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Financial Reform – New
 
“When banks benefit from the safety net that taxpayers provide—which includes lower-cost capital—it is not appropriate for them to turn around and use that cheap money to trade for profit,” Obama said. “And that is especially true when this kind of trading often puts banks in direct conflict with their customers' interests.”
The proposed restrictions, which have not been fleshed out in detail yet, are based on ideas put forward by Paul Volcker, the former chairman of the Federal Reserve who now serves as one of President Obama’s economic advisers. The restrictions would prevent any financial firm that is affiliated with a depository institution from engaging in proprietary trading operations unrelated to serving customers. The restrictions also would prevent any financial firm that is affiliated with a bank from owning, sponsoring or investing in a hedge fund or private equity fund. Thirdly, the restrictions would limit consolidation of the U.S. financial sector by setting “broader limits on the excessive growth of the market share of liabilities at the largest financial firms to supplement existing caps on the market share of deposits,” the White House said. On Feb. 2, the Senate Banking Committee held a hearing on the proposed restrictions.
Senator Chris Dodd, the Connecticut Democrat who chairs the committee, said he “strongly” supports the proposed restrictions and said the Obama administration “is heading in the right direction with these two proposals.” Dodd expressed concern, however, about the “practicalities” of the proposals and wondered aloud about how Congress should go about setting the boundaries of proprietary trading and separating hedging from profit-making. Dodd also warned that the proposals would be “unworkable” if the U.S. was the only country to put them into effect.
Several Republicans attacked the proposals. Senator Richard Shelby, the Alabama Republican who is the most senior Republican on the committee, said he was “quite disturbed” by the sudden introduction of the proposed restrictions and warned that the financial reform process should not determined by “whatever polls well on a given day.” Senator Bob Corker, a Republican from Tennessee, argued that none of the activities that would be restricted under these proposals actually caused the failure of any banks, and questioned whether such “arbitrary restrictions” were a necessary part of the financial reform package. Senator Mike Johanns, a Republican from Nebraska, expressed doubt that the proposals would have prevented the rescue of AIG or the failure of Lehman.
The main witness was Paul Volcker, the former Federal Reserve Chairman now serving as one of President Obama’s top economic advisers. Volcker presented several arguments for the proposed restrictions on proprietary trading but did not provide the committee with a detailed explanation on how the proposed restrictions would work. Volcker said the restrictions are necessary to limit the use of the “safety net” that the public provides to commercial banks and to prevent conflicts of interest within banking organizations. He also said that there were only “a couple of dozen banks” worldwide that might be impacted and that there were “substantial grounds to anticipate success” in creating an international consensus in this area.
Volcker emphasized that the proposed restrictions should not prevent banks from hedging their risks or taking positions in the course of meeting customer needs. Regulators therefore will need to carefully monitor bank activities to make sure that any “excesses” are contained. Exceptionally large gains and losses in the trading book “should raise an examiner’s eyebrows” and result in higher capital requirements, he said. Volcker also emphasized that the proposed restrictions should be viewed as only one part of the broader effort for structural reform of U.S. financial regulation.
“What we can do, what we should do, is recognize that curbing the proprietary interests of commercial banks is in the interest of fair and open competition as well as protecting the provision of essential financial services,” Volcker said. “By appropriately defining the business of commercial banks, and by providing for the complementary resolution authority to deal with an impending failure of very large capital market institutions, we can go a long way toward promoting the combination of competition, innovation, and underlying stability that we seek.”
The other witness at the hearing was Deputy Treasury Secretary Neal Wolin, who joined Volcker in urging Congress to adopt the proposed restrictions but also did not provide any specific language on implementation. During questions by members of the committee, Wolin did say that the proposed limit on bank size should be prospective and was not intended as a means to break up any existing banks. |
| FIA, SIFMA Comment on FINCEN Proposals on Information Sharing Procedures The Futures Industry Association and the Securities Industry and Financial Markets Association co-signed a Dec. 16 letter to the Treasury Department's Financial Crimes Enforcement Network. The two associations commented jointly on proposals regarding the expansion of special information sharing procedures that are intended to deter money laundering and terrorist activity. While FIA and SIFMA support efforts to combat terrorism and money laundering, they cautioned that the proposals could go beyond the intent of current law.  Click Here for the Comment Letter (1.5 MB)
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| Lynch Amendment to H.R. 4173 on ClearingWashington, D.C.—Dec. 7, 2009—The Futures Industry Association today sent a letter to Congress urging lawmakers to oppose a clearinghouse-related amendment to H.R. 4173, the financial reform legislation now pending in the House of Representatives. The amendment, which is expected to be offered by Representative Stephen Lynch (D-Mass.), is designed to eliminate one group of market participants from the expected competition to clear over-the-counter swaps. In addition to reducing competition, the amendment would prevent clearing members that put up their capital to guarantee trades through clearing from having a meaningful voice in the operations of any clearinghouse. The House is scheduled to begin voting on H.R. 4173 this week. The legislation, the Wall Street Reform and Consumer Protection Act of 2009, contains measures to regulate the trading and clearing of OTC derivatives. Click Here for the Text of the FIA letter on the Lynch Amendment. |
What’s Next
Comments by Chairman Lincoln at the end of the hearing suggested that she is not in a rush to bring out her version of the OTC derivatives legislation. She told reporters that she is discussing with other committee members the possibility of holding a third hearing on these issues. She said that while it is important to pass legislation quickly, “it is more important to do it correctly.” Lincoln also said she wants bipartisan support for her bill, which means that it will have to address concerns expressed by Republican members of her committee regarding the impact on end-users and the cost of new reporting requirements.
