Tag Archives: new hedge fund regulations

CFTC Head Addresses Futures Industry in Chicago

Futures Industry Association Annual Expo

CFTC Chairman Gary Gensler today spoke at the Futures Industry Association’s annual expo in Chicago. While most of the Chairman’s speech  focused on the proposed regulation of the OTC derivatives markets, Chairman Gensler also discussed the recent SEC and CFTC Harmonization report. As you can imagine, Gensler is for increasing regulation of the entire financial markets. Below I have included some of the more interested quotes which can be found in the text of the speech text of Chairman Gensler’s speech.

The CTA Expo was going on as well during this time and I will be writing more articles on the speakers at this conference over the next few days.


Both of the committees’ bills include three important elements of regulatory reform: First, they require swap dealers and major swap participants to register and come under comprehensive regulation. This includes capital standards, margin requirements, business conduct standards and recordkeeping and reporting requirements. Second, the bills require that dealers and major swap participants bring their clearable swaps into central clearinghouses. Third, they require dealers and major swap participants to use transparent trading venues for their clearable swaps.

The challenge remains, though, determining which transactions should be covered by these reforms. I believe that we must bring as many transactions under the regulatory umbrella as possible. This will best accomplish the two principal goals of reform: lowering risk to the American public and promoting transparency of the markets.


To promote market transparency, all standardized OTC products should be moved onto regulated exchanges or trade execution facilities. This is the best way to reduce information deficits for participants in these markets. Transparency greatly improves the functioning of the existing securities and futures markets. We should shine the same light on the swaps markets. Increasing transparency for standardized derivatives should enable both large and small end-users to obtain better pricing on standard and customized products.


Some have articulated a false choice between stronger regulation on the one hand and a free market on the other. Rules improve markets, however, by enhancing efficiency and integrity. Traffic lights require you to stop your car, but they also ensure that traffic is orderly and efficient. They reduce risks for every person on the highway. Similarly, this country’s markets work best with clear rules of the road.


Last year’s crisis also highlighted the need for regulators to change. In that regard, the CFTC last week released a joint report with the SEC to bring greater consistency, where appropriate, to our regulatory approaches. While the missions of the CFTC and the SEC may differ, our goal is the same: to protect the public, enhance market integrity and promote transparency. In preparing our report, we set turf aside and focused on those changes that would best benefit the markets and the American people.

We jointly made 20 recommendations where we can change our statutes and regulations to enhance both agencies’ enforcement powers, strengthen market and intermediary oversight and facilitate greater operational coordination.


Other related hedge fund law articles include:

Congress and Regulators Discuss OTC Derivatives Regulation

Increased regulation looming as SEC and CFTC jockey for position

The  severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation, as well as the pressing need for a comprehensive regulatory framework.  Part of President Obama’s new financial regulation plan is to regulate the over the counter (OTC) derivatives markets.  On June 22nd, 2009, both the SEC and CFTC testified to congress regarding the regulation of these markets.

Chairman Mary Shapiro (SEC) and Chairman Gary Gensler (CTFC) each testified before Congress to address the existing gaps in regulatory oversight of these securities-related OTC derivatives, and propose a new framework that would provide expand regulatory authority of the CTFC and SEC to oversee the OTC markets. The primary goal of the proposed regulatory reform measures is to achieve the following four primary objectives:

  1. preventing activities in the OTC derivatives markets from posing risk to the financial system;
  2. promoting efficiency and transparency of those markets;
  3. preventing market manipulation, fraud, and other market abuses; and
  4. ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

I have reprinted the entire SEC testimony and CFTC testimony below.


Testimony Concerning Regulation of Over-The-Counter Derivatives
by Chairman Mary L. Schapiro

U.S. Securities and Exchange Commission
Before the Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing and Urban Affairs
United States Senate
June 22, 2009

I. Introduction

Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee:

I am pleased to have this opportunity to testify on behalf of the Securities and Exchange Commission concerning the regulation of over-the-counter (“OTC”) derivatives. The severe financial crisis that has unfolded over the last two years has revealed serious weaknesses in the structure of U.S. financial regulation. One of these is the gap in regulation of OTC derivatives, which under current law are largely excluded or exempted from regulation. The SEC is committed to working closely with this Committee, the Congress, the Administration, and fellow regulatory agencies to close this gap and restore a sound structure for U.S. financial regulation.

My testimony today on the regulation of OTC derivatives will reflect the SEC’s perspective as the country’s capital markets regulator. First, I will give an overview of the OTC derivatives markets, with particular focus on those derivatives products that are directly related to or based on securities or issuers of securities and therefore directly connected with the SEC’s statutory mandate. Second, I will outline an approach that would address the existing gaps in regulatory oversight of these securities-related OTC derivatives.

I must tell you right at the start that, given the current limited regulation of OTC derivatives, no regulatory authority can give you a complete picture of OTC derivatives and how they have affected the regulated securities markets. One reason that we need legislation is that our sources of information about securities-related OTC derivatives products, participants, and trading are limited, particularly when contrasted with the tools we have to monitor the markets for other securities products subject to the federal securities laws.

The good news, however, is that the U.S. regulatory authorities have reached a broad consensus on the pressing need for a comprehensive regulatory framework for OTC derivatives. As reflected in Treasury Secretary Geithner’s letter to the Congressional leadership on May 13, 2009, this consensus covers all of the basics of sound financial regulation in the 21st century, including recordkeeping and reporting requirements, appropriate capital and margin requirements, transparent and efficient markets, clearing and settlement systems that monitor and manage risk, business conduct and disclosure standards to protect the interests of market participants, and vigorous enforcement against fraud and other wrongdoing.

One important aspect of a new regulatory framework will be well-regulated central counterparties (“CCPs”). CCPs address concerns about counterparty risk by substituting the creditworthiness and liquidity of the CCP for the creditworthiness and liquidity of counterparties. For this reason, CCPs contribute generally to the goal of market stability. Through uniform margining and other risk controls, including controls on market-wide concentrations that cannot be implemented effectively when counterparty risk management is decentralized, CCPs help protect the broader financial system. It is important to note that achieving standardization, a prerequisite for centralized clearing, may present significant challenges.

U.S. regulators agree on the objectives of a new regulatory framework for OTC derivatives that will protect the public interest, manage systemic risk, and promote capital formation and general economic welfare. Any new regulatory framework, however, should take into consideration the purposes that appropriately regulated derivatives can serve, including affording market participants the ability to hedge positions and effectively manage risk. My goal today is to assist the Congress as best I can in its efforts to craft legislation that empowers the respective regulatory authorities to do their jobs effectively in any new framework. I am confident that, working together, we will meet the challenge that is so important to the financial well-being of individual Americans.

II. Overview of Securities-Related OTC Derivatives

A derivative is a financial instrument whose value is based on the value of an underlying “reference” (e.g., an asset such as a commodity, bond, equity, or currency, or an index of such assets, or an event). For example, in exchange for $100 today, financial institution “A” will pay counterparty “B” $150 if “something” happens (something can be almost anything: Z company defaults on its debt payments; the S&P 500 falls 10%; the Dow rises 5%). A derivative is “OTC” when it is not traded on a regulated exchange. An OTC derivative is “securities-related” when the reference is to an entity that is an issuer of securities (such as a public company), to a security itself (or a related event such as a dividend payment), to a group or index of securities or issuers, or based on related aspects of a security or group or index of securities or issuers, such as price, yield, volatility, dividend payments, or value.

An OTC derivative is an incredibly flexible product that can, essentially, be engineered to achieve almost any financial purpose between two parties. Indeed, as I will discuss later, an OTC derivative can enable market participants to replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves. Transactions occurring in the OTC derivatives markets can serve important economic purposes such as allowing market participants to hedge exposure and manage risk. When market participants engage in these types of transactions in the OTC derivatives markets, the transactions, which are substantially similar to traditional securities transactions, and the parties engaged in them, would fall outside the current reach of key provisions of the federal securities laws.

OTC derivatives are largely excluded from the securities regulatory framework by the Commodity Futures Modernization Act of 2000.1 In a recent study on a type of securities-related OTC derivative known as a credit default swap, or CDS, the Government Accountability Office found that “comprehensive and consistent data on the overall market have not been readily available,” that “authoritative information about the actual size of the CDS market is generally not available,” and that regulators currently are unable “to monitor activities across the market.”

One source of information on OTC derivatives volume is the data collected by the Bank for International Settlements (“BIS”). BIS data cover the OTC derivatives exposure of major banks and dealers in the G10 countries. For all OTC derivatives in December 2008, BIS reported a notional amount outstanding of $592 trillion and a gross market value outstanding of $34 trillion. Interest rate contracts and foreign exchange contracts are the two largest sources of OTC derivatives volume. For those types of products that appear to be securities-related credit derivatives and equity derivatives in December 2008, BIS reported a notional amount outstanding of $48.4 trillion and a gross market value outstanding of $6.8 trillion. A notional amount of $70 trillion and a gross market value of $5 trillion are “unallocated” for December 2008. Clearly, this volume of largely unregulated financial activity is enormous, even when just considering the relatively small volume component that is securities-related.

