REGULATORY PERSPECTIVES ON THE

OBAMA ADMINISTRATIONS FINANCIAL

REGULATORY REFORM PROPOSALS, PART I

HEARING
BEFORE THE

COMMITTEE ON FINANCIAL SERVICES

U.S. HOUSE OF REPRESENTATIVES
ONE HUNDRED ELEVENTH CONGRESS
FIRST SESSION

JULY 22, 2009

Printed for the use of the Committee on Financial Services

Serial No. 11166

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WASHINGTON

53246 PDF

2010

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HOUSE COMMITTEE ON FINANCIAL SERVICES

BARNEY FRANK, Massachusetts, Chairman
PAUL E. KANJORSKI, Pennsylvania
MAXINE WATERS, California
CAROLYN B. MALONEY, New York
LUIS V. GUTIERREZ, Illinois
ZQUEZ, New York
NYDIA M. VELA
MELVIN L. WATT, North Carolina
GARY L. ACKERMAN, New York
BRAD SHERMAN, California
GREGORY W. MEEKS, New York
DENNIS MOORE, Kansas
MICHAEL E. CAPUANO, Massachusetts
N HINOJOSA, Texas
RUBE
WM. LACY CLAY, Missouri
CAROLYN MCCARTHY, New York
JOE BACA, California
STEPHEN F. LYNCH, Massachusetts
BRAD MILLER, North Carolina
DAVID SCOTT, Georgia
AL GREEN, Texas
EMANUEL CLEAVER, Missouri
MELISSA L. BEAN, Illinois
GWEN MOORE, Wisconsin
PAUL W. HODES, New Hampshire
KEITH ELLISON, Minnesota
RON KLEIN, Florida
CHARLES A. WILSON, Ohio
ED PERLMUTTER, Colorado
JOE DONNELLY, Indiana
BILL FOSTER, Illinois
CARSON, Indiana
ANDRE
JACKIE SPEIER, California
TRAVIS CHILDERS, Mississippi
WALT MINNICK, Idaho
JOHN ADLER, New Jersey
MARY JO KILROY, Ohio
STEVE DRIEHAUS, Ohio
SUZANNE KOSMAS, Florida
ALAN GRAYSON, Florida
JIM HIMES, Connecticut
GARY PETERS, Michigan
DAN MAFFEI, New York

SPENCER BACHUS, Alabama

MICHAEL N. CASTLE, Delaware
PETER T. KING, New York
EDWARD R. ROYCE, California
FRANK D. LUCAS, Oklahoma
RON PAUL, Texas
DONALD A. MANZULLO, Illinois
WALTER B. JONES, JR., North Carolina
JUDY BIGGERT, Illinois
GARY G. MILLER, California
SHELLEY MOORE CAPITO, West Virginia
JEB HENSARLING, Texas
SCOTT GARRETT, New Jersey
J. GRESHAM BARRETT, South Carolina
JIM GERLACH, Pennsylvania
RANDY NEUGEBAUER, Texas
TOM PRICE, Georgia
PATRICK T. MCHENRY, North Carolina
JOHN CAMPBELL, California
ADAM PUTNAM, Florida
MICHELE BACHMANN, Minnesota
KENNY MARCHANT, Texas
THADDEUS G. McCOTTER, Michigan
KEVIN McCARTHY, California
BILL POSEY, Florida
LYNN JENKINS, Kansas
CHRISTOPHER LEE, New York
ERIK PAULSEN, Minnesota
LEONARD LANCE, New Jersey

JEANNE M. ROSLANOWICK, Staff Director and Chief Counsel

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CONTENTS
Page

Hearing held on:

July 22, 2009 .....................................................................................................
Appendix:
July 22, 2009 .....................................................................................................

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39

WITNESSES
WEDNESDAY, JULY 22, 2009
Gensler, Hon. Gary, Chairman, Commodity Futures Trading Commission
(CFTC) ...................................................................................................................
Schapiro, Hon. Mary L., Chairman, U.S. Securities and Exchange Commission (SEC) .............................................................................................................

10
8

APPENDIX
Prepared statements:
Garrett, Hon. Scott ...........................................................................................
McCarthy, Hon. Carolyn ..................................................................................
Gensler, Hon. Gary ...........................................................................................
Schapiro, Hon. Mary L. ....................................................................................
ADDITIONAL MATERIAL SUBMITTED

FOR THE

RECORD

Schapiro, Hon. Mary L.:

Written responses to questions from Representative Royce .........................

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REGULATORY PERSPECTIVES ON THE

OBAMA ADMINISTRATIONS FINANCIAL
REGULATORY REFORM PROPOSALS, PART I
Wednesday, July 22, 2009

U.S. HOUSE OF REPRESENTATIVES,

COMMITTEE ON FINANCIAL SERVICES,
Washington, D.C.
The committee met, pursuant to notice, at 10 a.m., in room 2128,
Rayburn House Office Building, Hon. Barney Frank [chairman of
the committee] presiding.
Members present: Representatives Frank, Kanjorski, Maloney,
Watt, Sherman, Moore of Kansas, Capuano, Baca, Lynch, Miller of
North Carolina, Green, Cleaver, Moore of Wisconsin, Klein, Wilson,
Perlmutter, Foster, Carson, Speier, Minnick, Driehaus, Kosmas,
Himes; Bachus, Castle, Royce, Lucas, Biggert, Miller of California,
Capito, Hensarling, Garrett, Neugebauer, McHenry, Posey, Jenkins, Lee, Paulsen, and Lance.
The CHAIRMAN. The hearing will begin. We are very happy today
to have before us two Presidential appointees who head important
agencies: the Chair of the SEC, Mary Schapiro; and the Chair of
the Commodity Futures Trading Commission, Gary Gensler. I want
to begin by saying I am very happy that both agency heads are
here. I strongly believe that if we were starting from scratch, we
would not have two separate agencies, with the extent to which
they share a mission. But we do have the two separate agencies.
There is no point in wasting energy in trying to consolidate them
when there would be no chance of that happening. I am encouraged
by the fact that the two Chairs here today have, from the beginning of their appointment, worked closely together to try and avoid
friction.
I have to say that in my view, jurisdictional fightswhether between congressional committees or among congressional committees or between or among Federal agenciesrepresent Washington
at our worst, because the job getting done well ought to be the
issue. And people who insist thatpeoples egos get too tied up
with their positions. We are working hard to avoid that. I have also
been working closely with Chairman Peterson of the Agriculture
Committee because there is a shared jurisdiction here. And we
have come to a very good agreement on substance. We had the
hearing a week ago with the Secretary of the Treasury an unusual
hearing with two major full committees. We intend to keep doing
this. There will be some disagreements I believe at the edgesI am
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2
reluctant to say margins here because it will get too doubly interpretedbut at the edges, there may be some disagreements.
They clearly are outweighed by the substantial agreement that
we have. So one of the questions will be on derivatives. Another
will be in our jurisdiction which, we should be clear, is primarily
the SEC. I appreciate the fact that Mr. Gensler is here. This committee is not the committee of jurisdiction for him.
Mr. Peterson, in the spirit of cooperation, understands that. If
Mr. Peterson would ask Chair Schapiro to appear before Agriculture, I dont know if you have yet, but we would encourage that
as well, because we dont want these jurisdictional issues to be
there. With regard to derivatives, I will tell you the conceptual approach that Mr. Peterson and I have taken, Mr. Petersons committee has the jurisdiction over those for whom hedging is a part
of their business. That is, the Agriculture Committee are more the
end users of this who have a product to sell and who hedge because
they want to deal with price volatility. Our jurisdiction is more
over the people who do some of the hedging and are in the financial
area.
The concept, it seems to me, we ought to be guided by here is
what we ought to be thinking about with the financial institution
in general. Their role is to be intermediaries, not to be ends in and
of themselves. When there is a breakdown in the financial sector,
we call it disintermediation. Their job is to be a very important, I
was going to say bridge, but bridge understates the creativity involved. There is nothing passive about their role, but their job is
to link up essentially people in the end of the economy who are producing goods and services of value and the people with money to
invest in them. Their job is to help us in this society agglomerate
investment funds so that they are made available to the end users.
Obviously, people arent going to do that unless they make a
profit off it. That is a very important and sometimes complex business. People arent going to make their money available unless they
make a profit. But I do think that over the past couple of decades,
there are some examples in the financial sector of the means becoming the ends. We have had people tell us that we should not
restrict or regulate this or that because then certain entities would
not be able to make money. Yes, it is important that they make
money as a by-product of the intermediation function they perform.
The fact that a given institution wont make money is, in itself, no
reason to be opposed to this. And, in fact, activities whose major
justification is that they make a profit for some entity unconnected
to that intermediation function are not going to be well received by
us.
I will now add, finally, this is not just about derivatives, we have
other issues, this committee has been very interested in the whole
question of mark-to-market. The gentleman from Pennsylvania has
played a major role there. And there is also continued interest in
the question of short sale and corporate governance. I will say that
two of our members, the gentleman from California, Mr. Campbell,
and the gentleman from Michigan, Mr. Peters, in a bipartisan way,
have a great interest in corporate governance issues. And I expect
the committee will turn to them this fall after we have done some
of the major regulatory stuff. But both of those issues are, particu-

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3
larly the short sale and the mark-to-market, are going to be before
us today. The gentleman from New Jersey is recognized for 3 minutes.
Mr. GARRETT. Thank you, Mr. Chairman, and thank you, members of the panel. Todays hearing is on the Presidents financial
regulatory reform proposals. You know, your agencies oversee some
of the most transparent, efficient, and complex markets in the
world that are also responsible for ensuring that our capital markets promote price discovery, capital formation, and investor protection.
Now, the Administrations reform proposals task the SEC and
the CFTC with developing a regulatory infrastructure for over-thecounter derivatives and reporting to Congress by September 30th
on how the agencies will harmonize two very disparate regulatory
approaches. So I look forward to hearing from you to see how well
those are coming together and where some of your sticking points
are going to be, if there are some, I think there will, and whether
you will be able to meet that deadline. You know, with regard to
the Administrations proposals, I agree with some of them. I think
it is evenhanded and certainly less radical than other ideas that
have been proposed so far in Congress.
Still, there are some aspects of the Administrations proposals
that trouble me. And I am worried that in the name of systemic
risk reduction, requirements that would force more OTC transactions into central clearinghouses or onto exchanges, as well as
strident new margin requirements for both centrally cleared and
noncentrally cleared transactions will make hedging just too expensive for many end users of derivatives throughout the broader economy. The perverse outcome, therefore, of efforts to reduce systemic
risk in these markets can actually increase risk for many companies if they are no longer able to cost effectively engage in a comprehensive risk management practice.
So if you take a step back for a moment, perhaps an even more
fundamental question should be asked here: Were standardized derivatives significantly related to the recent meltdown of our financial markets, and if not, why are we prescribing cures for a nonexistent ailment? You know, the failed oversight of one large dealer
directly related to broader regulatory failures in the housing finance markets should not cause us to pursue radical fixes for the
broader OTC derivative markets and their nondealers participants
that had little or really nothing to do with the recent crisis.
What we do need is comprehensive regulatory reform, but it
needs to be sensible and we need to make sure that we are addressing actual problems in the way that we are doing it and not
causing more harm than good. The risk of mobile capital migrating
elsewhere as we overshoot the mark in regulatory reform, I think,
is a real one and we should take the time to carefully evaluate the
proposals presented to us before we move ahead with legislation.
So once again, thank you both for coming to the panel today,
thanks to the people who have been here numerous times in the
past as well. Thank you.
The CHAIRMAN. Let me just, to balance, because we have the
time, I call on the gentleman from Texas for 1 minute, Mr. Neugebauer.