Geithner Urges Rapid Action
In his prepared testimony, Treasury Secretary Geithner outlined the main reasons for establishing a comprehensive regulatory scheme for OTC derivatives. He said the proposed reforms are an important element in fixing the failures of the U.S. financial system and urged the committee to enact legislation quickly. “I don’t think time is with us,” he warned the committee. “Memories of the damage caused will fade.”
Geithner said the legislation should mandate clearing for all derivatives that are both liquid and standardized. He also said the legislation should mandate central trading of all cleared derivatives, either on regulated exchanges or regulated electronic execution facilities. This will lead to improved price discovery, greater price competition among dealers, and improved prices for end-users.
Regarding the difficult question of deciding which contracts should be cleared, Geithner said he supported a “two-channel approach.” Any derivatives that are accepted for clearing by a clearinghouse—and approved by the Commodity Futures Trading Commission or the Securities and Exchange Commission—must be centrally cleared, he said. Secondly, the CFTC and the SEC should have the authority to require central clearing “regardless of whether a clearinghouse would accept the derivative type for clearing today.”
Focus on End-User Exception
Several members of the committee expressed concerns about the potential impact of the legislation on end-users and pressed Geithner to provide them with “guidance” on the drafting of an exemption for end-users. Geithner agreed that such an exemption should be included in the legislation, but avoided making any specific recommendations except to say that it should apply to a “limited number of non-financial entities” that are using derivatives to hedge their risks. He stressed that the exemption should be “carefully crafted” to avoid “gutting” the rest of the legislation and urged Congress to “err on the side of caution.” He also argued that the costs of clearing are not as high as some have argued. “Markets probably charged too little for too long” for absorbing these risks, he said.
Need for Higher Capital and Margin
Geithner repeatedly stressed the importance of setting higher requirements for capital and margin to prevent a future threat to financial stability. Asked by Senator Charles Grassley (R-Iowa) how regulators can prevent greed from causing another AIG, Geithner agreed that there will always be people in the market who will try to avoid regulation and said this is why it is essential to have stronger “cushions” against the threat of a catastrophic loss. Geithner also argued for using capital and margin requirements as an “incentive” for greater use of clearinghouses, and recommended that non-cleared transactions should be subject to capital and margin requirements that are set “substantially above” the requirements for cleared contracts. “I am a capital hawk,” Gensler said, to which Senator Tom Harkin (D-Iowa) replied, “I like what I hear.”
Forex Exclusion
Geithner, responding to a question from Lincoln, said he did not support calls to include foreign exchange swaps and forwards in the OTC derivatives bill. He agreed that Congress should not allow exceptions to become loopholes, but he explained that those transactions are not derivatives, that the currency markets are different from the OTC derivatives markets, and that there is already a system in place to reduce settlement risk in currency trading. He added that he is working on a solution to this issue with other Obama administration officials, including CFTC Chairman Gary Gensler.
The Obama administration’s original proposal for OTC derivatives regulation applied only to currency swaps and did not include transactions in foreign exchange-based derivatives, but Gensler and House Financial Services Committee Chairman Barney Frank (D-Mass.) have suggested that a much broader range of foreign exchange products should be covered by the mandatory clearing and trading requirements.
Legal Certainty
Responding to a question from Senator Ben Nelson (D-Neb.) about the potential impact of the legislation on outstanding OTC derivatives, Geithner said the new requirements should apply only to transactions that take place in future. The law, he said, should be “crystal clear” to avoid any legal uncertainty that might jeopardize the status of existing OTC contracts. The only exception is the requirement to report transactions to a central repository; that would be retrospective and everything else would be prospective, he said.
Clearinghouse Oversight
Geithner, responding to concerns raised by Lincoln about “duplicative oversight” of market utilities such as CME and NYSE Euronext, defended the proposed creation of a systemic risk supervisor with authority for both markets and institutions that pose a threat to the stability of the financial system. “We need to make sure there is a set of standards and protections in place to prevent contagion,” Geithner told the committee. “So we propose that there is one entity in charge for making sure that those standards are strong enough.” The systemic regulator also would avoid differences in risk standards that might encourage risk to migrate to markets where the standards are lower. “There needs to be some protection against the risk that regulators compete to lower standards,” he said.
Position Limits
Several senators asked the industry representatives for their views on speculative position limits.
Terry Duffy, CME Group’s executive chairman, explained that each exchange is best positioned to set limits in its markets and opposed proposals to mandate the CFTC to set hard limits across all commodity futures markets. If Congress adopts such proposals, the CFTC should refrain from placing hard limits on regulated exchanges until they are simultaneously placed on OTC markets and foreign boards of trade, he said.
Duffy also argued for allowing each exchange to set its position limits based on its own liquidity, volume, open interest and other factors, rather than allowing an exchange to “simply mimic” the position limits set by another exchange. Position limits should not be used as a tool to control prices or limit speculation, Duffy said, and he warned that attempts to reduce speculation would have the effect of driving the business offshore. He specifically pointed to several exchange-traded funds that have switched out of U.S. crude oil and natural gas futures in order to avoid being constrained by position limits.
Johnathan Short, IntercontinentalExchange’s general counsel, agreed with Duffy that position limits if set too restrictively could drive a significant amount of business into other markets and supported proposals for aggregate limits across all derivatives based on the same underlying commodity, whether traded over-the-counter or on regulated futures exchanges. He disagreed, however, with Duffy’s recommendations on how position limits should be set. Short said position limits should not be set in each market based on its relative size. Instead they should be set by the CFTC in such a way that market participants have the choice to “spend” the limits “in the venue of their choice.” This would promote competition by allowing new markets to attract liquidity.
Blythe Masters, head of global commodities at J.P. Morgan, pointed out that market participants do not use the commodity futures markets in isolation but instead view the marketplace as a “single continuous” range of risk products. Position limits therefore should reflect trading in all the instruments based on the same underlying commodity, rather than only one segment. For this reason, regulators such as the CFTC are better positioned to set position limits, she asserted.
