Netting of Financial Contracts, Hedge Fund Disclosure, and Over-the-Counter Derivatives Transactions
By Annette L. Nazareth
Director, Division Of Market Regulation
U.S. Securities & Exchange Commission
Before the House Committee on Banking and Financial Services
April 11, 2000
Chairman Leach and Members of the Committee:
I am pleased to appear today to testify on behalf of the Securities and Exchange Commission ("SEC" or "Commission") as you consider recommendations by the President's Working Group on Financial Markets ("Working Group")1 that are currently the subject of legislative action before the Committee.
My testimony will address three topics that have been the subject of Working Group reports. First, I will discuss the netting of financial contracts, which is the subject of H.R. 1161, a bill currently pending before the Committee. Next, I will focus on the public disclosure of leverage and risk information by hedge funds, which is the subject of H.R. 2924, introduced by Rep. Richard Baker. Finally, I will address the regulatory structure affecting over-the-counter derivatives transactions.
I. Netting of Financial Contracts
H.R. 1161, the "Financial Contract Netting Improvement Act of 1999," includes a number of proposed amendments to the laws that govern the insolvency proceedings for a broker-dealer, bank or other financial institution. Many of these provisions incorporate, or are based on, amendments to statutes that were endorsed by the Working Group in draft legislation previously submitted to Congress.2 The Commission supports the Working Group's proposals to improve the legal framework for financial contract netting, which have the goal of reducing systemic risk3 and strengthening investor confidence in the U.S. financial markets.
For several years, the Commission, as part of the Working Group, has been developing proposals to improve the U.S. insolvency regime in an effort to address inconsistencies among the laws and reduce systemic risk. The current statutory provisions governing the treatment of financial contracts upon the insolvency of a counterparty are found primarily in the Bankruptcy Code ("Code"), the Securities Investor Protection Act of 1970, the Federal Deposit Insurance Act ("FDIA"), and the Federal Deposit Insurance Corporation Improvement Act of 1991.
Both the Code and the FDIA grant special treatment to financial contracts in insolvency proceedings, specifically by providing greater rights to entities that have entered into financial contracts with parties that subsequently become insolvent than entities that have entered into other types of contracts.4 For example, counterparties to financial contracts generally are not subject to automatic stay provisions and have greater rights to terminate the contracts and to net or offset their obligations to the debtor against the debtor's obligations to them. Our insolvency laws provide preferential treatment to counterparties to financial contracts to help maintain the efficient operation of our financial markets. However, these provisions contain significant variations in the definitions of the contracts to which they are applicable and in the potential treatment of counterparties.
On March 16, 1998, the Department of the Treasury on behalf of the Working Group recommended to Congress that it enact the "Financial Contract Netting Improvement Act of 1998" ("Netting Proposal"). The Netting Proposal was designed to (1) clarify the treatment of certain financial contracts (i.e., securities contracts, commodity contracts, forward contracts, repurchase agreements, and swap agreements) upon the insolvency of one of the counterparties to a transaction and (2) recognize certain netting arrangements in order to reduce the risk that the failure of one entity to pay its obligations would cause other firms to fail to meet their obligations.
The Netting Proposal would accomplish these goals by: (1) harmonizing the provisions of the Code and the FDIA so that they provide similar rights to counterparties with regard to financial agreements and transactions; (2) amending the Code and the FDIA to permit cross-product netting; and (3) eliminating the uncertainties surrounding the Federal Deposit Insurance Corporation's authority to permit transfers of financial contracts to financial institutions.
In sum, the Commission supports H.R. 1161 because it incorporates the improvements to financial contracts netting endorsed by the Working Group in the Netting Proposal.5 We believe H.R. 1161 will help to reduce systemic risk and strengthen investor confidence in the U.S. financial markets. The Commission looks forward to the enactment of this important legislation.
II. Hedge Fund Disclosures
As you know, hedge funds generally operate outside the existing framework of U.S. banking, securities, and futures laws. Consequently, limited information about their activities is currently available. The Working Group, in its April 1999 report (the "Hedge Fund Report"),6 found that the scope and timeliness of available information on the activities of unregulated hedge funds was too limited, and concluded that they should be required to disclose additional, and more up-to-date, information to the public. The Working Group agreed that enhanced disclosure would improve transparency and allow market participants to make better, more informed judgments about their borrowers and counterparties. As a result, the Working Group recommended that Congress enact legislation that authorizes mechanisms for public disclosure.
The Commission supports the principles underlying H.R. 2924 that is, that market forces are the most effective means of constraining excessive leverage, and that increased disclosure to the public by unregulated hedge funds about their financial activities should enhance market discipline. We offer the Committee our assistance in its efforts to implement the Working Group's recommendations in this area. We also anticipate that many of the specifics of implementing these recommendations will occur in the regulatory process. We are committed to continuing to work closely with our counterparts in the Working Group to work out the details of any proposed disclosure regulations.
