The
October 2009 edition of the International Association of Hedge
Funds Professionals (IAHFP) newsletter
The
Over-the-Counter Derivatives Markets Act of 2009:
One more effort to eliminate regulatory arbitrage ...
"While Treasury's proposal would go a long way towards bringing
OTC derivatives under a comprehensive regulatory framework, I
believe it should be strengthened in several ways to further avoid
regulatory gaps and eliminate regulatory arbitrage
opportunities".
Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
Dear members,
Is it possible to eliminate regulatory arbitrage, and some other
opportunities that have to do with the human nature?
I don't think so, but this is what all laws and regulations try to
do these days.
Today we will discuss the
Over-the-Counter Derivatives Markets Act of 2009
Testimony Concerning the Over-the-Counter Derivatives Markets Act
of 2009 by Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
Before the House Committee on Agriculture
I. Introduction
Chairman Peterson, Ranking Member Lucas, Members of the Committee:
Thank you for the opportunity to testify on behalf of the
Securities and Exchange Commission concerning
the regulation of over-the-counter ("OTC") derivatives and, in
particular, the Over-the-Counter Derivatives Markets Act of 2009,
which was proposed in August by the Department of the Treasury.
I am pleased to appear with CFTC Chairman Gary Gensler with whom I
have worked closely over the last several months on a variety of
issues.
As you know, our two agencies have already begun an ambitious
program of joint work to better harmonize our rules and
procedures.
Earlier this month, we held two days of joint hearings that
highlighted some of the key differences in our regulatory
approaches.
We are eager to address these issues.
Although some differences may remain over time, I believe this
process will help ensure that any differences are justified by
meaningful distinctions between markets and products and the
others will be harmonized and improved.
I also look forward to continuing our joint efforts to push for
real regulatory reform.
The recent financial crisis has revealed serious weaknesses in
U.S. financial regulation.
Among them were gaps in the existing regulatory structure;
failures to enforce existing standards; and failures to adapt the
existing regulatory framework and provide effective regulation
over traditionally siloed markets that had grown interconnected
through globalization, deregulation and technological advances.
Fixing these weaknesses is vital, particularly in the current
market environment, and it is a goal to which the SEC is
absolutely committed.
One very significant gap in the regulatory structure was
the lack of regulation of OTC derivatives, which were largely
excluded from the regulatory framework in 2000 by the Commodity
Futures Modernization Act.
It is critical that we work together to enact legislation that
will bring greater transparency and oversight to the OTC
derivatives market.
The derivatives market has grown enormously since the late 1990s
to approximately $450 trillion of outstanding notional amount in
June 2009.
This market presents a number of risks. Chief among these is
systemic risk. OTC derivatives can facilitate significant
leverage, result in concentrations of risk, and behave
unexpectedly in times of crisis. Some derivatives, like credit
default swaps (CDS), can reduce certain types of risk, while
causing others.
For example, CDS permit individual firms to obtain or reduce
credit risk exposure to a single company or a sector, thereby
reducing or increasing that risk. In addition to obtaining or
reducing exposure to credit risk, a CDS contract participant will
take on counterparty and liquidity risk from the other side of the
CDS.
Through CDS, financial institutions and other market participants
can shift credit risk from one party to another, and thus the CDS
market may be relevant to a particular firm's willingness to
participate in an issuer's securities offering or to lend to a
firm. However, CDS can also lead to greater systemic risk by,
among other things, concentrating risk in a small number of large
institutions and facilitating lax lending standards more
generally.
These risks are heightened by the
lack of regulatory oversight of dealers and other participants in
this market.
This combination can lead to inadequate capital and risk
management standards. Associated failures can cascade through the
global financial system.
Moreover, OTC derivatives markets directly affect the regulated
securities and futures markets by serving as a less regulated
alternative for engaging in economically equivalent activity.
The regulatory arbitrage possibilities can facilitate a flow of
funds out of the regulated markets and into the unregulated shadow
markets.
