to put an end to the antiquated n r the usage of central clearing houses will bring considerable value to society, in the form of greater price transparency. their executions for all of the users on these, and for the less frequent users, such as smaller corporations and banks, and the reduced responsibility for any systemic risk regulator. regulatory framework for all us, including regional banks, insurance companies, pension plans and other pools of

investment capital. margin requirements and daily mark to markets will apply to all user0s of the clearinghouse. capital requirements on the trading of derivatives not cleared through a central clearinghouse should reflect the significance systemic risk they create and should be substantially higher than those in existence today. citadel has a vested interest in seeing the modernization of the 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 of 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 comingled with the other assets because customer markets are nor separated they could be lost in defaults. in times of stresses customer will rush to close out positions to cover their margin, this could intensify the problems last pam. the prices at which they could terminate contracts were often extremely unfair. customers now have access to high quality market data in today's pair time. 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 customerred to prudently manage their portfolios is substantially limited. the large dealers earn extraordinary profit from the lack of transparency in the market place and from the privileged role they play as credit enter immediate years in transactions. the current market structure suits the interests and leaves this 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 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 muchized derivatives with a properly heightened regulatory capital requirements and far clearer risk disclosures to nonfinancial end users. these arguments are nothing more than a strategy to on fuse skate the reel issues at hand, principally the need to bring much overdue modernization to our market place. this problem has an international dimension. we must work to coordinate our actions with for regulators otherwise we face the risk of cross-border arbitrage.

the status quo cannot be allowed to continue. we must work together to drive market structure, in a form that fosters orderly and transparent markets and 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 a answer your questions. >> thank you very much. mr. pickel, please. >> members of the subcommittee, thank you for inviting to us testify today. we're grateful for the opportunity to discuss public policy issues regarding the private and negotiated or otc derivatives business. our business provides essential risk management and cost reduction tools for many years. it is an important source of employment value creation and innovation for the financial system. i would like to underscore the industries strong commitment

identifying the risks in the business. we believe that otc derivatives off significant value to the customers who use them, the dealers who provide them and the financial system? general by enabling the transfer of risk between counterparties, derivatives exist to serve the risk management and investment needs of end uses and include over 90% of the fortune 500. the vast majority of these transactions are interest rate and current si swaps and equity and commodity derivatives and privately negotiated contracts. we recognize that the industries today faces significant challenges and we are urgently moving forward with new solutions. we have delivered and are delivering on a sear's of reforms in order to promote greater standardization and resilience in the markets. they have been closely overseen and encouraged about regulators who recognize that optimal exclusions to market issues are

usually achieved through par participation of market participants and we believe it is essential to tailor to the needs of the customers. let me hay sure that that the members clearly understand the need to act quickly to implement the important measures i will describe. last week president obama announced a comprehensive regulatory reform proposal for the finance industry. the proposal is an important step toward much needed regulation. the reform proposal addressed otc derivatives inmark consistent with the prososes made by treasury secretary geithner. it welcomed in particular the recognition of industry measures to safeguard smooth function offering the markets and the emphasis on the continuing need for the companies to use customized derivatives tailored to their specific needs. the administration proposes to require that derivative dealers

be subject to regulation. he supports the appropriate regulation of financial institutions that have a large presence in the financial system that their failure to cause systemic concerns. most of the other issues ratessed in the administration roz proposal have been addressed in a letter delivered to the federal reserve in new york earlier this month. 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 mass been committed to all with the goal of risk reduction transparency and liquidity. these initiatives include increased standardation of trading terms, improvements in the trade settlement process, greater clarity in the settlement of defaults, significant positive momentum towards counterparty clearing, and a more open industry governing structure in our letter though new york fed this

month the industry expressed our firm commitment to strengthen the resilience and robustness of the otc derivative markets. we're 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 extends -- steps toward that end. the otc industries are committed to engaging with supervisors globally to expand responsible the improvements made in our business since 2005. we no that further action is required and we pledge our support in these efforts. it's our belief that much additional progress can be made. our clearance si and transspeier sir initiatives are well underway with specific commitments aired publicly. as we move forward we believe the effectiveness of policies will be determined how well they

