they then said we have corporate bonds. we better protect against them dropping in value and they bought some insurance and then said, well, we've got to pay for that insurance. we'll sell another form of insurance to create the revenues to pay for that, and pretty soon, they were in the position of doing what aig did, which was to sell lots of insurance very cheaply and when the bets went bad, they had to pay off. so it begins with this liquidity management issue, and that really hasn't been focused on much. what is the appropriate place to put your funds in between making loans so you are clearly in the deposit taking, loan making business and not in the hedge fund business? >> senator, i think that's a great question, and the rationale behind the liquidity management exclusion included in the rules was to make sure that banking entities would have sufficient, readily marketable assets to meet their short-term

liquidity needs, and we can agree that's critical to the safe and sound operation of a banking entity. and there is requirements around that that have to be a document liquidity management plan and criteria set out in the rule. but the question you raise really requires us to go back and look at that and see if we had carried that to its logical extreme, could we have anticipated what happened to jpmorgan and maybe we need to tighten this up and just look at it much more closely, much more carefully. in response to senator corker's question, this is very instructive. it would be wrong not to take this example as a real-life, real-world example of what can happen, whether it's the application of the cross-border provisions or the volcker rule itself, to use this example and to see what the impact would be of all the things we've proposed to do. >> so if you take the situation

that you have funds awaiting, making new loan, if you will, can be invested in a huge variety of things and essentially it is a gateway to be involved in proprietory trading, two, fund that went out the door, reduce liquidity and second introduces a lot of risk and complexity. chairman gensler? >> well, as derivatives and swaps regulator we're mostly going to be focused on the implementation of volcker rule with regard to swap dealers and futures commission merchants. i don't have as many views as chairman schapiro on the liquidity management piece, but if i could pick up on a second implied in there was, we received a letter from jpmorgan. all of us received, on our side of the regulators, in february, specifically saying that they thought we had to loosen up our

widen out the hedging exemption. we're entrusted by congress to figure how to prohibit proprietary trading so taxpayers don't stand behind these institutions. but permit market making and permit hedge chicago helps lower risk of these institutions. so it's that challenge. it's not an easy challenge, by the way, but i think you were very clear. it's got to be tied specifically to individual or aggregate positions. and i think congress was pretty clear on that, and it's instructive to me that it was actually february 13th that jpmorgan sent in like a 65-page letter and within that they said, you have to loosen up this portfolio hedging. so i think this has to be looked at in the context of their february letter as well. >> great. i'm out of time. so we're going to return to senator johanns. thank you. >> thank you, mr. chairman. thank you both for being here. madam chair, let me follow up on a statement you made a couple of

times during the hearing that i just want to understand better. you said that s.e.c. did not regulate the london branch that that actually was something over on the occ side. and i'm -- i'm trying to maybe take the next step here with my question. could this risk management that was being done by jpmorgan have been done in such a way that it would be under your jurisdiction, or are you just saying this doesn't fall within the purview of the powers given to me? >> if the trades were done in an s.e.c. regulated entity, broker dealer or ultimately when the rules are finalized, a security based swap dealer, then they would clearly be under the jurisdiction, excuse me, of the s.e.c. >> okay. which, of course, raises another question.

if i were running jpmorgan, couldn't i just set this up in a way to avoid you? >> well, that's an important issue that we're all wrestling with in the context of the cross-border release and how to apply our rules to activities that might not take place in the u.s. entity but might face a u.s. customer or take place in the affiliate of a u.s. entity but overseas or in a branch overseas. those we will lay out in our cross-border release. i think generally, a foreign entity with a foreign customer, we can feel reasonably comfortable that our title 7 rules wouldn't apply, but a foreign entity that's regulated -- registered with us with a foreign -- doing business with a foreign customer would likely be subject to our rules. a u.s. entity, including a branch of the u.s. entity

operating in a different country oish doing business with any u.s. person would have title 7 rules applying so we want to lay this out in detail for commenters. >> one of the concerns about dodd/frank, and it's been one of my concerns, is the more you crank it down, the more the regulations become more and more onerous. the greater need for people to hire lawyers and accountants and at the end of the day avoid you. >> that's why the international efforts were engaged and are really critical. they're painstakingly time consuming as we sit on a bilateral basis and multilateral basis with regulators in the other major markets and go through issues like pretrade transparency, post-trade transparency, margin t clearing

mandate, the exchange trading mandate and work through each issue to try to get the regimes as comparable as possible so that there isn't an opportunity for people to engage in regulatory arbitrage and just do their business in the least regulated market. but if it faces u.s. customers and has the potential to impact the u.s. financial system, we have to very seriously consider making that part of our mandate. >> mr. chairman, i want your comments on this. but before you comment, and i have no doubt you're working hard in the international arena and you want everybody to be as harmonized as a can be. but i've worked in that international arena in a position much like yours. you know, we would work days, weeks, months, years with the wto process, for example, with 150 countries trying to get people on the same page for