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Mr. NEUGEBAUER. Thank you, Mr. Chairman. I appreciate the
witnesses providing us with their views on the Administrations
regulatory proposals as well as an update on their efforts to find
more harmonization between futures and securities regulation.
While there are differences in the products in marketplaces, there
is quite a bit of overlap in regulation. One concern I have heard
from those with products that fall under both regulators is the
length of time it takes to get new products approved in the process
for determining whether the product falls under the CFTC or the
SEC. We all want our proper transparency and disclosure but we
also need the regulatory process to be effective. I am also interested in hearing from Chairman Gensler about the upcoming hearings at the CFTC regarding hedge exemptions and positional limits
in energy futures. We have had quite a bit of discussion on this
issue in the Agriculture Committee over the past couple of years
and added new authorities for the CFTC in the 2008 farm bill.
As the CFTC weighs options, we must maintain efficient price
discovery and open market and keep the United States competitive.
As we continue to work through these issues, we must remember
that government regulations cant substitute for the due diligence
for investors and other market participants.
The CHAIRMAN. The gentleman from Pennsylvania, the Chair of
the Subcommittee on Capital Markets, Mr. Kanjorski, for 3 minutes.
Mr. KANJORSKI. Thank you very much, Mr. Chairman. Among
other matters this morning we will address the need for effective
regulatory oversight of the over-the-counter derivatives market estimated at $500 trillion in notional value. These reforms are long
overdue. Fifteen years ago, I first advocated for increased regulation of our derivatives market. When I helped to introduce the Derivative Safety and Soundness Supervision Act, we sought to enhance the supervision of derivatives activities of financial institutions. Since then, I have endorsed other legislation aimed at improving transparency in and enhancing the oversight of our derivatives markets. Our witnesses today, SEC Chairman Mary Schapiro
and CFTC Chairman Gary Gensler, have an important task before
them. They must reposition their agencies to better respond to the
crises of today and the problems of tomorrow.
Fortunately, both of these leaders come equipped with extensive
experience and a commitment to effective regulation. While this
crisis also seems to me the ideal time to merge these two agencies,
political judgments have led us down a different path. Thankfully,
however, the two seem determined to work together constructively
rather than battle over jurisdictional turf. These two Chairmen are
working within the Obama Administration which will soon release
legislative language on derivatives reform and with Congress can
help to create a more transparent, safer, and less risky over-thecounter derivatives market. To increase investor protection and
market confidence, we must make this reform effort a top priority.
Most fair-minded observers have acknowledged that unregulated
derivatives, such as the credit default swaps, played a significant
role in contributing to our present financial crisis. AIGs disastrous
abuse of these potentially explosive financial instruments represents the most glaring example of the dangers to our system

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5
posed by derivatives. By moving forward, we should remain sensitive to the highly varied nature of derivatives products. Derivatives that consist of highly accustomed contracts which thousands
of nonfinancial businesses, both large and small, employed to managed risk simply do not easily fit within the mandatory clearing
and exchange trading regime. By mandating the collection of certain data on such contracts in a repository even where they cannot
be cleared, we can achieve transparency and access for regulators
in the hope that we can detect warning signs of systemically risky
transactions. And by requiring increased capital reserves for those
who enter into unique derivatives contracts, we can also provide incentives for markets to standardize these complex financial products going forward.
In closing, Chairman Schapiro and Chairman Gensler can help
Congress to sensibly regulate this dark corner of our financial markets. I look forward to their testimony.
The CHAIRMAN. The gentleman from Delaware, Mr. Castle
Mr. CASTLE. Thank you, Mr. Chairman.
The CHAIRMAN. for 1 minute.
Mr. CASTLE. I appreciate this opportunity to further explore the
Administrations regulatory reform proposal, particularly looking at
securities and futures related reforms in particular. A lot has been
said about derivatives; currency derivatives, interest rate derivatives, and the like. And I will be interested to hear what the witnesses have to say about the over-the-counter trades and cleared
and exchanged trades of derivatives. All of these are issues before
this committee and the organizations our witnesses represent. Although I believe registering hedge funds and reforming credit ratings are integral pieces of financial reform, I maintain that we
must fully vet the consequences of the entire proposed regulatory
reform plan. I hope to hear from the witnesses today about their
views on the reform proposal and areas that may need some improvement.
In particular, I am curious to know if you believe that there will
still be gaps in regulation between agencies, if investors will be
protected as expected, and whether the SEC and the CFTC will
have the resources necessary to carry out the requirements proposed under these reforms. Thank you. I yield back, Mr. Chairman.
The CHAIRMAN. The gentleman from California, Mr. Royce, for 1
minute.
Mr. ROYCE. Thank you, Mr. Chairman. Why has the SEC in the
course of the past dozen years experienced catastrophic failures in
every one of its four core competencies: rule making; filing review;
enforcement; and examinations? This was the question raised by
former SEC Commissioner Paul Atkins recently. And I think it is
a tough question that needs answering prior to giving additional
authority to the SEC. Mr. Atkins goes on to note that Enrons corporate filings were not reviewed for years in the late 1990s, enforcement examinations tips were not pursued on Bernie Madoff,
and again, potentially in the Allen Stanford fraud case.
In rule making, the Commission proposed in December of 1997,
and again in April of 2005, regulations regarding credit rating
agencies, but never adopted any of those. According to former SEC
Chairman Harvey Pitt, the enforcement examination failures in the

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Bernie Madoff case may have been the result of the SEC developing a blind spot because it is overlawyered and lacked the necessary traders, managers, and veterans of the market. This is certainly also the view of Harry Markopolos who, for years, tried to
bring this Ponzi scheme to the attention of the SEC. Before increasing the SECs regulatory authority, I hope we can get to the
bottom of these series of failures. Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman from California, Mr. Sherman,
for 112 minutes.
Mr. SHERMAN. Mr. Chairman, thank you for holding this series
of hearings on the Obama Administrations White Paper. At yesterdays hearing, I relied on secondary sources to agree with a witness
that the resolution authority set forth in the White Paper involved
a permanent unlimited bailout authority. In fact, page 77, paragraph 2, of the White Paper, does support that witness conclusion
in large part because the Treasury has been so bold in interpreting
whatever statutory authority we give them. Secretary Paulson
boasted that he went far beyond any authority.
And of course, the bill has been used to bail out auto companies
and to recycle funds, both real stretches of the statute. So the onus
is on us to draft a statute that cannot be stretched or manipulated
by any Treasury no matter how bold. And it is especially, the onus
is on us to make sure that any bill we pass does not provide a permanent bailout authority. Whether that is a fair reading of what
the Obama Administration wants or not, it is certainly not what
the people of this country expect us to do. So I look forward to revisiting the Chairmans statements that sometimes duplication is
better than ambiguity, and in this case, I may argue for
triplication. I yield back.
The CHAIRMAN. If the gentleman will yield, we will be glad to do
that at a hearing at which that is the subject, which is not today.
The gentlewoman from Illinois is recognized for 2 minutes.
Mrs. BIGGERT. Thank you, Mr. Chairman. Thank you for holding
todays hearing. And welcome, Chairman Schapiro and Chairman
Gensler. I am very interested in the Administrations evolving
ideas regarding regulatory reform. I am interested in hearing from
you all today about the discussions with the Administration about
OTC derivatives clearing and reporting. How will the Administration define standardized and customized OTC derivatives? Will new
rules include trigger mechanisms that will mandate that OTC
products be electronically traded, cleared or reported to a central
database for review. Which firms or trading will fall into these
three buckets?
I think I want to hear your views on the recently House-passed
cap and trade bill, which includes a transaction tax. Taxing transactions to raise Federal revenues for more spending or creating an
unnecessary burdensome regulatory environment may force U.S.
businesses and jobs to move overseas. Our economy cant afford it.
I also look forward to you addressing concerns about the SECCFTC regulatory harmonization, specifically concerns about the inefficiencies of the SECs rule-based approach to regulation.
My fear, which I think is shared by many in Chicago, is that an
effort to harmonize regulations between the SEC and the CFTC
may slow down market innovations and give international competi-

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tors an unfair advantage. It is crucial that we strike the right balance, not overreact and fashion sound regulation to address the deficiencies in the current regulatory environment. With that, I yield
back.
The CHAIRMAN. The gentleman from California, Mr. Miller, for 1
minute.
Mr. MILLER OF CALIFORNIA. Thank you, Mr. Chairman. In recent
months, it has become increasingly clear that accounting policy has
tremendous impacts on the credit markets which are experiencing
recovery efforts by the financial stability plan. Specifically, the
issue of mark-to-market has not been adequately addressed. In
fact, private market activities, lending and investing, as well as recovery efforts, remain hamstrung by pricing challenges while the
accounting policymakers have been willing to or are unable to offer
the necessary guidance.
The TALF program is an example. Under TALF, assets that investors owned that were placed as collateral are held in non-markto-market accounts to shield the investors from the exposure. To
me, this indicates the problem with the current pricing regime and
accounting policymakers ability to address the issues in a meaningful manner. More recently, FAS has made changes to the accounting standards that will have a tremendous impact on
securitization known as FAS 166 and 167. These enormous changes
are occurring at the same time that the Administration is trying
to restart the securitized credit markets to facilitate private lending.
It is our understanding that the Federal Reserve has serious concerns with the policy shift that will derail efforts to stabilize financial institutions and get credit flowing. Why is there a disconnect
between policymakers who own significant issues at a time when
we are experiencing extraordinary economic circumstances. There
is tremendous challenge facing the $6 billionokay, I guess my
time is over. Thank you, Mr. Chairman.
The CHAIRMAN. The gentleman from Massachusetts is recognized
for 112 minutes.
Mr. LYNCH. Thank you, Mr. Chairman. I want to thank our panelists. I appreciate the frequency of these hearings to try to get a
sense of the Administrations White Paper on regulatory reform. I
would like to hear from the panelists during their testimony about
the issue of these complex derivatives being traded over-thecounter. I still believe, in spite of the Administrations position, we
have a big payday problem with the major banks, so I think a lot
of money is going to gravitate to the OTC version of these things.
There is no exchange, so we dont have a consistent valuing mechanism in place. And I just think that the complexity here is
incentivized under the Presidents proposal.
I raised these issues with Secretary Geithner in the meetings
that the chairman has arranged, but I still dont think the protections are there. So I would like to hear the answer to that in your
testimony. And I yield back the balance of my time. Thank you.
The CHAIRMAN. The gentleman from Texas for 1 minute.
Mr. HENSARLING. Thank you, Mr. Chairman. I am disappointed
in the Administrations regulatory reform plan for a number of reasons, one of which is it doesnt seem to make sense of our current

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existing regulatory structure as much as simply adding new regulatory structure on top of it. Again, the premise is wrong that we
suffered from a lack of regulation. It wasnt lack of regulation, it
was regulators making a mistake, and frankly, some dumb regulation. I know that one of the members brought up the AIG matter.
I would have all my colleagues recall that the regulators said, do
you know what, we had the expertise, we had the regulatory authority, we had the manpower, we just missed it. And so maybe
there are things we can do to help make regulators smarter. I am
not sure that necessarily argues for more regulation. I continue to
be concerned that if you hamper or customize OTC derivative contracts, firms will find it more challenging to hedge their risk, that
means less credit, which means less job opportunities in an economy that has the highest unemployment in 25 years. We must do
better.
The CHAIRMAN. We will now begin with our statements. And we
will start with Chairman Schapiro.
STATEMENT OF THE HONORABLE MARY L. SCHAPIRO, CHAIRMAN, U.S. SECURITIES AND EXCHANGE COMMISSION (SEC)

Ms. SCHAPIRO. Thank you very much. Chairman Frank, Ranking

Member Bachus, members of the committee, thank you for the opportunity to testify today on behalf of the Securities and Exchange
Commission. I am especially pleased to be here with my colleague
Gary Gensler. I am committed to a long and successful collaboration. President Obama recently unveiled a plan for a stronger and
safer financial system. I believe the plan makes real progress in
filling gaps in our regulatory landscape that became apparent in
the wake of the financial crisis. In particular, it calls for improved
regulation, oversight, and transparency for over-the-counter derivatives, more consumer investor focus by financial regulators, and
improved macroprudential oversight so that regulators can identify
and minimize risks that flow across the financial system.
I believe this plan will strengthen the SEC, build on our internal
efforts and, in the process, improve investor protection and help us
to begin to restore confidence in our financial system. The most
critical regulatory gap we must fill involves the enormous over-thecounter derivatives market. Given the breadth of this market and
the importance and interconnectedness of institutions participating
in it, the Administration has proposed a comprehensive framework
for regulating OTC derivatives with four broad objectives: preventing activities that pose risk to the financial system; promoting
efficiency and transparency; preventing market manipulation and
other abuses; and ensuring that these products are not marketed
inappropriately to unsophisticated parties. The SEC, the CFTC,
and the Treasury Department have been working closely and have
general agreement on the pressing need for a comprehensive regulatory framework. There is agreement on the need for recordkeeping and reporting requirements, significant transparency, robust margin requirements, clearing systems that monitor and manage risk, comprehensive dealer regulation, business conduct and
disclosure standards, and vigorous enforcement.
In fashioning a regulatory framework for OTC derivatives, it is
crucial to recognize the close relationship between the regulated se-

