Panel I of a Hearing of the Securities, Insurance and Investment Subcommittee of the Senate Banking, Housing and Urban Affairs Committee - Over-The-Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks

Statement

Panel I of a Hearing of the Securities, Insurance and Investment Subcommittee of the Senate Banking, Housing and Urban Affairs Committee - Over-The-Counter Derivatives: Modernizing Oversight to Increase Transparency and Reduce Risks

Witnesses: Mary Schapiro, Chairman, U.S. Securities and Exchange Commission; Gary Gensler, Chairman, U.S. Commodity Futures Trading Commission; Patricia White, Associate Director of the Division of Research and Statistics, Board of Governors of the Federal Reserve System

Chaired By: Senator Jack Reed

Copyright ©2009 by Federal News Service, Inc., Ste. 500, 1000 Vermont Ave, Washington, DC 20005 USA. Federal News Service is a private firm not affiliated with the federal government. No portion of this transcript may be copied, sold or retransmitted without the written authority of Federal News Service, Inc. Copyright is not claimed as to any part of the original work prepared by a United States government officer or employee as a part of that person's official duties. For information on subscribing to the FNS Internet Service at www.fednews.com, please email Carina Nyberg at cnyberg@fednews.com or call 1-202-216-2706.

SEN. REED: Let me call the hearing to order.

I want to thank all of our witnesses for joining us this afternoon. I'm particularly happy to welcome back Chairman Schapiro. Thank you. And also I want to thank Chairman Gensler for asking to testify before us on the derivatives issue, which gives us a chance to talk directly to you about this issue which transcends several different agencies, and also Pat White from the Federal Reserve. Thank you.

Also I obviously want to recognize Chairman Harkin and his colleagues on the Agriculture Committee for their long-standing work on derivatives issues, and I look forward to having both committees coordinate closely as we work to provide transparency and reduce the risk in the financial sector.

This week we find ourselves more focused than ever on the important work of modernizing an outdated financial regulatory system. I've called this hearing to explore one of the key aspects of such reforms: To modernize the regulation of the over-the-counter derivatives markets and the institutions that participate in these markets.

Both exchange-traded and over-the-counter markets have grown extremely rapidly over the past decade. Until the recent downturn of the economic markets, every category of derivatives saw almost a decade of extreme growth, in many cases more than tripling or quadrupling trading volumes.

According to data compiled by the Congressional Research Service, between 2000 and 2008, the number of financial future contracts traded on exchanges rose by 425 percent, and the total notional amount of over-the-counter contracts outstanding rose by 522 percent over that period, representing trillions of dollars of trading.

This afternoon's hearing will focus in particular on over-the- counter derivative markets, which today are subject to no direct regulation. One of the key questions we will examine is the extent to which existing and emerging derivatives markets should be subject to regulatory oversight.

Until recently, the prevailing presumption was that market discipline alone largely protected us from any potential risks we faced from OTC derivatives. But we received a wake-up call, having had to seize AIG to keep its credit default swaps, worth trillions of dollars, from greatly exacerbating the financial crisis.

It is now clearer than ever that we need to find ways to make these markets much more transparent and to ensure that the dealers and other users of these markets do a better job than AIG of ensuring that their derivative activities do not threaten the stability of the overall financial system.

But we face difficult questions as we move forward in accomplishing this goal. These products are often extremely complex, and there is an equally complex history of regulation, or lack thereof, of such products. As a result, we need to take a careful and thoughtful approach to these issues. There's no doubt that improving the regulation and oversight of derivatives markets and those who trade in them is a key part of modernizing our financial regulatory system.

I hope my colleagues and our witnesses will help us identify the key steps that we can and should take right now to address the serious problems that we are confronting. For example, what key decisions need to be considered as Congress weighs proposals to move more over- the-counter derivatives to central counterparties or exchanges? How do various proposals to enhance oversight of OTC derivatives affect different market participants?

How does the issue of improved OTC derivatives regulation relate to broader regulatory reform issues such as the creation of a new systemic risk regulator? To what extent do U.S. efforts require international coordination? And these are just a few of the challenging questions that we will face together, and we rely on your expertise and your insights as we go forward.

At this time I'd like to call on the ranking member, Senator Bunning, for his comments.

Senator Bunning?

SEN. JIM BUNNING (R-KY): Thank you, Mr. Chairman.

I appreciate all of our witnesses coming here today for this very important hearing. It is important for everyone to understand the financial nature of derivatives, and thus the Banking Committee's interest in overseeing them.

Let me say at the beginning that I do not know what regulations and restrictions we should put on these products. Figuring that out is the purpose of this hearing. But it should be clear to everyone that the current regulations are not enough.

I understand the desire of firms to hedge their risks, whether those risks are interest or exchange rates, commodity prices, credit exposure, or something else. Genuine hedges are accurately priced -- that are accurately priced can provide the risk management firms need. But it is not clear that all derivative products are genuine hedges, are accurately priced. In fact, some look a lot more like a way to get around regulation and proper risk management, or just plain gambling.

Regulators and the public need a better understanding of all the exposures of firms to eliminate uncertainty and the justification for further bailouts. Increased transparency and standardization of derivative contracts will help and must be accomplished.

However, how far standardization requirements should go depends on whether there are true economic benefits to the custom products that outweigh the costs and risks associated with them. So far, specifics and credible evidence on that point is thin.

Credit derivatives may present the toughest questions. Should these products be treated as insurance with proper reserves? Should the buyer have an insurable interest and have to suffer actual losses or deliver the references -- the referred assets? How do we make sure credit protection does not undermine credit research or leave creditors to push debtors into bankruptcy. Should they even exist if not traded on an exchange? Someone has to bear the risk of every financial transaction. So we must not allow the wizards of finance to pretend it has disappeared.

Finally, just like with banks, we must eliminate the opportunity to avoid or choose favorable regulators or regulations. Similar activities must be regulated the same way by the same regulator. Otherwise firms will be able to game the system and regulators will not be able to effectively enforce the rules.

Thank you, Mr. Chairman.

SEN. REED: Thank you, Senator Bunning.

Senator Crapo, do you have an opening statement?

SEN. MIKE CRAPO (R-ID): I do, if I could, Mr. Chairman.

SEN. REED: Please.

SEN. CRAPO: First of all, Mr. Chairman, let me thank you for holding this hearing. I believe that although there is a breadth of derivative action in our economy, I believe that a significant amount, if not the significant majority of the amount of those jurisdictions, falls under the jurisdiction of this committee. And I appreciate your attention to that fact.

I also agree with the comments that both the chairman and ranking member have made. Recent events in the credit markets have highlighted the need for greater attention to risk management practices and counterparty risk in particular. And although I agree with the need to focus on where we can standardize and the types of risk reduction and better practices that we need to address, I also want, in my remarks, to just focus very quickly on one specific part of it, and that is not letting the pendulum swing too far to the other side to where we cause damage to an efficient economy.

