_________________________________________ REMARKS BY ARTHUR LEVITT CHAIRMAN, U.S. SECURITIES & EXCHANGE COMMISSION "DERIVATIVES USE IN THE 1990s" IDB/ISDA CONFERENCE WASHINGTON, D.C. -- NOVEMBER 9, 1995 _________________________________________ Good afternoon. I want to thank President Enrique Iglesias of the Inter-American Development Bank, and Gay Evans of the International Swap Dealers' Association, for inviting me to address you today. This meeting provides a unique opportunity for regulators and market participants to assess the issues raised by the increasing use of derivatives in Latin America and the Caribbean. The popularity of derivatives, and their international nature, has earned them plenty of attention -- some well deserved, but not all of it pleasant. Over the past two years, the headlines have been filled with significant derivatives losses by corporate and municipal end- users and dealers alike. The collapse of Britain's Barings Bank; the problems at MetallGesellschaft, and, in the United States, the "Bankers Trust" enforcement action are all still fresh in our minds. These events have heightened concern over whether derivatives are being used properly. It's clear that regulators and market participants must recognize and work together to address the potential risks posed by derivatives trading. At the same time, we must avoid the temptation to demonize derivatives, which are a vital tool in modern financial markets. They are so useful in managing risk that if they didn't exist, we would surely have to invent them. Like any financial instrument, derivatives require certain ground rules, and regulators can provide that. But we must resist the siren call for stringent regulation that occurs in the wake of every new loss -- especially since the typical derivatives loss is less a failure of regulation, than a failure of oversight by the parties involved. Derivatives are like electricity -- dangerous if mishandled, but also capable of doing enormous good. Intelligent oversight can often make the crucial difference. The markets of the Americas are not immune to these risks; indeed, derivatives activity is also increasing in Latin America and the Caribbean. Brazil has the fourth most active commodities futures exchange; countries that are just developing equity markets, such as Ecuador, already are faced with transactions involving swaps, options and other derivatives on their markets. In addition, markets and dealers around the world are trading derivatives based upon Latin American securities. The SEC recently approved several Latin American-based derivative products for trading in the U.S., for example, including warrants on the Mexican peso, and options on an index of 30 stocks traded on the Mexican bolsa. The SEC also worked with the Commodity Futures Trading Commission to approve the trading of futures on an index of Brady Bonds issued by Mexico, Argentina, Brazil, and Venezuela. Because these products now play a key role in all of our capital markets, the risks and rewards of derivative trading are of relevance to us all -- emerging markets as well as established. Derivatives can help manage the risks of volatility in emerging markets. A Barings-type event, however, could have an especially adverse effect on capital flows in such markets, at a time when capital formation is critical to stimulate economic growth. I want to share with you today some of the recent actions we've taken at the SEC to address the questions raised by derivatives. The hallmark of our policy has been its flexibility, which echoes the flexibility of derivatives themselves. You can't address fast-changing instruments with ironclad regulations. At the same time, I also want to address the responsibilities of the private sector -- the large securities firms and banks that are dealers in derivatives, the end-users that utilize derivatives, and the exchanges that list derivatives. If there is a single message that I hope to leave you with today it is that both the public and private sector have special responsibilities when it comes to derivatives. And both need to uphold their obligations, if we are to unlock the potential promise of derivatives without also exposing our markets to inordinate hazards. I'll focus on five basic issues raised by the proliferation of derivative products -- capital standards; internal controls; sales practices; disclosure; and international regulatory cooperation. Capital Regulators face the challenge of developing a modern and efficient system of capital standards for derivatives. Prudent capital standards are necessary to prevent any damaging consequences from a firm's failure, as well as guarding against excessive leverage. At the same time, it's important that capital standards are flexible enough to accommodate new products, without subjecting dealers to undue constraints. This is not an easy task, and the growth of off-exchange derivatives has made it still more complex. For example, banking regulators traditionally have tended to focus on credit risk, while securities regulators are more attuned to market risk. The growth of off-exchange derivatives has juxtaposed the two traditional approaches, raising difficult challenges for both banking and securities regulators. In response, firms dealing in derivatives have urged regulators to rely on the firms' internal models for determining capital charges. Banking regulators are now considering how best to do so. Although questions remain about the appropriateness of using models to determine capital requirements, we've begun examining the data from internal models, to gain a better understanding of the manner in which models operate, and the adequacy of capital charges derived from their use. Even when used for the firms' own risk management purposes, any reliance on models places a heavy responsibility on dealers to make sure that the models are not built on a house of cards. This places a great deal of importance on my next topic -- adequate internal controls. Internal Controls A system of sound internal controls is the first line of defense against misuse of derivatives. Barings, Codelco, MetallGesellschaft, and other losses demonstrate that sound controls should be a top priority of management for both dealers and customers using derivatives. Regulators have taken several steps to address internal controls. Last year, the International Organization of Securities Commissions and the Basle Committee on Banking Supervision issued papers on risk management guidelines and control mechanisms for derivatives. In addition, in late 1994, the SEC asked six of the largest non-bank derivatives dealers to establish a voluntary framework for derivatives oversight. The report of the Derivatives Policy Group, as it came to be known, was submitted to the SEC and the CFTC in March 1995; its recommendations include developing a sound system for implementing, measuring, and monitoring controls. Dealers and end-users alike have an obligation to implement adequate controls. It's already been proven that a failure to do so can be extremely costly, whether in terms of financial losses, regulatory actions, lawsuits, or damage to one's