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curities markets and the now mostly unregulated markets for OTC
derivatives. For example, when an OTC derivative references a security, it can be used to establish synthetic long or short positions
regarding that underlying security. In this way, market participants can replicate the economics of either a purchase or sale of securities without actually purchasing or selling any securities. Because market participants can use unregulated OTC derivatives to
service synthetic substitutes for securities, these securities-based
derivatives are closely interconnected with the regulated securities
markets. This creates significant regulatory arbitrage opportunities, that is, moving products away from traditionally regulated
transparent markets to customized unregulated and opaque bilateral contracts. In deciding how to fill this regulatory gap, it is important that similar products be regulated similarly so that market
participants cannot use size and leverage to work around the system.
Accordingly, we believe securities-based swaps should be subject
to the Federal securities laws. This approach would incorporate the
securities related OTC derivatives market into an existing unified
securities regulatory regime. As such, it would be relatively
straightforward to implement because these products would be
placed under the same umbrella of oversight as the underlying securities. This approach also would establish a clear delineation of
primary regulatory responsibility which would help avoid regulatory gaps.
And finally, it provides a workable framework for bringing transparency, clearing, and exchange trading to this market in the near
term without creating undue dislocation. In addition to OTC derivatives, the SEC and the CFTC have been working closely together to identify differences between our two regulatory frameworks that might be harmonized. While the cultures and missions
of our agencies are, in some ways different, we share many of the
same public policy objectives. While I focus largely on my remarks
on derivatives, there are many aspects of the Administrations plan
as well as complementary proposals that have a direct bearing on
the SECs oversight capabilities. Very briefly, the plan seeks to require that advisers to hedge funds and other private investment
pools register with the SEC. Currently, exemptions in the laws
have placed hedge funds and many of their advisers outside the
purview of regulation.
First, through registration and resulting oversight, we can enable
investors, regulators in the marketplace to have more complete and
meaningful information about private fund investors, the funds
they manage and the impact of their activities on the broader markets. Second, the SEC and the Administration also appreciate that
many investors do not realize that they may be treated differently
depending on whether they seek investment advice from a brokerdealer or an investment adviser. I fully support the view that financial professionals who provide similar services should be subject
to the same standard of care, namely, that they act solely in the
interest of their customers or clients and that they be subject to
comparable regulatory requirements.
Third, I support the Administrations proposals to strengthen
SEC enforcement by giving it expanded authority to compensate

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whistleblowers who bring significant enforcement information to
our attention, to pursue expanded sanctions against wrongdoers,
and to increase the potential grounds for seeking sanctions.
Fourth, I agree with the need to do more to address conflicts of
interest in the credit ratings process. To that end, I believe the Administrations legislative proposals are a valuable step forward and
will help to better align the interest of credit rating agencies with
investors who rely on them. Already, the SEC is taking steps to
heighten regulation of rating agencies, including establishing a
branch of examiners dedicated specifically to rating agencies.
Finally, I believe there is a need for a systemic risk regulator as
well as a strong and robust financial stability oversight council.
Such a council would help assess emerging systemic risk by setting
standards for liquidity, capital, and risk management practices.
There is clearly much to do, but I believe the steps the Administration, the SEC, and the Congress are taking will help restore investor confidence. Thank you, Mr. Chairman.
[The prepared statement of Chairman Schapiro can be found on
page 58 of the appendix.]
The CHAIRMAN. Chairman Gensler.
STATEMENT OF THE HONORABLE GARY GENSLER, CHAIRMAN,
COMMODITY FUTURES TRADING COMMISSION (CFTC)

Mr. GENSLER. Good morning, Chairman Frank, Ranking Member

Bachus, and members of the committee. It is good to be back with
you again after 8 years since I was last before this committee.
Thank you for inviting me to discuss the White Paper on Regulatory Reform on behalf of the full CFTC. Financial regulatory reform is critical for the health of our economy. As President Obama
outlined last month, we must urgently move to enact broad reforms
in our financial regulatory structure in order to rebuild and restore
confidence in our financial system.
I would like to start by discussing reforms most relevant to the
CFTC. First and foremost, this is with regard to bringing broad
regulatory reform for the derivatives marketplace. This will require
two complementary regimes: One regime that oversees the derivative dealers themselves; and another regime that oversees the market functions. I think it is only with those two complementary regimes that we are able to capture the reforms that are necessary.
For the dealers, we should set capital standards and margin requirements to help lower risk. We should set business conduct
standards to guard against fraud, manipulation, and other market
abuses. We should also mandate recordkeeping and reporting with
an audit trail to promote transparency. The dealer regulation will
cover all OTC derivatives, standardized as well as customized derivatives. This, I believe, wont go far enough, though, and we also
need to try to lower risk further by mandating that standard contracts be on central clearing and that standard contracts also be on
exchanges whether they be fully regulated exchanges or regulated
electronic trading systems which promotes transparency. Requiring
clearing and trading on exchanges or regulated transparent electronic trading systems will further promote transparency, and will
further lower risk in addition to the dealer regime that I talked

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about. To fully achieve the objectives, we must enact both of these
complementary regimes.
President Obama last month also called for recommendations to
change the statutes and regulations that would harmonize the regulation of the futures and securities markets, and I believe this is
essential. Specifically, I would just mention three areas where the
CFTC and SEC harmonization process, I think, would benefit the
American public. First, as we saw last year, there are gaps in our
regulatory structure right now. The heart of this hearing today is
filling one of the major gaps; over-the-counter derivatives.
Second, I think there are places where we may overlap in regulation. And while in certain circumstances that is appropriate, we
look to identify those overlaps and seek to work with this committee and Congress where we can help clarify those overlaps for
the marketplace and for all participants.
And third, there are places where we regulate similar products
or similar market events or exchanges where we might have inconsistent rules, and we look forward to working together to identify
those inconsistencies and try to harmonize them.
Chairman Schapiro and I are committed to doing this and seeking public comment. And in fact, we are looking to have joint hearings between the SEC and the CFTC in August and September to
help inform the Commissions on these views as we seek to inform
the rest of the Administration and you on our views on these matters. As we work with Congress to apply these regulations to overthe-counter derivatives, I think it is a real opportunity actually to
start with harmonization right here on over-the-counter derivatives.
And whether the SEC has jurisdiction or the CFTC, we need to
have similar fraud standards and manipulation standards, that the
electronic trading systems that we oversee have similar standards
and that we embed in statute, the over-the-counter derivative statute, that we have strong vigorous standards with this regard. I
would also like to just briefly touch upon hedge funds where the
Administration is called to require hedge funds to register and
other investment funds with the SEC, which I fully endorse. But
I think as we go forward to do that, we have to ensure that the
CFTC still can make sure that anyone participating in the futures
markets and those markets that we oversee that we are able to
have our full ability to police those markets and get ready access
to information from the SEC from these hedge funds.
Lastly, I just want to say how fortunate I believe to have a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable
expertise which gives me great confidence that we will be able to
provide Congress with sound recommendations on comprehensive
oversight of OTC derivatives in the markets as a whole. I look forward to your questions, and I am glad to testify in front of you at
any time, Mr. Chairman.
[The prepared statement of Chairman Gensler can be found on
page 43 of the appendix.]
The CHAIRMAN. Thank you. Ms. Schapiro, one of the issues that
you know people have concern about here that is clearly in your
jurisdiction is the short sale question. Could you give us the state

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of play now before the Commission, what are you thinking about,
what is pending, what do you think is going to be happening?
Ms. SCHAPIRO. I would be happy to, Mr. Chairman. As I have
told the committee before, that has been the number one issue on
which I receive comments and letters from both the public, the industry, and Congress as well. The SEC proposed a rule a couple
of months ago and the comment period closed on June 19th, multiple approaches to dealing with short selling in the marketplace.
Those approaches broke down roughly to two categories: a set of
proposals that would operate as a market-wide mechanism to slow
the descent of stocks during a declining market; and the other set
akin to the old uptick rule or a bid test.
The first set of proposals were triggered off of a circuit breaker
concept so that if the price of a particular stock declined by more
than, say, 10 percent in one day, then a circuit breaker would kick
in and no more short selling of that stock would be possible for
some period of time. As I said, the comment period closed on June
19th on the multiple proposals. We received 4,000 comment letters.
We are working our way through those comment letters. In addition, we held a roundtable to solicit views.
The CHAIRMAN. What is your timetable for a decision?
Ms. SCHAPIRO. I am hopeful that we will do some interim steps
very quickly with respect to fails to deliver and a number of other
rules that were also in play. And I am hopeful that over the next
several weeks or next 2 months we will be able to come to closure
and, assuming the votes on the Commission, an appropriate response.
The CHAIRMAN. Thank you. I know members may still have some
further questions about that. On the registration of hedge funds,
let me ask both of you, I think there is a fairly broad consensus
among some on our side of the committee that hedge funds should
register, but the question is how. That is, hedge funds are not mutual funds. And I know when you are a lawyer and you have to
choose, well, we will take this model or that model, A or B or C,
but we can make it A-plus or C-minus or ice cream. So we can do
whatever we want in terms of the form. When we come to the
drafting on registration of hedge funds, should we pick one of the
existing models, etc., or would you recommend that we draft a registration for hedge funds that might vary from some of the existing
forms taking into account their particular nature? Ms. Schapiro?
Ms. SCHAPIRO. I think, Mr. Chairman, there are obviously, as
you suggest, lots of ways to do this. You can register the funds
themselves as investment companies and then try to exempt them
from a lot of the requirements. You can register the adviser to the
hedge fund which is what the SEC has proposed doing which would
get us I think virtually everything we need to effectively regulate
hedge funds in terms of registration, inspection ability.
The CHAIRMAN. Let me just say, because again, we have the
power to write the law, requiring to register and then exempting
from some of the requirements of what we register doesnt make
a lot of sense, right? We ought to just write it right the first time.
Ms. SCHAPIRO. I dont disagree with that. And I think the concern would be that trying to stuff a hedge fund into the model of
an investment company isnt really the most rational way to go.

