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Committee on Banking, Housing and Urban Affairs : Statement by Christopher Whalen; United States Senate; June 22, 2009

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As noted above, since many OTC contracts for currencies, interest rates or energy, for example, have observable cash markets upon which to base their pricing, moving these contracts to an exchange-traded format is a relatively easy matter that does not pose significant hurdles for the Congress, investors or regulators. Indeed, most market participants would welcome and benefit from such change.

When it comes to CDS and complex structured assets, however, it is probably not possible to move these contracts to an exchange or to continue to tolerate them as OTC instruments. Because CDS contracts generally do not have a cash market or basis upon which to draw for the purpose of valuation, as a matter of law and regulation, these instruments are entirely speculative, unsuitable for most banks and investors, and thus should be banned entirely. It is not simply a question, as some observers have suggested, of buyers of CDS having an insurable interest in the underlying basis that is the problem. Rather, because there often times is not observable cash market for say a corporate bond or a CDO, the very act of a dealer offering these instruments to a customer must be viewed as entirely speculative and thus an act of deliberate securities fraud.

Pretending to price CDS contracts or complex structured securities using “models“ is a ridiculous deception that should be rejected by the Congress and by regulators. And members of Congress should remember that federal regulators and the academic economists who populate agencies like the Fed are almost entirely captured by the largest dealer banks. Even today, the Fed and other regulatory agencies raise little or no questions as to the efficacy of OTC derivatives and the absurd quantitative models that Wall Street pretends to use to value these gaming instruments. Why? Because the Fed knows that as the Congress properly regulates OTC derivatives, the largest banks will be forced to shrink their operations, the need for a “systemic risk regulator“ will fade and the role of the Fed within the financial regulatory framework will gradually diminish.

3) How would various proposals to enhance oversight of OTC derivatives affect different market participants?

Imposing appropriate prudential and legal limitations on OTC derivatives would have enormous benefits for investors in terms of better pricing, increase transparency regarding market and liquidity risk, and improved surveillance and oversight by regulators. The notion that requiring basic norms of price discovery and disclosure for OTC markets will hurt “innovation“ is an absurd position and only illustrates the grotesque conflict of interest that now infects the dealers and federal regulators.

If one equates “innovation“ with fraud and criminality, then yes regulation of OTC derivatives will certainly hurt innovation. But if the Congress does its duty and acts to conform the unregulated, opaque OTC markets to the basic standards of honesty and openness that have been the minimum requirement for markets in this country for over a century, then there should be no concern about stifling “innovation.“

Let's make a list of participants and suggest some winners and losers from OTC reform:

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