Monday, June 22, 2009

SEC Chair Presents Plan for Regulation of OTC Derivatives to Congress

Against the backdrop of the Obama Administration’s call for federal regulation of the OTC derivatives markets, SEC Chair Mary Schapiro has asked Congress to pass legislation subjecting securities-related OTC derivatives to the federal securities laws and Commission regulation. In her view, this could be achieved by clarifying the definition of “security” in the federal securities laws to expressly include securities-related OTC derivatives and removing the current express exclusion of swaps from that definition. Thus, securities-related OTC derivatives could be brought under the same umbrella of oversight as the related, underlying securities markets in a relatively straightforward manner with little need to reinvent the wheel. The SEC then would have authority to regulate securities-related OTC derivatives regardless of how the products are traded, whether on an exchange or over-the-counter; and regardless of how the products are cleared.

Regarding the nettlesome issue of how to deal with customized OTC derivative contracts that may be ineligible for central clearing, the SEC Chair suggested imposing appropriate margin and capital requirements on the participants in customized transactions to reflect the risks they pose to market systems generally. While acknowledging that there are legitimate economic reasons to engage in customized derivatives transactions, the SEC official emphasized that participants in individual transactions should not be permitted to externalize the costs of their decisions, such as by creating additional systemic risk.

In testimony before the Senate Subcommittee on Securities, the SEC Chair explained that OTC derivatives can be categorized as securities-related or non-securities-related based on the different types of their underlying assets. Securities-related OTC derivatives would include equity derivatives and credit and other fixed income derivatives. Non-securities-related derivatives would include interest rate derivatives, foreign currency derivatives, and all non-financial derivatives.

Securities-related OTC derivatives can be used to establish either a synthetic long exposure to an underlying security or group of securities, or a synthetic short exposure to an underlying security or group of securities In this way, market participants can replicate the economics of either a purchase or sale of securities without purchasing or selling the securities themselves Similarly, credit default swaps can be used as synthetic substitutes for the debt securities of one or more companies. Indeed, any exchange of cash for a security can be structured as an OTC derivatives contract.

By including securities-related OTC derivatives under the umbrella of the federal securities laws, noted the official, the SEC would oversee the portion of the OTC derivatives market that is vital to promote its mission of investor protection, the maintenance of fair and orderly markets, and the facilitation of capital formation. In addition, the SEC would continue to regulate those types of OTC derivatives that always have been considered securities, such as OTC security options, certain OTC notes, including equity-linked notes, and forward contracts on securities. These particular types of OTC derivatives always have been included in the definition of security and current law recognizes this fact by excluding these derivatives from the definition of “swap agreement” in Section 206A of the Gramm-Leach-Bliley Act

The SEC also recommended subjecting major participants in the OTC derivatives markets to oversight in order to ensure that there are no regulatory gaps. OTC derivatives dealers that are banks would be subject to regulation by the federal banking agencies, she said, while all other OTC derivatives dealers in securities-related OTC derivatives would be subject to SEC regulation. The Commission would also be authorized to set appropriate capital requirements for these OTC derivatives dealers.

The SEC Chair said that this approach would permit existing OTC derivatives dealers that are banks to continue to engage in derivatives activities without being subject to the full panoply of broker-dealer regulation; while at the same time ensuring that all currently unregulated dealers in securities-related OTC derivatives are subject to regulation. Moreover, if Congress establishes a new systemic risk regulator as proposed by the Obama Administration, that entity, be it a single regulator or a council of regulators, could help monitor institutions that might present systemic risk

The SEC should also be authorized to establish business conduct standards and recordkeeping and reporting requirements, including an audit trail, for all securities-related OTC derivatives dealers and major market participants with large counterparty exposures in securities-related OTC derivatives. According to the SEC official, this umbrella authority would help ensure that the Commission has the tools it needs to oversee the entire market for securities-related OTC derivatives. Major OTC participants also would be required to meet standards for the segregation of customer funds and securities.

Trading markets and clearing organizations for securities-related OTC derivatives would also be subject to registration requirements as exchanges and clearing agencies. Importantly, however, Ms. Schapiro assured that the conditional exemption from exchange registration that the SEC provided under Regulation ATS would be available to trading systems for securities-related OTC derivatives. Among other things, Regulation ATS lowers barriers to entry for trading systems in securities because the systems need not assume the full self-regulatory responsibilities associated with being a national securities exchange.

Both registered exchanges and ATSs are subject to important transparency requirements. Thus, the official believes that expanding the SEC’s authority over securities-related OTC derivatives would promote improved efficiency and transparency in the markets for securities-related OTC derivatives.

Similarly, the regulatory regime for securities clearing agencies would ensure that central counterparties for securities-related OTC derivatives impose appropriate margin requirements and other necessary risk controls. The SEC’s historic and efficient regulation of clearing agencies under the Exchange Act would support both the goal of having the greatest number of OTC derivatives centrally cleared, while retaining flexibility to allow variation in trading venues to meet the trading needs of different instruments and participants.

The SEC is currently considering whether reporting under the Exchange Act should apply to security-based OTC derivatives so that the ownership of and transactions in these derivatives would be considered ownership of and transactions in the underlying equity security. The Commission is further evaluating whether persons using equity derivatives, such as an equity swap, should be subject to the beneficial ownership reporting provisions of the Exchange Act when accumulating substantial share positions in connection with change of control transactions.

CFTC Chair

In his testimony before the subcommittee, CFTC Chair Gary Gensler said that a comprehensive regulatory framework governing OTC derivative dealers and OTC derivative markets should apply to all dealers and all derivatives, no matter what type of derivative is traded or marketed. It should include interest rate swaps, currency swaps, commodity swaps, credit default swaps, and equity swaps. Further, the regulatory framework should apply to dealers and derivatives, no matter what type of swaps or other derivatives may be invented in the future.

This framework should also apply regardless of whether the derivatives are standardized or customized. Anticipating the Obama Administration's plan, Chair Gensler testified that a new regulatory framework for OTC derivatives markets should be designed to achieve four key objectives: (1) Lower systemic risks; (2) Promote the transparency and efficiency of markets; (3) Promote market integrity by preventing fraud, manipulation, and other market abuses, and by setting position limits; and; (4) Protect the public from improper marketing practices. In order to achieve these objectives, said Mr. Gensler, regulators must regulate both derivatives dealers and derivatives markets.

According to Mr. Gensler, all derivatives that can be moved into central clearing should be required to be cleared through regulated central clearing houses, and traded on regulated exchanges or regulated transparent electronic trading systems.