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But registering the investment adviser gets us access to really everything we need as a regulator of these instruments with the exception of the ability to impose on the fund itself capital requirements, diversification requirements that nobody is envisioning, at
this time any event, needing to do. So we think adviser registration
works.
The CHAIRMAN. I figured that, and depending on how it works,
that could conceivably be something that a systemic risk regulator,
however it is constructed, might be taking a look at.
Let me ask the last point on derivatives. One of the questions
that has come up was mentioned today in one of the publications.
What is your view onwell, lets put it this way. What is the function that is served, and there may well be one, when someone who
does not own an asset buys insurance against a drop at its value,
people buying credit default swaps who dont have an economic interest, in particular, on the item for which they bought the credit
default swap. Is that an economically important function? Should
we, in any way, try to change that? Mr. Gensler?
Mr. GENSLER. I think that the function of using a derivative to
hedge a risk, first and foremost, is generally a risk that is in that
commercial enterprise. But there are some times that you are
hedging a risk that is similar to a risk you have. So it may be that
a commercial bank wants to hedge a portfolio of loans and enters
into a credit default swap which is on a portfolio, again, of listed
securities that have some correlation or relationship to it. So there
are
The CHAIRMAN. Let me ask you, and finish in writing, is there
a third category, that is, you might decide to buy one because you
are taking a good guess that something is going to go bad and you
will make some money if it does, and is that something that is good
or bad or indifferent? Well, let me get that in writing because we
dont have time. We have a lot of members who want to ask questions. The gentleman from New Jersey.
Mr. GARRETT. Thank you, Mr. Chairman. Taking a page out of
Mr. Royces comment, and as I said the last time, we have sort of
been here before with regard to having a problem and then coming
back to reform it, and we went through a litany of problems in the
past of the SEC. Just yesterday, we had a panel, and the idea was
we were going to give more authority to the Fed. And I went
through a litany of problems where they missed on capital requirements, they missed on regulation, they missed on monetary policy,
and yet it is the thought right now in Congress we are going to
give even more authority there to the Fed. So in a sentence, why
should the American public be watching the hearing today and be
sanguine to think that we should be at this point giving more authority to the SEC?
Ms. SCHAPIRO. Congressman, I think it is fair to say that every
regulator over the last several years has had episodic failures and
missed many of the issues that gave rise to the financial crisis, the
SEC included, but certainly not only the SEC. But at the end of
the day, there is an enormous amount of work that happens at the
SEC that benefits the American investor and taxpayer on a daily
basis. Whether it is the review of corporate filings to ensure that
they are honest and transparent or ensuring that mutual funds are

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actually operating as they have extremely effectively over the last
several years.
Mr. GARRETT. I appreciate it. They do some good, but obviously,
the failures in the past, present company excepted because you
were not there at the time, is something that just raises that question. I dont have much time, so let me go on to the next point, because I know you are going to sing the praises of things that have
been done well. A lot of people could have a disparate opinion as
to what brought us here. Some people would say it is GSEs and
their leveraging issues, other people would say it is the credit rating agencies and they have problems; other people would say it was
the regulators or the OTS and what have you that simply missed
things and what have you. A lot of people can point out different
things. We have not come to a conclusion as to what the problem
ultimately was that brought us here. Can you point to one example
where it was standardized derivative products that was ultimately
part of the cause that brought us here?
Mr. GENSLER. I think that the unregulated derivative dealers,
the affiliates at Lehman Brothers and Bear Stearns and, for that
matter, even that which was in the back allowed for a great deal
extra leverage in the system.
Mr. GARRETT. Okay. That is the
Mr. GENSLER. And even the standardized product.
Mr. GARRETT. That is the entities. How about the product themselves? What we are talking about here is regulating the product
and putting constrictions around the product itself, and its a standardized product as opposed to, because there is a whole host of
other proposals out there as far as regulating the brokers and investment advisers, can we point to where it was
Mr. GENSLER. I am of the firm belief that bringing standardized
products onto central exchanges and onto central clearing will
lower risk and enhance transparency. Tens of thousands of end
users will benefit by that.
Mr. GARRETT. I appreciate we can lower risk, but can we give one
example so I can go home and say this was part of the problem
that caused it and here is a specific example.
Mr. GENSLER. I think that AIG is Exhibit 1$180 billion of
American taxpayer money for standardized and maximized products.
Mr. GARRETT. Excellent point. AIG, would they be products that
would therefore go through and be considered a standardized product that would go through a clearinghouse?
Mr. GENSLER. Many of their products would. Some of them were
so customized they couldnt. But all of them would be regulated for
capital and margin. All of them would be regulated as a derivative
deal.
Mr. GARRETT. Wasnt most of the problem with the AIG situation
with their credit default swaps which were based upon the
subprime problem and the mortgage problem? They would not be
standardized product.
Mr. GENSLER. Also, there was no effective Federal regulation for
capital or margin. So last September, Congress was put in a terrible position we should never put Congress in to have to think
about the TARP bill and then the Federal Reserve and the Treas-

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15
ury loan, you know, this $180 billion of the Fed specifically. We
want to avoid that in the future. And that is for standardized products as well as customized products. We need capital and margin
requirements to do that.
Mr. GARRETT. Well, I have never heard anyone say that the problems over at AIG were with their standardized product.
Mr. GENSLER. It was actually both. The customized product get
a lot more publicity obviously because they are so exotic. But it was
also the standard. It is the amount of leverage that you can put
in the system, how much debt you can put on a very small basic
capital.
Mr. GARRETT. Very quickly, I have heard a lot of people from the
business community say even with the nonstandardized products
which would raise the capital requirements or the marginal requirements that this would basically make it impossible for them
to use them and hedge their businesses. You only have 30 seconds.
Mr. GENSLER. I think that it is a very good question, but they
could absolutelyend users could use the products. We are saying
there should be customized products. I think that by bringing
transparency to the standard part it would actually lower costs because they should see where the spreads are and they could price
off the standard product.
Mr. GARRETT. Thank you.
The CHAIRMAN. I recognize the gentleman from Pennsylvania
and take 15 seconds to say, Mr. Gensler, when you said that the
AIG thing put Congress in a terrible position, yes, but only as spectators. I do want to emphasize. We voted on the TARP, but the Administration came to us, the Secretary of the Treasury and the
Chairman of the Federal Reserve last September, and informed us
that they decided to advance money to AIG. There was never any
congressional input into that. A few jaws dropped but no votes
were taken. The gentleman from Pennsylvania.
Mr. KANJORSKI. Thank you, Mr. Chairman. And should we add
that there was a different President at that time?
The CHAIRMAN. Yes.
Mr. GARRETT. We dont want to get partisan, do we?
Mr. KANJORSKI. No, no. Just timeframe. First of all, the relationship between the two of you is something we should compliment,
and I do. And I anticipate that because of this good relationship we
are going to have very positive things. I understand because of
prior meetings and other testimony that you have made that you
have worked out and harmonized a great deal of the conflict between the two agencies but that you have not resolved all of those
conflicts. And you are down to what really I would like to ask,
what are the remaining disagreements between the SEC and the
CFTC that have not yet been harmonized and are still open in the
air, and do you have a suggestion where they are going to come
down and are they resolvable at a given time?
Ms. SCHAPIRO. Let me take the first crack at that and then ask
Gary obviously to fill in. I think you point out correctly that we
have tremendous agreement around most issues. There is a very
narrow area where we are not in full accord, and that is with respect to whether broad-based indices, OTC derivatives or swaps on
broad-based indices should be regulated by the SEC or the CFTC.

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Our view is that securities-related derivatives ought to be under
the SECs jurisdiction.
The Commodity Futures Modernization Act, while exempting
these products broadly from regulation, did retain with the SEC
antifraud authority over anything securities based. As Gary will
point out, under the Shad-Johnson Accord reached quite a few
years ago, there was a drawing line between narrow-based and
broad-based indices. Broad-based went to the CFTC and narrowbased went to the SEC for the purposes of options and futures. I
would say that is the one area that we still are trying to work
through. As we go through our harmonization process, and as Gary
said, we are going to hold joint hearings to get public input on this,
we will discover there are lots of areas where our rules approach
things differently.
And on those I dont even know that we will have particular disagreement. Some wont be able to be harmonized because the nature of the markets and the products is quite different. But that
is what we are working through right now.
Mr. GENSLER. I would agree with that. I think that we are in
agreement. And the products, the interest rate, currency, and commodity products, the CFTC would take the lead on. On the narrowbased, the SEC would take the lead. This is broad-based product
area. Currently, there are over 150 broad-based futures contracts.
There are five or six that trade actively that are regulated by the
CFTC. There are about 60 options on those futures, again, regulated by us. So broad-based implicate those. But there is a second
category that I should mention. I do think we can go in and harmonize for the trading platforms. And working with Congress and
working together we can do that, but we havent yet, between our
agencies, been able to get to that level of detail. But I think that
would be important.
Mr. KANJORSKI. I did hear, though, in Chairman Schapiros testimony, that there is a concession that there will be some areas that
cannot be harmonized and will take some other action. And that
is consistent with other things that I have seen in the last week
or so where regulators have not been able to agree as to where a
problem should lie in terms of who has the responsibility of solving
or moving in. I am particularly referring to the CIT. There seemed
to be three Federal regulating entities that were not quite in agreement as to who had the responsibility to take action if any.
As a result of that, and the fact that we have a concession, you
cannot harmonize, have you thought of the possibility of our creating an Uber-regulator so that there is a final resolver of conflict
of disagreement in the regulatory community of the United States
if the problem getsrather than just waiting around for months
and having the Congress enact some special features because of a
disaster. Can we close it down as if there is an actual decider and
a peak and have you given any consideration to that?
Ms. SCHAPIRO. I think it is certainly worth exploring. And I do
think, to the extent Congress might move forward with some sort
of financial stability oversight council, whether as the systemic risk
regulator or as a body over the systemic risk regulator as we would
propose that might be a forum for broader discussion of the dif-

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ferences with other regulators. It might help us achieve some kind
of a consensus on how to go forward.
The CHAIRMAN. The gentleman from Alabama.
Mr. BACHUS. Thank you. I noticed that both of you, in your opening statements, said that you were working together as colleagues
and in partnership and I think that is going to be critical and I was
glad to hear that. I think the key in doing this, we are going to
continue to have two separate agencies, that is apparent. We are
the only country in the world that really has that dual set of securities and futures, and you know they are regulated quite differently.
So I think there is obviously a need for harmonization. I think
the key is going to be the leadership of you two. I think that will
really set the tone and will determine how successful we are. So
I applaud you for your opening statements. I also want to focus on
something, and I agree that Chairman Schapiro said, she said I
want to emphasize to the committee that the SEC and other financial regulatory agencies have been making solid progress using our
existing authority to address the financial regulatory problems that
face this country.
You do have a lot of existing authority, and I think it is important that we as a Congress realize that. And actually, in all this
regulatory reform, my concern has been that we are telling you
what to do as opposed to you looking at your authority you have,
looking at the problems that we now all realize, and they are very
complex problems, and saying to us this is what we need, you know
this is how we are going to discharge that authority or we need additional statutory authority. As opposed to, particularly with some
of the banking regulators, saying we are going to totally change our
approach to regulation and some good, but maybe not so good
ways.
I am going to ask one question and one question only. Having to
do this by September 30th is to me an overwhelming and unrealistic goal. Now, I know that the problems are there, but you have
already taken steps. And other regulators have already taken
steps, I think, to minimize a recurrence of what we saw last year.
I dont think in the current climate that businesses are going to
take that kind of risk, number one, or that regulators are allowing
that kind of risk. But tell me, I will ask both of you, how realistic
is that? And will you not hesitate to ask for more time?
Mr. GENSLER. We certainly will not hesitate to ask for more time,
but what we are trying to doand I think why the President and
Secretary Geithner asked for that timeis to help inform Congress
as they are embarking upon legislative process. So we are going to
have joint public hearings to hear from the public. We are doing
what I will call a gap analysis to see where the gaps are right
now. And then we are going to try to have as many meetings as
we can fit into our schedule to try to resolve those and make recommendations. But again, we might have an interim step on September 30th, and then have more to report, but to help you in your
legislative process as well.
Mr. BACHUS. Chairman?
Ms. SCHAPIRO. I would agree with that completely. We are really
committed to getting as much done as we can by September 30th.

