OTC Derivatives in the U.S. Financial Markets
By Richard R. Lindsey
Director, Division of Market Regulation
U.S. Securities & Exchange Commission
Before the Senate Committee on Agriculture, Nutrition, and Forestry
December 16, 1998
Chairman Lugar and Members of the Committee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission ("SEC" or "Commission") on issues relating to the federal regulation of transactions involving over-the-counter ("OTC") derivative instruments. These issues involve significant questions of public policy that require the attention of Congress, members of the financial regulatory community, and interested industry participants. The Commission appreciates the opportunity to express its views on these important questions and to participate in the study of OTC derivatives.
A. Growth of OTC Derivatives Market
The OTC derivatives market has experienced tremendous growth over the past two decades. The latest International Swaps and Derivatives Association, Inc. ("ISDA") figures estimate that the combined notional amount of outstanding interest rate swaps, currency swaps, and interest rate options globally has grown from $29 trillion at the end of 1997 to over $36 trillion at the close of the first half of 1998, an increase of 24% in just six months.1 We expect this market to continue to grow at a rapid pace. It is clear that events in the OTC derivatives market can impact the capital markets as well. The proper regulation of the OTC derivatives market is therefore an important concern to this Committee and to all of the financial regulators.
While many factors have contributed to the growth and development of the OTC derivatives market, perhaps most notable is a series of rapid advances in technology. Twenty years ago, entities faced substantial limitations in their ability to design financial instruments or otherwise manage their risk exposures.2 New developments in financial engineering, however, have made significant progress toward the goal of allowing both dealers and end-users to more clearly identify and manage different kinds and degrees of risk in their portfolios. The tools that have been developed, although not fool-proof, can assist in the design of OTC derivative instruments to specifically address various risks. As a result, corporations, financial institutions, governmental entities, and even certain individuals, have much greater access to risk-mitigation products that suit particular needs.
Today, OTC derivatives transactions involve a wide range of products, including interest rate swaps, cross currency swaps, equity swaps, basis swaps, total return swaps, asset swaps, credit swaps, and an assortment of options. Asset classes can consist of securities or virtually any other financial instrument, financial measure, or physical commodity, such as interest rates, securities indices, foreign currencies, metals or energy products, or spreads between the values of different assets. Even the occurrence or non-occurrence of an event has proven a useful measure on which to base a financial instrument, as evidenced by the increasing popularity of credit derivatives.3 The complexity of these transactions and the advanced technology employed in their development require our close attention, lest the technology outrun our ability to deal with its products.
B. Recent Events
The growth of the OTC derivatives market has not occurred without incident. Indeed, over the past few years, several highly publicized events involving large financial losses have been attributed to the use, or misuse, of OTC derivative instruments. While financial losses of this magnitude are of concern to regulators, these incidents do not necessarily demonstrate a need to adopt a new, comprehensive system of regulation for this market. The fact that our system has survived these incidents shows the resiliency of the existing regulatory structure and the benefits of a coordinated effort.
Like any other tool, derivatives can be dangerous if misused. A sharp knife in the hands of a child can lead to disaster, but the same knife in the hands of a skilled woodworker can be deftly maneuvered to create a work of art. The incidents described below do not, in themselves, demonstrate that risks associated with OTC derivative instruments must be addressed by regulation of these instruments. The losses suffered by the various entities involved in these incidents, while of serious concern, did not appear to contribute to widespread systemic risk.
Instead, these incidents generally highlight the importance of supervision of financial institutions dealing in these instruments and, in particular, ensuring the adequacy of their internal controls. All market participants need to establish a system of internal controls to effectively monitor and manage risks associated with their business activities. The Group of Thirty, which consisted of a diverse cross-section of dealers, end-users, academics, accountants, and lawyers involved in derivatives, made a number of recommendations in 1993 to help market participants manage their derivatives activities.4 Many of the financial losses discussed below might well have been avoided or at least limited if the parties had implemented internal control systems along the lines recommended by the Group of Thirty.
1. Orange County Bankruptcy
In the Orange County case,5 approximately 187 municipalities and government bodies deposited tax revenues and other public monies in several pools, including a commingled pooled fund (the "County Pools"). The County Pools were managed by the Orange County treasurer and, by the beginning of December 1994, represented approximately $7.6 billion. A significant portion of the pools were invested in interest-rate sensitive two to five-year notes and structured notes issued by federal government sponsored entities ("GSEs"), such as Fannie Mae and Freddie Mac. In addition, the County treasurer employed a strategy of leverage using reverse repurchase agreements6 that was predicated on the assumption that interest rates would continue to remain low. By December 1994, the estimated $7.6 billion in deposits with the County treasurer had been leveraged to over $20 billion. Increases in short-term interest rates throughout 1994, however, had a devastating effect on the pools' portfolios, eventually precipitating a cash-flow squeeze and bankruptcy.