I would also like to take a brief moment to update the Committee on the Commission's progress in implementing another Working Group recommendation that is included in H.R. namely, public company disclosure. As you know, neither SEC rules nor generally accepted accounting principles currently require public companies to disclose material exposures to hedge funds and other significantly leveraged financial institutions. The Working Group recommended that public companies be required to disclose such material exposures in order to reinforce private market discipline. Commission staff has been working on proposed guidance that would require responsive disclosure in periodic reports filed with the Commission. The idea is that public companies would disclose exposures to hedge funds and other highly leveraged institutions that are material to their financial statements or could have a material effect on their financial statements as a result of possible future losses. We plan to work with our counterparts on the Working Group on this matter, with the expectation of issuing a proposed rule for public comment in the near future.
III. Over-the-Counter Derivatives Transactions
Finally, I would like to focus on the Working Group's November 1999 report on the over-the-counter derivatives markets ("OTC Derivatives Report").7 As you know, the potential application of the Commodity Exchange Act ("CEA") to over-the-counter ("OTC") derivative transactions raises significant questions of public policy. The OTC derivatives markets require a regulatory framework that promotes greater legal certainty as well as innovative financial instruments. The Working Group's Report and its recommendations represent an important step toward this goal.
In preparing the OTC Derivatives Report, the Working Group's task was fairly specific: to focus on how a particular piece of legislation, the CEA, might be modified to address issues related to OTC derivatives markets. Accordingly, the report makes recommendations in several areas.
A. Swap Agreements
Regulators have focused on the treatment of swaps for over a decade. In 1989, the CFTC issued a Policy Statement, noting that "most swap transactions, although possessing elements of futures or options contracts, are not appropriately regulated as such under the [CEA] and regulations."8 After receiving exemptive authority under the Futures Trading Practices Act of 1992,9 the CFTC followed up with its 1993 Swap Exemption.10 Notwithstanding the exemption's relief for some transactions, concerns arose about its scope. Because Congress did not explicitly determine whether swaps fell under the CEA absent such an exemption, the status of swaps remains unclear.
In light of this legal uncertainty, the OTC Derivatives Report recommends that Congress amend the CEA to exclude bilateral swap agreements (other than transactions involving non-financial commodities with finite supplies) between eligible swap participants, acting on a principal-to-principal basis, provided that the transactions are not conducted on a multilateral transaction execution facility ("MTEF").11 The Commission believes that excluding qualifying instruments from the CEA should create greater legal certainty than the current approach that merely provides for the possibility of exemption, thus leaving open the question of whether such instruments are futures.
B. Electronic Trading Systems
In addition to focusing on the regulatory treatment of particular instruments, the OTC Derivatives Report explores questions raised when electronic systems facilitate the trading of OTC derivatives. The Working Group was concerned that legal uncertainty might hinder technological development in the OTC derivatives market since technological innovation could promote transparency and efficiency. Moreover, the use of technology could help firms to apply more reliable internal controls on traders and to reduce risk.
The OTC Derivatives Report therefore recommends that Congress amend the CEA to exclude certain types of electronic trading systems for derivatives, provided that the systems limit participation to sophisticated counterparties trading for their own accounts and are not used to trade contracts that involve non-financial commodities with finite supplies. Systems clearly not covered by the definition of MTEF in the current Swap Exemption would be covered by this exclusion. The exclusion would also cover systems that assist eligible swap participants communicating about or negotiating bilateral agreements. In addition, the exclusion would cover systems (including ones where bids and offers are open to all participants) where: first, the system only allows participants to act solely for their own account, and, second, the system is not used to enter into agreements requiring a party to make physical delivery of a non-financial commodity with a finite supply.
Moreover, to avoid disadvantaging existing futures and commodities exchanges, those exchanges designated by the CFTC as contract markets also would be permitted to establish these kinds of electronic trading systems for swaps.
C. Clearing Systems
Like electronic trading systems, clearance systems for OTC derivatives transactions are subject to legal uncertainty. Because of their importance, the OTC Derivatives Report recommends that Congress enact legislation to regulate clearing systems used for OTC derivatives. More specifically, the SEC, the CFTC, another federal regulator, or a foreign financial regulator satisfying appropriate standards would regulate clearing systems for OTC derivatives.