The lack of transparency and oversight also enables bad actors to
hide trading activities that would be more easily detected if done
in the regulated markets.
These issues must be addressed, and I am committed to working
closely with this Committee, the Congress, the Administration, and
the CFTC to close this gap and restore a sound structure for U.S.
financial regulation.
The Treasury proposal would establish 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. Importantly, it emphasizes that the
securities and commodities laws should be amended to ensure that
the SEC and CFTC, consistent with their respective missions, have
the authority to achieve — together with the efforts of other
regulators — the four policy objectives for OTC derivatives
regulation.
The proposed legislation is an important step forward. It would
bring currently unregulated swaps, swaps dealers, and swaps
markets under a comprehensive regulatory framework, thereby
improving transparency and regulatory oversight. It also would
facilitate the standardization and central clearing of swaps,
thereby fostering a "better" market and reducing counterparty
risk.
II. Strengthening Treasury's Proposal
While Treasury's proposal would go a long way towards bringing OTC
derivatives under a comprehensive regulatory framework, I believe
it should be strengthened in several ways to further avoid
regulatory gaps and eliminate regulatory arbitrage opportunities.
I agree with Chairman Gensler that Treasury's proposal can be
enhanced to prevent the exclusions for foreign currency swaps and
forwards from being used by market participants to
avoid regulation and from undermining the CFTC's enforcement
authority over retail foreign currency fraud. I also agree that
the proposal can be enhanced to bolster protections against
insolvency risk, and on other matters.
In addition,
I offer the following suggestions:
A. Minimize Regulatory Arbitrage and
Gaming Opportunities by Regulating Swaps Like Their Underlying
"References"
Market participants often
view derivatives and the "underlying" assets they reference almost
interchangeably.
Thus, a participant may well decide to take a position in the
fortunes of a company by entering into transactions in OTC
derivatives like
equity swaps rather than through the purchase of common stock.
When carefully structured, the economic payoffs could be similar,
if not virtually identical. Yet the legal consequences attached to
these alternatives may be different.
Gaming — regulatory arbitrage — possibilities abound when
economically equivalent alternatives are subject to different
regulatory regimes. An individual market participant can have
incentives to migrate to products that are subject to lighter
regulatory oversight.
Treasury's proposal would for the first time bring the OTC
derivatives market under a regulatory umbrella by establishing a
new regulatory framework for OTC derivatives.
Treasury's proposal would divide regulatory responsibility for
securities-related OTC derivatives between the SEC and the CFTC,
and provide regulatory responsibility for other OTC derivatives to
the CFTC.
Although we believe this approach
would do much to eliminate differences
within the broad and varied world of "swaps," it
could result in significant regulatory differences between "swaps"
products and the currently "regulated" securities and futures
products.
For example,
energy swaps would not be regulated in the same way as energy
futures, and securities swaps would not be regulated in the same
way as securities.
This is significant because, in evaluating whether to engage in a
swap transaction, market participants are far more likely to focus
on the choice between a swap and regulated alternatives (e.g.,
between a Microsoft swap on the one hand and a Microsoft option or
Microsoft stock on the other, or between an oil swap and an oil
future), than between swaps involving different "underlying"
assets (e.g., a Microsoft swap and an oil swap).
Thus, these regulatory differences
could perpetuate existing regulatory arbitrage opportunities
that encourage the migration of activities from the traditional
regulated markets into the differently regulated swaps market.
In addition, Treasury's proposal would create regulatory arbitrage
between narrow-based security index swaps and broad-based security
index swaps.
For example, market participants could engage in the synthetic
transactions in the swaps market, or craft swaps specifically to
fall within the broad-based category instead of the narrow-based
category.
These
risks are particularly high in customized over-the-counter
transactions where individual market participants can self-select
the particular securities in one or more swaps.
Accordingly, Congress should consider modifying the proposal so
that all securities-related OTC derivatives are regulated more
like securities; and commodity and other non-securities-related
OTC derivatives are
regulated more like futures.