The creation of clearinghouses and increased information to trade information warehouses are positive steps to strengthen the infrastructure for clearing and settling credit default swaps. While central counterparty clearing and the exchange trading of simple standardized contracts has the potential to reduce and increase market efficiency, market participants must be permitted to continue to negotiate customized bilateral contracts in over-the-counter markets.

Many businesses use over-the-counter derivatives to minimize the impact of commodity price, interest rate and exchange rate volatility in order to maintain stability in earnings and predictability in their operations. If Congress overreaches or bans or generates significant uncertainty with regard to the legitimacy of decisions to customize individual OTC derivatives transactions, I believe there could be very significant negative implications on how companies manage risk.

In the contemplation of this hearing and this issue, Mr. Chairman, I actually requested that a number of the end users of these types of transactions respond to a question about what increased flexibility -- or a reduction of flexibility would do. And at this time I'd like to just share three or four examples of responses that I received.

David Dines, the president of Cargill Risk Management, indicates while margining and other credit support mechanisms are in place and utilized every day in the OTC markets, there is flexibility in the credit terms, the credit thresholds and types of collateral that can be applied.

This flexibility is a significant benefit for end users of OTC derivatives such as Cargill in managing working capital. Losing this flexibility is particularly concerning because mandatory margining will divert working capital from investments that can grow our business and idle it in margin accounts.

While it depends on market conditions, the diversion of working capital from Cargill for margining could be in excess of $1 billion. Multiply this across all companies in the United States and the ramifications are enormous, especially at a time when credit is critically tight.

Kevin Colgan, the corporate treasurer of Caterpillar: "Our understanding of currently pending regulation in this area is that it would require a clearing function which would standardize terms like duration and amount. Any standardization of this type would prohibit us from matching exactly the terms and underlying exposure we're attempting to hedge. Thus, in turn, it would expose us to uncovered risk and introduce needless volatility into our financial crisis."

I have a number of other examples which I will insert for the record, Mr. Chairman. And if possible, I'd like the permission of the committee to insert the letters that I received in response to these inquiries into the record. I may get another in the next couple of days.

The bottom line, Mr. Chairman, is I completely agree with the need to do as much as we can to assure that we have covered the risks in our economy that have been created by the utilization of these types of derivatives -- different types of derivatives; credit default swaps, for example.

I just believe that we ought to pay very careful attention to making sure that we do what's necessary to protect and strengthen our markets and that we leave flexibility where it's necessary and helpful for the utilization of these credit instruments to advance the interests of our businesses.

SEN. REED: Thank you, Senator Crapo. I think you've illustrated the challenges ahead very well in terms of that balance.

Senator Bennet, do you have an opening statement?

SEN. MICHAEL BENNETT (D-CO): I don't, Mr. Chairman. Thank you for holding the hearing, and I'm very appreciative that the witnesses are here.

SEN. REED: Thank you.

Senator Johanns, do you have an opening statement?

SEN. MIKE JOHANNS (R-NE): I do not. I'm ready for the witnesses.

SEN. REED: Thank you very much.

Let me at this juncture introduce our witnesses. We are very pleased to be joined today first by the honorable Mary Schapiro, chairman of the Securities and Exchange Commission. Prior to becoming SEC chairman, she was CEO of the Financial Industry Regulatory Authority, FINRA, the largest nongovernmental regulatory for all securities firms doing business within the United States.

Chairman Schapiro previously served as a commissioner of the SEC from December, 1988 to October, 1994; and then as chairman of the Commodities Futures Trading Commission from 1994 until 1996. Thank you, Chairman.

Next is The Honorable Gary Gensler. Gary Gensler is the chairman of the Commodity Futures Trading Commission. He previously served at the U.S. Department of the Treasury as under secretary of domestic finance from 1999 to 2000; as assistant secretary of financial markets, from 1997 to 1999. Prior to joining the Treasury, Chairman Gensler worked for 18 years at Goldman Sachs, most recently as a partner and co-head of finance.

Our third witness is Ms. Patricia White, associate director of the Federal Reserve Board's Division of Research and Statistics. Ms. White has oversight responsibilities for sections that analyze risk and process microeconomic data, and she has participated in domestic and international working groups on central counterparties, securities settlement and financial regulation.

We very much appreciate all of you joining us here this afternoon.

And, Chairman Schapiro, would you begin your testimony.

MS. SCHAPIRO: Thank you very much, Chairman Reed.

Mr. Chairman, Ranking Member Bunning and members of the subcommittee, I'm very pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission concerning the regulation of over-the-counter derivatives. The severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation.

One of these gaps is the gap in regulation of OTC derivatives, which, under current law, are largely excluded or exempted from regulation. The current regulatory framework has permitted certain opaque securities-related OTC derivatives to develop outside of investor protections afforded by the securities laws. The SEC is committed to working closely with this committee, the Congress, the administration and our fellow regulators to close this gap and restore sound structure for U.S. financial regulation.

I am pleased to be able to report to you that U.S. regulatory authorities have reached a broad consensus on the pressing need for a comprehensive regulatory framework for OTC derivatives. This consensus covers all of the basics of sound financial regulation in the 21st century, including record-keeping and reporting requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing. The SEC is also strongly supportive of ongoing initiatives to promote the standardization and central clearing of OTC derivatives.

The SEC, working in close consultation with the Board of Governors of the Federal Reserve System and the Commodity Futures Trading Commission, and operating under the parameters of the current legislative structure, already have taken a number of actions to help further centralized clearing for OTC derivatives, including providing temporary conditional exemptions for three central counterparties to begin centrally clearing credit default swaps.

More needs to be done, however, and in building a new regulatory framework for OTC derivatives it is vital that the system be designed to protect the public interest, manage systemic risk and promote capital formation and general economic welfare. Treasury Secretary Geithner's May 13th letter to the Congressional leadership outlined the administration's plan for establishing a comprehensive framework for regulating OTC derivatives. Multiple federal regulatory agencies will play critical roles, including those represented here today.

In fashioning a regulatory framework for OTC derivatives it is crucial to recognize the close relationship between the regulated securities and futures markets, and the now mostly unregulated markets for OTC derivatives. For example, with respect to the securities markets, when an OTC derivative references an issuer of securities -- such as a public company or a security itself, it can be used to establish synthetic long or short exposures to an underlying security or group of securities. In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves.

Because market participants can use these securities-related OTC derivatives to serve as synthetic substitutes for securities, the markets for these OTC derivatives are interconnected with the regulated securities markets. Moreover, the markets for these securities related OTC derivatives implicate the policy objectives for capital markets that Congress has set forth in the federal securities laws, including investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

For this reason it is important that Congress carefully consider whether securities-related OTC derivatives be subject to the federal securities laws so that the risk of arbitrage and manipulation is minimized. And certainly a similar analogy can be made to the futures markets by the CFTC.