Who are the major participants in the securities-related OTC derivatives markets? First, the markets are concentrated and appear to be almost exclusively “dealer-intermediated” — that is, one of a small number of major dealers is a party to almost all transactions, whether as a buyer or a seller. The customers of the dealers appear to be almost exclusively institutions. Many of these may be highly sophisticated, such as large hedge funds and other pooled short-term trading vehicles. As you know, many hedge funds have not been subject to direct regulation by the SEC and, accordingly, we have very little ability to obtain information concerning their trading activity at this point.

Other customers in the securities-related OTC derivatives markets have been institutions for which derivatives products may not be a suitable investment. In this regard, there is consensus among U.S. regulators reflected in Secretary Geithner’s letter is to ensure that OTC derivatives are not marketed inappropriately to unsophisticated parties. The SEC and CFTC staff, together with other financial regulators, currently are considering a tiered approach to regulation, with scaling that could be based in the first instance on indicia of sophistication and financial thresholds, with requirements for additional disclosure and standards of care with respect to the marketing of derivatives to less sophisticated counterparties. Implementation of such a regulatory approach would depend on a Congressional grant of authority in this area.

Finally, what are the purposes for which securities-related OTC derivatives may be used? One example of a useful purpose for securities-related OTC derivatives is to manage the risk associated with a particular securities position. An investor with a large position in the debt of a company may seek to reduce or hedge some of the risk associated with that investment by purchasing credit protection in the CDS market. In addition, market participants also may use a securities-related OTC derivative to establish a short position with respect to the debt of a specific company. In particular, a market participant that does not own a bond or other debt instrument of a company may purchase a CDS as a way to short that company’s debt.

Market participants take positions in a wide range of exchange-traded and OTC instruments. It is a market participant’s overall (or net) economic exposure that plays a role in determining the risks to which it is exposed. Because OTC derivatives can be customized, a market participant could take a long position in an index — such as the S&P 100 index — through a securities-related OTC derivative and a short position through another OTC derivative on a subset of the securities in the S&P 100 index. The flexibility to tailor OTC derivative contracts allows a participant to create an economic exposure to as large or small a portion of the market it chooses through one or a combination of contracts. This flexibility allowed by OTC derivatives is one of these contracts’ strengths. Because of the link to regulated securities market, however, it is important that the SEC have the tools to see all related activity so that it is in the best position possible to detect and deter market abuses that can disrupt the integrity of the market.

III. Filling Regulatory Gaps in Oversight of Securities-Related OTC Derivatives

Secretary Geithner’s May 13 letter to the Congressional leadership outlined the Administration’s plan for establishing a comprehensive framework for regulating OTC derivatives. The framework is designed to achieve four broad objectives: (1) preventing activities in the OTC derivatives markets from posing risk to the financial system; (2) promoting efficiency and transparency of those markets; (3) preventing market manipulation, fraud, and other market abuses; and (4) ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties.

Secretary Geithner recognized that multiple federal regulatory agencies would play critical roles in implementing the proposed framework, including the SEC and the CFTC. He emphasized that the securities and commodities laws should be amended to ensure that the SEC and CFTC, consistent with their respective missions, have the necessary authority to achieve — together with the efforts of other regulators — the four policy objectives for OTC derivatives regulation.

The final part of my testimony today is intended to follow up on Secretary Geithner’s letter by recommending a straightforward and principled approach for achieving these policy objectives. Stated briefly, primary responsibility for “securities-related” OTC derivatives would be retained by the SEC, which is also responsible for oversight of markets affected by this subset of OTC derivatives. Primary responsibility for all other OTC derivatives, including derivatives related to interest rates, foreign exchange, commodities, energy, and metals, , would rest with the CFTC.

Under this functional and sensible approach to regulation, OTC derivatives markets that are interconnected with the regulated securities markets would be incorporated within a unified securities regulatory regime. The direct link between securities-related OTC derivatives and securities is such that SEC regulation of the former is essential to the effectiveness of the SEC’s statutory mission with respect to the securities markets. The securities regulatory regime is specifically designed to promote the Congressional objectives for capital markets, which include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. It is important that securities-related OTC derivatives be subject to the federal securities laws so that the risk of arbitrage and manipulation of interconnected markets is minimized.

Over the years, Congress has fashioned a broad and flexible regulatory regime for securities that long has accommodated a wide range of products and trading venues. The products include equities, debt, other fixed income securities, options on securities, exchange-traded funds and other investment companies, and many other types of derivative contracts on securities. Some of these securities products are among the most actively traded financial products in the world, with exchange-listed US equities currently trading approximately 11 billion shares per day. Many other securities products trade rarely, if at all. In addition, securities products trade in many different ways in a wide variety of venues, depending on the particular features of the product. These venues include 11 national securities exchanges with self-regulatory responsibilities, more than 70 alternative trading systems that execute OTC transactions, and hundreds of broker-dealers that execute OTC transactions. Finally, securities products are cleared and settled in a variety of ways depending on the particular characteristics of the product.

The current securities laws are broad and flexible enough to regulate appropriately all of these varied securities products and trading venues. The regulatory requirements are specifically tailored to reflect the particular nature of products and venues and to promote the Congressional objectives for capital markets. Accordingly, securities-related OTC derivatives could be brought under the same umbrella of oversight as the related, underlying securities markets in a relatively straightforward manner with little need to “reinvent the wheel.” Specifically, Congress could make a limited number of discrete amendments to the statutory definition of a security to cover securities-related OTC derivatives. With these definitional changes, securities-related OTC derivatives could be incorporated within an existing regulatory framework that is appropriate for these products.

The rest of my testimony will elaborate on this basic approach. I first will discuss the close relationship between the regulated securities markets and the markets for securities-related OTC derivatives and then sketch an overview of how oversight of such instruments could be integrated with the SEC’s existing oversight of the securities markets.

A. Relationship between the Securities Markets and Securities-Related OTC Derivatives

In fashioning a regulatory framework for OTC derivatives, it is crucial to recognize the close relationship between the regulated securities markets and the now mostly unregulated markets for securities-related OTC derivatives. Securities-related OTC derivatives can be used to establish either a synthetic “long” exposure to an underlying security or group of securities, or a synthetic “short” exposure to an underlying security or group of securities. In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves.

For example, an equity swap on a single equity security or on an index, such as one of the Dow stocks or the Dow itself, would give the holder of the “long” position all of the economic exposure of owning the stock or index, without actual ownership of the stock or index. This would include exposure to price movements of the stock or index, as well as any dividends or other distributions. Similarly, credit default swaps (“CDS”) can be used as synthetic substitutes for the debt securities of one or more companies. Indeed, any exchange of cash for a security can be structured as an OTC derivatives contract.

Because market participants can readily use securities-related OTC derivatives to serve as synthetic substitutes for securities, the markets for these OTC derivatives directly and powerfully implicate the policy objectives for capital markets that Congress has set forth in the federal securities laws. These objectives include investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

1. Investor Protection

The current regulatory framework has permitted certain opaque securities-related OTC derivatives markets to develop outside of investor protection provisions of the securities laws. These provisions include requiring the disclosure of significant ownership provisions and recordkeeping and reporting (including those that serve as prophylactic measures against fraud, manipulation, or insider trading) that helps to promote enforcement of the securities laws.

The exclusion of certain securities-related OTC derivatives from most of the securities regulatory regime has detracted from the SEC’s ability to uphold its investor protection mandate. For example, in investigating possible market manipulation during the financial crisis, the SEC has used its anti-fraud authority over security-based swaps to gather information about transactions in OTC derivatives as well as in the underlying securities. Yet investigations of these OTC derivative transactions have been far more difficult and time-consuming than those involving cash equities and options. Audit trail data on OTC derivative transactions is not readily available and must be reconstructed manually, in contrast to the data available in the equity markets. The SEC’s enforcement efforts have been seriously complicated by the lack of a mechanism for promptly obtaining critical information — who traded, how much, and when — that is complete and accurate.

In addition, the SEC believes that it is important in the OTC derivatives market, as in the market for securities generally, that parties to transactions have access to financial information and other disclosures so they can evaluate the risks relating to a particular investment to make more informed investment decisions and can value and evaluate their OTC derivatives and their counterparty exposures. For example, this information assists market participants in performing adequate due diligence on their investments and in valuing their OTC derivatives and their other risks.

A basic tenet of functional regulation of securities markets is to have a regulatory regime under which similar products and activities should be subject to similar regulations and oversight. Currently, securities are subject to transparency, active enforcement, and appropriate regulation of business conduct. Whereas securities-related OTC derivatives, which are interconnected with the securities markets (and in some cases are economic substitutes for securities) are not subject to most of these investor protection requirements. The securities laws are uniquely designed to address these issues and should be extended to OTC derivatives.

2. Fair and Orderly Markets

Trading in securities-related OTC derivatives can directly affect trading in the securities markets. From an economic viewpoint, the interchangeability of securities and securities-related OTC derivatives means that they are driven by the same economic forces and are linked by common participants, trading strategies, and hedging activities.