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And if we need more time, we will ask for more time. It is very
important that we get this right. These are, as many of you have
pointed out, massively important markets, and we want to be sure
we are thoughtful about it.
Mr. BACHUS. And I endorse this idea of trying to get at least an
interim report, but I would caution you as well as you cautioned,
I think, in your statements, how complex these matters are and
that you want to get it right because these have tremendous implications for our economy if they are not done right.
So I thank you and look forward to what I hope will be an interim report September 30th.
But I would caution you also, you are going to be asked to speak
to all sorts of forums and all sorts of public addresses. You need
to limit some of that. You need to set your priorities because there
is a lot of hard work back at the agencies. And I hope that the public and the Congress will realize that the agencies are going to
have to do a lot of hard work, a lot of concentration, and a lot of
study in a very short period of time.
Mr. GENSLER. Thank you.
The CHAIRMAN. I just would say, I think the gentleman from Alabama has just shared with you the advice he probably gets from
his scheduler, as we all do: Dont speak at every forum of your priorities. So you are getting passed on what every one of us hears
every day.
The gentlewoman from California.
Ms. WATERS. Thank you very much, Mr. Chairman. And I thank
our presenters for being here today.
As you know, I have introduced H.R. 3145, a bill to ban credit
default swaps. And that has caused a lot of conversation with many
saying, well, they should not be banned but we should have the
central exchange and there should be transparency. But the more
I learn about them, the more concerned I am. I just want to cite
this particular situation.
McClatchy Company provides the most recent example of credit
default swaps hindering our lending markets. This California-based
newspaper publisher with large holdings in North Carolina and
Minnesota recently offered bondholders an above-market price for
its outstanding debt. The company made this offer in order to offset
declining advertising revenues with reduced costs. More than 90
percent of bondholders have turned down this offer.
According to an industry analyst, the debt offer failed because
many of the bondholders also had substantial credit default swap
positions. These bondholders stood to gain more from McClatchys
demise than from its continued operation.
While the company still exists today, it carries massive amounts
of debt, thanks to the many empty creditors who stand to profit
from McClatchys bankruptcy.
Some say we should only be concerned about naked credit default
swaps. I say we should be concerned with all credit default swaps,
particularly when they function as an incentive to drive a company
into bankruptcy.
Ms. Schapiro, if your agency was given authority over securitybased swap agreements, how would you deal with this very controversial question of credit default swaps? And if you could, com-

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ment on other types of swaps, such as interest rate and currency
swaps.
Ms. SCHAPIRO. Thank you. I will ask Chairman Gensler to talk
about the latter two since those are CFTC-related products.
You raise a very important question, and you and I have had a
little bit of a chance to discuss this previously. There is no question
but your economic interest, when you are on a credit default swap,
may dictate that you have less incentive to cooperate with a troubled company entering bankruptcy, because you are going to be
paid when that credit event happens in any event. And perhaps to
make things worse, there may also be an incentive to even short
the stock on top of that.
I think transparency would help tremendously in this regard.
And I think attaching some greater costs, frankly, to doing credit
default swaps via regulatory oversight, which obviously has a cost
to it, the provision of capital and margin requirements.
I do think that as we explore this issueand we are spending
a lot of time thinking about it, and whether at a minimum there
ought to be some kind of an insurable interestwe have to think
about the complexities even of just that piece of it, putting aside
whether you would ban the product entirely.
A bondholder has an underlying economic interest. Yet in this instance, they were not incented to cooperate in the bankruptcy. Does
an equity holder have an economic underlying insurable interest?
What about a large supplier to the company who would see their
revenues disappear if the company declares bankruptcy? Might not
they want to ensure that revenue stream through the purchase of
a credit default swap? So I think the complexities are very significant and ones we have to work through.
I would say that if Congress decides to go down the path of banning naked credit default swaps, it would be good to think about
doing something like that prospectively, given the size of the marketplace that already exists and the potential disruption of
unwinding those kinds of positions. But again, I think these are
very difficult questions.
Ms. WATERS. Thank you. I still have time.
Would you like to comment on that, please, Mr. Gensler?
Mr. GENSLER. Well, I do think that on the credit default swaps
and this is one of the reasons why we agreethe credit default
swaps on single issuers like McClatchy that you mentioned, are
very related to their stock, are very related to their bond. And appropriately, all of these interplay on investor protection and should
be regulated, I think, jointly by the SEC. And just as they are looking very closely at the short sale roles on equity, there is some similarity of the short sale or naked sales in credit default swaps.
I think as it relates to interest rate swaps and currency swaps,
what really are far more about broad interest rates or broadyou
know, where currencies are, that there is a role for both hedgers
and speculators. And speculators play an important role in the
marketplace, even if they are naked, so to speakif that term is
all rightbecause they provide the other side, so that hedgers can
find somebody that may, in essence, provide that insurance to them
who want to protect themselves in currency and interest rate markets.

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Ms. WATERS. Thank you very much.
I yield back the balance of my time.
The CHAIRMAN. The gentleman from Texas, Mr. Neugebauer.
Mr. NEUGEBAUER. Thank you, Mr. Chairman.
Chairman Gensler, I understand that the CFTC is going to have
some public hearings regarding hedge exemptions and position limits in the energy markets. As you are aware, in the 2008 farm bill
we had quite a bit of discussion about that, and we expanded some
of the CFTCs authority in that area. There is a lot of disagreement
about the role of speculators in the marketplace. And my opinion
is that they provide liquidity and price discovery by the fact that
they are in the marketplace.
But what do you think might be the impact if you move to limit,
and in some cases prohibit, some institutional investors from actually being in the energy commodities?
Mr. GENSLER. I thank you, and I thank you for the support in
last years farm bill for the additional authorities.
The CFTC, under a statute that had been in place for some 70
years, sets limits in the agricultural spacecorn, wheat, soy, and
so forthand has the authority, in fact, it says that we shall set
them in other markets.
And so what we have raised as a question is, we do it in the agricultural stock, we dont do it in the energy markets. The philosophy
really is to protect against the burdens that may come from excess
speculation. Speculators are good, they provide the other side for
hedgers to hedge their transactions. But conceptually, it is that we
have at least a minimum number of participants in a market place.
If there is a diversity, if you had that 10 percent limit, then you
would have at least 10 participants in a marketplace and lower the
risk that there are dislocations. If they have to liquidate those positions, it actually lowers the risk in clearinghouses that we have
been talking about today.
So we are going to have hearings starting next weekI see Commissioner Dunn from the CFTC is here also todayand we will be
looking at this over the next several weeks and then trying, if appropriate, to move on it during the fall.
Mr. NEUGEBAUER. One of the issues, though, that I get concerned
about, when you talk about beneficial interest and whether someone is hedging or they are speculating, I would submit to you that
in the energy business, everybody in this room has some beneficial
interest when it comes to energy. So one of the concerns I have is
if we move in this direction, what impact could that potentially
have on commercial hedging if we begin to limit the participants
in that? Because, as you know, it is a fairly large market.
Mr. GENSLER. And our mission is to make sure that the markets
are fair and orderly and provide the risk management for those
hedgers. But through position limits, Congress gave us the authority many years ago to set position limits to protect those markets,
so that they are fair and orderly and they represent the price discovery that you are soso I think we are aligned on that, and it
is whether this promotes market integrity along that front.
Mr. NEUGEBAUER. And then there is the question out there that
there are other places for the investors to go and trade energy. Obviously, the United States doesnt have a lock on that. What im-

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pacts, if we get two prescriptive, too overly protective here, could
that have on U.S. markets down the road?
Mr. GENSLER. It is a very good point. It is why we have asked
Congress and this committee to consider in over-the-counter derivatives regulation that we also make sure that the position limit authority for commodities of finite supply, that we also be able to do
that in the over-the-counter market if it serves a price discovery
function back into the other regulated markets.
Because you are right that you could move from the futures to
the over-the-counter derivatives. And we saw that in a number of
cases in the last several years.
Mr. NEUGEBAUER. Quickly, a question to both of you. You know,
we see in this regulatory proposal that the Administration is putting out, you have the clearinghouses, you have the regulators, and
you have obviously the investors. There has been a lot of discussion
about bringing more equity and margin to the marketplace. Do you
support a more aggressive setting of margin requirements from the
regulator, or still leaving that decision to be made by the individual
clearers, and basically with the regulators primarily looking at the
capital structure of the clearing entities?
Mr. GENSLER. I think we need to start with having in statute,
mandatory centralized clearing for the standardized product as contrasted todayit is voluntaryand that there be rigorous risk
management standards and that clearinghouses have open access
to members to be part of that.
Margin could first be set by the clearinghouse, but that the regulators, the SEC and the CFTC overseeing those clearinghouses
should be able to prescribe through rules those risk management
standards and, where appropriate, if we find that a clearinghousejust as we have in the futures clearing and an options
clearing now, the regulators do have authority to go in and comment on that.
Mr. NEUGEBAUER. Mr. Chairman, could I ask Ms. Schapiro to
quickly answer that? Could I ask unanimous consent to have an
additional 30 seconds?
The CHAIRMAN. We have members low down who dont get to ask
questions. If everybody gets an extra 30 or 45 seconds, then they
are not permitted. That is why I would object. People can answer
in writing.
The gentlewoman from New York.
Mrs. MALONEY. I first grant 30 seconds to Ms. Schapiro to answer his question.
Ms. SCHAPIRO. Thank you.
I very much agree. I think that margin levels can be set in the
initial instance at clearinghouses. I think it will be very important
for the regulators to have very robust oversight of those clearinghouses to ensure that they themselves dont become systemic risk
concerns over time. And that will involve, obviously, making sure
they are stress-testing those marginal levels and their capital levels, as well as ensuring they have all the proper systems and
backup and books and records and transparency.
Mrs. MALONEY. First, I would like to welcome our witnesses
particularly Mary Schapiro, a former constituent, a resident of New
York; New Yorkers are very proud of your service and your current

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appointmentand to Gary Gensler, the Chairman, who was part
of the Clinton team that brought us the longest period of economic
expansion in our countrys history of balanced budgets and surpluses. I am glad that you are back on the economic team. And
welcome, it is good to see you again.
First of all, I want to say that I truly believe that reforming the
financial markets and system is the most important issue before
our country. And getting it right will determine our economic
growth and expansion for the nextprobably 50 years.
And I want to go on record in support of the many honest hardworking men and women in the financial services industry. Many
people have made mistakes, and they feel like they are unjustly
being attacked when they are trying very, very hard to be part of
the solution and part of moving our economy forward.
I also want to state how important financial services are in terms
of our exports. Along with Boeing, it is one of the largest areas that
we export goods and services that helps with our trade deficit. So
moving forward in a correct way is tremendously important.
I for one would like to wait until the report comes back from the
Commission that we have put in place that will tell us what was
really the problem, so that we can make sure we are addressing
what is the thoughtful process of what caused the crisis. I truly believe the best chapter in government since I have been in Congress
was the 9/11 Commission report that expertly pointed out what
caused the problem, with concrete recommendations of what should
be done. And I would like to see what this Commission has to say.
But the first road map we saw was AIG. And it clearly showed
markets were out of control. No one knew what was going on. At
the beginning of the week, they said they didnt need help. By the
end of the week, they needed $50 million. By the end of the weekend, they needed another $30 million, and then it just continued.
Former Chairman Fuld testified before this committee on the
Lehman disaster and crisis and said if he had one recommendation,
it would be that there would be one central clearinghouse so that
you had control of what your exposure is internationally and nationally so you understood the exposure. I dont think you are going
to get that with capital requirements and margin requirements and
leverage requirements.
And my question, really to Mr. Gensler is, in these clearinghouses are you proposing one central clearinghouse, which is what
he suggested, or several clearinghouses? And then what do you determine is going to be over the counter, what is going to be in a
clearinghouse? But do we have one area where we are going to be
able to track the exposure of investors and the economy of our
country?
Mr. GENSLER. I thank you. And I thank you for that warm welcome. And having met my wife and having my three daughters
born in New York, I feel some closeness, too.
I think that we must bring the standard product into clearinghouses, but the reason for the regulation of the full dealers is so
we can also regulate the customized as well as standard
Mrs. MALONEY. Would it be one clearinghouse or many clearinghouses? How many clearinghouses?

