"THE LESSONS OF LONG-TERM CAPITAL
MANAGEMENT L.P."
REMARKS OF
BROOKSLEY BORN,
CHAIRPERSON
COMMODITY FUTURES TRADING
COMMISSION
CHICAGO KENT-IIT COMMODITIES LAW
INSTITUTE
CHICAGO, ILLINOIS
OCTOBER 15, 1998
I last addressed this conference two years ago, shortly after I
joined the Commodity Futures Trading Commission
("Commission" or "CFTC"), and I am pleased to be
back. I would like to discuss recent events in the over-the-counter
("OTC") derivatives markets and to share some thoughts about
the appropriate role of regulation in responding to them.
The events surrounding the financial difficulties of Long-Term Capital
Management L.P. ("LTCM") raise a number of important issues
relating to hedge funds and to the increasing use of OTC derivatives
by those funds and other institutions in the world financial markets.
Most of these issues were raised by the Commission in its Concept
Release on OTC Derivatives in May 1998. They include lack of
transparency, excessive leverage, insufficient prudential controls,
and the need for coordination and cooperation among international
regulators.
I welcome the heightened awareness of these issues that the LTCM
matter has engendered and believe that it is critically important for
all U.S. financial regulators to work together closely and
cooperatively on them. Therefore, I applaud Secretary of the Treasury
Robert Rubin's call for a meaningful study by the President's
Working Group on Financial Markets and look forward to working with
him and the other members of the Working Group. Swift regulatory
responses may well be needed to protect the U.S. and world
economy.
1. ���� Lack of
Transparency
While the CFTC and the U.S. futures exchanges had full and accurate
information about LTCM's exchange-traded futures positions through
the CFTC's required large position reports, no federal regulator
received reports from LTCM on its OTC derivatives positions. Notably,
no reporting requirements are imposed on most OTC derivatives market
participants. This lack of basic information about the positions held
by OTC derivatives users and about the nature and extent of their
exposures potentially allows OTC derivatives market participants to
take positions that may threaten our regulated markets or, indeed, our
economy without the knowledge of any federal regulatory
authority.
Furthermore, there are no requirements that a hedge fund like LTCM
provide disclosure documents to its counterparties or investors
concerning its positions, exposures, or investment strategies. It
appears that even LTCM's major creditors did not have a complete
picture. A hedge fund's derivatives transactions have
traditionally been treated as off-balance sheet transactions.
Therefore, even though some hedge funds like LTCM are registered with
the Commission as commodity pool operators and are required to file
annual financial reports with the Commission, those reports do not
fully reveal their OTC derivatives positions.
Unlike futures exchanges where bids and offers are quoted publicly,
the OTC derivatives market has little price transparency. Lack of
price transparency may aggravate problems arising from volatile
markets because traders may be unable accurately to judge the value of
their positions or the amount owed to them by their counterparties.
Lack of price transparency also may contribute to fraud and sales
practice abuses, allowing OTC derivatives market participants to be
misled as to the value of their interests.
Transparency is, of course, one of the hallmarks of exchange-based
derivatives trading in the U.S. Recordkeeping, reporting, and
disclosure requirements are established by the Commodity Exchange Act
and the Commission's regulations; prices are discovered openly and
competitively; and quotes are disseminated instantaneously. Positions
in exchange-traded contracts are marked-to-market at least daily, thus
ensuring that customers are always aware of the profit or loss on
their positions. This transparency significantly contributes to the
fact that U.S. futures markets are the most trusted in the
world.
A number of questions that commentators are now asking about the lack
of transparency in the OTC derivatives market in light of the LTCM
matter were raised by the Commission in its Concept Release on OTC
Derivatives. In that Release, the Commission specifically sought
comment on the need for recordkeeping and reporting requirements and
for disclosure by OTC derivatives dealers to their customers. At the
time that the Concept Release on OTC Derivatives was published, I
emphasized that neither the Commission nor I had preconceived notions
of whether changes in the regulation of the OTC derivatives market
were needed. Now, as a result of the LTCM episode and other
developments in the global economy in the past five months, I have
come to believe that more transparency is clearly necessary in the OTC
derivatives market.