The treasurer's aggressive use of leverage compounded losses in the investment pools. The treasurer's actions should have been identified and addressed by an effective internal controls system. Moreover, the structured notes themselves were regulated products, specifically "government securities," subject to the jurisdiction of the financial regulators that exercise authority under the government securities regulatory system.7
In addition, since the occurrence of events leading to the Orange County bankruptcy, changes have been made in the regulation of government securities. In particular, as a result of the Government Securities Act Amendments of 1993,8 the National Association of Securities Dealers, Inc. ("NASD") extended its sales practice rules to transactions in government securities.9 These rules require NASD members to have a reasonable basis for recommending a particular security or strategy, as well as to have reasonable grounds for believing the recommendation is suitable for the customer to whom it is made. At the time it extended its sales practice rules to government securities, the NASD also issued an accompanying interpretation on the application of its sales practice rules to institutional customers.10 These two actions should help to reduce inappropriate sales activities with respect to government securities.
2. BT Securities Corporation
In 1994, the Commission brought fraud charges against BT Securities Corporation, a broker-dealer subsidiary of Bankers Trust New York Corporation.11 The Commission's order in this matter stated that, between October 1992 and March 1994, BT Securities defrauded its customer, Gibson Greetings, Inc. ("Gibson"). The Commission alleged that, during this period, representatives of BT Securities misled Gibson about the risks involved in certain transactions and the value of the company's derivatives positions, by providing Gibson with values that significantly understated the magnitude of Gibson's losses. As a result, Gibson remained unaware of the actual losses from the derivatives transactions and continued to purchase derivatives from BT Securities. The Commission further alleged that BT Securities failed to reasonably supervise its employees. BT Securities consented to the entry of the orders by both the Commission and the Commodity Futures Trading Commission ("CFTC") that together imposed a $10 million civil penalty. In addition, the Commission's order censured BT Securities and directed it to cease and desist from violations of the antifraud and reporting provisions of the federal securities laws. The case sent a strong message that the SEC and the CFTC can and will work cooperatively to fight fraud involving derivatives.
3. Wisconsin Investment Board
The Wisconsin Investment Board oversees the State investment fund, which contained approximately $6.7 billion as of June 1995. This fund, which handles money from more than 1,000 Wisconsin municipalities, functions in many respects as a money market fund that allows municipalities to increase returns on idle cash reserves. The Investment Board is also responsible for the management of the State retirement pension fund, which contained approximately $32.1 billion as of June 1995. In 1994 and 1995, the Investment Board lost more than $95 million through positions in unspecified leveraged derivative instruments linked to movements in the Mexican economy and the value of the Mexican peso. One contract was linked to the spread between a U.S. interest rate and a Mexican interest rate. When the Mexican peso dropped in value in 1994, the Investment Board incurred $35 million in losses on that strategy.
While some of the Investment Board's investments were clearly too risky for municipalities, these losses raise issues regarding the adequacy of State oversight of the Investment Board's activities and its risk management practices. Following reports of the losses, questions were raised regarding the authority of the Investment Board to enter into the types of contracts that generated the losses. In June 1995, a report of the Investment Board's auditors, Price Waterhouse, called for the State to improve investment controls and more closely monitor the Investment Board's investments.12 In 1996, the Investment Board requested more than $7 million from the Wisconsin State legislature for a new information technology system to support improvements in its risk management function.
4. MG Refining & Marketing
Another case that illustrates the losses that can occur when effective internal control systems are not developed is the enforcement case brought by the CFTC against MG Refining & Marketing, Inc. ("MGR&M") and MG Futures, Inc. ("MGFI"). 13 MGR&M's activities involved the marketing, offer, and sale of petroleum product contracts (known as Firm Fixed Price (45 Day) Agreements) to gasoline station operators and heating oil distributors. MGR&M sustained heavy losses as a result of a substantial increase in the sale of the 45 Day Agreements coupled with adverse energy market conditions.
Following its investigation, the CFTC issued an order finding that MGR&M sold illegal off-exchange energy product futures contracts, and that MGFI failed to report material inadequacies in its internal controls and to file certified financial reports, all in violation of the Commodity Exchange Act and CFTC regulations. The order required MGFI to establish a special oversight committee comprised of representatives of certain of its affiliates, including the ultimate parent company. The order also required that prior to MGFI's resumption of business as a futures commission merchant, the committee must review and make recommendations regarding MGFI's internal control systems, including risk management procedures.