My goal today is to assist the Congress in its efforts to craft legislation that empowers the respective regulatory authorities to do their jobs effectively and cooperatively. I am confident that, working together, we will meet the challenge that is so important to the financial wellbeing of individual Americans. I would be pleased to answer your questions. Thank you.

SEN. REED: Thank you very much, Chairman Schapiro.

Chairman Gensler.

MR. GENSLER: Chairman Reed, Ranking Member Bunning, other members of this subcommittee, thank you for inviting me here to talk to you today about the over-the-counter derivatives market. I'd like my full testimony to be entered into the record, if that's all right.

I too (am) talking on behalf of the full commission. I believe we must urgently move now to bring the over-the-counter derivatives marketplace under regulation, and there are four key objectives in doing so -- in accomplishing this goal:

One, is to lower systemic risk.

Two, we need to provide the transparency and efficiency to these markets -- that we believe we have in our securities and futures and options markets, we need to bring to the derivatives marketplace.

Three, we need to ensure integrity in these market(s), preventing fraud, manipulation and other abuses.

And four, we need to protect the retail public in these markets as we do in other markets we oversee.

Meeting these objectives will also require close coordination between the CFTC, and SEC and other federal regulators.

Senators, I believe that these reforms must establish a regulatory regime that governs the entire over-the-counter marketplace, no matter who is trading them, what type of derivative is traded, whether it's standardized or tailored, or highly customized. I think this should include interest rate product, currency product, commodity product, equities products, credit default swaps, and those swaps that we haven't yet thought of, that are just a blip on the horizon.

As the administration laid out in its May 13th letter, I believe this can best be accomplished in two complementary regimes: one to regulate the derivative dealers, or the "actors," so to speak; and another regime to regulate the big market functions, or the stages upon which the actors perform their duties.

For the dealers in this marketplace -- the large financial institution, by and large, that deal, we should set capital standards and margin requirements to help lower the risk in the system. We should set business conduct standards to make sure that the market exercises itself without fraud, manipulation and the other abuses.

And thirdly, we should set recordkeeping and reporting, with audit trails, so that we have transparency in this market.

So, lower risk, promote market integrity and enhance the transparency.

But, I think this dealer regime won't really be enough. It's important, and -- (inaudible) -- gets to all the markets, customized and standardized. But, we can further lower risks by having central clearing on the standardized products, and also bringing the standardized products onto regulated trading venues, whether they be full exchanges or electronic platforms. And this will lower risk and further enhance transparency.

To fully achieve these objectives, we must enact both of these complementary regimes. Regulating both the traders and the trades will ensure that we cover both the actors and the stages upon which they create the significant risks.

I'm fortunate to have a partner in this effort in SEC chair, Mary Schapiro. She brings invaluable expertise which gives me great confident that we'll be able to work together on what is bound to be a lot of challenges moving forward. We have not only this, but we're going to be working together and advising Congress and the rest of the administration on how we, in cases, can best harmonize some of the rules between the securities and futures world, and cover gaps in our regulatory oversight.

President Obama has called for action to strengthen market integrity, lower risk and protect investors, and I look forward to working with members of this committee and others in Congress to accomplish this goal. I thank you again for the opportunity to testify and I look forward to answering any of your questions.

SEN. REED: Thank you very much, Chairman Gensler.

Ms. White.

MS. WHITE: Chairman Reed, Ranking Member Bunning and other members of the subcommittee, I appreciate this opportunity to provide the Federal Reserve Board's views on the development of a new regulatory structure for the over-the-counter, or OTC derivatives market.

The events of the last two years have demonstrated the potential for difficulties in one part of the financial system to create problems in other sectors, and in the macroeconomy broadly. Centralized clearing of standardized OTC products is a key component of efforts to mitigate such systemic risk.

The Board believes that moving towards centralized clearing for most, or all, standardized OTC products would have significant benefits.

If properly designed and overseen, central counterparties -- or CCPs -- offer an important tool for managing counterparty credit risk. The benefits from centralized clearing will be greatest if CCPs are structured so as to allow participation by end users within a framework that ensures protection of their positions and collateral.

Infrastructure changes in OTC markets will be required to move most standardized OTC contracts into centralized clearing systems. Such changes include agreement on key terms that constitute standardization and development of electronic systems for feeding data to CCP.

For their part, CCPs must have in place systems to manage the risk from this new business. Of particular importance are procedures to handle defaults, because OTC products are likely to be less liquid than the exchange-traded products that CCPs most commonly handle.

Although implementation challenges no doubt lie ahead, the board will work to ensure that these challenges are address quickly and constructively. Major dealers have committed to making improvements in back office systems that are important prerequisites for centralized clearing. Dealers also have committed to clearing standardized OCC products, and they will be expected to demonstrate progress on this commitment, even as the broader regulatory reform debate evolves.

Substantial progress in improving the transparency of the credit default swap, or CDS market, occurred with the creation of the trade information warehouse, a contract repository that contains an electronic record of a large and growing share of CDS trades. The board supports creating contract repositories for all asset classes and requiring a record of all OTC derivative contracts, that are not centrally cleared, to be stored in these repositories.

Aggregate data on volumes and open interest should be made public by repositories and more detailed data should be made available to authorities to support policy objectives related to the prevention of manipulation and systemic risk.

Although the creation of CCPs will provide an important new tool for managing counterparty credit risk, enhancements to risk management by individual market participants will continue to be a high priority for supervisors. If the reforms outlined here are implemented, the firm's currently most active in bilateral OTC markets will become the firms most active as clearing members of CCP. As such, the quality of their internal risk management is important to the CCP. Supervisory efforts are already under way to improve collateralization practices and to examine whether the current capital regime can be improved.

Policy issues associated with OTC derivatives are not limited to the United States. The markets are global and issues are unlikely to be fully addressed without international coordination. Much work must be done, but with effective oversight by supervisors, prudent risk management by end users and dealers and appropriate changes in the regulatory structure, derivatives can continue to provide significant benefits to businesses and investors who use them to manage financial market risk.

Thank you very much. I will look forward to answering your questions.

SEN. REED: Well, thank you all very much.

This is an issue of great complexity and great importance. So this is the beginning of a process, I think, not the conclusion of one in trying to determine what Congress must do and will do to provide adequate regulation for a complicated part of our financial markets.

Let me begin by saying that one aspect that we have to get right is to cover the whole waterfront, if you will. Make sure that there are no gaps, that there is an effective and efficient way to do this. And I wonder if all of you in turn could give your kind of comments about how we ensure there is a comprehensive approach and that we don't create these areas where there is an opportunity to operate outside of the framework.

And start with Commissioner Schapiro.

MS. SCHAPIRO: Thank you very much, Mr. Chairman.

I agree with you completely that it's really important that as we seek to solve the existing gaps we not create any additional ones. So I think there are several mechanisms for that.

