Panel II 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

Witnesses: Henry Hu, Allan Shivers Chair in the Law of Banking and Finance University of Texas School of Law; Kenneth Griffin, Founder, President, and Chief Executive Officer Citadel Investment Group, LLC; Robert Pickel, Executive Director and Chief Executive Officer International Swaps and Derivatives Association, Inc.; Christopher Whalen, Managing Director, Institutional Risk Analytics

Chaired By: Senator Jack Reed

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SEN. REED: Welcome, gentlemen. Let me introduce our second panel.

Our first witness is Dr. Henry Hu, the Allan Shivers chair in the Law of Banking and Finance at the University of Texas School of Law. His research centers on corporate governance and financial innovation. A 1993 Yale Law Journal article showed how sophisticated financial institutions may make big mistakes as to derivatives. His work on the decoupling of debt and equity rights from economic interests has attracted wide attention, including, coincidentally, a story in the current issue of The Economist. So, welcome, Dr. Hu, and thank you.

Our next witness is Mr. Kenneth C. Griffin. He is the founder, president and chief executive officer of Citadel Investment Group, LLC, a global hedge fund and asset management firm. Citadel operates in the world's major financial centers, including Chicago, London, New York, Hong Kong and San Francisco. Mr. Griffin is also a member of several philanthropic boards, including serving as vice chairman of the Chicago Public Education Fund. Thank you, Mr. Griffin.

Our next witness is Mr. Robert G. Pickel. He is the executive director and chief executive officer of the International Swaps and Derivatives Association, or ISDA, which is the global trade association for over-the-counter derivatives. Previously, Mr. Pickel was the general counsel of ISDA, serving in that capacity since November, 1997. Prior to joining ISDA, Mr. Pickel was assistant general counsel in the legal department of Amerada Hess Corporation, an international oil and gas company, from 1991 to 1997. Welcome, Mr. Pickel.

Our fourth witness is Mr. Christopher Whalen, the managing director of Institutional Risk Analytics, a Los Angeles-based provider of risk management tools, but Mr. Whalen is a proud resident of Croton-on-Hudson, New York. They provide consulting services to auditors, regulators and financial professionals. Mr. Whalen leads the company's risk advisory practice and consults for global companies on a variety of financial and regulatory issues. He is also the regional director of the Professional Risk Managers International Association, and is a board advisor to I-OnAsia, a global business security and risk consultancy based in Hong Kong. Thank you, Mr. Whalen.

Dr. Hu, would you please begin.

MR. HU: Mr. Chairman, and distinguished members of the subcommittee, thank you for this opportunity. My name is Henry Hu. I teach at the University of Texas Law School, and my testimony reflects my preliminary views as an academic. In the interest of full disclosure, I recently agreed to begin working soon at the Securities and Exchange Commission. I emphasize that I am currently a full-time academic -- have been so for over two decades, and after this forthcoming government service, will return to my normal academic duties.

What I will say today does not reflect the views of the SEC and has not been discussed with, or reviewed by, the SEC. I have submitted written testimony. I ask that it also be included in the record.

This is a seminal time for the regulation of over-the-counter derivatives. My understanding is that the subcommittee wanted me to offer a broad perspective as to undertaking this task, instead of analyzing specific elements of the president's proposal. Almost from the beginning of the OTC derivatives market, in the late 1970s, two overarching visions have animated the regulatory debate:

The first vision is that of science run amok, of a "financial Jurassic Park." In the face of relentless competition and capital market disintermediation, big financial institutions have hired financial scientists to develop new financial products, often operating in a international wholesale market open only to corporate and sovereign entities. A loosely regulated paradise hidden from public view, these scientists pushed a frontier relying on powerful computers and esoteric models laden with incomprehensible Greek letters.

But, danger lurks. As these financial creatures are created, evolved and mutate, exotic risks arise. Not only the trillions of mutant creatures that destroy the creators in the wholesale market -- wholesale capital market, they escape to cause havoc in the regional market and in economies world wide. This first vision focuses on the chaos that is presumed to result from the innovation process.

So, the chaos could be at the level of the entire financial system -- so that, what motivated, of course, the Federal Reserve's intervention in 1998 of long-term capital management, or perhaps they should have called it something else; or, in terms of the intervention in 2008, as to AIG, is representative of this. Also, there could be chaos at the level of individual market participants -- (all derivatives ?), the bankruptcy of Orange County in 1994; and in 1994 the huge derivatives losses at Proctor and Gamble. But, perhaps that company's name was appropriate.

(Laughter.)

But, there's also a second vision, one that's the converse of the first vision. Here, the focus is on the order, the sanctuary from an otherwise chaotic universe made possible by the innovation process. The notion is this: Corporations and others are subject to volatile financial and commodities markets. Derivatives, especially OTC derivatives, can allow corporations to hedge against almost any kind of risk.

This allows corporations to operate in a more ordered world. If the first vision is that of a Jurassic Park gone awry, the second vision is that of the soothing, perfect hedges found in formal English and Oriental gardens. While the first vision focuses on the private and social costs to derivatives, the second vision emphasizes the private and social benefits of OTC derivatives. In fact, there are elements of truth to both visions, and the essential task ahead is to try to reduce the costs of such derivatives without losing their benefits.

Now, that's easily said. How can we actually accomplish this? Well, in my academic articles on this matter I stress one theme: We must not just focus on the characteristics of individual OTC derivatives, but also the underlying process of financial innovation through which products are invented, introduced to marketplace and diffused. That is, the process itself -- not just individual derivatives, have regulatory significance.

Because of time limitations, I simply refer to two or three examples, and only very briefly. First, the innovation process can lead to chaos by causing important market participants to make big mistakes. In an article published in 1993, in the Yale Law Journal, entitled, "Misunderstood Derivatives," I argued that the particular characteristics of the modern financial innovation process will cause even the most sophisticated financial institutions to make big mistakes as to derivatives.