reputation. Investment in derivatives should always be preceded by investment in controls. As emerging markets begin to consider whether to develop derivatives exchanges, another thing to bear in mind is that exchanges will work only if the clearinghouse is operated in a safe and sound manner. This will entail not only adequate supervision by regulators, but an airtight system of controls at the clearinghouse. Sales Practices The growth of off-exchange derivatives, which is largely an institutional market, has made the question of sales practices one of the most contentious issues facing the industry today. Massive losses over the past two years have led to much finger pointing between buyers and sellers over their respective responsibilities. Obviously, dealers should not be held liable for investments that simply go wrong; at the same time, dealers would be extremely shortsighted to treat all end-users as mere counterparties. These transactions require a mutual understanding of obligations and responsibilities. As several others have observed, including my colleague Commissioner Steve Wallman, there's no question that the dealer is best suited for clarifying those obligations and responsibilities. Dealers must recognize their interest in doing so up front, before the deal is made. And for their part, end-users must recognize their interests in understanding the activities in which they engage, and in having sound control policies in place. I embrace the idea of working with broker-dealers and end- users to develop standards for risk management policies and sales practices. But I remain committed to the need for regulators to pursue those who violate the securities laws. As an example of this, the SEC and CFTC brought enforcement actions against BT Securities Corporation in connection with the sale of derivatives to Gibson Greetings. We found that "Bankers Trust" had violated antifraud and other provisions of the securities and commodities laws by, among other things, misleading Gibson about the value of the company's OTC derivatives positions. We will not hesitate to act in such cases -- for the sake of investors, but also for the sake of our markets. Disclosure Another important mechanism for protecting both investors and markets is disclosure. I'm happy to say that this is another area where we're making progress, in the U.S. and internationally. Disclosure has two aspects: disclosure to regulators, and disclosure to the public. The Commission has undertaken initiatives in both areas. With respect to disclosure to regulators, the Commission has been analyzing information obtained under its the risk assessment program since 1992. The program requires broker-dealers to file information with the Commission about the derivatives activities of their material affiliates. In addition to the risk assessment program, the Derivatives Policy Group in March 1995 agreed to provide us with quantitative periodic reports regarding credit exposure and other information relating to their OTC derivatives activities. As to the second type of disclosure -- disclosure to the public -- the Commission is working on a release concerning disclosure about derivatives and other similar instruments by public companies. As currently contemplated, the release would expand existing disclosure requirements to include integrated qualitative and quantitative disclosures of market risk information about such instruments. Alternative formats for the required disclosure of quantitative information may be offered, as well as narrative discussions of market risk exposures and the objectives and strategies for managing these exposures. Cooperation The final topic I want to raise with you today is international cooperation. As I noted earlier, derivative activities do not follow geographical and political boundaries. The SEC has undertaken a number of initiatives on the global level. We believe there's a need for a cooperative approach to regulating derivatives; but we also believe that the quest for uniformity must not overshadow the need for adequate standards. The SEC actively participated in IOSCO's effort last year to set forth a framework for management controls for OTC derivatives activities of securities firms. In addition, in July of this year, the U.K. Securities and Investments Board and the SEC announced a joint initiative to improve oversight of securities firms with significant cross- border derivatives activities. This initiative is especially important because it brings us together in a practical exercise that will lead to a better understanding of each regulator's approaches. Moreover, it will contribute to better information exchange between regulatory authorities in the U.S. and the United Kingdom. The global expansion of derivatives also has enabled fund managers and dealers around the world to increase their trading in the markets of emerging economies such as those in Latin America and the Caribbean. The SEC has been working closely with the Council of Securities Regulators of the Americas, known as COSRA, to address the issues raised by this expansion in activity. In June, the SEC chaired the Sao Paolo meeting of COSRA, at which members discussed the principles of effective market oversight. We also reviewed the supervision of derivatives trading in each of our countries. At this meeting, members adopted Principles of Effective Market Oversight which: 1) impose responsibility and accountability for fair and efficient markets on market operators and intermediaries; 2) monitor compliance with securities and futures laws and applicable self-regulatory organization rules; and 3) establish or bolster an effective enforcement system. We felt this was a very positive development that will lead to greater compatibility of standards and therefore, greater integration of our markets. The SEC also has taken some steps on its own to enhance international understanding of derivative products. Our International Institute for Securities Market Development is usually well-attended by representatives of securities regulators from throughout the world, including Latin America and the Caribbean. For several years, the program has included a discussion on the use and regulation of derivatives. CONCLUSION I've tried to cover a lot of ground today, so let me summarize: While regulators are responsible for establishing ground rules, ultimately it is up to all of us to keep this market in good order. Dealers in particular must establish sound internal controls, maintain adequate capital, clarify customer relationships, and so on. To the extent they fulfill these objectives, the job of the regulator is made easier. More importantly, however, capital markets and financial systems will be made more sound. This conference is an important milestone in addressing the questions raised by the growing use of derivatives in Latin America and the Caribbean. The increasing sophistication of these markets is part of a concerted effort to enhance their competitiveness in the global marketplace. Together, we can ensure that the explosive growth in derivatives is not a danger to our markets, but rather a positive force in advancing them. # # #