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Mr. GENSLER. What we would envision is that we would allow
the marketright now there are three or four clearinghouses sort
of, as I say, competing for this. They need not to be voluntary, but
they need to be mandated, and that the regulators would be able
to see them and rigorously oversee them. If they meet the standards, they would be able to compete. I believe over time you might
see a consolidation and a concentration in this, but initially the
statute would allow for more than one clearinghouse.
Mrs. MALONEY. Very clearly, my time has almost expired.
Brooksley Born fought very hard to keep derivatives, particularly
energy derivatives, on the exchange. I put forward an amendment
that mirrored her recommendation, which failed primarily because
the regulators were opposed to it. Where does that stand now? Are
the energy derivatives back on the exchange?
The CHAIRMAN. Quick answer.
Mr. GENSLER. We believe that energy derivatives need to be
brought onto the exchange if they are standardized. With the exempt commercial markets through the farm bill, we have more authorities than we used to have.
The CHAIRMAN. The gentleman from Delaware. And remember,
our witnesses are encouraged to respond in writing in greater detail, and we will have plenty of time this summer to read it before
we get to any legislative activity.
The gentleman from Delaware.
Mr. CASTLE. Chairman Schapiro, you and otherseven us up
hereexpressed some concern with the revolving-door issue of employees at the SEC. Actually, I dont see employees of the SEC. I
see you or your predecessors, or whatever. But as you know, the
concern has always been that people go to work at the SEC, they
are relatively young, they are relatively inexperienced, and they
may then be looking for offers from Wall Street, so that may taint
what they are doingnot to suggest there is anything wrong with
what they have been doing, but it may taint their thinking on it.
And the thinking wasand you statedthat we need more experienced people.
Is that starting to happen with the economy and with your desire
to change that? Can you give us a brief answer on that subject?
Ms. SCHAPIRO. Yes, very much so, Congressman. We have been
able to take advantage of some of Wall Streets woes by bringing
on board tremendously experienced people with a broad range of
skill sets.
I am sorry Congressman Royce isnt still here, but we arent just
hiring lawyers and accountants, we are actually bringing in financial analysts, forensic accountants, people with expertise in trading
and derivatives, in a wide range of areas, and we are very much
the beneficiaries of Wall Streets woes in that regard right now.
And that is very much by design that we are bringing in those skill
sets.
Mr. CASTLE. Thank you. Let me jump to another subject. When
you talk about hedge fundsand I think there are other private
pools of capital you were talking aboutyou indicated they should
be registered. And I couldnt find it in your written testimony, but
in your oral testimony you suggested that registration would lead
to other oversight of those particular entities.

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Can you elaborate on that a little bit? I mean, I can understand
and I am all for the registrationI am probably for the oversight
as wellbut does that automatically lead to other regulatory supervision of these entities?
Ms. SCHAPIRO. Not automatically, but I think there is an expectation on the part of the public that if an entity would be registered
with us, we would have some regulatory oversight, including reporting to the SEC and, ultimately, if there is a systemic risk regulator, to the systemic risk regulator about trading activity.
We would expect to have the ability to examine the books and
records of a hedge fund, potentially to write rules that might require the provision of certain kinds of information to their investors
or to counterparties.
But our commitment is also, though, not to try to force hedge
funds, PE firms, venture capital firms, into a model that doesnt fit
for them. We recognize these are different types of investment vehicles, but I think we need to bring them under the umbrella of
regulation.
Mr. CASTLE. And if you could share with us what is happening
with respect to credit-rating agencies, without going through all the
details of that. We all know that there have been some concerns
about the ratings of various products that ended up falling flat on
their faces, etc. And should we be doing more with transparency
registration of some of the credit-rating agencies? Where does that
stand right now from the SEC?
Ms. SCHAPIRO. Well, as you know, since the agency got authority
under the 2006 Act, it has engaged in no less than five
rulemakings to try to put some structure around the regulatory regime for rating agencies. And many of those rules are new and we
are seeing how they work.
But I will say that we are going to go forward later this summer
with some additional rules that we think will be very useful. One
would propose to require issuers to disclose preliminary ratings
they have received as a way to get at this issue, which I find really
pernicious, of ratings shopping.
Another would require disclosure of the underlying data in structured products that are being rated to all other rating agencies so
they can perform an unsolicited rating as a check on the conflicts
that exist in the issuer-pays business model.
We are going to look at sources of revenue disclosure, again, to
get at the conflicts issue. More performance history, how the ratings have performed over 1-, 5-, and 10-year periods of time. And
we are beginning a road map to explore how the SEC and its own
rules can lessen reliance on ratings as a way to hopefully get investors to do additional due diligence on their own as well.
So we have quite a lot in the works. And of course the Administration has a new proposal that came out yesterday to require
mandatory registration and a number of other things.
Mr. CASTLE. Well, thank you. I believe there are a lot of legitimate concerns with credit-rating agencies, and we should be trying
to help with that as well.
I thank you for your testimony and yield back.
Mr. KANJORSKI. [presiding] We will now hear from Mr. Watt of
North Carolina.

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Mr. WATT. Thank you, Mr. Chairman.
Let me go back to a question that was raised earlier by Mr. Kanjorski. A lot of people have said that if we were starting from
scratch, we would have only one agency. And I understand the political realities of two existing agencies, the history that exists
there.
And you addressed the process that the two of you engaged in
cooperatively to define what turf should be in the SEC and what
turf should be in the CFTC. You said you have come to fairly good
understandings about existing products.
I guess the question I want to ask is, with respect to a new product and the possibilityprobabilitythat at some point in the future the two administrators of these agencies wont be as nice and
kind and cooperative with each other as the two of you are, how
should we be assuring in this legislation that there is not the potential for future conflict and legislating a way to resolve that conflict if in fact it does occur?
Ms. SCHAPIRO. I am happy to take the first shot at that.
I think you have identified a real issue for sure. And we have
this concern now. We have products that are not clearly on the futures side or the securities side, and it takes the agencies a very
long timereally in some ways an unacceptably long timeto resolve where these products will trade and under which regulatory
regime. And we disadvantage commercial entities who are trying to
propose these new instruments.
I think we are of good will here. I think we will try and we will
be more successful in working those issues out.
Mr. WATT. I have the utmost confidence in the two of you, as I
said, but I am not sure that I have the utmost confidence in the
future. And we are trying to draw a process that will last, as this
process did until the meltdown, for 75 years or more.
Ms. SCHAPIRO. I think short of merging the agencieswhich is
also not in the cardsthat one option would be to use something
like the Financial Stability Oversight Council that has been proposed by the Administration as a mechanism or a forum for the
resolution of these kinds of issues.
Mr. WATT. And we can write that into this legislation.
What is your opinion on it?
Mr. GENSLER. I think if we limit the differences, if we harmonize
going in, Congress writes clear, statutory guidelines on the clearinghouses and on the exchanges, it sort of limits a little bit more
whether a product is under one set of Presidentially appointed people and career staff and another set of Presidentially appointed
people and career staffI mean, to the extent that we harmonize
going in. And so that is, I believe, a challenge for all of us.
Mr. WATT. But you acknowledge that we need to address that
probably in this legislation; do both of you agree on that?
Mr. GENSLER. Yes.
Mr. WATT. Mr. Gensler, you actually led to the next question I
want to try and get some further clarification on, because I am not
clear in my own mind. You have referred to clearinghouses, and I
think you also referred to electronic platforms. I want to get a
clearer understanding of the difference between those two as you

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see it. Just give us a little education here so the members of the
committee, including myself, fully understand.
Mr. GENSLER. I thank you. Both are very important. They serve
different functions, though. Both, I think, should be regulated by
the market regulators. The exchange is where buyers and sellers
meet, and there is transparency on the transactions themselves.
And what we are proposing is that after any transaction in a sort
of real-time basis, just like we have in the corporate bond market
now and the equity markets and the futures markets, those trades
are reported, so there is transparency between buyers and sellers,
and then that the trades are announced.
Clearinghouses have lower risk because it is where, after the
trade, after the transaction had happenedand some of these
transactions will go on for 30 years if it is a 30-year interest rate
swapthat we can lower risk because the transaction has to do
with a lot of things like marking it to market, posting collateral,
to make sure that the transaction can live those 30 years regardless of market events.
Mr. WATT. My time has expired. If you would just give me some
more written information about that distinction, because I am still
a little unclearelectronic platforms, clearinghouses, electronic exchanges. I would like to kind of
Mr. GENSLER. And I would also be glad to come and see you in
your office anytime you want us to come by.
Mr. WATT. Thank you, Mr. Chairman. I yield back.
Mr. KANJORSKI. The Chair recognizes Mr. Royce of California.
Mr. ROYCE. Thank you, Mr. Chairman.
Ms. Schapiro, Allen Stanford, who has been accused of being a
mini-made office, has been in the headlines for the last few weeks
as people have been trying to get a handle on exactly what happened to $8 billion and the full extent of the damage of his actions.
And recently an alleged Stanford whistleblower, Layla Wydler, was
interviewed on the matter. And she detailed her initial concerns
with the Stanford firm, her terminationwhich was allegedly tied
to her unwillingness to sell their offshore certificate of deposits
coming out of Antigua, which she had had concerns aboutand her
attempts to bring what she believed was a Ponzi scheme to the attention of NESB, now FINRA and the SEC. This was some 5 years
ago.
According to a complaint filed by the SEC in February of this
year, the Stanford bank allegedly touted improbable if not impossible returns while selling $8 billion in those very same, apparently cryptic, CDs to investors for more than a decade.
On going to the SEC in 2004, Ms. Wydler said, I had a list of
everything, all my concerns. I wrote down the document, and I sent
it to them and told them these are my concerns; this is what happened, look into it. This might save peoples savings in the future
because we can stop this. And it was just sent to them, and thats
it.
Now, I understand there is a criminal investigation going on. But
what can you tell us about this allegation? Are you aware of any
evidence legitimizing Ms. Wydlers claim that she did, in fact, approach the SEC 5 years ago raising concerns over this Ponzi

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scheme, laying out how they were doing it, with respect to Allen
Stanfords firm?
Ms. SCHAPIRO. Congressman, I am happy to address it.
I dont know about her specific claim, so let me be clear about
that. But I will tell you that prior to the SEC opening its formal
investigation in 2005 into Stanford, the Agency had looked into tips
that had come its way. But at the time, my understanding is that
the staff believed that these were largely foreign investors investing in foreign certificates of deposit issued by a foreign bank.
So those jurisdictional issues presented significant hurdles, offshore CDs issued by a foreign bank. And those jurisdictional issues,
we now understand, were significantly complicated by the fact that
the Antiguan securities regulator, who had jurisdiction and authority over Stanford International Bank, was on the payroll of Mr.
Stanford, and has been sued by the SEC, but was clearly subverting the SECs investigation into this matter.
There is also a period of time of significant coordination with
other Federal agencies, which also took timeundoubtedly longer
than it should have. But as soon as it became clear to the SEC that
there was adequate information for us to go forward and that we
could overcome those jurisdictional hurdles, the case was brought.
Nine people and entities have been sued, and, as I said, including
the CEO of the Antiguan Financial Services Regulatory Commission.
Mr. ROYCE. Well, I would like to ask you if you could then address the questions raised by Mr. Atkins, which I raised in my
opening statements; specifically, why do you think the SEC, in the
course of the past 12 years, experienced, in his words, catastrophic
failures in every one of its four core competencies. He started with
rulemaking, filing review, enforcement, and examinations.
Ms. SCHAPIRO. I would be happy to do that. I would also be
happy to come and talk with you directly about these. Needless to
say, I dont agree with Commissioner Atkins characterization of
the SECs failures over the last number of years during that period
he was a Commissioner of the Agency.
I do think all of the Federal financial regulators missed issues
related to the economic crisis in the last several years, but I also
think that an enormous amount of positive work and important
things have happened also under those same years.
Mr. ROYCE. Lets do it this way, then. For the benefit of members, you can do it in writing.
Ms. SCHAPIRO. I would be happy to.
Mr. ROYCE. And I would add two more questions in writing, if
you could submit. I think going forward it would help the committee members. What led to failures in financial institutions to
recognize the inadequacy of their own risk management systems
and strategy in time to avert a collapse? And second, how did many
investors get lulled into complacency and not adequately do their
own due diligence as well?
You probably will have some perspectives at the SEC on those
two questions, and I think a better understanding of the failure on
that front as well.
Ms. SCHAPIRO. I would be very happy to do that.
Mr. ROYCE. Thank you.