5. Long Term Capital Management
The recent financial difficulties experienced by certain hedge funds, including Long Term Capital Management ("LTCM"), have also been attributed by some to the use of OTC derivatives. LTCM's deteriorating financial condition, which led to a private- sector acquisition of the firm by its creditors, can in part be attributed to the complex trading strategies employed by the firm in a volatile market. Clearly, the extraordinary leverage employed by LTCM and furnished by its investors and lending institutions, invites further examination not only of LTCM's operations and strategies, but also those of its counterparties.
LTCM's losses resulted from its principals' overly optimistic faith in the reliability of their mathematical model. They failed to take into account any serious possibility that very low probability events events not previously seen in modern markets might occur. The erosion of LTCM's capital base appears to have been caused, in large part, by the fact that assumptions inherent in LTCM's trading strategies proved incorrect. Due to the excessive degree of leverage relied on by LTCM, those faulty assumptions resulted in substantial losses for the firm and its sophisticated investors and lenders. LTCM's significant financial problems may be attributed to a failure of proper risk management by the firm and a failure by lenders and investors to obtain relevant information from LTCM.
When the Commission learned of LTCM's financial difficulties in August of this year, staff from the Commission and the New York Stock Exchange surveyed major broker-dealers known to have credit exposure to one or more large hedge funds. Our survey indicated that no individual broker-dealer had exposure to LTCM that jeopardized its required regulatory capital or its financial stability. Although U.S. securities firms extended significant amounts of credit to LTCM, this lending was apparently secured with liquid collateral and was marked-to-market daily. Fortunately, at this time, we do not believe that LTCM's financial difficulties directly jeopardized any regulated securities firms. This is not the final word on LTCM or the problems a future LTCM-type of failure may pose. Accordingly, we are working closely with the President's Working Group on a separate study to examine the issues raised by LTCM's financial difficulties. The Working Group will report its findings and recommendations to the Congress.
An examination of these highly publicized incidents does not reveal glaring deficiencies in the current regulatory structure for OTC derivative instruments. While some market participants have suffered large losses during the past five years, these losses do not, in and of themselves, demonstrate a need for significant new regulation of OTC derivative instruments. These losses were generally a result of fraudulent practices or a lack of understanding of the degree of risk by both sellers and buyers, and inattention to the importance of effective internal controls.14 The Orange County bankruptcy, the losses suffered by the Wisconsin Investment Board, and the other incidents described above, as well as the historical failing of Barings, are largely attributable to management's failure to establish proper systems of internal controls and to monitor the organization's trading activities. They emphasize the need for effective management of complex financial activities, and for careful oversight of the activities of financial institutions in these markets. All market participants need to regularly assess the quality of their internal control systems, and to make adjustments appropriate to any new derivatives activities in which they may seek to engage.
C. Working Group Study
Although these highly publicized incidents have explanations not directly related to any inherent risks in OTC derivative instruments or markets, we believe the OTC derivatives markets in general deserve further study. The Commission is currently working closely with the other Working Group agencies to study the OTC derivatives market and hybrid instruments. The goal of this study is to develop appropriate recommendations for any necessary changes in statutes, regulations, and policies to improve operation of the market, to enhance legal certainty for OTC derivative instruments and to permit the development of new hybrid products. Among other things, the Working Group will need to assess the lessons of the incidents discussed above to determine whether additional steps should be taken to safeguard the increasingly sensitive and interconnected financial markets, where risks can become magnified by volume, technology, and complexity.
One area of particular importance for the Working Group is the development of recommendations for improving the legal certainty of OTC derivative instruments. The current lack of clarity as to the regulatory treatment of certain OTC derivative products, such as swap agreements, as well as hybrid instruments, creates questions as to their enforceability. This has a destabilizing effect on what has become a significant global financial market. Legal certainty concerns may also stifle competition and push transactions offshore, beyond the reach of any disclosure or other protections that may be afforded under U.S. law. It is important for the Working Group to devise ways to provide participants in the OTC derivatives markets with enhanced assurances that their contracts will be enforceable. A related issue being examined by the Working Group is regulatory parity, the promotion of a level playing field that at the same time takes into account differences in markets, participants, and regulatory approaches.
The Working Group is also examining market manipulation issues, with the goal of reducing the potential for manipulation both of the OTC derivatives markets and the underlying cash markets through the use of OTC derivative instruments. In addition, we are looking at ways to reduce the risk of fraud and sales practice abuses against participants in the OTC derivatives markets, as well as methods for improving financial integrity and limiting potential losses from counterparty defaults. Finally, the Working Group is reviewing the need to reduce systemic risk, such as the collateral effects in the markets of a sudden change in OTC derivatives activities or a failure by a large OTC derivatives participant, as well as excessive credit exposure of dealers and end-users.