Clearing systems that clear futures, commodity options, and options on futures could also clear OTC derivatives (other than OTC derivatives that are securities), subject to CFTC oversight. In addition, clearing agencies subject to SEC oversight could clear OTC derivatives other than instruments involving non-financial commodities with a finite supply. Under the Working Group proposal, legislation would authorize the CFTC to develop rules for the establishment and regulation of clearing systems for OTC derivatives involving non-financial commodities with a finite supply (to the extent they are exempted by the CFTC in a manner allowing clearing). All other OTC derivative clearing systems would need to organize as a bank, bank subsidiary or affiliate, or Edge Act corporation that would be subject to the supervisory jurisdiction of the Federal Reserve or the Office of the Comptroller of the Currency.
The OTC Derivatives Report also recommends that a clearing system subject to regulation by one agency should not become subject to regulation by another agency by virtue of clearing OTC derivatives. Finally, the Report recommends allowing clearing through foreign clearing systems supervised by foreign financial regulators that the appropriate U.S. regulator has determined satisfy appropriate standards.
Critical to the Working Group's unanimously recommended regulatory framework is that OTC derivatives could be cleared by all clearing agencies, both bank and non-bank, under the purview of the financial regulators currently responsible for those clearing agencies. We recognize that Chairman Leach introduced a bill last week that seeks to address clearing and other issues raised by the OTC Derivatives Report. We appreciate the savings clause in Chairman Leach's bill that preserves the SEC's authority over securities clearing agencies that clear OTC derivatives that are securities. As the Working Group recognizes, however, OTC derivatives legislation should clarify SEC jurisdiction over securities clearing agencies as they extend their businesses to OTC derivatives that are not securities. We look forward to working with the Committee as we study Chairman Leach's bill in greater detail.
D. The Treasury Amendment
The OTC Derivatives Report also focuses on providing greater certainty for instruments covered by the Treasury Amendment. The Treasury proposed this amendment in 1974 out of concern that the broad statutory definition of "commodity" would subject OTC markets in government securities and foreign currency to CEA regulation. Accordingly, the amendment excludes a list of instruments from the definition of commodity. These listed instruments, however, still may be subject to CEA regulation when traded on a "board of trade." By proposing to replace "board of trade" with "organized exchange," the OTC Derivatives Report seeks to more clearly delineate the parameters of the limitation on the exclusion.
The OTC Derivatives Report further recommends that the Treasury Amendment be clarified to allow the CFTC to address problems associated with foreign currency "bucket shops." Transactions in foreign currency futures and options would be subject to the CEA if entered into between a retail customer and an entity that is neither regulated or supervised by the SEC or a federal banking regulator nor affiliated with such a regulated or supervised entity.
E. Hybrid Instruments and CFTC Exclusive Jurisdiction
Although the members of the Working Group did not reach consensus in the OTC Derivatives Report that all hybrid instruments should be entirely excluded from the CEA or that a hybrid instruments rule needs to be codified at this time, the CFTC has agreed that it will not propose any new rule about hybrid instruments without the concurrence of the other Working Group members. This decision reflects recognition of the interests of the SEC and bank regulatory agencies in this area. These interests arise because hybrid instruments possess characteristics of securities and bank products. The OTC Derivatives Report, however, urges Congress to clarify that the Shad-Johnson Accord should not be construed to apply to hybrid instruments that have been exempted from the CEA.
Finally, over the years, the clause in the CEA granting the CFTC "exclusive jurisdiction" over certain matters has caused confusion. Questions have been raised over the appropriate regulator and regulatory scheme for complex derivative instruments possessing attributes of securities and futures contracts. All Working Group members agreed to recommend amending the CEA to explicitly clarify that insofar as hybrid instruments may be subject to the CEA, the exclusive jurisdiction clause shall not be construed to limit the authority of the SEC and the bank regulatory agencies with respect to such instruments.12
F. Single Stock Futures
The unanimous findings of the OTC Derivatives Report reiterate the Commission's position that although single stock futures may possess elements of traditional futures contracts, they also have the characteristics of traditional securities. Accordingly, when considering the Shad-Johnson Accord's13 ban on single stock futures, one must recognize that regulatory issues associated with the introduction of such products would be complex. Indeed, the members of the Working Group agree that numerous issues including but not limited to margin levels, insider trading, sales practices, real-time trade reporting, floor broker activities, and CFTC exclusive jurisdiction over futures contract markets would have to be resolved before the ban could be reconsidered.
As you know, your colleagues Chairmen Ewing, Combest, and Bliley asked that the SEC and the CFTC report back to their respective committees and subcommittees on issues associated with modifying the Shad-Johnson Accord.14 The Chairmen of the SEC and the CFTC provided their preliminary response by letter in March.15 The Commission staff continues to work diligently with their counterparts at the CFTC to review the relevant issues. Notwithstanding the many challenges that we face, we believe it is possible to craft a strong yet flexible regulatory framework for single stock futures.
