WRITTEN STATEMENT OF THE SECURITIES AND EXCHANGE COMMISSION REGARDING THE REGULATION OF THE OVER-THE-COUNTER DERIVATIVES MARKET AND HYBRID INSTRUMENTS JUNE 10, 1998 The Securities and Exchange Commission ("SEC" or "Commission") appreciates the opportunity to express its views on issues relating to the federal regulation of transactions involving over-the-counter ("OTC") derivatives and hybrid 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. Benefits of OTC Derivative Instruments It is widely recognized that OTC derivative instruments are important financial management tools that, in many respects, reflect the unique strength and innovation of the American capital markets. In fact, U.S. markets and market professionals have been the global leaders in derivatives technology and development. OTC derivative instruments provide significant benefits to corporations, financial institutions, and institutional investors by allowing them to manage risks associated with their business activities or their financial assets. These instruments, for example, can be used by corporations and local governments to lower funding costs, or by multinational corporations to manage risk associated with fluctuating exchange rates. They can also be used by portfolio managers to manage volatility in investment portfolios or to obtain exposure to different assets without actually taking a position in the cash market. Because of the benefits these products offer, the OTC derivatives market has grown significantly during the past two decades. The growth in activity involving this market has come, in part, as a result of the careful approach to regulation taken by Congress and by U.S. financial regulators. That approach has focused on promoting legal certainty for OTC derivative transactions and encouraging the development of sound industry practices.[1] That approach has also relied on building consensus among U.S. financial regulators through their participation in the President's Working Group on Financial Markets. Concerns Regarding the CFTC Concept Release on OTC Derivatives The recent concept release on OTC derivative instruments issued by the Commodity Futures Trading Commission ("CFTC") represents a significant departure from the careful approach taken by the SEC and other regulators to the OTC derivatives market.[2] In its concept release, the CFTC raises the possibility of applying a comprehensive regulatory regime to transactions involving swaps and hybrids as a condition for exempting such products from the requirements of the Commodity Exchange Act ("CEA"). Such a regulatory regime would necessarily be based on the CFTC's conclusion that swaps and hybrids are futures contracts or commodity options and, as such, are subject to CFTC jurisdiction under the CEA. Chairman Levitt joined the other members of the President's Working Group -- Treasury Secretary Rubin and Chairman Greenspan of the Federal Reserve Board -- in objecting to the issuance of the CFTC's concept release, citing grave concerns about the possible consequences of the CFTC's action.[3] In particular, these concerns focus on the risk that the CFTC's action may increase the legal uncertainty concerning swaps and other OTC derivative instruments and, thus, destabilize what has become a significant global financial market. Any consideration of the issues facing the OTC derivatives market, such as legal certainty, the concerns of industry participants, and the role of U.S. financial regulators, must begin with a long, hard look at how this market has evolved and which products are involved in the bilateral transactions conducted between market participants. A convincing argument has not been made that developments in the OTC derivatives market since 1994 -- when the members of the Working Group last testified before Congress on this market -- or since 1995 -- when the SEC and CFTC worked with the Derivatives Policy Group to develop a framework for voluntary oversight of OTC derivatives -- merit the CFTC's consideration of a vast, new scheme to regulate this market. Moreover, even if a case for new regulation were made, it is not appropriate for the CFTC to assert jurisdiction over a market outside the scope of the CEA. Swaps The CFTC's concept release is particularly troubling in that the CFTC sets out a broad regulatory agenda under the guise of exercising its exemptive authority. We disagree with this approach. First, this approach necessarily involves examining the extent to which swaps may be futures subject to regulation under the CEA. On this issue the SEC has been clear -- traditional swaps that are not traded through a multilateral transaction execution facility are not futures and are not subject to regulation under the CEA.[4] This view is shared overwhelmingly by the industry. Second, as Secretary Rubin, Chairman Greenspan, and Chairman Levitt suggested in their recent statement, we have serious doubts as to the CFTC's authority to regulate OTC markets. The CEA provides for the regulation of exchange-traded futures, making off-exchange futures transactions illegal under the statute. Nowhere in the CEA has Congress articulated an intent that the CFTC regulate off-exchange markets, nor has Congress established standards for the protection of the public interest should the CFTC assert jurisdiction over these markets. Third, we disagree with any plan by the CFTC to regulate through exemption. In enacting the Futures Trading Practices Act of 1992, Congress gave the CFTC broad exemptive -- not regulatory -- authority regarding OTC swap transactions.