At the core of this approach is
the principle that similar products should be regulated similarly,
or equivalently, if possible.
This straightforward approach would result in securities-related
OTC derivatives — which can be used to establish either synthetic
"long" exposures to an underlying security or group of securities,
or synthetic "short" exposures to an underlying security or group
of securities — and the underlying securities being regulated
consistently.
Similarly,
commodity-related OTC derivatives, such as swap contracts for oil
and natural gas, would be regulated in a similar manner as the
underlying oil or natural gas futures.
This approach also would be simpler to implement. Congress should
extend the federal securities laws to all securities-related OTC
derivatives and extend the Commodity Exchange Act to all
commodity-related and non-securities related OTC derivatives.
This would significantly reduce the arbitrage opportunities
between the regulated markets (securities or futures) and the
differently regulated swaps market, as well as between
narrow-based security index swaps and broad-based security index
swaps, while building off the existing regulatory framework.
Although some differences would likely remain (as they currently
do between the SEC and CFTC regimes), these differences could be
addressed through the harmonization process that we already have
underway.
B. Strengthen Existing Anti-Fraud and
Anti-Manipulation Authority
Treasury's proposal also attempts to retain the SEC's existing
anti-fraud authority over all securities-related OTC derivatives,
even those securities-related OTC derivatives over which the SEC
would not have regulatory authority.
This authority is essential to policing fraud in the securities
markets; to be effective, though, enforcement also requires:
(1) examination authority over entities dealing in
securities-related swaps;
(2) direct access to real-time data on these swaps; and
(3) comprehensive anti-fraud and anti-manipulation rulemaking
authority for these swaps.
For example, in investigating possible market manipulation during
the financial crisis, the SEC sought to use its anti-fraud
authority to gather information about transactions both in
securities-related OTC derivatives and in the underlying
securities.
Investigations of securities-related OTC derivative transactions,
however,
were far more difficult and time-consuming than those involving
cash equities and options.
In contrast to the audit trail data available in the equity
markets, data
on securities-related OTC derivative transactions were not readily
available and needed to be reconstructed manually.
The SEC's enforcement efforts were seriously complicated by the
lack of a mechanism for promptly obtaining critical information —
who traded, how much, and when — that is complete and accurate.
If Congress determines to split regulatory responsibility over
securities-related OTC derivatives, Congress should provide these
tools to help ensure effective anti-fraud enforcement over all
securities-related OTC derivatives.
C. Credit Default Swaps and
Regulatory Arbitrage
As we saw first hand during the financial crisis, trading
practices in the CDS market have a direct effect on the underlying
securities markets.
Both narrow- and broad-based index CDS can be used as synthetic
alternatives to debt — and even equity — securities of one or more
companies.
In addition, market participants may use CDS to establish a short
position with respect to the fortunes of a specific company.
In particular,
a
market participant may be able even to use a broad-based index CDS
that includes the company as a way to short that company's debt or
equity.
In brief, debt and equity securities and single-name and narrow-
and broad-based index CDS are all economic substitutes, and
therefore ripe for regulatory arbitrage.
Under current law, the Commission has stated that exchange-traded
CDS on securities, whether on one security or a basket of
securities, are securities.
To avoid gaming by financial engineers under the new regulatory
regime, Congress should consider clarifying that the definition of
"security-based swap" includes not only single-name and
narrow-based index CDS, but also broad-based index CDS, and other
similar products, when payment is triggered by a single security
or issuer or narrow-based index of securities or issuers. This
also would be consistent with the approach advocated above to
extend the federal securities laws to all securities-related OTC
derivatives.
D. Business Conduct Standards and
Eligible Contract Participants
One of the lessons learned from the most recent financial crisis
is that certain smaller and less sophisticated institutions need
protections from abusive practices by their swaps intermediaries.
There is a need for more stringent business conduct standards.
This is an area in which I believe we and the CFTC are largely in
agreement.