Second, in terms of the gaps in information, as to this innovation process between regulators and the regulated, are extraordinary. That regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used. And so, beginning in 1993, I have urged the creation of a centralized informational clearing house as to OTC derivatives.

Third, one particular example of the innovation process, the so- called "decoupling process." Beginning in 2006, I have -- as a lead or sole author, written a series of articles suggesting that this decoupling process can effect the core disclosure and substantive mechanisms of our economic system. So that, in the initial 2006 article, the focus on the equity side, showed how you could have an "empty voter" phenomenon -- for instance, the person holding the most number of votes in a company could be somebody with no economic interests, or a negative economic interest. And, similarly, there is a "hidden morphable ownership" issue.

That 2006 article showed how some hedge funds and others have used -- (inaudible) -- equity swaps in efforts to try to avoid making disclosures under Section 13-D. In 2007, it suddenly occurred to me that the same kind of decoupling process can work on the debt side. So that, for instance using credit default swaps you could have creditors who are empty creditors. That, with this empty creditor situation you could have a system where these creditors have much less incentives than traditionally to make sure that their borrowers stay out of bankruptcy. Indeed, if they hold enough credit default swaps, they would benefit from their borrowers going into bankruptcy. In these times, this is deeply troubling.

Let me conclude. Three econometricians went hunting in the wilds of Canada. They were getting hungry, and they suddenly see a deer. One econometrician shoots and misses three feet to the right. The other econometrician shoots and misses three feet to the right (sic). The third econometrician doesn't shoot, but shouts, "We've got it. We've got it." (Laughter.) It is very difficult to come up with a good model, much less one that would actually put food on the table. The task of coming up with a good model for regulating derivatives is no less difficult. And we now all know that this task is essential to making sure that food is, indeed, on the table for everyone. Thank you very much.

SEN. REED: Well, thank you very much, Dr. Hu.

Mr. Griffin, please.

MR. GRIFFIN: Chairman Reed, Senator Bunning, members of the committee, I am Kenneth Griffin, president and CEO of Citadel Investment Group, and I appreciate the opportunity to testify and share our views regarding effective oversight if the OTC derivatives market.

The appropriate oversight if the OTC derivatives market is of paramount importance to the safety and soundness of our financial system. The events of recent months have made it abundantly clear that large financial firms are not too big to fail but rather too interconnected to fail.

The idea that extreme measures must be taken to prevent the failure of a single firm such as Bear Stearns, which had just over $19 billion of shareholder's equity and a few thousand employees, drives home the point that greater regulation of our financial markets is warranted.

Derivatives serve an incredibly important role in our financial markets. Current notionals exceed several hundred trillion dollars and reflect the important role of these risk transference contracts. The commercial justifications for this market are well-established and well-understood.

Regretfully, as this market has grown to almost unimaginable scale, the regulatory framework and market structure have not kept pace. Now is the time to put an end to the antiquated practice of bilateral trading. The use of central clearinghouses open to all market participants will end the era of too interconnected to fail.

The use of central clearinghouses will bring considerable value to society in the form of far greater price transparency, fair executions for all users of these instruments, and in particular for less frequent users such as municipalities, smaller corporations and local banks, far greater ease of regulatory oversight and reduced responsibility for any systemic risk regulator.

In addition, a central clearinghouse will create a stronger regulatory framework for all users, including regional banks, insurance companies, pension plans, and other pools of investment capital.

For example, margin requirements and daily mark to markets will apply to all users of the clearinghouse. Capital requirements on the trading of derivatives not cleared though a central clearinghouse should reflect the significant systemic risk they create and should be substantially higher than those in existence today.

Citadel has a vested interest in seeing this modernization of our financial markets. We, and several of the largest asset managers in the world, have united behind the CME Group in the development of a neutral, open access, central counterparty clearing solution for credit default swaps.

As part of a larger community of investors, we are committed to the improvement, safety and soundness of our financial markets. The commitment of many of the leading buy-side firms to a central clearinghouse reflects the inherent weaknesses in today's dealer- centric bilateral trading model.

For example, customers are often required to post initial margin to their dealer counterparties to initiate a trade. These funds are commingled with the dealer's other assets. Because customer margin is not segregated, customer funds could be lost in a dealer default. In times of stress, customers will rush to close out positions to recover their margin. This can intensify a liquidity crisis, as we saw last fall.

And last fall, when customers sought to mitigate credit risk by closing out positions with dealers, the prices at which they could terminate contracts were often extremely unfair. Customers do not have access to high-quality market data in today's paradigm, such as transaction prices.

This information is closely held and not broadly available. Customers require transaction data and accurate prices to understand the riskiness of their portfolios. Without this information, the ability of customers to prudently manage their portfolios is substantially limited.

The large dealers earn extraordinary profit from the lack of transparency in the marketplace and from the privileged role they play as credit intermediaries in almost all transactions.

The current market structure suits their interests and leaves their customers at a significant disadvantage. But the memories of AIG, Bear Stearns and Lehman Brothers, to name a few, should prompt, in fact demand, a swift and thoughtful response from our regulators and legislators.

Today the vast majority of credit default and interest rate swap contracts have standardized terms and trade in large daily volumes. Arguments have been advanced about the importance of customized derivatives, about the importance of these instruments, which represent a small percentage of total activity.

Customized derivatives are important, but they come with significant operational risk, model risk and financial risk. We should permit the continued use of customized derivatives with appropriately heightened regulatory cap requirements and far clearer risk disclosures to non-financial institutions and users.

In the end, I strongly believe these arguments are nothing more than a strategy to obfuscate the real issues at hand, principally the need to bring much overdue modernization to our marketplace.

