Wednesday, August 04, 2010

Senior SEC Official Details Dodd-Frank Rulemaking Efforts, Particularly with CFTC On Derivatives

At a recent SIFMA seminar on financial reform, Robert W. Cook, Director of the SEC Division of Trading and Markets, said that the SEC has already undertaken extensive implementation planning for the rulemaking mandates in the Dodd-Frank Wall Street Reform and Consumer Protection Act in a Commission-wide effort to prepare for the next phase of financial regulatory reform. Mr. Cook identified four regulatory areas in which the SEC will play a key role: 1) OTC derivatives; 2) a standard of conduct for financial advisors; 3) private fund advisors; and 4) credit rating agencies.

Regarding the mechanics of implementation for OTC derivative regulations, the first of their kind for these products, Mr. Cook described the ultimate goal as creating a single integrated regulatory structure for OTC derivatives. A task force has already been created to map out a road to implementation, and will include the SEC’s new division, Risk, Strategy and Financial Innovation, as well as the Division of Corporation Finance, among others.

Of particular interest is the collaboration of regulators within the same markets. The SEC will coordinate with prudential regulators, who will have a role in setting capital and margin for bank entities. The CFTC and SEC will share primary jurisdiction over swaps. The SEC will have authority over security-based swaps, defined as swaps on a single security or a narrow based security group or index, including credit default swaps. The CFTC will have authority over all other swaps, including energy swaps, interest rate swaps, and swaps on a broad based security group or index. The CFTC would also have primary jurisdiction over securities-related swaps that are not securities-based swaps, which are called security-based swap agreements, such as a swap on a broad-based security index, like S&P 500.

Eliminating the potential for regulatory arbitrage would demand close collaboration between the CFTC and the SEC, including joint rulemaking regarding key definitions, stated Mr. Cook.

The SEC would retain antifraud jurisdiction over security-based swap agreements, including authority over insider trading. But Mr. Cook cautioned that experience teaches that antifraud authority alone is not enough to protect investors. SEC access to information will also be critical. In that regard, he noted that the legislation gives the SEC access to information on security-based swap agreement transactions provided by derivatives clearing agencies, swap execution facilities and boards of trade. He also anticipates that the CFTC will share information with the SEC on security-based swap agreements that are not cleared. This should seal any regulatory gaps between the SEC and CFTC for security-based swap agreements, he noted.

Moreover, the legislation would fill regulatory gaps opened by exotic products falling between the SEC and CFTC worlds. For example, the SEC will have antifraud authority over all securities-related swaps regardless of which agency has primary jurisdiction. In addition, the Act creates a new product approval process using a mechanism for the SEC to designate a novel derivatives product that is appropriately characterized as an option on a security as being subject to concurrent jurisdiction with the CFTC, preserving the SEC’s antifraud authority. The CFTC would have a similar approval process. In addition, the legislation creates an expedited procedure to determine the status of a new derivatives product. Under this procedure, either agency could request that the other agency make a determination of the status of a novel derivatives product with commodity and security characteristics. These provisions will facilitate even closer SEC-CFTC cooperation, in the director’s view.

With regard to a uniform standard for brokers and advisers, the director said that the SEC will conduct a six month study on the standards of conduct for broker-dealer activities with retail customers, culminating in a report to Congress. Mr. Cook pledged to move forward quickly on the six-month study, adding that an endeavor of this scale will necessarily be SEC-wide, involving also the Division of Investment Management, as well as public input.

The legislation provides the SEC with rulemaking authority after this fiduciary issue study is delivered, and requires that any harmonized standard be no less stringent than the standards already applicable to investment advisers under the Investment Advisers Act. The SEC is also charged with facilitating the provision of simple and clear disclosures to investors regarding the terms of their relations with broker dealers and investment advisers, including any material conflicts of interest.

Through the twin levers of adviser registration and reporting, the legislation would open a long closed window into the activities of hedge funds, private equity funds and other private investment vehicles, said Mr. Cook, who added that the ability to look through that window would enable the Commission to better protect investors and would facilitate the assessment of systemic risks these funds might pose. The concept of registration is central to managing systemic risk throughout the markets. New records and reports will need to be kept by the newly-registered adviser, detailing business aspects such as counterparty risk and trading practices. Proprietary information would be considered confidential. A one-year transition period will be in effect for these new regulations.

The SEC’s oversight of credit rating agencies would also expand considerably under the Dodd-Frank Act, continued Mr. Cook, with the goal of remedying an over-reliance on credit rating agencies that was a significant contributor to the explosive growth and then violent contraction of the securitization market. The Commission has already adopted several new rules over the past few years in order to increase transparency, he noted, and their authority will be further expanded. Over the next year, the SEC will focus rulemakings on three major areas within the operations of credit rating agencies: 1) internal controls and procedures; 2) transparency and consistency of ratings; and 3) conflicts of interest. They will also study the feasibility of a public or private entity that would be responsible for the assignment of a credit rating to the credit
rating agencies themselves.