I am not alone in this view. A report two weeks ago by the G-22 group
of industrialized and developing nations called for improved
transparency in both the public and private sectors, including an
examination of the feasibility of compiling and publishing data on the
international exposures of investment banks, hedge funds and other
large institutional traders. If reporting and disclosure requirements
had been in place in the U.S., some of the difficulties relating to
LTCM might have been averted.
2. ���� Excessive
Leverage
While traders on futures exchanges must post margin and have their
positions marked to market on at least a daily basis, no such
requirements exist in the OTC derivatives market. Reportedly, LTCM
managed to borrow approximately 100 times its capital and to hold
derivatives positions with a notional value of approximately $1.25
trillion � or 1000 times its capital. Indeed, it has been
reported that LTCM generally insisted that it would not provide OTC
derivatives counterparties with initial margin. LTCM's swap
counterparties and other creditors reportedly did not have full
information about its extensive borrowings from others and therefore
unknowingly extended enormous credit to it. This unlimited borrowing
in the OTC derivatives market � like the unlimited borrowing on
securities that contributed to the Great Depression � may pose
grave dangers to our economy.
The Commission's Concept Release on OTC Derivatives describes
many of the risk-limiting mechanisms of the futures exchanges �
including mutualized clearing arrangements, marking to market, margin
requirements, and capital and audit requirements. The Release requests
comment on whether similar protections are needed in the OTC
derivatives market. Some market participants have already answered in
the affirmative. For example, George Soros is among those currently
calling for margin requirements for OTC derivatives transactions. The
London Clearing House has applied to the Commission to permit clearing
of swaps. Clearing of OTC derivatives transactions could be a useful
vehicle for imposing controls on excessive extensions of credit. I
believe that it is essential for federal financial regulators to
consider how to reduce the high level of leverage in the OTC
derivatives market and its attendant risks.
3. ���� Insufficient
Prudential Controls
Closely related to the issue of excessive lending to LTCM is the
apparent insufficiency of the internal controls applied by the firm
itself and its lenders and counterparties. In the Concept Release on
OTC Derivatives, the Commission calls for comment on a number of
issues relating to the sufficiency of internal controls and risk
management mechanisms employed by OTC derivatives market participants,
including value-at-risk ("VAR") models. LTCM now stands as a
cautionary tale of the fallibility of even the most sophisticated VAR
models. The prudential controls of LTCM's OTC counterparties and
creditors, the parties that presumably had the greatest self-interest
in assessing LTCM's financial wherewithal, also appear to have
failed. They were reportedly unaware of the fund's extensive
borrowings and risk exposures. U.S. financial regulators urgently need
to address these failures.
4. ���� Need for a
Coordinated International Approach
International regulators have expressed concern for some time about
the lack of effective oversight of hedge funds and other large users
of OTC derivatives and their ability to avoid regulation by any one
nation in their global operations. Indeed, several emerging market
countries have attributed crises in their currencies and markets to
the actions of large hedge funds. The LTCM situation presents a new
opportunity for the Commission and other U.S. regulators to work with
authorities in other countries to harmonize regulation of the OTC
derivatives market and to implement international regulatory
standards. The recent report by the G-22 is an important step in this
direction and demonstrates a growing international consensus regarding
the need for increased transparency. A study by the G-22 of how to
implement reporting requirements will proceed more or less in parallel
with the President's Working Group study on the regulatory
implications of the LTCM episode. Important work by the International
Organization of Securities Commissions ("IOSCO") on the need
for transparency and large position reporting related to
exchange-traded derivatives will be useful to the G-22 study and the
President's Working Group study on OTC derivatives.
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In conclusion, there is an immediate and pressing need to address
possible regulatory protections in the OTC derivatives market. The
LTCM episode not only has demonstrated the potential risks posed by
the OTC derivatives market for the domestic and global economy, but
also has highlighted the importance of the safeguards in place for
exchange-traded futures and options. Obviously, regulation must be
adapted to the particular marketplace and must address the risks to
the public interest that that market poses. Thus, regulatory solutions
for exchanges are not necessarily appropriate for the OTC market.
Nonetheless, the markets involve similar instruments and pose many of
the same risks, and our successful experience with the U.S. futures
exchanges will be invaluable in the study of the OTC derivatives
market.
Thank you.