This problem has an international dimension. We must work to coordinate our actions with foreign regulators. Otherwise, we face the risk of crossed border capital and regulatory arbitrage. The status quo cannot be allowed to continue.

We must work together to drive market structure, reform that fosters orderly and transparent markets, that facilitates the growth and strength of the American economy and protects taxpayers from losses such as those that we have witnessed in the last year.

Thank you for the opportunity to testify today. I would be happy to answer your questions.

SEN. REED: Thank you very much, Mr. Griffin. Mr. Pickel, please.

MR. PICKEL: Chairman Reed, Ranking Member Bunning and members of the subcommittee, thank you very much for inviting ISDA to testify today. We are grateful for the opportunity to discuss public policy issues regarding the privately negotiated or OTC derivatives business.

Our business provides essential risk management and cost- reduction tools for many users. Additionally, it is an important source of employment, value creation and innovation for our financial system.

In my remarks today, I would briefly like to underscore ISDA's and the industry's strong commitment to identifying and reducing risks in the privately negotiated derivatives business. We believe that OTC derivatives offer significant value to the customers who use them, to the viewers who provide them, and to the financial system in general by enabling the transfer of risk between counterparties.

OTC derivatives exist to serve the risk management and investment needs of end users. They include over 90 percent of the Fortune 500, 50 percent of midsize companies, and thousands of other smaller American companies.

The vast majority of these transactions are interest rate and currency swaps and equity and commodity derivatives. These are privately negotiated bilateral contracts that address specific needs of thousands of companies.

We recognize, however, that the industry today faces significant challenges, and we are urgently moving forward with new solutions. We have delivered and are delivering on a series of reforms in order to promote greater standardization and resilience in the derivatives markets.

These developments have been closely overseen and encouraged by regulators who recognize that optimal solutions to market issues are usually achieved through the participation of market participants.

As ISDA and the industry work to reduce risk, we believe it is essential to preserve flexibility, to tailor solutions to meet the needs of customers and the recent administration proposals, and numerous end users agree.

Mr. Chairman, let me assure you that ISDA and our members clearly understand the need to act quickly and decisively to implement the important measures that I will describe in the next few minutes.

Last week President Obama announced a comprehensive regulatory reform proposal for the financial industry. The proposal is in important step toward much-needed reform of financial industry regulation. The reform proposal addressed OTC derivatives in a manner consistent with the proposals announced on May 13th by Treasury Secretary Geithner.

ISDA and the industry welcomed in particular the recognition of industry measures to safeguard smooth-functioning of our markets and the emphasis on the continuing need for the company's to use customized derivatives tailored to their specific needs.

The administration proposes to require that all derivative dealers and other systemically important firms be subject to prudential supervision and regulation. ISDA supports the appropriate regulation of financial and other institutions that have such a large presence in the financial system that their failure could cause systemic concerns.

Most of the other issues raised in the administration's proposal have been addressed in a letter from ISDA that ISDA and various market participants delivered to the Federal Reserve Bank of New York early this month.

As you may know, a Fed industry dialogue was initiated under Secretary Geithner's stewardship of the New York Fed nearly four years ago. Much has been achieved and much more has been committed to, all with the goal of risk reduction, transparency and liquidity.

These initiatives include increased standardization of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum towards central counterparty clearing, enhanced transparency, and a more open industry governance structure.

In our letter to the New York Fed this month, Industry and the Industry -- ISDA and the Industry, expressed our firm commitment to strengthen the resilience and robustness of the OTC derivatives markets.

As we stated, we are determined to implement changes to risk management, processing and transparency that will significantly transform the risk profile of these important financial markets. We outlined a number of steps toward that end, specifically in the areas of information transparency and central counterparty clearing.

ISDA and the OTC derivatives industry are committed to engaging with supervisors globally to expand upon the substantial improvements that have been made in our business since 2005. We know that further action is required and we pledge our support in these efforts.

It's our belief that much additional progress can be made within a relatively short period of time. Our clearing and transparency initiatives, for example, are well underway, with specific commitments aired publicly and provided to policymakers. As we move forward, we believe the effectiveness of future policy initiatives will be determined by how well they answer a few fundamental questions.

First, will these policy initiatives recognize that OTC derivatives play an important role in the U.S. economy? Second, will these policy initiatives enable firms of all types to improve how they manage risk? Third, will these policy initiatives reflect an understanding of how the OTC derivatives markets function and their true role in the financial crisis? Finally, will these policy initiatives ensure the availability and affordability of these essential risk management tools to a wide range of end users?

Mr. Chairman and committee members, the OTC derivatives industry is an important part of the financial services business in this country, and the services we provide help companies of all shapes and sizes. We are committed to assisting this committee and other policymakers in its considerations of these very important policy initiatives.

I look forward to your questions.

SEN. REED: Thank you very much, Mr. Pickel. Mr. Whalen, please.

MR. WHALEN: Mr. Chairman, Senator Bunning, thank you for inviting me to be with you today.

I'm going to summarize a couple of the key points in my remarks, which are part of the record. I'd also like to ask that an interview that we published today with Ann Rutledge, who is a great colleague of mine and an expert on derivatives and structured finance be included in the record as well. I'll be happy to submit that.

SEN. REED: Yes, submit it to us, please, Mr. Whalen.

MR. WHALEN: You know, I agree with many of the things that have been said in previous testimony and I'm very encouraged by what I hear.

I hope you will take this as an initial fact-finding session today, because I think it's important that the Congress build a complete public record on this issue, and that will take some time.

You've heard a lot about centralized clearing. I don't think anybody's opposed to that. It makes sense. It's part of the evolution of the markets. Whenever financial markets start, the first few people who figure out an opportunity never want standardization. They don't want too many people to know what they're doing, because they're harvesting the biggest returns that you'll ever see in that new market. And over time, as the crowd gets bigger, they all agree that standardization and a certain degree of consistency is important for the participants. This is the way all of our markets have evolved in this country over the last century and more.

