Monday, April 26, 2010

Key Senator Backs Strong Derivatives Legislation Along Ag Committee Bill Lines

Senator Olympia Snowe (R-Maine) has come out for strong federal regulation of derivatives along the lines of the bill reported out of the Senate Agriculture Committee last week. In a letter to Senate Majority Leader Harry Reid, Sen. Snowe said that the final derivatives title in the massive financial reform legislation must include mandatory clearing and execution requirements, real time reporting to the SEC or CFTC, a prohibition on abusive derivatives contracts and a narrow end user exemption confined to non-financial commercial firms. The letter was co-signed by Senators Dianne Feinstein (D-Calif.) and Maria Cantwell (D-Wash.),

The legislation should also require that trades that the CFTC or the SEC require to be cleared must also be traded on an exchange or on a swap execution facility. Trading on exchanges or execution facilities provides for pre-trade transparency, said the letter, which is necessary to fully understand and manage the risks being taken by market participants, to provide more efficient and accurate pricing, and to facilitate more cost-effective risk management. Along with an execution requirement, a robust mandatory clearing requirement for derivative contracts is needed in order to assess, manage, and collateralize risks, to ensure post-trade accountability, to ensure market stability, and to reduce systemic risk. Mandatory clearing provides an essential safety net in the market by requiring market participants to post margin and hold capital to support their positions in the market, and to prevent the default of any one party from putting the entire market at risk.

Further, the senator emphasized that all trades, including those that are not required to be cleared or traded on an exchange or execution facility, need to be reported to the SEC or CFTC in real time so regulators will for the first time have a full understanding of the aggregate positions held by each entity. To serve as large a share of the transparency objectives that would otherwise be served by the trading requirement, regulators should be required to disclose those trades to the public as soon as technologically feasible and in a manner that protects market integrity.

The legislation must also require the SEC and CFTC to set and enforce position limits, noted the letter, since position limits provide an important restriction on market manipulation and the amount of risk that can build up in any one market participant. Swaps dealers should have a fiduciary duty of care to pension funds, endowments, retirement funds, and state and local governments to protect vulnerable market participants from being taken advantage of by dealers.

The CFTC and SEC should be authorized to prohibit trading of derivative contracts, whether traded on an exchange, execution facility, or OTC, if they are created with the purpose of defrauding a third party, are otherwise abusive, or if their trading is against the public interest. More general protections that may presently exist in federal, state, or common law against fraud, for example, are not sufficient.

Swaps that are not cleared are likely to be some of the non-standard and risky contracts. Thus, to mitigate the risks that these contracts pose to financial stability, the CFTC and SEC must be authorized to set margin requirements for swaps that are not required to be cleared in addition to any capital requirements that may be set by a prudential regulator. Similarly, the CFTC and SEC should be authorized to require market participants to hold substantially higher levels of capital to support any swaps that they determine should be required to be cleared but that are not cleared. In Senator Snowe’s view, the substantially higher capital standard is essential to ensure that firms can adequately cover the risk of non-cleared swaps in times of market distress.

Senator Snowe emphasized that any exemption to the clearing requirements for commercial end-users must be narrowly constructed. If an end-user provision is included in the legislation it must apply only to commercial entities that use swaps to hedge their commercial risk. Financial entities of any type should not be allowed to qualify as end users. Also, counter-parties to end-users must be required to hold adequate capital to protect against risk, including systemic risk, associated with swaps eligible for the end-user exemption, and end-users must be given the option to clear standard transactions at their discretion.

Moreover, foreign exchange swaps should not have a statutory exemption from the clearing and execution requirements or any other requirements in the bill. Foreign boards of trade must be prohibited from allowing members or participants located in the United States to have access to the foreign board of trade for contracts that settle against prices for contracts traded on CFTC or SEC registered entities unless the foreign board of trade adheres to minimum standards comparable to those in the United States and reports all trading activity in these contracts to U.S. regulators on a timely basis.


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