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Mr. KANJORSKI. The gentleman from California, Mr. Sherman.
Mr. SHERMAN. Chairman Schapiro, I hope I have time to focus
on the SECswhat I would hope would be a policy, it is not your
policy nowto surf the Internet, pose as an investor, and deal with
all the unregistered activity. Because too much of the SECs attitude seems to be, well, if they dont register with us, we dont focus
on them. And that is especially necessary because we have relied
on State regulation. But now with the Internet, it is easy to steal
half a million dollars in each of 50 States; whereas in the past, if
you were going to steal several million dollars, you had to do it
pretty much in one area.
But I want to use my time to focus on derivatives. Derivatives
offer the potential to make huge fortunes to those who are very
powerful. And so they are defended because there is the tiniest argument that they do some good some of the time. And I refer here
to over-the-counter derivatives.
Secretary Geithner reserved the right to use taxpayer funds to
the full extent of the law not only to bail out old derivatives but
to bail out derivatives that are issued tomorrow. So they operate
with that subsidy, or implied subsidy, that maybe Treasury will figure out a way to bail out counterparties.
The defense of derivatives is that on rare occasions they are actually purchased by someone who has a risk they are trying to hedge;
and that on even rarer occasions, they cant hedge that risk efficiently on an exchange-traded derivative, so they need the over-thecounter derivative.
I dont know if either of you have done any studies. But what
percent of the over-the-counter derivatives are purchased by those
who really are hedging a risk rather than the more common case
of somebody just placing a casino bet? I mean, I could wake up
today and think pork bellies are going up and place a bet, and I
would lovethose who like gambling would think that is a wonderful idea, but I dont own any pigs. I will ask either of you.
Do either of you know what percentage of this multitrillion-dollar
industry, conducted in part at the risk of the U.S. taxpayer, is serving its alleged legitimate, societal purposes?
Ms. SCHAPIRO. I think because this has been such an opaque
market and it is such a broadly unregulated market, that it is very
hard for regulators to actually
Mr. SHERMAN. What if we simply said a derivative was illegal
unless you were really hedging a risk, and we basically said you
cant use over-the-counter derivatives as a casino?
Mr. GENSLER. We actually needand this has been a concept in
our financial markets for many decades, if not over 100 yearsfor
those that want to hedge a risk, you need speculators on the other
side
Mr. SHERMAN. One of the two parties has to have a real risk.
Mr. GENSLER. And so the vast majority of end usersand there
are tens of thousands of end userswhether it is a small municipality, a small hospital, or a large consumer products
Mr. SHERMAN. Although the vast majority of those end users can
and do use the exchange-traded derivatives.
Mr. GENSLER. And we believe and we share your view that we
have to bring the over-the-counter derivatives market onto ex-

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changes. And in that regard, I have heard various estimates. The
low estimate is about half, and the high estimate is about 80 percent of the over-the-counter derivatives marketplace could be considered standardized and on to exchanges. That would accommodate all end users. They would be able to see in real-time the pricing of these transactions and to be able to then decide to use
those
Mr. SHERMAN. So we could ban over-the-counter derivatives without major harm to the legitimate users of derivatives?
Mr. GENSLER. No, no. I would have to say I think that the tens
of thousands of end users are able to hedge risk in their day-to-day
businessit could be interest rate risk, it could be risk related to
a certain energy productbut we want to bring transparency and
lower the risk by the reforms we are calling for.
Mr. SHERMAN. Well, under these reforms, Wall Street will continue to have trillions of dollars of societally useless betting, using
over-the-counter derivatives, and the taxpayer may very well be
called upon to bail out these derivatives and their counterparties.
What I am asking is, given the risk to taxpayers, are there enormous benefits to our economy to have these over-the-counter derivatives where neither party has an insurable interest?
Chairman Schapiro?
Ms. SCHAPIRO. I think it is a very good question. And it is very
hard to answer when you are trying to balance societal risk with
trading, where neither party has an insurable interest.
I guess I would go back to what I said to Congresswoman
Waters, that defining insurable risk is a very difficult question and
one we need to think about very carefully.
I do think it is important where a party does have an insurable
risk, that there is some flexibility to have a customized over-thecounter product, that they not absolutely be forced onto the exchange.
But I think where there is no insurable risk and it is merely a
matter of two parties speculating, if we dont ban themand that
is a question for the Congress, obviouslyI think the answer is
that there has to be sufficient capital and dealer regulation and
protections in place to ensure that we dont end up walking down
this same path again.
Mr. SHERMAN. I would think we might ban them, and then we
could open the door later.
Ms. SCHAPIRO. Exemptive authority actually might be a possible
thing for Congress to consider.
Mr. KANJORSKI. The gentlemans time has expired.
Now I recognize the gentleman from California, Mr. Miller.
Mr. MILLER OF CALIFORNIA. Thank you very much, Mr. Chairman.
FASB has made changes to accounting standards that will have
tremendous impacts on securitizations known as FAS 166 and 167,
as I said in my opening statement. These changes are occurring at
the same time that the Administration is trying to restart the
securitized credit markets through programs like TAF to private
lending. On the other hand, it is our understanding that the Federal Reserve has serious concerns with this policy shift that could

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derail efforts to stabilize financial institutions and get credit flowing.
And, I guess, is that accurate; and what are their concerns?
Ms. SCHAPIRO. Thank you, Congressman. I guess I have a couple
of comments on this.
I would say that FASB walked down the path of reviewing off
balance sheet accounting, really as a result of a concern expressed
by the Fed and the Treasury and the Presidents Working Group,
that more transparency and improvement to all balance sheet accounting was absolutely essential; that it had been the lack of
transparency; the ability to push all these products off balance
sheet had, in fact, been a contributor and perhaps a significant one
to the financial crisis.
So I am surprised to learn that the Fed is not comfortable with
where FASB landed with the guidance that it issued in June. I
guess I would also say that these new standards were actually
the assumptions underlying these new standards were actually
even incorporated into the stress-testing that was done of the
banks. So the Fed has been quite involved and quite aware of what
FASB was doing here and had quite a lot of input throughout this
process.
With respect to what the Fed might do regarding capital rules,
I think that is a question, obviously, best perhaps directed to
Chairman Bernanke.
Mr. MILLER OF CALIFORNIA. That is applying stress tests to basically the banks with that slice of the market. How do you plan to
apply it to the rest? Basically applying the stress test to banks is
only a slice of the market.
Ms. SCHAPIRO. Yes. I brought that up only to indicate that the
Fed has had active involvement in these discussions.
Mr. MILLER OF CALIFORNIA. Okay. We discussed in Chairman
Bernankes hearing yesterday about the challenges facing the $6
trillion commercial marketplace that we see coming in the future.
Many of these accounting regulation changesaimed most at the
residential markethit the commercial real estate capital market
especially hard, which in turn impacts business and provides jobs.
Are the accounting policymakers communicating with the financial regulators who oversee the economy and recovery efforts? And
I guess that would be Chairman Schapiro.
Ms. SCHAPIRO. Very much so. There is very great sensitivity at
FASBand I will say on the international level, the International
Accounting Standards Boardthat while financial statements are
prepared for investors so that they can make rational decisions
about the allocation of capital and where and how to invest, that
there are other constituents that have interests. And so they have
been very open to receiving input from bank regulators, from the
SEC, as well as from investor groups and others.
Mr. MILLER OF CALIFORNIA. My concern is, if you look at the situation the banks were in at the beginning of the situation with the
subprime and the residential marketplace, the reserves were much
healthier than they are today and I think they were in a healthier
than they are today.
And if you look at the commercial-backed mortgage securities,
they are starting to hit about the fourth quarter this year; about

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$5 billion worth of loans are maturing and coming due. And then
about January, the default rate on the commercial sector was about
one-quarter of 1 percent. It is about 2 percent today. In the coming
days, it is expected to rise dramatically.
The loans due by about 2012 are about $1 trillion. The growing
expectation is that default rates will be between 12 and 15 percent.
How do we realistically handle that when most of these loans are
30-year loans, 5-year calls and you have gone from a 7 percent cap
rate in 2006 to a 10 percent cap rate today. Whereby a lender is
stuck in a situation where they might have a $14 million loan on
a piece of property that based on a declining marketplace, as we
see in a 10 percent cap rate, might value at $8 million when they
should only get 5 on it, how are you going to deal with them trying
to extend that loan when you have to apply mark-to-market to it,
which would require a $9 million set-aside?
Ms. SCHAPIRO. I guess I am not exactly the right person to answer that question. But if I could take a step back and say that
the SEC staff conducted a pretty extensive review of fair value and
mark-to-market accounting last year and published their report before I arrived at the agency in early January. And what they found
through their efforts is that investors value greatly fair-value accounting. It is what allows them to make decisions to invest at all.
Mr. MILLER OF CALIFORNIA. I understand that. But the situation
we are facing is you are hitting a second round of residential foreclosures that is occurring right now. And that is the people who
have good loans, but have lost their jobs. Or they are business people who are no longer able to make their payments who are losing
their homes today.
You have about 70 percent of the lending marketplace is commercial; you have lenders that are not in a situation they were in
4 years ago as far as liquidity and reserves. I am not talking about
a new loan that somebody wants to make for a piece of commercial
investor property. I am talking about a current situation that the
banking and lending industry is going be in today when these 5year calls come due. And based on accounting standards, you have
to apply mark-to-marketI mean, that is the rule today. And
based on that rule alone, the banking industry is going to be absolutely upside down. I dont know how they weather this, or the
economy weathers this next round of commercial foreclosures.
And my question isI am not saying new loansI am saying for
existing loans that are coming due, how are we going to deal with
them? We cant just say, well, mark-to-market requires. We are
faced with a financial situation that could be devastating.
Ms. SCHAPIRO. I guess I dont have a quick answer to your question. I would be more than happy to come up and maybe bring our
chief accountant with me and spend some time to talk with you
about that.
Mr. MILLER OF CALIFORNIA. I would love to, because this is a serious situation for the economy that is going to occur very rapidly,
and I dont think banks can handle it.
Ms. SCHAPIRO. I would be very happy to do that.
Mr. MILLER OF CALIFORNIA. I would love to meet with you.
Thank you.
Mr. KANJORSKI. Thank you, Mr. Miller.

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We will now hear from Mr. Moore of Kansas.
Mr. MOORE OF KANSAS. Thank you, Mr. Chairman.
In light of the Madoff scandal and other Ponzi schemes, what can
and should we do to improve the return of funds for defrauded investors? Chairman Schapiro, are the SECs fair funds fulfilling this
mission and should Congress consider additional steps for helping
out defrauded investors?
Ms. SCHAPIRO. I think, Congressman, the fair funds program has
been largely successful. It has returned billions and billions of dollars to investors. I think it was actually a brilliant idea on the part
of this committee and the Congress to enable the SEC to get money
back to investors through that mechanism.
That said, I think it takes us sometimes a little bit too long to
get that done. We have a new Director of Enforcement who has responsibility for fair funds administration, and he is looking at how
we can try to speed that process up to get the money back as quickly as we possibly can.
Mr. MOORE OF KANSAS. Thank you.
Chairman Gensler, do you have any comments, sir?
Mr. GENSLER. Not specifically on the fair funds proposal. But I
do think that in working to harmonize our roles, that we should
look very closely at whether our fraud standard between the CFTC
and the SEC should be the same. We bring about a third of our
fraud cases with the SEC, we do a lot jointly, and I think it would
be helpful.
Mr. MOORE OF KANSAS. Thank you.
Some people have suggested we should require the largest financial firms to undergo an annual stress test that would have aggregate information publicly released even in good times, not just bad
times. Is this something Congress should require, Chairman
Gensler? And what about leverage? Any thoughts on how best to
create incentives for firms to maintain reasonable leverage ratios?
Mr. GENSLER. Well, I think that one of the ways with regard to
over-the-counter derivatives is that we be explicit. In the past, I
think this is one of the assumptions that was sorely tested. We assumed that our overall capital standards would take into consideration these derivatives. And I think that we should be explicit in
whether it be the bank regulators or the SEC overseeing the broker
dealers where most of the derivatives take place, there should be
explicit capital standards for these derivatives. And then beyond
that, we lower risk, of course, with centralized clearing.
Mr. MOORE OF KANSAS. Chairman Schapiro, do you have any
comments?
Ms. SCHAPIRO. I guess I would add that I think stress-testing is
critically important. And one of the failures was perhaps to include
enough low-probability, high-impact events in stress tests historically. And that would be important for the regulators to insist upon
with respect to clearinghouses, as well as with respect to dealers
and other participants in the financial markets.
Mr. MOORE OF KANSAS. Thanks to our witnesses, Mr. Chairman.
I yield back.
Mr. KANJORSKI. Thank you, Mr. Moore.
We will now hear from the gentleman from Florida Mr. Posey.
Mr. POSEY. I thank you very much, Mr. Chairman.