But I would tell you that I think that clearing is a bit of a canard. I don't think it really is the problem. I think it -- it is part of the problem. It was manifest in many ways over the last few years. I also think that a lot's been said today about information and about a lack of transparency. And again, who disagrees with transparency? It's like motherhood and apple pie. Everybody's for it.

But I think, in working with our clients and in talking through these issues -- and my views on these issues have changed over the last 20 years, I'll be the first to admit. That's part of the learning process. But I think that everything we deal with today -- the systemic risk, the concern that's felt by buy-side investors today, who are basically on strike -- they don't want to know about any of these products until the sell-side of the street meets their concerns. I particularly appreciate Ken's comments from Citadel. I totally agree with what they're saying.

But to me, the basic problem is not with most of the over-counter derivatives for currencies or interest rates. These are all fine. They have a visible cash-basis market that everybody can see, the buyer and the seller. They can validate the contract price immediately.

Where I think we have a big problem that may not be surmountable is when you allow the investment community to create derivatives where there is no visible cash market. In other words, we're creating the derivative of something that can only be validated for the model. And as we all know, all models are always wrong. They're right at a certain point in time, but if they're not dynamic, the next day, the next week, the next month, it's off-base.

So I think the key question we have to ask -- and this goes back to the basic principles that underlie all of the futures and forward markets in our country -- is, if you can't see a real price, a cash price, and a price that reflects volume -- it reflects a large community of interests, so that that price means something -- how do you validate a derivative that's supposedly based on that asset?

Classic example: single name credit default swaps. These products essentially let you create a hedge for a corporate bond that's illiquid or a loan for that corporation. Now, it's a wonderful thing. Everybody in the market agrees this is a great facility to have to be able to hedge an exposure that I can't create in a cash market. I can't borrow that bond to deliver it against a short position. It's illiquid.

So we have decided that instead of that price that we don't see, that we can't observe, we're going to use models instead.

I think that is a very tenuous, speculative basis for a market.

Now, there may be a certain class of market participants who can participate in such activities. But I think for federally insured banks, for pension funds, for state and local agencies, that's probably a bridge too far.

I'm a simple old guy. I started off in the early, early days of asset swaps and currency swaps, working in the London office of Bear Stearns in the mid-1980s. But the beautiful thing about that time is that you never had any question what the swaps were worth.

And frankly, I don't even worry about customization. If I have a visible cash basis, I don't mind if someone wants to customize a contract. I don't see what the problem is there. But the problem I do see is that when you allow sophisticated organizations that are a lot smarter than most of us to create vehicles that cannot be validated in a cash marketplace, we have created risk that I think is very, very difficult to address, and particularly for the vast majority of companies and individuals, who really are not competent to make investment decisions.

I've worked as a supervisor of investment bankers, traders and researchers, and things like suitability and "know your customer" mean something to me. I've worked for two firms that have very large retail branch networks. And we always had to ask ourselves a question when we priced a deal: Were we serving the banking customer? And were we serving the retail investors that we were going to release securities to when we did a deal?

We had a duty to both sides of the trade. And it's that basic element of fairness -- not just transparency, and not just functionality and risk management, but fairness -- that I think this committee has to think about. And I look forward to your questions.

SEN. REED: Well, thank you very much, gentlemen, for excellent testimony and focusing in on a range of issues. Let me start off with asking each one of you to -- there appears to be a commonality between both the SEC and the CFTC about the need to register dealers as one of the basic starting points for at least partial reform of the system. And we all recognize that this is a long road and a challenging one. So starting with Professor Hu, your sense of the dealer registration, how central is it? Is that one of the top legislative items we should pursue?

Could you put your microphone on, Professor?

MR. HU: Yes. I think the prudential supervision of dealers is extremely important. I think that, as we've seen with AIG and the decision-making errors that AIG had in terms of its serving as a CDS dealer, it tends to illustrate how it's important for the federal government to, in fact, get involved into issues as to how these errors can occur, how these decision-making errors can occur.

To what extent are the payoff structures, the compensation structures within the various units highly asymmetric? You know, big payoff if some product works and, at most, presumably, losing your job if it doesn't work. How financially literate are the people who are supposed to be supervising these rocket scientists developing these products?

When did the risks arise? As we all know, in terms of the derivatives personnel, there tends to be high turnover. The risks may not arise until they're three banks away. So that as part of this process, in terms of prudential supervision, I think that we really need to look very carefully in terms of -- both in terms of -- as an administrative matter, in terms of how these errors can arise in terms of really these lopsided, weird compensation structures, in the face of the kind of the financial economics of derivatives, both in terms of the derivatives dealers, in fact, as well as -- and this came up earlier, in connection with end-users.

In terms of end-users -- clearly, in terms of end-users, there's been a pattern throughout the history of OTC derivatives of very unsophisticated entities basically gambling and losing. We don't need to even look at like today's municipalities looking -- getting into trouble. There are some famous examples from the late 1980s involving English local councils -- Hammersmith and Fulham -- that basically decided, hey, the way to keep taxes down is by speculating on interest rates through interest rate swaps. And dealers went along with that.

So that I think in terms of this area, certainly one of the things that we ought to look at is in terms of prudential supervision of derivatives dealers; but also, to look at the end-user side, both in terms of issues like suitability and those kinds of things, as well as forcing much more disclosure in terms of these end-users as to their derivatives activities and the like. What was Proctor and Gamble, or what was Gibson Greetings doing engaged in LIBOR-squared interest rate swaps?

So, I think that there are issues all around in this area.

SEN. REED: Thank you, Doctor.

Mr. Griffin, please, your comments.

MR. GRIFFIN: Thank you so much. If I could -- (off mike) -- sorry about that.