sanitary, phytosanitary issues and at the end of the day they all had their own agenda and interest. and some saw an economic benefit in doing something very different than what we were proposing they do. and before i take all the time go ahead, mr. chairman, because i could go on and on. i think this is a very serious problem. >> senator, i think you're right on both points. we'll ultimately have differences. we're working well together. but different cultures, different political agendas. there will be differences. and two, you're correct. modern finance, large complex financial institutions will rationally look to see if they can find the lowest tax regime and accounting regime that favors them. or regulatory regime to put customer money at risk with less capital. there will be differences and that rationally the large firms

will do all this. i did it once, when i was a co-finance officer of a large firm. we set up four to six legal entities in every jurisdiction. and long-term capital managements was in the cayman islands. and citibank's sivs originated in london but set up in the caymans. and aig financial products we think are in connecticut, they needed a bank license. so they went to france and got a bank license and put a branch in london. and the gentleman who ran it was running it out of london. all that risk came back here. so we have to be very careful to say, yes, there are costs on financial institutions. yes, there will be difference overseas, but the biggest cost is if we let the american taxpayer be at risk. so we're trying to cast this appropriately where there's direct and significant effect on u.s. commerce or activities that those transactions be in.

wall street rationally is advocating something different. if i was on the other side of the table representing them, i'd advocate something different than i enemy this job right now. so it's an interesting challenge. and we're not going to be as good as we hope to be. they'll get something by us and probably three to six years or ten years, somebody will say, you missed. they miggured out something in the mauricius islands or something. >> chairman schapiro, you've already indicated you don't have direct jurisdiction over the jpmorgan entity. but in this joint rule making, collaborative rule making, you are trying to define hedges in a way that covers the legitimate operations of financial institutions, minimizing their risk without allowing speculation. there is this tension, it seems, the tension between risk management and profit making.

and i know you've suggested so the criteria. do you have anything else to add in terms of this dilemma of defining a hedge so that it's properly protecting clients and protecting investments of the bank but not opening it up to speculation. >> i think that is the hard challenge the congress has given us. and i would say it's also true with the market making exemption as well. and we believe deeply that businesses have to be able to engage in both activities. market making to ensure our markets are operating. as efficiently as possible and hedging to reduce businesses' risk. and i think the criteria that are laid out are actually pretty good in terms of helping us keep the focus on hedging as truly hedging. you know, mitigating one or more specific risks of either individual positions or aggregated positions. the hedge itself, not giving

rise to significant exposures, at least at the inception but also monitoring and adjusting hedges if, as we've seen in some of the newspaper articles about the jpmorgan transactions, they morph into something else over time. that there be -- not be compensation programs and we've been working hard in the disclosure area with regard to compensation that really incentivize this outsized risk taking in a way that threatens the franchise by encouraging people to take bigger rinks than they should. the criteria are there. i think it's really incumbent upon the regulators to figure out how to write a rule that allows legitimate hedging to go forward as it needs to, but it must be really genuinely risk mitigating hedging and not anything people want to do called hedging. >> another variation that you have to deal with. and that is we've -- in

dodd/frank have end use or exceptions. for a nonfinancial company you could be doing hedging as an end user but you could also be very aggressive in your hedging. we saw the example of enron which was not, you know, a financial company but it collapsed because of very aggressive use of derivatives. is there anything that your contemplating in your rules or anything you are going to do to anticipate this type of problem? >> i think congress anticipated it because they included another category called major swap participant. i think congress said that if you are nonfinancial, you get to choose whether you are involved in this clearing and trading and we're suggesting through our margin rule that you'd get to choose on that, too. and i think -- but if you are so big that your major swap participant and you could be systemic, then you would be brought into this. could i answer your first question just a little bit?

i think chairman schapiro said it very well. one thing i would add is this concept of portfolio hedging can mean different things to different people. i think what congress said, it has to be tied to specific risk of individual or aggregate positions. and this experience reminds us maybe we have to go back and it maybe is tied to certain positions. it's not sort of like we think revenues will go up or we like the european debt markets these days. and one thing that, from my experience is these things sometimes morph or mutate into something else, particularly when set up as a separate business unit and separate compensati compensations. hedges generally lose money just about as many days as they make money because they are hedging something. the position is going up. the position makes money. the hedge loses money.