For example, credit default swap, or CDS trading is closely related to trading in the underlying securities that compose the capital structure of the companies on which protection is written. Trading practices in the CDS market, whether legitimate or abusive, can affect the securities markets. The CDS market, however, lacks the level of transparency and other protections that characterize the regulated securities markets. As a result, the SEC has been unable to monitor effectively for trading abuses and whether purchasers of CDS protection on an issuer’s debt have sold short the equity securities of that company as a trading strategy, effectively linking activities and changes in the CDS market with those in the cash equity market. These activities in the CDS market could adversely impact the regulated securities markets. Any regulatory reform that maintained distinct regulatory regimes for securities markets and markets for securities-related OTC derivatives would suffer from this same limitation.

The SEC is considering whether reporting under the Exchange Act should apply to security-based OTC derivatives so that the ownership of and transactions in security-based derivatives would be considered ownership of and transactions in the underlying equity security. We are further evaluating whether persons using equity derivatives, such as an equity swap, should be subject to the beneficial ownership reporting provisions of the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

3. Capital Formation

Facilitating capital formation depends on the existence of fair and efficient secondary markets for investors. Purchasers in the primary offering of a company are attracted by secondary markets that enable them to liquidate their positions readily. Less efficient markets can cause potential investors in companies either to find other uses for their funds or to demand a higher rate of return to compensate them for a less efficient secondary market. If a disparity in the regulatory requirements for securities and securities-related OTC derivatives cause securities markets to operate less efficiently, it will harm those companies that depend on the U.S. securities markets to access the capital that is essential for innovation and growth, as well as harming investors and the capital markets as a whole.

Because many securities-related OTC derivatives are allowed to trade outside of the securities regulatory regime, the SEC generally is unable to promote transparency in the trading of these products and efficiency in pricing. As noted above, companies whose securities are affected by the excluded products could suffer from the absence of transparency and efficiency. Moreover, manipulative activities in the markets for securities-related OTC derivatives can affect US issuers in the underlying equity market, thereby damaging the public perception of those companies and raising their cost of capital. To protect the integrity of the markets, trading in all securities-related OTC derivatives should be fully subject to the US regulatory regime designed to facilitate capital formation. Nevertheless, it is important to remember that derivatives transactions, including OTC derivatives transactions, allow parties to hedge and manage risk, which itself can promote capital formation. To the extent the ability to manage risk is inappropriately limited, it can discourage market participation, including by investors.

B. Regulatory Oversight of Securities-Related OTC Derivatives

To provide a unified, consistent framework for securities regulation, Congress should subject securities-related OTC derivatives to the federal securities laws. This result can be achieved simply by clarifying the definition of “security” to expressly include securities-related OTC derivatives, and removing the current express exclusion of swaps from that definition. The SEC then would have authority to regulate securities-related OTC derivatives regardless of how the products are traded, whether on an exchange or OTC, and regardless of how the products are cleared.

1. Definition of Securities-Related OTC Derivatives

OTC derivatives can be categorized generally as securities-related or non-securities-related, based on the different types of underlying assets, events, or interests to which they are related. Securities-related OTC derivatives would include equity derivatives and credit and other fixed income derivatives. Non-securities-related derivatives would include interest rate derivatives, foreign currency derivatives, and all non-financial derivatives. By including securities-related OTC derivatives under the umbrella of the federal securities laws, the SEC would have responsibility over the portion of the OTC derivatives market that is vital to promote its mission of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation.

In addition, the SEC would continue to regulate those types of OTC derivatives that always have been considered securities, such as OTC security options, certain OTC notes (including equity-linked notes), and forward contracts on securities. These particular types of OTC derivatives always have been included in the definition of security and current law recognizes this fact by excluding these derivatives from the definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act.

2.Regulation of OTC Derivatives Dealers and Major OTC Participants

Under our recommended approach, major participants in the OTC derivatives markets would be subject to oversight and supervision to ensure there are no gaps. To reduce duplication, OTC derivatives dealers that are banks would be subject to prudential supervision by their federal banking regulator. All other OTC derivatives dealers in securities-related OTC derivatives would be subject to supervision and regulation by the SEC. The SEC would have authority to set appropriate capital requirements for these OTC derivatives dealers. This approach would permit existing OTC derivatives dealers that are banks to continue to engage in OTC derivatives activities without being subject to the full panoply of broker-dealer regulation, while ensuring that all currently unregulated OTC derivatives dealers in securities-related OTC derivatives are subject to appropriate supervision and regulation. Should Congress establish a new systemic risk regulator or systemic risk council, that entity also could help monitor institutions that might present systemic risk.

In addition, the SEC would have authority to establish business conduct standards and recordkeeping and reporting requirements (including an audit trail) for all securities-related OTC derivatives dealers and other firms with large counterparty exposures in securities-related OTC derivatives (“Major OTC Participants”). This “umbrella” authority would help ensure that the SEC has the tools it needs to oversee the entire market for securities-related OTC derivatives. Major OTC Participants also would be required to meet appropriate standards for the segregation of customer funds and securities.

3. Trading Markets and Clearing Agencies

Trading markets and clearing organizations for securities-related OTC derivatives would be subject to registration requirements as exchanges and clearing agencies. Importantly, however, the conditional exemption from exchange registration the SEC provided under Regulation ATS would be available to trading systems for securities-related OTC derivatives. Among other things, Regulation ATS lowers barriers to entry for trading systems in securities because the systems need not assume the full self-regulatory responsibilities associated with being a national securities exchange. Both registered exchanges and ATSs are subject to important transparency requirements. Consequently, expanding the SEC’s authority over securities-related OTC derivatives would promote improved efficiency and transparency in the markets for securities-related OTC derivatives.

Similarly, the regulatory regime for securities clearing agencies would ensure that CCPs for securities-related OTC derivatives impose appropriate margin requirements and other necessary risk controls. The SEC’s historic regulation of clearing agencies under Section 17A of the Exchange Act has resulted in the most efficient, lowest cost clearing in the world. Indeed, the solid performance of securities clearing systems during the financial crisis bears out that they have the resilience to withstand difficult economic conditions. In addition, the regulation of securities clearance and settlement would directly affect market structure and competition in the trading markets for securities-related OTC derivatives. For example, the SEC’s statutory mandate governing clearing agencies prohibits clearing agencies from engaging in anti-competitive practices, such as imposing unreasonable limitations on access to services. Clearing agencies cannot exclude participants merely for executing their trades in a cleared product in a particular venue. This fair access requirement allows for multiple, competing markets, including OTC trading systems and OTC dealers, to trade the same securities and clear through a single clearing organization. The securities clearing system would support both the goal of having the greatest number of OTC derivatives centrally cleared, while retaining flexibility to allow variation in trading venues to meet the trading needs of different instruments and participants.

The SEC already has taken a number of actions to help further the centralized clearing for OTC derivatives, including exempting three CCPs from the requirement to register as securities clearing agencies. These exemptions were issued to speed the operation of central clearing for CDS. They are temporary and subject to conditions designed to ensure that important elements of Commission oversight apply, such as recordkeeping and Commission staff access to examine clearing facilities. In addition, to further the goal of transparency, each clearing agency is required to make publicly available on fair, reasonable, and not unreasonably discriminatory terms end-of-day settlement prices and any other pricing or valuation information that it publishes or distributes.

One important issue is how to deal with those OTC derivative contracts that may be ineligible for central clearing. OTC derivatives may be ineligible for clearing for a variety of reasons, including customized terms and an inability of CCPs to effectively manage the risks. In many cases, there are legitimate economic reasons to engage in customized transactions. Participants in individual transactions, however, should not be permitted to externalize the costs of their decisions, such as by creating additional systemic risk. Regulatory requirements often have costs, but they are costs incurred to protect the public interest and the general economic welfare. One way for regulators to help ensure market participants incorporate all the risks in the terms of a transaction would be to impose appropriate margin and capital requirements on the participants in customized transactions to reflect the risks they pose to market systems generally. This is an area in which the various functional regulators for particular entities could consult closely with any systemic risk agency that Congress might establish.

In addressing all of these issues with respect to OTC derivatives, moreover, the U.S. must coordinate its efforts with those of regulatory authorities abroad as they seek to address similar issues. The global financial crisis is a potent reminder of the extent to which economies around the world are linked by financial practices and market participants. A sound regulatory approach for managing the systemic risk of such practices and participants benefits from the implementation of complementary measures on an international basis.

V. Conclusion

Bringing securities-related OTC derivatives under the umbrella of the federal securities laws would be based on sound principles of functional regulation, would be relatively straightforward to implement, and would promote Congressional policy objectives for the capital markets. A clear delineation of primary regulatory responsibility for OTC derivatives also would help avoid regulatory gaps from arising in the future. Finally, integrating oversight of securities-related OTC derivatives with oversight of the related, underlying securities markets would minimize the extent of dislocation with respect to existing participants and current practices in the OTC derivatives markets, while still achieving the objectives for OTC derivatives regulation set forth in Secretary Geithner’s letter to the Congressional leadership.

Thank you for the opportunity to address issues of such importance for the strength and stability of the U.S. financial system, and the integrity of the U.S. capital markets. I would be pleased to answer your questions.


Commodity Futures Trading Commission
Office of External Affairs
Three Lafayette Centre
1155 21st Street, NW
Washington, DC 20581

Testimony of Chairman Gary Gensler, Commodity Futures Trading Commission Before the Senate Banking Subcommittee on Securities, Insurance, and Investment
June 22, 2009

Good morning Chairman Reed, Ranking Member Bunning, and Members of the Committee. I am here today testifying on behalf of the Commission.

