Subcommittee on Financial Services and General Government

Senate Committee on Appropriations Subcommittee on Financial Services and General Government FY 2011 Appropriations: SEC and CFTC April 28, 2010

Members Present: Richard Durbin (D-IL), Frank Lautenberg (D-NJ), Susan Collins (R-ME), Christopher Bond (R-MO), Thad Cochran (R-MS)

Witnesses: Panel 1 The Honorable Gary Gensler, Chairman, U.S. Commodity Futures Trading Commission

Panel 2 The Honorable Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission

Opening Statements: Durbin: We are now debating whether or not a committee should have oversight on these two agencies, and I believe that we should. Their responsibilities are growing, and so we need to provide resources to help with this. This subcommittee will continue to work diligently to continue its oversight responsibility. These agencies will be held accountable for how they use and spend these resources.

Collins: I also believe in effective congressional oversight, so if we allow these agencies to get out of the annual appropriations process, oversight will not be possible. We should take note of the significant funding increases that we provided to your agencies last year, which was more than the President’s request.

Highlights from Witness Testimony (Panel 1): Gensler: Futures trading volume is increasing, so we need to increase the number of staff. With our increased funding, we’ve been able to increase our enforcement division. We’ve embarked on a program to do automatic surveillance. We’ve implemented the authorities that Congress gave us under the Farm Bill in 2008. But now, market participants have new technology that we need to keep up with. We do need staffing levels and resources to conduct annual reviews. We need to increase our enforcement staff. If Congress were to move forward with derivatives reform, we will have a lot of additional authorities and responsibilities.

Questions and Answers (Panel 1): Durbin: I think with the new authorities and funding increases, we should also increase our oversight. My impression is that the Federal Government is the last to pick up on new technology. Do you feel that your technology improvements parallel the technology in the private sector? Gensler: We have had an ability to get the data resources. We’re trying to build 21st century software to find flags and alerts so our staff can see what’s going on and see if there’s a violation. There are hundreds of thousands of trades a day, so I don’t think we’re there yet. Durbin: Are there any built-in obstacles to obtaining this technology? Gensler: We have the legal ability to acquire it, but it’s usually just resources. Durbin: How much of this information is being made available to the public? Gensler: There’s a great deal of information that we make available in the aggregate data. If derivatives reform moves forward, there would be a lot of information about that as well. We’ve made more information available about index investments in the market. Collins: Position limits can help prevent abrupt market disruptions. What is being done to establish position limits for energy markets? Gensler: We proposed rules to re-establish position limits. We have over 8,000 comments, so we’ll review those and bring them up for recommendations. Collins: We clearly need more transparency in derivatives. Help us understand the debate on derivatives and whether there should be exemptions for end users. Gensler: One of the key ways to lower risk in the trading of derivatives is with clearinghouses. They stand as middlemen between two parties, so if one of the parties fails, they stand behind the contract, so it lowers risk. We’re recommending that there be clearing on products that are standard enough to bring through the clearinghouses. There would be an exemption for non-financial entities, such as agricultural entities.

Bond: If you’re a major energy producer that has a lot of contracts, would these be under the new regulations? Gensler: If they present themselves to the public dealing in swaps, then they would be regulated. We want to guard against the next AIG. We don’t want a loophole that only some swap dealers are being regulated and not others. I don’t think most of these would fit into the category of major swap dealers though.

Durbin: With this whole debate about derivatives, do you have any projection of the volume that we would be talking about? Gensler: This is such a dark market that it’s hard to estimate. We use them more in America than overseas. We don’t have an exact number. Durbin: So will this create a demand for more staffing? Gensler: Yes. Durbin: Are swaps so unique that it will be a burden for your regulators to be able understand? Gensler: I think we’re going to learn along the way. We’ll take the lead in interest rate derivatives, for example.

Collins: You said that the futures market is something like $34 trillion. This raises a question about Senator Dodd’s bill. Is the CFTC a member of the systemic risk council in it? Should you be a member? Gensler: Yes, I think so. Collins: How do you plan to help monitor and mitigate the potential for systemic risk arising from the concentration and interconnectedness of risks that are related to derivatives? Gensler: They weave a spider web throughout the financial markets. One way to lower this interconnectedness is to bring them through clearinghouses. There will be a lot of amendments for exemptions, and I hope we don’t have any for the financial entities. Collins: What kind of transparency would be helpful to you that would come with moving these through clearinghouses? What would you know that you don’t know now? Gensler: There are two kinds of transparency – to the public and to the regulators. Clearinghouses will give transparency to the regulators, and we’ll be able to better enforce and police the markets for manipulation and fraud. Public market transparency only comes from reporting the transactions on a real time basis. This leads to lower costs, and it takes the advantage away from Wall Street. It also lowers risk to the public. Collins: I’ve been hearing from oil companies that are worried that if they have to go through clearinghouses, it will jeopardize their ability to enter into fixed-price contracts. Gensler: I think you’ve heard from them because there are a number of bills. I think there would be an exemption for commercial parties hedging as long as they aren’t financial, so home heating oil companies would be exempted.

Cochran: I want to know about the new authorities that the CFTC should have. What is the status of the legislative authority that you’re talking about? Gensler: It’s a proposal. Right now, the House passed a strong bill and the Senate will hopefully soon. I think the Agriculture and Banking committees have merged their language, and hopefully it will be passed soon. Cochran: Won’t this have a budgetary impact? What are the other funds that will be needed? Gensler: We’ve estimated that we would need about 240 more people and about $18 million more for the technology budget. That’s included in the President’s budget request in a conditional way if Congress adopts regulatory reform.