Core Principles
CME’s Duffy urged the committee to preserve the principles-based approach to regulation that was established by the Commodity Futures Modernization Act of 200. This approach has improved the competitiveness of U.S. futures exchanges and played no role in the last year’s financial crisis, he stated. In particular, he objected to a provision in legislation now pending in the House that would replace the existing self-certification process with “some form of prior approval requirements” with respect to new rules or new contracts. Duffy said this would put U.S. futures markets “at a significant competitive disadvantage.” Congress should remove this provision, or at the minimum restrict it to rule amendments “that materially change the terms and conditions of listed contracts with open interest.”
Defining Standardization
In her prepared testimony, J.P. Morgan’s Masters took issue with one of the fundamental principles of the Obama administration’s proposal—the requirement to clear all “standardized” OTC derivatives. She noted that trying to define what contracts should be considered sufficiently standardized to be cleared will be very difficult and could create a “gigantic” potential for regulatory arbitrage. She proposed an alternative approach based on setting a ratio of cleared and uncleared trades. All dealers and major swap market participants would be required to clear a percentage of their OTC derivatives exposures that would be at or above a ratio set by the regulators. The ratio would vary by each asset class and by each institution, depending on its capital strength. The advantage of this approach, she argued, is that it would eliminate the problems with trying to define standardized. It also would give the regulators the flexibility to change the ratios over time, and it would give dealers and major swap market participants an incentive to move liquid contracts to clearinghouses. |
The Senate Banking Committee today will hold the first of a series of hearings on the “Restoring American Financial Stability Act of 2009,” a comprehensive proposal for overhauling the regulation of the U.S. financial system. The proposal, which runs to more than 1,100 pages, was drafted by Senator Chris Dodd (D-Conn.), the chairman of the Senate Banking Committee. It combines into one bill a range of proposals introduced separately in the House of Representatives, including proposals regarding over-the-counter derivatives, banking regulation, systemic risk, hedge fund registration and consumer protections. The proposal also calls for a comprehensive restructuring of financi6al services regulation that goes well beyond the changes proposed earlier this year by the Obama administration.
The Dodd proposal contains several measures that could have a direct impact on the listed futures and options markets. These measures include: Federal Reserve oversight of regulated derivatives exchanges and clearinghouses; a registration requirement for all foreign futures exchanges that offer direct access to members in the U.S.; aggregate position limits on commodity derivatives traded over the counter and on exchanges; and registration requirements that could force U.S. derivatives clearinghouses to register with both the Commodity Futures Trading Commission and the Securities and Exchange Commission. In addition, the proposal would apply strict new rules, including capital requirements, on “major swap market participants,” a category that could include hedge funds and proprietary trading groups that trade large numbers of OTC products.
What’s Next
Dodd’s proposal faces many hurdles before passage and it is likely to go through numerous changes as it moves through the legislative process. The Senate Banking Committee will hold a series of hearings over the next several weeks to consider amendments. Today’s hearing will give members of the committee a chance to make their opening statements. The committee is expected to begin marking up different sections of the bill during the first week of December.
In addition, Senator Blanche Lincoln (D-Ark.), the new chairman of the Senate Agriculture Committee, has stated that she plans to draft a separate bill focusing on the regulation of OTC derivatives. Lincoln held a hearing on OTC derivatives on Nov. 18 to hear the views of the CFTC and representatives of several corporate end-users of derivatives. She plans to hold another hearing on Dec. 2 to hear the views of Treasury Secretary Tim Geithner on this issue.
At some point in the process, the two Senate committees will have to determine how to reconcile their proposals for regulating OTC derivatives. Although there appears to be a consensus on the broad policy goals of reducing systemic risk and increasing transparency, they may take different approaches on certain key issues, such as the scope of the mandatory clearing requirement. Getting this legislation through the Senate therefore will require complex negotiations with a range of political players, interest groups and administration officials.
Restructuring the Regulatory Architecture
Dodd’s proposal calls for the creation of three new government agencies with distinct roles and responsibilities in the regulation and supervision of the financial services sector.
First, the proposal would create a new agency called the Agency for Financial Stability that will focus on systemic risk. This agency would set heightened prudential standards, reporting and disclosure requirements for systemically important financial institutions. This agency also would be responsible for identifying “financial market utilities” that are systemically important, which would trigger greater oversight by the Federal Reserve. (See section below on Fed Oversight of Clearinghouses.)
Second, the proposal would create a new consumer financial protection agency with authority over all financial institutions, large and small, as well as boards of trade, derivatives clearing organizations, and self-regulatory organizations.
Third, the proposal would consolidate all banking regulation into a single federal bank regulator called the Financial Institutions Regulatory Administration. This provision, which is not in the House legislation or the Obama proposal, would effectively strip the Federal Reserve of its banking regulatory powers, leaving it to concentrate on monetary policy and lender of last resort functions.
As with the Obama proposal and the House legislation, the Dodd proposal does not call for the merger of the CFTC and the SEC. Instead the two agencies would retain their existing powers and jurisdictions and would gain additional authority over OTC derivatives. The proposal does endorse, however, several recommendations for greater CFTC-SEC harmonization, including the creation of a joint advisory committee, a joint enforcement task force, and the rotation of staff across the two agencies. In addition, the proposal would require the two agencies to jointly draft rules for the regulation of OTC derivatives, a process that will require very close cooperation in this area.
OTC Derivatives
Like the bills that are working their way through the House, the Dodd proposal would require most OTC derivatives to be cleared by clearinghouses regulated by either the CFTC or the SEC. In general, securities-based swaps would be subject to the SEC’s authority; all other swaps, including swaps based on interest rates, foreign currency and commodities, would be subject to the CFTC’s authority.
