this. also, there could be chaos at the level of individual market participants, all drive activities, the bankruptcy of orange county in 1994, and in 1994 the huge derivatives losses at proctor & gamble, or perhaps that was appropriate. 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 o.t.c. derivatives conscious allow corporations to hedge against almost any kind of risk. . of risk which allows corporations to operate 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 how can we actually accomplish this? 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 know that this task is essential to make sure that food is indeed on the table for everyone. thank you very much. >> thank you very much, dr. hu. mr. griffin, please. >> chairman reed. senator bunting, 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

over sight of the otc derivatives market. the appropriate oversight is of paramount importance to at 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 if extreme measures must be taken to prevent the failure of a single firm such as bear stearns, which had just over $10 billion of shareholders 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 rules exceed several hundred trillion dollars and reflect the importance role of these risk transference contracts. the commercial justifications

for the market are well established and well understood. regret my as the market has grown to almost unimaginable scale the regular -- regulatory frame work -- now is the time to put an end to the antiquated practice of bilateral trading. the use of central clearinghouse open to up a participants will end the era of too interconnected to pavement the use of central clearinghouses will bring considerable value to society in the form of far greater price transparency, fairer executions for all users of the instruments, and in particular for less frequent uses such as municipalities, smaller corporations and local banks. far greater ease of regulatory oversight and reduced responsibility for any systemic

risk regulator. in addition, central clearinghouse will create a stronger regulatory framework for all uses, 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 reirements 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 the industry welcomed initial

measures to safeguard the smooth function of our markets and an emphasis on the continued need for companies to use customized derivatives to their special needs. it requires that all derivative dealers and others be subject to regulation. a private regulation of financial and other institutions this -- it could cause some systemic concerns. some of the other issues raised dealt with various market participants and a look at the federal reserve. the fed industry dialogue was initiated under the stewardship of the treasury secretary. much is achieved in much more has been done. it is with the goal of transparency and liquidity. it includes increased standardization of trading

terms, greater clarity in the settlement, significant positive momentum towards certain counterparties, and transparency in the more open industry gover. 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 a 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, and frankly i don't worry about customization. if i have a visible cash basis i don't have a problem if someone wants to muchize a contract. if you allow sophisticated organizations to create vehicles that cannot be validated in a cash marketplace we have created risk that is very, very difficult to address, and particularly for the vast majority of the companies and individuals who really are not competent to make investment decisions. irhaven't work as a supervisor

of investment bankers, treads and researchers, and things like suitability and know your customer means something to me. i worked with two firms that have very large retail branch networks and we always had to ask yourselves a question when we priced a deal, were we serving the banking customer and the retail investors we were going to release securities to. we had a deal to both sides of the trade and its that basic 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 maetplace 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