Highlights from Witness Testimony (Panel 2): Schapiro: We’ve made real progress with improvements, but improving investor confidence will be a continuous effort. The challenge we face grows every day. The number of registered investment advisers has grown by 50%. The FY 2011 budget will allow us to continue to hire more specialists with expertise that we need. It will provide a much-needed $12 million increase for technology. We’re also enhancing collection and distribution of disclosure documents. We plan to improve the case and exam management tools. We will never match the technology of the industry, but improving the technology that we do have will allow us to be competitive with that of the industry. I’m pleased with the progress that we made, but we realize that a lot more work needs to be done to improve our performance and restore investor confidence.

Questions and Answers (Panel 2): Durbin: Since the beginning of the credit crunch, credit rating agencies have come under fire for inflated ratings. You said that the FY 2011 budget will allow you to carry out a more robust examination of these agencies along with NRSROs by next year. You said that the SEC never received funding for these functions, but in FY 2009, Congress provided the SEC $913 million and in FY 2010, Congress provided $1.1 billion. So if overseeing these agencies is a priority, why didn’t you use the extra resources before to examine them? Schapiro: We’re quite committed to examining credit rating agencies, and we’ve already begun this work. Durbin: With the Madoff scheme, the SEC has proposed new improvements, such as enhanced whistleblower protections. A few weeks ago, the SEC’s inspector general released a report and said that even though you reward whistleblowers, there have been very few payments to whistleblowers over the last 20 years. They indicated that even though you’re seeking authority to reward whistleblowers, the current whistleblower program is not well designed in order to deserve increased resources. This report is troubling. Schapiro: When I arrived, I asked that we build a more robust, effective whistleblower program. Insider trading is rarely brought to the attention of the SEC by tips. It’s usually done by surveillance. The SEC staff crafted the whistleblower legislation that we think would be far more effective. I’m not discounting what they do. I believe we can make tremendous use from tips and complaints from whistleblowers, so we need legislative authority to design a more effective program. The program was flawed in many ways, so that’s why we want to expand it. I think the report is on track with what we need to do to make improvements.

Collins: There have three issues in the press lately that I want to ask you about. There’s been speculation that the SEC’s case against Goldman Sachs was somehow motivated by the timing of the financial reform bill. For the record, was the timing of this in any way connected to the Senate reform bill? Schapiro: Absolutely not. I put out a statement that made this clear. Collins: The second question is about the disciplining of the employees involved in the porn case that was recently revealed. According to the report, 33 employees of the agency were found to have looked at porn over the last five years, and 17 of them were highly paid. Another issue has to do with the IG’s criticisms of the SEC’s failure to uncover the Madoff scheme. Has the SEC taken any disciplinary actions as a result of these findings? Schapiro: In the first instance, it was the agency’s own filters that detected the activity. I share your disgust with this conduct, and it’s unacceptable. We will deal with these employees very swiftly and make it clear that anyone who does this will be subject to termination. A number of these incidences occurred years ago, so actions had already been taken. With respect to Madoff, there was a recommendation for us to consider whether discipline was appropriate to deal with this failure. Fifteen employees have already left the agency as a result of this. I can’t comment on any specific actions, but a disciplinary process is underway.

Cochran: Have any of the recommendations from the IG report been implemented? Schapiro: He issued his reports in August and October. The offices that were involved issued corrective action plans, which usually are taken within a year. As of March 31, offices have already begun to implement a number of these recommendations.

Durbin: I want to ask you about the IG’s report from April about the Stanford case. It states that even though the Fort Worth office had tips, they failed to take action to investigate, saying that the SEC was more concerned with quick turnaround with cases at the time. This offers another reminder of potential breakdowns in regulatory oversight. What controls does the SEC have in place now to ensure that big cases like this don’t occur? Schapiro: There were many missed opportunities during that period before the agency took the cases seriously and started to do something. We have new leadership across the board in the agency. We’ve created escalation committees so that if an examiner believes that they have found something that is a real problem and they feel that they are not getting a response when they refer it over to the enforcement division, they take it to an escalation committee and then it will go all the way up to the senior ranks of the organization. We have new management reporting metrics and regular review of open matters in the examinations and enforcement groups so that things aren’t sitting for a long time.

Collins: I asked a question in the Goldman Sachs hearing about whether or not they have a duty to act in the best interests of their clients. They evaded answering my question. The law currently does not impose that kind of fiduciary obligation on broker dealers. In your judgment, should the law impose this? Schapiro: It absolutely should, and we’ve been strongly advocating in the reform bill that at a minimum, the retail public is entitled to know that their financial professional is putting their interests first. We need the law to make this a uniform fiduciary. I hope that the Senate bill, that does not have this in place right now, will emerge with this in place. Right now under the Senate bill we’re required to do a study, and we’re happy to study the issue, although I will say that the SEC contracted with the RAND corporation years ago to do a study of this issue, so there’s a lot out there. So we’ll look at this again, but we hope that when a study is done, it will trigger our ability to write the rules. This is necessary. Collins: Should we distinguish between individual retail investors who are less sophisticated, so should it apply across the board? Schapiro: In the first instance, we need to take care of retail investors. Over time, I think we could expand it, but we should start with retail. I’ll provide you a copy of the RAND study on fiduciary duty.

Durbin: I applaud your last line of questioning. This is something that is absolutely essential and I hope we can find some bipartisan ground with this issue.