[5] In connection with this grant of authority, Section 4(c) of the CEA places certain conditions on the exercise of the CFTC's exemptive authority. These conditions include the requirement that any exemption be in the public interest, and that exemptions be limited to transactions that would be effected between persons meeting the definition of "appropriate persons" that also would not have a material adverse effect on the ability of the CFTC or any contract market to discharge its regulatory or self- regulatory abilities under the CEA. Beyond these general requirements, Congress did not direct the CFTC to impose substantial additional requirements as a condition for exercising its exemptive authority, choosing instead to allow the CFTC to either exempt transactions unconditionally or on stated terms or conditions. Given the willingness of Congress to allow the CFTC to exempt transactions without imposing conditions beyond those contained in Section 4(c), it is unlikely that Congress anticipated that the CFTC would establish exemptive conditions that, in effect, would require compliance with a new, comprehensive regulatory scheme for conducting off-exchange transactions. In fact, Congress specifically reserved for itself issues of regulatory policy relating to the OTC derivatives market. As stated in the Conference Report for the Futures Trading Practices Act of 1992, the purpose of giving the CFTC broad exemptive powers was to provide "a means of providing certainty and stability to existing and emerging markets so that financial innovation and market development [could] proceed in an effective and competitive manner."[6] The objective was legal certainty for swaps, not expansive regulation of an evolving market. Hybrids The CFTC's concept release also raises significant concerns regarding the current exemption for hybrid instruments contained in the CFTC's Part 34 rules.[7] Hybrid instruments are depository instruments or securities products, such as debt or equity securities, that have one or more commodity-dependent components with payment features similar to commodity futures or commodity option contracts. Under the CFTC's Part 34 rules, such instruments may be exempt from regulation under the CEA if the sum of the commodity-dependent values of the commodity-dependent components of the instrument is less that the commodity- independent value of the commodity-independent component. In its concept release, the CFTC indicates that some experienced practitioners have stated that the definition of hybrid instrument under the Part 34 rules is complex and difficult to understand and apply. We believe that the current definition is working well and that the mathematical computations required under the definition are generally well understood. However, if industry representatives believe that the Part 34 rules are difficult to apply, we would be interested in working with the industry, bank regulators, and the CFTC to resolve any difficulties. Notwithstanding the CFTC's concerns regarding the complexity of the Part 34 rules, we have reservations about the discussion of hybrid products in the concept release. It seems the CFTC is proposing to substantially narrow the scope of the current exemption, and make the availability of the exemption dependent upon compliance with a scheme of regulation that would be implemented based on the CFTC's exercise of its exemptive authority. As in the case of swaps, we oppose any attempt to impose a regulatory scheme on hybrids through the exemptive process. Moreover, all hybrids are already regulated as banking or securities products. Where the commodity-dependent variables are not paramount, there is no need to add another layer of regulation under the CEA. Exemptive Authority Should be Used to Encourage Innovation It is important to understand that the SEC's concerns about the regulatory approach suggested by the CFTC's concept release do not stem, as has been suggested, from disagreement over agency jurisdiction, nor from a fundamental opposition to the exercise of appropriate regulation in this market. We worked well with the CFTC three years ago on the Derivatives Policy Group initiative. The SEC also believes very strongly in regulation where necessary and appropriate, and in using its exemptive authority to fuel market innovation and development.[8] For example, last December the SEC issued a rulemaking proposal that would apply to a class of broker-dealers we would call "OTC derivatives dealers."[9] This rulemaking proposal would provide significant regulatory relief to broker-dealers that seek to combine a business involving OTC derivative instruments that are securities -- which would subject them to full regulation as a broker-dealer -- with an OTC derivatives business involving instruments that are not securities. This responds to the current concern that firms are placing their non- securities derivatives activities in separate, unregistered affiliates, and conducting some securities derivatives activities from abroad, due to the costs of broker-dealer regulation. In proposing rules for a limited class of broker-dealers, the Commission recognized that, in some instances, fragmenting a firm's OTC derivatives business may hinder the firm's ability to manage risk and compete for business. If adopted, the proposed rules would provide U.S. securities firms with greater flexibility in structuring their OTC derivatives activities by allowing them to conduct transactions involving both securities and non-securities OTC derivative products through one entity. It should be emphasized here that flexibility is the goal. The proposed exemption would reduce, rather than increase, the regulatory impediments to doing business. Furthermore, under the SEC's proposal, registration as an OTC derivatives dealer would be optional. No firm would be required to change its current business organization or to conduct its activities in a registered OTC derivatives dealer. The Commission's proposal for OTC derivatives dealers is intended to promote market development and innovation. As noted earlier, the OTC derivatives market has grown substantially in recent years, and this growth is indicative of the strength and vitality of U.S. capital markets. In contrast, conclusions drawn from the CFTC's concept release raise concerns regarding legal uncertainty for OTC derivative instruments and the imposition of new regulatory costs. These concerns may stifle innovation or push it offshore. In response, legislation to provide legal certainty to participants in the OTC derivatives market is needed. The Working Group's Legislative Proposal As stated earlier, the growth in the OTC derivatives market has resulted, in part, from the careful consideration of market issues and consensus building among financial regulators. To address the legal certainty concerns raised by the CFTC's concept release, Secretary Rubin, Chairman Greenspan, and Chairman Levitt have requested a temporary legislative response to provide Congress and the regulatory community time to consider the important public policy issues raised by activities in this market.