We look forward to continuing to work with the other U.S. financial regulators to complete the OTC derivatives market study and make appropriate recommendations to Congress. Nonetheless, at present, the Commission believes that we should move carefully in determining whether to impose any additional regulation on the OTC derivatives market. While the current regulatory structure was not specifically designed for these products, it appears to be reasonably effective when administered in a flexible manner, and Congress and the financial regulators have made accommodations to the regulatory structure for developments in the market, when needed.
I appreciate the opportunity to offer the Commission's perspectives on the regulation of the OTC derivatives market. The success of this market and the nature of abuses to date suggest the resilience of the existing regulatory approach. In particular, the existing approach does not appear to have compromised the integrity of the financial markets and has permitted U.S. financial regulators to bring actions where fraud has been shown to have been involved.
Nevertheless, it behooves Congress and the financial regulators to carefully examine the current structure to see whether it can be strengthened to better address issues raised by the evolving OTC derivatives market. At a minimum, we believe steps should be taken to improve the legal certainty of OTC derivative instruments; but other issues should also be explored. To further analyze these issues, the Commission is working together with the other members of the President's Working Group to study this market and to develop a coordinated response in this area.
The Commission welcomes any questions on these issues that the Committee may have, and looks forward to continued discussions with the Committee, the President's Working Group, and industry representatives on these important issues.
1See "ISDA Market Survey," ISDA Internet web site (http://www.isda.org).
2See generally John D. Finnerty, Financial Engineering in Corporate Finance: An Overview, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992).
3For example, a credit derivative option product may require the delivery to a counterparty of payments with respect to a bond issued by a foreign sovereign in the event the foreign sovereign defaults on payments due under the bond or on other specified payment obligations.
4Group of Thirty, Derivatives: Practices and Principles (July 1993). In sum, the Group recommended that each participant: (1) determine at the highest level of policy and decision making the scope of its involvement in derivatives activities and policies to be applied; (2) value derivatives positions at market, at least for risk management purposes; (3) quantify its market risk under adverse market conditions against limits, perform stress simulations, and forecast cash investing and funding needs; (4) assess the credit risk arising from derivatives activities based on frequent measures of current and potential exposure against credit limits; (5) reduce credit risk by broadening the use of multi-product master agreements with close-out netting provisions, and by working with other participants to ensure legal enforceability of derivatives transactions within and across jurisdictions; (6) establish market and credit risk management functions with clear authority, independent of the dealing function; (7) authorize only professionals with the requisite skills and experience to transact and manage risks, as well as to process, report, control, and audit derivatives activities; (8) establish management information systems sophisticated enough to measure, manage, and report the risks of derivatives activities in a timely and precise manner; and (9) voluntarily adopt accounting and disclosure practices for international harmonization and greater transparency, pending the arrival of international standards.
5See In re County of Orange, United States Bankruptcy Court for the Central District of California, Case No. SA 94-22272 JR.
6A "repurchase agreement" provides for the "sale" of securities (generally government securities) by a dealer to a customer, with a simultaneous agreement by the customer to "resell" the securities back to the dealer on a predetermined date or on demand at a certain price. "Reverse repurchase agreements" are repurchase agreements initiated by the dealer, where the dealer agrees to "buy" securities from the customer in exchange for funds and the customer simultaneously agrees to "buy back" the securities at a later predetermined date or on demand by the dealer at a certain price.
7See Government Securities Act of 1986, Pub. L. No. 99-571, 100 Stat. 3508 (1986) (which added, among other things, Section 15C(a) of the Exchange Act).
8Pub. L. No. 103-202, 107 Stat. 2344 (1993).
9See Securities Exchange Act Release No. 37588 (August 20, 1996), 61 FR 44100 (August 27, 1996) (Order approving application of NASD's Rules of Fair Practice to transactions in exempt securities). The Government Securities Act Amendments of 1993 also authorized the federal banking agencies to adopt similar regulations for financial institutions.
10See NASD IM-2310-3 "Suitability Obligations to Institutional Customers."
11In the Matter of BT Securities Corporation, Securities Act Release No. 7124, Securities Exchange Act Release No. 35136 (December 22, 1994).
12State of Wisconsin Investment Board, Derivative Instrument Risk Management & Control Environment Review, Price Waterhouse, L.L.P. (May 30, 1995).
13In the Matter of MG Refining and Marketing, Inc. and MG Futures, Inc., CFTC Docket No. 95-14 (July 27, 1995). At the time of this action, MGFI was registered with the CFTC as a futures commission merchant and carried futures trading accounts for MGR&M.
14See U.S. General Accounting Office, Financial Derivatives: Actions Taken or Proposed Since May 1994 (Nov. 1996).