SEN. REED: Yeah, that's all right.

MR. GRIFFIN: I would take a step back on the question and go, how do I simplify the regulatory oversight problem as much as possible? And central clearinghouses create a tremendous opportunity to reduce the size and scope of the regulatory oversight problem.

First of all, the notionals in existence today dramatically overstate the amount of economic risk being transferred but do not overstate both the operational risk and credit risk inherent in the system. Central clearinghouses will dramatically reduce, because of their inherent netting, the amount of notional risk in the marketplace. And that reduces both operational risk and materially reduces counterparty risk.

The market's understanding of cleared products is dramatically higher than the market's understanding of the paper contracts that define the market today. As ISDA pointed out, we've worked on reducing settlement problems in the system today, but we need to go back only a few years to when dealers had weeks and weeks of backlogs of unconfirmed and unprocessed trades, trades that could total into the hundreds of billions of dollars, for whom no one had taken the time to ensure they were properly recorded on the books and records of the institution.

Central clearinghouses with straight-through processing eliminate that dramatic operational risk.

This will then allow the regulators to focus their efforts around the customized derivatives that do have a role in the dealers' portfolios. It'll allow the regulators to spend their time focusing on the handful of contracts for which no standardized solution is appropriate. I believe that our regulators will have the ability and will acquire the abilities over time to find the people to understand the risks in the customized portfolios. To the extent they cannot, those products are not appropriate for regulated institutions to deal in. You cannot call an institution that is regulated well-regulated if no one actually understands the risks inherent in their portfolio, other than the 20-some-year-old traders that run the trading floors.

SEN. REED: Mr. Pickel, and then Mr. Whalen.

MR. PICKEL: Yes, I think what I would focus on, in terms of the priority, is systemic risk as issues, and specifically there, how do prevent another AIG-type situation? And while regulation of dealers could be helpful in that, I think more importantly (sic) is having some window for regulator sense of risk. And that will be achieved partly by these trade information warehouses that have been talked about, getting the information there, where frankly all regulators could have access to that, not just a systemic risk regulator, but all regulators.

And secondly, what happened with AIG is, each -- many of the counterparties were dealers, and many of them were banks and overseen by banking regulators -- they were each building up risk, but nobody was there to connect all the different dots, like a systemic risk regulator could, if established by the Congress, to give that window into risk and to put on the brakes or make changes when they see that risk building up in the system.

SEN. REED: Thank you.

And Mr. Whalen, your comments.

MR. WHALEN: I think it's an effective, practical question.

The chief purpose of regulation should be to focus on things like suitability and the customer-focused issues. Obviously systems and controls, risk management, all of that are very important within a dealer. There's no question. But as I was saying before, there are certain classes of instruments that you really can't risk manage.

You were talking before about an airline that wants to put together a complex, customized swap for fuel. There's no problem with that. Everybody knows what the price of fuel is today. And you do the work. You calculate the optionality in a complex structure. And you can figure out what it's worth.

The trouble comes if you look at the subprime, complex-structured asset market of a couple years ago -- was that we had everybody in agreement, much like playing liar's poker, on the model being the definition of value for this class of instruments. But one day, a number of people on the buy side started to question that assumption. They started backing away from these securities. So did the dealers.

So at some point, it's hard to say when, the consensus about value, for that class of asset broke down. And that's where we are today. The buy-side customer still does not want to know. So I question really how effective risk management can be, in those cases where we don't have a completely separate, independent reference point for value.

SEN. REED: Thank you.

Senator Bunning.

SEN. BUNNING: Yes.

Mr. Griffin, Whalen and Pickel, should parties to derivative contracts be required to post cash collateral? Or is other collateral acceptable? And is there any reason not to require segregation of customer collateral?

MR. GRIFFIN: Senator, I believe that one of the hallmarks of mature markets is a well-functioning margin paradigm where customer assets are segregated. If we look at the futures markets, we've had great success. The CME for example, in over 100 years -- through wars, through the Great Depression -- has never had a loss that needed to mutualized, because of their appropriate margin requirements.

Now, what should be postable as collateral? At the CME for example, you can post cash. You can post treasuries. You can post a variety of liquid, well-understood assets as collateral. And that is the right paradigm in my opinion.

SEN. BUNNING: Mr. Pickel.

MR. PICKEL: Yes.

As far as the types of collateral, I think, similarly cash and liquid instruments would be appropriate. There have been discussions about other types of securities that might be taken as collateral. But you would have to have significant haircuts applied to those, to even consider them, you know, 50 percent or something, in order to take them in.

I think as far as segregation of customer collateral, in the OTC -- I'm talking about the customized piece of the business -- the use of margin is extensive in that business.

And I think that one of the reasons it is used so effectively is that there is an ability to, as I say, rehypothecate or pass on collateral and use it for your own positions. But I think there is certainly room for greater exploration of segregation of collateral so that customers can have the confidence that when something like a Lehman Brothers situation should happen, they can get a hold of their collateral. So I think there's a lot of focus on that going forward.

SEN. BUNNING: Mr. Whalen?

MR. WHALEN: I agree with the other speakers. Segregation of collateral is one of those evolutions we badly need. But I think the other issue that we ought to touch on briefly is that the dealers amongst themselves tend to rely on overarching credit agreements and treaties to deal with all manner of collateral and exposure back and forth, whereas, if you move to an exchange-type model, everyone's treated the same. And whether you're a dealer or a customer, you have different tiers of collateral requirements, but the point is, there's a third party who holds the money. You don't have the dealer holding the collateral. You actually have the clearinghouse or a trust company that is separate from the dealer. And I think that's an important distinction.

SEN. BUNNING: This is for anybody. What economic value outweighs the social cost of allowing someone to buy insurance in the form of swaps for assets they do not own?