The first is to encourage and using tools like capital and margin, standardization and central clearing to the greatest extent possible -- and even encourage exchange trading of OTC -- currently OTC derivatives.

That will give us, as Chairman Gensler said, some control over the stage. And it will allow us to have a centralized view of what's happening in these markets and the benefits of capital and margin requirements with respect to those institutions.

But it's also critically important that we have regulation of the dealers who participate in the marketplace, meaning -- in my view -- registration, capital requirements, margin requirements, recordkeeping, reporting to regulators, reporting at least aggregated information to the public and very tight risk-management processes within the dealers, including governance, risk controls, trading limits -- all of the things we would normally think about as being important for dealers to control the risks that they are undertaking.

I also think that whether we have a systemic risk regulator at the end of this process or a council or a combination, as the administration proposes, it will be very important for the regulators to share as much information on a continuing basis as possible so that as new products are being developed -- and I'm sure that as we sit here, somebody is developing a new product that perhaps falls between the regulators current authorities -- that we know about those products as quickly as possible, understand their implications for the system and bring them under the federal regulatory umbrella either by moving them into a central clearing house or exchange platform or through the regulation of the dealers who participate in those transactions on a bilateral basis.

SEN. REED: Thank you.

Chairman Gensler.

MR. GENSLER: Well, I think that Chair Schapiro summed it up well. But I think, if I might say, one of the great lessons out of this financial crisis is that we had large financial institutions that were by and large out of the regulatory regime. I mean, some had ineffective federal oversight, but AIG is exhibit A. And I think, frankly, the derivate dealers that were affiliated with Lehman and Bear Stearns and others were sort of -- they were modestly regulated, but I think we all now feel we have to bring that in.

So the dealers -- by regulating the dealers, we get I would say nearly 100 percent of the marketplace. It would be possible, Senator, if you and I entered into a derivative, neither one of us is a dealer But any dealer that holds themselves out to the public and offers these types of transactions, I think we can lower risk by having the capital and margin, increased transparency with a recordkeeping reporting.

At the same time, we can let the tens of thousands of users of these products take greater comfort by regulating, as I call it, the stages or promoting the standard products onto exchanges and onto central clearing, while at the same time recognizing there will still be some tailored products. It could be an airline company that needs a certain grade of jet fuel delivered in a certain location on a certain date. That would still be regulated, because the dealer offering that product would have to put aside capital and margin and not participate in manipulation or fraud, but at the same time, we allow some customization so the tens of thousands of users could still use those products.

SEN. REED: Well, thank you.

Senator Crapo's comments and your comments -- there seems to be a range of real economic arrangements. I mean, there's a specific thing. They need the fuel on a certain day; they're hedging a certain price. And then there's a whole category, as Chairman Schapiro said, of synthetics that are mimicking the Dow, that are more sort of the creations and almost an infinite supply of them.

Is that one dimension that you would consider in terms of putting items on exchange?

MR. GENSLER: I believe, Mr. Chairman, that anything that a clearinghouse would accept for clearing, under prudent risk reduction, should be accepted for clearing and that the regulators could also be given authority working with Congress to add to it. It's basically, you know, a high-volume product or a similar product. So it's not just used to avoid.

I also believe that those products that are not on central clearing and not on exchanges, are by their definition less liquid, and thus should appropriately have higher capital or margin requirements. So if dealer wants to retain that customized product, they might have to set a higher capital or higher margin.

SEN. REED: Chairman Schapiro.

MS. SCHAPIRO: I would just add to that that one of the benefits of higher capital and margin might be to encourage more transactions into central clearing or onto exchanges.

But I do think the challenge will be standardization and how do we achieve a significant proportion of this market moving into central clearing? There is clearly a need for customized bilateral transactions -- as Senator Crapo has said and as Chairman Gensler has mentioned. The key thing is that they be brought into the regulatory umbrella through the regulation of the dealers and that there is adequate margin for those positions and adequate capital on behalf of the dealers.

And again, the regulator have the ability to see what's happening between counterparties.

SEN. REED: Before I recognize Senator Bunning, Ms. White, do you have a comment?

MS. WHITE: Thanks. The board has been focusing on the aspects of the market that relate to systemic risk and how to fill gaps there and, in particular, what infrastructure would be helpful.

One thing we'd like to point to is the creation of trade information warehouses for all asset classes and all contracts. That will provide an important base of knowledge for the authorities as they try to evaluate what is standardized enough to next move into a cleared environment.

In addition, I would want to add that, in terms of gaps, it's important to keep in mind that these are really international markets, and we're going to need a lot of international coordination to make sure all the gaps are full.

SEN. REED: Senator Bunning.

SEN. BUNNING: Thank you, Mr. Chairman.

As I said in my statement, I think similar activities should be regulated the same way by the same regulator. In other words, we need just one regulator for derivative products. Do you agree or disagree with that statement?

Go right ahead.

MS. SCHAPIRO: Thank you. I think -- my greater concern than having a single regulator for all derivative products is disconnecting securities-related derivatives from securities markets, because as I go on to probably a too great length in my written statement, the concern is that you can create a synthetic securities position utilizing derivative products that are intimately tied to the securities markets, for which we have primary concern. They're important for capital formation; they're important to millions of investors in the United States.

And so the impact that these securities derivatives can have on the primary securities market is a concern that I hate -- would hate to see be decoupled. It has been, as many derivatives have been decoupled from their primary markets over the last 15 or 20 years or so. But I think to me that's the more important linkage, is between the securities derivatives and the securities markets, the -- and the same would be true for the markets the CFTC regulates.

SEN. BUNNING: Go right ahead.

MR. GENSLER: Well, I think, Senator, you raise a very important point. We have two market regulators. And the securities and options markets that the SEC regulates and the futures markets that the CFTC regulate, and now we're bringing this market of derivatives, hopefully with Congress's help, under regulation. And derivatives have a lot of attributes of securities and a lot of attributes of futures, and, in some cases, more attributes towards futures. And those products, I think, we've -- have broad agreement on some of those -- would be best maybe regulated under the CFTC. And some that have far more attributes of securities that can clearly influence whether it's an issuer or the markets for an individual company or insider trading, that would really be where the SEC has -- best protect the investor.

So I think working together and with this committee in Congress we're going to find we don't leave any gaps, but also these derivatives have attributes sometimes that are far greater towards securities and some are far greater towards futures. Under your basic concept --

SEN. BUNNING: I'm trying to prevent any from slipping through the cracks.

MR. GENSLER: And we I think both agree with that goal. And I think we can achieve that goal together.

SEN. BUNNING: Ms. White, does the Fed have some opinion on this?

MS. WHITE: The products in the market have a lot of diversity to them. And both the CFTC and the SEC will bring different skills to the regulatory oversight of those products. And for the board, what is most important is that we try to avoid jurisdictional overlaps and harmonize the treatment of products.

MS. SCHAPIRO: Senator, if I could just add one point there --

SEN. BUNNING: Go ahead.

