Testimony of Governor Susan M. Phillips
Reform of derivatives under the Commodity Exchange Act
Before the Subcommittee on Risk Management and Specialty Crops of the Committee on Agriculture, U.S. House of Representatives
April 15, 1997
I am pleased to be here today to present the Federal Reserve Board's views on efforts to clarify and reform the regulation of derivatives contracts under the Commodity Exchange Act (CEA). The Board has been participating actively in discussions of derivatives regulation for the last ten years. In part, the Board's interest stems from its responsibilities for the supervision of banking organizations. Many U.S. banking organizations, especially the largest, are very significant participants in derivatives markets. They use exchange-traded derivatives to manage their interest rate, foreign exchange, and other market risks. Some operate subsidiaries that act as futures commission merchants. In addition, U.S. banking organizations are among the leading dealers in off-exchange, privately negotiated derivatives contracts. The Board also considers it important to address these issues because, as the nation's central bank, it has a broad interest in the integrity and efficiency of U.S. financial markets.
The Board strongly endorses the Congress's efforts to carefully reexamine the existing regulatory framework for derivatives. The key elements of the CEA were put in place in the 1920s and 1930s to regulate the trading on exchanges of grain futures by the general public, including retail investors. Since then, derivatives markets in the United States have undergone profound changes. On the futures exchanges themselves, financial futures, not agricultural futures, now account for the great bulk of the activity, and retail participation in many of the financial futures contracts is negligible. Outside the futures exchanges, enormous markets have developed in which banks, corporations, and other institutions privately negotiate customized derivatives contracts, the vast majority of which are based on interest rates or exchange rates. The cash markets for such financial instruments were well-developed long before the introduction of exchange-traded futures and options and, for some instruments, privately negotiated derivatives also predated exchange trading.
In my remarks today I shall indicate the types of amendments to the CEA that the Board believes are appropriate in light of these profound changes in the derivatives markets. I shall begin by offering some general observations about government regulation of financial markets. I shall then evaluate three sets of issues in which the Board has a particular interest: (1) the application of the CEA to privately negotiated transactions between institutions; (2) the regulation of the marketing of off-exchange derivatives to retail investors; and (3) the regulation of so-called professional markets, that is, organized exchanges not open to the general public.
Government Regulation of Financial Markets
Where there is disagreement is on the need for government regulation to achieve these objectives and, where regulation is agreed to be appropriate, on whether existing provisions of the CEA permit the best regulatory framework. The Board believes that, before implementing government regulation of a market, policymakers should consider whether market forces by themselves are sufficient to achieve the relevant public policy objectives. Participants in financial markets often are fully capable of protecting their own interests and, in so doing, often serve the public interest equally well. To be sure, this is not always the case. Some market participants may lack incentives or the ability to protect their interests, or their private interests may conflict with the public interest. In such circumstances, government regulation may assist market mechanisms, especially if it is designed to enhance the capabilities of market participants or to harmonize private incentives with the public interest.
The Board believes that a particular market's characteristics determine whether government regulation is necessary, and, if so, what form of government regulation is appropriate. Agricultural futures often tend to be susceptible to manipulation because physical delivery is required; because the deliverable supply is relatively price inelastic; and because exchange rules impose substantial costs on sellers who fail to deliver. By contrast, many financial derivatives are much more difficult if not impossible to manipulate, even when traded on exchanges, because they are settled in cash or, in any event, are based on underlying assets whose supply is highly price elastic. Similarly, the extent to which market participants are vulnerable to losses from fraud or counterparty insolvencies depends on the types of participants. Retail participants may lack the knowledge and sophistication to manage counterparty credit exposures or to protect themselves effectively against uncompensated losses from fraud. By contrast, institutions typically are quite adept at managing credit risks and are more likely to base their investment decisions on independent judgments and, if defrauded, usually are quite capable of gaining restitution through use of the legal system.
Because the need for and appropriate form of government regulation are market specific, the Board believes that a "one-size-fits-all" approach to financial market regulation is inappropriate. Privately negotiated transactions between principals should be regulated differently than transactions on organized exchanges, where trades often are executed on behalf of third parties. Institutional markets can and should be differently regulated than markets open to the retail public. Moreover, we believe counterparties should be free to choose whether to seek the protection and accept the burdens of government regulation or to opt out of those benefits and burdens and transact on their own terms.
Application of the CEA to Privately Negotiated Transactions Between Institutions
Institutional counterparties to privately negotiated contracts also have demonstrated their ability to protect themselves from losses from fraud and counterparty insolvencies. They have insisted that dealers have financial strength sufficient to warrant a credit rating of A or higher. Consequently, dealers are established institutions with substantial assets and significant investments in their reputations. When such dealers have engaged in deceptive practices, institutions that have been victimized have been able to obtain redress by going to court or directly negotiating a settlement with the dealer. The threat of legal damage awards provides dealers with incentives to avoid misconduct. A far more powerful incentive, however, is the fear of loss of the dealer's good reputation, without which it cannot compete effectively, regardless of its financial strength or financial engineering capabilities. Institutional counterparties to privately negotiated transactions have demonstrated their ability to manage credit risks quite effectively through careful evaluation of counterparties, the setting of internal credit limits, and the judicious use of netting agreements and collateral. Actual losses to institutional counterparties in the United States from dealer defaults have been negligible. Recent cooperative international efforts to improve the quality of public disclosure of financial information by banks and other dealers in privately negotiated transactions should further enhance the effectiveness of private market discipline.
In the future, counterparties to privately negotiated transactions may seek to establish some type of centralized clearing facilities for such transactions. Such facilities potentially could make management of counterparty credit risks and liquidity risks even more effective. At the same time, however, clearing facilities often concentrate and mutualize risk. For this reason, the Board believes that if counterparties were to choose to develop such facilities, some type of government oversight generally would be appropriate to supplement the private self-regulation that the counterparties would provide. However, it is not obvious that in all cases regulation of such clearing facilities under the CEA would be the best approach. For example, if a clearing facility were established for privately negotiated interest rate or exchange rate contracts between dealers, most of which were banks, oversight by the federal banking agencies would seem more appropriate. Likewise, a clearing facility for privately negotiated derivatives on underlying assets that are securities might best be regulated by the Securities and Exchange Commission. Thus, if an exclusion of privately negotiated transactions from the CEA were conditioned on government supervision or regulation of any centralized clearing facility, the Board believes that supervision of the clearing facility by one of the federal banking agencies, by the SEC, or by the Commodity Futures Trading Commission should be sufficient for exclusion.
Regulation of the Marketing of Off-Exchange Derivatives to Retail Investors
By way of background, in the case of banks, investigations by our staff and staff of the other banking agencies indicate that currently there is very little, if any, marketing of derivative contracts to retail investors. In any event, the Board and the other banking agencies already have issued supervisory guidance on sales practices for securities, mutual funds, and derivatives that would be broadly applicable to such transactions. If experience suggested that more specific or extensive guidance was needed to protect retail investors and, thereby, also to protect the reputation of banks engaged in retail marketing, the Board would work with the other banking agencies to develop and promulgate such guidance.
Regulation of Professional Markets
The Board has not examined existing exchange regulations sufficiently carefully to offer comprehensive suggestions as to which regulations need or need not be applied to professional markets. We would observe, however, that the gap between what the exchanges are perceived to be seeking and what is currently available under the Commodity Futures Trading Commission's pilot program for professional markets is quite wide, and would appear to offer ample room for a compromise that would address the exchanges' competitive concerns and still be consistent with the public interest.