Chairman Gensler's recommendations include amendments to existing laws such as the Bankruptcy Code, the Federal Deposit Insurance Corporation Improvement Act of 1991 and the core principles of the Commodity Exchange Act.
Gary Gensler, chairman of the Commodity Futures Trading Commission (CFTC), sent a letter on August 17, 2009, to the chairman and ranking member of the U.S. Senate Agriculture Committee, proposing several enhancements to recently proposed legislation language by the U.S. Department of the Treasury that would restructure the regulatory framework for the over-the-counter (OTC) derivatives markets. For more information, see McDermott’s On the Subject, “Treasury Proposes Legislative Language to Restructure the Current Landscape for Over-the-Counter Derivatives Market Regulation.”
Chairman Gensler’s recommendations include changes to Treasury’s proposal, as well as certain amendments to existing laws such as the Bankruptcy Code, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) and the core principles of the Commodity Exchange Act (CEA). The chairman also noted that CFTC staff would provide additional technical comments separately.
Chairman Gensler’s recommendations fall within the following categories.
Eliminate the Exclusion for Foreign Exchange Swaps from the Proposed Treasury Legislation
Chairman Gensler raises the concern that the proposed exclusion of foreign exchange swaps might encourage market participants to break-up currency and/or interest rate swaps into their component parts and to restructure them in a manner that makes them resemble foreign exchange swaps or forwards, which are excluded from CFTC regulation under the proposed language. In addition to eliminating the foreign exchange swap exclusion, Chairman Gensler suggests retaining, but narrowing, the exclusion for foreign exchange forwards.
Mandatory Clearing and Exchange Trading of Standardized Swaps
The administration’s proposal would repeal sections 2(d), 2(e), 2(g) and 2(h) of the CEA to create two new categories of registrants and require all “standardized” OTC derivatives, including credit default swaps, to be cleared through a derivatives clearing organization that is registered with the CFTC or through a securities clearing agency that is registered with the U.S. Securities and Exchange Commission (SEC). All standardized OTC derivatives would be required to be traded on a CFTC or SEC regulated exchange or “alternative swap execution facility” (a new registration category for registered entities). Under the Treasury proposal, any OTC derivative that is accepted for clearing by any regulated central clearinghouse will be presumed to be a standardized contract.
The proposed legislation provides two exceptions to the mandatory clearing and trading requirements, including:
- If no registered clearinghouse will accept the swap for clearing
- If one of the swap counterparties is “not a swap dealer or major swap participant” and does not qualify to clear the swaps with a clearinghouse
Chairman Gensler suggests eliminating these exceptions and, instead, proposes that an end-user without direct membership access to clearinghouses establish a client relationship with a clearing member who could clear transactions on the end-user’s behalf. Chairman Gensler explains that the two exceptions should be eliminated since they “undermine the policy objective of increasing transparency and market efficiency through bringing standardized OTC derivatives onto exchanges or alternative swap execution facilities.”
Bankruptcy and Set-Aside Provisions
In the event of a swap dealer’s bankruptcy, Chairman Gensler recommends a mandatory set-aside requirement for collateral received by swap dealers, equivalent to the CEA’s segregation requirement for futures dealers.
The chairman also recommends certain changes to the Bankruptcy Code to protect customers in the event of bankruptcy by a swap dealer. These recommendations would ensure for swaps customers the same protections provided to futures customers of commodity brokers. Such protections would include:
- Transfer of the customer’s funds to another solvent swap dealer in the event of bankruptcy without violating the automatic stay, and without the possibility of avoidance by the trustee
- Special priority (ahead of unsecured claims other than certain administrative expenses of the debtor’s estate) in bankruptcy with respect to customer property, including segregated funds
Multilateral Clearing Organizations
Chairman Gensler suggests repealing sections 408 and 409 of FDICIA, which allow banks and certain foreign clearinghouses (together, multilateral clearing organizations) to clear “over-the-counter-derivative instruments,” as defined in the FDICIA. These provisions, according to Chairman Gensler, are inconsistent with the overall regulatory scheme of the Treasury’s proposal. Under such a bifurcated regulatory system, swaps cleared by banks and certain foreign clearinghouses could be subject to different, and potentially lesser, regulatory standards.
Clarify the Regulatory Authority Over Mixed Swaps
Chairman Gensler notes in his letter that the proposed Treasury legislation provides for dual regulation of mixed swaps by the SEC and CFTC. Mixed swaps are those that derive their value in part from a security or narrow security index, and in part from something such as a currency, interest rate, broad-based security index or commodity. The chairman suggests that such dual regulation, which is a departure from the existing allocation of regulatory responsibility between the SEC and CFTC, would result in duplication and inefficiency. Instead, Chairman Gensler suggests that the mixed swap provisions of the Treasury legislation be stricken. If a mixed swap’s value is based primarily on a security or a narrow security index, it should be regulated by the SEC. Otherwise, it should be regulated by the CFTC.
Designated Contract Market Core Principles
The CEA provides a number of core principles for designated contract markets. Treasury’s proposed legislation amends current core principles for execution and adds additional core principles addressing minimum financial resources and system safeguards. Chairman Gensler suggests additional measures to streamline existing core principles for designated contract markets. Specifically, Chairman Gensler proposes unifying the designation criteria and core principles for designated contract markets because they are redundant.
Retail Off-Exchange Commodity Transactions (Non-Foreign Exchange)
Chairman Gensler addressed an element of the last Farm Bill known as the “Zelener fraud fix,” which overturned a Seventh Circuit Court of Appeals ruling permitting parties to escape the CFTC’s anti-fraud authority by selling off-exchange foreign exchange contracts to retail customers that were written as spot currency transactions, but which operated like futures contracts. Last year’s Farm Bill closed this so-called Zelener loophole, but did so only with respect to foreign currency transactions. Chairman Gensler notes that similar Zelener transactions are now emerging that involve transactions other than foreign exchange.
Noting that the proposed Treasury proposal includes a broader Zelener fix, Chairman Gensler asks for additional tools to enhance the CFTC’s anti-fraud capabilities, including:
- Reduced timeframe for actual delivery of a commodity
- Clarification of the term “actual delivery” so as to exclude delivery to a third party in a financed transaction where the commodity is held as collateral.
In addition to these comments, Chairman Gensler suggested that he is considering additional amendments to the CEA to promote the CFTC’s consumer protection goals through enhanced enforcement and oversight authorities.
Separately, the SEC and CFTC announced on August 19, 2009, that the two agencies intend to conduct joint hearings on September 2, 2009, and September 3, 2009, at the headquarters of the CFTC and the SEC, respectively. These hearings are part of both agencies’ efforts to respond to President Barack Obama’s call in June for the two regulators to recommend changes to statutes and regulations that would eliminate differences with respect to similar types of financial instruments. Both agencies must submit a report to the U.S. Congress by September 30, 2009, in which they:
- Identify all existing conflicts in statutes and regulations with respect to similar types of financial instruments
- Either explain why those differences are essential to achieve underlying policy objectives with respect to investor protection, market integrity and price transparency, or make recommendations for changes to statutes and regulations that would eliminate the differences
The purpose of the joint meetings appears to be to harmonize the statutes and rules of the two agencies. The Treasury proposal also calls for the total harmonization of SEC and CFTC regulations for the OTC derivatives markets.