MS. SCHAPIRO: I think that where you have products that are effectively economic substitutes for each other under the jurisdiction of different regulators it's really critical that we work as closely as we can to try to harmonize our regulatory regimes.

SEN. BUNNING: But isn't that where we failed in the -- in the last 15 years?

MS. SCHAPIRO: Well, except that with respect to most over-the- counter derivatives they've been exempted from or excluded --

SEN. BUNNING: Any --

MS. SCHAPIRO: -- from virtually all regulation.

SEN. BUNNING: But that's because we had two chairmen of the Federal Reserve who said to us at the Banking Committee that they shouldn't be regulated. I can go back and get you the --

MS. SCHAPIRO: No, I'm sure that's right. I don't think -- that's certainly not the position of the Securities and Exchange Commission. We believe that these products absolutely should be regulated and need to be regulated effectively because of the impact that they can have on the economy, broadly, but also on particular markets like the equity markets.

SEN. BUNNING: There seems to be agreement that all derivatives need to be reported to someone. Who should the trades be reported to and what information is necessary to be reported? And is there any information that should not be available to the public?

Anybody?

MR. GENSLER: Senator, I think that we need to bring a great deal more transparency to the markets. And I think this will actually lower the pricing for the tens of thousands of users. What we've found over many decades is when you have greater transparency, markets are more efficient.

So all of the products the dealers trade in should be reported into a central trade repository where the regulators get to see that and the market regulators get to police the fraud, manipulation. But also, the public should get to see anything that could be on an exchange or a trading platform. And what Secretary Geithner's letter says I fully subscribe to. There should be a real time, a reporting, a development of a -- sort of like a consolidated tape, very similar to what's in the over-the-counter bond market right now.

SEN. BUNNING: What do we do about the derivative or a credit default swap or that individual personalized hedge? Use Delta Airlines as an example and -- the delivery at a certain date at a certain price and that personalized derivative that they use for hedging against the market.

MR. GENSLER: Right. I believe, sir, that that should be reported into all the regulators and certainly aggregated and the aggregate positions by underlying commodity -- in that case, jet fuel -- should be reported to the public. I think, working together, we have to think through whether there -- that should also be part of this consolidated tape or whether there's some that would be so unique that the commercial attributes of, as you said, Delta Airlines might be put at risk. But they should -- I believe should be aggregated --

SEN. BUNNING: But I think --

MR. GENSLER: -- in part, seen clearly by the regulators, and possibly part of the consolidated tape.

SEN. BUNNING: I can't see how Delta Airlines would be put at risk if they're smart enough to hedge against the markets advance in future oils or future jet fuel or whatever it might be.

MR. GENSLER: Right. And there we -- in that case, I would recommend that it would be part of that consolidated tape. But I recognize there may be some transactions --

SEN. BUNNING: Thank you, Mr. Chairman.

SEN. REED: Thank you, Senator Bunning.

Senator Bennet?

SENATOR MICHAEL BENNET (D-CO): Thank you, Mr. Chairman.

I just had a couple of questions. The first goes back to this question of -- this -- the clearing of centralized contracts versus customized contracts, because, you know, in both the Agriculture Committee and Banking Committee, we've had some similar conversations. And I heard you today, Chairman Gensler, talk about how, well, it might be okay if we're -- if we can't put the customized on a centralized clearinghouse because we'll have different capital requirements, I think, or some capital requirements, which I think makes a great deal of sense.

My question is, what -- as you think about this -- all of you think about this -- what incentives there might be, if any, for people to structure around the clearinghouse for no good business purpose? I mean, what really would the incentives be to create a customized hedge here that didn't have a business purpose of some kind?

MR. GENSLER: I would hope that once there is a fully running central clearinghouse, there will be great benefits to moving all the transactions that a dealer could into that, because it does lower risk for them as well. Instead of having this interconnected spider's web -- one of the lessons we learned is not only are institutions too big to fail, but they're too interconnected to fail, so to speak. But it helps lower their risk, and that's why I subscribe to maybe lower capital or margin, but it may well be that some dealers don't agree with my point of view, and that they would want to keep some product outside of that standardized central clearing. But I think that it actually would help lower risks for their institutions and lower risk for the system.

Also, it would enhance transparency. The public would see it if it were on an exchange or trading platform. And it may well be that some dealers would like to keep the information advantage. But many decades of markets have taught that broad commerce in the economy benefits by having that type of information. And if you see the standard transaction in jet fuel -- we were talking about jet fuel. If you see the standard transaction in jet fuel or interest rates -- it could be a very plain vanilla interest rate -- then I think the small municipality or the small hospital that wants to hedge a four- and-a-half-year interest rate instead of a five-year interest rate would benefit by seeing that on an open and transparent exchange.

SEN. BENNET: The two of you?

MS. SCHAPIRO: The only thing I can think of is the informational advantage that one has from not trading in a transparent market and the benefits, to the extent there are some, of anonymity. That's why I think it's so important that the dealer regulation include full transparency, at least to the regulators, and then, over time, a decision I think by regulators about how much information needs to be made publicly available.

I think what's really critical is that we not structure the regulatory regime in any way that creates unintentionally incentives to go off exchange or off central clearing and stick with bilateral contracts.

SEN. BENNET: I completely agree with that. And I think that what -- and as we proceed here with this and much of the other regulation that we're talking about, we need to be very careful that we aren't creating perverse incentives that end up doing more harm than good.

And I was just trying to scratch my head to think about -- I get the point on transparency. But on the other hand, if it's reported to the regulator, I'm not sure there's much of an issue. But we'll keep working on it.

The other question I had -- and it may go back to the systemic risk regulator proposals that we've seen in the last week or so around here. You talked, Chairman Gensler, about the swap that hadn't yet been invented. And I started to sweat again about what we might be facing, because the American people are so tired of having us look in the rear view mirror and say, "What happened?" when there's all this carnage out there.

And I just wonder whether, on a going-forward basis, all of you felt that we were going to be in a better position -- not to predict the future, necessarily, but in a better position to monitor when things are starting to move in a certain way in our financial markets? My understanding, for example, is that between 2000 and 2008, the number of over-the-counter derivatives contracts grew by 522 percent. And -- but during that time, our regulatory authorities had little power to examine any of that. I wasn't here to know whether you asked Congress for that or not. But prospectively, is this some of the work that this council is meant to do? How are we going to keep track of these swaps that have no name?

MR. GENSLER: I think as it relates to over-the-counter derivatives -- and I could let some -- my chair and Ms. White answer the council -- but in terms of over-the-counter derivatives, I think that the federal regulators should have broad authority. If somebody holds themselves out to the public as a dealer, whether it's in the known derivatives that we know now -- from interest rates to securities to credit default swaps -- or maybe it's something that's not yet known, we should work together to make sure the statue gives that broad authority to also bring that in to this regulatory regime. I think that's important. It's one of the big lessons of the past, certainly, that I've learned.

