The House Committee on Agriculture held a series of hearings to review legislation proposed by the U.S. Department of Treasury regarding the regulation of over-the-counter (OTC) derivatives markets. Testifying before the committee at yesterday’s hearing were the following witnesses:
- Gary Gensler, Chairman, Commodity Futures Trading Commission
- Mary L. Schapiro, Chairman, U.S. Securities and Exchange Commission
Testifying before the committee at last Thursday’s hearing were the following witnesses:
- Jon Hixson, Director, Federal Government Relations, Cargill, Inc.
- Glenn English, President, National Rural Electric Cooperatives Association
- Dave Schryver, Executive Vice President, American Public Gas Association
- Richard B. Hirst, Senior Vice President and General Counsel, Delta Air Lines
- Garry N. O’Connor, Chief Product Officer, International Derivatives Clearing Group, LLC
- John M. Damgard, President, Futures Industry Association
- Terrence A. Duffy, Executive Chairman, CME Group Inc.
- Robert Pickel, CEO, International Swaps & Derivatives Association
- Johnathan Short, Vice President and General Counsel, IntercontinentalExchange, Inc.
- Daniel N. Budofsky, Davis Polk & Wardwell LLP, on behalf of the Securities Industry and Financial Markets Association
At yesterday’s hearing, both Mr. Gensler and Ms. Schapiro applauded Treasury’s initiative in proposing additional regulation for OTC derivatives, arguing that lack of transparency and regulation of such instruments was a significant contributing factor to the failure of the financial markets last fall. Each of Mr. Gensler and Ms. Schapiro, however, argued that the regulatory and enforcement powers of the SEC and the CFTC with respect to OTC derivatives must expand beyond what has been proposed by Treasury.
Mr. Gensler described the need for regulation of OTC derivatives in two parts: regulation of derivatives dealers and regulation of derivatives markets. In particular, he noted that the regulation of dealers would “ensure that regulations apply to both standardized and customized products.” He proposed that derivatives dealers be required to meet additional capital standards and margin requirements, regardless of the products in which they trade, but specifying that customized derivatives, being “less standard, less liquid and less transparent,” should require even greater capital and margin requirements. He argued that all or a portion of margins should be set aside specifically for the counterparty, in the event that the swap provider experiences financial difficulties.
In addition, he argued for a comprehensive reporting and recordkeeping system, including improved standards for back-office activities, and greater enforcement powers to monitor these activities. As for regulating derivatives markets, Mr. Gensler proposed that all OTC derivatives cease trading over the counter and instead be processed through clearinghouses. He added that the establishment of exchanges and the imposition of speculative position limits would further develop transparency in the derivatives markets. To address Committee concerns that requiring these transaction processes would preclude access by smaller commercial users to the derivatives markets, Mr. Gensler proposed the creation of “individualized credit arrangements” between end-users that are not “major market participants” and clearinghouses, such that the clearinghouses would cover related margin costs.
Ms. Schapiro agreed with much of Mr. Gensler’s testimony, and further argued for regulation based on the type of underlying instrument on which the particular OTC derivative is based. Implying criticism of Treasury’s proposal to bifurcate regulation of securities-derived instruments between the SEC and the CFTC based on the size of the index, she stated that derivatives derived from securities or a securities index are significantly more fungible with the underlying security or index that they are with another derivative, such as an energy derivative. As a result, she argued that the SEC should retain regulatory authority over all derivatives derived from securities or securities indices, no matter how small or broad, and the CFTC should retain authority over all non-security derivatives. Treasury’s proposed regulatory regime would, she argued, result in “gaming” or, in other words, the tailoring by market participants of their instruments to achieve the desired regulatory regime for their specific circumstances. She also advocated the expansion of the SEC’s and CFTC’s enforcement authority, and expressed a need for higher standards in trading by market participants. She expressly agreed with Mr. Gensler’s approach to protecting participants from their counter-parties’ credit risk, by arguing for preferential treatment to participants in the event of the counter-party’s insolvency, and also urged the elimination of any exemptions for foreign banks, which could utilize Treasury’s proposed exception for “bank products” (issued by federal or state regulated banking institutions) as a technical loophole to avoid regulation.
The hearing yesterday built on testimony presented last week, at which various market participants and industry organizations provided their view. In particular, the Panel I witnesses described their companies’ or clients’ use of derivatives as hedging instruments. The witnesses generally approved of Treasury’s proposals for regulating the OTC derivatives markets (including, in particular cases, applauding speculative position limits and large trader reporting systems), but nearly unanimously expressed the fear that mandatory clearing of derivatives would be cost-prohibitive for their continued use by them and other small businesses.
The testimony from Panel II witnesses concerned the perspectives of securities, commodities and derivatives industry participants. Mr. O’Connor testified in favor the proposed legislation, but noted three areas that required improvement: refining the definition of “standardized” derivatives that would require clearing, limiting the exceptions for non-Major Market Participants, and emphasizing the importance of independent governing of clearinghouses and exchanges. Mr. Damgard agreed with Mr. O’Connor’s concerns regarding the definition of “standardized” derivatives, and further criticized the proposed legislation’s efforts to bifurcate regulation between the SEC and the CFTC, to permit exemptions on position limits to derivatives but not to options or futures, and to attempt to regulate foreign boards of trade.
Mr. Duffy raised concerns similar to those that were raised in 2000 in the context of the Commodity Futures Modernization Act of 2000 – primarily the concern that the United States markets will lose to more competitive overseas derivatives markets – and also argued against the proposed bifurcated regulatory structure. He further criticized Treasury’s proposals for position limits (too restrictive), treatment of foreign boards of trade (fear of retribution by foreign countries), the elimination of the CFTC’s current principles-based regulatory regime, and government regulation of margin requirements, among others. He proposed five principles to “guide regulatory reform”:
- institute a single regulator,
- implement certain established principles as guidelines for the SEC’s and CFTC’s regulation of novel products,
- adopt a principles-based regulatory regime similar to that imposed by the Commodity Futures Modernization Act,
- establish guidelines for the treatment of particular customers in the event of a combined broker-dealer/futures commission merchant’s bankruptcy, and
- avoid mandating interoperability among clearing houses by legislation or regulation.
Mr. Pickel focused on the scope of the proposed legislation, arguing against Treasury’s inclusion of certain smaller derivatives dealers and noting the wide breadth of the proposed definition for “standardized” derivatives. He also argued against mandatory clearing, emphasizing in particular the need for privately negotiated derivatives in certain circumstances.
Mr. Short likewise argued (seemingly against interest) against mandatory clearing, noting the “significant unintended consequences by attempting to force transactions that are not readily amenable to clearing” or forcing participants to “incur the cost and expense of trading in standardized contracts that may not perfectly fit their risk management needs.” He also noted the same arguments made by the other panelists with regard to foreign boards of trade, stating that position limits on foreign exchange contracts without linkage to U.S. traded contracts “presents serious issues.”
Finally, Mr. Budofsky recited many of the same arguments made by the other panelists – in particular, he argued against mandatory clearing for “standardized” derivatives and the limits that would be imposed on smaller, commercial users forced to use clearinghouses, including increased margin costs.