through your process however long it takes and have set the capitol requirements and i want to challenge that and appealing because i think the capitol requirements are too low why have the benefit to do that? can i slow the process down even further? >> i think it might not be the cftc but it will be the federal reserve or the sec said in capital in this regime but just as there is capital standards in the full oversight iowa -- i defer. >> is to analyze the risk of our doing business with each other and to demand collateral against the position we are creating some much of that and now the system would be required here is analysis that i think the dealers are very comfortable doing. the difference would be there would be government oversight

but i don't think we will have the capacity to second-guess every transaction whether there is was analyzed appropriately but we would expect the firms to stress test of their models and ensure the risk-management procedures are first class. ..

>> what about your system would have stop that? would your system have kicked in ats' mind and you would call the ceo of aig and shay you're at $200 billion and you're down, you can't do this anymore. would we have stopped aig? >> it's always hard in hindsight. i think 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, one that i learned when i was in the investment banking business but one i think it an

important one, is to value on a daily basis or weekly basis the risks that a firm mass -- has and put aside capital and margin and aig wasn't doing that. >> senator johanns we're doing another round this is a complex topic and we're fortunate to have the chairmen and chairman and miss white from the federal reserve. let me just ask one question. 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 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 importantódáies are in terms of legislative changes, and chairman you seem poised to answer. >> i was poised to let chair shapiro answer first. it's a very appropriate question and it's hard when one's president lays out a bold agenda and i think it's a bold agenda that president obama laid out. i think it's incumbent upon all of us to address this over-the-counter derivatives. so one of them is absolutely over-the-counter derivatives and i would say protecting consumers. the whole approach to having a strong, vigorous, oversight of the mortgage -- i think the mortgage sales practices in this country 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 -- the consumer side. >> i should be more specific. within the context of regulating over-the-counter derivatives or the derivatives market, any specifics? >> it's hard to bring -- break it done. if we're not able to fully regulate the dealers we bill not give the public the comfort they need. if we just did central clearing, which is a very good idea, and even if we mandate it women by -- we will have not covered the legitimate turn. >> let me turn to chairman shapiro. will there be a definitional debate about who is the cftc dealer and who is an sec deal

center because there's agreement that the dealers have to be regulated. >> i would agree with that and actually i could go so far as to say if we don't regular late the dealers we will realize the concern that there's not really any reason to go with standardized -- because with anonymity my continue to engage in otc derivatives through a dealer that we cannot adequately examine and inspect. i think that to the extent there are disagreements between the sec and the -- first of all most dealers were deregulate by the bank regular laters, frankly, and certainly if the administration is going to create a systemic risk deregulator, that regulator is likely regulate in addition to the regulation.

>> my portfolio is much narrower. we really do think it's important to move on these trade information warehouses so we have the data for all the contracts, nonstandardized as well as standardeesed. >> thank you very much. >> for the chairman of the sec, can and should the security and exchange commission require all reporting companies to disclose counterparties and reference entitieses and assets in their derivative portfolios? >> require public disclosure? if they are -- their 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 filing

of their material to the -- >> i'm talking about -- you're talking about someone to regulate these people. i'm talking about -- >> for example, if boeing were to enter into a customized -- >> or even -- yes, customized one. >> if they were regularly engaged in the market they should should be regulated but otherwise our view would be we could get at the information through the dealers' requirement to keep records about counterparties and audit trail of the transaction, all of the at the terms of rev lens. >> in other words, i've asking about any entities. >> other than just dealers. >> that's correct. >> i believe that we simply could get the information through access to all the dealer information about who they were -- >> are there worries about

people slipping through. >> i share that concern with you. to the extent that anyone did not have a dealer at 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 we could get the information very clearly through the regulation hoff the dealer and access to the complete books and record of the dealer where they would show they were transacting with boeing, and i if the information is in the trade, where trade information warehouse or the transaction central, we would have access to the information in that method, in that way as well. >> here's one for all of you. how do we prevent a clearing house or an exchange from being too big to fail? and should they have access to fed borrowing?

