As the SEC and CFTC begin the momentous task of adopting regulations to implement the derivatives provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the conflict of interest and governance and control issues raised by Rep. Stephen Lynch (D-MA) throughout the legislative process will be a major part of regulatory consideration.
There was congressional concern throughout the process of passing Dodd-Frank that, with derivatives trading required to be conducted through clearinghouses, large financial institutions would own and control the clearinghouses and effectively set rules for their own derivatives deals. The Lynch Amendment in the bill the House passed last December would have prevented large financial institutions and major swap participants from taking over these new clearinghouses by imposing a 20-percent-voting-stake limitation on ownership interest in those institutions and the governance of the clearing and trading facilities.
The Lynch Amendment specifically provided that these restricted owners, which are defined as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants, cannot own more than a 20 percent voting stake in derivatives-clearing organization, a swap-execution facility, or a board of trade. Further, the rules of the clearing organization, swap-execution facility and board of trade must provide that a majority of the directors cannot be associated with a restricted owner.
The Lynch Amendment was not in the final legislation. Instead, in provisions some at the roundtable called Lynch Lite, sections 726 and 765, the CFTC and SEC must adopt rules on conflicts of interest. Specifically, for example, the SEC may include numerical limits on the control of clearing agencies and security-based swap execution facilities. In addition, in a colloquy with Rep. Lynch on the day the House passed the conference bill, Financial Services Chair Barney Frank (D-MA) agreed that sections 726 and 765 of the Dodd-Frank Act require the SEC and CFTC to adopt rules eliminating the conflicts of interest arising from the control of clearing and trading facilities by entities such as swap dealers, security-based swap dealers, and major swap and security-based swap participants. SEC and CFTC adoption of strong conflict of interest rules on control and governance of clearing and trading facilities is mandatory. (Cong. Record, June 30, 2010, H5217).
At the roundtable, CFTC Director of Clearing and Intermediary Oversight Ananda Radhakkrishnan said that Dodd-Frank mandates clearing as many OTC derivatives as possible and bringing transparency to these products through the listing of them on exchanges and swaps execution facilities. The Commission has to make a determination as to whether a group of swaps has to be cleared. But if the Commission makes a determination that said this class of swaps has to be cleared but nobody wants to clear it, then it won't be cleared and it won't be traded. It is thus important to ensure that the governance structures take care of the conflicts of interest to make sure that the mandate of Congress is not blocked. Jay Kastner of the Swaps and Derivatives Market Association (SDMA) said this issue goes directly to the Lynch Light section 726 of Dodd-Frank (the SEC analog is section 765). If there is not proper governance, he said, some derivatives clearing organization may refuse to engage.
SDMA believes that the SEC and CFTC must ensure that the risk committees of these derivatives clearing organizations are transparent such that we know who the membership is and that decisions on whether to permit new clearing members and whether to permit new products to be listed are transparent and readily appraisable.
Heather Slavkin of the AFL-CIO said that, in addition to independence and transparency, it is important to have real experts on the boards of clearing facilities who understand the risks that exist within a clearinghouse and are prepared to perceive potential risks that may arise in the system down the road and address them. Similarly, former Fed Governor Kroszner said the best way to ensure that experts have input into risk management decisions is to establish a transparent process. It would also be valuable for principles to be outlined in advance of what types of contracts can come onto exchanges and how the decision process will be made. Because one of the goals of Dodd-Frank is a migration of some of these contracts onto essentially bigger platforms. Ms. Slavkin believes that providing a roadmap for how to do that will help to encourage market participants to restructure contracts to make them in a way that they will be more readily clearable.
According to CFTC Special Counsel Nancy Schnabel, the SEC and CFTC must figure out how to not inject systemic risk into the clearing and listing of swaps, but then balance that against the systemic risk that would exist if bilateral swaps are not cleared or listed because of certain incentives. SIFMA said that ultimately the risk managers of the clearinghouse are the ones who need to figure out how to manage these risks and manage these conflicts. SIFMA encouraged the CFTC and the SEC to reach out to those risk managers to get their direct views on how these risks and these conflicts are best managed. The primary purpose of Dodd-Frank is to reduce systemic risk, said SIFMA, and that risk will now be concentrated primarily in the clearing houses, and it is critical that the regulators get the risk management correct.
Echoing these sentiments, former Fed. Governor Randy. Kroszner said that the success of clearinghouses is because of their success in managing risks. The Commissions should refrain from forcing types of contracts that cannot be properly risk managed onto the exchanges by using certain criteria that will undermine risk management. They must be tough about risk management, he said, and sometimes that means setting very tough criteria that some institutions and individuals may not like. We are betting the system on the stability of these clearinghouses, emphasized the former Fed official, and thus the clearinghouses must be seen as bulletproof or as near to bulletproof as any private institution can be.