Turn it on, please.

MR. HU: Ranking Member Bunning, this is really very interesting, this issue, in terms of credit default swaps and the incentives, so that the state insurance people have argued, "Well, gee, you should not be able to buy credit default swaps unless you have insurable interest," all right?

Well, interestingly, the problems may actually be more difficult if you do have a -- from a social perspective -- more difficult if you have insurable interest rather than if you didn't have insurable interest. Let me explain. When you think about owning a bond or owning a loan, all right, you're a creditor. Traditionally you have economic rights -- principal and interest; you have various control rights, the various affirmative covenants and negative covenants in the loan agreement or bond indenture; and you have various rights given to you under bankruptcy law, securities law and other laws. And sometimes we have obligations too, right? It's this package of rights that you get as a creditor.

Now, in -- traditionally in market practice, you assume that, because it's a package, a borrower is willing to give to the creditor, for instance, these control rights because he thinks the creditor would like to see it survive, to pay back the creditor. Well, in the -- today's world, what if the creditor has lent, say, a hundred million dollars -- and, to conjure up a really extreme example, has lent the borrower a hundred million dollars but buys $200 million of credit default swaps?

SEN. BUNNING: That's right.

MR. HU: In that circumstance, this is an extreme version of what in 2007 I called an empty creditor. This is a really extreme version; doesn't happen very much. But in this extreme example, you would have a creditor who, rather than wanting to work with the borrower, for the borrower to avoid bankruptcy, hey, he would love to grease the skids to make sure that the person goes into bankruptcy.

Now, even if you don't have that extreme example, if you have a creditor with a -- you know, who has actually lent money, that creditor has much weaker incentives to work with the borrower to avoid bankruptcy. And certainly, if the borrower is not aware that the creditor has bought credit default swaps -- right? -- he doesn't understand when he's trying to negotiate with that creditor what's really happening.

And if the borrower actually goes into bankruptcy, there are all kinds of complications, disclosure and substantive complications, that arise within bankruptcy.

And in terms of whether this is real or not, in terms of whether this really happens in terms of this empty creditor phenomenon, I wrote an op-ed, as some of you know, in the April 10 Wall Street Journal about Goldman Sachs. There was a really curious incident that became -- an incident that became curious in retrospect. In September, as you'll recall, AIG was -- Lehman had collapsed; AIG was teetering. The Fed felt compelled to intervene to prevent AIG from collapsing. That September 16th, Goldman Sachs said its exposure to AIG was, quote, "not material." That's fine. All right?

But come middle of March, it turns out that of the initial 85 billion (dollars) of federal bailout money AIG received, about 7 billion (dollars) went to Goldman. Well, how do you reconcile that -- that is, Goldman receiving 7 billion (dollars), and yet, hey, it had no material exposure to AIG? Well, it turns out, and I suggest in the op-end, Goldman was an empty creditor; that is, Goldman had bought credit default swaps on AIG from, quote, "large financial institutions," so it really didn't care terribly much about what happened to AIG; and that it indeed was quite aggressive in terms of calling for collateral from AIG. So you have a system -- I'm not saying Goldman did anything improper.

SEN. BUNNING: No, but it didn't work.

MR. HU: Right. It -- well, what was interesting was it did work for Goldman, but it illustrates this issue -- social issue: Do we really want to --

SEN. BUNNING: Well, we're still -- as you know, Professor, we're still wondering where the bottom is on AIG.

MR. HU: Oh, absolutely. And I'm only using this to illustrate exactly the concerns you have, that is, you know, do we really -- as a public-policy matter --

SEN. BUNNING: That's right.

MR. HU: -- shouldn't we be concerned about these creditors who used to really care about ensuring that their borrowers kind of stay out of bankruptcy, that they have much less of an incentive to do that and that in today's world --

SEN. BUNNING: We better correct that.

MR. HU: -- we might want to consider correcting that, yes, sir.

SEN. BUNNING: Thank you very much, Mr. Chairman.

SEN. REED: Senator Johanns?

MR. GRIFFIN: I -- actually, I'd like to add to that answer, if that's okay, for a moment.

SEN. REED: Go ahead.

MR. GRIFFIN: So --

SEN. REED: (Off mike.) (Laughter.)

MR. GRIFFIN: It's -- and please do. (Chuckles.)

It's important that we think about all the different reasons why a company might want to use credit default swaps -- or a bank, for that matter. I, for example, could be in the supply chain of an industry and worried that the company to whom I supply goods or services may not actually perform. They may go into default. The ability to buy credit default swaps against that company makes it much more economically attractive for me, for example, to enter into a long-term sales agreement to provide goods and services to that company. I don't own the bonds, but I do have a position over time as being a creditor of that company as a supplier to them.

Another example -- and this one strikes home at Citadel, because we lend money to a variety of companies around the world and the United States, from small companies up to the biggest of the Fortune 500 -- there is often no market for credit default swaps for mid-size companies. If I want to be a significant lender to a portion of the economy where I absorb a substantial amount of industry risk -- for example, to the airlines.

Let's say I want to lend money to a regional carrier. I can't buy a credit default swap on that regional carrier. But I can buy a credit default swap on the majors, American Airlines, Delta and others. It will help me to manage the industry-specific risk that I have. And that, most importantly, reduces the cost of capital for the mid-size company, vis-a-vis the large company.

So credit default swaps play a very important role in allowing banks, pension plans and other lenders to mid-size companies in America -- to allow them to reduce their industry-specific risk and to reduce the cost of capital of the companies in America that have created the most jobs over the last 30 years.

SEN. REED: Mr. Pickel, I think everyone wants -- since it was an excellent question --

MR. PICKEL: Yes. He's got us going.

SEN. REED: -- and Senator Bunning deserves a good answer from everyone --

MR. PICKEL: Okay.