The topic of today’s hearing, how to best modernize oversight of the over-the-counter derivatives markets, is of utmost importance during this crucial time for our economy. As President Obama laid out last week, we must urgently enact broad reforms in our financial regulatory structure in order to rebuild and restore confidence in our overall financial system.

Such reforms must comprehensively regulate both derivative dealers and the markets in which derivatives trade. I look forward to working with the Congress to ensure that the OTC derivatives markets are transparent and free from fraud, manipulation and other abuses.

This effort will require close coordination between the SEC and the CFTC to ensure the most appropriate regulation. I’m fortunate to have as a partner in this effort, SEC Chair Mary Schapiro. She brings invaluable expertise in both the security and commodity futures area, which gives me great confidence that we will be able to provide the Congress with a sound recommendation for comprehensive oversight of the OTC derivatives market. We also will work collaboratively on recommendations on how to best harmonize regulatory efforts between agencies as requested by President Obama. Comprehensive Regulatory Framework A comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, it should apply to the dealers and derivatives no matter what type of swaps or other derivatives may be invented in the future. This framework should apply regardless of whether the derivatives are standardized or customized.

A new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives:

  • Lower systemic risks;
  • Promote the transparency and efficiency of markets;
  • Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and
  • Protect the public from improper marketing practices.

To best achieve these objectives, two complementary regulatory regimes must be implemented: one focused on the dealers that make the markets in derivatives and one focused on the markets themselves – including regulated exchanges, electronic trading systems and clearing houses. Only with these two complementary regimes will we ensure that federal regulators have full authority to bring transparency to the OTC derivatives world and to prevent fraud, manipulation, and other types of market abuses. These two regimes should apply no matter which type of firm, method of trading or type of derivative or swap is involved.

Regulating Derivatives Dealers:

I believe that institutions that deal in derivatives must be explicitly regulated. In addition, regulations should cover any other firms whose activities in these markets can create large exposures to counterparties. The current financial crisis has taught us that the derivatives trading activities of a single firm can threaten the entire financial system and that all such firms should be subject to robust Federal regulation. The AIG subsidiary that dealt in derivatives – AIG Financial Products – for example, was not subject to any effective regulation. The derivatives dealers affiliated with Lehman Brothers, Bear Stearns, and other investment banks were not subject to mandatory regulation either. By fully regulating the institutions that trade or hold themselves out to the public as derivative dealers we can oversee and regulate the entire derivatives market. I believe that our laws should be amended to provide for the registration and regulation of all derivative dealers.

The full, mandatory regulation of all derivatives dealers would represent a dramatic change from the current system in which some dealers can operate with limited or no effective oversight. Specifically, all derivative dealers should be subject to capital requirements, initial margining requirements, business conduct rules, and reporting and recordkeeping requirements. Standards that already apply to some dealers, such as banking entities, should be strengthened and made consistent, regardless of the legal entity where the trading takes place.

Capital and Margin Requirements:

The Congress should explicitly require regulators to promulgate capital requirements for all derivatives dealers. Imposing prudent and conservative capital requirements, and initial margin requirements, on all transactions by these dealers will help prevent the types of systemic risks that AIG created. No longer would derivatives dealers or counterparties be able to amass large or highly leveraged risks outside the oversight and prudential safeguards of regulators.

Business Conduct and Transparency Requirements:

Business conduct standards should include measures to both protect the integrity of the market and lower the risk (both counterparty and operating) from OTC derivatives transactions. To promote market integrity, the business conduct standards should include prohibitions on fraud, manipulation and other abusive practices. For OTC derivatives that come under CFTC jurisdiction, these standards should require adherence to position limits when they perform or affect a significant price discovery function with respect to regulated markets.

Business conduct standards should ensure the timely and accurate confirmation, processing, netting, documentation, and valuation of all transactions. These standards for “back office” functions will help reduce risks by ensuring derivative dealers, their trading counterparties and regulators have complete, accurate and current knowledge of their outstanding risks.

Derivatives dealers also should be subject to recordkeeping and reporting requirements for all of their OTC derivatives positions and transactions. These requirements should include retaining a complete audit trail and mandated reporting of any trades that are not centrally cleared to a regulated trade repository. Trade repositories complement central clearing by providing a location where trades that are not centrally cleared can be recorded in a manner that allows the positions, transactions, and risks associated with those trades to be reported to regulators. To provide transparency of the entire OTC derivatives market, this information should be available to all relevant federal financial regulators. Additionally, there should be clear authority for regulating and setting standards for trade repositories and clearinghouses to ensure that the information recorded meets regulatory needs and that the repositories have strong business conduct practices.

The application of these business conduct standards and the transparency requirements will enable regulators to have timely and accurate knowledge of the risks and positions created by the dealers. It will provide authorities with the information and evidentiary record needed to take any appropriate action to address such risks and to protect and police market integrity. In this regard, the CFTC and SEC should have clear, unimpeded oversight and enforcement authority to prevent and punish fraud, manipulation and other market abuses.

Market transparency should be further enhanced by requiring that aggregated information on positions and trades be made available to the public. No longer should the public be in the dark about the extensive positions and trading in these markets. This public information will improve the price discovery process and market efficiency.

Regulating Derivatives Markets:

In addition to the significant benefits to be gained from broad regulation of derivatives dealers, I believe that additional safety and transparency must be afforded by regulating the derivative market functions as well. All derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses and brought onto regulated exchanges or regulated transparent electronic trading systems.  Requiring clearing and trading on exchanges or through regulated electronic trading systems will promote transparency and market integrity and lower systemic risks. To fully achieve these objectives, both of these complementary regimes must be enacted.

Regulating both the traders and the trades will ensure that both the actors and the actions that may create significant risks are covered. Exchange-trading and central clearing are the two key and related components of well functioning markets. Ever since President Roosevelt called for the regulation of the commodities and securities markets in the early 1930s, the CFTC (and its predecessor) and the SEC have each regulated the clearing functions for the exchanges under their respective jurisdiction. The practice of having the agency which regulates an exchange or trade execution facility also regulate the clearing houses for that market has worked well and should continue as we extend regulations to cover the OTC derivatives market.

Central Clearing:

Central clearing should help reduce systemic risks in addition to the benefits derived from comprehensive regulation of derivatives dealers. Clearing reduces risks by facilitating the netting of transactions and by mutualizing credit risks. Currently, most of the contracts entered into in the OTC derivatives market are not cleared, and remain as bilateral contracts between individual buyers and sellers.

In contrast, when a contract between a buyer and seller is submitted to a clearinghouse for clearing, the contract is “novated” to the clearinghouse. This means that the clearinghouse is substituted as the counterparty to the contract and then stands between the buyer and the seller. Clearinghouses then guarantee the performance of each trade that is submitted for clearing. Clearinghouses use a variety of risk management practices to assure the fulfillment of this guarantee function. Foremost, derivatives clearinghouses would lower risk through the daily discipline of marking to market the value of each transaction. They also require the daily posting of margin to cover the daily changes in the value of positions and collect initial margin as extra protection against potential market changes that are not covered by the daily mark-to-market.

The regulations applicable to clearing should require that clearinghouses establish and maintain robust margin standards and other necessary risk controls and measures. It is important that we incorporate the lessons from the current crisis as well as the best practices reflected in international standards. Working with Congress, we should consider possible amendments to the CEA to expand and deepen the core principles that registered derivatives clearing organizations must meet to achieve these goals to both strengthen these systems and to reduce the possibility of regulatory arbitrage. Clearinghouses should have transparent governance arrangements that incorporate a broad range of viewpoints from members and other market participants.

Central counterparties should also be required to have fair and open access criteria that allow any firm that meets objective, prudent standards to participate regardless of whether it is a dealer or a trading firm. Additionally, central clearinghouses should implement rules that allow indirect participation in central clearing. By novating contracts to a central clearinghouse coupled with effective risk management practices, the failure of a single trader, like AIG, would no longer jeopardize all of the counterparties to its trades.

One of the lessons that emerged from this recent crisis was that institutions were not just “too big to fail,” but rather too interconnected as well. By mandating the use of central clearinghouses, institutions would become much less interconnected, mitigating risk and increasing transparency. Throughout this entire financial crisis, trades that were carried out through regulated exchanges and clearinghouses continued to be cleared and settled.

In implementing these responsibilities, it will be appropriate to consider possible additional oversight requirements that may be imposed by any systemic risk regulator that Congress may establish.  Under the Administration’s approach, the systemic regulator, would be charged with ensuring consistent and robust standards for all systemically important clearing, settlement and payment systems. For clearinghouses overseen comprehensively by the CFTC and SEC, the CFTC or SEC would remain the primary regulatory, but the systemic regulator would be able to request information from the primary regulator, participate in examinations led by the primary regulator, make recommendations on strengthening standards to the primary regulator and ultimately, after consulting with the primary regulator and the new Financial Services Oversight Council, use emergency authority to compel a clearinghouse to take actions to address financial risks. Exchange-trading. Beyond the significant transparency afforded the regulators and the public through the record keeping and reporting requirements of derivatives dealers, market transparency and efficiency would be further improved by moving the standardized part of the OTC markets onto regulated exchanges and regulated transparent electronic trading systems. I believe that this should be required of all standardized contracts.