The Dodd proposal would allow the CFTC and the SEC to exempt swap transactions from the clearing requirement if no designated clearing organization accepts the swap for clearing. These transactions also could be exempted if one of the counterparties is not a swap dealer or a major swap market participant and that counterparty does not meet the eligibility requirements of any derivatives clearing organization that clears the swap. Clearinghouses would have to apply for CFTC or SEC approval before listing a swap for clearing.
The proposal would subject swaps dealers and major swap market participants to a host of new regulatory requirements intended to reduce the risk of financial instability. These include disclosure and business conduct rules as well as capital and margin requirements, with the newly created FIRA setting those requirements for banks and with the CFTC and the SEC setting those requirements for non-banks.
The proposal’s definition of major swap market participants is based on the size of their outstanding positions, and specifically, if a default would create “significant credit losses” for other market participants. Although the proposal does provide an exemption for corporate hedgers, it is much narrower than the exemption contained in the House legislation.
The Dodd proposal seeks to promote competition by requiring clearinghouses to treat swaps as fungible if they have the same terms, and includes a section that would establish core principles for clearinghouses. The proposal also would require all swaps that are cleared to be traded on an exchange or alternative swap execution facility to the extent that such an exchange or facility is available, and it would require swap dealers and major swap market participants to disclose the fees and other remuneration that they expect to receive.
Capital requirements for non-cleared swaps would be “substantially higher” for non-cleared swaps. Non-cleared swaps also would be subject to margin requirements except when the swap is being used by a non-financial end-user as a hedge under GAAP accounting rules. Collateral would have to be segregated if posted against a cleared swap. For non-cleared swaps, collateral would have to be segregated only if requested by the counterparty.
The Dodd proposal would authorize the CFTC to set position limits on swaps that have a “significant price discovery function” and set aggregate position limits across all commodity markets, including not only futures and swaps but also linked contracts traded on foreign boards of trade. Large trader reporting requirements would apply to all swaps. The SEC would be able to set position limits on security-based swaps as well as the underlying securities.
To ensure uniformity in the rules established by the CFTC and the SEC for their respective parts of the OTC markets, the Dodd proposal would create a joint rule-making process that would require the two agencies to agree on the rules. If the two agencies were not able to reach agreement, the proposal would authorize the Agency for Financial Stability, one of the three new government agencies that the proposal would create, to break the gridlock by making the rules itself. These rules would remain in effect until rescinded or replaced by corresponding CFTC/SEC joint rules.
Fed Oversight of Clearinghouses
As part of the general push for greater oversight of payment and clearing systems, the Dodd proposal would give the Federal Reserve greater authority over derivatives clearinghouses. Title VIII of the proposal authorizes the Fed to take an “enhanced role” in the supervision of risk management standards for systemically important “financial market utilities.” The decision as to which financial market utilities are systemically important would be made by the proposed Agency for Financial Stability.
The Fed’s authority to set risk management standards would cover such things as risk management policies and procedures, margin and collateral requirements, default policies and procedures, and financial resources. The Fed also would gain a role in setting risk management standards for clearing activities by financial institutions, including futures commission merchants and commodity trading advisors.
In contrast to the House proposals, which explicitly prohibit Fed assistance to clearinghouses, the Dodd proposal would give clearinghouses access to the Fed’s lending facilities on the same terms as depository institutions.
The Dodd proposal also would change the way that derivatives clearinghouses set their rules. The proposal would require financial market utilities to provide 60 days advance notice to their primary regulator and the Fed of any proposed change to their rules, procedures or operations that could “materially affect” the nature or level of their risks.
The Fed also would have the authority to recommend enforcement actions by the primary regulator, and if that regulator does not implement the recommendations, the Fed could take action on its own.
Foreign Boards of Trade and Other Matters
The Dodd proposal would authorize the CFTC to require foreign boards of trade to register if they provide members in the U.S. with direct access to their electronic trading systems. The proposal also would apply certain regulatory requirements to linked contracts, including large trader reporting and positions limits.
The proposal also includes a measure designed to prevent conflicts of interest in the research and trading functions of futures commission merchants. The measure would require that research or analysis of the price or market for any commodity be separated from the influence of profit centers in the firm.
Click Here for More Information on the Dodd Proposal
Click Here for the Full Text of the Dodd Proposal
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On Oct. 7, Frank’s committee heard testimony from regulators and industry experts on the discussion draft. At the hearing, Frank indicated that he plans to finalize the draft in the coming weeks and then hold a “mark-up” during the week of Oct. 12 to incorporate amendments from other members of the committee. Frank also plans to hold mark-ups on other financial regulatory reform measures, including the creation of a consumer protection agency for financial services, in the coming weeks. Separately, House Majority Leader and Maryland Democrat Steny Hoyer told reporters on Oct. 6 that he expects that the entire package of financial regulatory reform measures, including derivatives regulation, will be debated on the House floor in November.
In his opening statement, Frank emphasized that the discussion draft is likely to undergo “significant changes” as it moves through the legislative process and invited comment from all interested parties. Frank also emphasized that one of his goals in the legislation is to clearly distinguish end-users that only use derivatives as a means for reducing volatility from the banks and other financial institutions for whom derivatives trading is primarily aimed at making a profit.
Frank rebuffed suggestions that the SEC should receive more jurisdiction of OTC derivatives warning that any such attempt would be an “uphill battle” because of the controversy it would raise in Congress. The SEC has indicated on several occasions that it would like to have broader authority all security-based derivatives, include broad-based index-based contracts.
One uncertainty is the House Agriculture Committee’s role in the drafting process. That committee shares jurisdiction over derivatives with the Financial Services Committee and Representative Collin Peterson, the Minnesota Democrat who chairs the Agriculture Committee, has been very active on this issue. Peterson has said he may introduce his own version of the legislation, which would be based on the Treasury proposal but also would include provisions addressing concerns about speculation in the commodity markets.