I think in terms of a systemic regulator, what the administration has put forward is to make sure that the largest financial institutions, those that are either interconnected or by scale or scope can affect the American public, that those have to be under prudential regulation, meaning you can set capital and margin and so forth. And I think that's very important.

MS. SCHAPIRO: The only thing I would add to that is, in addition to the systemic regulator, the continuing role of the functional regulators -- the SEC, the CFTC or bank regulators -- looking at the business of the dealers in a way that really we've never been able to before, because of the exemptions that exist under existing law, ought to make a big difference in our ability to understand what kind of products are being developed and marketed. And I think the business conduct rules that really try to get to how these derivative products might be marketed and sold, whether to state and local governments or pension funds or even less sophisticated institutions, will give us real insight into what's happening within the firms and the ability, hopefully, to shut down problematic practices before they grow out of control.

SEN. BENNET: Thank you. Thank you, Mr. Chairman.

SEN. REED: Thanks, Senator Bennet.

Senator Crapo?

SEN. MIKE CRAPO (R-ID): Thank you very much, Mr. Chairman.

Each of you in your testimony have indicated, as I indicated in my opening remarks, that there are circumstances in which non-standard products are very legitimate, and that there are legitimate reasons for us to engage in customized transactions. And obviously, the question that I'm interested in here today is, how do we make sure that we regulate to the extent possible in such a way that makes certain that we don't basically engender greater inefficiencies and risk in our economy as a result of the way we treat these types of customized transactions?

As I've read your testimony, Ms. White, for example indicates that these non-standard products can pose significant risk management challenges because they can be complex, opaque, illiquid and difficult to value. And in your testimony, Chairman Schapiro, you indicate that one way to deal with these non-standard types of arrangements is to impose appropriate margin and capital requirements on the participants in these customized transactions to reflect the risk that they pose to the system in general. The question I had when we get to that point is do these -- can we evaluate the level of risk that these transactions pose. I think that you would each agree with me that as we have watched derivatives operate in the last few years that there have been some incredible abuses that have put incredible systemic risk in our economy. But there have also been a phenomenal number of very effective uses of credit default swaps and of other derivatives that have helped to create efficiencies and strength in our economy. And so the question I'm getting at is can we evaluate these non- standard arrangements in such a way that we can tell whether they are truly generating risk that should then be subjected to greater margin and capital requirements?

MS. SCHAPIRO: I think we can. Can we do it perfectly? Probably not. But I think through imposing risk limits on dealers, stress testing, ensuring that the margin levels are sufficiently conservative and high and stress tested so that we can have some comfort about that, requiring operational controls, things as simple as separation of duties and trading limitations on individual traders, requiring that they have robust compliance systems, that the firms have credit policies, that they are required to know their counterparty and understand the risk of a bilateral arrangement with that particular counterparty. I think through real vigilance on the part of dealers which will come mostly with real vigilance on the part of the regulators overseeing the dealer conduct, I think we can certainly do a much better job than has been done historically.

SEN. CRAPO: Mr. Gensler?

MR. GENSLER: I think we can. It certainly poses challenges. Much of the market place is standardized. There are various estimates, and I haven't seen any very good data, but over half of the market is certainly standardized and some would say a lot more. And even on the tailored or customized side, sometimes it's just that it's one month off. But on the truly exotic, you know, if it's highly customized, I think that beyond that which Chair Schapiro talked about, I think it will be appropriate to have higher capital, higher margin standards for that dealer. You mentioned the letter earlier from Caterpillar. I think they could absolutely customize and make sure that they hedge their risk. But if their risk is a little different than the standard, well, it's probably almost the same capital. But if the risk is really quite different, then it's hard to value that risk and then the dealer on the other side might have to put up even more capital in that regard. But risk, if I might say, is risk. And if it's really highly standardized, we want to make sure the dealers have enough cushion in tough markets to survive.

SEN. CRAPO: So are we saying then that our inability to standardize the risk means that the risk is higher?

MR. GENSLER: Well, it generally in markets does mean that. It's not always the case. But generally if you can't standardize a product or you don't see other people trading in that product, that risk then is a little harder to unwind if I -- it's not a technical term. And so if a commercial enterprise wants to enter into a transaction that's standardized, it probably means there's ten or twenty or maybe hundreds of other parties that want to either speculate on that risk or hedge that risk. The more difficulty is when there's no other party on the other side. And frankly, that's also the problem in crisis when there's no other parties to take the other side.

SEN. CRAPO: Thank you. Ms. White.

MS. WHITE: The board believes that there's value in these non- standardized products. But it also recognizes that there are challenges in managing the risk associated with the non-standardized products both from the standpoint of the firms and from the standpoint of the supervisors. Clearly, improvements need to be made, and there are projects already underway in the supervisory community of valuating, for example, the appropriateness of the capital standards associated with them to make sure that the non-standardized products, the capital charges attached to them fully reflect the risk of those products.

SEN. CRAPO: Thank you.

SEN. REED: Thank you, Senator Crapo. Senator Johanns.

SEN. MIKE JOHANNS (R-NE): Let me thank the witnesses for being here. Chairman Gensler, let me follow up on some things that Senator Crapo was asking, and I'll be very blunt. Your testimony worries me. So if I have a very standardized product, it's going to go through this system lightening speed. We're going to know exactly what the rules are. But if I have a little bit or maybe even significantly different product, it's going to hit a barrier because you're going to have to analyze the risk. Some bureaucracy is going to have to shake it and bake it and figure it out and discuss it. And then somebody's going to have to say, well, it's not standardized and therefore it's got to be X, Y and Z in terms of the capital requirement. Isn't that kind of what you're getting us to?

MR. GENSLER: Senator, I appreciate your concern. What we're recommending is that clear rules of the road would be put out by the regulators that are best at setting capital which is most likely for these dealers is going to be either their bank or other prudential, in some cases the Securities and Exchange Commission, possibly the systemic regulator. So those capital standards set by rule would be set out for customized and standardized products as well. So I would not envision a trade by trade circumstance or a contract by contract as you asked.

SEN. JOHANNS: No, but the nature of this system and the reason why it got some legs underneath it is because it was so darn adaptable knowing in the end that had its down side, too, and then you add stupidity to it and greed, and it really went south. But as Senator Crapo points out, many companies and therefore many shareholders got great benefit from this process. And it seems to me that if you run into anything that is not standardized, you run into the bureaucracy.

MR. GENSLER: Well, I appreciate your concern, and I share that concern. But I think that through clear rules of the road, the federal regulators can lay out what capital and margin is appropriate for the customized products. I do believe that we benefit as an economy and a society that commercial enterprises can hedge the risk that they're faced with, and they can focus on producing a product or producing a service for the public and hedge a risk. That's what the CFTC has been overseeing for decades in the agriculture and energy and financial markets. I think we have to promote that but at the same time recognize that if it's not standardized, it might be appropriate to have a little higher margin and higher capital but set again by a public process that those rules are set and that you don't have to come in and check each contract.