if the position goes down, vice versa. you set it up as a separate unit. maybe in a different country. different leadership. you start to -- it's prone to morph. >> i guess one of the -- just initial reaction and that is when you are -- you are an entity that's designed to be the risk manager and chastise everybody in the institution for being too aggressive or not response to risk is really one of your major profit centers. and that may be a sign that the roles are merging in a sort of unpredictable and unproductive way. just a final point i want to make is, you pointed out chairman gensler, the international interconnections here which suggest very strongly that our regulations have to be not only strong and internationally applicable, but we have to have people on the ground looking at these

institutions. if an american institution is going to locate their activities overseas, the comparable regulator, occ, should have not only have been there but been there in force with adequate personnel to look very closely at what was happening. and be the first line of defense if you will. >> i can't speak to them, but i think the system we have at the cftc unfortunately, or fortunately, doesn't contemplate that. we really have been kept reasonably small. we're just 10% larger than we were in the 1990s. and we rely foremost on the law and people complying with the law on the rules and the self regulatory organizations. we do examine the self-regulatory organization but we don't have people on site at any future commissions merchant. we don't have people on site at the clearing houses. that's just the reality of our funding and the decisions that have been made over decades in a bipartisan way. >> but just a point.

there's been questions consistently here today. when did you know? when were you aware of it? could you have anticipated it? recognized its occ's responsibility. if they don't have people on the ground sitting day-to-day in the desk, you won't know until some enterprise reporter breaks the news and by then, a lot of damage could be done. >> agreed. >> the other tremendous benefit we do get, though, will be when we have full reporting of these transactions and their transparency to regulators will make a big difference. >> thank you, mr. chairman. >> senator toomey. >> thank you both for being here. i'd like to follow up on a discussion that chairman gensler has been touching on but i'm a little confused about. and that is your views on the permissibility of hedging in the aggregate. i young just used the expression just a moment ago about portfolio hedging tied to specific positions. so i'm wondering if you could clarify that. if you tie hedges to individual specific positions on a one off

basis, and that is obviously the opposite of hedging an aggregate portfolio that has some cumulative net. so is it your view that it is and will continue to be permissible as well as cost effective to manage interest rate and currency and credit risks in the aggregate in these portfolios rather than limiting it to a one off individual basis? >> i think congress actually addressed themselves to this and said that it had to be tied to the specific risk of either individual or aggregate positions. but tied to the specific risk of some aggregate positions, to answer -- but it's got to be tied to -- >> so it could be the aggregate interest rate risk of a bond portfolio -- >> that may havebonds in it. >> so you could measure that and quantify that and hedge that. and then would the rule

prescribe the kinds of instruments that would be permissible to use to hedge that kind of portfolio? >> as written now, it speaks to, and this may change in a final rule, but as written out talks to instruments that are reasonably correlated with the risk. so it's all in that word reasonably. >> who decides what's reasonably correlated to the risk? ultimately the regulators do. >> well, through -- i think first order, the institution does. the firm does. but then there's a compliance program and the regulators would -- >> but the whole point of the rule is ultimately for you to set bands and say this is permitted and that's not. and that's the purpose of the rule? >> it is, though, as written, it's -- i would consider it more a principles based and compliance regime that the firm has to have policies and procedures to ensure that their hedges are reasonably correlated to the specific risks. >> but again, i think the

ultimate question in hedging is a question whof gof who gets to decide. there's an inherent risk in hedging. there's always some residual risk and there's always a subjective judgment call in large, complicated liquid markets like ours. there's a lot of options for anyone that wants to hedge any given portfolio. my concern that goes to the heart of what dodd/frank is all about. i think they are given an impossible task. and the task is to micromanage the activities of these institutions. that's what dodd/frank attempts to do. we're going to limit systemic risk by controlling everything you can do in great minute detail. let me give an example. chairman schapiro alluded to the challenges of establishing the market making exception. among the many specific rules that we're going to impose on

financial institutions, we're going to establish metrics that will quantify, for instance, how much income can be earned from the day one bid offer spread versus what can be earned from subsequent market moves. we'll have rules that will prescribe how much business a marketmaker must do with end users versus that done with the interdealer community. we're going to have to decide and have rules that will dig down into whether we're going to quantify these things at the level of the individual trader or will we aggregate several traders? or will we aggregate the entire trading floor? how will we do this? we're going to have to have rules that will establish which kintd kinds of asset classes are permitted to hedge which kind of risks. that has credit risk. can you short the s&p 500 against that? a proxy for credit risk or can you use credit default swaps? my point is, this has a huge cost. not just the direct staggering cost of compliance. but it also has a cost of less