Summary of Discussion Draft
Like the Treasury proposal, the discussion draft mandates clearing for standardized OTC derivatives, requires the reporting of non-cleared OTC derivatives, extends position limits to OTC derivatives, and establishes a comprehensive scheme for regulating dealers and “major swap market participants.” The draft also allocates jurisdiction for OTC derivatives based on individual securities and narrowly based security indices to the Securities and Exchange Commission and jurisdiction for all other OTC derivatives to the Commodity Futures Trading Commission.
The discussion draft differs from the Treasury proposal in several key respects. In response to concerns expressed by a number of U.S. corporations, the draft broadens the clearing exemption for end-users so that it is not limited to those following GAAP accounting. Instead the exclusion applies to any companies that hold OTC derivatives primarily for hedging and risk management purposes, provided they do not meet the definition of a “major swap market participant” or hold themselves out as a dealer. The draft also gives the CFTC and the SEC sole responsibility for determining whether OTC derivatives should be cleared, and does not include a presumption that if an OTC derivative is cleared by a clearinghouse then it should be subject to the mandatory clearing requirement.
Unlike the Treasury proposal, the draft includes provisions requiring that collateral for cleared swaps be segregated and allows customers to request that the collateral be held in a third-party custodial account. In an effort to address concerns raised about the need to borrow cash to meet margin requirements, the draft allows the use of non-cash assets as collateral. It also includes antitrust provisions requiring clearinghouses to avoid hindering competition and authorizes the CFTC and the SEC to ban any OTC derivatives that are deemed to be abusive or to be a threat to the stability of the financial system.
To address the potential for regulatory arbitrage across borders, the discussion draft authorizes the Treasury to prohibit any entity domiciled in a foreign country from participating in U.S. financial markets if that foreign country “regulates swaps in a way that would adversely affect the financial system.” On the other hand, the draft authorizes the CFTC and the SEC to exempt foreign financial institutions from the proposed requirements if they are subject to “comparable” regulation in their home countries.
Testimony from CFTC and SEC
CFTC Chairman Gary Gensler, in his testimony before the Financial Services Committee, spent much of his time emphasizing the merits of the proposed reforms and urging that Congress make them as strong and comprehensive as possible. He again pointed to the collapse of AIG as demonstrating the need for government oversight of the OTC derivatives markets, stronger capital requirements for OTC derivatives dealers, mandatory clearing for standardized OTC derivatives and stringent reporting requirements for all OTC derivatives.
Gensler did take issue, however, with certain provisions of the discussion draft. He strongly urged the committee to restore the mandatory exchange trading requirement proposed by Treasury, saying this would improve transparency of pricing and benefit end-users. He also opposed the provision in the discussion draft that would assign to the CFTC and the SEC the responsibility of determining what OTC derivatives should be cleared. Rather than having regulators force products onto clearinghouses, Gensler said that instead it should be the clearinghouses that decide if a particular OTC derivative should be cleared. And he argued that the discussion draft’s exemption for end-users was too broad and urged the committee to limit this exemption to nonfinancial entities that use swaps “to hedge actual commercial risks.”
Testifying on behalf of the SEC, Henry Hu, the director of the agency’s newly created division of risk, strategy and financial innovation, said Frank’s draft needs to be strengthened. He raised concerns about the different regulatory treatment proposed for securities-based swaps over traditional securities and urged the committee to clarify that the definition of security-based swap also includes broad-based index credit default swaps.
“Certain aspects of the discussion draft could unintentionally preserve existing regulatory gaps,” Hu said. “These regulatory differences could perpetuate existing regulatory arbitrage opportunities that encourage the migration of activities from traditional regulated markets into the differently regulated swaps market.”
Hu proposed that the language be modified so that all securities-related OTC derivatives are regulated more like securities. He further cautioned that inter-dealer brokers would remain outside of any regulatory framework and noted that most credit default swap trading in the U.S. is done through interdealer brokers.
Hu said the new discussion draft “may inadvertently weaken” the SEC’s anti-fraud and anti-manipulation authority over securities-based swaps. He further warned that the “overly broad” swap definition in the draft language could include a number of products or transactions already subject to federal and state securities laws, such as investment contracts, certain security options and security forwards.
Industry Views
Testifying on behalf of the Securities Industry and Financial Markets Association, Jim Hill, a managing director at Morgan Stanley, said that the legislation corrects the situation that “allowed the AIG problem to develop” and noted that many major derivatives dealers have committed to the New York Federal Reserve to clear a greater percentage of new and historical trades through a clearing organization by the end of the year. Hill spent most of his time, however, outlining concerns about specific provisions of the legislation.
Hill questioned the need to impose margin requirements on swap transactions when one of the counterparties is an end user. “It is difficult to understand why counterparty credit exposure created through a swap transaction would be required to be collateralized when lending arrangements between the parties can be made on an unsecured basis,” he said.
Hill also raised concerns about a provision that directs regulators to allow parties to post non-cash collateral. “Even that carries a cost, including reducing the end user’s borrowing capacity, and potentially causing an end user to violate negative pledge covenants.”
Hill urged the committee to take a less restrictive approach to requiring dealers to segregate funds or other property posted as margin. “We believe it is important for end users to have that option in connection with over-the-counter swaps, but both the decision to require margin and the details of how it is handled should be left to negotiation between the dealer and the end user in the ordinary course of their lending and risk management processes,” he said.
The legislation, he said, is appropriately focused on swap dealers and major swap participations but he said that the definition of swap dealers may be “overly broad.” He also warned of the risks of classifying certain OTC trades as securities transactions due to the unintended application of securities and other laws. And he opposed the application of business conduct rules that would require, among other things, the disclosure of fees and potential conflicts of interest.