SEN. JOHANNS: Okay. What if I am a competitor, and you've gone through your process however long it takes and you've now set the new capital requirements, and I'm going to challenge that and appeal it because I think your capital requirements are too low. Are we going to have -- will I have the benefit to do that? Can I slow the process down even further?

MR. GENSLER: Well, it might not be the CFTC, but it might be the Federal Reserve or the SEC that's setting capital in this regime. But just as there's capital standards in the full oversight, so I defer to Chairman Schapiro.

MS. SCHAPIRO: I guess I'd like to add that even the practice today among counterparties is to analyze the risk of our doing business with each other and to demand collateral against the position that we're creating. So much of that analysis that would be required here is an analysis that I think the dealers are very comfortable doing. The difference would be that there would be --

SEN. JOHANNS: Government oversight.

MS. SCHAPIRO: Government oversight, but not, I don't think, we'll have the capacity to second guess every transaction and whether the risk was analyzed appropriately. But we would expect the firms to stress test their models and to ensure that their risk management procedures were really first class. The difference, I think, will be that there will be capital standards as there already are for banks and broker-dealers that will help them, given what their risk analysis shows, determine what the appropriate level of capital is to hold against those positions or potentially the appropriate level of collateral or margin to seek with respect to each transaction.

SEN. JOHANNS: I'm running out of time. We never have enough time in a hugely complicated area. But let me ask this question. As AIG was ramping up its exposure and risk and hindsight's always 20-20, and we can look back and say, boy, that was really dumb, what about your system would have stopped that? Would your system have kicked in at some point and you would call the CEO of AIG and say, whoa, you're at $200 billion or whatever. You're done. You're out of the market place. You can't do this any more. Would we have stopped AIG?

MR. GENSLER: Senator, it's always hard in hindsight. But I think that a number of features here would have slowed down and maybe even stopped.

AIG put on an enormous book of business without putting aside capital or margin. And what happened just last fall when the rating agencies downgraded AIG, all of a sudden they had to post significant collateral. I think it was over $30 billion within a day or two. They would have had to have done that across the daily basis.

It is a harsh discipline, I know. It's one that I learned when I was in the investment banking business. But it's one I think is an important one, is to value, on a daily basis or weekly basis, the risks that a firm has and put aside appropriate capital margin. And AIG was not doing that.

There was a lot of other problems in AIG as well, I think, the system would have highlighted earlier

SEN. REED: Senator Johanns, we're going to do another round.

SEN. JOHANNS: Okay, great.

SEN. REED: Because you're right, this is a complex topic. And we are extraordinarily fortunate to have the chairmen and chairman and Ms. White from the Federal Reserve.

Let me just ask one question, though, and that is we're engaged in a very complicated regulatory reform process which is going to touch many, many different areas. So I would ask you to just tell us, what do you believe the two or three most important legislative changes that we have to enact, given the fear that it's going to be so big and so broad that every detail will be considered? But we need to know what you think the most important priorities are in terms of legislative changes.

And Chairman Gensler, you seem poised to answer.

MR. GENSLER: No. (Laughs.) I was poised to let Chair Schapiro answer first.

You know, it's a very appropriate question. It's hard when one's president lays out a bold agenda. And I think it is a very bold agenda that President Obama laid out. But I think it's incumbent upon all of us to address this over-the-counter derivatives. So if I'm allowed two, I would say one of them absolutely is over-the-counter derivatives.

And for me, I would say protecting the consumers. I mean, the whole approach to having a strong, vigorous oversight. I think the mortgage sales practices in this country have failed, failed terribly, all the way through the process of mortgage securitization.

But I would say the second big one, for me, there's others, but I would say the consumer side.

SEN. REED: I should be more specific. Within the context of regulating over-the-counter derivatives or the derivatives market, any specifics?

MR. GENSLER: Mr. Chairman, it's hard to break it down because I really do think these are complementary regimes. I think that if we are not able to fully regulate the dealers, we will not give the American public the comfort they need, and it will feel like we leave loopholes.

If we just did central clearing, which is a good idea, a very good idea, and even if we mandate it, I think we will not have covered the legitimate concern of covering the risk of the customized products.

SEN. REED: Well, let me turn to Chairman Schapiro now. But also, will there be a definitional debate about who is a CFTC dealer and who is an SEC dealer? Because I think that there is agreement among both of you that the dealers have to be regulated

MS. SCHAPIRO: I would agree with that. And actually, I would go so far as to say that if we don't regulate the dealers, we will realize Senator Bennett's concern that there's not really any reason to go the standardized route because you can really, with anonymity and in a very opaque way, continue to engage in OTC derivatives through unregulated dealers or dealers, at least, that we cannot adequately examine and inspect.

I think that to the extent there are disagreements between the SEC and the (CFTC ?), first of all, most dealers will be regulated by the bank regulators, frankly. And certainly, if the administration's plan to create systemic risk regulator is effectuated, that systemic risk regulator is likely to regulate, in addition to the functional regulator, any OTC derivatives dealer of any size at all.

SEN. REED: Thank you.

Ms. White, do you have a comment?

MS. WHITE: My portfolio is much narrower than the chairmen of the two commissions. But I would point to, we really do think it's important to move on these trade information warehouses so that we have the data for all of the contracts, non-standardized as well as standardized.

SEN. REED: Thank you very much.

SEN. JIM BUNNING (R-KY): Thank you.

For the chairman of the SEC, can and should the Securities and Exchange Commission require all reporting companies to disclose counterparties and reference entities and assets in their derivative portfolios?

MS. SCHAPIRO: Require public disclosure? If the relationships are material and they have material contracts with counterparties, they should be disclosed, at the risk of saying something incorrect here, in their public filings of their material to the companies.

SEN. BUNNING: I'm talking about -- you're talking about someone to regulate these people. I'm talking about --

MS. SCHAPIRO: So for example, if Boeing were to enter into a customized --

SEN. BUNNING: Customized or even -- yes, a customized one.

MS. SCHAPIRO: If they were regularly engaged in this market, I think that that should bring them under the umbrella of being regulated. But otherwise, I believe our view would be that we could get at the information through the dealer's requirement to keep records about counterparties, an audit trail of the transaction, all of the terms of reference of the transaction.

SEN. BUNNING: In other words, I'm asking about any entities.

MS. SCHAPIRO: Other than just dealers? I believe that we think we could get the information through access to all the dealer information about who they were --

SEN. BUNNING: I'm worried about people slipping through, like we have for the last 10 years.

MS. SCHAPIRO: And I share that concern very much with you. I think to the extent anybody did not have a dealer as their counterparty -- so a Boeing or another commercial company -- and they were engaged in this market with any frequency at all, we could get at that directly, but I believe we could get the information very clearly through our regulation of the dealer and access to the complete books and records of the dealer, where they would show that they were transacting with Boeing.