Treasury's proposal would require the SEC, the CFTC, and other
regulators to adopt business conduct rules for dealers and major
participants in the OTC derivatives markets.
This is an important component of regulatory reform, and we fully
support it. But these provisions should be stronger.
We believe that Congress should strengthen this authority so that
the SEC and CFTC may adopt stronger and more protective rules in
certain situations — for example, where a swaps dealer is selling
OTC derivatives to smaller or less sophisticated participants,
including certain municipalities, in the OTC derivatives market.
In addition,
Congress should consider revising the qualification standards for
participation in the OTC derivatives markets.
The standards for being an "eligible contract participant" ("ECP")
are important under Treasury's proposal because only ECPs may
trade derivatives over-the-counter.
All other market participants must trade on exchanges, which
provide better protections for less sophisticated participants.
More specifically, Congress should consider raising the
qualification standards for a governmental entity or political
subdivision — such as a municipal government — to qualify as an
ECP.
Higher standards may also be appropriate for individuals,
corporations and other entities.
E. Protecting Customer and
Counterparty Assets
One key issue is how best to protect customer and counterparty
assets in the event of insolvency.
I agree with Chairman Gensler that it would be prudent for
legislation to address this issue.
Recent events have focused attention on bankruptcy protections
with respect to resolution regimes for OTC derivatives dealers and
other major participants in the OTC derivatives market.
Chairman Gensler suggests that
legislation should provide for an insolvency framework that
protects, first and foremost, customers.
I absolutely agree. I believe that a resolution regime should
provide legal restrictions on how counterparty assets held by OTC
derivatives dealers and other major market participants would be
treated in the event of an insolvency, as well indicate the extent
to which counterparties would have a prior claim on the other
assets of the estate.
Without legal certainty, the insolvency of an OTC derivatives
dealer or other major OTC derivatives participant could result in
further market disruptions and systemic risk.
F. Ensuring that the "Identified
Banking Products" Exception is Not Abused
Treasury's proposal contains an exclusion from the regulatory
scheme for OTC derivatives for products that are "identified
banking products."
Although this exclusion may make sense for banks that are
regulated in the U.S., we believe that this exclusion could allow
foreign banks (and their subsidiaries) that are not subject to
oversight by any federal banking regulator, to offer OTC
derivatives to U.S. persons in the guise of "bank products."
I believe this exclusion should be revised to make clear that it
is not available to foreign banks or their subsidiaries that are
not subject to federal banking oversight.
III. Conclusion
The Treasury proposal is a significant step toward addressing
current problems in the OTC derivatives marketplace. It provides a
comprehensive regulatory framework that addresses risks to the
financial system and promotes efficiency and transparency in the
markets. I strongly encourage Congress to build off this proposal
and enact legislation that will bring even more vital transparency
and oversight to this market.
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 look forward to
answering your questions.
October 15, 2009
Financial Services Committee Approves Legislation to Regulate
Derivatives
Over-the-Counter Derivatives Markets Act of 2009 (“OCDMA”)
The House Financial Services Committee has approved legislation
that would, for the first time ever, require the comprehensive
regulation of the over-the-counter (OTC) derivatives marketplace.
The bill, which was approved by a vote of 43-26, represents a key
part of a broader effort by Congress and President Obama to
modernize America’s financial regulatory system in response to
last year’s financial crisis.
Under the bill, all standardized swap transactions between dealers
and large market participants, referred to as “major swap
participants,” would have to be cleared and must be traded on an
exchange or electronic platform.
A major swap participant is defined as anyone that maintains a
substantial net position in swaps, exclusive of hedging for
commercial risk, or whose positions creates such significant
exposure to others that it requires monitoring.
OTC derivatives include swaps, which are contracts that call for
an exchange of cash between two counterparties based on an
underlying rate, index, credit event or the performance of an
asset.
The legislation then sets out parallel regulatory frameworks for
the regulation of swap markets, dealers, and major swap
participants. Rulemaking authority is held jointly by the
Commodity Futures Trading Commission (CFTC),
which has jurisdiction over swaps, and the Securities and Exchange
Commission (SEC), which has jurisdiction over security-based
swaps.