Furthermore, a system for the timely reporting of trades and prompt dissemination of prices and other trade information to the public should be required. Both regulated exchanges and regulated transparent trading systems should allow market participants to see all of the bids and offers. A complete audit trail of all transactions on the exchanges or trade execution systems should be available to the regulators. Through a trade reporting system there should be timely public posting of the price, volume and key terms of completed transactions. The Trade Reporting and Compliance Engine (TRACE) system currently required for timely reporting in the OTC corporate bond market may provide a model.

The CFTC and SEC also should have authority to impose recordkeeping and reporting requirements and to police the operations of all exchanges and electronic trading systems to prevent fraud, manipulation and other abuses.

In contrast to long established on-exchange futures and securities markets, there is a need to encourage the further development of exchanges and electronic trading systems for OTC derivatives. In order to promote this goal and achieve market efficiency through competition, there should be sufficient product standardization so OTC derivative trades and open positions are fungible and can be transferred between one exchange or electronic trading system to another.

Position Limits:

Position limits must be applied consistently across all markets, across all trading platforms, and exemptions to them must be limited and well defined. The CFTC should have the ability to impose position limits, including aggregate limits, on all persons trading OTC derivatives that perform or affect a significant price discovery function with respect to regulated markets that the CFTC oversees. Such position limit authority should clearly empower the CFTC to establish aggregate position limits across markets in order to ensure that traders are not able to avoid position limits in a market by moving to a related exchange or market, including international markets.

Standardized and Customized Derivatives:

It is important that tailored or customized swaps that are not able to be cleared or traded on an exchange be sufficiently regulated. Regulations should also ensure that customized derivatives are not used solely as a means to avoid the clearing and exchange requirements. This could be accomplished in two ways. First, regulators should be given full authority to prevent fraud, manipulation and other abuses and to impose recordkeeping and transparency requirements with respect to the trading of all swaps, including customized swaps. Second, we must ensure that dealers and traders cannot change just a few minor terms of a standardized swap to avoid clearing and the added transparency of exchanges and electronic trading systems.

One way to ensure this would be to establish objective criteria for regulators to determine whether, in fact, a swap is standardized. For example, there should be a presumption that if an instrument is accepted for clearing by a fully regulated clearinghouse, then it should be required to be cleared. Additional potential criteria for consideration in determining whether a contract should be considered to be a standardized swap contract could include:

  • The volume of transactions in the contract;
  • The similarity of the terms in the contract to terms in standardized contracts;
  • Whether any differences in terms from a standardized contract are of economic significance; and
  • The extent to which any of the terms in the contract, including price, are disseminated to third parties.

Criteria such as these could be helpful in ensuring that parties are not able to avoid the requirements applicable to standardized contracts by tweaking the terms of such contracts and then labeling them “customized.  Regardless of whether an instrument is standardized or customized, or traded on an exchange or on a transparent electronic trade execution system, regulators should have clear, unimpeded authority to impose recordkeeping and reporting requirements, impose margin requirements, and prevent and punish fraud, manipulation and other market abuses. No matter how the instrument is traded, the CFTC and SEC as appropriate also should have clear, unimpeded authority to impose position limits, including aggregate limits, to prevent excessive speculation. A full audit trail should be available to the CFTC, SEC and other Federal regulators.


To achieve these goals, the Commodity Exchange Act and security laws should be amended to provide the CFTC and SEC with clear authority to regulate OTC derivatives. The term “OTC derivative” should be defined, and clear authority should be given over all such instruments regardless of the regulatory agency. To the extent that specific types of OTC derivatives might overlap agencies’ existing jurisdiction, care must be taken to avoid unnecessary duplication.

As we enact new laws and regulations, we should be careful not to call into question the enforceability of existing OTC derivatives contracts. New legislation and regulations should not provide excuses for traders to avoid performance under pre-existing, valid agreements or to nullify pre-existing contractual obligations.

Achieving the Four Key Objectives:

Overall, I believe the complimentary regimes of dealer and market regulation would best achieve the four objectives outlined earlier. As a summary, let me review how this would accomplish the measures applied to both the derivative dealers and the derivative markets.

Lower Systemic Risk:

This dual regime would lower systemic risk through the following four measures:

  • Setting capital requirements for derivative dealers;
  • Creating initial margin requirements for derivative dealers (whether dealing in standardized or customized swaps);
  • Requiring centralized clearing of standardized swaps; and
  • Requiring business conduct standards for dealers.

Promote Market Transparency and Efficiency:

This complementary regime would promote market transparency and efficiency by:

  • Requiring that all OTC transactions, both standardized and customized, be reported to a regulated trade repository or central clearinghouses;
  • Requiring clearinghouses and trade repositories to make aggregate data on open positions and trading volumes available to the public;
  • Requiring clearinghouses and trade repositories to make data on any individual counterparty’s trades and positions available on a confidential basis to regulators;
  • Requiring centralized clearing of standardized swaps;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
  • Requiring the timely reporting of trades and prompt dissemination of prices and other trade information;

Promote Market Integrity:

It would promote market integrity by:

  • Providing regulators with clear, unimpeded authority to impose reporting requirements and to prevent fraud, manipulation and other types of market abuses;
  • Providing regulators with authority to set position limits, including aggregate position limits;
  • Moving standardized products onto regulated exchanges and regulated, transparent trade execution systems; and
  • Requiring business conduct standards for dealers.

Protect Against Improper Marketing Practices:

It would ensure protection of the public from improper marketing practices by:

  • Business conduct standards applied to derivatives dealers regardless of the type of instrument involved; and
  • Amending the limitations on participating in the OTC derivatives market in current law to tighten them or to impose additional disclosure requirements, or standards of care (e.g. suitability or know your customer requirements) with respect to marketing of derivatives to institutions that infrequently trade in derivatives, such as small municipalities.


The need for reform of our financial system today has many similarities to the situation facing the country in the 1930s. In 1934, President Roosevelt boldly proposed to the Congress “the enactment of legislation providing for the regulation by the Federal Government of the operation of exchanges dealing in securities and commodities for the protection of investors, for the safeguarding of values, and so far as it may be possible, for the elimination of unnecessary, unwise, and destructive speculation.” The Congress swiftly responded to the clear need for reform by enacting the Securities Exchange Act of 1934. Two years later it passed the Commodity Exchange Act of 1936.

It is clear that we need the same type of comprehensive regulatory reform today. Today’s regulatory reform package should cover all types of OTC derivatives dealers and markets. It should provide regulators with full authority regarding OTC derivatives to lower risk; promote transparency, efficiency, and market integrity and to protect the American public.

Today’s complex financial markets are global and irreversibly interlinked. We must work with our partners in regulating markets around the world to promote consistent rigor in enforcing standards that we demand of our markets to prevent regulatory arbitrage.

These policies are consistent with what I laid out to this committee in February and the Administration’s objectives. I look forward to working with this Committee, and others in Congress, to accomplish these goals.

Mr. Chairman, thank you for the opportunity to appear before the Committee today. I look forward to answering any questions.


Please contact us if you have any questions of if you would like to start a hedge fund.  Other related hedge fund law articles include:

NASAA Takes Sides on Proposed Hedge Fund Legislation

Endorses House Bill Over the Grassley-Levin Hedge Fund Bill

Last week the North American Securities Administrators Association (NASAA) announced its support of the Hedge Fund Adviser Registration Act of 2009, a house bill introduced earlier this year by Representatives Capuano and Castle.  The Hedge Fund Adviser Registration Act is one of two bills introduced in Congress which would effectively require many unregistered hedge fund managers to register with the SEC.  The other bill, the Hedge Fund Transparency Act, was introduced into the Senate by Senators Grassley and Levin.  While the Adviser Registration Act would close what some are calling a loophole in the Investment Advisers Act of 1940, the Transparency Act would create a whole new regime for regulating hedge fund entities (as opposed to the management company).  The Transparency Act also came under fire earlier this year for being poorly drafted.

The NASAA support was announced in the release we have reprinted below.  If you have any questions on this issue, please feel free to contact us.  Related hedge fund registration articles include:


May 28, 2009

NASAA Supports the Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

Legislation Would Require Hedge Fund Advisers to Register with SEC

WASHINGTON (May 28, 2009) – The North America Securities Administrators Association (NASAA) today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

The Hedge Fund Adviser Registration Act of 2009 (H.R. 711), sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE), addresses one of NASAA’s Core Principles for Financial Services Regulatory Reform – closing regulatory gaps.

“NASAA appreciates the efforts of Rep. Capuano and Rep. Castle to promote the regulation of hedge fund advisers in a manner that will provide greater transparency to the marketplace while not overburdening the hedge fund industry,” said NASAA President and Colorado Securities Commissioner Fred Joseph. “Advisers to hedge funds should be subject to the same standards of examination as other investment advisers.”

Because they qualify for a number of exemptions to federal and state registration and disclosure laws, hedge funds remain largely unregulated today. The SEC has attempted to require hedge fund managers to register as investment advisers, but that effort was overturned by a U.S. Court of Appeals decision. “Given the need for greater oversight and transparency in many corners of the financial services industry in the wake of the market meltdown, Congress should give the SEC explicit statutory authority to regulate hedge fund advisers as investment advisers,” Joseph said.