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Madam Chairwoman, I know we have the IG report that we
should be receiving to give us more information. But I am curious
as to whether or not we can know if anyone has been fired or even
reprimanded over the way the Madoff fiasco was mishandled?
Ms. SCHAPIRO. Congressman, we are waiting, obviously, for the
release of the Inspector General Report, which has been quite comprehensive and quite extensive and is due to be released at the end
of the summer. And based upon whatever is in that report, we will
have to make decisions about whether any kind of personnel actions are appropriate. We do not want to interfere in any way with
the independent review of the Inspector General.
I will say, though, that I have not wanted to wait for the Inspector Generals Report to make really extensive changes in the Securities and Exchange Commission, both in how we are organized
Mr. POSEY. I know we are going to make changes in the future,
hopefully, but I think there should be some accountability for the
people who did not do their jobs. And I think that we made the illustration before: If you report a bank robbery to the local police
department and the bank robbery has gone on for 10 years and
they never walk over to the bank to investigate the robbery, somebody ought to lose their job, somebody ought to be reprimanded.
And it is just incredible that hasnt happened yet and that we
have to wait for a report to take any action against the negligence
that cost people, arguably, $70 billion in losses. Because your agency would not take any action, even after Barrons Magazine writes
a feature story about this guy. I mean, it was worldwide news.
The smart hedge fund managers and the money managers know
to stay away from him, but gullible members of the public were
still lured in by this because he was allowed to continue doing business.
I just would think that there should be some discipline taken for
the employees who allowed that to happen.
Ms. SCHAPIRO. Congressman, I think it is really critical that we
have the full story of exactly what happened, and that is what the
Inspector General has been charged with doing. There has not been
a separate inquiry down to the level of employee conduct because
that investigation is going on. And no one has wanted, and myself
included, to interfere in any way with that.
But we are not just making changes in the future, we are making changes right now and have, over the last 6 months, made extensive changes at the SEC. We have a new Enforcement Director,
a new Deputy, a new head of the New York office. We have new
technology, we have new rules
Mr. POSEY. But the question is, when employees dont do their
job to protect the public, do we have to have an Inspector General
come in there and tell us if it is okay to fire people? I mean,
wouldnt that be a normal management routine if you have an employee who is incompetent or lazy, or for whatever other reason
doesnt do his job to protect the public clearly like he should be
doing, that we just dont fire those people? I mean, isnt there a policy in place to do that?
Ms. SCHAPIRO. I believe deeply in holding employees accountable
for their work, but I cant do that until I have the facts and the
details about how they conducted their work and what the issues

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were. And that is what needs to wait for the Inspector General Report.
Mr. POSEY. But dont they have supervisors? Isnt there somebody in the organization that alreadyI mean, I know in any businessand I know government doesnt have competition like a business, but in any business where someone made a business blunder
that big, the whole department would be gone, the senior manager
would be gone. Doesnt that happen anywhere in government? I
mean, doesnt anybody have the authority to get rid of incompetent
employees, people who refuse or for whatever reason dont do their
jobs?
Ms. SCHAPIRO. We do certainly have the ability to get rid of incompetent employees, but I have to have the evidence that shows
me that employees were incompetent. I cant fire hundreds of people or tens of people without having a basis for doing that, and I
dont have that basis at this point. That is the purpose, in part, of
the Inspector Generals Report, to understandas was by my predecessor, Chairman Coxto understand what went wrong; what did
the SEC do; what did it fail to do; and where does the responsibility lie? And that is a necessary precondition, from my perspective, to taking any kind of personnel action.
Mr. POSEY. And with all due respectand I am not aiming this
at youbut I think the failure to know what went wrong and who
is responsible for things that go wrong is culpable negligence on
the part of management.
Ms. SCHAPIRO. I understand that concern. And there are things
that we do know went wrong. We know that, for example, the
agency receives 1.5 million tips a year and has no capability to
really manage them or manage that process, so we have attacked
that. We know we have gaps.
Mr. POSEY. We know twice they blew off Mr. Markopolos, even
after Barrons Magazine did a big feature cover story on this fraud.
I mean, anybody with half a brain in the agency, that should have
been plenty to know right there. I mean, this is not one of a million
tips that got ignored. This guy took a big file down there, he was
a qualified, experienced investigatorI am talking about Mr.
Markopoloshe took it down there and laid it in their hands, and
they did nothing. He went back, and they did nothing. It was exposed in Barrons; they did nothing.
I mean, I cant imagine any excuse. It is just a matter of finding
out who all had a fingerprint on this thing and getting rid of them.
Ms. SCHAPIRO. There is no question but that the agency did not
appropriately follow up on the information that he gave them; I am
not defending that at all. And that is why we are in this process.
And that is why we have devoted extraordinary resources both to
the Inspector Generals investigation, but also to filling all the gaps
that we can, putting in place all the processes and procedures, and
bringing in many senior new people to the agency to try to ensure
that we can protect against this ever happening again.
This is a tragedy of epic proportions, I fully appreciate that. And
we are doing everything we can do
Mr. POSEY. When do we expect the IGs report?
Ms. SCHAPIRO. The Inspector General has said that he would
hope to release his report by the end of the summer.

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Mr. KANJORSKI. By September 30th, Mr. Posey. And as soon as
he does, we anticipate having a special session.
We have five votes on the Floor, and we have another committee
hearing starting at 2 p.m., so I am going to pose the question to
the members, do they wish to return and poll the panel for an additional hour and then start up, which would only give us about 40
minutes? Or should we have one more individual on questions and
then recess the hearing until a further date or some other time?
Are there any preferences?
Mr. BACA. Continue, and have the hearing some other time.
Mr. KANJORSKI. You are next.
Mr. BACA. That is why I want to continue.
Mr. KANJORSKI. I am not suggesting we do not have you. The
question is, after you have had your opportunity, should we come
back in an hour from now after votes? Is there anyone terribly in
favor of that? Mr. McHenry says no.
Mr. MCHENRY. I am in favor of Mr. Baca getting his time,
though. He is a good pitcher.
Mr. KANJORSKI. We follow seniority, so Mr. Baca gets the next
question.
Ms. MOORE OF WISCONSIN. I guess I will write my questions to
them, Mr. Chairman. Whatever you decide, Mr. Chairman.
Mr. KANJORSKI. And return in an hour? That is what we will do.
We will hear Mr. Baca, and then take a recess for an hour and
then return. And we will give the opportunity for the witnesses to
have lunch or something in the meantime.
Mr. Baca.
Mr. BACA. Thank you very much, Mr. Chairman. And thank you
for holding this meeting, along with the ranking member. And
thank you, Chairwoman Schapiro and also Chairman Gensler.
My question is to either one of you two, or both of you can answer this. I have a question regarding both of your agencies roles
in the Consumer Financial Protection Agency. The bill states that
CFPA will be required to coordinate with both of your agencies in
an effort to promote consistent regulatory treatment of consumers
investment product and services.
Can you comment on your role in coordinating with CFPA? That
is one question. And how do you envision this taking place? And
what level of interaction would you like to see?
And finally, would you like to see the interactions be limited solely to derivatives, regulations; or does it expand beyond that?
Ms. SCHAPIRO. I am happy to start with that.
I think it is going to be critically important for the SEC to coordinate pretty closely with the CFPA. We both have investor or consumer protection missions at our core, and there is a possibility for
there to be products or issues that arise where we will both have
an interest. So I think a high level of pretty continuous coordination will be important.
The Presidents plan actually calls for, I think, a quarterly meeting, at a minimum, between the leadership of those agencies and
the FTC and others, to make sure we are sharing information and
that no gaps are able to arise between our authorities to protect
investors.

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Mr. GENSLER. I would concur with that. And while the CFTC
principle focuses on markets and risk management, there is a clear
consumer piece in protecting against fraud and manipulation
where we would envision coordination.
The second part of your question was about derivatives, and I am
sorry
Mr. BACA. Would you like to see interaction be limited solely to
derivatives regulation or does it expand beyond that?
Mr. GENSLER. I think it really does expand beyond that probably
for both of our agencies because derivatives are a new product. But
whether it be futures, options, or securities, there is some interplay.
I can even think of it in terms of how foreign currency transactions that are marketed to the retail public, which is very much
something that we look at and try to protect the public on. But this
consumer agency, as a bank product, might possibly get involved.
So I think we need coordination as well on other product areas.
Mr. BACA. And the other question I have, I was wondering if you
could speak to the concerns that a quick transaction to either a
mandatory clearing process or a mandatory exchange process for
all derivatives may cause a disruption in the market? Do you share
this concern? And what can be done to counter this potential problem?
Mr. GENSLER. I think that bringing derivatives onto centralized
clearing and exchanges will actually be an enormous benefit to the
market. I think it will promote transparency and efficiency, and
end users will get the benefit of seeing those prices, where right
now they cant. And I think it will lower risk.
So, though I might not have understood the question, but I dont
see it as a disruption, I see it as an enormous benefit to markets.
Mr. BACA. Chairman Schapiro?
Ms. SCHAPIRO. I agree.
Mr. BACA. Thank you.
Mr. Gensler, I want to follow up for a question that was asked
by one of my colleagues earlier about the clearinghouses. Chairman
Gensler, you said that you were in favor of having several different
clearinghouses compete. Wouldnt this create the same problem as
credit-rating agencies experience with conflict of interest, and how
do you safeguard against this?
Mr. GENSLER. I think that your analogy is a very apt one. And
how we safeguard against it is it should be mandatory regulation.
Not only do they have to registerwhich right now there is voluntary registration of the rating agenciesbut we have to have
regulation to manage the risk management. Rating agencies have
very real conflicts of interest.
And I will defer to Chair Schapiro on whether she has the right
authorities. But if she needs more, I would certainly support that.
But in this case, we should make sure that these clearinghouses
have open access, that any member who can meet the rigorous risk
management standards be able to be there and we not allow them
to be sort of too clubby or controlled by the dealer community, but
that they have to meet the rigorous risk management standards
that we would lay out.
Mr. BACA. Ms. Schapiro, how would you answer that?

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Ms. SCHAPIRO. I agree with that.
Mr. BACA. What do you agree with?
Ms. SCHAPIRO. That we have to have rigorous oversight of the
clearing agencies in order to assure that, to the extent any conflicts
of interest arise, that they are fully disclosed and, to the greatest
extent possible, eliminated.
Mr. BACA. How will we monitor the oversight? You said that we
need oversight. How will we monitor that we actually do have the
oversight and that oversight is really occurring right now and the
accountability that needs to be done?
Ms. SCHAPIRO. Both the SEC and the CFTC currently oversee
clearinghouses for other products, for securities at the SEC, for futures at the CFTC, for options at the SEC. So we have pretty extensive programs in place to review the governance models of clearinghouses, the risk management systems, the technology, because
if they have a major technology failure it can hugely disrupt markets. And so those programs exist. And my view would be we would
expand them to cover any new clearing platforms or agencies that
are created.
Mr. BACA. Thank you very much. I know that my time has expired. I yield back the balance of my time.
Mr. KANJORSKI. The Chair notes that some members may have
additional questions for this panel which they may wish to submit
in writing. Without objection, the hearing record will remain open
for 30 days for members to submit written questions to these witnesses and to place their responses in the record. Quite different
from what we had originally decided, we decided not only to give
you a lunch break but to give you the afternoon off to enjoy yourselves on the golf course.
Since we have votes, we are going to recess the meeting at this
point and ask you to return in the future, probably in September,
for the SEC as soon as the Inspector Generals report is out, Ms.
Schapiro. And we will annoy you, Gary. We wont let you feel abandoned. But with no further questions before the committee, the
committee stands adjourned.
[Whereupon, at 12:10 p.m., the hearing was adjourned.]

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APPENDIX

July 22, 2009

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