Saturday, January 17, 2009

Senate Bill Would Regulate OTC Derivatives and Credit Default Swaps

A bill introduced by Senator Tom Harkin would bring all OTC financial transactions and credit default swaps currently traded without federal oversight onto regulated exchanges. The Derivatives Trading Integrity Act, S. 272, would establish stronger standards of transparency and integrity in the trading of swaps and other over-the-counter financial derivatives as a critical step toward restoring confidence in the financial system. Senator Harkin is Chair of the Agriculture Committee.

The broad goal of the legislation is to establish the standard that all futures contracts trade on regulated exchanges. According to the chair, it will bring these transactions out into the sunlight where they can be monitored and appropriately regulated. Senator Harkin envisions that the regulated exchanges will work with the CFTC to ensure that trading on the exchange is fair and equitable and not subject to abuses. In calling for thee regulation of credit default swaps, SEC Chair Christopher Cox recently told the Senate Banking Committee that the credit derivatives market is a regulatory hole that must be closed by Congress.

Senator Harkin has noted that, while swaps contracts function much like futures contracts, they are not regulated as futures contracts because of a statutory exclusion from CFTC authority. Since they do not have to be traded on open, transparent exchanges, it is impossible to know whether credit default and other swaps are being traded at fair value or whether institutions trading them are becoming overly leveraged or dangerously overextended. Financial derivatives like credit-default swaps must be traded on a regulated exchange, said the senator, so that regulators can know the value of the contracts, who is trading them, and if they have enough assets to back the contract.

The SEC’s current authority with respect to these instruments, which are generally security-based swap agreements under the Commodity Futures Modernization Act, is limited to enforcing antifraud prohibitions under the federal securities laws. The SEC is prohibited under current law from promulgating any rules regarding credit default swaps in the over-the-counter market. Thus, the tools necessary to oversee this market effectively do not exist.Over the years, the CFTC and laws enacted by Congress have allowed instruments that are essentially futures contracts to be privately negotiated without the safeguards provided through exchange trading. In this economic downturn, said Senator Harkin, Congress does not have the luxury to sit back and let the markets work.

The Derivatives Trading Integrity Act will bring more transparency and accountability into the marketplace. Specifically, the bill amends the Commodity Exchange Act to eliminate the distinction between “excluded” and “exempt” commodities and transactions versus commodities and transactions traded or conducted on regulated exchanges. All commodities and transactions of the same nature would be treated the same.

In addition, the bill eliminates the statutory exclusion of swap transactions, and ends the CFTC’s authority to exempt such transactions from the general requirement that a contract for the purchase or sale of a commodity for future delivery can only trade on a regulated board of trade. In effect, this means that all futures contracts must trade on a designated contract market or a derivatives transaction execution facility. Virtually all contracts now commonly referred to as swaps fall under the definition of futures contracts and function basically in the same manner as futures contracts

The bill seeks to eliminate the negative consequences from the lack of price transparency and the failure to properly measure and collateralize the risk in trading over-the-counter derivatives. Similar problems have not been seen in the trading of financial futures on regulated futures markets, subject to CFTC oversight.

OTC credit derivatives emerged in the mid-1990s as a means for financial institutions to buy insurance against defaults on corporate obligations. Credit default swaps are executed bilaterally with derivatives dealers in the OTC market, which means that they are privately negotiated between two sophisticated, institutional parties.

They are not traded on an exchange and there is no required recordkeeping of who traded, how much and when. Although credit default swaps are frequently described as buying protection against the risk of default on, for example, corporate bonds, they are also used by investors for purposes other than hedging. Institutions can and do buy and sell credit default swap protection without any ownership in the entity or obligations underlying the swap. In this way, credit default swaps can be used to create synthetic long or short positions in the referenced entity.