatives hardly existed. In the early 1970s Congress passed legislation creating the CFTC and tasking it with administering a regime to regulate the trading on exchanges of commodity contracts for future delivery, which, at the time, were almost exclusively agricultural in nature. Perhaps because it then seemed obvious, Congress did not at the time define the statutory term "contract for the purchase or sale of a commodity for future delivery" and has not done so since. Since swaps and other over-the-counter financial derivatives exploded onto the banking scene in the 1980s, the absence of a definition of a futures contract has allowed some members of the futures community in both the CFTC and the private sector to argue or imply on various occasions that the new financial instruments should somehow be treated like exchanged-traded futures under the commodities laws. The de facto reality is that swaps have never been regulated as futures under the Commodity Exchange Act or "CEA" as the law is known. Efforts by the CFTC to extend its regulatory reach beyond its statutory authority over exchange-traded futures contracts have failed amidst resistance from the courts, other federal financial regulators, Congress, and the banking and securities industries. The mere possibility that over-the-counter derivatives might be futures, however, has - as many of you are aware - created serious problems. Particularly vexing from a bank regulation perspective have been questions about whether some swap contracts are illegal or unenforceable because they are not traded on futures exchanges. Piecemeal attempts by the CFTC to deal with the unintended damage inflicted by the CEA on over-the-counter derivatives through administrative action, though often well meaning, have failed to solve the underlying problems and have in many instances just created new layers of confusion and uncertainty about when new and ever more convoluted exemptions apply. Past CFTC actions have impeded standardization of contracts, electronic information sharing between banks about swaps deals, and reduction of systemic risk through multilateral netting and clearing systems. What has been needed is not short-term administrative fixes, but rather the passage of new law that explicitly clarifies that swaps and related derivatives are tools of the financial trade, not commodity futures, and resolves issues of when the CEA applies. The problems came to a head a year and a half ago when the CFTC issued a "concept release" asking for comment on whether swaps and other over-the-counter derivatives should be treated as futures. The CFTC?s concept release had the effect of firmly inserting the CFTC into the heart of the regulation of financial products. It implicitly called into question the lawfulness of billions of dollars worth of securities-linked swaps and other over-the-counter derivatives that do not fit neatly into the rag-tag collection of exceptions and carve-outs found in the CEA and the CFTC?s regulations. The release drew sharp rebukes from Secretary of the Treasury, the Chairman of the Federal Reserve Board, and the Chairman of the Securities and Exchange Commission. Faced with a possible menace to the safety and soundness of the banking system, our Committee held hearings and we, along with others in Congress, ultimately had to intervene to stop further CFTC actions in this direction. The executive branch is currently in a far more cohesive position than it was a short time ago. The person who receives much of the credit for this rapid and marked improvement in interagency attitude is the recently appointed Chairman of the CFTC, William J. Rainer. Chairman Rainer is the first CFTC leader to come from the financial industry. As such, he has displayed an unprecedented sensitivity to the problems that CFTC regulation creates for the financial instruments that Congress never intended to be covered by it. He has forthrightly acknowledged in recent Senate testimony that "OTC derivatives transactions as we know them today do not present regulatory concerns within the scope of the CEA." Although this core principle has always been central to the approach that our Committee and the banking regulators have taken toward financial derivatives, it is more than a little refreshing to hear it acknowledged by the head of the CFTC. By acknowledging that good policy dictates that over-the-counter derivatives should not be subject to the CEA, Chairman Rainer reinvigorates longstanding efforts to dispel fears that law governing commodity futures exchanges might interfere with other derivatives markets. The first concrete manifestation of the CFTC?s new stance occurred when Chairman Rainer joined the heads of the Treasury, the Fed, and the SEC in signing a late November report by the President?s Working Group on Financial Markets. In the Report, the Working Group unanimously recommends new legislation that clearly and explicitly pulls over-the-counter derivatives out of the reach of the CEA. This would guarantee, among other things, that parties who lose money in the swaps markets would not be able to use commodity law to attempt to renounce their obligations. The working group also called unanimously for legislation rectifying questions raised by CFTC actions about whether clearing swaps and related derivatives or trading them electronically might make them illegal under the CEA. If these measures are enacted, they will further the effectiveness and legal soundness of bank derivatives activities in the U.S. In any event, the atmosphere of agreement is heartening after years of tension and turf battles. At the same time that the executive and legislative branches of government have begun action to remedy legal ambiguities hampering over-the-counter transactions, we have recognized that this process should be accompanied by regulatory modernization for the exchange-traded futures markets that the CEA was intended to govern. Unnecessary and outdated requirements under the regime the CFTC administers may keep the U.S. futures exchanges - whose innovation and success