answer fundamental questions. will they recognize that otc derivatives play an important role in the u.s. economy. and will they enable the firms will these policy initiatives ensure the availability and affordability of these essential risk management tools to a wide range of end users. the otc derivative industry is an important part to the financial services business in this country and we help provide companies of all shapes and size. we are committed to assisting this committee in its consideration of these important policy initiatives. i look forward to your questioned. >> thank you very much. mr. whalen, please. >> mr. chairman, senator bunting, thank you for inviting me to be with to you today. i'm going to summarize a couple

key parts. i will be happy to submit that. >> submit it to us. >> i agree with many of the things that have been sunny day previous testimony and imencouraged by what i hear. happy you will take this as ananich session today because it's important that the congress build a complete public record on this issue and that will take some time. you have heard a lot about centralized clearing. i don't think anybody is opposed to that. it's part of the evolution of markets. whenever financial markets start the first few people figure out an opportunity never want standardation. they don't want people to know what they're doing because they're harvesting the biggest returns you'll ever see in that new market and over time as the crowd gets bigger they awe agree that standardization and consistency is important for the participants. the -- this is how all our

markets have formed. clearing is a bit of a canard. it's not really the problem. it's part of the problem. i also think that a lot has been said about information, a lack of transparency. again, who disaagrees with transparency in it's like motherhood and impeach everybody is for it in work -- and apple pie. everybody is for it. my views have changed over the last 20 years, i will be he first to admit as part of the learning process i think everything we deal with today, the systemic risk, the concern felt by buy-side investors. they don't want to know about the products. i particularly appreciate ken's comments from citadel. totally agree. to me the basic problem is not with the over-the-counter

dederivatives. they can validate the practice price immediately. where i think we have the big problem is when you allow the investment community to create derivatives where is there no visible cash market. in other words, we're creating the derivative of something that can only be val didded with a model -- validated with a model and all models are wrong. they're right a certain point in time but if they're not dynamic, the next day or next week it's all fake. so i think the key question we have to ask -- this goes back to the basic principles that underlie all of the futures and forward markets -- is if you can't see a real price, a cash price and price that reflects volume, reflect as large community of interest so that that price means something, how do you validate a derivative? that is supposedly based on that asset?

classic example. credit default swaps. these products essentially let you create a hedge for a corporate bond that is illiquid or loan for that cover. it's a wonderful thing. everybody in the market agrees, 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 we don't see, 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 ensured banks, for pension funds, for state and local agencies, that's probably a bridge too far. i am a simple 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. the beautiful thing is you never had any question what the swaps were worth, a@@@@@@@ @ @ @ @á if i have a cash basis, i do not mind if somebody is wanting to customize a contract. but when you allow sophisticated organizations to create vehicles that cannot be validated in the cash market place, this is something that is very difficult to address, particularly if the vast majority of the companies and the individuals, who are not, but had to make investment decisions. i was a supervisor for the investment bankers, and things like this means something to me. i worked for a very large retail branch networks and we always had to ask a question, are

reserving the banking customer, or the retail investors that we were going to sell these securities to. element of fairness, not just transparency, not just functionality and risk management but fairness, and i think this committee has to think about it. i look forward to your questions. >> thank you very much, gentlemen, for excellent testimony and focusing on a range of issues. let me start off with asking each one of you, there appears to be a commonnallity between the expect the cftc about the need to register dealers as one of the basic starting points for at least possible 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, is that one of the

top legislative testimonies we -- testimonies we should pursue. >> the supervision of dealers is extremely important. i think that as we have seen with aig, and the decisionmaking errors that aig had in terms of it 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 the decisionmaking errors can occur to what extent are the payoffs structures, the compensation structures within derivatives 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 we're spoused to be supervising, these rocket scientists developing these products. when did the risks arise inçf term0s deriff testify personnel there's high turnover. the risk may not arise until they're three banks away. in part of the process, we need look very carefully in terms of both in terms of as as an administrative matter in terms of how these error can arise in terms of the lob sided, weird compensation structures in the face of the financial economics of derivatives, both in terms deriverative dealers as well as 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. woe don't need to even look at today's' municipalities getting into trouble. there's fame news examples of the late 1980s involving english councils who decided the way to keep taxes down is by speculating on interest rates through interest rate swaps and dealingers went along with that. so in terms of this area, certainly one of the things we ought to look at is in terms of supervision of derivative dealers and look at the end user side, both no terms of issues like suitability and those kind 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 procter and gamble or what was gibson doing engaged in a live or squared interest rate swaps? so i think that there are issues all around in this area. >> thank you, doctor. mr. griffin, please. >> 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, their notion 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 would dramatically reduce because of their inherent netting the amount of notional risk in the marketplace and that reduces both operational risk and materially reducees counterparty risk. the market understanding of clear products is dramatically higher than the market's understanding of the paper contracts that define the market today. as pointed out, we 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. >> mr. pickel. >> i would focus on systemic risk issues and how do we prevent another aig type situation, and while regulation of dealers could be helpful in