SEN. REED: -- but as briefly as possible.

MR. PICKEL: I would say that in the derivative space -- and this has been around for 25 years -- a lot of the developments were on market risk, interest rates, currencies, equities, commodities, where you're managing a market risk. Credit risk is a new -- relatively new derivative. And I would say that we're still understanding some of the implications of that. And I think that Professor Hu's work has been very interesting in that regard.

I would say that regarding that empty creditor issue, the fact is that every time somebody's going into the market and buying protection -- which is what he suggests and somebody's doing -- they're sending signals to that company: Your business plan isn't working. Your business plan isn't working. The yellow light's getting brighter and brighter and brighter. And so when it comes to the end and somebody says "Time's up. I'm not going to, you know, play -- I'm not going to continue to lend to you," I think that's a natural evolution of this market. But let's certainly understand that.

I would also just mention that credit default swap spreads are becoming embedded in various ways. There are being used for pricing loans. It was done with the Royal Bank of Scotland extension of credit by the U.K. government. And just today in The Wall Street Journal it was mentioned that S&P has developed an additional means of providing information on credit exposure to the marketplace that incorporates credit default swap spread. So we see continuing evolution here, and I think it ought to be encouraged, but understood, certainly.

SEN. REED: I'm going to recognize Mr. Whalen very quickly. Senator Johanns deserves his round of -- and then, at the end, if we have time, we'll --

MR. WHALEN: I'm not ever worried about two people on one side or another of the market. So if somebody wants to buy and sell -- you know, you've heard some very good examples of the utility of credit default swaps. The concern I have is that, again, the small airline, the small company doesn't have a traded market in its debt that we can use to price these contracts.

So we have, again, the liar's poker scenario, which is, you've got a trader at one firm and a trader at another, and they've decided that the implied spread on the debt of this company is a good way to price a default contract.

Okay, the trouble is, most people on Wall Street trade these instruments like options. They use them for delta hedging, various exposures. And again these are wonderful examples. They have great utility. But the problem is, I suspect, the pricing is wrong. In other words, it's not priced like insurance.

So when that contract goes into default and the provider of protection has to come up with the money, you've got to ask yourself, going back to the question about the supervision of dealers, is that person doing the work, so that they're actually cognizant of what the cost of default is, versus the spread on a bond?

Lehman Brothers; you could have bought protection on Lehman Brothers, the week before it failed, at 7 percent. The next week, you had to come up with 97 percent worth of cash. So you know, it's a pricing issue that I think is at the core here. It's not whether there's utility. There's obvious utility in all of these strategies.

SEN. JOHANNS: I'm hoping somebody can answer this question.

Of this whole bank business, kind of an inartful term, but of this entire business arena, what percentage would be of that classification that's not easily valued?

MR. WHALEN: Well, I think, most over-the-counter contracts don't have a problem in that regard. If you talk about energy, currency, whatever it is, if there is a rigorous traded-cash market, it's easy to come up with a derivative, even if it's a very complex derivative.

But when you're talking about illiquid corporate bonds or even loans to corporations, if you're talking about a complex-structured asset that's, say, two or three levels of packaging away from the reference asset that it's supposed to be derived from, that creates complexity in terms of pricing that, I think, is rather daunting.

And I'll tell you now. There are very few firms on the street that have the people, the resources and the money to do that work. Let me give you an example.

SEN. JOHANNS: Mr. Whalen, doesn't that get us to the point that I was raising in previous questioning?

You know, you've now got a whole regulatory scheme. You've got somebody that's going to regulate it. They're hired and paid not very much money. And they're probably going to take the safe route here and say, boy, I'm not sure I understand this. I'm not sure it can be valued. It's a $100-million contract. We want capital.

MR. WHALEN: And that's appropriate.

SEN. JOHANNS: Yeah.

Okay, so isn't that just another way of getting to -- I mean, how will capital be posted in a circumstance like this?

MR. WHALEN: Indeed.

SEN. JOHANNS: If you had the capital, you'd probably either loan it or not loan it. If it's a bad deal, you wouldn't loan it.

But anyway, what I'm getting to is this. Doesn't that basically put that segment of this arena out of business?

MR. WHALEN: It may. And I'm not sure that wouldn't be inappropriate. I'm sure my colleagues will disagree with me. But let me just put it to you this way.

I don't think, at the end of the day, that most people on Wall Street are confident to be a rating agency. And if you're talking about calculating the probability of default, of a company or a security, that is not a trivial exercise.

It takes a lot of work. And I don't think most people on Wall Street do it. They look at the Bloomberg terminal. And by consensus, they've all agreed that the spread on the Bloomberg terminal, when you put it in this model, is the price they're going to deal on, whether it's right or not.

SEN. JOHANNS: You know, and I would say to you, Mr. Whalen, listening to your testimony just from a sterile standpoint and saying, well, you know, if it's that kind of risk, maybe it should be out of business, that's probably okay, unless that's the only regional airline in town. And when that one goes away, guess what, air transportation for half of Western Nebraska goes away.

MR. WHALEN: Well, I don't know any airlines that can't hedge their fuel costs in the --

SEN. JOHANNS: Well, I'm not talking about fuel costs. But you know what I'm getting at here. There are always unintended consequences. And I just want to understand them. If we're going to put a lot of little guys out of business, tell me that.

MR. WHALEN: Well, here's the thing. I want your little guy to have the same facility of pricing a contract as the dealer.

SEN. JOHANNS: How do we do that?

MR. WHALEN: That goes to transparency. But you know what; if I have transparency of an instrument that's still opaque, even after I've legislated transparency, then I have a problem.

SEN. JOHANNS: And the tool we've been given, I think, in the end is going to be the capital requirement. That's the ultimate protection. And boy, when you talk about what we require, you're talking about cash, treasuries. It sounds to me like you're really talking about cash. You're probably not going to take something very risky here, right?

