Statements to Congress.

I welcome the opportunity to appear on this panel this morning to discuss title IIIl of S.207, "The Intermarket Coordination Act of 1991." This bill addresses important issues affecting the integrity of our financial markets, and I compliment the committee on the contributions it has made toward better understanding of these issues and toward strengthening the regulatory system. Many of the questions addressed in this bill are extremely complex, and any proposed changes inevitably involve tradeoffs on which there will be disagreement. The compromises that members of this committee and of the Committee on Banking, Housing, and Urban Affairs have made in putting this package together have been reached in the spirit of bridging differences in viewpoint and moving ahead.

My remarks this morning will focus, as you have requested, on two provisions of the act that are particularly pertinent to the Board of Governors of the Federal Reserve System. The first is federal authority to set margins for stock-index futures contracts, and the second is the "exclusivity provision" of the Commodities Exchange Act (CEA). The Board's views on both these issues have been presented in testimony before, and letters to, the Congress on several occasions in the past, and my statement today will expand a bit on these views in the context of the current proposals. Let me begin with margins.

MARGIN Authority ON STOCK-INDEX FUTURES

As I have noted in previous testimony, the Board considers the primary purpose of margins to be to protect the clearing organizations, brokers, and other intermediaries from credit losses that may result from adverse movements in prices. Without appropriate safeguards, losses can lead to the failure of key market participants, jeopardize contract performance, and threaten the integrity not only of the market in question but of other markets as well. Margins, along with capital requirements, liquidity requirements, position limits, loss-sharing agreements, and other operational controls, are tools designed to limit the exposure of financial exchanges and participants to problems that may arise in the markets. Containment of risk through the use of these tools is essential to maintain public confidence in the soundness of our financial markets and to avoid excessive strains on our clearing and payment systems.

Recognition of the important role for margins leads to the critical operational question of how one determines the adequate level of margins for prudential purposes. Clearly if margins are set too low, markets and clearing systems will be exposed to undesirable levels of risk. On the other hand, if margins are set much higher than necessary for prudential purposes, liquidity in the markets will be reduced, and competitive pressures may drive business to less regulated markets, probably offshore.

For some time, the Board has been of the view that the exchanges and self regulatory organizations (SROs) are well positioned for developing and refining margin policy. These organizations have a strong economic interest in maintaining the integrity of their markets and membership, as well as a close familiarity with the instruments and trading practices in their markets. Moreover, they have the flexibility to adjust margin requirements quickly in response to changing economic, financial, or institutional developments. While we continue to believe that the SROs should play a lead role in structuring margin policy, the Board believes that federal oversight is important to ensure that margins on stocks and stock-index futures are adequate to protect against a wide range of conditions.

The need for federal regulation of margins on stock-index futures has become clearer in recent years, especially in light of behavior during periods of market stress. In particular, I expressed concerns last year that the self regulatory organizations tended to set margins at levels too low in periods of price stability and then were compelled to raise them when market prices moved sharply. Such behavior tends to exacerbate liquidity pressures on market participants and their creditors and the clearing and payment systems in periods of unusual price volatility. To avoid the possibility that margin decisions of a given exchange or clearing organization may not fully take into account implications across other markets and payment systems, a federal agency should have ultimate oversight authority. The Intermarket Coordination Act provides for just such federal responsibility, and the Board endorses this concept.

Nonetheless, while the Board believes that federal oversight is necessary, we have been of the view that this authority should rest with either the Commodity Futures Trading Commission (CFTC) or the Securities and Exchange Commission (SEC). Let me explain our reasons for this view.

I noted earlier that margin requirements are but one of many interdependent tools that play a role in the management of risk. Other elements in this process include, for example, capital requirements, surveillance activities, maintenance of guarantee funds, and financial support agreements. These factors have an important bearing on the overall level of risk associated with any given level of margins. Indeed, the margins applied against stock-index futures are only one part of the total amount of margin held to protect the integrity of the clearing organizations and member firms. The Board has been of the view that the agency or agencies that have overall responsibility for supervision of the institutions and the exchanges that trade these instruments can bring to bear appreciably more day-to-day information in these areas. These agencies could best take into account other elements of the risk management system when choosing appropriate margin levels.

Which agency, the CFTC or the SEC, is better suited for oversight of stock-index futures is less clear to us. The CFTC can be viewed as the better choice because of its oversight of the futures exchanges and their clearing organizations. On the other hand, the strong price and trading linkage among stocks and stock-derivative options and futures products presents a case for having a single regulator for all equity-related products. The SEC, to whom the Board, by rule, already has delegated oversight authority on options products and which has prudential responsibility for broker-dealers and securities markets, could be considered a logical choice to foster consistency of margins across equity-related products. We also appreciate that the Federal Reserve's position as the authority for setting margins on stocks and stock options places us in a position to achieve consistency across all equity-related instruments.

The Board recognizes the difficulty and the urgency of resolving this particular question. In these circumstances, while we prefer that the authority rest with one of the other agencies for the reasons discussed, if the Congress were to decide to assign this to the Federal Reserve, the Board would, of course, endeavor to discharge the responsibility for margins on stock-index futures in a careful and serious manner. In so doing, we would work closely with the other agencies that have broader authority over the entities that margins are intended to protect; in this regard, the proposed legislation appears to provide appropriate flexibility for implementing such a system.

EXCLUSIVITY AND HYBRID INSTRUMENTS

Let me turn now to the provisions of the bill that deal with the question of the CFTC's "exclusive jurisdiction" over futures products. The Board, as you know, has had serious concerns about the current interpretation of the Commodities Exchange Act that requires any contract with an element of futurity to be traded only on a CFTC-regulated exchange. Interpreted broadly, any financial contract has some element of futurity; hence this provision affects a wide range of existing and new financial products that might be offered outside the futures exchanges, including some depository instruments that are subject to other regulatory safeguards. The potential for the strict application of this principle to stifle the development of new products was demonstrated when the courts ruled that index participations fell under the futures definition and could not be offered by the securities exchanges.

The proposed bill would modify the exclusivity restriction to allow certain hybrid products to trade either on a securities exchange or a futures exchange. In addition, it would give the CFTC authority to exempt certain other products. The amendment explicitly directs the CFTC to exempt swap agreements and deposit accounts offered by insured and regulated financial institutions if it finds that such exemptions are not contrary to the public interest. I believe that these are positive steps that will provide the CFTC with greater ability to avoid conflicts such as have occurred in the past and to limit the risk that disputes over regulatory jurisdiction will have to be dealt with in the courts. More important, it should reassure the markets that financial innovations and new products will not be curbed by ambiguities in the regulatory process.