Joseph noted that the Managed Funds Association, which represents the hedge fund industry, now supports the registration of investment managers – including hedge fund managers – with the SEC. “This is a step in the right direction,” Joseph said. “While hedge funds did not cause the current economic and financial crisis facing the United States, they, along with the rest of the shadow banking industry, played a role. This reason alone is enough to require greater regulation of all parties in question.”

Joseph said NASAA will continue to press Congress for additional reforms of the hedge fund industry, including granting the SEC authority to require hedge funds to disclose their portfolios, including positions, leverage amounts and identities of counterparties, to the appropriate regulators; and appropriating the necessary funds to ensure that the regulators are sufficiently equipped, in terms of personnel and technology, to provide meaningful analysis of this data and to exercise proper oversight over hedge funds.

NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.

For more information:
Bob Webster, Director of Communications

Paulson to Hedge Funds: Time for Hedge Fund Registration

Treasury Secretary Paulson spoke today about new financial market regulations.  In his remarks he mentioned that there should be some new hedge fund regulations which allow oversight by a market regulator. I have posted an excerpt containing the comment as well as the whole speech. Continue reading

Previous SEC Testimony to Congress Regarding Hedge Funds

As noted in an earlier post, I have started a new section which will deal with the potential for new hedge fund regulations.  In order to get an idea of where we might be headed, I have looked backed to see what the SEC has said to Congress about hedge funds previously.  Below is a transcript of Susan Ferris Wyderko’s testimony before a Senate Subcommittee.  Some of the more interesting parts of this speech include:

  • background of hedge fund industry
  • hedge fund regulation
  • hedge fund fiduciary obligation
  • cases against fraudulent hedge fund managers
  • discussion of prime brokerage

Please note that the discussion on investment advisor registration for hedge fund managers is no longer accurate thanks to Phillip Goldstein of Bulldog Investors who successful challenged the SEC’s registration rule. The link for this testimony can be found here.

Testimony Concerning Hedge Funds

by Susan Ferris Wyderko
Director, Office of Investor Education and Assistance
U.S. Securities & Exchange Commission
Before the Subcommittee on Securities and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
May 16, 2006

Chairman Hagel, Ranking Member Dodd, and Members of the Subcommittee:

I. Introduction

Thank you for inviting me to testify today about hedge funds, the role they play in our securities markets, and the Commission’s role in their oversight. The Commission has a substantial interest in the activities of hedge funds and their advisers, which only recently have become major participants in our securities markets.

The Commission recognized the growing importance of hedge funds almost four years ago when it directed the staff of the Division of Investment Management to undertake a fact-finding mission aimed at reviewing the operation and practices of hedge funds and their advisers. That review led to the publication by the Commission of a staff report entitled “Implications of the Growth of Hedge Funds,” in which the staff described in detail the organization of the hedge fund industry, its growth, and regulation.1

While identifying a number of concerns and making several policy recommendations, the report also described the many benefits hedge funds provide investors and our national securities markets. They contribute substantially to market efficiency, price discovery and liquidity. By actively participating, for example, in markets for derivative instruments, hedge funds can help counterparties reduce or manage their own risks, thus reducing risk assumed by other market participants. Moreover, many hedge funds provide an important risk management tool for institutional investors wishing to allocate a portion of their portfolio to an investment with low correlation to overall market activity.2

II. Background

Hedge funds are pools of investment capital that are managed by professional investment advisers and that are not offered generally to the public. They are operated so that they are not subject to the same regulatory requirements of mutual funds, which are governed by the Investment Company Act of 1940 which contains many safeguards for retail investors. Hedge funds are not characterized by a single dominant investment strategy, although many seek to obtain returns that are not correlated to market returns and instead seek to obtain an “absolute return” in a variety of market environments. Some adopt a “multi-strategy” approach that permits the adviser to determine, at any given time, what investment strategy to follow to pursue returns for the investors. Hedge funds also do not have a single risk profile. Some utilize leveraging techniques that expose investors to substantial risks, while others adopt investment strategies more similar to mutual funds.

Hedge funds do, however, share some organizational characteristics that distinguish them from most mutual funds. Most are organized by advisers that retain a substantial equity participation in the fund, and who receive compensation based, in large part, upon gains achieved by the fund (a “performance fee”). A typical fee arrangement will pay the adviser two percent of the total amount of assets under management and 20% of both realized and unrealized gains. Hedge fund managers view these fee structures as better aligning their interests with the interests of their investors and providing substantial incentives for good performance.

Hedge fund managers usually have a great deal of flexibility in managing the fund, which permits them to take advantage of market opportunities that may not be available to other types of institutional investors. They can change investment strategies, trade rapidly, and utilize leveraging techniques not permitted to mutual funds. And, in contrast to mutual funds, which must disclose publicly their portfolio holdings quarterly, many hedge funds do not even disclose portfolio holdings to all of their investors. Hedge fund advisers do, however, often offer disclosure to their investors about the extent and flexibility of their investment strategies.

1. Growth and Significance of Hedge Funds

The ability of some hedge fund managers to generate significant returns has attracted a great deal of investor interest. It is estimated that hedge funds today have more than $1.2 trillion dollars of assets, a remarkable growth of almost 3,000% in the last 16 years.3 In 2005, an estimated 2,073 new hedge funds opened for business.4 One report recently projected that assets of hedge funds may grow to $6 trillion by 2015.5

Much of the growth of hedge funds is attributable to increased investment by institutions, such as private and public pension plans, endowments and foundations.6 Many of these investors sought out hedge funds during the recent bear markets in order to address losses from traditional investments.

The ability of hedge fund managers to sustain above-market returns is a matter of some debate, as is the likelihood that hedge funds as an asset class will continue to grow.7 Nonetheless, hedge funds play and will likely continue to play an important role in the securities markets, the significance of which exceeds the amount of their assets. Although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.8 They are highly active in the convertible bond and credit derivatives markets. Moreover, hedge funds are becoming more active in the markets for corporate control,9 private lending, and crude petroleum. Their activities affect all Americans directly or indirectly.

2. Application of the Federal Securities Laws

Press articles typically refer to hedge funds as “lightly regulated” investment pools. In a sense, they are correct. As noted above, hedge funds are organized and operated so that they are not subject to the Investment Company Act of 1940. In addition, hedge funds issue securities in “private offerings” that are not registered with the Commission under the Securities Act of 1933, and hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. However, hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary obligations as other investment advisers.

III. The Commission’s Oversight of Hedge Fund Activities

The Commission’s oversight responsibilities with respect to hedge fund activities generally fall into three principal areas: fiduciary obligations; market abuse; and risks to broker-dealers. Each is described below.

1. Fiduciary Obligations

Hedge fund managers are “investment advisers” under the Investment Advisers Act of 1940. As a result, a hedge fund manager owes the fund and its investors a fiduciary duty that requires the manager to place the interests of the hedge fund and its investors first, or at least fully disclose any material conflict of interest the manager may have with the fund and its investors. Hedge fund advisers have this fiduciary obligation as a matter of law regardless of whether they are registered with the Commission.

The Advisers Act provides the Commission with authority to enforce these obligations, which the Commission has exercised vigorously in order to protect investors. Over the past several years the Commission has brought a number of enforcement cases against hedge fund advisers who have violated their fiduciary obligations to their hedge funds and investors. These cases involve advisers who have engaged in misappropriation of fund assets; portfolio pumping; misrepresenting portfolio performance; falsification of experience, credentials and past returns; misleading disclosure regarding claimed trading strategies; and improper valuation of assets. In some cases we have worked with criminal authorities.

Recent examples of significant cases brought by the Commission include:

* SEC v. Samuel Israel III; Daniel E. Marino; Bayou Management, LLC et al. The Commission alleged that the advisers of a Connecticut-based group of hedge funds defrauded investors in the funds and misappropriated millions of dollars in investor assets for their personal use. Over $450 million was raised from investors. The advisers issued fictitious account statements to investors and used a sham accounting firm to forge audited financial statements in order to hide substantial losses. These losses resulted from, among other things, the theft of funds by the advisers who withdrew “incentive fees” to which they were not entitled. On September 29, 2005, the Commission filed an action in U.S. District Court seeking injunctions, disgorgement of ill-gotten gains, prejudgment interest, and civil money penalties.10 Also on that date, Israel and Marino pleaded guilty in a companion criminal case. They have not yet been sentenced. On April 19, 2006, the defendants in the civil case consented to an order permanently enjoining them from future violations of the antifraud statutes of the federal securities laws.11

* SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd. The Commission alleged that an Illinois hedge fund adviser registered with the Commission defrauded fund investors by improperly investing fund assets in a fraudulent “prime bank” trading scheme contrary to the fund’s disclosed trading strategy. According to the Commission’s complaint, the adviser and its principal had an undisclosed profit sharing agreement with one of the trading program promoters. The adviser and principal consented to injunctions and agreed to disgorgement of over $800,000.12 As a result of the SEC’s action and a subsequent criminal action brought by the U.S. Attorney’s office involving individuals associated with the trading program, hedge fund investors were returned most of their principal investment and profits prior to investment in the trading program.