On capital requirements, Hill emphasized that the clearing process makes OTC transactions less risky and he questioned the need for imposing additional incremental capital for cleared trades. “Policymakers should be careful about increasing the cost of these transactions, because doing so may discourage their use for risk management purposes,” he said, adding that giving the regulators the general authority to establish appropriate capital requirements should be enough of a safeguard.
Stuart Kaswell, general counsel of Managed Funds Association, testified that his association views the discussion draft as “a huge step in the right direction” that “largely addresses the outstanding concerns about the swaps markets. Kaswell noted that MFA members, most of whom are hedge funds, strongly support central clearing of standardized derivatives and continue to worry about the potential for another failure of a major broker-dealer. A large share of the money that was lost in the failure of Lehman Brothers belonged to customers who had posted collateral on their OTC swap transactions that was not segregated, Kaswell explained. These assets will likely be tied up in bankruptcy proceedings for many years, and for this reason the MFA’s members “appreciate and support the provisions in the committee’s discussion draft that address segregation of collateral.”
Kaswell recommended several changes to the legislation. Among other things, he said the committee should allow hedge funds and other institutional participants in the OTC derivatives markets to opt out of the segregation requirement for transactions that are not cleared. He recommended that the CFTC and the SEC set a clear and objective definition of “major swap market participant” so that market participants will know when they approach that threshold and become subject to greater regulatory requirements. He also urged the committee to go farther in promoting central clearing and suggested that the capital requirements for swap dealers be designed to “motivate” the dealers to trade through clearinghouses. And he suggested that the committee should require the regulators to examine any “artificial barriers” that might be blocking the development of exchange trading for standardized OTC derivatives.
Christopher Ferrari, a managing director at ICAP and the chairman of the Wholesale Markets Brokers’ Association, spoke out in favor of competition among trading venues in the OTC derivatives markets. Noting that Frank’s draft encourages the use of both exchanges and electronic trading platforms for OTC derivatives, Ferrari warned that there is a “serious risk” that clearinghouses m favor their own trading venues over competing platforms. Ferrari reminded the committee that the Justice Department set out in detail the arguments against “vertically integrated” market structures in a 2007 letter to the Treasury Department. Such structures have hindered competition in trade execution, Ferrari said, and he urged the committee to require “fungibility” in the OTC derivatives market.
Click Here for Discussion Draft
Click Here for Hearing Testimony
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House Committee Revises Derivatives Bill Ahead of Mark-Up Representative Barney Frank (D-Mass.), the chairman of the House Financial Services Committee, has changed several key provisions in his derivatives regulatory reform legislation ahead of the mark-up on Oct. 14, 2009. The mark-up will give members of the committee an opportunity to propose and vote on amendments to the legislation. The changes, which were contained in a “manager’s amendment” circulated on Oct. 9, include a shift back to relying on clearinghouses to determine what over-the-counter derivatives should be cleared, a clarification that swaps counterparties can request third-party segregation of either initial or variation margin, and a clarification that swap execution facilities can offer a combination of voice brokering and electronic trade submission.
Click Here for Mark-Up Details |
House Agriculture Committee Chairman Collin Peterson (D-Minn.) on Oct. 9, 2009 released a separate “discussion draft” of legislation to regulate the over-the-counter derivatives markets. It is not clear if this will be merged with the reforms being developed by the House Financial Services Committee (see above). While Peterson’s bill also aims to tighten oversight of OTC derivatives, it differs in certain key areas. For example, it eliminates the dual rule-making approach between the Commodity Futures Trading Commission and the Securities and Exchange Commission. Instead it requires that these agencies consult with each other as they develop rules for the OTC derivatives markets. The bill also narrows the definition of swap dealer and major swaps market participant, and does not require end-users to post margin on trades that are not submitted for clearing.
“This draft reflects the hearings the Agriculture Committee recently held looking at current OTC reform proposals, and it incorporates provisions that have been proposed by Chairman Barney Frank’s Committee and the Administration,” Peterson said in an Oct. 9 statement. “In this draft, we attempt to reflect the concerns of end users while bringing “oversight and transparency to OTC trading.”