MR. WHALEN: I think the standardized market could bring those costs down over time, I really do.

SEN. JOHANNS: Yes, Mr. Pickel.

MR. PICKEL: Senator, yes. You know, in the credit default swap area, we have introduced a very high degree of standardization to, I think, your first point about which of these contracts would be most standardized. And I think that in the credit default swap space we do have contracts that will be very easily to move into a cleared environment, perhaps more so into electronically traded or even exchange traded environment.

So those things are in place and, yes, I mean people look to Bloomberg screens, but it is a collective view of the marketplace; I mean, not arise on Wall Street. We've got very active dealers around the world who are expressing views on these contracts. And it's that collective reflection of the market judgment that indicates the spread at any particular point in time.

MR. GRIFFIN: I think the question that you are posing about capital and will the regulation of this market increase the amount of capital required in the marketplace;. The answer to that question is not as clear-cut as one might imagine. The reason for it is in today's silly market structure, if I buy a credit protection contract from Goldman Sachs, I'm just as likely to eliminate my economic risk, but not my counterparty risk by closing that contract out with Morgan Stanley.

I will still be posting margin as a customer to both of those firms. It's incredibly inefficient. If I had a central clearinghouse, I would open the contract with Goldman, clear it to a clearinghouse, close it with Morgan Stanley, clear it to a clearinghouse. And I would have no capital as a customer out the door any longer. I'd actually have capital that comes back to me net-net.

I think it's a very important concept to understand when we think of clearinghouses, this will not in any way necessarily increase the amount of capital demanded of the system as a whole because of the tremendous efficiency inherent in netting.

The other key concept that we should keep in mind is that price transparency will most favor the smaller, less frequent users of derivatives -- Citadel, the other world's largest asset managers. We can price all of the derivatives that we commonly trade with a great degree of precision, but we have a tremendous investment in infrastructure to do so. For smaller companies, that's outside their range of capability, but an exchange, a visible exchange traded price gives the CFO of a small company confidence that he's getting a fair deal. And part of what we want our capital markets to do is to create confidence in all Americans that our markets are fair, they are transparent and they are just because that reduces the cost of capital for every company in America.

SEN. JOHANNS: You know, Mr. Griffin -- and I'll wrap up with this, Mr. Chairman, appreciate your patience -- nobody is going to disagree with your last speech. Boy, that's about as motherhood and apple pie as we can possibly get. Nobody disagrees with that. It's -- like I said, I just want to know if this is where we're headed, what impact is it going to have on the marketplace from the very small to the very large. My experience is the very large survive and they get bigger.

MR. GRIFFIN: Actually, you would be surprised where our analysis on this ends up. Today, the largest dealers have a de facto monopoly in the business. It's because of their credit rating and privileged position as credit intermediaries to almost every contract. They earn extraordinary economic profits.

Where there's a clearinghouse -- for example, in the options market, the U.S. options market, the OCC acts as a clearinghouse for all listed transactions -- you find that there's a vibrant, an incredibly vibrant market of smaller trading firms that add a tremendous amount of liquidity to the marketplace.

Citadel, for example, is the single largest options marketmaker in the United States. We started it from scratch seven years ago, with zero market presence. Our ability to get to number one was because of a lack of barriers to entry. We were allowed to compete on a level playing field with other incumbents.

In the credit default swap or interest rate markets, the barriers to entry are enormous. Who would want to take as a counterparty anyone but, quote-unquote, the firms viewed today as "systemically important" or "too big to fail"?

SEN. JOHANNS: Here's -- again, to wrap up the second time -- (chuckles) -- here's what I would ask. If there are that many small firms out there that are going to benefit from this, my address is online, my phone number is online. Mr. Pickel, you probably represent some big and small people. Boy, I hope they overwhelm me with letters over the next 72 hours, or e-mails, saying, "Mike, this is great. We want this to happen." Because I am worried and concerned, and I don't want this in the end to create a situation where, literally, by our regulatory effort, we have damaged and created the very phenomena that we're -- that this hearing is for; and that is, the big just got bigger, to the point where literally we're all scratching our head about "too big to fail."

I think if we looked back in 20 years and found out that's where we ended up here, that would be a tragedy.

Thanks for your patience. I really appreciate it.

SEN. REED: Thank you, Mr. Chairman.

I want to thank you all, gentlemen. There are additional questions by our colleagues.

I think also that Professor Hu has been trying to get recognized. Can I give you a minute?

MR. HU: (Off mike.)

SEN. REED: All right. Put on your microphone, and you have a minute.

MR. HU: I think that these clearinghouse arrangements that we're moving into will reduce systemic risk. They will reduce the profits, in a sense, now available to derivatives dealers. You know, it will be cheaper for everybody in terms of these standardized products.

I think that one of the very interesting issues to think about in connection with these clearinghouse arrangements and the data that we're now going to be requiring of all derivatives -- in terms of customized derivatives, for instance, one of the real issues is how to solve this informational asymmetry between regulators and regulated.

So, for instance, in terms of this general movement to more information being provided to regulators, to what extent should regulators actually ask for model information? Regulators can't develop them, you know, can't understand how to value these things, unlike Citadel. To what extent should they actually require this kind of proprietary information? And if we require this kind of proprietary information, boy, how do we maintain safeguards in terms of respecting the proprietary nature of these things? So I think that this is a start of a very long process.

SEN. REED: Well, thank you. You have the last word this evening, but not the last word, because it is a long process. But this testimony has been excellent. Some of my colleagues might have written questions, which they will forward to you. We'd ask you within two weeks to please respond. Your -- all of your written testimony's part of the record. And I thank you all for excellent testimony and for your presence this afternoon, and I will adjourn in a hurry. (Gavels.)

END.

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