Wednesday, September 01, 2010

SEC and CFTC Consider if Lynch-Type Ownership Caps Can Mitigate Conflicts of Interest

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, House Financial Services Chair Barney Frank 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 recent SEC-CFTC roundtable, CFTC staffers asked if an ownership cap like the Lynch Amendment would mitigate the actual or potential conflicts of interest. Hal Scott of Harvard Law School and Director of the Committee on Capital Market Regulation, noted that the committee has opposed ownership restrictions based on its reasoning that they are counterproductive in getting needed capital liquidity into the clearinghouses which, he believes, should be the central focus in terms of systemic risk. In his view, the potential conflicts should be generally handled by board governance rules and not by ownership restrictions.

But Michael Greenberger, former CFTC Director of Trading and Markets, supports ownership restrictions. In his view, the reason the Lynch Amendment, put a 20 percent cap on ownership was a concern that then existing clearinghouses were setting their requirements for membership unreasonably high, in a discriminatory manner. If they set their membership so high, he reasoned, they are going to sift away the strongest members of the swaps market and the other clearing facilities are going to be left with everyone else. This is not open and fair access, said the former CFTC official, and it will create systemic risk in the other clearing facilities that have to take the leftovers from these clearing organizations. He pointed out that the Lynch Light provisions are extraordinarily broad. They empower the SEC and CFTC to mandate ownership restrictions in. Jason Kastner, Vice Chair of the Swaps and Derivatives Association said that SDMA strongly supports the Lynch Light provision such that no economically incentivized, monopolistic power can control and restrict access.

Roger Liddel, CEO, LCH ClearNet Group, said that, with established organizations, the concept of some combination of ownership limits and voting caps makes sense. But Lynn Martin, CEO, NYSE Euronext, said that the exchange opposes specific ownership limitations. The exchange thinks that a more effective manner in controlling conflicts of interest is around good governance structure at the board level. Thus, the exchange believes that a more balanced board structure, a more balanced governance structure, is the proper way to handle or potentially mitigate conflicts of interest

Heather Slavkin of the AFL-CIO said that people who support governance as opposed
to real caps on ownership are arguing in favor of the status quo. In her view, the Lynch Amendment that was passed in the House legislation and the Lynch Light version that
was passed by the entire Congress signaled a congressional intent to create real change in recognition of the fact that the current system is broken.

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