Click Here for Peterson Discussion Draft |
“While we believe it is important that the CFTC has adequate resources, we strongly urge you to reject the proposed transaction tax,” Damgard and Walter said in their letter. “At a time when the public is looking for greater transparency and improved confidence in U.S. financial markets, we do not believe that now is the time to punish market participants who choose to use the regulated and transparent exchange markets.” Click here for the PDF |
| GAO Issues Regulatory Restructuring ReportThe Government Accountability Office, the research and investigative arm of the U.S. Congress, released a report on Jan. 8, 2009 that highlights the weaknesses of the fragmented regulatory system for financial services industry. The report does not propose any specific changes but instead puts forward a framework for assessing proposals to restructure the financial regulatory system. The report is likely to guide members of Congress as they consider how to modernize the U.S. financial regulatory system in the coming months. http://www.gao.gov/new.items/d09216.pdf |
House Financial Services Committee Chairman Barney Frank (D-Mass.) unveiled a “discussion draft” of the bill on Oct. 27 and held a hearing on the bill on Oct. 29. If approved by the committee, it is expected to be combined with other parts of the financial regulatory reform package that the House leadership plans to bring to the House floor in December. Among other things, the legislation would transform the President’s Working Group on Financial Markets into the “Financial Services Oversight Council” which would monitor systemic risk across the financial system and identify potential threats to financial stability. The proposed council would not conduct examinations or enforce laws, but it would have the authority to set heightened oversight, standards and regulation for systemically important firms and activities as well as systemically important “financial market utilities” and payment, clearing and settlement activities. The proposed council would include the Commodity Futures Trading Commission and potentially could subject futures clearinghouses to heightened oversight, standards and regulation. For example, if the council determined that a futures clearinghouse was systemically important, the clearinghouse would have to provide advance notice of any proposed change to its rules, procedures or operations that could materially affect the nature or level of its risks. The proposed council also would have the power to resolve disagreements among regulators, including jurisdictional disputes between the CFTC and the Securities and Exchange Commission. The bill also would strengthen the ability of the Federal Reserve to take action to reduce systemic risk in coordination with the proposed council. The Fed would have rulemaking, examination and enforcement authority over systemically important financial institutions and would have the authority to limit the size of such firms and force asset sales in order to protect financial stability. The Fed also would gain authority to set risk management standards for systemically important payment, clearing and settlement systems. Although the CFTC and the SEC would continue to be the primary regulators of clearing and settlement systems in the futures and securities markets, the Fed would have the authority to set standards for these systems and take enforcement actions to protect financial stability if the CFTC and the SEC did not implement its recommendations or in case of an emergency. Although the bill is supported by the Obama administration, the Oct. 29 hearing revealed that many members of the committee disagreed with the provisions granting additional authority to the Treasury Department and the Federal Reserve. Many members also complained that the bill would not do enough to address the problem of “too big to fail.” For example, some members of the committee want to add an amendment that would give regulators the authority to break up large financial firms whose collapse could threaten the stability of the financial system. Committee members also worried that creating a list of systemically important financial institutions could be interpreted as a signal that these institutions are too big to fail, thereby undermining the protections against another bailout. |
The bill, H.R. 3817, includes several provisions that are important to the futures and options markets. These include a provision that amends the Securities Investor Protection Act so that SIPC insurance applies to futures contracts in a securities portfolio margining account. If the bill is enacted into law, this would remove one important legal obstacle to portfolio margining of futures and securities in a single account. The bill, which is called the “Investor Protection Act,” also includes a provision that treats every financial intermediary that provides advice to customers as having a fiduciary duty toward their customers, whether they are registered as broker-dealers or investment advisers. The bill only applies this standard to financial intermediaries registered with the SEC, but it could put pressure on the Commodity Futures Trading Commission to adopt a similar standard in the futures industry as part of the regulatory harmonization project now under way. The bill also doubles the SEC’s funding over five years, establishes a “whistleblower bounty program” to encourage tipsters, and directs the SEC to study the effect of high-frequency trading on investors. House Financial Services Committee Chairman Barney Frank (D-Mass.) has indicated that he plans to combine H.R. 3817 with other financial regulatory reform bills approved by his committee before going to the House floor as a single package. |
To address concerns about the potential impact of the new requirements, the bill would exempt funds with less than $150 million in assets. That threshold is substantially higher than the $30 million proposed by the Obama administration. As currently drafted, H.R. 3818 would require some fund managers that are registered with the Commodity Futures Trading Commission to also register with the SEC. However, Democratic leaders have agreed to consider exempting commodity trading advisers and commodity pool operators already registered with the CFTC when the bill is debated on the House floor. H.R. 3818 also contains provisions extending the SEC registration requirement to funds located outside the U.S. that engage in a certain amount of activity in the U.S. Overseas funds would have to meet certain criteria to be exempt from the SEC registration and reporting requirements. The bill would limit this exemption to those funds that do not have a place of business in the U.S. and have had less than 15 U.S. clients in the preceding year who accounted for less than $25 million in the fund’s assets under management. The bill is expected to come to the full House next month as part of a comprehensive package of financial regulatory reforms. |
During consideration of the bill, the committee agreed to several amendments that affect key provisions of the bill. The committee also agreed to set aside several other important amendments with the understanding that these would be considered at a later stage of the process. In addition, the bill was amended so that the regulators would have a full year to write the rules necessary to implement the new requirements, rather than the six months originally proposed. Last week the House Financial Services Committee passed its version of the proposed legislation. The chairmen of the two committees will now work to reconcile their bills before the next step in the process, when the House leadership will bring the reforms forward for consideration by the full House of Representatives. No date has been set yet, but it is expected that the final bill will be combined with other financial reforms and brought to the House floor in late November or early December. “This legislation reflects more than two years of public hearings and a lot of bipartisan work,” said Representative Collin Peterson, the Minnesota Democrat who chairs the House Agriculture Committee. “The clearing and exchange trading requirements, along with strong position limits provisions, will increase transparency in the marketplace, will benefit end users by not submitting them to onerous cash collateral requirements, and will hold swap dealers and major swap participants to new standards for capital, margin, business conduct and other requirements to reduce their ability to again place our financial system in such dire straits.” “Today was another step on the road to creating a pragmatic regulatory structure to the derivatives market,” said Representative Frank Lucas, a lawmaker from Oklahoma and the top Republican on