has been a continuing source of pride and economic strength for this nation - from offering innovative products, updating technology, and reducing transaction costs. Exchanges must meet these challenges to stay competitive. It is interesting to note in this connection that there is no open outcry market left in Europe and that an upstart electronic market based in Frankfurt is now the largest futures market in the world. The loss of business resulting from changes in the marketplace and misplaced regulatory exigencies can have real human costs, threatening the livelihoods of many people who depend on our futures exchanges for employment. The CFTC?s goal of shifting its regulatory paradigm for futures exchanges from direct regulation to oversight seems like a good way to confront the difficult challenges ahead. For these reasons, first the leadership of the House and Senate Agriculture Committees and later the President?s Working Group asked the CFTC to come up with a comprehensive proposal of administrative action to rationalize and, where possible, reduce the regulatory burden on the trading of futures contracts on exchanges. In response to these requests, the CFTC staff task force released a tentative initial proposal a little over a week ago. To the extent that it treats futures trading, the CFTC staff?s proposal is to be commended as probably the most conscientious and creative rethinking by a regulatory agency of its role in recent memory. But the proposal goes further than futures contracts, further than the President?s Working Group contemplated. Instead of just discussing how much to regulate or deregulate futures and futures exchanges, the CFTC staff proposes an entirely new regime of complicated exemptions, principles, and enforcement rules that appear to apply to all derivatives, whether they are futures or not. Thus the proposal raises a number of serious concerns. First, although different in substance, the new proposal stumbles into the same over-the-counter derivatives mine field that blew up Chairperson Borne?s concept release. Because of the uniquely exclusive regulatory structure of commodities law, the CFTC finds itself in a peculiar "Catch 22." Even if the CFTC wants to help the problems created for banking by the CEA, its actions may implicitly expand the agency?s jurisdiction in such a way that legal uncertainties increase rather than decrease. Any attempt by the CFTC to grant relief through administrative action lends credence to the legal argument that swaps are somehow futures under the CEA. Asking the CFTC to fix the legal uncertainties surrounding over-the-counter derivatives is like asking the Fed to administer farm policy. These practical concerns are joined by a very real statutory concern. The CFTC has authority over futures contracts and commodity options and little else. To the extent that it purports to regulate all derivatives, the CFTC proposal may run counter to a fundamental limitation imposed by Congress. Even if it made sense to expand the CFTC?s role to cover some aspects of over-the-counter derivatives trading, it is Congress and only Congress that should decide this. The opt-in nature of part of the CFTC?s proposed framework does not solve the authority problem. If one person opts to have his swaps business regulated as futures trading, others could argue with potentially deleterious results that identical transactions are also futures subject to the CEA. More fundamentally, exemptions are subject to regulatory whim and can be easily revoked. As John Locke warned three centuries ago, good princes can be particularly dangerous because, after authority is conferred out of trust, they are often followed by bad princes. Locke?s time-tested admonition applies to the current dilemma about CFTC regulation. This is among the reasons why the President?s Working Group strongly urged that balanced legislation not regulatory exemption was what was needed to deal with over-the-counter derivatives issues. The irony is that, after achieving better Working Group relationships, the Executive Branch has allowed the CFTC to release a preemptive proposal without securing the prior approval on language of the other agencies in the Working Group. Inter-agency discourse on possible approach is simply not a substitute for garnering support for language in an area where the devil lurks in every detail and the preemptor in every concept. In conclusion, let me state that I believe that the CFTC?s proposals hold the potential of becoming first class rulemaking if proper modifications are made. In this regard, I look forward to working with others in Congress and the CFTC to coming up with an approach that is appropriately tailored to the CFTC?s jurisdiction and provides sorely needed modernization and relief for futures trading on exchanges. As for legislation, our Committee is posited with responsibility for the safety and soundness of the banking system and we intend to keep all options open, including revisions to the banking laws necessary to implement the general spirit and specific recommendations of the President?s Working Group. Last Congress, the Banking Committee reported out legislation incorporating the President?s Working Group recommendations on the netting of derivatives and other financial contracts. These recommendations build on the existing statutory framework concerning the netting of derivatives and are designed to further the policy goal of minimizing the systemic risks that could occur with the insolvency of a counterparty to such contracts. This legislation will soon be considered as part of the larger bankruptcy bill conference. Throughout all of our work on derivatives over the years, the goals of the House Banking Committee have remained steadfast: ensuring the safety and soundness of the financial services industry; removing unnecessary and unintended obstacles to the effective management of risk in the financial system; and keeping U.S. derivatives markets as rational, competitive, and attractive for your institutions as any derivatives markets found elsewhere.