The rapid evolution of OTC derivatives markets requires a regulatory approach that promotes greater legal certainty as well as innovative financial instruments. The OTC Derivatives Report represents a balanced approach, but it is only a beginning. In addition to implementing the Report's recommendations, we must continue to study the OTC derivatives market as it develops. With input from Congress and industry participants, I feel confident that we can meet any regulatory challenges while allowing the efficient development of this market.
The Commission appreciates the efforts of this Committee in responding to the recommendations of the Working Group in the areas of netting, hedge fund disclosure, and OTC derivatives. We look forward to interacting with the Working Group, your Committee, and other legislators as they consider implementation of changes in these areas.
I would be happy to answer any questions you might have.
1The Working Group includes the Secretary of the Department of the Treasury ("Treasury") and the Chairmen of the Federal Reserve Board, the SEC, and the Commodities Futures Trading Commission.
2On March 16, 1998, then Secretary of the Treasury Robert Rubin submitted to Congress, on behalf of the Working Group, the "Financial Contract Netting Improvement Act of 1998."
3Systemic risk has been defined as the risk that a disruption at a firm, in a market segment, or to a settlement system can cause widespread difficulties at other firms, in other market segments, or in the financial system as a whole. If participants engaged in certain financial activities are unable to enforce their rights to terminate financial contracts with an insolvent entity in a timely manner and are unable to offset or net payment and other transfer obligations and entitlements arising under these contracts, the resulting uncertainty and potential lack of liquidity could increase the risk of an inter-market disruption.
4In particular, since its adoption in 1978, the Code has been amended several times in order to provide that, upon the filing of a bankruptcy petition, certain financial transactions are treated differently from other commercial contracts and transactions. For example, in 1982 the Code was amended so that "the exercise of a contractual right of a stockbroker, financial institution, or securities clearing agency to cause the liquidation of a securities contract" is not subject to the automatic stay provision of the Code. A similar provision also was adopted in 1982 for commodity brokers and forward contract merchants with respect to commodities and forward contracts. In 1984, the exemption from the automatic stay was extended to repurchase agreements and in 1990 to swap agreements.
5The provisions of H.R. 1161 are largely based on the provisions that were introduced by the Working Group. However, sections 13 and 14 of H.R. 1161 were not part of the Working Group's original proposal. Section 13 amends section 541 of the Code to provide that certain assets transferred to an eligible entity in connection with an asset-backed securitization generally will not be included within the bankruptcy of the debtor. Section 14 would broaden the range of discount window loans eligible to back currency to include those under sections 10A, 10B, 13 or 13A of the Federal Reserve Act.
6Report of the President's Working Group on Financial Markets, Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (April 1999).
7Report of the President's Working Group on Financial Markets, Over-the-Counter Derivatives Markets and the Commodity Exchange Act (Nov. 1999).
8Policy Statement Concerning Swap Transactions, 54 FR 30694 (July 21, 1989).
9Futures Trading Practices Act of 1992, Pub. L. No. 102-546, 106 Stat. 3590.
10for Certain Swap Agreements, 58 FR 5587 (Jan. 22, 1993) (codified at 17 C.F.R. pt. 35).
11The CFTC has explained that an MTEF "is a physical or electronic facility in which all market makers and other participants have the ability to execute transactions and bind both parties by accepting offers which are made by one member and open to all members of the facility." Exemption for Certain Swap Agreements, 58 FR 5587 (Jan. 22, 1993).
12The Commission, Treasury, and the Federal Reserve Board believe that the exclusive jurisdiction clause should apply only to transactions in futures contracts or options on futures contracts effected on designated contract markets, and that the clause should be clarified by providing that the CFTC's jurisdiction over such transactions is not exclusive in instances where the CEA or some other federal statute specifically grants another agency authority.
13Trading Act of 1982, Public Law No. 97-444, 96 Stat. 2294-97.
14Letter from the Honorable Larry Combest, Chairman, House of Representatives Committee on Agriculture, the Honorable Tom Bliley, Chairman, House of Representatives Committee on Commerce, and the Honorable Tom Ewing, Chairman, Subcommittee on Risk Management, Research, and Specialty Crops, House of Representatives Committee on Agriculture, to the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC (January 20, 2000).
15Letter from the Honorable Arthur Levitt, Chairman, SEC, and the Honorable William Rainer, Chairman, CFTC, to the Honorable Larry Combest, Chairman, House of Representatives Committee on Agriculture, the Honorable Tom Bliley, Chairman, House of Representatives Committee on Commerce, the Honorable Tom Ewing, Chairman, Subcommittee on Risk Management, Research, and Specialty Crops, House of Representatives Committee on Agriculture, and the Honorable Charles Stenholm, Ranking Member, House of Representatives Committee on Agriculture (March 2, 2000).