WASHINGTON - Rep. Edward Markey, D-Mass., yesterday suggested that Congress may need to enact derivatives legislation, including sales practice measures that will protect municipalities and other unsophisticated investors from being sold inappropriate, risky derivative products.
"I am not at all convinced that volunteerism by the dealers and incremental adjustments to regulations by the regulators will be sufficient to respond to the new risks created by derivatives," Markey, chairman of the House Energy and Commerce Committee's telecommunication and finance subcommittee, said at the end of the first of three subcommittee hearings on derivatives.
But the three industry officials who testified at the hearing, two of them former federal regulators, said they would be opposed to legislation. The derivatives market is currently limited to large, sophisticated players who are policing themselves, they said, adding that federal regulatory agencies have the tools they need to oversee the derivatives markets.
Gerald Corrigan, the former president of the Federal Reserve Bank of New York who started the derivatives debate by issuing strong warnings about derivatives practices in a February 1992 speech, told subcommittee members, "I am not in favor of legislation at this time."
Corrigan, now chairman of International Advisors, a company affiliated with Goldman, Sachs & Co., said derivatives "are both inevitable and welcome as useful, beneficial financial tools." In a clear change of tune from his 1992 speech, Corrigan told subcommittee members that "great progress has been made" in addressing concerns about derivatives products.
The two other panel members, Richard Breeden, the former chairman of the Securities and Exchange Commission who now heads Coopers & Lybrand's financial services practices, and Dennis Weatherstone, the chairman of J.P. Morgan & Co. who led the derivatives study that was completed last year by the Group of Thirty, also said derivatives market participants are making great strides in addressing derivatives concerns.
Markey said the subcommittee is "not seeking to ban derivatives or force these innovative products to move offshore," but that lawmakers are worried about "black holes in the current regulatory structure that leave some dealers subject to little or no effective supervision.
"All we want to do is to assure that the regulatory system we have in place mitigates the potential for derivatives to disrupt the financial system, that dealers and users have strong internal controls and risk management systems, and that there is adequate disclosure and customer protection," he said.
Markey entered into a lengthy debate with Breeden over the need for legislation mandating suitability or sales practice standards for derivatives. The legislation may be needed, Markey said, to protect municipalities and pension funds from unscrupulous dealers trying to sell them derivative products that are risky and unsuitable for them.
Congress included sales practice requirements for government securities in legislation last year. Markey, a sponsor of the measure, asked Breeden if they should be extended to derivatives.
Breeden said that existing federal and state laws either provide protections from securities fraud or dictate the kinds of investments that states and local governments can make.
But Markey said the same point was made about government securities. The real issue, he said, is whether Congress should address sales practice standards now on a "wholesale" basis through legislation or wait for "the horror stories to come in from cities and towns" and a "patchwork quilt of ~60 Minutes' exposes [that will] drive us to" take action.
Breeden told Markey, "I haven't seen ... a crying need for legislation to govern sales practices in this area." The derivatives market currently consists of a very small group of major financial institutions "that look very hard at controlling their own behavior," Breeden said.
But Markey said there will always be some "bad" securities officials willing to take advantage of unsophisticated investors like municipalities.
"We're here to protect against the 10% bad people who are going to prey on the 10% vulnerable" investors, Markey said.
Breeden said it would be more appropriate for taxpayers to vote a local treasurer out of office if he makes bad investment decisions and "loses the taxpayers' money by doing a bunch of dumb things."
This is the principle of "market discipline," Breeden said.
But Markey said that while market discipline may work for the financial markets or corporations, it could not be applied to municipalities.
"I don't have a problem with Acme going out of business. I do have a problem with Manhattan Beach, Calif., going out of business," he said. "Corporate executives come and go, but cities and towns of tens and hundreds of thousands of people ... [you're dealing with] their lives ... their police, their fire stations, their schools," he said. "I just don't think we want to reach the point" of having them saddled with huge debts.
Rep. Mike Synar, D-Okla., asked the industry officials why securities firms should not have suitability standards for derivatives if the comptroller of the currency is advocating them for banks.
The comptroller's office issued derivatives guidelines last year, saying nationally chartered banks should not recommend transactions if they know they are inappropriate for customers on the basis of available information.
Meanwhile, Rep. Michael Oxley, R-Ohio, said concerns about derivatives are being completely overplayed, especially by the press.
But Corrigan said press stories about derivatives losses "probably have a very useful purpose" by alerting the company officials to the potential risks of such products and to the need for them to stay on top of their frim's derivatives activities.
In a related matter, the comprtoller's office at yesterday's hearing distributed a list of more than 50 commonly asked questions and answers intended to explain the derivatives guidance that it issued last year.
In its explanation, the comptroller's office said that the possibility of systemic risks to the nation's financial system has increased in part because of derivatives.