The Treasury Department is given the authority to issue final
rules if the CFTC and SEC cannot decide on a joint approach within
180 days. Subsequent interpretations of rules must be agreed to
jointly by the Commissions.
Clearing
The legislation provides a mechanism to determine which swap
transactions are sufficiently standardized that they must be
submitted to a clearinghouse.
For transactions that are clearable, clearing is a requirement
when both counterparties are either dealers or major swap
participants. Clearing organizations must seek approval from the
appropriate regulator—either the CFTC or the SEC—before a swap or
class of swaps can be accepted for clearing.
Transactions in standardized swaps that involve end-users are not
required to be cleared. Such customized transactions must,
however, be reported to a trade repository.
Mandatory Trading on Exchange or Swap Execution Facility
A standardized and cleared swap transaction where both
counterparties are either dealers or major swap participants must
either be executed on a board of trade, a national securities
exchange or a “swap execution facility”—as defined in the
legislation.
If none of these venues makes a clearable swap available for
trading, the trading requirement would not apply. Counterparties
would, however, have to comply with transaction reporting
requirements established by the appropriate regulator.
The legislation also directs the regulators to eliminate
unnecessary obstacles to trading on a board of trade or a national
securities exchange.
Registration and Regulation of Swap
Dealers and Major Swap Participants
Swap dealers and major swap participants must register with the
appropriate Commission and dual registration is required in
applicable cases.
Capital requirements for swap dealers' and major swap
participants' positions in cleared swaps must be set at greater
than zero. Capital for non-cleared transaction must be set higher
than for cleared transactions.
The prudential regulators will set capital for banks, while the
Commissions will set capital for non-banks at a level that is “as
strict or stricter” than that set by the prudential regulators.
The regulators are directed to set margin levels for
counterparties in transactions that are not cleared.
The regulators are not required to set margin in transaction where
one of the counterparties is not a dealer or major swap
participant.
In cases where an end user is a counterparty to a transaction, any
margin requirements must permit the use of non-cash collateral.
Reporting and Public Disclosure of Swap Transactions
Reporting and recordkeeping is required for all over-the-counter
derivative transactions.
Clearing organizations must provide transaction information to the
relevant Commission and a designated trade repository.
Swap transactions that are not cleared and for which no trade
repository exists, must be reported directly to the relevant
Commission.
The legislation also provides for public disclosure of aggregate
data on swap trading volumes and positions—in a manner that does
not disclose the business transactions or market position of any
person.
Large positions in swaps must also be reported directly to
regulators.
Swap Execution Facilities
Swap execution facilities, or facility for the trading of swaps
that are not Boards of Trade or National Securities Exchanges,
must register with the relevant regulator as a swap execution
facility (SEF).
SEFs must also adhere to core regulatory principles relating to
enforcement, anti-manipulation, monitoring, information collection
and conflicts of interest, among others.
The CFTC and SEC are required to prescribe joint rules governing
the regulation of swap execution facilities.
A Commission may exempt a SEF from registration if it is subject
to comparable, comprehensive supervision and regulation by another
regulator.
Over-the-Counter Derivatives Markets Act of 2009
Part I. The overall structure of the legislation
Part II. Overlapping jurisdiction among the CFTC, SEC, and banking
regulators
Part III. The various definitions relating to the terms “swap,”
“security-based swap,” “standardized” and “security based swap
agreement” and the new definition of “security”
Part IV. Which parties to swaps must register with the CFTC or SEC
Part V. The regulations applicable to parties
Part VI. The new central market mechanisms: swap exchanges,
clearing corporations, and information repositories and the
treatment of standardized swaps
Part VII. New trading rules that would apply to swaps
Congressman Collin Peterson, Chairman, House Agriculture Committee
Congressman
Barney Frank, Chairman, House Financial Services Committee
Description of Principles for OTC Derivatives Legislation
Robust Oversight of Dealers and Markets
Depending on the underlying asset on which a derivative is based,
either the SEC or the CFTC, or potentially both, will oversee the
regulation of OTC derivative dealers, exchanges and
clearinghouses.