the committee. “I appreciate Chairman Peterson’s effort in working with us in a bipartisan fashion. The work we did today made significant improvements to the bill, but there is still a long way to go before it reaches the House floor. I am hopeful we can continue to make progress.”Key Requirements H.R. 3795 institutes a clearing and trading requirement for all OTC swap transactions between dealers and major swap market participants that are accepted by a clearinghouse. Once approved and available for clearing, any transactions in that type of swap would have to be submitted to a clearinghouse. The bill exempts commercial end users from these requirements if they use the contracts to hedge price risk. During the Oct. 21 mark-up, the committee agreed to an amendment that changes how these requirements are applied. The amendment clarified that clearinghouses would be required to seek government approval before listing swaps for clearing. Once a swap has been listed as available for clearing, the regulators would determine whether the mandatory clearing requirement would be triggered for transactions in that type of swap. In other words, the regulators could approve the listing of a swap for clearing without requiring that all such swaps be cleared. Non-cleared swaps must be reported to a central repository and major swap market participants and dealers must adhere to strengthened capital and margin requirements. To address concerns about the concentration of risk in clearinghouses, the bill would prohibit federal assistance to clearinghouses unless expressly authorized by Congress. With respect to the trading requirement, the bill would authorize the CFTC and the SEC to establish a regulatory framework for “alternative swap execution facilities” that would serve as an alternative to regulated exchanges. These swap execution facilities were defined as including any voice brokerage facility or any electronic confirmation facility. The bill also would allow the CFTC to impose position limits on swaps that perform a significant price discovery function as well as position limits on futures based on physically deliverable commodities. The SEC would gain the authority to impose position limits on security-based swaps. The bill also would provide for exclusive CFTC jurisdiction of swaps and exclusive SEC jurisdiction over security-based swaps. The bill also would prohibit the CFTC from permitting foreign boards of trade to provide U.S. participants with direct access to contracts that settle against a U.S. contract unless that foreign board of trade meets comparable regulatory standards. Further Changes Pending A number of amendments were offered by members of the committee. Those that passed by voice vote included a technical correction that swaps not cleared through a clearing organization will have to be reported to a central repository. In addition, lawmakers passed an amendment requiring that the CFTC study the impact of position limits on U.S. derivatives markets and submit a report to Congress within a year and thereafter a study every two years. Several amendments were offered and subsequently withdrawn with an agreement by the committee chairman that there would be an opportunity to work through the issues in a later stage of the drafting process. Among those issues to be addressed include the definition of ‘swap’ to avoid inclusion of end-user use of spot and forward contracts that ‘reset’ due to price changes. Also to be addressed is an amendment of the “bona fide hedge” definition to permit businesses that hedge their next exposure to seek position limit exemptions. Other amendments that will be considered before the legislation reaches the House floor include proposals to require all OTC trades be reported to a single trade repository, to permit the use of non-cash assets to satisfy capital or collateral requirements, to exclude variation margin from the segregation requirement, and to extend the segregation requirement to major swap participants as well as swap dealers. |
| FIA Comments on Treasury Derivatives Proposal in Testimony before House Agriculture Committee Speaking before the House Agriculture Committee on Sept. 17, 2009, FIA President John Damgard outlined several concerns with the Treasury Department’s proposal for derivatives regulation and urged the committee to “prune back” the proposal in many areas. Among other things, Damgard supported authorizing the CFTC to apply position limits to OTC derivatives that affect price discovery, but opposed forcing all standardized swaps onto trading platformsHe also warned that “fuzzy definitions” of standardization will create legal risk and assailed the Treasury proposal for attempting to impose U.S. regulatory standards on foreign futures exchanges. Click Here for the Text of the FIA's Statement |
U.S. Treasury Legislative Proposal for OTC Derivatives Regulation:
Treasury’s Section-by-Section Analysis of the LegislationClick Here for the PDF |
“We welcome the Obama plan to plug the gaps in financial market supervision and prevent a crisis of the magnitude that we have seen over the last year. Although much work remains to be done on the details of the administration’s proposals for regulatory reform, we commend the administration for the thoughtfulness and comprehensiveness of its plan for building a “new foundation” for financial regulation and supervision. Over the last two years, the U.S. futures markets have functioned extremely well despite extraordinary turmoil in the financial system. No customer money was lost through default and no taxpayer money was used to support the futures business. We believe this reflects the strengths of our regulatory system as well as the effectiveness of the industry’s own practices for limiting counterparty risk and maintaining confidence in market integrity. We look forward to working with the administration, the Congress and all regulatory agencies to do everything we can to promote and enhance the liquidity, risk management, price discovery and financial integrity of futures trading in the United States.”
The FIA is the leading trade organization for the futures industry. Its membership includes the world’s largest futures brokers as well as leading derivatives exchanges from more than 20 countries. For more information, please contact Will Acworth (wacworth@futuresindustry.org) at (202) 466-5460 or visit our website at www.futuresindustry.org.
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| FIA Responds to the U.S. Treasury’s Proposed Legislation for the Regulation of OTC DerivativesWashington, D.C. —August 11, 2009—The Futures Industry Association today issued the following statement in response to the transmission by the Treasury Department of legislative language to the Congress for the regulation of over-the-counter derivatives. We are studying the proposed legislation and its implications for the regulated futures markets. The legislation proposes major changes to the rules related to U.S. and global futures trading. We look forward to working with the administration and the Congress to ensure that the legislation allows futures markets to serve their price discovery and risk management purposes through liquid, fair and financially secure trading. |
The FIA commends the Treasury Department for taking a comprehensive look at the U.S. regulatory system and for recognizing the many benefits of the regulatory system that now applies to U.S. futures markets administered by the Commodity Futures Trading Commission. The FIA has long agreed with Treasury’s view that modern market realities compel the CFTC and the Securities and Exchange Commission to enhance their coordination and cooperation efforts. The Memorandum of Understanding recently entered into by the two agencies also reflects this view and the leadership of both agencies should be commended for their efforts. In the longer term, FIA stands ready to work with all interested parties on the many important issues raised by this proposal in order to develop constructive solutions that benefit our customers and the financial integrity of our markets. The FIA is the leading trade organization for the futures industry. Its membership includes the world’s largest futures brokers as well as leading derivatives exchanges from more than 20 countries. For more information, please contact Mary Ann Burns (maburns@futuresindustry.org) or Will Acworth (wacworth@futuresindustry.org) at (202) 466-5460. |
| FIA Urges Treasury to Endorse Principles-Based Regulation, Says Merger of CFTC with SEC Should Be Last StepThe Futures Industry Association submitted a comment letter to the Treasury Department on Nov. 20, 2007 outlining its views on the structure of financial services regulation in the U.S. |
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