[10] We recognized the seriousness of this request, but felt it was necessary to prevent any perception that the U.S. regulatory system imposes an unreasonable amount of legal uncertainty on transactions in the OTC derivatives market, and to avoid litigation that could increase this uncertainty. In particular, the requested legislation would require the members of the President's Working Group to study the OTC derivatives market to evaluate whether any additional safeguards are warranted. The scope of the study would be OTC derivative instruments, including swap agreements, and hybrid instruments. Following completion of the study, the President's Working Group would develop recommendations, as may be appropriate, for changes in statutes, regulations, and policies to improve operation of this market and to enhance legal certainty for swap agreements and hybrid instruments. The legislation would require the President's Working Group to submit a report to Congress describing the study and setting forth any recommendations. Because of the importance of legal certainty to market participants, the legislation would also maintain the regulatory status quo by imposing a temporary moratorium on the CFTC's ability to restrict its current exemptions for hybrid instruments and swap agreements. More specifically, the legislation would require that prior to the enactment of legislation reauthorizing the CFTC, the CFTC would not be permitted to promulgate any proposed or final rule, regulation, or order -- or issue any interpretive or policy statement -- restricting or regulating activity in any hybrid instrument or swap agreement currently eligible for exemption under the CFTC's regulations. The legislation would also provide legal certainty to derivatives based on non-exempt securities. In short, the CFTC's concept release raises important policy questions that should not be addressed by the CFTC alone, but rather require the attention of Congress, members of the financial regulatory community, and interested industry participants. The OTC derivatives market is a rapidly growing and extremely vital global market that crosses jurisdictional boundaries among the regulatory community. The legislative proposal put forward by Secretary Rubin, Chairman Greenspan, and Chairman Levitt recognizes the need to protect the market from unreasonable and potentially harmful legal uncertainty, while also providing the time needed to allow the President's Working Group to study the issues raised by activities in the OTC derivatives market and to develop, as a group, appropriate recommendations to Congress. The Commission appreciates the opportunity to offer its perspectives on the OTC derivatives market, and to re-emphasize its serious concerns with the CFTC's concept release and the potential harmful consequences that the concept release could have on this market. The President's Working Group should be provided with the opportunity to carefully study the OTC derivatives market and to analyze the need for any additional regulatory action. The Commission and its staff welcome any questions on these issues that the Subcommittee may have, and look forward to continued discussions with the Subcommittee, the President's Working Group, and industry representatives on these important issues. **FOOTNOTES** [1]: See, e.g., Derivatives Policy Group, Framework for Voluntary Oversight (Mar. 1995). The Derivatives Policy Group was comprised of principals representing six major U.S. securities firms, specifically, CS First Boston, Goldman Sachs, Morgan Stanley, Merrill Lynch, Salomon Brothers, and Lehman Brothers. [2]: Commodity Futures Trading Commission, Concept Release on Over-the-Counter Derivatives, 63 FR 26114 (May 12, 1998). [3]: Joint Statement by Treasury Secretary Robert E. Rubin, Federal Reserve Board Chairman Alan Greenspan and Securities and Exchange Commission Chairman Arthur Levitt, dated May 7, 1998. [4]: Letter dated Jan. 4, 1993 from Jonathan G. Katz, Secretary, SEC, to Jean A. Webb, Secretary, CFTC, commenting on CFTC proposed rules regarding the regulation of swaps and hybrid instruments. [5]: P.L. No. 102-546; 106 Stat. 3590 (1992). Using the exemptive authority granted to it under the Futures Trading Practices Act of 1992, the CFTC promulgated rules under Part 35 of its regulations exempting certain swap transactions from the provisions of the CEA, other than provisions prohibiting fraud and manipulation. 17 C.F.R. Part 35. [6]: H.R. Rep. No. 102-978, 102d Cong., 2d Sess. 81 (1992). [7]: 17 C.F.R. Part 34. [8]: In 1996, the 104th Congress completed a review of the federal securities laws and enacted the National Securities Markets Improvement Act of 1996 (P.L. 104-290; 110 Stat. 3416 (1996)), which granted the SEC broader exemptive authority, giving it the necessary flexibility to better address changing market conditions. [9]: Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940 (Dec. 30, 1997). [10]: See Letter dated June 5, 1998 to The Honorable Newt Gingrich, Speaker, U.S. House of Representatives, from Robert E. Rubin, Secretary, Department of the Treasury, Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System, and Arthur Levitt, Chairman, Securities and Exchange Commission.