that i think more importantly is have something window for regulator into risk and that would be achieved part live by the trade information ware houses, getting the information there where frankly all regulators have access. and secondly, what happened with aig is many of the counterparties were dealers and many of them were banks and overseen by bank regulatessors and 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 the window into risk and put on the brakes or make changes when the see the risk building. >> mr. whale '. >> i think as 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 that are very important within a dealer.

there's no question. as i was saying before, there are certain classes of instruments that you really can't risk man. ow were talking about before an airline that wants to put together a complex, customized swap for fume there's no problem with that. everybody knows what the price of fuel is today. and you do the work, you calculate the optionality and you can figure out what it's worth. the troublecomes if you look at the subprime complex structured asset market was that we head everybody in agreement, much like playing liars poker on the model being the definition of value for this class of instruments. one day a number of people on the buy side started to question that assumption. they started backing away from the securities, so did the dealers. so at in point -- it's hard to say win -- the consensus about value for that class of assets broke down. and that's where we are today. the buy side custom still does not want to know. so i question really how

effective risk management can be where we don't have a completely separate, independent reference point for value. >> thank you. senator bunning. >> 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? >> senator, i believe that one of the hallmarks of mature market is a well functioning margin paradigm where custom assets are egg segregated. in over 100 yours through wars and the great depression has never had a loss that needed to be neutralized because of the

appropriate margin requirements. what should be posted as collateral? you can post cash, you can post treasuries, variety of liquid, well understood assets and that's the right paradigm in my opinion. >> 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 chat a recall but you have to have significant haircut to apply to those to consider them, 50% or more to take them in as far as segregation of customer collateral, in the otc, talking about the customized peelings 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 rehypothecate or pass on collateral and use it for your own positions. i think there's room for greater

exploration of segregation of collateral so the customers can have the confidence that when something like a lehman brothers situation should happen they can get ahold of their collateral. so there's a lot of focus on that going forward. >> mr. whalen. >> i agree with in other speakers. segregation of collateral is something we need. the dealers mansion themselves tend to rely on overarching agreements and treaties to deal with collateral and exposure back and forth. if you mo of an exchange model everybody it treated the same and 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 have the clearinghouse or a trust company that is separate from the dealer. and i think that's an important distinction. >> this is for anybody. what economic value outweighs

the social cost of somebody being able to buy insurance in the form of swaps for asset that it do not own? turn it oven, please. >> 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 an insurance interest. all right? well, interestingly, the problems may be more difficult if you have insurable interests. met explain. whenup think about owning a bond or owning a loan, traditionally you have economic rights,

various affirmative covenants into loan agreement, and you have various right given to you under bankruptcy law, securities law, and other laws, and sometimes you have obligations, too. ... traditionally in the market practice, you see this package, the borrower is willing to give to the creditor, because he believes that the creditor would like to see this survive, to pay back the creditor. in today's world, what if the creditor is given $100 million, to conjure an extreme example, has given $100 million but will buy $200 million of credit defaults wants.

this is an extreme version of the of the creditor. in this example, you would have a creditor group rather than wanting to work for the borrower, he would love to make sure that the person goes into bankruptcy. even if you do not have this extreme example, if you have someone who has been lending money, they have a weaker incentive to avoid bankruptcy, and certainly if the borrower does not know that they have this. he does not understand what he's trying to negotiate, what is really happening. and if the bar were actually goes into bankruptcy, there becomes a some stances complication, within bankruptcy.