liquidity because traders have fewer options. it's going to lead to less innovation because people are going to be prescribed very narrowly in what they can do. and it's going to have who knows what kind of unintended consequences as senator johanns observed when people realize it's just better to avoid this incredible micromanagement and go somewhere else, which is why i think, mr. chairman, we've gone down the wrong road here. the better solution is require more capital so that we can let people do what they want to do. let the people in the marketplace make the decisions they will make. and then let them live with the consequences without having the taxpayer at risk because we've required a sufficient buffer that a firm could lose 1% of their capital and in a recent example and not have everybody sweating bullets about it. frankly, firms ought to be able to make decisions and live with the consequences and taxpayers shouldn't be at raisk. i think the alternative of a

tougher capital regime achiefs the goal of reducing systemic risk without putting us in the impossible position of trying to run these institutions. >> senator hagen. >> thank you, mr. chairman, and chairman ginsler and chairman schapiro. thanks for your comments today and your commitments. chairman schapiro, in senator reid's discussion, you mentioned data collection. and will the s.e.c. start -- when will the s.e.c. start collecting that data, and where does the implementation stand? >> the security-based swap reporting data collection will begin when the rules are finalized, which they are not yet for regulation sbsr. i would -- it's hard for me to predict with a five-member commission exactly when we will have final adopting rules.

hopefully some time later this year. we have one set of rules left to propose and then we've done one final. we'll do another final and the next month or so hopefully and then a steady stream after that. it's important, obviously, i'm a big believer in transparency in the marketplace. and we have seen it work extremely well in other markets. we think it's critical for the public to have access to this information. and very critical for regulators to have access to this information. it's a discipline that ultimately translates to, i think, management as well to know that the regulators and the public can see the information. so when we do have the rules in place, we will have a quite granular information right down to the trader and the trading desk from which a particular transaction emanated. >> and i would say, and maybe to senator toomey's comments earlier, i think transparency is so critical, too.

i am hoping maybe i can convince you that in addition to capital transparency because as senator hagen said, in the credit default swap area and in interest rates and so forth, it will be later this summer, probably as soon as -- possibly as soon as august. and then in the commodity, oil and gas and the others, three months after that because we've already completed the rules. both for the public to see the trades, which i think is very big, and then for the regulators as well. >> chairman gensler, speaking about transparency, you and i have talked at length about that, especially in the swaps market. and i think we all do agree that transparency, obviously is critical to reducing the risk and creating the efficient markets. the market cdx north american investment grade you mentioned in your testimony, it certainly has received attention recently for the role it played in the losses at jpmorgan. and this index of credit default swaps contracts is a transparent

product that's standardized and priced daily. i'd like to hear your thoughts on the transparency of a product, such these cdx index and how that can reduce risk in the financial system. and then how could we see such large losses in this tradeable product and what lessons do you think our financial institutions will take from this incident? >> well, i think you're correct it's a rather standardized product. right now the dealers are into a clearing house, but as we complete the roles, the nondealer, the hedge fund positions will also come into the clearing house. regulators will get more transparency, seeing all of the trades, not only in the clearing house but in the data repository. for the public right now, there's not mandatory post-trade transparency. i think as that comes into being in the next several months, there will be a benefit that the public would see the pricing. now we mask the sizes. if somebody did a very large size trade, it just gets a plus

at the end. i apologize. i can't remember where it gets a plus whether it's at $100 million size or $200 million and credit default swaps, but i think the public will greatly benefit from such transparency in addition to the regulators. >> thanks. >> chairman schapiro, i wanted to ask about the value at risk. industry standard reporting metric that most of the financial institutions include in their 10k filings. can you discuss the value at risk and how it is used by the financial institutions and what are the rules regarding its disclosure? >> sure. the var or value to risk estimates give you the potential decline in the value of a position or a portfolio under normal market conditions. and i would say that raises one of the weaknesses of ours that it doesn't measure for you the maximum possible losses in a

portfolio that could occur -- could be incurred, particularly during very stressed market conditions. nonetheless, public companies are required to discuss their risk and they are given an option of three ways to go forward in their item 305 reg sk disclosure. when they have to give quantitative information about market risk, they can use a tabular presentation of the information. they can do a sensitivity analysis or they can do a var disclosure. and most financial institutions, in fact, choose to do that. they also have to disclose at the same time, though, any material limitations on the model, what it's not telling about risk exposures and when there are changes to the var model, as on the newspapers have reported was done at jpmorgan,

they change their var model. those changes have to be disclosed to the changes to the model characteristics also have to be publicly disclosed. >> and have you followed that at some of these other losses that have taken place in recent past how it impacted from the s.e.c. evaluations? >> our staff would look at -- well, particularly in the capital context where var is also used to allow firms to -- certain firms, a very small number of firms in fact, to use var to compute the market risk deduction from net capital. if they have large losses, we make them back test and provide us with full information about why their estimates of losses were so far off. >> thank you. >> senator schumer. >> thank you, mr. chairman. my first question relates a little to funding. we've heard a lot of people being critical. why didn't you