a. New Registration Requirement

Until recently, registration with the Commission was optional for many hedge fund advisers. In February of this year, new rules became effective that require that most hedge fund advisers register with the Commission under the Advisers Act.13 The new rules do not regulate hedge fund strategies, risks or investments. The new rules have given the Commission basic census data about hedge fund advisers. In addition, registration has required hedge fund advisers to implement compliance programs to prevent, detect and correct compliance violations and to designate a chief compliance officer to administer each adviser’s compliance program. Registration also has provided the Commission authority to conduct compliance examinations of registered hedge fund advisers. Based upon registration data we now know that 24% of the 10,000 investment advisers currently registered with the Commission advise at least one hedge fund. Of the 2,456 hedge fund advisers registered with us as of the end of April, 1,179 (45%) registered in response to the new rule.14 The vast majority of the hedge fund advisers (88%) registered with the Commission are domiciled in the United States.

b. Examinations

As mentioned above, registered hedge fund advisers may be subject to on-site compliance examinations by SEC examiners in the Office of Compliance Inspections and Examinations (OCIE). The SEC maintains a risk-based examination program, and determines which firms to examine based on their risk characteristics. Hedge fund advisers have been included in the same pool as other registered advisers, and thus, like other advisers, the staff determines which firms to examine based on the compliance risks the firm presents to investors. Examination staff are working with the Division of Investment Management and Office of Risk Assessment to develop improved metrics to assess the compliance risks of registered advisers in order to continue to focus our exam resources. In addition, OCIE has developed a specialized training program to better familiarize examiners with the operation of hedge funds and thus improve the effectiveness of our examination of hedge fund advisers.

During a routine compliance examination, the staff reviews the effectiveness of the compliance controls that every registered investment adviser must have in place to prevent or detect violations of the federal securities laws. In those areas where controls appear to be weak, our examiners will obtain additional information to determine if the weak control environment has resulted in a violation of the securities laws. The staff also reviews disclosure documents, including any private placement memoranda provided to hedge fund investors, to determine whether the disclosure appears to accurately reflect the hedge fund adviser’s management of the fund. In addition, the staff identifies areas of potential conflicts of interest with respect to the hedge fund adviser and the fund that it advises to determine whether appropriate disclosure has been made.

It is the staff’s experience that many of the compliance issues raised by an adviser’s management of a hedge fund are similar to those raised by other advisers’ asset management activities. For example, these compliance issues include: the use of soft dollar arrangements, the allocation of investment opportunities among clients, the valuation of securities, the calculation of performance, and the safeguards over customers’ assets and non-public information. In this regard, let me identify a few areas in which we plan to focus our examinations of hedge fund advisers:

Side-by-Side Management. Some hedge fund managers also advise other types of advisory accounts, including mutual funds.15 Because the adviser’s fee from the hedge fund is based in large measure on the fund’s performance-and because the adviser typically invests heavily in the hedge fund itself, this “side-by-side” management presents significant conflicts of interest that could lead the adviser to favor the hedge fund over other clients. The staff will focus on whether the hedge fund manager appears to have sufficient controls in place to prevent such bias and whether, in fact, the adviser has favored its hedge funds over other clients.

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

Valuation of Fund Assets. A hedge fund manager typically values the assets of the hedge fund using the market value of those securities. When the fund holds publicly traded securities, that process is fairly simple. Many hedge funds, however, own thinly traded securities and derivative instruments whose valuation can be very complicated and, in some cases, highly subjective. Unlike a mutual fund, hedge fund valuation practices are not overseen by an independent board of directors. A number of the Commission’s enforcement cases against hedge fund advisers involve the adviser’s valuation of fund assets in order to hide losses or to artificially boost performance. Thus, a review of valuation policies and practices is a key element of hedge fund adviser examinations.

Custody of Fund Assets. A hedge fund manager typically has access to and directs the use of fund assets. Such access presents a significant risk to fund investors — as demonstrated in a number of the Commission’s enforcement actions involving theft or misuse of fund assets by a hedge fund manager. Therefore, Commission examiners focus attention on the controls used to protect fund assets.

2. Market Abuse

Hedge fund advisers’ active trading plays an important role in our capital markets. The federal securities laws and Commission regulations establish rules designed to prevent market abuses. When market activity by hedge fund advisers-like any other participant in the securities markets-crosses the line and violates the law, the Commission has taken appropriate remedial action. In the past year, the Commission has brought enforcement actions against hedge fund advisers for a variety of market abuses, including insider trading, improper activities in connection with short sales, market manipulation, scalping, and fraudulent market timing and late trading of mutual funds.

Recent significant cases have included:

* In the Matter of Millennium Partners, L.P., Millennium Management, L.L.C., Millennium International Management, L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan Pillai. The Commission brought an action against hedge fund managers alleging that the managers generated tens of millions of dollars in profits for their hedge funds through deceptive and fraudulent market timing of mutual funds at the expense of the mutual funds and their shareholders. The adviser and its principals agreed to disgorgement and civil monetary penalties, and have undertaken to implement particular compliance, legal, and ethics oversight measures.16

* SEC v. Hilary Shane. The Commission alleged a particular type of insider trading involving a PIPE transaction, where the hedge fund adviser agreed to buy shares of a public company in a private offering – a transaction that the Commission alleged was likely to have a significant dilutive effect on the value of the company’s shares – and then misused information she had been given (and which she had agreed to keep confidential) about the private offering by short-selling the company’s shares. The adviser agreed to disgorge the trading profits, paid a civil penalty, and has consented to be barred from the broker-dealer industry and suspended from the investment advisory industry.17

* SEC v. Scott R. Sacane, et al. The Commission alleged that hedge fund advisers manipulated the market by creating the appearance of greater demand for two stocks than actually existed. The individual defendants in this case have both pled guilty to related criminal charges and have been barred by the Commission from associating with an investment adviser. In addition, one of the defendants has agreed to pay disgorgement and a civil penalty in the Commission’s civil action, which remains pending against the other defendants.18

Not only has the Commission brought enforcement actions against the hedge funds and hedge fund advisers that engage in these transactions, it has brought actions against fund service providers who facilitated these unlawful securities trading activities. Recently, for example, we settled an enforcement action against a large broker-dealer that helped hedge funds foil the efforts of mutual funds to detect the hedge funds’ market timing, and made it possible for certain favored hedge fund clients to “late trade” mutual fund shares.19

3. Risks to Broker-Dealers

Hedge funds can (although we understand many do not) make significant use of leverage. Most hedge funds use one or more “prime brokers,” which provide clearing and related services to the fund and its adviser. One core service prime brokers offer their hedge fund customers is secured financing, notably margin lending, where the hedge fund borrows from the prime broker in order to buy securities, which then serve as collateral for the loan.20

The Commission continues to focus attention on broker-dealers’ exposure to hedge fund risks and the broader implications this aspect of the financial system may have. The Commission staff meets regularly with other members of the President’s Working Group on Financial Markets, and works with the industry members that comprise the Counterparty Risk Management Policy Group. In addition, the Commission’s consolidated supervision program for certain investment banks now allows the staff to examine not only the broker-dealer entities within a group, but also the unregulated affiliates and holding company where certain financing transactions with hedge funds are generally booked. Commission staff meets at least monthly with senior risk managers at these broker-dealer holding companies to review material risk exposures, including those resulting from hedge fund financing and those related to sectors in which hedge funds are highly active.

IV. Looking Forward

As a result of our recently-implemented hedge fund adviser registration rulemaking, the Commission now has more data about hedge funds and their advisers. The staff is in the process of evaluating those data and considering methods to refine its ability to target our examination resources by more precisely identifying those advisers, including hedge fund advisers, that pose greater compliance risks.

In addition, the Commission staff is working with the United Kingdom’s Financial Services Authority, to coordinate policy and oversight of the 165 hedge fund advisers registered with the Commission that are located in the United Kingdom. The staff also expects to coordinate examinations with the Commodity Futures Trading Commission (CFTC). To that end, we recently provided information to the CFTC indicating the identities of hedge fund advisers registered with the Commission who report on their registration forms that they are also actively engaged in commodities business (approximately 350 firms).

V. Conclusion

In conclusion, I would like to thank the Subcommittee for holding this hearing on a subject of growing importance to us and to all American investors. Hedge funds play an important role in our financial markets. With respect to hedge funds, their advisers and all market participants, the Commission will continue to enforce vigorously the federal securities laws.


1 Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (Sept. 2003), available at http://www.sec.gov/news/studies/hedgefunds0903.pdf.

2 A recent study reported that 78% of institutional investors surveyed said that hedge funds reduced the volatility of their portfolio. State Street Corporation, Hedge Fund Research Study (Mar. 2006) at 4.

3 See Hedge Fund Research, HFR Q1 2006 Industry Report.

4 See Hedge Fund Research, HFR Q1 2006 Industry Report. During 2005, 848 funds were liquidated. Id.

5 Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand and Capacity 2005-2015 (Aug. 2005).

6 See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (reporting that the investors surveyed had an average commitment of 17% of assets, and a projected commitment of 19% by 2005).

7 See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo, “Systemic Risk and Hedge Funds,” (Aug. 1, 2005) (unpublished manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of Financial Institutions and the Financial Sector, Chicago, IL: University of Chicago Press).