>> senator, i think that we actually already have a number of clearinghouses that have been very well and successfully regulated for decades and securities and options and futures markets, but if they were to fail, and they have been successfully regulated, their systematically relevant already. we are hoping we will have large clearinghouses for derivatives, so i think all will be somewhat systematically relevant, and we as you say, we need to sort of address this in stature as to that -- >> tell me how. >> well, i think that they should be regulated as they have been for decades. >> clearing -- >> the clearinghouses be regulated be the house regulators as they have been for decades and the regulation

should embody that similarly. regulate for mix management, how they net the contracts and regulation about the clearing members, but at the same time recognizing there may be something for the systemic regular laters' interest to make sure if they're called upon in an extreme case to lend money they also have authorities in addition to -- >> in other words, you wouldn't rule out the federal reserve as being a source they could go to in case of emergency? >> well, i think that it has never happened -- >> no -- >> but we can't rule it out and it's one of the lessons of this crisis, we have to make sure that our statutes are up to date so that in an extreme -- >> that's what we're trying to go through. >> i'm agreeing with you, senator. >> don't have much to add to

that. the securities clearinghouses did work very well in the last year under extraordinary circumstances but the last year taught us that anything can happen that we haven't anticipated historically, real key for clearinghouses will be robust risk management, that they are well capitalized, effective oversight and vigilance from regulatears, whether it's the fed as a backstop regulator or the functional regulators, the sec and the cftc. it will be important for them to have conservative margin requirements and procedures that are well-understood, transparent for how they resolve the default of a participant in the clearinghouse. >> would you like to comment in any way? >> the board believes that ccps are critical utilities in the financial markets and we think they need to be regulated and 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 meeting liquidity in extreme situations. the administration has proposed broad 'king the fed's ability to provide liquidity in extreme situations and the board supports that. >> thank you very much. >> senator johanns. >> thank you, mr. chairman. one of the observations at least that i have made as i went back over the last months is it seems to me that big got bigger, they got more tangled up in some 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 your adding more regulation, capital requirements, transparency, somebody is 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? 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? >> i will take a stab at that. the cost of regulation clearly will ultimately be borne by consumers and that's just a given historically and going forward. it would be my fervent hope that the cost of regulation going

forward would pail in compare son to what we have now but we have to be sensitive though cost of requirements we end up promoting -- >> chairman, i'm not debating that. i think some response to this is absolutely necessary. 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. one of the things 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 big tore pay the cost of the -- bigger to pay the cost of the regulation.

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. >> right. i completely agree with that. we have to be sensitive to costs going forward. one of the segments of our financial services industry that tellly weathered the past year reasonably well were smaller and medium-sized financial institutions, and so i think it's -- and which shows to me that the diversity of financial institutions in this country is important to safety and soundness feature in and of itself, and i think it's going to be very important for the regular laters as we create a new regulatory structure of congress to be sensitive to cost particularly those borne by smaller and made yum sized businesses who are very important to access to financial services for americans who will

not be going to the largest dealers. >> if i might, senator, i'm actually quite the optimist at this table. i believe for small firms that this will actually lower costs of doing the standard products, and most small firms hedging in interest rate risk or maybe shipping product to europe and want to hedge a currency risk, they don't have transparency right now and even a few basis points which it .01 of 1%, 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. >> 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 will 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 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, if -- unless you do something in that area, you're going to put the little guys out of business. >> 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 they will also greatly benefit by lowering some of the risk and increasing transparency in these markets. >> thank you, mr. chairman. >> 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 ask you to respond in a timely

fashion. thank you. we call for the second panel. >> thank you. [inaudible conversations] [inaudible conversations] >> welcome, gentlemen. let me introduce our second panel. our first witness is dr. henry yu, the allen finances chairs at the university of texas school of law. his research centers on corporate governance and financial innovation.

his article showed how financial institutions may make big mistakes. his work on the decoupling of debts has attracted a lot of attention including the current issue of the economyis. welcome. our next witness is mr. ken neglect c. griffen. head of citadel. they operate in major financial centers including london, chicago, hong kong, and san francisco. serves as vice-chairman of the chicago public education fund. our next witness is robert pickle. the executive director and chief executive officer of the international swaps and derivative associations the global trade association for over-the-counter derivatives. previously he was the general counsel of isda since 1997.

