Yesterday, the House Financial Services Committee held a hearing entitled “Reform of the Over-the-Counter Derivative Market: Limiting Risk and Ensuring Fairness,” to consider the effective regulation of the over-the-counter (OTC) derivatives market and reaction to the discussion draft of proposed legislation released late last week by Committee Chairman Barney Frank (D-MA). The following witnesses testified at the hearing:
- Gary Gensler, Chairman, Commodity Futures Trading Commission (CFTC)
- Henry Hu, Director, Division of Risk, Strategy, and Financial Innovation, U.S. Securities and Exchange Commission (SEC)
- Jon Hixson, Director, Federal Government Relations, Cargill Inc.
- René M. Stulz, Everett D. Reese Chair of Banking and Monetary Economics, Fisher College of Business, The Ohio State University
- Scott Sleyster, CFA, Chief Investment Officer, Domestic, Prudential Financial
- David Hall, Chief Operating Officer, Chatham Financial Corp.
- James J. Hill , Managing Director, Morgan Stanley on behalf of SIFMA
- Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association
- Steven A. Holmes, Director of Treasury Operations, Treasury Department, Deere & Company\
- Christopher Ferreri, Managing Director, ICAP on behalf of the Wholesale Markets Brokers Association
- Rob Johnson, Director of Economic Policy for the Roosevelt Institute in New York on behalf of Americans for Financial Reform
CFTC Chairman Gensler addressed the principal goals with respect to regulation of the OTC markets – lowering risk to the American public and promoting transparency of the markets. Gensler echoed his support of the elements of OTC derivatives reform set forth in the Obama administration’s proposal to promote the furtherance of these goals. With respect to the discussion draft, in addition to expressing his general sentiment that the draft is an “important contribution,” Chairmain Gensler identified six major concerns raised by the draft:
- Clearing: The presumption set forth in the Obama administration proposal “that all standardized derivatives must be cleared” has been replaced by “one where products would be cleared only if required by market regulators.”
- End-user clearing requirements: The broad clearing exception for end-users should be more narrowly defined than proposed in the discussion draft, to include only non-financial entities that use “swaps incidental to their business to hedge actual commercial risks.”
- Major swap participant: The discussion draft’s proposed definition of “major swap participant” would exempt entities entering into a swap for “risk management purposes” from regulatory requirements outlined in the proposal.
- Exchange trading: Trading on regulated exchanges or regulated trading platforms should be mandatory for all cleared swaps, instead of voluntary, as proposed in the discussion draft.
- Foreign regulation: Market participants should be exempt from American regulation through foreign compliance with foreign standards only when U.S. regulators have determined that the foreign regulatory scheme is comprehensive and comparable to U.S. standards.
- Agriculture swaps: Even though the distinctions between the various types of commodity swaps would be eliminated, protections for agricultural commodities in the OTC markets have not been provided in the discussion draft.
Director Hu largely focused his remarks on the regulatory arbitrage possibilities that currently exist within the OTC derivatives market, and stated that “certain aspects of the discussion draft could unintentionally preserve existing regulatory gaps.” Among his concerns were the significant regulatory differences that could result between swaps products and the currently regulated securities and futures products as a result of new regulation for swaps and securities swaps, which could “encourage the migration of activities from the traditional regulated markets into the differently regulated swaps market.” Hu proposed that “security-based swaps” be included within the definition of “security” under both the Securities Act of 1933 and the Securities Exchange Act of 1934. Hu also noted that the so-called “abusive swap” provision of the discussion draft, which would permit the CFTC and SEC to jointly prohibit transactions in swaps or security-based swaps which they find would be detrimental to the stability of a financial market or participants in the market, raised several concerns about how the regulators would make that determination and whether this authority should be provided to another forum instead of these two agencies. Furthermore, Hu recommended that Congress provide the SEC with all tools necessary for effective anti-fraud enforcement over all securities-related OTC derivatives, and that it clarify that products or transactions already subject to the federal securities laws do not fall within the definition of “swap.”
In contrast to the testimony offered from the regulatory perspective, several representatives testifying on behalf of end-users of derivative products (such as Deere and Cargill) raised concerns that the discussion draft ceded too much authority to the regulators in determining which companies would be subject to higher regulatory thresholds associated with being a major swap participant and to higher margin requirements imposed on end-user companies. These representatives also noted their concerns about higher capital requirements for non-centrally cleared transactions.
The other major contingent testifying at the hearing were representatives of various industry associations, including the Securities Industry and Financial Markets Association, the Managed Funds Association and the Wholesale Markets Brokers’ Association, all of whom commended the discussion draft as a positive step in the right direction. Several of these representatives did indicate concern with the proposed definition of “major swap participant,” and called for objective standards to define “substantial net position” for the purpose of providing market participants “with a clear understanding of the regulatory boundaries for becoming a major swap participant.” Another area of concern was the “regulatory bias driving customized derivatives onto clearinghouses or exchanges” by increasing the cost to engage in non-cleared transactions through higher margin and capital requirements.