Thursday, March 26, 2009

Administration Proposes Systemic Risk Legislation Covering Regulation of Hedge Funds, Credit Default Swaps, and OTC Derivatives

In testimony before the House Financial Services Committee, Treasury Secretary Tim Geithner outlined a broad legislative overhaul of the parallel unregulated universe of hedge funds, credit default swaps and OTC derivatives as part of creating a systemic risk regulator for the financial markets. The centerpiece of the legislative proposal is the creation of a federal systemic risk regulator with consolidated power over all systemically important firms that can impact the financial markets. The legislation should define the characteristics of covered firms, set objectives and principles for their oversight, and assigns responsibility for regulating these firms.

The Treasury Secretary suggested that, in identifying systemically important firms, the following characteristics should be considered: the financial system’s interdependence with the firm, the firm’s size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding, and the firm’s importance as a source of credit for households, businesses, and governments, and as a source of liquidity for the financial system.

The single systemic regulator must also be empowered to impose liquidity, counterparty, and credit risk management requirements that are more stringent than for other financial firms. For example, regulations must require more demanding liquidity constraints; and also mandate that these firms be able to aggregate counterparty risk exposures on an enterprise basis within a matter of hours.

In conjunction with the creation of a macro-prudential regulator for the markets, the Administration proposes federal regulation of systemically important financial institutions and entities that can impact the broader financial markets. The legislation should require SEC registration of all advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds, with assets under management over a certain threshold.

All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements. The regulatory reporting requirements should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the entity responsible for oversight of systemically important firms, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards administered by the systemic risk regulator.

The financial crisis has been amplified by excessive risk-taking by insurance companies and poor counterparty credit risk management by many banks trading credit default swaps on asset-backed securities. These complex instruments were poorly understood by counterparties, noted Mr. Geithner, and the implication that they could threaten the entire financial system or bring down a company of the size and scope of AIG was not identified by regulators, in part because the credit default swap markets lacked transparency.

Thus, the Administration proposes, for the first time, the federal regulation of the markets for credit default swaps and over-the-counter derivatives. Under the proposal, all dealers in OTC derivative markets and any other firms whose activities in those markets pose a systemic threat will be placed under a strong federal regulatory regime as systemically important firms. In addition, the legislation will mandate that all standardized OTC derivative contracts be cleared through appropriately designed central counterparties subject to comprehensive settlement systems supervision and oversight.

At the same time, all non-standardized customized derivatives contracts must be reported to trade repositories and will be subjected to robust standards for documentation and confirmation of trades, netting, collateral and margin practices, and close-out practices.

Further, in an effort to bring unparalleled transparency to the OTC derivatives markets, the legislation would require the central counterparties and trade repositories to make aggregate data on trading volumes and positions available to the public and make individual counterparty trade and position data available on a confidential basis to federal regulators, including those with responsibilities for market integrity. The draft will also strengthen participant eligibility requirements and, where appropriate, introduce disclosure or suitability requirements. Further, all market participants will be required to meet recordkeeping and reporting requirements.

There are currently bills in the Senate and House dealing with the regulation of credit default swaps. Recently, in testimony before the Committee, SEC Commissioner Elisse Walter said that credit default swaps are analogous to insurance arrangements with respect to the risk of default on a corporation's debt. In exchange for one party's payment of a specific sum of money to a counterparty (similar to an insurance premium), the counterparty guarantees payment of predetermined amount ("face value") of a corporation's debt in the event of default. The amount paid as a "premium" for default protection is directly correlated with the perceived risk of default by the corporation.

Turning to money market funds, the Secretary noted that the Lehman Brothers’ bankruptcy taught the lesson that even one of the most stable and least risky investment vehicles, money market mutual funds, is not safe from the failure of a systemically important institution. These funds are subject to strict regulation by the SEC and are billed as having a stable asset value, a dollar invested will always return the same amount. But when a major prime money fund broke the buck, the event sparked sharp withdrawals across the entire industry. Those withdrawals resulted in severe liquidity pressures, not only on prime money market funds, but also on financial and non-financial companies that relied significantly on money funds for funding. The vulnerability of money market funds to breaking the buck and the susceptibility of the entire industry to sharp withdrawals in such circumstances remains a significant source of systemic risk.

Thus, the Administration believes that the SEC should strengthen the regulatory framework around money market funds in order to reduce the credit and liquidity risk profile of individual funds and to make the money market fund industry as a whole is less susceptible to runs.

Weaknesses in the settlement systems for key funding and risk transfer markets, notably overnight and short-term lending markets and OTC derivatives, have been highlighted as a key mechanism that could spread financial distress between institutions and across borders. Authority over such arrangements is incomplete and fragmented.

Thus, legislation should give a single entity broad and clear authority over systemically important payment and settlement systems and activities. Where such systems or their participants are already federally regulated, the authority of those federal regulators should be preserved and the single entity should consult and coordinate with those regulators.