prior to joining isda he was in the legal department of an international oil and gas company from 1919 to 1997 -- 1991 do 1997. our fourth witness is christopher whalen, but mr. whalen is a proud resident of hudson, new york. they provide consulting services for audit tore, regular laters and he consults with global companies on a variety of financial and regulatory issues and the regional director of the professional risk managers international association and is a board adviser to a global business security risk in asia. -- huh, hu, would you please begin. >> mr. chairman and

distinguished members, thank you for this opportunity. i teach at the university of texas law school and my testimony reflects my view as an academic. i agreed to be working at the securities & exchange commission. i emphasize that i'm 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 but i will say tied does not reflect the views of the sec and has not been discussed with or reviewed by the sec. i ask that my written testimony be include in the record. this is a seminal time for the regulation of over-the-counter derivatives. my understanding is that the subcommittee want met to off a broad perspective as to undertaking this staff instead of analyzing specific elements of the president wednesday proposal. almost from the beginning of the otc derivatives market in the

late 1970s who you're arching vision have -- one is science run amok in the face of relentless competition, big financial institutions have hired financial scientists to develop now financial bugs, operating in an international whole sale market open to corporate and a paradise hiding from public view. the scientists relied on computers and models laden with incomprehensive greek letters, but danger lurks. absent these financial created, evolved and mutate exotic risk arise. they have caused havoc in the regional market in economies

worldwide. this first vision focuses on the chaos that is presumed to result from the innovational process. so the task at the level of the entire financial system so that what motivated the federal reserve's intervention in 1998, or in terms of the intervention in 2008 as to aig is representative of this. also, it could be chaos at the level of individual market participants, derivatives, the bankruptcy of orange county in 1994, and in 1994 the huge derivatives losses at procter and gamble or perhaps that company's name was appropriate. but there's also a second vision, one that is the converse of the first vision. here the focus is on the order,

from an otherwise chaotic universe made possible by the innovation products. derivatives, especially ot cs, can allow corps to hedge against almost any kind of risk which allows corporations to operate in a more ordered world. if the first vision is a injure was tick park gone awry, the second vision of the soothing hedges found in formal gardens. while the first version focuses on the private and social costs to derivatives the second is the benefits of otc derivatives and the essential task ahead is to try to reduce the costs of sump derivatives without losing their benefits. that's easily said. how can we actually accomplish this?

well, in my academic articles, i stress one theme, we must not just focus on the characteristic of individual otc derivatives, but also the underlying process of financial innovation through which products are invented, introduced to the market place and diffused. the process itself, not just individual derivatives, have regulatory significance because of the time limitation is referred 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 online entitled misunderstood derivatives, i argue that the particular characterricses of the modern financial innovation process will cause even the most sophisticated financial

institutions to make big mistakes has to derivatives. second, in terms of the gap 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 clearinghouse as to otc derivatives. third, one particular example of the innovation process, the so-called decoupling process, i have beginning in 2006 -- i have -- written a series of articles saying that the decoupling process can open up the core of the economic system so in the initial 2006 article

the focus on the equity side showed how you can have an empty voter phenomenon, for instance, the person holding the most number of votes in a company could be somebody with no economic interest or a negative economic interest, and similarly there's a hidle ownership issue. that 2006 article showed how some hedge funds have used equity swaps in efforts to avoid making disclosures under section 13d. 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 redders that with this empty creditor situation these creditors have much less insenttives than traditionally to make sure that their borrow ares stay out of bankruptcy. indeed, if they hold enough

credit default swaps it would benefit from the borrowers going into bankruptcy. in these times is it deeply troubling. let me conclude. three economic -- economists went hunting in he wild of canada. they were getting hungry and the see a deer. one shoots and misses three feet to the right. the other economist shoots and missed three feet to the right. the third economist didn't shut but shouts, we got it, we got it. it is very difficult to come up with a good model, much less one that would actually put food on the take. the task of coming up with a good model for regulating derivatives is no less difficult and all