•
Clearinghouse Regulation:
Clearinghouses will be robustly regulated. Primary oversight
authority of the CDS clearinghouse, ICE Trust, will be shifted
from the Federal Reserve to a market regulator after a period not
longer than six months from the date of enactment.
•
Trade Reporting:
All OTC derivative trades must be reported to a qualified trade
repository.
•
Regulatory Approval:
Requests for approval as a clearinghouse, exchange or electronic
trading platform must be acted on by the relative agency within
180 days.
•
Regulatory Harmonization:
The statutory and regulatory powers of the SEC and CFTC shall be
harmonized with respect to the OTC derivative market including
registration requirements for dealers.
Mandatory Clearing of OTC Derivatives Derivatives must be cleared
by an approved clearinghouse.
Exchange trading and trading on electronic trading platforms will
be strongly incentivized and encouraged.
Exceptions:
• Appropriate regulator determines the product is not sufficiently
standardized to be cleared or no qualified clearing mechanism
exists.
• One party in the transaction does not qualify as a “major market
participant” as determined by the appropriate regulator in
consultation with the Financial Services Oversight Council.
Regulators should have:
o Authority to prohibit or regulate transactions that are not
traded on exchange or cleared.
Strengthening Capital and Margin Requirements
Appropriate regulators will develop margin and capital
requirements that create a strong incentive for dealers and users
of derivatives to trade them on an exchange or electronic trading
platform or have them cleared whenever possible.
• Significantly higher capital and margin charges will apply to
non-standardized transactions that are not exchange-traded or
centrally cleared.
• Regulators can authorize use of non-cash collateral to satisfy
margin requirements.
Particular Attention to Speculation
At least two options will be considered:
1. Limitation on Speculation
Prohibition on any purchase of credit protection using a CDS
contracts unless:
• The party owns the referenced security or (one or more) of the
securities in an index of securities.
• The party has a bona fide economic interest that will be
protected by the contract.
• The party is a bona fide market maker.
• Regulators will have authority to monitor market activity and
impose position limit where necessary.
2. Enhanced Oversight of Speculative Positions
Require confidential reporting to the appropriate regulator of all
short interest in CDS contracts by:
• OTC derivatives dealers;
• Investment advisers that manages in excess of $100 million;
• Other entities that are deemed “major market participants”.
In order to prevent abuse, the appropriate regulator has authority
to:
• Impose position limits on market participants;
• Ban the purchase of credit protection using CDS by any
non-dealer that is not hedging a risk.
Protect U.S. Financial Institutions from Lesser Regulatory
Standards in Other Countries
• U.S. regulators will coordinate with foreign regulators on
harmonizing OTC derivative market regulation including recognized
international standards with respect to clearinghouses.
• The Treasury Department will be authorized to restrict access to
the U.S. banking system for institutions of any jurisdiction
Treasury finds permits capital-related standards that are lower
than the United States or that promote reckless market activity.
Role of Financial Services Oversight Council
• Resolve disputes between the SEC and CFTC over authority over
new products within 180 days.
• Resolve disputes between the SEC and CFTC over joint regulation
of derivative products within 180 days.
Enforcement
• Agencies shall have enforcement authority over products under
their jurisdiction.
• Agencies shall hold enforcement authority jointly for any
products subject to joint jurisdiction.
Dear
members,
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are members of the International Association of Hedge Funds
Professionals
Take advantage of the distance learning and online
certification program of our Association - at a cost that is unheard
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Best
Regards,
George Lekatis
President of the International
Association of Hedge Funds Professionals (IAHFP)
General
Manager, Compliance LLC
1200 G Street NW Suite 800, Washington
DC 20005, USA
Tel: (202) 449-9750
Email:
lekatis@hedge-funds-association.com
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