And of course, if the information is in a trade information warehouse or the transaction was done through central counterparty, we would have access to the information in that way as well.

SEN. BUNNING: Here's one for all of you. How do we prevent a clearinghouse or an exchange from being too big to fail? And should they have access to Fed borrowing?

MR. GENSLER: Senator, I think that we actually already have a number of clearinghouses that have been very well and successfully regulated for decades in the securities and options and futures markets. But if they were to fail, and they've been successfully regulated, they are systemically relevant already.

We are hoping that we will have large clearinghouses for derivatives. So I think all will be somewhat systemically relevant. And we, as you say, will need to sort of address this in statute as to that possibility.

SEN. BUNNING: Tell me how.

MR. GENSLER: Well, I think that they should be regulated, as they have been for decades, by the principal --

SEN. BUNNING: The clearing --

MR. GENSLER: The clearinghouses and exchanges be regulated by the principal market regulators, as each of our agencies have for decades. And the derivative regulation should embody that similarly. They should be regulated for risk management, making sure they have capital and margining and various practices on how they net the contracts and also regulation about their clearing members.

But at the same time, recognizing there may be something for the systemic regulator's interest to make sure that if they're going to be called upon in an extreme case to lend money, that they also have some authorities in addition to those of the principal regulators.

SEN. BUNNING: In other words, you wouldn't rule out the Federal Reserve as being a source they could go to in case of emergency?

MR. GENSLER: Well, I think that it has never happened.

SEN. BUNNING: No?

MR. GENSLER: But we can't rule it out, and we should make sure that -- and it's one of the lessons of this crisis is that we have to make sure that our statutes are up to date so that in an extreme circumstance --

SEN. BUNNING: That's what we're trying to go through.

MR. GENSLER: Right. So I'm agreeing with you, Senator.

SEN. BUNNING: Okay.

MS. SCHAPIRO: I don't have much to add to that. I would say that the securities clearinghouses did work very well in the last year under really extraordinary circumstances. But I think the last year also taught us that almost anything can happen that we haven't anticipated historically.

I think a real key for clearinghouses will be very robust risk management, so that they are very well-capitalized, they have effective oversight and real vigilance from the regulators, whether it's the Fed as a backstop regulator to clearance and payment systems or the functional regulators, the SEC and the CFTC.

It will be important for them to have conservative margin requirement. And very important for them to have procedures that are well-understood, very transparent for how they will resolve the default of a participant in the clearinghouse.

SEN. BUNNING: Ms. White, would you like to comment anyway?

MS. WHITE: The board believes that CCPs are critical utilities in the financial markets, and we think they need to be regulated, and they need to have risk management that would ensure that they carry out their functions in a sound manner.

They are, as you pointed out, subject to the possibility of needing liquidity in extreme situations. The administration has proposed broadening the Fed's ability to provide liquidity in extreme situations, and the board supports that.

SEN. BUNNING: Thank you very much.

SEN. REED: Senator Johanns.

SEN. JOHANNS: Thank you, Mr. Chairman.

One of the observations, at least that I have made, as I look back over the last months, is it seems to me that big got bigger, they got more tangled up on so many parts of the economy, very, very bad decisions were made, and you're off to the races.

And then the taxpayer was asked, or told, as in General Motors' case, that, guess what, they bailed them out.

If you're adding more regulation, capital requirements, transparency, somebody's going to have to comply with that within the dealers' organization. And there's going to be a cost to that.

Where, in your judgment, will the cost of that be borne? I mean, somebody has to pay for it. If it's the airline industry and they're hedging against the rising cost of fuel for their jets, won't consumers pay for that in higher ticket prices?

MS. SCHAPIRO: I'll take a stab at that. The cost of regulation clearly will ultimately be borne by consumers. And I think that's just a given historically and going forward.

It would be my fervent hope that the cost of regulation going forward would pale in comparison to the cost of what we've been through in the last year or two. But it does, I think, point out, very rightfully so, that we have to be sensitive to the cost of the requirements that we may end up proposing --

SEN. JOHANNS: You know -- and Chairman, gosh, I'm not debating that. I think some response to this is absolutely necessary. You know, I'm one of the people screaming about General Motors. I thought it was a very bad decision to buy the company. But having said that, we now own it.

I would hate to think that we're not doing something here that will protect taxpayers in the future. So that's not even really a debating point. But one of the things that I found out as secretary of Agriculture, once you try to do these overarching regulations and press those down upon the agricultural system, the large operators who had access to capital, et cetera, they tended to survive and get bigger, because they needed to get bigger to pay the cost of the regulations. The small operators went out of business. They just could not endure what you were asking them to endure. And over time, you ended up with exactly what we're trying to deal with here is the big got bigger.

MS. SCHAPIRO: Right. I completely agree with that. And I think we have to be sensitive to cost going forward. One of the segments of our financial services industry that actually weathered the past year reasonably well were smaller and medium-size financial institutions. And so I think it's -- which shows to me that the diversity of financial institutions in this country is an important safety and soundness feature in and of itself.

And I think it's going to be very important for the regulators, as we create -- a new regulatory structure of Congress empowers that, to be sensitive to cost, particularly those that will be borne by smaller and medium-size businesses that are very important ultimately to access to financial services for millions of Americans, who will not be going to the largest dealers.

MR. GENSLER: If I might, Senator, I'm actually quite the optimist at this table. I believe, for small firms, that this will actually lower cost of doing the standard products. And most small firms' hedging and interest rate risk, or maybe they're shipping product to Europe and they want to hedge a currency risk, they don't have transparency right now. And even a few basis points, which is a hundredth of 1 percent, costs something over the years.

I think lending greater transparency to these markets will benefit the many thousands of small businesses and municipalities in this country, particularly on the standard product.

SEN. JOHANNS: The transparency is not the issue. You can bring up the transparency, and I think everybody would love that. The issue is what they have to deal with every day to try to get their transaction done. And I'll just tell you, having worked with overarching regulations, I think, in the end, you hammer the little guy.

It just seems to me that the little guy is going to look at this and say, "I can't make it. I don't have enough where I can pass it on to the consumer," just like the person with 100 cows today is struggling to survive. And I just worry that what you're doing here is, unless you do something in that area, you're going to put the little guys out of business.

MR. GENSLER: Well, I think that you raise a very important point. And as we work together on this regulation and legislation, I look forward to talking more. But I think that they will also greatly benefit by lowering some of the risk and increasing transparency in these markets.

SEN. JOHANNS: Thank you, Mr. Chairman.

SEN. REED: Thank you very much.

Thank you for your excellent testimony. There may be additional questions that will be submitted to you for the record, and we're going to ask you to respond in a very timely fashion. But thank you very much.

Let me call forward the second panel.

MR. GENSLER: Thank you.

END.

Source