8 See Pam Abramowitz, “Trade Secrets,” Institutional Investor’s Alpha, January/February 2006.

9 Mara Der Hovanesian, “Attack of the Hungry Hedge Funds,” Business Week (Feb. 2006); Henry Sender, “Hedge Funds: The New Corporate Activists–Investment Vehicles Amass Clout In Public Firms, Then Demand Management Boost Share Price,” The Wall Street Journal (May 13, 2005).

10 Litigation Release No. 19406 (Sept. 29, 2005).

11 Litigation Release No. 19692 (May 9, 2006).

12 Litigation Release No. 19589 (Mar. 3, 2006).

13 The Commission’s recent rulemaking required certain hedge fund advisers to register as investment advisers with the Commission under the Investment Advisers Act of 1940, under which registration previously had been optional for many hedge fund advisers. Commissioners Glassman and Atkins dissented from the rulemaking. Registration Rule at 72089. With respect to the management of hedge funds whose advisers are registered with the Commission, the Commission in adopting the adviser registration requirement observed that, “The [Advisers] Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments.” Registration Rule at section II.A. [Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at 72060, petition for review filed (D.C. Cir. No. 04-1434 (argued Dec. 9, 2005). (“Registration Rule”).]

14 Registration forms indicate that these advisers report just over 13,000 hedge funds with aggregate assets of about $2 trillion. Because reported assets include assets of “feeder” funds as well as “master” funds in which they invest, total reported assets likely are higher than if assets of “feeder” funds were excluded.

15 Almost 15% (379) of the hedge fund advisers registered with the Commission report that they also advise at least one mutual fund.

16 Investment Advisers Act Release No. 2453 (Dec. 1, 2005).

17 Litigation Release No. 19227 (May 18, 2005). Because she entered into the short sales prior to the effective date of the registration statement for the PIPE and then covered her short sales with those she obtained in the PIPE offering, the Commission also alleged that Ms. Shane violated section 5 of the Securities Act.

18 Litigation Release No. 19424 (Oct. 12, 2005). See also In the Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483 (Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane, et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R. Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).

19 In the Matter of Bear, Stearns & Co., Inc., and Bear, Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16, 2006) (defendants agreed to censure, payment of disgorgement and civil monetary penalties, and have undertaken to implement particular compliance oversight measures).

20 Prime brokers may also structure these financing transactions as repurchase agreements, where they buy the securities from the hedge fund subject to the fund’s obligation to repurchase the securities from the broker in the future at a specified price. Prime brokers may also produce similar economics through the use of over-the-counter derivative contracts with hedge funds.

New Hedge Fund Regulations – SEC to Conduct Roundtable Today

As I’ve mentioned previously we can expect tighter regulations in the coming months for the financial services industry in general and the hedge fund industry specifically.  To track these changes I’ve instituted a new section entitled new hedge fund regulations which I will keep updated with information.

Below the SEC is taking the first steps to decide how to move forward in this new world financial order through a series of panel discussions.  The SEC is also soliciting comments from the financial services industry on a variety of questions.  These steps are obviously necessary and should be productive if the SEC really listens to the practitioners from the industry.  The release can be found here.

SEC Roundtable on More Transparent Disclosure to Address Lessons of Current Credit Crisis

Washington, D.C., Oct. 7, 2008 — The Securities and Exchange Commission today announced the agenda for Wednesday’s roundtable on providing more transparency to investors that will include discussion of lessons from the current credit crisis. Among other issues, panelists will address better ways to explain complex financial instruments to investors and the marketplace, and will propose ways to provide investors with more transparent, useful, and timely access to high-quality information. The roundtable is part of the SEC’s 21st Century Disclosure Initiative (www.sec.gov/disclosureinitiative) that is fundamentally rethinking disclosure.

Panel One: The Market’s Use of Disclosure Information and the SEC’s Disclosure System

This panel will explore whether the current system of collecting and filing data for SEC disclosure obligations has kept pace with the market. It will examine how investors can get all the information they need to make increasingly complex investment decisions. It will also consider the data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations. The panel will compare the needs and uses of investors and companies to the capabilities of the SEC’s disclosure system in an effort to better understand any gaps and inefficiencies that can lead to inaccuracies, delays, and unnecessary complexity.

  • John Bajkowski, Vice President and Senior Financial Analyst, American Association of Individual Investors
  • Robert Sorrentino, Director of Accounting Policy and External Reporting, Xerox Corp.
  • David Copenhafer, former Director of EDGAR Services, Bowne & Co., Inc.
  • Glenn Doggett, Policy Analyst, CFA Institute Centre for Financial Market Integrity
  • Paul Haaga, Jr., Vice Chairman, Capital Research and Management Co.
  • Kara Jenny, Chief Financial Officer, Bluefly, Inc.
  • Timothy Thornton, Principal, Web Services, The Vanguard Group, Inc.

Panel Two: Modernizing the SEC’s Disclosure System

This panel will consider how the SEC could better organize and operate its disclosure system so that investors could have better access to high-quality information and companies could enjoy efficiencies. In particular, the panel will discuss ways to structure disclosure data so investors can more effectively search for company data and compare investment options. The panel will describe a possible “company file system,” in which core company information would be collected in a central structured data file, and will also discuss other approaches that harness technology to better serve investors and the markets.

  • Alan Beller, Partner, Cleary Gottlieb Steen & Hamilton LLP
  • Steven Bochner, Partner, Wilson Sonsini Goodrich & Rosati
  • Esther Dyson, Chairman, EDventure Holdings
  • Joseph Grundfest, Professor of Law, Stanford Law School
  • Eric Roiter, Lecturer on Law, Harvard University Law School and Boston University School of Law
  • Liv Watson, Member, Board of Directors, IRIS
  • Hillary Sale, Chair in Corporate Finance and Law, University of Iowa College of Law
  • Douglas Chia, Senior Counsel and Assistant Corporate Secretary, Johnson & Johnson


  • John White, Director of SEC’s Division of Corporate Finance
  • Andrew Donohue, Director of SEC’s Division of Investment Management
  • Jim Kaput, Counsel to 21st Century Disclosure Initiative
  • Matthew Reed, Assistant Director of 21st Century Disclosure Initiative

The SEC’s roundtable will be held on Wednesday, October 8 in the auditorium of the SEC’s Washington D.C. headquarters at 100 F Street, NE from 9 a.m. until approximately 1 p.m. The roundtable will be open to the public on a first-come, first-served basis. It will be webcast live on the SEC’s Web site, and an archived version of the webcast will later be available for free download.

The Commission welcomes feedback regarding any of the topics to be addressed at the roundtable, and has issued a formal request for public comment. The Commission is particularly interested in comments responding to these questions:

General Issues

  1. Should the Commission make changes to its current forms-based disclosure system? Please explain why or why not.
  2. What are the key issues to be considered in the review of the Commission’s disclosure system? Are particular aspects of the system and process especially useful and well executed, and are particular aspects especially in need of improvement?
  3. What are the purposes of issuer disclosure from the perspective of investors, filers, and regulators?

Specific Issues

The Market’s Use of Disclosure Information

  1. How do operating and investment companies collect, summarize, analyze, file, and disseminate the information that is submitted to the Commission?
  2. How do operating and investment companies submit disclosure and reporting information to the Commission? How have these methods changed during the last 15 years, particularly after filing via EDGAR was fully implemented? How could the Commission’s system be changed to reduce burdens and create efficiencies, consistent with investor protection?
  3. How do investors retrieve and use the disclosure information that companies submit to the Commission? How could this information be better presented, and more easily retrieved and used through technological improvements?
  4. What disclosure information that companies submit to the Commission is used by investors to make investment decisions? Is any information that companies submit to the Commission not used? What information that is not required to be filed or furnished with the Commission do investors and others use to make investment decisions or give investment advice?

The Commission’s Current Disclosure Syste

  1. Does the Commission’s current disclosure system present difficulties? What difficulties can be attributed to technological problems? Which can be attributed to regulatory or statutory problems?

Modernizing the Commission’s Disclosure System

  1. How should the Commission’s disclosure system be modernized? One possibility is a company file system. What alternative systems should be considered? What different or additional benefits might these alternatives provide?
  2. How should a modern disclosure system, such as a company file system, be organized, and how could it improve the way disclosure information is submitted and used?
  3. What features should any modernized disclosure system provide in order to serve the needs of filers, investors, regulators, and other users of information? Why? Data tagging using XBRL, or eXtensible Business Reporting Language, is one way, but we understand there are other ways to structure data. What alternative ways could be used by companies to submit structured data to the Commission?
  4. What are the costs and benefits to investors and other market participants of structuring non-financial disclosures, including, for example, data tagging?
  5. What time frame would be appropriate for implementing a company file system?
  6. What benefits and costs to preparers and users of information would accompany the implementation of modernized disclosure system, such as a company file system, that requires all, or virtually all, data to be filed in a structured format? Would such a system be more useful to some investors, such as small or less sophisticated investors? Would some investors be harmed by such a system? Would larger companies benefit more than smaller companies? Would costs fall disproportionately on one group of companies?
  7. Are any changes to the Commission’s disclosure regulations required for a transition to a company file system? How could these changes be identified?

The information that is submitted for comment will become part of the public record of the roundtable. All submissions received will be posted without change. The SEC does not edit personal identifying information from submissions. Only information desired to be shared publicly should be submitted.